Appeal of Composite and Management Ratings, Violations of Law, and Other Material Supervisory Determinations (First Quarter 2018)

Background

A bank supervised by the Office of the Comptroller of the Currency (OCC) appealed to the Ombudsman several material supervisory office (SO) determinations in the most recent report of examination (ROE). Specifically, the bank appealed the following:

  • Violation of Regulatory Conditions Imposed in Writing (RCIW).
  • Determination that the bank's new business plan materially changed or significantly deviated from the approved business plan.
  • Risk assessment of insufficient for the quality of credit risk management.
  • Violation of 12 CFR 359 and certain statements in the 12 CFR 359 violation write-up.
  • Composite rating of 3.
  • Component rating of 3 for management.
  • Maintenance of the Individual Minimum Capital Requirement (IMCR).

Discussion

The appeal disagreed that a deposit product the bank introduced violated the RCIW, imposed in connection with certain OCC applications, which required the bank to provide the OCC 60 days written notice before implementing a material change to or a significant deviation from the approved business plan. In addition, the RCIW required the bank to provide the OCC with certain minimum information, such as an assessment of the adequacy of the bank's management, policies, procedures, and controls over the proposed significant deviation. The bank asserted the deposit product did not materially change or significantly deviate from the bank's approved business plan, and that a prior written determination of no supervisory objection (NSO) from the OCC was not required. The appeal stated it is normal in banking and business to offer temporary attractive pricing to promote expansion of a company's customer base and nothing in the business plan limited the board's discretionary authority to pay interest on deposits it believed were in the best interest of the bank.

The appeal disagreed with the SO's determination that its updated business plan materially changed or significantly deviated from the business plan previously approved under the RCIW, and that the updated plan did not include information required by the RCIW. The appeal asserted the bank offers traditional banking products in the same markets as its previous business plan, and the bank's additional capital supported the growth in the new business plan and related pro formas. The appeal asserted appendix F of the "Charters" booklet of the Comptroller's Licensing Manual states that deviations in financial performance alone are not significant deviations. Specifically, appendix F states, "if the bank's strategies are consistent with its business plan, but the bank simply experiences significantly more growth than planned, that growth may or may not qualify as a significant deviation for this condition depending on the type of growth."

The appeal disagreed with the SO's risk assessment of insufficient for the quality of credit risk management. The appeal asserted the credit matters requiring attention (MRA) in the ROE were mostly lower-level credit administration issues that could be easily corrected and focus primarily on the purchase of loans from another bank. The appeal contended policy exception identification and tracking, oversight of participation loans purchased, and failure to obtain one "as complete" appraisal were isolated and immaterial events that have nothing to do with growing the loan portfolio. The appeal contended the bank's overall credit administration management is strong and management's remediation efforts have already addressed the credit-related MRAs in the ROE.

The appeal disagreed that the bank violated 12 CFR 359 when it entered into employment agreements with executive officers that included agreements to make golden parachute payments, without a prior determination of permissibility from the OCC and written concurrence from the Federal Deposit Insurance Corporation (FDIC). The appeal contended the subject employment agreements contained modified language that prevented the severance provisions from being an agreement to make a golden parachute payment until the OCC and FDIC provide approval under 12 CFR 359. Alternatively, the appeal contended that if the bank did violate 12 CFR 359, the violation was based on a highly technical interpretation of 12 CFR 359, as the bank did not make any golden parachute payments without the approval of the OCC and FDIC.

The appeal disagreed with the statement in the violation write-up that the bank attempted to circumvent 12 CFR 359. The appeal contended that after receipt of the warning letter from the SO advising the bank that execution of employment agreements with golden parachute payments before approval may violate 12 CFR 359, the board retained a law firm to prepare 12 CFR 359 submissions to the OCC and FDIC, which included the modified language described above. Further, the appeal asserted the violation write-up suggests the bank ignored the OCC's warning letter and omits the fact that the bank sought legal advice.

