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Board Report:  February 19, 2010

Material Loss Review of BankFirst

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BankFirst was supervised by the Federal Reserve Bank of Minneapolis (FRB Minneapolis), under delegated authority from the Board, and by the South Dakota Division of Banking (State). The State closed BankFirst on July 17, 2009, and named the FDIC receiver. On August 19, 2009, the FDIC IG notified us that BankFirst's failure would result in an estimated loss to the Deposit Insurance Fund of $90 million, or 36.6 percent of the bank's $246.1 million in total assets.

BankFirst failed because its Board of Directors and management did not establish a corporate governance and oversight framework to control the risks associated with its aggressive loan growth and high concentration in commercial real estate (CRE) loans. The lack of effective credit risk management controls resulted in a large volume of poorly underwritten CRE loans that were originated within an 18-month period. BankFirst had pervasive internal control deficiencies, and bank management'sinability to identify and address loan portfolio weaknesses led to asset quality deterioration and significant losses. Mounting losses eliminated earnings and depleted capital, which ultimately caused the State to close BankFirst. 

Our analysis of BankFirst's supervision revealed that FRB Minneapolis did not devote sufficient supervisory attention to verifying that BankFirst's Board of Directors and management implemented a credit risk management framework to sufficiently control the bank's rapid growth in a new activity--CRE lending. Supervisory guidance related to assessing Board of Directors and management oversight of new business activities stated that examiners should confirm that bank management has implemented the infrastructure and internal controls necessary to manage the risks associated with new business activities. A target examination report issued in March 2007 marked the point when FRB Minneapolis began to identify the full extent of the credit risk managementweaknesses that contributed to BankFirst's eventual failure. Many of the findingsand conclusions cited during the 2007 target examination contradicted the results from five prior examinations. We believe that FRB Minneapolis should have focused greater attention on credit risk controls during examinations thatimmediately followed the bank's transition to commercial lending.

Specifically, we believe that full scope examinations conducted in 2005 and 2006 presented opportunities for FRB Minneapolis to take more forceful supervisory action. During the May 2005 examination, FRB Minneapolis noted that BankFirst's updated annual projection for loan portfolio growth would almost triple the forecasted amount cited in management's business plan. In our opinion, the magnitude of this projected increase provided FRB Minneapolis with an opportunity to take immediate supervisory action to restrain further loan portfolio growth. During the July 2006 full scope examination, examiners did request that BankFirst curtail further loan growth to allow the loan  ortfolio to "season," so examiners could assess the risks associated with the bank's strategy. However, examiners did not conduct sufficient testing to confirm that the bank's CRE lending controls were adequate to support the bank's rapid loan growth.

In our opinion, the 2006 full scope examination represented a missed opportunity at a critical juncture to (1) uncover the full extent of BankFirst's credit risk management weaknesses, including a compensation program that rewarded making loans but lacked incentives to ensure that the loans were safe and sound, and (2) compel management to address identified deficiencies. We believe that an earlier supervisory action to have BankFirst refrain from making additional loans may have reduced the loss to the DIF. 

Recurring corporate governance weaknesses throughout the timeframe preceding the 2007 target examination also presented an opportunity for FRB Minneapolis to take more forceful supervisory action. During examinations conducted between May 2005 and October 2006, examiners noted a variety of corporate governance deficiencies, including (1) persistent strategic planning issues; (2) a corporate organizational structure that created divided loyalty between BankFirst and its holding company; (3) the substantial sharing of employees between affiliated entities; and (4) the need for a Chief Risk Officer, or other advocate, with sufficient power to manage financial and legal risks resulting from BankFirst's transactions with affiliated entities. We believe that the corporate governance deficiencies identified by examiners during these multiple examinations represented red flags that, at a minimum, warranted an earlier and more forceful supervisory response, including an appropriate enforcement action.

FRB Minneapolis did not conclude that a formal enforcement action was necessary until the 2007 target examination. Upon reaching that conclusion, issuing the formal enforcement action took five months. We believe that the time taken to issue the enforcement action was unduly prolonged, but likely did not have a material impact. The critical juncture to uncover and forcefully address BankFirst's loan growth and pervasive control deficiencies was in 2005 and 2006. 

In our view, BankFirst's failure offered important lessons learned. First, heightened supervisory attention is vital when a bank implements a new business strategy featuring growth in high-risk lending outside of the institution's traditional market area. Second, BankFirst's failure demonstrated the importance of confirming that new business activities operate within an effective internal control infrastructure. The failure also highlighted the need for immediate, aggressive, and forceful supervisory action when (1) management deviates from business plan projections or (2) examiners detect corporate governance deficiencies that blur the barriers between affiliated entities. 

The Director of the Division of Banking Supervision and Regulation concurred with our conclusions and lessons learned and noted the critical importance of supervisors detecting and addressing serious issues sufficiently early so that risks to the bank's viability can be controlled.