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Capital Equivalency Report

June 19, 1992

HG
1616
C34C36

1992

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overnors of the
eserve system

Secretary of the Department
of the Treasury

CAPITAL EQOIVALENCY REPORT

EXECUTIVE SUMMARY: COMPARABILITY OF CAPITAL STANDARDS AND
ESTABLISHMENT OF GUIDELINES
Section 214(b) of the Foreign Bank Supervision
Enhancement Act of 1991 requires the Board and the Secretary of
the Treasury jointly to submit to the Committee on Banking,
Housing, and Urban Affairs of the Senate and the Committee on
Banking, Finance and Urban Affairs of the House of
Representatives a report analyzing:

(1) the capital standards

contained in the Basle Accord for measurement of capital
adequacy; (2) foreign regulatory capital standards that apply to
foreign banks conducting banking operations in the United States;
and (3) the relationship of the Basle and foreign capital
standards to the risk-based capital and leverage requirements
applicable to U.S. banks.

The report by the Board and the

Secretary of the Treasury also is required to include guidelines
to be used by the Board in converting data on the capital of
foreign banks to the equivalent risk-based capital and leverage
requirements for U.S. banks for purposes of determinations under
Sections 3 and 4 of the Bank Holding Company Act of 1956 and
Section 7 of the International Banking Act of 1978, as amended.
The Board and Treasury will continue to work together to consider
issues related to the analysis in this report and any necessary
modification of the guidelines, with a view to the preparation of
the annual updates to this report mandated by Section 214(b).

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The capital standards of a broad range of countries
were included in the sample employed in the study pursuant to
Section 214(b).

Capital standards in these countries generally

fall into two categories: risk-based capital requirements or
requirements based upon the amount of capital in relation to
total assets or categories of liabilities.

This study has

demonstrated the extent to which risk-based capital requirements
have become the accepted international standard for the
measurement and assessment of capital adequacy.

Of the twenty-

two foreign countries included in the sample underlying this
study, supervisors in only two (Brazil and Venezuela) continue to
rely upon a capital measure other than a risk-based capital
standard.
In those countries applying the risk-based capital
framework, all are implementing uniformly the Basle minimum
capital ratios of four percent Tier 1 capital and eight percent
total capital in relation to total risk-weighted assets.

These

ratios constitute the minimum requirements; national authorities
have the discretion, under the Basle Accord, to require banks to
maintain higher risk-asset ratios.

In addition, national

discretion is provided regarding whether to allow banks to
include certain of the components in Tier 2 capital and, to a
lesser degree, in Tier 1 capital.

The discretion exercised by

national authorities with regard to the capital components
results in definitions of qualifying capital that are equivalent,

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although not identical, among countries subscribing to the
Accord.
The Board and Treasury agree that, in assessing the
capital of foreign banks in connection with applications, capital
ratios should be equivalent, but not necessarily identical, to
those required of U.S. banks.

This approach is consistent with

the Board's existing policy, which has been based upon the
recognition that financial markets in different countries, and
the instruments issued in those markets, vary but that these
variations do not necessarily have a substantive effect on
overall safety and soundness.

Banking regulators in the United

States have recognized that strict application to foreign banks
of capital standards with definitions identical to those applied
to U.S. banks would disregard important differences in capital
instruments and accounting practices in other countries.

fundamental premise of the Basle Accord is the acceptance of such
differences in order to advance the international convergence of
capital standards.
With regard to the definition and composition of Tier 1
capital, a high degree of convergence has been achieved.

Some

differences arise with respect to the composition of Tier 2
capital and the application of risk weights; the Basle Accord
specifically permits limited national discretion in the
implementation of these areas of the risk-based framework.
Generally, these differences do not have a significant impact on

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the equivalence of capital requirements applicable to
internationally active banks.
With regard to the composition of Tier 1 capital, a
high degree of comparability exists among the countries
subscribing to the Accord.

A few minor differences arise which

render certain components of Tier 1 capital unavailable to banks
in certain countries due to either the structure and limitations
of their capital markets or differences in accounting practices.
These differences have no effect on the equivalence of Tier 1 or
core capital ratios among countries, but instead relate primarily
to the absence of a market for certain components of core capital
in many countries subscribing to the Accord.

Capital markets in

the United States are such that U.S. banks have considerable
flexibility regarding the availability of Tier 1 capital
instruments, principally preferred stock.
Tier 2, or supplementary, capital was included in the
definition of total capital in the Accord because it was agreed
that some components of a bank's balance sheet, which do not
qualify as Tier 1 capital, do provide protection to depositors
and can enhance safety and soundness.

The Basle Committee also

recognized that the existence and utilization of various eligible
components of Tier 2 differed from country to country, due in
large part to differences in local capital markets, accounting
and disclosure practices, and certain historical developments.
Therefore, the Committee adopted a menu approach to these Tier 2
capital items, which the Committee agreed served the purpose of

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supplementary capital, with different countries making use of the
various components to differing degrees.

The greatest variation

among countries with regard to Tier 2 arises in relation to the
availability of hybrid capital and subordinated debt instruments
and the inclusion of latent reserves stemming from the
revaluation of equity securities.
With regard to hybrid capital and subordinated debt
instruments, the degree of innovation in, and the depth of, local
capital markets in certain countries provide banks greater access
to such instruments.

Banks in the United States benefit from

access to the U.S. capital markets in this regard and,
consequently, Tier 2 capital has not been a constraining factor
in meeting the minimum total capital standard.
With regard to latent revaluation reserves, banks from
a few countries have been allowed to include such reserves, to
some extent, in Tier 2.

These reserves arise primarily from the

revaluation of equity securities held for investment.

Latent

revaluation reserves, however, can be volatile, as the recent
decline in the Japanese stock market has demonstrated.

Partly

for that reason, such reserves are allowable in Tier 2 only with
a discount.

Even so, banks placing significant reliance upon

such reserves risk having their capital diminish as equity prices
fall; Tier 2, therefore, may be a constraining factor for such
banks over time.
Despite differences in the composition of Tier 2 among
countries, all elements eligible for inclusion in Tier 2 were

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considered by the Basle Committee members to be acceptable forms
of supplementary capital.

Overall, taking these differences into

account, there is broad equivalence among countries in the
quality of Tier 2 capital in relation to its role as a supplement
to core capital.
The risk weights assigned by countries to asset
categories are virtually identical aside from three differences.
As discussed at pages 35 to 36 below, two of these differences
are likely to be only transitional in nature.

The third area

relates to mortgage-backed securities which, to date, have been
issued primarily in the United States.
Capital standards in countries that have adopted riskbased capital frameworks obviously differ from standards in
countries that employ other measures of assessing capital.

Under

any of these standards, the definition of capital may be similar.
A risk-based capital standard relates capital to the composition
of assets and off-balance sheet items.

Alternative measures take

into account neither the composition of the balance sheet nor
levels of off-balance sheet activities.
Guidelines to be used by the Board in the future when
evaluating the capital of foreign banking organizations in
connection with applications are set out at pages 42 to 45 of
this report.

These guidelines are broadly consistent with the

Board's existing approach to the evaluation of the financial
condition of foreign banks in connection with such applications.
Thus, in general, foreign banks seeking to establish operations

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in the United States have been expected to meet the same general
standards of strength, experience, and reputation as required for
domestic institutions.

