[Code of Federal Regulations]
[Title 12, Volume 2]
[Revised as of January 1, 2003]
From the U.S. Government Printing Office via GPO Access
[CITE: 12CFR208.101]
[Page 256-307]
TITLE 12--BANKS AND BANKING
CHAPTER II--FEDERAL RESERVE SYSTEM
PART 208--MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE FEDERAL RESERVE SYSTEM (REGULATION H)--Table of Contents
Subpart I--Interpretations
Sec. 208.101 Obligations concerning institutional customers.
(a) As a result of broadened authority provided by the Government
Securities Act Amendments of 1993 (15 U.S.C. 78o-3 and 78o-5), the Board
is adopting sales practice rules for the government securities market, a
market with a particularly broad institutional component. Accordingly,
the Board believes it is appropriate to provide further guidance to
banks on their suitability obligations when making recommendations to
institutional customers.
(b) The Board's Suitability Rule, Sec. 208.37(d), is fundamental to
fair dealing and is intended to promote ethical sales practices and high
standards of
[[Page 257]]
professional conduct. Banks' responsibilities include having a
reasonable basis for recommending a particular security or strategy, as
well as having reasonable grounds for believing the recommendation is
suitable for the customer to whom it is made. Banks are expected to meet
the same high standards of competence, professionalism, and good faith
regardless of the financial circumstances of the customer.
(c) In recommending to a customer the purchase, sale, or exchange of
any government security, the bank shall have reasonable grounds for
believing that the recommendation is suitable for the customer upon the
basis of the facts, if any, disclosed by the customer as to the
customer's other security holdings and financial situation and needs.
(d) The interpretation in this section concerns only the manner in
which a bank determines that a recommendation is suitable for a
particular institutional customer. The manner in which a bank fulfills
this suitability obligation will vary, depending on the nature of the
customer and the specific transaction. Accordingly, the interpretation
in this section deals only with guidance regarding how a bank may
fulfill customer-specific suitability obligations under
Sec. 208.37(d).\7\
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\7\ The interpretation in this section does not address the
obligation related to suitability that requires that a bank have''* * *
a `reasonable basis' to believe that the recommendation could be
suitable for at least some customers.'' In the Matter of the Application
of F.J. Kaufman and Company of Virginia and Frederick J. Kaufman, Jr.,
50 SEC 164 (1989).
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(e) While it is difficult to define in advance the scope of a bank's
suitability obligation with respect to a specific institutional customer
transaction recommended by a bank, the Board has identified certain
factors that may be relevant when considering compliance with
Sec. 208.37(d). These factors are not intended to be requirements or the
only factors to be considered but are offered merely as guidance in
determining the scope of a bank's suitability obligations.
(f) The two most important considerations in determining the scope
of a bank's suitability obligations in making recommendations to an
institutional customer are the customer's capability to evaluate
investment risk independently and the extent to which the customer is
exercising independent judgement in evaluating a bank's recommendation.
A bank must determine, based on the information available to it, the
customer's capability to evaluate investment risk. In some cases, the
bank may conclude that the customer is not capable of making independent
investment decisions in general. In other cases, the institutional
customer may have general capability, but may not be able to understand
a particular type of instrument or its risk. This is more likely to
arise with relatively new types of instruments, or those with
significantly different risk or volatility characteristics than other
investments generally made by the institution. If a customer is either
generally not capable of evaluating investment risk or lacks sufficient
capability to evaluate the particular product, the scope of a bank's
customer-specific obligations under Sec. 208.37(d) would not be
diminished by the fact that the bank was dealing with an institutional
customer. On the other hand, the fact that a customer initially needed
help understanding a potential investment need not necessarily imply
that the customer did not ultimately develop an understanding and make
an independent investment decision.
(g) A bank may conclude that a customer is exercising independent
judgement if the customer's investment decision will be based on its own
independent assessment of the opportunities and risks presented by a
potential investment, market factors and other investment
considerations. Where the bank has reasonable grounds for concluding
that the institutional customer is making independent investment
decisions and is capable of independently evaluating investment risk,
then a bank's obligations under Sec. 208.25(d) for a particular customer
are fulfilled.\8\ Where a customer has delegated decision-making
authority to an agent, such as an investment advisor or a
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bank trust department, the interpretation in this section shall be
applied to the agent.
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\8\ See footnote 7 in paragraph (d) of this section.
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(h) A determination of capability to evaluate investment risk
independently will depend on an examination of the customer's capability
to make its own investment decisions, including the resources available
to the customer to make informed decisions. Relevant considerations
could include:
(1) The use of one or more consultants, investment advisers, or bank
trust departments;
(2) The general level of experience of the institutional customer in
financial markets and specific experience with the type of instruments
under consideration;
(3) The customer's ability to understand the economic features of
the security involved;
(4) The customer's ability to independently evaluate how market
developments would affect the security; and
(5) The complexity of the security or securities involved.
(i) A determination that a customer is making independent investment
decisions will depend on the nature of the relationship that exists
between the bank and the customer. Relevant considerations could
include:
(1) Any written or oral understanding that exists between the bank
and the customer regarding the nature of the relationship between the
bank and the customer and the services to be rendered by the bank;
(2) The presence or absence of a pattern of acceptance of the bank's
recommendations;
(3) The use by the customer of ideas, suggestions, market views and
information obtained from other government securities brokers or dealers
or market professionals, particularly those relating to the same type of
securities; and
(4) The extent to which the bank has received from the customer
current comprehensive portfolio information in connection with
discussing recommended transactions or has not been provided important
information regarding its portfolio or investment objectives.
(j) Banks are reminded that these factors are merely guidelines that
will be utilized to determine whether a bank has fulfilled its
suitability obligation with respect to a specific institutional customer
transaction and that the inclusion or absence of any of these factors is
not dispositive of the determination of suitability. Such a
determination can only be made on a case-by-case basis taking into
consideration all the facts and circumstances of a particular bank/
customer relationship, assessed in the context of a particular
transaction.
(k) For purposes of the interpretation in this section, an
institutional customer shall be any entity other than a natural person.
In determining the applicability of the interpretation in this section
to an institutional customer, the Board will consider the dollar value
of the securities that the institutional customer has in its portfolio
and/or under management. While the interpretation in this section is
potentially applicable to any institutional customer, the guidance
contained in this section is more appropriately applied to an
institutional customer with at least $10 million invested in securities
in the aggregate in its portfolio and/or under management.
Appendix A to Part 208--Capital Adequacy Guidelines for State Member
Banks: Risk-Based Measure
I. Overview
The Board of Governors of the Federal Reserve System has adopted a
risk-based capital measure to assist in the assessment of the capital
adequacy of state member banks.\1\ The principal objectives of this
measure are to: (i) Make regulatory capital requirements more sensitive
to differences in risk profiles among banks; (ii) factor off-balance
sheet exposures into the assessment of capital adequacy; (iii) minimize
disincentives to holding liquid, low-risk assets; and (iv) achieve
greater consistency in the evaluation of the capital adequacy of major
banks throughout the world.\2\
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\1\ Supervisory ratios that relate capital to total assets for state
member banks are outlined in appendix B of this part and in appendix B
to part 225 of the Federal Reserve's Regulation Y, 12 CFR part 225.
\2\ The risk-based capital measure is based upon a framework
developed jointly by supervisory authorities from the countries
represented on the Basle Committee on Banking Regulations and
Supervisory Practices (Basle Supervisors' Committee) and endorsed by the
Group of Ten Central Bank Governors. The framework is described in a
paper prepared by the BSC entitled ``International Convergence of
Capital Measurement,'' July 1988.
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[[Page 259]]
The risk-based capital guidelines include both a definition of
capital and a framework for calculating weighted risk assets by
assigning assets and off-balance sheet items to broad risk categories. A
bank's risk-based capital ratio is calculated by dividing its qualifying
capital (the numerator of the ratio) by its weighted risk assets (the
denominator).\3\ The definition of qualifying capital is outlined below
in section II, and the procedures for calculating weighted risk assets
are discussed in Section III. Attachment I illustrates a sample
calculation of weighted risk assets and the risk-based capital ratio.
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\3\ Banks will initially be expected to utilize period-end amounts
in calculating their risk-based capital ratios. When necessary and
appropriate, ratios based on average balances may also be calculated on
a case-by-case basis. Moreover, to the extent banks have data on average
balances that can be used to calculate risk-based ratios, the Federal
Reserve will take such data into account.
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In addition, when certain banks that engage in trading activities
calculate their risk-based capital ratio under this appendix A, they
must also refer to appendix E of this part, which incorporates capital
charges for certain market risks into the risk-based capital ratio. When
calculating their risk-based capital ratio under this appendix A, such
banks are required to refer to appendix E of this part for supplemental
rules to determine qualifying and excess capital, calculate risk-
weighted assets, calculate market risk equivalent assets, and calculate
risk-based capital ratios adjusted for market risk.
The risk-based capital guidelines also establish a schedule for
achieving a minimum supervisory standard for the ratio of qualifying
capital to weighted risk assets and provide for transitional
arrangements during a phase-in period to facilitate adoption and
implementation of the measure at the end of 1992. These interim
standards and transitional arrangements are set forth in section IV.
The risk-based guidelines apply to all state member banks on a
consolidated basis. They are to be used in the examination and
supervisory process as well as in the analysis of applications acted
upon by the Federal Reserve. Thus, in considering an application filed
by a state member bank, the Federal Reserve will take into account the
bank's risk-based capital ratio, the reasonableness of its capital
plans, and the degree of progress it has demonstrated toward meeting the
interim and final risk-based capital standards.
The risk-based capital ratio focuses principally on broad categories
of credit risk, although the framework for assigning assets and off-
balance-sheet items to risk categories does incorporate elements of
transfer risk, as well as limited instances of interest rate and market
risk. The framework incorporates risks arising from traditional banking
activities as well as risks arising from nontraditional activities. The
risk-based ratio does not, however, incorporate other factors that can
affect an institution's financial condition. These factors include
overall interest-rate exposure; liquidity, funding and market risks; the
quality and level of earnings; investment, loan portfolio, and other
concentrations of credit; certain risks arising from nontraditional
activities; the quality of loans and investments; the effectiveness of
loan and investment policies; and management's overall ability to
monitor and control financial and operating risks, including the risks
presented by concentrations of credit and nontraditional activities.
In addition to evaluating capital ratios, an overall assessment of
capital adequacy must take account of those factors, including, in
particular, the level and severity of problem and classified assets as
well as a bank's exposure to declines in the economic value of its
capital due to changes in interest rates. For this reason, the final
supervisory judgment on a bank's capital adequacy may differ
significantly from conclusions that might be drawn solely from the level
of its risk-based capital ratio.
The risk-based capital guidelines establish minimum ratios of
capital to weighted risk assets. In light of the considerations just
discussed, banks generally are expected to operate well above the
minimum risk-based ratios. In particular, banks contemplating
significant expansion proposals are expected to maintain strong capital
levels substantially above the minimum ratios and should not allow
significant diminution of financial strength below these strong levels
to fund their expansion plans. Institutions with high or inordinate
levels of risk are also expected to operate well above minimum capital
standards. In all cases, institutions should hold capital commensurate
with the level and nature of the risks to which they are exposed. Banks
that do not meet the minimum risk-based standard, or that are otherwise
considered to be inadequately capitalized, are expected to develop and
implement plans acceptable to the Federal Reserve for achieving adequate
levels of capital within a reasonable period of time.
The Board will monitor the implementation and effect of these
guidelines in relation to domestic and international developments in the
banking industry. When necessary and appropriate, the Board will
consider the need
[[Page 260]]
to modify the guidelines in light of any significant changes in the
economy, financial markets, banking practices, or other relevant
factors.
II. Definition of Qualifying Capital for the Risk-Based Capital Ratio
A bank's qualifying total capital consists of two types of capital
components: ``core capital elements'' (comprising tier 1 capital) and
``supplementary capital elements'' (comprising tier 2 capital). These
capital elements and the various limits, restrictions, and deductions to
which they are subject, are discussed below and are set forth in
Attachment II.
The Federal Reserve will, on a case-by-case basis, determine whether
and, if so, how much of any instrument that does not fit wholly within
the terms of one of the capital categories set forth below or that does
not have an ability to absorb losses commensurate with the capital
treatment otherwise specified below will be counted as an element of
tier 1 or tier 2 capital. In making such a determination, the Federal
Reserve will consider the similarity of the instrument to instruments
explicitly treated in the guidelines, the ability of the instrument to
absorb losses while the bank operates as a going concern, the maturity
and redemption features of the instrument, and other relevant terms and
factors. To qualify as an element of tier 1 or tier 2 capital, a capital
instrument may not contain or be covered by any covenants, terms, or
restrictions that are inconsistent with safe and sound banking
practices.
Redemptions of permanent equity or other capital instruments before
stated maturity could have a significant impact on a bank's overall
capital structure. Consequently, a bank considering such a step should
consult with the Federal Reserve before redeeming any equity or debt
capital instrument (prior to maturity) if such redemption could have a
material effect on the level or composition of the institution's capital
base.\4\
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\4\ Consultation would not ordinarily be necessary if an instrument
were redeemed with the proceeds of, or replaced by, a like amount of a
similar or higher quality capital instrument and the organization's
capital position is considered fully adequate by the Federal Reserve.
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A. The Components of Qualifying Capital
1. Core capital elements (tier 1 capital). The tier 1 component of a
bank's qualifying capital must represent at least 50 percent of
qualifying total capital and may consist of the following items that are
defined as core capital elements:
(i) Common stockholders' equity;
(ii) Qualifying noncumulative perpetual preferred stock (including
related surplus); and
(iii) Minority interest in the equity accounts of consolidated
subsidiaries.
Tier 1 capital is generally defined as the sum of core capital
elements \5\ less any amounts of goodwill, other intangible assets,
interest-only strips receivables and nonfinancial equity investments
that are required to be deducted in accordance with section II.B. of
this appendix A.
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\5\ [Reserved]
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a. Common stockholders' equity. For purposes of calculating the
risk-based capital ratio, common stockholders' equity is limited to
common stock; related surplus; and retained earnings, including capital
reserves and adjustments for the cumulative effect of foreign currency
translation, net of any treasury stock; less net unrealized holding
losses on available-for-sale equity securities with readily determinable
fair values. For this purpose, net unrealized holding gains on such
equity securities and net unrealized holding gains (losses) on
available-for-sale debt securities are not included in common
stockholders' equity.
b. Perpetual preferred stock. Perpetual preferred stock is defined
as preferred stock that does not have a maturity date, that cannot be
redeemed at the option of the holder of the instrument, and that has no
other provisions that will require future redemption of the issue.
Consistent with these provisions, any perpetual preferred stock with a
feature permitting redemption at the option of the issuer may qualify as
capital only if the redemption is subject to prior approval of the
Federal Reserve. In general, preferred stock will qualify for inclusion
in capital only if it can absorb losses while the issuer operates as a
going concern (a fundamental characteristic of equity capital) and only
if the issuer has the ability and legal right to defer or eliminate
preferred dividends.
The only form of perpetual preferred stock that state member banks
may consider as an element of Tier 1 capital is noncumulative perpetual
preferred. While the guidelines allow for the inclusion of noncumulative
perpetual preferred stock in Tier 1, it is desirable from a supervisory
standpoint that voting common stockholders' equity remain the dominant
form of Tier 1 capital. Thus, state member banks should avoid
overreliance on preferred stock or non-voting equity elements within
Tier 1.
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\6\ [Reserved]
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Perpetual preferred stock in which the dividend is reset
periodically based, in whole or in part, upon the bank's current credit
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standing (that is, auction rate perpetual preferred stock, including so-
called Dutch auction, money market, and remarketable preferred) will not
qualify for inclusion in Tier 1 capital.\7\ Such instruments, however,
qualify for inclusion in Tier 2 capital.
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\7\ Adjustable rate noncumulative perpetual preferred stock (that
is, perpetual preferred stock in which the dividend rate is not affected
by the issuer's credit standing or financial condition but is adjusted
periodically according to a formula based solely on general market
interest rates) may be included in Tier 1.
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c. Minority interest in equity accounts of consolidated
subsidiaries. This element is included in Tier 1 because, as a general
rule, it represents equity that is freely available to absorb losses in
operating subsidiaries. While not subject to an explicit sublimit within
Tier 1, banks are expected to avoid using minority interest in the
equity accounts of consolidated subsidiaries as an avenue for
introducing into their capital structures elements that might not
otherwise qualify as Tier 1 capital or that would, in effect, result in
an excessive reliance on preferred stock within Tier 1. Minority
interests in small business investment companies, investment funds that
hold nonfinancial equity investments (as defined in section II.B.5.b. of
this appendix A), and subsidiaries engaged in nonfinancial activities
are not included in the bank's Tier 1 or total capital base if the
bank's interest in the company or fund is held under one of the legal
authorities listed in section II.B.5.b.
2. Supplementary capital elements (tier 2 capital). The tier 2
component of a bank's qualifying capital may consist of the following
items that are defined as supplementary capital elements:
(i) Allowance for loan and lease losses (subject to limitations
discussed below);
(ii) Perpetual preferred stock and related surplus (subject to
conditions discussed below);
(iii) Hybrid capital instruments (as defined below), and mandatory
convertible debt securities;
(iv) Term subordinated debt and intermediate-term preferred stock,
including related surplus (subject to limitations discussed below);
(v) Unrealized holding gains on equity securities (subject to
limitations discussed in section II.A.2.e. of this appendix).
The maximum amount of tier 2 capital that may be included in a
bank's qualifying total capital is limited to 100 percent of tier 1
capital (net of goodwill, other intangible assets, interest-only strips
receivables and nonfinancial equity investments that are required to be
deducted in accordance with section II.B. of this appendix A).
The elements of supplementary capital are discussed in greater
detail below.
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\8\ [Reserved]
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a. Allowance for loan and lease losses. Allowances for loan and
lease losses are reserves that have been established through a charge
against earnings to absorb future losses on loans or lease financing
receivables. Allowances for loan and lease losses exclude ``allocated
transfer risk reserves,'' \9\ and reserves created against identified
losses.
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\9\ Allocated transfer risk reserves are reserves that have been
established in accordance with Section 905(a) of the International
Lending Supervision Act of 1983, 12 U.S.C. 3904(a), against certain
assets whose value U.S. supervisory authorities have found to be
significantly impaired by protracted transfer risk problems.
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During the transition period, the risk-based capital guidelines
provide for reducing the amount of this allowance that may be included
in an institution's total capital. Initially, it is unlimited. However,
by year-end 1990, the amount of the allowance for loan and lease losses
that will qualify as capital will be limited to 1.5 percent of an
institution's weighted risk assets. By the end of the transition period,
the amount of the allowance qualifying for inclusion in Tier 2 capital
may not exceed 1.25 percent of weighted risk assets.\10\
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\10\ The amount of the allowance for loan and lease losses that may
be included in Tier 2 capital is based on a percentage of gross weighted
risk assets. A bank may deduct reserves for loan and lease losses in
excess of the amount permitted to be included in Tier 2 capital, as well
as allocated transfer risk reserves, from the sum of gross weighted risk
assets and use the resulting net sum of weighted risk assets in
computing the denominator of the risk-based capital ratio.
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b. Perpetual preferred stock. Perpetual preferred stock, as noted
above, is defined as preferred stock that has no maturity date, that
cannot be redeemed at the option of the holder, and that has no other
provisions that will require future redemption of the issue. Such
instruments are eligible for inclusion in Tier 2 capital without
limit.\11\
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\11\ Long-term preferred stock with an original maturity of 20 years
or more (including related surplus) will also qualify in this category
as an element of Tier 2. If the holder of such an instrument has a right
to require the issuer to redeem, repay, or repurchase the instrument
prior to the original stated maturity, maturity would be defined, for
risk-based capital purposes, as the earliest possible date on which the
holder can put the instrument back to the issuing bank.
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c. Hybrid capital instruments and mandatory convertible debt
securities. Hybrid capital instruments include instruments that are
essentially permanent in nature and that have certain characteristics of
both equity and debt. Such instruments may be included in Tier 2 without
limit. The general criteria hybrid capital instruments must meet in
order to qualify for inclusion in Tier 2 capital are listed below:
(1) The instrument must be unsecured; fully paid-up; and
subordinated to general creditors and must also be subordinated to
claims of depositors.
(2) The instrument must not be redeemable at the option of the
holder prior to maturity, except with the prior approval of the Federal
Reserve. (Consistent with the Board's criteria for perpetual debt and
mandatory convertible securities, this requirement implies that holders
of such instruments may not accelerate the payment of principal except
in the event of bankruptcy, insolvency, or reorganization.)
(3) The instrument must be available to participate in losses while
the issuer is operating as a going concern. (Term subordinated debt
would not meet this requirement.) To satisfy this requirement, the
instrument must convert to common or perpetual preferred stock in the
event that the accumulated losses exceed the sum of the retained
earnings and capital surplus accounts of the issuer.
(4) The instrument must provide the option for the issuer to defer
interest payments if: (a) The issuer does not report a profit in the
preceding annual period (defined as combined profits for the most recent
four quarters), and (b) the issuer eliminates cash dividends on common
and preferred stock.
Mandatory convertible debt securities in the form of equity contract
notes that meet the criteria set forth in 12 CFR part 225, appendix B,
also qualify as unlimited elements of Tier 2 capital. In accordance with
that appendix, equity commitment notes issued prior to May 15, 1985 also
qualify for inclusion in Tier 2.
d. Subordinated debt and intermediate term preferred stock. (i) The
aggregate amount of term subordinated debt (excluding mandatory
convertible debt) and intermediate-term preferred stock that may be
treated as supplementary capital is limited to 50 percent of Tier 1
capital (net of goodwill and other intangible assets required to be
deducted in accordance with section II.B.1.b. of this appendix). Amounts
in excess of these limits may be issued and, while not included in the
ratio calculation, will be taken into account in the overall assessment
of a bank's funding and financial condition.
(ii) Subordinated debt and intermediate-term preferred stock must
have an original weighted average maturity of at least five years to
qualify as supplementary capital. (If the holder has the option to
require the issuer to redeem, repay, or repurchase the instrument prior
to the original stated maturity, maturity would be defined, for risk-
based capital purposes, as the earliest possible date on which the
holder can put the instrument back to the issuing bank.) \12\ In the
case of subordinated debt, the instrument must be unsecured and must
clearly state on its face that it is not a deposit and is not insured by
a Federal agency. To qualify as capital in banks, debt must be
subordinated to general creditors and claims of depositors. Consistent
with current regulatory requirements, if a state member bank wishes to
redeem subordinated debt before the stated maturity, it must receive
prior approval of the Federal Reserve.
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\12\ As a limited-life capital instrument approaches maturity it
begins to take on characteristics of a short-term obligation. For this
reason, the outstanding amount of term subordinated debt and limited-
life preferred stock eligible for inclusion in Tier 2 is reduced, or
discounted, as these instruments approach maturity: one-fifth of the
original amount (less redemptions) is excluded each year during the
instrument's last five years before maturity. When the remaining
maturity is less than one year, the instrument is excluded from Tier 2
capital.
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e. Unrealized gains on equity securities and unrealized gains
(losses) on other assets. Up to 45 percent of pretax net unrealized
holding gains (that is, the excess, if any, of the fair value over
historical cost) on available-for-sale equity securities with readily
determinable fair values may be included in supplementary capital.
However, the Federal Reserve may exclude all or a portion of these
unrealized gains from Tier 2 capital if the Federal Reserve determines
that the equity securities are not prudently valued. Unrealized gains
(losses) on other types of assets, such as bank premises and available-
for-sale debt securities, are not included in supplementary capital, but
the Federal Reserve may take these unrealized gains (losses) into
account as additional factors when assessing a bank's overall capital
adequacy.
f. Revaluation reserves. i. Such reserves reflect the formal balance
sheet restatement or revaluation for capital purposes of asset carrying
values to reflect current market values. The federal banking agencies
generally have not included unrealized asset appreciation in capital
ratio calculations, although they have long taken such values into
account as a separate factor in assessing the overall financial strength
of a bank.
ii. Consistent with long-standing supervisory practice, the excess
of market values over book values for assets held by state
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member banks will generally not be recognized in supplementary capital
or in the calculation of the risk-based capital ratio. However, all
banks are encouraged to disclose their equivalent of premises (building)
and security revaluation reserves. The Federal Reserve will consider any
appreciation, as well as any depreciation, in specific asset values as
additional considerations in assessing overall capital strength and
financial condition.
B. Deductions from Capital and Other Adjustments
Certain assets are deducted from a bank's capital for the purpose of
calculating the risk-based capital ratio.\13\ These assets include:
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\13\ Any assets deducted from capital in computing the numerator of
the ratio are not included in weighted risk assets in computing the
denominator of the ratio.
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(i)(a) Goodwill--deducted from the sum of core capital elements.
(b) Certain identifiable intangible assets, that is, intangible
assets other than goodwill--deducted from the sum of core capital
elements in accordance with section II.B.1.b. of this appendix.
(c) Certain credit-enhancing interest-only strips receivables--
deducted from the sum of core capital elements in accordance with
sections II.B.1.c. through e. of this appendix.
(ii) Investments in banking and finance subsidiaries that are not
consolidated for accounting or supervisory purposes and, on a case-by-
case basis, investments in other designated subsidiaries or associated
companies at the discretion of the Federal Reserve--deducted from total
capital components.
(iii) Reciprocal holdings of capital instruments of banking
organizations--deducted from total capital components.
(iv) Deferred tax assets--portions are deducted from the sum of core
capital elements in accordance with section II.B.4. of this Appendix A.
