FCA Info Memo - OE Focus Areas for Fiscal Years 2000/2001

Informational Memorandum
Subject:	OE Focus Areas for Fiscal Years 2000/2001
Date of Memorandum:	10/20/1999
Expiration Date:
Office:	OE
Signed By:	Smith, Roland
FCA Contact Person:	Smith, Roland
Contact Phone:	703-883-4160
List of Attachments:	Bookletter BL-040

INFORMATIONAL MEMORANDUM

October 20, 1999

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 2000/2001

As part of the Farm Credit Administration’s (FCA or Agency) Strategic Plan, examination focus areas are developed to ensure the scope of each examination addresses emerging areas of potential risk to the Farm Credit System. Sharing these focus areas with each of you, as has been the Agency’s practice over the past several years, will help you better understand FCA’s examination of your institution. Additionally, this information will give you the opportunity to evaluate the various aspects of your operations and ensure that business planning, lending standards, and internal control programs are sound, and effectively mitigate risks pertaining to these issues. We encourage you to share and discuss your activities in these areas with the FCA Examiner-in-Charge so that the examination will benefit you as much as possible.

While the conditions unique to each institution are considered in establishing the scope of examination and allocating examiner resources for each examination, we have identified the following five focus areas that are more fully explained in Attachment 1:

· Portfolio Concentrations
· Distressed Borrowers
· Young, Beginning, and Small Farmers and Ranchers, and Lending to Minority Farmers
· Scorecard Lending
· Year 2000 Readiness

Once again, we would like to express our appreciation to you and your staff for the high level of cooperation and communication with FCA examiners this past year. Although there may be some difficult times ahead for some borrowers and some institutions, sharing this information

will help all of us maintain a successful, safe, and sound Farm Credit System. Should you have any questions regarding these focus areas, please contact me at (703) 883-4160 or on the Internet at e-mail address smithr@fca.gov, or the Director of your respective FCA Field Office.

Attachment 1: Office of Examination Focus Areas – FY 2000/2001
Attachment 2: Bookletter BL-040

Attachment 1

Office of Examination (OE) Focus Areas – Fiscal Years 2000/2001

OE 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 are experiencing stress in 1999 with adverse weather conditions, low commodity prices, and declining demand for exports caused by increased world production and global economic stress. Emerging risk for Farm Credit System (FCS or System) institutions results from declining government programs, heightened competition within the lending industry, and environmental and concentration risk associated with commercialization and larger operations.

The Farm Credit Administration (FCA), as the regulator, must ensure FCS institutions effectively manage operational risks and meet rural America’s demand for agricultural credit. Therefore, OE examinations will focus on the adequacy of portfolio management strategies to contain risks (both individual loan risks as well as portfolio-wide risks) within the risk-bearing capacity of each institution, while meeting increased demand for financial services in a highly competitive market. This will include the analysis of institution practices to monitor and assess risk associated with specific integrators, adjustment of underwriting standards, and management strategies to offset production and financial risks. At a minimum, examination and oversight programs should conclude in Reports of Examination on the following focus areas.

Portfolio Concentrations
Price and income volatility of some commodities and continued consolidation of agriculture segments in the United States affects the market environment and portfolio risk for FCS institutions. Over 40 institutions had loan concentrations in a single commodity representing more than 200 percent of capital. Examiners will:

· Continue to thoroughly evaluate concentrations in large loans and loans to individual commodities to assess the extent that disruptions in the agricultural economy may have on the institution’s financial stability.

· Assess the nature and potential impact of these concentrations, as well as the institution’s actions and effectiveness in risk mitigation tools. Many borrowers and lenders are still learning ways to spread out or minimize risk.

· Evaluate the risk management practices of these borrowers, particularly the large and integrated producers, to determine whether they use hedges and/or contracts to mitigate market risk.

· Evaluate the risk management of the institution through such processes as establishing “industry” or “house” limits at levels below the legal lending limit, the use of syndications, participations, guarantees, or other risk mitigating activities.

Distressed Borrowers
A sustained period of low commodity prices and weak farm incomes will likely have a significant impact on the financial condition and, ultimately, the loan performance of many FCS borrowers. Actions taken by borrowers in response to this adversity and their financial strength will ultimately impact the level of risk borne by their lenders. Similarly, the lender’s response to this adversity and their financial capacity to work with borrowers will also significantly impact the ultimate amount of portfolio risk.

With borrower stress likely to increase, prudent risk management dictates that lenders take advantage of opportunities to prevent distressed loan situations. Examiners will ensure institutions have taken reasonable measures to maintain manageable risk exposures and sound portfolio management processes. An Informational Memorandum issued by the Chief Examiner on September 14, 1998, stressed the need for FCS institutions to accelerate contact with borrowers who they believe may become distressed, and initiate timely resolution of problems. Examiners will evaluate both strategic and operational plans and processes for fair, equitable, and effective treatment of borrowers experiencing financial problems. Timely identification of problems; early, frequent and meaningful communications with the borrower or community experiencing the problems; and effective resolution (formal or informal forbearance, work out plans, collection plans, etc.) will be a central focus of examination activities, especially where loan volume is concentrated in an industry experiencing stress. It is incumbent upon the institution’s board to analyze and understand the risk composition of distressed loan volume within a portfolio and the impact on the institution’s risk-bearing capacity.

