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SARC- 2006-01 (November 14, 2006)

I. Introduction.
This appeal arises from the Request for Review (“Request”) of the ***, (“X,” or the “Bank”) of certain material supervisory determinations made by the Dallas Regional Office (“Regional Office”) and the Tennessee Department of Financial Institutions (“TDFI”). Specifically, X seeks review of all six of its component ratings – Capital, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to Market Risk – as well as of the composite rating assigned jointly by the Regional Office and TDFI in the Safety and Soundness Report of Examination (“2005 Examination”), dated April 18, 2005. Accordingly, X disputes the “2” Capital, Liquidity, and Sensitivity to Market Risk component ratings, as well as the “3” Asset Quality, Management, and Earnings component ratings. Also disputed is the “3” composite rating. The 2005 Examination used financial information as of December 31, 2004; assets were reviewed as of April 18, 2005.

A. A Preliminary Matter: The 2004 Examination.
This case involves allegations by the Bank of incidents of examiner misconduct. The Supervision Appeals Review Committee (“Committee”) regards such allegations with significant concern. �౦��Ϸ���� policy prohibits any retaliation, abuse, or retribution by an agency examiner against an institution. Accordingly, these allegations have been directed to the appropriate channels within the �౦��Ϸ����.

The issue for Supervision Appeals Review Committee Case No. 2006-01 is whether the material supervisory determinations made by the Regional Office with respect to X’s six component ratings and its composite rating, as set forth in the 2005 Examination, are supported by the facts of record. This Decision is rendered solely with respect to that issue.

In accordance with the Guidelines for Appeals of Material Supervisory Determinations ¹ , the Committee reviews the appeal for consistency with the policies, practices, and mission of the �౦��Ϸ����, as well as the reasonableness of and support for the respective positions of the parties. The Committee granted X’s request to appear, and a meeting was held on June 6, 2006. Appearing on behalf of the Bank were Chief Executive Officer *** (“A”), Director *** (“B”), and the Bank’s outside counsel, *** (“C”). The Committee has carefully considered the written submissions made by the Bank and the Division of Supervision and Consumer Protection (“DSC”), as well as the oral presentations at the June 6 meeting. Under the Guidelines, the scope of the Committee’s review is limited to facts and circumstances existing at the time of the examination. No consideration isgiven to facts or circumstances that developed following the examination.

The Bank’s oral presentation at the June 6 meeting focused on examiner misconduct alleged to have occurred during the February 2, 2004, Safety and Soundness Examination (“2004 Examination”) and the October 4, 2004, Safety and Soundness Joint Visitation (“2004 Joint Visitation”). Bank representatives further stated their belief that misconduct as well as erroneous findings in 2004 were the underlying cause for the material supervisory determinations made at the 2005 Examination.

While the findings and the underlying facts and circumstances of the 2004 Examination are not a subject of this appeal, the Committee, in its concern for the serious allegations made with respect to the 2004 Examination and 2004 Joint Visitation, reconvened the independent Review Panel that previously evaluated the Bank’s appeal of the material supervisory determinations made at the 2005 Examination. The Review Panel was asked to examine 1) the validity of the 2004 Examination and 2004 Joint Visitation findings, and 2) whether the 2005 Examination was influenced by the assertions or by any other factors. The Review Panel conducted a comprehensive evaluation. This evaluation included a review of examination and visitation reports and supporting work papers; a review of file memoranda, emails, correspondence, and other relevant written documents; and extensive interviews with 19 individuals.

The Review Panel found that the analyses and conclusions in the 2004 Examination were accurate based on work papers, other documents reviewed, and the interviews of examination personnel.

The Review Panel did identify three errors in the 2004 Joint Visitation Report:

(1) There was criticism of a loan that had been previously paid off; ¹

(2) In regard to the Compliance Plan’s requirement that the full Board approve extensions on adversely classified loans, X’s extension of the *** (“D”) loan by other than the full Board was made prior to the effective date of the Compliance Plan and thus, this extension should not have been criticized; and

(3) With respect to the Bank’s allowance for loan and lease losses (ALLL) methodology, the Bank provides a 50 percent reserve against the balance in the Late Charges Receivable account in its ALLL. The Report criticized this practice despite the fact that X had obtained concurrence on its acceptability from the Regional Accountant in the Memphis Area Office of the �౦��Ϸ����. Further, the allocation method is allowable and should not have been criticized.