(v) Nonfinancial equity investments-portions are deducted from the
sum of core capital elements in accordance with section II.B.5 of this
appendix.
1. Goodwill and other intangible assets.--a. Goodwill. Goodwill in
an intangible asset that represents the excess of the purchase price
over the fair market value of identifiable assets acquired less
liabilities assumed in acquisitions accounted for under the purchase
method of accounting. State member banks generally have not been allowed
to include goodwill in regulatory capital under current supervisory
policies. Consistent with this policy, all goodwill in state member
banks will be deducted from Tier 1 capital.
b. Other intangible assets. i. All servicing assets, including
servicing assets on assets other than mortgages (i.e., nonmortgage
servicing assets), are included in this appendix as identifiable
intangible assets. The only types of identifiable intangible assets that
may be included in, that is, not deducted from, a bank's capital are
readily marketable mortgage servicing assets, nonmortgage servicing
assets, and purchased credit card relationships. The total amount of
these assets that may be included in capital is subject to the
limitations described below in sections II.B.1.d. and e. of this
appendix.
ii. The treatment of identifiable intangible assets set forth in
this section generally will be used in the calculation of a bank's
capital ratios for supervisory and applications purposes. However, in
making an overall assessment of a bank's capital adequacy for
applications purposes, the Board may, if it deems appropriate, take into
account the quality and composition of a bank's capital, together with
the quality and value of its tangible and intangible assets.
c. Credit-enhancing interest-only strips receivables (I/Os). i.
Credit-enhancing I/Os are on-balance sheet assets that, in form or in
substance, represent the contractual right to receive some or all of the
interest due on transferred assets and expose the bank to credit risk
directly or indirectly associated with transferred assets that exceeds a
pro rata share of the bank's claim on the assets, whether through
subordination provisions or other credit enhancement techniques. Such I/
Os, whether purchased or retained, including other similar ``spread''
assets, may be included in, that is, not deducted from, a bank's capital
subject to the limitations described below in sections II.B.1.d. and e.
of this appendix.
ii. Both purchased and retained credit-enhancing I/Os, on a non-tax
adjusted basis, are included in the total amount that is used for
purposes of determining whether a bank exceeds the tier 1 limitation
described below in this section. In determining whether an I/O or other
types of spread assets serve as a credit enhancement, the Federal
Reserve will look to the economic substance of the transaction.
d. Fair value limitation. The amount of mortgage servicing assets,
nonmortgage servicing assets, and purchased credit card relationships
that a bank may include in capital shall be the lesser of 90 percent of
their fair value, as determined in accordance with section II.B.1.f. of
this appendix, or 100 percent of their book value, as adjusted for
capital purposes in accordance with the instructions in the commercial
bank Consolidated Reports of Condition and Income (Call Reports). The
amount of I/Os that a bank may include in capital shall be its fair
value. If both the application of the limits on mortgage servicing
assets, nonmortgage servicing
[[Page 264]]
assets, and purchased credit card relationships and the adjustment of
the balance sheet amount for these assets would result in an amount
being deducted from capital, the bank would deduct only the greater of
the two amounts from its core capital elements in determining tier 1
capital.
e. Tier 1 capital limitation. i. The total amount of mortgage
servicing assets, nonmortgage servicing assets, and purchased credit
card relationships that may be included in capital, in the aggregate,
cannot exceed 100 percent of tier 1 capital. The aggregate of
nonmortgage servicing assets and purchased credit card relationships are
subject to a separate sublimit of 25 percent of tier 1 capital. In
addition, the total amount of credit-enhancing I/Os (both purchased and
retained) that may be included in capital cannot exceed 25 percent of
tier 1 capital.\14\
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\14\ Amounts of servicing assets, purchased credit card
relationships, and credit-enhancing I/Os (both retained and purchased)
in excess of these limitations, as well as all other identifiable
intangible assets, including core deposit intangibles and favorable
leaseholds, are to be deducted from a bank's core capital elements in
determining tier 1 capital. However, identifiable intangible assets
(other than mortgage servicing assets and purchased credit card
relationships) acquired on or before February 19, 1992, generally will
not be deducted from capital for supervisory purposes, although they
will continue to be deducted for applications purposes.
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ii. For purposes of calculating these limitations on mortgage
servicing assets, nonmortgage servicing assets, purchased credit card
relationships, and credit-enhancing I/Os, tier 1 capital is defined as
the sum of core capital elements, net of goodwill, and net of all
identifiable intangible assets other than mortgage servicing assets,
nonmortgage servicing assets, and purchased credit card relationships,
but prior to the deduction of any disallowed mortgage servicing assets,
any disallowed nonmortgage servicing assets, any disallowed purchased
credit card relationships, any disallowed credit-enhancing I/Os (both
purchased and retained), any disallowed deferred tax assets, and any
nonfinancial equity investments.
iii. Banks may elect to deduct disallowed mortgage servicing assets,
disallowed nonmortgage servicing assets, and disallowed credit-enhancing
I/Os (both purchased and retained) on a basis that is net of any
associated deferred tax liability. Deferred tax liabilities netted in
this manner cannot also be netted against deferred-tax assets when
determining the amount of deferred-tax assets that are dependent upon
future taxable income.
f. Valuation. Banks must review the book value of all intangible
assets at least quarterly and make adjustments to these values as
necessary. The fair value of mortgage servicing assets, nonmortgage
servicing assets, purchased credit card relationships, and credit-
enhancing I/Os also must be determined at least quarterly. This
determination shall include adjustments for any significant changes in
original valuation assumptions, including changes in prepayment
estimates or account attrition rates. Examiners will review both the
book value and the fair value assigned to these assets, together with
supporting documentation, during the examination process. In addition,
the Federal Reserve may require, on a case-by-case basis, an independent
valuation of a bank's intangible assets or credit-enhancing I/Os.
g. Growing organizations. Consistent with long-standing Board
policy, banks experiencing substantial growth, whether internally or by
acquisition, are expected to maintain strong capital positions
substantially above minimum supervisory levels, without significant
reliance on intangible assets or credit-enhancing I/Os.
2. Investments in certain subsidiaries. The aggregate amount of
investments in banking or finance subsidiaries \15\ whose financial
statements are not consolidated for accounting or bank regulatory
reporting purposes will be deducted from a bank's total capital
components.\16\ Generally, investments for this purpose are defined as
equity and debt capital investments and any other instruments that are
deemed to be capital in the particular subsidiary.
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\15\ For this purpose, a banking and finance subsidiary generally is
defined as any company engaged in banking or finance in which the parent
institution holds directly or indirectly more than 50 percent of the
outstanding voting stock, or which is otherwise controlled or capable of
being controlled by the parent institution.
\16\ An exception to this deduction would be made in the case of
shares acquired in the regular course of securing or collecting a debt
previously contracted in good faith. The requirements for consolidation
are spelled out in the instructions to the Call Report.
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Advances (that is, loans, extensions of credit, guarantees,
commitments, or any other forms of credit exposure) to the subsidiary
that are not deemed to be capital will generally not be deducted from a
bank's capital. Rather, such advances generally will be included in the
bank's consolidated assets and be assigned to the 100 percent risk
category, unless such obligations are backed by recognized collateral or
guarantees, in which case they will be assigned to the risk category
appropriate to such collateral or guarantees. These advances may,
however, also be deducted from the bank's capital if, in the judgment of
the Federal Reserve, the risks
[[Page 265]]
stemming from such advances are comparable to the risks associated with
capital investments or if the advances involve other risk factors that
warrant such an adjustment to capital for supervisory purposes. These
other factors could include, for example, the absence of collateral
support.
Inasmuch as the assets of unconsolidated banking and finance
subsidiaries are not fully reflected in a bank's consolidated total
assets, such assets may be viewed as the equivalent of off-balance sheet
exposures since the operations of an unconsolidated subsidiary could
expose the bank to considerable risk. For this reason, it is generally
appropriate to view the capital resources invested in these
unconsolidated entities as primarily supporting the risks inherent in
these off-balance sheet assets, and not generally available to support
risks or absorb losses elsewhere in the bank.
The Federal Reserve may, on a case-by-case basis, also deduct from a
bank's capital, investments in certain other subsidiaries in order to
determine if the consolidated bank meets minimum supervisory capital
requirements without reliance on the resources invested in such
subsidiaries.
The Federal Reserve will not automatically deduct investments in
other consolidated subsidiaries or investments in joint ventures and
associated companies.\17\ Nonetheless, the resources invested in these
entities, like investments in unconsolidated banking and finance
subsidiaries, support assets not consolidated with the rest of the
bank's activities and, therefore, may not be generally available to
support additional leverage or absorb losses elsewhere in the bank.
Moreover, experience has shown that banks stand behind the losses of
affiliated institutions, such as joint ventures and associated
companies, in order to protect the reputation of the organization as a
whole. In some cases, this has led to losses that have exceeded the
investments in such organizations.
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\17\ The definition of such entities is contained in the
instructions to the commercial bank Call Report. Under regulatory
reporting procedures, associated companies and joint ventures generally
are defined as companies in which the bank owns 20 to 50 percent of the
voting stock.
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For this reason, the Federal Reserve will monitor the level and
nature of such investments for individual banks and, on a case-by-case
basis may, for risk-based capital purposes, deduct such investments from
total capital components, apply an appropriate risk-weighted capital
charge against the bank's proportionate share of the assets of its
associated companies, require a line-by-line consolidation of the entity
(in the event that the bank's control over the entity makes it the
functional equivalent of a subsidiary), or otherwise require the bank to
operate with a risk-based capital ratio above the minimum.
In considering the appropriateness of such adjustments or actions,
the Federal Reserve will generally take into account whether:
(1) The bank has significant influence over the financial or
managerial policies or operations of the subsidiary, joint venture, or
associated company;
(2) The bank is the largest investor in the affiliated company; or
(3) Other circumstances prevail that appear to closely tie the
activities of the affiliated company to the bank.
3. Reciprocal holdings of banking organizations' capital
instruments. Reciprocal holdings of banking organizations' capital
instruments (that is, instruments that qualify as Tier 1 or Tier 2
capital) \18\ will be deducted from a bank's total capital components
for the purpose of determining the numerator of the risk-based capital
ratio.
---------------------------------------------------------------------------
\18\ See 12 CFR part 225, appendix A for instruments that qualify as
Tier 1 and Tier 2 capital for bank holding companies.
---------------------------------------------------------------------------
Reciprocal holdings are cross-holdings resulting from formal or
informal arrangements in which two or more banking organizations swap,
exchange, or otherwise agree to hold each other's capital instruments.
Generally, deductions will be limited to intentional cross-holdings. At
present, the Board does not intend to require banks to deduct non-
reciprocal holdings of such capital instruments.\19\
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\19\ Deductions of holdings of capital securities also would not be
made in the case of interstate ``stake out'' investments that comply
with the Board's Policy Statement on Nonvoting Equity Investments, 12
CFR 225.143 (Federal Reserve Regulatory Service 4-172.1; 68 Federal
Reserve Bulletin 413 (1982)). In addition, holdings of capital
instruments issued by other banking organizations but taken in
satisfaction of debts previously contracted would be exempt from any
deduction from capital. The Board intends to monitor nonreciprocal
holdings of other banking organizations' capital instruments and to
provide information on such holdings to the Basle Supervisors' Committee
as called for under the Basle capital framework.
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4. Deferred-tax assets. a. The amount of deferred-tax assets that is
dependent upon future taxable income, net of the valuation allowance for
deferred-tax assets, that may be included in, that is, not deducted
from, a bank's capital may not exceed the lesser of:
i. The amount of these deferred-tax assets that the bank is expected
to realize within one year of the calendar quarter-end date,
[[Page 266]]
based on its projections of future taxable income for that year,\20\ or
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\20\ To determine the amount of expected deferred-tax assets
realizable in the next 12 months, an institution should assume that all
existing temporary differences fully reverse as of the report date.
Projected future taxable income should not include net operating loss
carry-forwards to be used during that year or the amount of existing
temporary differences a bank expects to reverse within the year. Such
projections should include the estimated effect of tax-planning
strategies that the organization expects to implement to realize net
operating losses or tax-credit carry-forwards that would otherwise
expire during the year. Institutions do not have to prepare a new 12-
month projection each quarter. Rather, on interim report dates,
institutions may use the future-taxable income projections for their
current fiscal year, adjusted for any significant changes that have
occurred or are expected to occur.
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ii. 10 percent of tier 1 capital.
b. The reported amount of deferred-tax assets, net of any valuation
allowance for deferred-tax assets, in excess of the lesser of these two
amounts is to be deducted from a bank's core capital elements in
determining tier 1 capital. For purposes of calculating the 10 percent
limitation, tier 1 capital is defined as the sum of core capital
elements, net of goodwill and net of all identifiable intangible assets
other than mortgage servicing assets, nonmortgage servicing assets, and
purchased credit card relationships, but prior to the deduction of any
disallowed mortgage servicing assets, any disallowed nonmortgage
servicing assets, any disallowed purchased credit card relationships,
any disallowed credit-enhancing I/Os, any disallowed deferred-tax
assets, and any nonfinancial equity investments. There generally is no
limit in tier 1 capital on the amount of deferred-tax assets that can be
realized from taxes paid in prior carry-back years or from future
reversals of existing taxable temporary differences.
5. Nonfinancial equity investments--a. General. A bank must deduct
from its core capital elements the sum of the appropriate percentages
(as determined below) of the adjusted carrying value of all nonfinancial
equity investments held by the bank or by its direct or indirect
subsidiaries. For purposes of this section II.B.5, investments held by a
bank include all investments held directly or indirectly by the bank or
any of its subsidiaries.
b. Scope of nonfinancial equity investments. A nonfinancial equity
investment means any equity investment held by the bank in a
nonfinancial company: through a small business investment company (SBIC)
under section 302(b) of the Small Business Investment Act of 1958 (15
U.S.C. 682(b)); \21\ or under the portfolio investment provisions of the
Board's Regulation K (12 CFR 211.8(c)(3)). A nonfinancial company is an
entity that engages in any activity that has not been determined to be
permissible for the bank to conduct directly, or to be financial in
nature or incidental to financial activities under section 4(k) of the
Bank Holding Company Act (12 U.S.C. 1843(k)).
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\21\ An equity investment made under section 302(b) of the Small
Business Investment Act of 1958 in an SBIC that is not consolidated with
the bank is treated as a nonfinancial equity investment.
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c. Amount of deduction from core capital. i. The bank must deduct
from its core capital elements the sum of the appropriate percentages,
as set forth in Table 1, of the adjusted carrying value of all
nonfinancial equity investments held by the bank. The amount of the
percentage deduction increases as the aggregate amount of nonfinancial
equity investments held by the bank increases as a percentage of the
bank's Tier 1 capital.
Table 1.--Deduction for Nonfinancial Equity Investments
------------------------------------------------------------------------
Aggregate adjusted carrying value of all
nonfinancial equity investments held Deduction from Core Capital
directly or indirectly by the bank (as a Elements (as a percentage of
percentage of the Tier 1 capital of the the adjusted carrying value
bank) \1\ of the investment)
------------------------------------------------------------------------
Less than 15 percent..................... 8 percent.
15 percent to 24.99 percent.............. 12 percent.
25 percent and above..................... 25 percent.
------------------------------------------------------------------------
\1\ For purposes of calculating the adjusted carrying value of
nonfinancial equity investments as a percentage of Tier 1 capital,
Tier 1 capital is defined as the sum of core capital elements net of
goodwill and net of all identifiable intangible assets other than
mortgage servicing assets, nonmortgage servicing assets and purchased
credit card relationships, but prior to the deduction for any
disallowed mortgage servicing assets, any disallowed nonmortgage
servicing assets, any disallowed purchased credit card relationships,
any disallowed credit enhancing I/Os (both purchased and retained),
any disallowed deferred tax assets, and any nonfinancial equity
investments.
ii. These deductions are applied on a marginal basis to the portions
of the adjusted carrying value of nonfinancial equity investments that
fall within the specified ranges of
[[Page 267]]
the parent bank's Tier 1 capital. For example, if the adjusted carrying
value of all nonfinancial equity investments held by a bank equals 20
percent of the Tier 1 capital of the bank, then the amount of the
deduction would be 8 percent of the adjusted carrying value of all
investments up to 15 percent of the bank's Tier 1 capital, and 12
percent of the adjusted carrying value of all investments in excess of
15 percent of the bank's Tier 1 capital.
iii. The total adjusted carrying value of any nonfinancial equity
investment that is subject to deduction under this paragraph is excluded
from the bank's risk-weighted assets for purposes of computing the
denominator of the bank's risk-based capital ratio.\22\
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\22\ For example, if 8 percent of the adjusted carrying value of a
nonfinancial equity investment is deducted from Tier 1 capital, the
entire adjusted carrying value of the investment will be excluded from
risk-weighted assets in calculating the denominator for the risk-based
capital ratio.
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iv. As noted in section I, this appendix establishes minimum risk-
based capital ratios and banks are at all times expected to maintain
capital commensurate with the level and nature of the risks to which
they are exposed. The risk to a bank from nonfinancial equity
investments increases with its concentration in such investments and
strong capital levels above the minimum requirements are particularly
important when a bank has a high degree of concentration in nonfinancial
equity investments (e.g., in excess of 50 percent of Tier 1 capital).
The Federal Reserve intends to monitor banks and apply heightened
supervision to equity investment activities as appropriate, including
where the bank has a high degree of concentration in nonfinancial equity
investments, to ensure that each bank maintains capital levels that are
appropriate in light of its equity investment activities. The Federal
Reserve also reserves authority to impose a higher capital charge in any
case where the circumstances, such as the level of risk of the
particular investment or portfolio of investments, the risk management
systems of the bank, or other information, indicate that a higher
minimum capital requirement is appropriate.
d. SBIC investments. i. No deduction is required for nonfinancial
equity investments that are held by a bank through one or more SBICs
that are consolidated with the bank or in one or more SBICs that are not
consolidated with the bank to the extent that all such investments, in
the aggregate, do not exceed 15 percent of the bank's Tier 1 capital.
Any nonfinancial equity investment that is held through or in an SBIC
and that is not required to be deducted from Tier 1 capital under this
section II.B.5.d. will be assigned a 100 percent risk-weight and
included in the bank's consolidated risk-weighted assets.\23\
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\23\ If a bank has an investment in an SBIC that is consolidated for
accounting purposes but that is not wholly owned by the bank, the
adjusted carrying value of the bank's nonfinancial equity investments
through the SBIC is equal to the bank's proportionate share of the
adjusted carrying value of the SBIC's equity investments in nonfinancial
companies. The remainder of the SBIC's adjusted carrying value (i.e.,
the minority interest holders' proportionate share) is excluded from the
risk-weighted assets of the bank. If a bank has an investment in an SBIC
that is not consolidated for accounting purposes and has current
information that identifies the percentage of the SBIC's assets that are
equity investments in nonfinancial companies, the bank may reduce the
adjusted carrying value of its investment in the SBIC proportionately to
reflect the percentage of the adjusted carrying value of the SBIC's
assets that are not equity investments in nonfinancial companies. If a
bank reduces the adjusted carrying value of its investment in a non-
consolidated SBIC to reflect financial investments of the SBIC, the
amount of the adjustment will be risk weighted at 100 percent and
included in the bank's risk-weighted assets.
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ii. To the extent the adjusted carrying value of all nonfinancial
equity investments that a bank holds through one or more SBICs that are
consolidated with the bank or in one or more SBICs that are not
consolidated with the bank exceeds, in the aggregate, 15 percent of the
bank's Tier 1 capital, the appropriate percentage of such amounts (as
set forth in Table 1) must be deducted from the bank's core capital
elements. In addition, the aggregate adjusted carrying value of all
nonfinancial equity investments held through a consolidated SBIC and in
a non-consolidated SBIC (including any investments for which no
deduction is required) must be included in determining, for purposes of
Table 1, the total amount of nonfinancial equity investments held by the
bank in relation to its Tier 1 capital.
e. Transition provisions. No deduction under this section II.B.5 is
required to be made with respect to the adjusted carrying value of any
nonfinancial equity investment (or portion of such an investment) that
was made by the bank prior to March 13, 2000, or that was made by the
bank after such date pursuant to a binding written commitment \24\
[[Page 268]]
entered into prior to March 13, 2000, provided that in either case the
bank has continuously held the investment since the relevant investment
date.\25\ For purposes of this section II.B.5.e., a nonfinancial equity
investment made prior to March 13, 2000, includes any shares or other
interests received by the bank through a stock split or stock dividend
on an investment made prior to March 13, 2000, provided the bank
provides no consideration for the shares or interests received and the
transaction does not materially increase the bank's proportional
interest in the company. The exercise on or after March 13, 2000, of
options or warrants acquired prior to March 13, 2000, is not considered
to be an investment made prior to March 13, 2000, if the bank provides
any consideration for the shares or interests received upon exercise of
the options or warrants. Any nonfinancial equity investment (or portion
thereof) that is not required to be deducted from Tier 1 capital under
this section II.B.5.e. must be included in determining the total amount
of nonfinancial equity investments held by the bank in relation to its
Tier 1 capital for purposes of Table 1. In addition, any nonfinancial
equity investment (or portion thereof) that is not required to be
deducted from Tier 1 capital under this section II.B.5.e. will be
assigned a 100-percent risk weight and included in the bank's
consolidated risk-weighted assets.
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\24\ A ``binding written commitment'' means a legally binding
written agreement that requires the bank to acquire shares or other
equity of the company, or make a capital contribution to the company,
under terms and conditions set forth in the agreement. Options,
warrants, and other agreements that give a bank the right to acquire
equity or make an investment, but do not require the bank to take such
actions, are not considered a binding written commitment for purposes of
this section II.B.5.
\25\ For example, if a bank made an equity investment in 100 shares
of a nonfinancial company prior to March 13, 2000, the adjusted carrying
value of that investment would not be subject to a deduction under this
section II.B.5. However, if the bank made any additional equity
investment in the company after March 13, 2000, such as by purchasing
additional shares of the company (including through the exercise of
options or warrants acquired before or after March 13, 2000) or by
making a capital contribution to the company and such investment was not
made pursuant to a binding written commitment entered into before March
13, 2000, the adjusted carrying value of the additional investment would
be subject to a deduction under this section II.B.5. In addition, if the
bank sold and repurchased, after March 13, 2000, 40 shares of the
company, the adjusted carrying value of those 40 shares would be subject
to a deduction under this section II.B.5.
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f. Adjusted carrying value. i. For purposes of this section II.B.5.,
the ``adjusted carrying value'' of investments is the aggregate value at
which the investments are carried on the balance sheet of the bank
reduced by any unrealized gains on those investments that are reflected
in such carrying value but excluded from the bank's Tier 1 capital and
associated deferred tax liabilities. For example, for investments held
as available-for-sale (AFS), the adjusted carrying value of the
investments would be the aggregate carrying value of the investments (as
reflected on the consolidated balance sheet of the bank) less any
unrealized gains on those investments that are included in other
comprehensive income and not reflected in Tier 1 capital, and associated
deferred tax liabilities.\26\
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\26\ Unrealized gains on AFS equity investments may be included in
supplementary capital to the extent permitted under section II.A.2.e. of
this appendix A. In addition, the unrealized losses on AFS equity
investments are deducted from Tier 1 capital in accordance with section
II.A.1.a. of this appendix A.
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ii. As discussed above with respect to consolidated SBICs, some
equity investments may be in companies that are consolidated for
accounting purposes. For investments in a nonfinancial company that is
consolidated for accounting purposes under generally accepted accounting
principles, the bank's adjusted carrying value of the investment is
determined under the equity method of accounting (net of any intangibles
associated with the investment that are deducted from the bank's core
capital in accordance with section II.B.1. of this appendix A). Even
though the assets of the nonfinancial company are consolidated for
accounting purposes, these assets (as well as the credit equivalent
amounts of the company's off-balance sheet items) should be excluded
from the bank's risk-weighted assets for regulatory capital purposes.
g. Equity investments. For purposes of this section II.B.5., an
equity investment means any equity instrument (including common stock,
preferred stock, partnership interests, interests in limited liability
companies, trust certificates and warrants and call options that give
the holder the right to purchase an equity instrument), any equity
feature of a debt instrument (such as a warrant or call option), and any
debt instrument that is convertible into equity where the instrument or
feature is held under one of the legal authorities listed in section
II.B.5.b. of this appendix A. An investment in any other instrument
(including subordinated debt) may be treated as an equity investment if,
in the judgment of the Federal Reserve, the instrument is the functional
equivalent of equity or exposes the state member bank to essentially the
same risks as an equity instrument.
[[Page 269]]
III. Procedures for Computing Weighted Risk Assets and Off-Balance Sheet
Items
A. Procedures
Assets and credit equivalent amounts of off-balance sheet items of
state member banks are assigned to one of several broad risk categories,
according to the obligor, or, if relevant, the guarantor or the nature
of the collateral. The aggregate dollar value of the amount in each
category is then multiplied by the risk weight associated with that
category. The resulting weighted values from each of the risk categories
are added together, and this sum is the bank's total weighted risk
assets that comprise the denominator of the risk-based capital ratio.
Attachment I provides a sample calculation.
Risk weights for all off-balance sheet items are determined by a
two-step process. First, the ``credit equivalent amount'' of off-balance
sheet items is determined, in most cases by multiplying the off-balance
sheet item by a credit conversion factor. Second, the credit equivalent
amount is treated like any balance sheet asset and generally is assigned
to the appropriate risk category according to the obligor, or, if
relevant, the guarantor or the nature of the collateral.
