Full text of Federal Reserve Bank of New York Circulars : 10647. Interagency Policy Statements on Examination and Credit Matters

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FEDERAL RESERVE BANK
OF NEW YORK

[

Circular No. 10647
July 2, 1993

INTERAGENCY POLICY STATEMENTS ON EXAMINATION
AND CREDIT MATTERS

To All State Member Banks, Bank Holding
Companies, and Branches and Agencies of
Foreign Banks, in the Second Federal Reserve District:

Enclosed — for member banks, bank holding companies, Edge and
Agreement corporations, and branches and agencies of foreign banks in this District
— are several policy statements jointly issued by the Office of the Comptroller of
the Currency, the Federal Deposit Insurance Corporation, the Office o f Thrift
Supervision, and the Board of Governors of the Federal Reserve System. The
statements contain new guidelines for interagency examination coordination, credit
availability initiatives, reporting of in-substance foreclosures, accrual status of
certain loans, fair lending initiatives, “special mention” assets, and review and
classification o f commercial real estate loans.
Additional, single copies of the enclosure may be obtained at this Bank (33
Liberty Street) from the Issues Division on the first floor, or by calling the Circulars
Division (Tel. No. 212-720-5215 or 5216).
Questions may be directed to Donald E. Schmid, Manager, Domestic Banking
Department (Tel. No. 212-720-6611).

erald

o r r ig a n

P r e s id e n t.

O ffice o f the C om ptroller o f the C urrency
Joint Statem ent
______ Federal D eposit Insurance C orporation
_______________________F ederal R eserve Board
______________________________________ O ffice o f T hrift Supervision

Interagency Policy Statement on
Examination Coordination and Implementation Guidelines
June 10, 1993
This statement outlines a program for coordinating examinations of insured depository
institutions and inspections of their holding companies by the federal financial regulatory
agencies. This program expands on existing interagency agreements, and responds to the
industry’s concern over the increased burden on organizations supervised by multiple regulatory
agencies.
The objective of the program is to minimize disruption and avoid duplicative examination efforts
and information requests, whenever possible. The significant elements of the program include:
■

Coordinating the planning, timing and scope of examinations and inspections of
federally insured depository institutions and their holding companies;

■

Conducting joint interagency examinations or inspections, when necessary;

■

Coordinating and conducting joint meetings between bank or bank holding
company management and the regulators;

■

Coordinating information requests; and

■

Coordinating enforcement actions, when appropriate.

The program emphasizes full cooperation and coordination by the agencies in supervising large
banking organizations and organizations that are in a less than satisfactory condition. Additional
effort will also be made to reduce the regulatory burden on the remaining population of
depository institutions.
Guidelines for implementation of the program are attached.

it####
[Enc. Cir. No. 10647]

IMPLEMENTATION GUIDELINES
1. PURPOSE
These guidelines were developed to strengthen coordination and cooperation among the
federal banking agencies in examining and supervising banking organizations and to carry out
the provisions of the March 10 Interagency Policy Statement intended to minimize the
disruptions and burdens associated with the examination process. The provisions are:
■

Eliminate duplication in examinations by multiple agencies, unless
clearly required by law;

■

Increase coordination of examinations among agencies when duplication
is required; and

■

Establish procedures to centralize and streamline examinations in
multibank organizations.

These guidelines address the coordination of the examinations by federal agencies of
depository institutions and the inspections of their holding companies. To achieve the desired
strengthening in the coordination of the federal agencies’ examination/inspection activities,
the guidelines focus on the planning, staffing, timing and conduct of examinations and
inspections; the conduct of joint management meetings to discuss inspection and examination
findings; and other areas of mutual concern.
2. PRIMARY SUPERVISORY AND COORDINATION RESPONSIBILITY
Examinations/inspections of a particular legal entity will be conducted by the federal
regulatory agency that has primary supervisory authority for that entity. In carrying out its
supervisory responsibilities for a particular entity within a banking organization, each
regulatory agency will rely on examinations/inspections conducted by the primary regulator
of the affiliate to the extent possible, thereby avoiding unnecessary duplication and disruption
to the banking organization. In certain situations, however, it may be necessary for a
regulatory agency other than the entity’s primary supervisory authority to participate in the
examination or inspection of the entity in order to fulfill its regulatory responsibilities.
These guidelines provide procedures for handling such situations.
Primary supervisory authority and coordination responsibilities are organized as follows:

OCC

national banks;

FDIC

state nonmember banks;

OTS

thrift holding companies and savings associations; and
2

FRB

parent bank holding companies, nonbank subsidiaries of bank
holding companies, the consolidated bank holding company and
state member banks.

The primary federal regulator is responsible for scheduling, staffing and setting the scope of
supervisory activities, including coordinating formal and informal administrative actions, as
necessary. In fulfilling these responsibilities, the primary regulatory agency should consult
closely with the other appropriate agencies when there is need for coordination.
3. OVERVIEW
The agencies will make every effort to coordinate the examinations and the inspections of
banking organizations. Coordinated examinations and inspections may not be practical in all
cases because of resource constraints, serious scheduling conflicts, or geographic
considerations; however, particular emphasis for implementing this program will be placed
on banking organizations with over $10 billion in consolidated assets and those banking
organizations (generally, with assets in excess of $1 billion) that exhibit financial weaknesses.
4. PRE-EXAMINATION COORDINATION
Where multiple regulators have authority over a legal entity, representatives from the
appropriate supervisory offices should meet quarterly as necessary to discuss supervisory
strategies for specific banking organizations, and at least annually to review and establish
examination and inspection schedules, to plan for the next year, and to consider the need for
coordination in the following areas:

■

Sharing the strategy and scope of each examination/inspection;

■

Determining if agencies other than the primary regulator of a particular
entity should participate in the examination/inspection of that entity;

■

Determining whether a consolidated request letter should be prepared to
avoid duplicative information requests;

■

Sharing examination/inspection work papers and resulting findings and
conclusions from prior examination/inspection efforts; or

■

Other areas as necessary.

INTERAGENCY REVIEW OF BANK, NONBANK AND PARENT COMPANY
ACTIVITIES

Certain areas or functions transcend legal entity distinctions, such as internal audit, credit
review and the methodology for determining the allowance for loan and lease losses. Such
functions may be located at the bank or holding company level. The primary regulator of
the depository institution and the holding company may both have supervisory responsibility
to assess such functions. In these cases, examinations or inspections of such areas should be
conducted on a coordinated and concurrent basis to avoid duplicative reviews and
unnecessary disruption.
The primary regulator of the entity being examined/inspected should take the lead on such a
coordinated examination or inspection, unless there is mutual agreement that another agency
will serve as the lead agency. The responsibilities of the lead agency, in consultation with
other appropriate agencies, include developing the scope of the examination or inspection and
determining the staff requirements. The lead agency will also coordinate
examination/inspection scheduling and the presentation of examination/inspection findings to
the appropriate management.
6.

COORDINATION OF MANAGEMENT MEETINGS

At the conclusion of examinations and inspections conducted under these guidelines, the
agencies should coordinate and plan joint meetings with the board of directors to discuss the
findings and conclusions. Agencies will be guided by the coordination responsibility
definitions outlined in Provision 2 of this program, unless otherwise agreed upon.
7. PROCESS FOR HANDLING SIGNIFICANT DIFFERENCES BETWEEN THE
AGENCIES IN FINDINGS, CONCLUSIONS AND RECOMMENDATIONS
Prior to forwarding examination and inspection results to management or boards of directors,
every effort should be made to resolve any significant differences concerning major
findings, conclusions and recommendations.
Such differences should be resolved by examiners, or officials at the regional level, within 10
business days of identification. If resolution cannot be achieved following full review and
communication between the regional offices, the matter should be referred to the national
level, where it will be resolved within a reasonable time frame.

