[Federal Register Volume 69, Number 141 (Friday, July 23, 2004)]
[Notices]
[Pages 43996-44007]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-16865]


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Federal Reserve System

Docket No. OP-1207


Bank Holding Company Rating System

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Notice and request for comment.

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SUMMARY: The increased complexity of the U.S. banking industry has 
necessitated over time a shift in the focus of the Federal Reserve's 
supervisory practices for bank holding companies (BHCs), including 
financial holding companies (FHCs), away from historical analyses of 
financial condition toward more forward looking assessments of risk 
management and financial factors. While the emphasis on risk management 
has been well established in the Federal Reserve's supervisory 
processes for BHCs of all sizes, this emphasis is not reflected in the 
primary components of the current BHC supervisory rating system, BOPEC 
(Bank subsidiaries, Other subsidiaries, Parent, Earnings, Capital). 
This document proposes a revised BHC rating system that emphasizes risk 
management; introduces a more comprehensive and adaptable framework for 
analyzing and rating financial factors; and provides a framework for 
assessing and rating the potential impact of the nondepository entities 
of a holding company on the subsidiary depository institution(s). After 
reviewing public comments, the Federal Reserve intends to make any 
necessary changes to the proposal and adopt a final BHC rating system.

DATES: Comments must be received by September 21, 2004.

ADDRESSES: You may submit comments, identified by Docket No. OP-1207, 
by any of the following methods:
    Board's Web Site: http://www.federalreserve.gov. Follow the 
instructions for submitting comments at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm.
    Federal eRulemaking Portal: http://www.regulations.gov. Follow the 
instructions for submitting comments.
    E-mail: [email protected]. Include docket number in 
the subject line of the message.
    Fax: (202) 452-3819 or (202) 452-3102.
    Mail: Jennifer J. Johnson, Secretary, Board of Governors of the 
Federal Reserve System, 20th Street and Constitution Avenue, NW., 
Washington, DC 20551.
    All public comments are available from the Board's Web site at 
http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as 
submitted, except as necessary for technical reasons. Accordingly, your 
comments will not be edited to remove any identifying or contact 
information. Public comments also may be viewed electronically or in 
paper form in Room MP-500 of the Board's Martin Building (C and 20th 
Streets, NW.) between 9 a.m. and 5 p.m. on weekdays.

FOR FURTHER INFORMATION CONTACT: Deborah Bailey, Associate Director, 
(202-452-2634), Barbara Bouchard, Deputy Associate Director, (202-452-
3072), Molly Mahar, Senior Supervisory Financial Analyst, (202-452-
2568), or Anna Lee Hewko, Supervisory Financial Analyst, (202-530-
6260). For users of Telecommunications Device for the Deaf (``TDD'') 
only, contact (202) 263-4869.

SUPPLEMENTARY INFORMATION:

Background

    The BHC rating system is a management information and supervisory 
tool that defines the condition of BHCs in a systematic way. It serves 
three primary purposes in the supervisory process. First and foremost, 
the BHC rating provides a summary evaluation of the BHC's condition for 
use by the supervisory community. Second, the BHC ratings form the 
basis of supervisory responses and actions. Third, the BHC rating 
system provides the basis for supervisors' discussion of the firm's 
condition with BHC management. The current BHC rating system was 
implemented in 1979. Known as BOPEC/F-M, the rating system components 
are defined as follows:
     The B rating represents the Federal Reserve's view of the 
condition of the banking subsidiary(ies).
     The O rating represents the Federal Reserve's view of the 
condition of the nonbank subsidiary(ies).
     The P rating represents the Federal Reserve's view of the 
condition of the parent company.
     The E and C represent the Federal Reserve's view of the 
consolidated capital and earnings position of the BHC, respectively.
     The F rating represents the financial composite rating, 
whereas the M represents the management composite rating.
    During the almost 25 years since the BOPEC/F-M rating system was 
introduced, the banking industry has become increasingly concentrated 
and complex. BHCs with assets exceeding $10 billion, as of year-end 
2003, accounted for over 83 percent of total company assets, up from 66 
percent, as of year-end 1992. In addition, the growing depth and 
sophistication of financial markets in the United States and around the 
world has introduced a wider range of activities undertaken by banking 
institutions. The Gramm-Leach-Bliley Act of 1999 further raised the 
complexity of the U.S. banking industry by expanding the range of

[[Page 43997]]

acceptable activities for FHCs, a subset of BHCs. This upsurge in BHC 
complexity prompted a fundamental shift in supervisory focus away from 
historical financial analyses toward more forward-looking assessments 
of risk management and financial factors.
    In response to these developments, commencing in 1996 with the 
implementation of SR 95-51\1\, the Federal Reserve's safety and 
soundness supervisory staff have assigned a formal supervisory rating 
to the adequacy of risk management processes at all BHCs, although that 
rating remains separate from the BOPEC/F-M rating system. As the 
banking industry has continued to evolve over the past eight years, the 
focus of the Federal Reserve's examination program for BHCs has 
increasingly centered on a comprehensive review of financial risk and 
the adequacy of risk management. However, the BOPEC/F-M rating system 
has not been updated to facilitate a broader assessment of financial 
risk or to emphasize risk management, reducing the significance of 
supervisory information conveyed by the rating.
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    \1\ See Supervisory Letter 95-51, Rating the Adequacy of Risk 
Management Processes and Internal Controls at State Member Banks and 
Bank Holding Companies.
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    To better align the assessment process for BHCs with current 
supervisory practices, the Federal Reserve identified the following key 
objectives for a new BHC rating system:
     Elevate the prominence of risk management in the rating 
system in order to align the emphasis of the rating system with that of 
our supervisory process;
     Provide a more comprehensive framework for assessing risk 
management;
     Define the financial strength components of the rating 
system in a more comprehensive and flexible manner, to ensure that the 
unique structure of each BHC is recognized, and that the related impact 
of that structure on the depository institution subsidiaries is 
evaluated; and
     Require an explicit determination as to the likelihood 
that the BHC and its nondepository subsidiaries (nondepository 
entities) will have a significant negative impact on the depository 
subsidiaries, considering the effectiveness of risk management systems 
and the financial strength of the nondepository entities.
    The Federal Reserve believes that the BHC rating system proposed 
below satisfies these objectives. It also believes that the proposed 
rating system is flexible enough to remain relevant as the banking 
industry continues to evolve.
    As under the current BHC rating system, all BHCs would be assigned 
a rating, although they would be subject to differing degrees of 
supervisory scrutiny depending on their size and complexity, the 
significance of their depository subsidiary(ies), and other factors. 
For example, the small shell BHC inspection program would remain in 
place. Certain noncomplex BHCs with consolidated assets of less than $1 
billion in which all subsidiary depository institutions have 
satisfactory composite and management ratings would receive only a 
composite rating and a risk management rating, which would be based on 
the composite and management ratings of the lead depository 
institution. Further details are provided in the implementation 
guidance section of the proposal.
    The Federal Reserve recognizes that certain regulations and 
administrative processes, such as expedited application processing, 
currently use a BHC's composite or BOPEC component rating in 
determining the BHC's status under those regulations. It would expect 
to conform those regulations and processes to incorporate any changes 
made to the BHC rating system.
    Proposed Text of the Bank Holding Company Rating System
Bank Holding Company Rating System
Introduction and Overview
    The bank holding company (BHC) rating system takes into 
consideration certain financial, managerial, and compliance factors 
that are common to all BHCs. Under this system, the Federal Reserve 
endeavors to ensure that all BHCs are evaluated in a comprehensive and 
uniform manner, and that supervisory attention is appropriately focused 
on the BHCs exhibiting financial and operational weaknesses or adverse 
trends. The rating system serves as a useful vehicle for identifying 
problem or deteriorating BHCs, as well as for categorizing BHCs with 
deficiencies in particular areas. Further, the rating system assists 
the Federal Reserve in following safety and soundness trends and in 
assessing the aggregate strength and soundness of the financial 
industry.
    Each BHC\2\ is assigned a composite rating (C) based on an 
evaluation and rating of three essential components and eight 
subcomponents of an institution's financial condition and operations. 
The main components represent: R - risk management; F - financial 
condition; I - impact of the parent company and nondepository 
subsidiaries (collectively nondepository entities) on the subsidiary 
depository institutions. A fourth rating, (D), will generally mirror 
the primary regulator's assessment of the subsidiary depository 
institutions. Thus, the component and composite ratings are displayed:
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    \2\ A simplified version of the rating system that includes only 
the R and C components will be applied to noncomplex bank holding 
companies with assets below $1 billion.
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    R F I / C (D)
    In order to provide a consistent framework for assessing risk 
management, the R component is supported by four qualitatively rated 
subcomponents that reflect the effectiveness of the banking 
organization's risk management and controls. The subcomponents are: 
Competence of Board and Senior Management; Policies, Procedures, and 
Limits; Risk Monitoring and Management Information Systems; and, 
Internal Controls. The F component is supported by four numerically 
rated subcomponents reflecting an assessment of the quality of the 
banking organization's C - capital; A - asset quality; E - earnings; 
and L - liquidity.
    With the exception of the risk management subcomponents, composite, 
component, and subcomponent ratings are assigned based on a 1 to 5 
numerical scale. A 1 indicates the highest rating, strongest 
performance and practices, and least degree of supervisory concern, 
whereas a 5 indicates the lowest rating, weakest performance, and the 
highest degree of supervisory concern. Given that the level of detail 
in the analysis of the risk management subcomponents does not lend 
itself to rating on a five-point scale, the subcomponents will be 
assigned a qualitative rating of Strong, Adequate, or Weak.
    The composite rating generally bears a close relationship to the 
component ratings assigned. Each component rating is based on a 
qualitative 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 situation of the BHC. In general, assignment of a composite 
rating may incorporate any factor that bears significantly on the 
overall condition and soundness of the BHC. Therefore, the composite 
rating is not derived by computing the arithmetic average of the 
component ratings.
    The following three sections contain detailed descriptions of the 
composite, component, and subcomponent ratings, definitions of the 
ratings, and implementation guidance by BHC type.