In general, if a particular item qualifies for placement in more
than one risk category, it is assigned to the category that has the
lowest risk weight. A holding of a U.S. municipal revenue bond that is
fully guaranteed by a U.S. bank, for example, would be assigned the 20
percent risk weight appropriate to claims guaranteed by U.S. banks,
rather than the 50 percent risk weight appropriate to U.S. municipal
revenue bonds.\27\
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\27\ An investment in shares of a fund whose portfolio consists
primarily of various securities or money market instruments that, if
held separately, would be assigned to different risk categories,
generally is assigned to the risk category appropriate to the highest
risk-weighted asset that the fund is permitted to hold in accordance
with the stated investment objectives set forth in its prospectus. A
bank may, at its option, assign a fund investment on a pro rata basis to
different risk categories according to the investment limits in the
fund's prospectus. In no case will an investment in shares in any fund
be assigned to a total risk weight less than 20 percent. If a bank
chooses to assign a fund investment on a pro rata basis, and the sum of
the investment limits of assets in the fund's prospectus exceeds 100
percent, the bank must assign risk weights in descending order. If, in
order to maintain a necessary degree of short-term liquidity, a fund is
permitted to hold an insignificant amount of its assets in short-term,
highly liquid securities of superior credit quality that do not qualify
for a preferential risk weight, such securities generally will be
disregarded when determining the risk category into which the bank's
holding in the overall fund should be assigned. The prudent use of
hedging instruments by a fund to reduce the risk of its assets also will
not increase the risk weighting of the fund investment. For example, the
use of hedging instruments by a fund to reduce the interest rate risk of
its government bond portfolio will not increase the risk weight of that
fund above the 20 percent category. Nonetheless, if a fund engages in
any activities that appear speculative in nature or has any other
characteristics that are inconsistent with the preferential risk
weighting assigned to the fund's assets, holdings in the fund will be
assigned to the 100 percent risk category.
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The terms claims and securities used in the context of the
discussion of risk weights, unless otherwise specified, refer to loans
or debt obligations of the entity on whom the claim is held. Assets in
the form of stock or equity holdings in commercial or financial firms
are assigned to the 100 percent risk category, unless some other
treatment is explicitly permitted.
The Federal Reserve will, on a case-by-case basis, determine the
appropriate risk weight for any asset or credit equivalent amount of an
off-balance sheet item that does not fit wholly within one of the risk
weight categories set forth below or that imposes risks on a bank that
are incommensurate with the risk weight otherwise specified below for
the asset or off-balance sheet item. In addition, the Federal Reserve
will, on a case-by-case basis, determine the appropriate credit
conversion factor for any off-balance sheet item that does not fit
wholly within one of the credit conversion factors set forth below or
that imposes risks on a bank that are incommensurate with the credit
conversion factors otherwise specified below for the off-balance sheet
item. In making such a determination, the Federal Reserve will consider
the similarity of the asset or off-balance sheet item to assets or off-
balance sheet items explicitly treated in the guidelines, as well as
other relevant factors.
B. Collateral, Guarantees, and Other Considerations
1. Collateral. The only forms of collateral that are formally
recognized by the risk-based capital framework are: Cash on deposit in
the bank; securities issued or guaranteed by the central governments of
the OECD-based group of countries,\28\ U.S. Government
[[Page 270]]
agencies, or U.S. Government-sponsored agencies; and securities issued
by multilateral lending institutions or regional development banks.
Claims fully secured by such collateral generally are assigned to the 20
percent risk-weight category. Collateralized transactions meeting all
the conditions described in section III.C.1. may be assigned a zero
percent risk weight.
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\28\The OECD-based group of countries comprises all full members of
the Organization for Economic Cooperation and Development (OECD)
regardless of entry date, as well as countries that have concluded
special lending arrangements with the International Monetary Fund (IMF)
associated with the IMF's General Arrangements to Borrow, but excludes
any country that has rescheduled its external sovereign debt within the
previous five years. As of November 1995, the OECD included the
following countries: Australia, Austria, Belgium, Canada, Denmark,
Finland, France, Germany, Greece, Iceland, Ireland, Italy, Japan,
Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Portugal,
Spain, Sweden, Switzerland, Turkey, the United Kingdom, and the United
States; and Saudi Arabia had concluded special lending arrangements with
the IMF associated with the IMF's General Arrangements to Borrow. A
rescheduling of external sovereign debt generally would include any
renegotiation of terms arising from a country's inability or
unwillingness to meet its external debt service obligations, but
generally would not include renegotiations of debt in the normal course
of business, such as a renegotiation to allow the borrower to take
advantage of a decline in interest rates or other change in market
conditions.
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With regard to collateralized claims that may be assigned to the 20
percent risk-weight category, the extent to which qualifying securities
are recognized as collateral is determined by their current market
value. If such a claim is only partially secured, that is, the market
value of the pledged securities is less than the face amount of a
balance-sheet asset or an off-balance-sheet item, the portion that is
covered by the market value of the qualifying collateral is assigned to
the 20 percent risk category, and the portion of the claim that is not
covered by collateral in the form of cash or a qualifying security is
assigned to the risk category appropriate to the obligor or, if
relevant, the guarantor. For example, to the extent that a claim on a
private sector obligor is collateralized by the current market value of
U.S. Government securities, it would be placed in the 20 percent risk
category, and the balance would be assigned to the 100 percent risk
category.
2. Guarantees. Guarantees of the OECD and non-OECD central
governments, U.S. Government agencies, U.S. Government-sponsored
agencies, state and local governments of the OECD-based group of
countries, multilateral lending institutions and regional development
banks, U.S. depository institutions, and foreign banks are also
recognized. If a claim is partially guaranteed, that is, coverage of the
guarantee is less than the face amount of a balance sheet asset or an
off-balance sheet item, the portion that is not fully covered by the
guarantee is assigned to the risk category appropriate to the obligor
or, if relevant, to any collateral. The face amount of a claim covered
by two types of guarantees that have different risk weights, such as a
U.S. Government guarantee and a state guarantee, is to be apportioned
between the two risk categories appropriate to the guarantors.
The existence of other forms of collateral or guarantees that the
risk-based capital framework does not formally recognize may be taken
into consideration in evaluating the risks inherent in a bank's loan
portfolio--which, in turn, would affect the overall supervisory
assessment of the bank's capital adequacy.
3. Recourse obligations, direct credit substitutes, residual
interests, and asset- and mortgage-backed securities. Direct credit
substitutes, assets transferred with recourse, and securities issued in
connection with asset securitizations and structured financings are
treated as described below. The term ``asset securitizations'' or
``securitizations'' in this rule includes structured financings, as well
as asset securitization transactions.
a. Definitions--i. Credit derivative means a contract that allows
one party (the ``protection purchaser'') to transfer the credit risk of
an asset or off-balance sheet credit exposure to another party (the
``protection provider'') The value of a credit derivative is dependent,
at least in part, on the credit performance of the ``reference asset.''
ii. Credit-enhancing representations and warranties means
representations and warranties that are made or assumed in connection
with a transfer of assets (including loan servicing assets) and that
obligate the bank to protect investors from losses arising from credit
risk in the assets transferred or the loans serviced. Credit-enhancing
representations and warranties include promises to protect a party from
losses resulting from the default or nonperformance of another party or
from an insufficiency in the value of the collateral. Credit-enhancing
representations and warranties do not include:
1. Early default clauses and similar warranties that permit the
return of, or premium refund clauses covering, 1-4 family residential
first mortgage loans that qualify for a 50 percent risk weight for a
period not to exceed 120 days from the date of transfer. These
warranties may cover only those loans that were originated within 1 year
of the date of transfer;
2. Premium refund clauses that cover assets guaranteed, in whole or
in part, by the U.S. Government, a U.S. Government agency
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or a government-sponsored enterprise, provided the premium refund
clauses are for a period not to exceed 120 days from the date of
transfer; or
3. Warranties that permit the return of assets in instances of
misrepresentation, fraud or incomplete documentation.
iii. Direct credit substitute means an arrangement in which a bank
assumes, in form or in substance, credit risk associated with an on-or
off-balance sheet credit exposure that was not previously owned by the
bank (third-party asset) and the risk assumed by the bank exceeds the
pro rata share of the bank's interest in the third-party asset. If the
bank has no claim on the third-party asset, then the bank's assumption
of any credit risk with respect to the third party asset is a direct
credit substitute. Direct credit substitutes include, but are not
limited to:
1. Financial standby letters of credit that support financial claims
on a third party that exceed a bank's pro rata share of losses in the
financial claim;
2. Guarantees, surety arrangements, credit derivatives, and similar
instruments backing financial claims that exceed a bank's pro rata share
in the financial claim;
3. Purchased subordinated interests or securities that absorb more
than their pro rata share of losses from the underlying assets;
4. Credit derivative contracts under which the bank assumes more
than its pro rata share of credit risk on a third party exposure;
5. Loans or lines of credit that provide credit enhancement for the
financial obligations of an account party;
6. Purchased loan servicing assets if the servicer is responsible
for credit losses or if the servicer makes or assumes credit-enhancing
representations and warranties with respect to the loans serviced.
Mortgage servicer cash advances that meet the conditions of section
III.B.3.a.viii. of this appendix are not direct credit substitutes; and
7. Clean-up calls on third party assets are direct credit
substittues. Clean-up calls that are 10 percent or less of the original
pool balance that are exercisable at the option of the bank are not
direct credit substitutes.
iv. Externally rated means that an instrument or obligation has
received a credit rating from a nationally-recognized statistical rating
organization.
v. Face amount means the notional principal, or face value, amount
of an off-balance sheet item; the amortized cost of an asset not held
for trading purposes; and the fair value of a trading asset.
vi. Financial asset means cash or other monetary instrument,
evidence of debt, evidence of an ownership interest in an entity, or a
contract that conveys a right to receive or exchange cash or another
financial instrument from another party.
vii. Financial standby letter of credit means a letter of credit or
similar arrangement that represents an irrevocable obligation to a
third-party beneficiary:
1. To repay money borrowed by, or advanced to, or for the account
of, a second party (the account party), or
2. To make payment on behalf of the account party, in the event that
the account party fails to fulfill its obligation to the beneficiary.
viii. Mortgage servicer cash advance means funds that a residential
mortgage loan servicer advances to ensure an uninterrupted flow of
payments, including advances made to cover foreclosure costs or other
expenses to facilitate the timely collection of the loan. A mortgage
servicer cash advance is not a recourse obligation or a direct credit
substitute if:
1. The servicer is entitled to full reimbursement and this right is
not subordinated to other claims on the cash flows from the underlying
asset pool; or
2. For any one loan, the servicer's obligation to make
nonreimbursable advances is contractually limited to an insignificant
amount of the outstanding principal balance of that loan.
ix. Nationally recognized statistical rating organization (NRSRO)
means an entity recognized by the Division of Market Regulation of the
Securities and Exchange Commission (or any successor Division)
(Commission) as a nationally recognized statistical rating organization
for various purposes, including the Commission's uniform net capital
requirements for brokers and dealers.
x. Recourse means the retention, by a bank, in form or in substance,
of any credit risk directly or indirectly associated with an asset it
has transferred and sold that exceeds a pro rata share of the bank's
claim on the asset. If a bank has no claim on a transferred asset, then
the retention of any risk of credit loss is recourse. A recourse
obligation typically arises when a bank transfers assets and retains an
explicit obligation to repurchase the assets or absorb losses due to a
default on the payment of principal or interest or any other deficiency
in the performance of the underlying obligor or some other party.
Recourse may also exist implicitly if a bank provides credit enhancement
beyond any contractual obligation to support assets it has sold. The
following are examples of recourse arrangements:
1. Credit-enhancing representations and warranties made on the
transferred assets;
2. Loan servicing assets retained pursuant to an agreement under
which the bank will be responsible for credit losses associated with the
loans being serviced. Mortgage servicer cash advances that meet the
conditions of section III.B.3.a.viii. of this appendix are not recourse
arrangements;
[[Page 272]]
3. Retained subordinated interests that absorb more than their pro
rata share of losses from the underlying assets;
4. Assets sold under an agreement to repurchase, if the assets are
not already included on the balance sheet;
5. Loan strips sold without contractual recourse where the maturity
of the transferred loan is shorter than the maturity of the commitment
under which the loan is drawn;
6. Credit derivatives issued that absorb more than the bank's pro
rata share of losses from the transferred assets; and
7. Clean-up calls at inception that are greater than 10 percent of
the balance of the original pool of transferred loans. Clean-up calls
that are 10 percent or less of the original pool balance that are
exercisable at the option of the bank are not recourse arrangements.
xi. Residual interest means any on-balance sheet asset that
represents an interest (including a beneficial interest) created by a
transfer that qualifies as a sale (in accordance with generally accepted
accounting principles) of financial assets, whether through a
securitization or otherwise, and that exposes the bank to credit risk
directly or indirectly associated with the transferred assets that
exceeds a pro rata share of the bank's claim on the assets, whether
through subordination provisions or other credit enhancement techniques.
Residual interests generally include credit-enhancing I/Os, spread
accounts, cash collateral accounts, retained subordinated interests,
other forms of over-collateralization, and similar assets that function
as a credit enhancement. Residual interests further include those
exposures that, in substance, cause the bank to retain the credit risk
of an asset or exposure that had qualified as a residual interest before
it was sold. Residual interests generally do not include interests
purchased from a third party, except that purchased credit-enhancing I/
Os are residual interests for purposes of this appendix.
xii. Risk participation means a participation in which the
originating party remains liable to the beneficiary for the full amount
of an obligation (e.g., a direct credit substitute) notwithstanding that
another party has acquired a participation in that obligation.
xiii. Securitization means the pooling and repackaging by a special
purpose entity of assets or other credit exposures into securities that
can be sold to investors. Securitization includes transactions that
create stratified credit risk positions whose performance is dependent
upon an underlying pool of credit exposures, including loans and
commitments.
xiv. Structured finance program means a program where receivable
interests and asset-backed securities issued by multiple participants
are purchased by a special purpose entity that repackages those
exposures into securities that can be sold to investors. Structured
finance programs allocate credit risks, generally, between the
participants and credit enhancement provided to the program.
xv. Traded position means a position that is externally rated and is
retained, assumed, or issued in connection with an asset securitization,
where there is a reasonable expectation that, in the near future, the
rating will be relied upon by unaffiliated investors to purchase the
position; or an unaffiliated third party to enter into a transaction
involving the position, such as a purchase, loan, or repurchase
agreement.
b. Credit equivalent amounts and risk weight of recourse obligations
and direct credit substitutes. i. Credit equivalent amount. Except as
otherwise provided in sections III.B.3.c. through f. and III.B.5. of
this appendix, the credit equivalent amount for a recourse obligation or
direct credit substitute is the full amount of the credit-enhanced
assets for which the bank directly or indirectly retains or assumes
credit risk multiplied by a 100 percent conversion factor.
ii. Risk-weight factor. To determine the bank's risk-weight factor
for off-balance sheet recourse obligations and direct credit
substitutes, the credit equivalent amount is assigned to the risk
category appropriate to the obligor in the underlying transaction, after
considering any associated guarantees or collateral. For a direct credit
substitute that is an on-balance sheet asset (e.g., a purchased
subordinated security), a bank must calculate risk-weighted assets using
the amount of the direct credit substitute and the full amount of the
assets it supports, i.e., all the more senior positions in the
structure. The treatment of direct credit substitutes that have been
syndicated or in which risk participations have been conveyed or
acquired is set forth in section III.D.1 of this appendix.
c. Externally-rated positions: credit equivalent amounts and risk
weights of recourse obligations, direct credit substitutes, residual
interests, and asset- and mortgage-backed securities (including asset-
backed commercial paper). i. Traded positions. With respect to a
recourse obligation, direct credit substitute, residual interest (other
than a credit-enhancing I/O strip) or asset- and mortgage-backed
security (including asset-backed commercial paper) that is a traded
position and that has received an external rating on a long-term
position that is one grade below investment grade or better or a short-
term rating that is investment grade, the bank may multiply the face
amount of the position by the appropriate risk weight, determined in
accordance with the tables below. Stripped mortgage-backed securities
and other similar instruments, such as interest-only or principal-only
strips that are not credit enhancements, must be assigned to the 100
percent
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risk category. If a traded position has received more than one external
rating, the lowest single rating will apply.
------------------------------------------------------------------------
Risk weight
Long-term rating category Examples (In percent)
------------------------------------------------------------------------
Highest or second highest AAA, AA............. 20
investment grade.
Third highest investment grade.... A................... 50
Lowest investment grade........... BBB................. 100
One category below investment BB.................. 200
grade.
------------------------------------------------------------------------
Risk weight
Short-term rating Examples (In percent)
------------------------------------------------------------------------
Highest investment grade.......... A-1, P-1............ 20
Second highest investment grade... A-2, P-2............ 50
Lowest investment grade........... A-3, P-3............ 100
------------------------------------------------------------------------
ii. Non-traded positions. A recourse obligation, direct credit
substitute, or residual interest (but not a credit-enhancing I/O strip)
extended in connection with a securitization that is not a traded
position may be assigned a risk weight in accordance with section
III.B.3.c.i. of this appendix if:
1. It has been externally rated by more than one NRSRO;
2. It has received an external rating on a long-term position that
is one grade below investment grade or better or on a short-term
position that is investment grade by all NRSROs providing a rating;
3. The ratings are publicly available; and
4. The ratings are based on the same criteria used to rate traded
positions.
If the ratings are different, the lowest rating will determine the
risk category to which the recourse obligation, direct credit
substitute, or residual interest will be assigned.
d. Senior positions not externally rated. For a recourse obligation,
direct credit substitute, residual interest, or asset- or mortgage-
backed security that is not externally rated but is senior or preferred
in all features to a traded position (including collateralization and
maturity), a bank may apply a risk weight to the face amount of the
senior position in accordance with section III.B.3.c.i. of this
appendix, based on the traded position, subject to any current or
prospective supervisory guidance and the bank satisfying the Federal
Reserve that this treatment is appropriate. This section will apply only
if the traded subordinated position provides substantive credit support
to the unrated position until the unrated position matures.
e. Capital requirement for residual interests--i. Capital
requirement for credit-enhancing I/O strips. After applying the
concentration limit to credit-enhancing I/O strips (both purchased and
retained) in accordance with sections II.B.2.c. through e. of this
appendix, a bank must maintain risk-based capital for a credit-enhancing
I/O strip (both purchased and retained), regardless of the external
rating on that position, equal to the remaining amount of the credit-
enhancing I/O strip (net of any existing associated deferred tax
liability), even if the amount of risk-based capital required to be
maintained exceeds the full risk-based capital requirement for the
assets transferred. Transactions that, in substance, result in the
retention of credit risk associated with a transferred credit-enhancing
I/O strip will be treated as if the credit-enhancing I/O strip was
retained by the bank and not transferred.
ii. Capital requirement for other residual interests. 1. If a
residual interest does not meet the requirements of sections III.B.3.c.
or d. of this appendix, a bank must maintain risk-based capital equal to
the remaining amount of the residual interest that is retained on the
balance sheet (net of any existing associated deferred tax liability),
even if the amount of risk-based capital required to be maintained
exceeds the full risk-based capital requirement for the assets
transferred. Transactions that, in substance, result in the retention of
credit risk associated with a transferred residual interest will be
treated as if the residual interest was retained by the bank and not
transferred.
2. Where the aggregate capital requirement for residual interests
and other recourse obligation in connection with the same transfer of
assets exceed the full risk-based capital requirement for those assets,
a bank must maintain risk-based capital equal to the greater of the
risk-based capital requirement for the residual interest as calculated
under section III.B.3.e.ii.1 of this appendix or the full risk-based
capital requirement for the assets transferred.
f. Positions that are not rated by an NRSRO. A position (but not a
residual interest) maintained in connection with a securitization and
that is not rated by a NRSRO may be risk-weighted based on the bank's
determination of the credit rating of the position, as specified in the
table below, multiplied by the face amount of the position. In order to
obtain this treatment, the bank's system for
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determining the credit rating of the position must meet one of the three
alternative standards set out in sections III.B.3.f.i. through
III.B.3.f.iii. of this appendix.
------------------------------------------------------------------------
Risk weight
Rating category Examples (In percent)
------------------------------------------------------------------------
Highest or second highest AAA,AA.............. 100
investment grade.
Third highet investment grade..... A................... 100
Lowest investment grade........... BBB................. 100
One category below investment BB.................. 200
grade.
------------------------------------------------------------------------
i. Internal risk rating used for asset-backed programs. A direct
credit substitute (other than a purchased credit-enhancing I/O) is
assumed in connection with an asset-backed commercial paper program
sponsored by the bank and the bank is able to demonstrate to the
satisfaction of the Federal Reserve, prior to relying upon its use, that
the bank's internal credit risk rating system is adequate. Adequate
internal credit risk rating systems usually contain the following
criteria:
1. The internal credit risk system is an integral part of the bank's
risk management system, which explicitly incorporates the full range of
risks arising from a bank's participation in securitization activities;
2. Internal credit ratings are linked to measurable outcomes, such
as the probability that the position will experience any loss, the
position's expected loss given default, and the degree of variance in
losses given default on that position;
3. The bank's internal credit risk system must separately consider
the risk associated with the underlying loans or borrowers, and the risk
associated with the structure of a particular securitization
transaction;
4. The bank's internal credit risk system must identify gradations
of risk among ``pass'' assets and other risk positions;
5. The bank must have clear, explicit criteria that are used to
classify assets into each internal risk grade, including subjective
factors;
6. The bank must have independent credit risk management or loan
review personnel assigning or reviewing the credit risk ratings;
7. The bank must have an internal audit procedure that periodically
verifies that the internal credit risk ratings are assigned in
accordance with the established criteria;
8. The bank must monitor the performance of the internal credit risk
ratings assigned to nonrated, nontraded direct credit substitutes over
time to determine the appropriateness of the initial credit risk rating
assignment and adjust individual credit risk ratings, or the overall
internal credit risk ratings system, as needed; and
9. The internal credit risk system must make credit risk rating
assumptions that are consistent with, or more conservative than, the
credit risk rating assumptions and methodologies of NRSROs.
ii. Program Ratings. A direct credit substitute or recourse
obligation (other than a residual interest) is assumed or retained in
connection with a structured finance program and a NRSRO has reviewed
the terms of the program and stated a rating for positions associated
with the program. If the program has options for different combinations
of assets, standards, internal credit enhancements and other relevant
factors, and the NRSRO specifies ranges of rating categories to them,
the bank may apply the rating category that corresponds to the bank's
position. In order to rely on a program rating, the bank must
demonstrate to the Federal Reserve's satisfaction that the credit risk
rating assigned to the program meets the same standards generally used
by NRSROs for rating traded positions. The bank must also demonstrate to
the Federal Reserve's satisfaction that the criteria underlying the
NRSRO's assignment of ratings for the program are satisfied for the
particular position. If a bank participates in a securitization
sponsored by another party, the Federal Reserve may authorize the bank
to use this approach based on a programmatic rating obtained by the
sponsor of the program.
iii. Computer Program. The bank is using an acceptable credit
assessment computer program to determine the rating of a direct credit
substitute or recourse obligation (but not residual interest) issued in
connection with a structured finance program. A NRSRO must have
developed the computer program, and the bank must demonstrate to the
Federal Reserve's satisfaction that ratings under the program correspond
credibly and reliably with the rating of traded positions.
g. Limitations on risk-based capital requirements--i. Low-level
exposure. If the maximum contractual exposure to loss retained or
assumed by a bank in connection with a recourse obligation or a direct
credit substitute is less than the effective risk-based capital
requirement for the enhanced assets, the risk-based capital requirement
is limited to the maximum contractual exposure, less any recourse
liability account established in accordance with generally accepted
accounting principles. This limitation does not apply when a bank
provides credit enhancement
[[Page 275]]
beyond any contractual obligation to support assets it has sold.
ii. Mortgage-related securities or participation certificates
retained in a mortgage loan swap. If a bank holds a mortgage-related
security or a participation certificate as a result of a mortgage loan
swap with recourse, capital is required to support the recourse
obligation plus the percentage of the mortgage-related security or
participation certificate that is not covered by the recourse
obligation. The total amount of capital required for the on-balance
sheet asset and the recourse obligation, however, is limited to the
capital requirement for the underlying loans, calculated as if the bank
continued to hold these loans as on-balance sheet assets.
iii. Related on-balance sheet assets. If a recourse obligation or
direct credit substitute subject to section III.B.3. of this appendix
also appears as a balance sheet asset, the balance sheet asset is not
included in a bank's risk-weighted assets to the extent the value of the
balance sheet asset is already included in the off-balance sheet credit
equivalent amount for the recourse obligation or direct credit
substitute, except in the case of loan servicing assets and similar
arrangements with embedded recourse obligations or direct credit
substitutes. In that case, both the on-balance sheet assets and the
related recourse obligations and direct credit substitutes must be
separately risk-weighted and incorporated into the risk-based capital
calculation.
4. Maturity. Maturity is generally not a factor in assigning items
to risk categories with the exception of claims on non-OECD banks,
commitments, and interest rate and foreign exchange rate contracts.
Except for commitments, short-term is defined as one year or less
remaining maturity and long-term is defined as over one year remaining
maturity. In the case of commitments, short-term is defined as one year
or less original maturity and long-term is defined as over one year
original maturity.
