Page R14.8 – Administrative Policy #003 - Revised

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ADMINISTRATIVE POLICY #003

~~BILL J. FORD,~~FRANK WHITE, BANK COMMISSIONER RETAIN FOR

ISSUED: MARCH 30, 1988 FUTURE

REVISED: SEPTEMBER 30, 2001 REFERENCE

SUBJECT: RISK RATING/RESERVE ALLOCATION

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OVERVIEW

The quality of the loan portfolio of many banks has been dramatically affected by recent developments in economic affairs of the state and region. In an effort to prudently assess the quality of the loan portfolio, bankers have developed a wide array of methods to review loans on an ongoing basis. Examiners assess the quality of a bank's loan portfolio in an attempt to determine the associated risk and to determine that adequate reserves are maintained.

Administrative Policy #003 defines a risk rating system and reserve allocation calculation method that is recommended for implementation by bank management. The State Bank Department does not require that the system defined herein be adopted, but does ~~strongly recommend~~ require that a system be implemented. Any system implemented by the bank will be subject to review and analysis by examiners during regularly scheduled examinations and/or visitations.

The risk rating system and reserve allocation calculation method described is recommended for all banks which have total loans in excess of ten million dollars ($10,000,000). It is designed to aid management and the Board of Directors in (1) the management of risk associated with the loan portfolio, (2) the identification of "problem" loans, and (3) maintaining the adequacy of the bank's reserve allocation.

Prior to the implementation of any risk rating/reserve allocation program, it is essential for the bank's Board of Directors to approve the program and consider amendments to the bank's loan policy.

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RISK RATING GUIDELINES

All loans, with the exception of loans identified as monthly‑pay, consumer‑ type loans, must be assigned a risk rating. A numbering system from one (1) to six (6) is utilized for the guidelines contained herein. Banks presently utilizing other numbering schemes may wish to continue to use

the system already in place. A numbering system is necessary to monitor the quality of the loan portfolio and address the adequacy of the loan loss reserve account.

This rating system is based on the potential risk associated with each loan. The initial rating is assigned by the loan officer and should be reflected on the loan application. The loan review personnel or the individual loan officer is responsible for periodic reviews and the assessment of the adequacy of the rating during the life of the loan. Any differences in ratings between the loan officer and loan review personnel are to be resolved by the loan review committee and the appropriate rating entered into the loan system. Reviews and updates must be made on a quarterly basis, or more frequently if appropriate. Reviews should be noted at least quarterly in the minutes of the meeting of the bank's Board of Directors.

The risk ratings for this system appear below and a definition of each follows. The risk rating system should be implemented in the main computer system to provide for an automated monitoring program. A field in the loan program can be designated to carry the risk rating code. The bank's EDP/Information Systems servicer can provide this field on the existing loan program.

1 ‑ Excellent

2 ‑ Good

3 ‑ Moderate

4 ‑ Watch

5 ‑ Substandard

6 ‑ Doubtful

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DEFINITIONS

RISK RATING: 1 ‑ EXCELLENT

A loan secured by a bank's own certificate of deposit, U.S. Government securities, or governmental agency securities. The loan is properly structured with maturities not to exceed one (1) year. No credit or collateral exceptions exist and the loan adheres to the bank's loan policy in every respect. ability of the borrower to repay is excellent as evidenced by cash flow analysis or the conversion of liquid assets to cash.

RISK RATING: 2 ‑ GOOD

Loans to established borrowers that represent a reasonable credit risk. A financial analysis displays a satisfactory financial condition and earnings ability along with sound asset quality and cash flow capacity to meet debt obligations in a timely manner. Loans in this category are generally limited to short to medium term maturities. The borrower exhibits a good ability to service the debt based on prior history and an ability to service debts through the conversion of liquid assets, cash flow or, perhaps, letters of credit from quality financial institutions.

RISK RATING: 3 ‑ MODERATE

Loans in this category are considered to have satisfactory asset quality and are made to borrowers with proven earnings history, liquidity or other adequate margins of credit protection. Loans are considered collectible in full but may require some additional supervision. Loans in this category are evidenced by a level of slow reduction along with some extensions and/or renewals outside of the original payment plan. The borrower is capable of absorbing normal setbacks without the advent of failure. The ability to repay is considered average through the conversion of liquid assets, cash flow or co‑signors ability to reduce the debt.