[[Page 43998]]

I. Description of the Rating System Elements

The ``R'' (Risk Management) Component

     R represents an evaluation of the ability of the board of 
directors and senior management to identify, measure, monitor, and 
control risk. The R rating will underscore the importance of the 
control environment, taking into consideration the financial complexity 
and strength of the organization and the risk inherent in its 
activities.
     The R rating is supported by four subcomponents that are 
each assigned a separate qualitative rating (strong, adequate, or 
weak\3\). The four subcomponents are as follows: 1) Competence of the 
Board and Senior Management; 2) Policies, Procedures and Limits; 3) 
Risk Monitoring and Management Information Systems; and 4) Internal 
Controls.\4\ The subcomponents will be evaluated in the context of the 
risks undertaken by and inherent to a banking organization and the 
overall level of complexity of the firm's operations.
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    \3\ The use of the three-point qualitative evaluation system 
(versus a five-point numerical rating system) will be evaluated 
during testing of the new rating system.
    \4\ Another subcomponent assessing the adequacy of disclosure 
for bank holding companies using the advanced internal ratings based 
approach to capital allocation may be added once the Basel II 
framework has been implemented in the United States.
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     The subcomponents provide the Federal Reserve System with 
a consistent framework for evaluating risk management and the control 
environment. Moreover, the subcomponents provide a clear structure and 
basis for discussion of the R rating with BHC management.
     The subcomponents reflect the principles of SR 95-51, are 
familiar to examiners, and parallel the existing risk assessment 
process.
    ``R'' Component Subcomponents\5\
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    \5\ A detailed description of the four subcomponents is listed 
in SR 95-51.
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Competence of the Board and Senior Management

    This subcomponent evaluates the adequacy and effectiveness of board 
and senior management oversight, and the general capabilities of 
management. This analysis will include a review of management's ability 
to identify and understand the risks undertaken by the institution, to 
hire competent staff, and to respond to changes in the institution's 
risk profile or innovations in the banking sector.

Policies, Procedures and Limits

    This subcomponent evaluates the adequacy of a BHC's policies, 
procedures, and limits given the risks inherent in the activities of 
the consolidated BHC and the organization's stated goals and 
objectives. This analysis will include consideration of the adequacy of 
the institution's accounting and risk disclosure policies and 
procedures.

Risk Monitoring and Management Information Systems

    This subcomponent assesses the adequacy of a BHC's risk measurement 
and monitoring, and the adequacy of its management reports and 
information systems. This analysis will include a review of the 
assumptions, data and procedures used to measure risk and the 
consistency of these tools with the level of complexity of the 
organization's activities.

Internal Controls

    This subcomponent evaluates the adequacy of a BHC's internal 
controls and audit procedures, including the accuracy of financial 
reporting and disclosure and the strength and influence, within the 
organization, of the audit team. This analysis will also include a 
review of the independence of control areas from business lines and the 
consistency of the scope coverage of the audit team with the complexity 
of the organization.

The ``F'' (Financial Condition) Component

     F represents an evaluation of the consolidated 
organization's financial strength. The F rating focuses on the ability 
of the BHC's resources to support the level of risk associated with its 
activities, while taking into consideration the ability of management 
to identify, measure, monitor and control those risks.
     The analysis of the F component will encompass a review of 
financial issues at the parent company and nondepository subsidiaries 
and an assessment of the financial impact of those nondepository 
entities on the depository institution subsidiaries. This review should 
include discussions with management, an examination of internal 
documents and procedures, and all relevant public information, 
including market indicators.
     Any significant difference between the Federal Reserve's 
view of the financial condition of the consolidated BHC, based on 
public and nonpublic information, and the market's view of the 
consolidated company should be thoroughly assessed to determine the 
cause of the disparity. If the Federal Reserve's view of the BHC is 
significantly more positive than the market's view of the BHC, then 
examination staff should review the factors that influenced the 
market's assessment of the company, and include those influences in 
their assessment of the financial condition of the BHC, as appropriate. 
Alternatively, if the Federal Reserve's view of the BHC is more 
negative than the market's view of the company, then examination staff 
should assess the effectiveness of the policies, procedures and 
controls around the BHC's public disclosures. Any deficiencies in those 
controls should be factored into the overall risk management (R) rating 
and the appropriate risk management subcomponent ratings.
     The F rating is supported by four subcomponents that 
consist of the following: C (capital), A (asset quality), E (earnings), 
and L (liquidity). The CAEL subcomponents can be evaluated along 
individual business lines, product lines, or on a legal entity basis, 
depending on what is most appropriate given the structure of the 
organization. The assessment of the CAEL components should utilize 
benchmarks and metrics appropriate to the business activity being 
evaluated.
     The weight afforded to each of the CAEL subcomponents in 
developing the overall F component rating will depend on the relative 
importance of each subcomponent to the consolidated organization, as 
well as the severity of the rating assigned to each subcomponent.
    ``F'' Component (CAEL) Subcomponents
    In evaluating each of the CAEL subcomponents, examination staff 
should include a review of relevant market indicators, such as equity 
and debt prices, debt ratings, credit spreads, and qualitative rating 
agency assessments.

``C'' Capital Adequacy

    C reflects the adequacy of an organization's consolidated capital 
position, from a regulatory perspective and an economic capital 
perspective, as appropriate to the BHC. The evaluation of capital 
adequacy should consider the risk inherent in an organization's 
activities, the distribution of capital across legal entities, and the 
transferability of capital among legal entities.

``A'' Asset Quality

    A reflects the quality of an organization's consolidated assets. 
The evaluation should include, as

[[Page 43999]]

appropriate, on-balance sheet and off-balance sheet exposures and the 
attendant risks, the level of criticized and nonperforming assets, the 
adequacy of underwriting standards, the level of concentration risk, 
the adequacy of credit administration policies and procedures, and the 
adequacy of management information systems for credit risk.

``E'' Earnings

    E reflects the quality of consolidated earnings. The evaluation 
considers the level, trend, and sources of earnings, as well as the 
ability of earnings to augment capital as necessary, to provide ongoing 
support for a BHC's activities. The earnings analysis should also 
consider the generation of earnings across legal entities and the 
implications of that distribution.

