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F ederal R eserve Bank

D. M c T E E R , J R .


April 9 , 1991

dallas,texas 75222

Notice 91-25

The Chief Executive Officer of each
member bank and others concerned in
the Eleventh Federal Reserve District
Joint Supervisory Policy Guidelines on
Lending Practices of Banks and Thrifts

The Federal Reserve Board, Comptroller of the Currency, Office of
Thrift Supervision, and the Federal Deposit Insurance Corporation have issued
a joint statement clarifying supervisory policies on lending practices of
banks and thrifts. The guidelines are intended to clarify regulatory policies
and reduce concerns about extensions of credit to sound borrowers.
Specifically, the joint statement:
(1) encourages disclosure of
additional information about nonaccrual loans; (2) encourages the extension of
sound loans to credit-worthy borrowers and the workout of problem loans to
sound borrowers who are experiencing temporary difficulties; (3) discusses the
supervisory technique for evaluating real estate loans; (4) addresses ques­
tions regarding the recognition of income on partially charged-off credits;
and (5) clarifies other issues which may have been perceived as impediments to
lending to credit-worthy customers.
A copy of the general statement and the joint policy guidelines are
For more information, please contact Robert Hankins at (214)
For additional copies of this notice, please contact the Public
Affairs Department at (214) 651-6289.
Sincerely yours,

For additional copies, bankers and others are encouraged to use one of the following toll-free numbers in contacting the Federal Reserve Bank of Dallas:
Dallas Office (800) 333-4460; El Paso Branch Intrastate (800) 592-1631, Interstate (800) 351-1012; Houston Branch Intrastate (800) 392-4162,
Interstate (800) 221-0363; San Antonio Branch Intrastate (800) 292-5810.

This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (

joint News Release

___ _________

Federal Reserve Board______________
Comptroller of the Currency
Office of Thrift Supervision
Federal Deposit Insurance Corporation

Recent credit problems have underscored the importance of
prudent lending practices to the overall safety and soundness of
the nation's financial system.

The emergence of credit problems

in a number of sectors of the economy has prompted many
depository institutions to review their lending practices as
well as their capacity to meet credit demands.

Many institutions

have wisely tightened credit standards where such standards had
become too loose.

Others have reduced the pace of lending in

response to the need to shore up their capital positions and
strengthen their balance sheets.
It is possible, however, that some depository institutions
may have become overly cautious in their lending practices.


some instances this caution has been attributed to concerns on
the part of lenders that the regulators of depository
institutions are applying excessively rigorous examination
The Federal banking and thrift regulators do not want the
availability of credit to sound borrowers to be adversely
affected by supervisory policies or depository institutions'
misunderstandings about them.

As a result, the agencies today

are issuing a series of guidelines and statements that are
intended to clarify regulatory policies in a number of areas and
reduce concerns depository institutions may have about extensions
of credit to sound borrowers.
statements released today:

Specifically, the guidelines and

(1) encourage enhanced disclosure to

the public,

(2) facilitate extensions of credit to sound

borrowers and the workout of problem loans, and (3) better assure
sound assessments of the value of real estate by depository
institutions and Federal examiners.
Recent concerns related to a tightening of credit have
focused the agencies' attention on regulatory policies and their
effects on institutions' willingness to extend new credit and to
work with troubled borrowers.

The guidelines and statements

released today, which have been under development for some time,
are not intended, nor are they expected, to "solve" all credit
availability problems.

When combined with other steps that have

been taken (such as lower money market interest rates and changes
in reserve requirements), these initiatives should help
facilitate prudent credit extensions to sound borrowers.
Enhanced disclosure will help to ensure that the public is
better informed about the nature of institutions' portfolios.
The new guidance recently issued by the Office of the Comptroller
of the Currency (OCC) on suggested disclosures of more detailed
information about nonaccrual loans in public financial
statements, and recent banking agency guidelines on Highly
Leveraged Transactions, should help by differentiating among
broad groups of assets with varying degrees of risk.
Depository institutions have traditionally worked with their
borrowers who are experiencing problems.

