Supervisory Upgrades and Enforcement Actions: An Overview, Highlights and Insights
By Angela Knight-Davis and Suzanne Reynolds
As reported in the summer edition of S&R Perspectives, SR 12-4 was issued on March 1, 2012, to address supervisory rating upgrades. The primary purpose of the SR letter is to reemphasize long-standing rating and risk management guidelines consistent with SR 96-38 and SR 95-51. Regulators used these guidelines to downgrade institutions during the financial crisis. Now that the economy is showing signs of stabilization and glimmers of improvement, the SR letter is a reminder — to both the industry and examiners — that these same guidelines will be used to support rating upgrades as warranted. SR 12-4 emphasizes two primary factors in the upgrade process: (1) demonstrated improvement in institutions’ financial condition and risk management practices and (2) the sustainability of improvement. In addition to concerns about the implementation of this SR letter, bankers have posed several questions regarding enforcement actions. The intent of this article is to: provide a brief overview of the SR letter, with examples of implementation of the principles; highlight key institution-based enforcement tools used by the Federal Reserve System, noting key factors used in selecting an action; and provide insight on how enforcement actions are evaluated and adjusted as progress is made by an institution.
SR 12-4 (Upgrades of Supervisory Ratings for Banking Organizations with $10 Billion or Less in Total Consolidated Assets) applies to community banking institutions supervised by the Federal Reserve with total assets of $10 billion or less and relates to evaluating upgrades for both component and composite ratings across all rating categories for safety and soundness examinations only. While ratings decisions must remain consistent with interagency rating guidelines (SR 96-38) as well as the Federal Reserve risk management rating guidance (SR 95-51), an institution that demonstrates significant progress in addressing supervisory issues and restoring the organization to a satisfactory condition will be given upgrade consideration. The SR 12-4 guidance stresses that examiners should use balanced judgment when assigning ratings, with particular focus on the strength of the institution’s financial condition, overall risk management and board oversight.
Numerous financial institutions experienced ratings downgrades during the financial crisis because of asset quality weaknesses that impacted their overall financial condition. However, while a moderate level of problem assets may remain, an asset quality rating upgrade may be supported by the following factors:
Ratings upgrades for other core components, including the composite rating, will be based on overall favorable trends that are sustainable, as well as appropriate risk management practices and oversight. Some factors supporting an upgrade may include the following:
The guidance provided in the SR letter places particular emphasis on improvements made in board oversight and risk management practices where such weaknesses were associated with prior ratings issues. Essentially the board has established or is making reasonable progress in establishing a culture of manageable risk tolerance within the organization. For example purposes, consideration for a management rating upgrade could be given to the following:
Many institutions experiencing ratings downgrades in the financial crisis also were placed under some type of enforcement action. The overall purpose of an enforcement action is to address concerns that need to be handled outside of the normal supervisory process to prevent either further deterioration or more severe issues from occurring and to ensure appropriate internal and supervisory attention is given to the institution. While the above-referenced rating guidelines aid in the identification of the relative level of supervisory concern, ratings are not the sole criteria for determining the need for or type of an enforcement action. Rather, supervisory guidance directed at selecting an enforcement action allows for the exercise of supervisory judgment. The type of enforcement action used generally varies in relation to the number and severity of issues, duration of issues, governance, overall condition and the need to legally enforce such requirements.
Institution-based enforcement actions commonly used by the Federal Reserve System include board resolutions, memorandums of understanding, written agreements, cease and desist orders (consent or non-consent), and Prompt Corrective Action Directives. The first two actions are considered informal and are not required to be publically disclosed, while the third, fourth and fifth types of actions are formal actions that require public disclosure. A few high-level factors that are considered in determining whether an informal or formal action is used include the number and severity of issues, the correction of previously identified issues, management’s and the directors’ willingness and understanding to correct problems, and the impact of issues on the institution’s safety and soundness. Each situation is evaluated independently on a case-by-case basis.
Similar to the downgrades of institution ratings during the financial crisis, regulators utilized and implemented various enforcement actions as well. Like ratings upgrade considerations, a balanced approach will also be used in recognizing and adjusting enforcement actions as situations and changes in overall condition warrant. The termination of an enforcement action or downgrade to a less severe enforcement action will not be based solely on an institution’s ratings, but will also depend on compliance with provisions of the enforcement action, demonstrated and sustainable improvement, the correction of previously identified or related issues, and whether needed governance oversight is in place.
For instance (as a high-level example only), an institution with an enforcement action aimed at substantial credit risk management concerns may be considered for enforcement action relief under the following circumstances:
However, the circumstances above are not the only considerations. Additional factors considered in weighing enforcement action changes would include progress made and be substantiated on the remaining provisions, the number and severity of other outstanding issues, confidence in governance oversight and the strength to identify and address issues going forward, and the overall condition and related trends in the organization. It’s important to emphasize again that each situation is different, and each institution must be evaluated on its own merits and circumstances.
Further information can be found in the following guidance:
Commercial Bank Examination Manual Sections 5020.10 and 5040.10
Angela Knight-Davis is a supervisory examiner with the Federal Reserve Bank of Richmond. She can be reached at email@example.com.
Suzanne Reynolds is a supervisory examiner with the Federal Reserve Bank of Richmond. She can be reached at firstname.lastname@example.org.
The analyses and conclusions set forth in this publication are those of the authors and do not necessarily indicate concurrence by the Board of Governors, the Federal Reserve Banks, or the members of their staffs. Although we strive to make the information in this publication as accurate as possible, it is made available for educational and informational purposes only. Accordingly, for purposes of determining compliance with any legal requirement, the statements and views expressed in this publication do not constitute an interpretation of any law, rule or regulation by the Board or by the officials or employees of the Federal Reserve System.
Supervision, Regulation & Credit