8. INSPECTION AND EXAMINATION REPORTS
The primary regulator will prepare the formal report of examination or inspection covering
the entity for which it is the primary federal regulator and in those cases for which it serves
as the lead agency. The report should be addressed and transmitted to the directors of the
entity for which the regulator is the primary federal supervisory authority and, as necessary,
it may be sent to the directors of other entities that have a need for the information. The
agencies may mutually agree, if necessary and appropriate, to prepare a joint report.
9. INFORMATION REQUESTS
Any request for information to be obtained from an entity for supervisory purposes should
normally be made through the entity’s primary regulator. The primary regulator should also
share relevant supervisory information with the other appropriate regulatory agencies.
10. COORDINATING ENFORC art i aNT ACTIONS
When enforcement action is contemplated by one or more regulatory agencies, consideration
should be given to initiating a joint enforcement action to address and correct deficiencies
within a banking organization. At a minimum, each agency considering enforcement action
should inform other regulatory agencies. This provision reaffirms the existing interagency
enforcement agreement.
11. OTHER MATTERS
The agencies will establish arrangements to monitor coordination efforts and to resolve any
differences that arise under this program.
The agencies will also endeavor to coordinate with state banking departments, where
appropriate and feasible.
June 10, 1993

O ffice o f the C om ptroller o f the C urrency
______ Federal D eposit Insurance C orporation
Joint R elease
_______________________ Federal R eserve Board
_______________________________________ O ffice o f T hrift Supervision
For immediate release

F ederal R egulators A nnounce
A dditional C redit A vailability Initiatives
June 10, 1993
The four federal regulators of banks and thrifts today announced six additional initiatives to
implement the President’s March 10 program to improve the availability of credit to businesses
and individuals. These initiatives include changes to regulatory reporting requirements and the
issuance of joint policy statements on the valuation of real estate collateral, use of the "Special
Mention" category in reviewing loans, and improved coordination of examinations. The
changes to regulatory reporting requirements are consistent with generally accepted accounting
principles (GAAP).
The agencies noted that these latest actions bring to a close the first phase of the President’s
credit availability program. However, all four agencies emphasized that they are continuing
efforts to reduce the paperwork and regulatory burden that impedes the flow of funds to
creditworthy borrowers.
The actions announced today cover these areas:
■

In-Substance Foreclosures
In the past, the agencies’ rules required certain loans to be reported as in-substance
foreclosures. In die revised guidance issued today, the agencies make it clear that a
collateral dependent real estate loan need not be reported as foreclosed real estate unless
the lender has taken possession of the collateral. However, appropriate losses must be
recognized. This guidance is consistent with the approach taken by the Financial
Accounting Standards Board (FASB) in its new standard on loan impairment

■

Returning Nonaccrual Loans to Accrual Status

In the past, a loan that was partially charged off could not be returned to accrual status
until all missed payments had been made up to bring the loan to current status and the
institution expected to receive the full contractual principal and interest on the loan.
(more)
6

This reporting requirement also applied in situations where the borrower showed a
renewed ability and willingness to service the remaining debt Accordingly, institutions
sometimes found it difficult to work with borrowers who were experiencing temporary
difficulties in a way that would maximize recovery on these troubled loans.
To address this problem, the agencies are making two revisions to their nonaccrual
guidelines. First, banks and thrifts will be allowed to formally restructure troubled debt
in a manner that will allow a portion of the debt to become an accruing asset, provided
certain criteria are met This revised reporting guidance makes the policies of the bank
and thrift regulatory agencies consistent
Second, in some cases, borrowers have resumed paying the full amount of scheduled
contractual principal and interest payments on loans that are past due and in nonaccrual
status. Under the guidance issued today, banks and thrifts will be allowed to return
such past due loans to accrual status, provided the institution expects to collect all
principal and interest due and the borrower has made regular payments in accordance
with die terms of the loan over a specific period of time.
Regulatory Reporting Requirements for Sales of Other Real Estate Owned
(OREO)
The agencies will separately issue guidance to banks and thrifts that generally conforms
regulatory reporting requirements for sales of OREO with generally accepted accounting
principles (GAAP), as set forth in FASB Statement No. 66. These changes delete
certain requirements for minimum down payments for sales of OREO. Financial
institutions and examiners should refer to FASB Statement No. 66 for a detailed
discussion of the accounting principles that apply to sales of real estate.
Review and Classification of Commercial Real Estate Loans
The agencies are reaffirming their guidelines issued in November 1991 to ensure that
examiners are reviewing commercial real estate loans in a consistent, prudent and
balanced manner. Today’s policy statement reiterates that the evaluation of commercial
real estate loans is based on a review of the borrower’s willingness and capacity to
repay and on the income-producing capacity of the underlying collateral over time. The
statement emphasized that it is NOT regulatory policy to value collateral that underlies
real estate loans on a liquidation basis.

(more)

■

Supervisory Definition of Special Mention Assets
The agencies are concerned that improper use of the "Special Mention" loan category
in examiners’ reviews of loan portfolios may inhibit lending to small- and medium-size
businesses. Accordingly, all four agencies have adopted a uniform definition for this
category.
The use of a common definition will lead to more consistent supervision among the
four agencies. It will also enable examiners to more readily segregate Special Mention
assets from those warranting adverse classification. The agencies have agreed to use
classified assets, which by definition do not include Special Mention assets, as the
standard measure in expressing the quality of a bank or thrift’s asset portfolio.

■

Coordination of Holding Company, Thrift and Bank Examinations

The four agencies are issuing interagency guidelines to coordinate their supervision and
examinations in order to minimize the disruptions and burdens assdciated with the
examination process. Under the principles laid out in the guidelines, the agencies will
work to eliminate duplication in examinations by multiple agencies. Examinations and
inspections of a particular legal entity will be conducted by the primary supervisor for
that entity. The agencies will increase coordination of examinations and will establish
procedures to centralize and streamline examinations in multibank organizations.
The initiatives announced today follow a number of actions previously taken by the four
agencies to implement the President’s credit availability program. Those actions include:
■

Interagency Policy Statement on Documentation of Loans (March 30, 1993)

■

Interagency Letter on Lending Discrimination (May 27, 1993)

■

Proposed Rule on Revised Appraisal Requirements (June 4, 1993)

■

Interagency Release on Joint Fair Lending Initiatives {June 10, 1993)

The four agencies emphasized that they will continue their efforts to reduce paperwork and
regulatory burdens and improve the ability o f small businesses and consumers to gain access
to credit For example, in the coming months, the agencies expect to modify their procedures
for corporate applications (e.g., applications for charters, mergers, and branches) to make them
less duplicative and more uniform.

# # # # #

O ffice o f the C om ptroller o f the C urrency
Joint Statement
______ Federal D eposit Insurance C orporation
_______________________ Federal R eserve Board
___________________________ O ffice o f T hrift Supervision
For immediate release

Interagency G uidance on
R eporting o f In-Substance Foreclosures
June 10, 1993

On March 10, 1993, the four federal banking and thrift regulatory agencies issued an
Interagency Policy Statement on Credit Availability. That statement indicated that the agencies
■would seek to clarify the reporting treatment for in-substance foreclosures (iSF) and would
work with the accounting authorities to achieve consistency between generally accepted
accounting principles (GAAP) and regulatory reporting requirements in this area.
Under existing accounting guidelines for determining whether the collateral for a loan has been
in-substance foreclosed, a loan is transferred to "other real estate owned" (OREO or REO) and
appropriate losses are recognized if certain criteria are met Such OREO designations may
impede efforts to improve credit availability and may discourage lenders from working with
borrowers experiencing temporary financial difficulties.
The Financial Accounting Standards Board (FASB) recently issued Statement No. 114,
"Accounting by Creditors for Impairment o f a Loan," addressing the accounting for impaired
loans. This Standard also clarifies the existing accounting for in-substance foreclosures. Under
the new impairment standard and related amendments to Statement No. 15," Accounting by
Debtors and Creditors for Troubled Debt Restructurings" (FAS 15), a collateral dependent real
estate loan (i.e., a loan for which repayment is expected to be provided solely by the
underlying collateral) would be reported as OREO only if the lender had taken possession o f
the collateral. For other collateral dependent real estate loans, loss recognition would be based
on the fair value1 o f the collateral if foreclosure is probable. However, such loans would no
longer be reported as OREO. Rather, they would remain in the loan category.
(more)

1 Fair value is defined in paragraph 13 of FAS 15.

Accordingly, the agencies have concluded that losses2 must be recognized on real estate loans
that meet the existing ISF criteria based on the fair value of the collateral, but such loans need
not be reported as OREO unless possession of the underlying collateral has been obtained. The
agencies believe that this interagency guidance, coupled with other agency actions currently
being taken, will reduce impediments to the availability of credit.

# # # # #

2 Consistent with GAAP, loss recognition would consider estimated costs to sell.

O ffice o f the C om ptroller o f the C urrency
Joint Statement
______ F ederal D eposit Insurance C orporation
__ __________________ Federal R eserve Board
______________________________________ O ffice o f Thrift Supervision
For immediate release

R evised Interagency G uidance on
R eturning C ertain N on accrual Loans to A ccrual Status
June 10, 1993
Introduction
On March 10* 1993, the four federal banking agencies issued an Interagency Policy Statement
on Credit Availability. That policy statement outlined a program of interagency initiatives to
reduce impediments to the availability of credit to businesses and individuals.
As part of that program, the agencies are making two revisions to existing policies for
returning certain nonaccrual loans to accrual status. The revised policies should remove
impediments to working with borrowers who are experiencing temporary difficulties in a
manner that maximizes recovery on their loans, while at the same time improving disclosures
in this area.
The first change conforms the banking and thrift agencies* policies on troubled debt
restructurings (TDRs) that involve multiple notes (sometimes referred to as "A*y"B" note
structures). The second change would permit institutions to return past due loans to accrual
status, provided the institution expects to collect all contractual principal and interest due and
the borrower has demonstrated a sustained period of repayment performance in accordance
with the contractual terms.
The revised policies are effective immediately. Thus, institutions may elect to adopt such
changes for purposes of the June 30, 1993, Consolidated Reports of Condition and Income
(Call Report) and Thrift Financial Report (TFR). Revised Call Report and TFR instructions
will be distributed as of September 30, 1993.

