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SRC Insights: Third Quarter 2007

Don't Take that 2 for Granted!

The scene is pretty familiar. An examiner-in-charge meets with a bank's board of directors and recites the CAMELS exam ratings assigned to the bank at its recent examination.1 Management breathes a sigh of relief, and board members bravely take in the maze of acronyms and ratios inherent to the examination process. Because examiners are trained to refrain from laudatory comments, these meetings with examiners may be considered anti-climatic, yet banks may not fully realize how important achieving an overall "satisfactory" assessment is and how it supports management's ability to execute the bank's strategic plan.

Today's supervisory process is tailored to the risk profile of the supervised institution. Through their ratings, examiners potentially pre-qualify institutions to receive a variety of supervisory benefits. This article will discuss some of the benefits of receiving a satisfactory (2) composite rating, which range from reduced examination and regulatory application burden to very tangible benefits, such as lower deposit insurance premiums and discount window availability. The downside of examinations (i.e., when a rating is poor) and how to avoid such a situation will also be discussed.

Before delving into the benefits of a 2 rating, it is worthwhile to touch upon a common question asked by many bankers: What do I have to do to receive a strong (1) composite rating? Bankers may strive to attain a 1 rating, but it may not always be the most desirable goal. Although examiners focus on safety and soundness, bankers must strive to satisfy other stakeholders, such as shareholders and market analysts. And while examiners take comfort in high levels of capital and liquidity, earnings may suffer if levels are too high. Similarly, asset quality that reflects nominal levels of problem loans may be indicative of an overly conservative credit culture. However, in regard to earnings and management, both examiners and bankers typically agree that ample earnings, in conjunction with sound risk management practices, represent the ideal situation.

Reduced Examination Burden
The frequency of safety and soundness, compliance, and CRA examinations is tailored to the size and risk profile of financial institutions. The banking industry has been consistently strong in recent years, and Congress has gradually reduced examination burden. All but the largest institutions are examined less frequently if they are rated at least satisfactory, thereby reducing burden on banks.

The Financial Services Regulatory Relief Act of 2006 increased the asset threshold to $500 million for well-capitalized and well-managed banks to qualify for an extended 18-month safety and soundness examination cycle. The term "well managed" is generally based on satisfactory CAMELS composite and management component ratings. Another example is the Gramm-Leach-Bliley Act (GLBA), which reduced the frequency of consumer compliance examinations to either four or five years for banks with $250 million or less in assets if they achieve satisfactory or outstanding CRA ratings, respectively.

Expedited Applications
Examination ratings have a great impact on a bank or bank holding company's ability to expand. Although most of the Federal Reserve's supervisory processes take place through off-site surveillance and periodic on-site examinations, state and federal banking regulations identify certain events that require prior regulatory approval. Most revolve around expansion events like branch formations, mergers and acquisitions, and the conduct of certain activities.

The good news is that the applications process has been retooled to provide expedited processing to institutions that are well managed and well capitalized. The benefits range from reduced processing timeframes and streamlined information requests to full exemption from the application requirement. The concept of pre-qualification through examination ratings and capital levels was an integral part of GLBA, which authorized expanded activities through financial holding companies and financial subsidiaries.

Management's proven ability to effectively oversee existing activities as evidenced by satisfactory examination ratings provides comfort to regulators that new activities will also be well managed. Therefore, new activities, to include insurance and securities activities, are available to qualified banking institutions without prior notice to their regulators.

An institution's capital levels also play an important part in qualifying for expansionary proposals. With bank capital levels at historic highs, the well-capitalized threshold established by FDICIA has become relatively standard and should be maintained upon consummation of any expansion that requires regulatory approval. This would apply to proposals by bank holding companies, as well as insured depository institutions. Also, bank holding companies that are well capitalized and well managed are generally not required to give prior notice when repurchasing their stock.

It is also noteworthy that, with certain exceptions, bank holding companies with consolidated assets of less than $500 million are not subject to the Federal Reserve's capital adequacy guidelines. In these situations, the focus shifts to the impact of the proposal on the capital levels of the subsidiary bank and to any debt burden incurred by the bank holding company, in particular, its ability to service the debt without undue reliance on the bank for cash flow.

