View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Federal Reserve Bank of Dallas
2200 N. PEARL ST.
DALLAS, TX 75201-2272

August 17, 2004

Notice 04-53

TO: The Chief Executive Officer of each
financial institution and others concerned
in the Eleventh Federal Reserve District
SUBJECT
Request for Comment on
Bank Holding Company Rating System
DETAILS
The increased complexity of the U.S. banking industry has necessitated over time a
shift in the focus of the Federal Reserve’s supervisory practices for bank holding companies
(BHCs), including financial holding companies (FHCs), away from historical analyses of
financial condition toward more forward-looking assessments of risk management and financial
factors. While the emphasis on risk management has been well established in the Federal
Reserve’s supervisory processes for BHCs of all sizes, this emphasis is not reflected in the
primary components of the current BHC supervisory rating system, BOPEC (Bank subsidiaries,
Other subsidiaries, Parent, Earnings, Capital).
This document
•

Proposes a revised BHC rating system that emphasizes risk management;

•

Introduces a more comprehensive and adaptable framework for analyzing and
rating financial factors; and

•

Provides a framework for assessing and rating the potential impact of the
nondepository entities of a holding company on the subsidiary depository
institution(s).

For additional copies, bankers and others are encouraged to use one of the following toll-free numbers in contacting the Federal
Reserve Bank of Dallas: Dallas Office (800) 333-4460; El Paso Branch Intrastate (800) 592-1631, Interstate (800) 351-1012;
Houston Branch Intrastate (800) 392-4162, Interstate (800) 221-0363; San Antonio Branch Intrastate (800) 292-5810.

-2After reviewing public comments, the Federal Reserve intends to make any necessary
changes to the proposal and adopt a final BHC rating system. The Board must receive comments
by September 21, 2004. Please address comments to Jennifer J. Johnson, Secretary, Board of
Governors of the Federal Reserve System, 20th Street and Constitution Avenue, N.W.,
Washington, DC 20551. Also, you may mail comments electronically to
regs.comments@federalreserve.gov. All comments should refer to Docket No. OP-1207.
The public can also view and submit comments on proposals by the Board and other
federal agencies from the www.regulations.gov web site.
ATTACHMENT
A copy of the Board’s notice as it appears on pages 43996–44007, Vol. 69, No. 141 of
the Federal Register dated July 23, 2004, is attached.
MORE INFORMATION
For more information, please contact Dick Burda, Banking Supervision Department,
(713) 652-1503. Paper copies of this notice or previous Federal Reserve Bank notices can be
printed from our web site at www.dallasfed.org/banking/notices/index.html.

43996

Federal Register / Vol. 69, No. 141 / Friday, July 23, 2004 / Notices

Federal Reserve System
Docket No. OP–1207

Bank Holding Company Rating System
Board of Governors of the
Federal Reserve System.
ACTION: Notice and request for comment.
AGENCY:

VerDate jul<14>2003

16:28 Jul 22, 2004

Jkt 203001

SUMMARY: The increased complexity of
the U.S. banking industry has
necessitated over time a shift in the
focus of the Federal Reserve’s
supervisory practices for bank holding
companies (BHCs), including financial
holding companies (FHCs), away from
historical analyses of financial
condition toward more forward looking
assessments of risk management and
financial factors. While the emphasis on
risk management has been well
established in the Federal Reserve’s
supervisory processes for BHCs of all
sizes, this emphasis is not reflected in
the primary components of the current
BHC supervisory rating system, BOPEC
(Bank subsidiaries, Other subsidiaries,
Parent, Earnings, Capital). This
document proposes a revised BHC
rating system that emphasizes risk
management; introduces a more
comprehensive and adaptable
framework for analyzing and rating
financial factors; and provides a
framework for assessing and rating the
potential impact of the nondepository
entities of a holding company on the
subsidiary depository institution(s).
After reviewing public comments, the
Federal Reserve intends to make any
necessary changes to the proposal and
adopt a final BHC rating system.
DATES: Comments must be received by
September 21, 2004.
ADDRESSES: You may submit comments,
identified by Docket No. OP–1207, by
any of the following methods:
Board’s Web Site: http://
www.federalreserve.gov. Follow the
instructions for submitting comments at
http://www.federalreserve.gov/
generalinfo/foia/ProposedRegs.cfm.
Federal eRulemaking Portal: http://
www.regulations.gov. Follow the
instructions for submitting comments.
E–mail:
regs.comments@federalreserve.gov.
Include docket number in the subject
line of the message.
Fax: (202) 452–3819 or (202) 452–
3102.
Mail: Jennifer J. Johnson, Secretary,
Board of Governors of the Federal
Reserve System, 20th Street and
Constitution Avenue, NW., Washington,
DC 20551.
All public comments are available
from the Board’s Web site at http://
www.federalreserve.gov/generalinfo/
foia/ProposedRegs.cfm as submitted,
except as necessary for technical
reasons. Accordingly, your comments
will not be edited to remove any
identifying or contact information.
Public comments also may be viewed
electronically or in paper form in Room
MP–500 of the Board’s Martin Building

PO 00000

Frm 00032

Fmt 4703

Sfmt 4703

(C and 20th Streets, NW.) between 9
a.m. and 5 p.m. on weekdays.
FOR FURTHER INFORMATION CONTACT:
Deborah Bailey, Associate Director,
(202–452–2634), Barbara Bouchard,
Deputy Associate Director, (202–452–
3072), Molly Mahar, Senior Supervisory
Financial Analyst, (202–452–2568), or
Anna Lee Hewko, Supervisory Financial
Analyst, (202–530–6260). For users of
Telecommunications Device for the Deaf
(‘‘TDD’’) only, contact (202) 263–4869.
SUPPLEMENTARY INFORMATION:
Background
The BHC rating system is a
management information and
supervisory tool that defines the
condition of BHCs in a systematic way.
It serves three primary purposes in the
supervisory process. First and foremost,
the BHC rating provides a summary
evaluation of the BHC’s condition for
use by the supervisory community.
Second, the BHC ratings form the basis
of supervisory responses and actions.
Third, the BHC rating system provides
the basis for supervisors’ discussion of
the firm’s condition with BHC
management. The current BHC rating
system was implemented in 1979.
Known as BOPEC/F–M, the rating
system components are defined as
follows:
• The B rating represents the Federal
Reserve’s view of the condition of the
banking subsidiary(ies).
• The O rating represents the Federal
Reserve’s view of the condition of the
nonbank subsidiary(ies).
• The P rating represents the Federal
Reserve’s view of the condition of the
parent company.
• The E and C represent the Federal
Reserve’s view of the consolidated
capital and earnings position of the
BHC, respectively.
• The F rating represents the financial
composite rating, whereas the M
represents the management composite
rating.
During the almost 25 years since the
BOPEC/F–M rating system was
introduced, the banking industry has
become increasingly concentrated and
complex. BHCs with assets exceeding
$10 billion, as of year–end 2003,
accounted for over 83 percent of total
company assets, up from 66 percent, as
of year–end 1992. In addition, the
growing depth and sophistication of
financial markets in the United States
and around the world has introduced a
wider range of activities undertaken by
banking institutions. The Gramm–
Leach–Bliley Act of 1999 further raised
the complexity of the U.S. banking
industry by expanding the range of

E:\FR\FM\23JYN1.SGM

23JYN1

Federal Register / Vol. 69, No. 141 / Friday, July 23, 2004 / Notices
acceptable activities for FHCs, a subset
of BHCs. This upsurge in BHC
complexity prompted a fundamental
shift in supervisory focus away from
historical financial analyses toward
more forward–looking assessments of
risk management and financial factors.
In response to these developments,
commencing in 1996 with the
implementation of SR 95–511, the
Federal Reserve’s safety and soundness
supervisory staff have assigned a formal
supervisory rating to the adequacy of
risk management processes at all BHCs,
although that rating remains separate
from the BOPEC/F–M rating system. As
the banking industry has continued to
evolve over the past eight years, the
focus of the Federal Reserve’s
examination program for BHCs has
increasingly centered on a
comprehensive review of financial risk
and the adequacy of risk management.
However, the BOPEC/F–M rating system
has not been updated to facilitate a
broader assessment of financial risk or
to emphasize risk management,
reducing the significance of supervisory
information conveyed by the rating.
To better align the assessment process
for BHCs with current supervisory
practices, the Federal Reserve identified
the following key objectives for a new
BHC rating system:
• Elevate the prominence of risk
management in the rating system in
order to align the emphasis of the rating
system with that of our supervisory
process;
• Provide a more comprehensive
framework for assessing risk
management;
• Define the financial strength
components of the rating system in a
more comprehensive and flexible
manner, to ensure that the unique
structure of each BHC is recognized, and
that the related impact of that structure
on the depository institution
subsidiaries is evaluated; and
• Require an explicit determination as
to the likelihood that the BHC and its
nondepository subsidiaries
(nondepository entities) will have a
significant negative impact on the
depository subsidiaries, considering the
effectiveness of risk management
systems and the financial strength of the
nondepository entities.
The Federal Reserve believes that the
BHC rating system proposed below
satisfies these objectives. It also believes
that the proposed rating system is
flexible enough to remain relevant as

