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Informational Memorandum
Subject:Office of Examination Focus Areas for Fiscal Year 2002
Date of Memorandum:02/15/2002
Expiration Date:
Office:OE
Signed By:Smith, Roland
FCA Contact Person:Smith, Roland
Contact Phone:703-883-4121
List of Attachments:Examination Focus Areas; Self-Audit Questionnaires

INFORMATIONAL MEMORANDUM



February 15, 2002


To: Chairman, Board of Directors
Chief Executive Officer
Each Farm Credit System Institution

From: Roland E. Smith, Chief Examiner
Office of Examination

Subject: Office of Examination Focus Areas for Fiscal Year 2002


As part of our annual examination planning process, focus areas are developed to ensure the scope of each examination addresses areas of risk and special interest to the Farm Credit System (FCS or System). These focus areas are shared with you, as has been our practice over the past several years, to help you better understand the Farm Credit Administration’s (FCA) examination of your institution.

The principal focus of all examinations is safety and soundness, and compliance with laws and regulations. While the conditions unique to each institution are considered in establishing the scope of examination, we have identified the following four focus areas that are more fully explained in Attachment 1:

Young, Beginning, and Small Farmers and Ranchers
Portfolio Risk Management
Business Planning
Electronic Commerce Activities

In addition to the narrative discussion provided in Attachment 1, to apprise you of the specific criteria that examiners will be utilizing in assessing the focus areas and to enhance our survey work in planning upcoming fiscal year 2002 examinations, we have included four separate self-audit questionnaires in Attachment 2. These questionnaires should alert you to examination expectations and allow you to determine if you need to take additional actions before your next FCA examination. During the planning stage of the examination of your institution, the appropriate Examiner-in-Charge (EIC) may request you to complete and submit these questionnaires. If so, the EIC will inform you of when and where to send your submission.

We continue to appreciate and rely on the high level of cooperation and communication from you and your staff with FCA examiners. Although there may be some difficult times ahead for some borrowers and some institutions, the System is, in the aggregate, materially sound in all respects and is well positioned to deal with and manage adversity. The government’s assistance to agriculture over the past several years substantially enhanced farmers’ income and repayment abilities. However, without continued assistance or a rebound in commodity prices, the profitability of agriculture producers in 2002 will continue to be under stress. Just as you, we want to ensure that the System remains successful. I urge you to continue to carefully evaluate the capacity of your institution to handle any increased risk that may emerge, and take whatever actions are needed to ensure it remains financially sound. I also urge you to work with borrowers to find the best solution to make their operations successful and protect their accumulated net worth.

Should you have any questions regarding these focus areas or the self-audit questionnaires, please contact me at (703) 883-4160 or correspond on the Internet at e-mail address smithr@fca.gov, or contact the Director of your respective FCA Field Office.

Attachments

Attachment 1
Examination Focus Areas

FCA examination and oversight efforts will continue to focus on safety and soundness areas and compliance with regulations, as well as the progress FCS institutions are making in accomplishing public purposes. The four areas selected for this examination cycle are based on a survey of FCA examiners and will be evaluated on a risk-based approach for each institution examined. For example, large direct lender associations are expected to have a much more robust performance management system and internal controls than small institutions that pose little risk to the System’s financial safety and soundness. In addition, in assessing risks to institutions, the appropriateness of the management of risks, and other areas to assign the FIRS risk rating, Reports of Examination will specifically conclude on: (1) Young, Beginning, and Small Farmers and Ranchers; (2) Portfolio Risk Management; (3) Business Planning; and (4) E-Commerce, when appropriate.

1. Young, Beginning, and Small Farmers and Ranchers The availability of sound and constructive credit and financially related services to borrowers identified as young, beginning, or small (YBS) farmers and ranchers continues to be a high priority of the System and FCA. Loans to borrowers meeting these characteristics help ensure the institutions’ continued business and the smooth transition of farming and ranching operations to the next generation. These loans also help provide assistance in servicing a changing agriculture industry that includes many new and smaller farmers and ranchers. Over the past several years, significant efforts have been made to improve the identification and reporting of these borrowers, as well as their credit and financial service needs. In this regard, FCA Bookletter-040 provided guidance to the System in December 1998, communicating new definitions and reporting procedures to be phased in by January 1, 2001. The bookletter also reiterated the need for each direct lender to establish policy direction for lending programs to these borrowers, including measurable goals, commensurate with institution risk-bearing capacity.

Examinations will focus on board policies, underwriting standards, demographic studies, and marketing programs evidencing the board’s commitment to these groups of potential borrowers. For example, the adequacy of demographic studies and marketing plans will be evaluated to assess progress toward achieving the goals established in the business plan for YBS farmers and ranchers. Also, as the revised FCA reporting procedures became effective January 1, 2001, we will evaluate the adequacy of support for the data reported and the level of service provided to these sectors. Emphasis will be placed on reviewing the adequacy of an institution’s efforts and coordination with other governmental and private sources of credit or guarantees to ensure adequate service to these sectors of the industry. Where deficiencies are identified in either the program support or the accuracy of data reported, we will ensure the boards of directors establish corrective action plans to meet their regulatory and public policy obligations.

