Material Loss Review of Sherman County Bank, Loup City, Nebraska
As required by section 38(k) of the Federal Deposit Insurance Act (FDI Act), the Office of Inspector General (OIG) conducted a material loss1 review of the failure of Sherman County Bank (SCB). On February 13, 2009, the Nebraska Department of Banking and Finance (NDBF) closed the institution and named the FDIC as receiver. On March 4, 2009, the FDIC notified the OIG that SCBís total assets at closing were $126.6 million with an estimated loss to the Deposit Insurance Fund (DIF) of $28 million. Since that time, the loss decreased to $26.8 million.
When the DIF incurs a material loss with respect to an insured depository institution for which the FDIC is appointed receiver, the FDI Act states that the Inspector General of the appropriate federal banking agency shall make a written report to that agency which reviews the agencyís supervision of the institution, including the agencyís implementation of FDI Act section 38, Prompt Corrective Action (PCA); ascertains why the institutionís problems resulted in a material loss to the DIF; and makes recommendations to prevent future losses.
The audit objectives were to: (1) determine the causes of the financial institutionís failure and resulting material loss to the DIF and (2) evaluate the FDICís supervision2 of the institution, including implementation of the PCA provisions of section 38 of the FDI Act. Appendix 1 contains details on our objectives, scope, and methodology; Appendix 2 provides a summary of previous regulatory activities related to SCB; Appendix 3 contains a glossary of terms; and Appendix 5 contains a list of acronyms used in the report.
This report presents the FDIC OIGís analysis of SCBís failure and the FDICís efforts to ensure bank management operated the bank in a safe and sound manner. We are not making recommendations. Instead, as major causes, trends, and common characteristics of financial institution failures are identified in our reviews, we will communicate those to management for its consideration. As resources allow, we may also conduct more in-depth reviews of specific aspects of the FDICís supervision program and make recommendations, as warranted.
SCB was a state-chartered savings bank, established on June 27, 1932 by the NDBF, and insured by the FDIC effective January 1, 1934.3 SCB, which was headquartered in Loup City, Nebraska:
Sherman County Management, Incorporated, a one-bank holding company, was the parent company of SCB. Details on SCBís financial condition, as of December 31, 2008, and for the 4 preceding calendar years follow in Table 1.
Table 1: Financial Condition of Sherman County Bank
a Financial institution regulators and examiners use the Uniform Financial Institutions Rating System (UFIRS) to evaluate a bankís performance in six components represented by the CAMELS acronym: Capital adequacy, Asset quality, Management practices, Earnings performance, Liquidity position, and Sensitivity to market risk. Each component, and an overall composite score, is assigned a rating of 1 through 5, with 1 having the least regulatory concern and 5 having the greatest concern.
b FDIC Visitation.
CAUSES OF FAILURE AND MATERIAL LOSS
SCB failed primarily due to the bank Board of Directorsí (BOD) and managementís decision to increase and fund loan commitments without adequately considering the borrowersí ability to repay and the sufficiency of the underlying collateral. These loans were made to 34 agricultural customers participating in a Commodity Marketing Program4 (Program). The activities of the Program, principally the purchase and sale of commodity futures and options contracts, resulted in significant losses to these customers in late 2008 and early 2009. In order to facilitate continued Program trading, SCB increased and funded individual borrowerís loan commitments,5 often in apparent violation of Nebraskaís legal lending limits (LLL) and
without due regard for sound risk management controls, including those associated with assessing the customersí ability to repay and collateral asset value. SCB also relied heavily on volatile funding such as brokered deposits and large time deposits to fund the significant increases in its loans to Program participants. As SCB funded these loans, the bankís credit concentration related to the Program and overall risk exposure significantly increased. Ultimately, losses associated with these loans depleted capital and strained liquidity, resulting in the bankís failure.
Specifically, during late 2008 and early 2009, SCB increased loan commitments and resulting funding that totaled $46.2 million to cover trades made by the Programís broker. During the same period, SCB increased its use of brokered and time deposits by $34 million to help fund these loans. The increases in these loan advances, totaling $23.9 million, resulted in over 300 apparent violations of the LLL. In addition, collateral for the Program loans was not sufficient to support the increased commitments. At the time of SCBís failure in February 2009, total collateral for the $62.2 million in Program loans was valued at $31.5 million, or a loan-to-value ratio of 198 percent. The FDIC classified $31.7 million of the $62.2 million in Program loans as loss, which significantly exceeded SCBís capital. SCB did not adequately assess the risk that the third-party arrangement posed to the bank prior to increasing loan commitments to Program participants.Inadequate Risk Management Controls
SCBís BOD and senior management did not implement adequate risk management controls over the lending for the Program and failed to protect the operations of the bank. These control weaknesses included:
The BODís failure to ensure that bank management implemented and followed adequate risk management controls, especially during the last quarter of 2008 and early 2009, materially affected the bankís overall financial condition, and eventually led to the bankís insolvency in February 2009.
Credit Concentration and Open-Ended Funding for Program Loans. SCBís BOD and management did not adequately address the risks associated with the concentration in agricultural loans for Program participants and the open-ended funding for those loans.