5. Small Business Loans and Leases on Personal Property Transferred
with Recourse. a. Notwithstanding other provisions of this appendix A, a
qualifying bank that has transferred small business loans and leases on
personal property (small business obligations) with recourse shall
include in weighted-risk assets only the amount of retained recourse,
provided two conditions are met. First, the transaction must be treated
as a sale under GAAP and, second, the bank must establish pursuant to
GAAP a non-capital reserve sufficient to meet the bank's reasonably
estimated liability under the recourse arrangement. Only loans and
leases to businesses that meet the criteria for a small business concern
established by the Small Business Administration under section 3(a) of
the Small Business Act are eligible for this capital treatment.
b. For purposes of this appendix A, a bank is qualifying if it meets
the criteria set forth in the Board's prompt corrective action
regulation (12 CFR 208.40) for well capitalized or, by order of the
Board, adequately capitalized. For purposes of determining whether a
bank meets the criteria, its capital ratios must be calculated without
regard to the preferential capital treatment for transfers of small
business obligations with recourse specified in section III.B.5.a. of
this appendix A. The total outstanding amount of recourse retained by a
qualifying bank on transfers of small business obligations receiving the
preferential capital treatment cannot exceed 15 percent of the bank's
total risk-based capital. By order, the Board may approve a higher
limit.
c. If a bank ceases to be qualifying or exceeds the 15 percent
capital limitation, the preferential capital treatment will continue to
apply to any transfers of small business obligations with recourse that
were consummated during the time that the bank was qualifying and did
not exceed the capital limit.
d. The risk-based capital ratios of the bank shall be calculated
without regard to the preferential capital treatment for transfers of
small business obligations with recourse specified in section III.B.5.a.
of this appendix A for purposes of:
(i) Determining whether a bank is adequately capitalized,
undercapitalized, significantly undercapitalized, or critically
undercapitalized under prompt corrective action (12 CFR 208.43(b)(1));
and
(ii) Reclassifying a well capitalized bank to adequately capitalized
and requiring an adequately capitalized bank to comply with certain
mandatory or discretionary supervisory actions as if the bank were in
the next lower prompt corrective action capital category (12 CFR
208.43(c)).
C. Risk Weights
Attachment III contains a listing of the risk categories, a summary
of the types of assets assigned to each category and the weight
associated with each category, that is, 0 percent, 20 percent, 50
percent, and 100 percent. A brief explanation of the components of each
category follows.
1. Category 1: zero percent. This category includes cash (domestic
and foreign) owned and held in all offices of the bank or in transit and
gold bullion held in the bank's own vaults or in another bank's vaults
on an allocated basis, to the extent it is offset by gold bullion
liabilities.\29\ The category also includes all direct claims (including
securities, loans, and leases) on, and the portions of claims that are
directly and unconditionally
[[Page 276]]
guaranteed by, the central governments \30\ of the OECD countries and
U.S. Government agencies,\31\ as well as all direct local currency
claims on, and the portions of local currency claims that are directly
and unconditionally guaranteed by, the central governments of non-OECD
countries, to the extent that the bank has liabilities booked in that
currency. A claim is not considered to be unconditionally guaranteed by
a central government if the validity of the guarantee is dependent upon
some affirmative action by the holder or a third party. Generally,
securities guaranteed by the U.S. Government or its agencies that are
actively traded in financial markets, such as GNMA securities, are
considered to be unconditionally guaranteed.
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\29\ All other holdings of bullion are assigned to the 100 percent
risk category.
\30\ A central government is defined to include departments and
ministries, including the central bank, of the central government. The
U.S. central bank includes the 12 Federal Reserve Banks, and the stock
held in these banks as a condition of membership is assigned to the zero
percent risk category. The definition of central government does not
include state, provincial, or local governments; or commercial
enterprises owned by the central government. In addition, it does not
include local government entities or commercial enterprises whose
obligations are guaranteed by the central government, although any
claims on such entities guaranteed by central governments are placed in
the same general risk category as other claims guaranteed by central
governments. OECD central governments are defined as central governments
of the OECD-based group of countries; non-OECD central governments are
defined as central governments that do not belong to the OECD-based
group countries.
\31\ A U.S. Government agency is defined as an instrumentality of
the U.S. Government whose obligations are fully and explicitly
guaranteed as to the timely payment of principal and interest by the
full faith and credit of the U.S. Government. Such agencies include the
Government National Mortgage Association (GNMA), the Veterans
Administration (VA), the Federal Housing Administration (FHA), the
Export-Import Bank (Exim Bank), the Overseas Private Investment
Corporation (OPIC), the Commodity Credit Corporation (CCC), and the
Small Business Administration (SBA).
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This category also includes claims collateralized by cash on deposit
in the bank or by securities issued or guaranteed by OECD central
governments or U.S. government agencies for which a positive margin of
collateral is maintained on a daily basis, fully taking into account any
change in the bank's exposure to the obligor or counterparty under a
claim in relation to the market value of the collateral held in support
of that claim.
2. Category 2: 20 percent. a. This category includes cash items in
the process of collection, both foreign and domestic; short-term claims
(including demand deposits) on, and the portions of short-term claims
that are guaranteed \32\ by, U.S. depository institutions \33\ and
foreign banks; \34\ and long-term claims on, and the portions of long-
term claims that are guaranteed by, U.S. depository institutions and
OECD banks.\35\
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\32\ Claims guaranteed by U.S. depository institutions and foreign
banks include risk participations in both bankers acceptances and
standby letters of credit, as well as participations in commitments,
that are conveyed to other U.S. depository institutions or foreign
banks.
\33\ U.S. depository institutions are defined to include branches
(foreign and domestic) of federally-insured banks and depository
institutions chartered and headquartered in the 50 states of the United
States, the District of Columbia, Puerto Rico, and U.S. territories and
possessions. The definition encompasses banks, mutual or stock savings
banks, savings or building and loan associations, cooperative banks,
credit unions, and international banking facilities of domestic banks.
U.S.-chartered depository institutions owned by foreigners are also
included in the definition. However, branches and agencies of foreign
banks located in the U.S., as well as all bank holding companies, are
excluded.
\34\ Foreign banks are distinguished as either OECD banks or non-
OECD banks. OECD banks include banks and their branches (foreign and
domestic) organized under the laws of countries (other than the U.S.)
that belong to the OECD-based group of countries. Non-OECD banks include
banks and their branches (foreign and domestic) organized under the laws
of countries that do not belong to the OECD-based group of countries.
For this purpose, a bank is defined as an institution that engages in
the business of banking; is recognized as a bank by the bank supervisory
or monetary authorities of the country of its organization or principal
banking operations; receives deposits to a substantial extent in the
regular course of business; and has the power to accept demand deposits.
\35\ Long-term claims on, or guaranteed by, non-OECD banks and all
claims on bank holding companies are assigned to the 100 percent risk
category, as are holdings of bank-issued securities that qualify as
capital of the issuing banks.
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b. This category also includes the portions of claims that are
conditionally guaranteed by OECD central governments and U.S. Government
agencies, as well as the portions of
[[Page 277]]
local currency claims that are conditionally guaranteed by non-OECD
central governments, to the extent that the bank has liabilities booked
in that currency. In addition, this category also includes claims on,
and the portions of claims that are guaranteed by, U.S. government-
sponsored \36\ agencies and claims on, and the portions of claims
guaranteed by, the International Bank for Reconstruction and Development
(World Bank), the International Finance Corporation, the Interamerican
Development Bank, the Asian Development Bank, the African Development
Bank, the European Investment Bank, the European Bank for Reconstruction
and Development, the Nordic Investment Bank, and other multilateral
lending institutions or regional development banks in which the U.S.
government is a shareholder or contributing member. General obligation
claims on, or portions of claims guaranteed by the full faith and credit
of, states or other political subdivisions of the U.S. or other
countries of the OECD-based group are also assigned to this
category.\37\
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\36\ For this purpose, U.S. government-sponsored agencies are
defined as agencies originally established or chartered by the Federal
government to serve public purposes specified by the U.S. Congress but
whose obligations are not explicitly guaranteed by the full faith and
credit of the U.S. government. These agencies include the Federal Home
Loan Mortgage Corporation (FHLMC), the Federal National Mortgage
Association (FNMA), the Farm Credit System, the Federal Home Loan Bank
System, and the Student Loan Marketing Association (SLMA). Claims on
U.S. government-sponsored agencies include capital stock in a Federal
Home Loan Bank that is held as a condition of membership in that Bank.
\37\ Claims on, or guaranteed by, states or other political
subdivisions of countries that do not belong to the OECD-based group of
countries are placed in the 100 percent risk category.
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c. This category also includes the portions of claims (including
repurchase transactions) collateralized by cash on deposit in the bank
or by securities issued or guaranteed by OECD central governments or
U.S. government agencies that do not qualify for the zero percent risk-
weight category; collateralized by securities issued or guaranteed by
U.S. government-sponsored agencies; or collateralized by securities
issued by multilateral lending institutions or regional development
banks in which the U.S. government is a shareholder or contributing
member.
d. This category also includes claims \38\ on, or guaranteed by, a
qualifying securities firm incorporated in the United States or other
member of the OECD-based group of countries \39\ provided that: The
qualifying securities firm has a long-term issuer credit rating, or a
rating on at least one issue of long-term debt, in one of the three
highest investment grade rating categories from a nationally recognized
statistical rating organization; or the claim is guaranteed by the
firm's parent company and the parent company has such a rating. If
ratings are available from more than one rating agency, the lowest
rating will be used to determine whether the rating requirement has been
met. This category also includes a collateralized claim on a qualifying
securities firm in such a country, without regard to satisfaction of the
rating standard, provided that the claim arises under a contract that:
(1) Is a reverse repurchase/repurchase agreement or securities
lending/borrowing transaction executed using standard industry
documentation;
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\38\ Claims on a qualifying securities firm that are instruments the
firm, or its parent company, uses to satisfy its applicable capital
requirements are not eligible for this risk weight.
\39\ With regard to securities firms incorporated in the United
States, qualifying securities firms are those securities firms that are
broker-dealers registered with the Securities and Exchange Commission
(SEC) and are in compliance with the SEC's net capital rule, 17 CFR
240.15c3-1. With regard to securities firms incorporated in any other
country in the OECD-based group of countries, qualifying securities
firms are those securities firms that a bank is able to demonstrate are
subject to consolidated supervision and regulation (covering their
direct and indirect subsidiaries, but not necessarily their parent
organizations) comparable to that imposed on banks in OECD countries.
Such regulation must include risk-based capital requirements comparable
to those applied to banks under the Accord on International Convergence
of Capital Measurement and Capital Standards (1988, as amended in 1998)
(Basel Accord).
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(2) Is collateralized by debt or equity securities that are liquid
and readily marketable;
(3) Is marked-to-market daily;
(4) Is subject to a daily margin maintenance requirement under the
standard industry documentation; and
(5) Can be liquidated, terminated, or accelerated immediately in
bankruptcy or similar proceeding, and the security or collateral
agreement will not be stayed or avoided,
[[Page 278]]
under applicable law of the relevant jurisdiction.\40\
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\40\ For example, a claim is exempt from the automatic stay in
bankruptcy in the United States if it arises under a securities contract
or a repurchase agreement subject to section 555 or 559 of the
Bankruptcy Code, respectively (11 U.S.C. 555 or 559), a qualified
financial contract under section 11(e)(8) of the Federal Deposit
Insurance Act (12 U.S.C. 1821(e)(8)), or a netting contract between
financial institutions under sections 401-407 of the Federal Deposit
Insurance Corporation Improvement Act of 1991 (12 U.S.C. 4401-4407), or
the Board's Regulation EE (12 CFR Part 231).
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3. Category 3: 50 percent. This category includes loans fully
secured by first liens \41\ on 1- to 4-family residential properties,
either owner-occupied or rented, or on multifamily residential
properties,\42\ that meet certain criteria.\43\ Loans included in this
category must have been made in accordance with prudent underwriting
standards;\44\ be performing in accordance with their original terms;
and not be 90 days or more past due or carried in nonaccrual status. The
following additional criteria must also be applied to a loan secured by
a multifamily residential property that is included in this category:
all principal and interest payments on the loan must have been made on
time for at least the year preceding placement in this category, or in
the case where the existing property owner is refinancing a loan on that
property, all principal and interest payments on the loan being
refinanced must have been made on time for at least the year preceding
placement in this category; amortization of the principal and interest
must occur over a period of not more than 30 years and the minimum
original maturity for repayment of principal must not be less than 7
years; and the annual net operating income (before debt service)
generated by the property during its most recent fiscal year must not be
[[Page 279]]
less than 120 percent of the loan's current annual debt service (115
percent if the loan is based on a floating interest rate) or, in the
case of a cooperative or other not-for-profit housing project, the
property must generate sufficient cash flow to provide comparable
protection to the institution. Also included in this category are
privately-issued mortgage-backed securities provided that
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\41\ If a bank holds the first and junior lien(s) on a residential
property and no other party holds an intervening lien, the transaction
is treated as a single loan secured by a first lien for the purposes of
determining the loan-to-value ratio and assigning a risk weight.
\42\ Loans that qualify as loans secured by 1- to 4-family
residential properties or multifamily residential properties are listed
in the instructions to the commercial bank Call Report. In addition, for
risk-based capital purposes, loans secured by 1- to 4-family residential
properties include loans to builders with substantial project equity for
the construction of 1- to 4-family residences that have been presold
under firm contracts to purchasers who have obtained firm commitments
for permanent qualifying mortgage loans and have made substantial
earnest money deposits. Such loans to builders will be considered
prudently underwritten only if the bank has obtained sufficient
documentation that the buyer of the home intends to purchase the home
(i.e., has a legally binding written sales contract) and has the ability
to obtain a mortgage loan sufficient to purchase the home (i.e., has a
firm written commitment for permanent financing of the home upon
completion).
The instructions to the Call Report also discuss the treatment of
loans, including multifamily housing loans, that are sold subject to a
pro rata loss sharing arrangement. Such an arrangement should be treated
by the selling bank as sold (and excluded from balance sheet assets) to
the extent that the sales agreement provides for the purchaser of the
loan to share in any loss incurred on the loan on a pro rata basis with
the selling bank. In such a transaction, from the standpoint of the
selling bank, the portion of the loan that is treated as sold is not
subject to the risk-based capital standards. In connection with sales of
multifamily housing loans in which the purchaser of a loan shares in any
loss incurred on the loan with the selling institution on other than a
pro rata basis, these other loss sharing arrangements are taken into
account for purposes of determining the extent to which such loans are
treated by the selling bank as sold (and excluded from balance sheet
assets) under the risk-based capital framework in the same manner as
prescribed for reporting purposes in the instructions to the Call
Report.
\43\ Residential property loans that do not meet all the specified
criteria or that are made for the purpose of speculative property
development are placed in the 100 percent risk category.
\44\ Prudent underwriting standards include a conservative ratio of
the current loan balance to the value of the property. In the case of a
loan secured by multifamily residential property, the loan-to-value
ratio is not conservative if it exceeds 80 percent (75 percent if the
loan is based on a floating interest rate). Prudent underwriting
standards also dictate that a loan-to-value ratio used in the case of
originating a loan to acquire a property would not be deemed
conservative unless the value is based on the lower of the acquisition
cost of the property or appraised (or if appropriate, evaluated) value.
Otherwise, the loan-to-value ratio generally would be based upon the
value of the property as determined by the most current appraisal, or if
appropriate, the most current evaluation. All appraisals must be made in
a manner consistent with the Federal banking agencies' real estate
appraisal regulations and guidelines and with the bank's own appraisal
guidelines.
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(1) The structure of the security meets the criteria described in
section III(B)(3) above;
(2) If the security is backed by a pool of conventional mortgages,
on 1- to 4-family residential or multifamily residential properties each
underlying mortgage meets the criteria described above in this section
for eligibility for the 50 percent risk category at the time the pool is
originated;
(3) If the security is backed by privately-issued mortgage-backed
securities, each underlying security qualifies for the 50 percent risk
category; and
(4) If the security is backed by a pool of multifamily residential
mortgages, principal and interest payments on the security are not 30
days or more past due.
Privately-issued mortgage-backed securities that do not meet these
criteria or that do not qualify for a lower risk weight are generally
assigned to the 100 percent risk category.
Also assigned to this category are revenue (non-general obligation)
bonds or similar obligations, including loans and leases, that are
obligations of states or other political subdivisions of the U.S. (for
example, municipal revenue bonds) or other countries of the OECD-based
group, but for which the government entity is committed to repay the
debt with revenues from the specific projects financed, rather than from
general tax funds.
Credit equivalent amounts of derivative contracts involving standard
risk obligors (that is, obligors whose loans or debt securities would be
assigned to the 100 percent risk category) are included in the 50
percent category, unless they are backed by collateral or guarantees
that allow them to be placed in a lower risk category.
4. Category 4: 100 percent. a. All assets not included in the
categories above are assigned to this category, which comprises standard
risk assets. The bulk of the assets typically found in a loan portfolio
would be assigned to the 100 percent category.
b. This category includes long-term claims on, and the portions of
long-term claims that are guaranteed by, non-OECD banks, and all claims
on non-OECD central governments that entail some degree of transfer
risk.\45\ This category includes all claims on foreign and domestic
private-sector obligors not included in the categories above (including
loans to nondepository financial institutions and bank holding
companies); claims on commercial firms owned by the public sector;
customer liabilities to the bank on acceptances outstanding involving
standard risk claims;\46\ investments in fixed assets, premises, and
other real estate owned; common and preferred stock of corporations,
including stock acquired for debts previously contracted; all stripped
mortgage-backed securities and similar instruments; and commercial and
consumer loans (except those assigned to lower risk categories due to
recognized guarantees or collateral and loans secured by residential
property that qualify for a lower risk weight). This category also
includes claims representing capital of a qualifying securities firm.
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\45\ Such assets include all nonlocal currency claims on, and the
portions of claims that are guaranteed by, non-OECD central governments
and those portions of local currency claims on, or guaranteed by, non-
OECD central governments that exceed the local currency liabilities held
by the bank.
\46\ Customer liabilities on acceptances outstanding involving
nonstandard risk claims, such as claims on U.S. depository institutions,
are assigned to the risk category appropriate to the identity of the
obligor or, if relevant, the nature of the collateral or guarantees
backing the claims. Portions of acceptances conveyed as risk
participations to U.S. depository institutions or foreign banks are
assigned to the 20 percent risk category appropriate to short-term
claims guaranteed by U.S. depository institutions and foreign banks.
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c. Also included in this category are industrial-development bonds
and similar obligations issued under the auspices of states or political
subdivisions of the OECD-based group of countries for the benefit of a
private party or enterprise where that party or enterprise, not the
government entity, is obligated to pay the principal and interest, and
all obligations of states or political subdivisions of countries that do
not belong to the OECD-based group.
d. The following assets also are assigned a risk weight of 100
percent if they have not been deducted from capital: investments in
unconsolidated companies, joint ventures, or associated companies;
instruments that qualify as capital issued by other banking
organizations; and any intangibles, including those that may have been
grandfathered into capital.
D. Off-Balance Sheet Items
The face amount of an off-balance sheet item is generally
incorporated into risk-weighted assets in two steps. The face amount is
first multiplied by a credit conversion factor, except for direct credit
substitutes and recourse obligations as discussed in section III.D.1. of
this appendix. The resultant credit equivalent amount is
[[Page 280]]
assigned to the appropriate risk category according to the obligor or,
if relevant, the guarantor or the nature of the collateral.\47\
Attachment IV to this appendix sets forth the conversion factors for
various types of off-balance sheet items.
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\47\ The sufficiency of collateral and guarantees for off-balance-
sheet items is determined by the market value of the collateral or the
amount of the guarantee in relation to the face amount of the item,
except for derivative contracts, for which this determination is
generally made in relation to the credit equivalent amount. Collateral
and guarantees are subject to the same provisions noted under section
III.B. of this appendix A.
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1. Items with a 100-percent conversion factor. a. Except as
otherwise provided in section III.B.3. of this appendix, the full amount
of an asset or transaction supported, in whole or in part, by a direct
credit substitute or a recourse obligation. Direct credit substitutes
and recourse obligations are defined in section III.B.3. of this
appendix.
b. Sale and repurchase agreements and forward agreements. Forward
agreements are legally binding contractual obligations to purchase
assets with certain drawdown at a specified future date. Such
obligations include forward purchases, forward forward deposits
placed,\48\ and partly-paid shares and securities; they do not include
commitments to make residential mortgage loans or forward foreign
exchange contracts.
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\48\ Forward forward deposits accepted are treated as interest rate
contracts.
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c. Securities lent by a bank are treated in one of two ways,
depending upon whether the lender is at risk of loss. If a bank, as
agent for a customer, lends the customer's securities and does not
indemnify the customer against loss, then the transaction is excluded
from the risk-based capital calculation. If, alternatively, a bank lends
its own securities or, acting as agent for a customer, lends the
customer's securities and indemnifies the customer against loss, the
transaction is converted at 100 percent and assigned to the risk weight
category appropriate to the obligor, or, if applicable, to any
collateral delivered to the lending bank, or the independent custodian
acting on the lending bank's behalf. Where a bank is acting as agent for
a customer in a transaction involving the lending or sale of securities
that is collateralized by cash delivered to the bank, the transaction is
deemed to be collateralized by cash on deposit in the bank for purposes
of determining the appropriate risk-weight category, provided that any
indemnification is limited to no more than the difference between the
market value of the securities and the cash collateral received and any
reinvestment risk associated with that cash collateral is borne by the
customer.
d. In the case of direct credit substitutes in which a risk
participation \49\ has been conveyed, the full amount of the assets that
are supported, in whole or in part, by the credit enhancement are
converted to a credit equivalent amount at 100 percent. However, the pro
rata share of the credit equivalent amount that has been conveyed
through a risk participation is assigned to whichever risk category is
lower: the risk category appropriate to the obligor, after considering
any relevant guarantees or collateral, or the risk category appropriate
to the institution acquiring the participation.\50\ Any remainder is
assigned to the risk category appropriate to the obligor, guarantor, or
collateral. For example, the pro rata share of the full amount of the
assets supported, in whole or in part, by a direct credit substitute
conveyed as a risk participation to a U.S. domestic depository
institution or foreign bank is assigned to the 20 percent risk
category.\51\
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\49\ That is, a participation in which the originating bank remains
liable to the beneficiary for the full amount of the direct credit
substitute if the party that has acquired the participation fails to pay
when the instrument is drawn.
\50\ A risk participation in bankers acceptances conveyed to other
institutions is also assigned to the risk category appropriate to the
institution acquiring the participation or, if relevant, the guarantor
or nature of the collateral.
\51\ Risk participations with a remaining maturity of over one year
that are conveyed to non-OECD banks are to be assigned to the 100
percent risk category, unless a lower risk category is appropriate to
the obligor, guarantor, or collateral.
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e. In the case of direct credit substitutes in which a risk
participation has been acquired, the acquiring bank's percentage share
of the direct credit substitute is multiplied by the full amount of the
assets that are supported, in whole or in part, by the credit
enhancement and converted to a credit equivalent amount at 100 percent.
The credit equivalent amount of an acquisition of a risk participation
in a direct credit substitute is assigned to the risk category
appropriate to the account party obligor or, if relevant, the nature of
the collateral or guarantees.
f. In the case of direct credit substitutes that take the form of a
syndication where each bank is obligated only for its pro rata share of
the risk and there is no recourse to the originating bank, each bank
will only include its pro rata share of the assets supported, in whole
or in part, by the direct
[[Page 281]]
credit substitute in its risk-based capital calculation.\52\
* * * * *
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\52\ For example, if a bank has a 10 percent share of a $10
syndicated direct credit substitute that provides credit support to a
$100 loan, then the bank's $1 pro rata share in the enhancement means
that a $10 pro rata share of the loan is included in risk weighted
assets.
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2. Items with a 50 percent conversion factor. Transaction-related
contingencies are converted at 50 percent. Such contingencies include
bid bonds, performance bonds, warranties, standby letters of credit
related to particular transactions, and performance standby letters of
credit, as well as acquisitions of risk participations in performance
standby letters of credit. Performance standby letters of credit
represent obligations backing the performance of nonfinancial or
commercial contracts or undertakings. To the extent permitted by law or
regulation, performance standby letters of credit include arrangements
backing, among other things, subcontractors' and suppliers' performance,
labor and materials contracts, and construction bids.
The unused portion of commitments with an original maturity
exceeding one year, including underwriting commitments, and commercial
and consumer credit commitments also are converted at 50 percent.
Original maturity is defined as the length of time between the date the
commitment is issued and the earliest date on which: (1) The bank can,
at its option, unconditionally (without cause) cancel the
commitment,\53\ and (2) the bank is scheduled to (and as a normal
practice actually does) review the facility to determine whether or not
it should be extended. Such reviews must continue to be conducted at
least annually for such a facility to qualify as a short-term
commitment.
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\53\ In the case of consumer home equity or mortgage lines of credit
secured by liens on 1-4 family residential properties, the bank is
deemed able to unconditionally cancel the commitment for the purpose of
this criterion if, at its option, it can prohibit additional extensions
of credit, reduce the credit line, and terminate the commitment to the
full extent permitted by relevant Federal law.
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Commitments are defined as any legally binding arrangements that
obligate a bank to extend credit in the form of loans or leases; to
purchase loans, securities, or other assets; or to participate in loans
and leases. They also include overdraft facilities, revolving credit,
home equity and mortgage lines of credit, and similar transactions.
Normally, commitments involve a written contract or agreement and a
commitment fee, or some other form of consideration. Commitments are
included in weighted risk assets regardless of whether they contain
``material adverse change'' clauses or other provisions that are
intended to relieve the issuer of its funding obligation under certain
conditions. In the case of commitments structured as syndications, where
the bank is obligated solely for its pro rata share, only the bank's
proportional share of the syndicated commitment is taken into account in
calculating the risk-based capital ratio.
Facilities that are unconditionally cancellable (without cause) at
any time by the bank are not deemed to be commitments, provided the bank
makes a separate credit decision before each drawing under the facility.