``L'' Liquidity

    L reflects the organization's ability to attract and maintain the 
sources of funds necessary to support its operations and meet its 
obligations, both on a consolidated basis and across legal entities. 
The L assessment requires an analysis of parent company cash flow, as 
well as an analysis of liquidity on a legal entity basis. The funding 
conditions for each of the legal entities in the holding company 
structure should be evaluated to determine if any weaknesses exist that 
could affect the funding profile of the consolidated organization or 
the subsidiary depository institution(s).

The ``I'' (Impact) Component

     The I component is rated on a five point numerical scale. 
Ratings will be assigned in ascending order of supervisory concern as 
follows:
    1 - low likelihood of significant negative impact;
    2 - limited likelihood of significant negative impact;
    3 - moderate likelihood of significant negative impact;
    4 - considerable likelihood of significant negative impact; and
    5 - high likelihood of significant negative impact.
     The I component is an assessment of the impact of the 
nondepository entities on the subsidiary depository institution(s). The 
I assessment will consider an evaluation of both the risk management 
practices and financial condition of the nondepository entities--an 
analysis that will borrow heavily from the analysis conducted for the R 
and F components. Further, in rating the I component, examination staff 
is required to evaluate the degree to which current or potential issues 
within those entities present a threat to the safety and soundness of 
the subsidiary depository institution(s). In this regard, the I 
component will give a clearer indication of the degree of risk posed by 
the nondepository entity(ies) to the federal safety net than the 
current rating system.
     The I component focuses on the aggregate impact of the 
nondepository entities on the subsidiary depository institution(s). In 
this regard, the I rating does not include individual subcomponent 
ratings for the parent company and nondepository subsidiaries. Any risk 
management and financial issues at the parent company and/or 
nondepository subsidiaries that potentially impact the safety and 
soundness of the subsidiary depository institution(s) should be 
identified in the written comments under the I rating. This approach is 
consistent with the Federal Reserve's objective not to extend bank-like 
supervision to nondepository entities.
     The analysis of the parent company for the purpose of 
assigning an I rating should emphasize weaknesses that impair the 
parent company's ability to provide support to its subsidiary 
depository institution(s) and weaknesses that directly impact the risk 
management or financial condition of the subsidiary depository 
institution(s).
     Similarly, the analysis of the nondepository subsidiaries 
for the purpose of assigning an I rating should emphasize weaknesses 
that impact the ability of the parent company to support the subsidiary 
depository institution(s) and weaknesses that have a direct impact on 
the risk management practices or financial condition of the subsidiary 
depository institution(s).
     The analysis under the I component should consider 
existing as well as potential issues and risks that may impact the 
subsidiary depository institution(s) now or in the future.
    The Reserve Bank should pay particular attention to the following 
risk management and financial factors in assigning the I rating:
    Risk Management Factors
     Strategic Considerations: The potential risks posed to the 
subsidiary depository institution(s) by the parent company and/or 
nondepository subsidiaries' strategic plans for growth in existing 
activities and expansion into new products and services;
     Operational Considerations: The spillover impact on the 
subsidiary depository institution(s) from actual losses, a poor control 
environment, or an operational loss history of the nondepository 
entities; and,
     Legal and Reputational Considerations: The spillover 
effect on the subsidiary depository institution(s) of complaints and 
litigation that name the parent company and/or nondepository 
subsidiaries as defendants, or violations of laws or regulations, 
especially pertaining to intercompany transactions where the subsidiary 
depository institution(s) is involved.
     Concentration Considerations: The potential risks posed to 
the subsidiary depository institution(s) by concentrations within the 
nondepository entities in business lines, geographic areas, industries, 
customers, or other factors.
    Financial Factors
     Capital Distribution: The distribution of capital across 
the organization, given that, in general, the Federal Reserve cannot 
unilaterally require the capital of a functionally regulated entity to 
be transferred to the subsidiary depository institution(s);
     Intra-Group Exposures: The extent to which intra-group 
exposures, including servicing agreements, credit concentrations, and 
derivative and payment system exposures, have the potential to 
undermine the condition of subsidiary depository institution(s); and,
     Parent Company Cash Flow and Leverage: The extent to which 
the parent company is dependent on dividend payments, from both the 
nondepository subsidiaries and the subsidiary depository 
institution(s), to service debt and cover fixed charges. Also, the 
effect that these upstreamed cash flows have had, or can be expected to 
have, on the financial condition of the BHC's nondepository 
subsidiaries and subsidiary depository institution(s).

The ``C'' (Composite) Rating

     C represents the overall composite assessment of the 
organization based on the quality and effectiveness of consolidated 
risk management, the BHC's consolidated financial strength, and the 
impact of the parent company and nondepository subsidiaries on the 
subsidiary depository institution(s). The composite rating encompasses 
both a forward-looking and static assessment of the consolidated 
organization, and incorporates an assessment of issues related to the 
ability of the parent company and nondepository subsidiaries to act as 
a source of support to the subsidiary depository institution(s). The C 
rating is not derived as a simple average of the R, F, I and (D) 
components, but instead, reflects examiner judgement with respect to 
the relative importance of

[[Page 44000]]

each of the components to the overall safety and soundness of the 
institution's operations.

The ``(D)'' (Depository Institutions) Component

     The (D) component will generally reflect the composite 
CAMELS rating assigned by the subsidiary depository institution's 
primary regulator. In a multi-bank BHC, the (D) rating will reflect the 
combined CAMELS composite ratings of the individual subsidiary 
depository institutions, and will consider both asset size and the 
relative importance of each depository institution within the holding 
company structure. In this regard, the CAMELS composite rating for a 
subsidiary depository institution that dominates the corporate culture 
may figure more prominently in the assignment of the (D) rating than 
normally dictated by asset size, particularly when problems exist 
within that depository institution.
     If in the process of analyzing the financial condition and 
risk management programs of the consolidated organization, a major 
difference of opinion relative to the safety and soundness of the 
depository institution emerges between the Federal Reserve and the 
depository institution's primary regulator, then the (D) rating should 
reflect the Federal Reserve's evaluation.