The appeal disagreed with the management component rating of 3. The appeal asserted the bank meets the 2 management rating definition in the Uniform Financial Institutions Rating System (UFIRS) based on the management section of the ROE. The appeal stated that the ROE notes the bank has an overall satisfactory rating for risk management systems and ratings of adequate for board and board committee structure and for enterprise risk management program and reporting. The appeal contended that in justifying the management component rating of 3, the ROE relied primarily on findings that are not true. Specifically, assertions that the new business plan significantly deviated from the approved plan, the bank violated the RCIW, the bank violated 12 CFR 359, the board and management changed the strategic direction of the bank without appropriately assessing and documenting the risks, and credit risk management is insufficient.

The appeal disagreed with the composite rating of 3. The appeal stated that based on the UFIRS definition, the bank is fundamentally sound, and while generally a composite 2 bank is expected not to have any component ratings more severe than 3, it is not a hard and fast requirement. The appeal asserted the bank is stable and any moderate weaknesses are well within the board and management's capabilities and willingness to correct. The appeal further asserted the bank has characteristics of a de novo bank in its first or second year considering its new, qualified, and seasoned executive management team, new board members, additional capital, and updated policies and procedures. The appeal argued that de novo banks are not rated composite 3 on the sole basis of losses in their early years; they are rated 2, assuming the other components would support a 2 composite rating.

The appeal disagreed with the SO's decision to maintain the IMCR, stating it did not apply the factors the OCC considers in deciding whether to impose an IMCR. The appeal asserted the decision was within months of the bank raising capital, which has since increased the capital ratios to above IMCR minimums.

Supervisory Standards

The Ombudsman conducted a comprehensive review of information regarding the appeal and relied on the following supervisory standards:

  • 12 USC 1828(k), "Authority to regulate or prohibit certain forms of benefits to institution-affiliated parties"
  • 12 CFR 3, subpart H, "Establishment of Minimum Capital Ratios for an Individual Bank or Individual Federal Savings Association"
  • 12 CFR 359, "Golden Parachute and Indemnification Payments"
  • "Charters" booklet of the Comptroller's Licensing Manual, September 2016 (Charters Manual)
  • "Bank Supervision Process" booklet of the Comptroller's Handbook, May 2017 (BSP Handbook)
  • "Community Bank Supervision" booklet of the Comptroller's Handbook, May 2017 (CBS Handbook)
  • OCC Bulletin 2015-48, "Risk Assessment System," December 3, 2015 (RAS bulletin)
  • RCIW
  • Enforcement Action (EA) between the bank and the OCC
  • IMCR between the bank and the OCC

Conclusion

The Ombudsman concurred with the bank that it did not violate the RCIW by offering the deposit product and advised the SO to remove references to the violation throughout the ROE. A significant deviation or change is a material variance from the bank's business plan or operations or the introduction of any new product, service, or activity, or change in market that was not part of the approved business plan that occurs after the proposed bank has opened for business. Refer to appendix F of the Charters Manual. The higher-rate deposit product was not a material change or significant deviation from the business plan approved under the RCIW and, therefore, did not require a prior written determination of NSO from the OCC. The approved business plan discussed the deposit product, did not contain specific or required pricing strategies for deposits, and did not include pro forma financial statements containing a specific breakdown of the amount and type of various deposit products. The only limitation on deposits in the approved business plan was that the bank would not accept brokered deposits except for certain reciprocal deposit programs, which was not relevant to this product. The Ombudsman also concluded that total interest-bearing deposits did not significantly deviate from the pro forma financial statements included in the business plan. The Ombudsman reminded management and the board of their responsibility to ensure bank systems adequately identify, measure, monitor, and control the risk of this product, especially given the bank's deficient earnings performance.

The Ombudsman concurred with the SO that the bank's recently updated business plan and related pro forma projections reflected a significant increase in both mortgage banking activity and loan growth that constituted material changes to or significant deviations from the bank's business plan previously approved under the RCIW. The RCIW requires the bank to update the previously approved business plan annually to cover the next three-year period, and prohibits a material change or significant deviation from the previously approved business plan unless the bank provides at least 60 days prior notice to the OCC, provides the required information for the material change, and receives the OCC's NSO. A change in the bank's projected growth, such as planning significant growth in a product or service, is a significant deviation. Refer to appendix F of the Charters Manual. In addition, while not noted as a conclusion in the ROE, the Ombudsman determined the overall significant deposit growth projected in the updated business plan, which the bank implemented without OCC's prior NSO, also represented a material change or significant deviation. Therefore, the Ombudsman determined the bank must submit the information required by the RCIW for prior OCC NSO for the aforementioned material changes or significant deviations. The Ombudsman instructed the SO to revise the ROE to reflect the addition of total deposit growth as another material change or significant deviation.