Commitments with an original maturity of one year or less are deemed to
involve low risk and, therefore, are not assessed a capital charge. Such
short-term commitments are defined to include the unused portion of
lines of credit on retail credit cards and related plans (as defined in
the instructions to the commercial bank Call Report) if the bank has the
unconditional right to cancel the line of credit at any time, in
accordance with applicable law.
Once a commitment has been converted at 50 percent, any portion that
has been conveyed to other U.S. depository institutions or OECD banks as
participations in which the originating bank retains the full obligation
to the borrower if the participating bank fails to pay when the
instrument is drawn, is assigned to the 20 percent risk category. This
treatment is analogous to that accorded to conveyances of risk
participations in standby letters of credit. The acquisition of a
participation in a commitment by a bank is converted at 50 percent and
assigned to the risk category appropriate to the account party obligor
or, if relevant, the nature of the collateral or guarantees.
Revolving underwriting facilities (RUFs), note issuance facilities
(NIFs), and other similar arrangements also are converted at 50 percent
regardless of maturity. These are facilities under which a borrower can
issue on a revolving basis short-term paper in its own name, but for
which the underwriting banks have a legally binding commitment either to
purchase any notes the borrower is unable to sell by the roll-over date
or to advance funds to the borrower.
3. Items with a 20 percent conversion factor. Short-term, self-
liquidating trade-related contingencies which arise from the movement of
goods are converted at 20 percent. Such contingencies generally include
commercial letters of credit and other documentary letters of credit
collateralized by the underlying shipments.
4. Items with a zero percent conversion factor. These include unused
portions of commitments with an original maturity of one year
[[Page 282]]
or less,\54\ or which are unconditionally cancellable at any time,
provided a separate credit decision is made before each drawing under
the facility. Unused portions of lines of credit on retail credit cards
and related plans are deemed to be short-term commitments if the bank
has the unconditional right to cancel the line of credit at any time, in
accordance with applicable law.
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\54\ Through year-end 1992, remaining maturity may be used for
determining term to maturity for off-balance sheet loan commitments;
thereafter, original maturity must be used.
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E. Derivative Contracts (Interest Rate, Exchange Rate, Commodity--
(including precious metals) and Equity-Linked Contracts)
1. Scope. Credit equivalent amounts are computed for each of the
following off-balance-sheet derivative contracts:
a. Interest Rate Contracts. These include single currency interest
rate swaps, basis swaps, forward rate agreements, interest rate options
purchased (including caps, collars, and floors purchased), and any other
instrument linked to interest rates that gives rise to similar credit
risks (including when-issued securities and forward forward deposits
accepted).
b. Exchange Rate Contracts. These include cross-currency interest
rate swaps, forward foreign exchange contracts, currency options
purchased, and any other instrument linked to exchange rates that gives
rise to similar credit risks.
c. Equity Derivative Contracts. These include equity-linked swaps,
equity-linked options purchased, forward equity-linked contracts, and
any other instrument linked to equities that gives rise to similar
credit risks.
d. Commodity (including precious metal) Derivative Contracts. These
include commodity-linked swaps, commodity-linked options purchased,
forward commodity-linked contracts, and any other instrument linked to
commodities that gives rise to similar credit risks.
e. Exceptions. Exchange rate contracts with an original maturity of
fourteen or fewer calendar days and derivative contracts traded on
exchanges that require daily receipt and payment of cash variation
margin may be excluded from the risk-based ratio calculation. Gold
contracts are accorded the same treatment as exchange rate contracts
except that gold contracts with an original maturity of fourteen or
fewer calendar days are included in the risk-based ratio calculation.
Over-the-counter options purchased are included and treated in the same
way as other derivative contracts.
2. Calculation of credit equivalent amounts. a. The credit
equivalent amount of a derivative contract that is not subject to a
qualifying bilateral netting contract in accordance with section
III.E.3. of this appendix A is equal to the sum of (i) the current
exposure (sometimes referred to as the replacement cost) of the
contract; and (ii) an estimate of the potential future credit exposure
of the contract.
b. The current exposure is determined by the mark-to-market value of
the contract. If the mark-to-market value is positive, then the current
exposure is equal to that mark-to-market value. If the mark-to-market
value is zero or negative, then the current exposure is zero. Mark-to-
market values are measured in dollars, regardless of the currency or
currencies specified in the contract, and should reflect changes in
underlying rates, prices, and indices, as well as counterparty credit
quality.
c. The potential future credit exposure of a contract, including a
contract with a negative mark-to-market value, is estimated by
multiplying the notional principal amount of the contract by a credit
conversion factor. Banks should use, subject to examiner review, the
effective rather than the apparent or stated notional amount in this
calculation. The credit conversion factors are:
Conversion Factors
[In percent]
----------------------------------------------------------------------------------------------------------------
Commodity,
Interest Exchange excluding Precious
Remaining maturity rate rate and Equity precious metals,
gold metals except gold
----------------------------------------------------------------------------------------------------------------
One year or less............................... 0.0 1.0 6.0 10.0 7.0
Over one to five years......................... 0.5 5.0 8.0 12.0 7.0
Over five years................................ 1.5 7.5 10.0 15.0 8.0
----------------------------------------------------------------------------------------------------------------
d. For a contract that is structured such that on specified dates
any outstanding exposure is settled and the terms are reset so that the
market value of the contract is zero, the remaining maturity is equal to
the time until the next reset date. For an interest rate contract with a
remaining maturity
[[Page 283]]
of more than one year that meets these criteria, the minimum conversion
factor is 0.5 percent.
e. For a contract with multiple exchanges of principal, the
conversion factor is multiplied by the number of remaining payments in
the contract. A derivative contract not included in the definitions of
interest rate, exchange rate, equity, or commodity contracts as set
forth in section III.E.1. of this appendix A, is subject to the same
conversion factors as a commodity, excluding precious metals.
f. No potential future exposure is calculated for a single currency
interest rate swap in which payments are made based upon two floating
rate indices (a so called floating/floating or basis swap); the credit
exposure on such a contract is evaluated solely on the basis of the
mark-to-market value.
g. The Board notes that the conversion factors set forth above,
which are based on observed volatilities of the particular types of
instruments, are subject to review and modification in light of changing
volatilities or market conditions.
3. Netting. a. For purposes of this appendix A, netting refers to
the offsetting of positive and negative mark-to-market values when
determining a current exposure to be used in the calculation of a credit
equivalent amount. Any legally enforceable form of bilateral netting
(that is, netting with a single counterparty) of derivative contracts is
recognized for purposes of calculating the credit equivalent amount
provided that:
i. The netting is accomplished under a written netting contract that
creates a single legal obligation, covering all included individual
contracts, with the effect that the bank would have a claim to receive,
or obligation to pay, only the net amount of the sum of the positive and
negative mark-to-market values on included individual contracts in the
event that a counterparty, or a counterparty to whom the contract has
been validly assigned, fails to perform due to any of the following
events: default, insolvency, liquidation, or similar circumstances.
ii. The bank obtains a written and reasoned legal opinion(s)
representing that in the event of a legal challenge--including one
resulting from default, insolvency, liquidation, or similar
circumstances--the relevant court and administrative authorities would
find the bank's exposure to be the net amount under:
1. The law of the jurisdiction in which the counterparty is
chartered or the equivalent location in the case of noncorporate
entities, and if a branch of the counterparty is involved, then also
under the law of the jurisdiction in which the branch is located;
2. The law that governs the individual contracts covered by the
netting contract; and
3. The law that governs the netting contract.
iii. The bank establishes and maintains procedures to ensure that
the legal characteristics of netting contracts are kept under review in
the light of possible changes in relevant law.
iv. The bank maintains in its files documentation adequate to
support the netting of derivative contracts, including a copy of the
bilateral netting contract and necessary legal opinions.
b. A contract containing a walkaway clause is not eligible for
netting for purposes of calculating the credit equivalent amount.\55\
---------------------------------------------------------------------------
\55\ A walkaway clause is a provision in a netting contract that
permits a non-defaulting counterparty to make lower payments than it
would make otherwise under the contract, or no payment at all, to a
defaulter or to the estate of a defaulter, even if the defaulter or the
estate of the defaulter is a net creditor under the contract.
---------------------------------------------------------------------------
c. A bank netting individual contracts for the purpose of
calculating credit equivalent amounts of derivative contracts,
represents that it has met the requirements of this appendix A and all
the appropriate documents are in the bank's files and available for
inspection by the Federal Reserve. The Federal Reserve may determine
that a bank's files are inadequate or that a netting contract, or any of
its underlying individual contracts, may not be legally enforceable
under any one of the bodies of law described in section III.E.3.a.ii. of
this appendix A. If such a determination is made, the netting contract
may be disqualified from recognition for risk-based capital purposes or
underlying individual contracts may be treated as though they are not
subject to the netting contract.
d. The credit equivalent amount of contracts that are subject to a
qualifying bilateral netting contract is calculated by adding (i) the
current exposure of the netting contract (net current exposure) and (ii)
the sum of the estimates of potential future credit exposures on all
individual contracts subject to the netting contract (gross potential
future exposure) adjusted to reflect the effects of the netting
contract.\56\
---------------------------------------------------------------------------
\56\ For purposes of calculating potential future credit exposure to
a netting counterparty for foreign exchange contracts and other similar
contracts in which notional principal is equivalent to cash flows, total
notional principal is defined as the net receipts falling due on each
value date in each currency.
---------------------------------------------------------------------------
e. The net current exposure is the sum of all positive and negative
mark-to-market values of the individual contracts included in the
netting contract. If the net sum of the mark-to-market values is
positive, then the
[[Page 284]]
net current exposure is equal to that sum. If the net sum of the mark-
to-market values is zero or negative, then the net current exposure is
zero. The Federal Reserve may determine that a netting contract
qualifies for risk-based capital netting treatment even though certain
individual contracts included under the netting contract may not
qualify. In such instances, the nonqualifying contracts should be
treated as individual contracts that are not subject to the netting
contract.
f. Gross potential future exposure, or Agross is
calculated by summing the estimates of potential future exposure
(determined in accordance with section III.E.2 of this appendix A) for
each individual contract subject to the qualifying bilateral netting
contract.
g. The effects of the bilateral netting contract on the gross
potential future exposure are recognized through the application of a
formula that results in an adjusted add-on amount (Anet). The
formula, which employs the ratio of net current exposure to gross
current exposure (NGR) is expressed as:
Anet = (0.4xAgross) +
0.6(NGRxAgross)
h. The NGR may be calculated in accordance with either the
counterparty-by-counterparty approach or the aggregate approach.
i. Under the counterparty-by-counterparty approach, the NGR is the
ratio of the net current exposure for a netting contract to the gross
current exposure of the netting contract. The gross current exposure is
the sum of the current exposures of all individual contracts subject to
the netting contract calculated in accordance with section III.E.2. of
this appendix A. Net negative mark-to-market values for individual
netting contracts with the same counterparty may not be used to offset
net positive mark-to-market values for other netting contracts with that
counterparty.
ii. Under the aggregate approach, the NGR is the ratio of the sum of
all of the net current exposures for qualifying bilateral netting
contracts to the sum of all of the gross current exposures for those
netting contracts (each gross current exposure is calculated in the same
manner as in section III.E.3.h.i. of this appendix A). Net negative
mark-to-market values for individual counterparties may not be used to
offset net positive mark-to-market values for other counterparties.
iii. A bank must consistently use either the counterparty-by-
counterparty approach or the aggregate approach to calculate the NGR.
Regardless of the approach used, the NGR should be applied individually
to each qualifying bilateral netting contract to determine the adjusted
add-on for that netting contract.
i. In the event a netting contract covers contracts that are
normally excluded from the risk-based ratio calculation--for example,
exchange rate contracts with an original maturity of fourteen or fewer
calendar days or instruments traded on exchanges that require daily
payment and receipt of cash variation margin--a bank may elect to either
include or exclude all mark-to-market values of such contracts when
determining net current exposure, provided the method chosen is applied
consistently.
4. Risk Weights. Once the credit equivalent amount for a derivative
contract, or a group of derivative contracts subject to a qualifying
bilateral netting contract, has been determined, that amount is assigned
to the risk category appropriate to the counterparty, or, if relevant,
the guarantor or the nature of any collateral.\57\ However, the maximum
risk weight applicable to the credit equivalent amount of such contracts
is 50 percent.
---------------------------------------------------------------------------
\57\ For derivative contracts, sufficiency of collateral or
guarantees is generally determined by the market value of the collateral
or the amount of the guarantee in relation to the credit equivalent
amount. Collateral and guarantees are subject to the same provisions
noted under section III.B. of this appendix A.
---------------------------------------------------------------------------
5. Avoidance of double counting. a. In certain cases, credit
exposures arising from the derivative contracts covered by section
III.E. of this appendix A may already be reflected, in part, on the
balance sheet. To avoid double counting such exposures in the assessment
of capital adequacy and, perhaps, assigning inappropriate risk weights,
counterparty credit exposures arising from the derivative instruments
covered by these guidelines may need to be excluded from balance sheet
assets in calculating a bank's risk-based capital ratios.
b. Examples of the calculation of credit equivalent amounts for
contracts covered under this section III.E. are contained in Attachment
V of this appendix A.
IV. Minimum Supervisory Ratios and Standards
The interim and final supervisory standards set forth below specify
minimum supervisory ratios based primarily on broad credit risk
considerations. As noted above, the risk-based ratio does not take
explicit account of the quality of individual asset portfolios or the
range of other types of risks to which banks may be exposed, such as
interest rate, liquidity, market or operational risks. For this reason,
banks are generally expected to operate with capital positions above the
minimum ratios.
Institutions with high or inordinate levels of risk are expected to
operate well above minimum capital standards. Banks experiencing or
anticipating significant growth are also expected to maintain capital,
including
[[Page 285]]
tangible capital positions, well above the minimum levels. For example,
most such institutions generally have operated at capital levels ranging
from 100 to 200 basis points above the stated minimums. Higher capital
ratios could be required if warranted by the particular circumstances or
risk profiles of individual banks. In all cases, banks should hold
capital commensurate with the level and nature of all of the risks,
including the volume and severity of problem loans, to which they are
exposed.
Upon adoption of the risk-based framework, any bank that does not
meet the interim or final supervisory ratios, or whose capital is
otherwise considered inadequate, is expected to develop and implement a
plan acceptable to the Federal Reserve for achieving an adequate level
of capital consistent with the provisions of these guidelines or with
the special circumstances affecting the individual institution. In
addition, such banks should avoid any actions, including increased risk-
taking or unwarranted expansion, that would lower or further erode their
capital positions.
A. Minimum Risk-Based Ratio After Transition Period
As reflected in Attachment VI, by year-end 1992, all state member
banks should meet a minimum ratio of qualifying total capital to
weighted risk assets of 8 percent, of which at least 4.0 percentage
points should be in the form of Tier 1 capital. For purposes of section
IV.A., Tier 1 capital is defined as the sum of core capital elements
less goodwill and other intangible assets required to be deducted in
accordance with section II.B.1.b. of this appendix. The maximum amount
of supplementary capital elements that qualifies as Tier 2 capital is
limited to 100 percent of Tier 1 capital. In addition, the combined
maximum amount of subordinated debt and intermediate-term preferred
stock that qualifies as Tier 2 capital is limited to 50 percent of Tier
1 capital. The maximum amount of the allowance for loan and lease losses
that qualifies as Tier 2 capital is limited to 1.25 percent of gross
weighted risk assets. Allowances for loan and lease losses in excess of
this limit may, of course, be maintained, but would not be included in a
bank's total capital. The Federal Reserve will continue to require banks
to maintain reserves at levels fully sufficient to cover losses inherent
in their loan portfolios.
Qualifying total capital is calculated by adding Tier 1 capital and
Tier 2 capital (limited to 100 percent of Tier 1 capital) and then
deducting from this sum certain investments in banking or finance
subsidiaries that are not consolidated for accounting or supervisory
purposes, reciprocal holdings of banking organization capital
securities, or other items at the direction of the Federal Reserve.
These deductions are discussed above in section II(B).
B. Transition Arrangements
The transition period for implementing the risk-based capital
standard ends on December 31, 1992. Initially, the risk-based capital
guidelines do not establish a minimum level of capital. However, by
year-end 1990, banks are expected to meet a minimum interim target ratio
for qualifying total capital to weighted risk assets of 7.25 percent, at
least one-half of which should be in the form of Tier 1 capital. For
purposes of meeting the 1990 interim target, the amount of loan loss
reserves that may be included in capital is limited to 1.5 percent of
weighted risk assets and up to 10 percent of a bank's Tier 1 capital may
consist of supplementary capital elements. Thus, the 7.25 percent
interim target ratio implies a minimum ratio of Tier 1 capital to
weighted risk assets of 3.6 percent (one-half of 7.25) and a minimum
ratio of core capital elements to weighted risk assets ratio of 3.25
percent (nine-tenths of the Tier 1 capital ratio).
Through year-end 1990, banks have the option of complying with the
minimum 7.25 percent year-end 1990 risk-based capital standard, in lieu
of the minimum 5.5 percent primary and 6 percent total capital to total
assets capital ratios set forth in appendix B to part 225 of the Federal
Reserve's Regulation Y. In addition, as more fully set forth in appendix
B to this part, banks are expected to maintain a minimum ratio of Tier 1
capital total assets during this transition period.
[[Page 286]]
Attachment I--Sample Calculation of Risk-Based Capital Ratio for State Member Banks
Example of a bank with $6,000 in total capital and the following assets and off-balance sheet items:
Balance Sheet Assets:
Cash........................................................................................... $5,000
U.S. Treasuries................................................................................ 20,000
Balances at domestic banks..................................................................... 5,000
Loans secured by first liens on 1-4 family residential properties.............................. 5,000
Loans to private corporations.................................................................. 65,000
------------
Total Balance Sheet Assets................................................................... $100,000
Off-Balance Sheet Items:
Standby letters of credit (``SLCs'') backing general obligation debt issues of U.S. $10,000
municipalities (``GOs'')......................................................................
Long-term legally binding commitments to private corporations.................................. 20,000
------------
Total Off-Balance Sheet Items................................................................ 30,000
This bank's total capital to total assets (leverage) ratio would be: ($6,000/$100,000)=6.00%
To compute the bank's weighted risk assets:
1. Compute the credit equivalent amount of each off-balance sheet (``OBS'') item
----------------------------------------------------------------------------------------------------------------
Credit
OBS item Face value Conversion equivalent
factor amount
----------------------------------------------------------------------------------------------------------------
SLCS backing municipal GOs........................................ $10,000 x 1.00 = $10,000
Long-term commitments to private corporations..................... 20,000 x 0.50 = 10,000
2. Multiply each balance sheet asset and the credit equivalent amount of each
OBS item by the appropriate risk weight.
0% Category:
Cash.......................................................... $ 5,000
U.S. Treasuries............................................... 20,000
-------------
25,000 x 0 = 0
20% Category:
Balances at domestic banks.................................... 5,000
Credit equivalent amounts of SLCs backing GOs of U.S. 10,000
municipalities...............................................
-------------
15,000 x .20 = $3,000
50% Category:
Loans secured by first liens on 1-4 family residential 5,000 x .50 = 2,500
properties...................................................
100% Category:
Loans to private corporations................................. 65,000
Credit equivalent amounts of long-term commitments to private 10,000
corporations.................................................
-------------
75,000 x 1.00 = 75,000
------------
Total risk-weighted assets.................................. ........... . ........... .. 80,500
This bank's ratio of total capital to weighted risk assets (risk-based capital ratio) would be: ($6,000/
$80,500)=7.45%
[[Page 287]]
Attachment II--Summary of Definition of Qualifying Capital for State
Member Banks \*\
[Using the Year-End 1992 Standard]
------------------------------------------------------------------------
Components Minimum requirements
------------------------------------------------------------------------
CORE CAPITAL (Tier 1).................. Must equal or exceed 4% of
weighted-risk assets.
Common stockholders' equity............ No limit.
Qualifying noncumulative perpetual No limit; banks should avoid
preferred stock. undue reliance on preferred
stock in tier 1.
Minority interest in equity accounts of Banks should avoid using
consolidated. minority interests to
subsidiaries introduce
elements not otherwise
qualifying for tier 1 capital.
Less: Goodwill, other intangible
assets, credit-enhancing interest-only
strips and nonfinancial equity
investments required to be deducted
from capital \1\
SUPPLEMENTARY CAPITAL (Tier 2)......... Total of tier 2 is limited to
100% of tier 1.\2\
Allowance for loan and lease losses Limited to 1.25% of weighted-
risk assets.\2\
Perpetual preferred stock.......... No limit within tier 2.
Hybrid capital instruments and No limit within tier 2.
equity contract notes.
Subordinated debt and intermediate- Subordinated debt and
term preferred stock (original intermediate-term preferred
weighted average maturity of 5 stock are limited to 50% of
years or more). tier 1,2 amortized for capital
purposes as they approach
maturity.
Revaluation reserves (equity and Not included; banks encouraged
building). to disclose; may be evaluated
on a case-by-case basis for
international comparisons; and
taken into account in making
an overall assessment of
capital.
DEDUCTIONS (from sum of tier 1 and tier
2)
Investments in unconsolidated As a general rule, one-half of
subsidiaries. the aggregate investments will
be deducted from tier 1
capital and one-half from tier
2 capital.\3\
Reciprocal holdings of banking
organizations' capital securities
Other deductions (such as other On a case-by-case basis or as a
subsidiaries or joint ventures) as matter of policy.
determined by supervisory
authority after a formal
rulemaking.
TOTAL CAPITAL (tier 1 + tier Must equal or exceed 8% of
2--deductions). weighted-risk assets.
------------------------------------------------------------------------
\1\ Requirements for the deduction of other intangible assets, residual
interests and nonfinancial equity investments are set forth in section
II.B. of this appendix.
\2\ Amounts in excess of limitations are permitted but do not qualify as
capital.
\3\ A proportionately greater amount may be deducted from tier 1
capital, if the risks associated with the subsidiary so warrant.
* See discussion in section II of the guidelines for a complete
description of the requirements for, and the limitations on, the
components of qualifying capital.
Attachment III--Summary of Risk Weights and Risk Categories for State
Member Banks
Category 1: Zero Percent
1. Cash (domestic and foreign) held in the bank or in transit.
2. Balances due from Federal Reserve Banks (including Federal
Reserve Bank stock) and central banks in other OECD countries.
3. Direct claims on, and the portions of claims that are
unconditionally guaranteed by, the U.S. Treasury and U.S. Government
agencies \1\ and the central governments of other OECD countries, and
local currency claims on, and the portions of local currency claims that
are unconditionally guaranteed by, the central governments of non-OECD
countries including the central banks of non-OECD countries), to the
extent that the bank has liabilities booked in that currency.
---------------------------------------------------------------------------
\1\ For the purpose of calculating the risk-based capital ratio, a
U.S. Government agency is defined as an instrumentality of the U.S.
Government whose obligations are fully and explicitly guaranteed as to
the timely payment of principal and interest by the full faith and
credit of the U.S. Government.
---------------------------------------------------------------------------
4. Gold bullion held in the bank's vaults or in another's vaults on
an allocated basis, to the extent offset by gold bullion liabilities.
5. Claims collateralized by cash on deposit in the bank or by
securities issued or guaranteed by OECD central governments or U.S.
government agencies for which a positive margin of collateral is
maintained on a daily basis, fully taking into account any change in the
bank's exposure to the obligor or counterparty under a claim in relation
to the market value of the collateral held in support of that claim.
Category 2: 20 Percent
1. Cash items in the process of collection.
2. All claims (long- or short-term) on, and the portions of claims
(long- or short-term) that are guaranteed by, U.S. depository
institutions and OCED banks.
3. Short-term claims (remaining maturity of one year or less) on,
and the portions of short-term claims that are guaranteed by, non-OECD
banks.
[[Page 288]]
4. The portions of claims that are conditionally guaranteed by the
central governments of OECD countries and U.S. Government agencies, and
the portions of local currency claims that are conditionally guaranteed
by the central governments of non-OECD countries, to the extent that the
bank has liabilities booked in that currency.
5. Claims on, and the portions of claims that are guaranteed by,
U.S. Government-sponsored agencies.\2\
---------------------------------------------------------------------------
\2\ For the purpose of calculating the risk-based capital ratio, a
U.S. Government-sponsored agency is defined as an agency originally
established or chartered to serve public purposes specified by the U.S.
Congress but whose obligations are not explicitly guaranteed by the full
faith and credit of the U.S. Government.
---------------------------------------------------------------------------
6. General obligation claims on, and the portions of claims that are
guaranteed by the full faith and credit of, local governments and
political subdivisions of the U.S. and other OECD local governments.
7. Claims on, and the portions of claims that are guaranteed by,
official multilateral lending institutions or regional development
banks.
8. The portions of claims that are collateralized \3\ by cash on
deposit in the bank or by securities issued or guaranteed by the U.S.
Treasury, the central governments of other OECD countries, and U.S
government agencies that do not qualify for the zero percent risk-weight
category, or that are collateralized by securities issued or guaranteed
by U.S. government-sponsored agencies.
---------------------------------------------------------------------------
\3\ The extent of collateralization is determined by current market
value.
---------------------------------------------------------------------------
9. The portions of claims that are collateralized \3\ by securities
issued by official multilateral lending institutions or regional
development banks.
10. Certain privately-issued securities representing indirect
ownership of mortgage-backed U.S. Government agency or U.S. Government-
sponsored agency securities.
11. Investment in shares of a fund whose portfolio is permitted to
hold only securities that would qualify for the zero or 20 percent risk
categories.
