[Federal Register Volume 69, Number 233 (Monday, December 6, 2004)]
[Notices]
[Pages 70444-70456]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-26723]


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FEDERAL RESERVE SYSTEM

[Docket No. OP-1207]


Bank Holding Company Rating System

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Notice.

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SUMMARY: The Federal Reserve has revised its bank holding company (BHC) 
rating system to better reflect and communicate its supervisory 
priorities and practices. The revised BHC rating system emphasizes risk 
management; implements a comprehensive and adaptable framework for 
analyzing and rating financial factors; and provides a framework for 
assessing and rating the potential impact of the nondepository entities 
of a holding company on the subsidiary depository institution(s).

DATES: The revised rating system will be applied to all BHC inspections 
beginning on or after January 1, 2005, as well as to inspections opened 
in 2004 and closed in 2005, at the discretion of the Reserve Bank.

FOR FURTHER INFORMATION CONTACT: Deborah Bailey, Associate Director, 
(202-452-2634), Barbara Bouchard, Deputy Associate Director, (202-452-
3072), Molly Mahar, Senior Supervisory Financial Analyst, (202-452-
2568), or Anna Lee Hewko, Supervisory Financial Analyst, (202-530-
6260). For users of Telecommunications Device for the Deaf (``TDD'') 
only, contact (202) 263-4869.

SUPPLEMENTARY INFORMATION: 

Background

    On July 23, 2004, the Federal Reserve published a notice in the 
Federal Register (69 FR 43996) requesting comment on proposed revisions 
to the BHC rating system. The BHC rating system is an internal rating 
system used by the Federal Reserve as a management information and 
supervisory tool that defines the condition of all BHCs, including 
financial holding companies (FHCs), in a systematic way. First and 
foremost, a BHC's rating provides a summary evaluation of the BHC's 
condition for use by the supervisory community. Second, the BHC rating 
forms the basis of supervisory responses and actions. Third, the BHC 
rating provides the basis for supervisors' discussion of the firm's 
condition with BHC management. Fourth, the BHC rating determines 
whether the BHC is entitled to expedited applications processing and to 
certain regulatory exemptions.
    The former BHC rating system, implemented in 1979 and commonly 
referred to as the BOPEC rating system, focused on the financial 
condition of discrete legal entities, consolidated capital, and 
consolidated earnings. It also included composite financial condition 
and management ratings. Since that time, a number of changes have 
occurred in the financial services industry, prompting a shift in 
supervisory policies and procedures away from historical analyses of 
financial condition, toward more forward looking assessments of risk 
management and financial factors. In order to address this shift, the 
Federal Reserve introduced a risk management rating for all bank 
holding companies in the mid-1990s. Although this adjustment proved an 
effective tool for assessing risk management, it was not the central 
focus of the rating system. Moreover, as the banking industry has 
continued to evolve over the past decade, the focus of the Federal 
Reserve's examination program for bank holding companies has 
increasingly centered on a comprehensive review of financial risk and 
the adequacy of risk management. As a result, in order to more fully 
align the rating process for BHCs with current supervisory practices, 
the Federal Reserve is revising the BHC rating system to emphasize risk 
management; introduce a comprehensive and adaptable framework for 
analyzing and rating financial factors; and provide a framework for 
assessing and rating the potential impact of the nondepository entities 
of a holding company on the subsidiary depository institution(s).

Summary of the Revised Rating System

    Each BHC is assigned a composite rating (C) based on an evaluation 
and rating of its managerial and financial condition and an assessment 
of future potential risk to its subsidiary depository institution(s). 
The main components of the rating system represent: Risk Management 
(R); Financial Condition (F); and potential Impact (I) of the parent 
company and nondepository subsidiaries (collectively nondepository 
entities) on the subsidiary depository institutions. While the Federal 
Reserve expects all bank holding companies to act as a source of 
strength to their subsidiary depository institutions, the Impact rating 
focuses on downside risk--that is, on the likelihood of significant 
negative impact by the nondepository entities on the subsidiary 
depository institution. A fourth component rating, Depository 
Institution (D), will generally mirror the primary regulator's 
assessment of the subsidiary depository institutions. Thus, the primary 
component and composite ratings are displayed:

RFI/C (D)

    In order to provide a consistent framework for assessing risk 
management, the R component is supported by four subcomponents that 
reflect the effectiveness of the banking organization's risk management 
and controls. The subcomponents are: Board and Senior Management 
Oversight; Policies, Procedures, and Limits; Risk Monitoring and 
Management Information Systems; and Internal Controls. The F component 
is similarly supported by four subcomponents reflecting an assessment 
of the quality of the banking organization's Capital; Asset Quality; 
Earnings; and Liquidity. A simplified version of the rating system that 
requires only the assignment of the risk management component rating 
and composite rating will be applied to noncomplex bank holding 
companies with assets at or below $1 billion.
    Composite, component, and subcomponent ratings are assigned based 
on a 1 to 5 numeric scale. A 1 numeric rating indicates the highest 
rating, strongest performance and practices, and least degree of 
supervisory concern, whereas a 5 numeric rating indicates the lowest 
rating, weakest performance, and the highest degree of supervisory 
concern.
    The Federal Reserve recognizes the interrelationship between the 
risk management and financial performance components of the revised 
rating system, an interrelationship that is

[[Page 70445]]

inherent in all supervisory rating systems. As such, examiners are 
expected to consider that a risk management factor may have a bearing 
on the assessment of a financial subcomponent or component rating and 
vice versa. In general, however, the risk management component and 
subcomponents should be viewed as the forward-looking component of the 
rating system and the financial condition component and subcomponents 
should be viewed as the current component of the rating system. For 
example, a BHC's ability to monitor and manage market risk (or 
sensitivity to market risk) should be evaluated together with the 
organization's ability to monitor and manage all risks under the R 
component of the rating system. However, poor market risk management 
may also be reflected in the F component if it impacts earnings or 
capital.

Comments Received and Changes Made

    The Federal Reserve received a total of 13 comments regarding the 
proposed revisions to the BHC rating system. The comments came from 
banking organizations, trade associations, several Reserve Banks and 
one law firm. Commenters generally supported changes to the rating 
system, stating that the move to a more forward-looking assessment of 
risk management systems and the condition of the consolidated 
organization is appropriate.
    Many commenters recommended that the rating scale for the 
subcomponents under the risk management rating be changed from a three 
point qualitative scale to a five point numeric rating scale in order 
to provide more granularity and consistency with the rest of the rating 
system. In response, the Federal Reserve has changed the rating scale 
for the risk management subcomponent ratings to a five point numeric 
rating scale.
    Several commenters raised concerns that the new rating system is 
signaling a move by the Federal Reserve to lessen its reliance on the 
work of primary bank regulators and other functional nonbank regulators 
in its supervision of BHCs. The revised BHC rating system was developed 
to align the BHC rating process with the Federal Reserve's current 
supervisory practices in carrying out consolidated or umbrella 
supervision of BHCs. As such, the revised rating system and the 
accompanying implementation guidance is not intended to signal a shift 
in the Federal Reserve's supervisory practices of coordinating with and 
relying to the greatest extent possible on the work of primary bank and 
other functional nonbank regulators. This intent is clearly stated in 
the final policy.
    Commenters also raised concerns about the ability of the Federal 
Reserve to apply the new rating system in a consistent manner due to 
the large number of subcomponent ratings in the new system and the 
inherent subjectivity in the rating process. As is the case with all 
supervisory rating systems, there is some subjectivity inherent in the 
revised BHC rating system; however, the Federal Reserve has made and 
will continue to make every effort to provide appropriate examiner 
guidance and training around the revised BHC rating system to ensure 
that the system is applied in a consistent manner. In addition, the 
Federal Reserve notes that the subcomponents under the R rating are 
based on the same guidance that has been used to rate risk management 
since 1995 and are therefore familiar to examination staff. Examination 
staff also is very familiar with assigning capital, asset quality, 
earnings, and liquidity ratings, as these components are important 
elements of our existing rating systems. The Federal Reserve believes 
that the subcomponents will increase consistency and transparency in 
the rating process by providing a clearer basis for the component 
ratings.
    Commenters raised concerns about the possibility of one factor 
being weighted too heavily in the composite rating due to overlap 
between the component ratings and because the proposal stated that the 
composite rating may not be the numerical average of the component 
ratings. There is an interrelationship among the component ratings in 
the revised BHC rating system that is inherent in all supervisory 
rating systems. Federal Reserve examiners will consider that a risk 
management factor may have a bearing on the assessment of a financial 
subcomponent or component rating and vice versa, and weight that factor 
proportionately in the overall composite rating. Consistent with 
current rating practices for the BOPEC and CAMELS rating systems, some 
components may be given more weight than others in determining the 
composite rating, depending on the importance of that component in the 
overall condition of the BHC. In general, assignment of a composite 
rating may incorporate any factor that bears significantly on the 
overall condition and soundness of the BHC. Therefore, the composite 
rating is not derived by computing the arithmetic average of the 
component ratings. Nevertheless, the composite rating generally bears a 
close relationship to the component ratings assigned.
    Commenters also raised questions about whether the Federal Reserve 
intends to impose de facto capital requirements on nondepository 
subsidiaries, whether the language in the proposal around the use of 
market indicators is signaling more extensive use of these references 
in the rating process, and whether the Federal Reserve intends to run 
the BOPEC rating system in conjunction with the revised BHC rating 
system for some time period of time. The Federal Reserve has clarified 
in the final policy that, consistent with current practice, the revised 
BHC rating system assesses the consolidated capital adequacy of the 
organization and is not intended to impose de facto capital 
requirements on nondepository subsidiaries. In addition, the Federal 
Reserve has clarified and simplified the language around the use of 
market indicators in the revised rating system to indicate that, 
consistent with current practice, examination staff should use these 
indicators as a source of information complementary to the examination 
process. Also, the Federal Reserve is implementing a quality assurance 
program around the new rating system during the first year of 
implementation that includes a mechanism to collect feedback from 
examination staff to address any significant implementation issues and 
to discuss difficult rating decisions to ensure consistent application 
of the revised rating system.
    Finally, a few commenters suggested that BHC understanding of the 
revised rating system would be enhanced if the Federal Reserve were to 
utilize a temporary dual implementation period during which the BOPEC 
rating system and the revised rating system would be applied 
simultaneously and a BHC's BOPEC rating would prevail. The Federal 
Reserve has determined that a direct and prompt adoption of the revised 
rating system is preferable because the revised rating system better 
reflects current supervisory practices and because use of a single 
rating system would minimize regulatory burden on both examination 
staff and institutions. To ensure that BHCs understand the revised 
rating system, examination staff will be prepared to discuss the 
differences and similarities between the revised rating system and the 
BOPEC system with senior BHC officials during the first inspection 
cycle under the revised rating system. Moreover, during the first 
inspection cycle under the revised rating system, in situations in 
which a BHC has received a ratings downgrade, examiners will be 
prepared to discuss with senior BHC