In the current economic

environment, it is especially important for institutions to avoid
shutting off credit to sound borrowers, especially in sectors of
the economy that are experiencing temporary problems.
Consistent with sound banking practices, depository
institutions, including those with low capital positions, should
work in an appropriate and constructive fashion with borrowers

who may be experiencing temporary difficulties.

Such efforts may

include reasonable workout arrangements or prudent steps to
restructure extensions of credit,

institutions that have in

place effective internal controls to manage and reduce excessive
concentrations over a reasonable period of time, need not
automatically refuse credit to sound borrowers because of the
borrower's particular industry or geographic location.
The documents released today by the Federal bank and thrift
regulatory agencies aim to facilitate the workout of problem
loans by addressing the income accrual treatment of formally
restructured debt and acquired nonaccrual loans consistent with
generally accepted accounting principles.

Further, there is a

clarification of the accounting treatment of multiple loans to a
single borrower when some, but not all, of the loans to the
borrower are troubled.
The agencies have also clarified when payments may be
recognized as income on a cash basis for loans that have been
partially charged-off.

In addition, the agencies are developing

guidelines that address how institutions can accrue income on
loans that have been partially charged-off.
Finally, the agencies are also clarifying their policies on
the supervisory valuation of real estate.

The policies provide

that the evaluation of loan loss reserves or net carrying values
for real estate loans should reflect a realistic market analysis
and not be based solely on liquidation values.

Enhanced Disclosure to the Public

Disclosure of Nonaccrual Loans

Nonaccrual loans

vary widely with respect to their quality and cash
generating capacity.

Consequently, the simple total of such


loans on an institution's books may not be a good indicator
of the institution's financial position.

One method to

address this is to provide more information to the public on
these assets.

For example, useful supplemental disclosures

might include information on the amount of charge-offs taken
on nonaccrual loans, the amount of cash payments received on
these assets, and the portion of these loans that generate
substantial cash flow.
OCC recently issued a Banking Bulletin that contains
suggestions for the voluntary disclosure of additional
information on nonaccrual loans.

The Federal regulatory

agencies fully support the voluntary disclosures of the type
suggested by the OCC and described in the attached

Disclosure of Highly Leveraged Transactions (HLTs)

The Federal banking agencies have previously developed a
uniform supervisory definition for HLTs.

The purpose of the

definition is to provide a consistent means to monitor loans
to HLT borrowers.

The agencies have recently provided the

attached additional guidance to examiners and bankers on the
application of this definition.

This guidance stresses that

the HLT designation does not imply a supervisory criticism
of the credit.
The guidance also makes clear that certain extensions
of credit, such as loans to debtors-in-possession (DIPs), do
not fit the definition of HLT loans and should not be so

The criteria for the removal of a loan from HLT

status have been expanded in the attached document.


agencies will continue to review these criteria to determine
if other steps are warranted in view of the characteristics
and performance of HLT credits, including the quality and

reliability of the borrower's cash flow.

Other Lending Issues
There appears to be some concern that any new lending

by institutions that fail to meet minimum capital
requirements will result in supervisory criticism.

While it

is essential that depository institutions that fail to meet
minimum capital standards take effective and timely steps to
address this deficiency, such institutions are not
necessarily required to cease prudent, low-risk lending

Institutions should attain capital compliance

in a prudent manner that strengthens their financial

Institutions that seek to improve their

capital-to-assets ratios through shrinking their balance
sheets should avoid actions that raise their risk exposure,
such as the sale of all high-quality assets or of core

Such actions by themselves, or the refusal to

lend to sound borrowers, fail to achieve the important
objective of improving the quality of under-capitalized
institutions' portfolios.
The agencies share common procedures to address capital
deficiencies at depository institutions.

In general, each

agency requires such institutions to prepare a plan that
details the steps they will take to attain the minimum
capital levels.

Approved plans generally do not preclude a

continuation of sound lending activities, including prudent
steps to work with borrowers encountering financial
Similarly, there appears to be some concern that
institutions with loan concentrations are automatically
turning down good loans.