While being empathetic to the stress faced by FCS borrowers in dealing with adversity, examiners must also be mindful that Congress enacted as law the rights of System borrowers. It is FCA’s duty to ensure that borrowers are provided their rights granted by law and make certain that the institutions’ borrower rights programs comply with the law and regulations. In those cases where borrowers were not provided their rights, the Report of Examination or other correspondence shall require prompt corrective action.

Young, Beginning, and Small Farmers and Ranchers, and Lending to Minority Farmers
The availability of sound and constructive credit and financially related services to borrowers identified as young, beginning, and small farmers and ranchers continues to be a high priority of FCS institutions and FCA. Loans to borrowers meeting these characteristics are a good business practice that help ensure the institutions’ continued business and the smooth transition of agribusiness to the next generation. Over the past several years, significant efforts have been made to improve the identification and reporting of borrowers meeting these characteristics, as well as the credit and financial service needs of these borrowers. In this regard, FCA Bookletter BL-040 (Attachment 2) provided guidance to FCS institutions about new definitions and reporting procedures for young, beginning, and small farmers and ranchers, to be phased in by January 1, 2001. The bookletter also reiterated the need for each direct lender to establish policy direction for young, beginning, and small farmers and ranchers programs, including measurable goals, commensurate with the institution’s risk-bearing capacity.

The adequacy and effectiveness of System lending programs to serve the needs of minority farmers are also a high priority. Many System institutions have made significant progress in identifying how well minority farmers are being served in their territory. Over the past year, FCA has discussed this issue with institution boards of directors. Examiners have stressed the need for institutions to understand all the demographics of their chartered territories and heightened the awareness for board leadership to address any shortfall in service that may exist.

Examinations will focus on board policies and other actions reflecting the commitment of institutions to carry out these programs and report the efforts and results achieved. Examiners will focus on demographic and marketing studies to ascertain the level of service provided to lending territories and, where there are material differences, institution plans that rectify shortfalls in meeting the needs of minority, young, beginning, and small borrowers. Emphasis will be placed on reviewing the adequacy of FCS efforts and coordination with other governmental and private sources of credit to obtain alternative credit enhancements to serve their lending territory. In addition, FCS marketing efforts should be reviewed to determine if outreach and underwriting practices and credit delivery methods do not inherently discriminate against any credit applicants on the basis of age, race, color, religion, national origin, sex, marital status, or receipt of income from public assistance programs.

Scorecard Lending
Some FCS institutions continue to report significant increases in scorecard volume both in relation to risk funds and total loan volume. This trend is a concern given the existing and projected stress in agriculture and that scorecard loan performance has not been fully tested under a sustained downturn in the business cycle. Furthermore, FY 1999 examinations reported increasing volume of unsecured loans as a percentage of total loans originated through scorecard programs. This risk composition factor is often not identified or reported to institution boards. Also, some portfolio management systems do not delineate acceptable risk exposure limits (to capital or risk funds) for scorecard loans or contain tolerances limiting unsecured loan volume originating through scorecard programs.

Growth in the use of scorecard lending programs is likely to continue as institutions attempt to increase efficiencies and enhance customer service in an increasingly competitive environment. Examiners will therefore continue to focus on the soundness of portfolio management practices over scorecard lending programs when those programs are material to institution capital. Examiners will assess lending policies and practices to ensure those scorecard programs:

Ø Do not present an undue exposure to capital either via increased risk exposures or inadequate pricing of scorecard loans,
Ø Are monitored through loan portfolio management systems that include reasonable underwriting criteria and appropriate risk parameters that limit concentrations,
Ø Provide for reporting to the board on the volume of scorecard loans originated with “exceptions” and “scorecard overrides” as guided by board policy, and
Ø Are statistically valid, based on sound and reliable information, are nondiscriminatory, and do not artificially preclude credit availability to any class of borrower.

Year 2000 Readiness
The preparedness of System personnel and information systems to deal with the date change will remain a focus of OE oversight and examination work during the ensuing 12 months. The FCS made satisfactory progress through June 30, 1999. All FCS institutions’ information processes have been renovated and tested and contingency plans developed. As such, risk for individual institutions exists primarily with the potential impact of disruptions from third-party business partners and infrastructure providers. To mitigate the operational risk of core business functions failing, business resumption contingency planning has become even more important. OE will emphasize the need for ongoing and continuous remediation and contingency planning as new issues emerge through the remainder of 1999 to ensure resumption of core business functions regardless of whether mission-critical systems operate as planned.

OE will take action, as necessary, to ensure risk(s) associated with Year 2000 problems do not threaten the safety and soundness of the System or individual institutions. It is possible that systems will not operate as expected or institutions may experience isolated disruptions in financial and lending operations. Therefore, OE developed a “Contingency Plan for Business Continuity – Year 2000” (Contingency Plan) that provides examination guidance covering the period shortly before and after January 1, 2000. OE will continue to coordinate examination efforts through its Year 2000 Task Force to survey, examine, and report System readiness and exposures to institution boards, the FCA Board, and Congress. The Contingency Plan provides both external and internal strategies for mitigating and reporting risks associated with the century date change. Actions to follow up with institutions that experience mission-critical system and core business function failures are described in the Contingency Plan.