[Federal Register: December 19, 1996 (Volume 61, Number 245)]
[Notices]
[Page 67021-67029]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
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FEDERAL FINANCIAL INSTITUTIONS EXAMINATION COUNCIL
Uniform Financial Institutions Rating System
AGENCY: Federal Financial Institutions Examination Council.
ACTION: Notice.
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SUMMARY: The Federal Financial Institutions Examination Council (FFIEC)
is revising the Uniform Financial Institutions Rating System (UFIRS),
which is commonly referred to as the CAMEL rating system. The term
``financial institutions'' refers to those insured depository
institutions whose primary Federal supervisory agency is represented on
the FFIEC. The agencies comprising the FFIEC are the Board of Governors
of the Federal Reserve System (FRB), the Federal Deposit Insurance
Corporation (FDIC), the National Credit Union Administration (NCUA),
the Office of the Comptroller of the Currency (OCC), and the Office of
Thrift Supervision (OTS). The revisions update the rating system to
address changes in the financial services industry and in supervisory
policies and procedures occurring since the rating system was adopted
in 1979. The changes include: reformatting and clarification of
component rating descriptions and component rating definitions; adding
a sixth component addressing sensitivity to market risk; increasing
emphasis on the quality of risk management practices in each of the
rating components, particularly in the Management component; revising
the composite rating definitions; and explicitly identifying the risks
considered in assigning component ratings.
DATES: December 19, 1996.
FOR FURTHER INFORMATION CONTACT:
OCC: Lawrence W. (Bill) Morris, National Bank Examiner, Office of
the Chief National Bank Examiner, (202) 874-5350, Office of the
Comptroller of the Currency, 250 E Street SW, Washington, D.C. 20219.
FRB: Kevin Bertsch, Supervisory Financial Analyst, (202) 452-5265,
or Constance Powell, Supervisory Financial Analyst, (202) 452-3506,
Division of Banking Supervision and Regulation, Board of Governors of
the Federal Reserve System, 20th and C Streets NW, Washington, D.C.
20551. For the hearing impaired only, Telecommunication Device for the
Deaf (TDD), Dorothea Thompson, (202) 452-3544.
FDIC: Daniel M. Gautsch, Examination Specialist, (202) 898-6912,
[[Page 67022]]
Office of Policy, Division of Supervision. For legal issues, Linda L.
Stamp, Counsel, (202) 898-7310, Supervision and Legislation Branch,
Federal Deposit Insurance Corporation, 550 17th Street NW, Washington,
D.C. 20429.
OTS: William J. Magrini, Senior Project Manager, (202) 906-5744,
Supervision Policy, Office of Thrift Supervision, 1700 G Street NW,
Washington, D.C. 20552.
SUPPLEMENTARY INFORMATION:
Background Information
On July 18, 1996, the FFIEC published a notice and request for
comment in the Federal Register (July Notice), 60 FR 37472, requesting
comment on proposed revisions to the UFIRS. The UFIRS is an internal
rating system used by the Federal supervisory agencies and State
supervisory agencies for evaluating the soundness of financial
institutions on a uniform basis and for identifying those institutions
requiring special supervisory attention or concern. The UFIRS takes
into consideration a careful evaluation of managerial, operational,
financial, and compliance performance factors common to all
institutions. The UFIRS is used by the supervisory agencies to monitor
aggregate trends in the overall soundness of financial institutions.
The UFIRS also provides a means for the supervisory agencies to
monitor, for various statistical and supervisory purposes, the types
and severity of problems that institutions may be experiencing, and to
determine the level of supervisory concern that is warranted.
Under the UFIRS, each financial institution is assigned a composite
rating based on an evaluation and rating of essential components of an
institution's financial condition and operations. Under the former
UFIRS, the component factors addressed the adequacy of capital, the
quality of assets, the capability of the board of directors and
management, the quality and level of earnings, and the adequacy of
liquidity. The composite and component ratings are assigned on a 1 to 5
numerical scale. A 1 indicates the strongest performance and management
practices and the lowest degree of supervisory concern. A 5 indicates
the weakest performance and management practices and the highest degree
of supervisory concern.
The UFIRS is an effective tool for the supervisory agencies to
determine the safety and soundness of financial institutions. A number
of changes, however, have occurred in the financial services industry
and in supervisory policies and procedures since the rating system was
adopted in 1979. As a result, the FFIEC is making certain enhancements
to the rating system but is retaining its basic framework. The
enhancements include: reformatting and clarifying the component rating
descriptions and component rating definitions; adding a new sixth
component, Sensitivity to Market Risk; increasing emphasis on the
quality of risk management processes in each of the component ratings,
particularly in the Management component; adding language in the
composite rating definitions to parallel the changes in the component
rating descriptions; and identifying the types of risk associated with
each component area.
The FFIEC notes that some Federal supervisory agencies' regulations
reference the institution's UFIRS or CAMEL rating in determining an
institution's status under those regulations. The Federal supervisory
agencies may consider amending those regulations to incorporate changes
made to the UFIRS system.
Comments Received and Changes Made
The FFIEC received 55 comments regarding the proposed revisions to
UFIRS. Thirty-four of the comments were from banks and thrifts, ten
from state banking departments, five from trade associations, two from
FRB offices, two from consultants, and two from Federal bank examiners.
Commenters generally favored the changes to the rating system
regarding structure and format, reference to risk management practices,
identification of risk types, and revisions to the composite and
component rating definitions. However, commenters were divided
regarding the new component on sensitivity to market risk.
