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Board Report:  September 29, 2011

Review of the Failure of Pierce Commercial Bank


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Pierce Commercial Bank (Pierce) began operations on December 8, 1997, as a denovo state member bank headquartered in Tacoma, Washington. Pierce was supervised by the Federal Reserve Bank of San Francisco (FRB San Francisco), under delegated authority from the Federal Reserve Board, and by the Washington Department of Financial Institutions (State). The State closed Pierce on November 5, 2010, and named the FDIC as receiver. According to the FDIC, the bank's total assets at closing were $217.8 million and its failure resulted in an estimated $24.8 million loss to the Deposit Insurance Fund (DIF). While the loss to the DIF did not meet the standards for materiality, we conducted an in-depth review after determining that Pierce's failure presented unusual circumstances because of fraud allegations associated with the bank's mortgage lending activities.

Pierce failed because its Board of Directors and management did not adequately control the risks associated with the bank's residential mortgage lending activities. Specifically, the Board of Directors and senior management allowed the mortgage banking division--PC Bank--to operate independently without appropriate oversight and failed to conduct adequate strategic planning or implement robust internal controls. PC Bank pursued an originate-to-distribute business model that involved originating residential mortgages to be sold in the secondary market. Although this business model appeared to transfer the credit risk associated with mortgage loans to investors, Pierce remained exposed to the risk that investors could demand that the bank repurchase loans or reimburse investors for losses, subject to certain conditions. Examiners ultimately uncovered possibly fraudulent activity at PC Bank related to employees misrepresenting borrower financial information and steering customers into loans for which they were not qualified. These practices led to the bank incurring losses resulting from significant investor repurchase and indemnification demands.

In addition, inadequate credit risk management and weak underwriting made the bank's commercial loan portfolio susceptible to declining economic conditions. Although Pierce received $6.8 million in TARP funds under the Treasury's Capital Purchase Program (CPP) in January 2009, mounting losses resulting from investor repurchase and indemnification demands and commercial loan portfolio deterioration due to declining economic conditions eliminated the bank's earnings, depleted capital (including the TARP funds), and eventually led to the bank's failure.

With respect to supervision, FRB San Francisco complied with the safety and soundness examination frequency guidelines and conducted regular off-site monitoring for the time frame we reviewed, 2003 to 2010. Our analysis of FRB San Francisco's supervision indicated that examiners missed several opportunities to conduct the detailed testing necessary to more accurately assess the bank's risk profile. While it is not possible to determine whether detailed testing would have resulted in earlier detection of the fraud, such testing likely would have identified the control weaknesses that created an opportunity for fraudulent activity.

We also believe that FRB San Francisco did not sufficiently assess the risk associated with the bank's recourse obligations or closely supervise its offbalance sheet reserve to mitigate the risk associated with the bank's secondary market credit activities in accordance with Supervision and Regulation Letter 97-21, Risk Management and Capital Adequacy of Exposures Arising from Secondary Market Credit Activities. In our opinion, FRB San Francisco was late to identify these risks, and the expenses associated with addressing investor repurchase and indemnification demands ultimately contributed to the bank's failure.

In late November 2008, Pierce's holding company applied for TARP funds under the CPP, and FRB San Francisco evaluated the application. We believe that FRB San Francisco complied with the process outlined in the Treasury guidance for banks that had not been examined during the previous six months and the limited decision-making criteria available at the time. However, as discussed below, the evaluation might have had different results if examiners had appropriately identified Pierce's risk profile earlier and taken stronger supervisory action sooner.

In our opinion, FRB San Francisco had multiple opportunities to conduct detailed testing consistent with expectations in the Commercial Bank Examination Manual (CBEM). If FRB San Francisco had acted on those opportunities sooner, it would have likely resulted in (1) a more accurate assessment of the bank's risk profile and (2) earlier CAMELS composite and component rating downgrades, such as the downgrades issued during the July 2009 safety and soundness examination once examiners realized the extent of the bank's weaknesses. Because the time span during which these opportunities presented themselves coincided with the bank's growth period, earlier detection might have mitigated the loss to the DIF and resulted in the CAMELS composite rating downgrades necessary to preclude the bank from receiving TARP CPP funds. Nevertheless, it is not possible to determine whether alternative supervisory action might have prevented the failure.

Although the failure of an individual institution does not necessarily provide sufficient evidence to draw broad-based conclusions, we believe that Pierce's failure offers lessons learned that can be applied to supervising banks with similar characteristics and circumstances. Pierce's failure demonstrates the importance of (1) examiners appropriately identifying key risks early; (2) examiners timely conducting detailed testing of new business activities consistent with CBEM expectations; (3) active Board of Directors and management oversight of the bank's business activities; and (4) banks incorporating secondary market credit activities into overall risk management systems, including setting adequate minimum internal standards for allowances or liabilities for losses, capital, and contingency funding. This failure also demonstrates that recurring weaknesses with strategic planning, compliance with laws and regulations, and internal controls can indicate broader corporate governance and risk management deficiencies.

The Director of the Division of Banking Supervision and Regulation concurred with our conclusions, lessons learned, and recommendations. The Director said that he planned to implement our recommendations concerning the need to reinforce the corporate governance principles outlined in the CBEM and cross-referencing guidance addressing secondary market asset sales.