[[Page 70446]]

officials the new ratings and how they compare with the BOPEC ratings 
for that institution.

Disclosure

    The numeric ratings for bank holding companies under the revised 
BHC rating system will be disclosed to the bank holding company for its 
confidential use, in accordance with current disclosure practices. 
Under no circumstances should the bank holding company or any of its 
directors, officers, or employees disclose or make public any of the 
ratings.

Implementation

    The revised BHC rating system becomes effective January 1, 2005, 
and is to be used for all BHC inspections commencing after that date. 
Inspections opened in 2004 and closed in 2005 may assign either the 
BOPEC rating or the RFI/C(D) rating. Although the timing of 
implementation is relatively close to the December release of the final 
rating system, supervision and examination staff at all twelve Reserve 
Banks and the Board of Governors have had and will continue to receive 
appropriate training in the revised rating system. Moreover, the 
revised rating system was developed and reviewed over a number of years 
with participation from a wide range of Federal Reserve System 
supervision and examination staff. Because the revised BHC rating 
system incorporates factors that have been routinely considered by 
examiners for years in evaluating a BHC's condition, the revised rating 
system should not have a significant effect on the conduct of 
inspections or on the regulatory burden of supervised institutions.

Text of the Bank Holding Company Rating System

Bank Holding Company Rating System

    The bank holding company (BHC) rating system provides an assessment 
of certain risk management and financial condition factors that are 
common to all BHCs, as well as an assessment of the potential impact of 
the parent BHC and its nondepository subsidiaries (collectively 
nondepository entities) on the BHC's subsidiary depository 
institutions. Under this system, the Federal Reserve endeavors to 
ensure that all BHCs, including financial holding companies (FHCs), are 
evaluated in a comprehensive and uniform manner, and that supervisory 
attention is appropriately focused on the BHCs that exhibit financial 
and operational weaknesses or adverse trends. The rating system serves 
as a useful vehicle for identifying problem or deteriorating BHCs, as 
well as for categorizing BHCs with deficiencies in particular areas. 
Further, the rating system assists the Federal Reserve in following 
safety and soundness trends and in assessing the aggregate strength and 
soundness of the financial industry.
    Each BHC \1\ is assigned a composite rating (C) based on an overall 
evaluation and rating of its managerial and financial condition and an 
assessment of future potential risk to its subsidiary depository 
institution(s). The main components of the rating system represent: 
Risk Management \2\ (R); Financial Condition (F); and Impact (I) of the 
nondepository entities on the subsidiary depository institutions. While 
the Federal Reserve expects all bank holding companies to act as a 
source of strength to their subsidiary depository institutions, the 
Impact rating focuses on downside risk--that is, on the likelihood of 
significant negative impact by the nondepository entities on the 
subsidiary depository institution(s). A fourth rating, Depository 
Institution(s) (D), will generally mirror the primary regulator's 
assessment of the subsidiary depository institution(s). Thus, the 
primary component and composite ratings are displayed:
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    \1\ A simplified version of the rating system that includes only 
the R and C components will be applied to noncomplex bank holding 
companies with assets at or below $1 billion.
    \2\ This risk management rating replaces the risk management 
rating required for BHCs by SR 95-51.
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RFI/C (D)

    In order to provide a consistent framework for assessing risk 
management, the R component is supported by four subcomponents that 
reflect the effectiveness of the banking organization's risk management 
and controls. The subcomponents are: Board and Senior Management 
Oversight; Policies, Procedures, and Limits; Risk Monitoring and 
Management Information Systems; and Internal Controls. The F component 
is also supported by four subcomponents reflecting an assessment of the 
quality of the consolidated banking organization's Capital; Asset 
Quality; Earnings; and Liquidity.
    Composite, component, and subcomponent ratings are assigned based 
on a 1 to 5 numeric scale. A 1 numeric rating indicates the highest 
rating, strongest performance and practices, and least degree of 
supervisory concern, whereas a 5 numeric rating indicates the lowest 
rating, weakest performance, and the highest degree of supervisory 
concern.
    The following three sections contain detailed descriptions of the 
composite, component, and subcomponent ratings, implementation guidance 
by BHC type, and definitions of the ratings.

I. Description of the Rating System Elements

The Composite (C) Rating

    C is the overall composite assessment of the BHC as reflected by 
consolidated risk management, consolidated financial strength, and the 
potential impact of the nondepository entities on the subsidiary 
depository institutions. The composite rating encompasses both a 
forward-looking and static assessment of the consolidated organization, 
as well as an assessment of the relationship between the depository and 
nondepository entities. Consistent with current Federal Reserve 
practice, the C rating is not derived as a simple numeric average of 
the R, F, and I components; rather, it reflects examiner judgment with 
respect to the relative importance of each component to the safe and 
sound operation of the BHC.

The Risk Management (R) Component

    R represents an evaluation of the ability of the BHC's board of 
directors and senior management, as appropriate for their respective 
positions, to identify, measure, monitor, and control risk. The R 
rating underscores the importance of the control environment, taking 
into consideration the complexity of the organization and the risk 
inherent in its activities.
    The R rating is supported by four subcomponents that are each 
assigned a separate rating. The four subcomponents are as follows: (1) 
Board and Senior Management Oversight; (2) Policies, Procedures and 
Limits; (3) Risk Monitoring and Management Information Systems; and (4) 
Internal Controls.\3\ The subcomponents are evaluated in the context of 
the risks undertaken by and inherent in a banking organization and the 
overall level of complexity of the firm's operations. They provide the 
Federal Reserve System with a consistent framework for evaluating risk 
management and the control environment. Moreover, the subcomponents 
provide a clear structure and basis for discussion of the R rating with 
BHC management, reflect the principles of SR Letter 95-51, are

[[Page 70447]]

familiar to examiners, and parallel the existing risk assessment 
process.
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    \3\ Another subcomponent assessing the adequacy of disclosures 
relating to risk exposures, risk assessment, and capital adequacy 
for BHCs using the advanced internal ratings based approach to risk-
based capital may be added once the Basel II framework has been 
implemented in the United States. The Federal Reserve does not 
intend to adopt such a disclosure rating without going out for 
public comment.
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Risk Management Subcomponents \4\
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    \4\ SR Letter 95-51 contains a detailed description of the four 
risk management subcomponents.
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Board and Senior Management Oversight \5\
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    \5\ The Board of Directors is considered separate from 
Management.
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    This subcomponent evaluates the adequacy and effectiveness of board 
and senior management's understanding and management of risk inherent 
in the BHC's activities, as well as the general capabilities of 
management. It also includes consideration of management's ability to 
identify, understand, and control the risks undertaken by the 
institution, to hire competent staff, and to respond to changes in the 
institution's risk profile or innovations in the banking sector.
Policies, Procedures and Limits
    This subcomponent evaluates the adequacy of a BHC's policies, 
procedures, and limits given the risks inherent in the activities of 
the consolidated BHC and the organization's stated goals and 
objectives. This analysis will include consideration of the adequacy of 
the institution's accounting and risk disclosure policies and 
procedures.
Risk Monitoring and Management Information Systems
    This subcomponent assesses the adequacy of a BHC's risk measurement 
and monitoring, and the adequacy of its management reports and 
information systems. This analysis will include a review of the 
assumptions, data, and procedures used to measure risk and the 
consistency of these tools with the level of complexity of the 
organization's activities.
Internal Controls
    This subcomponent evaluates the adequacy of a BHC's internal 
controls and internal audit procedures, including the accuracy of 
financial reporting and disclosure and the strength and influence, 
within the organization, of the internal audit team. This analysis will 
also include a review of the independence of control areas from 
management and the consistency of the scope coverage of the internal 
audit team with the complexity of the organization.

