FCA Info Memo - Office of Examination Focus Areas for Fiscal Years 1998/1999

Informational Memorandum
Subject:	Office of Examination Focus Areas for Fiscal Years 1998/1999
Date of Memorandum:	11/24/1997
Expiration Date:
Office:	OE
Signed By:	Smith, Roland
FCA Contact Person:	Smith, Roland
Contact Phone:	703-883-4160
List of Attachments:

INFORMATIONAL MEMORANDUM

November 24, 1997

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 Years 1998/1999

The Farm Credit Administration (FCA or Agency) follows a risk-based examination approach in establishing the scope of its examinations of Farm Credit System (System) institutions. The conditions unique to each institution are considered when determining the resources allocated for an examination, as well as the areas to be examined. However, we also document areas on an annual basis that, because of their importance or degree of concern in the current operating environment, may warrant some examination coverage in each institution's examination. The amount and degree of examination activities in these areas are determined under the risk-based examination principles and, therefore, can vary substantially between institutions. Those areas are termed the Office of Examination (OE) Focus Areas.

For the fiscal year (FY) 1998/1999 time period, OE identified nine Focus Areas. To help you better understand FCA’s examination of your institution, I believe it is important that we share with you the OE Focus Areas. Hopefully, this will give you an opportunity to review each of those aspects of your operations so you can ensure your institutions have appropriately addressed the concerns raised in the OE Focus Areas. I am certain that many of you may have already included many of these items as a part of your institution’s internal control program. I also encourage you to share and discuss your assessments of these areas with the FCA Examiner-in-Charge during your next examination. The OE Focus Areas for FY 1998/1999 are:

· Board Policy Direction and Control
· Lending Practices and Loan Underwriting Standards
· Participations and Syndications
· Collateral Risk
· Capital Adequacy
· Customer Eligibility
· Year 2000 Potential Problems with Computer Systems
· New Business Opportunities
· Flood Insurance

Further explanation of the above issues is included in the accompanying attachment. This attachment is an excerpt from the OE Operating Plan, which provides guidance to all FCA examiners. Should you have any questions regarding the OE Focus Areas, or any other aspect of the Agency’s examination program, please contact the Director of your respective FCA Field Office.

In closing, I want to thank you and your staff members for the cooperation given to FCA examiners over the years and I trust they will continue to receive the same level of cooperation into the future. I believe that because we are all working towards the same goal, sharing information will perhaps help all of us strive to maintain a successful, safe and sound Farm Credit System.

Attachment
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OE Focus Areas

The following represent primary focus areas for examination activities. These focus areas shall be considered in individual examination and oversight programs, and they will be discussed and concluded on as appropriate in Reports of Examination. Several of the focus area discussions include specific guidance on the treatment of deficiencies found. However, as always, judgement must be used in the application of this guidance after considering the specific circumstances of the institution.

Board Policy Direction and Control: The examination of board direction and control has been employed in OE’s program for the past several years. At this time most System institutions have established programs that effectively maintain a system of board policies, controls, and periodic reporting. However, some policy programs are still in various stages of development. Accordingly, the examination of policies in those institutions may require more extensive examination than those institutions with well-defined policy programs. Because the board is ultimately responsible for the successful operations of the institution, it is essential that policies approved by the board provide adequate direction and control over the management of the institution. Beyond what is required by law or regulation, policies should cover every significant aspect of institution operations. An effective policy should include or address the six components which are contained in EM-520 of the Examination Manual and the FCA publication entitled “The Director’s Role” and should also be addressed in the Reports of Examination of those institutions with well-defined weaknesses in policy direction and control.

Most institutions have well-defined internal control systems that provide assurances to the board that all its operations comply with law, regulation, and board policy. However, examination programs should still continue to focus on the adequacy of institution operations to ensure they function as intended, achieve objectives, prevent excessive risks, provide for effective management, and safeguard assets. In particular, the board’s ongoing program of audit and review remains an integral control mechanism. Accordingly, examiners should continue to assess internal review and internal audit policies and programs to ensure they: (1) routinely assess risk in accordance with a risk rating system adopted by the board, (2) assess credit administration and provide for prompt correction of weaknesses identified, and (3) report periodically on the ongoing review process to management and the board.

