Decision and Order on Appeal Supervisory Review Committee

UNITED STATES OF AMERICA

BEFORE THE NATIONAL CREDIT UNION ADMINISTRATION

In the Matter of

XXXX

Appeal of Supervisory Review Committee Determination

Docket No. BD-02-21

Decision and Order on Appeal

Decision

This matter comes before the National Credit Union Administration Board (Board) under 12 C.F.R. Part 746, Subpart A. The appeal concerns the determination by the Supervisory Review Committee (SRC) to affirm the determination by the Regional Director for the XXXX Region (Region) assigning XXXX (Petitioner) a composite CAMEL 3 rating.

Background

Petitioner, a federal credit union located in XXXX, XXXX with assets of approximately XXXX, is appealing the SRC’s decision to affirm the Region’s determination to assign Petitioner a composite CAMEL 3 rating, effective December 31, 2019.¹

After completing an examination², the Region authorized the release of Petitioner’s examination report to the credit union on June 25, 2020 and regional staff met with the credit union board and officials regarding the report on July 14, 2020. On August 13, 2020, Petitioner made a request for reconsideration of its composite CAMEL 3 rating, and the Region affirmed the rating upon reconsideration on September 11, 2020. Petitioner appealed the Region’s determination to the SRC on October 8, 2020, and an oral hearing before the SRC was held on February 2, 2021. Following a review of the record and hearing oral presentations, on March 2, 2021, the SRC issued a decision affirming the Region’s assignment of a composite CAMEL 3 rating. Petitioner is seeking administrative review of that determination by the Board. In connection with its appeal, Petitioner requested approval to present its case orally before the Board. The Board granted this request on April 20, 2021 and an oral hearing was held on June 10, 2021.

Legal Standards

The issue before the Board in this appeal is whether Petitioner’s composite CAMEL 3 rating,³ as assigned by the Region and reviewed and confirmed by the SRC, is appropriate, well-reasoned, and supportable.

Administrative review. Subpart A of Part 746, issued pursuant to Section 309 of the Riegle Community Development and Regulatory Improvement Act of 1994,⁴ establishes an expeditious review process for insured credit unions to appeal material supervisory determinations made by NCUA staff to the SRC, an independent supervisory panel.⁵ The term “material supervisory determination” means a written decision by a program office (unless ineligible for appeal) that may significantly affect the capital, earnings, operating flexibility, or that may otherwise affect the nature or level of supervisory oversight of an insured credit union. The term includes, but is not limited to, a “composite examination rating of 3” or worse.⁶ An adverse decision by the SRC may in turn be appealed, in writing, to the Board within 30 calendar days after receiving that decision.⁷

Upon appeal, the Board will conduct a de novo⁸ review of the administrative record⁹ and, where an oral hearing is granted, take both parties’ oral presentations under advisement. The Board will then make an independent decision regarding whether the material supervisory determination by the Region was appropriate, giving no deference to the legal or factual conclusions of the Region or the SRC.¹⁰ However, the burden of showing an error in a material supervisory determination rests solely with the insured credit union.¹¹

The objective of the de novo standard of review is to ensure that the appealed determination is correct and not merely reasonable.¹² Thus, if the Board determines the appealed determination is incorrect upon its independent review, then it may substitute its own judgment and render a corrected determination.¹³

Composite CAMEL rating. The CAMEL rating system is based upon an evaluation of five critical elements of a credit union's operations: Capital Adequacy, Asset Quality, Management, Earnings, and Liquidity/Asset-Liability Management. The system is designed to take into account and reflect all significant financial, operational, and management factors examiners assess in their evaluation of a credit union's performance and risk profile.¹⁴ The evaluation factors for component and composite CAMEL ratings are set forth in the NCUA’s Letter to Credit Unions 07-CU-12, December 2007 (LCU 07-CU-12).