The benefits of adequate portfolio

diversification are well recognized by depository
institutions and their regulators.

Although the regulatory

agencies have not established rigid rules on asset
concentrations, they are in agreement that, as a matter of
sound operating policy, depository institutions should
establish and adhere to policies that control "concentration
Institutions that have in place effective internal
controls to manage and reduce undue concentrations over a
reasonable period of time, need not automatically refuse
credit to sound borrowers.

The purpose of institutions'

policies should be to improve the overall quality of their

The replacement of unsound loans with sound

loans can enhance the quality of a depository institution's
portfolio, even when concentration levels are not reduced.

Recognition of Income on Certain Nonperforminq Loans
Questions have been raised regarding the recognition of

income on loans that have been partially charged-off.


subject is not explicitly addressed in the agencies'
regulatory reporting requirements.

The agencies wish to

clarify that payments can be recognized as income on a cash
basis for loans that have been partially charged-off,
without requiring that the prior charge-off first be
recovered, so long as the remaining book balance is deemed
fully collectible.
The agencies, along with the Securities and Exchange
Commission (SEC), each plan to solicit public comment on
proposed guidelines which would allow certain nonperforming
loans to be placed back on accrual status once the loans are
reduced to an appropriate level through charge-offs.


formal guidance issued will be based on the comments
received from the public and on-going discussions between
the agencies and the SEC.
The agencies have released today supervisory guidance
on a variety of other issues related to nonaccrual assets
and formally restructured debt.

These guidelines include a

discussion of regulatory requirements related to cash basis
income recognition, multiple loans to one borrower, and the
acquisition of nonaccrual assets.

Valuation of Real Estate Loans
In recent months, there have beensignificantdeclines

in real estate values in certain markets.



these declines, examiners have reviewed the adequacy of
institutions' loan loss reserves and, where they believed it
appropriate, have required additional reserves based on, in
part, their estimates of real estate values.
These actions have focused attention on the techniques
used to assess the value of real estate, especially
commercial real estate.

It is important that valuation

techniques reflect not only existing market conditions, but
also reasonable expectations of the property's performance
in the market over time.

The Federal regulatory agencies

are reiterating their policy on the assessment of real
estate values and the establishment of loan loss reserves.
The basic thrust of this guidance is to ensure that
income property loans not be assessed solely on the basis of
liquidation values but also on the income-producing capacity
of the properties over time.

Supervisory evaluations should

take into account the lack of liquidity and cyclical nature

of real estate markets and the temporary imbalances in the
supply and demand for real estate that may occur.

Review of Supervisory Findings
The agencies want to make clear their policy that any

institution may request a review of any major decision
reached as part of the supervisory process, including those
related to asset classification and required reserve levels.


The purpose of the attached schedule is to provide a
suggested format to banking and thrift organizations for
reporting more information in public disclosures about nonaccrual
assets, including loans, leases, and securities.

The additional

disclosures presented in this guidance are not required.
However, financial institutions are encouraged to disclose
publicly this type of information or other information deemed
useful or relevant, in order to improve understanding of the
impact of nonaccrual assets on the institution's financial
condition and results of operations.

Such disclosures may

utilize whatever format is considered appropriate by the
financial institution.
In recent months, the financial institutions industry and
their analysts have placed increasing emphasis on the amount of
nonaccrual assets at banking and thrift organisations.


public disclosures about these assets have generally been limited
to the total amount of nonaccrual assets, interest income, and
interest foregone.

Such information may not be sufficient to

fully explain the impact of nonaccrual assets on the earnings and
financial condition of financial institutions.

As a result, some

financial institutions have said they want to make additional
disclosures about nonaccrual assets in their annual reports.
Attached is an example of a format that could be used to
provide additional information on the characteristics of
nonaccrual assets and their contribution to net income.


information may prove useful in assessing the prospects for the
orderly workout and ultimate repayment of assets placed in
nonaccrual status.