the banking industry continues to
evolve.
As under the current BHC rating
system, all BHCs would be assigned a
rating, although they would be subject
to differing degrees of supervisory
scrutiny depending on their size and
complexity, the significance of their
depository subsidiary(ies), and other
factors. For example, the small shell
BHC inspection program would remain
in place. Certain noncomplex BHCs
with consolidated assets of less than $1
billion in which all subsidiary
depository institutions have satisfactory
composite and management ratings
would receive only a composite rating
and a risk management rating, which
would be based on the composite and
management ratings of the lead
depository institution. Further details
are provided in the implementation
guidance section of the proposal.
The Federal Reserve recognizes that
certain regulations and administrative
processes, such as expedited application
processing, currently use a BHC’s
composite or BOPEC component rating
in determining the BHC’s status under
those regulations. It would expect to
conform those regulations and processes
to incorporate any changes made to the
BHC rating system.
Proposed Text of the Bank Holding
Company Rating System
Bank Holding Company Rating System
Introduction and Overview
The bank holding company (BHC)
rating system takes into consideration
certain financial, managerial, and
compliance factors that are common to
all BHCs. Under this system, the Federal
Reserve endeavors to ensure that all
BHCs are evaluated in a comprehensive
and uniform manner, and that
supervisory attention is appropriately
focused on the BHCs exhibiting
financial and operational weaknesses or
adverse trends. The rating system serves
as a useful vehicle for identifying
problem or deteriorating BHCs, as well
as for categorizing BHCs with
deficiencies in particular areas. Further,
the rating system assists the Federal
Reserve in following safety and
soundness trends and in assessing the
aggregate strength and soundness of the
financial industry.
Each BHC2 is assigned a composite
rating (C) based on an evaluation and
rating of three essential components and
eight subcomponents of an institution’s
financial condition and operations. The
main components represent: R – risk

1 See Supervisory Letter 95–51, Rating the
Adequacy of Risk Management Processes and
Internal Controls at State Member Banks and Bank
Holding Companies.

2 A simplified version of the rating system that
includes only the R and C components will be
applied to noncomplex bank holding companies
with assets below $1 billion.

VerDate jul<14>2003

16:28 Jul 22, 2004

Jkt 203001

PO 00000

Frm 00033

Fmt 4703

Sfmt 4703

43997

management; F – financial condition; I
– impact of the parent company and
nondepository subsidiaries (collectively
nondepository entities) on the
subsidiary depository institutions. A
fourth rating, (D), will generally mirror
the primary regulator’s assessment of
the subsidiary depository institutions.
Thus, the component and composite
ratings are displayed:
R F I / C (D)
In order to provide a consistent
framework for assessing risk
management, the R component is
supported by four qualitatively rated
subcomponents that reflect the
effectiveness of the banking
organization’s risk management and
controls. The subcomponents are:
Competence of Board and Senior
Management; Policies, Procedures, and
Limits; Risk Monitoring and
Management Information Systems; and,
Internal Controls. The F component is
supported by four numerically rated
subcomponents reflecting an assessment
of the quality of the banking
organization’s C – capital; A – asset
quality; E – earnings; and L – liquidity.
With the exception of the risk
management subcomponents,
composite, component, and
subcomponent ratings are assigned
based on a 1 to 5 numerical scale. A 1
indicates the highest rating, strongest
performance and practices, and least
degree of supervisory concern, whereas
a 5 indicates the lowest rating, weakest
performance, and the highest degree of
supervisory concern. Given that the
level of detail in the analysis of the risk
management subcomponents does not
lend itself to rating on a five–point
scale, the subcomponents will be
assigned a qualitative rating of Strong,
Adequate, or Weak.
The composite rating generally bears
a close relationship to the component
ratings assigned. Each component rating
is based on a qualitative analysis of the
factors comprising that component and
its interrelationship with the other
components. When assigning a
composite rating, some components
may be given more weight than others
depending on the situation of the BHC.
In general, assignment of a composite
rating may incorporate any factor that
bears significantly on the overall
condition and soundness of the BHC.
Therefore, the composite rating is not
derived by computing the arithmetic
average of the component ratings.
The following three sections contain
detailed descriptions of the composite,
component, and subcomponent ratings,
definitions of the ratings, and
implementation guidance by BHC type.

E:\FR\FM\23JYN1.SGM

23JYN1

43998

Federal Register / Vol. 69, No. 141 / Friday, July 23, 2004 / Notices

I. Description of the Rating System
Elements
The ‘‘R’’ (Risk Management)
Component
• R represents an evaluation of the
ability of the board of directors and
senior management to identify, measure,
monitor, and control risk. The R rating
will underscore the importance of the
control environment, taking into
consideration the financial complexity
and strength of the organization and the
risk inherent in its activities.
• The R rating is supported by four
subcomponents that are each assigned a
separate qualitative rating (strong,
adequate, or weak3). The four
subcomponents are as follows: 1)
Competence of the Board and Senior
Management; 2) Policies, Procedures
and Limits; 3) Risk Monitoring and
Management Information Systems; and
4) Internal Controls.4 The
subcomponents will be evaluated in the
context of the risks undertaken by and
inherent to a banking organization and
the overall level of complexity of the
firm’s operations.
• The subcomponents provide the
Federal Reserve System with a
consistent framework for evaluating risk
management and the control
environment. Moreover, the
subcomponents provide a clear
structure and basis for discussion of the
R rating with BHC management.
• The subcomponents reflect the
principles of SR 95–51, are familiar to
examiners, and parallel the existing risk
assessment process.
‘‘R’’ Component Subcomponents5
Competence of the Board and Senior
Management
This subcomponent evaluates the
adequacy and effectiveness of board and
senior management oversight, and the
general capabilities of management.
This analysis will include a review of
management’s ability to identify and
understand the risks undertaken by the
institution, to hire competent staff, and
to respond to changes in the
institution’s risk profile or innovations
in the banking sector.
3 The use of the three–point qualitative
evaluation system (versus a five–point numerical
rating system) will be evaluated during testing of
the new rating system.
4 Another subcomponent assessing the adequacy
of disclosure for bank holding companies using the
advanced internal ratings based approach to capital
allocation may be added once the Basel II
framework has been implemented in the United
States.
5 A detailed description of the four
subcomponents is listed in SR 95–51.

VerDate jul<14>2003

16:28 Jul 22, 2004

Jkt 203001

Policies, Procedures and Limits
This subcomponent evaluates the
adequacy of a BHC’s policies,
procedures, and limits given the risks
inherent in the activities of the
consolidated BHC and the
organization’s stated goals and
objectives. This analysis will include
consideration of the adequacy of the
institution’s accounting and risk
disclosure policies and procedures.
Risk Monitoring and Management
Information Systems
This subcomponent assesses the
adequacy of a BHC’s risk measurement
and monitoring, and the adequacy of its
management reports and information
systems. This analysis will include a
review of the assumptions, data and
procedures used to measure risk and the
consistency of these tools with the level
of complexity of the organization’s
activities.
Internal Controls
This subcomponent evaluates the
adequacy of a BHC’s internal controls
and audit procedures, including the
accuracy of financial reporting and
disclosure and the strength and
influence, within the organization, of
the audit team. This analysis will also
include a review of the independence of
control areas from business lines and
the consistency of the scope coverage of
the audit team with the complexity of
the organization.
The ‘‘F’’ (Financial Condition)
Component
• F represents an evaluation of the
consolidated organization’s financial
strength. The F rating focuses on the
ability of the BHC’s resources to support
the level of risk associated with its
activities, while taking into
consideration the ability of management
to identify, measure, monitor and
control those risks.
• The analysis of the F component
will encompass a review of financial
issues at the parent company and
nondepository subsidiaries and an
assessment of the financial impact of
those nondepository entities on the
depository institution subsidiaries. This
review should include discussions with
management, an examination of internal
documents and procedures, and all
relevant public information, including
market indicators.
• Any significant difference between
the Federal Reserve’s view of the
financial condition of the consolidated
BHC, based on public and nonpublic
information, and the market’s view of
the consolidated company should be
thoroughly assessed to determine the