II. Rating Definitions for the RFI/C (D) Rating System

``R'' (Risk Management) Component and Subcomponents

The R component is rated on a five point numerical scale. Ratings will 
be assigned in ascending order of supervisory concern as follows:
1 - Strong; 2 - Satisfactory; 3 - Fair; 4 - Marginal; and 5 - 
Unsatisfactory.
Rating 1 (Strong). A rating of 1 indicates that management effectively 
identifies and controls all major types of risk posed by the BHC's 
activities, including those emanating from new products and changing 
market conditions. The board and management are active participants in 
managing risk. Management ensures that appropriate policies and limits 
exist and are understood, reviewed, and approved by the board. Policies 
and limits are supported by risk monitoring procedures, reports, and 
management information systems that provide management and the board 
with the information and analysis that is necessary to make timely and 
appropriate decisions in response to changing conditions. Risk 
management practices and the organization's infrastructure are flexible 
and are adjusted appropriately in response to changing industry 
practices and current regulatory guidance. Staff has sufficient 
experience, expertise and depth to manage the risks assumed by the 
institution.
    Internal controls and audit procedures are sufficiently 
comprehensive and appropriate to the size and activities of the 
institution. There are few noted exceptions to the institution's 
established policies and procedures, and none is material. Management 
effectively and accurately monitors the condition of the institution 
consistent with the standards of safety and soundness, and in 
accordance with internal and supervisory policies and practices. Risk 
management processes are fully effective in identifying, monitoring, 
and controlling the risks to the institution.
    Rating 2 (Satisfactory). A rating of 2 indicates that the 
institution's management of risk is largely effective, but lacking in 
some modest degree. Management demonstrates a responsiveness and 
ability to cope successfully with existing and foreseeable risks that 
may arise in carrying out the institution's business plan. While the 
institution may have some minor risk management weaknesses, these 
problems have been recognized and are in the process of being resolved. 
Overall, board and senior management oversight, policies and limits, 
risk monitoring procedures, reports, and management information systems 
are considered satisfactory and effective in maintaining a safe and 
sound institution. Generally, risks are controlled in a manner that 
does not require more than normal supervisory attention.
    Internal controls may display modest weaknesses or deficiencies, 
but they are correctable in the normal course of business. The examiner 
may have recommendations for improvement, but the weaknesses noted 
should not have a significant effect on the safety and soundness of the 
institution.
Rating 3 (Fair). A rating of 3 signifies that risk management practices 
are lacking in some important ways and, therefore, are a cause for more 
than normal supervisory attention. One or more of the four elements of 
sound risk management\6\ (active board and senior management oversight; 
adequate policies, procedures, and limits; adequate risk management 
monitoring, and management information systems; comprehensive internal 
controls) is considered less than acceptable, and has precluded the 
institution from fully addressing one or more significant risks to its 
operations. Certain risk management practices are in need of 
improvement to ensure that management and the board are able to 
identify, monitor, and control all significant risks to the 
institution. Weaknesses may include continued control exceptions or 
failures to adhere to written policies and procedures that could have 
adverse effects on the institution. Also, the risk management structure 
may need to be improved in areas of significant business activity, or 
staff expertise may not be commensurate with the scope and complexity 
of business activities. In addition, management's response to changing 
industry practices and regulatory guidance may need to improve.
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    \6\ Framework for Risk-Focused Supervision of Large Complex 
Institutions, August 1997; SR Letter 95-51, Rating the Adequacy of 
Risk Management Processes and Internal Controls at State Member 
Banks and Bank Holding Companies.
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    The internal control system may be lacking in some important 
aspects, particularly as indicated by continued control exceptions or 
by a failure to adhere to written policies and procedures. The risks 
associated with the internal control system could have adverse effects 
on the safety and soundness of the institution if corrective action is 
not taken by management.
Rating 4 (Marginal). A rating of 4 represents marginal risk management 
practices that generally fail to identify, monitor, and control 
significant risk exposures in many material respects. Generally, such a 
situation reflects a lack of adequate guidance and supervision by 
management and the board. One or more of the four elements of sound 
risk management is deficient and requires immediate and concerted 
corrective action by the board and management. A number of significant 
risks to the institution have not been adequately addressed, and the 
risk management deficiencies warrant a high degree of supervisory 
attention.
    The institution may have serious identified weaknesses, such as an 
inadequate separation of duties, that require substantial improvement 
in internal control or accounting procedures, or improved adherence to 
supervisory standards or requirements. Unless properly addressed, these 
conditions may result in unreliable financial records or reports, or 
operating losses that could seriously affect the safety and soundness 
of the institution.
Rating 5 (Unsatisfactory). A rating of 5 indicates a critical absence 
of effective risk management practices with respect to the 
identification, monitoring, or control over significant risk exposures. 
One or more of the four elements of

[[Page 44001]]

sound risk management is considered wholly deficient, and management 
and the board have not demonstrated the capability to address these 
deficiencies.
    Internal controls are critically weak and, as such, could seriously 
jeopardize the continued viability of the institution. If not already 
evident, there is an immediate concern as to the reliability of 
accounting records and regulatory reports and the potential for losses 
if corrective measures are not taken immediately. Deficiencies in the 
institution's risk management procedures and internal controls require 
immediate and close supervisory attention.

``R'' (Risk Management) Subcategories

The four R subcomponents are each assigned a qualitative rating of 
Strong, Acceptable or Weak. The following are the descriptions of the 
ratings as they apply to each of the subcategories.

Competence of Board and Senior Management

Strong Assessment. An assessment of Strong signifies that the board and 
senior management clearly understand the types of risk inherent in the 
BHC's activities and actively participate in managing those risks. 
Policies, limits, and tracking reports are appropriate and understood, 
reviewed, and approved by the board. Board and senior management are 
informed about changes in market conditions and respond appropriately. 
Oversight of risk management practices is strong and the organization's 
overall business strategy is effective. Risk management practices are 
appropriately adjusted in accordance with enhancements to industry 
practices and regulatory guidance, and exposure limits are adjusted as 
necessary to reflect the institution's changing risk profile.
    Staff possesses the experience and expertise consistent with the 
scope and complexity of the organization's business activities. There 
is a sufficient depth of staff to ensure sound operations. Management 
provides adequate supervision of the day-to-day activities of all 
officers and employees, including the supervision of the senior 
officers and the heads of business lines. Management ensures that 
employees have the integrity, ethical values, and competence that are 
consistent with a prudent management philosophy and operating style.
    Management is able to respond to changes in competition or 
innovations in the marketplace and proactively identifies all risks 
associated with proposed new activities or products and ensures that 
the appropriate infrastructure and internal controls are established.
Acceptable Assessment. An assessment of Acceptable indicates that board 
and senior management oversight is satisfactory. In this regard, the 
board and senior management have a good understanding of the 
organization's risk profile, provide adequate oversight of risk 
management practices, effectively utilize risk management reporting, 
set appropriate policies and limits, appropriately adapt to changes in 
market conditions, and develop and executes reasonable business 
strategies, although these practices may be lacking in some modest 
degree. The level of staffing, and its experience, expertise, and 
depth, is sufficient to operate the business lines in a safe and sound 
manner. Day-to-day supervision of management and staff at all levels is 
generally effective. Management responds in a timely fashion to changes 
in competition, innovations in the marketplace, evolving industry 
practices, and current regulatory guidance, and has in place an 
effective process for reviewing new activities and products. Minor 
weaknesses may exist in the staffing, infrastructure, and risk 
management processes for individual business lines or products, but 
these weaknesses have been recognized and are in the process of being 
addressed.
Weak Assessment. An assessment of Weak signifies that deficiencies 
exist in board and management oversight that require more than normal 
supervisory attention. The deficiencies may involve a broad range of 
activities or be material to a major business line or activity. Board 
and senior management may not be adequately informed as to the type and 
severity of the deficiencies or have not demonstrated an ability to 
provide corrective action in a timely manner. The deficiencies may 
include a lack of knowledge with respect to the organization's risk 
profile, insufficient oversight of risk management practices, 
ineffective policies or limits, inadequate or under-utilized management 
reporting, an inability to respond to industry enhancements and changes 
in regulatory guidance, or failure to execute appropriate business 
strategies. Staffing may not be adequate or staff may not possess the 
experience and expertise needed for the scope and complexity of the 
organization's business activities, and the day-to-day supervision of 
officer and staff activities, including the management of senior 
officers or heads of business lines, may be lacking.

Policies, Procedures and Limits

Strong Assessment. An assessment of Strong indicates that the policies, 
procedures, and limits provide for effective identification, 
measurement, monitoring, and control of the risks posed by the lending, 
investing, trading, trust, fiduciary, and other significant activities. 
Policies, procedures, and limits are consistent with the institution's 
goals and objectives and its overall financial strength. The policies 
clearly delineate accountability and lines of authority across the 
institution's activities. The policies also provide for the review of 
new activities to ensure that the infrastructure necessary to identify, 
monitor, and control the risks is in place before the activities are 
initiated.
Acceptable Assessment. An assessment of Acceptable indicates that the 
policies, procedures and limits cover all major business areas, are 
thorough and substantially up-to-date, and provide a clear delineation 
of accountability and lines of authority across the institution's 
activities. Policies, procedures, and limits are generally consistent 
with the institution's goals and objectives and its overall financial 
strength. Any deficiencies or gaps that have been identified are minor 
in nature and in the process of being addressed.
Weak Assessment. An assessment of Weak signifies that deficiencies 
exist in policies, procedures, and limits that require more than normal 
supervisory attention. The deficiencies may involve a broad range of 
activities or be material to a major business line or activity. Board 
and senior management may not be adequately informed as to the type and 
severity of the deficiencies or have not demonstrated an ability to 
provide corrective action in a timely manner. The deficiencies may 
include policies, procedures, or limits (or the lack thereof) that do 
not adequately identify, measure, monitor, or control the risks posed 
by significant activities; are not consistent with the experience of 
staff, the organization's strategic goals and objectives, or the 
financial strength of the institution; or do not clearly delineate 
accountability or lines of authority. Also, the policies may not 
provide for adequate due-diligence before engaging in new activities or 
products.