Examiners field tested the revised rating system during 185 bank
and thrift examinations conducted between July and October, 1996. The
examiners provided comments regarding the revised rating system.
Examiner response generally was favorable for the revised rating
system, including the new sixth component. Few significant problems or
rating differences were encountered between the former and the updated
UFIRS.
Many commenters and examiners recommended clarifying changes to
various aspects of the revised rating system. The FFIEC carefully
considered each comment and examiner response and is making certain
changes. The following discussion describes the comments received and
changes made to the UFIRS in response to the comments. The updated
UFIRS is included at the end of this Notice.
July Notice Specific Questions
In addition to requesting general comments regarding the proposed
rating system, the FFIEC invited comments on two specific questions:
(1) Does the proposed, revised rating system capture the essential
aspects of a financial institution's condition, compliance with laws
and regulations, and overall operating soundness? If not, what
additional or different components should be considered?
The majority of responses to this question were positive and
indicated no additional or different components should be considered.
Some commenters noted concerns with or the need for clarification of
the new sixth component. These concerns are addressed later in this
Notice.
(2) Does the proposed management component rating adequately
represent an assessment of the quality of the board of directors' and
management's oversight regarding an institution's operating
performance, risk management practices, and internal controls? If not,
what other factors should be considered when rating management?
The majority of responses to this question were favorable. A number
of commenters recommended that the Management component make a clearer
distinction between the role of the board of directors and the role of
senior management.
The FFIEC added language to the Management component that
recognizes the different responsibilities of these two management
groups.
Structure and Format of Component Descriptions
The July Notice enhanced and clarified component rating
descriptions by reformatting each component into three distinct
sections: (1) An introductory paragraph discussing the areas to be
considered when rating each component; (2) a bullet-style listing of
the evaluation factors to be considered when assigning component
ratings; and (3) a brief, qualitative description of the five rating
grades that can be assigned to a particular component.
Several commenters expressed concern that component descriptions
and component rating definitions need clear distinction and
differentiation between rating levels.
The FFIEC acknowledges the need for clear distinction and
differentiation between component rating levels. The UFIRS now reflects
changed or added language to clarify that the component
[[Page 67023]]
rating assessments consider an institution's size, the nature and
complexity of its business activities, and its risk profile. Sentence
structure, coupled with other minor language changes, were made to
enhance parallelism and to improve differentiation between component
rating levels.
Some commenters expressed concern regarding the number of
evaluation factors within each component, the subjectivity associated
with the evaluation factors, the order in which evaluation factors were
listed, the redundancy of evaluation factors between components, and
the need for clarification of some of the evaluation factors.
The FFIEC made revisions to the UFIRS to better structure and
identify the factors that examiners traditionally consider as part of
their assessment of a component area. This allows examiners and bankers
to have a better understanding of what is being assessed under each
component. Since its inception, the UFIRS has always contained elements
of subjectivity and examiner judgment when assigning a rating,
particularly as it relates to qualitative assessments of policies,
practices, processes, and systems. Subjectivity and judgment cannot be
eliminated but, as in the past, it can be reasonably applied based on
the examiner's experience and knowledge, and their familiarity with the
unique characteristics of the institution being examined.
The list of evaluation factors under each component is not meant to
be all inclusive and appropriate language is added to the UFIRS noting
that the evaluation factors are not listed in any particular order of
importance. This allows examiners the flexibility of assessing factors
that are most pertinent to the institution's situation and risk
profile.
The FFIEC also acknowledges that there is a certain degree of
redundancy between the component evaluation factors. For example,
certain factors, such as the ability of management to identify,
measure, monitor, and control risk, apply to each of the components and
are an integral part of each component's rating. In addition, the level
of classified assets will also impact the Asset Quality component and
the Capital and Earnings components. This analysis should not be
considered as ``double counting,'' but rather as a balanced assessment
of how an evaluation factor can impact several component areas.
The FFIEC, however, has removed the evaluation factor referring to
compliance with laws and regulations from all but the Management
component. In addition, minor language changes are made to some of the
component evaluation factors for clarification purposes.
Sensitivity to Market Risk Component
The July Notice added a sixth rating component addressing
sensitivity to market risk and the degree to which changes in interest
rates, foreign exchange rates, commodity prices, or equity prices can
adversely affect a financial institution's earnings or economic
capital.
A number of commenters noted that the sensitivity to market risk
already is considered under the existing components and questioned the
need for the new component.
The FFIEC acknowledges that market risk is already considered under
the UFIRS; however, adding a new component provides a more precise
indication of an institution's ability to monitor and manage its market
risk. Since the sensitivity to market risk is already considered when
assigning UFIRS ratings, the addition of the new component should not
result in a change to the composite ratings being assigned.
The principal benefit of this new component is that it gives a
clearer indication of supervisory concerns related to market risk than
can be gained from the former UFIRS. For example, a financial
institution with weak earnings and poor liquidity also might have
significant and poorly managed exposures to interest rate risk. Less
than satisfactory component ratings for earnings or liquidity accorded
an institution under the former UFIRS would not specifically note a
problem with exposure to, or the management of, market risk. Under the
updated UFIRS, however, it is now possible to determine whether an
institution has less than satisfactory earnings, a deficiency in its
level or management of liquidity, and a problem with its exposure to
market risks.
