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FED E R A L R ESER VE BANK OF NEW YORK ["Circular No. 7 3 2 4 t L January 21, 1974 J REGULATION H Proposed Amendments Regarding Standby Letters of Credit and Ineligible Acceptances by State Member Banks T o A ll M em ber Banks, and O thers Concerned, in the Second Federal R eserve D istrict: The following statement was issued January 17 by the Board of Governors of the Federal Reserve System: T h e B oard o f G overnors of the Federal Reserve System today proposed limitations on the issuance o f socalled standby letters of credit and ineligible acceptances by State banks that are members o f the Federal R e serve. Com m ent on the proposal should be received by the Board by M arch 15, 1974. T he B oa rd ’s proposal w ould require State mem ber banks to treat standby letters of credit and ineligible acceptances in the same manner that they treat ordinary loans. T his means that the instruments would be subject to State restrictions on the amount o f credit provided to any one borrow er and to Federal require ments on loans to affiliates. A s part of a coordinated approach to the matter, similar proposals are also being issued for banks under their supervision by the Com ptroller of the C urrency and the Federal Deposit Insurance C orporation. A standby letter o f credit does not norm ally involve an immediate outlay of funds by a bank. Such a let ter, how ever, creates an obligation of the bank that involves a credit risk and could result in an outflow of funds at a later date. Banks sometimes issue standby letters o f credit to businesses that use them to support their ow n notes that are sold in the m oney markets to raise funds either for long-term investment or for general short-term w orking capital. S o used, these fetters of credit function virtually as a guaranty by a bank o f the business m en’s note. T hese instruments are sometimes called docum ented discount notes. A n ineligible acceptance is a time draft, accepted by a bank, which does not meet the requirements for discount by a Federal R eserve Bank. Both standby letters of credit and ineligible acceptances are similar in sofar as credit risk is concerned because the timing, am ount and degree o f exposure can be virtually identical in the tw o types of transactions. T he B oard proposal w ould treat the issuance of both instruments as an unsafe or unsound banking practice in any case where the issuing bank does not subject the instruments to credit practices and require ments similar to those that are applied to ordinary loans. T he proposal would not affect “ traditional” letters o f credit used to finance the shipment of goods. Printed on the reverse side is the text of the Board of Governors’ proposal. Comments thereon should be submitted by March 15 and may be sent to our Regulations and Bank Analysis De partment. A lfred H a y e s, President. (Reg. H) MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE FEDERAL RESERVE SYSTEM Standby Letters of Credit and Ineligible Acceptances T he Board has under current consideration regulatory action with respect to certain practices which have d e veloped in the issuance o f some standby letters o f credit and ineligible acceptances by State member banks. F or the purposes of this proposal, standby letters of credit include every letter of credit (o r similar arrange ment, howrever named or d escrib ed ), other than a letter of credit issued to facilitate the sale of good s and under which sight drafts or bankers’ acceptances of the kind eligible, or which w ould becom e eligible, fo r discount by a Federal R eserve Bank under Regulation A , could be drawn. Standby letters o f credit would include, but not be limited to, letters of credit attached to prom issory notes (so-called docum ented discount n o te s). A n ineli gible acceptance is a time draft, accepted by a bank, which does not meet the requirements for rediscount writh a Federal Reserve Bank. A standby letter o f credit, unlike an ordinary loan, does not usually involve an immediate outlay of funds by the issuing bank. T h e standby letter of credit creates an obligation of the bank that may mature into a current liability, how ever, and, in this regard, the standby letter o f credit and the loan involve a similar degree of credit risk. T he risk exposure of an issuing bank under a letter of credit obligation is demonstrated by the fo llo w ing e x a m p les: If a standby letter of credit is issued with a p ro vision that the beneficiary o f the letter may collect from the bank upon default o f the account party under a construction contract, and if fo r any reason at any time perform ance of the contract is not accepted, the bank could be required to pay. In the case o f the issuance o f a documented discount note, the duty o f the issuing bank is to pay the beneficiary in the event the account party does not pay. W h ile the bank might have legal re course to the account party for payment of the o b ligation, often such party may be found insolvent. In both o f the above exam ples, the issuing bank may be called upon at any time to disburse funds and, should the account party becom e insolvent, the issuing bank is situated as if a b orrow er under an ordinary loan agreement had becom e insolvent. In view of the foregoing, safe and sound banking practices would require that the credit of the account party under a standby letter of credit be exam ined with the same care as the credit of a potential b orrow er in an ordinary loan situation. W ith respect to credit risk, the timing, amount, and degree o f exposure to risk, standby letters of credit and ineligible acceptances are virtually identical. In view of these and other considerations that are involved in the issue o f standby letters of credit and ineligible acceptances, the B oard proposes to amend Federal R eserve R egulation H (1 2 C F R 2 0 8 ), M em bership of State Banking Institutions in the Federal R eserve System. T he proposed amendment w ould aggregate in each bank the amounts of standby letters of credit and ineli gible acceptances with other loans in determining whether each bank w ould exceed Federal and State loan limitations. M oreover, a bank wrould be required to subject the account party to credit analysis equivalent to that applicable to a potential b orrow er in an ordinary situation. T he proposed amendment also requires that the total amount o f standby letters o f credit and ineligi ble acceptances be adequately disclosed on published financial statements. If the proposed amendments are adopted, the B oard will use its cease and desist pow ers (1 2 U .S .C . 