Risk Monitoring and MIS

Strong Assessment. An assessment of Strong indicates that risk 
monitoring practices and MIS reports address all material risks. The 
key assumptions, data sources, and procedures used in measuring and 
monitoring risk are

[[Page 44002]]

appropriate, adequately documented, and tested for reliability on an 
ongoing basis. Reports and other forms of communication are consistent 
with activities, are structured to monitor exposures and compliance 
with established limits, goals, or objectives, and compare actual 
versus expected performance when appropriate. Management and board 
reports are accurate and timely and contain sufficient information to 
identify adverse trends and to adequately evaluate the level of risk 
faced by the institution.
Acceptable Assessment. An assessment of Acceptable indicates that risk 
monitoring practices and MIS reports cover major risks and business 
areas. In general, the reports contain valid assumptions that are 
periodically tested for accuracy and reliability and are properly 
documented and distributed to the appropriate decision-makers. Reports 
and other forms of communication generally are consistent with 
activities, are structured to monitor exposures and compliance with 
established limits, goals, or objectives, and compare actual versus 
expected performance when appropriate. Management and board reports are 
accurate and timely, although they may be lacking in some modest 
degree. Any weaknesses or deficiencies that have been identified are in 
the process of being addressed.
Weak Assessment. An assessment of Weak signifies that deficiencies 
exist in the risk monitoring practices or the MIS reports that require 
more than normal supervisory attention. The deficiencies may involve a 
broad range of activities or be material to a major business line or 
activity. Board and senior management may not be adequately informed as 
to the type and severity of the deficiencies or have not demonstrated 
an ability to provide corrective action in a timely manner. The 
deficiencies contribute to ineffective risk identification through 
inappropriate assumptions, incorrect data, poor documentation, or the 
lack of timely testing. In addition, MIS reports may not be distributed 
to the appropriate decision-makers, adequately monitor significant 
risks, or properly identify adverse trends and the level of risk faced 
by the institution.

Internal Controls

Strong Assessment. An assessment of Strong indicates that the system of 
internal controls is appropriate for the type and level of risks posed 
by the nature and scope of the organization's activities. The 
organizational structure establishes clear lines of authority and 
responsibility for monitoring adherence to policies, procedures, and 
limits. Reporting lines provide sufficient independence of the control 
areas from the business lines and adequate separation of duties 
throughout the organization-including areas relating to trading, 
custodial, and back-office activities. The organizational structure 
reflects actual operating practices. Financial, operational, and 
regulatory reports are reliable, accurate, and timely, and wherever 
applicable, exceptions are noted and promptly investigated. Adequate 
procedures exist for ensuring compliance with applicable laws and 
regulations, including consumer laws and regulations. Internal audit or 
other control review practices provide for independence and 
objectivity. Internal controls and information systems are adequately 
tested and reviewed; the coverage, procedures, findings, and responses 
to audits and review tests are adequately documented; identified 
material weaknesses are given appropriate and timely high level 
attention; and management's actions to address material weaknesses are 
objectively reviewed and verified. The board or its audit committee 
regularly reviews the effectiveness of internal audits and other 
control review activities.
Acceptable Assessment. An assessment of Acceptable indicates that the 
system of internal controls adequately covers major risks and business 
areas. In general, the system is independent, establishes appropriate 
separation of duties, supports accuracy in record-keeping practices and 
reporting systems, is adequately documented, and verifies compliance 
with laws and regulations, including consumer laws and regulations. In 
most cases identified material weaknesses are given appropriate and 
timely attention and management's actions to address material 
weaknesses are objectively reviewed and verified. The board or its 
audit committee have reviewed the effectiveness of internal audits and 
other control review activities. Any weaknesses or deficiencies that 
have been identified are modest in nature and in the process of being 
addressed.
Weak Assessment. An assessment of Weak signifies that deficiencies 
exist in the system of internal controls that require more than normal 
supervisory attention. The deficiencies may involve a broad range of 
activities or be material to a major business line or activity. Board 
and senior management may not be adequately informed as to the type and 
severity of the deficiencies or have not demonstrated an ability to 
provide corrective action in a timely manner. The deficiencies may 
include insufficient oversight by the board or its committee; unclear 
lines of authority and responsibility; a lack of independence; 
ineffective separation of duties; inadequate or untimely risk coverage 
and verification, including monitoring compliance with both safety and 
soundness and consumer laws and regulations; inaccurate records or 
regulatory reporting; a lack of documentation for work performed; or a 
lack of timeliness in the correction of identified weaknesses.

``F'' (Financial Condition) Component and CAEL Subcomponents

The F (Financial Condition) rating is supported by four subcomponents: 
``C''(Capital), ``A'' (Asset Quality), ``E'' (Earnings) and ``L'' 
(Liquidity). The F component and the CAEL subcomponents are rated on a 
five point numerical scale in ascending order of supervisory concern as 
follows:
1 - Strong; 2 - Satisfactory; 3 - Fair; 4 - Marginal; and 5 - 
Unsatisfactory.

The ``F'' (Financial Condition) Component

Rating 1 (Strong). A rating of 1 indicates that the consolidated BHC is 
financially sound in almost every respect; any negative findings are 
basically of a minor nature and can be handled in a routine manner. The 
capital adequacy, asset quality, earnings, and liquidity of the 
consolidated BHC are more than adequate to protect the company from 
external economic and financial disturbances. The company generates 
more than sufficient cash flow to service its debt and fixed 
obligations with no harm to subsidiaries of the organization.
Rating 2 (Satisfactory). A rating of 2 indicates that the consolidated 
BHC is fundamentally financially sound, but may reflect modest 
weaknesses correctable in the normal course of business. The capital 
adequacy, asset quality, earnings and liquidity of the consolidated BHC 
are adequate to protect the company from external economic and 
financial disturbances. The company also generates sufficient cash flow 
to service their obligations; however, areas of weakness could develop 
into areas of greater concern. To the extent minor adjustments are 
handled in the normal course of business, the supervisory response is 
limited.
Rating 3 (Fair). A rating of 3 indicates that the consolidated BHC 
exhibits a combination of weaknesses ranging from fair to moderately 
severe. The company has less than adequate financial strength stemming 
from one or more of the following: modest capital

[[Page 44003]]

deficiencies, poor asset quality, weak earnings, or liquidity problems. 
As a result, the BHC and its subsidiaries are less resistant to adverse 
business conditions. The financial condition of the BHC will likely 
deteriorate if concerted action is not taken to correct areas of 
weakness. The company's cash flow is sufficient to meet immediate 
obligations, but may not remain adequate if action is not taken to 
correct weaknesses. Consequently, the BHC is vulnerable and requires 
more than normal supervision. Overall financial strength and capacity 
are still such as to pose only a remote threat to the viability of the 
company.
Rating 4 (Marginal). A rating of 4 indicates that the consolidated BHC 
has either inadequate capital, an immoderate volume of problem assets, 
very weak earnings, serious liquidity issues, or a combination of 
factors that are less than satisfactory. An additional weakness may be 
that the BHC's cash flow needs are met only by upstreaming imprudent 
dividends and/or fees from subsidiaries. Unless prompt action is taken 
to correct these conditions, they could impair future viability. BHCs 
in this category require close supervisory attention and increased 
financial surveillance.
Rating 5 (Unsatisfactory). A rating of 5 indicates that the volume and 
character of financial weaknesses of the BHC are so critical as to 
require urgent aid from shareholders or other sources to prevent 
insolvency. The imminent inability of such a company to service its 
fixed obligations and/or prevent capital depletion due to severe 
operating losses places its viability in serious doubt. Such companies 
require immediate corrective action and constant supervisory attention.

The ``CAEL'' (Capital, Asset Quality, Earnings, and Liquidity) 
Subcategories

    The CAEL subcategories can be evaluated along business lines, 
product lines, or legal entity lines--depending on which type of review 
is most appropriate for the holding company structure. The weight 
afforded to each subcategory in the overall F rating will depend on the 
severity of the condition of that subcategory and the relative 
importance of that subcategory to the consolidated organization. The 
following is a description of rating definitions for the CAEL 
subcategories.