Other commenters objected to the new component on the grounds that
it will place too much weight on a risk that is insignificant to most
institutions and may result in examiners requiring elaborate market
risk management systems where relatively basic management practices
would suffice.
The FFIEC acknowledges that, for most institutions, market risk
primarily reflects exposures to changes in interest rates.
Currently, interest rate risk is not a significant problem for the
industry. In light of the level of risk embodied in this component for
most institutions, the Federal supervisory agencies do not anticipate
examiners overemphasizing this component when assigning a composite
rating.
For the institutions that choose to take on greater market risk
through holdings of complicated investments or hedging instruments or
as part of significant trading activities, the exposure to, and
management of, market risk is more significant to their overall risk
profile. Thus, it is possible more weight will be assigned to the new
component in determining the composite rating under UFIRS for
institutions engaging in these activities. This is consistent with the
Federal supervisory agencies' views that, when assigning a composite
rating, examiners should determine the weight placed on each component
based upon the particular situation of the institution, not on an
arithmetic average of the components.
Thus, supervisory expectations for the management of market risk
remain unchanged; the quality of management systems must be
commensurate with risk exposure. Accordingly, the new component does
not imply a requirement to develop enhanced management systems where
market risk already is being identified, measured, monitored, and
controlled in a manner appropriate to the institution's market risk
exposure.
Several commenters also raised concerns about a perceived emphasis
on the absolute level of market risk in the rating descriptions for the
sensitivity to market risk component.
The FFIEC agrees that the evaluation of market risk must take into
account the capital and earnings of an institution and the quality of
its risk management practices. Accordingly, the description of the new
component and its rating definitions have been revised to reflect this
view.
Risk Management
The revised rating system reflects an increased emphasis on risk
management processes. The Federal supervisory agencies currently
consider the quality of risk management practices when applying the
UFIRS, particularly in the management component. Changes in the
financial services industry, however, have broadened the range of
financial products offered by institutions and accelerated the pace of
transactions. These trends reinforce the importance of institutions
having sound risk management systems. Accordingly, the revised rating
system contains explicit language in each of the components emphasizing
management's ability to
[[Page 67024]]
identify, measure, monitor, and control risks.
Several commenters expressed concern that the revised rating system
would add to an institution's regulatory burden; require additional
policies, processes, and highly formalized management information
systems; or prevent institutions from attaining the highest ratings if
they did not have formalized risk management policies and systems.
The FFIEC recognizes that management practices, particularly as
they relate to risk management, vary considerably among financial
institutions depending on their size and sophistication, the nature and
complexity of their business activities, and their risk profile. Each
institution must properly manage its risks and have appropriate
policies, processes, or practices in place that management follows and
uses. Activities undertaken in a less complex institution engaging in
less sophisticated risk-taking activities may only need basic
management and control systems compared to the detailed and formalized
systems and controls needed for the broader and more complex range of
activities undertaken at a larger and more complex institution.
The FFIEC added appropriate language clarifying that the UFIRS does
not add to the regulatory burden of institutions, but promotes and
complements efficient examination processes. The FFIEC also added
language clarifying that detailed or highly formalized management
systems and controls are not required for less complex institutions
engaging in less sophisticated risk taking activities to receive the
higher composite and component ratings.
Composite Rating Definitions
The July Notice retained the basic context of the existing
composite rating definitions. The composite ratings are based on a
careful evaluation of an institution's managerial, operational,
financial, and compliance performance. The revised composite rating
definitions contain an explicit reference to the quality of overall
risk management practices.
A number of commenters recommended that the composite rating
definitions contain a clearer distinction between rating levels,
include a better perspective on examiner flexibility in considering the
evaluation factors, and clarify other language to ensure consistent and
uniform application by supervisory agencies.
The FFIEC agrees and has made certain changes in the structure and
language of the composite rating definitions to address the concerns
raised about examiner flexibility when assigning ratings based on an
institution's particular circumstances. The principal change includes
language to note explicitly that examiners consider an institution's
size, complexity, and risk profile when assessing risk management
practices. Other changes include sentence structure and other language
changes in each of the composite rating definitions for better
parallelism and readability from one definition to another and to
provide clearer distinction between rating levels.
Peer Data Comparisons
Some commenters noted the lack of references to peer comparisons in
component descriptions and rating definitions in the UFIRS.
The FFIEC acknowledges that it does not include peer comparison
data in the updated rating system. The principal reason is to avoid
over reliance on statistical comparisons to justify the component
rating being assigned. Examiners are encouraged to consider all
relevant factors when assigning a component rating. The rating system
is designed to reflect an assessment of the individual institution.
Peer data are a part of the overall assessment process, however.
Component Rating Disclosure
Several commenters noted that component ratings should be disclosed
to an institution's board of directors and senior management.
The FFIEC agrees that component ratings should be disclosed to an
institution's board of directors and senior management and recommended
that the FDIC, FRB, OCC, and OTS begin disclosing component ratings in
reports of examination no later than January 1, 1997. The FDIC began
disclosing component ratings in reports of examination in process after
September 30, 1996. The other Federal supervisory agencies expect to
begin such disclosures on or before January 1, 1997.
The FFIEC inserted into the Overview section of the UFIRS
appropriate language noting that both composite and component ratings
are disclosed to an institution's board of directors and senior
management.
Specialty Area Examinations
Some commenters recommended that the specialty area examinations,
i.e., Bank Information Systems, Fiduciary, Consumer Compliance, CRA,
etc., be integrated into the rating system.