TDR Multiple Note Structure
The agencies are conforming their reporting requirements for TDR structures involving
multiple notes. The basic example is a troubled loan that is restructured into two notes where
the first or "A" note represents the portion of the original loan principal amount which is
expected to be fully collected along with contractual interest. The second part of the
restructured loan, or "B" note, represents the portion of the original loan that has been charged
off.
Such TDRs generally may take any of three forms. (1) In certain TDRs, the "B" note may be
a contingent receivable that is payable only if certain conditions are met (e.g., sufficient cash
flow from the property). (2) For other TDRs, the "B" note may be contingently forgiven (e.g.,
note "B" is forgiven if note "A" is paid in full). (3) In other instances, an institution would
have granted a concession (e.g., rate reduction) to the troubled borrower but the "B" note
would remain a contractual obligation of the borrower. Because the "B" note is not reflected
as an asset on the institution’s books and is unlikely to be collected, the agencies have
concluded that for reporting purposes the "B" note could be viewed as a contingent receivable.
Institutions may return the "A" note to accrual status provided the following conditions are
met:

(1)

The restructuring qualifies as a TDR as defined by FASB Statement No. 15,
"Accounting by Debtors and Creditors for Troubled Debt Restructuring," (SFAS
15) and there is economic substance to the restructuring. (Under SFAS 15, a
restructuring of debt is considered a TDR if "the creditor for economic or legal
reasons related to the debtor’s financial difficulties grants a concession to the
debtor that it would not otherwise consider.")

(2)

The portion of the original loan represented by the "B" note has been charged
off. The charge-off must be supported by a current, well documented credit
evaluation of die borrower’s financial condition and prospects for repayment
under the revised terms. The charge-off must be recorded before or at the time
of the restructuring.

(3)

The "A" note is reasonably assured o f repayment and of performance in
accordance with the modified terms.

(4)

In general, the borrower must have demonstrated sustained repayment
performance (either immediately before or after the restructuring) in accordance
with the modified terms for a reasonable period prior to die date on which the
"A" note is returned to accrual status. A sustained period o f payment
performance generally would be a minimum o f six months and involve
payments in the form of cash or cash equivalents.
12

Under existing reporting requirements, the "A" note would be disclosed as a TDR. In
accordance with these requirements, if the "A" note yields a market rate of interest and
performs in accordance with the restructured terms, such disclosures could be eliminated in the
year following the restructuring. To be considered a market rate of interest, the interest rate
on the "A" note at the time of the restructuring must be equal to or greater than the rate that
the institution is willing to accept for a new receivable with comparable risk.
Nonaccrual Loans That Have Demonstrated Sustained Contractual Performance
Certain borrowers have resumed paying the full amount of scheduled contractual interest and
principal payments on loans that are past due and in nonaccrual status. Although prior
arrearages may not have been eliminated by payments from the borrowers, some borrowers
have demonstrated sustained performance over a period of time in accordance with the
contractual terms. Under existing regulatory standards, institutions cannot return these loans
to accrual status unless they expect to collect all contractual principal and interest and the loans
are brought fully current (or unless the loan becomes well secured and in the process of
collection).
Such loans may henceforth be returned to accrual status, even though the loans have not been
brought fully current, provided two criteria are met: (1) all principal and interest amounts
contractually due (including arrearages) are reasonably assured of repayment within a
reasonable period, and (2) there is a sustained period of repayment performance (generally a
minimum of six months) by the borrower, in accordance with the contractual terms involving
payments of cash or cash equivalents. Consistent with existing guidance, when the regulatory
reporting criteria for restoration to accrual status are met, previous charge-offs taken would not
have to be fully recovered before such loans are returned 'to accrual status.
Loans that meet the above criteria would continue to be disclosed as past due (e.g., 90 days
past due and still accruing for Call Report and TFR purposes), as appropriate, until they have
been brought fully current.
Additional Guidance
The Financial Accounting Standards Board (FASB) recently issued Statement No. 114,
"Accounting by Creditors for Impairment o f a Loan," which establishes a new approach for
recognizing impairment on problem loans and for recognizing income on such loans. In
addition, the standard establishes new disclosure requirements for impaired loans for financial
reporting purposes. In light o f the significance o f those changes, the agencies are reevaluating
regulatory disclosure and nonaccrual requirements that will apply when the statement becomes
effective, and expect to issue revised policies at a later date.

# # # # #

O ffice o f the C om ptroller o f th e C u rren cy
______ Federal Deposit Insurance C orporation
Joint Release
_______________________F ederal R eserve B oard
____________________________________ O ffice o f T hrift Supervision
For immediate release

Interagency Policy Statem ent on
F air L ending Initiatives
June 10, 1993

The four financial institution regulatory agencies are announcing initiatives that they
will pursue over the next several months to enhance their ability to detect lending
discrimination, to improve the level of education they provide to the industry and to
their examiners, and to strengthen fair lending enforcement
Background
A number of interagency efforts are already completed or are under way to improve fanlending detection techniques, enforcement, and education. For example:
■

The agencies have issued a joint statement to financial institutions that reaffirms
their commitment to the enforcement of the fair lending laws and provides the
industry with guidance and suggestions on fair lending matters.

■

The agencies are working on a revised supervisory enforcement policy for
dealing with violations of the Equal Credit Opportunity and Fair Housing Acts.
This revised policy will replace a policy issued in 1981. The revised policy
specifies corrective actions for several different substantive violations of the
ECOA and FHA.

■

The agencies are developing uniform fair lending examination procedures and
training programs. The agencies believe these new procedures will significantly
strengthen existing discrimination detection programs. These new examination
procedures will be publicly available this summer.

New Initiatives
The four agencies will pursue the following new initiatives over the next several
months:

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14

Fair Lending Training for Examiners

The agencies will develop a new training program in fair lending for
experienced compliance examiners that will be conducted on a regional basis.
A pilot program could be held as early as Fall 1993.
2.

Fair Lending Seminar for Industry Executives

The agencies will develop and sponsor regional fair lending programs for top
level industry executives (chief executive officers and executive vice presidents)
to explain their efforts to enforce fair lending laws and to foster additional
sensitivity and awareness among lenders about discrimination issues, specifically
subtle practices that impede the availability of credit to low-income and minority
individuals. The first session of this program could be held later this year.
3.

Alternative Discrimination Detection Methods

The agencies will explore statistically-based discrimination analysis models.
These models may help identify loan applications files for review as part of the
examination process. This will significantly enhance the agencies’ abilities to
identify loan applicants that may have received differential treatment
4.

Stronger Enforcement of Fair Lending Laws
Each agency will implement an internal process for making referrals to the
Department o f Justice for violations o f the Equal Credit Opportunity A ct These
internal procedures will ensure that appropriate cases are being put forth for
consideration by senior management

Improved Consumer Complaint Programs
The agencies believe that refinements to their consumer complaint systems can
also better promote the broad availability o f credit on a non-discriminatoiy basis.
During the next few months, each agency will evaluate the effectiveness o f its
consumer complaint system in detecting and correcting credit discrimination, and
alerting the agencies to industry practices that may inhibit the free flow o f
credit Each agency will announce its own specific initiatives in these areas.

# # # # #

O ffice o f the C om ptroller o f the C urrency
Joint Statement
______ Federal D eposit Insurance Corporation
_______________________ F ed eral R eserve Board
______________________________________ O ffice o f T hrift Supervision
For immediate release

Interagency Statem ent on the
Supervisory Definition o f Special M ention A ssets
June 10, 1993
The March 10, 1993 Interagency Policy Statement on Credit Availability indicated the federal
banking and thrift regulatory agencies would issue guidance clarifying use of the Special
Mention definition for regulatory supervision purposes. The four agencies have agreed on the
definition of "Special Mention" as stated below. This definition should also be considered by
an institution when performing its own internal asset review.
The definition of Special Mention is as follows:
A Special Mention asset has potential weaknesses that deserve management’s
close attention. If left uncorrected, these potential weaknesses may result in
deterioration of the repayment prospects for the asset or in the institution’s credit
position at some future date. Special Mention assets are not adversely classified
and do not expose an institution to sufficient risk to warrant adverse
classification.
In the past, the agencies used different terminology and definitions for Special Mention.
Supervisory reports and their contents also varied between agencies. The use of a common
definition will lead to more consistent application of supervisory procedures. The definition
will also enable examiners to more readily segregate Special Mention assets from those
warranting adverse classification. It will also-ensure that the Special Mention category is not
used to identify an asset which has as its sole weakness credit data exceptions or collateral
documentation exceptions that are not material to the repayment of the asset
The agencies are in the process of developing examiner guidance, explaining how the Special
Mention category will be used in the assessment of the overall condition of an institution. The
agencies have agreed to conform their policies and guidance to the following principles:

(more)
16

■

Classified assets, which by definition do not include Special Mention assets, will
be the standard measure used in expressing the quality of a bank or thrift’s loan
portfolio and other assets. The agencies will not express asset quality in terms
of "criticized assets," a term that is generally recognized as including both
Special Mention and classified assets.

