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Board Report:  May 12, 2010

Material Loss Review of Bank of Elmwood


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The Bank of Elmwood (Elmwood) was supervised by the Federal Reserve Bank of Chicago (FRB Chicago), under delegated authority from the Board, and by the State of Wisconsin Department of Financial Institutions Division of Banking (State). The State closed Elmwood on October 23, 2009, and the FDIC was named receiver. On November 12, 2009, the FDIC IG notified our office that Elmwood’s failure would result in an estimated loss to the Deposit Insurance Fund (DIF) of $90.6 million, or about 26.7 percent of the bank’s approximately $339.1 million in total assets.

Elmwood failed because its Board of Directors and management pursued a risky loan growth strategy that featured new loan products and out-of-market lending without developing adequate credit risk management controls. The growth strategy, coupled with insufficient credit risk management controls, resulted in poorly underwritten loans. Bank management’s inability to adequately address loan portfolio weaknesses led to asset quality deterioration and significant losses. Mounting losses eliminated earnings, depleted capital, and strained liquidity, which ultimately led to the State closing Elmwood.

Our analysis of FRB Chicago’s supervision of Elmwood revealed that FRB Chicago had opportunities for earlier and more forceful supervisory actions. Elmwood’s loan strategy was first discussed in a 2004 State examination report that also noted that the bank’s earnings performance “continued to be deficient” and capital ratios remained below peer bank averages. State examiners noted that Elmwood should control further loan growth until the bank demonstrated that it could produce “sufficient retention of earnings to provide the bank with adequate internal capital generation.” In its 2005 examination report, FRB Chicago observed that the bank increased its loan portfolio by about 30 percent over the previous two years by strategically expanding into new geographical markets and purchasing CRE loan participations to enhance income. However, examiners once again cited weak earnings and capital levels that remained below peer averages.

We also believe that credit risk management weaknesses noted by examiners in 2006 and 2007 provided early warning signs regarding (1) the potential for asset quality deterioration in Elmwood’s growing loan portfolio, and (2) management’s ability to control the bank’s increasing credit risk profile. The examination reports issued during this period highlighted credit administration deficiencies, such as inadequate monitoring of out-of-market CRE participation loans, incomplete financial data on borrowers and projects, and weak loan underwriting standards. Examiners warned that credit administration deficiencies could make it difficult for management to detect and promptly correct credit problems. Additionally, the 2007 examination report noted a significant increase in classified assets and a corresponding rise in past due and non-accrual loans, yet the bank received a “fair” rating for its asset quality. In our opinion, the weaknesses cited by examiners, coupled with continued marginal earnings and capital levels below peer averages, warranted an appropriate supervisory response in 2007 compelling bank management to immediately correct the identified deficiencies.

While we believe that FRB Chicago had opportunities for earlier and more forceful supervisory actions, it was not possible for us to predict the effectiveness or impact of any corrective measures that might have been taken by the bank. Therefore, we could not evaluate the degree to which an earlier or alternative supervisory response would have affected Elmwood’s financial deterioration or the ultimate cost to the DIF. With respect to lessons learned, Elmwood’s failure illustrated the risks posed when a bank with modest earnings and capital levels below peer averages implements a risky loan growth strategy that features new product lines or out-ofmarket lending. In these situations, examiners should ensure that management has implemented a robust credit risk management infrastructure and is effectively addressing shortcomings in the bank’s earnings and capital. Elmwood’s failure also demonstrated that banks exhibiting significant growth require heightened supervisory attention and should be subject to an immediate and forceful supervisory response when signs of credit risk management deficiencies first appear.

The Director of the Board’s Division of Banking Supervision and Regulation agreed with our conclusion and lessons learned.