The Panel determined that these errors were not material to the 2004 Joint Visitation findings. Overall, the Review Panel found that analyses and conclusions in the 2004 Joint Visitation Report were accurate, based on work papers and other documentation reviewed.

Based on the Review Panel’s findings and evaluation of the 2004 Examination and 2004 Joint Visitation reports, the Review Panel determined that the 2005 Examination material supervisory determinations were not influenced by any other factors and that they were based upon the financial condition and risk management practices in place at the Bank as of April 18, 2005.

B. Factual Background: The 2005 Examination.
The Bank is a commercial bank headquartered in ***, Tennessee, in the *** portion of the state. The Bank opened in July 2001 and conducts traditional commercial bank operations from its main office and one full-service branch location. X experienced rapid growth in 2002. Concerns with Management supervision and operational weaknesses initially surfaced in the February 24, 2003, TDFI Report of Examination (“2003 Report”). Management was assigned a “3” rating, based largely on identified weaknesses in the areas of loan administration, operating policies, and managing Information Technology (“IT”) and Registered Transfer Agent (“RTA”) functions. The TDFI required a Board Resolution that became effective April 2003 to address the identified weaknesses. The 2004 Examination revealed corrective measures previously proposed by Management were not sustained, and material deterioration was noted. Inadequate oversight and weak management by the Bank’s Board; the decline of leverage capital; the rise of classified assets; weak earnings; dependency on Internet deposits; and an inability on the part of Management to identify, assess, monitor, or control risk in the institution were all flagged; and regulatory concern was heightened. As a result, a comprehensive Compliance Plan pursuant to Section 39 of the FDI Act was implemented, which encompassed Risk Management, Bank Secrecy Act, IT, and RTA. The Compliance Plan became effective July 26, 2004.

The 2005 Examination was delivered to X on August 31, 2005. On November 30, 2005, X filed its Request with the Acting Director of DSC. On December 22, 2005, the Acting Director affirmed the decision of the Dallas Regional Office and determined that the ratings were consistent with �౦��Ϸ���� policy and existing examination guidance and appropriate, given the facts available at the time of the examination. The Bank filed an appeal with the Committee by letter dated February 22, 2006.

The Bank appeals all six component ratings as well as its composite rating. While acknowledging difficulties with asset quality, business decisions, and overall condition in the past, X argues that today the Bank is fundamentally sound; that its asset quality has been enhanced with the implementation of new and effective underwriting, administration, and risk identification procedures; that its capital is well above the minimum requirements for a well-capitalized bank; that its management has significantly improved; that its earnings are on an upward trend; that its liquidity is excellent; and that it has developed its sensitivity to market risk by refining its reports, allowing management to adjust assets and liabilities to maintain a strong net interest margin.

With respect to the 2005 Examination findings, in summary, DSC argues that, when the Bank developed the Safety and Soundness Compliance Plan in July 2004 and thereafter implemented corrective measures, Management made considerable efforts to correct identified weaknesses and to adhere to the Compliance Plan. However, previous decisions and actions continued to affect the Bank’s condition, including asset quality and earnings. DSC asserts that the ratings assigned at the 2005 Examination appropriately reflect the identified weaknesses in loan quality, Management oversight, core earnings, and the Bank’s overall risk profile.

II. Analysis: The Safety and Soundness Material Supervisory Determinations of the 2005 Examination.
The Bank disputes the Composite rating of “3,” and the component ratings for Capital of “2,” Asset Quality of “3,”Management of “3,” Earnings of “3,” Liquidity of “2,” and Sensitivity to Market Risk of “2.” The Bank seeks ratings of “2” for Management, Asset Quality, and Earnings, ratings of “1” for Capital, Liquidity, and Sensitivity to Market Risk, and a Composite rating of “2.”

