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Federal Reserve Bank OF DALLAS ROBERT D. M c T E E R , J R . P R E S ID E N T AND C H IE F E X E C U T IV E O F F IC E R January 7, 1993 DALLAS, TEXAS 75222 Notice 93-04 TO: The Chief Executive Officer of each member bank and others concerned in the Eleventh Federal Reserve District SUBJECT Interim Rule and Request for Comments on Risk-based Capital Guidelines DETAILS The Federal Reserve Board has issued an interim rule amending the risk-based capital guidelines for state member banks and holding companies to lower from 100 to 50 percent the risk weight on loans to finance the construc tion of 1- to 4-family residences that have been presold. The interim rule, which became effective December 29, 1992, amends the B o a r d ’s Regulation H and Regulation Y and will be reviewed by the Board after the receipt of public comment. The interim rule implements section 618 (a) of the Resolution Trust Corporation Refinancing, Restructuring, and Improvement Act of 1991 (RTCRRIA). The Board must receive comments by January 27, 1993. Comments should be addressed to William W. Wiles, Secretary, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue, N.W., Washington, D.C. 20551. All comments should refer to Docket No. R-0787. ATTACHMENT A copy of the Bo a r d ’s notice (Federal Reserve System Docket No. R-0787) is attached. MORE INFORMATION For more information, please contact Dorsey Davis at (214) 922-6051. For additional copies of this B a n k ’s notice, please contact the Public Affairs Department at (214) 922-5254. Sincerely yours, 'fiW ' B . . 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 (FedHistory@dal.frb.org) FEDERAL RESERVE SYSTEM 12 CFR Parts 208 and 225 [Regulations H and Y; Docket No. R-0787] Capital; Capital Adequacy Guidelines AGENCY: Board of Governors of the Federal Reserve System. ACTION: Interim rule with request for comments. SUMMARY: The Federal Reserve is amending its risk-based capital guidelines to lower from 100 percent to 50 percent the risk weight assigned to certain loans to builders to finance the construction of presold residential (1- to 4-family) properties. This interim rule implements section 618(a) of the Resolution Trust Corporation Refinancing, Restructuring, and Improvement Act of 1991 (RTCRRIA). In February 1992, the Federal Reserve, under the auspices of the Federal Financial Institutions Examination Council (FFIEC), sought public comment on a proposal to implement section 618(a) of RTCRRIA through a change to the commercial bank Consolidated Reports of Condition and Income (Call Report). It was suggested in the comments that section 618(a) of the RTCRRIA be implemented through an amendment to the Federal banking agencies’ risk-based capital rules and guidelines instead of to the Call Report. The Board has determined to adopt this suggestion as an alternative to the original proposal. The Board has adopted this change to the risk-based capital guidelines on an interim basis in order to provide interested parties an opportunity to comment on this approach. EFFECTIVE DATE: This interim rule is effective as of December 29, 1992. Comments must be received by January 27, 1993. ADDRESSES: Comments should be addressed to Mr. William Wiles, Secretary of the Board, Board of Governors of the Federal Reserve System, 20th and Constitution Avenue NW., Washington, DC 20551, or delivered to room B-2223, Eccles Building, between 8:45 am and 5 pm. Comments may be inspected in room B -l 122 between 9 am and 5 pm, except as provided in § 261.8 of the Board’s Rules Regarding Availability of Information, 12 CFR 261.8. FOR FURTHER INFORMATION CONTACT: Rhoger H. Pugh, Assistant Director (202/ 728-5883), Norah M. Barger, Manager (202/452-2402), and Robert E. Motyka, Senior Financial Analyst (202/452-3621), Division of Banking Supervision and Regulation, Board of Governors of the Federal Reserve System. For the hearing impaired only, Telecommunication Device for the Deaf (TDD), Dorothea Thompson (202/452-3544), Board of Governors of the Federal Reserve System, 20th and C Streets, NW., Washington, DC 20551. SUPPLEMENTARY INFORMATION: 2 Background The international bank capital standards (Basle Accord)1 place all assets into the 100 percent risk category unless the asset specifically qualifies for a preferential risk category. In this regard, the Accord allows member countries at their discretion to assign a 50 percent risk weight to loans secured by residential property provided that such loans are fully secured by mortgages on residential property that is rented or is occupied (or is intended to be occupied) by the borrower and the risk weight is applied in accordance with strict prudential criteria. The U.S. risk-based capital guidelines, which implement the Basle Accord, assign 1- to 4-family residential mortgages that meet certain criteria to the 50 percent risk category. In order to qualify for a 50 percent risk weight, a loan secured by a 1- to 4-family residential property must be a first lien; must be