August 13, 2009
Authored by: Robert Klingler
On August 6, 2009, the Office of the Special Inspector General for TARP (SIGTARP) published its report on whether external parties (i.e. politicians) unduly influenced TARP Capital Purchase Program decisions. We will write more about that subject shortly, but the Report also provided the most detailed summary that we’ve seen of the factors considered by Treasury and the federal banking regulators in determining whether to approve a TARP application.
First, composite CAMELS ratings clearly played a significant role in determining the likelihood of success for any given institution.
- 1-rated institutions were generally sent directly to Treasury for approval, and seemingly regularly approved for Capital Purchase Program funds.
- 2-rated institutions with “acceptable performance ratios” were also sent directly to Treasury for approval, and again appear to have been regularly approved for funds. 2-rated institutions with “unacceptable performance ratios” were subject to further review by the interagency council, where at least three of the four federal banking regulators had to approve the application. The Report states that the interagency council then analyzed “the viability of the institution based on the quantitative and qualitative factors of the case” in determining whether to recommend approval to Treasury.
- 3-rated institutions were originally treated like 2-rated institutions, but “relatively early in the CPP application review process,” Treasury decided that all 3-rated institutions needed to be reviewed by the interagency council.
- 4- or 5-rated institutions were generally asked to withdraw, without the application being forwarded to the interagency council.
The Treasury would then make an independent evaluation of each application before making recommendations to the three-member Treasury Investment Committee. The Treasury Investment Committee would then make a recommendation for final approval to the Assistant Secretary. While only the Assistant Secretary can actually approve a TARP CPP application (all other actions are merely recommendations to approve), according to the Report, the Assistant Secretary had not rejected any recommendation forwarded by the Investment Committee for approval.
The Report also includes, as an Appendix, a copy of a “Case Decision Memo Template” that appears to have been the form used by the region/district level office of each federal banking regulator that reviewed TARP CPP applications. The Memo provides further guidance on the specific performance ratios considered by the agencies. In addition to CAMELS and CRA ratings, the Memo called for an evaluation of the following performance ratios, both before and after a TARP infusion and both for the holding company and the largest bank subsidiary:
- Tier 1 Risk-Based Capital
- Total Risk-Based Capital
- Tier 1 Leverage Ratio
- Classified Assets/(Net Tier 1 Capital + ALLL)
- (NPLs + OREO)/(Net Tier 1 Capital + ALLL)
- Construction & Development Loans/Total Risk-Based Capital
While the first three performance ratios are consistent with the three historical measures of bank capitalization, the last three performance factors highlight the focus of the banking regulators on these ratios.
The use of the classified asset ratio (measured by considering all classified assets (substandard, doubtful, and loss) and dividing by total Tier 1 Capital plus the Allowance for Loan and Lease Losses (but not double counting the portion of the ALLL that counts as Tier 1 Capital)) is consistent with our understanding that this is currently one of the most important ratios considered by the regulators. It is also interesting that one of the ratios that the banking regulators apparently consider to be extremely relevant to their analysis can’t be calculated from the Call Reports, as banks are not required to publicly state their total classified assets.
The use of the non-performing asset ratio to capital plus reserves is particularly interesting given the regulator’s stated dislike of the so-called “Texas Ratio.” Given increased capital levels and mark-to-market accounting, the standard for what constitutes a good or bad Texas Ratio number has likely significantly changed since the ratio’s creation in prior decades. However, it remains a significant performance ratio used by the regulators as a rough-indicator of the bank’s condition.
The final performance ratio certainly appears to be a favorite of the banking regulators, at least in the Southeast. The ratio focuses on the institution’s concentration in Acquisition & Development lending.
In addition to the quantitative ratios provided in the Memo, the Report notes that qualitative, mitigating factors were also considered when there are weaker quantitative measurements for a particular institution. Specifically, the Treasury and the federal banking regulators noted the following mitigating factors as weighing in favor of granting an application:
- existence of a merger agreement;
- possible adverse effect of a write-down on government-sponsored entities stocks;
- ability of an institution to raise outside capital;
- an applicant’s plans to address areas of concern;
- regional considerations regarding loan concentrations; and
- cash position and ability of the institution to pay the CPP dividend required as a condition of receiving funds.
Given the importance placed on these performance ratios by the federal banking regulators (now explicitly for TARP decisions, but they’re also consistently being used in all other supervision settings, including determining the appropriate form of enforcement action), all banks should consider (a) explicitly measuring themselves on these performance measures, and (b) including the ratios in their monthly board packages so that their directors can see the same numbers that the regulators will be looking at.