As described in LCU 07-CU-12, the following characteristics apply with respect to a composite CAMEL 3 credit union:

Credit unions in this group exhibit some degree of supervisory concern in one or more of the component areas. These credit unions exhibit a combination of weaknesses that may range from moderate to severe; however, the magnitude of the deficiencies generally will not cause a component to be rated more severely than 4. Management may lack the ability or willingness to effectively address weaknesses within appropriate time frames. Credit unions in this group generally are less capable of withstanding business fluctuations and are more vulnerable to outside influences than those rated a composite 1 or 2. Additionally, these credit unions may be in significant noncompliance with laws and regulations. Risk management practices may be less than satisfactory relative to the credit union’s size, complexity, and risk profile. These credit unions require more than normal supervision which may include enforcement actions. Failure appears unlikely, however, given overall strength and financial capacity of these credit unions.

By comparison, the following characteristics apply with respect to a composite CAMEL 2 credit union, as described in LCU 07-CU-12:

Credit unions in this group are fundamentally sound. For a credit union to receive this rating, generally no component rating should be more severe than a 3. Only moderate weaknesses are present and are well within the board of directors’ and management’s capabilities and willingness to correct. These credit unions are stable and are capable of withstanding business fluctuations. These credit unions are in substantial compliance with laws and regulations. Overall risk management practices are satisfactory relative to the credit union’s size, complexity, and risk profile. There are no material supervisory concerns and, as a result, the supervisory response is informal and limited.

Normally, a credit union’s overall CAMEL composite rating bears a close relationship to the component ratings, but the composite rating is not simply a mathematical average of the component ratings.¹⁵ When analyzing a credit union's performance, examiners utilize a risk-focused approach and are expected to use their professional judgment and consider both quantitative and qualitative factors. Quantitative factors are often lagging indicators of a credit union's condition; thus, examiners must also conduct a qualitative analysis of current and projected operations when assigning CAMEL ratings.¹⁶ Such qualitative analysis includes an assessment of the credit union’s risk management program and the amount and direction of risk exposure in seven risk categories: Credit, Interest Rate, Liquidity, Transaction, Compliance, Reputation, and Strategic.

Region’s Determination

On August 13, 2020, the Region received a request for reconsideration from Petitioner, challenging its composite CAMEL 3 rating and requesting a composite CAMEL 2 rating. After conducting a review of Petitioner’s examination report and the contents of its request for reconsideration, the Region determined, by letter of September 11, 2020, that the assigned composite CAMEL 3 rating was warranted and supported by agency guidance.

The Region’s reconsideration determination noted:

[Y]our risk management practices are less than satisfactory as noted in the exam report’s Document of Resolution and Examiner’s Findings. Your XXXX during the period examined are key performance indicators warranting supervision. The credit union’s overall strength and financial capacity makes failure only a remote possibility, but we have determined your credit union warrants more than normal supervision. CAMEL ratings can be somewhat subjective, but the exam report supports the composite CAMEL 3 rating based on the guidance set forth in NCUA’s Letter to Credit Unions 07-CU-12.

Further, the Region cited weaknesses in the Capital Adequacy, Asset Quality, and Management components identified during the examination as supporting the composite CAMEL 3 rating, as documented in Petitioner’s examination report and summarized as follows:

• Capital Adequacy – A rating of 3 is appropriate given Petitioner’s XXXX.
• Asset Quality – A rating of 3 is appropriate given the aforementioned concentration in XXXX, and concerns with lending policies and controls identified during the exam. Credit risk was also assessed as high for similar reasons.
• Management – A rating of 3 is supportable given the nature of the Document of Resolution (DOR) and Examiner’s Findings, as well as the inadequate response to previous exam concerns.

However, upon its review, the Region found that staff had mistakenly excluded from the examination report closing language that had been approved for release. Noting that the reconsideration determination should be considered an addendum to the examination report, the Region’s September 11 letter indicated that the final paragraph in the Examination Overview that discussed Petitioner’s composite CAMEL 3 rating should have read:

The Composite CAMEL rating is 3. [Petitioner] continues to generate supervisory concern. The overall risk profile is moderate to high. Management oversight and performance need improvement. Risk management practices are less than satisfactory relative to the size, complexity, and risk profile.