SCBís credit concentration related to the Program loans was first noted during the NDBFís January 2007 examination when these loans totaled $2.9 million or 34.78 percent of SCBís Tier 1 Capital. During the FDICís July 2008 examination, the FDIC reported that the credit concentration was almost $16 million or 183 percent of Tier 1 Capital. By the time SCB failed, the concentration had increased to over $62 million. As of January 2009, $62.2 million or 78 percent of SCBís total agricultural loans were loans advanced by SCB to cover commodity trading activities for the Program participants. All of these loans were adversely classified by examiners in February 2009. Further, examiners determined that SCB had only $12.5 million in capital and reserves, which was insufficient to cover the adverse classifications of $62.2 million. In addition, the associated collateral, which is discussed later in this report, was grossly inadequate. Table 2 summarizes the Program loans for the period May 2005 to January 2009.
Table 2: Concentration in Program Loans
From the July 2008 examination to early 2009, SCB management did not implement controls to limit the level of funding associated with the Program. Specifically:
Implementation of such controls would have allowed the bank to (1) limit amounts loaned to Program participants, (2) ensure compliance with state laws regarding LLL, and (3) limit the negative financial consequences to the bank.
The documentation for the three-way arrangement entitled, Security Agreement and Assignment of Hedging Account,7 included a control mechanism that would have protected the bankís viability if the BOD had implemented it. The agreement states:
Whenever Secured Party deems it necessary for its protection, it shall be entirely without the consent or concurrence of or prior to Debtor, to direct the Broker to liquidate any or all of the outstanding open positions in the Account.8
Contrary to this provision, SCBís BOD and management chose to continue to fund the loans. As a result, by January 2009, the concentration had increased by a total of $46.2 million as follows.
According to DSC officials, had the bank implemented this control in September 2008 and liquidated the borrowersí accounts, the bank would not have failed.
According to SCBís Loan Committee minutes, in October 2008, committee members were concerned about the Program loans. The minutes also indicated that the committee planned to take action to limit the Program in the future. However, action to stop the funding either was not taken or was not effective because SCB continued to provide substantial funding for these loans. As the funding increased, the bankís risk and exposure also increased.
Part 364, Appendix A, Interagency Guidelines Establishing Standards for Safety and Soundness, states that an institution should establish and maintain loan documentation practices and prudent credit underwriting that:
During the last quarter of 2008 and early 2009, SCB significantly increased the funding for 34 Program loans by $46.2 million without regard for the customersí ability to repay and in noncompliance with the State of Nebraskaís LLL, as discussed in the following paragraphs. Further, SCBís BOD and management failed to effectively diversify the bankís loan portfolio during the end of 2008 and early 2009.
Material Violations of the State of Nebraskaís LLL. SCB did not comply with the State of Nebraskaís LLL laws designed to help banks avoid concentrations of lending to individuals. SCB violated Nebraska Statute 8-141, which states that a bank shall not directly or indirectly make loans to any one person or corporation which, in the aggregate, exceed 25 percent of the bankís Tier 1 Leverage Capital. However, examiners determined that from June 2008 through January 2009, SCBís advances, which totaled $23.9 million, to fund Program
loans resulted in 300 violations of Nebraskaís LLL. Figure 1, which follows, provides a summary of the apparent violations.
SCBís Apparent Violations of Nebraskaís LLL
[ D ]
In the July 2008 Report of Examination (ROE), FDIC examiners cited the bank for five apparent violations of the stateís LLL. Of the five advances that totaled $410,000, four advances, totaling $218,000, were extended beyond the LLL to fund some of the Program loans. During the FDICís July 2008 examination, SCB:
Although SCB was cited for apparent LLL violations during the July 2008 examination, bank management disregarded its responsibility to comply with laws and regulations and failed to implement appropriate and effective corrective actions to avoid future apparent LLL violations.
According to the DSC Risk Management Manual for Examination Policies (Examination Manual):
SCBís BOD did not ensure that bank management complied with laws and regulations. Although bank management and the BOD were alerted to apparent LLL violations during the June 2008 examination and the bank took action to address those apparent violations, SCBís BOD did not ensure that timely and effective action was taken to prevent future violations.
Inadequate Underlying Collateral. SCB did not establish a loan review system to identify, monitor, and control the adequacy of the underlying collateral for the 34 Program loans to ensure the repayment of the debt. Part 364, Appendix A, Interagency Guidelines Establishing Standards for Safety and Soundness, states that an institution should establish and maintain loan documentation practices and prudent credit underwriting that provide for consideration, prior to credit commitment, of the:
According to DSCís Examination Manual, each financial institution is expected to establish an internal loan-to-value limit, which should not exceed 65-85 percent depending on the loan category. However, SCB did not ensure that the collateral for the 34 loans was adequate to ensure the repayment of the debt. In addition, loan-to-value ratios for 29 of the 34 Program loans exceeded and, in some cases, significantly exceeded 85 percent. At the time of SCBís failure in February 2009, total collateral for those loans was valued at $31.5 million of the $62.2 million funded for the Program loans, or a loan-to- value ratio of 198 percent. Loan-to-value ratios for 16 (47 percent) of the 34 Program loans was more than 200 percent.