Nonaccrual loans to developing countries are

-2not intended to be included in the attached example, because
these are generally disclosed separately.
The detail provided in the example may not be considered
appropriate or necessary for all banks.

Some banks may elect to

disclose more specific categories of nonaccrual assets or only
part of the data in the example.

Others may wish to disclose

principal payments on nonaccrual assets, associated collateral
values, or other significant facts.

Financial institutions may

also consider providing appropriate similar disclosures related
to other real estate owned,

including net cash inflows from the

properties, and a segregation of properties with significant net
cash inflows.


Generally, the accrual of Income is discontinued when the full collection of principal or interest is in doubt, or when the
payment of principal or interest has become contractually 90 days past due unless the obligation is both well secured and in
the process of collection. Nonaccrual loans amounted to $___ at December 31, 1990. This amount is net of aggregate
charge-offs on these loans of $____.
Further information regarding the balance of nonaccrual loans at December 31, 1990, and related interest payment
information, is as follows:
Book balance
at December
31, 1990
_____ L5J____

balance at
December 31,

Cash interest payments applied as <6)<7)
recovery of
prior partial
reduction of
_ charqe-pffa

___ ma _____

Contractually past due with:

substantial performance (1 )
limited performance (2)
no performance



Contractually current, however,:

payment in full of principal
or interest in doubt (3)
other (4)












While unable to cure contractual delinquency, the borrower

in this category would be consistently making substantial
periodic payments relative to the required periodic payments due.
If substantial performance is disclosed, management should be
able to identify a threshold of performance which it considers to
be substantial.

While there is not a specified minimum, the

threshold should be sufficient to provide a meaningful
distinction within the information disclosed.

This threshold or

definition used should also be disclosed.
The determination of substantial performance will differ
depending upon the loan repayment terms.

For amortizing loans,

both principal and interest payments would likely be considered.
For loans with contractual interest-only payments and then a
single principal payment at a specified time, interest
performance only might be considered.

However, if a significant

principal payment were missed, then performance would likely be
considered something less than substantial.

In any event,

management should disclose its definition of "substantial"

Borrower is demonstrating less than substantial performance,

as defined, but is making some periodic payment.

While not contractually past due, the loan has been placed

on nonaccrual status due to doubt as to the full collection of
principal or interest.

Interest payments on such loans are being

applied to reduce principal to the extent necessary to eliminate
doubt as to full collectibility of the book balance.

There is no longer doubt as to full collectibility of

principal or interest.
reported as nonaccrual.

However, for other reasons, the loan is
For example, interest income is being

-2recorded on a cash basis, while the borrower demonstrates a
period of performance or interest payments are recorded as loan
loss recoveries.

Net of charge-offs to-date and interest payments applied to


The book balance should not include any reductions

for any allocations of the allowance for loan and lease losses,
if such allocations are made.

Represents the application of cash interest payments during

1990, on the loans in nonaccrual status at December 31, 1990,
from the time those loans were placed on nonaccrual status.


amount should not include the cash interest payments during the
year from any of these loans prior to their placement on
nonaccrual status.
It will be likely that some loans will move between categories
between reporting dates.

In such cases, year-to-date cash

interest payment data would be reclassified to the same category
where the period-end balance is reported.

Additionally, management may consider it useful to disclose

the yield provided from cash payments of interest on nonaccrual

A simple rate might be disclosed or data provided to

allow the reader to determine the yield, as follows:

As the cash interest data in the table relates to

year-end balances only, the disclosure might provide a
weighted average book balance of loans on nonaccrual status
at December 31, 1990, for the period they were in nonaccrual
status during the year then ended.

The average balances

would be properly weighted when aggregated, to reflect the
relative amount of time within the year that individual
loans were in nonaccrual status.


It may prove difficult to monitor and report weighted

average balances suggested in (a) , above, because they
relate to period-end balances.

Alternatively, management

might supplement the suggested tabular disclosure with the
following two disclosures related to nonaccrual activity for
the entire reporting period:
Cash interest payments on all nonaccrual loans while in
nonaccrual status during the period (including loans no
longer in nonaccrual status at period end).