A. Capital.
Under the Federal Financial Institutions Examination Council’s Uniform Financial Institutions Rating System (the “FFIEC Rating System”), an institution is expected to maintain capital commensurate with the nature and extent of risks to the institution and the ability of Management to identify, monitor, and control such risks. The types and quantity of risk inherent in an institution’s activities will determine the extent to which it may be necessary to maintain capital at levels above required regulatory minimums. X’s Capital rating of “2” indicates a “satisfactory,” as opposed to a “strong” capital level.

X argues for a revised Capital adequacy rating of “1,” contending that the “2” was assigned “only because of the Bank’s level of classified assets.” X points to the rapidly improving trends in its asset quality and the implementation of effective corrective action by the Board and Management. The Bank argues its capital ratios provide more than a sufficient cushion to cover any perceived higher risk from the classified assets, as the ratios exceed the minimum requirements for “well-capitalized” banks. Further, the Bank contends that it has been improperly criticized for lacking a capital plan, and that, in fact, a capital plan was in place at the time of the 2005 Examination.

DSC responds that the asset quality continued to show signs of deterioration, with adversely classified assets increasing from 57 percent to 64 percent of Tier 1 capital and the allowance for loan and lease losses (“ALLL”). Nonperforming loans as a percentage of gross loans and leases were increasing and approaching seven percent. Internally identified Pass/Watch and Special Mention loans represented approximately 70 percent of capital. With regard to X’s claim that it met the minimum requirements for “well-capitalized” banks, adequate capital for safety and soundness purposes may differ significantly from minimum leverage and risk-based standards. The “well-capitalized” standards on which X relies are used in implementing the Prompt Corrective Action provisions – to resolve problems of insured institutions at the least possible long-term loss to the deposit insurance fund. Safety and Soundness concerns require institutions to maintain capital commensurate with the level and nature of risks to which they are exposed, and that includes the volume and severity of adversely classified assets. Finally, the 2005 Examination specifically comments that the Bank had not developed a formal written Capital Plan; the 2005 Examination also notes Management’s response to this deficiency was that A committed to develop such a written Capital Plan.

The Committee finds unpersuasive the Bank’s argument that an improving trend in asset quality and its well-capitalized status for Prompt Corrective Action purposes supports a Capital component rating of “1.” Most notably, classified assets increased from 57 percent to 64 percent of Tier 1 capital and ALLL. Further, internally identified Pass/Watch and Special Mention loans represented nearly 70 percent of capital. These facts do not denote strong, or even an improving, asset quality trend. A rating of “2” indicates a satisfactory though not a strong capital level, and that rating is appropriate here.

B. Asset Quality.
Asset quality is one of the most critical areas in determining the overall condition of a bank. The asset quality rating reflects the quantity of existing and potential credit risk associated with the loan and investment portfolios, other real estate owned, and other assets, as well as off-balance sheet transactions. A FFIEC Rating of “3,” as here assigned to X, denotes asset quality or credit administration practices that are less than satisfactory. Trends may be stable or indicate deterioration in asset quality or an increase in risk exposure. The level and severity of classified assets, other weaknesses, and risks require an elevated level of supervisory concern. There is generally a need to improve credit administration and risk management practices.

X argues that DSC considered an increase in the number of classified assets as the sole indication of deteriorating asset quality. The Bank explains that the number of classified assets and delinquent loans increased only because the Bank improved its risk identification system and that the elevated level of classified assets was temporary and caused by the “very aggressive risk identification system.”

In fact, while the new risk identification system improved the Bank’s ability to identify and properly monitor problem credits, the system simply measures the continued increase in, but is not responsible for the existence of, past due and nonaccrual loans. The 2005 Examination states that the Adversely Classified Items Coverage Ratio was elevated – at nearly 65 percent – with delinquent loans approaching 7 percent. That ratio reflects even a slight increase from the 2004 Examination, and both are clearly high, particularly for a bank in only its fourth year of operation. As indicated in the discussion of the Capital component, internally identified watch list loans that are not included in the adversely classified totals were also high, aggregating nearly 70 percent of capital. The level of problem loans is largely the result of inadequate lending practices and decisions during high growth periods before the 2004 Examination. The Bank’s Compliance Plan required corrective action in a number of areas, including asset quality and loan administration. The 2005 Examination takes specific account of Management’s efforts to address provisions of the Compliance Plan and previously identified weaknesses in the Bank’s lending practices. The addition of a senior vice president and chief credit officer was also beneficial and was noted in the Report.