``C'' Capital Adequacy

Rating 1 (Strong). A rating of 1 indicates that the consolidated BHC 
maintains more than adequate capital to: 1) support the volume and risk 
characteristics of all parent and subsidiary business lines and 
products; 2) provide a sufficient cushion to absorb unanticipated 
losses arising from holding company and subsidiary activities; and, 3) 
support the level and composition of corporate and subsidiary 
borrowing. In addition, a company assigned a rating of 1 has more than 
sufficient capital to provide a base for the growth of risk assets and 
the entry into capital markets as the need arises for the parent 
company and subsidiaries.
Rating 2 (Satisfactory). A rating of 2 indicates that the consolidated 
BHC maintains adequate capital to: 1) support the volume and risk 
characteristics of all parent and subsidiary business lines and 
products; 2) provide a sufficient cushion to absorb unanticipated 
losses arising from holding company and subsidiary activities; and, 3) 
support the level and composition of corporate and subsidiary 
borrowing. In addition, a company assigned a rating of 2 has sufficient 
capital to provide a base for the growth of risk assets and the entry 
into capital markets as the need arises for the parent company and 
subsidiaries.
Rating 3 (Fair). A rating of 3 indicates that the consolidated BHC may 
not maintain sufficient capital to ensure support for one or more of 
the following: 1) the volume and risk characteristics of all parent and 
subsidiary business lines and products; 2) the unanticipated losses 
arising from holding company and subsidiary activities; or, 3) the 
level and composition of corporate and subsidiary borrowing. In 
addition, a company assigned a rating of 3 may not maintain a 
sufficient capital position to provide a base for the growth of risk 
assets and the entry into capital markets as the need arises for the 
parent company and subsidiaries. The capital position of the 
consolidated BHC could quickly become inadequate in the event of 
further asset deterioration or other negative factors and therefore 
requires more than normal supervisory attention.
Rating 4 (Marginal). A rating of 4 indicates that the capital level of 
the consolidated BHC is significantly below the amount needed to ensure 
support for one or more of the following: 1) the volume and risk 
characteristics of all parent and subsidiary business lines and 
products; 2) the unanticipated losses arising from holding company and 
subsidiary activities; and, 3) the level and composition of corporate 
and subsidiary borrowing. In addition, a company assigned a rating of 4 
does not maintain a sufficient capital position to provide a base for 
the growth of risk assets and the entry into capital markets as the 
need arises for the parent company and subsidiaries. If left unchecked, 
the consolidated capital position of the company might evolve into 
weaknesses or conditions that could threaten the viability of the 
institution. The capital position of the consolidated BHC requires 
immediate supervisory attention.
Rating 5 (Unsatisfactory). A rating of 5 indicates that the level of 
capital of the consolidated BHC is critically deficient and in needed 
of immediate corrective action. The consolidated capital position 
threatens the viability of the institution and requires constant 
supervisory attention.

``A'' Asset Quality

Rating 1 (Strong). A rating of 1 indicates that the BHC maintains 
strong asset quality and credit administration practices across all 
parts of the organization. Any identified weaknesses in asset quality 
are minor in nature. Credit risk across the organization for a 1 rated 
company is commensurate with management's abilities and modest in 
relation to credit risk management practices.
Rating 2 (Satisfactory). A rating of 2 indicates that the BHC maintains 
satisfactory asset quality and credit administration practices across 
all parts of the organization. Any identified weaknesses in asset 
quality are correctable in the normal course of business. Credit risk 
across the organization for a 2 rated company is commensurate with 
management's abilities and generally modest in relation to credit risk 
management practices.
Rating 3 (Fair). A rating of 3 indicates that the asset quality or 
credit administration across all or part of the consolidated BHC is 
less than satisfactory. The BHC may be experiencing an increase in 
credit risk exposure that has not been met with an appropriate 
improvement in risk management practices. It may also be facing a 
decrease in the overall quality of assets currently maintained on and 
off balance sheet. BHCs assigned a rating of 3 require more than normal 
supervisory attention.
Rating 4 (Marginal). A rating of 4 indicates that the BHC's asset 
quality or credit administration practices are deficient. The level of 
problem assets and/or unmitigated credit risk subjects the holding 
company to potential losses that, if left unchecked, may threaten its 
viability. BHCs assigned a rating of 4 require immediate supervisory 
attention.
Rating 5 (Unsatisfactory). A rating of 5 indicates that the BHC's asset 
quality or

[[Page 44004]]

credit administration practices are critically deficient and present an 
imminent threat to the institution's viability. BHCs assigned a rating 
of 5 require immediate remedial action and constant supervisory 
attention.

``E'' Earnings

Rating 1 (Strong). A rating of 1 indicates that the quantity and 
quality of the BHC's consolidated earnings are more than sufficient to 
make full provision for the absorption of losses and accretion of 
capital when due consideration is given to asset quality and BHC 
growth. Generally, BHCs with a 1 rating have earnings well above peer-
group averages.
Rating 2 (Satisfactory). A rating of 2 indicates that the quantity and 
quality of the BHC's consolidated earnings are generally adequate to 
make provision for the absorption of losses and accretion of capital 
when due consideration is given to asset quality and BHC growth. BHCs 
with a 2 earnings rating have earnings that are in line with or 
slightly above peer-group averages.
Rating 3 (Fair). A rating of 3 indicates that the BHC's consolidated 
earnings are not fully adequate to make provisions for the absorption 
of losses and the accretion of capital in relation to company growth. 
The consolidated earnings of companies rated 3 may be further clouded 
by static or inconsistent earnings trends, chronically insufficient 
earnings, or less than satisfactory asset quality. BHCs with a 3 rating 
for earnings generally have earnings below peer-group averages. Such 
BHCs require more than normal supervisory attention.
Rating 4 (Marginal). A rating of 4 indicates that the BHC's earnings, 
while generally positive, are clearly not sufficient to make full 
provision for losses and the necessary accretion of capital. BHCs with 
earnings rated 4 may be characterized by erratic fluctuations in net 
income, poor earnings (and the likelihood of the development of a 
further downward trend), intermittent losses, chronically depressed 
earnings, or a substantial drop from the previous year. The earnings of 
such companies are ordinarily substantially below peer-group averages. 
Such BHCs require immediate supervisory attention.
Rating 5 (Unsatisfactory). A rating of 5 indicates that the BHC is 
experiencing losses or reflecting a level of earnings that is worse 
than that described for the 4 rating. Such losses, if not reversed, 
represent a distinct threat to the BHC's solvency through erosion of 
capital. Such BHCs require immediate and constant supervisory 
attention.

``L'' Liquidity

Rating 1 (Strong). A rating of 1 indicates that the BHC maintains 
strong liquidity levels and well developed funds management practices. 
The parent company and subsidiaries have reliable access to sufficient 
sources of funds on favorable terms to meet present and anticipated 
liquidity needs.
Rating 2 (Satisfactory). A rating of 2 indicates that the BHC maintains 
satisfactory liquidity levels and funds management practices. The 
parent company and subsidiaries have access to sufficient sources of 
funds on acceptable terms to meet present and anticipated liquidity 
needs. Modest weaknesses in funds management practices may be evident, 
but those weaknesses are correctable in the normal course of business.
Rating 3 (Fair). A rating of 3 indicates that the BHC's liquidity 
levels or funds management practices are in need of improvement. BHCs 
rated 3 may lack ready access to funds on reasonable terms or may 
evidence significant weaknesses in funds management practices at the 
parent company and/or subsidiary levels. However, these deficiencies 
are considered correctable in the normal course of business. Such BHCs 
require more than normal supervisory attention.
Rating 4 (Marginal). A rating of 4 indicates that the BHC's liquidity 
levels or funds management practices are deficient. Institutions rated 
4 may not have or be able to obtain a sufficient volume of funds on 
reasonable terms to meet liquidity needs at the parent company and/or 
subsidiary levels and require immediate supervisory attention.
Rating 5 (Unsatisfactory). A rating of 5 indicates that the BHC's 
liquidity levels or funds management practices are critically deficient 
and may threaten the continued viability of the institution. 
Institutions rated 5 require immediate external financial assistance to 
meet maturing obligations or other liquidity needs and constant 
supervisory attention.