The Financial Condition (F) Component

    F represents an evaluation of the consolidated organization's 
financial strength. The F rating focuses on the ability of the BHC's 
resources to support the level of risk associated with its activities. 
The F rating is supported by four subcomponents: capital (C), asset 
quality (A), earnings (E), and liquidity (L). The CAEL subcomponents 
can be evaluated along individual business lines, product lines, or on 
a legal entity basis, depending on what is most appropriate given the 
structure of the organization. The assessment of the CAEL components 
should utilize benchmarks and metrics appropriate to the business 
activity being evaluated.
    Consistent with current supervisory practices, examination staff 
should continue to review relevant market indicators, such as external 
debt ratings, credit spreads, debt and equity prices, and qualitative 
rating agency assessments as a source of information complementary to 
examination findings.

Financial Condition Subcomponents (CAEL)

Capital Adequacy
    C reflects the adequacy of an organization's consolidated capital 
position, from a regulatory capital perspective and an economic capital 
perspective, as appropriate to the BHC.\6\ The evaluation of capital 
adequacy should consider the risk inherent in an organization's 
activities and the ability of capital to absorb unanticipated losses, 
to provide a base for growth, and to support the level and composition 
of the parent company and subsidiaries' debt.
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    \6\ Of course, the regulatory minimum capital ratios for BHCs 
are eight percent total risk-based capital, four percent tier 1 
risk-based capital, three percent tier 1 leverage for BHCs rated 
strong, and four percent tier 1 leverage for all other BHCs. See 12 
CFR 225, Appendices A and D.
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Asset Quality
    A reflects the quality of an organization's consolidated assets. 
The evaluation should include, as appropriate, both on-balance sheet 
and off-balance sheet exposures, and the level of criticized and 
nonperforming assets. Forward-looking indicators of asset quality, such 
as the adequacy of underwriting standards, the level of concentration 
risk, the adequacy of credit administration policies and procedures, 
and the adequacy of management information systems for credit risk may 
also inform the Federal Reserve's view of asset quality.
Earnings
    E reflects the quality of consolidated earnings. The evaluation 
considers the level, trend, and sources of earnings, as well as the 
ability of earnings to augment capital as necessary, to provide ongoing 
support for a BHC's activities.
Liquidity
    L reflects the consolidated organization's ability to attract and 
maintain the sources of funds necessary to support its operations and 
meet its obligations. The funding conditions for each of the material 
legal entities in the holding company structure should be evaluated to 
determine if any weaknesses exist that could affect the funding profile 
of the consolidated organization.

The Impact (I) Component

    Like the other components and subcomponents, the I component is 
rated on a five point numerical scale. However, the descriptive 
definitions of the numerical ratings for I are different than those of 
the other components and subcomponents. The I ratings are defined as 
follows:
    1--Low likelihood of significant negative impact;
    2--Limited likelihood of significant negative impact;
    3--Moderate likelihood of significant negative impact;
    4--Considerable likelihood of significant negative impact; and
    5--High likelihood of significant negative impact.
    The I component is an assessment of the potential impact of the 
nondepository entities on the subsidiary depository institution(s). The 
I assessment will evaluate both the risk management practices and 
financial condition of the nondepository entities--an analysis that 
will borrow heavily from the analysis conducted for the R and F 
components. Consistent with current practices, nondepository entities 
will be evaluated using benchmarks and analysis appropriate for those 
businesses. In addition, for functionally regulated nondepository 
subsidiaries, examination staff will continue to rely, to the extent 
possible, on the work of those functional regulators to assess the risk 
management practices and financial condition of those entities. In 
rating the I component, examination staff is required to evaluate the 
degree to which current or potential issues within the nondepository 
entities present a threat to the safety and soundness of the subsidiary 
depository institution(s). In this regard, the I component will give a 
clearer indication of the degree of risk posed by the nondepository 
entities to the federal safety net than does the current rating system.
    The I component focuses on the aggregate impact of the 
nondepository entities on the subsidiary depository institution(s). In 
this regard, the I rating

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does not include individual subcomponent ratings for the parent company 
and nondepository subsidiaries. An I rating is always assigned for each 
BHC; however, as is currently the case, nonmaterial nondepository 
subsidiaries\7\ may be excluded from the I analysis at examiner 
discretion. Any risk management and financial issues at the 
nondepository entities that potentially impact the safety and soundness 
of the subsidiary depository institution(s) should be identified in the 
written comments under the I rating. This approach is consistent with 
the Federal Reserve's objective not to extend bank-like supervision to 
nondepository entities.
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    \7\ As a general rule, nondepository subsidiaries should be 
included in the I analysis whenever their assets exceed five percent 
of the BHC's consolidated capital or $10 million, whichever is 
lower.
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    The analysis of the parent company for the purpose of assigning an 
I rating should emphasize weaknesses that could directly impact the 
risk management or financial condition of the subsidiary depository 
institution(s). Similarly, the analysis of the nondepository 
subsidiaries for the purpose of assigning an I rating should emphasize 
weaknesses that could negatively impact the parent company's 
relationship with its subsidiary depository institution(s) and 
weaknesses that could have a direct impact on the risk management 
practices or financial condition of the subsidiary depository 
institution(s). The analysis under the I component should consider 
existing as well as potential issues and risks that may impact the 
subsidiary depository institution(s) now or in the future. Particular 
attention should be paid to the following risk management and financial 
factors in assigning the I rating:
Risk Management Factors
    <bullet> Strategic Considerations: The potential risks posed to the 
subsidiary depository institution(s) by the nondepository entities' 
strategic plans for growth in existing activities and expansion into 
new products and services;
    <bullet> Operational Considerations: The spillover impact on the 
subsidiary depository institution(s) from actual losses, a poor control 
environment, or an operational loss history in the nondepository 
entities;
    <bullet> Legal and Reputational Considerations: The spillover 
effect on the subsidiary depository institution(s) of complaints and 
litigation that name one or more of the nondepository entities as 
defendants, or violations of laws or regulations, especially pertaining 
to intercompany transactions where the subsidiary depository 
institution(s) is involved; and
    <bullet> Concentration Considerations: The potential risks posed to 
the subsidiary depository institution(s) by concentrations within the 
nondepository entities in business lines, geographic areas, industries, 
customers, or other factors.
Financial Factors
    <bullet> Capital Distribution: The distribution and transferability 
of capital across the legal entities;
    <bullet> Intra-Group Exposures: The extent to which intra-group 
exposures, including servicing agreements, have the potential to 
undermine the condition of subsidiary depository institution(s); and,
    <bullet> Parent Company Cash Flow and Leverage: The extent to which 
the parent company is dependent on dividend payments, from both the 
nondepository subsidiaries and the subsidiary depository 
institution(s), to service debt and cover fixed charges. Also, the 
effect that these upstreamed cash flows have had, or can be expected to 
have, on the financial condition of the BHC's nondepository 
subsidiaries and subsidiary depository institution(s).

The Depository Institutions (D) Component

    The (D) component will generally reflect the composite CAMELS 
rating assigned by the subsidiary depository institution's primary 
supervisor. In a multi-bank BHC, the (D) rating will reflect a weighted 
average of the CAMELS composite ratings of the individual subsidiary 
depository institutions, weighted by both asset size and the relative 
importance of each depository institution within the holding company 
structure. In this regard, the CAMELS composite rating for a subsidiary 
depository institution that dominates the corporate culture may figure 
more prominently in the assignment of the (D) rating than would be 
dictated by asset size, particularly when problems exist within that 
depository institution.
    The (D) component conveys important supervisory information, 
reflecting the primary supervisor's assessment of the legal entity. The 
(D) component stands outside of the composite rating although 
significant risk management and financial condition considerations at 
the depository institution level are incorporated in the consolidated R 
and F ratings, which are then factored into the C rating.
    Consistent with current practice, if, in the process of analyzing 
the financial condition and risk management programs of the 
consolidated organization, a major difference of opinion regarding the 
safety and soundness of the subsidiary depository institution(s) 
emerges between the Federal Reserve and the depository institution's 
primary regulator, then the (D) rating should reflect the Federal 
Reserve's evaluation.
    To highlight the presence of one or more problem depository 
institution(s) in a multi-bank BHC whose depository institution 
component, based on weighted averages, might not otherwise reveal their 
presence (i.e., depository institution ratings of 1, 2 or 3), a problem 
modifier, ``P'' would be attached to the depository institution rating 
(e.g., 1P, 2P, or 3P). Thus, 2P would indicate that, while on balance 
the depository subsidiaries are rated satisfactory, there exists a 
problem depository institution (composite 4 or 5) among the subsidiary 
depository institutions. The problem identifier is unnecessary when the 
depository institution component is rated 4 or 5.