made in accordance with prudent underwriting standards, including a conservative loan-to-value ratio; must be performing in accordance with its original terms; and must not be more than 90 days past due or carried in nonaccrual status. The U.S. risk-based capital guidelines assign loans to builders to finance the construction of residential properties that have been presold to purchasers who intend to occupy the property to the 100 percent risk category on the basis of the perceived inherent riskiness of these loans. Under the Basle Accord such loans could, at national discretion, be assigned a 50 percent risk weight. After the risk-based capital guidelines were adopted, the Federal Reserve along with the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and the Office of Thrift Supervision (OTS) reexamined the issue of the capital treatment of residential mortgages. Specifically, the banking agencies considered the appropriateness of applying a 50 percent risk weight to certain loans to builders to finance the construction of residential properties that have been presold to qualifying individuals. Before the agencies proceeded with a proposal, Congress enacted the RTCRRIA on December 12, 1991. Section 618(a) of the Act requires the Federal banking agencies to provide for a risk weight of 50 percent in their regulations and guidelines for any single family residential construction loan that meets the following criteria: (1) The loan is for the construction of 1- to 4-family residential property; (2) The bank has sufficient documentation, as may be required by the appropriate Federal banking agency, to demonstrate the intent and ability of the buyer to purchase the property; 1 The Basle Accord is a risk-based capital framework that was proposed by the Basle Committee on Banking Regulations and Supervisory Practices and endorsed by the central bank governors o f the Group o f Ten (G-10) countries in July 1988. The Committee is comprised o f representatives o f the central banks and supervisory authorities from the G-10 countries (Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, Switzerland, the United Kingdom, and the United States) and Luxembourg. 3 (3) The purchaser provides to the builder a nonrefundable deposit in an amount determined by the appropriate Federal banking agency, but not less than 1 percent of the principal amount of the mortgage; and (4) The loan satisfies prudent underwriting standards as established by the appropriate Federal banking agency. In order to effect a lower risk weight for these loans in conformance with the legislation, the agencies decided to propose expanding the definition of loans “ secured by 1- to 4-family residential properties” contained in the commercial bank Call Report to include presold residential construction loans that meet certain criteria. In this regard, the FFTEC published for comment on February 3, 1992, a proposal to add to the list of loans that are secured by 1- to 4-family residential properties, and exclude from the list of loans made for the purpose of construction and land development, loans that are “ made in accordance with sound lending principles 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.” For the Federal Reserve and the FDIC, the proposed definitional change would have resulted in lowering the risk weight for presold 1- to 4-family residential construction loans because these agencies’ risk-based capital guidelines assign loans that meet the Call Report definition of 1- to 4-family residential mortgages to the 50 percent risk category. The definitional change would have had no effect on the risk weight for presold residential construction loans held by national banks or thrifts since neither the OCC’s nor the OTS’s risk-based capital rules reference the Call Report definition for loans secured by 1- to 4-family residential properties. As a result, both the OCC and OTS were required to amend their risk-based capital rules to effect the lower risk weight. The OTS amendment became effective May 13, 1992, while the OCC amendment became effective October 5, 1992. Once a final version of the Call Report change was agreed to, the Federal Reserve intended to make conforming changes to the Consolidated Financial Statements for Bank Holding Companies (Y-9C Report). Comments Received Comments were received from 41 public respondents. These included one multinational, one regional, and twenty-nine community banking organizations; one thrift association; one government-sponsored entity; seven trade associations; and one member of the public. Overall, 32 commenters, or approximately 78 percent of the total respondents, agreed with the proposal. They expressed the view that the definitional change and reassignment of these loans to a lower risk category was fair and consistent with the riskiness inherent in these types of residential real estate loans. The nine commenters that opposed the FFIEC’s proposal did so on the grounds that, in their view, the perceived reporting burden to implement the proposal