The appeal assertion that the changes described in the aforementioned paragraph do not represent significant deviations because appendix F makes it clear "that deviations in financial performance alone are not significant deviations." This assertion failed to distinguish that the information used by the SO to conclude on the significant deviations is based on plan projections, not on actual deviations in financial performance. Business plan projections are properly differentiated from actual financial performance. This is because, while a number of factors outside the bank's control can affect financial performance, business plan projections illustrate a bank's future intentions regarding the strategic direction of the bank. The RCIW requires the bank to carefully plan, document, and receive the OCC's prior approval before implementing any material changes or significant deviations to the bank's approved business plan. This condition provides the OCC with the opportunity to evaluate any enhanced risks before the bank initiates a significant change to its business plan or operations. Refer to appendix F of the Charters Manual.

The Ombudsman concurred with the SO's assessment of insufficient for the quality of credit risk management given identification of new deficient credit practices, i.e., credit-related MRAs (Exception Tracking, Participations Purchased, Concentrations of Credit Monitoring) and violations of the appraisal regulation. The quality of risk management assesses whether the bank's risk management systems are capable of identifying, measuring, monitoring, and controlling the risk. An assessment of insufficient indicates the presence of deficient practices (concerns) that have the potential to adversely affect the bank's condition, if not corrected. Refer to the RAS Bulletin. Further, the Ombudsman determined the credit-related MRAs are neither immaterial nor based on isolated outliers. MRAs describe practices that deviate from sound governance, internal control, and risk management principles, and have the potential to adversely affect the bank's condition, including its financial performance or risk profile, if not addressed; or result in substantive noncompliance with laws and regulations, enforcement actions, or conditions imposed in writing in connection with the approval of any application or other request by the bank. Refer to the BSP Handbook. The bank's remediation efforts after the examination are not considered in the appeal decision because the MRAs and risk assessments are based on the information available to the examiners during the examination cycle.

Violation of 12 CFR 359

The Ombudsman agreed with the SO that the bank violated 12 CFR 359.2 when it entered into employment agreements containing golden parachutes, as defined in 12 CFR 359.1(f), with executive officers, at a time when the bank was in a troubled condition and without first receiving the OCC's determination of permissibility and the FDIC's written concurrence, as required by 12 CFR 359.4. The Ombudsman disagreed with the bank's assertion that the addition of the contingency language to the employment agreements prevented the severance provisions from being an agreement to make a golden parachute payment under 12 CFR 359.1(f)(1). The Ombudsman concluded that contractual agreements frequently contain one or more contingencies that must occur before an obligation becomes binding. The existence of such a contingency does not diminish an executed contract's status as an "agreement." The severance payment contingency language in the employment agreements was unnecessary because even if those contingency provisions were removed, the bank still could not make the severance payments, and the agreement to make the payments would not be enforceable until the payments became permissible under 12 CFR 359.

The Ombudsman disagreed with the bank's argument that the violation was highly technical. Accepting the contingency in the agreement would undermine the regulatory review framework the FDIC established in 12 CFR 359.4(a)(l). The statute and regulation both define the term "golden parachute payment" to include any payment and any agreement to make a payment, and the FDIC implemented this definition by establishing a dual approval process, whereby a troubled bank must seek regulatory approval for a severance agreement at both the agreement stage and the payment stage. If a bank could structure its severance payment provisions such that the bank did not have to seek regulatory approval until it was on the verge of making a severance payment pursuant to a long-established employment agreement, the separation between the dual stages of review would, as a practical matter, disappear. That outcome would be inconsistent with the FDIC's intended review process.

The Ombudsman concurred with the bank that the facts and circumstances did not support that the bank attempted to circumvent the requirements of 12 CFR 359. After the bank received a warning letter from the SO, the bank sought and used legal advice, updated its employment contracts with the contingency language, and provided several executed agreements for other executive officers of the bank to the OCC and FDIC for review and approval. In addition, the Ombudsman agreed with the bank that the ROE violation write-up should more completely describe the cause of the violation, i.e., the bank's unsuccessful attempt, through amending its employment contracts, to address the OCC's concerns. The Ombudsman advised the SO to remove the circumvent sentence from the violation write-up and to add information regarding the bank's attempt to comply with 12 CFR 359 to the cause section of the write-up.