II. Implementation of the BHC Rating System by Bank Holding Company 
Type

    The Federal Reserve revised the BHC rating system to align the 
rating system with current Federal Reserve supervisory practices. The 
rating system will require analysis and support similar to that 
required by the former BOPEC rating system for BHCs of all sizes.\8\ As 
such, the level of analysis and support will vary based upon whether a 
BHC has been determined to be ``complex'' or ``noncomplex.'' \9\ In 
addition, the resources dedicated to the inspection of each BHC will 
continue to

[[Page 70449]]

be determined by the risk posed by the subsidiary depository 
institution(s) to the federal safety net \10\ and the risk posed by the 
BHC to the subsidiary depository institution(s).
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    \8\ As described in the BHC inspection manual, SR 95-51, SR 97-
24, SR 99-15, and SR 02-01.
    \9\ The determination of whether a holding company is 
``complex'' versus ``noncomplex'' is made at least annually on a 
case-by-case basis taking into account and weighing a number of 
considerations, such as: The size and structure of the holding 
company; the extent of intercompany transactions between depository 
institution subsidiaries and the holding company or nondepository 
subsidiaries of the holding company; the nature and scale of any 
nondepository activities, including whether the activities are 
subject to review by another regulator and the extent to which the 
holding company is conducting Gramm-Leach-Bliley authorized 
activities (e.g., insurance, securities, merchant banking); whether 
risk management processes for the holding company are consolidated; 
and whether the holding company has material debt outstanding to the 
public. Size is a less important determinant of complexity than many 
of the factors noted above, but generally companies of significant 
size (e.g., assets of $10 billion on balance sheet or managed) would 
be considered complex, irrespective of the other considerations.
    \10\ The federal safety net includes the federal deposit 
insurance fund, the payments system, and the Federal Reserve's 
discount window.
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Noncomplex BHCs with Assets of $1 Billion or Less (Shell Holding 
Companies)

Rating: R and C
    Consistent with SR 02-1, examination staff will assign only an R 
and C rating for all companies in the shell BHC program (noncomplex 
BHCs with assets under $1 billion). The R rating is the M rating from 
the subsidiary depository institution's CAMELS rating. To provide 
consistent rating terminology across BHCs of all sizes, the terminology 
is changed to R from the former M. The C rating is the subsidiary 
depository institution's composite CAMELS rating.

Noncomplex BHCs With Assets Greater Than $1 Billion

One-Bank Holding Company
Rating: RFI/C (D)
    For all noncomplex, one-bank holding companies with assets of 
greater than $1 billion, examination staff will assign all component 
and subcomponent ratings; however, examination staff should continue to 
rely heavily on information and analysis contained in the primary 
regulator's report of examination for the subsidiary depository 
institution to assign the R and F ratings. If examination staff have 
reviewed the primary regulator's examination report and are comfortable 
with the analysis and conclusions contained in that report, then the 
BHC ratings should be supported with concise language that indicates 
that the conclusions are based on the analysis of the primary 
regulator. No additional analysis will be required.
    Please note, however, in cases where the analysis and conclusions 
of the primary regulator are insufficient to assign the ratings, the 
primary regulator should be contacted to ascertain whether additional 
analysis and support may be available. Further, if discussions with the 
primary regulator do not provide sufficient information to assign the 
ratings, discussions with BHC management may be warranted to obtain 
adequate information to assign the ratings. In most cases, additional 
information or support obtained through these steps will be sufficient 
to permit the assignment of the R and F ratings. To the extent that 
additional analysis is deemed necessary, the level of analysis and 
resources spent on this assessment should be in line with the level of 
risk the subsidiary depository institution poses to the federal safety 
net. In addition, any activities that involve information gathering 
with respect to the subsidiary depository institution should be 
coordinated with and, if possible, conducted by, the primary regulator 
of that institution.
    Examination staff are required to make an independent assessment in 
order to assign the I rating, which provides an evaluation of the 
impact of the BHC on the subsidiary depository institution. Analysis 
for the I rating in non-complex one-bank holding companies should place 
particular emphasis on issues related to parent company cash flow and 
compliance with sections 23A and 23B of the Federal Reserve Act.
Multi-Bank Holding Company
Rating: RFI/C (D)
    For all noncomplex BHCs with assets of greater than $1 billion and 
more than one subsidiary depository institution, examination staff will 
assign all component and subcomponent ratings of the new system. 
Examiners should rely, to the extent possible, on the work conducted by 
the primary regulators of the subsidiary depository institutions to 
assign the R and F ratings. However, any risk management or other 
important functions conducted by the nondepository entities of the BHC, 
or conducted across legal entity lines, should be subject to review by 
Federal Reserve examination staff. These reviews should be conducted in 
coordination with the primary regulator(s). The assessment for the I 
rating requires an independent assessment by Federal Reserve 
examination staff.

Complex BHCs

Rating: RFI/C (D)
    For complex BHCs, examination staff will assign all component and 
subcomponent ratings of the new rating system. The ratings analysis 
should be based on the primary and functional regulators' assessment of 
the subsidiary entities, as well as on the examiners' assessment of the 
consolidated organization as determined through off-site review and the 
BHC inspection process, as appropriate. The resources needed for the 
inspection and the level of support needed for developing a full rating 
will depend on the complexity of the organization, including structure 
and activities (see footnote 7), and should be commensurate with the 
level of risk posed by the subsidiary depository institution(s) to the 
federal safety net and the level of risk posed by the BHC to the 
subsidiary depository institution(s).

Nontraditional BHCs

Rating: RFI/C (D)
    Examination staff are required to assign the full rating system for 
nontraditional BHCs. Nontraditional BHCs include BHCs in which most or 
all nondepository entities are regulated by a functional regulator and 
in which the subsidiary depository institution(s) are small in relation 
to the nondepository entities. The rating system is not intended to 
introduce significant additional work in the rating process for these 
organizations. As discussed above, the level of analysis conducted and 
resources needed to inspect the BHC and to assign the consolidated R 
and F ratings should be commensurate with the level of risk posed by 
the subsidiary depository institution(s) to the federal safety net and 
the level of risk posed by the BHC to the subsidiary depository 
institution(s). The report of examination by, and other information 
obtained from, the functional and primary bank regulators should 
provide the basis for the consolidated R and F ratings. On-site work, 
to the extent it involves areas that are the primary responsibility of 
the functional or primary bank regulator, should be coordinated with 
and, if possible, conducted by, those regulators. Examination staff 
should concentrate their independent analysis for the R and F ratings 
around activities and risk management conducted by the parent company 
and non-functionally regulated nondepository subsidiaries, as well as 
around activities and risk management functions that are related to the 
subsidiary depository institution(s), for example, audit functions for 
the depository institution(s) and compliance with sections 23A and 23B.
    Examination staff are required to make an independent assessment of 
the impact of the nondepository entities on the subsidiary depository 
institution(s) in order to assign the I rating.

III. Rating Definitions for the RFI/C (D) Rating System

    All component and subcomponent ratings are rated on a five point 
numeric scale. With the exception of the I component, ratings will be 
assigned in ascending order of supervisory concern as follows: 1--
Strong; 2--Satisfactory; 3--Fair; 4--Marginal; and 5--Unsatisfactory.

[[Page 70450]]

    A description of the I component ratings is in the I section below.
    As is current Federal Reserve practice, the component ratings are 
not derived as a simple numeric average of the subcomponent ratings; 
rather, weight afforded to each subcomponent in the overall component 
rating will depend on the severity of the condition of that 
subcomponent and the relative importance of that subcomponent to the 
consolidated organization. Similarly, some components may be given more 
weight than others in determining the composite rating, depending on 
the situation of the BHC. Assignment of a composite rating may 
incorporate any factor that bears significantly on the overall 
condition and soundness of the BHC, although generally the composite 
rating bears a close relationship to the component ratings assigned.

Composite Rating

    Rating 1 (Strong). BHCs in this group are sound in almost every 
respect; any negative findings are basically of a minor nature and can 
be handled in a routine manner. Risk management practices and financial 
condition provide resistance to external economic and financial 
disturbances. Cash flow is more than adequate to service debt and other 
fixed obligations, and the nondepository entities pose little risk to 
the subsidiary depository institution(s).
    Rating 2 (Satisfactory). BHCs in this group are fundamentally sound 
but may have modest weaknesses in risk management practices or 
financial condition. The weaknesses could develop into conditions of 
greater concern but are believed correctable in the normal course of 
business. As such, the supervisory response is limited. Cash flow is 
adequate to service obligations, and the nondepository entities are 
unlikely to have a significant negative impact on the subsidiary 
depository institution(s).
    Rating 3 (Fair). BHCs in this group exhibit a combination of 
weaknesses in risk management practices and financial condition that 
range from fair to moderately severe. These companies are less 
resistant to the onset of adverse business conditions and would likely 
deteriorate if concerted action is not effective in correcting the 
areas of weakness. Consequently, these companies are vulnerable and 
require more than normal supervisory attention and financial 
surveillance. However, the risk management and financial capacity of 
the company, including the potential negative impact of the 
nondepository entities on the subsidiary depository institution(s), 
pose only a remote threat to its continued viability.
    Rating 4 (Marginal). BHCs in this group have an immoderate volume 
of risk management and financial weaknesses, which may pose a 
heightened risk of significant negative impact on the subsidiary 
depository institution(s). The holding company's cash flow needs may be 
being met only by upstreaming imprudent dividends and/or fees from its 
subsidiaries. Unless prompt action is taken to correct these 
conditions, the organization's future viability could be impaired. 
These companies require close supervisory attention and substantially 
increased financial surveillance.
    Rating 5 (Unsatisfactory). The critical volume and character of the 
risk management and financial weaknesses of BHCs in this category, and 
concerns about the nondepository entities negatively impacting the 
subsidiary depository institution(s), could lead to insolvency without 
urgent aid from shareholders or other sources. The imminent inability 
to prevent liquidity and/or capital depletion places the BHC's 
continued viability in serious doubt. These companies require immediate 
corrective action and constant supervisory attention.