The Board has sought to assure itself of

the foreign bank's ability to support its U.S. operations.
For purposes of making determinations in the future
with regard to applications submitted by foreign banks, the Board
will continue to take into account a number of factors indicative
of a bank's financial condition, including capital.

determining whether a bank's capital meets the minimum standard,
as an initial requirement applicants from countries that adhere
to the Basle Accord will be required, at a minimum, to meet the
Basle guidelines as administered by their home country
supervisors.

The Basle standard provides a common basis for

evaluating the general equivalency of capital among banks from
various countries.

In acting on applications submitted by banks

from countries not subscribing to the Basle Accord, the applicant
will be required to provide information regarding the capital
standard applied by its home country supervisor, information
sufficient to evaluate the applicant's capital position adjusted
as appropriate for accounting and structural differences, and, to
the extent possible, information comparable to the Basle
framework.
It must be pointed out that simply meeting the minimum·
capital standard will not automatically imply that the financial
condition of the foreign bank applicant is consistent with the
Board's approval of any particular application.

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As with

applications by U.S. banking organizations, the capital ratio
necessary for applications by foreign banking organizations to be
considered for approval by the Board will depend on the level of
risk associated with the activities which are the subject of the
application.

For example, the capital ratio necessary to obtain

full underwriting and dealing authority will be higher than the
ratio required to conduct a low-risk activity.
The table below summarizes the key conclusions with
regard to each of the elements of the risk-based capital standard
referenced above.

Page numbers are provided to indicate the

location in the text of further discussion of each point.

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Findings on Comparability of Risk-Based Capital Standards
Tier 1:

Uniform definition
(page 21)

Minor differences in usage of Tier 1 instruments
(pages 22-25)

Tier 2:

Menu of eligible components
(page 26)

Common definition of components
(page 26)

Differing levels of reliance on certain components
among countries
(pages 26-33)

Overall equivalence of Tier 2 components
(page 26)

Risk
Weights:

Identical risk weights for most assets
(page 35)

Differences in the risk weight assigned to
privately-issued mortgage-backed securities
(page 35)

Some differences in treatment of claims on government
entities within limits of authorized national discretion
(page 36)

INTRODUCTION

Section 214(b) of the Foreign Bank Supervision
Enhancement Act of 199111 requires the Board and the Secretary
of the Treasury jointly to submit to the Committee on Banking,
Housing, and Urban Affairs of the Senate and the Committee on
Banking, Finance and Urban Affairs of the House of
Representatives a report analyzing:

(1) the capital standards

contained in the Basle Accord for measurement of capital
adequacy; (2) foreign regulatory capital standards that apply te
foreign banks conducting banking operations in the United States;
and (3) the relationship of the Basle and foreign capital
standards to the risk-based capital and leverage requirements
applicable to U.S. banks.Y
The report also is required to include guidelines to be
used by the Board in converting data on the capital of foreign
banks to the equivalent risk-based capital and leverage
requirements for U.S. banks for purposes of determinations under
Sections 3 and 4 of the Bank Holding Company Act of 1956 and
Section 7 of the International Banking Act of 1978, as

1/ The full text of Section 214(b) of the Foreign Bank
Supervision Enhancement Act of 1991 is attached as Appendix A.
~1 Section 214(b) also requires that an update of this
report shall be prepared annually explaining any changes in the
analysis regarding capital equivalency and any resulting changes
in the Board's guidelines.

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amended.11

As required by Section 214(b) of the Foreign Bank

Supervision Enhancement Act, this report will discuss relevant
capital requirements, summarizing and comparing U.S. and foreign
capital standards.
Broadly, there are two categories of capital: equity,
which consists of funds contributed by shareholders, and other
instruments which are also subordinated to the interests of
depositors and other creditors.

The former instills discipline

by placing shareholders' funds at risk and is essential for
maintaining the bank as a going concern; the latter, although a
junior form of capital, provides additional protection for
depositors and any relevant deposit insurance fund.
In order to protect depositors and maintain a stable
banking system, banking supervisors adopt capital standards which
must be met by banking institutions in their respective
Al Section 3 of the Bank Holding Company Act requires,
subject to certain exemptions, application to the Board in
relation to the formation or merger of bank holding companies.
Application is also required under this section for acquisition
of subsidiary banks or bank assets and acquisition of control of
bank or bank holding company securities. Section 4 requires
application to the Board with regard to the acquisition of
permissible non-banking companies or engaging directly in such
non-banking activities. Section 7 of the International Banking
Act, inter alia, requires the approval of the Board prior to a
foreign bank establishing a federally or state-licensed branch or
agency or acquiring ownership or control of a commercial lending
company.
Factors considered by the Board in acting on such
applications, among other things, include the financial condition
and managerial resources of the entities involved, any anticompetitive effects and the convenience and needs of the
community to be served. With regard to financial condition, the
Board also takes into account whether current and projected
capital positions and levels of indebtedness conform to standards
and policies established by the Board.

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countries.

The financial markets also impose discipline upon

banks seeking access to funds regarding the quality and amount of
capital.

One capital standard adopted by banking regulators is

the risk-based capital standard, which gained international
acceptance through the efforts of the Basle Committee on Banking
Supervision,!' of which the United States is a member.
Recognition of the importance of achieving convergence
internationally in the measurement and assessment of capital
adequacy led to the adoption of the Accord by the Basle Committee
members in 1988.
It is important to note, however, that capital adequacy
is only one indicator of the financial condition of banks.

Other

factors taken into account in assessing financial condition
include profitability, concentrations of risk, the nature of the
bank's operations and strategic plan, liquidity, asset quality,
adequacy of loan loss reserves, accounting systems and controls,
management and the degree of home country supervision.
Following passage of the International Banking Act of
1978, two policy statements were issued by U.S. banking
regulators addressing the supervision and regulation of the U.S.

ii The Basle Committee on Banking Supervision (hereafter
referred to as "the Basle Committee") is comprised of
representatives of the central banks and supervisory authorities
from the Group of Ten ("G-10 11 ) countries (Belgium, Canada,
France, Germany, Italy, Japan, the Netherlands, Sweden,
Switzerland, the United Kingdom and the United States) and
Luxembourg. The Basle Committee meets at the Bank for
International Settlements in Basle, Switzerland. The Committee
is currently chaired by the President of the Federal Reserve Bank
of New York.

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operations of foreign banks.11

These policy statements made

clear that the regulators would seek to ascertain that a foreign
bank had the ability to support its U.S. operations.

addition, it was recognized that foreign banks operate outside
the United States in accordance with different banking and
accounting practices and traditions and in different legal and
social environments.
Given these differences, the Board's policy in relation
to foreign banks has been that capital ratios should be
equivalent, but not necessarily identical, to those required of
U.S. banks.

This policy stems from the Board's recognition that

financial markets in different countries, and the instruments
issued in those markets, vary but that these variations do not
necessarily have a substantive effect on overall safety and
soundness.

Banking regulators in the United States have

recognized that strict application to foreign banks of capital
standards with definitions identical to those applied to U.S.
banks would disregard important differences in capital
instruments and accounting practices in other countries.

fundamental premise of the Accord is the acceptance of such
differences in order to advance the international convergence of
capital standards.
For purposes of this study, the capital standards of a
sample of twenty-two foreign countries were analyzed and compared

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See 65 F.R.B. 634 (August, 1979); 1 F.R.R.S. 4-835.

13
to U.S. capital standards.£1

Banks from these twenty-two

countries collectively held, as of December 31, 1991,
approximately 97 percent of total U.S. banking assets held by
foreign banks.

The sample encompasses countries that are Basle

Committee members, countries that have voluntarily subscribed to
the principles of the Accord, and countries that have not adopted
the Basle framework.