did not justify the merits of the outcome. One of these commenters 4 stated it would agree with the proposal if the Call Report change would be optional. It was suggested in the comments that the Federal Reserve implement the provisions of section 618(a) of the RTCRRIA by amending the risk-based capital guidelines rather than by changing the definition of loans secured by 1- to 4family residential properties contained in the Call Report. One commenter, the multinational banking organization, noted that this approach would be more appropriate and much simpler for banking organizations to implement than a regulatory reporting change. The FF1EC proposal requested specific comment on builder equity and purchaser earnest money standards, “ including the most appropriate way to define and compute a builder’s project equity and the percentages or amounts of builder equity and purchaser earnest money that should be at risk.” Eleven comment letters suggested definitions and amounts for “ builder equity” and “ purchaser earnest money deposit.” The amounts suggested for builder’s equity ranged from 10 percent to 75 percent of the contract price. In addition, a number of commenters offered specific suggestions on what that percentage should be based on, such as cost of land acquisition or hard costs of construction. Suggested amounts for substantial earnest money deposits ranged from 1 percent to 20 percent. Amendment To The Risk-Based Capital Guidelines Based upon discussions with the other Federal banking agencies and the public comments received, the Board is amending the risk-based capital guidelines for state member banks and bank holding companies to state that loans secured by 1- to 4-family residential properties eligible for the 50 percent risk category for risk-based capital purposes 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.” In order to be assigned a 50 percent risk weight, such loans, like other loans for 1- to 4-family residences, would have to be made in accordance with prudent underwriting standards, including a conservative loanto-value ratio; to be performing in accordance with their original terms; and to not be 90 days or more past due or carried in nonaccrual status. This change to the risk-based capital guidelines would have the effect of including in the 50 percent risk category presold residential construction loans that RTCRRIA requires to be included in this category. The Board notes that the statute specifies that the agencies may establish prudent underwriting standards for presold 1- to 4-family residential construction loans accorded a 50 percent risk weight. In this regard, the agencies expect that institutions will apply a 50 percent risk weight to loans to builders for 1- to 4-family residential property construction 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 5 commitment for permanent financing of the home upon completion), so long as the following additional criteria are met: (A) The purchaser is an individual(s) who intends to occupy the residence and is not a partnership, joint venture, trust corporation, or any other entity (including an entity acting as a sole proprietorship) that is purchasing one or more of the homes for speculative purposes. (B) The builder must incur at least the first 10 percent of the direct costs (i.e., actual costs of the land, labor, and material) before any drawdown is made under the construction loan and the construction loan may not exceed 80 percent of the sales price of the presold home.2 (C) The purchaser has made a substantial “ earnest money deposit” of no less than 3 percent of the residence’s sales price and that deposit must be subject to forfeiture if the purchaser terminates the sales contract. (D) The earnest money deposit must be held in escrow by the bank financing the builder or by an independent party in a fiduciary capacity and the escrow agreement must provide that, in the event of default arising from the cancellation of the sales contract by the buyer, the escrow funds must first be used to defray any costs incurred by the lending bank. Section 618(a) requires the agencies to take action within 120 days of enactment of the RTCRRIA to permit the different capital treatment of the type of housing loans discussed above. As suggested in the comments received, the Board has decided to implement section 618(a) by adopting revisions to the riskbased capital guidelines directly rather than changing the Call Report and Y9C Report provisions. The effect on the calculation of capital for state member banks and bank holding companies of amending the guidelines is substantially the same as the effect of revising the Call Report and the Y-9C Report, and will satisfy the requirements of section 618(a). The Board adopted the change to the risk-based capital guidelines as an interim rule, rather than a final rule, however, in order to provide interested parties an opportunity to comment on this alternative approach. The adoption of an interim rule will permit state member banks and bank holding companies to take advantage of a lower risk weight for presold residential construction loans effective immediately. The Board will revise the rule as required to address comments received during the thirty-day comment period. 