1. A rating of 1 indicates strong asset quality and credit administration practices. Identified weaknesses are minor in nature and risk exposure is modest in relation to capital protection and management's abilities. Asset quality in such institutions is of minimal supervisory concern.
2. A rating of 2 indicates satisfactory asset quality and credit administration practices. The level and severity of classifications and other weaknesses warrant a limited level of supervisory attention. Risk exposure is commensurate with capital protection and management's abilities.
3. A rating of 3 is assigned when asset quality or credit administration practices are less than satisfactory. Trends may be stable or indicate deterioration in asset quality or an increase in risk exposure. The level and severity of classified assets, other weaknesses, and risks require an elevated level of supervisory concern. There is generally a need to improve credit administration and risk management practices.
4. A rating of 4 is assigned to financial institutions with deficient asset quality or credit administration practices. The levels of risk and problem assets are significant, inadequately controlled, and subject the financial institution to potential losses that, if left unchecked, may threaten its viability.
5. A rating of 5 represents critically deficient asset quality or credit administration practices that present an imminent threat to the institution's viability.

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 a financial institution's safe, sound, and efficient operation in compliance with applicable laws and regulations is reflected in this rating. Generally, directors need not be actively involved in day-to-day operations; however, they must provide clear guidance regarding acceptable risk exposure levels and ensure that appropriate policies, procedures, and practices have been established. Senior management is responsible for developing and implementing policies, procedures, and practices that translate the board's goals, objectives, and risk limits into prudent operating standards.

Depending on the nature and scope of an institution's activities, management practices may need to address some or all of the following risks: credit, market, operating or transaction, reputation, strategic, compliance, legal, liquidity, and other risks. 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. This rating should reflect the board's and management's ability as it applies to all aspects of banking operations as well as other financial service activities in which the institution is involved.

The capability and performance of management and the board of directors is rated based upon, but not limited to, an assessment of the following evaluation factors:

• The level and quality of oversight and support of all institution activities by the board of directors and management.
• 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.
• The adequacies of, and conformance with, appropriate internal policies and controls addressing the operations and risks of significant activities.
• The accuracy, timeliness, and effectiveness of management information and risk monitoring systems appropriate for the institution's size, complexity, and risk profile.
• 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.
• Compliance with laws and regulations.
• Responsiveness to recommendations from auditors and supervisory authorities.
• Management depth and succession.
• The extent that the board of directors and management is affected by, or susceptible to, dominant influence or concentration of authority.
• Reasonableness of compensation policies and avoidance of self-dealing.
• Demonstrated willingness to serve the legitimate banking needs of the community.
• The overall performance of the institution and its risk profile.

Ratings

1. A rating of 1 indicates strong performance by management and the board of directors and strong risk management practices relative to the institution's size, complexity, and risk profile. All significant risks are consistently and effectively identified, measured, monitored, and controlled. Management and the board have demonstrated the ability to promptly and successfully address existing and potential problems and risks.
2. A rating of 2 indicates satisfactory management and board performance and risk management practices relative to the institution's size, complexity, and risk profile. Minor weaknesses may exist, but are not material to the safety and soundness of the institution and are being addressed. In general, significant risks and problems are effectively identified, measured, monitored, and controlled.
3. A rating of 3 indicates management and board performance that need improvement or risk management practices that are less than satisfactory given the nature of the institution's activities. The capabilities of management or the board of directors may be insufficient for the type, size, or condition of the institution. Problems and significant risks may be inadequately identified, measured, monitored, or controlled.
4. A rating of 4 indicates deficient management and board performance or risk management practices that are inadequate considering the nature of an institution's activities. The level of problems and risk exposure is excessive. Problems and significant risks are inadequately identified, measured, monitored, or controlled and require immediate action by the board and management to preserve the soundness of the institution. Replacing or strengthening management or the board may be necessary.
5. A rating of 5 indicates critically deficient management and board performance or risk management practices. Management and the board of directors have not demonstrated the ability to correct problems and implement appropriate risk management practices. Problems and significant risks are inadequately identified, measured, monitored, or controlled and now threaten the continued viability of the institution. Replacing or strengthening management or the board of directors is necessary.