The FFIEC acknowledges that results of such specialty examinations
currently are taken into consideration when assigning an institution's
composite rating or component ratings, as appropriate. Generally, the
impact of specialty area examination findings are reflected in the
composite and Management component ratings. However, other factors,
such as reimbursable violations under Regulation Z (12 CFR Part 226),
if substantial, could impact an institution's capital or earnings
performance.
The FFIEC added appropriate language to the revised UFIRS noting
that Foreign Branch examination and specialty examination findings
(Compliance, CRA, Government Security Dealers, Information Systems,
Municipal Security Dealers, Transfer Agent, and Fiduciary) and the
ratings assigned to those areas are taken into consideration, as
appropriate, when assigning a composite rating and component ratings
under UFIRS.
Implementation Date
The FFIEC recommends that the Federal supervisory agencies
implement the updated UFIRS no later than January 1, 1997. This date
provides the Federal supervisory agencies flexibility to implement the
updated UFIRS in conjunction with procedures for disclosing both
composite and component ratings, as appropriate, to institutions'
boards of directors and senior management. This date also ensures that
institutions with examinations commenced in 1997 will be assessed under
the updated UFIRS.
Text of the Revised Uniform Financial Institutions Rating System
Uniform Financial Institutions 1 Rating System
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\1\ For purposes of this rating system, the term ``financial
institution'' refers to those insured depository institutions whose
primary Federal supervisory agency is represented on the Federal
Financial Institutions Examination Council (FFIEC). The agencies
comprising the FFIEC are the Board of Governors of the Federal
Reserve System, the Federal Deposit Insurance Corporation, the
National Credit Union Administration, the Office of the Comptroller
of the Currency, and the Office of Thrift Supervision. The term
``financial institution'' includes Federally supervised commercial
banks, savings and loan associations, mutual savings banks, and
credit unions.
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Introduction
The Uniform Financial Institutions Rating System (UFIRS) was
adopted by the Federal Financial Institutions Examination Council
(FFIEC) on November 13, 1979. Over the years, the UFIRS has proven to
be an effective internal supervisory tool for evaluating
[[Page 67025]]
the soundness of financial institutions on a uniform basis and for
identifying those institutions requiring special attention or concern.
A number of changes, however, have occurred in the banking industry and
in the Federal supervisory agencies' policies and procedures which have
prompted a review and revision of the 1979 rating system. The revisions
to UFIRS include the addition of a sixth component addressing
sensitivity to market risks, the explicit reference to the quality of
risk management processes in the management component, and the
identification of risk elements within the composite and component
rating descriptions.
The revisions to UFIRS are not intended to add to the regulatory
burden of institutions or require additional policies or processes. The
revisions are intended to promote and complement efficient examination
processes. The revisions have been made to update the rating system,
while retaining the basic framework of the original rating system.
The UFIRS takes into consideration certain financial, managerial,
and compliance factors that are common to all institutions. Under this
system, the supervisory agencies endeavor to ensure that all financial
institutions are evaluated in a comprehensive and uniform manner, and
that supervisory attention is appropriately focused on the financial
institutions exhibiting financial and operational weaknesses or adverse
trends.
The UFIRS also serves as a useful vehicle for identifying problem
or deteriorating financial institutions, as well as for categorizing
institutions with deficiencies in particular component areas. Further,
the rating system assists Congress in following safety and soundness
trends and in assessing the aggregate strength and soundness of the
financial industry. As such, the UFIRS assists the agencies in
fulfilling their collective mission of maintaining stability and public
confidence in the nation's financial system.
Overview
Under the UFIRS, each financial institution is assigned a composite
rating based on an evaluation and rating of six essential components of
an institution's financial condition and operations. These component
factors address the adequacy of capital, the quality of assets, the
capability of management, the quality and level of earnings, the
adequacy of liquidity, and the sensitivity to market risk. Evaluations
of the components take into consideration the institution's size and
sophistication, the nature and complexity of its activities, and its
risk profile.
Composite and component ratings are assigned based on a 1 to 5
numerical scale. A 1 indicates the highest rating, strongest
performance and risk management practices, and least degree of
supervisory concern, while a 5 indicates the lowest rating, weakest
performance, inadequate risk management practices and, therefore, the
highest degree of supervisory concern.
The composite rating generally bears a close relationship to the
component ratings assigned. However, the composite rating is not
derived by computing an arithmetic average of the component ratings.
Each component rating is based on a qualitative analysis of the factors
comprising that component and its interrelationship with the other
components. When assigning a composite rating, some components may be
given more weight than others depending on the situation at the
institution. In general, assignment of a composite rating may
incorporate any factor that bears significantly on the overall
condition and soundness of the financial institution. Assigned
composite and component ratings are disclosed to the institution's
board of directors and senior management.
The ability of management to respond to changing circumstances and
to address the risks that may arise from changing business conditions,
or the initiation of new activities or products, is an important factor
in evaluating a financial institution's overall risk profile and the
level of supervisory attention warranted. For this reason, the
management component is given special consideration when assigning a
composite rating.
The ability of management to identify, measure, monitor, and
control the risks of its operations is also taken into account when
assigning each component rating. It is recognized, however, that
appropriate management practices vary considerably among financial
institutions, depending on their size, complexity, and risk profile.
