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Federal R eserve Bank OF DALLAS ROBERT D. M C T E E R , J R . DA LLAS, TEXAS p re s id e n t and c h ie f e x e c u t e o m cE R December 30, 1996 75 2 6 5 -5 9 0 6 Notice 96-133 TO: The Chief Executive Officer of each financial institution and others concerned in the Eleventh Federal Reserve District SUBJECT Approval of an Updated Uniform Financial Institutions Rating System and Extension of Comment Period on Proposed Amendments to Regulations G, T, and U DETAILS The Federal Financial Institutions Examination Council’s (FFIEC) Task Force on Supervision announced the approval of an updated Uniform Financial Institu tions Rating System. The task force is recommending that FFIEC member agencies adopt and implement the updated rating system effective January 1, 1997. The Board of Governors of the Federal Reserve System has extended the time to receive public comments on proposed amendments to its margin regulations (Regulations G, T, and U). This action has been taken at the request of commenters to allow more time to analyze the proposal and provide meaningful comments. Comments must now be received by January 31, 1997. Please address com ments to William W. Wiles, Secretary, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue, N.W., Washington, D.C. 20551. All comments should refer to Docket No. R-0944. ATTACHMENT A copy of the updated rating system as it appears on pages 67021-29, Vol. 61, No. 245, of the Federal Register dated December 19, 1996, is attached. For additional copies, bankers and others are encouraged to use one o f the following toll-free numbers in contacting the Federal Reserve Bank o f Dallas: Dallas Office (800) 333 -4460; El Paso Branch Intrastate (800) 592-1631, Interstate (800) 351-1012; H ouston Branch Intrastate (800) 392-4162, Interstate (800) 221-0363; San A ntonio Branch Intrastate (800) 292-5810. This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org) MORE INFORMATION For more information regarding the updated rating system, please contact M arion White at (214) 922-6155, or Ann Worthy at (214) 922-6156. For more information regarding Regulations G, T, and U, please contact Eugene Coy at (214) 922-6201. For additional copies of this Bank’s notice, please contact the Public Affairs Departm ent at (214) 922-5254. Sincerely yours, Federal Register / Vol. 61, No. 245 / Thursday, December 19, 1996 / Notices 67021 FEDERAL FINANCIAL INSTITUTIONS EXAMINATION COUNCIL Uniform Financial Institutions Rating System AGENCY: Federal Financial Institutions Examination Council. ACTION: Notice. The Federal Financial Institutions Examination Council (FFIEC) is revising the Uniform Financial Institutions Rating System (UFIRS), which is commonly referred to as the CAMEL rating system. The term “financial institutions” refers to those insured depository institutions whose primary Federal supervisory agency is represented on the FFIEC. The agencies comprising the FFIEC are the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Adm inistration (NCUA), the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS). The revisions update the rating system to address changes in the financial services industry and in supervisory policies and procedures occurring since the rating system was adopted in 1979. The changes include: reformatting and clarification of component rating descriptions and com ponent rating definitions; adding a sixth component addressing sensitivity to market risk; increasing emphasis on the quality of risk management practices in each of the rating components, particularly in the Management component; revising the composite rating definitions; and explicitly identifying the risks considered in assigning component ratings. DATES: December 19, 1996. SUMMARY: FOR FURTHER INFORMATION CONTACT: OCC: Lawrence W. (Bill) Morris, National Bank Examiner, Office of the Chief National Bank Examiner, (202) 874-5350, Office of the Comptroller of the Currency, 250 E Street SW, Washington, D.C. 20219. FRB: Kevin Bertsch, Supervisory Financial Analyst, (202) 452-5265, or Constance Powell, Supervisory Financial Analyst, (202) 452-3506, Division of Banking Supervision and Regulation, Board of Governors of the Federal Reserve System, 20th and C Streets NW, Washington, D.C. 20551. For the hearing impaired only, Telecommunication Device for the Deaf (TDD), Dorothea Thompson, (202) 452 3544. FDIC: Daniel M. Gautsch, Examination Specialist, (202) 898-6912, 67022 Federal Register / Vol. 61, No. 245 / Thursday, December 19, 1996 / Notices Office of Policy, Division of Supervision. For legal issues, Linda L. Stamp, Counsel, (202) 898-7310, Supervision and Legislation Branch, Federal Deposit Insurance Corporation, 550 17th Street NW, Washington, D.C. 20429. OTS: William J. Magrini, Senior Project Manager, (202) 906-5744, Supervision Policy, Office of Thrift Supervision, 1700 G Street NW, Washington, D.C. 20552. SUPPLEMENTARY INFORMATION: Background Information On July 18,1996, the FFIEC published a notice and request for comment in the Federal Register (July Notice), 60 FR 37472, requesting comment on proposed revisions to the UFIRS. The UFIRS is an internal rating system used by the Federal supervisory agencies and State supervisory agencies for evaluating the soundness of financial institutions on a uniform basis and for identifying those institutions requiring special supervisory attention or concern. The UFIRS takes into consideration a careful evaluation of managerial, operational, financial, and compliance performance factors common to all institutions. The UFIRS is used by the supervisory agencies to monitor aggregate trends in the overall soundness of financial institutions. The UFIRS also provides a means for the supervisory agencies to monitor, for various statistical and supervisory purposes, the types and severity of problems that institutions may be experiencing, and to determ ine the level of supervisory concern that is warranted. Under the UFIRS, each financial institution is assigned a composite rating based on an evaluation and rating of essential components of an institution’s financial condition and operations. Under the former UFIRS, the com ponent factors addressed the adequacy of capital, the quality of assets, the capability of the board of directors and management, the quality and level of earnings, and the adequacy of liquidity. The composite and com ponent ratings are assigned on a 1 to 5 num erical scale. A 1 indicates the strongest performance and management practices and the lowest degree of supervisory concern. A 5 indicates the weakest performance and management practices and the highest degree of supervisory concern. The UFIRS is an effective tool for the supervisory agencies to determine the safety and soundness of financial institutions. A num ber of changes, however, have occurred in the financial services industry and in supervisory policies and procedures since the rating system was adopted in 1979. As a result, the FFIEC is making certain enhancements to the rating system but is retaining its basic framework. The enhancements include: reformatting and clarifying the com ponent rating descriptions and com ponent rating definitions; adding a new sixth component, Sensitivity to Market Risk; increasing emphasis on the quality of risk management processes in each of the component ratings, particularly in the Management component; adding