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A community bank appealed the composite rating and component ratings for capital, asset quality, management, earnings, liquidity, sensitivity to market risk, and consumer compliance assigned at the most recent examination. Some of the ratings reflected downgrades from the previous examination. Ratings were changed from 4/34543213 to 5/54554414. The bank also appealed violations of the call report under 12 U.S.C. § 161(a), Regulation O under 12 C.F.R. § 215.4(a)(1)(i) and (ii), and the Bank Secrecy Act (BSA) under 12 C.F.R. § 21.21.
The bank also appealed the violation of 12 U.S.C. § 1829(a)(1)(B) for unauthorized participation by a convicted individual. The ombudsman determined this violation was not an appealable matter because it was subject to pending judicial review.
The bank further appealed conclusions regarding its level of compliance with the formal enforcement action. The ombudsman determined that, consistent with OCC Bulletin 2011-44, “Bank Appeals Process,” decisions regarding the bank’s compliance with a formal enforcement action were not appealable.
The appeal stated that the composite and management ratings in the report of examination (ROE) materially misrepresented the good faith and efforts by the board and management to strengthen its management team, systems, policies, controls, financial condition as well as significantly reduce the bank’s risk profile. The appeal asserted that the asset quality rating did not take into account the reduction in criticized and nonperforming assets, the reduction in commercial real estate concentrations, and the improvement in loan and investment policies and credit administration. The appeal asserted that the ROE materially misrepresented the financial condition of the bank on four quarter-end dates used selectively in the ROE, which adversely influenced the financial component ratings of capital, earnings, liquidity, and sensitivity to market risk. The appeal asserted that the bank’s financial condition improved significantly from the beginning of the examination until the ROE was issued, warranting an upgrade in the financial ratings components. The appeal also states the consumer compliance downgrade relied on erroneous findings that the bank violated BSA program requirements.
The appeal also asserted the bank did not violate 12 U.S.C. § 161 because the board and management attested to the best of their knowledge and belief that the report was true and correct. The appeal asserted that filing corrected call reports is not an indication the bank has violated the regulation. The bank stated it was also not in violation of this law because management had included a disclaimer in the call reports stating that information was an estimate and could not be relied upon for investment decisions.
The appeal further asserted the bank did not violate Regulation O in connection with an automobile floor plan loan to a director’s interest. Comparable transactions to non-insiders with similar financial strength as the director demonstrate that the loan to the insider was not preferential. In addition, the appeal denies the director was shown preferentiality through his ability to purchase a participation from the bank on its loan to the dealership because that is not a transaction subject to Regulation O.
The appeal asserted the bank did not violate BSA based on the lack of three required program elements: independent testing, designation of a BSA Officer, and a system of internal controls. The appeal contended the bank was in compliance with all of these. In addition, the bank stated it did not believe any of the internal control deficiencies discussed in the ROE was a basis for concluding that the bank failed to adopt or implement the internal controls provision of the program.
Prior to accepting the appeal, the ombudsman determined that since the ROE reflected information using several quarter-end dates, ratings decisions should be determined using the most recent quarter-end for uniformity.
With respect to the asset quality rating of 4, the ombudsman found the bank’s asset quality exhibited characteristics of this rating and was deficient. The level of classified and special mention assets as a percentage of the bank’s capital structure was high. An extremely high level of net credit losses incurred in the two prior years affected earnings and capital significantly. In addition, past dues and nonaccrual loans, while trending down, were still high and above peer banks. While management made improvements, credit administration was less than satisfactory due to high credit exception rates and concerns with the risk identification system as noted by the bank’s external loan review.
With respect to the earnings rating of 5, the ombudsman found the bank’s earnings exhibited characteristics of a 4 rating and were deficient. Earnings trends, including credit losses, improved since the large net losses taken at year-end; however, as of the appeal date, the bank still suffered losses. This level of earnings was insufficient to support operations and maintain appropriate capital levels. In addition, net interest margin was poor, indicating weak core earnings.
With respect to the capital rating of 5, the ombudsman found the bank’s capital position exhibited characteristics of a 4 rating and was deficient. Capital was negatively affected by elevated credit, liquidity, and interest rate risks. Net Tier 1 Capital declined excessively in one year’s time, resulting in a reduced Tier 1 leverage capital ratio. Assistance from shareholders or other external sources is needed to increase the Tier 1 leverage ratio as required in the Consent Order. Viability of the bank may be threatened if capital continues to decline. Capital could show further deterioration after amending the bank’s call report.
With respect to the liquidity rating of 4, the ombudsman found the bank’s liquidity position exhibited characteristics of this rating and was deficient. While liquidity risk management practices improved, quantity of liquidity risk was still high. The bank’s deficient overall condition impacted its ability to access funding sources at a reasonable cost. Due to the bank’s problem status, the Federal Home Loan Bank took physical possession of the bank’s collateral securing the total commitment. Access to Federal Funds and brokered deposits was significantly reduced or unavailable. In one year’s time, the bank lost a significant amount of core deposits. Despite runoff of some higher cost funds, cost of funds and interest expense remained high and well above peer banks. Net noncore funding dependence remained high. Asset liquidity was strained with a low volume of short-term investments and on-hand liquidity. Pledged securities to total securities were high. Also, realized losses on securities sold and unrealized losses on available for sale securities were very significant through the appeal date.