This rating reflects not only the quantity and trend of earnings, but also factors that may affect the sustainability or quality of earnings. 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 by high levels of market risk that may unduly expose an institution's earnings to volatility in interest rates. The quality of earnings may also be diminished by undue reliance on extraordinary gains, nonrecurring events, or favorable tax effects. 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.

The rating of an institution's earnings is based upon, but not limited to, an assessment of the following evaluation factors:

• The level of earnings, including trends and stability.
• The ability to provide for adequate capital through retained earnings.
• The quality and sources of earnings.
• The level of expenses in relation to operations.
• The adequacy of the budgeting systems, forecasting processes, and management information systems in general.
• The adequacy of provisions to maintain the allowance for loan and lease losses and other valuation allowance accounts.
• The earnings exposure to market risk such as interest rate, foreign exchange, and price risks.

1. A rating of 1 indicates earnings that are strong. Earnings are more than sufficient to support operations and maintain adequate capital and allowance levels after consideration is given to asset quality, growth, and other factors affecting the quality, quantity, and trend of earnings.
2. A rating of 2 indicates earnings that are satisfactory. Earnings are sufficient to support operations and maintain adequate capital and allowance levels after consideration is given to asset quality, growth, and other factors affecting the quality, quantity, and trend of earnings. Earnings that are relatively static, or even experiencing a slight decline, may receive a 2 rating provided the institution's level of earnings is adequate in view of the assessment factors listed above.
3. A rating of 3 indicates earnings that need to be improved. Earnings may not fully support operations and provide for the accretion of capital and allowance levels in relation to the institution's overall condition, growth, and other factors affecting the quality, quantity, and trend of earnings.
4. A rating of 4 indicates earnings that are deficient. Earnings are insufficient to support operations and maintain appropriate capital and allowance levels. Institutions so rated may be characterized by erratic fluctuations in net income or net interest margin, the development of significant negative trends, nominal or unsustainable earnings, intermittent losses, or a substantive drop in earnings from the previous years.
5. A rating of 5 indicates earnings that are critically deficient. A financial institution with earnings rated 5 is experiencing losses that represent a distinct threat to its viability through the erosion of capital.

In evaluating the adequacy of a financial 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. In general, funds management practices should ensure that an institution is able to maintain a level of liquidity sufficient to meet its financial obligations in a timely manner and to fulfill the legitimate banking needs of its community. 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 of liquidity sources compared to present and future needs and the ability of the institution to meet liquidity needs without adversely affecting its operations or condition.
• The availability of assets readily convertible to cash without undue loss.
• Access to money markets and other sources of funding.
• The level of diversification of funding sources, both on- and off-balance sheet.
• The degree of reliance on short-term, volatile sources of funds, including borrowings and brokered deposits, to fund longer term assets.
• The trend and stability of deposits.
• The ability to securitize and sell certain pools of assets.
• 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.

1. A rating of 1 indicates strong liquidity levels and well-developed funds management practices. The institution has reliable access to sufficient sources of funds on favorable terms to meet present and anticipated liquidity needs.
2. A rating of 2 indicates satisfactory liquidity levels and funds management practices. The institution has access to sufficient sources of funds on acceptable terms to meet present and anticipated liquidity needs. Modest weaknesses may be evident in funds management practices.
3. A rating of 3 indicates liquidity levels or funds management practices in need of improvement. Institutions rated 3 may lack ready access to funds on reasonable terms or may evidence significant weaknesses in funds management practices.
4. A rating of 4 indicates deficient liquidity levels or inadequate funds management practices. Institutions rated 4 may not have or be able to obtain a sufficient volume of funds on reasonable terms to meet liquidity needs.
5. A rating of 5 indicates liquidity levels or funds management practices so critically deficient that the continued viability of the institution is threatened. Institutions rated 5 require immediate external financial assistance to meet maturing obligations or other liquidity needs.

The sensitivity to market risk component reflects the degree to which changes in interest rates, foreign exchange rates, commodity prices, or equity prices can adversely affect a financial institution's earnings or economic capital. When evaluating this component, consideration should be given to: management's ability to identify, measure, monitor, and control market risk; the institution's size; the nature and complexity of its activities; and the adequacy of its capital and earnings in relation to its level of market risk exposure.