language in the composite rating definitions to parallel the changes in the com ponent rating descriptions; and identifying the types of risk associated w ith each com ponent area. The FFIEC notes that some Federal supervisory agencies’ regulations reference the institution’s UFIRS or CAMEL rating in determining an institution’s status under those regulations. The Federal supervisory agencies may consider amending those regulations to incorporate changes made to the UFIRS system. Comments Received and Changes Made The FFIEC received 55 comments regarding the proposed revisions to UFIRS. Thirty-four of the comments were from banks and thrifts, ten from state banking departments, five from trade associations, two from FRB offices, two from consultants, and two from Federal bank examiners. Commenters generally favored the changes to the rating system regarding structure and format, reference to risk management practices, identification ofrisk types, and revisions to the composite and com ponent rating definitions. However, commenters were divided regarding the new component on sensitivity to market risk. Examiners field tested the revised rating system during 185 bank and thrift examinations conducted between July and October, 1996. The examiners provided comments regarding the revised rating system. Examiner response generally was favorable for the revised rating system, including the new sixth component. Few significant problems or rating differences were encountered between the former and the updated UFIRS. Many commenters and examiners recommended clarifying changes to' various aspects of the revised rating system. The FFIEC carefully considered each comment and examiner response and is making certain changes. The following discussion describes the comments received and changes made to the UFIRS in response to the comments. The updated UFIRS is included at the end of this Notice. July Notice Specific Questions In addition to requesting general comments regarding the proposed rating system, the FFIEC invited comments on two specific questions: (1) Does the proposed, revised rating system capture the essential aspects o f a financial institution’s condition, com pliance with laws and regulations, and overall operating soundness? I f not, what additional or different com ponents should be considered? The majority of responses to this question were positive and indicated no additional or different components should be considered. Some commenters noted concerns with or the need for clarification of the new sixth component. These concerns are addressed later in this Notice. (2) Does the proposed m anagem ent com ponent rating adequately represent an assessm ent o f the quality o f the board o f directors’ and m anagem ent’s oversight regarding an institution’s operating performance, risk m anagem ent practices, and internal controls? If not, what other factors should be considered when rating management? The majority of responses to this question were favorable. A num ber of commenters recommended that the Management com ponent make a clearer distinction between the role of the board of directors and the role of senior management. The FFIEC added language to the Management com ponent that recognizes the different responsibilities of these two management groups. Structure and Format o f Component Descriptions The July Notice enhanced and clarified component rating descriptions by reformatting each component into three distinct sections: (1) An introductory paragraph discussing the areas to be considered when rating each component; (2) a bullet-style listing of the evaluation factors to be considered w hen assigning com ponent ratings; and (3) a brief, qualitative description of the five rating grades that can be assigned to a particular component. Several commenters expressed concern that component descriptions and component rating definitions need clear distinction and differentiation between rating levels. The FFIEC acknowledges the need for clear distinction and differentiation between com ponent rating levels. The UFIRS now reflects changed o r added language tp clarify that the component Federal Register / Vol. 61, No. 245 / Thursday, December 19, 1996 / Notices rating assessments consider an institution’s size, the nature and complexity of its business activities, and its risk profile. Sentence structure, coupled w ith other m inor language changes, were m ade to enhance parallelism and to improve differentiation between com ponent rating levels. Some commenters expressed concern regarding the num ber of evaluation factors w ithin each com ponent, the subjectivity associated w ith the evaluation factors, the order in which evaluation factors were listed, the redundancy of evaluation factors between components, and the need for clarification of some of the evaluation factors. The FFIEC made revisions to the UFIRS to better structure and identify the factors that examiners traditionally consider as part of their assessment of a com ponent area. This allows examiners and bankers to have a better understanding of w hat is being assessed under each component. Since its inception, the UFIRS has always contained elem ents of subjectivity and examiner judgment w hen assigning a rating, particularly as it relates to qualitative assessments of policies, practices, processes, and systems. Subjectivity and judgment cannot be elim inated but, as in the past, it can be reasonably applied based on the exam iner’s experience and knowledge, and their familiarity w ith the unique characteristics of the institution being examined. The list of evaluation factors under each component is not meant to be all inclusive and appropriate language is added to the UFIRS noting that the evaluation factors are not listed in any particular order of importance. This allows examiners the flexibility of. assessing factors that are most pertinent to the institution’s situation and risk profile. The FFIEC also acknowledges that there is a certain degree of redundancy between the component evaluation factors. For example, certain factors, such as the ability of management to identify, measure, monitor, and control risk, apply to each of the components and are an integral part of each com ponent’s rating. In addition, the level of classified assets will also impact the Asset Quality com ponent and the Capital and Earnings components. This analysis should not be considered as “double counting,” but rather as a balanced assessment of how an evaluation factor can impact several component areas. The FFIEC, however, has removed the evaluation factor referring to com pliance w ith laws and regulations from all but the Management component. In addition, m inor language changes are made to some of the com ponent evaluation factors for clarification purposes. Sensitivity to M arket Risk Component The July Notice added a sixth rating com ponent addressing sensitivity to market risk and the degree to which changes in interest rates, foreign exchange rates, commodity prices, or equity prices can adversely affect a financial institution’s earnings or economic capital. A number of commenters noted that the sensitivity to market risk already is considered under the existing com ponents and questioned the need for the new component. The FFIEC acknowledges that market risk is already considered under the UFIRS; however, adding a new component provides a more precise indication