RISK RATING: 4 ‑ WATCH

Loans in this category are presently protected from apparent loss, however, weaknesses do exist which could cause future impairment of repayment. These loans require more than an ordinary amount of supervision and may exhibit potential weaknesses due to questionable trends in financial position, high debt to worth ratios, or questionable or unproven management capabilities. Loans may be made to new or expanding businesses or borrowers whose ability to repay is considered only average. Collateral values afford marginal protection and the collateral may not be considered immediately marketable. Loans in this category may exhibit early signs of problems such as overdue status, extensions, or overdrafts of demand accounts. Loans in this category may also exhibit weak origination and/or servicing policies and may contain documentation deficiencies. This risk rating category may also be used for new or untested borrowers.

RISK RATING: 5 ‑ SUBSTANDARD

Loans in this category are characterized by deterioration in quality exhibited by any number of well defined weaknesses requiring corrective action. The weaknesses may include, but are not limited to: high debt to worth ratios, declining or negative earnings trends, declining or inadequate liquidity, improper loan structure, questionable repayment sources, lack of well‑defined secondary repayment source, and unfavorable competitive comparisons. Such loans are no longer considered to be adequately protected due to the borrower's declining net worth, lack of earnings capacity, declining collateral margins and/or unperfected collateral positions. A possibility of loss of a portion of the loan balance cannot be ruled out. The repayment ability of the borrower is marginal or weak and the loan may have exhibited excessive overdue status or extensions and/or renewals.

RISK RATING: 6 ‑ DOUBTFUL

Loans in this category exhibit the same weaknesses found in the Substandard loan, however, the weaknesses are more pronounced. Such loans are static and collection in full is improbable. However, these loans are not yet rated as loss because certain events may occur which would salvage the debt. Among these events are: acquisition by, or merger with, a stronger entity, injection of capital, alternative financing, liquidation of assets, or the pledging of additional collateral. The ability of the borrower to service the debt is extremely weak, overdue status is constant, the debt has been placed on non‑accrual status, and no definite repayment schedule exists.

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MANAGEMENT AND BOARD REPORTS

A risk rating system provides management and the Board of Directors the ability to monitor and assess the quality and soundness of the lending function of the bank and compliance with rules and regulations regarding the adequacy of the loan loss reserve account. Effective management of the loan portfolio is essential if the goals and objectives of the bank's Board of Directors are to be met. Proper implementation of the program provided herein will ensure that information is available for management and the Board to properly analyze its reserve adequacy. The program should be supported by the following reports:

A. Monthly "problem" loan reporting system (risk rating);

B. Monthly list of recommended risk rating changes;

C. Monthly list of loans to be placed on non‑accrual;

D. Monthly list of loans to be charged‑off;

E. Monthly, or quarterly, progress reports of all weak or classified loans; ~~and~~

F. Monthly overdue loan report.

G. Monthly list of loans that exceed supervisory loan-to-value limits

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RESERVE ALLOCATION GUIDELINES

Management has the responsibility to use reasonable judgment to arrive at an appropriate loan loss reserve which is adequate and which is based upon reliable information. Historical data, combined with the results of a comprehensive review of the present loan portfolio, provides a prudent basis for determining the adequacy of the loan loss reserve account. Examiners will review the appropriateness of the procedures and methodology utilized by management in attaining the reserve balance ~~as required by Bank Department regulation~~. Examination classifications should only be changed during subsequent examinations or visitations;, however, management may vary the amount of reserve based on current information.

The Board of Directors has the responsibility of determining the amount of provision for loan losses to be allocated on a monthly, or quarterly, basis. Such determination should be based on the balance of loans in each of the six (6) risk rating categories; the minimum and maximum amounts of the reserve allocations required based on a pre‑determined percentage; the specific allocations required on previously identified "problem" loans; and the allocations to be assigned to current and overdue installment loans.

Additional information that the Board may find beneficial in the determination of the adequacy of the reserve includes: the loan portfolio composition; any identifiable concentrations of credit; economic conditions on the local and regional levels; the adequacy of the lending policy and the loan administration function (documentation); and the potential for major losses.

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SAMPLE SYSTEM

The following example provides a system to determine the adequacy of the bank's loan loss reserve account. ~~This system may be implemented manually or with the aid of a micro computer.~~ The information needed is obtained from the risk rating program.

