Expert Model for Assessing Asset Quality - DOC

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					                                                              Expert Model for Assessing Capital
Capital serves four primary purposes. It:

    Acts as a buffer in times of poor performance.
    Supports the reasonable growth of financial organizations. Minimum regulatory capital requirements impose restraints on
     excessive or unjustified expansion.
    Maintains public confidence.
    Provides protection to depositors and the FDIC deposit insurance fund.

This expert model provides guidance for completing two analyses for capital:

    An off-site analysis of UBPR data, which involves two steps:

     1. Review the balance sheet structure
     2. Analyze the levels and trends of key ratios

    An on-site analysis, in conjunction with the examination team, to follow up on off-site concerns and review the bank’s capital
     adequacy.


Off-Site Analysis ................................................................................................................................................................................ 2
Step 1. Review Balance Sheet Structure.............................................................................................................................................. 2
Step 2. Analyze levels and trends of key ratios .................................................................................................................................... 2
     Tier 1 Leverage Capital ............................................................................................................................................................ 3
     Cash dividends to net income ................................................................................................................................................... 3
     Assets and Tier 1 Capital growth rates ..................................................................................................................................... 4
     Net Income to average total equity ........................................................................................................................................... 4
     Tier 1 risk-based capital to risk-weighted assets and Total risk-based capital to risk-weighted assets ...................................... 5
On-Site Analysis ................................................................................................................................................................................ 5
Capital Evaluation Factors and Rating Definitions .......................................................................................................................... 6




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Expert Model for Assessing Capital

                                                        OFF-SITE ANALYSIS

Step 1. Review the balance sheet structure

Review balance sheet items to assess if the capital level is reasonable based on the asset mix.

Review this UBPR page:               To determine:
Page 4, Balance Sheet - Assets,         The percentage of all common and preferred capital to total assets to make a preliminary
Liabilities and Capital                  determination if capital is high (e.g., 10 percent or more).
                                        If the assets are composed of a higher percentage of loans or investments. If loans represent
                                         a higher proportion of assets, you would expect the bank to have higher capital levels.

Step 2. Analyze the levels and trends of key ratios

Reviewing key off-site capital ratios helps you prepare for your on-site analysis and gives you an indication if regulatory actions may
be required. Because the performance of the capital component is closely related to the performance of the other components, you
will need on-site information to complete your final assessment of capital. The key capital ratios are found on UBPR pages 1, 11,
and 11A.




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Expert Model for Assessing Capital

Summary Ratios: UBPR Page 1

Ratio and Calculation                Analysis
Tier 1 Leverage Capital              This ratio indicates the level of protection through tangible and allowable owners' equity. The
                                     regulatory minimum for Tier 1 Leverage Capital is 3 percent for 1-rated banks and 4 percent for
          Tier 1 Capital
                                     other banks. Consider the:
     Adjusted Average Assets            Level. A higher level is desirable from a regulatory perspective. However, acceptable capital
                                         levels depend on the bank's overall risk profile identified during the on-site analysis.
                                        Trend. An increasing trend is preferable.
                                     Answer the following questions to more thoroughly assess an increase or decrease in capital.
                                        If the trend is decreasing, is it caused by an increase in assets or capital erosion?
                                            If assets increased, determine if asset growth is excessive. Generally, excessive asset
                                             growth and/or a substantial increase in riskier assets is a red flag that should be closely
                                             investigated. If asset growth is excessive, capital ratios may decline to unacceptable
                                             levels.
                                            If capital eroded, determine the circumstances that caused the capital erosion (e.g.,
                                             extraordinary items, poor asset quality, insufficient earnings).
                                        If the trend is increasing, is it caused by a decrease in assets or increased capital?
                                            If assets decreased, identify the reasons for the decline in assets.
                                            If capital increased, determine if there has been any external support to capital (e.g.,
                                             capital injections). If so, determine the effect and if the support can continue if needed.
Cash dividends to net income         This ratio indicates how much current income the bank has allocated for dividends. Consider the:
                                      Level. A lower ratio is better and indicates strong earnings or that a greater level of earnings
  Dividends declared year-to-date       is retained to augment capital because the bank is now paying fewer dividends. A high ratio
      Net income year-to-date           indicates low earnings or low earnings retention to augment capital (i.e., a high level of
                                        dividends).
                                        Trend. A stable or decreasing trend may be more favorable depending on the institution's risk
                                         profile. Plan on expanding your on-site analysis when there is an increasing trend.
                                     When assessing the level and trend for this ratio, consider if the bank is a Subchapter S
                                     corporation. Banks having a Subchapter S structure usually pay higher dividends and have higher
                                     earnings and return on assets (ROA).


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Expert Model for Assessing Capital

Summary Ratios: UBPR Page 1 (continued)

Ratio and Calculation                   Analysis
Assets and Tier 1 Capital growth        Compare the Tier 1 Capital growth rate with the assets growth rate. Capital growth should
rates                                   generally be commensurate with asset growth.
Assets:                                    If capital growth has outpaced asset growth, then the trend is of less concern.