12. Claims on, and claims guaranteed by, qualifying securities firms
incorporated in the United States or other member of the OECD-based
group of countries provided that:
a. The qualifying securities firm has a rating in one of the top
three investment grade rating categories from a nationally recognized
statistical rating organization; or
b. The claim is guaranteed by a qualifying securities firm's parent
company with such a rating.
13. Certain collateralized claims on qualifying securities firms in
the United States or other member of the OECD-based group of countries,
without regard to satisfaction of the rating standard, provided that the
claim arises under a contract that:
a. Is a reverse repurchase/repurchase agreement or securities
lending/borrowing transaction executed using standard industry
documentation;
b. Is collateralized by liquid and readily marketable debt or equity
securities;
c. Is marked to market daily;
d. Is subject to a daily margin maintenance requirement under the
standard industry documentation; and
e. Can be liquidated, terminated, or accelerated immediately in
bankruptcy or similar proceeding, and the security or collateral
agreement will not be stayed or avoided, under applicable law of the
relevant jurisdiction.
Category 3: 50 Percent
1. Loans fully secured by first liens on 1-to 4-family residential
properties or on multifamily residential properties that have been made
in accordance with prudent underwriting standards, that are performing
in accordance with their original terms, that are not past due or in
nonaccrual status, and that meet other qualifying criteria, and certain
privately-issued mortgage-backed securities representing indirect
ownership of such loans. (Loans made for speculative purposes are
excluded.)
2. Revenue bonds or similar claims that are obligations of U.S.
state or local governments, or other OECD local governments, but for
which the government entity is committed to repay the debt only out of
revenues from the facilities financed.
3. Credit equivalent amounts of interest rate and foreign exchange
rate related contracts, except for those assigned to a lower risk
category.
Category 4: 100 Percent
1. All other claims on private obligors.
2. Claims on, or guaranteed by, non-OECD foreign banks with a
remaining maturity exceeding one year.
3. Claims on, or guaranteed by, non-OECD central governments that
are not included in item 3 of Category 1 or item 4 of Category 2; all
claims on non-OECD state or local governments.
4. Obligations issued by U.S. state or local governments, or other
OECD local governments (including industrial development authorities and
similar entities), repayable solely by a private party or enterprise.
5. Premises, plant, and equipment; other fixed assets; and other
real estate owned.
6. Investments in any unconsolidated subsidiaries, joint ventures,
or associated companies--if not deducted from capital.
[[Page 289]]
7. Instruments issued by other banking organizations that qualify as
capital--if not deducted from capital.
8. Claims on commercial firms owned by a government.
9. All other assets, including any intangible assets that are not
deducted from capital.
Attachment IV--Credit Conversion Factors for Off-Balance-Sheet Items for
State Member Banks
100 Percent Conversion Factor
1. Direct credit substitutes. (These include general guarantees of
indebtedness and all guarantee-type instruments, including standby
letters of credit backing the financial obligations of other parties.)
2. Risk participations in bankers acceptances and direct credit
substitutes, such as standby letters of credit.
3. Sale and repurchase agreements and assets sold with recourse that
are not included on the balance sheet.
4. Forward agreements to purchase assets, including financing
facilities, on which drawdown is certain.
5. Securities lent for which the bank is at risk.
50 Percent Conversion Factor
1. Transaction-related contingencies. (These include bid-bonds,
performance bonds, warranties, and standby letters of credit backing the
nonfinancial performance of other parties.)
2. Unused portions of commitments with an original maturity
exceeding one year, including underwriting commitments and commercial
credit lines.
3. Revolving underwriting facilities (RUFs), note issuance
facilities (NIFs), and similar arrangements.
20 Percent Conversion Factor
Short-term, self-liquidating trade-related contingencies, including
commercial letters of credit.
Zero Percent Conversion Factor
Unused portions of commitments with an original maturity of one year
or less, or which are unconditionally cancellable at any time, provided
a separate credit decision is made before each drawing.
Credit Conversion for Derivative Contracts
1. The credit equivalent amount of a derivative contract is the sum
of the current credit exposure of the contract and an estimate of
potential future increases in credit exposure. The current exposure is
the positive mark-to-market value of the contract (or zero if the mark-
to-market value is zero or negative). For derivative contracts that are
subject to a qualifying bilateral netting contract, the current exposure
is, generally, the net sum of the positive and negative mark-to-market
values of the contracts included in the netting contract (or zero if the
net sum of the mark-to-market values is zero or negative). The potential
future exposure is calculated by multiplying the effective notional
amount of a contract by one of the following credit conversion factors,
as appropriate:
Conversion Factors
[In percent]
----------------------------------------------------------------------------------------------------------------
Commodity,
Interest Exchange excluding Precious
Remaining maturity rate rate and Equity precious metals,
gold metals except gold
----------------------------------------------------------------------------------------------------------------
One year or less............................... 0.0 1.0 6.0 10.0 7.0
Over one to five years......................... 0.5 5.0 8.0 12.0 7.0
Over five years................................ 1.5 7.5 10.0 15.0 8.0
----------------------------------------------------------------------------------------------------------------
For contracts subject to a qualifying bilateral netting contract,
the potential future exposure is, generally, the sum of the individual
potential future exposures for each contract included under the netting
contract adjusted by the application of the following formula:
Anet=(0.4xAgross)+0.6(NGRxAgross)
NGR is the ratio of net current exposure to gross current exposure.
2. No potential future exposure is calculated for single currency
interest rate swaps in which payments are made based upon two floating
indices, that is, so called floating/floating or basis swaps. The credit
exposure on these contracts is evaluated solely on the basis of their
mark-to-market value. Exchange rate contracts with an original maturity
of fourteen days or fewer are excluded. Instruments traded on exchanges
that require daily receipt and payment of cash variation margin are also
excluded.
[[Page 290]]
Attachment V--Calculating Credit Equivalent Amounts for Derivative Contracts
----------------------------------------------------------------------------------------------------------------
Notional Potential Current Credit
Type of contract principal Conversion exposure Mark-to- exposure equivalent
amount factor (dollars) market (dollars) amount
----------------------------------------------------------------------------------------------------------------
(1) 120-day forward foreign 5,000,000 0.01 50,000 100,000 100,000 150,000
exchange.........................
(2) 4-year forward foreign 6,000,000 0.05 300,000 -120,000 0 300,000
exchange.........................
(3) 3-year single-currency fixed & 10,000,000 0.005 50,000 200,000 200,000 250,000
floating interest rate swap......
(4) 6-month oil swap.............. 10,000,000 0.10 1,000,000 -250,000 0 1,000,000
(5) 7-year cross-currency floating 20,000,000 0.075 1,500,000 -1,500,000 0 1,500,000
& floating interest rate swap....
Total....................... ........... ........... 2,900,000 + 300,000 3,200,000
----------------------------------------------------------------------------------------------------------------
a. If contracts (1) through (5) above are subject to a qualifying
bilateral netting contract, then the following applies:
------------------------------------------------------------------------
Potential Credit
Contract future Net current equivalent
exposure exposure amount
------------------------------------------------------------------------
(1).............................. 50,000 ........... ...........
(2).............................. 300,000 ........... ...........
(3).............................. 50,000 ........... ...........
(4).............................. 1,000,000 ........... ...........
(5).............................. 1,500,000 ........... ...........
Total...................... 2,900,000 +0 2,900,000
------------------------------------------------------------------------
Note: The total of the mark-to-market values from the first table is -
$1,370,000. Since this is a negative amount, the net current exposure
is zero.
b. To recognize the effects of bilateral netting on potential future
exposure the following formula applies:
Anet=(.4xAgross)+.6(NGRxAgross)
c. In the above example where the net current exposure is zero, the
credit equivalent amount would be calculated as follows:
NGR=0=(0/300,000)
Anet=(0.4x$2,900,000)+0.6 (0x$2,900,000)
Anet=$1,160,000
The credit equivalent amount is $1,160,000+0=$1,160,000.
d. If the net current exposure was a positive number, for example
$200,000, the credit equivalent amount would be calculated as follows:
NGR=.67=($200,000/$300,000)
Anet=(0.4x$2,900,000)+0.6(.67x$2,900,000)
Anet=$2,325,800.
The credit equivalent amount would be
$2,325,800+$200,000=$2,525,800.
[[Page 291]]
Attachment VI--Summary
----------------------------------------------------------------------------------------------------------------
Transitional arrangements for State member banks
---------------------------------------------------- Final arrangement--Year-
Initial Year-end 1990 end 1992
----------------------------------------------------------------------------------------------------------------
1. Minimum standard of total None.................... 7.25%................... 8.0%
capital to weighted risk assets.
2. Definition of Tier 1 capital.... Common equity, Common equity, Common equity,
qualifying noncum. qualifying noncum. qualifying
perpetual preferred perpetual preferred noncumulative
stock, minority stock, minority perpetual preferred
interests, plus interests, plus stock, and minority
supplementary elements supplementary elements interest less goodwill
\1\ less goodwill. \2\ less goodwill. and other intangible
assets required to be
deducted from
capital.\3\
3. Minimum standard of Tier 1 None.................... 3.625%.................. 4.0%
capital to weighted risk assets.
4. Minimum standard of None.................... 3.25%................... 4.0%
stockholders' equity to weighted
risk assets.
5. Limitations on supplementary
capital elements:
a. Allowance for loan and lease No limit within Tier 2.. 1.5% of weighted risk 1.25% of weighted risk
losses. assets. assets.
b. Qualifying perpetual No limit within Tier 2.. No limit within Tier 2.. No limit within Tier 2.
preferred stock.
c. Hybrid capital instruments No limit within Tier 2.. No limit within Tier 2.. No limit within Tier 2.
and equity contract notes.
d. Subordinated debt and Combined maximum of 50% Combined maximum of 50% Combined maximum of 50%
intermediate term preferred of Tier 1. of Tier 1. of Tier 1.
stock.
e. Total qualifying Tier 2 May not exceed Tier 1 May not exceed Tier 1 May not exceed Tier 1
capital. capital. capital. capital.
6. Definition of total capital..... Tier 1 plus Tier 2 less. Tier 1 plus Tier 2 less. Tier 1 plus Tier 2 less
--reciprocal holdings --reciprocal holdings --reciprocal holdings
of banking of banking of banking
organizations' organizations' organizations'
capital instruments. capital instruments. capital instruments.
--investments in --investments in --investments in
unconsolidated unconsolidated unconsolidated
subsidiaries. subsidiaries. subsidiaries.
----------------------------------------------------------------------------------------------------------------
\1\ Supplementary elements may be included in Tier 1 up to 25% of the sum of Tier 1 plus goodwill.
\2\ Supplementary elements may be included in Tier 1 up to 10% of the sum of Tier 1 plus goodwill.
\3\ Requirements for the deduction of other intangible assets are set forth in section II.B.1.b. of this
appendix.
[54 FR 4198, Jan. 27, 1989; 54 FR 12531, Mar. 27, 1989, as amended at 55
FR 32831, Aug. 10, 1990; 56 FR 51156, Oct. 10, 1991; 57 FR 2012, Jan.
17, 1992; 57 FR 60719, Dec. 22, 1992; 57 FR 62179, 62182, Dec. 30, 1992;
58 FR 7979, Feb. 11, 1993; 58 FR 68738, Dec. 29, 1993; Reg. H, 59 FR
62992, Dec. 7, 1994; 59 FR 63244, Dec. 8, 1994; 59 FR 64563, Dec. 15,
1994; 59 FR 65924, 65925, Dec. 22, 1994; 60 FR 8180, Feb. 13, 1995; 60
FR 39229, 39230, Aug. 1, 1995; 60 FR 39493, Aug. 2, 1995; 60 FR 45615,
Aug. 31, 1995; 60 FR 46176, 46178, Sept. 5, 1995; 60 FR 66044, Dec. 20,
1995; 61 FR 47370, Sept. 6, 1996; 63 FR 42675, Aug. 10, 1998; 63 FR
46522, Sept. 1, 1998; 63 FR 58621, Nov. 2, 1998; 64 FR 10200, Mar. 2,
1999; 66 FR 59636, Nov. 29, 2001; 66 FR 67074, Dec. 28, 2001; 67 FR
3797, Jan. 25, 2002; 67 FR 16977, Apr. 9, 2002]
[[Page 292]]
Appendix B to Part 208--Capital Adequacy Guidelines for State Member
Banks: Tier 1 Leverage Measure
I. Overview
a. The Board of Governors of the Federal Reserve System has adopted
a minimum ratio of tier 1 capital to total assets to assist in the
assessment of the capital adequacy of state member banks.\1\ The
principal objective of this measure is to place a constraint on the
maximum degree to which a state member bank can leverage its equity
capital base. It is intended to be used as a supplement to the risk-
based capital measure.
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\1\ Supervisory risk-based capital ratios that related capital to
weighted-risk assets for state member banks are outlined in Appendix A
to this part.
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b. The guidelines apply to all state member banks on a consolidated
basis and are to be used in the examination and supervisory process as
well as in the analysis of applications acted upon by the Federal
Reserve. The Board will review the guidelines from time to time and will
consider the need for possible adjustments in light of any significant
changes in the economy, financial markets, and banking practices.
II. The Tier 1 Leverage Ratio
a. The minimum ratio of Tier 1 capital to total assets for strong
banking institutions (rated composite ``1'' under the UFIRS rating
system of banks) is 3.0 percent. For all other institutions, the minimum
ratio of Tier 1 capital to total assets is 4.0 percent. Banking
institutions with supervisory, financial, operational, or managerial
weaknesses, as well as institutions that are anticipating or
experiencing significant growth, are expected to maintain capital ratios
well above the minimum levels. Moreover, higher capital ratios may be
required for any banking institution if warranted by its particular
circumstances or risk profile. In all cases, institutions should hold
capital commensurate with the level and nature of the risks, including
the volume and severity of problem loans, to which they are exposed.
b. A bank's tier 1 leverage ratio is calculated by dividing its tier
1 capital (the numerator of the ratio) by its average total consolidated
assets (the denominator of the ratio). The ratio will also be calculated
using period-end assets whenever necessary, on a case-by-case basis. For
the purpose of this leverage ratio, the definition of tier 1 capital as
set forth in the risk-based capital guidelines contained in appendix A
of this part will be used.\2\ As a general matter, average total
consolidated assets are defined as the quarterly average total assets
(defined net of the allowance for loan and lease losses) reported on the
bank's Reports of Condition and Income (Call Reports), less goodwill;
amounts of mortgage servicing assets, nonmortgage servicing assets, and
purchased credit card relationships that, in the aggregate, are in
excess of 100 percent of Tier 1 capital; amounts of nonmortgage
servicing assets and purchased credit card relationships that, in the
aggregate, are in excess of 25 percent of Tier 1 capital; amounts of
credit-enhancing interest-only strips that are in excess of 25 percent
of Tier 1 capital; all other identifiable intangible assets; any
investments in subsidiaries or associated companies that the Federal
Reserve determines should be deducted Tier 1 capital; deferred tax
assets that are dependent upon future taxable income, net of their
valuation allowance, in excess of the limitations set forth in section
II.B.4 of appendix A of this part; and the amount of the total adjusted
carrying value of nonfinancial equity investments that is subject to a
deduction from Tier 1 capital.\3\
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\2\ Tier 1 capital for state member banks includes common equity,
minority interest in the equity accounts of consolidated subsidiaries,
and qualifying noncumulative perpetual preferred stock. In addition, as
a general matter, Tier 1 capital excludes goodwill; amounts of mortgage
servicing assets, nonmortgage servicing assets, and purchased credit
card relationships that, in the aggregate, exceed 100 percent of Tier 1
capital; nonmortgage servicing assets and purchased credit card
relationships that, in the aggregate, exceed 25 percent of Tier 1
capital; amounts of credit enhancing interest-only strips in excess of
25 percent of Tier 1 capital; other identifiable intangible assets;
deferred tax assets that are dependent upon future taxable income, net
of their valuation allowance, in excess of certain limitations; and a
percentage of the bank's nonfinancial equity investments. The Federal
Reserve may exclude certain other investments in subsidiaries or
associated companies as appropriate.
\3\ Deductions from Tier 1 capital and other adjustments are
discussed more fully in section II.B in appendix A of this part.
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c. Notwithstanding other provisions of this appendix B, a qualifying
bank that has transferred small business loans and leases on personal
property (small business obligations) with recourse shall, for purposes
of calculating its tier 1 leverage ratio, exclude from its average total
consolidated assets the outstanding principal amount of the small
business loans and leases transferred with recourse, provided two
conditions are met. First, the transaction must be treated as a sale
under generally accepted accounting principles (GAAP) and, second, the
bank
[[Page 293]]
must establish pursuant to GAAP a non-capital reserve sufficient to meet
the bank's reasonably estimated liability under the recourse
arrangement. Only loans and leases to businesses that meet the criteria
for a small business concern established by the Small Business
Administration under section 3(a) of the Small Business Act are eligible
for this capital treatment.
d. For purposes of this appendix B, a bank is qualifying if it meets
the criteria set forth in the Board's prompt corrective action
regulation (12 CFR 208.40) for well capitalized or, by order of the
Board, adequately capitalized. For purposes of determining whether a
bank meets these criteria, its capital ratios must be calculated without
regard to the preferential capital treatment for transfers of small
business obligations with recourse specified in section II.c. of this
appendix B. The total outstanding amount of recourse retained by a
qualifying bank on transfers of small business obligations receiving the
preferential capital treatment cannot exceed 15 percent of the bank's
total risk-based capital. By order, the Board may approve a higher
limit.
e. If a bank ceases to be qualifying or exceeds the 15 percent
capital limitation, the preferential capital treatment will continue to
apply to any transfers of small business obligations with recourse that
were consummated during the time that the bank was qualifying and did
not exceed the capital limit.
f. The leverage capital ratio of the bank shall be calculated
without regard to the preferential capital treatment for transfers of
small business obligations with recourse specified in section II of this
appendix B for purposes of:
(i) Determining whether a bank is adequately capitalized,
undercapitalized, significantly undercapitalized, or critically
undercapitalized under prompt corrective action (12 CFR 208.43(b)(1));
and
(ii) Reclassifying a well capitalized bank to adequately capitalized
and requiring an adequately capitalized bank to comply with certain
mandatory or discretionary supervisory actions as if the bank were in
the next lower prompt corrective action capital category (12 CFR
208.43(c)).
g. Whenever appropriate, including when a bank is undertaking
expansion, seeking to engage in new activities or otherwise facing
unusual or abnormal risks, the Board will continue to consider the level
of an individual bank's tangible tier 1 leverage ratio (after deducting
all intangibles) in making an overall assessment of capital adequacy.
This is consistent with the Federal Reserve's risk-based capital
guidelines an long-standing Board policy and practice with regard to
leverage guidelines. Banks experiencing growth, whether internally or by
acquisition, are expected to maintain strong capital position
substantially above minimum supervisory levels, without significant
reliance on intangible assets.
[Reg. H, 59 FR 65925, Dec. 22, 1994, as amended at 60 FR 39230, Aug. 1,
1995; 60 FR 45615, Aug. 31, 1995; 63 FR 42675, Aug. 10, 1998; 63 FR
58621, Nov. 2, 1998; 64 FR 10200, Mar. 2, 1999; 66 FR 59643, Nov. 29,
2001; 67 FR 3800, Jan. 25, 2002]
Appendix C to Part 208--Interagency Guidelines for Real Estate Lending
Policies
The agencies' regulations require that each insured depository
institution adopt and maintain a written policy that establishes
appropriate limits and standards for all extensions of credit that are
secured by liens on or interests in real estate or made for the purpose
of financing the construction of a building or other improvements.\1\
These guidelines are intended to assist institutions in the formulation
and maintenance of a real estate lending policy that is appropriate to
the size of the institution and the nature and scope of its individual
operations, as well as satisfies the requirements of the regulation.
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\1\ The agencies have adopted a uniform rule on real estate lending.
See 12 CFR part 365 (FDIC); 12 CFR part 208, subpart E (FRB); 12 CFR
part 34, subpart D (OCC); and 12 CFR 563.100-101 (OTS).
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Each institution's policies must be comprehensive, and consistent
with safe and sound lending practices, and must ensure that the
institution operates within limits and according to standards that are
reviewed and approved at least annually by the board of directors. Real
estate lending is an integral part of many institutions' business plans
and, when undertaken in a prudent manner, will not be subject to
examiner criticism.
Loan Portfolio Management Considerations
The lending policy should contain a general outline of the scope and
distribution of the institution's credit facilities and the manner in
which real estate loans are made, serviced, and collected. In
particular, the institution's policies on real estate lending should:
[sbull] Identify the geographic areas in which the institution will
consider lending.
[sbull] Establish a loan portfolio diversification policy and set
limits for real estate loans by type and geographic market (e.g., limits
on higher risk loans).
[sbull] Identify appropriate terms and conditions by type of real
estate loan.
[[Page 294]]
[sbull] Establish loan origination and approval procedures, both
generally and by size and type of loan.
[sbull] Establish prudent underwriting standards that are clear and
measurable, including loan-to-value limits, that are consistent with
these supervisory guidelines.
[sbull] Establish review and approval procedures for exception
loans, including loans with loan-to-value percentages in excess of
supervisory limits.
[sbull] Establish loan administration procedures, including
documentation, disbursement, collateral inspection, collection, and loan
review.
[sbull] Establish real estate appraisal and evaluation programs.
[sbull] Require that management monitor the loan portfolio and
provide timely and adequate reports to the board of directors.
The institution should consider both internal and external factors
in the formulation of its loan policies and strategic plan. Factors that
should be considered include:
[sbull] The size and financial condition of the institution.
[sbull] The expertise and size of the lending staff.
[sbull] The need to avoid undue concentrations of risk.
[sbull] Compliance with all real estate related laws and
regulations, including the Community Reinvestment Act, anti-
discrimination laws, and for savings associations, the Qualified Thrift
Lender test.
[sbull] Market conditions.
The institution should monitor conditions in the real estate markets
in its lending area so that it can react quickly to changes in market
conditions that are relevant to its lending decisions. Market supply and
demand factors that should be considered include:
[sbull] Demographic indicators, including population and employment
trends.
[sbull] Zoning requirements.
[sbull] Current and projected vacancy, construction, and absorption
rates.
[sbull] Current and projected lease terms, rental rates, and sales
prices, including concessions.
[sbull] Current and projected operating expenses for different types
of projects.
[sbull] Economic indicators, including trends and diversification of
the lending area.
[sbull] Valuation trends, including discount and direct
capitalization rates.
Underwriting Standards
Prudently underwritten real estate loans should reflect all relevant
credit factors, including:
[sbull] The capacity of the borrower, or income from the underlying
property, to adequately service the debt.
[sbull] The value of the mortgaged property.
[sbull] The overall creditworthiness of the borrower.
[sbull] The level of equity invested in the property.
[sbull] Any secondary sources of repayment.
[sbull] Any additional collateral or credit enhancements (such as
guarantees, mortgage insurance or takeout commitments).
The lending policies should reflect the level of risk that is
acceptable to the board of directors and provide clear and measurable
underwriting standards that enable the institution's lending staff to
evaluate these credit factors. The underwriting standards should
address:
[sbull] The maximum loan amount by type of property.
[sbull] Maximum loan maturities by type of property.
[sbull] Amortization schedules.
[sbull] Pricing structure for different types of real estate loans.
[sbull] Loan-to-value limits by type of property.
For development and construction projects, and completed commercial
properties, the policy should also establish, commensurate with the size
and type of the project or property:
[sbull] Requirements for feasibility studies and sensitivity and
risk analyses (e.g., sensitivity of income projections to changes in
economic variables such as interest rates, vacancy rates, or operating
expenses).
[sbull] Minimum requirements for initial investment and maintenance
of hard equity by the borrower (e.g., cash or unencumbered investment in
the underlying property).
[sbull] Minimum standards for net worth, cash flow, and debt service
coverage of the borrower or underlying property.
[sbull] Standards for the acceptability of and limits on non-
amortizing loans.
[sbull] Standards for the acceptability of and limits on the use of
interest reserves.
[sbull] Pre-leasing and pre-sale requirements for income-producing
property.
[sbull] Pre-sale and minimum unit release requirements for non-
income-producing property loans.
[sbull] Limits on partial recourse or nonrecourse loans and
requirements for guarantor support.
[sbull] Requirements for takeout commitments.
[sbull] Minimum covenants for loan agreements.
Loan Administration
The institution should also establish loan administration procedures
for its real estate portfolio that address:
[sbull] Documentation, including:
[[Page 295]]
Type and frequency of financial statements, including requirements
for verification of information provided by the borrower;
Type and frequency of collateral evaluations (appraisals and other
estimates of value).
[sbull] Loan closing and disbursement.
[sbull] Payment processing.
[sbull] Escrow administration.
[sbull] Collateral administration.
[sbull] Loan payoffs.
[sbull] Collections and foreclosure, including:
Delinquency follow-up procedures;
Foreclosure timing;
Extensions and other forms of forbearance;
Acceptance of deeds in lieu of foreclosure.
[sbull] Claims processing (e.g., seeking recovery on a defaulted
loan covered by a government guaranty or insurance program).
[sbull] Servicing and participation agreements.
Supervisory Loan-to-Value Limits
Institutions should establish their own internal loan-to-value
limits for real estate loans. These internal limits should not exceed
the following supervisory limits:
------------------------------------------------------------------------
Loan-to-
value
Loan category limit
(percent)
------------------------------------------------------------------------
Raw land.................................................... 65
Land development............................................ 75
Construction:
Commercial, multifamily,\1\ and other nonresidential.... 80
1- to 4-family residential.............................. 85
Improved property........................................... 85
Owner-occupied 1- to 4-family and home equity............... (\2\)
------------------------------------------------------------------------
\1\ Multifamily construction includes condominiums and cooperatives.
