Milestone and Millstone

 (Part 2)

The previous National Bank Examiner blog post Milestone and Millstone (Part 1) recapped the milestone judicial decision regarding the legal liability of bank directors under the North Carolina business judgement rule in a case involving the failure of the Cooperative Bank of Wilmington, North Carolina.  This blog post deals with the millstones borne by bank examiners in the form of blemished or uneven bank supervisory policy guidance.  Policy guidance that really needs to be addressed across all bank regulatory agencies if this judicial decision survives the appellate process.

If what bank examiners do (or do not do) in the performance of their examining duties, their CAMELS ratings, and their subsequent followup activities, are going to be legally mapped to the question of whether a bank director does (or does not) have legal liability in a failed bank receivership scenario, then (at least) two things ought to change.

Specifically, there is a need to address a fundamental structural flaw in the Uniform Financial Institutions Rating System (UFIRS), in terms of appropriately weighing today's immediate problems against today's risks (tomorrow's problems) in its numerical CAMELS composite and component ratings.

And second, there is a need to install policy guardrails, consistent across all bank regulatory agencies, that appropriately balance standardized calibrated escalation of adverse examination findings with the boundaries of examiner/field office discretion and latitude in using moral suasion as a bank supervisory tool.


 UFIRS: A job half-completed is an incomplete job.

The Uniform Financial Institutions Rating System (UFIRS) was originally created in 1979 as an internal rating system, used by federal bank regulators, for uniformly evaluating the soundness of financial institutions and to identify those institutions requiring special supervisory attention.   Supervisory agencies derived composite ratings for each financial institution from a subsidiary set of component ratings for Capital adequacy, Asset quality, Management, Earnings, and Liquidity (the old CAMEL ratings system)

Composite ratings ranged on a scale from "1" (sound in every respect), to "2" (fundamentally sound), to "3" (exhibits some degree of supervisory concern), to "4" (exhibits serious financial or managerial deficiencies that result in unsatisfactory performance), to "5" (exhibits critically deficient performance).

The original UFIRS considered both banking practices and performance, but the rating standard, or rubric, driving the determination of a financial institution's composite rating was the bank's record of performance and the "snapshot" evaluation of bank soundness derived from the bank's latest examination results.   While risk was considered implicitly in the old CAMEL rating system, the progressive adoption of risk-focused supervision by banking supervisors over the years since 1979 argued for making risk assessment in the UFIRS clear and explicit.

So on December 19, 1996, the Federal banking agencies issued the 1996 Revision of the UFIRS.  The major changes included an increased emphasis on the quality of risk management practices and the addition of a sixth component rating called "Sensitivity to Market Risk".  The CAMEL rating system became the CAMELS rating system and the evaluation standards for component ratings now included explicit consideration of processes to identify, measure, monitor, and control risks.

The drafting work done by the Interagency CAMEL Working Group of the Federal Financial Institutions Examination Council (FFIEC) was admirable, and the revised, risk mangement-sensitive component rating definitions remain quite good and continue to be germane and very useful.  But when the proposed UFIRS revisions were considered by the FFIEC Task Force on Supervison (the senior staff supervisors within each federal banking agency), the Task Force on Supervision chose to retain the performance-based context of the existing composite rating definitions. 

"4. Composite Rating Definitions.  The composite rating definitions parallel proposed changes for component descriptions and ratings. The revised composite rating definitions contain an explicit reference to the quality of overall risk management practices.  The basic context of the existing rating definitions is being retained.  The composite ratings would continue to be based on a careful evaluation of an institutions managerial, operational, financial, and compliance performance." (my emphasis) 

The FFIEC Task Force on Supervision, and later the agency heads themselves, took a nicely remodeled home and placed it on the old, creaky performance-based UFIRS composite rating foundation.

Performance is fundamentally retrospective... it looks back from the present to the past.  It's a lagging indicator.  Quality of risk management is prospective, looks forward in time, and can be a leading indicator.  The focus on performance, as the composite rating bottom-line, relegates, in a de facto manner, the evaluation of the quality of risk management practices to an important, but still secondary consideration.  So at the end of the day, the UFIRS composite and component ratings present a time-distorted view of intrinsic bank soundness.