II.

CONVERGENCE OF INTERNATIONAL CAPITAL STANDARDS

History of convergence.

Banking regulators in the

United States have long advocated appropriate capital standards
for banks in order to safeguard safety and soundness and to
minimize risk of loss to depositors and the insurance fund.

The

United States Congress has evidenced the same concern and passed
the International Lending Supervision Act of 1983, which directed
the Federal Reserve and the Treasury to encourage other countries
to work toward maintaining or improving the capital of banks.11
§I The sample includes ten of the twelve Basle Committee
member countries, namely Belgium, Canada, France, Germany, Italy,
Japan, the Netherlands, Sweden, Switzerland, and the United
Kingdom. Also included are Australia, Austria, Finland, Hong
Kong, Ireland, Israel, Korea, Mexico, Spain and Taiwan, which,
although not members of the Basle Committee, voluntarily
subscribe to the principles of the Accord. Two additional
countries, namely Brazil and Venezuela, which do not subscribe to
the Accord, were also included.
ll The Omnibus Trade and Competitiveness Act of 1988 also
requires discussions with the governments of countries that are
major financial centers aimed at, inter alia, developing uniform
supervisory standards for banking organizations and securities
companies, including uniform capital standards.

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The early 1980's were characterized by declining
capital levels at major international banks.

Banking regulators

in different countries attempted to reverse this trend in various
ways, including, for example, the adoption of risk-weighted
capital requirements in many European countries.

In the United

States, a different approach was taken by regulators, namely, the
adoption of leverage ratios, which related primary and total
capital to total assets without regard to the relative risk of
the assets.

These leverage ratios had the advantage of being

straightforward in application and, to some extent, they achieved
the goal of curbing the erosion of capital levels.

However, use

of these ratios encouraged U.S. banks to divest low-risk, liquid
assets and to move business off the balance sheet in order to
reduce capital requirements.
The decline in capital ratios of some internationally
active banks, the diverse approaches to the measurement of
capital in major industrialized countries, the increasing trend
towards globalization of banking operations, innovations in the
financial markets, and liberalization of these markets
underscored the importance of efforts to reach international
agreement on capital standards.

Supervisors in the United States

also wished to remove the bias in favor of off-balance sheet
activities and against the holding of low-risk, liquid assets
created by the introduction of leverage ratios.
After extensive efforts to promote the international
convergence of capital standards, the Board and the Bank of

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England announced in January 1987 that an agreement had been
reached on common standards for evaluating capital adequacy.

The

convergence agreement provided a common definition of capital, a
minimum capital ratio for "internationally active" banks, a
system for assessing the relative riskiness of various activities
and the inclusion of off-balance sheet activities in making
capital adequacy determinations.

Trilateral discussions

subsequently proceeded among the United States, the United
Kingdom and Japan, following which agreement was reached broadly
on the same basis.
On December 10, 1987, the Basle Committee announced
that its members had adopted a proposal for "international
convergence of capital measurement and capital standards"
(commonly referred to as the "Basle Accord").

The proposal

served as a basis for discussion and public comment in the member
countries.

In light of comments received from the public by the

different supervisory authorities, a number of changes were
subsequently made to the proposal.

Central banking authorities

of the G-10 countries endorsed the·Basle Accord in July 1988.
The Basle framework.

The Basle Accord is a risk-based

capital framework that applies a standard system of assessment
and measurement of capital to internationally active banks from
member countries.

The principal objectives of the Accord are to

strengthen the capital positions of internationally active banks
and to provide a framework that is fair and has a high degree of
consistency in its application to banks in different countries.

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In developing the framework, the Basle Committee sought to give
due regard to the structure of the financial markets and
particular features of the supervisory and accounting systems in
individual member countries.
The Basle Accord establishes an analytical framework
that relates regulatory capital requirements to differences in
risk profiles among banks, including off-balance sheet exposures,
and minimizes disincentives for banks to hold liquid, low-risk
assets.

The Basle framework establishes minimum levels of

capital for internationally active banks; national authorities
are free to adopt more stringent capital requirements.
The Accord focuses principally on broad categories of
credit risk.

The Accord does not yet take explicit account of

other factors that may affect a bank's financial condition, such
as overall interest-rate exposure, liquidity, and market risks.
The risk-based capital standard established by the
Accord is composed of four basic elements: (1) an agreed
definition of Tier 1 (or core) capital, consisting primarily of
common stockholders' equity and certain categories of perpetual
preferred stock; (2) a "menu" of internationally agreed items,
constituting Tier 2 capital, which supplements core capital; (3)
a general framework for assigning assets and off-balance sheet
items to broad risk categories, as well as procedures for
calculating a risk-based capital ratio; and (4) a schedule for
achieving, by no later than the end of 1992, a minimum ratio of
total capital to risk-weighted assets of eight percent (of which

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at least four percent should be in the form of core capital).
The provisions of the Accord are discussed in greater detail in
Appendix B.
Ongoing efforts to improve international supervision.
The Basle Committee continues to work on the international
convergence of capital standards; it has always been recognized
that convergence necessarily must be evolutionary in approach.
The Basle Committee continues to address issues regarding risk
weights and eligibility of instruments as Tier 1 and Tier 2
capital in order to remove potential differences that may arise
among countries from time to time.
In addition, the Committee is dedicating significant
resources to the evaluation of methods of measuring and assessing
the non-credit risks that are inherent in a bank's balance sheet,
such as interest rate, foreign exchange and other market risks.
As noted above, these non-credit risks generally are not
currently addressed by the Accord.
EC capital standards.

The European Community, as part

of the harmonization exercise underlying the development of a
single market in financial services, adopted in 1989 a capital
standard that will apply to all banks of member states.

The EC

Directives setting out these capital standards closely follow the
Basle Accord, except that, in a number of respects, national
discretion granted under the Accord to Basle members is removed.
Whereas the Basle framework is non-compulsory, the EC Directives
have the force of law within the EC and, therefore, establish

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mandatory minimum standards.

The EC standard broadly follows the

Basle definitions of Tier 1 and Tier 2 capital, risk weights and
off-balance sheet treatment, and requires the same minimum
capital ratios.

Because the EC Directives, like the Basle

Accord, establish only minimum standards, a number of member
states have opted to implement more stringent capital standards.
A comparison of the capital standards implemented by
the EC member states with the U.S. and other Basle subscribers is
set out in section III. below.

A more detailed discussion of the

minimum capital standards established in the EC Directives is
provided in Appendix

Effect of local capital markets on convergence.

Any

analysis of the convergence of international capital standards
must take into account the importance of local capital markets
and the structure of national banking and financial systems to
the ability of banks to raise required amounts of capital.

These

factors affect the ability of banks to compete internationally.
The nature of local capital markets primarily affects
banks' balance sheets in two ways.

First, techniques have

evolved in some markets that permit banks to securitize a number
of different types of assets.

This permits banks to remove these

assets from their balance sheets, earn fees from loan
originations and recycle capital in order to originate new loans.
A major development in the U.S. market has been the
securitization of residential mortgage loans.

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The only other

securitized mortgage market of any significance is in the United
Kingdom although, by comparison to the U.S. market, it is small.
Second, the nature of local financial markets will also
be important in terms of the development of new instruments.
Specifically, some markets have developed quasi-equity or hybrid
capital instruments to supplement capital.

In this regard, U.S.

capital markets are very receptive to hybrid capital instruments,
such as cumulative perpetual preferred stock, and U.S. banks have
benefitted from ready access to these types of capital
instruments.