Risk Management Component

    Rating 1 (Strong). A rating of 1 indicates that management 
effectively identifies and controls all major types of risk posed by 
the BHC's activities. Management is fully prepared to address risks 
emanating from new products and changing market conditions. The board 
and management are forward-looking and active participants in managing 
risk. Management ensures that appropriate policies and limits exist and 
are understood, reviewed, and approved by the board. Policies and 
limits are supported by risk monitoring procedures, reports, and 
management information systems that provide management and the board 
with the information and analysis that is necessary to make timely and 
appropriate decisions in response to changing conditions. Risk 
management practices and the organization's infrastructure are flexible 
and highly responsive to changing industry practices and current 
regulatory guidance. Staff has sufficient experience, expertise and 
depth to manage the risks assumed by the institution.
    Internal controls and audit procedures are sufficiently 
comprehensive and appropriate to the size and activities of the 
institution. There are few noted exceptions to the institution's 
established policies and procedures, and none is material. Management 
effectively and accurately monitors the condition of the institution 
consistent with the standards of safety and soundness, and in 
accordance with internal and supervisory policies and practices. Risk 
management processes are fully effective in identifying, monitoring, 
and controlling the risks to the institution.
    Rating 2 (Satisfactory). A rating of 2 indicates that the 
institution's management of risk is largely effective, but lacking in 
some modest degree. Management demonstrates a responsiveness and 
ability to cope successfully with existing and foreseeable risks that 
may arise in carrying out the institution's business plan. While the 
institution may have some minor risk management weaknesses, these 
problems have been recognized and are in the process of being resolved. 
Overall, board and senior management oversight, policies and limits, 
risk monitoring procedures, reports, and management information systems 
are considered satisfactory and effective in maintaining a safe and 
sound institution. Risks are controlled in a manner that does not 
require more than normal supervisory attention.
    The BHC's risk management practices and infrastructure are 
satisfactory and generally are adjusted appropriately in response to 
changing industry practices and current regulatory guidance. Staff 
experience, expertise and depth are generally appropriate to manage the 
risks assumed by the institution.
    Internal controls may display modest weaknesses or deficiencies, 
but they are correctable in the normal course of business. The examiner 
may have recommendations for improvement, but the weaknesses noted 
should not have a significant effect on the safety and soundness of the 
institution.
    Rating 3 (Fair). A rating of 3 signifies that risk management 
practices are lacking in some important ways and, therefore, are a 
cause for more than normal supervisory attention. One or more of the 
four elements of sound risk management\11\ (active board and senior 
management oversight; adequate policies, procedures, and limits; 
adequate risk management monitoring and management information systems; 
comprehensive internal controls) is considered less than acceptable, 
and has precluded the institution from fully addressing one or more 
significant risks to its operations. Certain risk

[[Page 70451]]

management practices are in need of improvement to ensure that 
management and the board are able to identify, monitor, and control all 
significant risks to the institution. Also, the risk management 
structure may need to be improved in areas of significant business 
activity, or staff expertise may not be commensurate with the scope and 
complexity of business activities. In addition, management's response 
to changing industry practices and regulatory guidance may need to 
improve.
---------------------------------------------------------------------------

    \11\ Framework for Risk-Focused Supervision of Large Complex 
Institutions, August 1997; SR Letter 95-51, Rating the Adequacy of 
Risk Management Processes and Internal Controls at State Member 
Banks and Bank Holding Companies.
---------------------------------------------------------------------------

    The internal control system may be lacking in some important 
aspects, particularly as indicated by continued control exceptions or 
by a failure to adhere to written policies and procedures. The risk 
management weaknesses could have adverse effects on the safety and 
soundness of the institution if corrective action is not taken by 
management.
    Rating 4 (Marginal). A rating of 4 represents deficient risk 
management practices that fail to identify, monitor, and control 
significant risk exposures in many material respects. Generally, such a 
situation reflects a lack of adequate guidance and supervision by 
management and the board. One or more of the four elements of sound 
risk management is deficient and requires immediate and concerted 
corrective action by the board and management.
    The institution may have serious identified weaknesses, such as an 
inadequate separation of duties, that require substantial improvement 
in internal control or accounting procedures, or improved adherence to 
supervisory standards or requirements. The risk management deficiencies 
warrant a high degree of supervisory attention because, unless properly 
addressed, they could seriously affect the safety and soundness of the 
institution.
    Rating 5 (Unsatisfactory). A rating of 5 indicates a critical 
absence of effective risk management practices with respect to the 
identification, monitoring, or control over significant risk exposures. 
One or more of the four elements of sound risk management is considered 
wholly deficient, and management and the board have not demonstrated 
the capability to address these deficiencies.
    Internal controls are critically weak and, as such, could seriously 
jeopardize the continued viability of the institution. If not already 
evident, there is an immediate concern as to the reliability of 
accounting records and regulatory reports and the potential for losses 
if corrective measures are not taken immediately. Deficiencies in the 
institution's risk management procedures and internal controls require 
immediate and close supervisory attention.

Risk Management Subcomponents

Board and Senior Management Oversight
    Rating 1 (Strong). An assessment of Strong signifies that the board 
and senior management are forward-looking, fully understand the types 
of risk inherent in the BHC's activities, and actively participate in 
managing those risks. The board has approved overall business 
strategies and significant policies, and ensures that senior management 
is fully capable of managing the activities that the BHC conducts. 
Consistent with the standards of safety and soundness, oversight of 
risk management practices is strong and the organization's overall 
business strategy is effective.
    Senior management ensures that risk management practices are 
rapidly adjusted in accordance with enhancements to industry practices 
and regulatory guidance, and exposure limits are adjusted as necessary 
to reflect the institution's changing risk profile. Policies, limits, 
and tracking reports are appropriate, understood, and regularly 
reviewed.
    Management provides effective supervision of the day-to-day 
activities of all officers and employees, including the supervision of 
the senior officers and the heads of business lines. It hires staff 
that possess experience and expertise consistent with the scope and 
complexity of the organization's business activities. There is a 
sufficient depth of staff to ensure sound operations. Management 
ensures compliance with laws and regulations and that employees have 
the integrity, ethical values, and competence consistent with a prudent 
management philosophy and operating style.
    Management responds appropriately to changes in the marketplace. It 
identifies all risks associated with new activities or products before 
they are launched, and ensures that the appropriate infrastructure and 
internal controls are established.
    Rating 2 (Satisfactory). An assessment of Satisfactory indicates 
that board and senior management have an adequate understanding of the 
organization's risk profile and provide largely effective oversight of 
risk management practices. In this regard, the board has approved all 
major business strategies and significant policies, and ensures that 
senior management is capable of managing the activities that the BHC 
conducts. Oversight of risk management practices is satisfactory and 
the organization's overall business strategy is generally sound.
    Senior management generally adjusts risk management practices 
appropriately in accordance with enhancements to industry practices and 
regulatory guidance, and adjusts exposure limits as necessary to 
reflect the institution's changing risk profile, although these 
practices may be lacking in some modest degree. Policies, limits, and 
tracking reports are generally appropriate, understood, and regularly 
reviewed, and the new product approval process adequately identifies 
the associated risks and necessary controls.
    Senior management's day-to-day supervision of management and staff 
at all levels is generally effective. The level of staffing, and its 
experience, expertise, and depth, is sufficient to operate the business 
lines in a safe and sound manner. Minor weaknesses may exist in the 
staffing, infrastructure, and risk management processes for individual 
business lines or products, but these weaknesses have been identified 
by management, are correctable in the normal course of business, and 
are in the process of being addressed. Weaknesses noted should not have 
a significant effect on the safety and soundness of the institution.
    Rating 3 (Fair). An assessment of Fair signifies that board and 
senior management oversight is lacking in some important way and, 
therefore, is a cause for more than normal supervisory attention. The 
weaknesses may involve a broad range of activities or be material to a 
major business line or activity. Weaknesses in one or more aspect of 
board and senior management oversight have precluded the institution 
from fully addressing one or more significant risks to the institution. 
The deficiencies may include a lack of knowledge with respect to the 
organization's risk profile, insufficient oversight of risk management 
practices, ineffective policies or limits, inadequate or under-utilized 
management reporting, an inability to respond to industry enhancements 
and changes in regulatory guidance, or failure to execute appropriate 
business strategies. Staffing may not be adequate or staff may not 
possess the experience and expertise needed for the scope and 
complexity of the organization's business activities. The day-to-day 
supervision of officer and staff activities, including the management 
of senior officers or heads of business lines, may be lacking. Certain 
risk management practices are in need of improvement to ensure that 
management and the board is able to

[[Page 70452]]

identify, monitor, and control all significant risks to the 
institution. Weaknesses noted could have adverse effects on the safety 
and soundness of the institution if corrective action is not taken by 
management.
    Rating 4 (Marginal). An assessment of Marginal represents deficient 
oversight practices that reflect a lack of adequate guidance and 
supervision by management and the board. A number of significant risks 
to the institution have not been adequately addressed, and the board 
and senior management function warrants a high degree of supervisory 
attention. Multiple board and senior management weaknesses are in need 
of immediate improvement. They may include a significant lack of 
knowledge with respect to the organization's risk profile, largely 
insufficient oversight of risk management practices, ineffective 
policies or limits, inadequate or considerably under-utilized 
management reporting, an inability to respond to industry enhancements 
and changes in regulatory guidance, or failure to execute appropriate 
business strategies. Staffing may not be adequate or possess the 
experience and expertise needed for the scope and complexity of the 
organization's business activities, and the day-to-day supervision of 
officer and staff activities, including the management of senior 
officers or heads of business lines, may be considerably lacking. These 
conditions warrant a high degree of supervisory attention because, 
unless properly addressed, they could seriously affect the safety and 
soundness of the institution.
    Rating 5 (Unsatisfactory). An assessment of Unsatisfactory 
indicates a critical absence of effective board and senior management 
oversight practices. Problems may include a severe lack of knowledge 
with respect to the organization's risk profile, insufficient oversight 
of risk management practices, wholly ineffective policies or limits, 
critically inadequate or under-utilized management reporting, a 
complete inability to respond to industry enhancements and changes in 
regulatory guidance, or failure to execute appropriate business 
strategies. Staffing may be inadequate, inexpert, and/or inadequately 
supervised. The deficiencies require immediate and close supervisory 
attention, as management and the board have not demonstrated the 
capability to address them. Weaknesses could seriously jeopardize the 
continued viability of the institution.