PO 00000

Frm 00034

Fmt 4703

Sfmt 4703

cause of the disparity. If the Federal
Reserve’s view of the BHC is
significantly more positive than the
market’s view of the BHC, then
examination staff should review the
factors that influenced the market’s
assessment of the company, and include
those influences in their assessment of
the financial condition of the BHC, as
appropriate. Alternatively, if the Federal
Reserve’s view of the BHC is more
negative than the market’s view of the
company, then examination staff should
assess the effectiveness of the policies,
procedures and controls around the
BHC’s public disclosures. Any
deficiencies in those controls should be
factored into the overall risk
management (R) rating and the
appropriate risk management
subcomponent ratings.
• The F rating is supported by four
subcomponents that consist of the
following: C (capital), A (asset quality),
E (earnings), and L (liquidity). The
CAEL subcomponents can be evaluated
along individual business lines, product
lines, or on a legal entity basis,
depending on what is most appropriate
given the structure of the organization.
The assessment of the CAEL
components should utilize benchmarks
and metrics appropriate to the business
activity being evaluated.
• The weight afforded to each of the
CAEL subcomponents in developing the
overall F component rating will depend
on the relative importance of each
subcomponent to the consolidated
organization, as well as the severity of
the rating assigned to each
subcomponent.
‘‘F’’ Component (CAEL)
Subcomponents
In evaluating each of the CAEL
subcomponents, examination staff
should include a review of relevant
market indicators, such as equity and
debt prices, debt ratings, credit spreads,
and qualitative rating agency
assessments.
‘‘C’’ Capital Adequacy
C reflects the adequacy of an
organization’s consolidated capital
position, from a regulatory perspective
and an economic capital perspective, as
appropriate to the BHC. The evaluation
of capital adequacy should consider the
risk inherent in an organization’s
activities, the distribution of capital
across legal entities, and the
transferability of capital among legal
entities.
‘‘A’’ Asset Quality
A reflects the quality of an
organization’s consolidated assets. The
evaluation should include, as

E:\FR\FM\23JYN1.SGM

23JYN1

Federal Register / Vol. 69, No. 141 / Friday, July 23, 2004 / Notices
appropriate, on–balance sheet and off–
balance sheet exposures and the
attendant risks, the level of criticized
and nonperforming assets, the adequacy
of underwriting standards, the level of
concentration risk, the adequacy of
credit administration policies and
procedures, and the adequacy of
management information systems for
credit risk.
‘‘E’’ Earnings
E reflects the quality of consolidated
earnings. The evaluation considers the
level, trend, and sources of earnings, as
well as the ability of earnings to
augment capital as necessary, to provide
ongoing support for a BHC’s activities.
The earnings analysis should also
consider the generation of earnings
across legal entities and the
implications of that distribution.
‘‘L’’ Liquidity
L reflects the organization’s ability to
attract and maintain the sources of
funds necessary to support its
operations and meet its obligations, both
on a consolidated basis and across legal
entities. The L assessment requires an
analysis of parent company cash flow,
as well as an analysis of liquidity on a
legal entity basis. The funding
conditions for each of the legal entities
in the holding company structure
should be evaluated to determine if any
weaknesses exist that could affect the
funding profile of the consolidated
organization or the subsidiary
depository institution(s).
The ‘‘I’’ (Impact) Component
• The I component is rated on a five
point numerical scale. Ratings will be
assigned in ascending order of
supervisory concern as follows:
1 – low likelihood of significant
negative impact;
2 – limited likelihood of significant
negative impact;
3 – moderate likelihood of significant
negative impact;
4 – considerable likelihood of
significant negative impact; and
5 – high likelihood of significant
negative impact.
• The I component is an assessment
of the impact of the nondepository
entities on the subsidiary depository
institution(s). The I assessment will
consider an evaluation of both the risk
management practices and financial
condition of the nondepository entities–
–an analysis that will borrow heavily
from the analysis conducted for the R
and F components. Further, in rating the
I component, examination staff is
required to evaluate the degree to which
current or potential issues within those

VerDate jul<14>2003

16:28 Jul 22, 2004

Jkt 203001

entities present a threat to the safety and
soundness of the subsidiary depository
institution(s). In this regard, the I
component will give a clearer indication
of the degree of risk posed by the
nondepository entity(ies) to the federal
safety net than the current rating
system.
• The I component focuses on the
aggregate impact of the nondepository
entities on the subsidiary depository
institution(s). In this regard, the I rating
does not include individual
subcomponent ratings for the parent
company and nondepository
subsidiaries. Any risk management and
financial issues at the parent company
and/or nondepository subsidiaries that
potentially impact the safety and
soundness of the subsidiary depository
institution(s) should be identified in the
written comments under the I rating.
This approach is consistent with the
Federal Reserve’s objective not to
extend bank–like supervision to
nondepository entities.
• The analysis of the parent company
for the purpose of assigning an I rating
should emphasize weaknesses that
impair the parent company’s ability to
provide support to its subsidiary
depository institution(s) and
weaknesses that directly impact the risk
management or financial condition of
the subsidiary depository institution(s).
• Similarly, the analysis of the
nondepository subsidiaries for the
purpose of assigning an I rating should
emphasize weaknesses that impact the
ability of the parent company to support
the subsidiary depository institution(s)
and weaknesses that have a direct
impact on the risk management
practices or financial condition of the
subsidiary depository institution(s).
• The analysis under the I component
should consider existing as well as
potential issues and risks that may
impact the subsidiary depository
institution(s) now or in the future.
The Reserve Bank should pay
particular attention to the following risk
management and financial factors in
assigning the I rating:
Risk Management Factors
• Strategic Considerations: The
potential risks posed to the subsidiary
depository institution(s) by the parent
company and/or nondepository
subsidiaries’ strategic plans for growth
in existing activities and expansion into
new products and services;
• Operational Considerations: The
spillover impact on the subsidiary
depository institution(s) from actual
losses, a poor control environment, or
an operational loss history of the
nondepository entities; and,

PO 00000

Frm 00035

Fmt 4703

Sfmt 4703

43999

• Legal and Reputational
Considerations: The spillover effect on
the subsidiary depository institution(s)
of complaints and litigation that name
the parent company and/or
nondepository subsidiaries as
defendants, or violations of laws or
regulations, especially pertaining to
intercompany transactions where the
subsidiary depository institution(s) is
involved.
• Concentration Considerations: The
potential risks posed to the subsidiary
depository institution(s) by
concentrations within the
nondepository entities in business lines,
geographic areas, industries, customers,
or other factors.
Financial Factors
• Capital Distribution: The
distribution of capital across the
organization, given that, in general, the
Federal Reserve cannot unilaterally
require the capital of a functionally
regulated entity to be transferred to the
subsidiary depository institution(s);
• Intra–Group Exposures: The extent
to which intra–group exposures,
including servicing agreements, credit
concentrations, and derivative and
payment system exposures, have the
potential to undermine the condition of
subsidiary depository institution(s);
and,
• Parent Company Cash Flow and
Leverage: The extent to which the
parent company is dependent on
dividend payments, from both the
nondepository subsidiaries and the
subsidiary depository institution(s), to
service debt and cover fixed charges.
Also, the effect that these upstreamed
cash flows have had, or can be expected
to have, on the financial condition of
the BHC’s nondepository subsidiaries
and subsidiary depository institution(s).
The ‘‘C’’ (Composite) Rating
• C represents the overall composite
assessment of the organization based on
the quality and effectiveness of
consolidated risk management, the
BHC’s consolidated financial strength,
and the impact of the parent company
and nondepository subsidiaries on the
subsidiary depository institution(s). The
composite rating encompasses both a
forward–looking and static assessment
of the consolidated organization, and
incorporates an assessment of issues
related to the ability of the parent
company and nondepository
subsidiaries to act as a source of support
to the subsidiary depository
institution(s). The C rating is not
derived as a simple average of the R, F,
I and (D) components, but instead,
reflects examiner judgement with
respect to the relative importance of

E:\FR\FM\23JYN1.SGM

23JYN1

44000

Federal Register / Vol. 69, No. 141 / Friday, July 23, 2004 / Notices

each of the components to the overall
safety and soundness of the institution’s
operations.
The ‘‘(D)’’ (Depository Institutions)
Component
• The (D) component will generally
reflect the composite CAMELS rating
assigned by the subsidiary depository
institution’s primary regulator. In a
multi–bank BHC, the (D) rating will
reflect the combined CAMELS
composite ratings of the individual
subsidiary depository institutions, and
will consider both asset size and the
relative importance of each depository
institution within the holding company
structure. In this regard, the CAMELS
composite rating for a subsidiary
depository institution that dominates
the corporate culture may figure more
prominently in the assignment of the (D)
rating than normally dictated by asset
size, particularly when problems exist
within that depository institution.
• If in the process of analyzing the
financial condition and risk
management programs of the
consolidated organization, a major
difference of opinion relative to the
safety and soundness of the depository
institution emerges between the Federal
Reserve and the depository institution’s
primary regulator, then the (D) rating
should reflect the Federal Reserve’s
evaluation.
II. Rating Definitions for the RFI/C (D)
Rating System
‘‘R’’ (Risk Management) Component
and Subcomponents
The R component is rated on a five
point numerical scale. Ratings will be
assigned in ascending order of
supervisory concern as follows:
1 – Strong; 2 – Satisfactory; 3 – Fair; 4
– Marginal; and 5 – Unsatisfactory.
Rating 1 (Strong). A rating of 1 indicates
that management effectively identifies
and controls all major types of risk
posed by the BHC’s activities, including
those emanating from new products and
changing market conditions. The board
and management are active participants
in managing risk. Management ensures
that appropriate policies and limits exist
and are understood, reviewed, and
approved by the board. Policies and
limits are supported by risk monitoring
procedures, reports, and management
information systems that provide
management and the board with the
information and analysis that is
necessary to make timely and
appropriate decisions in response to
changing conditions. Risk management
practices and the organization’s
infrastructure are flexible and are