Examiners shall employ an accuracy standard to determine the reliability of an institution’s internal credit review (ICR). ICRs shall be classified “unreliable” where incorrect classifications are found in excess of 10 percent of the loan volume examined; however, this standard must be applied with judicious caution. For example, the examiner may need to expand the scope of the asset examination to appropriately determine if a pattern of practice exists where the ICR failed to identify the correct classifications. Also, instances of incorrect classifications in a few loans do not necessarily make an ICR unreliable unless the error was caused by a serious error in judgment. Institutions whose ICR is deemed to be unreliable should obtain quarterly ICR reports from reliable sources until such time as reliability is re-established. For institutions with incorrect classifications that range from 5 to 10 percent of loan volume examined, examiners should include in the letter to the board chairman a request for their action plan to strengthen controls in order to correct the weakness. For institutions with incorrect classification errors of 5 percent or less of volume examined, examiners should cite the weakness in the Report but conclude the ICR remains reliable.

Lending Practices and Loan Underwriting Standards: Lending practices and loan underwriting standards continue to be an area of special examination focus. Most System institutions established underwriting standards through board policy and other guidelines while the lending environment was favorable. However, such standards may not adequately control risk in a deteriorating economic environment. Furthermore, the increasing competitive pressures on System institutions may result in certain lenders liberalizing standards and permitting increased exceptions in order to maintain or build loan volume. The development of new lending programs such as scorecard lending may also precipitate the need for new standards to adequately control risk. Risks found in specific loan portfolio segments should be examined in concert with the related underwriting standards and institution business and capital plans. The Examination Manual, “The Director’s Role”, and the internal FCA white paper on loan underwriting standards contain additional insight on lending practices and the adequacy of loan underwriting standards.

Examiners should make sure the following areas are covered in tests of internal controls and examine sufficient lending processes and loans to conclude whether lending standards are appropriate and remain effective in identifying and controlling risk:

· Each institution should have and operate within written loan underwriting standards for all programs authorized by law, regulation, or institution policy. Such standards should be approved by the institution’s board of directors.

· Loan underwriting standards should result in loans that have acceptable risk both on an individual and collective basis as compared to capital and risk funds.

· Board and management should periodically review and make timely adjustments in order to adjust to changes in lending environment risks and to ensure standards result in sound financial management of the institution.

· The board should ensure that controls and information systems are adequate to (1) monitor compliance with underwriting standards, (2) report exceptions, and (3) hold management accountable.

Reports of Examination should conclude on the effectiveness of loan underwriting standards for all lending practices and the underlying causes of weaknesses. Examiners should also link the impact of weaknesses to the institution’s asset quality and financial condition.

Participations and Syndications: Loan participations and syndications are increasingly used to offset the risks in large loans of those containing unique or specialized risk to the lender. These lending arrangements are being used primarily in response to competitive pressures and by legal lending limits. While such activities can provide significant loan volume and earnings, they can also result in significant risk. The institution(s) responsible for originating and servicing these loans must utilize sound underwriting standards with sufficient ongoing controls and monitoring. Participating institutions must also perform adequate due diligence in acquiring and maintaining participations and syndications of acceptable risk.

Collateral Risk: System institutions continue to employ repayment capacity as the primary basis for extending credit. However, some institutions have not sufficiently assessed the potential for decline in the income producing capacity of farmland or the value of collateral, thus exposing the institution to risk. The lack of such analyses, coupled with declining collateral values, resulted in substantial losses in the 1980’s. Even in the 1990’s, some institutions incurred substantial losses because they did not adequately monitor the value and condition of collateral, especially large and specialized facilities. The recent growth in farmland values, especially in the Midwest, coupled with the prospects for rising interest rates and decreasing government support, may increase the probability of collateral value declines and thereby increase risk to System institutions. Examiners should determine whether institution underwriting standards, lending practices, and collateral appraisals sufficiently identify and control collateral risk. Examination scope and approach will vary considerably among institutions depending on risk factors such as:

· Whether loan underwriting standards assess and limit the amount of collateral risk the institution is willing to accept in terms of capital.