Contrary to this guidance, SCB did not adequately consider the concentration risk, ensure that the debt was secured by adequate collateral, and take steps to restrict/limit the amount of
funding for the Program loans to ensure that the borrowers had the ability to repay the loans. In addition, SCBís BOD and management made loans for which the loan-to-value limits far exceeded industry standards.
Inadequacy of, and Noncompliance with, the Loan Policy. SCBís Loan Policy included some guidance related to agricultural loans but did not include all areas suggested in DSCís Examination Manual. SCBís loan guidance included lending limits, in terms of dollar value, for each loan officer and a general loan supervision policy and stated that all secured loans should have an ample margin of safety between the funds borrowed and the current market value of the collateral.
The Loan Policy addressed loan-to-value for real estate loans but did not specifically address the Program loans. Further, the Loan Policy (1) acknowledged that the bank had a concentration of credit in agricultural loans due to the nature of the bankís local economy and (2) stated that when concentrations of credit developed, the bank would attempt to sell participations out of the concentration until it was reduced to the lending limits specified in the Loan Policy. SCBís management did not comply with its Loan Policy guidelines.
According to SCBís Loan Policy, a concentration of credit was defined as direct, indirect, or contingent obligations of one individual or entity where the aggregate exposure exceeded 25 percent of the bankís capital. At the time of the January 2007 examination, Program loans represented 34.78 percent of the bankís Tier 1 Capital. The concentration in Program loans continued and significantly increased through the July 2008 examination and became more pronounced from September 2008 through January 2009. Contrary to the bankís Loan Policy, however, SCB did not take action to sell participations9 from the concentration to comply with limits specified in the Loan Policy and significantly reduce the risk to the bank. Further, although SCBís Loan Policy addressed loan authorities for lending limits, the bank apparently violated LLL 300 times totaling nearly $24 million.
SCBís loan policies and procedures did not provide specific guidance related to monitoring the collateral values for commodity trading-related loans. In addition, FDIC guidance included in DSCís Examination Manual and the Agricultural Lending Examination Documentation Module, dated November 1997, relates to agricultural lending, underwriting, and loan administration. The guidance recommends that banks specializing in agricultural lending establish policies and procedures that address the:
However, we found no evidence that SCB had incorporated this guidance into its loan policies and procedures. Specifically, SCB did not have policies related to the collateral limits for Program loans and did not set limitations/thresholds on the amounts loaned to Program participants or the volume of high-risk agricultural concentrations, which in this case, included the Program loans.Inadequate ALLL Methodology and Funding
SCBís methodology for determining the ALLL did not comply with interagency policy. According to Financial Institution Letter (FIL) 105-2006, Interagency Policy Statement on the Allowance for Loan and Lease Losses, dated December 13, 2006, each institution must analyze the collectibility of its loans and maintain an ALLL at a level that is appropriate and determined to be in accordance with Generally Accepted Accounting Principles (GAAP).10 An appropriate ALLL covers estimated loan losses on individually evaluated loans that are determined to be impaired as well as estimated loan losses inherent in the remainder of the bankís loan and lease portfolio.
The July 2008 examination identified deficiencies in SCBís ALLL methodology, and examiners concluded that the methodology did not specifically evaluate loans for impairment and that reserve allocation calculations for loans not individually reserved for had not been quantified. SCBís president committed to modifying the ALLL methodology to adhere with the policy statement.
In October 2008, SCBís president requested additional time to develop and provide the FDIC with a revised ALLL methodology. The FDIC requested that SCB provide the revised ALLL information prior to December 31, 2008. We found no evidence that SCB had provided the revised ALLL methodology to the FDIC before the bank failed.
During the February 2009 visitation, examiners reported that SCBís ALLL of $1.5 million was insufficient to cover loan losses estimated at $31.7 million. As SCBís assets deteriorated, it became apparent that its ALLL was insufficient to absorb loan losses and could not be adequately funded.Heavy Reliance on Volatile Funding Sources
SCBís management employed a funding structure that centered heavily on potentially volatile funding to cover its growth of high-risk agricultural loans. Those sources of funding included brokered deposits and time deposits of $100,000 or more. As stated in the DSC Examination
Manual, a heavy reliance on potentially volatile liabilities to fund asset growth is a risky business strategy because the availability and access to these funds may be limited in the event of deteriorating financial or economic conditions, and assets may need to be sold at a loss in order to fund deposit withdrawals and other liquidity needs. However, SCB management did not establish policies or controls that adequately limited or mitigated the level of risk related to these funding sources. Table 3, which follows, summarizes SCBís dependence on high-cost volatile funds used for the significant increases in Program loans during 2008.
Table 3: Funding Sources Used for the Significant Increases in Program Loans
*The July 2008 examination used financial information dated March 31, 2008.
As indicated above:
The overall deterioration in the bankís condition affected its access to alternative sources of funding. Specifically, the FDIC issued a PCA Notification on February 4, 2009 that restricted the bankís use of brokered deposits.
