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A national bank formally appealed the following:
The appeal highlighted the bank's position on each of the individual component ratings, the internal audit process, the composite rating, and the custody arrangement. In this appeal summary, the discussion and conclusion on each of the appealed component ratings and internal audit issues will be discussed individually, followed by an overall discussion and conclusion on the composite rating and the custodial arrangement.
The appeal stated that with its existing capital ratios the bank was "well-capitalized," yet the OCC concluded that capital was unsatisfactory. The appeal further stated that this was inappropriate because the OCC should have realized that the bank's capital position would improve in the coming months with planned reductions in certain exposures. According to the bank, the OCC seemed to base its conclusions on the bank's recent rate of asset growth and on comparisons with the bank's peers, not on the established regulatory benchmarks for measuring capital adequacy.
A financial institution is expected to maintain capital commensurate with the nature and extent of its risks and management's ability to identify, measure, monitor, and control these risks. The bank's risk profile increased primarily due to rapid asset growth and a large concentration of exposure in high-risk emerging countries. At the time of the examination, the bank's criticized assets doubled, earnings performance was only fair, and weaknesses were noted in the allowance for loan and lease losses (ALLL) methodology, loan administration, and operations. While the bank's capital and strategic plans called for continued growth, efforts to increase capital had not been successful. Although the bank met the prompt corrective action (PCA) benchmark ratios, there were significant qualitative factors that supported the need for additional capital. The capital posture did not fully support the bank's risk profile, even though the quantitative ratios exceeded the minimum statutory requirements. Therefore, the ombudsman concluded that the assigned 3 rating was appropriate at the time of the examination.
The appeal stated that the OCC's view that management and the board did not adequately supervise the bank was based on a faulty two-pronged analysis. First, it incorrectly assumed that the bank's overall condition was less than satisfactory. Secondly, it rested on two events that occurred at the bank, the increase in an emerging market exposure and a certain custodial arrangement. The appeal stated that neither of these events was indicative of lax supervision at the bank.
The management rating reflects the quality of board and management supervision of a bank. Management practices differ depending on the size and complexity of the organization. Risk management practices and controls should be commensurate with the bank's risk profile and complexity. The ability and willingness of management to respond to changing circumstances and to address risks that may arise from changing business conditions in a timely manner are important factors in determining the management rating. The ombudsman recognized the tenure and experience of the management team and the board; however, at the time of the examination, management had not implemented risk management processes to adequately identify, monitor, and control risk in key areas of the bank, such as capital, liquidity management, concentrations, and supervision of affiliate activities. The ombudsman concluded that at the time of the examination, the assigned 3 rating was appropriate.
The appeal indicated that earnings were stable and that, prior to agreeing to record an almost $2 million ALLL provision against 1997 earnings, the bank's return on equity would have been in excess of 13 percent and its return on assets would have been 0.68 percent.
Pursuant to OCC Bulletin 97-1, "Uniform Financial Institutions Rating System and Disclosure of Component Ratings," the earnings rating reflect not only the quantity and trend of earnings, but also factors in events that may affect the sustainability or quality of earnings. Earnings should be sufficient to support operations and to provide for the accretion of capital and adequate provisions to the ALLL. The bank's 1997 earnings performance was sufficient to support operations and the ALLL, but capital augmentation was minimal considering the bank's growth. Trends noted in lower asset yields, higher deposit costs, and increased provisions were factored into the analysis. Based on this, the ombudsman concluded that a 3 rating was appropriate, at the time of the examination.
The appeal indicated that the OCC's 3 rating was based on a set of contingencies that are highly unlikely to occur. The bank does not believe that they are at risk of losing their ability to attract brokered deposits, its principal source of funding. The appeal also stated that the bank has access to substantial sources of stable capital that could and would be used if its ability to accept brokered deposits were in jeopardy.
The bank has high liquidity risk based on its capital position and the increased risk resulting from the bank's exposure in some of their emerging markets portfolios. In addition, the bank did not have an adequate contingency funding plan should its eligibility for brokered deposits become jeopardized. Based on these factors, the ombudsman determined that a 3 rating appropriately reflected the bank's liquidity posture at the time of the examination.