Instead, in the unauthorized version of the examination report that was erroneously issued to the credit union, the final paragraph in the Examination Overview that discussed Petitioner’s composite CAMEL 3 rating read as follows:

The Composite CAMEL rating is based on our assessment that you are fundamentally sound. For a credit union to receive this rating, generally no component rating should be more severe than a 3. Only moderate weaknesses are present and are well within the board of directors’ and management’s capabilities and willingness to correct.

While this rating results in an upgrade, as you do not pose material concerns, we have retained a management rating of “3.” This rating indicates some degree of supervisory concern. You will not qualify for an extended exam program and will remain on a 12-month examination supervision schedule.

SRC Decision

By letter of October 8, 2020, Petitioner filed a notice of appeal¹⁷ to the SRC challenging its composite CAMEL 3 rating and requesting a composite CAMEL 2 rating.¹⁸

The SRC conducted an independent review of the documents submitted by Petitioner¹⁹ and the Region²⁰ and considered the oral arguments made by both parties at an oral hearing held on February 2, 2021. As a result of its review, the SRC issued a decision, by letter of March 2, 2021, affirming the Region’s determination.

The SRC concluded that a composite CAMEL 3 rating “best characterizes the Petitioner’s status as of the December 31, 2019 exam effective date.” In support of its decision, the SRC cited a number of factors to support the reasonableness of the Region’s rating. Those factors are summarized as follows:

• CAMEL 2 credit unions are “stable and capable of withstanding business fluctuations.” CAMEL 3 credit unions are “less capable of withstanding business fluctuations and are more vulnerable to outside influences.” Capital levels are one of the key elements of a credit union’s ability to withstand fluctuations. XXXX
• Earnings support capital accumulation. Earnings are not stable and are in fact underwhelming and lag behind industry standards. XXXX
• Operating expense levels are a key indicator of a credit union’s ability to withstand business fluctuations. At the exam date, operating expenses were XXXX percent of average assets. XXXX Given the time and other considerations needed to reduce operating expenses in a down economy, the expense levels of Petitioner are not indicative of a credit union capable of withstanding business fluctuations.

• Another distinguishing characteristic of CAMEL 2 credit unions is “overall risk management practices are satisfactory relative to the credit union’s size, complexity, and risk profile. A CAMEL 3 credit union is characterized by “risk management practices that may be less than satisfactory relative to the credit union’s size, complexity, and risk profile.”
  
  Petitioner’s examination report included 5 DOR items and 25 Examiner’s Findings. Three of the Examiner’s Findings were characterized as repeat items. The inclusion of 30 combined DOR and Examiner’s Findings are not indicative of satisfactory risk management practices.

• Petitioner’s appeal cites improving trends in delinquency and net charge off levels. Economic conditions were stable and improving during this period across the country. One would expect improvements in delinquency and loan loss levels during this time period. Petitioner’s improvements are reflective of improving trends across the entire credit union industry. NCUA cautions examiners that delinquency and net charge off ratios are often lagging indicators.
  
  Petitioner indicates that FICO scores averaged XXXX at June 2019, which implies a higher potential for loss in the portfolio. The SRC requested information regarding the credit union’s credit scores at the time of the exam. At the hearing, we also inquired about Petitioner’s practices with respect to monitoring migration across credit tiers. Credit risk management practices appear to focus on static analysis of credit risk characteristics at origination date. Analysis of performance would seem to be annual. Given the nature of Petitioner’s portfolio, the SRC finds the lack of credit risk migration concerning and not indicative of sound risk management practices.

• A CAMEL Composite 2 rating reflects a credit union with “no material supervisory concerns.” A CAMEL composite 3 rating reflects a credit union unlikely to fail, but “requires more than normal supervision.” Petitioner exhibits a number of characteristics that do require more than normal supervision. The preceding bullet points are all issues that individually warrant increased supervision. Collectively, they represent a clear and compelling reason for increased supervision.