For less complex institutions engaged solely in traditional banking
activities and whose directors and senior managers, in their respective
roles, are actively involved in the oversight and management of day-to-
day operations, relatively basic management systems and controls may be
adequate. At more complex institutions, on the other hand, detailed and
formal management systems and controls are needed to address their
broader range of financial activities and to provide senior managers
and directors, in their respective roles, with the information they
need to monitor and direct day-to-day activities. All institutions are
expected to properly manage their risks. For less complex institutions
engaging in less sophisticated risk taking activities, detailed or
highly formalized management systems and controls are not required to
receive strong or satisfactory component or composite ratings.
Foreign Branch and specialty examination findings and the ratings
assigned to those areas are taken into consideration, as appropriate,
when assigning component and composite ratings under UFIRS. The
specialty examination areas include: Compliance, Community
Reinvestment, Government Security Dealers, Information Systems,
Municipal Security Dealers, Transfer Agent, and Trust.
The following two sections contain the composite rating
definitions, and the descriptions and definitions for the six component
ratings.
Composite Ratings
Composite ratings are based on a careful evaluation of an
institution's managerial, operational, financial, and compliance
performance. The six key components used to assess an institution's
financial condition and operations are: capital adequacy, asset
quality, management capability, earnings quantity and quality, the
adequacy of liquidity, and sensitivity to market risk. The rating scale
ranges from 1 to 5, with a rating of 1 indicating: the strongest
performance and risk management practices relative to the institution's
size, complexity, and risk profile; and the level of least supervisory
concern. A 5 rating indicates: the most critically deficient level of
performance; inadequate risk management practices relative to the
institution's size, complexity, and risk profile; and the greatest
supervisory concern. The composite ratings are defined as follows:
Composite 1
Financial institutions in this group are sound in every respect and
generally have components rated 1 or 2. Any weaknesses are minor and
can be handled in a routine manner by the board of directors and
management. These financial institutions are the most capable of
withstanding the vagaries of business conditions and are resistant to
outside influences such as economic instability in their trade area.
These financial institutions are in substantial compliance with laws
and regulations. As a result, these financial institutions exhibit the
strongest performance and
[[Page 67026]]
risk management practices relative to the institution's size,
complexity, and risk profile, and give no cause for supervisory
concern.
Composite 2
Financial institutions in this group are fundamentally sound. For a
financial institution to receive this rating, generally no component
rating should be more severe than 3. Only moderate weaknesses are
present and are well within the board of directors' and management's
capabilities and willingness to correct. These financial institutions
are stable and are capable of withstanding business fluctuations. These
financial institutions are in substantial compliance with laws and
regulations. Overall risk management practices are satisfactory
relative to the institution's size, complexity, and risk profile. There
are no material supervisory concerns and, as a result, the supervisory
response is informal and limited.
Composite 3
Financial institutions in this group exhibit some degree of
supervisory concern in one or more of the component areas. These
financial institutions exhibit a combination of weaknesses that may
range from moderate to severe; however, the magnitude of the
deficiencies generally will not cause a component to be rated more
severely than 4. Management may lack the ability or willingness to
effectively address weaknesses within appropriate time frames.
Financial institutions in this group generally are less capable of
withstanding business fluctuations and are more vulnerable to outside
influences than those institutions rated a composite 1 or 2.
Additionally, these financial institutions may be in significant
noncompliance with laws and regulations. Risk management practices may
be less than satisfactory relative to the institution's size,
complexity, and risk profile. These financial institutions require more
than normal supervision, which may include formal or informal
enforcement actions. Failure appears unlikely, however, given the
overall strength and financial capacity of these institutions.
Composite 4
Financial institutions in this group generally exhibit unsafe and
unsound practices or conditions. There are serious financial or
managerial deficiencies that result in unsatisfactory performance. The
problems range from severe to critically deficient. The weaknesses and
problems are not being satisfactorily addressed or resolved by the
board of directors and management. Financial institutions in this group
generally are not capable of withstanding business fluctuations. There
may be significant noncompliance with laws and regulations. Risk
management practices are generally unacceptable relative to the
institution's size, complexity, and risk profile. Close supervisory
attention is required, which means, in most cases, formal enforcement
action is necessary to address the problems. Institutions in this group
pose a risk to the deposit insurance fund. Failure is a distinct
possibility if the problems and weaknesses are not satisfactorily
addressed and resolved.
Composite 5
Financial institutions in this group exhibit extremely unsafe and
unsound practices or conditions; exhibit a critically deficient
performance; often contain inadequate risk management practices
relative to the institution's size, complexity, and risk profile; and
are of the greatest supervisory concern. The volume and severity of
problems are beyond management's ability or willingness to control or
correct. Immediate outside financial or other assistance is needed in
order for the financial institution to be viable. Ongoing supervisory
attention is necessary. Institutions in this group pose a significant
risk to the deposit insurance fund and failure is highly probable.
Component Ratings
Each of the component rating descriptions is divided into three
sections: an introductory paragraph; a list of the principal evaluation
factors that relate to that component; and a brief description of each
numerical rating for that component. Some of the evaluation factors are
reiterated under one or more of the other components to reinforce the
interrelationship between components. The listing of evaluation factors
for each component rating is in no particular order of importance.
Capital Adequacy
A financial institution is expected to maintain capital
commensurate with the nature and extent of risks to the institution and
the ability of management to identify, measure, monitor, and control
these risks. The effect of credit, market, and other risks on the
institution's financial condition should be considered when evaluating
the adequacy of capital. The types and quantity of risk inherent in an
institution's activities will determine the extent to which it may be
necessary to maintain capital at levels above required regulatory
minimums to properly reflect the potentially adverse consequences that
these risks may have on the institution's capital.