For many institutions, the primary source of market risk arises from nontrading positions and their sensitivity to changes in interest rates. In some larger institutions, foreign operations can be a significant source of market risk. For some institutions, trading activities are a major source of market risk.

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

• The sensitivity of the financial institution's earnings or the economic value of its capital to adverse changes in interest rates, foreign exchange rates, commodity prices, or equity prices.
• The ability of management to identify, measure, monitor, and control exposure to market risk given the institution's size, complexity, and risk profile.
• The nature and complexity of interest rate risk exposure arising from nontrading positions.
• Where appropriate, the nature and complexity of market risk exposure arising from trading and foreign operations.

Ratings

1. A rating of 1 indicates that market risk sensitivity is well controlled and that there is minimal potential that the earnings performance or capital position will be adversely affected. Risk management practices are strong for the size, sophistication, and market risk accepted by the institution. The level of earnings and capital provide substantial support for the degree of market risk taken by the institution.
2. A rating of 2 indicates that market risk sensitivity is adequately controlled and that there is only moderate potential that the earnings performance or capital position will be adversely affected. Risk management practices are satisfactory for the size, sophistication, and market risk accepted by the institution. The level of earnings and capital provide adequate support for the degree of market risk taken by the institution.
3. A rating of 3 indicates that control of market risk sensitivity needs improvement or that there is significant potential that the earnings performance or capital position will be adversely affected. Risk management practices need to be improved given the size, sophistication, and level of market risk accepted by the institution. The level of earnings and capital may not adequately support the degree of market risk taken by the institution.
4. A rating of 4 indicates that control of market risk sensitivity is unacceptable or that there is high potential that the earnings performance or capital position will be adversely affected. Risk management practices are deficient for the size, sophistication, and level of market risk accepted by the institution. The level of earnings and capital provide inadequate support for the degree of market risk taken by the institution.
5. A rating of 5 indicates that control of market risk sensitivity is unacceptable or that the level of market risk taken by the institution is an imminent threat to its viability. Risk management practices are wholly inadequate for the size, sophistication, and level of market risk accepted by the institution.

Additionally, open discussion of the CAMELS component ratings provides institutions with a better understanding of how ratings are derived, and enables management to better address any weaknesses in specific areas.

Discussions With Management

The examiner-in-charge should discuss the recommended component and composite ratings with senior management, and when appropriate the board of directors, at the conclusion of the examination. Examiners should clearly explain that the ratings are tentative and subject to final approval by the Regional Director.

Examiners should discuss the factors they considered when assigning the component and composite ratings. Examiners should also indicate that the composite rating is not based on a numerical average, but rather that it is based on a qualitative evaluation of an institution's overall managerial, operational, and financial performance.

The rating of the management component will be particularly sensitive and important. The quality of management is often the single most important element in the successful operation of an insured institution, and is usually the factor that is most indicative of how well risk is identified, measured, monitored, and controlled. For this reason, examiners should thoroughly review and explain the factors considered when assigning the management rating. Written comments in support of the management rating should include an assessment of the effectiveness of existing policies and procedures in identifying, monitoring, and managing risk.

Finally, management should be reminded that the composite and component ratings, whether disclosed verbally or in the written report of examination, are subject to the confidentiality rules imposed by Part 309 of the FDIC's Rules and Regulations.

Examination Priorities and Frequency Criteria

The Division's first priority is the effective surveillance and supervision of banks requiring special supervisory attention. The examination process best accomplishes identification of those banks. Section 10(d) of the FDI Act requires annual full-scope examinations for all depository institutions, including insured bank affiliates of multi-bank holding companies and insured branches of foreign banks. Annual examination intervals may be extended to 18 months under the following conditions:

1. The institution is not subject to a formal enforcement action by the FDIC or other Federal banking agency; and
2. No person acquired control of the institution during the 12-month period in which a full-scope, on-site examination would be required without this extension; and
3. The institution has total assets of less than $250 million, is well managed (most recent Management rating was "1" or "2"), is Well Capitalized (as defined in Section 38 of the FDI Act), and was assigned a composite "1" rating at its most recent examination; or
4. The institution has total assets of not more than $100 million, is well managed, Well Capitalized, and was assigned a composite 1" or "2" rating at its most recent examination.

