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FCA Examination Manual
ModuleGeneral
SectionFinancial Institution Rating System
NumberEM-135
Date Published02/2009

Introduction

Most financial institutions are categorized and rated by their respective regulators through the Uniform Financial Institutions Rating System. This system has been modified to reflect the non-depository nature of Farm Credit System (System) institutions and adopted by FCA FCA Handbook to evaluate and categorize the safety and soundness of System institutions on an ongoing, uniform, and comprehensive basis. FCA’s Financial Institution Rating System (FIRS) provides valuable information to the Agency for assessing risk and allocating resources based on the safety and soundness of regulated institutions. As such, it is a key component of the Agency’s risk assessment process. The FIRS also provides an effective mechanism for identifying problem or deteriorating institutions, categorizing institutions with deficiencies in particular component areas, and communicating the overall condition of the System to internal and external stakeholders.

This section of the Examination Manual provides an overview of the FIRS process and describes the general factors considered in assigning institution ratings. A more detailed description of the factors and criteria used in assigning ratings is provided in Supplement 4, FIRS Guide.

Overview
Although each institution has its own examination and supervisory issues and concerns, the FIRS is structured to provide a consistent rating system for all significant financial, asset quality, and management factors. Under the FIRS, each institution is assigned composite and component ratings based on an evaluation and rating of six essential components of an institution’s financial condition and operations. These component factors address the adequacy of Capital, Assets, Management, Earnings, Liquidity, and Sensitivity to market risk, and are commonly referred to as “CAMELS.” Evaluations of the components take into consideration many factors, including the institution’s size and sophistication, the nature and complexity of its activities, and its risk profile.

Composite and component ratings are assigned based on a 1 to 5 numerical scale. A 1 is the highest rating, and indicates the strongest level of performance and risk management practices, and the least degree of supervisory concern, while a 5 is the lowest rating, and indicates the weakest performance, inadequate risk management practices and, therefore, the highest degree of supervisory concern. Assigned composite and component ratings are disclosed to the institution’s board of directors and chief executive officer (CEO).

The composite rating generally bears a close relationship to the component ratings assigned. Each component rating is based on an analysis of the factors comprising that component and its interrelationship with the other components. When assigning a composite rating, some components may be given more weight than others depending on the risk exposure at the institution. In general, assignment of a composite rating may incorporate any factors that bear significantly on the overall condition and soundness of the institution.

The ability of management to respond to changing circumstances and to address the risks that may arise from changing business conditions is an important factor in evaluating an institution’s overall risk profile and the level of supervisory attention warranted. For this reason, the management component is given special consideration when assigning a composite rating. While the evaluation of management requires examiner judgment, FCA has developed a FIRS Guide (Supplement 4) FCA Examination Manual to provide a list of key factors for examiners to consider in evaluating management and related guidance in assessing each of these factors.

The level and management of risk is also taken into account when assigning the composite and component ratings. These risks include credit, interest rate, liquidity, operations, compliance, strategic, and reputation risk. Management’s ability to identify, measure, monitor, and control these risks is a key factor in the rating process. While all institutions are expected to properly manage their risks, it is recognized that appropriate management practices vary considerably among financial institutions, depending on their size, complexity, and risk profile.
For small or less complex institutions engaged solely in traditional lending activities and whose directors and senior managers, in their respective roles, are actively involved in the oversight and management of day-to-day operations, relatively basic management systems and controls may be adequate. At more complex institutions, on the other hand, detailed and formal management systems and controls are needed to address their broader range of financial activities and to provide senior managers and directors, in their respective roles, with the information they need to monitor and direct day-to-day activities.

FCA Ratings

As detailed in the FIRS Guide, FCA utilizes a 1 through 5 scale to assess a composite rating and the six key performance components upon which the composite rating is principally based (i.e., Capital, Assets, Management, Earnings, Liquidity, and Sensitivity). These components are assessed by considering a wide range of factors and applying examiner judgment. While examiner judgment is of paramount importance in the rating process, the Office of Examination maintains quantitative and qualitative factors to assist examiners in their evaluations and promote a consistent application of rating criteria. These factors include benchmarks for evaluating the capital, assets, earnings, and liquidity of direct lender associations, other criterion applicable to all System institutions, and the rating definitions for each component. This section summarizes the key factors outlined in the FIRS Guide.

Capital

A financial institution is expected to maintain capital commensurate with the nature and extent of risks to the institution and the ability of management to identify, measure, monitor, and control these risks. The effect of credit, interest rate, and other risks on the institution’s financial condition should be considered when evaluating the adequacy of capital. The types and quantity of risk inherent in an institution’s activities will determine the extent to which it may be necessary to maintain capital at levels above required regulatory minimums to properly reflect the potentially adverse consequences that these risks may have on the institution’s capital.