■

The agencies will ensure their policies, examiner guidance, and internal
monitoring systems do not call for internal reporting of criticized asset totals or
percentages. However, examiners will continue to consider the level and trends
of assets categorized as Special Mention in their analysis as appropriate.

■

In implementing Section 132 of the FDIC Improvement Act, Standards for
Safety and Soundness, the agencies will use classified assets and not use
criticized assets as a measure of asset quality.

■

Special Mention assets will not be combined with classified assets in reports of
examination or in corporate applications.

Each agency will make appropriate revisions to its examiner guidance, and all will work to
ensure their guidance is consistent among the agencies. The guidance will emphasize that it
is inappropriate to use the Special Mention category to capture loans solely because of their
nature or type, such as small business lending or affordable housing lending.
Implementation of the revised definition will be effective immediately. Examiner guidance will
be forthcoming shortly.

# # # # #

O ffice o f the C om ptroller o f th e C urrency
Joint R elease
______ Federal D eposit Insurance C orporation
_______________________ Federal R eserve Board
_____________________________________O ffice o f T hrift Supervision
For immediate release

Interagency Policy Statem ent on
R eview and C lassification o f C om m ercial R eal E state Loans
June 10, 1993

On March 10, 1993, the four federal regulators of banks and thrifts issued an Interagency
Policy Statement on Credit Availability. This policy statement outlined a program of
interagency initiatives to reduce impediments to making credit available to businesses and
individuals.
One impediment to making credit available to commercial real estate borrowers may be
problems in evaluation of real estate collateral. The federal bank and thrift regulatory agencies
have been working with their examination staffs for some time to ensure that commercial real
estate loans are evaluated in accordance with agency policy. In issuing today’s policy
statement, the federal bank and thrift regulatory agencies are reaffirming the guidelines in the
November 7, 1991 Interagency Policy Statement on the Review and Classification of
Commercial Real Estate Loans. The November 7, 1991 policy statement provides clear and
comprehensive guidance to ensure supervisory personnel are reviewing commercial real estate
loans in a consistent, prudent and balanced manner. A copy of that statement is attached.
The November 7, 1991 statement clarified regulatory policy on real estate valuation and
classification. The evaluation of commercial real estate loans is based on a review of the
borrower’s willingness and capacity to repay and on the income-producing capacity of the
underlying collateral over time. The value of collateral increases in importance as a loan
becomes troubled and the borrower’s ability to repay the loan becomes more questionable. The
statement emphasizes that it is NOT regulatory policy to value collateral that underlies real
estate loans on a liquidation basis. (See the discussion on "Examiner Review of Individual
Loans, Including the Analysis of Collateral Value," beginning on page 3 of the policy
statement.)
Furthermore, the policy statement discusses management’s responsibility for reviewing
appraisal assumptions and conclusions for reasonableness. Appraisal assumptions should not
be based solely on current conditions that ignore the stabilized income-producing capacity of
the property.

Management should adjust any assumptions used by an appraiser in determining values that
are overly optimistic or pessimistic. The policy statement also indicates that the assumptions
used in a discounted cash flow analysis (such as discount rates and direct capitalization rates)
should reflect reasonable expectations about the rate o f return that investors require under
normal, orderly and sustainable market conditions. Unrealistic or unsustainable high or low
discount rates, "cap” rates, and income projections should not be used.
The use o f appropriate assumptions in a discounted cash flow analysis is particularly important
in determining the value o f collateral for a troubled, project-dependent commercial real estate
loan (involving income-producing property). The agencies use this valuation for determining
the amount o f the loan that is adequately secured by the value o f the collateral. The November
7, 1991 Interagency Policy Statement indicates that generally, any portion o f the loan balance
that exceeds the amount adequately secured by collateral values and that can be clearly
identified as uncollectible should be classified "loss." The portion o f the loan balance that is
adequately secured by the value o f the collateral should generally be classified no worse than
"substandard." The policy statement also indicates that, when an institution has taken a chargeo ff in sufficient amount so that the remaining recorded balance o f the loan (a) is being serviced
(based on reliable sources) and (b) is reasonably assured o f collection, classification o f the
remaining recorded balance may not be appropriate.
The federal bank and thrift regulatory agencies will continue to ensure their examiners
implement the policy statement appropriately and uniformly. Each agency has an appeals
process for institutions with significant concerns about examinations, including any concerns
relating to the supervisory treatment o f commercial real estate loans.

Reference:

Interagency Policy Statement on Review and Classification o f Commercial Real
Estate Loans, November 7, 1991

# # # # #

Interagency Policy Statement on the Review and
Classification of Commercial Real Estate Loans1

Introduction
This policy sutcm ent addresses the review and classification o f commercial real estate
loans by examiners o f the federal bank and thrift regulatory agencies.1 Guidance is
also provided on the analysis o f the value o f the underiying collateral. In addition,
this policy statement summarizes principles for evaluating an institution's process for
determining the appropriate level for the allowance for loan and lease losses, including
amounts that have been based on an analysis o f the commercial real estate loan
portfolio.3 These guidelines arc intended to promote the prudent, balanced, and
consistent supervisory treatment o f commercial real estate loans, including those to
borrowers experiencing financial difficulties.
The an&chments to this policy statement address three topics related to the review o f
commercial real estate loans by examiners. The topics include the treatment of
guarantees in the classification process (Attachment 1); background information on the
vamation o f income-producing commercial real estate loans in the examination process
(Attachment 2): and definitions o f classification terms used by the federal bank and
thrift regulatory agencies (Attachment 3).

Examiner Review of Commercial Real Estate Loans
L o in Policy and A dm inistration R eview . As part o f the analysis o f an institution's
commercial real estate loan portfolio, examiners review lending policies, loan
administration procedures, and credit risk control procedures. The maimenance o f
piudent written lending policies, effective internal systems and controls, and thorough

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loan documentation art essential to the institution's management o f the (ending
function. ...
The policies governing an institution's teal estate lending activities must include
prudent underwriting standards that are periodically reviewed by the board o f directors
and dearly communicated to the institution's management and lending staff. The
institution must also have credit risk control procedures that include, for exam ple,
prudent internal lim its on exposure, an effective credit review and classification
process, and a m ethodology for ensuring that the allowance for loan and lease losses is
maintained at an adequate le v e l The complexity and scope o f these policies and
procedures should be appropriate to the size o f the Institution and the nature o f the
institution's activities, and should be consistent with prudent banking practices and
relevant regulatory requirements.

Indicators o f Troubled R eal E state M arkets and Projects, and R elated
Indebtedness. In order to evaluate the collectibility o f an institution's commercial real
estate portfolio, examiners should be alert for Indicators o f weakness in the real estate
markets served by the Institution. They should also be alert for indicators o f actual or
potential problems in the individual commercial real estate projects or transactions
financed by the institution.
Available indic*..ors, such as permits for — and the value o f — new construction,
absorption rates, employment trends, and vacancy rates, are useful in evaluating the
condition o f commercial real estate markets. W eaknesses disclosed by these types o f
statistics may indicate that a real estate market is experiencing difficulties that may
result in cash flow problems for individual real estate projects, declining real estate
values, and ultimately, in troubled commercial real estate loans.
Indicators o f potential or actual difficulties in commercial real estate projects may
include:
«

An excess o f similar projects under construction.

•

Construction delays or other unplanned adverse events resulting in cost overruns
that may require renegotiation o f loan terms.

•

Lack o f a sound feasibility study or analysis that reflects current and reasonably
anticipated market conditions.

•

Changes in concept or plan (for example, a condominium project convened to an
apartment project because o f unfavorable market conditions).

•

Rem concessions or sales discounts resulting in cash flow below the level projected
in the original feasibility study or appraisal.

•

Concessions on finishing tenant space, moving expenses, and lease buyouts.

•

Slow leasing or la c k o f sustained sales activity and increasing sales cancellations
that may reduce the project's income potential, resulting in protracted repayment or
default on the loan.

•

Delinquent lease payments from major tenants.

« Land values that assume Amirc rezoning.
•

Tax arrearages.

A s the problems associated with a commercial real estate project become more
pronounced, problems with the related indebtedness may also arise. Such problems
include diminished cash flow to service the debt and delinquent interest and principal
payments.
W hile som e commercial real estate loans become troubled because o f a general
downturn in the market, others become troubled because they were originated on an
unsound or a liberal basis. Common examples o f these types o f problems include:
•
•

Loans with no or minimal borrower equity.
Loans on speculative undeveloped property where the borrowers’ only aource o f
repayment is the sale o f the property.

•

Loans based on land values that have been driven up by rapid turnover o f
ownership, but without any corresponding improvements to die property or support
able income projections to justify an increase in value.

•

Additional advances to service an existing loan that lacks credible support for full
repayment from reliable sources.

Loam to borrowers with no development plans or noncurrent development plans.