Banks in countries whose markets are less receptive

to hybrid capital instruments have found it difficult, if not
impossible, to issue such instruments.
The Basle risk-based capital standards, therefore,
while establishing common capital definitions and assessment
techniques, do not eliminate differences among financial markets
of various countries.

So long as these differences exist, the

capital requirements for banks from different countries cannot be
identical.

Nevertheless, as discussed below, the Accord, by

accommodating such differences, promotes the principle of capital
equivalence for internationally active banks from countries
subscribing to its terms and constitutes an unprecedented step
forward in the convergence of international capital standards.

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III.

COMPARISON OF CAPITAL STANDARDS OF COUNTRIES SUBSCRIBING
TO THE BASLE ACCORD

A sample of twenty foreign countries which subscribe to
the principles of the Basle Accord (Australia, Austria, Belgium,
Canada, Finland, France, Germany, Hong Kong, Ireland, Israel,
Italy, Japan, Korea, Mexico, Netherlands, Spain, Sweden,
Switzerland, Taiwan and the United Kingdom) was used for purposes
of analyzing capital standards implemented under the Basle
framework and comparing those standards to U.S. capital
standards.§/

Several of the countries included in the sample

are currently in the process of finalizing their rules
implementing the Basle Accord.i1
The data set out in this report reflect the most
current information available; however, in some cases, national
§I Of these countries, Belgium, France, Germany, Italy, the
Netherlands and the United Kingdom are members of both the Basle
Committee and the European Community. Canada, Japan, Sweden,
Switzerland and the United States are members of the Basle
Committee. Ireland and Spain, although not members of the Basle
Committee, effectively follow the Basle Accord by virtue of their
membership in the EC. Austria, Fir.land and Switzerland, which
are members of the European Free Trade Association (EFTA), also
effectively follow the Basle Accord in anticipation of
ratification of the European Economic Area (EEA) Agreement and
planned entry into the European Community. Australia, Hong Kong
and Israel voluntarily subscribe to the principles of the Basle
Accord (as do many countries not included in this survey).
Korea, Mexico and Taiwan also recently have adopted capital
requirements in line with the Basle framework. All of these
countries, for purposes of this report, will be referred to as
"Basle subscribers."

fl The Basle Accord permits, at national discretion, various
transitional arrangements. Due to the fact that these
arrangements, for the most part, must be phased out by year-end
1992, these arrangements are not addressed in this study.

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rules may be subject to change.

Capital standards, in any event,

are under continuous review by national authorities in light of
developments in local financial markets and further work by the
Basle Committee.

Capital requirements applicable in the United

States, including the different treatment of certain capital
components for bank holding companies, are discussed in detail in
Appendix D.

Differences between U.S. standards and those in the

sample countries are discussed below.

Tier 1 Capital

Within Tier 1 capital, there is a great deal of
comparability and uniformity of definition among the countries
subscribing to the Accord.

Tier 1 is intended to be the purest

form of capital and is accorded the greatest significance by
banking supervisors and financial markets generally in assessing
the adequacy of bank capital.

Under the Accord, Tier 1 capital

must constitute at least four percent of the eight percent total
minimum capital requirement.
The components of Tier l,capital include paid-up share
capital (otherwise generally referred to as common stock), noncumulative perpetual preferred stock, disclosed equity reserves
(including the Fund for General Banking Risks described below),
minority interests in the equity accounts of consolidated
subsidiaries which are less than wholly owned, and current year
profit (or loss).

In calculating Tier 1 capital, goodwill is

deducted from the total of these components.

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All countries include paid-up share capital and
retained earnings within Tier 1.

National banking authorities

have discretion to include the following components in Tier 1
capital:

non-cumulative perpetual preferred stock, current year

profit or losses, and the Fund for General Banking Risks.

Slight

divergences in these areas occur among countries that subscribe
to the Basle Accord.

Some differences among countries also arise

regarding intangible assets other than goodwill.!!!/

Each of

these areas is discussed below.
Non-cumulative perpetual preferred stock.

The

divergence among countries in respect of the inclusion of this
type of instrument in Tier 1 capital is not the result of
differing definitions or treatment of this component but instead
arises because not all Basle subscribers issue such instruments.
It is important to note that, even in those countries which issue
these instruments, the amount is very limited.

This type of

instrument is most prevalent in the United States; banks from
Canada and the United Kingdom also have issued these instruments
in the U.S. market.

Banks from Germany, Sweden and Belgium,ll1

to date have not issued any of this type of stock even though
permitted to do so.

Switzerland does not permit the inclusion of

.!Q/ As discussed further below, the Accord is silent
regarding the deduction of intangible assets other than goodwill.

ll/ Examples included in this report regarding different
national standards are included for purposes of illustrating the
main areas of difference. Examples focus primarily on those
countries in the sample which have the most internationally
active banks.

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these instruments in capital and Japanese banks face legal
obstacles in issuing such instruments.
Fund for General Banking Risks.

The EC Directives

establish a "Fund for General Banking Risks" {hereafter "the
Fund"), which may be included in Tier 1 capital subject to
certain limitations discussed below, in order to facilitate the
gradual phasing out of so-called "hidden" or undisclosed
reserves.

Undisclosed equity reserves constitute shareholders'

funds and, although not published or disclosed other than to
supervisory authorities, are permitted by accounting practices in
Belgium, Germany, Hong Kong and Switzerland.

If published, these

balances would have been included in Tier 1 capital as are
retained earnings; however, because of their lack of transparency
these reserves were included in Tier 2 or supplementary capital
under the Basle Accord.
Limitations which apply to the Fund are: (1) amounts
can only be transferred to or from the Fund via the post-tax
balance on the profit and loss account, i.e., losses may not be
directly charged to the Fund but must be taken through the profit
and loss account: (2) the Fund must be disclosed separately in
the bank's published accounts; and (3) the Fund must be freely
available to a bank to meet losses as soon as they occur.
The Basle Committee has agreed that balances in such
accounts are properly part of core capital and should be included
in Tier 1 under the Accord; funds with the same characteristics
in the accounts of non-EC countries will be entitled to similar

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treatment.

The Committee will continue to review the inclusion

of the Fund in Tier 1 capital to ensure that the desired effect
of further convergence and improved quality of capital is
achieved.
The EC Directives include the Fund in Tier 1 generally;
however, the Fund must be deducted from Tier 1 for purposes of
calculating the maximum level of Tier 2 capital.

Member states

may choose to restrict the inclusion of the Fund in Tier 1.

is anticipated that implementation of the terms of the relevant
Directive permitting the establishment of the Fund for EC member
states will occur in 1993.

Until then, banks in these countries

will not be able to include in Tier 1 capital amounts that they
may wish to allocate to the Fund.
Current year profit {or loss}.

Australia, Canada,

France, Italy, Japan, the Netherlands and the United States allow
the inclusion of current year profit (and require the deduction
of current year losses) in Tier 1 capital without restriction.
In Germany, Hong Kong and Switzerland, the inclusion of current
year profit is not permitted nor is the deduction of current year
losses required: such profit or losses are only taken into the
balance sheet in the following year as part of retained earnings.
Belgium and Sweden also do not permit the inclusion of current
year profit until taken into the balance sheet as retained
earnings but do require the deduction of losses in the year in
which they are incurred.

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Goodwill and other intangible assets.