``I'' (Impact) Component

The I component rating reflects the aggregate impact of the parent 
company and nonbank subsidiaries on the subsidiary depository 
institution(s).
The I component is rated on a five point numerical scale. Ratings will 
be assigned in ascending order of supervisory concern as follows:
    1 - low likelihood of significant negative impact;
    2 - limited likelihood of significant negative impact;
    3 - moderate likelihood of significant negative impact;
    4 - considerable likelihood of significant negative impact; and
    5 - high likelihood of significant negative impact.
Rating 1 (Low Likelihood of Significant Negative Impact). A rating of 1 
indicates that the aggregate impact of the parent company and nonbank 
subsidiaries of the BHC on the subsidiary depository institution(s) is 
positive due to factors that include the: 1) sound financial condition 
of the parent company and nondepository subsidiaries, and 2) strong 
risk management practices within the parent company and nondepository 
subsidiaries. A 1 rated BHC maintains an appropriate capital position 
across all legal entities in line with the risks undertaken by those 
entities. Intra-group exposures, including servicing agreements and 
derivative and payment system exposures of a 1 rated BHC do not have 
the potential to undermine the financial condition of the subsidiary 
depository institution(s). Parent company cash flow is not dependent on 
excessive dividend payments from subsidiaries which can potentially 
undermine the financial condition of the subsidiary depository 
institution(s). The potential risks posed to the subsidiary depository 
institution(s) by plans for growth, a poor control environment, and/or 
complaints and litigation within or facing the parent company or 
nondepository subsidiaries can be corrected in a routine manner.
Rating 2 (Limited Likelihood of Significant Negative Impact). A rating 
of 2 indicates that the aggregate impact of the parent company and 
nonbank subsidiaries of the BHC on the subsidiary depository 
institution(s) is neutral due to factors that include the: 1) adequate 
financial condition of the parent company and nondepository 
subsidiaries, and 2) satisfactory risk management practices within the 
parent company and nondepository subsidiaries. A 2 rated BHC maintains 
an adequate capital position across all legal entities in line with the 
risks undertaken by those entities. Intra-group exposures, including 
servicing agreements and derivative and payment system exposures, of a 
2 rated BHC generally do not have the potential to undermine the 
financial condition of the subsidiary depository institution(s). Parent 
company cash flow generally is not dependent on excessive dividend 
payments from subsidiaries which can potentially undermine the 
financial condition of the subsidiary depository institution(s). The 
potential risks posed to the subsidiary depository institution(s) by 
strategic growth plans

[[Page 44005]]

or a poor control environment within the parent company or 
nondepository subsidiaries are minor in nature and can be corrected in 
the normal course of business.
Rating 3 (Moderate Likelihood of Significant Negative Impact). A rating 
of 3 indicates that the aggregate impact of the parent company and 
nonbank subsidiaries of the BHC on the subsidiary depository 
institution(s) is potentially negative due to weaknesses in the 
financial condition and/or risk management practices of the parent 
company and nondepository subsidiaries. A 3 rated BHC may have only 
marginally sufficient capital within the parent company and/or 
nondepository subsidiary(ies) to support its activities. Intra-group 
exposures, including servicing agreements and derivative and payment 
system exposures, of a 3 rated BHC may have the potential to undermine 
the financial condition of the subsidiary depository institution(s). 
Parent company cash flow may be partially dependent on excessive 
dividend payments from subsidiaries, potentially undermining the 
financial condition of the subsidiary depository institution(s). The 
potential risks posed to the subsidiary depository institution(s) by 
strategic growth plans or a poor control environment within the parent 
company or nondepository subsidiaries may be significant. A BHC 
assigned a 3 impact rating requires more than normal supervisory 
attention.
Rating 4 (Considerable Likelihood of Significant Negative Impact). A 
rating of 4 indicates that the aggregate impact of the parent company 
and nonbank subsidiaries of the BHC on the subsidiary depository 
institution(s) is negative due to weaknesses in the financial condition 
and/or risk management practices of the parent company and 
nondepository subsidiaries. A 4 rated BHC may have insufficient capital 
within the parent company and/or nondepository subsidiary(ies) to 
support its activities. Intra-group exposures, including servicing 
agreements and derivative and payment system exposures, of a 4 rated 
BHC may also have the potential to undermine the financial condition of 
the subsidiary depository institution(s). Parent company cash flow may 
be dependent on excessive dividend payments from subsidiaries, 
potentially undermining the financial condition of the subsidiary 
depository institution(s). The potential risks posed to the subsidiary 
depository institution(s) by strategic growth plans or a poor control 
environment within the parent company or nondepository subsidiaries may 
also be significant. A BHC assigned a 4 impact rating requires 
immediate remedial action and close supervisory attention.
Rating 5 (High Likelihood of Significant Negative Impact). A rating of 
5 indicates that the aggregate impact of the parent company and nonbank 
subsidiaries of the BHC on the subsidiary depository institution(s) is 
extremely negative due to significant weaknesses in the financial 
condition and/or risk management practices of the parent company or 
nondepository subsidiaries. Critical deficiencies in the parent company 
or nondepository subsidiaries pose an immediate threat to the viability 
of the subsidiary depository institution(s). The parent company also 
may be unable to meet its obligations without support from the 
subsidiary depository institution(s). The BHC requires immediate 
remedial action and constant supervisory attention.

``C'' (Composite) Component

C is the overall composite assessment of the BHC as reflected by 
consolidated risk management, consolidated financial strength, and the 
impact of the parent company and nonbank subsidiaries on the depository 
institutions. The composite rating encompasses both a forward-looking 
and static assessment of the consolidated organization, as well as an 
assessment of issues related to the parent company and nonbank 
subsidiaries acting as a source of strength to the depository 
institutions. The C rating is not derived as a simple numeric average 
of the rating system components; rather, it reflects examiner judgement 
with respect to the relative importance of each component to the safe 
and sound operation of the BHC.
Rating 1 (Strong). BHCs in this group are sound in almost every 
respect; any negative findings are basically of a minor nature and can 
be handled in a routine manner. Risk management practices and financial 
stability provide resistance to external economic and monetary 
disturbances. The parent company and nondepository subsidiaries are a 
source of financial strength to the depository institutions.
Rating 2 (Satisfactory). BHCs in this group are also fundamentally 
sound but may have modest weaknesses in risk management practices or 
financial stability. The weaknesses could develop into conditions of 
greater concern but are believed correctable in the normal course of 
business. As such, the supervisory response is limited. The parent 
company and nondepository subsidiaries are not a source of financial 
weakness to the depository institutions.
Rating 3 (Fair). BHCs in this group exhibit a combination of weaknesses 
in risk management practices and financial stability that range from 
fair to moderately severe. These companies are less resistant to the 
onset of adverse business conditions and could likely deteriorate if 
concerted action is not effective in correcting the areas of weakness. 
Consequently, these companies are vulnerable and require more than 
normal supervisory attention and financial surveillance. However, the 
strength and financial capacity of the company, including the ability 
of the parent company and nondepository subsidiaries to provide 
financial support, if necessary, pose only a remote threat to its 
continued viability.
Rating 4 (Marginal). BHCs in this group have an immoderate volume of 
risk management and financial weaknesses. The parent company and 
nonbank subsidiaries' combined ability to provide financial support to 
the depository institutions has been limited by these weaknesses. 
Unless prompt action is taken to correct these conditions, the 
organization's future viability could be impaired. These companies 
require close supervisory attention and increased financial 
surveillance.
Rating 5 (Unsatisfactory). The critical volume and character of the 
risk management and financial weaknesses of BHCs in this category, and 
concerns about the parent company and nondepository subsidiaries acting 
as a source of weaknesses to the subsidiary depository institution(s), 
could lead to insolvency without urgent aid from shareholders or other 
sources. The imminent inability to prevent liquidity and/or capital 
depletion places the BHC's continued viability in serious doubt. These 
companies require immediate corrective action and constant supervisory 
attention.