•

Renewals, extensions and refinancings that lack credible support for full repayment
from reliable sources and that do not have a reasonable repayment schedule.4

E xam iner R eview o f Individual Loans, Including the A nalysis o f C ollateral Value*
The focus o f an exam iner's review o f a commercial real estate loan, including binding
commitments, is the ability o f the loan to be repaid. Ih e principal factors that bear on
this analysis arc the income-producing potential o f the underlying collateral and the
borrower's w illingness and capacity to repay under the existing loan terms from the
borrower's other resources i f necessary. In evaluating the overall risk associated with

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a commercial real estate loan, examiners consider a number o f factors, including the
character, overall financial condition and resource*, and payment record o f the
borrower; the prospects for support from any financially responsible guarantors; and
the nature and degree o f protection provided by the cash flow and value o f the
underlying collateral.9 However, as other sources o f repayment for a troubled
com m ercial real estate loan become inadequate over time, the importance o f the
collateral's value in the analysis o f the loan necessarily increases.

The appraisal regulations o f the federal bank and thrift regulatory agencies require
institutions to obtain appraisals when certain criteria are m et9 Management is
responsible for reviewing each appraisal's assumptions and conclusions for reasonableI ness. Appraisal assumptions should not be based solely on current conditions that
! ignore the stabilized income-producing capacity o f the property.7 Management should
1 adjust any assumptions used by an appraiser in determining value that are overly
* optim istic or pessim istic.
r

; An examiner analyzes the collateral's value as determined by the institution's most
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recent appraisal (or internal evaluation, as applicable). An examiner reviews the major
facts, assumptions, and approaches used by the appraiser (including any comments
made by management on the value rendered by the appraiser). Under the
circumstances described below, the examiner may make adjustments to this assessment
o f value. This review and any resulting adjustments to value are solely for purposes

* o f an exam iner's analysis and classification o f a credit and do not involve actual
; adjustments to an appraisal.
A discounted cash flow analysis is an appropriate method for estimating the value o f
: income-producing real estate collateral.1 This approach is discussed in more detail in
$ Attachment 2. This analysis should not be based solely on the current performance o f
: the collateral or sim ilar properties; rather, it should take into account, on a discounted
j basis, the ability o f the real estate to generate income over time based upon reasonable

i and supportable assumptions.
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! When reviewing the reasonableness o f the facts and assumptions associated with the
value o f the collateral, examiner* may evaluate:
j « Current and projected, vacancy and absorption rates:
| •

Lease renewal trends and anticipated rents;

! •

Volum e and trends in past due leases;

j•

E ffective rental rates or sale prices (taking into account all concessions);

l •

N et operating income o f the property as compared with budget projections; and

• •

D iscount rates and direct capitalization C a p ”) rates.1

• The capacity o f a property to generate cash flow to service a loan is evaluated based
upon rents (or sales), expenses, and rates o f occupancy that are reasonably estimated to
• be achieved over time. The determination o f the level o f stabilized occupancy and
rental rates should be based upon in analysis o f current and reasonably expected
! market conditions, taking into consideration historical levels when appropriate. The
• analysis o f collateral values should not be based upon a simple projection o f current
j levels o f net operating income if markets are depressed or reflect speculative pressures
. but can be expected over a reasonable period o f time to reum to normal (stabilised)
i conditions. Judgment is involved in determining the time that it w ill take for a
’ property to achieve stabilized occupancy and rental rates.
: Examiners do not make adjustments to appraisal assumptions for credit analysis
purposes based on worst case scenarios that ire unlikely to occur. For example, an
exam iner would not necessarily assume that a building w ill become vacant just
• because an existing tenant who is renting at a rate above today’s market rate may
;
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vacate the property when the current lease expires. On the other hand, an adjustment
to value may be appropriate for credit analysis purposes when the valuation assumes
renewal at the above-market rate, unless that rate is a reasonable estimate o f the
expected market rate at the time o f renewal.

•

* W hen estimating the value o f income-producing real estate, discount rates and "cap”
; rates ahould reflect reasonable expectations about the rate o f return that investors
require under normal, orderly and sustainable market conditions. Exaggerated,
imprudent, or unsustainably high or low discount rates, "cap" rates, and income
; projections should not be used. Direct capitalization o f nonstabilized income flow s
.

should also not be used.

Assum ptions, when recently made by qualified appraisers (and, as appropriate, by

;

institution management) and when consistent with the discussion above, should be

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i

given a reasonable amount o f deference. Examiners should not challenge the
underlying assumptions, including discount rates and "cap" flie s used in appraisals,
that differ only in a lim ited way from norms that would generally be associated with
the property under review. The estimated value o f the underlying collateral may be
adjusted for credit analysis purposes when the examiner can establish that any underly
ing facts or assumptions are inappropriate and can support alternative assumptions.

Classification Guidelines
As with other types o f loans, commercial real estate loans that are adequately protected
by the current sound worth and debt service capacity o f the borrower, guarantor, or the
underlying collateral generally are not classified. Similarly, loans to sound borrowers
that are refinanced or renewed in accordance with prudent underwriting standards,
including loans to creditworthy commercial or residential real estate developers, should
not be classified or criticized unless well-defined weaknesses exist that jeopardize
repayment. A n institution w ill not be criticized for continuing to carry loans having
weaknesses that result in classification or criticism as long as the institution has a wellconceived and effective workout plan for such borrowers, and effective internal
controls to manage the level o f these loans.
In evaluating commercial real estate credits for possible classification, examiners apply
standard classification definitions (Attachment 3).10 In determining the appropriate
classification, consideration should be given to all important information on repayment
prospects, including Information on the borrower's creditworthiness, the value of, and
cash flow provided by, all collateral supporting the loan, and any support provided by
financially responsible guarantors.
The loan's record o f performance to date is important and must be taken into
consideration. A s a general principle, a performing commercial real estate loan should
not automatically be classified or charged-off solely because the value o f the
underlying collateral has declined to in amount that is less than the loan balance.
However, It would be appropriate to classify a performing loan when well-defined
weaknesses exist that jeopardize repayment, such as the lack o f credible support for
fo il repayment from reliable sources,1
1
These principles hold for individual credits, even If portions or segm ents o f the
industry to which the borrower belongs are experiencing financial difficulties. The
evaluation o f each credit should be based upon the fundamental characteristics

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I affecting the collectibility o f the particular credit. The problems broadly associated
) with som e sec tore or segments o f an industry, such as certain commercial teal estate
markets, should not lead to overly pessim istic assessments o f particular credits that are
: not affected by the problems o f the troubled sectors.
C lassification o f troubled project-dependent com m ercial real estate loans.n The
follow ing guidelines for classifying a troubled commercial teal estate loan apply when
the repayment o f the debt w ill he provided solely by the underlying real estate
collateral, and there are no other available and reliable sources o f repayment.
I
j A s a general principle, for a troubled project-dependent commercial real estate loan,

| any portion o f the loan balance that exceeds the amount that is adequately secured by
j the value o f the collateral, and that can clearly be identified as uncollectible, should be

i classified "loss."11 The portion o f the loan balance that is adequately secured by the
! value o f the collateral should generally be classified no worse than "substandard.*' The
j amount o f the loan balance in excess o f the value o f foe collateral, or portions thereof,
i should be classified "doubtful" wlrcn foe potential for foil loss may be mitigated by the
outcom es o f certain pending events, or when loss is expected but foe amount o f foe
loss cannot be reasonably determined.
. I f warranted by foe underlying circumstances, an examiner may use a "doubtful"
: classification on the entire loan balance. However, this would occur infrequently.
i

i G uidelines for classifying partially charged-off loans. Based upon consideration o f
; all relevant factors, an evaluation may indicate that a credit has well-defined
; w eaknesses that jeopardize collection in foil, but foal a portion o f the loan may be
: reasonably assured o f collection. When an institution has taken a charge-off in an
j amount sufficient that the remaining recorded balance o f the loan (a) is being serviced
: (based upon reliable sources) and (b) is reasonably assured o f collection, classification
; o f foe remaining recorded balance may not be appropriate. Classification would be
j appropriate w hen well-defined weaknesses continue to be present in the remaining
! recorded balance. In such cases, the remaining reoorded balance would generally be
J classified no more severely than "substandard."
A more severe classification than "substandard" for the remaining recorded balance
: would be appropriate if the loss exposure cannot be reasonably determined, e.g., where
< significant risk exposures art perceived, such as might be the case for bankruptcy
, situations or for loans collateralized by properties subject to environmental hazards,
i Jn addition, classification o f the remaining recorded balance would be appropriate
j when sources o f repayment are considered unreliable.

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G uidelines for classifying form ally restructured loans. The classification treatment
previously discussed for a partially charged o ff loan would also generally be
appropriate* for a formally restructured loan when panial charge-otTs have been taken,
For a formally restructured loan, the focus o f the examiner’* analysis Is on the ability
o f the borrower to repay the loan in accordance with its modified terms. Classification
o f a formally restructured Joan would be appropriate, if, after the restructuring, w elldefined weaknesses exist that jeopardise the orderly repayment o f the loan in
accordance with reasonable m o d ifie d te r m s .14 Troubled commercial real estate loans
whose terms have been restructured should be identified in the institution's internal
credit review system , and closely monitored by management.