2. Business Planning to Accomplish Public Mission

Business planning and the implementation of proper strategies are important in directing FCS institutions to accomplish their public mission in a safe and sound manner in a changing lending environment. The profile of FCS institutions is rapidly changing as they consolidate and pursue loans and participations to processing and marketing facilities with greater risks than traditional “farm loans.” As institutions implement these new strategies, it is important that well thought out plans are in place to guide the institutions in properly servicing eligible borrowers and expanding the scope of their operations in a safe and sound manner, in accordance with public policy. A specific area of interest is the institution’s plan for growth and outcomes achieved – particularly where the growth rate is relatively high (i.e., exceeds 10 percent annually). Growth that is planned and controlled clearly benefits an institution. However, the institution needs to ensure that loans are appropriately priced, serve to diversify the loan portfolio, do not result in large loan concentrations, and make the portfolio stronger. Further, an institution needs to ensure it has the capacity to service this growth in the future. Some very large institutions will have to develop sophisticated systems to track changing risks in their portfolios, prepare accurate reports on trends, and analyze the capital necessary to support growth and risks.

Our examination programs will focus on the adequacy of strategic planning by FCS institutions to accomplish their public mission and the implementation of those plans to maintain financially strong institutions. We will evaluate compliance with FCA Regulations, follow up on prior examination findings regarding strategic planning, and review effectiveness of the planning process. In addition, we will evaluate how the strategic planning process addresses the institution’s public mission. The examiners will evaluate processes for: (1) developing and defining public mission goals and implementing strategies; (2) measuring progress in meeting the goals; and (3) reporting to the board of directors and disclosing to others the public mission accomplishments.

3. Portfolio Risk Management

Effective portfolio risk management is needed to ensure strong FCS institutions capable of accomplishing their public mission. While there are many aspects to managing portfolio risks, our examinations will place particular emphasis on: (1) reviewing the linkage between government support programs and portfolio management assumptions and strategies regarding those programs; (2) loan participations and loan syndications as risk management tools; and (3) impact of the availability and costs of energy on the loan portfolio.

Our examinations will continue to evaluate portfolio risks and the capability of institutions to assess the extent that disruptions in the agricultural economy may have on an institution’s financial stability. We will evaluate how well institutions have managed exposure to these risks, as well as the institution’s actions and effectiveness in the use of risk mitigation tools. For example, the FCA has been urging institutions to stress test the loan portfolio to assess the impact that adverse conditions may have on the loan portfolio and financial condition of the institution. The purpose of stress testing is to evaluate the prospective risk in institutions and to determine the adequacy of capital to insulate the institution from risk. We will also continue to evaluate other risk management controls of the institution such as loan underwriting standards; industry or house limits on loans or loan concentrations; the use of syndications, participations, and guarantees; and long-term standby purchase commitments from the Federal Agricultural Mortgage Corporation. Finally, many borrowers are still learning ways to disperse or divest risks, particularly the large and integrated producers. Accordingly, we will consider the tools used by the institution to control risk in individual loans, such as requiring hedges or contracts to mitigate borrowers’ risk and, ultimately, risk to the institution.

We will also evaluate the effectiveness of portfolio risk management strategies to ensure loan underwriting standards and practices, capital levels, and allowance levels are appropriate. A key component of each examination is assessing the adequacy of internal controls to detect and prevent risks that may materially threaten the risk-bearing capacity of System institutions, either individually or collectively. Accordingly, Internal Credit Reviews (ICR) are a critical part of internal controls. On each examination, examiners will determine the adequacy and reliability of the institution’s ICR. Material weaknesses or flaws in the institution’s ICR will warrant prompt corrective action by the board and management.

4. Electronic Commerce Activities

Electronic commerce (E-Commerce) provides FCS institutions both new opportunities and potentially greater risk. The financial services industry’s use of E-Commerce to promote their services, disperse information, take online applications, and assist in their own internal operations has substantially increased in recent years. For the most part, System institutions’ entry into E-Commerce is more recent than other financial institutions and has largely concentrated on the use of the Internet. With technology rapidly changing, the array of services and products offered will expand, thereby offering additional income opportunities for System institutions. But management must understand the risks associated with E-Commerce if they are to make informed decisions regarding the development of a particular product or service. It is important for management to understand the risks and ramifications of the institution’s involvement in E-Commerce and the controls necessary to address those risks. For any System institution using E-Commerce, a good understanding of the risks and opportunities associated with E-Commerce is a necessary inclusion to the strategic planning process.

FCA does not take a position that System institutions must engage in E-Commerce activities. But for institutions that are involved with E-Commerce, examiners will evaluate if those E-Commerce activities are effectively incorporated into their operations while safety and soundness is retained. Accordingly, each System institution Web site will be subject to a centralized review semi-annually. An internal report will be developed that summarizes the findings of this review and will be distributed internally to the field offices for follow up, as they deem appropriate. As a part of each examination, we will evaluate security measures taken by management to ensure the safety of its information and protect the institution and its borrowers. Our examination efforts will also ascertain if there is an adequate and appropriate link between E-Commerce activities the institution has chosen to engage in and the institution’s policies, planning efforts, and internal controls.
Attachment 2

Focus areas 2002 self-audit.doc