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Informational Memorandum
Subject:Office of Examination Focus Areas for Fiscal Year 2001
Date of Memorandum:02/01/2001
Expiration Date:
Office:OE
Signed By:Smith, Roland
FCA Contact Person:Smith, Roland
Contact Phone:703-883-4121
List of Attachments:

INFORMATIONAL MEMORANDUM



February 1, 2001


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 2001

As part of our annual examination planning process, focus areas are developed to ensure the scope of each examination addresses areas of potential risk 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 or Agency) 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 three focus areas that are more fully explained in the attachment:

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

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 in 2000 substantially enhanced farmers’ income and repayment abilities. However, without continued assistance or a significant rebound in commodity prices, the profitability of agriculture producers in 2001 may decline. Just as you, we want to ensure that the Farm Credit System remains successful, financially sound, and operates safely. 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. Should you have any questions regarding these focus areas, 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.

Attachment: Office of Examination Focus Areas – FY 2001/2002





Attachment

Office of Examination Focus Areas – Fiscal Year 2001/2002

Examination and oversight programs will focus on areas representing emerging risk and regulatory concerns for System institutions. Although the national economy remains strong, most farming sectors have experienced stress due to adverse weather conditions, low commodity prices, and declining demand for exports caused by expanding world production and slow economic recovery.

FCA examinations will focus primarily on the adequacy of business planning and portfolio management strategies to contain risks (both individual loan risks as well as portfolio-wide risks) within the risk-bearing capacity of each institution. The Agency’s examination and oversight programs of FCS institutions will conclude in Reports of Examination on the following focus areas.

1. Business Planning
The System and the financial services industry as a whole are undergoing unprecedented changes that make business planning critical to an institution’s success. Institutions must have well-defined business and capital adequacy plans that ensure the future success of the institution. For some institutions, lending authorities that cover broad geographic territory allow greater opportunity for product and commodity diversification, mitigate concentration risks, and perhaps provide for a lower cost of credit. However, some institutions have certain geographic constraints that do not provide for commodity diversification in the loan portfolio. In such instances, it is incumbent on management to ensure business planning addresses the risk posed by concentrations in the loan portfolio and how this risk will be managed.

Through examination programs focused on strategic planning, we will determine if institutions maintain capital and risk funds appropriate for the scope and risk of lending activities and business risks. FCA Regulations 618.8440 and 615.5200 provide the regulatory criteria for business and capital adequacy plans. We will evaluate an institution’s compliance with the business and capital planning requirements as prescribed by these regulations. Further, where lending programs and financial services are expanded, we will evaluate internal controls to ensure controls are commensurate with the scope of operations, lending programs and services offered.

2. Portfolio Risk Management
The effective management of risk in the loan portfolio is crucial to the safety and soundness of an institution. While there are many aspects to managing risk, our examinations will place particular focus on two areas: (1) Portfolio Concentrations, and (2) Scorecard Lending.

Portfolio Concentrations —-- Price volatility of some commodities, production uncertainty, and continued consolidation of agriculture segments in the U.S. affects the market environment and portfolio risk for System institutions. In addition, the movement towards larger and more complex borrowing entities has continued. Government payments to farmers in 1998, 1999, and 2000 increased net farm income and strengthened repayment capacity, thus averting financial disaster for many producers. The prospects for such government aid in 2001 are not known at this time.

The examiners will continue to evaluate concentrations of large loans and individual commodities 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 their exposure to these concentrations, as well as the effectiveness 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 in primary commodities may have on the loan portfolio, capital adequacy, and earnings. 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 in its operating environment. We will also evaluate other risk management controls of the institution, such as underwriting standards, industry or in-house lending limits on loans or loan concentrations, and the use of syndications, participations, guarantees, and long-term standby purchase commitments. Finally, many borrowers are still learning ways to spread or lay off 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. Scorecard Lending —-- Several System institutions continue to report significant growth and expansion of scorecard lending programs. Some institutions use scorecard lending programs for making operating and equipment loans whichthat in some instances are unsecured. Yet the quality and quantity of borrower financial information on scorecard loans is substantially less than that gathered on other loans in the portfolio. A significant concentration of these loans could materially lessen the ability of institutions to evaluate prospective risks in the loan portfolio. Unless paired with a fully documented loan, the first sign that a scorecard loan has deteriorated is when the borrower defaults. To date, the risk characteristics of scorecard-based portfolios usually have not been materially different from the portfolio as a whole. The inherent risk in relying on scorecard lending programs is that credit quality and delinquency indicators lag changes in economic conditions. Also, scorecard loan portfolios have not been tested over time or by a sustained downturn in the business cycle, especially in the absence of government support payments. Further, portfolio performance has been improved by significant government financial aid to the farm sector. Even if a scorecard correctly rank-orders risk, the probabilities for repayment expectations assigned to the various scoring bands could change with economic and agricultural conditions in the absence of government aid. We will focus on the soundness of portfolio management practices governing scorecard lending programs when those programs are material relative to the institution’s capital. Growth of scorecard lending programs is likely to increase as a result of electronic commerce and attempts to increase efficiencies and improve customer service in an increasingly competitive environment. Because these lending programs may involve greater risk, it is imperative that such programs are properly managed and do not expose the institution’s capital to excessive risk. Scorecard programs will be examined to ensure they are:


v Managed in a manner that does not present excessive exposure to capital from either credit risk or pricing;

v Properly monitored and reported to the institution’s board (loans originated on an “exception” or “override” basis, delinquency data and trends, changes in borrower risk characteristics, etc.) in accordance with board policy;

v Statistically valid and based on sound and reliable information; and

v Not discriminatory.


We will evaluate the effectiveness of portfolio risk management strategies to ensure loan underwriting standards and practices, capital levels, and allowances for loan losses keep pace with growth and emerging risks. A key component of each examination is to assess the adequacy of internal controls to prevent and detect 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. Each examination will evaluate the adequacy and reliability of the institution’s ICR. Material weaknesses or flaws in the institution’s ICR warrant prompt corrective action by the board and management.

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

Examinations will focus on board policies, underwriting standards, demographic studies, and marketing programs evidencing the board’s commitment to potential YBS 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, we will evaluate the data used to determine the level of service provided to these borrowers. Emphasis will be placed on reviewing the institution’s efforts and coordination with other Governmentgovernmental and private sources of credit to ensure adequate service to these borrowers. 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.