of an institution’s ability to m onitor and manage its market risk. Since the sensitivity to market risk is already considered w hen assigning UFIRS ratings, the addition of the new com ponent should not result in a change to the composite ratings being assigned. The principal benefit of this new component is that it gives a clearer indication of supervisory concerns related to market risk than can be gained from the former UFIRS. For example, a financial institution w ith weak earnings and poor liquidity also might have significant and poorly managed exposures to interest rate risk. Less than satisfactory com ponent ratings for earnings or liquidity accorded an institution under the former UFIRS would not specifically note a problem with exposure to, or the management of, market risk. Under the updated UFIRS, however, it is now possible to determine whether an institution has less than satisfactory earnings, a deficiency in its level or management of liquidity, and a problem with its exposure to market risks. Other commenters objected to the new component on the grounds that it will place too much weight on a risk that is insignificant to most institutions and may result in examiners requiring elaborate market risk management systems where relatively basic management practices would suffice. The FFIEC acknowledges that, for most institutions, market risk primarily reflects exposures to changes in interest rates. Currently, interest rate risk is not a significant problem for the industry. In light of the level of risk embodied in 67023 this component for most institutions, the Federal supervisory agencies do not anticipate examiners overemphasizing this com ponent when assigning a composite rating. For the institutions that choose to take on greater market risk through holdings of complicated investments or hedging instrum ents or as part of significant trading activities, the exposure to, and management of, market risk is more significant to their overall risk profile. Thus, it is possible more weight will be assigned to the new component in determining the composite rating under UFIRS for institutions engaging in these activities. This is consistent with the Federal supervisory agencies’ views that, when assigning a composite rating, examiners should determine the weight placed on each component based upon the particular situation of the institution, not on an arithmetic average of the components. Thus, supervisory expectations for the management of market risk remain unchanged; the quality of management systems m ust be commensurate with risk exposure. Accordingly, the new com ponent does not imply a requirement to develop enhanced management systems where market risk already is being identified, measured, monitored, and controlled in a manner appropriate to the institution’s market risk exposure. Several commenters also raised concerns about a perceived emphasis on the absolute level of market risk in the rating descriptions for the sensitivity to market risk component. The FFIEC agrees that the evaluation of market risk m ust take into account the capital and earnings of an institution and the quality of its risk management practices. Accordingly, the description of the new component and its rating definitions have been revised to reflect this view. Risk M anagement The revised rating system reflects an increased emphasis on risk management processes. The Federal supervisory agencies currently consider the quality of risk management practices when applying the UFIRS, particularly in the management component. Changes in the financial services industry, however, have broadened the range of financial products offered by institutions and accelerated the pace of transactions. These trends reinforce the importance of institutions having sound risk management systems. Accordingly, the revised rating system contains explicit language in each of the components emphasizing management’s ability to 67024 Federal Register / Vol. 61, No. 245 / Thursday, December 19, 1996 / Notices identify, measure, m onitor, and control risks. Several commenters expressed concern that the revised rating system would add to an institution’s regulatory burden; require additional policies, processes, and highly formalized management information systems; or prevent institutions from attaining the highest ratings if they did not have formalized risk management policies and systems. The FFIEC recognizes that management practices, particularly as they relate to risk management, vary considerably among financial institutions depending on their size and sophistication, the nature and complexity of their business activities, and their risk profile. Each institution must properly manage its risks and have appropriate policies, processes, or practices in place that management follows and uses. Activities undertaken in a less complex institution engaging in less sophisticated risk-taking activities may only need basic management and control systems compared to the detailed and formalized systems and controls needed for the broader and more complex range of activities undertaken at a larger and more complex institution. The FFIEC added appropriate language clarifying that the UFIRS does not add to the regulatory burden of institutions, but promotes and complements efficient examination processes. The FFIEC also added language clarifying that detailed or highly formalized management systems and controls are not required for less complex institutions engaging in less sophisticated risk taking activities to receive the higher composite and com ponent ratings. Composite Rating D efinitions The July Notice retained the basic context of the existing composite rating definitions. The composite ratings are based on a careful evaluation of ah institution’s managerial, operational, financial, and com pliance performance. The revised composite rating definitions contain an explicit reference to the quality of overall risk management practices. A number of commenters recommended that the composite rating definitions contain a clearer distinction between rating levels, include a better perspective oh examiner flexibility in considering the evaluation factors, and clarify other language to ensure consistent and uniform application by supervisory agencies. The FFIEC agrees and has made certain changes in the structure and language of the composite rating definitions to address the concerns raised about examiner flexibility when assigning ratings based on an institution’s particular circumstances. The principal change includes language to note explicitly that examiners consider an institution’s size, complexity, and risk profile w hen assessing risk management practices. O ther changes include sentence structure and other language changes in each of the composite rating definitions for better parallelism and readability from one definition to another and to provide clearer distinction between rating levels. Peer Data Comparisons Some commenters noted the lack of references to peer comparisons in component descriptions and rating definitions in the UFIRS. The FFIEC acknowledges that it does not include peer comparison data in the updated rating system. The principal reason is to avoid over reliance on statistical comparisons to justify the com ponent rating being assigned. Examiners are encouraged to consider all relevant factors when assigning a com ponent rating. The rating