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FIL-105-96 Attachment

[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.

---------------------------------------------------------------------------


 

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

Last Updated: March 24, 2024