· The adequacy of the institution’s internal controls and whether such controls include sufficient testing of collateral appraisals.

· Local economic, agricultural, and land value trends and the degree to which they are based on speculative or nonagricultural influences.

In those institutions where concerns exist as to the degree of collateral risk, examiners should focus on board and management oversight and controls over lending practices and collateral evaluation. Examination work should include a desk review of market and sales data and, in some instances, it might call for the institution to make physical inspections of collateral and evaluate market support. Examiners should also determine whether lending staff assesses the income producing capacity of collateral in accordance with FCA Regulation 12 CFR 614.4265(e). Additional guidance on the examination of collateral risk is being developed and will be provided to staff through training in the first quarter of FY ‘98.

Capital Adequacy: Examiners will continue to assess capital adequacy in relation to institution risk and capital needs. The relationship of adverse assets, criticized assets, and portfolio concentrations to risk funds will be the primary considerations in assessing capital adequacy. Examiners should be mindful that adequate levels of capital may be greater than minimum requirements set forth in the regulations.

Amendments to existing regulations governing capital adequacy were adopted by the FCA Board in January 1997. This regulation adds core surplus and total surplus standards for banks, associations, and the Farm Credit Leasing Services Corporation. It also adds a collateral ratio for banks and adds procedures for setting higher capital standards for individual institutions and for issuing capital directives, when warranted. Examiners need to assess levels of capital to determine compliance with the intent and parameters of the regulations. Institutions that do not comply will be required to develop and submit a Capital Restoration Plan to the Agency. At May 31, 1997, only two institutions did not meet the requirements of these regulations.

Customer Eligibility: Amendments to existing regulations governing customer eligibility rules for lending under Title III of the Farm Credit Act of 1971, as amended, and new authorities to participate with non-System lenders in loans to similar entities were adopted by the FCA Board in January 1997. Examiners need to assess institutions’ development and implementation of policies and procedures to ensure they comply with the regulations.

Year 2000 Potential Problems with Computer Systems: The most pervasive technological change that will take place over the next several years will be the efforts of the System to correctly interpret dates associated with the Year 2000. Most information systems will require modifications to perform as intended beginning January 1, 2000.

The computer problems associated with the Year 2000 potentially pose safety and soundness concerns because there is zero tolerance for late delivery or project failure. Also, experience has shown that modification projects are nearly always more costly and time consuming than anticipated. The purpose of the examination program is to be able to accurately assess what degree of exposure exists in the System and in individual institutions as a result of the millennium date change on January 1, 2000. This assessment will enable the Agency to identify high risk institutions early enough so corrective action can be implemented. The Agency also has a number of initiatives that will be employed such as (1) development of a Year 2000 awareness program for System institutions and Agency staff, (2) development of examination procedures for monitoring of progress, (3) development of Year 2000 examination schedules to be completed by Information Systems examiners in FY ’98, and (4) training examiners in Year 2000 methodology.

New Business Opportunities: There will continue to be additional business opportunities that relate to eligibility and scope of financing and scorecard lending. This special focus area includes not only these business opportunities but other ventures such as alliances, new lending programs, flood insurance requirements, service corporations, and electronic commerce. Overall, the assessment of the institution’s implementation of these various business opportunities should include adequacy of board policies, procedures and controls, capital, and allowance for losses.

Loan underwriting through the use of scorecard lending has begun to proliferate throughout the System and warrants close scrutiny. Many institutions already aggressively use this tool through local and districtwide programs. In addition, the System is expected to begin a national trade credit program using scorecard technology under the AgSmart trade name. This lending approach, like any underwriting mechanism, must be closely monitored. Examiners should evaluate:

· Operating parameters established by the board relative to capital.
· Risk associated with override decisions.
· Adequacy of risk controls.
· Portfolio management.
· Regulatory compliance.

Flood Insurance: The flood insurance regulations implementing the provisions of the National Flood Insurance Reform Act of 1994 became effective October 4, 1996. Generally, examination activities should be focused on compliance with these regulations. More comprehensive guidance is contained in the Federal Financial Institution Examination Council’s examination policies and procedures.