The Division strives to provide safety and soundness and specialty examinations of all state nonmember banks within prescribed intervals. If examination frequency requirements, other than a few nominal and non-recurring exceptions, can not be met, a memorandum should be prepared and submitted to the Director of the Division of Supervision. The memorandum should include a description of the nature and cause of the situation and a description of any needed, planned, or implemented corrective measures designed to maintain an adequate supervision program.

Alternate Examinations

Examinations may be conducted in alternate 12 (or 18) month periods if the FDIC determines that a full-scope, on-site examination completed by the appropriate state supervisory authority during the interim period is acceptable. However, such alternate examinations should be accepted only for the following institutions: composite 1- or 2-rated institutions; and for stable and improving composite 3-rated institutions if the composite rating is confirmed by the CAEL off-site monitoring system and no adverse trends are noted from other available information. The length of time between the end of one examination and the start of the next (whether one or both of the examinations are conducted by a state supervisory agency or the FDIC) should not exceed 12 (or 18) months.

For purposes of monitoring compliance with examination frequency schedules, the end of the examination is defined as the earlier of the date the report is submitted for review or 60 calendar days from the Examination Start Date as defined in the Report of Examination Instructions.

Full - Scope Examinations

Limited scope examinations or visitations may address the overall condition of the institution including material changes since the previous examination and areas that exhibit more than normal risk. Depending on the focus of the scope and the purpose of the examination or visitation, examiners can assign composite ratings as well as component ratings for areas that were sufficiently reviewed. Component ratings that were not reviewed should be carried forward from the previous examination.

Completion of the standard examination report form is not required although appropriate report pages may be included if considered necessary to clarify a finding or recommendation. Results should generally be conveyed in a memorandum from the examiner-in-charge to the Regional Director. If the examination or visitation results are to be sent to the institution, they can be in whatever form (letter or other suitable format) is considered appropriate.

Other Situations

In addition to the preceding instructions, examinations should be performed in the following situations:

Newly Chartered And Insured Institutions

Every effort should be made to coordinate examination schedules with state authorities to take advantage of state resources, to minimize duplications of effort, and to lessen business disruptions to the institutions. A representative of the Regional Office should meet with representatives from each state banking authority to determine examination responsibilities for the upcoming year. Responsibilities may be defined in broad categories by rating, size and location of institutions, or may be done by specific institution as deemed appropriate. Such agreements should contain enough flexibility to allow either party to alter schedules with minimal notice.

While state examination requirements should be considered in the coordination process, statutory requirements should not be the determining factor in the final agreement.

Coordination of Bank Holding Company Inspections and Subsidiary Institution Examinations

Examinations of nonbank affiliates may be conducted at the discretion of the Regional Director, but independent examinations of holding companies supervised by the Federal Reserve may not be conducted without prior approval of the Washington Office.

Supervision of Interstate Banking Organizations and Chain Banks

It is the policy of the Division to monitor and supervise banks that are part of a chain banking organization in a manner that fully considers the financial impact of the consolidated chain on the individual institutions within that chain. Regional Directors are responsible for maintaining a record system for chain banking organizations and for developing an overall supervisory strategy for those organizations.

Specialty Examination Intervals

Specialty examinations should generally be conducted concurrently with safety and soundness examinations, except when the size or arrangement of the department makes it impractical or inefficient to do so. Specialty examinations (including IS, trust, registered transfer agent, government securities brokers/dealers, municipal securities broker/dealers, and BSA) are generally subject to the same examination intervals, including appropriate extensions, as safety and soundness examinations.

Regional Directors can make reasonable adjustments to specialty examination intervals to accommodate concurrent examinations in situations where rating differences or alternate state examinations result in examination intervals that are not conducive to scheduling concurrent examinations. Reasonable adjustments include extending the examination cycle for 1-, 2-, or 3-rated specialty areas. Specialty areas rated 4 or 5 should normally not be extended beyond a one-year interval. Additionally, since Municipal Securities Dealers are subject to a two-year examination cycle under Municipal Securities Rulemaking Board rules, any adjustment in this area should not exceed the two-year requirement. The possibility of conducting specialty examinations with state authorities should be explored if reasonable adjustments can be made.