The Accord

requires the deduction of goodwill from Tier 1 capital if carried
on the balance sheet.ll1

The treatment of other intangible

assets, however, is not addressed in the Accord largely because
they do not exist in most countries other than the United States.
Banking regulators in the United States have allowed
banks to book intangible assets (in addition to goodwill) if
those assets qualify under certain criteria.

Generally, any non-

qualifying intangible asset is required to be deducted from
capital.

The amount of total qualifying intangible assets has

been limited to a percentage of Tier 1 capital.

Regulators have

recently proposed that limited amounts of purchased mortgage
servicing rights and purchased credit card receivables would
constitute qualifying intangible assets due to the active, liquid
market for such assets.

United states banks, therefore, would

not have to deduct these intangible assets up to specified limits
from Tier 1 capital.

These intangible assets generally are not

available in other countries.ll1

In a number of the countries surveyed, goodwill is not
carried on the balance sheet and instead is required by national
accounting practices to be charged off in the year acquired.
Hence, the question of the deduction of goodwill does not arise
in these countries.
121

ill U.K. banks, to a minor extent, also gain some capital
benefit from the inclusion of U.S. purchased mortgage servicing
rights held by their bank subsidiaries in the United States.

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Tier 2 - Supplementary Capital

As discussed above, Tier 1 capital is intended to be
the purest form of capital and essentially represents
unencumbered shareholder funds.

It was also recognized by the

Basle committee in adopting the Accord that various instruments
issued in different countries protect depositors to some degree
and can enhance safety and soundness.

Thus, the Committee also

incorporated the concept of Tier 2 capital, which is structured
to accommodate the differences in capital instruments prevalent
in the member countries, as well as differences in accounting
practices relating to the valuation of assets.
Tier 2 capital, therefore, could be viewed as a menu of
capital enhancements to supplement Tier 1, or core, capital.

this basis, Tier 2 capital is limited to 100 percent of the
amount of Tier 1.

The Accord establishes common definitions of

potentially eligible instruments, which Committee members agreed
were acceptable for Tier 2 purposes, but discretion is provided
to individual supervisory bodies regarding the use of such
instruments in their national capital standards.

Because a

number of the Tier 2 capital items were included to accommodate
the financial markets and accounting practices of different Basle
members, not all of the components are available to each of the
Basle members.

overall, taking these differences into account,

there is broad equivalence among countries in the quality of Tier
2 capital as a supplement to core capital.

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27
Tier 2 capital includes:

undisclosed reserves: asset

revaluation items, including revaluation of fixed assets
(normally banks' own premises) and latent revaluation of equity
securities held for investment; general loan loss reserves;
hybrid capital instruments, including,~, cumulative perpetual
preferred stock: and term instruments, such as subordinated term
debt and limited-life redeemable preferred stock.

There are

various limitations on the inclusion of certain of these
instruments within Tier 2.
Tier 2 capital components may broadly be assigned to
three categories, namely, undisclosed reserves, Tier 2 capital
instruments, and other reserves (including revaluation and loan
loss reserves).

Differences among countries surveyed with regard

to these categories are discussed below.
a.

Undisclosed Reserves

As noted above, accounting systems in Belgium, Germany,
Hong Kong and Switzerland have historically permitted banks to
undervalue certain asset accounts or overstate liabilities in
order to set aside funds to absorb the fluctuations in the return
on assets inherent in banking.

Such undervaluation leads to the

creation of undisclosed, or so-called hidden, equity reserves.
These reserves differ from latent revaluation reserves, which are
addressed at page 32 of this report.

Undisclosed reserves most

closely resemble retained earnings included in Tier 1 capital,
except for their lack of transparency.

It was because of this

lack of transparency that the Accord included such reserves in

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Tier 2 rather than Tier 1 capital.

Although unpublished, these

reserves must be passed through the profit and loss statement and
must be accepted by the local supervisory authorities before they
may be included in Tier 2 capital.
The extent to which these undisclosed reserves are
permitted to be included in Tier 2 capital varies from country to
country.

For example, German and Swiss banks may only include in

Tier 2 unpublished equity reserves that have been taxed; Belgian
banks are prohibited from including any such reserves in capital.
These types of reserves are not, however, permitted by the
accounting principles in most other countries, including the
United States.

Instead, any such gains must be recognized and

published and, therefore, are included in Tier 1.
In those countries which at present have such reserves,
the general trend is towards reduction of this type of
unpublished reserve.

This trend is primarily the result of

international market forces requiring more extensive disclosure.
The Fund for General Banking Risks, discussed above, was
established in the European Community to facilitate the gradual
phasing out of these reserves by bringing them on to the balance
sheet.
b.

Tier 2 Capital Instruments

Tier 2 capital instruments are comprised of hybrid
capital instruments and subordinated term debt instruments.
of these is discussed below.

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Each

Hybrid capital instruments that meet certain criteria
may be included in Tier 2 capital without any sublimit.

These

instruments combine certain characteristics of both equity
capital and debt.

The precise specifications for hybrid capital

differ from country to country.

However, under the Accord, these

instruments should meet the following general requirements:
(1) issuance on an unsecured, subordinated and fully paid-up
basis; (2) not redeemable at the initiative of the holder or
without the prior consent of the supervisory authority;
(3) available to participate in losses without the bank being
obliged to cease trading; and (4) although the capital
instruments may carry an obligation to pay interest that cannot
be permanently reduced or waived, service obligations should be
deferrable where the profitability of the bank would not support
payment.
Examples of hybrid capital instruments issued in the
United States are cumulative perpetual preferred stock, long-term
preferred stock, perpetual subordinated debt and mandatory
convertible debt instruments.

Genian, French and U.K. banks also

issue various types of hybrid capital instruments.
Hybrid capital instruments, however, are not prevalent
in a number of countries that subscribe to the Accord, such as
Belgium, Italy and the Netherlands.

Japan historically has

prohibited its banks from issuing such instruments, but this
prohibition has recently been relaxed.

Switzerland continues to

prohibit its banks from issuing such instruments.

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Subordinated term debt includes conventional unsecured
subordinated debt instruments and limited-life redeemable
preferred stock, which may be counted as Tier 2 up to a limit of
50 percent of Tier 1 capital.

Such term instruments, under the

Accord, are included as Tier 2 capital because of the measure of
protection they afford to depositors in the event of liquidation.
The 50 percent limit, however, recognizes the less permanent
nature of term instruments and the fact that such instruments
afford minimal protection to depositors so long as the bank
remains a going concern.
The major type of term instrument is subordinated term
debt, which includes conventional unsecured subordinated debt
instruments with a minimum original fixed term to maturity of
more than five years.

During the last five years to maturity, a

cumulative discount or amortization factor of 20 percent per year
is applied ·to reflect the diminishing value of these instruments
as a continuing source of strength as they approach maturity.
Theoretically, banking regulators in all countries
subscribing to the Accord, except Germany, permit the inclusion
of subordinated term debt in Tier 2 within the 50 percent limit.
Banks from almost all of the countries surveyed have issued
subordinated debt and include such debt in Tier 2.ll1

However,

many countries, in practice, have not issued more specialized
ll/ Many countries impose conditions on subordinated term
debt which are more restrictive than those imposed on U.S. banks.
For example, several countries require an original fixed term to
maturity of seven years or more compared to a minimum term of
five years for U.S. banks.

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types of subordinated term debt, such as limited-life redeemable
preferred stock for which there is a market in the United States.
Countries that have not issued limited-life redeemable preferred
stock to date include France, Japan~1 , the Netherlands,
Belgium, and Ireland.

