On August 16, 2011, the U.S. House of Representatives Financial Institution Subcommittee on Financial Institutions and Consumer Credit conducted a hearing into supervision of community banks. Gilbert Barker, the Office of the Comptroller of the Currency’s (“OCC”) Deputy Comptroller for the Southern District, testified about OCC examination policies and procedures. Deputy Comptroller Barker’s prepared testimony addressed seven concerns that have been expressed about actions of bank examiners.
- Criticizing Loans to Borrowers in States with High Foreclosure Rates or in Industries Experiencing Problems
Mr. Barker asserted that examiners should not criticize loans simply because a borrower is located in a certain geographic region or operates in a certain industry.
However, he also noted that market conditions can influence repayment prospects by influencing the cash flow potential of a business’ operations or of underlying collateral, which management is expected to consider in evaluating a loan.
Thus, while not expressly stating so, OCC examiner criticism may be expected if the borrower is in a geographic region or industry in which the OCC considers market conditions are sufficiently adverse as to affect repayment prospects.
- Working with Borrowers Whose Loans Have Been Classified
Some bankers believe that they are no longer allowed to extend credit to borrowers whose loans have been classified.
However, Mr. Barker insisted “this is simply not the OCC’s position.” He said that the OCC encourages bankers to continue to work with “classified” borrowers who are “viable.”
- “Performing Non-performing Loans”
Community banks have expressed concerns where examiners are classifying loans even when the loan payments are current and borrowers can meet their debt obligations.
Mr. Barker acknowledged that a loan will not necessarily be considered good quality just because it is current as the OCC also needs to evaluate the borrower’s ability to make future payments required by the terms of the loan. He cited examples of bank-funded interest reserves on commercial real estate projects where interest reserves are being used to keep the loan current, but where expected leases or sales have not occurred as projected and property values have declined. Other examples he cited were terms that require interest-only payments for extended periods and the use of proceeds from other credit facilities to keep otherwise troubled loans current.
- Criticizing Loans Simply Because the Value of Collateral Has Declined
Mr. Barker testified that examiners will not classify or write down loans solely because the value of underlying collateral has declined to an amount less than the loan balance.
However, he cautioned that, in the cases of many loans, both the value of collateral and repayment of the loan are dependent on cash flows that the underlying project is expected to generate. Thus, if cash flows drop, collateral value and repayment prospects may both decline, and the decline in repayment prospects may be the basis for criticism. He suggested that examiners will first focus on adequacy of cash flow to service the debt, whether it is from collateral, financially responsible guarantors, or other bona fide repayment sources. However, if those do not exist, Mr. Barker testified that examiners will direct the bank to write down the loan balances to the value of the collateral less estimated costs to sell.
- Second-Guessing of Appraisers
Mr. Barker insisted that the OCC has taken steps, including, in 2008, conducting a nationwide teleconference and issuing a supervisory memo, to minimize the need for examiners to adjust real estate appraisals.
However, he cited the October 2009 Interagency Commercial Real Estate Policy Statement to the effect that “appropriately supported assumptions” are to be given a “reasonable degree of deference” by examiners. That implicitly suggests that examiners may second-guess professional independent appraisers in some circumstances. He assured the Subcommittee that “[p]rovided that the appraisal is reasonable, our examiners will not make adjustments or apply an additional haircut to the collateral.” An appropriate interpretation from Mr. Barker’s testimony may be that if an examiner finds an appraisal “unreasonable,” the examiner may make adjustments.
- Penalizing Loan Modifications
Community bankers have expressed concerns that examiners are penalizing loan modifications by placing loans on nonaccrual status following a modification even though the borrower has demonstrated a pattern of making contractual principal and interest payments under the modified terms.
Mr. Barker essentially acknowledged this practice and insisted that it is required by General Accepted Accounting Principles (“GAAP”). He suggested that GAAP, in order to avoid non-accrual status, not only requires capacity to continue to perform under restructured terms, but also requires demonstrated performance under previous terms. In the absence of the latter, the loan must remain on nonaccrual status until the borrower has demonstrated a reasonable period of performance.
- Arbitrarily Applying De Facto Higher Capital Requirements
Community banks have complained that examiners impose higher than minimum capital requirements on them, in many cases much higher than the capital ratios money center banks are expected to have.
Mr. Barker essentially acknowledged this, explaining that the recent crisis has underscored the need for strong capital and that most banks are expected to maintain capital levels above regulatory minimums, especially if a bank has significant risk concentrations. However, such decisions are not made unilaterally by the examiner, but must be reviewed and approved by the District supervision management team.
Mr. Barker was very candid in acknowledging four of the seven criticisms that have been leveled at bank examiners, essentially admitting that:
- loans to certain geographic areas or industries may be discouraged because market conditions may adversely affect repayment prospects;
- appraisers may be second-guessed;
- loan modifications may be penalized because of GAAP; and
- higher capital requirements are applied as needed.
However, he disagreed with community bank complaints about prohibitions against lending to classified borrowers; ”performing non-performing loans”; and criticism of loans simply because collateral values decline, suggesting, at least in the latter two cases, that matters may be a bit more complicated than criticisms suggest.