In our most recent safety and soundness exam, it was discovered that a joint loan by our president, exec. VP, CFO and a director was in violation of reg O. The loan should never have been originated.

The lead examiner said we could sell the loan, thereby taking it out of our portfolio, and they would be satisfied. They wouldn’t see the loan the next time they came in because it’s sold. We sold it to FHLB.

Now, the loan has been refinanced for a lower rate. It paid off the other loan, a new loan number was created, a new note and mortgage were created. This refinanced loan was sold to FHLB as well.

The senior executives on this loan think that as long as it’s sold, the examiners won’t be concerned about it. My concern is the practice of refinacing a loan that should never have been made to begin with. I feel the examiner was being generous by allowing us to sell the original loan to solve the problem. If they find that we refinanced it, then sold it again, I’m concerned that they will take this as us trying to get around the reg.

Any input from anyone would be appreciated.

I believe that the only way you could prove that you had not violated Reg O again, would be to provide the examiner an unconditional guaranteed takeout commitment from the FHLB. If you did not receive an unconditional takeout commitment prior to granting the loan - you're back to square one. You may want to share the possible CMP assessments for violations of Reg O with the Board and executive management. I also don't think that the examiners will be quite as forgiving the second time around.

When you say the loan was in violation of Reg O, do you mean that hte loan was made without prior Board approval, that the terms were preferential, that the loan involved the normal amount of repayment risk, or that the loan exceeded the amount that executive officers can borrow for an "other purpose" under 215.5?

Was the loan cited as a violation of law and regulation in your last examination report?

If the loan has problems other than prior approval, then re-financing the loan repeated the violation. The only way out would be if the loan was made subject to a written agreement with FHLB to purchase the loan made prior to closing. That might mitigate the problem, but I would not hold my breath.

Expect some major criticism in your next exam.

pbrinker, it was in violation of Reg O with respect to the amount an executive can borrow for "other purposes".

So you recreated your violation. The examiner gave you a "freebie" by suggesting you sell the loan. That did not give you license to repeat the error. You can be assured the examining team will be looking for this transaction when they return, and I agree they will be a lot less charitable the second time around.

There is nothing further you can do about the loan at this point except to put the board and the parties to the note on notice that insider loans are nothing to trifle with. Suggest strongly that the next refinance be done with another lender -- and don't forget the requirement that the parties to the loan will have to provide your board notice of the loan (at the other bank, if it is a bank that takes it out) when they sign the paperwork.

Good luck! This will not be an easy sell for you.

Thanks for the input everyone. I figured this loan was going to be a mess. Your opinions are appreciated.

Good luck, tmf. And thanks for registering. It's lots easier to provide input when you "know your customer."

You might want to consider a training program for all of your executive officers and directors for Regulation O, in light of this occurrence. The regulators may be more inclined to be forgiving if you can demonstrate that you improved the compliance climate by education.

As part of the education process, you might want to mention that regulators take Reg O very seriously, since approximately 75% of failed banks had some form of insider abuse.

I would also consider reporting this situation to the regulators before they come in for their next exam. If you decided to do that, the approach I would take is "Hey, we screwed up again, and here's how. To fix the problem going forward, we're doing training for all the Reg O Insiders and...(whatever other fixes you decide to implement)."

Truthfully, I think you are going to get really hammered anyway, but at this point, anything that might mitigate the damage is worth at least considering.

I agree - as an ex-regulator, they are going to flip when they find this refinance. And they will find it. The criticism will fall on the Board & senior management, but everyone knows that bad news flows downhill. I strongly encourage you to speak up, educate everyone you can get your hands on, draft policies & procedures to prevent this from recurring, implement audits, etc. etc. etc. Of course, unless you are given a lot more power than most compliance officers, you may not have a free rein with this, either. I'm not sure I would hand it to the examiners though, unless you really wanted to teach the execs. a lesson. But I would be darn sure I had all my ducks in a row. Maybe you'll get lucky and it will be a trainee job and they'll miss it for some weird reason.

Good luck - a tough row to hoe.

The following may be information you'll want to suggest in your (re)training of your lenders, executives, and board:

It looks like the version of the corporate responsibility legislation that's going to pass in Washington will have an "out" for bank loans to their executives (within Regulation O limits), but it's obvious that the question of insider abuse is very prominent on Washington's radar screen.

That means, of course, that your regulator will be emphasizing Reg. O in its communications with examiners, and it will be another of the causes célèbres during the coming examination cycle.

An update to this situation:

Our secondary market officer was out yesterday so I didn't have this information until now. The loan in question was originated 6/28 and sold 6/28.

Would this help with an examiner? The loan was never on our books for a day.

Also, it was mentioned in this thread that an agreement by the purchaser that they accept the loan prior to the loan originating may help. If we made a practice of doing this, would it still be looked at as if we were trying to get around the reg? I wouldn't suggest to our senior officers that this gives us the right to go over Reg O limits whenever they want if they get this agreement.

I would make a recommendation to aviod further scrutiny that they take thier banking somewhere else. At my last bank, it was an unwritten rule that if you were an exec. or dir. you didn't borrow from the bank. Makes Reg O compliance (except for overdrafts) pretty simple.