system is designed to reflect an assessment of the individual institution. Peer data are a part of the overall assessment process, however. Com ponent Rating Disclosure Several commenters noted that com ponent ratings should be disclosed to an institution’s board of directors and senior management. The FFIEC agrees that component ratings should be disclosed to an institution’s board of directors and senior management and recommended that the FDIC, FRB, OCC, and OTS begin disclosing component ratings in reports of examination no later than January 1, 1997. The FDIC began disclosing com ponent ratings in reports of examination in process after September 30,1996. The other Federal supervisory agencies expect to begin such disclosures oh or before January 1,1997. The FFIEC inserted into the Overview section of ths UFIRS appropriate language noting that both composite and component ratings are disclosed to an institution’s board of directors and senior management. Specialty Area Examinations Some commenters recommended that the specialty area examinations, i.e., Bank Information Systems, Fiduciary, Consumer Compliance, CRA, etc., be integrated into the rating system. The FFIEC acknowledges that results of such specialty examinations currently are taken into consideration w hen assigning an institution’s composite rating or component ratings, as appropriate. Generally, the im pact of specialty area examination findings are reflected in the composite and Management component ratings. However, other factors, such as reimbursable violations under Regulation Z (12 CFRPart 226), if substantial, could impact an institution’s capital or earnings performance. The FFIEC added appropriate language to the revised UFIRS noting that Foreign Branch examination and specialty examination findings (Compliance, CRA, Government Security Dealers, Information Systems, M unicipal Security Dealers, Transfer Agent, and Fiduciary) and the ratings assigned to those areas are taken into consideration, as appropriate, when assigning a composite rating and component ratings under UFIRS. Im plem entation Date The FFIEC recommends that the Federal supervisory agencies implement the updated UFIRS no later than January 1,1997. This date provides the Federal supervisory agencies flexibility to implement the updated UFIRS in conjunction with procedures for disclosing both composite and component ratings, as appropriate, to institutions’ boards of directors and senior management. This date also ensures that institutions with examinations commenced in 1997 will be assessed under the updated UFIRS. Text of the Revised Uniform Financial Institutions Rating System Uniform Financial Institutions1 Rating System Introduction The Uniform Financial Institutions Rating System (UFIRS) was adopted by the Federal Financial Institutions Examination Council (FFIEC) on November 13,1979. Over the years, the UFIRS has proven to be an effective internal supervisory tool for evaluating 1For purposes of this rating system, the term “financial institution” refers to those insured depository institutions whose primary Federal supervisory agency is represented on the Federal Financial Institutions Examination Council (FFIEC). The agencies comprising the FFIEC are the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the National Credit Union Administration, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision. The term “ financial institution” includes Federally supervised commercial banks, savings and loan associations, mutual savings banks, and credit unions. Federal Register / Vol. 61, No. 245 / Thursday, December 19, 1996 / Notices the soundness of financial institutions on a uniform basis and for identifying those institutions requiring special attention or concern. A num ber of changes, however, have occurred in the banking industry and in the Federal supervisory agencies’ policies and procedures which have prom pted a review and revision of the 1979 rating system. The revisions to UFIRS include the addition of a sixth com ponent addressing sensitivity to market risks, the explicit reference to the quality of risk management processes in the management component, and the identification of risk elem ents w ithin the composite and com ponent rating descriptions. The revisions to UFIRS are not intended to add to the regulatory burden of institutions or require additional policies or processes. The revisions are intended to promote and complement efficient examination processes. The revisions have been made to update the rating system, w hile retaining the basic framework of the original rating system. The UFIRS takes into consideration certain financial, managerial, and compliance factors that are common to all institutions. Under this system, the supervisory agencies endeavor to ensure that all financial institutions are evaluated in a com prehensive and uniform manner, and that supervisory attention is appropriately focused on the financial institutions exhibiting financial and operational weaknesses or adverse trends. The UFIRS also serves as a useful vehicle for identifying problem or deteriorating financial institutions, as well as for categorizing institutions with deficiencies in particular component areas. Further, the rating system assists Congress in following safety and soundness trends and in assessing the aggregate strength and soundness of the financial industry. As such, the UFIRS assists the agencies in fulfilling their collective mission of maintaining stability and public confidence in the nation’s financial system. Overview Under the UFIRS, each financial institution is assigned a composite rating based on an evaluation and rating of six essential com ponents of an institution’s financial condition and operations. These com ponent factors address the adequacy of capital, the quality of assets, the capability of management, the quality and level of earnings, the adequacy of liquidity, and the sensitivity to market risk. Evaluations of the com ponents take into consideration the institution’s size and sophistication, the nature and complexity of its activities, and its risk profile. Composite and com ponent ratings are assigned based on a 1 to 5 numerical scale. A 1 indicates the highest rating, strongest performance and risk management practices, and least degree of supervisory concern, while a 5 indicates the lowest rating, weakest performance, inadequate risk management practices and, therefore, the highest degree of supervisory concern. The composite rating generally bears a close relationship to the component ratings assigned. However, the composite rating is not derived by computing an arithmetic average of the com ponent ratings. Each component rating is based on a qualitative analysis of the factors comprising that com ponent and its interrelationship w ith the other components. When assigning a composite rating, some com ponents may be given more weight than others depending on the situation at the institution. In general, assignment of a composite rating may incorporate any factor that bears significantly on the overall condition and soundness of the financial institution. Assigned composite and com ponent ratings are disclosed to the institution’s board of directors and senior management. The ability of management to respond to changing circumstances and to address the risks that may arise from changing business conditions, or the initiation of