Two countries, Switzerland and Sweden,

specifically disallow the inclusion of limited-life redeemable
preferred stock in Tier 2.
c.

Other Reserves

The capital structure of all banks includes items that
are not actual instruments of capital.

For this reason, the

Accord also includes in Tier 2 certain types of accounts that
accommodate the asset valuation practices or methods of
provisioning for unidentified losses found in all countries in
one form or another.
Revaluation reserves arise primarily in two ways.

The

first instance is with regard to the revaluation of fixed assets
permitted in many countries.

Revaluation on this basis is

normally limited to the bank's premises and is designed to
accommodate significant changes in market value relative to the
original book value.

These revaluations are reflected on the

balance sheet through an increase in the value of the particular
asset.

The offsetting entry is an increase in the revaluation

reserve, which is in the capital block.

This type of revaluation

is allowed in many countries including Belgium, France, Italy,

~ 1 Until recently, Japanese banks were prohibited from
issuing subordinated debt instruments.

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the Netherlands, the United Kingdom, and, to a more limited
extent, Hong Kong.

These reserves, however, generally have a

limited affect on capital because fixed assets comprise only a
small portion of a bank's total assets.

Fixed-asset revaluations

historically have not been permitted by accounting practices in
the United States, Germany, Switzerland, Canada and Japan.
Another form of "reserve" is the so-called latent
revaluation reserve, which arises from the implicit revaluation
of long-term holdings of equity securities valued on the balance
sheet at their original cost.

Under the Basle Accord, latent

revaluation reserves are permitted in Tier 2 subject to a
discount of 55 percent, which is applied to the difference
between the historic cost and the current market value of listed
equity securities in the investment portfolio.

The purpose of

the discount is to reflect the potential volatility of this form
of unrealized capital, as well as the tax charge which would be
associated with an actual sale.

Therefore, in practice, only 45

percent of such latent reserves may be included in Tier 2.

date, the only countries permitting the inclusion of latent
revaluation reserves in Tier 2 capital are Japan and Hong Kong;
the German authorities are currently considering the inclusion of
these reserves subject to additional restrictions. 161

ll/ The German authorities at present have under
consideration a proposal to allow the inclusion of latent
revaluation reserves within Tier 2, but only for banks with a
Tier 1 capital ratio of at least five percent. such reserves
would be limited to a maximum of one percentage point of Tier 2.

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General loan loss reserves can also be taken into Tier
2 capital up to 1.25 percent of total risk assets.

Under the

Accord, such reserves are only eligible for Tier 2 if the
reserves are created against the possibility of losses not yet
identified and are freely available to meet losses which may
subsequently materialize.

Provisions allocated to the impairment

of specific assets are excluded.
Countries such as the United States, the United
Kingdom, France, Japan, the Netherlands, Italy and Australia
permit the inclusion of general loan loss reserves up to the full
1.25 percent of total risk assets permitted by the Accord.

Many

countries, however, such as Canada, Belgium, Sweden, Switzerland
and Hong Kong prohibit the inclusion of any loan loss reserves in
Tier 2 capital.
The existence and treatment of general loan loss
reserves within Tier 2 varies from country to country as does the
distinction among specific, general and problem country loan loss
reserves.

In November, 1991, the Bale

Committee amended the

definition of general loan loss reserves for purposes of Tier 2
capital in order to remove some of these differences among
countries.

These changes were, at least in part, directed at

U.S. practices with regard to the inclusion of country risk
reserves in general provisions.

The U.S. banking regulators

concluded that the revised language was not in conflict with
current U.S. practice and announced that no change in existing

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U.S. risk-based capital guidelines would be required by this
amendment.

Deductions from Total Capital

The Accord requires the deduction from total capital of
investments in unconsolidated banking and financial subsidiaries.
This treatment of investments in unconsolidated banking and
financial subsidiaries was intended to prevent the use of capital
resources by different parts of the same banking group, which
would effectively double-count existing capital where the
subsidiaries are not consolidated.

Under the EC Directives, this

type of investment is deducted only if it constitutes more than
10 percent of the capital of the investee.
In addition, under the Accord, supervisory authorities
have the discretion to require the deduction, in whole or in
part, of investments in the capital of other banking and
financial institutions.

The practice of deducting a bank's

holding of capital instruments issued by other banks or financial
companies, whether equity or in other forms, stems from a desire
to discourage national banking systems from creating crossshareholdings of bank capital rather than seeking capital from
sources outside the banking and finance sectors.
Most countries require deduction of such investments
regardless of the purpose.

These investments must be deducted by

banks in the United States and Japan only if the sole purpose of
the investment is to increase the capital ratio.

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The EC

Directives require deduction only if the aggregate amount of this
type of investment exceeds 10 percent of the capital of the
reporting institution; only that part of the investment in excess
of 10 percent is deducted.

Risk Weights

The risk weights in the Accord were developed to
recognize the differences in risk between broad categories of
assets.

Risk weights act as a proxy for credit risk inherent in

categories of assets.
percent.

The weights range from zero percent to 100

For the most part, only five weights are used.

are O, 10, 20, SO, and 100 percent.

These

Member countries have

limited national discretion regarding the application of these
weights.
Of the countries surveyed, there are only a few
instances in which different risk weights have been assigned to
similar asset categories.

First, the risk weight assigned to

privately-issued residential mortgage-backed securities varies
from so percent in the United states to 100 percent in many other
countries (particularly members of the European Community).
Supervisors in the United States view mortgage-backed securities
as indirect holdings of the underlying mortgages and, thus, U.S.
banks may assign a so percent risk weight to such securities, as
well as to direct holdings of residential mortgages.

Most other

countries do not have such a market for mortgage-backed

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securities and banks from these countries, therefore, generally
hold residential mortgages on their books until maturity.
Second, claims collateralized by cash or OECD
government securities are given different treatment.

The

majority of countries reviewed assign this particular asset
category a zero percent risk weight; however, a few, such as the
United Kingdom, Australia, Hong Kong, and Ireland, currently
assign risk weights ranging between zero percent and 20 percent.
The United states has assigned a 20 percent risk weight to these
types of claims to limit the amount of assets in the zero percent
risk category, as well as to address concerns regarding the
operational risk of maintaining and liquidating collateral.

The

Board, however, is considering reducing the risk weight for
certain of these collateralized transactions from 20 percent to
zero percent.
A final area where there is some difference at this
time is the risk weight assigned to loans secured by mortgages on
commercial properties.

Currently, Basle subscribers assign this

particular asset category a 100 pe~cent risk weight; however, the
EC Directives permit Germany (as well as two other countries not
included in the sample) to apply, until January 1, 1996, a 50
percent weight to assets secured by mortgages on commercial
premises if the loan does not exceed 60 percent of the value of
the property.

In all other EC countries, mortgages on commercial

premises are currently assigned a 100 percent risk weight.

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Off-balance Sheet Activities

One of the driving forces behind the development of the
Basle Accord was the need to take into account, in the assessment
of capital, the increasing level of off-balance sheet activities
conducted by many internationally active banks.

The Basle Accord

accomplishes this by converting the various off-balance sheet
activities into on-balance sheet credit equivalent amounts.

The

credit equivalent amount of an off-balance sheet transaction is
intended to reflect the risk characteristics of the activity.
The credit equivalent amount of an off-balance sheet transaction
is assigned to one of the same risk categories that apply to onbalance sheet claims.
The Basle framework accords limited national discretion
with regard to the conversion factors used to convert off-balance
sheet transactions to on-balance sheet equivalents.There are,
therefore, a few differences in the credit equivalent conversion
factors used for particular off-balance sheet activities in
different countries.