With respect to sensitivity to market risk rating of 4, the ombudsman found the bank’s interest rate risk (IRR) position exhibited characteristics of this rating. Control over IRR was unacceptable. Reports available to the board disclosed that the bank’s economic value of equity (EVE) would be adversely affected in an upward rate scenario, which would have a deleterious effect on the bank’s leverage capital ratio. EVE is considered a leading indicator of the expected decline in future earnings and capital. In addition, the bank’s poor credit quality compounded IRR and negatively impacted earnings and capital. The bank’s risk management practices and the bank’s ability to identify, measure, monitor, and control interest rate risk were also deficient for the size, sophistication, and level of market risk accepted by the bank.
With respect to the consumer compliance rating of 4, the ombudsman found the bank’s compliance position exhibited characteristics of a 3 rating. The bank was in a less-than-satisfactory compliance position due to a compliance audit function that was not fully functioning and several deficiencies noted in a prior ROE were still evident as of the appeal date. The bank did not perform a comprehensive compliance audit or compliance risk assessment. Contributing to the 3 rating were deficiencies noted in the Bank Secrecy Act (BSA) program related to internal controls. The bank’s internal audit report on BSA listed controls as “unsatisfactory” with numerous moderate and high-risk areas requiring attention.
With respect to compliance with the BSA program requirements of 12 C.F.R. § 21.21, the ombudsman found the bank addressed two areas but remained in violation of another. The bank improved and adequately addressed parts of the program related to the BSA Officer and independent testing. However, deficiencies in the bank’s internal control processes remained. As of the appeal date, there were still deficiencies related to Suspicious Activity Report monitoring and documentation, monetary instrument sales practices and procedures, wire transfer monitoring procedures, account closure requirements, and high-risk customer assessment.
With respect to compliance with insider regulations, the ombudsman found the bank violated 12 C.F.R. § 215.4(a)(1)(i) and (ii) (Regulation O). Regulation O prohibits banks from extending credit to an insider of the bank unless the extension is made on substantially the same terms as those prevailing at the time for comparable transactions by the bank with non-insiders. The director’s automobile floor plan line of credit (LOC) was not made on substantially the same terms as those prevailing at the time for comparable transactions with non-insiders. The loans to non-insiders that the bank identified as comparable transactions did not have participation agreements, which is a term or feature of the LOC. Therefore, the terms of the LOC were not substantially similar to those of the comparable transactions. Furthermore, the regulation requires that any extension of credit to an insider not involve more than the normal risk of repayment or present other unfavorable features. The director’s participation agreement constituted an unfavorable feature because, at the director’s discretion and without any bank approval, he could adjust downward his participation in the outstanding principal balance of the loan.
With respect to compliance with regulatory reporting requirements, the ombudsman found the bank violated 12 U.S.C. § 161 when it filed inaccurate call reports. 12 U.S.C. § 161 requires a bank to file call reports with the OCC, and although not explicitly stated, courts have held that a requirement of accuracy is implied. Further, pursuant to 12 U.S.C. § 164, a national bank that maintains procedures reasonably adapted to avoid any inadvertent error and, unintentionally and as a result of such an error, submits a false or misleading report, shall be subject to a monetary penalty. Despite the officers’ and directors’ compliance with the attestation requirement in 12 U.S.C. § 161, the bank violated the law when the bank filed several inaccurate call reports during the examination period. Moreover, including language that warns the user that the report may not be accurate does not relieve the bank of the statutory requirement to file accurate call reports.
With respect to the management rating of 5, the ombudsman found board and management supervision exhibited characteristics of a 4 rating. While the bank made progress in addressing Matters Requiring Attention (MRAs), board and management performance and risk management practices remain deficient. The bank was still without leadership from a President/CEO after more than a year. Some of the same deficiencies noted in two prior ROEs still existed, including those related to the compliance audit function, BSA, regulatory reporting, IRR, credit exceptions, credit risk rating system, staffing, insider loans, credit analysis, and allowance for loan and lease loss.
With respect to the composite rating of 5, based on the collective facts as presented above, the ombudsman found the bank’s overall condition reflected a 4 rating. At the time of the appeal, the bank exhibited unsafe and unsound practices including serious financial and managerial deficiencies. While the board and management made progress in addressing previous MRAs, the bank’s overall performance was unsatisfactory and the bank’s problems were still severe. In addition, the bank remained in violation of several significant laws and regulations as noted above. The bank’s internal controls and risk management practices, while improved, were still weak. In addition, total criticized assets, while improved from their highest level, remained elevated. Therefore, the overall condition of the bank as of the appeal date was deficient.
The ombudsman directed the supervisory office to change its supervisory records to reflect the ombudsman’s decisions as of the appeal date. The board and management were encouraged to work with their supervisory office to correct the identified deficiencies and violations of law and regulation raised in the examination.