The appeal stated that the 3 rating was assigned solely on the basis of a certain foreign country exposure. The ROE stated that interest rate and foreign exchange risks were considered low at the time of the examination and that the rating was assigned based on the foreign country exposure. The ombudsman concluded that a 2 rating was more reflective of the condition of this area, at the time of the examination rather than the assigned 3 rating.
The appeal stated that the bank's internal audit process was considered less than satisfactory by the OCC because the audit schedule had not been completed and that the bank's audit committee had not met from late1996 through mid-1997. The appeal also discussed a number of events occurring in early 1997 that adversely affected the internal audit function. The appeal stated that there were no negative repercussions in the bank during the period in which the events occurred.
While the ombudsman acknowledged the bank's arguments regarding the various audit function weaknesses noted in the ROE, there was need for improvement, particularly in light of the high operational risks noted in certain areas such as in Treasury. Although some weaknesses, individually, could have been mitigated by unplanned events that occurred during the examination, collectively they posed a concern that warranted management and the board's attention. OCC Bulletin 98-1, "Interagency Policy Statement on Internal Audit and Internal Audit Outsourcing" (January 7, 1998), states in part that "In discharging their responsibilities, directors and senior management should have reasonable assurance that the system of internal control prevents or detects inaccurate, incomplete or unauthorized transactions; deficiencies in the safeguarding of assets; unreliable financial and regulatory reporting; and deviations from laws, regulations, and the institution's policies. . . . Directors should be confident that the internal audit function meets the demands posed by the institution's current and planned activities."
Bank management indicated to the ombudsman that most of these audit deficiencies had been corrected subsequent to the examination.
The bank's appellate submission stated that based on the bank's discussions of the component ratings, its overall condition during the period covered by this examination was not less than satisfactory. The appeal indicated that many of the conclusions in the ROE were reached with no factual or other evidentiary support. It further stated that the conclusions were inconsistent with the true condition of the bank and seemed designed to serve a justification for the 3 rating, rather than an accurate description of the bank's condition.
The OCC Bulletin 97-1, "Uniform Financial Institutions Rating System," states:
Financial institutions . . . [rated 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. . . Management may lack the ability or willingness to effectively address weaknesses within appropriate time frames. Financial institutions in this group generally are less capable of withstanding business fluctuations and are more vulnerable to outside influences than those institutions rated a composite 1 or 2. 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. Failure appears unlikely, however, given the overall strength and financial capacity of these institutions. [Fed. Reg.: December 19, 1996, Vol. 61, No. 245, p. 67026]
At the time of the examination, the bank exhibited a significant degree of supervisory concern because of its rapid growth, increased exposure in particular emerging markets, and their impact on the bank's capital, earnings, and liquidity positions. Furthermore, the bank had not implemented risk management processes to adequately identify, monitor, and control risk in key areas of the bank, such as capital, liquidity management, concentrations, and supervision of affiliate activities. Based on this, the ombudsman determined that the 3 composite rating was reflective of the condition of the bank at the time of the examination. Additionally, these adverse trends and concerns continued through the processing of this appeal.
The bank also appealed the OCC's conclusion that a custodial arrangement between the bank and its foreign affiliate constituted an unsafe and unsound banking practice and a violation of section 23B of the Federal Reserve Act, 12 USC 371c-1. The appeal states that while the custody arrangement with its affiliate could have been better documented and administered, it did not constitute an unsafe and unsound banking practice and did not result in a violation of law as noted in the ROE. The ombudsman reviewed this issue and carefully considered the points of discussion in the appeal and in the bank's outside counsel's letter.
Although banking is characterized by risk-taking, this arrangement reflected characteristics that were not prudent banking practices. For example:
Furthermore, the ombudsman determined that the arrangement was not "on terms and under circumstances that in good faith would be offered to, or would apply to, nonaffiliated companies." Therefore, the ombudsman concluded that the custody arrangement was an unsafe and unsound practice and violated section 23B of the Federal Reserve Act, 12 USC 371c-1.