Treatment of interest rate and foreign

exchange rate contracts also varies among countries.

These

differences, however, are of a very technical nature and their
effect is regarded as minor.

IV.

CAPITAL STANDARDS IN COUNTRIES NOT SUBSCRIBING TO THE BASLE
ACCORD AND COMPARISON WITH U.S. STANDARDS

Almost all of the countries included in the sample used
for this study subscribe to the Basle Accord.

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However, two

countries included in the sample - Brazil and Venezuela - do not
follow the Basle framework.

Banking supervisors in these

countries evaluate the capital adequacy of local banking
institutions with reference to local capital standards.

The

capital standards applied in these countries, however, do not
involve risk-weighting assets, but instead compare each
institution's total capital base to its total assets or to
certain specified liabilities.
Banking regulators in both Brazil and Venezuela are in
the process of revising the capital standards that banks must
meet.

The Brazilians have historically placed primary emphasis

upon the relationship of capital to liabilities and have required
banks to limit certain liability accounts to a specified multiple
of capital.

Banking regulators in Venezuela have judged the

capital adequacy of banks on a case-by-case basis and have used a
ratio relating capital to total assets as the primary tool in
this evaluation.

Several of the larger Venezuelan banks also

have begun to publish voluntarily a statement of their capital
position under the Basle framework in order to meet the
informational requirements of the international markets.
The components of capital in these countries are
limited predominantly to those elements of capital which under
the Basle Accord comprise Tier 1, including paid-up share capital
or common stock, disclosed equity reserves and minority
interests.

General loan loss reserves, which count as Tier 2

capital under the Accord, also would generally tend to be counted

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as part of total capital in these countries.

This is similar to

the treatment accorded such reserves under the capital guidelines
in effect in the United States prior to adoption of the riskbased capital standard.

The other types of capital instruments,

which under the Accord are permitted in Tier 2 capital, generally
are not issued.

Banking supervisors in countries experiencing

hyper-inflation, such as Brazil, also tend to permit banks to
take asset revaluations into their balance sheet to adjust at
least partially for the disruptive effects of hyper-inflation.
Although the capital standards in these countries are
different from those established by the Basle Accord or the EC
Directives, they still provide relevant and useful supervisory
information with regard to the financial condition of individual
institutions.

As noted above, one of the moving forces behind

the Basle Accord was concern within the G-10 regarding the
increase of off-balance sheet activities and concern that a
capital-to-assets standard, which was not risk-based, would not
sufficiently account for the risk inherent in off-balance sheet
activities.

Typically, however, banks in these countries, which

continue to rely upon ratios other than risk-based capital in
assessing capital adequacy, do not have significant levels of
off-balance sheet activities.

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THE U.S. LEVERAGE RATIO

Following implementation of the Basle Accord, a
leverage ratio requirement has remained in effect for U.S. banks.
The leverage ratio, as revised in August 1990, is defined as Tier
1 capital to total assets.

The leverage measure requires a

minimum ratio of three percent for banks that have received the
best rating accorded on supervisory examinations and are not
intending to grow inordinately.

All other institutions are

required to have ratios at least 100 to 200 basis points above
the minimum depending on their risk profile, plans for expansion
and other relevant factors.
This ratio was considered by U.S. regulators to be
necessary because the risk-based capital ratio, by itself, would
not constrain institutions from buying certain long-term
securities with a zero or low credit-risk weighting using, for
example, the proceeds of short-term borrowings.

Thus the

leverage ratio has been retained to address this aspect of
interest-rate risk, which is not yet taken into account by the
Basle framework.

The leverage measure was intended to provide a

temporary safeguard against heavy exposure to interest-rate risk
until such time as a separate supervisory measure for this risk
was devised and incorporated into the risk-based capital
framework.
Pursuant to the Federal Deposit Insurance Corporation
Improvement Act of 1991, U.S. regulators are currently in the

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process of developing proposals to supplement the risk-based
capital framework in order to take into account non-credit risks,
such as interest-rate risk.

These issues also are being

discussed by the Basle Committee.

Once interest-rate risk has

been incorporated into the risk-based capital framework, the need
for a leverage measure will need to be revisited.

At this time,

no other country subscribing to the Accord has adopted a leverage
measure, although many countries have other prudential or
regulatory means for addressing non-credit risks.
While U.S. regulators are considering the continuing
usefulness of leverage-ratio requirements generally, such
requirements may be of limited relevance to internationally
active foreign banks, especially once interest-rate risk is
factored into the risk-based capital framework.

The composition

of these banks' balance sheets reflects the structure of national
banking systems, the degree of sophistication of the markets in
which the particular banks operate, and the types of instruments
issued in those markets.
Although at the time of adoption of the Basle Accord
U.S. regulators chose to retain, at least temporarily, a leverage
ratio for U.S. banks, it was recognized that the internationally
agreed basis for assessing the capital adequacy of
internationally active banks was the risk-based capital standard.
This standard accommodates the significant differences in asset
structures of banks from different countries and takes into
account off-balance sheet activities.

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42
VI.

GUIDELINES FOR CONVERTING FOREIGN BANK CAPITAL DATA INTO
EQUIVALENT U.S. STANDARDS
Section 214(b) of the Foreign Bank Supervision

Enhancement Act of 1991 also requires the establishment of
guidelines to be used by the Board in converting data on the
capital of foreign banks to equivalent U.S. standards for
purposes of determinations under Sections 3 and 4 of the Bank
_Holding Company Act of 1956 and Section 7 of the International
Banking Act of 1978, as amended.
Section 3 of the Bank Holding Company Act requires
prior approval by the Board for the formation or merger of bank
holding companies and the acquisition of interests of banks, bank
assets, or control of bank or bank holding company securities.
Section 4 requires application to the Board with regard to the
acquisition of permissible nonbanking companies or engaging
directly in such nonbanking activities.

Section 7 of the

International Banking Act, inter alia, requires approval by the
Board prior to a foreign bank establishing a federally or statelicensed branch or agency or acquiring ownership or control of a
commercial lending company.

As noted above, two policy

statements previously have been issued by U.S. banking regulators
regarding the supervision and regulation of the U.S. operations
of foreign banks.
In acting on applications under these sections, the
Board considers several factors, including the financial and
managerial resources of the applicant, the future prospects of

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both the applicant and the firm to be acquired, the convenience
and needs of the community to be served, the potential public
benefits, and the competitive effects of the proposal.

With

respect to financial factors, specific areas of review have
included profitability, concentrations of risk, liquidity, asset
quality, adequacy of loan loss reserves, the proposed method of
funding the transaction, current and projected capital positions,
the risks associated with the proposed transaction, and the
effect of the transaction on the applicant's overall financial
resources.
In general, foreign banks seeking to establish
operations in the United States have been expected to meet the
same general standards of strength, experience, and reputation as
required for domestic institutions.

The Board has sought to

assure itself of the foreign bank's ability to support its U.S.
operations.
For purposes of making determinations in the future
with regard to applications submitted by foreign banks pursuant
to these sections, the Board will continue to take into account a
number of factors.

In determining whether a bank's capital meets

the minimum standard, as an initial requirement applicants from
countries that adhere to the Basle Accord will be required to
meet the Basle guidelines as administered by their home country
supervisors.

This study has shown that the Basle standard

provides a common basis for evaluating the general equivalency of
capital among banks from various countries.