new activities or products, is an important factor in evaluating a financial institution’s overall risk profile and the level of supervisory attention warranted. For this reason, the management com ponent is given special consideration when assigning a composite rating. The ability of management to identify, measure, monitor, and control the risks of its operations is also taken into account when assigning each component rating. It is recognized, however, that appropriate management practices vary considerably among financial institutions, depending on their size, complexity, and risk profile. For less complex institutions engaged solely in traditional banking activities and whose directors and senior managers, in their respective roles, are actively involved in the oversight and management of day-to-day operations, relatively basic management systems and controls may be adequate. At more complex institutions, on the other hand, detailed and formal management systems and controls are needed to address their broader range of financial activities and to provide senior managers and directors, in their 67025 respective roles, w ith the information they need to monitor and direct day-today activities. All institutions are expected to properly manage their risks. For less complex institutions engaging in less sophisticated risk taking activities, detailed or highly formalized management systems and controls are not required to receive strong or satisfactory com ponent or composite ratings. Foreign Branch and specialty examination findings and the ratings assigned to those areas are taken into consideration, as appropriate, when assigning component and composite ratings under UFIRS. The specialty examination areas include: Compliance, Community Reinvestment, Government Security Dealers, Information Systems, M unicipal Security Dealers, Transfer Agent, and Trust. The following two, sections contain the composite rating definitions, and the descriptions and definitions for the six component ratings. Composite Ratings Composite ratings are based on a careful evaluation of an institution’s managerial, operational, financial, and compliance performance. The six key components used to assess an institution’s financial condition and operations are: capital adequacy, asset quality, management capability, earnings quantity and quality, the adequacy of liquidity, and sensitivity to market risk. The rating scale ranges from 1 to 5, with a rating of 1 indicating: the strongest performance and risk management practices relative to the institution’s size, complexity, and risk profile; and the level of least supervisory concern. A 5 rating indicates: the most critically deficient level of performance; inadequate risk management practices relative to the institution’s size, complexity, and risk profile; and the greatest supervisory concern. The composite ratings are defined as follows: Composite 1 Financial institutions in this group are sound in every respect and generally have components rated 1 or 2. Any weaknesses are m inor and can be handled in a routine manner by the board of directors and management. These financial institutions are the most capable of withstanding the vagaries of business conditions and are resistant to outside influences such as economic instability in their trade area. These financial institutions are in substantial compliance with laws and regulations. As a result, these financial institutions exhibit the strongest performance and 67026 Federal Register / Vol. 61, No. 245 / Thursday, December 19, 1996 / Notices risk management practices relative to the institution’s size, complexity, and risk profile, and give no cause for supervisory concern. Composite 2 Financial institutions in this group are fundamentally sound. For a financial institution to receive this rating, generally no com ponent rating should be more severe than 3. Only moderate weaknesses are present and are well w ithin the board of directors’ and management’s capabilities and willingness to correct. These financial institutions are stable and are capable of withstanding business fluctuations. These financial institutions are in substantial com pliance w ith laws and regulations. Overall risk management practices .are satisfactory relative to the institution’s siz§, complexity, and risk profile. There are no material supervisory concerns and, as a result, the supervisory response is informal and limited. Composite 3 Financial institutions in this group exhibit some degree of supervisory concern in one or more of the component areas. These financial institutions exhibit a com bination of weaknesses that may range from moderate to severe; however, the magnitude of the deficiencies generally w ill not cause a component to be rated more severely than 4. Management may lack the ability or willingness to effectively address weaknesses w ithin appropriate tim e frames. Financial institutions in this group generally are less capable of w ithstanding business fluctuations and are more vulnerable to outside influences than those institutions rated a composite 1 or 2. Additionally, these financial institutions may be in significant noncompliance with laws and regulations. Risk management practices may be less than satisfactory relative to the institution’s size, complexity, and risk profile. These financial institutions require more than normal supervision, which may include formal or informal enforcement actions. Failure appears unlikely, however, given the overall strength and financial capacity of these institutions. Composite 4 Financial institutions in this group generally exhibit unsafe and unsound practices or conditions. There are serious financial or managerial deficiencies that result in unsatisfactory performance. The problems range from severe to critically deficient. The weaknesses and problems are not being satisfactorily addressed or resolved by the board of directors and management. Financial institutions in this group generally are not capable of w ithstanding business fluctuations. There may be significant noncom pliance w ith laws and regulations. Risk management practices are generally unacceptable relative to the institution’s size, complexity, and risk profile. Close supervisory attention is required, w hich means, in m ost cases, formal enforcement action is necessary to address the problems. Institutions in this group pose a risk to the deposit insurance hind. Failure is a distinct possibility if the problems and weaknesses are not satisfactorily addressed and resolved. Composite 5 Financial institutions in this group exhibit extremely unsafe and unsound practices or conditions; exhibit a critically deficient performance; often contain inadequate risk management practices relative to the institution’s size, complexity, and risk profile; and are of the greatest supervisory concern. The volume and severity of problems are beyond management’s ability or willingness to control or correct. Immediate outside financial or other assistance is needed in order for the financial institution to be viable. Ongoing supervisory attention is necessary. Institutions in this group pose a significant risk to the deposit insurance fund and failure is highly probable. Component Ratings Each of the com ponent rating descriptions is divided into three sections: an introductory paragraph; a list of the principal evaluation factors that relate to that component; and