The amount

of payments applied to principal should generally be
distinguished from those which contributed directly to
income to facilitate the determination of yields.
Average balance of all nonaccrual loans during the


The guidelines below are intended to supplement the
uniform interagency definition of HLTs and the existing
procedures for applying this definition.

A highly-leveraged transaction is a type of

financing which involves the restructuring of an ongoing business
concern financed primarily with debt.

The purpose of an

individual credit is most important when initially determining
HLT status.

Once an individual credit is designated as an HLT,

all currently outstanding and future obligations of the same
borrower are also included in HLT totals until such time as the
borrower is removed from HLT status.
The regulatory purpose of the HLT definition is to
provide a consistent means of aggregating and monitoring this
type of financing transaction.

The HLT designation does not

imply a supervisory criticism of a credit.
other credit is criticized,

Before any HLT or any

an examiner reviews a whole range of

factors on a credit-by-credit basis.

These factors include cash

flow, general ability to pay interest and principal on
outstanding debt, economic conditions and trends,

the borrower's

future prospects, the quality and continuity of the borrower's
management, and the lender's collateral position.


of banking organizations in highly-leveraged transactions is not
considered inappropriate so long as it is conducted in a sound
and prudent manner, including the maintenance of adequate capital
and loan loss reserves to support the risks associated with these

Treatment of Debtor-In-Possession (DIP^ Financings.
The agencies have further considered the question of whether some
DIP loans should be included in the HLT portfolio.

One important

consideration in this regard is that the bankruptcy estate is
considered a legally separate and distinct borrower from the pre­
bankruptcy borrower.

In addition, loans to DIPs generally do not

meet the HLT purpose test.

Further, the Chapter 11 bankruptcy

code is designed to promote DIP lending and, thereby, affords
significant protection to DIP lenders in order to preserve the
value of the bankruptcy estate and to promote rehabilitation of
the debtor.

Therefore, court-approved debtor-in-possession (or


financing for a business concern in

Chapter 11 reorganization proceedings will generally be exempt
from HLT designation.

All pre-petition debt of an HLT borrower

and any post-reorganization debt (after a company emerges from
Chapter 11 bankruptcy) will continue to be included in HLT
exposure until delisting occurs.
Guidance on Delisting Credits from HLT Status.


are being added to the specific HLT delisting criteria that make
borrowers eligible for delisting from HLT status when all direct
buyout, acquisition, or recapitalization debt satisfying the HLT
purpose test has been paid and when companies perform well for
an extended period of time, despite operating with high leverage.
Further, the wording of the specific delisting criteria
pertaining to exposures designated as HLTs because of the 75
percent leverage test is being made consistent with these new

The general delisting criteria are reiterated below

along with the four specific ways to become eligible for
delisting from HLT status.
(a) General Criteria —

For credits to become eligible for

removal from HLT status, a company must demonstrate an
ability to operate successfully as a highly-leveraged

company over a period of time.

Under normal circumstances,

two years should be sufficient for the credit to show
performance and to validate the appropriateness of

The banking organization should conduct a

thorough review of the obligor to include, at a minimum,
overall management performance against the business plan,
cash flow coverages, operating margins, status of asset
sales, if applicable, reduction in leverage, and industry

Specific Criteria —

In addition to these general

criteria, at least cne of the following specific criteria
must be met to become eligible for delisting:
(1) For exposures that were included because of the 75
percent leverage test, exposures are eligible for
delisting from HLT status when leverage is reduced
below 7 5 percent, and the company has demonstrated an
ability to continue servicing debt satisfactorily
without undue reliance on unplanned asset sales.
(2) If two years have passed since a company's most
recent acquisition, buyout, or recapitalization
satisfying the HLT purpose test, then the borrower's
credits are eligible for delisting from HLT status if
ail debt satisfying the HLT purpose test is repaid in
full, even if the borrower's total liabilities to total
assets leverage ratio continues to exceed 75 percent.
The refinancing of HLT purpose-related debt through
additional borrowings does not constitute a repayment
of HLT debt.