Policies, Procedures and Limits

    Rating 1 (Strong). An assessment of Strong indicates that the 
policies, procedures, and limits provide for effective identification, 
measurement, monitoring, and control of the risks posed by all 
significant activities, including lending, investing, trading, trust, 
and fiduciary activities. Policies, procedures, and limits are 
consistent with the institution's goals and objectives and its overall 
financial strength. The policies clearly delineate accountability and 
lines of authority across the institution's activities. The policies 
also provide for the review of new activities to ensure that the 
infrastructure necessary to identify, monitor, and control the 
associated risks is in place before the activities are initiated.
    Rating 2 (Satisfactory). An assessment of Satisfactory indicates 
that the policies, procedures and limits cover all major business 
areas, are thorough and substantially up-to-date, and provide a clear 
delineation of accountability and lines of authority across the 
institution's activities. Policies, procedures, and limits are 
generally consistent with the institution's goals and objectives and 
its overall financial strength. Also, the policies provide for adequate 
due diligence before engaging in new activities or products. Any 
deficiencies or gaps that have been identified are minor in nature and 
in the process of being addressed. Weaknesses should not have a 
significant effect on the safety and soundness of the institution.
    Rating 3 (Fair). An assessment of Fair signifies that deficiencies 
exist in policies, procedures, and limits that require more than normal 
supervisory attention. The deficiencies may involve a broad range of 
activities or be material to a major business line or activity. The 
deficiencies may include policies, procedures, or limits (or the lack 
thereof) that do not adequately identify, measure, monitor, or control 
the risks posed by significant activities; are not consistent with the 
experience of staff, the organization's strategic goals and objectives, 
or the financial strength of the institution; or do not clearly 
delineate accountability or lines of authority. Also, the policies may 
not provide for adequate due diligence before engaging in new 
activities or products. Weaknesses noted could have adverse effects on 
the safety and soundness of the institution unless corrective action is 
taken by management.
    Rating 4 (Marginal). An assessment of Marginal indicates deficient 
policies, procedures, and limits that do not address a number of 
significant risks to the institution. Multiple practices are in need of 
immediate improvement, which may include policies, procedures, or 
limits (or the lack thereof) that ineffectively identify, measure, 
monitor, or control the risks posed by significant activities; are not 
commensurate with the experience of staff, the institution's strategic 
goals and objectives, or the financial strength of the institution; or 
do not delineate accountability or lines of authority. Moreover, 
policies may be considerably lacking with regards to providing for 
effective due diligence before engaging in new activities or products. 
These conditions warrant a high degree of supervisory attention 
because, unless properly addressed, they could seriously affect the 
safety and soundness of the institution.
    Rating 5 (Unsatisfactory). An assessment of Unsatisfactory 
indicates a critical absence of effective policies, procedures, and 
limits. Policies, procedures, or limits (or the lack thereof) are 
largely or entirely ineffective with regard to identifying, measuring, 
monitoring, or controlling the risks posed by significant activities; 
are completely inconsistent with the experience of staff, the 
organization's strategic goals and objectives, or the financial 
strength of the institution; or do not delineate accountability or 
lines of authority. Also, policies may be completely lacking with 
regard to providing for effective due diligence before engaging in new 
activities or products. Critical weaknesses could seriously jeopardize 
the continued viability of the institution and require immediate and 
close supervisory attention.

Risk Monitoring and MIS

    Rating 1 (Strong). An assessment of Strong indicates that risk 
monitoring practices and MIS reports address all material risks. The 
key assumptions, data sources, and procedures used in measuring and 
monitoring risk are appropriate, thoroughly documented, and frequently 
tested for reliability. Reports and other forms of communication are 
consistent with activities, are structured to monitor exposures and 
compliance with established limits, goals, or objectives, and compare 
actual versus expected performance when appropriate. Management and 
board reports are accurate and timely and contain sufficient 
information to identify adverse trends and to thoroughly evaluate the 
level of risk faced by the institution.
    Rating 2 (Satisfactory). An assessment of Satisfactory indicates 
that risk

[[Page 70453]]

monitoring practices and MIS reports cover major risks and business 
areas, although they may be lacking in some modest degree. In general, 
the reports contain valid assumptions that are periodically tested for 
accuracy and reliability and are adequately documented and distributed 
to the appropriate decision-makers. Reports and other forms of 
communication generally are consistent with activities; are structured 
to monitor exposures and compliance with established limits, goals, or 
objectives; and compare actual versus expected performance when 
appropriate. Management and board reports are generally accurate and 
timely, and broadly identify adverse trends and the level of risk faced 
by the institution. Any weaknesses or deficiencies that have been 
identified are in the process of being addressed.
    Rating 3 (Fair). An assessment of Fair signifies that weaknesses 
exist in the institution's risk monitoring practices or MIS reports 
that require more than normal supervisory attention. The weaknesses may 
involve a broad range of activities or be material to a major business 
line or activity. They may contribute to ineffective risk 
identification or monitoring through inappropriate assumptions, 
incorrect data, poor documentation, or the lack of timely testing. In 
addition, MIS reports may not be distributed to the appropriate 
decision-makers, adequately monitor significant risks, or properly 
identify adverse trends and the level of risk faced by the institution. 
Weaknesses noted could have adverse effects on the safety and soundness 
of the institution if corrective action is not taken by management.
    Rating 4 (Marginal). An assessment of Marginal represents deficient 
risk monitoring practices or MIS reports that, unless properly 
addressed, could seriously affect the safety and soundness of the 
institution. A number of significant risks to the institution are not 
adequately monitored or reported. Ineffective risk identification may 
result from notably inappropriate assumptions, incorrect data, poor 
documentation, or the lack of timely testing. In addition, MIS reports 
may not be distributed to the appropriate decision-makers, may 
inadequately monitor significant risks, or fail to identify adverse 
trends and the level of risk faced by the institution. The risk 
monitoring and MIS deficiencies warrant a high degree of supervisory 
attention because, unless properly addressed, they could seriously 
affect the safety and soundness of the institution.
    Rating 5 (Unsatisfactory). An assessment of Unsatisfactory 
indicates a critical absence of risk monitoring and MIS. They are 
wholly deficient due to inappropriate assumptions, incorrect data, poor 
documentation, or the lack of timely testing. Moreover, MIS reports may 
not be distributed to the appropriate decision-makers, fail to monitor 
significant risks, or fail to identify adverse trends and the level of 
risk faced by the institution. These critical weaknesses require 
immediate and close supervisory attention, as they could seriously 
jeopardize the continued viability of the institution.

Internal Controls

    Rating 1 (Strong). An assessment of Strong indicates that the 
system of internal controls is robust for the type and level of risks 
posed by the nature and scope of the organization's activities. The 
organizational structure establishes clear lines of authority and 
responsibility for monitoring adherence to policies, procedures, and 
limits, and wherever applicable, exceptions are noted and promptly 
investigated. Reporting lines provide clear independence of the control 
areas from the business lines and separation of duties throughout the 
organization. Robust procedures exist for ensuring compliance with 
applicable laws and regulations, including consumer laws and 
regulations. Financial, operational, and regulatory reports are 
reliable, accurate, and timely. Internal audit or other control review 
practices provide for independence and objectivity. Internal controls 
and information systems are thoroughly tested and reviewed; the 
coverage, procedures, findings, and responses to audits and review 
tests are well documented; identified material weaknesses are given 
thorough and timely high level attention; and management's actions to 
address material weaknesses are objectively reviewed and verified. The 
board or its audit committee regularly reviews the effectiveness of 
internal audits and other control review activities.
    Rating 2 (Satisfactory). An assessment of Satisfactory indicates 
that the system of internal controls adequately covers major risks and 
business areas, with some modest weaknesses. In general, the control 
functions are independent from the business lines, and there is 
appropriate separation of duties. The control system supports accuracy 
in record-keeping practices and reporting systems, is adequately 
documented, and verifies compliance with laws and regulations, 
including consumer laws and regulations. Internal controls and 
information systems are adequately tested and reviewed, and the 
coverage, procedures, findings, and responses to audits and review 
tests are documented. Identified material weaknesses are given 
appropriate attention and management's actions to address material 
weaknesses are objectively reviewed and verified. The board or its 
audit committee reviews the effectiveness of internal audits and other 
control review activities. Any weaknesses or deficiencies that have 
been identified are modest in nature and in the process of being 
addressed.
    Rating 3 (Fair). An assessment of Fair signifies that weaknesses 
exist in the system of internal controls that require more than normal 
supervisory attention. The weaknesses may involve a broad range of 
activities or be material to a major business line or activity. The 
weaknesses may include insufficient oversight of internal controls and 
audit by the board or its audit committee; unclear or conflicting lines 
of authority and responsibility; a lack of independence between control 
areas and business activities; or ineffective separation of duties. The 
internal control system may produce inadequate or untimely risk 
coverage and verification, including monitoring compliance with both 
safety and soundness and consumer laws and regulations; inaccurate 
records or financial, operational, or regulatory reporting; a lack of 
documentation for work performed; or a lack of timeliness in management 
review and correction of identified weaknesses. Weaknesses noted could 
have adverse effects on the safety and soundness of the institution if 
corrective action is not taken by management.
    Rating 4 (Marginal). An assessment of Marginal represents a 
deficient internal control system that does not adequately address a 
number of significant risks to the institution. The deficiencies may 
include neglect of internal controls and audit by the board or its 
audit committee; conflicting lines of authority and responsibility; a 
lack of independence between control areas and business activities; or 
no separation of duties in critical areas. The internal control system 
may produce inadequate, untimely, or nonexistent risk coverage and 
verification in certain areas, including monitoring compliance with 
both safety and soundness and consumer laws and regulations; inaccurate 
records or financial, operational, or regulatory reporting; a lack of 
documentation for work performed; or infrequent management review and 
correction of identified weaknesses. The internal control