•J Review of the Allowance for Loan and Lease Losses (ALLL)U
i

| The adequacy o f a depository institution's ALLL, including amounts based on an
] analysis o f the commercial real estate portfolio, must be based on a careful w ell
! documented, and consistently applied analysis o f the institution’s loan and lease ponfoj lio .l<
The determination o f the adequacy o f the ALLL should be based upon management's
; consideration o f all current significant conditions that might affect the ability o f
borrowers (or guarantors, if any) to fulfill their obligations to the institution. W hile
| historical loss experience provides a reasonable starting point, historical losses or even
! recent trends in losses are not sufficient without further analysis and cannot produce a
I reliable estimate o f anticipated loss.
i

In determining the adequacy or the ALLL, management should also consider other
I
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!

factors, including changes in the nature and volum e o f the portfolio; the experience,
ability, and depth o f lending management and staff; changes in credit standards; c o llc o
tion policies and historical collection experience; concentrations o f credit risk; trends in
the volum e and severity o f past due and classified loans; and trends in the volum e o f

: nonaccrual loans, specific problem loans and commitments. In addition, this analysis
should consider the quality o f the institution's system s and management in identifying,
1 monitoring, and addressing asset quality problems. Furthermore, management should
! consider external factors such as local and national econom ic conditions and

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" O d a t tef d rlb n t dtrf rtfaaoyagenda h m kned g i a c o tea l w n ef rben m i tmm
a h h e ea a k a hit ltt
udne o h loac o
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ae.
•

M Ikee t m t o p o e d s r b di ti e a a p i i for• sore a crt e i i io mdupetaJ l n st a c u d
s i a i n r u a e c i e n hn e i n e m u
cuae n a l f
a e hn ol
b a h e e b as s i gt el a portfolio sll an a a g t a bsl H w v r h i o l a e u
e c i v d y sesn h o n
oey n g r g u ai. o e e , s n y a s matiw p c s a d
ue* n
i
d e n ti p yta c yp r o d eALLL i s g e a e fr o alctdt,a ypriua a d u g o po ast. Ike
o s o m l ht r e t f i
t e r g t d o. r loae o n atclr n . r r u f ses
I
ALU, i aalbet a * r alcei lse oiiaigf o tel a a dl a eprflo
s vial o h o b l rdt oss rgntn r m h o n n e a otoi.
i

8
j

developments; competition; and legal and regulatory requirements; as w ell as
reasonably .foreseeable events that are likely to affect the collectibility o f the loan
portfolio.
Management should adequately document the factors that were considered, the
m ethodology and process that were used in determining the adequacy o f the ALLL,
and the range o f possible credit losses estimated by this process. The com plexity and
scope o f this analysis must be appropriate to the size and nature o f the institution and
provide for sufficient flexibility to accommodate changing circumstances.
Examiners w ill evaluate the methodology and process that management has follow ed
in arriving at an overall estimate o f the ALLL in order to assure that all o f the relevant
factors affecting the collectibility o f the portfolio have been appropriately considered.
In addition, the overall estimate o f the ALLL and the range o f possible credit losses
estimated by management w ill be reviewed for reasonableness in view o f these factors.
T his examiner analysis will also consider the quality o f the institution's system s and
management in identifying, monitoring, and addressing asset quality problems.
A s discussed in the previous section on classification guidelines, the value o f the
collateral is considered by examiners in reviewing and classifying a commercial real
estate loan. However, for a performing commercial real estate loan, the supervisory
policies o f the agencies do n ot require automatic increases to the ALLL solely because
the value o f the collateral has declined to an amount that is less than the loan balance.
In assessing the ALLL during examinations, it is important to recognize that
m anagem ent's process, methodology, and underlying assumptions require a substantial
degree o f judgment. Even when an institution maintains sound loan administration and
collection procedures and effective internal systems and controls, the estimation o f
anticipated losses may not be precise due to the wide range o f factors that must be
considered. Further, the ability to estimate anticipated loss on specific loans and
categories o f loans Improves over time as substantive information accumulates
regarding the factors affecting repayment prospects. When management has (a)
maintained effective system s and controls for identifying, monitoring and addressing
asset quality problems a n d (b) analyzed all significant factors affecting the
collectibility o f die portfolio, considerable weight should be given to management's
estim ates in assessing the adequacy o f the A LLL

\
.
•I
i
t

•

Attachment I

TREATMENT OF GUARANTEES
IN THE CLASSIFICATION PROCESS
:

Initially, the original source o f repayment and the borrower's Intent and ability to
fu lfill the obligation without reliance on third party guarantors w ill be the primary
basin for the review and classification o f assets.1 The federal bank and thrift

regulatory agencies w ill, however, consider the support provided by guarantees in the
| determination o f the appropriate classification treatment for troubled loans. The
| presence o f a guarantee from a "financially responsible guarantor," as described below,
| may be sufficient to preclude classification or reduce the severity o f classification.

For purposes o f this discussion, a guarantee from a "financially responsible guarantor"

< has the following attributes:
I

1 •

The guarantor must have both the financial capacity and willingness to provide

support for the credit;
•

} •

The nature o f the guarantee lx such that it can provide support for repayment o f the
indebtedness, in whole or in pan, during the remaining loan term; and3
The guarantee should be legally enforceable.

| The above characteristics generally indicate that a guarantee may improve the
! prospects for repayment o f the debt obligation.
i

! C onsiderations relating to a guarantor’s financial capacity. The lending institution
| must have sufficient Information on the guarantor's financial condition, income,
j liquidity, cash flow , contingent liabilities, and other relevant factors (including credit
I ratings, when available) to demonstrate the guarantor's financial capacity to fulfill the
f obligation. A lso, it is important to consider the number and amount o f guarantees
j currently extended by a guarantor, in order to determine that the guarantor has the
[ financial capacity to fulfill the contingent claims that e x ist
i
, C onsiderations relating to a guarantor’s w illingness to repay. Examiners normally
, rely on their analysis o f the guarantor's financial strength and assume a w illingness to
• perform unless there Is evidence to the contrary. This assumption may be m odified

|
1Some Vans re e ffhead b a dp i a i yu o At d c d l menfth ct Ae f a a o , who w I a b a c ,t e
r
a e rmrl p e
eaa
urmr
. n tcae h
p i a ys u c o r p y e t I s c d c m t n o ,eaammen g n n l a a ut ecl e iiiyo tel r b a du o
r m r ore f eamn. e u h rui a o i
c e l y i e h o l g blt f h o t a e p e
t ef i w o ' aiiyt r p yAc \om.
h u f J r i blt o e a
9Some funnteei may o l p o i efrj p o tfrcranptacio ara emitpoet I w u dmi b a p o r a e
n y r v d o u p r o e ti
f el
rjc. t o l
e p r pit
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p n he u r n M o f u t ruld
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a p e i n l thenp a e .
lia

1
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i
i
| based on the "track record" o f the guarantor, including payments made to date on the
asset under review or other obligations.
Examiners give due consideration to those guarantors that have demonstrated their
ability and w illingness to fulfill previous obligations in their evaluation o f current
guarantees on sim ilar assets. An important consideration w ill be whether previously
required performance under guarantees was voluntary or the result o f legal or other
actions by the lender to enforce the guarantee. However, examiners give lim ited
credence, if any, to guarantees from obligors who have reneged on obligations in the
past, unless there is clear evidence that die guarantor has the ability and intent to
j honor the specific guarantee obligation under review.
Examiners also consider the econom ic incentives for performance from guarantors:
•

W ho have already partially performed under the guarantee or who have other
significant investments in the project;

' •

W hose other sound projects art cross-collateralized or otherwise intertwined with
the credit; or

j •
j.

Where the guarantees arc collateralized by readily marketable assets that are under
the control o f a third party.