\2\ A loan-to-value limit has not been established for permanent
mortgage or home equity loans on owner-occupied, 1- to 4-family
residential property. However, for any such loan with a loan-to-value
ratio that equals or exceeds 90 percent at origination, an institution
should require appropriate credit enhancement in the form of either
mortgage insurance or readily marketable collateral.
The supervisory loan-to-value limits should be applied to the
underlying property that collateralizes the loan. For loans that fund
multiple phases of the same real estate project (e.g., a loan for both
land development and construction of an office building), the
appropriate loan-to-value limit is the limit applicable to the final
phase of the project funded by the loan; however, loan disbursements
should not exceed actual development or construction outlays. In
situations where a loan is fully cross-collateralized by two or more
properties or is secured by a collateral pool of two or more properties,
the appropriate maximum loan amount under supervisory loan-to-value
limits is the sum of the value of each property, less senior liens,
multiplied by the appropriate loan-to-value limit for each property. To
ensure that collateral margins remain within the supervisory limits,
lenders should redetermine conformity whenever collateral substitutions
are made to the collateral pool.
In establishing internal loan-to-value limits, each lender is
expected to carefully consider the institution-specific and market
factors listed under ``Loan Portfolio Management Considerations,'' as
well as any other relevant factors, such as the particular subcategory
or type of loan. For any subcategory of loans that exhibits greater
credit risk than the overall category, a lender should consider the
establishment of an internal loan-to-value limit for that subcategory
that is lower than the limit for the overall category.
The loan-to-value ratio is only one of several pertinent credit
factors to be considered when underwriting a real estate loan. Other
credit factors to be taken into account are highlighted in the
``Underwriting Standards'' section above. Because of these other
factors, the establishment of these supervisory limits should not be
interpreted to mean that loans at these levels will automatically be
considered sound.
Loans in Excess of the Supervisory Loan-to-Value Limits
The agencies recognize that appropriate loan-to-value limits vary
not only among categories of real estate loans but also among individual
loans. Therefore, it may be appropriate in individual cases to originate
or purchase loans with loan-to-value ratios in excess of the supervisory
loan-to-value limits, based on the support provided by other credit
factors. Such loans should be identified in the institutions's records,
and their aggregate amount reported at least quarterly to the
institution's board of directors. (See additional reporting requirements
described under ``Exceptions to the General Policy.'')
The aggregate amount of all loans in excess of the supervisory loan-
to-value limits should not exceed 100 percent of total capital.\2\
Moreover, within the aggregate limit, total loans for all commercial,
agricultural, multifamily or other non-1-to-4 family residential
properties should not exceed 30 percent of total capital. An institution
will
[[Page 296]]
come under increased supervisory scrutiny as the total of such loans
approaches these levels.
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\2\ For the state member banks, the term ``total capital'' means
``total risk-based capital'' as defined in appendix A to 12 CFR part
208. For insured state non-member banks, ``total capital'' refers to
that term described in table I of appendix A to 12 CFR part 325. For
national banks, the term ``total capital'' is defined at 12 CFR 3.2(e).
For savings associations, the term ``total capital'' is defined at 12
CFR 567.5(c).
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In determining the aggregate amount of such loans, institutions
should: (a) Include all loans secured by the same property if any one of
those loans exceeds the supervisory loan-to-value limits; and (b)
include the recourse obligation of any such loan sold with recourse.
Conversely, a loan should no longer be reported to the directors as part
of aggregate totals when reduction in principal or senior liens, or
additional contribution of collateral or equity (e.g., improvements to
the real property securing the loan), bring the loan-to-value ratio into
compliance with supervisory limits.
Excluded Transactions
The agencies also recognize that there are a number of lending
situations in which other factors significantly outweigh the need to
apply the supervisory loan-to-value limits. These include:
[sbull] Loans guaranteed or insured by the U.S. government or its
agencies, provided that the amount of the guaranty or insurance is at
least equal to the portion of the loan that exceeds the supervisory
loan-to-value limit.
[sbull] Loans backed by the full faith and credit of a state
government, provided that the amount of the assurance is at least equal
to the portion of the loan that exceeds the supervisory loan-to-value
limit.
[sbull] Loans guaranteed or insured by a state, municipal or local
government, or an agency thereof, provided that the amount of the
guaranty or insurance is at least equal to the portion of the loan that
exceeds the supervisory loan-to-value limit, and provided that the
lender has determined that the guarantor or insurer has the financial
capacity and willingness to perform under the terms of the guaranty or
insurance agreement.
[sbull] Loans that are to be sold promptly after origination,
without recourse, to a financially responsible third party.
[sbull] Loans that are renewed, refinanced, or restructured without
the advancement of new funds or an increase in the line of credit
(except for reasonable closing costs), or loans that are renewed,
refinanced, or restructured in connection with a workout situation,
either with or without the advancement of new funds, where consistent
with safe and sound banking practices and part of a clearly defined and
well-documented program to achieve orderly liquidation of the debt,
reduce risk of loss, or maximize recovery on the loan.
[sbull] Loans that facilitate the sale of real estate acquired by
the lender in the ordinary course of collecting a debt previously
contracted in good faith.
[sbull] Loans for which a lien on or interest in real property is
taken as additional collateral through an abundance of caution by the
lender (e.g., the institution takes a blanket lien on all or
substantially all of the assets of the borrower, and the value of the
real property is low relative to the aggregate value of all other
collateral).
[sbull] Loans, such as working capital loans, where the lender does
not rely principally on real estate as security and the extension of
credit is not used to acquire, develop, or construct permanent
improvements on real property.
[sbull] Loans for the purpose of financing permanent improvements to
real property, but not secured by the property, if such security
interest is not required by prudent underwriting practice.
Exceptions to the General Lending Policy
Some provision should be made for the consideration of loan requests
from creditworthy borrowers whose credit needs do not fit within the
institution's general lending policy. An institution may provide for
prudently underwritten exceptions to its lending policies, including
loan-to-value limits, on a loan-by-loan basis. However, any exceptions
from the supervisory loan-to-value limits should conform to the
aggregate limits on such loans discussed above.
The board of directors is responsible for establishing standards for
the review and approval of exception loans. Each institution should
establish an appropriate internal process for the review and approval of
loans that do not conform to its own internal policy standards. The
approval of any such loan should be supported by a written justification
that clearly sets forth all of the relevant credit factors that support
the underwriting decision. The justification and approval documents for
such loans should be maintained as a part of the permanent loan file.
Each institution should monitor compliance with its real estate lending
policy and individually report exception loans of a significant size to
its board of directors.
Supervisory Review of Real Estate Lending Policies and Practices
The real estate lending policies of institutions will be evaluated
by examiners during the course of their examinations to determine if the
policies are consistent with safe and sound lending practices, these
guidelines, and the requirements of the regulation. In evaluating the
adequacy of the institution's real estate lending policies and
practices, examiners will take into consideration the following factors:
[sbull] The nature and scope of the institution's real estate
lending activities.
[sbull] The size and financial condition of the institution.
[sbull] The quality of the institution's management and internal
controls.
[[Page 297]]
[sbull] The expertise and size of the lending and loan
administration staff.
[sbull] Market conditions.
Lending policy exception reports will also be reviewed by examiners
during the course of their examinations to determine whether the
institutions' exceptions are adequately documented and appropriate in
light of all of the relevant credit considerations. An excessive volume
of exceptions to an institution's real estate lending policy may signal
a weakening of its underwriting practices, or may suggest a need to
revise the loan policy.
Definitions
For the purposes of these Guidelines:
Construction loan means an extension of credit for the purpose of
erecting or rehabilitating buildings or other structures, including any
infrastructure necessary for development.
Extension of credit or loan means:
(1) The total amount of any loan, line of credit, or other legally
binding lending commitment with respect to real property; and
(2) The total amount, based on the amount of consideration paid, of
any loan, line of credit, or other legally binding lending commitment
acquired by a lender by purchase, assignment, or otherwise.
Improved property loan means an extension of credit secured by one
of the following types of real property:
(1) Farmland, ranchland or timberland committed to ongoing
management and agricultural production;
(2) 1- to 4-family residential property that is not owner-occupied;
(3) Residential property containing five or more individual dwelling
units;
(4) Completed commercial property; or
(5) Other income-producing property that has been completed and is
available for occupancy and use, except income-producing owner-occupied
1- to 4-family residential property.
Land development loan means an extension of credit for the purpose
of improving unimproved real property prior to the erection of
structures. The improvement of unimproved real property may include the
laying or placement of sewers, water pipes, utility cables, streets, and
other infrastructure necessary for future development.
Loan origination means the time of inception of the obligation to
extend credit (i.e., when the last event or prerequisite, controllable
by the lender, occurs causing the lender to become legally bound to fund
an extension of credit).
Loan-to-value or loan-to-value ratio means the percentage or ratio
that is derived at the time of loan origination by dividing an extension
of credit by the total value of the property(ies) securing or being
improved by the extension of credit plus the amount of any readily
marketable collateral and other acceptable collateral that secures the
extension of credit. The total amount of all senior liens on or
interests in such property(ies) should be included in determining the
loan-to-value ratio. When mortgage insurance or collateral is used in
the calculation of the loan-to-value ratio, and such credit enhancement
is later released or replaced, the loan-to-value ratio should be
recalculated.
Other acceptable collateral means any collateral in which the lender
has a perfected security interest, that has a quantifiable value, and is
accepted by the lender in accordance with safe and sound lending
practices. Other acceptable collateral should be appropriately
discounted by the lender consistent with the lender's usual practices
for making loans secured by such collateral. Other acceptable collateral
includes, among other items, unconditional irrevocable standby letters
of credit for the benefit of the lender.
Owner-occupied, when used in conjunction with the term 1- to 4-
family residential property means that the owner of the underlying real
property occupies at least one unit of the real property as a principal
residence of the owner.
Readily marketable collateral means insured deposits, financial
instruments, and bullion in which the lender has a perfected interest.
Financial instruments and bullion must be salable under ordinary
circumstances with reasonable promptness at a fair market value
determined by quotations based on actual transactions, on an auction or
similarly available daily bid and ask price market. Readily marketable
collateral should be appropriately discounted by the lender consistent
with the lender's usual practices for making loans secured by such
collateral.
Value means an opinion or estimate, set forth in an appraisal or
evaluation, whichever may be appropriate, of the market value of real
property, prepared in accordance with the agency's appraisal regulations
and guidance. For loans to purchase an existing property, the term
``value'' means the lesser of the actual acquisition cost or the
estimate of value.
1- to 4-family residential property means property containing fewer
than five individual dwelling units, including manufactured homes
permanently affixed to the underlying property (when deemed to be real
property under state law).
[57 FR 62896, 62900, Dec. 31, 1992; 58 FR 4460, Jan. 14, 1993; 63 FR
58621, Nov. 2, 1998]
[[Page 298]]
Appendix D-1 to Part 208--Interagency Guidelines Establishing Standards
for Safety and Soundness
Table of Contents
I. Introduction
A. Preservation of existing authority.
B. Definitions.
II. Operational and Managerial Standards
A. Internal controls and information systems.
B. Internal audit system.
C. Loan documentation.
D. Credit underwriting.
E. Interest rate exposure.
F. Asset growth.
G. Asset quality.
H. Earnings.
I. Compensation, fees and benefits.
III. Prohibition on Compensation That Constitutes an Unsafe and Unsound
Practice
A. Excessive compensation.
B. Compensation leading to material financial loss.
I. Introduction
i. Section 39 of the Federal Deposit Insurance Act \1\ (FDI Act)
requires each Federal banking agency (collectively, the agencies) to
establish certain safety and soundness standards by regulation or by
guideline for all insured depository institutions. Under section 39, the
agencies must establish three types of standards: (1) Operational and
managerial standards; (2) compensation standards; and (3) such standards
relating to asset quality, earnings, and stock valuation as they
determine to be appropriate.
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\1\ Section 39 of the Federal Deposit Insurance Act (12 U.S.C.
1831p-1) was added by section 132 of the Federal Deposit Insurance
Corporation Improvement Act of 1991 (FDICIA), Pub. L. 102-242, 105 Stat.
2236 (1991), and amended by section 956 of the Housing and Community
Development Act of 1992, Pub. L. 102-550, 106 Stat. 3895 (1992) and
section 318 of the Riegle Community Development and Regulatory
Improvement Act of 1994, Pub. L. 103-325, 108 Stat. 2160 (1994).
---------------------------------------------------------------------------
ii. Section 39(a) requires the agencies to establish operational and
managerial standards relating to: (1) Internal controls, information
systems and internal audit systems, in accordance with section 36 of the
FDI Act (12 U.S.C. 1831m); (2) loan documentation; (3) credit
underwriting; (4) interest rate exposure; (5) asset growth; and (6)
compensation, fees, and benefits, in accordance with subsection (c) of
section 39. Section 39(b) requires the agencies to establish standards
relating to asset quality, earnings, and stock valuation that the
agencies determine to be appropriate.
iii. Section 39(c) requires the agencies to establish standards
prohibiting as an unsafe and unsound practice any compensatory
arrangement that would provide any executive officer, employee,
director, or principal shareholder of the institution with excessive
compensation, fees or benefits and any compensatory arrangement that
could lead to material financial loss to an institution. Section 39(c)
also requires that the agencies establish standards that specify when
compensation is excessive.
iv. If an agency determines that an institution fails to meet any
standard established by guideline under subsection (a) or (b) of section
39, the agency may require the institution to submit to the agency an
acceptable plan to achieve compliance with the standard. In the event
that an institution fails to submit an acceptable plan within the time
allowed by the agency or fails in any material respect to implement an
accepted plan, the agency must, by order, require the institution to
correct the deficiency. The agency may, and in some cases must, take
other supervisory actions until the deficiency has been corrected.
v. The agencies have adopted amendments to their rules and
regulations to establish deadlines for submission and review of
compliance plans.\2\
---------------------------------------------------------------------------
\2\ For the Office of the Comptroller of the Currency, these
regulations appear at 12 CFR Part 30; for the Board of Governors of the
Federal Reserve System, these regulations appear at 12 CFR Part 263; for
the Federal Deposit Insurance Corporation, these regulations appear at
12 CFR Part 308, subpart R, and for the Office of Thrift Supervision,
these regulations appear at 12 CFR Part 570.
---------------------------------------------------------------------------
vi. The following Guidelines set out the safety and soundness
standards that the agencies use to identify and address problems at
insured depository institutions before capital becomes impaired. The
agencies believe that the standards adopted in these Guidelines serve
this end without dictating how institutions must be managed and
operated. These standards are designed to identify potential safety and
soundness concerns and ensure that action is taken to address those
concerns before they pose a risk to the deposit insurance funds.
A. Preservation of Existing Authority
Neither section 39 nor these Guidelines in any way limits the
authority of the agencies to address unsafe or unsound practices,
violations of law, unsafe or unsound conditions, or other practices.
Action under section 39 and these Guidelines may be taken independently
of, in conjunction with, or in addition
[[Page 299]]
to any other enforcement action available to the agencies. Nothing in
these Guidelines limits the authority of the FDIC pursuant to section
38(i)(2)(F) of the FDI Act (12 U.S.C. 1831(o)) and Part 325 of Title 12
of the Code of Federal Regulations.
B. Definitions
1. In general. For purposes of these Guidelines, except as modified
in the Guidelines or unless the context otherwise requires, the terms
used have the same meanings as set forth in sections 3 and 39 of the FDI
Act (12 U.S.C. 1813 and 1831p-1).
2. Board of directors, in the case of a state-licensed insured
branch of a foreign bank and in the case of a federal branch of a
foreign bank, means the managing official in charge of the insured
foreign branch.
3. Compensation means all direct and indirect payments or benefits,
both cash and non-cash, granted to or for the benefit of any executive
officer, employee, director, or principal shareholder, including but not
limited to payments or benefits derived from an employment contract,
compensation or benefit agreement, fee arrangement, perquisite, stock
option plan, postemployment benefit, or other compensatory arrangement.
4. Director shall have the meaning described in 12 CFR 215.2(c).\3\
---------------------------------------------------------------------------
\3\ In applying these definitions for savings associations, pursuant
to 12 U.S.C. 1464, savings associations shall use the terms ``savings
association'' and ``insured savings association'' in place of the terms
``member bank'' and ``insured bank''.
---------------------------------------------------------------------------
5. Executive officer shall have the meaning described in 12 CFR
215.2(d).\4\
---------------------------------------------------------------------------
\4\ See footnote 3 in section I.B.4. of this appendix.
---------------------------------------------------------------------------
6. Principal shareholder shall have the meaning described in 12 CFR
215.2(l).\5\
---------------------------------------------------------------------------
\5\ See footnote 3 in section I.B.4. of this appendix.
---------------------------------------------------------------------------
II. Operational and Managerial Standards
A. Internal controls and information systems. An institution should
have internal controls and information systems that are appropriate to
the size of the institution and the nature, scope and risk of its
activities and that provide for:
1. An organizational structure that establishes clear lines of
authority and responsibility for monitoring adherence to established
policies;
2. Effective risk assessment;
3. Timely and accurate financial, operational and regulatory
reports;
4. Adequate procedures to safeguard and manage assets; and
5. Compliance with applicable laws and regulations.
B. Internal audit system. An institution should have an internal
audit system that is appropriate to the size of the institution and the
nature and scope of its activities and that provides for:
1. Adequate monitoring of the system of internal controls through an
internal audit function. For an institution whose size, complexity or
scope of operations does not warrant a full scale internal audit
function, a system of independent reviews of key internal controls may
be used;
2. Independence and objectivity;
3. Qualified persons;
4. Adequate testing and review of information systems;
5. Adequate documentation of tests and findings and any corrective
actions;
6. Verification and review of management actions to address material
weaknesses; and
7. Review by the institution's audit committee or board of directors
of the effectiveness of the internal audit systems.
C. Loan documentation. An institution should establish and maintain
loan documentation practices that:
1. Enable the institution to make an informed lending decision and
to assess risk, as necessary, on an ongoing basis;
2. Identify the purpose of a loan and the source of repayment, and
assess the ability of the borrower to repay the indebtedness in a timely
manner;
3. Ensure that any claim against a borrower is legally enforceable;
4. Demonstrate appropriate administration and monitoring of a loan;
and
5. Take account of the size and complexity of a loan.
D. Credit underwriting. An institution should establish and maintain
prudent credit underwriting practices that:
1. Are commensurate with the types of loans the institution will
make and consider the terms and conditions under which they will be
made;
2. Consider the nature of the markets in which loans will be made;
3. Provide for consideration, prior to credit commitment, of the
borrower's overall financial condition and resources, the financial
responsibility of any guarantor, the nature and value of any underlying
collateral, and the borrower's character and willingness to repay as
agreed;
4. Establish a system of independent, ongoing credit review and
appropriate communication to management and to the board of directors;
5. Take adequate account of concentration of credit risk; and
6. Are appropriate to the size of the institution and the nature and
scope of its activities.
E. Interest rate exposure. An institution should:
[[Page 300]]
1. Manage interest rate risk in a manner that is appropriate to the
size of the institution and the complexity of its assets and
liabilities; and
2. Provide for periodic reporting to management and the board of
directors regarding interest rate risk with adequate information for
management and the board of directors to assess the level of risk.
F. Asset growth. An institution's asset growth should be prudent and
consider:
1. The source, volatility and use of the funds that support asset
growth;
2. Any increase in credit risk or interest rate risk as a result of
growth; and
3. The effect of growth on the institution's capital.
G. Asset quality. An insured depository institution should establish
and maintain a system that is commensurate with the institution's size
and the nature and scope of its operations to identify problem assets
and prevent deterioration in those assets. The institution should:
1. Conduct periodic asset quality reviews to identify problem
assets;
2. Estimate the inherent losses in those assets and establish
reserves that are sufficient to absorb estimated losses;
3. Compare problem asset totals to capital;
4. Take appropriate corrective action to resolve problem assets;
5. Consider the size and potential risks of material asset
concentrations; and
6. Provide periodic asset reports with adequate information for
management and the board of directors to assess the level of asset risk.
H. Earnings. An insured depository institution should establish and
maintain a system that is commensurate with the institution's size and
the nature and scope of its operations to evaluate and monitor earnings
and ensure that earnings are sufficient to maintain adequate capital and
reserves. The institution should:
1. Compare recent earnings trends relative to equity, assets, or
other commonly used benchmarks to the institution's historical results
and those of its peers;
2. Evaluate the adequacy of earnings given the size, complexity, and
risk profile of the institution's assets and operations;
3. Assess the source, volatility, and sustainability of earnings,
including the effect of nonrecurring or extraordinary income or expense;
4. Take steps to ensure that earnings are sufficient to maintain
adequate capital and reserves after considering the institution's asset
quality and growth rate; and
5. Provide periodic earnings reports with adequate information for
management and the board of directors to assess earnings performance.
I. Compensation, fees and benefits. An institution should maintain
safeguards to prevent the payment of compensation, fees, and benefits
that are excessive or that could lead to material financial loss to the
institution.
III. Prohibition on Compensation That Constitutes an Unsafe and Unsound
Practice
A. Excessive Compensation
Excessive compensation is prohibited as an unsafe and unsound
practice. Compensation shall be considered excessive when amounts paid
are unreasonable or disproportionate to the services performed by an
executive officer, employee, director, or principal shareholder,
considering the following:
1. The combined value of all cash and non-cash benefits provided to
the individual;
2. The compensation history of the individual and other individuals
with comparable expertise at the institution;
3. The financial condition of the institution;
4. Comparable compensation practices at comparable institutions,
based upon such factors as asset size, geographic location, and the
complexity of the loan portfolio or other assets;
5. For postemployment benefits, the projected total cost and benefit
to the institution;
6. Any connection between the individual and any fraudulent act or
omission, breach of trust or fiduciary duty, or insider abuse with
regard to the institution; and
7. Any other factors the agencies determines to be relevant.
B. Compensation Leading to Material Financial Loss
Compensation that could lead to material financial loss to an
institution is prohibited as an unsafe and unsound practice.
[60 FR 35678, 35682, July 10, 1995, as amended by Reg. H, 61 FR 43951,
Aug. 27, 1996]
Appendix D-2 To Part 208--Interagency Guidelines Establishing Standards
For Safeguarding Customer Information
Table of Contents
I. Introduction
A. Scope
B. Preservation of Existing Authority
C. Definitions
II. Standards for Safeguarding Customer Information
A. Information Security Program
B. Objectives
III. Development and Implementation of Customer Information Security
Program
A. Involve the Board of Directors
B. Assess Risk
C. Manage and Control Risk
[[Page 301]]
D. Oversee Service Provider Arrangements
E. Adjust the Program
F. Report to the Board
G. Implement the Standards
I. Introduction
These Interagency Guidelines Establishing Standards for Safeguarding
Customer Information (Guidelines) set forth standards pursuant to
sections 501 and 505 of the Gramm-Leach-Bliley Act (15 U.S.C. 6801 and
6805), in the same manner, to the extent practicable, as standards
prescribed pursuant to section 39 of the Federal Deposit Insurance Act
(12 U.S.C. 1831p-1). These Guidelines address standards for developing
and implementing administrative, technical, and physical safeguards to
protect the security, confidentiality, and integrity of customer
information.
A. Scope. The Guidelines apply to customer information maintained by
or on behalf of state member banks (banks) and their nonbank
subsidiaries, except for brokers, dealers, persons providing insurance,
investment companies, and investment advisors. Pursuant to Secs. 211.9
and 211.24 of this chapter, these guidelines also apply to customer
information maintained by or on behalf of Edge corporations, agreement
corporations, and uninsured state-licensed branches or agencies of a
foreign bank.
B. Preservation of Existing Authority. Neither section 39 nor these
Guidelines in any way limit the authority of the Board to address unsafe
or unsound practices, violations of law, unsafe or unsound conditions,
or other practices. The Board may take action under section 39 and these
Guidelines independently of, in conjunction with, or in addition to, any
other enforcement action available to the Board.
C. Definitions.
1. Except as modified in the Guidelines, or unless the context
otherwise requires, the terms used in these Guidelines have the same
meanings as set forth in sections 3 and 39 of the Federal Deposit
Insurance Act (12 U.S.C. 1813 and 1831p-1).
2. For purposes of the Guidelines, the following definitions apply:
a. Board of directors, in the case of a branch or agency of a
foreign bank, means the managing official in charge of the branch or
agency.
b. Customer means any customer of the bank as defined in
Sec. 216.3(h) of this chapter.
c. Customer information means any record containing nonpublic
personal information, as defined in Sec. 216.3(n) of this chapter, about
a customer, whether in paper, electronic, or other form, that is
maintained by or on behalf of the bank.
d. Customer information systems means any methods used to access,
collect, store, use, transmit, protect, or dispose of customer
information.
e. Service provider means any person or entity that maintains,
processes, or otherwise is permitted access to customer information
through its provision of services directly to the bank.
f. Subsidiary means any company controlled by a bank, except a
broker, dealer, person providing insurance, investment company,
investment advisor, insured depository institution, or subsidiary of an
insured depository institution.
II. Standards for Safeguarding Customer Information
A. Information Security Program. Each bank shall implement a
comprehensive written information security program that includes
administrative, technical, and physical safeguards appropriate to the
size and complexity of the bank and the nature and scope of its
activities. While all parts of the bank are not required to implement a
uniform set of policies, all elements of the information security
program must be coordinated. A bank also shall ensure that each of its
subsidiaries is subject to a comprehensive information security program.
The bank may fulfill this requirement either by including a subsidiary
within the scope of the bank's comprehensive information security
program or by causing the subsidiary to implement a separate
comprehensive information security program in accordance with the
standards and procedures in sections II and III of this appendix that
apply to banks.