a brief description of each numerical rating for that component.' Some of the evaluation factors are reiterated under one or more of the other components to reinforce the interrelationship between components. The listing of evaluation factors for each com ponent rating is in no particular order of importance. Capital A dequacy A financial institution is expected to maintain capital commensurate w ith the nature and extent of risks to the institution and the ability of management to identify, measure, monitor, and control these risks. The effect of credit, market, and other risks on the institution’s financial condition should be considered when evaluating the adequacy of capital. The types and quantity of risk inherent in an institution’s activities will determine the extent to w hich it may be necessary to m aintain capital at levels above required regulatory minim um s to properly reflect the potentially adverse consequences that these risks may have on the institution’s capital. The capital adequacy of an institution is rated based upon, but not limited to, an assessment of the following evaluation factors: • The level and quality of capital and the overall financial condition of the institution. • The ability of management to address emerging needs for additional capital. • The nature, trend, and volume of problem assets, and the adequacy of allowances for loan and lease losses and other valuation reserves. • Balance sheet composition, including the nature and am ount of intangible assets, market risk, concentration risk, and risks associated w ith nontraditiohal activities. • Risk exposure represented by offbalance sheet activities. • The quality and strength of earnings, and the reasonableness of dividends. • Prospects and plans for growth, as well as past experience in managing growth. • Access to capital markets and other sources of capital, including support provided by a parent holding company. Ratings 1 A rating of 1 indicates a strong capital level relative to the institution’s risk profile. 2 A rating of 2 indicates a satisfactory capital level relative to the financial institution’s risk profile. 3 A rating of 3 indicates a less than satisfactory level of capital that- does not fully support the institution’s risk profile. The rating indicates a need for improvement, even if the institution’s capital level exceeds minimum regulatory and statutory requirements. 4 A rating of 4 indicates a deficient level of capital. In light of the institution’s risk profile, viability of the institution may be threatened. Assistance from shareholders or other external sources of financial support may be required. 5 A rating of 5 indicates a critically deficient level of capital such that the institution’s viability is threatened. Immediate assistance from shareholders or other external sources of financial support is required. A sset Quality The asset quality rating reflects the quantity of existing and potential credit risk associated witih the loan and Federal Register / Vol. 61, No. 245 / Thursday, December 19, 1996 / Notices investment portfolios, other real estate owned, and other assets, as well as offbalance sheet transactions. The ability of management to identify, measure, monitor, and control credit risk is also reflected here. The evaluation of asset quality should consider the adequacy of the allowance for loan and lease losses and weigh the exposure to counterparty, issuer, or borrower default under actual or im plied contractual agreements. All other risks that may affect the value or marketability of an institution’s assets, including, but not lim ited to, operating, market, reputation, strategic, or compliance risks, should also be considered. The asset quality of a financial ■ institution is rated based upon, but not limited to, an assessment of the following evaluation factors: • The adequacy of underwriting standards, soundness of credit adm inistration practices, and appropriateness of risk identification practices. • The level, distribution, severity, and trend of problem, classified, nonaccrual, restructured, delinquent, and nonperforming assets for both onand off-balance sheet transactions. • The adequacy of the allowance for loan and lease losses and other asset valuation reserves. • The credit risk arising from or reduced by off-balance sheet transactions, such as unfunded commitments, credit derivatives, commercial and standby letters of credit, and lines of credit. • The diversification and quality of the loan and investm ent portfolios. • The extent of securities underwriting activities and exposure to counterparties in trading activities. • The existence of asset concentrations. • The adequacy of loan and investment policies, procedures, and practices. • The ability of management to properly adm inister its assets, including the timely identification and collection of problem assets. • The adequacy of internal controls and management information systems. • The volume and nature of credit documentation exceptions. Ratings 1 A rating of 1 indicates strong asset quality and credit adm inistration practices. Identified weaknesses are minor in nature and risk exposure is modest in relation to capital protection and management’s abilities. Asset quality in such institutions is of minimal supervisory concern. 2 A rating of 2 indicates satisfactory asset quality and credit _ adm inistration practices. The level and severity of classifications and other weaknesses warrant a limited level of supervisory attention. Risk exposure is commensurate with capital protection and m anagement’s abilities. 3 A rating of 3 is assigned w hen asset quality or credit adm inistration practices 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 adm inistration and risk management practices. 4 A rating of 4 is assigned to financial institutions w ith deficient asset quality or credit administration practices. The levels of risk and problem assets are significant, inadequately controlled, and subject the financial institution to potential losses that, if left unchecked, may threaten its viability. 5 A rating of 5 represents critically deficient asset quality or credit adm inistration practices that present an imminent threat to the institution’s viability. M anagement The capability of the board of directors and management, in their respective roles, to identify, measure, monitor, and control the risks of an institution’s activities and to ensure a financial institution’s safe, sound, and efficient operation in compliance with applicable laws and regulations is reflected in this rating. Generally, directors need not be actively involved in day-to-day operations; however, they must provide clear guidance regarding acceptable risk exposure levels and ensure that appropriate policies, procedures, and practices have been established. Senior management is responsible for developing and implementing policies, procedures, and practices that translate the board’s goals, objectives, and risk lim its into prudent operating standards. Depending on the nature and scope of an institution’s activities, management practices may need to address some or all of the following risks: credit, market, operating or transaction, reputation, strategic, compliance, legal, liquidity, and other risks. Sound management practices are dem onstrated by: active oversight by the board of directors and management; competent personnel; adequate