Assessment of Third-Party Risk. SCBís BOD and management did not assess the risk that the third-party arrangement presented to the bank. The FDIC issued Guidance for Monitoring Third Party Risks (FIL-44-2008), dated June 8, 2008, which provides guidance to financial institutions regarding the assessment of risk associated with third-party arrangements. The guidance (1) describes potential risks arising from third-party arrangements, (2) outlines risk management principles that may be tailored to suit the complexity and risk potential of a financial institutionís significant third-party arrangements, and (3) outlines the potential risks
that may arise from the use of third parties. The guidance also addresses the following three basic elements of an effective third-party risk management program:
According to FIL-44-2008, the financial institutionís BOD and senior management should understand the nature of associated risks, including, but not limited to:
Strategic risk - the risk arising from adverse business decisions, or the failure to
implement appropriate business decisions in a manner that is consistent with the
institutionís strategic goals.
SCBís association with the Program resulted in the bank experiencing a negative impact in all of the above categories of risk.
The guidance states that the BOD and management are responsible for assessing these risks as follows:
The failure of SCBís BOD and management to adequately assess the risk of the Program and their decision to increase and fund loan commitments without adequately considering the (1) borrowersí ability to repay and (2) sufficiency of the underlying collateral proved detrimental to the viability of the institution and resulted in the bankís failure and a material loss to the DIF.
ASSESSMENT OF SUPERVISION
The FDIC and NDBF performed oversight of SCB, including conducting risk management examinations and visitations. However, we identified one area where DSCís supervision could have been improved. The FDIC could have taken earlier and more assertive actions related to SCBís third-party arrangement. Specifically, the FDIC could have done more to consider the risk that the third-party arrangement posed to SCB. Although the examiners for the FDICís 2005 and 2008 examinations discussed the Program with bank management, the FDIC did not fully assess the risk that the third-party arrangement and Program posed to SCB. The FDIC recognized during the July 2008 examination of SCB that there were deficiencies in the bankís lending activity. However, the FDIC did not ensure that SCBís Loan Policy included adequate guidance to limit (1) loan commitments in relation to collateral value or the borrowerís ability to repay for Program loans and (2) the concentration in the Program loans.Historical Snapshot of FDIC Supervision
The FDIC and NDBF performed alternating safety and soundness examinations of SCB in a timely manner, conducting a total of four examinations, beginning November 2003 through July 2008 (see Table 4, on the next page). The FDIC also conducted three visitations between March 2003 and December 2004 due to concerns over litigation and investigations directed at SCBís affiliated broker, the Program, and SCB and its holding company (refer to the discussion that follows on page 14 and Appendix 2). In addition, the FDIC conducted a visitation in February 2009 after SCBís management informed the FDIC of the significant deterioration in the bankís financial condition. SCBís composite ratings remained at 2 until the February 2009 visitation when the bankís composite rating was downgraded to 5, indicating extremely unsafe and unsound practices or conditions, critically deficient performance, and inadequate risk management practices.
Table 4: Examination Dates and CAMELS Ratings
The FDIC examiners identified and reported concerns such as apparent violations of laws and regulations and repeat apparent contraventions of interagency policies. In addition, the examiners made recommendations to SCB to improve risk management and loan underwriting and credit administration issues.
Further, to address examiner concerns documented during a Federal Reserve Bank (FRB) March 2004 visitation (refer to Appendix 2 for additional information), the FDIC and NDBF requested that SCB adopt a Bank Board Resolution (BBR), which the bankís BOD adopted on July 14, 2004. The BBR resulted from the FDICís concerns over SCBís potential liability in an outstanding lawsuit by the Commodity Futures Trading Commission (CFTC) and National Futures Association (NFA) and required the bank to manage its capital position in anticipation of any judgment that might result from the suit. The BBR contained one provision restricting cash dividends, capital distributions, earnings distributions, or management fees in excess of $100,000 per calendar quarter, without the prior written consent of the FDIC and NDBF. Also, the FDIC placed SCB on a Supervisory Watchlist due to pending litigation and settlement as a result of the CFTC/NFA lawsuit. Once that lawsuit was settled in 2007, the FDIC removed SCB from the Watchlist.
In addition, in October 2008, SCBís holding company submitted an application to participate in the Troubled Asset Relief Programís (TARP) Capital Purchase Program, administered by the United States Department of the Treasury (Treasury), and requested $2.8 million in funds. In December 2008, the FDIC approved the request and referred it to the Treasury, which also approved SCBís TARP request. In January 2009, SCBís president and chairman requested a meeting with the FDIC and informed the FDIC that the bank was likely insolvent due to expected losses on loans related to activities directed by the Programís broker. During that meeting, SCBís president provided details regarding the Program and the bankís substantially deteriorated financial condition since the FDICís last full-scope examination in July 2008. On January 30, 2009, SCBís president requested an increase in TARP funds. However, due to significant declines in the bankís financial condition and the inability to certify that there had not been a material change in the bankís status, SCBís president withdrew the bankís request for TARP funds.
