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January 28, 1958

ISemor&n&usi far Mr. Upimm

Lawrence (Clayton

This is In reply to your telephone request lor a brief statement of the policy of the Federal Beserve System respecting four
questions involved in examination policy* fbe questions and the
policy with reference thereto are gat forth separately below, I
have changed the order of the points la order to dispose of the
siaple ones first.
(1) What kind of securities can be purchased for investment by
member banks?
This matter is governed by the Comptroller*a Regulation
on Investment Securities since State member banks are by law
subjected to the same standards to which national banks ©re
(2) What is the Reserve System policy respecting unrealised appreciation in securities?
Axxj such appreciation is aot treated a s profitj hows
even appreciation in any part of the se&ber bank's portfolio say be used to offset depreciation in any other part
of the portfolio,
(3) What is the Reserve Systea policy respecting depreciation in
a member bankfs securities?

Jkn lo this the Reserve S y i — policy differentiates between so-called group 1 securities and other securities.
Group 1 securities include the following*

Issues of the United States Government, direct
or fully guaranteed,
fe* Issues of federal i*and and Intermediate Credit

Mr. Uphaa - 2

Issues considered of good standing, and not in
default, of States and Municipalities In the
United States and of the territories and insular

miscellaneous issues in the four highest grades
as classified by a recognized investment service
organisation regularly engaged in the business
of rating or grading securities.

Depreciation is otner grades ie shots M losr except that &B
noted in #2 above any appreciation in group 1 securities may Im
offset against such depreciation and the net depreciation osly is
required to be treated as loss.
(4) Hhat is th© Reserve System policy respecting profits realized
by member banks dp the sale of securities?

there is no rule of examination policy of the Federal,
Reserve System nor is there any sanction in law for treating
such profits differently froa profits realised fro® any other
banking operation. The policy involved here is really a part
of the System's policy with reference to the sound capital and
reserves of seiaber banks. Thus if a member bank should realise
a large profit from the sale of securities and the securities
sold were replaced by others on a high market, the Federal reserve exaiainer *?ould require that such portion of the profits
be transferred to the bank's reserves as would be n#c©ssary to
sake adequate provision for possible loss in th© securities
purchased. On the othar hand, where a bank is carrying a
large portfolio, particularly where it is weighted heavily with
non-government issues and no profits have been realised om the
sale of securitiesv our ex&adners would require that anappropriate portion of profits realised from other banking operations
should be transferred to reserve which would be available to absorb loss in securities.. Thus the treatment of profits realized
from sales of securities as well as any other profits realized by
the ae&ber bank is subjected to the System policy respecting the
adequacy of net capital and surplus funds which include, of course,
reserves. At the time of applying for membership, State banks
are uniformly required to agree, among other things, that "the
net capital and surplus funds of such bank shall be adequate in


Upfaaa - 3

relation to the character and condition of its assets aad
to its deposit liabilities aad other corporate responsibilities**

very truly,

Assistant to the Chairaan


Fo*m F. B. 131


Office Correspondence

Mr. Eccles

Date January 28, 1958

Mr. Clayton

At 10:15 this morning Cy Upham called and said the
Secretary would like the information regarding the System's
policy on bond profits, appreciation and depreciation by
10:45. I told him it would be impossible to get him a
written memorandum by that time so I gave him the high
spots over the telephone. My memorandum was completed
about 10:45 and I called Leo Paulger down to check it.
Leo is not entirely in accord with the statement under
(4) which is the matter we discussed yesterday evening.
He does not specifically object to what if said but would
like to say that the System policy requires that bond
profits be set aside in reserves unless the bank has already accumulated ample reserves for all other losses
plus about 25/b of the bond portfolio. He does not like
to admit that bond profits are treated the same as any
other profits.
As a matter of fact, after an extended discussion
with Leo and referring to the extensive file on this
question, it appears that the System does not have a firm
policy. The last instructions on the matter were issued
to the Federal reserve agents in December 1953 and April
1954. These instructions exempted group 1 securities from
any charge-off requirement but stated "it is believed that
the Federal Reserve Agents should endeavor generally to obtain the same corrections on the part of State member banks
as ?/ould be required in the case of banks applying for membership in the System." It is interesting to note that in
carrying out this 'tendeavor policy" there is considerable
variation among the several reserve banks in spite of the
fact that in transferring the examining function to the
banks;we specifically reserved the right in effect to
determine policy.
In view of the above, do you think the attached memorandum, even if in accord with your personal views, should
go to the Treasury? Perhaps your meeting this morning offers
a way out.