Composite and Management Component Ratings

The Ombudsman concurred with the SO's assigned management component rating of 3. A rating of 3 indicates management and board performance that need improvement or risk management practices that are less than satisfactory. Problems and significant risks may be inadequately identified, measured, monitored, or controlled. Refer to the UFIRS. The ROE described material supervisory concerns with the bank's planning processes as well as insufficient credit risk management and violations of the appraisal regulation. Inadequate tracking of loan policy exceptions and weak risk management of concentrations supported the conclusion that management does not adequately identify, measure, monitor, or control significant risks. The board and management did not ensure compliance with the RCIW, as they failed to identify significant deviations related to mortgage banking and loan and deposit growth. The board and management also violated the golden parachute regulation and were in noncompliance with the EA. The Ombudsman determined the risk management deficiencies, coupled with significant operating losses, reflected significant supervisory concerns at the bank that demonstrated management and board performance needed improvement and supported the 3 management rating.

Regarding the appeal assertion that the ROE described overall risk management as satisfactory, the Ombudsman instructed the SO to change this conclusion in the management section of the ROE to reflect insufficient strategic, credit, and compliance risk management to more accurately communicate the supervisory concerns with the bank's risk management practices.

The Ombudsman agreed with the SO's assigned composite rating of 3. Financial institutions with a composite 3 exhibit some degree of supervisory concern in one or more of the component areas. These financial institutions exhibit a combination of weaknesses that may range from moderate to severe; however, the magnitude of the deficiencies generally will not cause a component to be rated more severely than 4. Risk management practices may be less than satisfactory relative to the institution's size, complexity, and risk profile. These financial institutions require more than normal supervision, which may include formal or informal enforcement actions. Refer to the UFIRS. Further, the composite rating is not derived by computing an arithmetic average of the component ratings. Each component rating is based on a qualitative analysis of the factors comprising that component and its interrelationship with the other components. When assigning a composite rating, some components may be given more weight than others depending on the situation at the institution. The ability of management to respond to changing circumstances and to address the risks that may arise from changing business conditions is an important factor in evaluating a financial institution's overall risk profile and the level of supervisory attention warranted. For this reason, the management component is given special consideration when assigning a composite rating. Refer to the BSP Handbook.

The Ombudsman determined the supervisory concerns reflected in the earnings rating of 4 and the management rating of 3 fully supported the SO's assigned composite rating of 3. Earnings are deficient, depleting capital, and the board and management have not implemented an effective business plan. The risk management weaknesses ranged from moderate to severe and added support to the composite 3 rating. The bank is in troubled condition, and is operating under an EA and an IMCR, reflecting more than normal supervision.

The Ombudsman disagreed with the bank's assertion that it should be rated a composite 2 because it has characteristics of a de novo bank. A new charter would not preclude the OCC from rating a bank's composite rating a 3, or more severe, if the OCC found the bank materially changed or significantly deviated from its approved business plan and had other management deficiencies and risk management concerns. The additional capital and new executive management team placed the bank in a better position to be successful in the future; however, management and the board had not demonstrated the ability to adopt and implement a successful business plan and achieve profitability.

IMCR

The Ombudsman determined the ROE contained appropriate support for the continuation of the IMCR, including the bank's actual and projected rapid growth coupled with the bank receiving special supervisory attention. 12 CFR 3.402 describes several examples of when it may be appropriate for the OCC to impose an IMCR. These examples include, but are not limited to, "[a] national bank or Federal savings association that is growing rapidly, either internally or through acquisitions, and [a] national bank or Federal savings association receiving special supervisory attention." Although some of the reasons regarding why the SO imposed the IMCR are different from the reasons why the SO is maintaining the IMCR, the IMCR has no expiration date and remains in place until the OCC removes it. The Ombudsman agreed with the SO's decision to keep the IMCR in place given the bank's continued net losses, significant asset and loan growth rates, projections for continued rapid growth, and ongoing less-than-satisfactory condition requiring special supervisory attention.