The evaluation of an institution's capital adequacy focuses on its capacity to absorb losses and provide for future growth. Capital is rated based on such factors as:

The quantity of capital, e.g., permanent capital, total surplus, and core surplus positions in relation to the minimum regulatory requirements, the board’s capital goals and objectives, and peer levels;
The quality of capital, composition of the capital structure, and the stability of the capital position, e.g., trends, potential permanent capital reallocations, asset growth, earnings, dividends, and stock retirement; the risk exposure to capital, e.g., the overall level of credit, interest rate, liquidity, operations, strategic, reputation, compliance and counterparty risk relative to the institution’s capital position; and the overall quality and strength of capital management and compliance with capital-related regulations; and
The management of capital, including actions to plan for the institution’s capital needs, build capital sufficient to meet growth and risk expectations, and protect and add value to shareholder investments.

Assets

The assets rating reflects the quantity of existing and potential credit risk associated with the loan and investment portfolios, other real estate owned, and other assets. Management’s ability to identify, measure, monitor, and control credit risk is also reflected here. The evaluation of asset quality should consider the adequacy of the allowance for loan and lease losses and weigh the exposure to counterparty, issuer, or borrower default under actual or implied contractual agreements. All other risks that may affect the value or marketability of an institution’s assets, including, but not limited to, operating, market, reputation, strategic, or compliance risks, should be considered. Assets are rated based on, but not limited to an assessment of such factors as:

The level, composition, severity, and trends of criticized, adverse, delinquent, restructured, and nonaccrual assets for both on and off balance sheet transactions;
The existence of commodity, large loan, investment or other concentrations;
The quality, composition, and rate of asset growth;
Credit risk arising from or reduced by off-balance sheet transactions, such as unfunded commitments, credit derivatives, standby letters of credit, and lines of credit;
The adequacy of loan portfolio management, including portfolio planning, credit policies and procedures, adequacy of loan underwriting standards, management information systems, and other credit internal controls;
The internal credit review process and appropriateness of risk identification and reporting practices;
Credit administration standards and practices;
The adequacy of the allowance for loan losses process; and
Adequacy of investment portfolio management, including investment portfolio planning, policies and procedures regarding credit and market value risks to the investment portfolio, and compliance with FCA regulations and guidelines.

Management

The management rating reflects the capability of the board of directors and management, in their respective roles, to identify, measure, monitor, and control the risks of an institution’s activities and to ensure that the institution operates in a safe, sound, and efficient manner and complies with applicable laws and regulations. Sound management practices are demonstrated by: active oversight by the board of directors and management; competent personnel; adequate policies, processes, and controls (taking into consideration the size and sophistication of the institution); maintenance of an appropriate audit program and internal control environment; and effective risk monitoring and management information systems. The capability and performance of the board of directors and management is rated based upon, but not limited to, an assessment of the following evaluation factors:

The level and quality of corporate governance provided by the board of directors;
Responsiveness to recommendations from auditors and supervisory authorities;
Reasonableness of compensation policies and avoidance of self-dealing;
The adequacy of, and conformance with, appropriate internal policies and controls addressing the operations and risks of significant activities;
The adequacy of audits and internal controls to: promote effective operations and reliable financial and regulatory reporting; safeguard assets; and ensure compliance with laws, regulations, and internal policies;
The extent that the board of directors and management is affected by, or susceptible to, dominant influence or concentration of authority;
The capability, depth, succession, and performance of executive management;
The institution’s business strategy, planning process, and strategic, operational, capital, and business continuity plans;
Risk management and the ability of the board of directors and management, in their respective roles, to plan for, and respond to, risks that may arise from changing business conditions or the initiation of new activities or products;
Demonstrated willingness and ability to meet the institutions public mission; and
Compliance with laws and regulations.

Earnings

The evaluation of earnings focuses on the quantity, quality, and sustainability of the institution's earning performance. The quantity as well as the quality of earnings can be affected by excessive or inadequately managed credit risk that may result in loan losses and require additions to the allowance for loan and lease losses, or other risks that may unduly expose an institution’s earnings to volatility. Future earnings may be adversely affected by an inability to forecast or control funding and operating expenses, improperly executed or ill-advised business strategies, or poorly managed or uncontrolled exposure to other risks. Earnings are rated based on such factors as:

The quantity of earnings compared to applicable standards, financial goals, and peer group performance;
The quality, composition, and stability of net income;
The risk exposure to earnings, e.g., the overall level of credit, interest rate, liquidity, operations, strategic, reputation, compliance and counterparty risk relative to the institution’s earnings capacity; and
The quality of earnings management, e.g., philosophy, goals, planning, loan pricing, operating efficiency, dividend declaration, etc.