Examination protocol. The SRC noted in its decision that a “significant part of the credit union’s appeal rests on its claim that the Supervisor Examiner (SE) and District Examiner (DE) verbally informed the credit union that they believed the credit union was a CAMEL composite 2.” Petitioner provided written documentation and audio recordings to substantiate those assertions and to support its argument that the Region’s composite CAMEL 3 rating was assigned in error. Upon review, however, while the SRC determined that “a number of unique circumstances²¹ [may] have led to some false expectations” on the part of the credit union, ultimately, those “irregularities [were] not dispositive of our decision as to the appropriateness of Petitioner’s composite CAMEL 3 rating. Irrespective of how or why examination policies were not followed in this specific instance . . . the record supports the SRC’s finding that a composite CAMEL rating of 3 was appropriate.”

Board Appeal

By letter dated March 30, 2021,²² Petitioner filed a timely notice of appeal²³ to the Board, challenging its composite CAMEL 3 rating as assigned by the Region and affirmed by the SRC. Petitioner subsequently supplemented its initial notice of appeal by letter dated April 14, 2021. Petitioner and the Region also provided oral presentations before the Board on June 10, 2021.

On appeal, Petitioner argues it should have received a composite CAMEL 2 rating, rather than the composite CAMEL 3 rating that was assigned to it by the Region and affirmed by the SRC. Central to Petitioner’s argument for error is its contention that on multiple occasions, the Region’s examination staff failed to follow the agency’s examination procedures and verbally represented to the credit union that it would receive a composite CAMEL 2 rating. Further, Petitioner argues that after issuing the examination report (which Petitioner alleges was drafted in support of and with a conclusion of a composite CAMEL 2 rating but subsequently “redlined” only to reflect a composite CAMEL 3 rating), the Region’s field examiners continued to hold that a composite CAMEL 2 rating was accurate.²⁴ Petitioner asserts that the issuance of an identical examination report, except for a revision from a “2 to 3,” is insufficient to provide substantial evidence to support a rational and reasoned conclusion for Petitioner’s composite CAMEL 3 rating, and “reveal an arbitrary and capricious outcome,” in violation of the Administrative Procedure Act (APA).

Petitioner further contends that the Region’s field examiners followed NCUA’s published examination procedure by including their first-hand observations and on-site assessments of the credit union into a draft examination report that concluded a composite CAMEL 2 rating was appropriate, but that same draft examination report was subsequently altered after field staff was “overruled,” to reflect the final composite CAMEL 3 rating that was issued to the credit union. Petitioner argues that “the same set of facts resulting in two different and inconsistent conclusions is by definition arbitrary and capricious and fundamentally lacks a rational and reasoned connection to the evidence.” Accordingly, Petitioner contends the Region’s assignment of a composite CAMEL 3 rating is “barred” by the APA and Petitioner should instead be assigned a composite CAMEL 2 rating.

XXXX Petitioner contends the Region assessed the credit union as having a higher risk rating “based solely on the weighted FICO scores vs actual performance of the portfolio” XXXX. Petitioner argues that the Region’s assessment of its portfolio “strictly on FICO score is discriminatory and inappropriate,” and puts the mission of CDFI credit unions at risk. Therefore, Petitioner argues the Board should exercise its authority under §746.104(a) of the SRC appeal rule and substitute its own judgment for that of the Region by way of assigning Petitioner a composite CAMEL 2 rating.

The Region maintains that a CAMEL composite 3 rating was appropriately assigned to Petitioner during the 2019 examination. From the Region’s perspective, Petitioner’s CAMEL composite 3 rating is supported by LCU 07-CU-12, and the supervision concerns noted in the exam report. While acknowledging that effective communication did not occur with respect to different aspects of the examination, the Region contends any mistakes made do not in and of themselves justify change to the CAMEL rating.