policies, processes, and 67027 controls taking into consideration the size and sophistication of the institution; m aintenance of an appropriate audit program and internal control environment; and effective risk monitoring and management information systems. This rating should reflect the board’s and management’s ability as it applies to all aspects of banking operations as well as other financial service activities in w hich the institution is involved. The capability and performance of management and the board of directors is rated based upon, but not limited to, an assessment of the following evaluation factors: • The level and quality of oversight and support of all institution activities by the board of directors and management. • The ability of the board of directors and management, in their respective roles, to plan for, and respond to, risks that may arise from changing business conditions or the initiation of new activities or products. • The adequacy of, and conformance with, appropriate internal policies and controls addressing the operations and risks of significant activities. • The accuracy, timeliness, and effectiveness of management information and risk monitoring systems appropriate for the institution’s size, complexity, and risk profile. • The adequacy of audits and internal controls to: promote effective operations and reliable financial and regulatory reporting; safeguard assets; and ensure compliance w ith laws, regulations, and internal policies. • Compliance with laws and regulations. • Responsiveness to recommendations from auditors and supervisory authorities. • Management depth and succession. • The extent that the board of directors and management is affected by, or susceptible to, dominant influence or concentration of authority. • Reasonableness of compensation policies and avoidance of Self-dealing. • Demonstrated willingness to serve the legitimate banking needs of the community. • The overall performance of the institution and its risk profile. Ratings 1 A rating of 1 indicates strong performance by management and the board of directors and strong risk management practices relative to the institution’s size, complexity, and risk profile. All significant risks are consistently and effectively identified, measured, monitored, and controlled. 67028 2 3 4 5 Federal Register / Vol. 61, No. 245 / Thursday, December 19, 1996 / Notices Management and the board have dem onstrated the ability to promptly and successfully address existing and potential problems and risks. A rating of 2 indicates satisfactory management and board performance and risk management practices relative to the institution’s size, complexity, and risk profile. Minor weaknesses may exist, but are not material to the safety and soundness of the institution and are being addressed. In general, significant risks and problems are effectively identified, measured, monitored, and controlled. A rating of 3 indicates management and board performance that need improvement or risk management practices that are less than satisfactory given the nature of the institution’s activities. The capabilities of management or the board of directors may be insufficient for the type, size, or condition of the institution. Problems and significant risks may be inadequately identified, measured, m onitored, or controlled. A rating of 4 indicates deficient management and board performance or risk management practices that are inadequate considering the nature of an institution’s activities. The level of problems and risk exposure is excessive. Problems and significant risks are inadequately identified, measured, monitored, or controlled and'require immediate action by the board and management to preserve the soundness of the institution. Replacing or strengthening management or the board may be necessary. A rating of 5 indicates critically deficient management and board performance or risk management practices. Management and the board of directors have not demonstrated the ability to correct problems and im plem ent appropriate risk management practices. Problems and significant risks are inadequately identified, measured, monitored, or controlled and now threaten the continued viability of the institution. Replacing or strengthening management or the board of directors is necessary. Earnings This rating reflects not only the quantity and trend of earnings, but also factors that may affect the sustainability or quality of earnings. The quantity as well as the quality of earnings can be affected by excessive or inadequately managed credit risk that may result in loan losses and require additions to the allowance for loan and lease losses, or by high levels of market risk that may unduly expose an institution’s earnings to volatility in interest rates. The quality of earnings may also be dim inished by undue reliance on extraordinary gains, nonrecurring events, or favorable tax effects. Future earnings may be adversely affected by an inability to forecast or control funding and operating expenses, im properly executed or ill-advised business strategies, or poorly managed or uncontrolled exposure to other risks. The rating of an institution’is earnings is based upon, but not limited to, an assessment of the following evaluation factors: • The level of earnings, including trends and stability. • The ability to provide for adequate capital through retained earnings. • The quality and sources of earnings. • The level of expenses in relation to operations. • The adequacy of the budgeting systems, forecasting processes, and management information systems in general. • The adequacy of provisions to m aintain the allowance for loan and lease losses and other valuation allowance accounts. • The earnings exposure to market risk such as interest rate, foreign exchange, and price risks. Ratings 1 A rating of 1 indicates earnings that are strong. Earnings are more than sufficient to support operations and m aintain adequate capital and allowance levels after consideration is given to asset quality, growth, and other factors affecting the quality, quantity, and trend of earnings. 2 A rating of 2 indicates earnings that are satisfactory. Earnings are sufficient to support operations and maintain adequate capital and allowance levels after consideration is given to asset quality, growth, and other factors affecting the quality, quantity, and trend of earnings. Earnings that are relatively static, or even experiencing a slight decline, may receive a 2 rating provided the institution’s level of earnings is adequate in view of the assessment factors listed above. 3 A rating of 3 indicates earnings that need to be improved. Earnings may not fully support operations and provide for the accretion of capital and allowance levels in relation to the institution’s overall condition, growth, and other factors affecting the quality, quantity, and trend of earnings. 4 A rating of 4 indicates earnings that are deficient. Earnings are insufficient to support operations and m aintain appropriate capital and allowance levels. Institutions so rated may be characterized by erratic fluctuations in net income or net interest margin, the development of significant negative trends, nominal or unsustainable earnings, interm ittent losses, or a substantive drop in earnings from the previous years. 