VerDate jul<14>2003

16:28 Jul 22, 2004

Jkt 203001

adjusted appropriately in response to
changing industry practices and current
regulatory guidance. Staff has sufficient
experience, expertise and depth to
manage the risks assumed by the
institution.
Internal controls and audit procedures
are sufficiently comprehensive and
appropriate to the size and activities of
the institution. There are few noted
exceptions to the institution’s
established policies and procedures,
and none is material. Management
effectively and accurately monitors the
condition of the institution consistent
with the standards of safety and
soundness, and in accordance with
internal and supervisory policies and
practices. Risk management processes
are fully effective in identifying,
monitoring, and controlling the risks to
the institution.
Rating 2 (Satisfactory). A rating of 2
indicates that the institution’s
management of risk is largely effective,
but lacking in some modest degree.
Management demonstrates a
responsiveness and ability to cope
successfully with existing and
foreseeable risks that may arise in
carrying out the institution’s business
plan. While the institution may have
some minor risk management
weaknesses, these problems have been
recognized and are in the process of
being resolved. Overall, board and
senior management oversight, policies
and limits, risk monitoring procedures,
reports, and management information
systems are considered satisfactory and
effective in maintaining a safe and
sound institution. Generally, risks are
controlled in a manner that does not
require more than normal supervisory
attention.
Internal controls may display modest
weaknesses or deficiencies, but they are
correctable in the normal course of
business. The examiner may have
recommendations for improvement, but
the weaknesses noted should not have
a significant effect on the safety and
soundness of the institution.
Rating 3 (Fair). A rating of 3 signifies
that risk management practices are
lacking in some important ways and,
therefore, are a cause for more than
normal supervisory attention. One or
more of the four elements of sound risk
management6 (active board and senior
management oversight; adequate
policies, procedures, and limits;
adequate risk management monitoring,
and management information systems;
6 Framework for Risk–Focused Supervision of
Large Complex Institutions, August 1997; SR Letter
95–51, Rating the Adequacy of Risk Management
Processes and Internal Controls at State Member
Banks and Bank Holding Companies.

PO 00000

Frm 00036

Fmt 4703

Sfmt 4703

comprehensive internal controls) is
considered less than acceptable, and has
precluded the institution from fully
addressing one or more significant risks
to its operations. Certain risk
management practices are in need of
improvement to ensure that
management and the board are able to
identify, monitor, and control all
significant risks to the institution.
Weaknesses may include continued
control exceptions or failures to adhere
to written policies and procedures that
could have adverse effects on the
institution. Also, the risk management
structure may need to be improved in
areas of significant business activity, or
staff expertise may not be
commensurate with the scope and
complexity of business activities. In
addition, management’s response to
changing industry practices and
regulatory guidance may need to
improve.
The internal control system may be
lacking in some important aspects,
particularly as indicated by continued
control exceptions or by a failure to
adhere to written policies and
procedures. The risks associated with
the internal control system could have
adverse effects on the safety and
soundness of the institution if corrective
action is not taken by management.
Rating 4 (Marginal). A rating of 4
represents marginal risk management
practices that generally fail to identify,
monitor, and control significant risk
exposures in many material respects.
Generally, such a situation reflects a
lack of adequate guidance and
supervision by management and the
board. One or more of the four elements
of sound risk management is deficient
and requires immediate and concerted
corrective action by the board and
management. A number of significant
risks to the institution have not been
adequately addressed, and the risk
management deficiencies warrant a high
degree of supervisory attention.
The institution may have serious
identified weaknesses, such as an
inadequate separation of duties, that
require substantial improvement in
internal control or accounting
procedures, or improved adherence to
supervisory standards or requirements.
Unless properly addressed, these
conditions may result in unreliable
financial records or reports, or operating
losses that could seriously affect the
safety and soundness of the institution.
Rating 5 (Unsatisfactory). A rating of 5
indicates a critical absence of effective
risk management practices with respect
to the identification, monitoring, or
control over significant risk exposures.
One or more of the four elements of

E:\FR\FM\23JYN1.SGM

23JYN1

Federal Register / Vol. 69, No. 141 / Friday, July 23, 2004 / Notices
sound risk management is considered
wholly deficient, and management and
the board have not demonstrated the
capability to address these deficiencies.
Internal controls are critically weak
and, as such, could seriously jeopardize
the continued viability of the
institution. If not already evident, there
is an immediate concern as to the
reliability of accounting records and
regulatory reports and the potential for
losses if corrective measures are not
taken immediately. Deficiencies in the
institution’s risk management
procedures and internal controls require
immediate and close supervisory
attention.
‘‘R’’ (Risk Management) Subcategories
The four R subcomponents are each
assigned a qualitative rating of Strong,
Acceptable or Weak. The following are
the descriptions of the ratings as they
apply to each of the subcategories.
Competence of Board and Senior
Management
Strong Assessment. An assessment of
Strong signifies that the board and
senior management clearly understand
the types of risk inherent in the BHC’s
activities and actively participate in
managing those risks. Policies, limits,
and tracking reports are appropriate and
understood, reviewed, and approved by
the board. Board and senior
management are informed about
changes in market conditions and
respond appropriately. Oversight of risk
management practices is strong and the
organization’s overall business strategy
is effective. Risk management practices
are appropriately adjusted in
accordance with enhancements to
industry practices and regulatory
guidance, and exposure limits are
adjusted as necessary to reflect the
institution’s changing risk profile.
Staff possesses the experience and
expertise consistent with the scope and
complexity of the organization’s
business activities. There is a sufficient
depth of staff to ensure sound
operations. Management provides
adequate supervision of the day–to–day
activities of all officers and employees,
including the supervision of the senior
officers and the heads of business lines.
Management ensures that employees
have the integrity, ethical values, and
competence that are consistent with a
prudent management philosophy and
operating style.
Management is able to respond to
changes in competition or innovations
in the marketplace and proactively
identifies all risks associated with
proposed new activities or products and
ensures that the appropriate

VerDate jul<14>2003

16:28 Jul 22, 2004

Jkt 203001

infrastructure and internal controls are
established.
Acceptable Assessment. An assessment
of Acceptable indicates that board and
senior management oversight is
satisfactory. In this regard, the board
and senior management have a good
understanding of the organization’s risk
profile, provide adequate oversight of
risk management practices, effectively
utilize risk management reporting, set
appropriate policies and limits,
appropriately adapt to changes in
market conditions, and develop and
executes reasonable business strategies,
although these practices may be lacking
in some modest degree. The level of
staffing, and its experience, expertise,
and depth, is sufficient to operate the
business lines in a safe and sound
manner. Day–to–day supervision of
management and staff at all levels is
generally effective. Management
responds in a timely fashion to changes
in competition, innovations in the
marketplace, evolving industry
practices, and current regulatory
guidance, and has in place an effective
process for reviewing new activities and
products. Minor weaknesses may exist
in the staffing, infrastructure, and risk
management processes for individual
business lines or products, but these
weaknesses have been recognized and
are in the process of being addressed.
Weak Assessment. An assessment of
Weak signifies that deficiencies exist in
board and management oversight that
require more than normal supervisory
attention. The deficiencies may involve
a broad range of activities or be material
to a major business line or activity.
Board and senior management may not
be adequately informed as to the type
and severity of the deficiencies or have
not demonstrated an ability to provide
corrective action in a timely manner.
The deficiencies may include a lack of
knowledge with respect to the
organization’s risk profile, insufficient
oversight of risk management practices,
ineffective policies or limits, inadequate
or under–utilized management
reporting, an inability to respond to
industry enhancements and changes in
regulatory guidance, or failure to
execute appropriate business strategies.
Staffing may not be adequate or staff
may not possess the experience and
expertise needed for the scope and
complexity of the organization’s
business activities, and the day–to–day
supervision of officer and staff
activities, including the management of
senior officers or heads of business
lines, may be lacking.

