Ramifications of a Less Than Satisfactory Examination
By: KAREN L. GRANDSTRAND
June 2008
This year’s headlines have included the mortgage meltdown, concerns over commercial real estate, capital market dysfunction, a Bear Stearns bailout, and Paulson’s “blueprint” for financial regulatory reform. Given this climate, bank examinations are tough right now -- loan classifications are up, there’s pressure to increase reserves and capital levels, and exam ratings are declining. As a result, more banks will likely see component and composite ratings of 3, 4, or 5. The FDIC’s Quarterly Banking Profile for December 2007 reported that the number of “problem” institutions (which are 4 and 5 rated institutions) increased to 76. This article gives a brief overview of the ramifications of receiving a less than satisfactory exam.
First, an unsatisfactory exam can lead the examiners to deem an institution to be in ”troubled condition.” Under federal law, bank regulators generally deem a bank to be in troubled condition if it obtains a composite rating of 4 or 5, is subject to a cease-and-desist order or written agreement, is subject to a proceeding for termination or suspension of deposit insurance, or is otherwise informed in writing that it is in troubled condition. With this designation, two important restrictions come into play. One restriction places limitations on golden parachute payments to insiders. A “golden parachute payment” is any compensation, or agreement to make such compensation, for the benefit of any current or former institution affiliated party of an insured depository institution or its holding company, where the payment or agreement is (i) contingent upon termination; (ii) received on or after, or made in contemplation of, among other things, a determination that the institution or holding company is in a troubled condition; and (iii) payable to an institution affiliated party who is terminated when the institution or holding company meets certain conditions, including being subject to a determination that it is in troubled condition. A second restriction limits director and officer appointments. Troubled institutions can change senior executive officers and directors only upon providing at least 30 days’ advance written notice to appropriate federal regulators.
Second, an unsatisfactory exam can result in a downgrade of an institution’s prompt corrective action (“PCA”) capital designation. As a result of federal legislation following the savings and loan debacle, regulators are required to classify insured institutions according to the institution’s level of capital, using the leverage ratio, the total risk-based capital ratio (“RBCR”), and the Tier 1 RBCR. Based on these ratios, banks receive one of the following classifications:
Classification |
Leverage Ratio |
Total RBCR |
Tier 1 RBCR |
Well-Capitalized |
≥ 5% |
≥ 10% |
≥ 6% |
Adequately Capitalized |
≥ 4% |
≥ 8% |
≥ 4% |
Undercapitalized |
< 4% |
< 8% |
< 4% |
Significantly Undercapitalized |
< 3% |
< 6% |
< 3% |
Critically Undercapitalized |
< 2% |
Not Considered |
Not Considered |
Under this classification system, a bank is subject to certain restrictions based on its capital level. For example, adequately capitalized institutions face restrictions on accepting, renewing or rolling over brokered deposits. Undercapitalized institutions face limits on asset growth, expansion, interaffiliate transactions, and interest rates. Further, once an institution becomes undercapitalized, federal law mandates that regulators issue a prompt corrective action directive requiring the institution to restore capital. An institution receiving such a directive has 45 days to file a capital restoration plan outlining the measures it will take to become adequately capitalized. At the critically undercapitalized level, federal law generally mandates the appointment of a receiver or conservator within 90 days.
Significantly, the regulators have the ability to lower an institution’s classification by one level if the institution is deemed to be in an unsafe or unsound condition or engaging in an unsafe or unsound practice. Thus, certain exam findings can lead to reclassification and a lowering of a bank’s PCA designation.
Third, receipt of an unsatisfactory exam rating makes it more difficult to receive approval on expansion applications, even seemingly de minimus expansions.
Fourth, unsatisfactory examinations can lead to the issuance of enforcement actions against the bank and/or its insiders. Such actions can be either informal or formal in nature. The most commonly used informal enforcement actions include board resolutions, commitment letters, supervisory agreements, and memorandums of understanding. Informal actions are not made public and cannot be formally enforced in a court.
The most commonly used formal enforcement actions include written agreements, cease-and-desist orders, prohibitions and removal orders, civil money penalties, and termination of insured status. Formal actions are generally made public and are enforceable in court. Further, a failure to comply with a formal action can result in additional actions for noncompliance.
Takeaway
The above summary covers only some of the issues and ramifications of a bad exam. Clearly, less than satisfactory ratings and any type of enforcement action need to be taken seriously. The board and management need to understand the legal significance of certain seemingly innocuous designations (like “troubled condition”) and the ramifications of the various types of enforcement actions.