Why is this a millstone for bank examiners?  One only needs to look at the seeds of the recent financial crisis.  The erosion of credit underwriting standards, particularly in the real estate sector, and the pursuit of hot money funding drove unprecedented banking performance in terms of profitability and growth.  Until late July 2007, when the credit markets first started to lock-up and the banking system began its inexorable march toward financial crisis and taxpayer bailout.

When confronted with a situation where a bank exhibits superior performance metrics but questionable risk management practices, which aspect drives the component and composite ratings under the UFIRS?  The basic context of the UFIRS emphasizes performance.

This was underscored by the Office of the Comptroller of the Currency (OCC) at the time in OCC Bulletin 97-14 , a follow-up on common questions and answers about the 1996 revised UFIRS :

"How do the revised rating system and the OCC's supervision by risk program interrelate?

They exist in tandem... The CAMELS rating system remains a measurement of the bank's current overall financial, managerial, operational, and compliance performance.  (all emphasis mine)  Supervision by risk prospectively assesses not only the quality of risk management and the quantity of risks, but also the direction of risk."

Even in the current Bank Supervision Process section of the Comptroller's Handbook, the OCC reinforces this concept:

"The major distinction between the RAS [Risk Assessment System] and rating systems is the prospective nature of the RAS. The rating systems primarily provide a point-in-time assessment of an institution’s current performance. (my emphasis) The RAS reflects both a current (aggregate risk) and a prospective (direction of risk) view of the institution’s risk profile."

How to fix this structural weakness in the UFIRS?  Although CAMELS composite ratings are enshrined in the granite bedrock of certain federal statutes, the means by which they are arrived at are not.  I would suggest creating explicit sub-ratings, for analytical purposes, within each CAMELS component rating.  One for performance and one for risk management.  Then, to be conservatively prudent, use the worst of the two sub-ratings to drive the individual CAMELS component ratings and, ultimately, roll those up into the composite rating of the bank.  I think this would be a small step forward by providing a more accurate measure of a bank's intrinsic soundness.


Will Character Bank Supervision Go the Way of Character Lending in Banking?

The Cooperative Bank case highlights the fact that there can be significant variation in the intensity of bank supervisory followup on examination criticisms.  This case appears to be an extreme example, likely complicated by the policy of alternating annual examinations between the FDIC and the North Carolina banking commissioner's office.

But, in general, individual examiners, individual field offices, even individual bank regulatory agencies, differ on the degree of patience shown regarding the pace and effectiveness of bank management's resolution of examination criticisms.

Factors such as the seriousness of the criticism; the urgency associated with the risks involved; the potential for a criticism to balloon into something larger and more dangerous; the confidence the examiner or field office has in the capabilities of the bank's executive management and board of directors; and the physics of the corrective action process (particularly those involving significant data processing changes, multiple vendors, and/or changes in business culture) ---- all of these things, and many more, play into the calculus of the bank supervisory followup on examination criticisms.

But there need to be boundaries.  And those boundaries need to be lined with policy guardrails and a robust quality assurance process.  In this respect, I believe that the Office of the Comptroller of the Currency (OCC) has ably dealt with this issue in its old and new Matters Requiring Attention (MRA) guidance when read together with the OCC's Enforcement Action Policy.

A character loan is a type of unsecured loan whose repayment is premised on the borrower's reputation and the bank's past experience with the borrower.  Is there still a place in banking for character lending?  Yes, but there should be a backstop in the form of demonstrable indications of the ability to repay.

Character bank supervision is premised on the reputation and perceived abilities of a bank's executive management team and the bank regulatory agency's past experience with them.  Is there still a place for character bank supervision in banking by the temperate use of moral suasion prior to resorting to harsher enforcement measures?

Absolutely!  The overwhelming majority of examination criticisms are corrected in this manner.  But there need to be policy guardrails that limit bank management's use of dilatory tactics that may stem from either their unwillingness or inability to correct examination criticisms.  Policy guardrails that also limit a bank regulator's supervisory office from countenancing unresolved examination criticisms over an extended period of time by buying into repeated unfulfilled promises, vague assurances, and incomplete (or ineffective) progress.