As previously discussed, based on SCBís disclosure of the bankís financial deterioration, the FDIC initiated a visitation of SCB on February 2, 2009. On February 7, 2009, the FDIC issued a Cease and Desist Order (C&D), which required SCB to:
On February 5, 2009, the NDBF informed SCB that the bank needed to obtain additional capital totaling $34.1 million by February 12, 2009. Because the bank was unable to raise the additional capital, the NDBF closed the bank on February 13, 2009.OIG Assessment of FDIC Supervision
The FDIC provided regular examinations of SCB and reported some of the issues in the July 2008 examination that were ultimately related to the bankís failure. However, we concluded that the FDICís supervision and assessment of the risk that the third-party arrangement presented to the bank, including an assessment of the bankís Loan Policy related to the Program, could have been improved. A more complete assessment would have included a determination of how the bank was measuring, monitoring, and controlling risks associated with the institutionís significant third-party arrangement.
The FDICís and other regulatorsí concerns regarding the Program date back to, at least, 2004. In conjunction with the FRB and NDBF, the FDIC conducted a visitation of SCB in March 2004 that focused on the CFTC and NFA investigation of the third-party commodity broker and the conflict of interest relating to the dual roles of SCBís vice president. The activities of the
broker in SCBís third-party arrangement prompted lawsuits by some of the brokerís customers (some of who were also SCB borrowers). The customers alleged that the broker had acted inappropriately by engaging in trading activities outside the scope of the Program and, consequently, caused significant losses to SCB customers who were participating in the Program.
Third-Party Risks Related to the Program. The FDIC could have done more to consider the risk presented by the Program to ensure that SCB established and appropriately implemented risk management controls over the Programís broker.
FDIC Follow-up on Regulatory Concerns. According to the FDIC, as part of its follow-up to the CFTC/NFA concerns, examiners reviewed documents to ensure that SCB management abided by the terms and provisions of the final CFTC/NFA agreement. The FDIC reviewed the Program during the visitation conducted in December 2004 and the FDIC examinations conducted in May 2005 and July 2008,11 after the FRB issued its 2004 inspection report.12 However, the FDIC did not adequately follow up on the risk that the third-party arrangement presented to SCB to ensure that the bank established and appropriately implemented controls to prevent excessive funding of high-risk agricultural loans.
During the 2005 and 2008 FDIC examinations, the FDIC assigned a Subject Matter Expert (SME) to review SCBís commodity marketing program. According to the FDIC, the SME performed a thorough evaluation of the marketing Program to determine whether the Program was working as intended and that Program objectives were in place. However, the analyses and results of the reviews of the Program were not summarized and documented in the ROEs or the related examination work papers, and these reviews did not consider the risk that the Program presented to SCB.
Heightened Risk to SCB. The third-party arrangement heightened risk to SCB because (1) the bank used only one broker for the Program, (2) the broker made ďbatch ordersĒ for all participants at one time, (3) one bank (SCB) funded all of the loans for each of the 34 Program participants, and (4) the third-party agreement provided for open-ended funding. Although the agreement also allowed the bank to discontinue funding when deemed necessary, SCB did not implement this control. The third-party agreements that the bank and participants signed were in effect prior to the FDICís 2009 visitation which occurred after a January 2009 meeting with SCB. In addition, the FDIC did not question (1) loan underwriting and credit administration weaknesses resulting in open-ended
funding for the 34 Program loans and (2) Loan Policy deficiencies that resulted in substantial risk to SCB, inadequate collateral, and material apparent violations of the State of Nebraskaís LLL.
Examples of the FDICís examination/visitation comments related to SCBís Program and the third-party broker are shown below in Table 5.13
Table 5: Examples of FDIC Comments Regarding the Program and SCB
* It was later determined that there were only 34 borrowers.
As indicated above, the FDICís assessment of the Program did not take into consideration the risk that the Program presented to SCB. SCB disclosed the bankís substantial financial deterioration to the FDIC on January 30, 2009, that is, reporting the substantial loan losses from advances made for the Program participants. As a result, the FDIC took quick and
decisive action 3 days later and began an onsite examination of SCB on February 2, 2009 to more accurately identify the extent of losses in the bankís loan portfolio.
Noncompliance with Examination Guidance Related to Third-Party Risk. During 2007, the FDIC included third-party-related guidance in (1) the FDICís Supervisory Insights Summer 2007 article and (2) a Regional Directors Memorandum (Transmittal 2008-020), Guidance for Monitoring Third Party Risks, dated June 8, 2008. However, FDIC examiners could have more fully considered and adequately documented their use or consideration of this guidance during the July 2008 examination of SCB.
Guidance in Supervisory Insights Summer 2007. This article addresses the benefits and potential risks associated with third-party agreements and offers some best practices to assist banks in avoiding the financial losses and reputation risks that can result from poorly managed third-party arrangements. The article also states that third-party arrangements can present risks and discusses how failure to manage these risks can expose a financial institution to everything from financial loss to regulatory action and loss of customer relationships. The article also states that inadequate management and control of third-party risks can result in a significant financial impact on an institution.