The capital adequacy of an institution is rated based upon, but not
limited to, an assessment of the following evaluation factors:
The level and quality of capital and the overall financial
condition of the institution.
The ability of management to address emerging needs for
additional capital.
The nature, trend, and volume of problem assets, and the
adequacy of allowances for loan and lease losses and other valuation
reserves.
Balance sheet composition, including the nature and amount
of intangible assets, market risk, concentration risk, and risks
associated with nontraditional activities.
Risk exposure represented by off-balance sheet activities.
The quality and strength of earnings, and the
reasonableness of dividends.
Prospects and plans for growth, as well as past experience
in managing growth.
Access to capital markets and other sources of capital,
including support provided by a parent holding company.
Ratings
1 A rating of 1 indicates a strong capital level relative to the
institution's risk profile.
2 A rating of 2 indicates a satisfactory capital level relative to the
financial institution's risk profile.
3 A rating of 3 indicates a less than satisfactory level of capital
that does not fully support the institution's risk profile. The rating
indicates a need for improvement, even if the institution's capital
level exceeds minimum regulatory and statutory requirements.
4 A rating of 4 indicates a deficient level of capital. In light of
the institution's risk profile, viability of the institution may be
threatened. Assistance from shareholders or other external sources of
financial support may be required.
5 A rating of 5 indicates a critically deficient level of capital such
that the institution's viability is threatened. Immediate assistance
from shareholders or other external sources of financial support is
required.
Asset Quality
The asset quality rating reflects the quantity of existing and
potential credit risk associated with the loan and
[[Page 67027]]
investment portfolios, other real estate owned, and other assets, as
well as off-balance sheet transactions. The ability of management to
identify, measure, monitor, and control credit risk is also reflected
here. The evaluation of asset quality should consider the adequacy of
the allowance for loan and lease losses and weigh the exposure to
counterparty, issuer, or borrower default under actual or implied
contractual agreements. All other risks that may affect the value or
marketability of an institution's assets, including, but not limited
to, operating, market, reputation, strategic, or compliance risks,
should also be considered.
The asset quality of a financial institution is rated based upon,
but not limited to, an assessment of the following evaluation factors:
The adequacy of underwriting standards, soundness of
credit administration practices, and appropriateness of risk
identification practices.
The level, distribution, severity, and trend of problem,
classified, nonaccrual, restructured, delinquent, and nonperforming
assets for both on- and off-balance sheet transactions.
The adequacy of the allowance for loan and lease losses
and other asset valuation reserves.
The credit risk arising from or reduced by off-balance
sheet transactions, such as unfunded commitments, credit derivatives,
commercial and standby letters of credit, and lines of credit.
The diversification and quality of the loan and investment
portfolios.
The extent of securities underwriting activities and
exposure to counterparties in trading activities.
The existence of asset concentrations.
The adequacy of loan and investment policies, procedures,
and practices.
The ability of management to properly administer its
assets, including the timely identification and collection of problem
assets.
The adequacy of internal controls and management
information systems.
The volume and nature of credit documentation exceptions.
Ratings
1 A rating of 1 indicates strong asset quality and credit
administration practices. Identified weaknesses are minor in nature and
risk exposure is modest in relation to capital protection and
management's abilities. Asset quality in such institutions is of
minimal supervisory concern.
2 A rating of 2 indicates satisfactory asset quality and credit
administration practices. The level and severity of classifications and
other weaknesses warrant a limited level of supervisory attention. Risk
exposure is commensurate with capital protection and management's
abilities.
3 A rating of 3 is assigned when asset quality or credit
administration practices are less than satisfactory. Trends may be
stable or indicate deterioration in asset quality or an increase in
risk exposure. The level and severity of classified assets, other
weaknesses, and risks require an elevated level of supervisory concern.
There is generally a need to improve credit administration and risk
management practices.
4 A rating of 4 is assigned to financial institutions with deficient
asset quality or credit administration practices. The levels of risk
and problem assets are significant, inadequately controlled, and
subject the financial institution to potential losses that, if left
unchecked, may threaten its viability.
5 A rating of 5 represents critically deficient asset quality or
credit administration practices that present an imminent threat to the
institution's viability.
Management
The capability of the board of directors and management, in their
respective roles, to identify, measure, monitor, and control the risks
of an institution's activities and to ensure a financial institution's
safe, sound, and efficient operation in compliance with applicable laws
and regulations is reflected in this rating. Generally, directors need
not be actively involved in day-to-day operations; however, they must
provide clear guidance regarding acceptable risk exposure levels and
ensure that appropriate policies, procedures, and practices have been
established. Senior management is responsible for developing and
implementing policies, procedures, and practices that translate the
board's goals, objectives, and risk limits into prudent operating
standards.
Depending on the nature and scope of an institution's activities,
management practices may need to address some or all of the following
risks: credit, market, operating or transaction, reputation, strategic,
compliance, legal, liquidity, and other risks. Sound management
practices are demonstrated by: active oversight by the board of
directors and management; competent personnel; adequate policies,
processes, and controls taking into consideration the size and
sophistication of the institution; maintenance of an appropriate audit
program and internal control environment; and effective risk monitoring
and management information systems. This rating should reflect the
board's and management's ability as it applies to all aspects of
banking operations as well as other financial service activities in
which the institution is involved.
