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Board Report:  March 15, 2010

Material Loss Review of CapitalSouth Bank

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CapitalSouth Bank (Capital South) was supervised by the Federal Reserve Bank of Atlanta (FRB Atlanta), under delegated authority from the Board, and by the Alabama Department of Banking and Finance (State). The State closed CapitalSouth on August 21, 2009, and named the FDIC as receiver. On September 15, 2009, the FDIC IG notified us that CapitalSouth's failure would result in an estimated loss to the Deposit Insurance Fund (DIF) of $146 million, or 24.8 percent of the bank's $588.5 million in total assets.

CapitalSouth, headquartered in Birmingham, Alabama, became a state member bank in October 1978. From its inception until 2003, the bank's primary business strategy involved lending to small- and medium-sized businesses in metropolitan areas. In 2003, CapitalSouth's strategy evolved to include expanding through (1) internal growth of the bank's traditional business lending activities, including commercial real estate (CRE) lending; and (2) targeted acquisitions. In September 2007, CapitalSouth acquired Monticello Bank, a federal savings association, and its mortgage subsidiary, Mortgage Lion, Inc.

CapitalSouth failed because its Board of Directors and management did not implement a credit risk management infrastructure commensurate with its aggressive expansion strategy and high concentration of CRE loans, including ADC loans. The bank pursued an aggressive expansion strategy even though its modest earnings and capital position did not provide the buffer necessary to withstand significant asset quality deterioration. CapitalSouth's acquisition of Monticello Bank compounded CapitalSouth's preexisting credit risk management weaknesses. A declining real estate market revealed the full extent of the combined entity's credit administration and loan underwriting deficiencies and resulted in asset quality deterioration and significant losses. Mounting losses eliminated earnings, depleted capital, and ultimately caused the State to close CapitalSouth.

Our analysis of FRB Atlanta's supervision of CapitalSouth indicated that examiners identified key weaknesses in 2005, but missed subsequent opportunities to take more forceful supervisory action. In a 2005 examination report, FRB Atlanta highlighted a fundamental issue with the bank's growth strategy, observing that the bank had no margin for error and "cannot afford to have any substantial problem assets or loan losses given its robust growth objectives and modest earnings." We believe that FRB Atlanta should have stressed to CapitalSouth the need for solid earnings performance before the bank pursued its risky growth strategy. In our opinion, examiners should have suggested that CapitalSouth postpone its growth objectives until it enhanced its modest earnings and credit risk management practices. The eventual loss to the DIF may have been reduced if examiners took a more aggressive supervisory approach at this juncture. 

FRB Atlanta, with the concurrence of Board applications staff, approved CapitalSouth's acquisition of Monticello Bank, without conducting a pre-merger examination or documenting a waiver as specified in the Board's Supervision and Regulation (SR) Letter 98-28. This guidance established the criteria for conducting safety and soundness examinations of depository institutions seeking to become, or merge into, a state member bank. It outlined an "eligible bank" test and the factors to be evaluated when determining whether pre-merger examinations should be conducted, including whether the institution being acquired has a composite rating of 1 or 2 and has no major unresolved supervisory issues. At the time of the application, Monticello Bank had a composite 3 rating and was under a Cease and Desist Order issued by its primary regulator, the Office of Thrift Supervision, because of its credit risk management weaknesses. In fact, post-acquisition examinations highlighted numerous high-risk elements in Mortgage Lion's loan portfolio, including sub-prime and "no documentation" lending activities. In our opinion, a full scope pre-merger examination was warranted and may have led FRB Atlanta to recommend that the Board deny the acquisition application. If CapitalSouth had not acquired Monticello Bank, the loss to the DIF may have been reduced.

According to an FRB Atlanta official, the Reserve Bank's noncompliance with SR Letter 98-28 was attributable to the structure of the SR letter and confusion concerning how to apply the eligible bank test. Our report included a recommendation that the guidance be clarified.

We believe that CapitalSouth's failure offered lessons learned that can be applied in supervising banks with similar characteristics and circumstances. Specifically, CapitalSouth's failure illustrated that banks with a pattern of modest earnings, an aggressive growth strategy, and a high CRE concentration require heightened supervisory attention. In these situations, examiners should ensure that the bank has (1) sufficient earnings and capital to support an aggressive expansion strategy, and (2) credit risk management controls that are sufficiently robust to fully support the bank's growth. In addition, CapitalSouth's failure demonstrated that pre-merger examinations need to be conducted consistent with the guidance in SR Letter 98-28. The Director of the Division of Banking Supervision and Regulation concurred with our conclusions, lessons learned, and recommendation. 

The Director said that he planned to implement our recommendation to clarify supervisory guidance that sets forth the conditions under which examinations should be conducted when depository institutions seek to become, or merge into, state member banks.