With the new year, each financial institution faces the prospect of the next regulatory examination―and no matter which agency (or agencies) examines your bank, seasoned bankers know how critically important it is to have a good exam. When that examination team arrives to ensure public confidence in the banking system by identifying any undue risks or weak management practices, make no mistake about it, the future of the enterprise is at stake.
A negative outcome will disrupt the business plan, profitability and growth of the bank for years to come, while a positive or at least “satisfactory” rating will allow the institution to continue to move forward with its business plan. That is why being prepared and being ready to assist the examiners is so important to the bank.
As bankers know, the focus of a safety and soundness examination is the bank’s performance as measured against the Uniform Financial Institutions Rating System, which evaluates the bank’s capital, assets, management, earnings, liquidity and sensitivity to risk, or “CAMELS,” within a 1-5 composite rating system; with 1 being the best and 4 and 5 requiring regulatory corrective action.
The significance of the results of the examination requires that the board of directors and, in turn, bank management take all steps necessary to demonstrate the bank’s commitment of financial resources and personnel, and the employment of the systems and processes, to ensure compliance with safe and sound banking principles. Those steps cannot be successfully employed when the notification of the examination has arrived. They must start right now and be checked on regularly so that full compliance is evident from the moment the examination team arrives.
The examination is a project that requires full attention to detail and organization. The key persons in all of the functions that are likely to be examined―risk management, loan quality, liquidity, and liability management, BSA/AML, information technology and cyber security―should be fully prepared, evaluating their respective strengths and weaknesses.
A plan of action should be established, including the flow of questions and responses to and from the examination team. The initial information to be provided to the examiners should be coordinated and fully reviewed to confirm content, accuracy and completeness. Those identified to answer questions should be instructed to listen carefully to the question and respond only to the exact question, with no extra information offered gratuitously. The bank may want to engage an independent consultant to assist in the preparation, including digging into issues, posing questions and providing feedback to management responses. Role-playing and practice in this regard may be employed. The review of relevant regulatory examination manuals and guidance should be accomplished. Third-party independent audits and internal self-assessments should be looked at to make sure any weaknesses identified therein have been remediated. Any material deviations from the bank’s business plan should be considered and full explanations prepared. The prior reports of examination should be reviewed to make sure all problems identified therein and matters requiring special attention have been addressed.
It is important to note that repeated violations or the failure to address and solve issues discussed in prior exams can result in the imposition of civil money penalties (“CMPs”) against officers and/or directors, prompt corrective action and, in extreme cases, removal actions. Beginning in January 2019, the Office of the Comptroller of Currency (“OCC”) implemented inflation-adjusted CMPs, which may be adjusted in January of each year. For 2019, the maximum penalty amount per day was generally $10,000 and the lesser of 1 percent of total assets or $2,000,000, in the aggregate. The OCC imposed four civil money penalty orders in 2019.
Senior bank management should meet and greet the examination group upon arrival to get the exam off on the right foot. If there is a new exam team, the bank’s history should be explained, any significant changes described, and any material changes in management or the business plan reviewed and explained. The examiners should be made to feel comfortable and housed in a setting that allows them to operate freely.
During the exam, senior management should meet daily with the examiners to check on issues of concern being identified, confirm the information being provided, and make sure all information requested is being made available. Notes of all meetings and material discussions with examiners should be taken and maintained until at least the final report of examination (“ROE”) is issued and accepted. Interaction with the examiners is critical to make sure any problem situation is managed as best as possible. Always ask for as much information as possible when an issue arises and bring the right member of bank management to the table when appropriate to address any concern and help find solutions. Make sure all information provided to examiners is reviewed before delivered. If possible, it is important to informally resolve any issues before the examiners leave the bank.
At the exit review, ask examiners to clearly explain their preliminary ratings and the key factors they considered when assigning the component and composite ratings, as the composite rating is not an average of the components, but rather a qualitative evaluation of performance. Make sure management fully understands any recommendations from the examiners and asks questions so any corrective action can be properly implemented before the final ROE is completed. If the board of directors will be involved at the exit review meeting, management should meet with the board to prepare them, make them fully aware of the preliminary findings from the examiners, and establish a coordinated method for their responding during the meeting.
If there are disagreements in the results of examination that cannot be resolved through informal discussions, the regulators offer an appeal process. The OCC allows issues regarding examination ratings, the adequacy of the allowance for loan losses and the classification of significant loans to qualify for an appeal by the submission of a written description of the disputed matter(s) to the bank’s immediate supervisory office or the OCC ombudsman.