The capability and performance of management and the board of
directors is rated based upon, but not limited to, an assessment of the
following evaluation factors:
The level and quality of oversight and support of all
institution activities by the board of directors and management.
The ability of the board of directors and management, in
their respective roles, to plan for, and respond to, risks that may
arise from changing business conditions or the initiation of new
activities or products.
The adequacy of, and conformance with, appropriate
internal policies and controls addressing the operations and risks of
significant activities.
The accuracy, timeliness, and effectiveness of management
information and risk monitoring systems appropriate for the
institution's size, complexity, and risk profile.
The adequacy of audits and internal controls to: promote
effective operations and reliable financial and regulatory reporting;
safeguard assets; and ensure compliance with laws, regulations, and
internal policies.
Compliance with laws and regulations.
Responsiveness to recommendations from auditors and
supervisory authorities.
Management depth and succession.
The extent that the board of directors and management is
affected by, or susceptible to, dominant influence or concentration of
authority.
Reasonableness of compensation policies and avoidance of
self-dealing.
Demonstrated willingness to serve the legitimate banking
needs of the community.
The overall performance of the institution and its risk
profile.
Ratings
1 A rating of 1 indicates strong performance by management and the
board of directors and strong risk management practices relative to the
institution's size, complexity, and risk profile. All significant risks
are consistently and effectively identified, measured, monitored, and
controlled.
[[Page 67028]]
Management and the board have demonstrated the ability to promptly and
successfully address existing and potential problems and risks.
2 A rating of 2 indicates satisfactory management and board performance
and risk management practices relative to the institution's size,
complexity, and risk profile. Minor weaknesses may exist, but are not
material to the safety and soundness of the institution and are being
addressed. In general, significant risks and problems are effectively
identified, measured, monitored, and controlled.
3 A rating of 3 indicates management and board performance that need
improvement or risk management practices that are less than
satisfactory given the nature of the institution's activities. The
capabilities of management or the board of directors may be
insufficient for the type, size, or condition of the institution.
Problems and significant risks may be inadequately identified,
measured, monitored, or controlled.
4 A rating of 4 indicates deficient management and board performance or
risk management practices that are inadequate considering the nature of
an institution's activities. The level of problems and risk exposure is
excessive. Problems and significant risks are inadequately identified,
measured, monitored, or controlled and require immediate action by the
board and management to preserve the soundness of the institution.
Replacing or strengthening management or the board may be necessary.
5 A rating of 5 indicates critically deficient management and board
performance or risk management practices. Management and the board of
directors have not demonstrated the ability to correct problems and
implement appropriate risk management practices. Problems and
significant risks are inadequately identified, measured, monitored, or
controlled and now threaten the continued viability of the institution.
Replacing or strengthening management or the board of directors is
necessary.
Earnings
This rating reflects not only the quantity and trend of earnings,
but also factors that may affect the sustainability or quality of
earnings. The quantity as well as the quality of earnings can be
affected by excessive or inadequately managed credit risk that may
result in loan losses and require additions to the allowance for loan
and lease losses, or by high levels of market risk that may unduly
expose an institution's earnings to volatility in interest rates. The
quality of earnings may also be diminished by undue reliance on
extraordinary gains, nonrecurring events, or favorable tax effects.
Future earnings may be adversely affected by an inability to forecast
or control funding and operating expenses, improperly executed or ill-
advised business strategies, or poorly managed or uncontrolled exposure
to other risks.
The rating of an institution's earnings is based upon, but not
limited to, an assessment of the following evaluation factors:
The level of earnings, including trends and stability.
The ability to provide for adequate capital through
retained earnings.
The quality and sources of earnings.
The level of expenses in relation to operations.
The adequacy of the budgeting systems, forecasting
processes, and management information systems in general.
The adequacy of provisions to maintain the allowance for
loan and lease losses and other valuation allowance accounts.
The earnings exposure to market risk such as interest
rate, foreign exchange, and price risks.
Ratings
1 A rating of 1 indicates earnings that are strong. Earnings are more
than sufficient to support operations and maintain adequate capital and
allowance levels after consideration is given to asset quality, growth,
and other factors affecting the quality, quantity, and trend of
earnings.
2 A rating of 2 indicates earnings that are satisfactory. Earnings are
sufficient to support operations and maintain adequate capital and
allowance levels after consideration is given to asset quality, growth,
and other factors affecting the quality, quantity, and trend of
earnings. Earnings that are relatively static, or even experiencing a
slight decline, may receive a 2 rating provided the institution's level
of earnings is adequate in view of the assessment factors listed above.
3 A rating of 3 indicates earnings that need to be improved. Earnings
may not fully support operations and provide for the accretion of
capital and allowance levels in relation to the institution's overall
condition, growth, and other factors affecting the quality, quantity,
and trend of earnings.
4 A rating of 4 indicates earnings that are deficient. Earnings are
insufficient to support operations and maintain appropriate capital and
allowance levels. Institutions so rated may be characterized by erratic
fluctuations in net income or net interest margin, the development of
significant negative trends, nominal or unsustainable earnings,
intermittent losses, or a substantive drop in earnings from the
previous years.
5 A rating of 5 indicates earnings that are critically deficient. A
financial institution with earnings rated 5 is experiencing losses that
represent a distinct threat to its viability through the erosion of
capital.