When the state supervisory authority has examination responsibility for the safety and soundness examination of an institution, it will not be the responsibility of the region to conduct any specialty examinations that are not conducted by the state supervisory authority in order to maintain compliance with the requirements of section 10(d) of the FDI Act.

Insured Branches Of Foreign Banks

The same priorities and frequency of examinations including instructions regarding other situations that are applicable to domestic FDIC supervised institutions are applicable to insured branches of foreign banks.

Scheduling Guidelines

Periodic on-site examinations are critical to the supervisory process and are an integral part of the examination program. Diversified risks in the industry and the volatile performance and financial condition of individual institutions necessitate emphasis on more frequent and less structured supervision. Investigations, phone calls, limited scope examinations, correspondence and other forms of customized contact should be made as necessary. The purpose is to identify and obtain corrections in an institution's policies and procedures before serious financial problems develop.

Pre-examination activities should include efforts to determine the activities engaged in and the condition of nonbank subsidiaries. If not determinable in advance, this should be conducted early in the examination in order to assess the necessity of and depth of examination of subsidiaries.

The success of this effort depends largely on the effectiveness of assignment scheduling and preordination. Examiner resources should be allocated and directed based on the best information available as to potential problems without over emphasizing the mere passage of time.

Anticipatory Supervision

A prospective supervisory approach, entailing criticism of policies and practices before unsafe and unsound conditions actually develop calls for serious thought and studied reaction by examiners. Critical comments must be well supported and based on logic, prudent banking standards, and the potential for harm. In questionable circumstances where formal action is a possibility, examiners should consult with the Regional Office while the examination is in progress regarding the material needed to support a potential action.

Scheduling Process

Moreover, a formal examination may not be the most efficient use of resources in investigating the risk potential a bank may present. The objective is to assess the problem and, if necessary, devise a solution in the quickest, most efficient manner possible. Frequently, a telephone call or brief on-site visit may suffice. Sometimes such preliminary efforts will indicate that a full-scope examination is appropriate.

In order for all available information to be considered, it is critical that the Field Office Supervisor and other appropriate personnel be aware of and have access to the scheduling process. Regional Directors should ensure that copies of relevant correspondence and other pertinent information are made available. Procedures should ensure that information that may affect scheduling decisions is documented and made available to the involved personnel. Individuals doing scheduling must review and consider this information.

Because of the variety of sources and forms of relevant information available, it is not possible to design a uniform system of information gathering and reporting. However, the list below includes some information that may come to the FDIC's attention and have an influence in prioritizing assignments. Some of these items, such as involvement in FDIC assistance transactions, have supervisory schedules specified in our policy. Others are merely information that, in and of themselves, may or may not raise a concern depending on what else is known about the bank. However, these or similar items may give a signal that requires further follow-up. Such clues should not be ignored. The list, while not all inclusive, indicates a need for supervision to be anticipatory and provides a reminder of some of the common sources of information that may warrant consideration when scheduling.

Information to Consider in Scheduling Examinations

Effective bank supervision entails the continual assimilation of information from numerous sources, both within and outside the FDIC. The appropriate response, if any, depends on the circumstances, supervisory action already underway, what is known about the institution, and what can be learned from follow-up procedures. In some instances, the information serves as a"red flag," leading to an immediate examination. In less severe situations, the information is retained and factored into the process of scheduling future examinations. It is possible that a given piece of information can be derived from more than one source. Thus, some of the items listed below are included under more than one source.

Offsite Analysis And Monitoring

• CAEL Monitoring System
• Comprehensive Analytical Reports/Financial Interim Reports
• Growth Monitoring System
• UBPR Analysis
• Other:
• Loss for the year or an interim period.
• Rapid growth in assets or deposits.
• Significant change in asset composition.
• Significant change in liability composition.
• Use of brokered funds.
• Excessive dividends relative to earnings.
• Excessive bond trading.
• Other ratios or numbers that are unusual or have changed dramatically.