PO 00000

Frm 00037

Fmt 4703

Sfmt 4703

44001

Policies, Procedures and Limits
Strong Assessment. An assessment of
Strong indicates that the policies,
procedures, and limits provide for
effective identification, measurement,
monitoring, and control of the risks
posed by the lending, investing, trading,
trust, fiduciary, and other significant
activities. Policies, procedures, and
limits are consistent with the
institution’s goals and objectives and its
overall financial strength. The policies
clearly delineate accountability and
lines of authority across the institution’s
activities. The policies also provide for
the review of new activities to ensure
that the infrastructure necessary to
identify, monitor, and control the risks
is in place before the activities are
initiated.
Acceptable Assessment. An assessment
of Acceptable indicates that the policies,
procedures and limits cover all major
business areas, are thorough and
substantially up–to–date, and provide a
clear delineation of accountability and
lines of authority across the institution’s
activities. Policies, procedures, and
limits are generally consistent with the
institution’s goals and objectives and its
overall financial strength. Any
deficiencies or gaps that have been
identified are minor in nature and in the
process of being addressed.
Weak Assessment. An assessment of
Weak signifies that deficiencies exist in
policies, procedures, and limits that
require more than normal supervisory
attention. The deficiencies may involve
a broad range of activities or be material
to a major business line or activity.
Board and senior management may not
be adequately informed as to the type
and severity of the deficiencies or have
not demonstrated an ability to provide
corrective action in a timely manner.
The deficiencies may include policies,
procedures, or limits (or the lack
thereof) that do not adequately identify,
measure, monitor, or control the risks
posed by significant activities; are not
consistent with the experience of staff,
the organization’s strategic goals and
objectives, or the financial strength of
the institution; or do not clearly
delineate accountability or lines of
authority. Also, the policies may not
provide for adequate due–diligence
before engaging in new activities or
products.
Risk Monitoring and MIS
Strong Assessment. An assessment of
Strong indicates that risk monitoring
practices and MIS reports address all
material risks. The key assumptions,
data sources, and procedures used in
measuring and monitoring risk are

E:\FR\FM\23JYN1.SGM

23JYN1

44002

Federal Register / Vol. 69, No. 141 / Friday, July 23, 2004 / Notices

appropriate, adequately documented,
and tested for reliability on an ongoing
basis. Reports and other forms of
communication are consistent with
activities, are structured to monitor
exposures and compliance with
established limits, goals, or objectives,
and compare actual versus expected
performance when appropriate.
Management and board reports are
accurate and timely and contain
sufficient information to identify
adverse trends and to adequately
evaluate the level of risk faced by the
institution.
Acceptable Assessment. An assessment
of Acceptable indicates that risk
monitoring practices and MIS reports
cover major risks and business areas. In
general, the reports contain valid
assumptions that are periodically tested
for accuracy and reliability and are
properly documented and distributed to
the appropriate decision–makers.
Reports and other forms of
communication generally are consistent
with activities, are structured to monitor
exposures and compliance with
established limits, goals, or objectives,
and compare actual versus expected
performance when appropriate.
Management and board reports are
accurate and timely, although they may
be lacking in some modest degree. Any
weaknesses or deficiencies that have
been identified are in the process of
being addressed.
Weak Assessment. An assessment of
Weak signifies that deficiencies exist in
the risk monitoring practices or the MIS
reports that require more than normal
supervisory attention. The deficiencies
may involve a broad range of activities
or be material to a major business line
or activity. Board and senior
management may not be adequately
informed as to the type and severity of
the deficiencies or have not
demonstrated an ability to provide
corrective action in a timely manner.
The deficiencies contribute to
ineffective risk identification through
inappropriate assumptions, incorrect
data, poor documentation, or the lack of
timely testing. In addition, MIS reports
may not be distributed to the
appropriate decision–makers,
adequately monitor significant risks, or
properly identify adverse trends and the
level of risk faced by the institution.
Internal Controls
Strong Assessment. An assessment of
Strong indicates that the system of
internal controls is appropriate for the
type and level of risks posed by the
nature and scope of the organization’s
activities. The organizational structure
establishes clear lines of authority and

VerDate jul<14>2003

16:28 Jul 22, 2004

Jkt 203001

responsibility for monitoring adherence
to policies, procedures, and limits.
Reporting lines provide sufficient
independence of the control areas from
the business lines and adequate
separation of duties throughout the
organization–including areas relating to
trading, custodial, and back–office
activities. The organizational structure
reflects actual operating practices.
Financial, operational, and regulatory
reports are reliable, accurate, and
timely, and wherever applicable,
exceptions are noted and promptly
investigated. Adequate procedures exist
for ensuring compliance with applicable
laws and regulations, including
consumer laws and regulations. Internal
audit or other control review practices
provide for independence and
objectivity. Internal controls and
information systems are adequately
tested and reviewed; the coverage,
procedures, findings, and responses to
audits and review tests are adequately
documented; identified material
weaknesses are given appropriate and
timely high level attention; and
management’s actions to address
material weaknesses are objectively
reviewed and verified. The board or its
audit committee regularly reviews the
effectiveness of internal audits and
other control review activities.
Acceptable Assessment. An assessment
of Acceptable indicates that the system
of internal controls adequately covers
major risks and business areas. In
general, the system is independent,
establishes appropriate separation of
duties, supports accuracy in record–
keeping practices and reporting systems,
is adequately documented, and verifies
compliance with laws and regulations,
including consumer laws and
regulations. In most cases identified
material weaknesses are given
appropriate and timely attention and
management’s actions to address
material weaknesses are objectively
reviewed and verified. The board or its
audit committee have reviewed the
effectiveness of internal audits and
other control review activities. Any
weaknesses or deficiencies that have
been identified are modest in nature and
in the process of being addressed.
Weak Assessment. An assessment of
Weak signifies that deficiencies exist in
the system of internal controls that
require more than normal supervisory
attention. The deficiencies may involve
a broad range of activities or be material
to a major business line or activity.
Board and senior management may not
be adequately informed as to the type
and severity of the deficiencies or have
not demonstrated an ability to provide
corrective action in a timely manner.

PO 00000

Frm 00038

Fmt 4703

Sfmt 4703

The deficiencies may include
insufficient oversight by the board or its
committee; unclear lines of authority
and responsibility; a lack of
independence; ineffective separation of
duties; inadequate or untimely risk
coverage and verification, including
monitoring compliance with both safety
and soundness and consumer laws and
regulations; inaccurate records or
regulatory reporting; a lack of
documentation for work performed; or a
lack of timeliness in the correction of
identified weaknesses.
‘‘F’’ (Financial Condition) Component
and CAEL Subcomponents
The F (Financial Condition) rating is
supported by four subcomponents:
‘‘C’’(Capital), ‘‘A’’ (Asset Quality), ‘‘E’’
(Earnings) and ‘‘L’’ (Liquidity). The F
component and the CAEL
subcomponents are rated on a five point
numerical scale in ascending order of
supervisory concern as follows:
1 – Strong; 2 – Satisfactory; 3 – Fair; 4
– Marginal; and 5 – Unsatisfactory.
The ‘‘F’’ (Financial Condition)
Component
Rating 1 (Strong). A rating of 1 indicates
that the consolidated BHC is financially
sound in almost every respect; any
negative findings are basically of a
minor nature and can be handled in a
routine manner. The capital adequacy,
asset quality, earnings, and liquidity of
the consolidated BHC are more than
adequate to protect the company from
external economic and financial
disturbances. The company generates
more than sufficient cash flow to service
its debt and fixed obligations with no
harm to subsidiaries of the organization.
Rating 2 (Satisfactory). A rating of 2
indicates that the consolidated BHC is
fundamentally financially sound, but
may reflect modest weaknesses
correctable in the normal course of
business. The capital adequacy, asset
quality, earnings and liquidity of the
consolidated BHC are adequate to
protect the company from external
economic and financial disturbances.
The company also generates sufficient
cash flow to service their obligations;
however, areas of weakness could
develop into areas of greater concern. To
the extent minor adjustments are
handled in the normal course of
business, the supervisory response is
limited.
Rating 3 (Fair). A rating of 3 indicates
that the consolidated BHC exhibits a
combination of weaknesses ranging
from fair to moderately severe. The
company has less than adequate
financial strength stemming from one or
more of the following: modest capital