Liquidity
In evaluating the adequacy of a financial institution's liquidity
position, consideration should be given to the current level and
prospective sources of liquidity compared to funding needs, as well as
to the adequacy of funds management practices relative to the
institution's size, complexity, and risk profile. In general, funds
management practices should ensure that an institution is able to
maintain a level of liquidity sufficient to meet its financial
obligations in a timely manner and to fulfill the legitimate banking
needs of its community. Practices should reflect the ability of the
institution to manage unplanned changes in funding sources, as well as
react to changes in market conditions that affect the ability to
quickly liquidate assets with minimal loss. In addition, funds
management practices should ensure that liquidity is not maintained at
a high cost, or through undue reliance on funding sources that may not
be available in times of financial stress or adverse changes in market
conditions.
Liquidity is rated based upon, but not limited to, an assessment of
the following evaluation factors:
The adequacy of liquidity sources compared to present and
future needs and the ability of the institution to meet liquidity needs
without adversely affecting its operations or condition.
The availability of assets readily convertible to cash
without undue loss.
Access to money markets and other sources of funding.
The level of diversification of funding sources, both on-
and off-balance sheet.
The degree of reliance on short-term, volatile sources of
funds, including borrowings and brokered deposits, to fund longer term
assets.
The trend and stability of deposits.
The ability to securitize and sell certain pools of
assets.
[[Page 67029]]
The capability of management to properly identify,
measure, monitor, and control the institution's liquidity position,
including the effectiveness of funds management strategies, liquidity
policies, management information systems, and contingency funding
plans.
Ratings
1 A rating of 1 indicates strong liquidity levels and well-developed
funds management practices. The institution has reliable access to
sufficient sources of funds on favorable terms to meet present and
anticipated liquidity needs.
2 A rating of 2 indicates satisfactory liquidity levels and funds
management practices. The institution has access to sufficient sources
of funds on acceptable terms to meet present and anticipated liquidity
needs. Modest weaknesses may be evident in funds management practices.
3 A rating of 3 indicates liquidity levels or funds management
practices in need of improvement. Institutions rated 3 may lack ready
access to funds on reasonable terms or may evidence significant
weaknesses in funds management practices.
4 A rating of 4 indicates deficient liquidity levels or inadequate
funds management practices. Institutions rated 4 may not have or be
able to obtain a sufficient volume of funds on reasonable terms to meet
liquidity needs.
5 A rating of 5 indicates liquidity levels or funds management
practices so critically deficient that the continued viability of the
institution is threatened. Institutions rated 5 require immediate
external financial assistance to meet maturing obligations or other
liquidity needs.
Sensitivity to Market Risk
The sensitivity to market risk component reflects the degree to
which changes in interest rates, foreign exchange rates, commodity
prices, or equity prices can adversely affect a financial institution's
earnings or economic capital. When evaluating this component,
consideration should be given to: management's ability to identify,
measure, monitor, and control market risk; the institution's size; the
nature and complexity of its activities; and the adequacy of its
capital and earnings in relation to its level of market risk exposure.
For many institutions, the primary source of market risk arises
from nontrading positions and their sensitivity to changes in interest
rates. In some larger institutions, foreign operations can be a
significant source of market risk. For some institutions, trading
activities are a major source of market risk.
Market risk is rated based upon, but not limited to, an assessment
of the following evaluation factors:
The sensitivity of the financial institution's earnings or
the economic value of its capital to adverse changes in interest rates,
foreign exchanges rates, commodity prices, or equity prices.
The ability of management to identify, measure, monitor,
and control exposure to market risk given the institution's size,
complexity, and risk profile.
The nature and complexity of interest rate risk exposure
arising from nontrading positions.
Where appropriate, the nature and complexity of market
risk exposure arising from trading and foreign operations.
Ratings
1 A rating of 1 indicates that market risk sensitivity is well
controlled and that there is minimal potential that the earnings
performance or capital position will be adversely affected. Risk
management practices are strong for the size, sophistication, and
market risk accepted by the institution. The level of earnings and
capital provide substantial support for the degree of market risk taken
by the institution.
2 A rating of 2 indicates that market risk sensitivity is adequately
controlled and that there is only moderate potential that the earnings
performance or capital position will be adversely affected. Risk
management practices are satisfactory for the size, sophistication, and
market risk accepted by the institution. The level of earnings and
capital provide adequate support for the degree of market risk taken by
the institution.
3 A rating of 3 indicates that control of market risk sensitivity
needs improvement or that there is significant potential that the
earnings performance or capital position will be adversely affected.
Risk management practices need to be improved given the size,
sophistication, and level of market risk accepted by the institution.
The level of earnings and capital may not adequately support the degree
of market risk taken by the institution.
4 A rating of 4 indicates that control of market risk sensitivity is
unacceptable or that there is high potential that the earnings
performance or capital position will be adversely affected. Risk
management practices are deficient for the size, sophistication, and
level of market risk accepted by the institution. The level of earnings
and capital provide inadequate support for the degree of market risk
taken by the institution.
5 A rating of 5 indicates that control of market risk sensitivity is
unacceptable or that the level of market risk taken by the institution
is an imminent threat to its viability. Risk management practices are
wholly inadequate for the size, sophistication, and level of market
risk accepted by the institution.
End of Proposed Text of Uniform Financial Institutions Rating
System
Dated: December 13, 1996.
Keith J. Todd,
Assistant Executive Secretary, Federal Financial Institutions
Examination Council.
[FR Doc. 96-32174 Filed 12-18-96; 8:45 am]
BILLING CODE 4810-33-P; 6210-01-P; 6710-01-P; 6720-01-P