RISK RATING/ SUGGESTED * PRINCIPAL REQUIRED

CATEGORY ALLOCATION BALANCE RESERVE

COMMERCIAL LOANS: RESERVE ALLOCATION:

1 ‑ EXCELLENT 0.000%* 1,500,000 00,000

2 ‑ GOOD 0.275%* 8,000,000 22,000

3 ‑ MODERATE 0.750%* 12,500,000 93,750

4 ‑ WATCH 1.000%* 3,000,000 30,000

5 ‑ SUBSTANDARD 15.000%*10.000%* 750,000 112,500~~75,000~~

6 ‑ DOUBTFUL 50.000%* 50,000 25,000

COMMERCIAL LOANS ‑ SUB TOTALS 25,800,000 283,250~~245,750~~

ADD: SPECIFIC ALLOCATIONS** 200,000 50,000

SUB: PREVIOUS ALLOCATIONS** (200,000) (20,000)

COMMERCIAL LOANS – TOTALS $25,800,000 313,250~~275,750~~

MONTHLY PAY/CONSUMER LOANS: RESERVE ALLOCATION:

CURRENT 0.225%* 6,000,000 13,500

OVERDUE

(31‑90 DAYS) 7.500%* 200,000 15,000

(OVER 90 DAYS) 37.500%* 25,000 9,375

INSTALLMENT LOANS ‑ TOTALS 6,225,000 37,875

LOAN PORTFOLIO TOTALS: 32,025,000 351,125~~313,625~~

BALANCE OF RESERVE ACCOUNT 334,520

AMOUNT IN EXCESS OF RESERVE

REQUIREMENT: (DEFICIT) (16,605)~~20,895~~

+/-10% = ACCEPTABLE RANGE 316,013 to 386,238~~282,263 to 344,988~~

*Suggested allocation based on average of acceptable ranges. Systems may vary. Percentages are to be determined by the bank's Board.

**Loans previously risk rated one (1) through (6) for which specific reserve allocations have been assigned. The adjustment is necessary to prevent duplications. Specific allocations must be fully documented.

Page R2.4 – Bank Powers – Added sections 48-307.1 and 48-309.1

~~CAPITAL NOTES~~

48-307.1. CHARTER AMENDMENT APPLICATION FOR CHANGE OF BANK CORPORATE NAME.

Prior to filing an application with the State Bank Department for a charter amendment to change the corporate name of a state bank, the bank must complete the following procedures:

A) Publish legal notice of intention to change the corporate name of the bank one (1) time in a newspaper of statewide circulation. Such notice shall include both the current corporate name of the bank and the proposed new name. A copy of the legal notice must accompany the application; and

B) Request a current check of both state and federal trademark or servicemark filings on the proposed new name. This request may be implemented through the Arkansas State Library, Reference Department, One Capitol Mall, Little Rock, Arkansas 72201. The fax number for the Library is 501-682-1529. Requests must be submitted in writing and the check will be performed in the exact or almost exact name as requested. Evidence must accompany the application for charter amendment verifying the applicant has made a trademark or servicemark search and no trademark or servicemark exists for the proposed name.

Once the charter amendment is received by the State Bank Department, notice of the filing of the application will be sent to all state-chartered banks by electronic transmission. Any protestants will have seven (7) days from the date the Department notice was sent to file an official protest to the application. An official protest must be provided to the Department in written form delineating the reasons for the protest and must be accompanied by a filing fee of two hundred dollars ($200).

48-309.1. RESERVATION OF BANK CORPORATE NAME

The State Bank Department will accept a reservation for a bank corporate name only prior to and for the purpose of formation of a new state bank or prior to the consummation of an interstate merger transaction. The reservation will be for a nonrenewable two hundred seventy day period. A name not used permanently prior to the expiration of this period will be cancelled. Prior to filing a reservation of corporate name an applicant must:

Request a current check of both state and federal trademark or servicemark filings on the proposed name. This request may be implemented through the Arkansas State Library, Reference Department, One Capitol Mall, Little Rock, Arkansas 72201. The fax number for the Library is 501-682-1529. Requests must be submitted in writing and the check will be performed in the exact or almost exact name as requested. Evidence must accompany the application for reservation of corporate name verifying the applicant has made a trademark or servicemark search and no trademark or servicemark exists for the proposed name.