E:\FR\FM\23JYN1.SGM

23JYN1

Federal Register / Vol. 69, No. 141 / Friday, July 23, 2004 / Notices
deficiencies, poor asset quality, weak
earnings, or liquidity problems. As a
result, the BHC and its subsidiaries are
less resistant to adverse business
conditions. The financial condition of
the BHC will likely deteriorate if
concerted action is not taken to correct
areas of weakness. The company’s cash
flow is sufficient to meet immediate
obligations, but may not remain
adequate if action is not taken to correct
weaknesses. Consequently, the BHC is
vulnerable and requires more than
normal supervision. Overall financial
strength and capacity are still such as to
pose only a remote threat to the viability
of the company.
Rating 4 (Marginal). A rating of 4
indicates that the consolidated BHC has
either inadequate capital, an
immoderate volume of problem assets,
very weak earnings, serious liquidity
issues, or a combination of factors that
are less than satisfactory. An additional
weakness may be that the BHC’s cash
flow needs are met only by upstreaming
imprudent dividends and/or fees from
subsidiaries. Unless prompt action is
taken to correct these conditions, they
could impair future viability. BHCs in
this category require close supervisory
attention and increased financial
surveillance.
Rating 5 (Unsatisfactory). A rating of 5
indicates that the volume and character
of financial weaknesses of the BHC are
so critical as to require urgent aid from
shareholders or other sources to prevent
insolvency. The imminent inability of
such a company to service its fixed
obligations and/or prevent capital
depletion due to severe operating losses
places its viability in serious doubt.
Such companies require immediate
corrective action and constant
supervisory attention.
The ‘‘CAEL’’ (Capital, Asset Quality,
Earnings, and Liquidity) Subcategories
The CAEL subcategories can be
evaluated along business lines, product
lines, or legal entity lines––depending
on which type of review is most
appropriate for the holding company
structure. The weight afforded to each
subcategory in the overall F rating will
depend on the severity of the condition
of that subcategory and the relative
importance of that subcategory to the
consolidated organization. The
following is a description of rating
definitions for the CAEL subcategories.
‘‘C’’ Capital Adequacy
Rating 1 (Strong). A rating of 1 indicates
that the consolidated BHC maintains
more than adequate capital to: 1)
support the volume and risk
characteristics of all parent and

VerDate jul<14>2003

16:28 Jul 22, 2004

Jkt 203001

subsidiary business lines and products;
2) provide a sufficient cushion to absorb
unanticipated losses arising from
holding company and subsidiary
activities; and, 3) support the level and
composition of corporate and subsidiary
borrowing. In addition, a company
assigned a rating of 1 has more than
sufficient capital to provide a base for
the growth of risk assets and the entry
into capital markets as the need arises
for the parent company and
subsidiaries.
Rating 2 (Satisfactory). A rating of 2
indicates that the consolidated BHC
maintains adequate capital to: 1)
support the volume and risk
characteristics of all parent and
subsidiary business lines and products;
2) provide a sufficient cushion to absorb
unanticipated losses arising from
holding company and subsidiary
activities; and, 3) support the level and
composition of corporate and subsidiary
borrowing. In addition, a company
assigned a rating of 2 has sufficient
capital to provide a base for the growth
of risk assets and the entry into capital
markets as the need arises for the parent
company and subsidiaries.
Rating 3 (Fair). A rating of 3 indicates
that the consolidated BHC may not
maintain sufficient capital to ensure
support for one or more of the
following: 1) the volume and risk
characteristics of all parent and
subsidiary business lines and products;
2) the unanticipated losses arising from
holding company and subsidiary
activities; or, 3) the level and
composition of corporate and subsidiary
borrowing. In addition, a company
assigned a rating of 3 may not maintain
a sufficient capital position to provide a
base for the growth of risk assets and the
entry into capital markets as the need
arises for the parent company and
subsidiaries. The capital position of the
consolidated BHC could quickly become
inadequate in the event of further asset
deterioration or other negative factors
and therefore requires more than normal
supervisory attention.
Rating 4 (Marginal). A rating of 4
indicates that the capital level of the
consolidated BHC is significantly below
the amount needed to ensure support
for one or more of the following: 1) the
volume and risk characteristics of all
parent and subsidiary business lines
and products; 2) the unanticipated
losses arising from holding company
and subsidiary activities; and, 3) the
level and composition of corporate and
subsidiary borrowing. In addition, a
company assigned a rating of 4 does not
maintain a sufficient capital position to
provide a base for the growth of risk
assets and the entry into capital markets

PO 00000

Frm 00039

Fmt 4703

Sfmt 4703

44003

as the need arises for the parent
company and subsidiaries. If left
unchecked, the consolidated capital
position of the company might evolve
into weaknesses or conditions that
could threaten the viability of the
institution. The capital position of the
consolidated BHC requires immediate
supervisory attention.
Rating 5 (Unsatisfactory). A rating of 5
indicates that the level of capital of the
consolidated BHC is critically deficient
and in needed of immediate corrective
action. The consolidated capital
position threatens the viability of the
institution and requires constant
supervisory attention.
‘‘A’’ Asset Quality
Rating 1 (Strong). A rating of 1 indicates
that the BHC maintains strong asset
quality and credit administration
practices across all parts of the
organization. Any identified weaknesses
in asset quality are minor in nature.
Credit risk across the organization for a
1 rated company is commensurate with
management’s abilities and modest in
relation to credit risk management
practices.
Rating 2 (Satisfactory). A rating of 2
indicates that the BHC maintains
satisfactory asset quality and credit
administration practices across all parts
of the organization. Any identified
weaknesses in asset quality are
correctable in the normal course of
business. Credit risk across the
organization for a 2 rated company is
commensurate with management’s
abilities and generally modest in
relation to credit risk management
practices.
Rating 3 (Fair). A rating of 3 indicates
that the asset quality or credit
administration across all or part of the
consolidated BHC is less than
satisfactory. The BHC may be
experiencing an increase in credit risk
exposure that has not been met with an
appropriate improvement in risk
management practices. It may also be
facing a decrease in the overall quality
of assets currently maintained on and
off balance sheet. BHCs assigned a
rating of 3 require more than normal
supervisory attention.
Rating 4 (Marginal). A rating of 4
indicates that the BHC’s asset quality or
credit administration practices are
deficient. The level of problem assets
and/or unmitigated credit risk subjects
the holding company to potential losses
that, if left unchecked, may threaten its
viability. BHCs assigned a rating of 4
require immediate supervisory
attention.
Rating 5 (Unsatisfactory). A rating of 5
indicates that the BHC’s asset quality or

E:\FR\FM\23JYN1.SGM

23JYN1

44004

Federal Register / Vol. 69, No. 141 / Friday, July 23, 2004 / Notices

credit administration practices are
critically deficient and present an
imminent threat to the institution’s
viability. BHCs assigned a rating of 5
require immediate remedial action and
constant supervisory attention.
‘‘E’’ Earnings
Rating 1 (Strong). A rating of 1 indicates
that the quantity and quality of the
BHC’s consolidated earnings are more
than sufficient to make full provision for
the absorption of losses and accretion of
capital when due consideration is given
to asset quality and BHC growth.
Generally, BHCs with a 1 rating have
earnings well above peer–group
averages.
Rating 2 (Satisfactory). A rating of 2
indicates that the quantity and quality
of the BHC’s consolidated earnings are
generally adequate to make provision
for the absorption of losses and
accretion of capital when due
consideration is given to asset quality
and BHC growth. BHCs with a 2
earnings rating have earnings that are in
line with or slightly above peer–group
averages.
Rating 3 (Fair). A rating of 3 indicates
that the BHC’s consolidated earnings are
not fully adequate to make provisions
for the absorption of losses and the
accretion of capital in relation to
company growth. The consolidated
earnings of companies rated 3 may be
further clouded by static or inconsistent
earnings trends, chronically insufficient
earnings, or less than satisfactory asset
quality. BHCs with a 3 rating for
earnings generally have earnings below
peer–group averages. Such BHCs require
more than normal supervisory attention.
Rating 4 (Marginal). A rating of 4
indicates that the BHC’s earnings, while
generally positive, are clearly not
sufficient to make full provision for
losses and the necessary accretion of
capital. BHCs with earnings rated 4 may
be characterized by erratic fluctuations
in net income, poor earnings (and the
likelihood of the development of a
further downward trend), intermittent
losses, chronically depressed earnings,
or a substantial drop from the previous
year. The earnings of such companies
are ordinarily substantially below peer–
group averages. Such BHCs require
immediate supervisory attention.
Rating 5 (Unsatisfactory). A rating of 5
indicates that the BHC is experiencing
losses or reflecting a level of earnings
that is worse than that described for the
4 rating. Such losses, if not reversed,
represent a distinct threat to the BHC’s
solvency through erosion of capital.
Such BHCs require immediate and
constant supervisory attention.