• Excessive salaries
• Failure to pay competitive salaries
• Compensation ed to future performance such as income, loan volume or deposit growth
• Infighting involving senior bank officers and/or directors
• Significant litigation against the institution or insiders
• Operating at the margin of Laws and regulations
• Management believed to be less than trustworthy
• Self-serving management
• Dominating management
• Inexperienced management
• Substantial outside business interests of a key officer
• Conducting business with questionable firms such as certain bond dealers

• Hiring of a dismissed, unethical or marginal officer
• Refinancing poor quality loans
• Improper handling of correspondent bank accounts
• Advertising above market interest rates
• Undercutting on price and credit quality to increase market share of loans
• Large blocks of stock in the institution pledged as collateral
• Increased or unusual loan participations among affiliated or closely held institutions
• Banker with past due loans at another institution

• Improper handling of correspondent bank accounts
• Increased or unusual loan participations among affiliated or closely held institutions
• Large blocks of stock pledged as collateral
• Affiliation with a 3-, 4- or 5-rated institution or holding company
• Large defalcation
• Banker with past due loans at another institution
• Hiring of a dismissed, unethical or marginal officer
• Loans classified at other institutions

• New chief executive officer or chief lending officer
• Adverse publicity
• Loss for the year or an interim period
• Adverse economic event in the community
• Natural disaster such as a flood, fire or earthquake
• Large defalcation
• Large financial commitment as sponsor or lead bank in a major project or development
• Banker death or disappearance
• Announcement of major new activity or department

• Change in external auditor
• High or sudden employee turnover
• Significant litigation against the institution or insiders
• Unusual activity in stock of the institution (price movement up or down or heavy trading volume)
• Institution advertising above market rates
• Significant change in the composition of assets or liabilities
• Questionable loans being booked
• Institution dealing with borrowers of questionable character
• Confidential or anonymous tips

Guidelines For Relying On State Examinations

Section 349 of the Riegle Community Development and Regulatory Improvement Act of 1994 requires the FFIEC to issue guidelines establishing standards for the purpose of determining the acceptability of state reports of examination under Section 10(d)(3) of the FDI Act. Under Section 10(d)(3), a Federal banking agency may conduct an annual, on-site examination of an insured depository institution in alternate 12 (or 18) month periods if the agency determines that a state examination conducted during the intervening period is adequate. The standards issued by the FFIEC are to be used at the discretion of the appropriate Federal banking agency.

The supervisory divisions of the Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve System and the Office of Thrift Supervision (Federal banking agencies) responsible for the examination of state-chartered, insured depository institutions, and the branches and agencies of foreign banks that have been chartered by the states have a long history of coordinating with the state banking departments in fulfilling a mutual goal of promoting a safe and sound banking system. It is recognized that this close cooperation between the Federal and State regulators promotes efficiency in the examination process, reduces the regulatory burden on state-chartered, insured depository institutions, and improves the supervisory process.

The Federal and State banking agencies have worked together, to varying degrees, in the following areas:

• Conducting alternate, joint and concurrent safety and soundness examinations of insured depository institutions and of the branches and agencies of foreign banks that have been chartered by the states.
• Processing safety and soundness examination reports and applications on a timely basis.
• Using common examination report and application forms.
• Developing and issuing informal (e.g., board resolutions, memoranda of understanding or other similar agreements) and formal enforcement actions.
• Exchanging supervisory information.
• Offering Federal agency training programs to State Examiners.
• Providing access to the Federal agency data bases.

The FDIC intends to continue these cooperative efforts to the maximum extent possible. It is recognized, however, that the adequacy of state budgeting, examiner staffing, and training are important factors to enhancing Federal and State coordination. The FDIC has entered into formal and informal arrangements or working agreements with most state banking departments. These working agreements or informal arrangements generally address the following areas:

• The number of state-chartered, insured institutions to be examined on an alternating basis by the state banking department and by the FDIC.
• The frequency of safety and soundness examinations.
• The type of examinations to be conducted (independent, joint, or concurrent) by each agency.
• The pre-examination procedures to be performed.
• The responsibilities of each agency for processing reports of examination.
• The responsibilities of each agency for conducting specialty examinations (compliance, information systems, trust, etc.).
• The procedures for coordinating informal and formal enforcement actions.
• The procedures for processing joint applications.
• The procedures for sharing supervisory information.