Additionally, DSC points out that the Bank has focused on working out problem loans and resolving other regulatory concerns since the 2004 Examination. During this low-growth period, Management has concentrated on addressing weaknesses in the lending function. Implementation of revised credit administration practices is relatively new and has not been tested during a period of growth. Management’s ability to maintain loan quality during an expansion period, while continuing to address existing problem loans, remains largely unproven.

Taking these factors into consideration – the high level of adversely classified and delinquent loans, the significant volume of internally identified watch list loans, the increasing level of adversely classified loans, and Management’s unproven ability to manage loan quality in a growth period – the Committee determines that asset quality is less than satisfactory, and an Asset Quality rating of “3” is justified.

C. Management.
Sound management is demonstrated by active Board and Management oversight; competent personnel; adequate policies, processes, and controls; maintenance of an appropriate audit program and internal control environment; and effective risk monitoring and management information systems. A “3” rating, such as that assigned to X, signals the need for improved Management and Board performance and possible inadequate identification, measurement, monitoring, and control of risk.

X believes that examiners ignored Management’s many efforts in swiftly identifying the causes for the Bank’s problems and expeditiously implementing corrective action, thus reversing the declining trend in overall condition and asset quality. Further, the Bank complains that in analyzing Management, DSC heavily (and improperly) emphasized the RTA Examination that was conducted concurrently with the 2005 Examination, thus placing undue reliance on technical RTA issues emanating from a single transaction. In addition, the Bank argues that all five items relating to RTA activities in the Compliance Plan have been properly addressed. With regard to its strategic plan and budget, X argues that DSC has an overly formalistic approach to those documents, contending that the Bank’s plan and budget are satisfactory planning tools for a community bank with less than $100 million in total assets and that the plan and budget were reviewed and approved by a local CPA firm.

DSC responds that Management failed to identify causes for its problems in a timely manner. Management only began corrective action after regulatory criticism in the 2004 Examination and the implementation of the Compliance Plan. Asset quality was not improving but deteriorating, and the Bank had no formal written strategic plan and was relying on an inadequate budgeting process. DSC asserts that, with respect to its treatment of RTA issues, all aspects of the Bank are considered in determining the capabilities and risk management practices of Bank Management. A single transaction would not necessarily adversely affect the Management rating. However, X’s RTA activities have been rated a “3” in three consecutive exams. The continued less-than-satisfactory condition is reflective of Management’s weak control and poor performance in this area. Further, the eleven apparent violations cited in the 2005 RTA Examination were not repeat violations, and indicate a lack of familiarity with the rules and regulations and weak risk management practices on the part of Management. According to the 2005 RTA Examination, only two of the five provisions in the Compliance Plan had been met. The remaining three were not met, given Management’s failure to record or reflect the 2004 exchange of bank stock for holding company stock.

The Bank’s assertion that the strategic plan and budget are satisfactory is not supported by the evidence. As of the date of the 2005 Examination, X did not have a formal written strategic plan. Rather, the Bank was using the Compliance Plan as its strategic plan. Moreover, the lack of adequately documented budget assumptions and the lack of a formal budget variance reporting process are strong indicators of a weak budgeting process. Three budgets prepared between October 2004 and June 2005 showed a wide range of growth projections and operating results. For example, the original budget submitted with the October 2004 Compliance Plan progress report indicated net operating income (“NOI”) for 2005 of $804,000. The revised budget provided during the 2005 Examination (April 2005 budget) projected NOI of $314,000, which included $5,000 in negative provisions. An addendum comment in the 2005 Examination states that a revised budget dated June 2005 projected NOI of $367,000, which included a negative provision of $500,000. The budgeting process requires greater rigor.