The Region notes risk-focused examinations were introduced in 2002, focusing examiner resources on risk, using a forward-looking perspective rather than a comparison of performance against benchmarks. Examiners look beyond current financial conditions and evaluate management’s ability to recognize and adapt to changing economic conditions, competitive environments, and risk profiles. Examiners determine the significance of ratios, trends, projections, interrelationships using the seven risk categories (Credit Risk, Interest Rate Risk, Liquidity Risk, Strategic Risk, Compliance Risk, Reputation Risk, and Transaction Risk). In risk-focused exams, the seven risk categories are assessed a level, high, moderate, or low, reflecting the current and prospective risk to the credit union. Material risk identified in a risk category is reflected in the appropriate CAMEL component codes and overall CAMEL code. CAMEL quantifies the impact material risk has on the credit union’s soundness and identifies the level of NCUA supervision required. The CAMEL 3 composite rating generally defines credit unions in this group as exhibiting some degree of supervisory concern in one or more of the component areas.

The Region maintains that Petitioner’s exam report identifies that the credit union’s risk management practices were less than satisfactory. As noted in the exam report, Petitioner received five DOR items and 25 Examiner’s Findings, which cover a wide range of operational areas including consumer compliance and information system security. The Region contends Petitioner’s XXXX during the period examined are key performance indicators warranting supervision. While CAMEL ratings contain a component of subjectivity, the Region asserts the concerns noted in the exam report reasonably support the CAMEL composite 3 rating, based on the guidance set forth in LCU 07-CU-12.

Further, although Petitioner’s individual component CAMEL ratings of 3 in Capital Adequacy, Asset Quality, and Management; and 2 ratings in Earnings and Liquidity/Asset-Liability Management were not appealed by the credit union, the Region notes that its review on reconsideration included an assessment of each of those component ratings. The Region contends the following factors in particular continue to support sustaining the composite CAMEL 3 rating:

• Although well-capitalized, Petitioner’s net worth position was not strong at XXXX percent. XXXX
• Petitioner’s earnings demonstrated instability XXXX evincing a lesser ability to withstand business fluctuations.
• Petitioner had been assigned a composite CAMEL 3 rating at each of its examinations since the exam effective September 30th, 2017. Based on the 2019 examination, there was not enough evidence of sustained improvement to warrant an upgrade, as examiners continued to identify numerous exam concerns. These supervisory concerns in particular pointed to deficient risk management practices, which calls into question the ability of Petitioner to withstand business fluctuations.

Discussion and Analysis

After a de novo review of the administrative record, and taking both parties’ oral presentations under advisement, the Board finds, by a two to one vote, that the Region erred in assigning Petitioner a composite CAMEL 3 rating, effective December 31, 2019.

The Board notes the record in this case reflects several documented errors on the part of the Region, including miscommunications and breaches of NCUA examination procedures. Notably, the credit union was given an exam report containing composite CAMEL 2 language to support a composite CAMEL 3 rating. In addition, the exam report included DORs that did not cite a specific regulation, in violation of agency policy and regulation.²⁵ Accordingly, the Board considers those DORs²⁶ invalid and they are accorded no weight in this appeal.

Looking purely at the numbers, Petitioner’s ratios appear to be better than, or in line with, the average lowest rated composite CAMEL 2 credit unions:

	Net Worth Ratio	Loan-to-Share Ratio	Delinquency Rate	ROAA	Net Charge Off Ratio
2019: Avg 50 lowest “2” by NW	XXXX	XXXX	XXXX	XXXX	XXXX
2019: Petitioner	XXXX	XXXX	XXXX	XXXX	XXXX
2020: Avg 50 lowest “2” by NW	XXXX	XXXX	XXXX	XXXX	XXXX
2020: Petitioner	XXXX	XXXX	XXXX	XXXX	XXXX

In the view of the Board, if Petitioner’s data were shown to the average examiner, it would be reasonable for the examiner to conclude the credit union is a composite CAMEL 2 credit union.

The Board disagrees with the Region’s Asset Quality rating. The solid performance of Petitioner’s loan portfolio infers that the Region’s rating was based on the quality of the borrowers, rather than the quality of the loans. For example, although the borrowers’ average FICO scores were in the low 600s, delinquencies are very low. The Board notes it is much easier to achieve low delinquencies with borrowers with higher (e.g., 750 – 800) FICO scores.