•

: O ther considerations. In general, only guarantees that are legally enforceable w ill be
relied upon. However, all legally enforceable guarantees may not be acceptable. In
j addition to the guarantor's financial capacity and willingness to perform, it is expected
j that the guarantee will not be subject to significant delays in collection, or undue
| com plexities or uncertainties about the guarantee.
I

1
;
!
I

The nature o f the guarantee Is also considered by examiners. For example, some
guarantees for real estate projects only pertain to the development and constmction
phases o f the project. A s such, these limited guarantees would not be relied upon to
support a troubled loan after the com pletion o f those phases.

i
. Examiners also consider the institution's intent to enforce the guarantee and whether
i there are valid reasons to preclude an institution from pursuing the guarantee. A
history o f timely enforcement and successful collection o f the M

amount o f

guarantees w ill be a positive consideration in the classification process.i

i
i

A ttachm ent 2

T H E VALUATION OF INCOME-PRODUCING REAL ESTATE
Approaches to the Valuation of Real Estate
Appraisals are professional judgments o f the market value o f real property. Three
basic valuation approaches are used by professional appraisers in estimating the market
value o f real property - the cost approach, the market data or direct sales comparison
approach, and the income approach. The principles governing the three approaches are
w idely known in the appraisal field and were recently referenced in parallel regulations
issued by each o f the federal hank and thrift regulatory agencies. When evaluating die
collateral for problem credits, the three valuation approaches are not equally
appropriate.
1. C ost A pproach. In the cost approach, the appraiser estimates the reproduction
cost o f the building and improvements, deducts estimated depreciation, and adds
the value o f the land. The cost approach is particularly helpful when reviewing
draws on construction loans. However, as the property increases in age, both
reproduction cost and depredation become more difficult to estimate. Except
for special purpose facilities, the cost approach is usually inappropriate in a
troubled real estate market because construction costs for a new facility normally
exceed the market value o f existing comparable properties.
2. M arket D ata or D irect Sales Com parison A pproach. This approach examines
the price o f sim ilar properties that have sold recently in the local market,
estim ating the value o f the subject property based on the comparable properties’
selling price. It is very important that the characteristics o f the observed
transactions be similar in terms o f market location, financing terms, property
condition and use, timing, and transaction costs. The market approach generally
is used in valuing owner-occupied residential property because comparable talcs
data are typically available. When adequate sales data are available, an analyst
generally w ill give the most weight to this type o f estim ate. Often, however, the
available sales data for commercial properties are not sufficient to justify a
conclusion.
3. T he Incom e A pproach. The econom ic value o f an income-producing property
is the discounted value o f the future net operating income stream, including any
"reversion" value o f property when sold. If com petitive markets arc working
perfectly, the observed sales price should be equal to this value. For unique
properties or in markets that are thin or subject to disorderly or unusual
conditions, market value based on a comparable sales approach may be either
unavailable or distorted. In such cases, the income approach is usually the
appropriate method for valuing the property.

1
2

The income approach converts all expected future net operating Income into
present value terms. When market conditions arc stable and no unusual patterns
o f future rents and occupancy rates are expected, the direct capitalization method
is often used to estimate the present value o f future incom e streams. For
troubled properties, however, examiners typically utilize the more explicit
discounted cash flow (net present value) method for analytical purposes. In that
m ethod, a time frame for achieving a "stabilized*, or normal, occupancy and
rent level is projocted Each year's net operating income during that period is
discounted to arrive at the present value o f expected future cash flow s. The
property1 anticipated sales value at the end o f the period until stabilization (its
!
terminal or reversion value) is then estim ated The reversion value represents
the capitalization o f all future income streams o f the property after the projected
occupancy level is achieved. The terminal or reversion value is then discounted
to its present value and added to the discounted Income stream to arrive at the
total present market value o f the property.

Valuation of Troubled Income-Producing Properties
W hen an income property is experiencing financial difficulties due to general market
conutians or due to it* own characteristics, data on comparable property sales often
are difficult to obtain. Troubled properties may be hard to market, and normal
financing arrangements may not be available. Moreover, forced and liquidation sales
can dominate market activity. When the use o f comparables is not feasible (which is
often the case for commercial properties), the net present value o f the most reasonable
expectation o f the property's income-producing capacity — not just in today's market
but over time — offers the most appropriate method o f valuation In the supervisory
process.
Estimates o f the property's value should be based upon reasonable and supportable
projections o f the determinants o f future net operating income: rents (or sales),
expenses and rates o f occupancy. Judgment ii involved in estimating all o f these
factors. The primary considerations for these projections include historical levels and
trends, the current market performance achieved by the subject and similar properties,
and econom ically feasible and defensible projections o f foturc demand and supply
conditions. T o the extent that current market activity is dominated by a lim ited
number o f transactions or liquidation tales, high "capitalization" and discount rates
im plied by such transactions should not be used. Rather, analysts should use rates that
reflect market conditions that arc neither highly speculative nor depressed for the type
o f property being valued and thai property's location.

! Technical Notes
| In the process o f reviewing s reel estate loan and in the use o f the net present value
approach o f collateral valuation, several conceptual issues often arc raised. The
follow ing discussion acts forth the meaning and use o f those key concepts.
{ T h e D iscount R ate. The discount rate used in the net present value approach to
| convert future net cash flow s o f income-producing real estate into present market value
terms is the rate o f return that market participants require for this type o f real estate
investm ent The discount rate w ill vary over time with changes in overall interest
I rates and in the risk associated with the physical and financial characteristics o f the
[ property. The riskiness o f the property depends both on the type o f real estate in
| question and on local market conditions.1
!
| The D irect C apitalization ("Cap" R ate) T echnique. The use o f "cap” rates, or direct
; incom e capitalization, is a method used by many market participants and analysts to
i relate the value o f a property to the net operating income it generates. In many
| applications, a "cap" rate is used us a short cut for computing the discounted value o f a
| property's income streams.
I

; The direct incom e c pitalizadon method calculates the value o f a property by dividing
an estimate o f its "stabilized" annual income by a factor called a "cap" rate. Stabilized
income generally is defined as the yearly net operating income produced by the
property at normal occupancy and rental rates; it may be adjusted upward or
i downward from today's actual market condidons.The "cap" rate — usually defined for
caeh property type in a market area — is viewed by some analysts as the required rate

: o f return stated in terms o f current income. That is to say. the "cap" rate can be
i considered a direct observation o f the required camings-to-price ratio in current income
terms. The "cap" rate also can he viewed as the number o f cents per dollar o f today's
} purchase price investors would require annually over the life o f the property to achieve
S their required rate o f return,

i
. The "cap" rate method is appropriate if the net operating income to which it is applied
I is representative o f all future income streams or if net operating Income and the
| property's selling price arc expected to increase at a fixed rafc. The use o f this
'• technique assumes that cither the stabilized income or the "cap" rate used accurately
i

captures all relevant characteristics o f the property relating to its risk and income

potential. If the same risk factors, required rate o f return, financing arrangements, and

incom e projections are used, explicit discounting and direct capitalization w ill yield the

r sam e results.

1 e u i o yp l c o teU G *o Trf S p r i i nseiisAs. frs p r i o yp r o e ,trfseet u ed s o n
R f l t t o i y f h f c f hit u e v s o pcfe
o u e v s r u p s s hit r o s i c u t
w e tctuv cnitn w t f n i l a c p e a c u t n picpe frtrfs( h c a l wteok o m i e teci-f
t i f& osset i h e w l y c e t d c o n i | rnils o hit w i h l o h
f v rf-otoi c p u o u d we 10 clsacn treiil n oc)o d s o n n c t e accnitn w t t ep l c s o tefdrl
eiIfDs
irJi e al/hc l
r i c u t t i h r o s s e t i h h o i e f h eea
: U l i ii end«.
fkn f

' This method alone is not appropriate for troubled real estate since income generated by
. the property is not at normal or stabilized levels. In evaluating troubled teal estate,
ordinary discounting typically is used for the period before the project reaches its full
incom e potential. A "terminal" "cap" rate is then utilized to estimate the value o f the
property (its reversion or sales price) at the end o f that period.
D ifferences Between D iscount and Cap R ates. When used for estimating real estate
market values, discount and "cap" rates should reflect the current market requirements
for rates o f return on properties o f a given type. The discount rate is the required rate
j o f return including the expected increases in ftiture prices and is applied to incom e
I streams reflecting inflation. In contrast, the "cap" rate is used in conjunction with a
I stabilized net operating income figure. The fact that discount rates for real estate are
I typically higher than "cap" rates reflects the principal difference in the treatment o f
! expected increases in net operating income and/or property values.
«

Other factors affecting the "cap" rate used (but not the discount m e ) include the useful

i life o f the property and financing arrangements. The useful life o f the property being
evaluated affects the magnitude o f the "cap" rale because the income generated by a
• property, in addition to providing the required return on investment, must be sufficient
; to compensate the investor for the depreciation o f the property over its useful life.

j The longer the useful life, the smaller is the depreciation in any one year, hence, the
’ sm aller Is the annual income requ.:ed by the investor, and the lower is the "cap" rate.
! D ifferences in terms and the extent u f debt financing and the related costs must also be
« taken into account.
<

• Selecting D iscount and Cap R ates. The choice o f the appropriate values for discount
I and "cap" rates is a key aspect o f income analysis. Both in markets marked by lack o f
i transactions and those characterized by highly speculative or unusually pessim istic
!
:
i
I

attitudes, analysts consider historical required returns on the type o f property in
question. Where market information is available to determine current required yields,
analysts carefully analyze sales prices for differences in financing, special rental
arrangements, tenant improvements, property location, and building characteristics. In

; m ost local markets, the estimates o f discount and "cap" rates used in income analysis
j should generally fall within a fairly narrow range for comparable properties.
• H olding Period vs. M arketing Period. When the income approach is applied to
:• troubled properties, a time frame is chosen over which a property is expected to
achieve stabilized occupancy and rental rates (stabilized income). Ttial time period is
1 som etim es referred to as the "folding period." Tbe longer the period before
\

stabilization, the smaller w ill be the reversion value included in the total value

} estim ate.
f
I

The holding period should be distinguished from the concept o f "marketing period" —
a term used in estimating the value o f a property under the sales comparison approach

\
and in discussions o f property value when real estate is being sold. The marketing
period is the length o f time that may be required to sell the property in an open
m a r k e t .__