VerDate jul<14>2003

16:28 Jul 22, 2004

Jkt 203001

‘‘L’’ Liquidity
Rating 1 (Strong). A rating of 1 indicates
that the BHC maintains strong liquidity
levels and well developed funds
management practices. The parent
company and subsidiaries have reliable
access to sufficient sources of funds on
favorable terms to meet present and
anticipated liquidity needs.
Rating 2 (Satisfactory). A rating of 2
indicates that the BHC maintains
satisfactory liquidity levels and funds
management practices. The parent
company and subsidiaries have access
to sufficient sources of funds on
acceptable terms to meet present and
anticipated liquidity needs. Modest
weaknesses in funds management
practices may be evident, but those
weaknesses are correctable in the
normal course of business.
Rating 3 (Fair). A rating of 3 indicates
that the BHC’s liquidity levels or funds
management practices are in need of
improvement. BHCs rated 3 may lack
ready access to funds on reasonable
terms or may evidence significant
weaknesses in funds management
practices at the parent company and/or
subsidiary levels. However, these
deficiencies are considered correctable
in the normal course of business. Such
BHCs require more than normal
supervisory attention.
Rating 4 (Marginal). A rating of 4
indicates that the BHC’s liquidity levels
or funds management practices are
deficient. Institutions rated 4 may not
have or be able to obtain a sufficient
volume of funds on reasonable terms to
meet liquidity needs at the parent
company and/or subsidiary levels and
require immediate supervisory
attention.
Rating 5 (Unsatisfactory). A rating of 5
indicates that the BHC’s liquidity levels
or funds management practices are
critically deficient and may threaten the
continued viability of the institution.
Institutions rated 5 require immediate
external financial assistance to meet
maturing obligations or other liquidity
needs and constant supervisory
attention.
‘‘I’’ (Impact) Component
The I component rating reflects the
aggregate impact of the parent company
and nonbank subsidiaries on the
subsidiary depository institution(s).
The I component is rated on a five point
numerical scale. Ratings will be
assigned in ascending order of
supervisory concern as follows:
1 – low likelihood of significant
negative impact;
2 – limited likelihood of significant
negative impact;

PO 00000

Frm 00040

Fmt 4703

Sfmt 4703

3 – moderate likelihood of significant
negative impact;
4 – considerable likelihood of
significant negative impact; and
5 – high likelihood of significant
negative impact.
Rating 1 (Low Likelihood of Significant
Negative Impact). A rating of 1 indicates
that the aggregate impact of the parent
company and nonbank subsidiaries of
the BHC on the subsidiary depository
institution(s) is positive due to factors
that include the: 1) sound financial
condition of the parent company and
nondepository subsidiaries, and 2)
strong risk management practices within
the parent company and nondepository
subsidiaries. A 1 rated BHC maintains
an appropriate capital position across
all legal entities in line with the risks
undertaken by those entities. Intra–
group exposures, including servicing
agreements and derivative and payment
system exposures of a 1 rated BHC do
not have the potential to undermine the
financial condition of the subsidiary
depository institution(s). Parent
company cash flow is not dependent on
excessive dividend payments from
subsidiaries which can potentially
undermine the financial condition of
the subsidiary depository institution(s).
The potential risks posed to the
subsidiary depository institution(s) by
plans for growth, a poor control
environment, and/or complaints and
litigation within or facing the parent
company or nondepository subsidiaries
can be corrected in a routine manner.
Rating 2 (Limited Likelihood of
Significant Negative Impact). A rating
of 2 indicates that the aggregate impact
of the parent company and nonbank
subsidiaries of the BHC on the
subsidiary depository institution(s) is
neutral due to factors that include the:
1) adequate financial condition of the
parent company and nondepository
subsidiaries, and 2) satisfactory risk
management practices within the parent
company and nondepository
subsidiaries. A 2 rated BHC maintains
an adequate capital position across all
legal entities in line with the risks
undertaken by those entities. Intra–
group exposures, including servicing
agreements and derivative and payment
system exposures, of a 2 rated BHC
generally do not have the potential to
undermine the financial condition of
the subsidiary depository institution(s).
Parent company cash flow generally is
not dependent on excessive dividend
payments from subsidiaries which can
potentially undermine the financial
condition of the subsidiary depository
institution(s). The potential risks posed
to the subsidiary depository
institution(s) by strategic growth plans

E:\FR\FM\23JYN1.SGM

23JYN1

Federal Register / Vol. 69, No. 141 / Friday, July 23, 2004 / Notices
or a poor control environment within
the parent company or nondepository
subsidiaries are minor in nature and can
be corrected in the normal course of
business.
Rating 3 (Moderate Likelihood of
Significant Negative Impact). A rating
of 3 indicates that the aggregate impact
of the parent company and nonbank
subsidiaries of the BHC on the
subsidiary depository institution(s) is
potentially negative due to weaknesses
in the financial condition and/or risk
management practices of the parent
company and nondepository
subsidiaries. A 3 rated BHC may have
only marginally sufficient capital within
the parent company and/or
nondepository subsidiary(ies) to support
its activities. Intra–group exposures,
including servicing agreements and
derivative and payment system
exposures, of a 3 rated BHC may have
the potential to undermine the financial
condition of the subsidiary depository
institution(s). Parent company cash flow
may be partially dependent on excessive
dividend payments from subsidiaries,
potentially undermining the financial
condition of the subsidiary depository
institution(s). The potential risks posed
to the subsidiary depository
institution(s) by strategic growth plans
or a poor control environment within
the parent company or nondepository
subsidiaries may be significant. A BHC
assigned a 3 impact rating requires more
than normal supervisory attention.
Rating 4 (Considerable Likelihood of
Significant Negative Impact). A rating
of 4 indicates that the aggregate impact
of the parent company and nonbank
subsidiaries of the BHC on the
subsidiary depository institution(s) is
negative due to weaknesses in the
financial condition and/or risk
management practices of the parent
company and nondepository
subsidiaries. A 4 rated BHC may have
insufficient capital within the parent
company and/or nondepository
subsidiary(ies) to support its activities.
Intra–group exposures, including
servicing agreements and derivative and
payment system exposures, of a 4 rated
BHC may also have the potential to
undermine the financial condition of
the subsidiary depository institution(s).
Parent company cash flow may be
dependent on excessive dividend
payments from subsidiaries, potentially
undermining the financial condition of
the subsidiary depository institution(s).
The potential risks posed to the
subsidiary depository institution(s) by
strategic growth plans or a poor control
environment within the parent company
or nondepository subsidiaries may also
be significant. A BHC assigned a 4

VerDate jul<14>2003

16:28 Jul 22, 2004

Jkt 203001

impact rating requires immediate
remedial action and close supervisory
attention.
Rating 5 (High Likelihood of Significant
Negative Impact). A rating of 5 indicates
that the aggregate impact of the parent
company and nonbank subsidiaries of
the BHC on the subsidiary depository
institution(s) is extremely negative due
to significant weaknesses in the
financial condition and/or risk
management practices of the parent
company or nondepository subsidiaries.
Critical deficiencies in the parent
company or nondepository subsidiaries
pose an immediate threat to the viability
of the subsidiary depository
institution(s). The parent company also
may be unable to meet its obligations
without support from the subsidiary
depository institution(s). The BHC
requires immediate remedial action and
constant supervisory attention.
‘‘C’’ (Composite) Component
C is the overall composite assessment of
the BHC as reflected by consolidated
risk management, consolidated financial
strength, and the impact of the parent
company and nonbank subsidiaries on
the depository institutions. The
composite rating encompasses both a
forward–looking and static assessment
of the consolidated organization, as well
as an assessment of issues related to the
parent company and nonbank
subsidiaries acting as a source of
strength to the depository institutions.
The C rating is not derived as a simple
numeric average of the rating system
components; rather, it reflects examiner
judgement with respect to the relative
importance of each component to the
safe and sound operation of the BHC.
Rating 1 (Strong). BHCs in this group
are sound in almost every respect; any
negative findings are basically of a
minor nature and can be handled in a
routine manner. Risk management
practices and financial stability provide
resistance to external economic and
monetary disturbances. The parent
company and nondepository
subsidiaries are a source of financial
strength to the depository institutions.
Rating 2 (Satisfactory). BHCs in this
group are also fundamentally sound but
may have modest weaknesses in risk
management practices or financial
stability. The weaknesses could develop
into conditions of greater concern but
are believed correctable in the normal
course of business. As such, the
supervisory response is limited. The
parent company and nondepository
subsidiaries are not a source of financial
weakness to the depository institutions.
Rating 3 (Fair). BHCs in this group
exhibit a combination of weaknesses in