(D) (Depository Institutions) Component

    The (D) component is intended to identify the overall condition of 
the subsidiary depository institution or the combined condition of the 
depository subsidiaries. For BHCs with only one depository institution, 
the (D) component rating will mirror the CAMELS composite rating for 
that depository institution. To arrive at a (D) component rating for 
BHCs with multi-bank subsidiaries, the CAMELS composite ratings for 
each of the depository institutions should be weighted, giving 
consideration to asset size and the relative importance of each 
depository institution within the overall structure of the 
organization. In general, it is expected that the resulting (D) 
component rating will reflect the lead

[[Page 44006]]

depository institution's CAMELS composite rating.
    If in the process of analyzing the financial condition and risk 
management programs of the consolidated organization, a major 
difference of opinion relative to the safety and soundness of the 
depository institution emerges between the Federal Reserve and the 
depository institution's primary regulator, then the (D) rating should 
reflect the Federal Reserve's evaluation.

III. Implementation of Revised Rating System by Bank Holding Company 
Type

    The proposal to change the BHC rating system was driven by the need 
to align the rating system with current Federal Reserve supervisory 
practices. The new rating system will require analysis and support 
similar to that required by current supervisory policy for institutions 
of all sizes.\7\ As such, the level of analysis and support will vary 
based upon whether a BHC has been determined to be ``complex'' or 
``noncomplex.''\8\ In addition, the resources dedicated to the 
inspection of each BHC will continue to be determined by the risk posed 
by the subsidiary depository institution(s) to the federal safety 
net\9\ and the risk posed by the BHC to the subsidiary depository 
institution(s).
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    \7\ Including the BHC inspection manual, SR 95-51, SR 97-24, SR 
97-25, SR 99-15, and SR 02-01.
    \8\ The determination of whether a holding company is 
``complex'' versus ``noncomplex'' is made at least annually on a 
case-by-case basis taking into account and weighing a number of 
considerations, such as: the size and structure of the holding 
company; the extent of intercompany transactions between depository 
institution subsidiaries and the holding company or nondepository 
subsidiaries of the holding company; the nature and scale of any 
nondepository activities, including whether the activities are 
subject to review by another regulator and the extent to which the 
holding company is conducting Gramm-Leach-Bliley authorized 
activities (e.g., insurance, securities, merchant banking); whether 
risk management processes for the holding company are consolidated; 
and whether the holding company has material debt outstanding to the 
public. Size is less important determinant of complexity than many 
of the factors noted above, but generally companies of significant 
size (e.g., assets of $10 billion on balance sheet or managed) would 
be considered complex, irrespective of the other considerations.
    \9\ The federal safety net is defined as the deposit insurance 
fund, the payments system, and the Federal Reserve's discount 
window.
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Noncomplex BHCs with Assets of $1 Billion or Less (Shell Holding 
Companies)

New Rating: R and C
    Consistent with SR 02-1, examination staff will be required only to 
assign an R and C rating for all companies in the shell BHC program 
(noncomplex BHCs with assets under $1 billion). The R rating is the M 
rating from the subsidiary depository institution's CAMELS rating. The 
rating will be changed from the current M to an R to provide consistent 
terminology. The C rating is the subsidiary depository institution's 
composite CAMELS rating.

Noncomplex BHCs with Assets Greater than $1 Billion

One-Bank Holding Company
New Rating: RFI/C (D)
    For all noncomplex, one-bank holding companies with assets of 
greater than $1 billion, examination staff will assign all component 
and subcomponent ratings in the new rating system; however, examination 
staff should continue to rely heavily on information and analysis 
contained in the report of examination for the subsidiary depository 
institution to assign the R and F ratings. If examination staff have 
reviewed the primary regulator's examination report and are comfortable 
with the analysis and conclusions contained in that report, then the 
BHC ratings should be supported with concise language that indicates 
that the conclusions are based on the analysis of the primary 
regulator. No additional analysis will be required.
    Please note, however, in cases where the analysis and conclusions 
of the primary regulator are insufficient to assign the new ratings, 
the primary regulator should be contacted to ascertain whether 
additional analysis and support may be available. Further, if 
discussions with the primary regulator do not provide sufficient 
information to assign the ratings, discussions with BHC management may 
be warranted to obtain adequate information to assign the ratings. In 
most cases, additional information or support obtained through these 
steps will be sufficient to permit the assignment of the R and F 
ratings. To the extent that additional analysis is deemed necessary, 
the level of analysis and resources spent on this assessment should be 
in line with the level of risk the subsidiary depository institution 
poses to the federal safety net. In addition, any activities that 
involve information gathering with respect to the subsidiary depository 
institution should be coordinated with and, if possible, conducted by, 
the primary regulator of that institution.
    Examination staff will be required to make an independent 
assessment in order to assign the I rating, which provides an 
evaluation of the impact of the BHC on the subsidiary depository 
institution. Analysis for the I rating in non-complex one-bank holding 
companies should place particular emphasis on issues related to parent 
company cash flow and compliance with 23A.
Multi-Bank Holding Company
New Rating: RFI/C (D)
    For all noncomplex BHCs with assets of greater than $1 billion and 
having more than one subsidiary depository institution, examination 
staff will assign all component and subcomponent ratings of the new 
system, also relying, to the extent possible, on the work conducted by 
the primary bank regulators to assign the R and F ratings. However, any 
risk management or other important functions conducted by the parent 
company or any nondepository subsidiary of the BHC, or conducted across 
legal entity lines, should be subject to review by Federal Reserve 
examination staff. These reviews should be conducted in coordination 
with the primary regulator(s). The assessment for the I rating will 
require an independent assessment by Federal Reserve examination staff.

Complex BHCs

New Rating: RFI/C (D)
    For complex BHCs, examination staff will assign all component and 
subcomponent ratings of the new rating system. The ratings analysis 
should be based on the primary regulator's assessment of the subsidiary 
depository institution(s), as well as on the examiners' assessment of 
the consolidated organization as determined through the BHC inspection 
process. The resources needed for the inspection and the level of 
support needed for developing a full rating will depend upon the 
complexity of the organization, including structure and activities (see 
footnote 7), and should be commensurate with the level of risk posed by 
the subsidiary depository institution(s) to the federal safety net and 
the level of risk posed by the BHC to the subsidiary depository 
institution(s).

Nontraditional BHCs

New Rating: RFI/C (D)
    Examination staff will be required to assign the full rating system 
for nontraditional BHCs. Nontraditional BHCs include BHCs in which most 
or all nondepository operations are regulated by a functional regulator 
and in which the subsidiary depository institution(s) is small in 
relation to the nondepository operations. The new rating system is not 
intended to introduce significant additional work in the rating process 
for these organizations. As discussed above, the

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level of analysis conducted and resources needed to inspect the BHC and 
to assign the consolidated R and F ratings should be commensurate with 
the level of risk posed by the subsidiary depository institution(s) to 
the federal safety net and the level of risk posed by the BHC to the 
subsidiary depository institution(s). The report of examination by, and 
other information obtained from, the functional and primary bank 
regulators should provide the basis for the consolidated R and F 
ratings. On-site work, to the extent it involves areas that are the 
primary responsibility of the functional or primary bank regulator, 
should be coordinated with and, if possible, conducted by, those 
regulators. Examination staff should concentrate their independent 
analysis for the R and F ratings around activities and risk management 
conducted by the parent company and non-functionally regulated 
nondepository subsidiaries, as well as around activities and risk 
management functions that are related to the subsidiary depository 
institution(s), for example, audit functions for the depository 
institution(s) and compliance with 23A.
    Examination staff will be required to make an independent 
assessment of the impact of the parent company and nondepository 
subsidiary(ies) on the subsidiary depository institution(s) in order to 
assign the I rating.
    By order of the Board of Governors of the Federal Reserve System, 
July 20, 2004.

Jennifer J. Johnson
Secretary of the Board.
[FR Doc. 04-16865 Filed 7-22-04; 8:45 am]
BILLING CODE 6210-01-S