Undiversified relationships with a small number of clients caused Bank of the Bluegrass's non-current loans to more than quadruple in a year's time and helped lead to an order from state and federal regulators' to change the way the two-location community bank does business.
The FDIC, along with the Kentucky Department of Financial Institutions, issued a cease and desist order (C&D) against Bank of the Bluegrass in July, citing "hazardous lending and lax collection practices including but not limited to: the failure to obtain proper loan documentation; the failure to obtain adequate collateral; the failure to establish and monitor collateral margins of secured borrowers; the failure to establish and enforce adequate loan repayment programs; the failure to obtain current and complete financial information, extending credit with inadequate diversification or portfolio risk (and) other poor credit administration practices."
"Our problems really have been centered in the residential real estate market," Bank of the Bluegrass CEO and Chairman Mark Herren said in an interview. "We didn't do subprime lending, (we're) not really a big commercial lender, but we did have four builders who not only had construction loans - not that many, quite frankly - two, three, four apiece, but the problem is we also financed their rental properties for them as well.
"So when they started having financial problems, it hit all their loans. Thus they're in the position where they have to liquidate. Those are part of those substandard loans that have been cited in the report," he said.
The recent downturn in the economy that has affected the builders - who Herren did not name - and other loans going into default caused the bank's non-current loans to rise from $1.82 million at the end of March 2007 to $7.916 million this year, almost 3 percent of the bank's overall assets of more than $268 million, according to a filing with the FDIC.
"We're working with (the loan holders), either having to foreclose, or hopefully they're getting them either auctioned or sold and off our books. That is a large piece of the problem right there," Herren said.
But the problems were allowed to happen, according to the FDIC and KDFI's order, because the bank lacked the proper safeguards during the loan approval process.
"We'd outsourced loan review, and with that, (the FDIC and KDFI) were not happy with the results of those reviews, so we've now hired our own internal loan review person," Herren said.
The bank with 63 employees takes pride in its local roots. It is headquartered in the same building that housed a family-owned appliance store and service center that started in the 1940s and has evolved into the bank it is today from financing appliance purchases. Though remnants of the appliance store still can be found in the building on the corner of High and Limestone, the local bank with a putting green greeting customers has been finding itself a part of a national banking concern.
"It's going to be a challenging time, there is no question about it," said Bank President Bill Allen. "We've got $24 million in capital, we've set aside money for allowance for loan loss - we'll call that the rainy day fund - in order to prepare, and we've added folks, from a chief lending officer to internal loan review to loan operations, in that area to strengthen that experience."
"We never were the 'handshake and a loan' either; there was structure in place. We just changed that structure," Allen said. "Cash flowÖ we look at that much more closely today, and have been for the past 18 months really, than we have been in the past, and a lot of that has to do with changes that we needed to make internally, and some of it has to do with the overall general economy."
On top of requiring more infrastructure within the bank, the order also requires a consultant to conduct a "management study." The order states "each member of management shall have the qualifications and experience commensurate with his or her duties and responsibilities at the Bank."
Herren said the management audit has been completed and has been sent to regulators for approval.
"There was absolutely no fraud involved here, there was no dishonesty involved here, and the staff that we've always had, they're still here," Herren said. "The FDIC didn't come in and recommend that anyone be let go, so I think that gave a lot of stability to our customers."
The bank's customers were top of mind for Herren and Allen between the point in mid-July when the C&D was finalized and when it was made public 10 days later, as the bank sent a series of letters to customers and shareholders, as well as time spent on the phone restating the strength of the bank and the owner's commitment to keep the bank community-based.
"(We) definitely want to keep it independent; they don't want to sell. We've certainly had one or two people call us, as you can imagine (interested in buying the bank), but they are no less committed. Ö They want to keep it a community independent bank," Herren said.
Part of the order requires the bank's board to establish a three-year strategic plan, which Herren said is complete. In the plan, Herren said, is a commitment not to sell and to remain a community bank. He said the 36-year-old bank hopes to add a third location in the next two to three years to go along with its Southland Drive location that opened in 2003.
Both Herren and Allen said customers have been supportive since the C&D was announced.
"I'm sure that we have lost some customers, but it is not something that has been abnormal in my mind," Allen said. In most cases, if customers made changes, Allen and Herren said, it was in restructuring their deposits and spreading them out between banks to stay below the FDIC's $100,000 insured level.
Kelly May, a spokeswoman with the KDFI, couldn't comment on the negotiation process or previous examinations, but said, "The Bank of the Bluegrass cease and desist came about through the regular exam process, and we let the cease and desist speak for itself." FDIC spokesman David Carr also said the cease and desist against Bank of the Bluegrass, the fourth Kentucky bank to receive one since 2007, "speaks for itself."
Despite adding new infrastructure and a more rigorous process for granting loans, the bank hopes to maintain its community feel. "We may be changing how we care for our customers, possibly; we want to make sure that we educate customers through this process," Allen said. "When you walk into our bank, I think you're still going to see people laughing, going to see people smiling, and it's not just the employees. I think it is going to be the customers, and that's not going to change."