[[Page 70454]]

deficiencies warrant a high degree of supervisory attention because, 
unless properly addressed, they could seriously affect the safety and 
soundness of the institution.
    Rating 5 (Unsatisfactory). An assessment of Unsatisfactory 
indicates a critical absence of an internal control system. There may 
be no oversight by the board or its audit committee; conflicting lines 
of authority and responsibility; no distinction between control areas 
and business activities; or no separation of duties. The internal 
control system may produce totally inadequate or untimely risk coverage 
and verification, including monitoring compliance with both safety and 
soundness and consumer laws and regulations; completely inaccurate 
records or regulatory reporting; a severe lack of documentation for 
work performed; or no management review and correction of identified 
weaknesses. Such deficiencies require immediate and close supervisory 
attention, as they could seriously jeopardize the continued viability 
of the institution.

Financial Condition Component

    Rating 1 (Strong). A rating of 1 indicates that the consolidated 
BHC is financially sound in almost every respect; any negative findings 
are basically of a minor nature and can be handled in a routine manner. 
The capital adequacy, asset quality, earnings, and liquidity of the 
consolidated BHC are more than adequate to protect the company from 
reasonably foreseeable external economic and financial disturbances. 
The company generates more than sufficient cash flow to service its 
debt and fixed obligations with no harm to subsidiaries of the 
organization.
    Rating 2 (Satisfactory). A rating of 2 indicates that the 
consolidated BHC is fundamentally financially sound, but may have 
modest weaknesses correctable in the normal course of business. The 
capital adequacy, asset quality, earnings and liquidity of the 
consolidated BHC are adequate to protect the company from external 
economic and financial disturbances. The company also generates 
sufficient cash flow to service its obligations; however, areas of 
weakness could develop into areas of greater concern. To the extent 
minor adjustments are handled in the normal course of business, the 
supervisory response is limited.
    Rating 3 (Fair). A rating of 3 indicates that the consolidated BHC 
exhibits a combination of weaknesses ranging from fair to moderately 
severe. The company has less than adequate financial strength stemming 
from one or more of the following: modest capital deficiencies, 
substandard asset quality, weak earnings, or liquidity problems. As a 
result, the BHC and its subsidiaries are less resistant to adverse 
business conditions. The financial condition of the BHC will likely 
deteriorate if concerted action is not taken to correct areas of 
weakness. The company's cash flow is sufficient to meet immediate 
obligations, but may not remain adequate if action is not taken to 
correct weaknesses. Consequently, the BHC is vulnerable and requires 
more than normal supervision. Overall financial strength and capacity 
are still such as to pose only a remote threat to the viability of the 
company.
    Rating 4 (Marginal). A rating of 4 indicates that the consolidated 
BHC has either inadequate capital, an immoderate volume of problem 
assets, very weak earnings, serious liquidity issues, or a combination 
of factors that are less than satisfactory. An additional weakness may 
be that the BHC's cash flow needs are met only by upstreaming imprudent 
dividends and/or fees from subsidiaries. Unless prompt action is taken 
to correct these conditions, they could impair future viability. BHCs 
in this category require close supervisory attention and increased 
financial surveillance.
    Rating 5 (Unsatisfactory). A rating of 5 indicates that the volume 
and character of financial weaknesses of the BHC are so critical as to 
require urgent aid from shareholders or other sources to prevent 
insolvency. The imminent inability of such a company to service its 
fixed obligations and/or prevent capital depletion due to severe 
operating losses places its viability in serious doubt. Such companies 
require immediate corrective action and constant supervisory attention.

The Financial Condition Subcomponents

    The financial condition subcomponents can be evaluated along 
business lines, product lines, or legal entity lines--depending on 
which type of review is most appropriate for the holding company 
structure.

Capital Adequacy

    Rating 1 (Strong). A rating of 1 indicates that the consolidated 
BHC maintains more than adequate capital to support the volume and risk 
characteristics of all parent and subsidiary business lines and 
products; provide a sufficient cushion to absorb unanticipated losses 
arising from the parent and subsidiary activities; and support the 
level and composition of parent and subsidiary borrowing. In addition, 
a company assigned a rating of 1 has more than sufficient capital to 
provide a base for the growth of risk assets and the entry into capital 
markets as the need arises for the parent company and subsidiaries.
    Rating 2 (Satisfactory). A rating of 2 indicates that the 
consolidated BHC maintains adequate capital to support the volume and 
risk characteristics of all parent and subsidiary business lines and 
products; provide a sufficient cushion to absorb unanticipated losses 
arising from the parent and subsidiary activities; and support the 
level and composition of parent and subsidiary borrowing. In addition, 
a company assigned a rating of 2 has sufficient capital to provide a 
base for the growth of risk assets and the entry into capital markets 
as the need arises for the parent company and subsidiaries.
    Rating 3 (Fair). A rating of 3 indicates that the consolidated BHC 
may not maintain sufficient capital to ensure support for the volume 
and risk characteristics of all parent and subsidiary business lines 
and products; the unanticipated losses arising from the parent and 
subsidiary activities; or the level and composition of parent and 
subsidiary borrowing. In addition, a company assigned a rating of 3 may 
not maintain a sufficient capital position to provide a base for the 
growth of risk assets and the entry into capital markets as the need 
arises for the parent company and subsidiaries. The capital position of 
the consolidated BHC could quickly become inadequate in the event of 
asset deterioration or other negative factors and therefore requires 
more than normal supervisory attention.
    Rating 4 (Marginal). A rating of 4 indicates that the capital level 
of the consolidated BHC is significantly below the amount needed to 
ensure support for the volume and risk characteristics of all parent 
and subsidiary business lines and products; the unanticipated losses 
arising from the parent and subsidiary activities; and the level and 
composition of parent and subsidiary borrowing. In addition, a company 
assigned a rating of 4 does not maintain a sufficient capital position 
to provide a base for the growth of risk assets and the entry into 
capital markets as the need arises for the parent company and 
subsidiaries. If left unchecked, the consolidated capital position of 
the company might evolve into weaknesses or conditions that could 
threaten the viability of the institution. The capital position of the 
consolidated BHC requires immediate supervisory attention.

[[Page 70455]]

    Rating 5 (Unsatisfactory). A rating of 5 indicates that the level 
of capital of the consolidated BHC is critically deficient and in need 
of immediate corrective action. The consolidated capital position 
threatens the viability of the institution and requires constant 
supervisory attention.

Asset Quality

    Rating 1 (Strong). A rating of 1 indicates that the BHC maintains 
strong asset quality across all parts of the organization, with a very 
low level of criticized and nonperforming assets. Credit risk across 
the organization is commensurate with management's abilities and modest 
in relation to credit risk management practices.
    Rating 2 (Satisfactory). A rating of 2 indicates that the BHC 
maintains satisfactory asset quality across all parts of the 
organization, with a manageable level of criticized and nonperforming 
assets. Any identified weaknesses in asset quality are correctable in 
the normal course of business. Credit risk across the organization is 
commensurate with management's abilities and generally modest in 
relation to credit risk management practices.
    Rating 3 (Fair). A rating of 3 indicates that the asset quality 
across all or a material part of the consolidated BHC is less than 
satisfactory. The BHC may be facing a decrease in the overall quality 
of assets currently maintained on and off balance sheet. The BHC may 
also be experiencing an increase in credit risk exposure that has not 
been met with an appropriate improvement in risk management practices. 
BHCs assigned a rating of 3 require more than normal supervisory 
attention.
    Rating 4 (Marginal). A rating of 4 indicates that the BHC's asset 
quality is deficient. The level of problem assets and/or unmitigated 
credit risk subjects the holding company to potential losses that, if 
left unchecked, may threaten its viability. BHCs assigned a rating of 4 
require immediate supervisory attention.
    Rating 5 (Unsatisfactory). A rating of 5 indicates that the BHC's 
asset quality is critically deficient and presents an imminent threat 
to the institution's viability. BHCs assigned a rating of 5 require 
immediate remedial action and constant supervisory attention.