2 Under the agencies’ 1992 real estate underwriting standards regulation and guidelines, as a general matter, institutions may extend loans for the construction o f 1- to 4-family residences with loan-to-value ratios (LTV) of up to 85 percent. These guidelines, which implement section 304 of the Federal Deposit Insurance Corporation Improvement Act of 1991, become effective on March 19,1993. While these guidelines permit institutions to make presold residential construction loans with LTV ratios that exceed 80 percent, such loans would not qualify for the 50 percent risk category. Rather, they should be assigned to the 100 percent risk category. 6 Regulatory Flexibility Act Analysis The Federal Reserve Board does not believe that adoption of this amendment would have a significant economic impact on a substantial number of small business entities in accord with the spirit and purposes of the Regulatory Flexibility Act (5 U.S.C. 601 et seq.) In that regard, the amendment would reduce certain regulatory burdens on bank holding companies. In addition, because the risk-based and leverage capital guidelines generally do not apply to bank holding companies with consolidated assets of less than $150 million, this amendment will not affect such companies. List of Subjects 12 CFR Part 208 Accounting, Agriculture, Banks, banking, Confidential business information, Currency, Federal Reserve System, Reporting and recordkeeping requirements, Securities. 12 CFR Part 225 Administrative practice and procedure, Banks, banking, Federal Reserve System, Holding companies, Reporting and recordkeeping requirements, Securities. For the reasons set forth in the preamble, and pursuant to the Board’s authority under section 5(b) of the Bank Holding Company Act of 1956 (12 U.S.C. 1844(b)), and section 910 of the International Lending Supervision Act of 1983 (12 U.S.C. 3909), the Board is amending 12 CFR parts 208 and 225 as follows: PART 208—MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE FEDERAL RESERVE SYSTEM 1. The authority citation for part 208 is revised to read as follows: Authority: Sections 9, 11(a), 11(c), 19, 21, 25, and 25(a) of the Federal Reserve Act, as amended (12 U.S.C. 321-338, 248(a), 248(c), 461, 481-486, 601, and 611, respectively); sections 4 and 13(j) of the Federal Deposit Insurance Act, as amended (12 U.S.C. 1814 and 1823(j), respectively); section 7(a) of the International Banking Act of 1978 (12 U.S.C. 3105); sections 907-910 of the International Lending Supervision Act of 1983 (12 U.S.C. 3906-3909); sections 2, 12(b), 12(g), 12(i), 15B(c) (5), 17, 17A, and 23 of the Securities Exchange Act of 1934 (15 U.S.C. 78b, 78/(b), 78/(g), 78/(i), 78o-4(c) (5), 78q, 78q-l, and 78w, respectively); section 5155 of the Revised Statutes (12 U.S.C. 36) as amended by the McFadden Act of 1927; and sections 1101-1122 of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (12 U.S.C. 3310 and 3331-3351); 12 U.S.C. 93a, 161, 1818, 3907, 3909, Sec. 618, Pub. L. 102-233, 105 Stat. 1761 (Resolution Trust Corporation Refinancing, Restructuring, and Improvement Act of 1991). 2. Appendix A to part 208 is amended by revising footnote 35 to read as follows: APPENDIX A TO PART 208—[Amended] * * * * * HI. Procedures for Computing Weighted-Risk Assets and Off-Balance-Sheet Items * * * * * C. Risk Weights * * 3 * * * ***3 5 35 Loans that qualify as loans secured by one- to four-family residential properties are listed in the instructions to the commercial bank call report. In addition, for riskbased capital purposes, loans secured by one- to four-family residential properties include loans to builders with substantial project equity for the construction of oneto four-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. PART 225— BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL 1. The authority citation for part 225 is revised to read as follows: Authority: 12 U.S.C. 1817(j)(13), 1818, 1831i, 1843(c)(8), 1844(b), 3106, 3108, 3907, 3909, 3310, and 33313351. 2. Appendix A to Part 225 is amended by revising footnote 38 to read as follows: APPENDIX A TO PART 225 - [Amended] * * * * * m. PROCEDURES FOR COMPUTING WEIGHTED-RISK ASSETS AND OFFBALANCE-SHEET ITEMS * * * * * C. Risk Weights * * * * * 3. ***38 38 Loans that qualify as loans secured by one- to four-family residential properties are listed in the instructions to the FR Y-9C Report. In addition, for risk-based capital purposes, loans secured by one- to four-family residential properties include loans to builders with substantial project equity for the construction of one- to four-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. Board of Governors of the Federal Reserve System, December 22, 1992. William W. Wiles, Secretary of the Board. [FR Doc. 92-00000 Filed 00-00-92; 8:45 am] BILLING CODE 6210-01 -F