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Board Report: September 1, 2010
Barnes Banking Company (Barnes) was supervised by the Federal Reserve Bank of San Francisco (FRB San Francisco) under delegated authority from the Board, and by the Utah Department of Financial Institutions (State). The State closed Barnes in January 2010, and the FDIC was appointed receiver. On March 3, 2010, the FDIC IG notified our office that Barnes’ failure would result in an estimated loss to the Deposit Insurance Fund of $266.3 million, or 35.7 percent of the bank’s $745.5 million in total assets.
Barnes failed because its Board of Directors and management did not effectively control the risks associated with the bank’s aggressive growth strategy that led to a Commercial Real Estate (CRE) loan concentration, particularly in residential Construction, Land, and Land Development (CLD) loans. The bank continued to originate Construction, Land, and Land Development (CLD) loans in 2007 and 2008, despite apparent weaknesses in Utah’s real estate market and economy. The Board of Directors’ and management’s failure to effectively manage the resulting credit risk, in conjunction with declining market conditions, led to rapid asset quality deterioration. The resulting loan losses depleted earnings and eroded capital, which ultimately led the State to close Barnes.
With respect to supervision, we believe that circumstances noted during a 2007 full scope examination—including repeated regulatory criticisms, declining market trends, and continuing growth of Barnes’ CLD loan portfolio—provided FRB San Francisco an opportunity to pursue earlier, more forceful supervisory action. The examination cited several deficiencies regarding credit risk management, CRE concentrations monitoring, Allowance for Loans and Lease Losses methodology, and other critically important control processes. Additionally, examiners expressed concern over (1) Barnes’ aggressive growth in CRE lending despite evidence of pronounced economic weaknesses within that market segment, and (2) “continued inaction” by the bank to resolve prior recommendations. We believe that other supervisory actions were warranted at the conclusion of the 2007 examination, such as downgrading CAMELS ratings or executing an informal enforcement action.
We also believe that a June 2008 credit risk target examination provided another opportunity to pursue earlier, more forceful supervisory action. The target examination provided strong evidence that Barnes’ risk profile and financial condition had significantly changed, and examiners repeated prior criticisms. While FRB San Francisco subsequently performed a separate ratings assessment and downgraded several CAMELS ratings, an enforcement action was not executed until May 2009, nearly one year after the target examination was initiated. Further, although not explicitly required by supervisory guidance, examiners decided not to attend a full Board of Directors meeting following the target examination or assessment. Given the history of repeated recommendations, continued market deterioration, and additional growth of the bank’s CLD loan portfolio, FRB San Francisco could have taken such actions as (1) conducting a formal exit meeting with the Board of Directors, (2) considering more aggressive ratings downgrades, or (3) executing an enforcement action.
While we believe that FRB San Francisco had opportunities for earlier and more forceful supervisory actions, it was not possible for us to predict the effectiveness or impact of any such actions. Therefore, we could not evaluate the degree to which earlier or more forceful supervisory responses might have affected Barnes’ financial deterioration or the failure’s cost to the DIF.
Barnes’ failure offered valuable lessons learned because it illustrated (1) the need for close regulatory scrutiny and a forceful supervisory response when financial institutions increase credit risk exposure within a weakened or deterioratingmarket segment; and (2) although not explicitly required by supervisory guidance, examiner attendance at a Board of Directors meeting can be a prudent supervisory practice when a target examination notes a significant change in the institution’s financial condition and risk profile.
The Director of the Board’s Division of Banking Supervision and Regulation agreed with our conclusion and concurred with the lessons learned.