Guidance in Transmittal 2008-020. This guidance forms a general framework that BOD and senior management may use to provide appropriate oversight and risk management of any significant third-party arrangement. The principles and procedures outlined in this guidance should serve as a resource to ensure that risks arising from third-party arrangements are appropriately managed. The guidance also:
DSCís Examination Manual states that situations occasionally arise where the safety and soundness of an insured depository institution is materially affected by transactions, contracts, or business arrangements with parties that are not affiliated with the institution. When such situations arise, the FDIC should examine the other side of the transaction. The potential impact of these business relationships on the insured depository institution necessitates a complete understanding of the nature of the transaction and relationship and its effect on the insured institution. The guidance also states that, by statute, the FDIC has authority to obtain records of unaffiliated service providers and other counterparties relating to an insured financial institution. The information that the FDIC can obtain from an unaffiliated service provider or other counterparty is not limited to specific transactions with, or relating to, the insured depository institution but can extend to the financial books and records of the
servicer or entity so long as such documents are needed in furtherance of an examination that relates to the affairs of an insured bank.
The FDIC could have done more to identify, evaluate, or monitor the risks associated with SCBís third-party arrangement. Not doing so resulted in the FDICís inability to ensure that SCB had appropriate procedures in place to address the complexity and risk potential of the Program. Program participant losses escalated during the last quarter of 2008 and early 2009. Attempts to recover from the losses to Program participants resulted in significant loan advances, totaling $46.2 million, through the bankís open-ended funding practices, from October 2008 to January 2009, leading to SCBís failure on February 13, 2009.
Loan Policy. In the FDICís July 2008 ROE, examiners recognized that SCB had significantly increased the amount of funding for Program loans, had apparent violations of the State of Nebraskaís LLL, and needed to improve its day-to-day loan monitoring of lending to ensure the bank complied with the LLL requirements. However, the FDIC did not ensure that SCBís Loan Policy included adequate guidance to limit (1) loan commitments in relation to collateral value and a borrowerís ability to repay Program loans and (2) the concentration in Program loans.
DSCís Examination Manual states that the examinerís evaluation of a bankís credit administration and loan policies and the quality of the loan portfolio are among the most important aspects of the examination process. However, FDIC examiners did not adequately assess SCBís loan policies and procedures to ensure that appropriate controls were in place to mitigate third-party risks related to the Program. As discussed on page 9 of this report, DSCís Agricultural Lending Examination Documentation Module provides guidance to examiners to use when evaluating agricultural lending. The bankís Loan Policy included some guidance related to agricultural loans (as discussed on page 9). However, the bankís Loan Policy did not include guidance related to:
The FDIC examiners did not ensure that SCBís Loan Policy and procedures (1) included adequate guidance to ensure that SCBís management adjusted collateral value, (2) considered the borrowerís ability to repay before increasing loan commitments, or (3) set limitations/thresholds on the amounts advanced to program participants or the volume of higher-risk agricultural loans. SCBís Loan Policy addressed agricultural loans but did not specifically address possible concentrations in Program loans and the risk that the concentration might present to the bank. Greater supervisory concern by the FDIC regarding
the adequacy of SCBís loan policies could have led to elevated supervisory attention and earlier supervisory action.
Conclusion. The FDIC could have done more to consider and mitigate the bankís risks associated with the Program before the bankís financial condition had significantly deteriorated. The FDICís SME focused attention on some areas of the Program during the FDICís 2005 and 2008 examinations. However, additional attention was needed to analyze/monitor the SCBís control weaknesses associated with the risks that the Program presented to the bank, including the concentration in Program loans, loan underwriting and credit administration deficiencies, inadequate loan policies, and apparent violations of the LLL. Although the FDIC issued examiner guidance related to third-party risk in 2007 and June 2008, that guidance was not fully used to assess the risk that SCBís third-party arrangement presented to the bank. FDIC officials stated that the three-way arrangement was a normal industry practice for agriculture-related loans and that the FDIC did not consider the arrangement to present elevated risk to the bank. However, all 34 Program participants used the same third-party broker to place trading orders, and the same bank, which in this case was SCB, funded the Program loans. The risk associated with the Program caused severe financial deterioration and ultimately led to SCBís failure and a material loss to the DIF.
IMPLEMENTATION OF PCA
The purpose of PCA is to resolve problems of insured depository institutions at the least possible long-term cost to the DIF. PCA establishes a system of restrictions and mandatory and discretionary supervisory actions that are to be triggered depending on an institutionís capital levels. Part 325 of the FDICís Rules and Regulations implements PCA requirements by establishing a framework for taking prompt corrective action against insured nonmember banks that are not adequately capitalized.
SCB was categorized as Critically Undercapitalized, under PCA provisions, just prior to its failure. As a result, the FDIC issued a C&D that contained a capital provision, directing SCB to increase its capital. The C&D was issued on February 7, 2009, 6 days before the bank was closed. SCB received a capital component rating of 1 or 2 for each of the four examinations conducted from November 2003 through July 2008. The capital component was downgraded to a 5 rating during the February 2009 visitation. The downgrade in February 2009 resulted from the bankís critically deficient level of capital due to severe asset quality problems and losses that rapidly eroded the bankís capital position.