5 A rating of 5 indicates earnings that are critically deficient. A financial institution w ith earnings rated 5 is experiencing losses that represent a distinct threat to its viability through the erosion of capital. Liquidity In evaluating the adequacy of a financial institution’s liquidity position, consideration should be given to the current levefcand prospective sources of liquidity compared to funding needs, as well as to the adequacy of funds management practices relative to the institution’s size, complexity, and risk profile. In general, funds management practices should ensure that an institution is able to m aintain a level of liquidity sufficient to meet its financial obligations in a timely m anner and to fulfill the legitimate banking needs of its community. Practices should reflect the ability of the institution to manage unplanned changes in funding sources, as well as react to changes in market conditions that affect the ability to quickly liquidate assets w ith minimal loss. In addition, funds management practices should ensure that liquidity is not maintained at a high cost, or through undue reliance on funding sources that may not be available in times of financial stress or adverse changes in market conditions. Liquidity is rated based upon, but not limited to, an assessment of the following evaluation factors: • The adequacy of liquidity sources compared to present and future needs and the ability of the institution to meet liquidity needs w ithout adversely affecting its operations or condition. • The availability of assets readily convertible to cash without undue loss. • Access to money markets and other sources of funding. • The level of diversification of funding sources, both on- and offbalance sheet. • The degree of reliance on short term, volatile sources of funds, including borrowings and brokered deposits, to fund longer term assets. • The trend and stability of deposits. • The ability to securitize and sell certain pools of assets. Federal Register / Vol. 61, No. 245 / Thursday, December 19, 1996 / Notices • The capability of management to properly identify, measure, monitor, and control the institution’s liquidity position, including the effectiveness of funds management strategies, liquidity policies, management information systems, and contingency funding plans. In some larger institutions, foreign operations can be a significant source of market risk. For some institutions, trading activities are a major source of market risk. Market risk is rated based upon, but not limited to, an assessment of the following evaluation factors: • The sensitivity of the financial Ratings institution’s earnings or the economic 1 A rating of 1 indicates strong liquidity value of its capital to adverse changes in levels and well-developed funds interest rates, foreign exchanges rates, management practices. The institution commodity prices, or equity prices. has reliable access to sufficient . • The ability of management to sources of funds on favorable terms to identify, measure, monitor, and control meet present and anticipated liquidity exposure to market risk given the needs. institution’s size, complexity, and risk 2 A rating of 2 indicates satisfactory profile. liquidity levels and funds • The nature and complexity of management practices. The institution interest rate risk exposure arising from nontrading positions. has access to sufficient sources of • Where appropriate, the nature and funds on acceptable terms to meet complexity of market risk exposure present and anticipated liquidity arising from trading and foreign needs. Modest weaknesses may be operations. evident in funds management practices. Ratings 3 A rating of 3 indicates liquidity levels 1 A rating of 1 indicates that market or funds management practices in risk sensitivity is well controlled and need of improvement. Institutions that there is m inim al potential that rated 3 may lack ready access to funds the earnings performance or capital on reasonable terms or may evidence position will be adversely affected. significant weaknesses in funds Risk management practices are strong management practices. for the size, sophistication, and 4 A rating of 4 indicates deficient market risk accepted by the liquidity levels or inadequate funds institution. The level of earnings and management practices. Institutions capital provide substantial support for rated 4 may not have or be able to the degree of market risk taken by the obtain a sufficient volume of funds on institution. reasonable terms to meet liquidity 2 A rating of 2 indicates that market needs. risk sensitivity is adequately 5 A rating of 5 indicates liquidity levels controlled and that there is only or funds management practices so moderate potential that the earnings critically deficient that the continued performance or capital position will viability of the institution is be adversely affected. Risk threatened. Institutions rated 5 management practices are satisfactory require immediate external financial for the size, sophistication, and assistance to meet maturing market risk accepted by the obligations or other liquidity needs. institution. The level of earnings and Sensitivity to M arket Risk capital provide adequate support for The sensitivity to market risk the degree of market risk taken by the component reflects the degree to which institution. changes in interest rates, foreign 3 A rating of 3 indicates that control of exchange rates, commodity prices, or market risk sensitivity needs equity prices can adversely affect a improvement or that there is financial institution’s earnings or significant potential that the earnings economic capital. When evaluating this performance or capital position will component, consideration should be be adversely affected. Risk given to: management’s ability to management practices need to be identify, measure, monitor, and control improved given the size, market risk; the institution’s size; the sophistication, and level of market nature and complexity of its activities; risk accepted by the institution. The and the adequacy of its capital and level of earnings and capital may not earnings in relation to its level of market adequately support the degree of risk exposure. market risk taken by the institution. For many institutions, the primary 4 A rating of 4 indicates that control of source of market risk arises from market risk sensitivity is unacceptable nontrading positions and their or that there is high potential that the sensitivity to changes in interest rates. earnings performance or capital 67029 position will be adversely affected. Risk management practices are deficient for the size, sophistication, and level of market risk accepted by the institution. The level of earnings and capital provide inadequate support for the degree of market risk taken by the institution. 5 A rating of 5 indicates that control of market risk sensitivity is unacceptable or that the level of market risk taken by the institution is an imm inent threat to its viability. Risk management practices are wholly inadequate for the size, sophistication, and level of market risk accepted by the institution. End o f Proposed Text of Uniform Financial Institutions Rating System Dated: December 13,1996. Keith I. Todd, Assistant Executive Secretary, Federal Financial Institutions Exam ination Council. [FR Doc. 96-32174 Filed 12 -1 8 -9 6 ; 8:45 am] BILLING CODE 4810-33-P ; 6210-01-P ; 8710-01-P ; 6 720-01-P
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