Liquidity

An institution's liquidity is evaluated according to its capacity to promptly meet the demand for payment of its obligations and to readily meet the reasonable credit needs of the territory it serves. In evaluating the adequacy of an institution’s liquidity position, consideration should be given to the current level and prospective sources of liquidity compared to funding needs, as well as to the adequacy of funds management practices relative to the institution’s size, complexity, and risk profile. Practices should reflect the ability of the institution to manage unplanned changes in funding sources, as well as react to changes in market conditions that affect the ability to quickly liquidate assets with minimal loss. In addition, funds management practices should ensure that liquidity is not maintained at a high cost, or through undue reliance on funding sources that may not be available in times of financial stress or adverse changes in market conditions. Liquidity is rated based upon, but not limited to, an assessment of the following evaluation factors:

The adequacy and stability of liquidity sources to meet present and future needs and the ability of the institution, including the financial strength of the funding bank;
Existence of secondary sources of liquidity, e.g., marketable investments, marketable loans, and supplemental lines of credit;
Nature and magnitude of liquidity demands, e.g., debt payments, loan demand, litigation, near-term capital expenditures, operating expenses, and any dividends and/or stock retirements to be paid in cash;
The quantity, quality, and trends in collateral;
Strength of other CAMELS factors, cost of available funding, and loanable funds position;
For associations, General Financing Agreement (GFA) compliance and borrowing margin on direct loan;
For banks, performance under any operative System self-discipline mechanisms, e.g., the Contractual Interbank Performance Agreement (CIPA); and
Liquidity management, e.g., the capability of management to properly identify, measure, monitor, and control the institution’s liquidity position, including the effectiveness of funds management strategies, liquidity policies, management information systems, and contingency funding plans.

Sensitivity

This component reflects the degree to which changes in interest rates can adversely affect an institution's earnings or the market value of equity (MVE). When evaluating this component, consideration should be given to: 1) management's ability to measure, manage, and control interest rate risk; the institution's size; the nature and complexity of asset/liability management activities; and 2) the level of interest rate risk exposure relative to the adequacy of capital and earnings. One of the primary sources of interest rate risk arises from on- and off-balance sheet positions and their sensitivity to changes in interest rates. For associations, the level of interest rate risk depends on the funding bank's practices for managing interest rate risk and the manner in which the association relies upon the funding bank for interest rate risk management responsibilities. Associations may also be exposed to interest rate risk in loan pricing practices. Even though an association may contract with a bank to manage its interest rate risk, the association board remains ultimately accountable for the exposure that occurs in the association.

An evaluation of interest rate risk is rated based upon, but not limited to, an assessment of the following factors:

The sensitivity of the institution's earnings and/or the market value of its equity to adverse changes in interest rates;
The nature and complexity of interest rate risk exposure arising from on- and off-balance sheet positions;
The ability of management to identify, measure, monitor, and control exposure to interest rate risk given the institution's size, complexity, and risk profile; and
Where appropriate, the management of interest rate risk by the funding bank.

Assignment of Ratings

Ratings assigned to System institutions under the FIRS will be reviewed on an ongoing basis and adjusted as needed to accurately reflect the current conditions of institutions and FCA’s level of supervisory concern. Ratings are reviewed anytime there is a material change in the institution’s risk profile, financial condition, performance, and management, and upon the receipt of quarterly Call Report information.

The Examiner-in-Charge (EIC) is responsible for reviewing and updating ratings as needed. The EIC, or designee, documents this review by completing an internal FIRS Report any time a rating is changed and upon the receipt and review of quarterly Call Report information. The FIRS Report includes the basis for any rating changes, or in the case of a quarterly review of Call Report information, updated financial information, statistics, and qualitative ratings supporting the existing ratings. FIRS Reports completed in conjunction with the review of December 31 Call Report information, FIRS Reports completed on institutions with composite or component ratings of 3, 4, or 5, and any FIRS Reports indicating a change in ratings include additional documentation to reflect the increased level of analysis completed in these instances.

Completed FIRS Reports are subject to supervisory review and do not establish or change the Agency’s official FIRS ratings of record until approved by the reviewing official. For institutions under special supervision or enforcement actions, recommended rating changes are discussed with the Risk Supervision Division.

Disclosure of Ratings

While the FIRS is the Agency’s rating system, which is maintained to meet the specific needs of its oversight and examination program, FIRS ratings are disclosed to System institutions to enhance communications and the System’s understanding of the Agency’s regulatory approach. In that regard, FIRS ratings are reported to each System institution’s board of directors and Chief Executive Officer annually as of December 31, and whenever a composite or component rating is changed, with a copy to the funding bank. FCA will also provide a quarterly summary of association FIRS ratings in each respective district to the affiliated funding bank for its confidential use in oversight and servicing of the direct loans.

FIRS ratings are formally reported to the board chairman and Chief Executive Officer of each System institution in a letter, which is subject to the same confidentiality requirements as those established for Reports of Examination. Whenever a FIRS rating is changed, the letter will communicate the basis for that change and offer to discuss the change with the board of directors and management. Any conditions leading to a potential rating downgrade will first be discussed with institution management, and where needed, accompanied by additional examination activities or a meeting with the board of directors to confirm the conditions and obtain management’s response. In those instances where the composite rating is lowered to a 3 or worse, the FIRS letter will be hand delivered to the board of directors as part of a meeting to discuss the FIRS ratings and the Agency’s supervisory concerns.

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