B. Objectives. A bank's information security program shall be
designed to:
1. Ensure the security and confidentiality of customer information;
2. Protect against any anticipated threats or hazards to the
security or integrity of such information; and
3. Protect against unauthorized access to or use of such information
that could result in substantial harm or inconvenience to any customer.
III. Development and Implementation of Information Security Program
A. Involve the Board of Directors. The board of directors or an
appropriate committee of the board of each bank shall:
1. Approve the bank's written information security program; and
2. Oversee the development, implementation, and maintenance of the
bank's information security program, including assigning specific
responsibility for its implementation and reviewing reports from
management.
B. Assess Risk. Each bank shall:
1. Identify reasonably foreseeable internal and external threats
that could result in unauthorized disclosure, misuse, alteration, or
destruction of customer information or customer information systems.
[[Page 302]]
2. Assess the likelihood and potential damage of these threats,
taking into consideration the sensitivity of customer information.
3. Assess the sufficiency of policies, procedures, customer
information systems, and other arrangements in place to control risks.
C. Manage and Control Risk. Each bank shall:
1. Design its information security program to control the identified
risks, commensurate with the sensitivity of the information as well as
the complexity and scope of the bank's activities. Each bank must
consider whether the following security measures are appropriate for the
bank and, if so, adopt those measures the bank concludes are
appropriate:
a. Access controls on customer information systems, including
controls to authenticate and permit access only to authorized
individuals and controls to prevent employees from providing customer
information to unauthorized individuals who may seek to obtain this
information through fraudulent means.
b. Access restrictions at physical locations containing customer
information, such as buildings, computer facilities, and records storage
facilities to permit access only to authorized individuals;
c. Encryption of electronic customer information, including while in
transit or in storage on networks or systems to which unauthorized
individuals may have access;
d. Procedures designed to ensure that customer information system
modifications are consistent with the bank's information security
program;
e. Dual control procedures, segregation of duties, and employee
background checks for employees with responsibilities for or access to
customer information;
f. Monitoring systems and procedures to detect actual and attempted
attacks on or intrusions into customer information systems;
g. Response programs that specify actions to be taken when the bank
suspects or detects that unauthorized individuals have gained access to
customer information systems, including appropriate reports to
regulatory and law enforcement agencies; and
h. Measures to protect against destruction, loss, or damage of
customer information due to potential environmental hazards, such as
fire and water damage or technological failures.
2. Train staff to implement the bank's information security program.
3. Regularly test the key controls, systems and procedures of the
information security program. The frequency and nature of such tests
should be determined by the bank's risk assessment. Tests should be
conducted or reviewed by independent third parties or staff independent
of those that develop or maintain the security programs.
D. Oversee Service Provider Arrangements. Each bank shall:
1. Exercise appropriate due diligence in selecting its service
providers;
2. Require its service providers by contract to implement
appropriate measures designed to meet the objectives of these
Guidelines; and
3. Where indicated by the bank's risk assessment, monitor its
service providers to confirm that they have satisfied their obligations
as required by paragraph D.2. As part of this monitoring, a bank should
review audits, summaries of test results, or other equivalent
evaluations of its service providers.
E. Adjust the Program. Each bank shall monitor, evaluate, and
adjust, as appropriate, the information security program in light of any
relevant changes in technology, the sensitivity of its customer
information, internal or external threats to information, and the bank's
own changing business arrangements, such as mergers and acquisitions,
alliances and joint ventures, outsourcing arrangements, and changes to
customer information systems.
F. Report to the Board. Each bank shall report to its board or an
appropriate committee of the board at least annually. This report should
describe the overall status of the information security program and the
bank's compliance with these Guidelines. The reports should discuss
material matters related to its program, addressing issues such as: risk
assessment; risk management and control decisions; service provider
arrangements; results of testing; security breaches or violations and
management's responses; and recommendations for changes in the
information security program.
G. Implement the Standards.
1. Effective date. Each bank must implement an information security
program pursuant to these Guidelines by July 1, 2001.
2. Two-year grandfathering of agreements with service providers.
Until July 1, 2003, a contract that a bank has entered into with a
service provider to perform services for it or functions on its behalf
satisfies the provisions of section III.D., even if the contract does
not include a requirement that the servicer maintain the security and
confidentiality of customer information, as long as the bank entered
into the contract on or before March 5, 2001.
[Reg. H, 66 FR 8634, Feb. 1, 2001]
[[Page 303]]
Appendix E to Part 208--Capital Adequacy Guidelines for State Member
Banks; Market Risk Measure
Section 1. Purpose, Applicability, Scope, and Effective Date
(a) Purpose. The purpose of this appendix is to ensure that banks
with significant exposure to market risk maintain adequate capital to
support that exposure.\1\ This appendix supplements and adjusts the
risk-based capital ratio calculations under appendix A of this part with
respect to those banks.
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\1\ This appendix is based on a framework developed jointly by
supervisory authorities from the countries represented on the Basle
Committee on Banking Supervision and endorsed by the Group of Ten
Central Bank Governors. The framework is described in a Basle Committee
paper entitled ``Amendment to the Capital Accord to Incorporate Market
Risks,'' January 1996. Also see modifications issued in September 1997.
---------------------------------------------------------------------------
(b) Applicability. (1) This appendix applies to any insured state
member bank whose trading activity \2\ (on a worldwide consolidated
basis) equals:
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\2\ Trading activity means the gross sum of trading assets and
liabilities as reported in the bank's most recent quarterly Consolidated
Report of Condition and Income (Call Report).
---------------------------------------------------------------------------
(i) 10 percent or more of total assets; \3\ or
---------------------------------------------------------------------------
\3\ Total assets means quarter-end total assets as reported in the
bank's most recent Call Report.
---------------------------------------------------------------------------
(ii) $1 billion or more.
(2) The Federal Reserve may additionally apply this appendix to any
insured state member bank if the Federal Reserve deems it necessary or
appropriate for safe and sound banking practices.
(3) The Federal Reserve may exclude an insured state member bank
otherwise meeting the criteria of paragraph (b)(1) of this section from
coverage under this appendix if it determines the bank meets such
criteria as a consequence of accounting, operational, or similar
considerations, and the Federal Reserve deems it consistent with safe
and sound banking practices.
(c) Scope. The capital requirements of this appendix support market
risk associated with a bank's covered positions.
(d) Effective date. This appendix is effective as of January 1,
1997. Compliance is not mandatory until January 1, 1998. Subject to
supervisory approval, a bank may opt to comply with this appendix as
early as January 1, 1997.\4\
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\4\ A bank that voluntarily complies with the final rule prior to
January 1, 1998, must comply with all of its provisions.
---------------------------------------------------------------------------
Section 2. Definitions
For purposes of this appendix, the following definitions apply:
(a) Covered positions means all positions in a bank's trading
account, and all foreign exchange \5\ and commodity positions, whether
or not in the trading account.\6\ Positions include on-balance-sheet
assets and liabilities and off-balance-sheet items. Securities subject
to repurchase and lending agreements are included as if they are still
owned by the lender.
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\5\ Subject to supervisory review, a bank may exclude structural
positions in foreign currencies from its covered positions.
\6\ The term trading account is defined in the instructions to the
Call Report.
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(b) Market risk means the risk of loss resulting from movements in
market prices. Market risk consists of general market risk and specific
risk components.
(1) General market risk means changes in the market value of covered
positions resulting from broad market movements, such as changes in the
general level of interest rates, equity prices, foreign exchange rates,
or commodity prices.
(2) Specific risk means changes in the market value of specific
positions due to factors other than broad market movements and includes
event and default risk as well as idiosyncratic variations.
(c) Tier 1 and Tier 2 capital are defined in appendix A of this
part.
(d) Tier 3 capital is subordinated debt that is unsecured; is fully
paid up; has an original maturity of at least two years; is not
redeemable before maturity without prior approval by the Federal
Reserve; includes a lock-in clause precluding payment of either interest
or principal (even at maturity) if the payment would cause the issuing
bank's risk-based capital ratio to fall or remain below the minimum
required under appendix A of this part; and does not contain and is not
covered by any covenants, terms, or restrictions that are inconsistent
with safe and sound banking practices.
(e) Value-at-risk (VAR) means the estimate of the maximum amount
that the value of covered positions could decline during a fixed holding
period within a stated confidence level, measured in accordance with
section 4 of this appendix.
Section 3. Adjustments to the Risk-Based Capital Ratio Calculations
(a) Risk-based capital ratio denominator. A bank subject to this
appendix shall calculate its risk-based capital ratio denominator as
follows:
(1) Adjusted risk-weighted assets. Calcuate adjusted risk-weighted
assets, which equals
[[Page 304]]
risk-weighted assets (as determined in accordance with appendix A of
this part), excluding the risk-weighted amounts of all covered positions
(except foreign exchange positions outside the trading account and over-
the counter derivative positions) \7\ and receivables arising from the
posting of cash collateral that is associated with securities borrowing
transactions to the extent the receivables are collateralized by the
market value of the borrowed securities, provided that the following
conditions are met:
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\7\ Foreign exchange positions outside the trading account and all
over-the-counter derivative positions, whether or not in the trading
account, must be included in the adjusted risk weighted assets
asdetermined in appendix A of this part.
---------------------------------------------------------------------------
(i) The transaction is based on securities includable in the trading
book that are liquid and readily marketable,
(ii) The transaction is marked to market daily,
(iii) The transaction is subject to daily margin maintenance
requirements,
(iv) The transaction is a securities contract for the purposes of
section 555 of the Bankruptcy Code (11 U.S.C. 555), a qualified
financial contract for the purposes of section 11(e)(8) of the Federal
Deposit Insurance Act (12 U.S.C. 1821(e)(8)), or a netting contract
between or among financial institutions for the purposes of sections
401-407 of the Federal Deposit Insurance Corporation Improvement Act of
1991 (12 U.S.C. 4401-4407), or the Board's Regulation EE (12 CFR part
231).
(2) Measure for market risk. Calculate the measure for market risk,
which equals the sum of the VAR-based capital charge, the specific risk
add-on (if any), and the capital charge for de minimis exposures (if
any).
(i) VAR-based capital charge. The VAR-based capital charge equals
the higher of:
(A) The previous day's VAR measure; or
(B) The average of the daily VAR measures for each of the preceding
60 business days multiplied by three, except as provided in section 4(e)
of this appendix;
(ii) Specific risk add-on. The specific risk add-on is calculated in
accordance with section 5 of this appendix; and
(iii) Capital charge for de minimis exposure. The capital charge for
de minimis exposure is calculated in accordance with section 4(a) of
this appendix.
(3) Market risk equivalent assets. Calculate market risk equivalent
assets by multiplying the measure for market risk (as calculated in
paragraph (a)(2) of this section) by 12.5.
(4) Denominator calculation. Add market risk equivalent assets (as
calculated in paragraph (a)(3) of this section) to adjusted risk-
weighted assets (as calculated in paragraph (a)(1) of this section). The
resulting sum is the bank's risk-based capital ratio denominator.
(b) Risk-based capital ratio numerator. A bank subject to this
appendix shall calculate its risk-based capital ratio numerator by
allocating capital as follows:
(1) Credit risk allocation. Allocate Tier 1 and Tier 2 capital equal
to 8.0 percent of adjusted risk-weighted assets (as calculated in
paragraph (a)(1) of this section).\8\
---------------------------------------------------------------------------
\8\ A bank may not allocate Tier 3 capital to support credit risk
(as calculated under appendix A of this part).
---------------------------------------------------------------------------
(2) Market risk allocation. Allocate Tier 1, Tier 2, and Tier 3
capital equal to the measure for market risk as calculated in paragraph
(a)(2) of this section. The sum of Tier 2 and Tier 3 capital allocated
for market risk must not exceed 250 percent of Tier 1 capital allocated
for market risk. (This requirement means that Tier 1 capital allocated
in this paragraph (b)(2) must equal at least 28.6 percent of the measure
for market risk.)
(3) Restrictions. (i) The sum of Tier 2 capital (both allocated and
excess) and Tier 3 capital (allocated in paragraph (b)(2) of this
section) may not exceed 100 percent of Tier 1 capital (both allocated
and excess).\9\
---------------------------------------------------------------------------
\9\ Excess Tier 1 capital means Tier 1 capital that has not been
allocated in paragraphs (b)(1) and (b)(2) of this section. Excess Tier 2
capital means Tier 2 capital that has not been allocated in paragraph
(b)(1) and (b)(2) of this section, subject to the restrictions in
paragraph (b)(3) of this section.
---------------------------------------------------------------------------
(ii) Term subordinated debt (and intermediate-term preferred stock
and related surplus) included in Tier 2 capital (both allocated and
excess) may not exceed 50 percent of Tier 1 capital (both allocated and
excess).
(4) Numerator calculation. Add Tier 1 capital (both allocated and
excess), Tier 2 capital (both allocated and excess), and Tier 3 capital
(allocated under paragraph (b)(2) of this section). The resulting sum is
the bank's risk-based capital ratio numerator.
Section 4. Internal Models.
(a) General. For risk-based capital purposes, a bank subject to this
appendix must use its internal model to measure its daily VAR, in
accordance with the requirements of this section.\10\ The Federal
Reserve may permit a bank to use alternative techniques to
[[Page 305]]
measure the market risk of de minimis exposures so long as the
techniques adequately measure associated market risk.
---------------------------------------------------------------------------
\10\ A bank's internal model may use any generally accepted
measurement techniques, such as variance-covariance models, historical
simulations, or Monte Carlo simulations. However, the level of
sophistication and accuracy of a bank's internal model must be
commensurate with the nature and size of its covered positions. A bank
that modifies its existing modeling procedures to comply with the
requirements of this appendix for risk-based capital purposes should,
nonetheless, continue to use the internal model it considers most
appropriate in evaluating risks for other purposes.
---------------------------------------------------------------------------
(b) Qualitative requirements. A bank subject to this appendix must
have a risk management system that meets the following minimum
qualitative requirements:
(1) The bank must have a risk control unit that reports directly to
senior management and is independent from business trading units.
(2) The bank's internal risk measurement model must be integrated
into the daily management process.
(3) The bank's policies and procedures must identify, and the bank
must conduct, appropriate stress tests and backtests.\11\ The bank's
policies and procedures must identify the procedures to follow in
response to the results of such tests.
---------------------------------------------------------------------------
\11\ Stress tests provide information about the impact of adverse
market events on a bank's covered positions. Backtests provide
information about the accuracy of an internal model by comparing a
bank's daily VAR measures to its corresponding daily trading profits and
losses.
---------------------------------------------------------------------------
(4) The bank must conduct independent reviews of its risk
measurement and risk management systems at least annually.
(c) Market risk factors. The bank's internal model must use risk
factors sufficient to measure the market risk inherent in all covered
positions. The risk factors must address interest rate risk,\12\ equity
price risk, foreign exchange rate risk, and commodity price risk.
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\12\ For material exposures in the major currencies and markets,
modeling techniques must capture spread risk and must incorporate enough
segments of the yield curve--at least six--to capture differences in
volatility and less than perfect correlation of rates along the yield
curve.
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(d) Quantitative requirements. For regulatory capital purposes, VAR
measures must meet the following quantitative requirements:
(1) The VAR measures must be calculated on a daily basis using a 99
percent, one-tailed confidence level with a price shock equivalent to a
ten-business day movement in rates and prices. In order to calculate VAR
measures based on a ten-day price shock, the bank may either calculate
ten-day figures directly or convert VAR figures based on holding periods
other than ten days to the equivalent of a ten-day holding period (for
instance, by multiplying a one-day VAR measure by the square root of
ten).
(2) The VAR measures must be based on an historical observation
period (or effective observation period for a bank using a weighting
scheme or other similar method) of at least one year. The bank must
update data sets at least once every three months or more frequently as
market conditions warrant.
(3) The VAR measures must include the risks arising from the non-
linear price characteristics of options positions and the sensitivity of
the market value of the positions to changes in the volatility of the
underlying rates or prices. A bank with a large or complex options
portfolio must measure the volatility of options positions by different
maturities.
(4) The VAR measures may incorporate empirical correlations within
and across risk categories, provided that the bank's process for
measuring correlations is sound. In the event that the VAR measures do
not incorporate empirical correlations across risk categories, then the
bank must add the separate VAR measures for the four major risk
categories to determine its aggregate VAR measure.
(e) Backtesting. (1) Beginning one year after a bank starts to
comply with this appendix, a bank must conduct backtesting by comparing
each of its most recent 250 business days' actual net trading profit or
loss \13\ with the corresponding daily VAR measures generated for
internal risk measurement purposes and calibrated to a one-day holding
period and a 99 percent, one-tailed confidence level.
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\13\ Actual net trading profits and losses typically include such
things as realized and unrealized gains and losses on portfolio
positions as well as fee income and commissions associated with trading
activities.
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(2) Once each quarter, the bank must identify the number of
exceptions, that is, the number of business days for which the magnitude
of the actual daily net trading loss, if any, exceeds the corresponding
daily VAR measure.
(3) A bank must use the multiplication factor indicated in Table 1
of this appendix in determining its capital charge for market risk under
section 3(a)(2)(i)(B) of this appendix until it obtains the next
quarter's backtesting results, unless the Federal Reserve determines
that a different adjustment or other action is appropriate.
Table 1--Multiplication Factor Based on Results of Backtesting
------------------------------------------------------------------------
Multiplication
Number of exceptions factor
------------------------------------------------------------------------
4 or fewer.............................................. 3.00
5....................................................... 3.40
6....................................................... 3.50
7....................................................... 3.65
8....................................................... 3.75
9....................................................... 3.85
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10 or more.............................................. 4.00
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Section 5. Specific Risk
(a) Modeled specific risk. A bank may use its internal model to
measure specific risk. If the bank has demonstrated to the Federal
Reserve that its internal model measures the specific risk, including
event and default risk as well as idiosyncratic variation, of covered
debt and equity positions and includes the specific risk measures in the
VAR-based capital charge in section 3(a)(2)(i) of this appendix, then
the bank has no specific risk add-on for purposes of section 3(a)(2)(ii)
of this appendix. The model should explain the historical price
variation in the trading portfolio and capture concentration, both
magnitude and changes in composition. The model should also be robust to
an adverse environment and have been validated through backtesting which
assesses whether specific risk is being accurately captured.
(b) Partially modeled specific risk. (1) A bank that incorporates
specific risk in its internal model but fails to demonstrate to the
Federal Reserve that its internal model adequately measures all aspects
of specific risk for covered debt and equity positions, including event
and default risk, as provided by section 5(a), of this appendix must
calculate its specific risk add-on in accordance with one of the
following methods:
(i) If the model is susceptible to valid separation of the VAR
measure into a specific risk portion and a general market risk portion,
then the specific risk add-on is equal to the previous day's specific
risk portion.
(ii) If the model does not separate the VAR measure into a specific
risk portion and a general market risk portion, then the specific risk
add-on is the sum of the previous day's VAR measures for subportfolios
of covered debt and equity positions that contain specific risk.
(2) If a bank models the specific risk of covered debt positions but
not covered equity positions (or vice versa), then the bank may
determine its specific risk charge for the included positions under
section 5(a) or 5(b)(1) of this appendix, as appropriate. The specific
risk charge for the positions not included equals the standard specific
risk capital charge under paragraph (c) of this section.
(c) Specific risk not modeled. If a bank does not model specific
risk in accordance with section 5(a) or 5(b) of this appendix, then the
bank's specific risk capital charge shall equal the standard specific
risk capital charge, calculated as follows:
(1) Covered debt positions. (i) For purposes of this section 5,
covered debt positions means fixed-rate or floating-rate debt
instruments located in the trading account and instruments located in
the trading account with values that react primarily to changes in
interest rates, including certain non-convertible preferred stock,
convertible bonds, and instruments subject to repurchase and lending
agreements. Also included are derivatives (including written and
purchased options) for which the underlying instrument is a covered debt
instrument that is subject to a non-zero specific risk capital charge.
(A) For covered debt positions that are derivatives, a bank must
risk-weight (as described in paragraph (c)(1)(iii) of this section) the
market value of the effective notional amount of the underlying debt
instrument or index portfolio. Swaps must be included as the notional
position in the underlying debt instrument or index portfolio, with a
receiving side treated as a long position and a paying side treated as a
short position; and
(B) For covered debt positions that are options, whether long or
short, a bank must risk-weight (as described in paragraph (c)(1)(iii) of
this section) the market value of the effective notional amount of the
underlying debt instrument or index multiplied by the option's delta.
(ii) A bank may net long and short covered debt positions (including
derivatives) in identical debt issues or indices.
(iii) A bank must multiply the absolute value of the current market
value of each net long or short covered debt position by the appropriate
specific risk weighting factor indicated in Table 2 of this appendix.
The specific risk capital charge component for covered debt positions is
the sum of the weighted values.
Table 2--Specific Risk Weighting Factors for Covered Debt Positions
------------------------------------------------------------------------
Weighting
Remaining maturity factor
Category (contractual) (in
percent)
------------------------------------------------------------------------
Government.......................... N/A.................... 0.00
Qualifying.......................... 6 months or less....... 0.25
Over 6 months to 24 1.00
months.
Over 24 months......... 1.60
Other............................... N/A.................... 8.00
------------------------------------------------------------------------
(A) The government category includes all debt instruments of central
governments of OECD-based countries \14\ including bonds, Treasury
bills, and other short-term instruments, as well as local currency
instruments
[[Page 307]]
of non-OECD central governments to the extent the bank has liabilities
booked in that currency.
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\14\ Organization for Economic Cooperation and Development (OECD)-
based countries is defined in appendix A of this part.
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(B) The qualifying category includes debt instruments of U.S.
government-sponsored agencies, general obligation debt instruments
issued by states and other political subdivisions of OECD-based
countries, multilateral development banks, and debt instruments issued
by U.S. depository institutions or OECD-banks that do not qualify as
capital of the issuing institution.\15\ This category also includes
other debt instruments, including corporate debt and revenue instruments
issued by states and other political subdivisions of OECD countries,
that are:
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\15\ U.S. government-sponsored agencies, multilateral development
banks, and OECD banks are defined in appendix A of this part.
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(1) Rated investment-grade by at least two nationally recognized
credit rating services;
(2) Rated investment-grade by one nationally recognized credit
rating agency and not rated less than investment-grade by any other
credit rating agency; or
(3) Unrated, but deemed to be of comparable investment quality by
the reporting bank and the issuer has instruments listed on a recognized
stock exchange, subject to review by the Federal Reserve.
(C) The other category includes debt instruments that are not
included in the government or qualifying categories.
(2) Covered equity positions. (i) For purposes of this section 5,
covered equity positions means equity instruments located in the trading
account and instruments located in the trading account with values that
react primarily to changes in equity prices, including voting or non-
voting common stock, certain convertible bonds, and commitments to buy
or sell equity instruments. Also included are derivatives (including
written and purchased options) for which the underlying is a covered
equity position.
(A) For covered equity positions that are derivatives, a bank must
risk weight (as described in paragraph (c)(2)(iii) of this section) the
market value of the effective notional amount of the underlying equity
instrument or equity portfolio. Swaps must be included as the notional
position in the underlying equity instrument or index portfolio, with a
receiving side treated as a long position and a paying side treated as a
short position; and
(B) For covered equity positions that are options, whether long or
short, a bank must risk weight (as described in paragraph (c)(2)(iii) of
this section) the market value of the effective notional amount of the
underlying equity instrument or index multiplied by the option's delta.
(ii) A bank may net long and short covered equity positions
(including derivatives) in identical equity issues or equity indices in
the same market.\16\
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\16\ A bank may also net positions in depository receipts against an
opposite position in the underlying equity or identical equity in
different markets, provided that the bank includes the costs of
conversion.
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(iii)(A) A bank must multiply the absolute value of the current
market value of each net long or short covered equity position by a risk
weighting factor of 8.0 percent, or by 4.0 percent if the equity is held
in a portfolio that is both liquid and well-diversified.\17\ For covered
equity positions that are index contracts comprising a well-diversified
portfolio of equity instruments, the net long or short position is
multiplied by a risk weighting factor of 2.0 percent.
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\17\ A portfolio is liquid and well-diversified if: (1) It is
characterized by a limited sensitivity to price changes of any single
equity issue or closely related group of equity issues held in the
portfolio; (2) the volatility of the portfolio's value is not dominated
by the volatility of any individual equity issue or by equity issues
from any single industry or economic sector; (3) it contains a large
number of individual equity positions, with no single position
representing a substantial portion of the portfolio's total market
value; and (4) it consists mainly of issues traded on organized
exchanges or in well-established over-the-counter markets.
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(B) For covered equity positions from the following futures-related
arbitrage strategies, a bank may apply a 2.0 percent risk weighting
factor to one side (long or short) of each position with the opposite
side exempt from charge, subject to review by the Federal Reserve:
(1) Long and short positions in exactly the same index at different
dates or in different market centers; or
(2) Long and short positions in index contracts at the same date in
different but similar indices.
(C) For futures contracts on broadly-based indices that are matched
by offsetting positions in a basket of stocks comprising the index, a
bank may apply a 2.0 percent risk weighting factor to the futures and
stock basket positions (long and short), provided that such trades are
deliberately entered into and separately controlled, and that the basket
of stocks comprises at least 90 percent of the capitalization of the
index.
(iv) The specific risk capital charge component for covered equity
positions is the sum of the weighted values.
[Reg. H, 61 FR 47370, Sept. 6, 1996, as amended at 62 FR 68067, Dec. 30,
1997; 64 FR 19037, 19038, Apr. 19, 1999; 65 FR 75858, Dec. 5, 2000]
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