PO 00000

Frm 00041

Fmt 4703

Sfmt 4703

44005

risk management practices and financial
stability that range from fair to
moderately severe. These companies are
less resistant to the onset of adverse
business conditions and could likely
deteriorate if concerted action is not
effective in correcting the areas of
weakness. Consequently, these
companies are vulnerable and require
more than normal supervisory attention
and financial surveillance. However, the
strength and financial capacity of the
company, including the ability of the
parent company and nondepository
subsidiaries to provide financial
support, if necessary, pose only a
remote threat to its continued viability.
Rating 4 (Marginal). BHCs in this group
have an immoderate volume of risk
management and financial weaknesses.
The parent company and nonbank
subsidiaries’ combined ability to
provide financial support to the
depository institutions has been limited
by these weaknesses. Unless prompt
action is taken to correct these
conditions, the organization’s future
viability could be impaired. These
companies require close supervisory
attention and increased financial
surveillance.
Rating 5 (Unsatisfactory). The critical
volume and character of the risk
management and financial weaknesses
of BHCs in this category, and concerns
about the parent company and
nondepository subsidiaries acting as a
source of weaknesses to the subsidiary
depository institution(s), could lead to
insolvency without urgent aid from
shareholders or other sources. The
imminent inability to prevent liquidity
and/or capital depletion places the
BHC’s continued viability in serious
doubt. These companies require
immediate corrective action and
constant supervisory attention.
(D) (Depository Institutions) Component
The (D) component is intended to
identify the overall condition of the
subsidiary depository institution or the
combined condition of the depository
subsidiaries. For BHCs with only one
depository institution, the (D)
component rating will mirror the
CAMELS composite rating for that
depository institution. To arrive at a (D)
component rating for BHCs with multi–
bank subsidiaries, the CAMELS
composite ratings for each of the
depository institutions should be
weighted, giving consideration to asset
size and the relative importance of each
depository institution within the overall
structure of the organization. In general,
it is expected that the resulting (D)
component rating will reflect the lead

E:\FR\FM\23JYN1.SGM

23JYN1

44006

Federal Register / Vol. 69, No. 141 / Friday, July 23, 2004 / Notices

depository institution’s CAMELS
composite rating.
If in the process of analyzing the
financial condition and risk
management programs of the
consolidated organization, a major
difference of opinion relative to the
safety and soundness of the depository
institution emerges between the Federal
Reserve and the depository institution’s
primary regulator, then the (D) rating
should reflect the Federal Reserve’s
evaluation.

shell BHC program (noncomplex BHCs
with assets under $1 billion). The R
rating is the M rating from the
subsidiary depository institution’s
CAMELS rating. The rating will be
changed from the current M to an R to
provide consistent terminology. The C
rating is the subsidiary depository
institution’s composite CAMELS rating.

Noncomplex BHCs with Assets Greater
than $1 Billion
One–Bank Holding Company
New Rating: RFI/C (D)
III. Implementation of Revised Rating
For all noncomplex, one–bank
System by Bank Holding Company
holding companies with assets of greater
Type
than $1 billion, examination staff will
assign all component and
The proposal to change the BHC
rating system was driven by the need to subcomponent ratings in the new rating
system; however, examination staff
align the rating system with current
should continue to rely heavily on
Federal Reserve supervisory practices.
information and analysis contained in
The new rating system will require
the report of examination for the
analysis and support similar to that
subsidiary depository institution to
required by current supervisory policy
7
for institutions of all sizes. As such, the assign the R and F ratings. If
examination staff have reviewed the
level of analysis and support will vary
primary regulator’s examination report
based upon whether a BHC has been
and are comfortable with the analysis
determined to be ‘‘complex’’ or
and conclusions contained in that
8
‘‘noncomplex.’’ In addition, the
resources dedicated to the inspection of report, then the BHC ratings should be
supported with concise language that
each BHC will continue to be
indicates that the conclusions are based
determined by the risk posed by the
on the analysis of the primary regulator.
subsidiary depository institution(s) to
No additional analysis will be required.
the federal safety net9 and the risk posed
Please note, however, in cases where
by the BHC to the subsidiary depository
the analysis and conclusions of the
institution(s).
primary regulator are insufficient to
assign the new ratings, the primary
Noncomplex BHCs with Assets of $1
regulator should be contacted to
Billion or Less (Shell Holding
ascertain whether additional analysis
Companies)
and support may be available. Further,
New Rating: R and C
Consistent with SR 02–1, examination if discussions with the primary
regulator do not provide sufficient
staff will be required only to assign an
information to assign the ratings,
R and C rating for all companies in the
discussions with BHC management may
be warranted to obtain adequate
7 Including the BHC inspection manual, SR 95–
information to assign the ratings. In
51, SR 97–24, SR 97–25, SR 99–15, and SR 02–01.
8 The determination of whether a holding
most cases, additional information or
company is ‘‘complex’’ versus ‘‘noncomplex’’ is
support obtained through these steps
made at least annually on a case–by–case basis
will be sufficient to permit the
taking into account and weighing a number of
considerations, such as: the size and structure of the assignment of the R and F ratings. To
the extent that additional analysis is
holding company; the extent of intercompany
transactions between depository institution
deemed necessary, the level of analysis
subsidiaries and the holding company or
and resources spent on this assessment
nondepository subsidiaries of the holding company;
the nature and scale of any nondepository activities, should be in line with the level of risk
the subsidiary depository institution
including whether the activities are subject to
review by another regulator and the extent to which poses to the federal safety net. In
the holding company is conducting Gramm–Leach–
addition, any activities that involve
Bliley authorized activities (e.g., insurance,
information gathering with respect to
securities, merchant banking); whether risk
the subsidiary depository institution
management processes for the holding company are
consolidated; and whether the holding company
should be coordinated with and, if
has material debt outstanding to the public. Size is
possible, conducted by, the primary
less important determinant of complexity than
regulator of that institution.
many of the factors noted above, but generally
Examination staff will be required to
companies of significant size (e.g., assets of $10
billion on balance sheet or managed) would be
make an independent assessment in
considered complex, irrespective of the other
order to assign the I rating, which
considerations.
provides an evaluation of the impact of
9 The federal safety net is defined as the deposit
the BHC on the subsidiary depository
insurance fund, the payments system, and the
Federal Reserve’s discount window.
institution. Analysis for the I rating in

VerDate jul<14>2003

16:28 Jul 22, 2004

Jkt 203001

PO 00000

Frm 00042

Fmt 4703

Sfmt 4703

non–complex one–bank holding
companies should place particular
emphasis on issues related to parent
company cash flow and compliance
with 23A.
Multi–Bank Holding Company
New Rating: RFI/C (D)
For all noncomplex BHCs with assets
of greater than $1 billion and having
more than one subsidiary depository
institution, examination staff will assign
all component and subcomponent
ratings of the new system, also relying,
to the extent possible, on the work
conducted by the primary bank
regulators to assign the R and F ratings.
However, any risk management or other
important functions conducted by the
parent company or any nondepository
subsidiary of the BHC, or conducted
across legal entity lines, should be
subject to review by Federal Reserve
examination staff. These reviews should
be conducted in coordination with the
primary regulator(s). The assessment for
the I rating will require an independent
assessment by Federal Reserve
examination staff.
Complex BHCs
New Rating: RFI/C (D)
For complex BHCs, examination staff
will assign all component and
subcomponent ratings of the new rating
system. The ratings analysis should be
based on the primary regulator’s
assessment of the subsidiary depository
institution(s), as well as on the
examiners’ assessment of the
consolidated organization as determined
through the BHC inspection process.
The resources needed for the inspection
and the level of support needed for
developing a full rating will depend
upon the complexity of the
organization, including structure and
activities (see footnote 7), and should be
commensurate with the level of risk
posed by the subsidiary depository
institution(s) to the federal safety net
and the level of risk posed by the BHC
to the subsidiary depository
institution(s).
Nontraditional BHCs
New Rating: RFI/C (D)
Examination staff will be required to
assign the full rating system for
nontraditional BHCs. Nontraditional
BHCs include BHCs in which most or
all nondepository operations are
regulated by a functional regulator and
in which the subsidiary depository
institution(s) is small in relation to the
nondepository operations. The new
rating system is not intended to
introduce significant additional work in
the rating process for these
organizations. As discussed above, the

E:\FR\FM\23JYN1.SGM

23JYN1

Federal Register / Vol. 69, No. 141 / Friday, July 23, 2004 / Notices
level of analysis conducted and
resources needed to inspect the BHC
and to assign the consolidated R and F
ratings should be commensurate with
the level of risk posed by the subsidiary
depository institution(s) to the federal
safety net and the level of risk posed by
the BHC to the subsidiary depository
institution(s). The report of examination
by, and other information obtained
from, the functional and primary bank
regulators should provide the basis for
the consolidated R and F ratings. On–
site work, to the extent it involves areas
that are the primary responsibility of the
functional or primary bank regulator,
should be coordinated with and, if
possible, conducted by, those regulators.
Examination staff should concentrate
their independent analysis for the R and
F ratings around activities and risk
management conducted by the parent
company and non–functionally
regulated nondepository subsidiaries, as
well as around activities and risk
management functions that are related
to the subsidiary depository
institution(s), for example, audit
functions for the depository
institution(s) and compliance with 23A.
Examination staff will be required to
make an independent assessment of the
impact of the parent company and
nondepository subsidiary(ies) on the
subsidiary depository institution(s) in
order to assign the I rating.
By order of the Board of Governors of
the Federal Reserve System, July 20,
2004.
Jennifer J. Johnson
Secretary of the Board.
[FR Doc. 04–16865 Filed 7–22–04; 8:45 am]
BILLING CODE 6210–01–S

44007