Lower Deposit Insurance Premiums
The Federal Deposit Insurance Reform Act of 2006 authorized the FDIC to implement a more risk-sensitive deposit insurance premium. The change is intended to spread the assessment more fairly across institutions. The FDIC adopted a new rule in November 2006, which became effective January 1, 2007. The rules place each institution into one of four risk categories using a two-step process based first on capital ratios (capital group assignment) and then on other relevant information (supervisory group assignment).

Subgroup A of the supervisory group consists of financially sound institutions with few minor weaknesses and generally corresponds to the primary federal regulator's composite ratings of 1 or 2. Institutions that qualify for the lowest overall Risk Category I will be assessed premium rates based on their CAMELS component ratings, certain financial ratios, and long-term debt issuer ratings, as applicable.

Beginning in 2007, rates will range between 5 and 43 cents per $100 in assessable deposits, while institutions in Risk Category I will be charged a rate between 5 and 7 cents. At the maximum end in each range, a bank with $100 million in insured deposits would be assessed $430 thousand, while a bank in Risk Category I would only be assessed $70 thousand.

Availability of Federal Reserve Daylight Credit and Discount Window Programs
Supervisory ratings are confidential and therefore cannot be disclosed by a depository institution (DI) in obtaining credit. An exception to this is the Federal Reserve, where the bank's rating is already known and factored into its ability to access daylight overdraft credit and discount window programs. Generally, any institution that has a composite rating of 1, 2, or 3 will have access to both daylight and overnight credit from the Federal Reserve.

Under the Federal Reserve's Payment System Risk Policy on Daylight Credit, CAMELS ratings of 1, 2, and 3 are highly correlated to the three self-assessed net debit cap categories and are the primary driver in determining an institution's daylight credit capacity.2 The other factor used to determine daylight overdraft capacity is the institution's capital category. Under normal circumstances, an institution would need to be well or adequately capitalized to qualify for a net debit cap. In extenuating circumstances, an undercapitalized DI with a rating of 1 or 2 may qualify for a net debit cap. Each cap category is assigned a multiple that is applied to the DI's risk-based capital to determine its daylight credit capacity.

Similarly, an institution qualifies for the Discount Window's Primary Credit Program if it is assigned a CAMELS rating of 1, 2, or 3 and is at least adequately capitalized, unless supplementary information indicates that the institution is not generally sound. DIs assigned a CAMELS rating of 4 may be eligible under limited circumstances, while a 5 rating results in ineligibility. DIs that are ineligible for primary credit may borrow under the Secondary Credit Program, when use of such credit is consistent with a timely return to a reliance on market sources of funding or the orderly resolution of a troubled institution, subject to certain limitations.

The Downside
There are multiple consequences to losing a 2 rating, but it is sufficient to note that examination frequency accelerates, the ability to expand through mergers or engage in new activities is sharply curtailed, and there is the likelihood of an enforcement action-either formal or informal-until the underlying problems are addressed. On a positive note, institutions do not lose their satisfactory assessments without fair warning from regulators.

The underlying causes do not generally manifest themselves in one examination cycle. In most cases, negative trends are identified and criticized by examiners well in advance of a composite rating downgrade. Bankers should be alert for slippages in asset quality, capital positions that no longer support the bank's risk profile, declining earnings performance and liquidity, and increased exposure to interest rate risk. The satisfactory management assessment is particularly vulnerable to inadequate risk management practices and failure to comply with laws and regulations.

In the past, examiners focused heavily on the financial components. Today's examiners emphasize risk management to a much greater extent and are not hesitant to downgrade the management rating, as well as financial components, if they are not managed in a safe and sound manner. In addition, management should be sensitive to emerging issues. When topics become hot issues or emerging trends, management should be vigilant to ensure that there are appropriate processes and controls in place to avoid criticism. Finally, ratings downgrades can largely be avoided if management addresses examination recommendations in a timely manner and avoids repeat criticism.

In Summary
There are positive and tangible benefits to be derived from a successful examination. Although it may be intrusive and time consuming, an examination that results in a satisfactory or better rating provides a number of benefits and helps to reduce regulatory burden, thus allowing more time to devote to core business activities.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.

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