These working agreements or informal arrangements are structured to permit both Federal and State agencies the flexibility to conduct an independent examination subject only to notification to the other party. Generally, only institutions rated"1" or"2" are examined on an alternating basis allowing for a reasonable interval between examinations.

A hallmark of a successful program has been the flexibility to tailor cooperation to the particulars of each state and to the specifics of individual banks within a state, plus the reality of changing circumstances at both the Federal and State levels. The FFIEC guidelines strive to maintain that flexibility.

Guidelines for Relying on State Examinations

Pre-examination Activities

Thorough pre-examination planning is critical to the efficient completion of an examination. Pre-examination planning can help set scope decisions in terms of work to be performed and areas to receive special attention. It can also help determine staffing needs in regards to the number and expertise of personnel required. Finally, it can enhance the general orderliness and efficiency of an examination.

Part of the pre-planning process should also address the need for, or extent of, branch examinations. It is the FDIC's practice to examine the various offices of a branch banking system on an as-needed basis only. Such decisions are within the province of the Regional Director or may be delegated by the Regional Director to the Field Office Supervisor or examiner-in-charge of a particular examination.

As a general rule, bankers should be given at least two weeks notice of an upcoming safety and soundness examination in order to provide them with enough time to complete pre-examination requests. A shorter period is permissible if the institution is not unduly burdened or if a shorter period is occasionally needed due to planning requirements. Exceptions to this general policy may include problem institutions, situations where management and ownership of the institution are identical, or in situations where conditions are deteriorating rapidly.

Examiners should make every effort to conduct as many pre-, post- and other examination procedures as reasonably possible off-site in order to minimize disruptions to an institution's normal business activities. Additionally, examiners should be mindful of an institution's space and personnel limitations and schedule the number of examiners working on bank premises accordingly.

An examination procedures module titled Risk Scoping Activities is included in the Examination Modules Handbook. This module identifies and lists several activities to be completed by examiners during the pre-examination process. Refer to this module for additional guidance.

Examiner Meetings with Bank Management

Regardless of the number or type of meetings held, it is critical that examiners ensure that on-going two-way communication takes place. Such communication allows both parties to freely exchange information, and enhances the effectiveness of the examination process.

Meetings With Directors

When it is concluded that a meeting with a board committee rather than the full board is appropriate, selection of the committee must be based on the group's actual responsibilities and functions rather than its title. In all cases, the committee chosen should include an acceptable representation of board members who are not full time officers.

The success of the board meeting is highly dependent upon the examiner's preparation. A written agenda that lists all areas to be discussed and provides supporting documents or schedules will usually be worthwhile as a means of assisting in the explanation of certain aspects of the examination. Failure to adequately prepare for the meeting may substantially diminish the supervisory value of the examination.

To encourage awareness and participation on the part of board members, examiners should inform bank management that the examination report (or copies thereof) should be made available to each director for thorough and timely review and that a signature page is included in the examination report to be signed by each director after review of the report. Management should also be reminded the report is confidential, remains the property of the FDIC, and that utmost care should be exercised in its reproduction and distribution. The bank should be advised to retrieve, destroy and record the fact of destruction of any reproduced copies when they have served their purpose.

Examination Program

Effective risk management has always been central to safe and sound banking activities and it has become more important as new technologies, product innovation, and the size and speed of financial transactions have changed the nature of banking markets. The objective of a risk-focused examination is to effectively evaluate the safety and soundness of the bank, including the assessment of risk management systems, financial condition, and compliance with applicable laws and regulations, while focusing resources on the bank's highest risks. The exercise of examiner judgement to determine the depth of review in each functional area is crucial to the success of the risk-focused supervisory process.

Examination Modules

Examination procedure modules have been developed jointly by the FDIC and the Federal Reserve to provide examiners with a tool to focus on risk management and establish an appropriate examination scope. The modules incorporate questions and points of consideration into examination procedures to specifically address a bank's risk management strategies for each of its major business activities. The modules direct examiners to consider areas of potential risk and associated risk control practices, thereby facilitating an effective supervisory program. The guidelines set forth standards or "best practices" and the risks associated with not meeting the standards.