The FDIC also provides for a regional ombudsman who can act as a neutral party to resolve differences between the financial institution and the assistant regional director before the ROE is finalized. If that process is not successful or the bank wants to bypass the ombudsman, the FDIC has a formal appeals process. The bank may appeal material supervisory determinations (“MSD”) with the division director within 60 days following the receipt of the written determination. If the bank does not agree with the division director’s determination, the matter may be appealed to the Supervisory Appeal Review Committee (“SARC”) which consists of three voting members including the chairperson or vice chairperson of the FDIC. A hearing is usually held within 90 days and a decision issued within 45 days after the hearing. The regulations specially prohibit any retaliation or abuse of the bank by the FDIC for an appeal of the MSD.
In assessing capital adequacy, the examiners will be considering the level and quality of capital in conjunction with the overall financial condition of the institution including: (i) the nature and volume of problem assets; (ii) the adequacy of the allowance for loan losses (“ALL”); (iii) the nature and amount of market and concentration risk; (iv) off-balance-sheet risk exposure; (v) plans for growth; and (vi) the quality and strength of earnings.
Asset quality is at the heart of every safety and soundness exam. The focus will be on the bank’s underwriting standards, credit administration practices, level of classified, nonaccrual, delinquent and nonperforming assets, the adequacy of the ALL, loan concentrations and the adequacy of internal controls and management information systems.
The board’s provision of clear guidance regarding the bank’s direction, acceptable levels of risk and active oversight will be fundamental to the assessment of management. Management’s practices in compliance with laws, regulations and internal bank polices; depth and succession planning; response to audit and supervisory recommendations; the lawful and timely implementation of board directives and policies; the ability to plan for and adapt to changes in business conditions; and the development and implementation of policies, procedures and prudent operation standards to effectuate the board’s goals and objectives all play a role in the regulator’s determining a composite rating on management.
In assessing earnings, the examiners will focus not only on the quantity and earnings trends, but on the quality and sustainability of earnings. Reliance on extraordinary or one-time gains will be a negative. The level of expenses in relation to operations and the adequacy of the budgeting and forecasting system employed by management will be considered. Earnings exposure to market risk and volatility in interest rates will be examined.
The regulators will focus on current levels and prospective sources of the bank’s liquidity. Funds management practices need to ensure not only the bank’s ability to meet its identifiable financial obligations but to manage unplanned changes in funding sources and market conditions. The reliance on short-term, more volatile funds to satisfy long-time obligations will be considered and the bank’s ability to have information systems in place that identify, measure and effectively respond to liquidity needs must be demonstrated.
Finally, the bank’s sensitivity to changes in interest rates―which might negatively affect its earning and/or capital as well as its ability to identify, measure and adjust to such changes in light of the bank’s complexity, size and risk tolerance―will be fully considering by the bank examination team.
As we all know, a negative examination can, at the minimum, undermine the regulator’s confidence and trust in a bank’s board and management, which may affect the bank’s future in subtle ways, while significant problems identified during an examination can result in corrective action. The corrective action can take the form of: (i) the adoption of board resolutions to commit the bank to addressing the issues of concern; (ii) the implementation of a memorandum of understanding, which, while an informal action, still identifies specific action items and requires written updates to the regulators by management; or (iii) the execution of a formal agreement or cease and desist order which includes the board’s formal agreement to take corrective action to address major failures in the bank’s operations and permits court action if the deficiencies identified are not timely remediated. The bank’s commitment of financial resources and personnel and management time and attention to correct the problems are substantial and it normally takes repeated exams and even a year or two to raise the bank’s CAMELS composite rating. During that time, the expansion of the bank’s business, the implantation of new products and services, and the consideration of any merger or acquisition activity is usually prohibited. The bank’s market reputation may also suffer.
In short, it is vitally important for bank management, including the board, to consider the next regulatory examination now and assess the bank’s condition, address concerns, review and consider all policies and procedures, and fully prepare its team. Such actions will put the bank in a position to achieve the best possible results out of its next regulatory examination.
Arthur A. Coren and S. Alan Rosen are partners at Duane Morris LLP, an international law firm with 800 lawyers and 29 offices, including five offices in California. Based in the firm’s Los Angeles office, they represent community banks and their holding companies, as well as large banking institutions, in regulatory matters, corporate governance, M&A and capital raising.