In light of the weaknesses identified in Management oversight and budgeting procedures, the Bank’s overall financial condition, and apparent regulatory violations, the Committee believes the Bank’s risk management practices cannot be considered adequate, given X’s size, complexity, and risk profile. The Committee finds that Management performance needs further improvement and risk management practices have been less than satisfactory. The Management component is properly rated a “3.”

D. Earnings.
Bank earnings, both current and accumulated, absorb losses and augment capital. Earnings are the initial safeguard against the risks of engaging in the banking business and represent the first line of defense against capital depletion. The quality and quantity of an institution’s earnings are affected by inadequately managed credit risk or by high levels of market risk that may unduly expose an institution’s earnings to volatility in interest rates. X’s rating of “3” signifies its need to improve. Under such a rating, earnings may not fully support operations and provide for the accretion of capital and allowance levels in relation to the Bank’s overall condition, growth, and other factors affecting the quality, quantity, and trend of earnings.

X notes that the 2005 Examination based the Earnings component rating on the compressing net interest margin (“NIM”) and the rising overhead expenses, indicating, the Bank charges, that the 2005 Examination Report does not adequately address the fact that many of the increases in overhead expenses are nonrecurring, resulting from corrective actions taken to meet the requirements of the Compliance Plan. Additionally, the Bank asserts that the 2005 Examination focused on the lack of non-core earnings, as net income was significantly buoyed by reversing provision expenses. Moreover, the Bank’s NIM continues to be above its peer group.

DSC responds that the Earnings component was based, not only on the NIM and overhead expenses, but also on the weak budgeting process, the lack of core earnings, and the significant negative provisions. Acknowledging that some overhead costs may be associated with implementing the Compliance Plan, DSC nevertheless points out that the Bank failed to provide supporting documentation, either to the examiners in April 2005 or in its Request or Appeal documents. Further, while concurring that the Bank’s NIM is higher than peer, DSC counters that since 2002, the Bank’s NIM has had an aggregate decline of more than 100 basis points, while over the same period, the Bank’s peer group saw its NIM increase in the aggregate by more than 50 basis points. While the NIM level is in line with peer, the decline is noteworthy, especially since over the same time frame, the Bank’s peers moved in an opposite direction.

Given the level and declining trend in key earnings and profitability measures, the exposure to interest rate risk, and the need to improve budgeting processes, the Committee determines that the Earnings component of “3” is fully supported.

E. Liquidity.
Liquidity, which represents the ability to fund assets and meet obligations as they become due, is essential to compensate for expected and unexpected balance sheet fluctuations and provide funds for growth. Liquidity risk is the risk of not being able to obtain funds at a reasonable price within a reasonable time to meet obligations as they become due. To qualify for the highest FFIEC Rating of “1,” an institution must not only have strong liquidity levels, but it also must have well-developed funds management policies. Such an institution will have reliable access to sufficient sources of funds on favorable terms to meet present and anticipated liquidity needs.

X argues that the Bank’s Liquidity rating of “2” was based wholly on the Bank’s use of Internet-derived deposits, which deposits X maintains have been a stable source of funding since the Bank’s establishment. Additionally, the Bank maintains that the 2005 Examination, by “discounting” the reliability of Internet-derived deposits, takes a position that is contrary to an article regarding interest rate risk and funds management that appeared in the Spring 2005 issue of �౦��Ϸ���� Outlook.

DSC counters that X’s funds management practices also played a role in its Liquidity component rating of “2,” which is deemed a “satisfactory” rating, describing an institution having access to “sufficient sources of funds on acceptable terms to meet present and anticipated liquidity needs.” However, “[m]odest weaknesses may be evident in funds management practices” in an institution with a “2” Liquidity rating. The DSC Risk Management Manual of Examination Policies states that Internet-derived deposits may be highly rate sensitive and can be a less stable source of funding than typical relationship deposit customers. Accordingly, various risk management safeguards are required to manage accounts and any other future funding strategies. Funds management practices criticized in the 2005 Examination included: (1) the need to establish specific goals to monitor Management’s stated plans for increasing the level of core deposits; (2) the lack of integration of cash flow projections into the funds management process; (3) the lack of a comparison of the cost of Internet-derived deposits to local core deposit funding; (4) the lack of funding options other than Internet-derived deposits; and (5) the absence of a contingency funding plan. DSC points out that the �౦��Ϸ���� Outlook article cited by X, (which expresses the views of the authors and not official positions of �౦��Ϸ����) never addressed Internet-derived deposits but discussed the use of brokered deposits.