Further, while the Board is not prepared to overturn the Region’s Capital rating, the Board is concerned that the Region failed to articulate to Petitioner why this credit union’s risk profile demands such high capital levels, especially when capital adequacy is defined by the Federal Credit Union Act (FCU Act).²⁷ Petitioner’s net worth position of XXXX percent is considered well capitalized under prompt corrective action.²⁸ The Board notes XXXX Petitioner’s net worth was still stronger than statutorily required by the FCU Act.

Additionally, the Board disagrees with the Region’s Management rating. XXXX Management understands how best to work with the credit union’s members XXXX.

Conclusion

The Board finds nothing in the record to support this credit union is “less capable of withstanding business fluctuations and [is] more vulnerable to outside influences.”²⁹ Based on the Board’s full and independent review on appeal, the Board finds the Petitioner’s composite CAMEL 3 rating is not justified. Instead, a composite CAMEL 2 rating is appropriate.

Order

For the reasons set forth above, it is ORDERED as follows:

The determination by the Supervisory Review Committee to affirm the determination by the Regional Director for the XXXX Region assigning XXXX a composite CAMEL 3 rating is REVERSED and XXXX’s appeal is APPROVED.

The Board assigns XXXX a composite CAMEL 2 rating, effective December 31, 2019.

The Board’s decision constitutes a final agency determination and is subject to judicial review in accordance with Chapter 7 of Title 5 of the United States Code.

So ORDERED this 8^th day of September 2021, by the National Credit Union Administration Board.

/s/

Melane Conyers-Ausbrooks
Secretary of the Board

 

Dissenting Opinion

Chairman Todd M. Harper

The issue before the Board in this appeal is whether the composite CAMEL 3 rating for Petitioner, as determined by the Region and affirmed by the SRC, is appropriate, well-reasoned, and supportable. While the majority of the Board³⁰ has voted to reverse the SRC’s decision to affirm the Region’s rating assignment, I respectfully dissent.

Although the process by which the credit union received its report and rating was inconsistent and flawed,³¹ an inconsistent and flawed process can still produce a reasonable and supportable result. In this instance, the composite CAMEL 3 is appropriate because there is a rational connection between the relevant data and the CAMEL rating, notwithstanding the fact that the words in the examination report indicated an upgraded CAMEL rating.

Specifically, during the exam period, XXXX. And, as noted by the SRC’s decision, Petitioner was in the bottom XXXX compared to its peers in Capital, Earnings, and Expense levels. These are all statistics of supervisory concern.

What is more, there were a high number of DOR and Examiner’s Findings associated with this exam (30 total in all), much higher than would be expected for a CAMEL 2 institution. Additionally, three of these findings were repeat issues. The delay in responding to prior exam issues indicates that management was not addressing issues in a timely basis and this should reflect negatively in the composite CAMEL score. An effective depository institutions regulator needs to be risk-focused and ready to act expeditiously when problems are identified. Here, the Region was effectively responding to the situation.

The Region also found that Petitioner had “high” ratings related to Credit Risk, Transaction Risk, and Compliance Risk. Together, these risks demonstrate that there are greater problems at this institution than one would expect from a composite CAMEL 2 credit union. The issues related to Transaction Risk are especially revealing, as problems with electronic payment systems, bank reconciliations, information security, and supervisory committee all indicate that the credit union has more weaknesses, in addition to those reflected in its numerical performance ratios.

Ultimately, Petitioner demonstrated some degree of supervisory concern in one or more of the component areas that could be characterized as moderate to severe. It was also rated as high risk in three of seven areas. As such, Petitioner’s composite CAMEL 3 rating was appropriate.

Finally, in conducting a de novo review of the administrative record and oral hearing, the Board may make an independent decision and assign another rating. However, the burden of showing an error in a material supervisory determination rests solely with the credit union. The total evidence presented in the written and oral record by Petitioner does not meet this standard. While there was some disagreement between the principal examiner and the Regional office, that disagreement, does not, in and of itself, dictate that the CAMEL 3 rating was misapplied in this instance.

 

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