Sba sop 51 00 On-Site Lender Reviews/Examinations Office of Lender Oversight

4. Capital Examination Component

a. Introduction

The purest and most stable forms of capital an SBA Supervised Lender may hold include: the common shareholders’ equity (common stock, surplus, and retained earnings); non-cumulative perpetual preferred stock; and the minority interests in the equity accounts of consolidated subsidiaries. It is the equity of an SBA Supervised Lender that will comfort investors and borrowers. An acceptable level of these forms of capital:

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  Assure customer and shareholder confidence in the SBA Supervised Lender’s stability;
  
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  Support volume growth in the SBA Supervised Lender’s primary business;
  
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  Absorb any unexpected loan or operating losses;
  
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  Permit the SBA Supervised Lender to continue to meet the credit demands within its territory; and
  
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  Evidence owner/management investment.
  

There are other forms of capital that exist in the financial institution community, although quite rare and which have limited value. A discussion of these follows. Limited-life preferred stock is not as strong a form of capital because it has a maturity date, and in certain circumstances, does not retire as a class. Subordinated debt, when issued by an SBA Supervised Lender, may also be of limited value. Careful consideration is warranted. A subordinated debt issue can take different forms, including an interim repayment schedule prior to maturity. Examiners must recognize that this form of capital is not available to absorb loan losses. Such debt instruments should be investigated to determine their impact on the SBA Supervised Lender’s long and near term capital position.

b. Examination Criteria

13 CFR §120.470(b)(3) requires that each SBLC have “unencumbered paid-in capital and paid-in surplus of at least $1,000,000 or ten percent of the aggregate of its share of all outstanding loans, whichever is more. However, these are minimum requirements, and as such may not prove to be adequate capital for an SBLC. Furthermore, 13 CFR §120.470(b)(4) states that each SBLC “must avoid capital impairment at all times.” The regulations further provide that “impairment exists if the retained earnings deficit of an SBLC exceeds 50 percent of combined paid-in capital and paid-in surplus, excluding treasury stock.” The same regulation requires any impaired SBLC to give SBA written notice within 30 days of the first month end report that reflects said condition. Finally, the regulation provides that an SBLC may not present any loans to SBA for guarantee until the impairment is cured. The requirements of these regulations demonstrate the importance that SBA places on capital held by an SBLC.

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  13 CFR §120.470(b)(6) “Voluntary capital reduction.” Without SBA prior written approval, an SBLC must not reduce its capital, or purchase and hold more than two (2) percent of any class or combination of classes of its stock;
  
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  13 CFR §120.470(b)(13) “Borrowed funds.” SBLCs must not be capitalized with borrowed funds without SBA’s prior written approval;
  
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  13 CFR §120.472(d)(3) “Reports to SBA.” SBLCs must report any changes to its capitalization;
  
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  13 CFR §120.472(d)(5) “Reports to SBA.” A notice of pledge of stock as collateral for indebtedness must be submitted to SBA if more than ten (10) percent of the stock is pledged; and
  
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  13 CFR §120.473 “Change of Ownership or Control.” Any change in ownership or control without SBA’s prior written approval is prohibited.
  

The following provide SBA guidance regarding calculation of capital adequacy:

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  Both 13 CFR §120.425(a) and 13 CFR §120.470(b)(3) provide guidance on the minimum capital structure for an SBLC. Which regulation applies to an individual SBLC depends on whether or not the individual SBLC has securitized any of the unguaranteed portions of its 7(a) loans after April 12, 1999; and
  
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  13 CFR §120.470(b)(4) is applicable to all SBLCs, regardless of whether or not they have securitized the unguaranteed portion. However, this regulation would only be triggered if the SBLC had a retained earnings deficit.
  

Regulations Summary

While SBA’s regulations and summary provide a basis to assess capital adequacy, the final judgment involves evaluation of other critical variables that could impact an SBA Supervised Lender’s financial condition. The adequacy of the allowance for loan losses, management capability, loan demands, and the quantity and quality of earnings represent a partial list of these variables. Therefore, an examiner evaluating capital must maintain a routine dialogue with other examiners participating in the Examination who are evaluating the SBA Supervised Lender’s operation to obtain information on the other variables. It is very important that the examiner evaluating the allowance for loan losses be queried early. An examiner cannot conclude the adequacy of capital until it is determined that the allowance is adequate.

c. Examination Objectives

The objectives of the Capital component section are to:

Determine whether capital is adequate in relation to the risks presented;

Assure that the SBA Supervised Lender’s owners are not exercising undue influence on the financial affairs of the SBA Supervised Lender (e.g. exerting pressure to distribute dividends which are inappropriate as to timing and amount);

Determine whether the policies, practices, procedures, and controls regarding capital accounts are adequate; and

Determine if financial statements related to capital are fairly stated.

d. Examination Procedures

The following is a model examination procedure for evaluating capital. It is consistent with risk-based examination principles and can be added to, deleted, or modified as the situation dictates.

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  Review the SBA Supervised Lender’s most recent disclosure to determine if there have been any changes to the capital base compared to previous disclosures or examinations.
  
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  Ascertain whether the previous examination or the external auditor identified any deficiencies regarding the capital accounts, and whether appropriate Corrective Actions were taken.
  
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  Review the financial forecasts prepared by the SBA Supervised Lender to learn whether a capital plan was developed in conjunction with the forecast. If asset growth is planned, determine how the supporting capital will be generated.
  
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  Review the individual capital accounts on the most recent financial statement and determine if there have been any changes or unusual fluctuations in the accounts. If changes have occurred, determine why.
  
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  Determine whether the dealings of the major shareholders with the SBA Supervised Lender are appropriate.
  
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  If dividends were paid since the last examination or during the most recent disclosure, verify that the distribution came from earnings and assess the impact on capital.
  
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  Determine what impact future dividends would have on the capital base.
  
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  Review board meeting minutes or other documentation to determine whether a public or private offering of bank stock or subordination of notes or debentures is planned. If so, determine whether the board or management has evaluated the market for the stock or debt issues. Also, determine whether they have considered the underwriting expenses, dilution of shareholders’ equity, aspirations of any known purchasers, and any other impacts the examiner deems warranted.
  
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  If there is a pending change in control, ensure the SBLC has sought SBA approval.
  
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  Determine whether the SBLC is operating in compliance with the minimum capital level prescribed by SBA and with all other SBA Loan Program Requirements on capital. Obtain and review the SBLC capital calculations for adherence to the guidance set forth in the latest Capital Letter issued by SBA to all SBLCs.
  
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  Team members must coordinate with the examiners evaluating the allowance for loan losses to determine if they have reached any tentative conclusions that would impact capital.
  
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  Evaluate current earnings and the impact to capital by reviewing the following issues:
  
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    Is current income sufficient to cover expenses and any necessary provisions to the allowance for loan losses, and still provide net income;
    
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    Does income performance meet business plan targets; and
    
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    Address any dividends, distributions to the parent, or payments to subordinate debt holders that may be due.
    
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  Discuss Findings with management.
  
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  Draw conclusion on capital adequacy.