Table 6, which follows, shows how SCBís capital ratios compared to the bankís peer group for three of the bankís examinations and as of December 31, 2008.
Table 6: SCBís Capital Ratios Compared to Peer Group
*UBPR dated December 31, 2008.
As indicated above, SCBís capital ratios were slightly below the bankís peer group through December 2008.
PCAís focus is on capital, and capital can be a lagging indicator of an institutionís financial health. In addition, the use of PCA Directives depends on the accuracy of capital ratios in an institutionís financial data. SCBís capital designation for PCA purposes remained in the Well Capitalized range through the July 2008 examination.14 However, the BOD did not ensure that the institution had sufficient capital to support the significant increase in lending activities. Due to SCBís funding of $46.2 million for Program loans from October 2008 to January 2009, SCBís capital level fell to Critically Undercapitalized in January 2009. In February 2009, the FDIC notified the BOD of the bankís change in PCA category to Critically Undercapitalized, subjecting the bank to brokered deposit rate restrictions. On February 5, 2009, the NDBF notified the bank that a capital infusion of $34.1 million was required by February 12, 2009. However, SCB was unable to obtain additional capital and was closed on February 13, 2009.
On September 3, 2009, the Director, DSC, provided a written response to the draft report. DSCís response is provided in its entirety as Appendix 4 of this report. In its response, DSC reiterated that SCB failed primarily due to the BODís and managementís decision to increase and fund loans without adequately considering the borrowersí ability to repay and the sufficiency of the underlying collateral. DSC also stated that the Program parameters were violated when the hedged position was allowed to lapse on September 26, 2008, and SCB continued to fund speculative positions. DSC also stated that while the Program loans represented a concentration at the time of the July 2008 examination, the Program was operating within its parameters and that there was more than adequate commodity and market account collateral to repay the outstanding loans. DSC continued that examiners had discussed the importance of the Program hedging parameters and LLL with SCB management during the 2008 examination, yet management ignored internal controls and LLL only 3 months later.
DSC acknowledged that earlier and more complete recognition of the risks posed by the single-broker arrangement and the weaknesses in SCBís internal controls could have led to elevated supervisory attention and more timely supervisory action. DSC also acknowledged the importance of commodity price protection programs to the agriculture industry and supports well-controlled risk management programs designed to hedge against commodity market price fluctuations.
OBJECTIVES, SCOPE, AND METHODOLOGY
We performed the audit field work at the DSC offices in Kansas City, Missouri, and Grand Island, Nebraska.
Our ability to evaluate certain issues related to the Program activities and related loans were restricted due to the lack of certain documents, such as copies of three-way agreements, promissory notes, and brokerís records.Internal Control, Reliance on Computer-processed Information, Performance Measurement, and Compliance With Laws and Regulations
Due to the limited nature of the audit objectives, we did not assess DSCís overall internal control or management control structure. We performed a limited review of SCBís management controls pertaining to its operations as discussed in the body of this report.
We obtained data from various systems but determined that information system controls were not significant to the audit objectives, and, therefore, we did not evaluate the effectiveness of information system controls. We relied on our analysis of information from various sources, including ROEs, correspondence files, and testimonial evidence to corroborate data obtained from systems that were used to support our audit conclusions.
The Government Performance and Results Act of 1993 (the Results Act) directs Executive Branch agencies to develop a customer-focused strategic plan, align agency programs and activities with concrete missions and goals, and prepare and report on annual performance plans. For this material loss review, we did not assess the strengths and weaknesses of DSCís annual performance plan in meeting the requirements of the Results Act because such an assessment is not part of the audit objectives. DSCís compliance with the Results Act is reviewed in program audits of DSC operations.
Regarding compliance with laws and regulations, we performed tests to determine whether the FDIC had complied with provisions of PCA and limited tests to determine compliance with certain aspects of the FDI Act. The results of our tests were discussed, where appropriate, in the report. Additionally, we assessed the risk of fraud and abuse related to our objectives in the course of evaluating audit evidence.
2004 Lawsuit and Investigation
ADDITIONAL REGULATORY ACTIVITIES RELATED TO SCB
However, the financial condition of the brokerage company had deteriorated significantly and was considered to be unsatisfactory. The brokerage companyís problems were directly related to customersí losses stemming from the brokerís commodity brokerage activities.
The FRB concluded the following.
Accordingly, as a one-bank holding company, the risk presented by the broker also spilled over to the bankóSCB. The FRBís inspection report outlined specific concerns, including the appropriateness of the brokerís marketing strategies and the type of trades the broker made for the Program participants. The FRBís inspection resulted in recommendations to improve oversight and monitoring of the brokerís activity by SCB management.