1 8 1 8 (b )) with respect to any violation of the regulation. T he B oard will not regard the issuance of standby letters of credit and ineligible acceptances within the proposed guidelines as an unsound practice. T he Board believes these instruments, if issued prudently, can provide flexibility in financial transactions and be used in current com m ercial practices. T his notice is published for com m ent pursuant to Section 5 5 3 (b ) o f Title 5, U nited States Code and Section 2 6 2 .2 (a ) o f the Rules o f Procedure of the B oard of G overnors, and pursuant to the B oard’s super visory authority over State member banks contained in Section 9 (1 2 U .S .C . 321) and Section 11 (1 2 U .S .C . 2 4 8 (a ) and ( o ) ) of the Federal Reserve A ct, and the Financial Institutions Supervisory A ct o f 1966 (1 2 U .S .C . 1 8 1 8 ( b ) ) , and related provisions of the law. A n y com m ents should be submitted in writing to the Secretary, Board of G overnors of the Federal R eserve System, W ashington, D. C. 20551, to be received not later than M arch 15, 1974. Such material will be made available fo r inspection and copyin g on request, except as provided in section 2 6 1 .6 (a ) of the B oard’s Rules Regarding Availability of Inform ation. T o implement its proposal, the Board is consideringam ending Regulation H (1 2 C F R 2 0 8 ) by adding a new section 208.8, “ Banking practices,” and renum bering the succeeding sections as set forth below. 1. T he table of contents of Part 208 wrould be changed to read as fo llo w s : SEC. 208.1 208.2 208.3 208.4 208.5 208.6 208.7 208.8 208.9 208.10 Definitions E ligibility requirements Insurance o f deposits A pplication for mem bership A pproval o f application Privileges and requirements o f membership Conditions of membership Banking practices Establishment or maintenance of branches Publication of reports o f member banks and their affiliates 208.11 V oluntary withdrawal from Federal Reserve System 208.12 Board form s 2. A s an incident to these amendments, sections 208.8, 208.9, 208.10, and 208.11 w ould be redesignated 208.9, 208.10, 208.11, and 208.12, respectively. nevertheless to be an unsafe or unsound banking p rac tice. A new section 208.8 would be added, as fo llo w s : ( 1 ) R e striction . A State mem ber bank shall aggregate the amounts o f any and all outstanding stand by letters o f credit (o r other similar arrangements, how ever named or d escrib ed ), ineligible acceptances, and loans in determ ining whether the bank w ou ld be in excess o f State legal limitations on loans o f the bank (including limitations on loans to any one borrow er or on aggregate loan s) or on legal limits pertaining to loans to affiliates under Federal law (1 2 U .S .C . 3 7 1 c). In addition, the credit standing o f the account party under any letter of credit a n d /o r the credit standing o f the custom er under the ineligible acceptance must be the subject o f credit analysis equivalent to that applica ble to a potential borrow er in an ordinary loan situation. S E C T I O N 208.8— B A N K I N G P R A C T I C E S ( a ) Scope. N o State member bank shall engage in practices which are unsafe or unsound or which result in a violation of law, rule, or regulation, or which v io late any condition im posed by or agreements entered into with the Board. T his section outlines certain of the practices in which State member banks should not engage. ( b ) Waiver. A State member bank has the right to petition the Board to waive the conditions o f section 208.8. A waiver may be granted upon a show ing of g ood cause. T he B oard in its discretion may choose to limit, am ong other items, the scope, duration, and tim ing of the waiver. ( c ) Effect on other banking practices. N othing in this section shall be construed as restricting in any manner the B oard’ s authority to deal with any banking practice which is deemed to be unsafe or unsound or otherwise not in accordance with law, rule, or regula tion or which violates any condition im posed in writing by the B oard in connection with the granting o f any application or other request by a State member bank, or any written agreement entered into by such bank with the B oard. Com pliance with the provisions o f this section shall neither relieve a State member bank o f its duty to conduct all operations in a safe and sound m an ner nor prevent the B oard from taking whatever action it deems necessary and desirable to deal with general or specific acts or practices which, although perhaps not violating the provisions of this section, are considered ( d ) Letters of credit and ineligible acceptances. ( 2 ) Definitions. F or the purposes of this para graph, standby letters o f credit include every letter of credit (o r similar arrangement, how ever named or de scrib e d ), other than a letter o f credit issued to facilitate the sale of g ood s and under which sight drafts or bankers’ acceptances of the kind eligible or w hich w ould becom e eligible for discount by a Federal R eserve Bank under R egulation A , could be drawn. Standby letters of credit w ould include, but not be limited to, letters o f credit attached to prom issory notes (so-ca lled d ocu mented discount n o te s). A n ineligible acceptance is a time draft, accepted by a bank, which does not meet the requirements for rediscount with a Federal R eserve Bank. ( 3 ) D isclosu re. T h e amount and general term of outstanding standby letters o f credit and ineligible acceptances shall be adequately disclosed in the bank’ s published financial statements.
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