Examination procedures are separated into three distinct tiers: Core Analysis; Expanded Analysis; and Impact Analysis. The extent to which an examiner works through each of these levels of analysis depends upon conclusions reached regarding the presence of significant concerns or deficiencies. The modules are contained in a separate Examination Modules Handbook.

The most effective and efficient examination approach focuses examiner resources on validating bank management's ability to identify, measure, monitor, and control risks. Internal audits, external audits, loan review, and other control activities are integral to a bank's own assessment of its risk profile.

Examiners should consider the adequacy of these functions in determining the risk profile of the bank and the opportunities to reduce regulatory burden by testing rather than duplicating the work of these audit and control functions. Transaction testing remains a reliable and essential examination technique for use in the assessment of a bank's condition. The amount of transaction testing necessary to evaluate particular activities generally depends on the quality of the bank's process to identify, measure, monitor, and control the risks in the banking activity. Once the integrity of the management system is verified through testing, conclusions on the extent of risks within the activity can be based on the internal management system rather than on evaluating the potential risk to the bank.

Where significant deficiencies or weaknesses are noted in the core analysis review, the examiner will be required to complete the Expanded Analysis section but only for those decision factors that present the greatest degree of risk to the bank. On the other hand, if the risks are properly managed, the examiner can conclude the review after documenting conclusions concerning the Core Analysis Decision Factors and carry any comments to the Report of Examination. The Expanded Analysis section provides guidance to the examiner in determining if weaknesses are material to the bank's condition and if the activity is adequately managed.

Examiners are required to document the Expanded Analysis Decision Factors. If the risks are material or the activity is inadequately managed, the examiner is directed to perform an Impact Analysis to assess the financial impact to the bank and assess whether any enforcement action is necessary.

The use of the modules should be tailored to the characteristics of each bank based on its size, complexity, and risk profile. As a result, the extent to which each module is completed will vary from bank to bank. Individual procedures presented for each level are meant only to serve as a guide for answering the decision factors. Each procedure does not require an individual response; however, the automation allows for notes under each procedure. Examiners are required to document their responses to both the Core Analysis Decision Factors and the Expanded Analysis Decision Factors.

Other Sources of Examination Information and Policy Guidance

As stated earlier, the primary purpose of this manual is to provide policy guidance and direction to the field examiner that may then be applied in the safety and soundness examination process. Policy manuals or other instructional materials pertaining to other areas of examination interest, such as trust department operations, information systems (IS) activities, transfer agent and consumer compliance, have also been developed. Those areas were not included in this manual simply to enhance the organization of the material, keep the document reasonable in length, and thereby maximize its usefulness. However, exclusion of these topics in no way implies that these activities are not of interest to the safety and soundness examination. To the contrary, deficiencies in these other aspects of a bank's operations can have a major impact on the institution's overall soundness. Therefore, it is critical for the examiner to be aware of the existence and significance of any deficiencies in these other areas. Separate examination reports or schedules have been designed to evaluate these functions, and it is the Corporation's policy that such examinations generally should be conducted concurrently with the safety and soundness review. Some exceptions to this concurrent examination preference are permitted and are detailed in the instructions pertaining to these specialty areas.

To emphasize and illustrate how weaknesses in these ancillary activities can adversely affect the whole bank, a brief overview of trust, EDP and compliance operations is provided.

Trust Department

In order to perform their duties properly, examiners must be knowledgeable of the principles, policies and practices contained in the aforementioned handbooks on EDP, compliance, trust and others. There are other reference sources also very relevant to the examination process and with which it is essential for the examiner to become familiar. These include the body of state laws and regulations which apply to the bank being examined; the rules, regulations, statements of policy and various banking-related statutes contained in the Prentice-Hall volumes; and the instructions for completion of the Consolidated Report of Condition and the Consolidated Report of Income. The last mentioned source is the principal reference for balance sheet and income statement presentation of various transactions and accounts in both the foregoing Reports and the Report of Examination.

Disclosure of Reports of Examination

Examination Workpapers

Workpapers should be a written trail of decisions and supporting logic that also indicate individual responsibility. They should provide written support for examination and verification procedures performed and the assertions of fact or opinion in the financial schedules and narrative comments in the report of examination.

Substance of Workpapers