    Current period total assets –          If asset growth has outpaced capital growth, study the level to determine if the Tier 1
          total assets for the              Leverage Capital ratio is high enough to support the current level and expected asset growth.
     corresponding prior period
   Total assets for the prior period

Tier 1 Capital:

   Current period Tier 1 Capital –
         Tier 1 Capital for the
     corresponding prior period
  Tier 1 Capital for the prior period



UBPR Page 11: Capital Analysis Ratios

Ratio and Calculation                   Analysis
Net Income to Average Total             This ratio indicates the rate of return for shareholders.
Equity
                                           Lower capital levels will create a higher ratio of return on investment, which is more desirable
                                            for management and shareholders.
              Net income
          Average total equity             In most cases, regulators prefer higher capital equity ratios, which may result in a lower return
                                            on equity. However, a higher return on equity in a large publicly traded institution indicates it
                                            may have access to the capital markets. Higher ratios are better for obtaining external capital
                                            because investors generally look at income potential versus market equity.
                                        Determine if management has applied inappropriate strategies that reduce capital and take on
                                        increased risk to obtain a higher return on equity (e.g., increasing leverage, operating at lower
                                        capital levels, attempting to generate greater earnings by taking more risks).




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Expert Model for Assessing Capital

UBPR Page 11A: Capital Analysis Ratios

Ratio and Calculation                Analysis
Tier 1 risk-based capital to risk-   These ratios indicate the equity cushion based on different risk levels created by varying on-
weighted assets                      balance sheet assets and off-balance sheet items. Focus on the difference between the Tier 1
                                     Leverage Capital ratio and the Tier 1 risk-based capital and total-risk based capital ratios.
Total risk-based capital to risk-       The Tier 1 Leverage Capital ratio (UBPR page 1) does not risk-weight assets nor account for
weighted assets                          off-balance sheet items.
                                        The Tier 1 risk-based capital and total risk-based capital ratios do risk-weight assets and
        Tier 1 risk-based capital
         Risk-weighted assets            account for off-balance sheet items.
                                     The Tier 1 risk-based capital regulatory minimum is 4 percent for the Adequately PCA capitalized
        Total risk-based capital     category. The total risk-based capital regulatory minimum is 8 percent. A higher risk profile will
         Risk-weighted assets
                                     necessitate the bank having a higher level of capital for each ratio.



                                                         ON-SITE ANALYSIS

The capital rating is highly dependent upon the institution's performance in the other components. Specifically, asset quality and
earnings performance can have the greatest impact on capital. Problems with liquidity and sensitivity to market risk may also
manifest into capital problems or have impacts on capital through asset quality and earnings.

        A high level of adversely classified assets and/or a high level of nonperforming loans will place capital at risk. When adverse
         classifications are significant, a bank has increased risk of loss. Since capital protects against loss, a bank that has more
         adverse classifications will need to maintain a higher level of capital to offset risk. The single most telling sign of capital
         adequacy is the adversely classified items coverage in the Report of Examination. Asset quality problems will flow through
         earnings to impact capital. This occurs through high ALLL provisions, other asset and ORE losses, and the general costs
         associated with holding and collecting problem assets.

        Earnings that are less than satisfactory can negatively affect a capital rating because retained earnings serve as a primary
         source for capital augmentation.




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Expert Model for Assessing Capital

                                       Capital Evaluation Factors and Rating Definitions

Evaluation      The UFIRS evaluation factors for capital include the:
Factors
                   The level and quality of capital and the overall financial condition of the institution
                   The ability of management to address emerging needs for additional capital
                   The nature, trend, and volume of problem assets and the adequacy of allowances for loan and lease losses and
                    other valuation reserves
                   The balance sheet composition, including the nature and amount of intangible assets, market risk, concentration
                    risk, and risks associated with nontraditional activities
                   The risk exposure represented by off-balance sheet activities
                   The quality and strength of earnings and the reasonableness of dividends
                   Prospects and plans for growth as well as past experience in managing growth
                   Access to capital markets and other sources of capital, including support provided by a parent holding company.
Rating             A rating of 1 means a strong capital level relative to the financial institution’s risk profile.
Definitions
                   A rating of 2 indicates a satisfactory capital level relative to the financial institution’s risk profile.
                   A rating of 3 indicates a less than satisfactory level of capital that does not fully support the institution’s risk
                    profile. The rating indicates a need for improvement, even if the institution’s capital level exceeds minimum
                    regulatory and statutory requirements.
                   A rating of 4 indicates a deficient level of capital. In light of the institution’s risk profile, viability of the institution
                    may be threatened. Assistance from shareholders or other external sources of financial support may be
                    required.
                   A rating of 5 indicates a critically deficient level of capital such that the institution’s viability is threatened.
                    Immediate assistance from shareholders or other external sources of financial support is required.




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