Rather, the repayment of debt must occur

from cash generated from operations, planned sales of
assets, or a capital injection.

(3) For exposures that were included because of the 75
percent leverage test, a borrower's credits are
eligible for delisting when the borrower satisfies the
general performance criteria for delisting for at least








acquisition, or recapitalization involving financing; the


a positive

net worth;




leverage ratio does not significantly exceed its industry

Although this criteria does not require leverage

to be reduced to less than 7 5 percent, the borrower must
demonstrate an ability to continue servicing debt
satisfactorily without undue reliance on unplanned
asset sales.
(4) For those exposures that arose under the "doubling
of liabilities to greater than 50 percent" leverage
criteria, delisting is acceptable based upon the
general criteria in (a) above and a demonstrated
ability to satisfactorily continue to service the debt.
As was stated in previous guidance,

any significant changes

in the borrower's financial condition after delisting should
cause the exposure to be reviewed for relisting.


Cash basis income recognition.

Current regulatory

reporting requirements do not preclude the cash basis
recognition of income on nonaccrual assets (including loans
that have been partially charged off), provided that the
remaining book balance of the loan is deemed fully collectible.
Recognition of interest income on a cash basis should
be limited to that which would have been accrued on the
recorded balance at the contractual rate.

Any cash interest

received in excess of this limit should be recorded as
recoveries of prior charge-offs until these charge-offs have
been fully recovered.



one borrower.


a general


nonaccrual status for an asset should be determined based on an
assessment of the individual asset's collectibility and payment
ability and performance.
placed in nonaccrual

Thus, when one loan to a borrower is


a depository

institution does not

automatically have to place all other extensions of credit to that
borrower in nonaccrual status.

When a depository institution has

multiple loans or other extensions of credit outstanding to
a single borrower,


and one


loan meets




for nonaccrual




extensions of credit to that borrower to determine whether one or
more of these other assets should also be placed in nonaccrual
Acquisition of nonaccrual assets.

A depository institution

(or the receiver of a failed institution) may sell loans or debt









Such loans or debt securities that have been acquired from

an unaffiliated third party by a depository institution should be



Bulletin No. 6.







When the criteria specified in this Bulletin are

met, these assets may be placed in accrual status.1
Treatment of formally restructured debt. A loan or other debt
instrument that has been formally restructured in accordance with
FASB Statement No. 15 so as to be reasonably assured of repayment
and of performance according to a reasonable repayment schedule
need not be maintained in a nonaccrual status.2
loan to accrual status,

In returning the

sustained historical payment performance

for a reasonable time prior to the restructuring may be taken into
A FASB 15 restructuring may result in a market yield on the
recorded investment in the loan, i.e., an effective interest rate

is equal




that the



willing to accept for a new loan with comparable risk.


While a

loan or other debt instrument that qualifies as a FASB Statement
No. 15 restructuring must be disclosed as such in the year that the
restructuring took place,

restructured assets that yield market

rates of interest need not continue to be reported as FASB 15
troubled debt restructurings in subsequent years.

1 Practice Bulletin No. 6, Amortization of Discounts on
Certain Acquired Loans. American Institute of Certified
Public Accountants, August 1989.
2 Statement of Financial Accounting Standards No. 15,
for_ Troubled- Qeb£
Restructurings. Financial Accounting Standards Board, June

Other issues.

Because an analysis of the Allowance for Loan

and Lease Losses






requires an assessment of the relative





attribute for analytical purposes portions of the ALLL to loans and



supervisory agency.








Management may do this because it believes,
















category in the aggregate.
Furthermore, management may use this analytical approach in
estimating the total amount necessary for the ALLL and in comparing
the ALLL to various categories of loans over time.





As a general

substandard may



accrual status as long as the regulatory reporting requirements for
accrual treatment are met, even when an attribution of the ALLL has
been made.

Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102