GLOSSARY OF TERMS
|Adversely Classified Assets||Assets subject to criticism and/or comment in an examination report. Adversely classified assets are allocated on the basis of risk (lowest to highest) into three categories: Substandard, Doubtful, and Loss.|
|Allowance for Loan and Lease Losses (ALLL)||Federally insured depository institutions must maintain an ALLL that is adequate to absorb the estimated loan losses associated with the loan and lease portfolio (including all binding commitments to lend). To the extent not provided for in a separate liability account, the ALLL should also be sufficient to absorb estimated loan losses associated with off-balance sheet loan instruments such as standby letters of loan.|
|Cease and Desist Order (C&D)||A C&D is a formal enforcement action issued by a financial institution regulator to a bank or affiliated party to stop an unsafe or unsound practice or a violation of laws and regulations. A C&D may be terminated when the bankís condition has significantly improved and the action is no longer needed or the bank has materially complied with its terms.|
|Commodity Futures Trading Association||The federal regulatory agency established by the Commodity Futures Trading Act of 1974 to administer the Commodity Exchange Act.|
|Concentration||A concentration is a significantly large volume of economically related assets that an institution has advanced or committed to a certain industry, person, entity, or affiliated group. These assets may, in the aggregate, present a substantial risk to the safety and soundness of the institution.|
|Margin||The required level of equity/funding that the Program participants were required to maintain in the commodity Program account.|
|National Futures Association||A self-regulatory organization whose members include futures commission merchants and introducing brokers. NFA is responsibleóunder CFTC oversightófor certain aspects of the regulation of futures commission merchants and introducing brokers, focusing primarily on the qualifications and proficiency, financial condition, retail sales practices, and business conduct of these futures professionals.|
|Prompt Corrective Action (PCA)||
The purpose of PCA is to resolve the problems of insured depository institutions at the
least possible long-term cost to the DIF. Part 325 of the FDIC Rules and Regulations,
12 Code of Federal Regulations, section 325.101, et. seq., implements section 38,
Prompt Corrective Action, of the FDI Act, 12 United States Code section 1831o, by
establishing a framework for taking prompt supervisory actions against insured
nonmember banks that are less than adequately capitalized. The following terms are
used to describe capital adequacy: (1) Well Capitalized, (2) Adequately Capitalized,
(3) Undercapitalized, (4) Significantly Undercapitalized, and (5) Critically
A PCA Directive is a formal enforcement action seeking corrective action or compliance with the PCA statute with respect to an institution that falls within any of the three categories of undercapitalized institutions.
September 3, 2009
Pursuant to Section 38(k) of the Federal Deposit Insurance Act (FDI Act), the Federal Deposit Insurance Corporationís Office of Inspector General (OIG) conducted a material loss review of Sherman County Bank (Sherman) which failed on February 13, 2009. This memorandum is the response of the Division of Supervision and Consumer Protection (DSC) to the OIGís Draft Audit Report (Report) received on August 6, 2009.
Sherman failed primarily due to Board and managementís decision to increase and fund loans without adequately considering the borrowerís ability to repay and the sufficiency of the underlying collateral. These loans were supposed to provide borrower funding for participation in a commodity market hedging program (Program) for corn crops and be fully secured at all times based upon the Program parameters. The Program parameters were violated when the hedged position was allowed to lapse on September 26, 2008, and Sherman continued to fund speculative positions. While the Program loans represented a concentration at the time of the July 2008 examination, the Program was operating within its parameters and there was more than adequate commodity and market account collateral to repay the outstanding loans. Examiners discussed the importance of the Program hedging parameters and legal lending limits with Sherman management and yet management ignored internal controls and legal lending limits only three months later.
The Report found that the FDIC and the Nebraska Department of Banking and Finance conducted timely and regular safety and soundness visitations and examinations of Sherman. The Report also found that the FDIC could have done more to consider the risk the third-party broker arrangement posed to Sherman. We acknowledge the Reportís findings that earlier and more complete recognition of the risks posed by the single broker arrangement and the weaknesses in Shermanís internal controls could have led to elevated supervisory attention and more timely supervisory action. DSC also acknowledges the importance of commodity price protection programs to the agriculture industry and supports well-controlled risk management programs designed to hedge against commodity market price fluctuations.
Thank you for the opportunity to review and comment on the Draft Audit Report.
ACRONYMS IN THE REPORT
|ALLL||Allowance for Loan and Lease Losses|
|BBR||Bank Board Resolution|
|BOD||Board of Directors|
|C&D||Cease and Desist Order|
|CAMELS||Capital, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to Market Risk|
|CFTC||Commodities Futures Trading Commission||DIF||Deposit Insurance Fund|
|DRR||Division of Resolutions and Receiverships|
|DSC||Division of Supervision and Consumer Protection|
|FDI||Federal Deposit Insurance|
|FIL||Financial Institution Letter|
|FRB||Federal Reserve Bank|
|GAAP||Generally Acceptable Accounting Principles|
|LLL||Legal Lending Limits|
|NDBF||Nebraska Department of Banking and Finance|
|NFA||National Futures Association|
|OIG||Office of Inspector General|
|PCA||Prompt Corrective Action|
|ROE||Report of Examination|
|SCB||Sherman County Bank|
|SME||Subject Matter Expert|
|TARP||Troubled Asset Relief Program|
|UBPR||Uniform Bank Performance Report|
|UFIRS||Uniform Financial Institution Rating System|