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Informational Memorandum
Subject:OE Focus Areas for Fiscal Year 2003
Date of Memorandum:03/20/2003
Expiration Date:
Office:OE
Signed By:Smith, Roland
FCA Contact Person:Smith, Roland
Contact Phone:703-883-4121
List of Attachments:Examination Focus Areas


INFORMATIONAL MEMORANDUM



March 20, 2003


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

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

Subject: Office of Examination (OE) Focus Areas for Fiscal Year 2003

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 or agency) examination of your institution.

The primary 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 areas for Fiscal Year 2003 examinations:

Young, Beginning and Small (YBS) Farmers and Ranchers
Internal Controls

The attachment to this memorandum describes in detail what we will evaluate in examining these two areas. The overall examination scope for each institution, however, will continue to be risk based, as developed by the Examiner-in-Charge during the survey/planning stage of the examination.

The objective of the YBS Farmers and Ranchers focus area is to provide emphasis and resources to the evaluation of the System’s fulfillment of its public mission. We now have a mission-related FCA performance measure that is based on an evaluation of the effectiveness of every direct lender’s YBS program. The goal is for all direct lenders to have programs that meet the guidelines of FCA’s Bookletter BL-040 and Board Policy Statement PS-75 that address YBS farmers and ranchers. Corrective actions will be recommended and in some cases required in Reports of Examination for those YBS programs needing improvement.

Internal controls have been a focus area in prior years, as well as a standard examination manual approach to risk-based examinations. The emphasis this year is controls and reporting from a corporate governance level, as well as whether controls in general are keeping pace with growth and organizational/product changes. Within the broad area of internal controls, we will specifically examine for key considerations relating to board governance, lending, capital markets, and information technology. For example, our examinations will 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.

As mentioned, our examinations will continue to focus on safety and soundness, compliance with laws and regulations, as well as the progress FCS institutions are making in accomplishing public mission. The two focus areas selected for this examination cycle will be evaluated on a risk-based approach for each institution examined. For example, a large direct lender association will be expected to have a much more robust internal control system than a small institution.

If you have any questions, please call me at (703) 883-4160 or correspond on the Internet at
e-mail address smithr@fca.gov.

Attachment

Attachment
Examination Focus Areas
FCA examination and oversight efforts will continue to focus on safety and soundness and compliance with laws and regulations. In addition, in assessing risks to institutions, the appropriateness of the management of risks, and other areas to assign the Financial Institution Ratings System component and composite ratings, Reports of Examination will specifically conclude on the following two focus areas.

1. Young, Beginning and Small Farmers and Ranchers

The availability of sound and constructive credit and financially related services to borrowers identified as YBS farmers and ranchers will continue to be a high priority of the System and FCA. Loans to YBS borrowers 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 borrowers meeting these characteristics, as well as the credit and financial service needs of these borrowers. In this regard, FCA Bookletter BL-040 and Board Policy Statement PS-75 provided guidance to the System in December 1998, communicating new definitions and reporting procedures to be phased in by January 1, 2001. The Bookletter and Policy Statement also reiterated the need for each direct lender to establish policy direction for these lending programs, including measurable goals, commensurate with institution risk-bearing capacity.

Our examinations will continue to evaluate YBS programs evidencing the board’s commitment to these groups of potential borrowers. The agency goal is for each FCS direct lender to have a viable program to meet the needs of YBS farmers and ranchers in their territory. Core requirements for a satisfactory program include adequate policy direction, demographic studies of their territory, measurable goals, and accurate periodic reporting to the board of directors and FCA. The FCA has a performance measure and goal for 100 percent of FCS direct lender institutions to have programs established to furnish sound and constructive credit and related services to YBS borrowers. Therefore, for those institutions whose YBS programs need improvement, our objective will be to obtain the necessary corrective actions within 90 days of issuing the Report of Examination. Comprehensive YBS examinations for each institution, which began in January 2002, will continue in 2003. Once an institution has achieved an acceptable program either in the initial examination or through subsequent corrective actions, a comprehensive scope and special YBS report section may not be required in subsequent examinations. Recommendations to enhance programs will be evaluated in the follow-up examination, as well as progress in meeting goals.

2. Internal Controls

A strong internal control system provides the framework for the accomplishment of management objectives, safeguarding of assets, accurate financial reporting, and compliance with laws and regulations. Effective internal controls serve as checks and balances against undesired actions and provide reasonable assurance that institutions operate in a safe and sound manner. The lack of internal controls puts institutions at risk of mismanagement, waste, fraud, and abuse. A prerequisite for effective internal controls is a strong internal control environment. The internal control environment represents the collective effect of various factors that establish, enhance, or mitigate the effectiveness of specific management processes. The control environment reflects the overall attitude, awareness, and actions of management. The examiner’s assessment of an institution’s internal control environment will include consideration of the following factors: Management philosophy and operating style;
Organizational structure;
Methods of assigning authority and responsibility;
Personnel policies and practices;
Performance accountability;
External influences (FCA, external auditors, funding bank for associations); and
Audit and review program.

Internal controls are a risk-based focus area that should be expanded for institutions that are large, and fast growing, with increasing risk profiles. System institutions continue to look for new and different ways to serve their constituencies and in doing so are assuming new risks that their internal control systems must be equipped to identify and deal with. The FCS has expanded its lending through the use of participations among System institutions and commercial banks, involvement in the syndicated loan market, and financing more marketing and processing activities, and integrated poultry and livestock operations. This expansion has seen the System venture into types of lending that can only be labeled as non-traditional.

Beyond the lending arena, some institutions are expanding quite significantly their related services activity, including the formation of subsidiaries for related services in some cases. Accordingly, our examination efforts will focus on whether internal controls are keeping pace with growth and organizational/product changes. This evaluation for every institution will need to include not only controls over the lending environment, but also fiscal and operational controls, to ensure accurate and reliable financial reporting to the institution’s board, FCA, and institution stockholders. The educational and experience level of the board also needs to keep pace in such institutions, and an increased level of management reporting is normally required to keep the board adequately informed. Consequently, we will consider each board’s tenure, educational level, and business experience level, and whether it is receiving adequate information from management to remain well informed and capable of making prudent decisions. The success, or lack thereof, of an institution’s director nomination and election process to keep qualified members on the board will also be evaluated. Finally, in those environments where lucrative incentive/bonus compensation programs tied to operational performance exist, we will assess whether adequate controls are in place to prevent the misrepresentation of credit risk or the management of earnings through unwarranted allowance for loan losses adjustments.