On the basis of these facts, the Committee believes that X’s Liquidity is satisfactory and is properly rated a “2.”

F. Sensitivity to Market Risk.
Sensitivity to Market Risk, for most institutions, addresses the degree to which changes in interest rates can adversely affect an institution’s earnings or capital. The component focuses on the bank’s ability to identify, monitor, manage, and control its market risk. X seeks a rating of “1,” which denotes a bank with well-controlled market risk and minimal potential that earnings performance or capital position will be adversely affected. In a “1” rated institution, risk management practices are strong, calibrated by the size, sophistication, and market risk accepted by the institution. The level of earnings and capital provide substantial support for the degree of market risk taken by the institution.

X contends that its Sensitivity to Market Risk component rating of “2” was assigned solely because the examiners suggested some fine tuning to interest rate and market sensitivity reports.

DSC asserts that the rating is based on X’s interest rate risk exposure, which is considered moderate, with a highly asset-sensitive position in the short term. The compression in the NIM is evidence that fluctuations in interest rates have and may continue to affect the Bank’s earnings. (The Bank’s NIM dropped 60 basis points in one quarter.) Moreover, 11 percent of the Bank’s loan portfolio have reached their contractual interest rate floors. Consequently, these loans will not reprice until the interest rate index rises to a level that causes the contractual interest rate to exceed the floor interest rate. Further affecting the rating are X’s capital and earnings positions, as well as the deficiencies in risk management practices. Banks rated “2” in Sensitivity to Market Risk have adequately controlled market risk, with only moderate potential that the earnings performance or capital position will be adversely affected.

The Committee is mindful of X’s interest rate risk exposure, as well as the compression in its NIM. However, we are persuaded that its Sensitivity to Market Risk is satisfactory and is properly rated a “2.”

G. The Composite Rating.
Composite ratings are based on a careful evaluation of an institution’s managerial, operational, financial, and compliance performance. The composite rating is not the arithmetic average of the component ratings, as some components are given more weight than others, depending on how critical they are to the overall health
of the bank. The Management component, for example, is factored heavily, as weaknesses in Management oversight can affect every aspect of bank operations. Asset Quality, too, is emphasized because of the cumulative effect that asset problems can have on an institution.

X asserts that the 2005 Examination overemphasizes earlier activities in assigning a Composite rating of “3.” The Bank feels that the 2005 Examination fails to focus on the timely corrective action implemented by Management and the overall positive trend in, and future prospects of, the Bank’s financial performance.

DSC’s notes both asset quality and earnings have deteriorated, and there are new apparent violations in the RTA function. Further, there are weaknesses in the budgeting process, in liquidity and sensitivity to market risk monitoring and reporting, and in the lack of strategic and capital plans. Also, Bank Management did not execute timely corrective action. Rather, such action was taken following the discovery of significant deficiencies and their citation in the 2004 Examination. The Bank executed a Compliance Plan specifically to implement corrective action. The Committee finds on the basis of all this evidence that the overall condition of the institution remained less than satisfactory and is correctly rated a “3.”

III. Conclusion.
For the reasons set forth above, X’s appeal is denied. This decision is considered a final supervisory decision by the �౦��Ϸ����.

By direction of the Supervision Appeals Review Committee of the �౦��Ϸ����, dated November 14, 2006.

__________________________

Valerie J. Best
Assistant Executive Secretary

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¹ The examiner had intended to criticize a different loan, which loan was correctly cited on a later page in the Report. The Dallas Regional Director informed X’s President of this fact in his letter of February 9, 2005.