Earnings

    Rating 1 (Strong). A rating of 1 indicates that the quantity and 
quality of the BHC's consolidated earnings over time are more than 
sufficient to make full provision for the absorption of losses and/or 
accretion of capital when due consideration is given to asset quality 
and BHC growth. Generally, BHCs with a 1 rating have earnings well 
above peer-group averages.
    Rating 2 (Satisfactory). A rating of 2 indicates that the quantity 
and quality of the BHC's consolidated earnings over time are generally 
adequate to make provision for the absorption of losses and/or 
accretion of capital when due consideration is given to asset quality 
and BHC growth. Generally, BHCs with a 2 earnings rating have earnings 
that are in line with or slightly above peer-group averages.
    Rating 3 (Fair). A rating of 3 indicates that the BHC's 
consolidated earnings are not fully adequate to make provisions for the 
absorption of losses and the accretion of capital in relation to 
company growth. The consolidated earnings of companies rated 3 may be 
further clouded by static or inconsistent earnings trends, chronically 
insufficient earnings, or less than satisfactory asset quality. BHCs 
with a 3 rating for earnings generally have earnings below peer-group 
averages. Such BHCs require more than normal supervisory attention.
    Rating 4 (Marginal). A rating of 4 indicates that the BHC's 
consolidated earnings, while generally positive, are clearly not 
sufficient to make full provision for losses and the necessary 
accretion of capital. BHCs with earnings rated 4 may be characterized 
by erratic fluctuations in net income, poor earnings (and the 
likelihood of the development of a further downward trend), 
intermittent losses, chronically depressed earnings, or a substantial 
drop from the previous year. The earnings of such companies are 
generally substantially below peer-group averages. Such BHCs require 
immediate supervisory attention.
    Rating 5 (Unsatisfactory). A rating of 5 indicates that the BHC is 
experiencing losses or a level of earnings that is worse than that 
described for the 4 rating. Such losses, if not reversed, represent a 
distinct threat to the BHC's solvency through erosion of capital. Such 
BHCs require immediate and constant supervisory attention.

Liquidity

    Rating 1 (Strong). A rating of 1 indicates that the BHC maintains 
strong liquidity levels and well developed funds management practices. 
The parent company and subsidiaries have reliable access to sufficient 
sources of funds on favorable terms to meet present and anticipated 
liquidity needs.
    Rating 2 (Satisfactory). A rating of 2 indicates that the BHC 
maintains satisfactory liquidity levels and funds management practices. 
The parent company and subsidiaries have access to sufficient sources 
of funds on acceptable terms to meet present and anticipated liquidity 
needs. Modest weaknesses in funds management practices may be evident, 
but those weaknesses are correctable in the normal course of business.
    Rating 3 (Fair). A rating of 3 indicates that the BHC's liquidity 
levels or funds management practices are in need of improvement. BHCs 
rated 3 may lack ready access to funds on reasonable terms or may 
evidence significant weaknesses in funds management practices at the 
parent company or subsidiary levels. However, these deficiencies are 
considered correctable in the normal course of business. Such BHCs 
require more than normal supervisory attention.
    Rating 4 (Marginal). A rating of 4 indicates that the BHC's 
liquidity levels or funds management practices are deficient. 
Institutions rated 4 may not have or be able to obtain a sufficient 
volume of funds on reasonable terms to meet liquidity needs at the 
parent company or subsidiary levels and require immediate supervisory 
attention.
    Rating 5 (Unsatisfactory). A rating of 5 indicates that the BHC's 
liquidity levels or funds management practices are critically deficient 
and may threaten the continued viability of the institution. 
Institutions rated 5 require constant supervisory attention and 
immediate external financial assistance to meet maturing obligations or 
other liquidity needs.

Impact Component

    The I component rating reflects the aggregate potential impact of 
the nondepository entities on the subsidiary depository institution(s). 
It is rated on a five point numerical scale. Ratings will be assigned 
in ascending order of supervisory concern as follows:
    1--Low likelihood of significant negative impact;
    2--Limited likelihood of significant negative impact;
    3--Moderate likelihood of significant negative impact;
    4--Considerable likelihood of significant negative impact; and
    5--High likelihood of significant negative impact.
    Rating 1 (Low Likelihood of Significant Negative Impact). A rating 
of 1 indicates that the nondepository entities of the BHC are highly 
unlikely to have a significant negative impact on the subsidiary 
depository institution(s) due to the sound financial condition of the 
nondepository entities, the strong risk management practices within the 
nondepository entities, or the corporate

[[Page 70456]]

structure of the BHC. The BHC maintains an appropriate capital 
allocation across the organization commensurate with associated risks. 
Intra-group exposures, including servicing agreements, are very 
unlikely to undermine the financial condition of the subsidiary 
depository institution(s). Parent company cash flow is sufficient and 
not dependent on excessive dividend payments from subsidiaries. The 
potential risks posed to the subsidiary depository institution(s) by 
strategic plans, the control environment, risk concentrations, or legal 
or reputational issues within or facing the nondepository entities are 
minor in nature and can be addressed in the normal course of business.
    Rating 2 (Limited Likelihood of Significant Negative Impact). A 
rating of 2 indicates a limited likelihood that the nondepository 
entities of the BHC will have a significant negative impact on the 
subsidiary depository institution(s) due to the adequate financial 
condition of the nondepository entities, the satisfactory risk 
management practices within the parent nondepository entities, or the 
corporate structure of the BHC. The BHC maintains adequate capital 
allocation across the organization commensurate with associated risks. 
Intra-group exposures, including servicing agreements, are unlikely to 
undermine the financial condition of the subsidiary depository 
institution(s). Parent company cash flow is satisfactory and generally 
does not require excessive dividend payments from subsidiaries. The 
potential risks posed to the subsidiary depository institution(s) by 
strategic plans, the control environment, risk concentrations, or legal 
or reputational issues within the nondepository entities are modest and 
can be addressed in the normal course of business.
    Rating 3 (Moderate Likelihood of Significant Negative Impact). A 
rating of 3 indicates a moderate likelihood that the aggregate impact 
of the nondepository entities of the BHC on the subsidiary depository 
institution(s) will have a significant negative impact on the 
subsidiary depository institution(s) due to weaknesses in the financial 
condition and/or risk management practices of the nondepository 
entities. The BHC may have only marginally sufficient allocation of 
capital across the organization to support risks. Intra-group 
exposures, including servicing agreements, may have the potential to 
undermine the financial condition of the subsidiary depository 
institution(s). Parent company cash flow may at times require excessive 
dividend payments from subsidiaries. Strategic growth plans, weaknesses 
in the control environment, risk concentrations or legal or 
reputational issues within the nondepository entities may pose 
significant risks to the subsidiary depository institution(s). A BHC 
assigned a 3 impact rating requires more than normal supervisory 
attention, as there could be adverse effects on the safety and 
soundness of the subsidiary depository institution(s) if corrective 
action is not taken by management.
    Rating 4 (Considerable Likelihood of Significant Negative Impact). 
A rating of 4 indicates that there is a considerable likelihood that 
the nondepository entities of the BHC will have a significant negative 
impact on the subsidiary depository institution(s) due to weaknesses in 
the financial condition and/or risk management practices of the 
nondepository entities. A 4-rated BHC may have insufficient capital 
within the nondepository entities to support their risks and 
activities. Intra-group exposures, including servicing agreements, may 
also have the immediate potential to undermine the financial condition 
of the subsidiary depository institution(s). Parent company cash flow 
may be dependent on excessive dividend payments from subsidiaries. 
Strategic growth plans, weaknesses in the control environment, risk 
concentrations or legal or reputational issues within the nondepository 
entities may pose considerable risks to the subsidiary depository 
institution(s). A BHC assigned a 4 impact rating requires immediate 
remedial action and close supervisory attention because the 
nondepository entities could seriously affect the safety and soundness 
of the subsidiary depository institution(s).
    Rating 5 (High Likelihood of Significant Negative Impact). A rating 
of 5 indicates a high likelihood that the aggregate impact of the 
nondepository entities of the BHC on the subsidiary depository 
institution(s) is or will become significantly negative due to 
substantial weaknesses in the financial condition and/or risk 
management practices of the nondepository entities. Strategic growth 
plans, a deficient control environment, risk concentrations or legal or 
reputational issues within the nondepository entities may pose critical 
risks to the subsidiary depository institution(s). The parent company 
also may be unable to meet its obligations without excessive support 
from the subsidiary depository institution(s). The BHC requires 
immediate and close supervisory attention, as the nondepository 
entities seriously jeopardize the continued viability of the subsidiary 
depository institution(s).
(D) (Depository Institutions) Component
    The (D) component identifies the overall condition of the 
subsidiary depository institution(s) of the BHC. For BHCs with only one 
subsidiary depository institution, the (D) component rating generally 
will mirror the CAMELS composite rating for that depository 
institution. To arrive at a (D) component rating for BHCs with multiple 
subsidiary depository institutions, the CAMELS composite ratings for 
each of the depository institutions should be weighted, giving 
consideration to asset size and the relative importance of each 
depository institution within the overall structure of the 
organization. In general, it is expected that the resulting (D) 
component rating will reflect the lead depository institution's CAMELS 
composite rating.
    If in the process of analyzing the financial condition and risk 
management programs of the consolidated organization, a major 
difference of opinion regarding the safety and soundness of the 
subsidiary depository institution(s) emerges between the Federal 
Reserve and the depository institution's primary regulator, then the 
(D) rating should reflect the Federal Reserve's evaluation.

    By order of the Board of Governors of the Federal Reserve 
System.

    Dated: December 1, 2004.
Jennifer J. Johnson,
 Secretary of the Board.
[FR Doc. 04-26723 Filed 12-3-04; 8:45 am]
BILLING CODE 6210-01-P