Glossary
Appraisal. A written statement independently and impartially prepared by a qualified
appraiser setting forth an opinion as to the market value o f an adequately described
property as o f a specific date(s), supported by the presentation and analysis o f relevant
j market information.
J Capitalization rate. A rate used to convert income into value. Specifically, it is the
! ratio between a property's stabilized net operating income and the property's sale*
| price. Sometimes referred to as an overall rate because it can be computed as a
i weighted average o f component investment claims on net operating Income.
9

| Discount rate. A rate o f return used to convert future payments or receipts into their
| present value.
: Holding period. The time frame over which a property is expected to achieve
; stabilized occupancy and rental rates (stabilized income).
«

j M arket value. The most probable cash sale price which a property should bring in a
! competitive and open market under all conditions requisite to a fair sale, die buyer and
i teller eaeh acting prudently and knowledgeably, and assuming the price is not affected
by undue stimulus. Implicit in this definition is the consummation o f a sale as o f a
> specified date and the passing o f title from seller to buyer under conditions whereby:
i

1. buyer and seller are typically motivated (i.e., motivated by self-interest);
«

2. both parties are well informed or well advised, and acting in what they consider
their own best interests;
|

3. a reasonable time is allowed for exposure in the open rnaikeu
4. payment is made in terms o f cash in U.S. dollars or in terms o f financial
arrangements comparable thereto; and
5. the price represents the normal consideration for the property sold unaffected by
special or creative financing or sales concessions granted by anyone associated
with the tale.
M arketing period. The term in which an owner o f a property is actively attempting to
sell that property in a competitive and open market

Net operating income (NOT). Annual income after all expenses have been deducted,
except for depreciation and debt service.

12/12*d TyiOl
\

Attachment 3

Classification Definitions1

The federal bank *nd thrift regulatory agencies currently utilize the following
iefinitiona for assets classified "substandard," "doubtful," and "loss" for supervisory
purposes:

{Substandard A ssets. A substandard asset is inadequately protected by the current
sound worth and paying capacity o f die obligor or o f the collateral pledged, if any.
•Assets so classified must have a well-defined weakness or weaknesses that jeopardize
jthe liquidation o f the debt. They arc characterized by the distinct possibility that the
|institution will sustain some loss if the deficiencies are not corrected.
jDoubtftil Assets. An asset dasslfled doubtftil has all the weaknesses inherent in one
classified substandard with the added characteristic that the weaknesses make
i collection or liquidation in full, on the basis of currently existing facts, conditions, and
values, highly questionable and improbable.

J
j

Loss Assets. Assets classified loss are considered uncollectible and o f such little value
| that their continuunce as bankable assets is not warranted. Ih is classification does not
mean that the asset has absolutely no recovery nr salvage value, but rather it is not
I practical or desirable to defer writing off this basically worthless asset even though
• partial recovery may be effected in the future.

1Of c o tiC m t o l ro teC r e c ,Comptroller Handbookfat National link tuminon, S c i n231
fie f b o p r l e f h u r n y
eto 1.,
"QiuiC t o of C t l / Bom! cfGonmon o teFdrlR ervcS s e .Commtreial Bank Examination Manual,
can idu
i
f h eea u
ytm
S c i 219.1" m f c i o v C e i s Ofc o Trf S p r i i ,Thrift Aaintits Rtftdatory Handbook, Scin2 0
otm
, O l i a i n f r d t / fie f hit u e v i m
eto 6 ,
• u i i * o o A s t /F d r lD p t iI t u c C r o i o .Division efSuptrrubn Mannal ofExarimtion Poliritt,
G r f c i n f s e * eea e oi n u n i o p n i n
Sento31 "Uem.*
o ..

1
8

F e d e r a l R e s e r v e B a n k o f N e w Yo r k
N E W Y O R K , N. Y. 1 0 0 4 - 5 - 0 0 0 1
AREA CODE

h e s t e r

e l d b e r g

E xecut ive V ice P r e s i d e n t

212

720-6375

A7/06W7

July 8, 1993

TO THE CHIEF EXECUTIVE OFFICER OF ALL STATE MEMBER BANKS,
BANK HOLDING COMPANIES AND STATE CHARTERED, UNINSURED
BRANCHES AND AGENCIES OF FOREIGN BANKS
On January 9, 1992, we summarized the longstanding policy
of the Board of Governors of the Federal Reserve System for
affording bank management an opportunity to discuss and appeal
safety and soundness examination findings with which management
disagrees. The Board believes that it is important to provide
bankers with such opportunities to ensure that examination
findings are fair and balanced, and that they consider all
relevant information.
In the January 1992 letter, we noted that institutions
supervised by the Federal Reserve can raise questions during
the on-site examination and have the further option of referring
their questions or concerns directly to senior Reserve Bank
officials or, on occasion, the President of this Bank. In such
situations, these officials have the discretion to decide if the
matters under review suggest that they be resolved by individuals
who did not participate directly in the particular decision or
examination finding in question. In addition, we emphasized that
the officials have the latitude to decide if the matter should be
resolved in a confidential manner not involving the individual in
charge of the examination. The purpose of setting forth these
procedures in writing was to ensure that state member bank
management and directors were aware of the various avenues of
appeal available to them. Of course, the same avenues of appeal
are also available to senior officials of bank holding companies
and state chartered, uninsured branches and agencies of foreign
banks.
The Board believes that Federal Reserve examiners have acted
responsibly in conducting on-site examinations, and that the
January 1992 statement, together with the System's longstanding
practices regarding the resolution of examination differences,
have provided an effective avenue of appeal for state member
banks. Nevertheless, concerns have been expressed that some
bankers may not be satisfied with the appeals procedures estab
lished by the regulators generally or may still be reluctant to
question examination findings for fear of adverse consequences.

FEDERAL RESERVE BANK OF NEW YORK

To address these concerns and to assure that the findings of
safety and soundness examinations are based on a balanced and
fair consideration of all relevant information, the Board
believes it is appropriate to reemphasize its procedures and
practices in this area and to encourage institutions supervised
by the Federal Reserve with legitimate material concerns to bring
these matters to the attention of appropriate Reserve Bank
officials. The Board hopes that the restatement of these
practices will serve to assure bank management and directors that
the Federal Reserve's current procedures are fair and effective.
Moreover, it is the policy of the Federal Reserve that bank
management should have the opportunity to raise legitimate
concerns or make a bona fide appeal regarding substantive
examination findings without fear of adverse consequences.
Opportunities for discussion and resolution of examination
differences exist at many levels — both during and subsequent to
the completion of the examination. For example, during the exam
ination, bank management may discuss examination findings and
loan classifications with the examiner-in-charge. Bankers also
have the option of taking their concerns directly to senior
supervisory officials at the Reserve Bank if the matter has not
been resolved in discussions with the examiner. At the comple
tion of the examination, examiners or supervisory officials
normally meet with bank management and, if appropriate, with the
board of directors, affording the bank yet another opportunity to
discuss examination results.
In addition to these avenues, legitimate and bona fide
concerns about substantive examination findings may be taken
directly to the President of this Bank. Bankers may request that
matters appealed to the President be resolved by parties who did
not directly participate in the examination in question. In
these situations, both bank management and the examiners involved
in the examination may be consulted, but the final determination
regarding the resolution would, if appropriate, be made by the
President of this Bank or an official designated by, and directly
accountable to the President who did not participate directly in
the examination. Bankers may also request that the matter be
resolved in a confidential manner not involving the examiner-incharge.
These practices, taken together, are designed to provide
bankers an opportunity to express their views and to address
differences between bankers and examiners in a manner that is
fair and impartial. Normally, matters or questions appealed to
the President of this Bank would be expected to be those that
would have a significant effect on the safety and soundness,
operation, management, or financial standing of the institution,
or that would have a material impact on the Federal Reserve's
supervision of the institution.

t
FEDERAL RESERVE BANK OF NEW YORK_______ 3

The method for resolving questions or appeals brought to the
attention of senior Reserve Bank officials is at the discretion
of the Reserve Bank. These appeal procedures are intended to
afford an avenue for discussing and resolving legitimate concerns
or good faith differences pertaining to material examination
findings. They are not to be used to impede any supervisory or
enforcement action necessary to protect depositors or ensure the
bank's safety and soundness. The existence of these avenues for
communication and resolution does not prevent the Federal Reserve
from taking any supervisory or enforcement action — formal or
informal — it deems appropriate to discharge the Federal Reserve
System's supervisory and examination responsibilities in a timely
manner.
Questions regarding this process may be directed to Robert
A. O'Sullivan, Vice President, Domestic Banking Department, at
(212) 720-5692 for state member banks and bank holding companies
and to Kathleen A. O'Neil, Vice President, International Banking
Department, at (212) 720-5371 for state chartered, uninsured
branches and agencies of foreign banks.

Yours sincerely,

Chester B. Feldberg
Executive Vice President

Full text of Federal Reserve Bank of New York Circulars : 10647. Interagency Policy Statements on Examination and Credit Matters

FRASER