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The eight percent

standard established by the Basle Accord is an agreed minimum
necessary to conduct basic banking and financial activities by
internationally active banks, both U.S. and foreign.

In this

regard, the guidelines should be applied to assure that any
differences in capital standards do not place U.S. banks at a
competitive disadvantage in their own market.
The Board will apply the minimum capital standard as
part of its guidelines.

However, it must be pointed out that

simply meeting the minimum capital standard will not
automatically imply that the financial condition of the foreign
bank applicant is consistent with the Board's approval of any
particular application.

As with applications by U.S. banking

organizations, the capital ratio necessary for applications by
foreign banking organizations to be considered for approval by
the Board will depend on the level of risk associated with the
activities which are the subject of the application.

For

example, the capital ratio necessary to obtain full underwriting
and dealing authority will be higher than the ratio required to
conduct a low-risk activity.
As part of an overall financial analysis, all foreign
banks from countries subscribing to the Basle Accord will be
required to submit detailed information supporting their capital
ratios.

Such information would include the various components of

Tier 1 and Tier 2 capital, a breakdown of assets by risk
categories and an explanation of any material differences between
U.S. accounting standards and those employed in the home country.

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The Board also anticipates receiving applications
from banks in countries not subscribing to the Accord.

In these

cases, the applicant will be requested to provide information
regarding the capital standard applied by its home country, as
well as information sufficient to evaluate the applicant's
capital position adjusted as appropriate for accounting and
structural differences.

The applicant will also be requested to

provide, to the extent possible, information comparable to the
Basle format.
As noted above, the capital position of both U.S. and
foreign bank applicants is generally the starting point for the
overall analysis of the financial condition of the applicant.

with domestic banks, a further analysis of the additional
financial factors referenced above, including asset structure and
quality, earnings, liquidity and supplementary capital
composition, will be necessary to determine whether the
applicant's financial strength is equivalent to that expected of
U.S. banks.

The Board, in making determinations on applications,

never relies solely upon one factor.

Instead, prior to reaching

a determination, the Board will take into account all of the
factors enumerated by the applicable statutes.

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APPENDIX A

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SEC.

214

TEXT OF SECTION 214(b) OF THE FOREIGN BANK
SUPERVISION ENHANCEMENT ACT OF 1991
MISCELLANEOUS AMENDMENTS
BANKING ACT OF 1978

THE

INTERNATIONAL

(b) SECTION 7. - Section 7 of the International Banking
Act of 1978 (12 U.S.C. 3105) is amended by adding at the
end the following new subsection:
"(j) STUDY ON EQUIVALENCE OF FOREIGN BANK CAPITAL - Not
later than 180 days after enactment of this subsection,
the Board and the Secretary of the Treasury shall jointly
submit to the Committee on Banking, Housing, and Urban
Affairs of the Senate and the Cammi ttee on Banking,
Finance and Urban Affairs of the House of Representatives
a report"(l) analyzing the capital standards contained in
the framework for measurement of capital adequacy
established by the Supervisory committee of the
Bank
for
International
Settlements,
foreign
regulatory capital standards that apply to foreign
banks conducting banking operations in the United
States, and the relationship of the Basle and
foreign
standards to
risk-based capital
and
leverage requirements for United States banks; and
"(2) establishing guidelines for the adjustments to
be used by the Board in converting data on the
capital of such foreign banks to the equivalent
risk-based capital and leverage requirements for
United States banks for purposes of determining
whether
a
foreign
bank' s
capital
level
is
equivalent to that imposed on United States banks
for purposes of determinations under section 7 of
the International B~nking Act of 1978 and sections
3 and 4 of the Bank Holding Company Act of 1956.
An update shall be prepared annually explaining any
changes in the analysis under paragraph (1) and resulting
changes in the guidelines pursuant to paragraph (2).

APPENDIX B

THE BABLE ACCORD

INTRODUCTION

The Basle Accord is a risk-based capital framework for
the assessment and measurement of capital that is applicable to
member countries.
that:

The Accord establishes an analytical framework

(1) makes regulatory capital requirements more sensitive

to differences in risk profiles among banking organizations; (2)
takes off-balance sheet exposures into explicit account in
assessing capital adequacy; and (3) minimizes disincentives to
holding liquid, low-risk assets.
The framework is designed to establish minimum levels
of capital for internationally active banks.

National

authorities are free to adopt arrangements that set higher
levels.

In addition, limited national discretion is provided

regarding whether to allow banks to include certain components,
which are eligible under the Accord, in capital.
The Basle Accord focuses principally on broad
categories of credit risk, although the risk-based framework does
take some transfer risk considerations, as well as limited
instances of interest rate and market risk, into account in
assigning certain assets to risk categories.

The measure does

not take explicit account of factors other than credit risk,
which may affect an organization's financial condition, such as
overall interest rate exposure; liquidity, funding and market
risks; the quality and level of earnings; investment of loan
portfolio concentrations; the quality of loans and investments;

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the effectiveness of loan and investment policies; and
management's overall ability to monitor and control other
financial and operating risks.

II.

OVERVIEW OF THE BASLE ACCORD

The Accord comprises three basic elements:

(1) an

agreed definition of Tier 1 capital, consisting primarily of
common stockholders• equity and certain categories of perpetual
preferred stock, and a "menu" of internationally accepted items
for supplementing core capital (Tier 2 capital);

(2) a general

framework for assigning assets and off-balance sheet items to
broad risk categories and procedures for calculating a risk-based
capital ratio; and (3) a schedule for achieving, by no later than
the end of 1992, a minimum ratio of total capital-to-riskweighted assets of eight percent (of which at least four
percentage points should be in the form of core capital
elements.)

Components of Capital

Under the risk-based framework, a bank's total capital
is the sum of Tier 1 and Tier 2 capital, less any deductions.
The various capital elements and deductions are described below.
Included at pages 16 to 18 of this appendix is a table that

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summarizes the areas in which national discretion is permitted in
the G-7 countries, as allowed by the Accord.

Tier 1 Capital (Core Capital}

A fundamental premise underlying the Basle Accord is
that the key element of capital on which the main emphasis should
be placed is equity capital. Accordingly, Tier 1 capital includes
only permanent shareholders' equity (issued and fully paid common
stock and noncumulative preferred stock and related surplus) and
disclosed reserves created or increased by appropriations from
post-tax retained earnings.

It also includes minority interests

in the equity accounts of consolidated subsidiaries that are less
than wholly owned.

This definition of equity capital excludes

revaluation reserves and cumulative preferred stock.

Equity

capital is the only element of capital common to all countries'
banking systems; this results from recognition of the importance
of equity capital in maintaining a bank as a going concern.

Tier 2 Capital (Supplementary Capital)

The amount of Tier 2 capital included in total capital
is limited to 100 percent of an institution's Tier 1 capital.
Tier 2 capital elements consist of a menu of internationally
accepted items for supplementing equity capital.

Each of these

elements may be included by national authorities at their
discretion in light of their national accounting and supervisory
regulations.

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These elements are discussed below.
3

Undisclosed reserves

These reserves consist of portions of accumulated
after-tax retained earnings that banking supervisors in some
countries permit banks to maintain on an undisclosed basis.
Apart from the fact that such reserves are not identified in the
published balance sheet, they have the same high quality and
character as disclosed capital reserves, which are included in
Tier 1 capital.

Revaluation reserves

There are two types of such reserves.

The first type

arises from a formal revaluation, carried through to the balance
sheet, of a bank's own premises.

The second type arises from a

notional addition to capital of latent, or hidden, values
inherent in long-term holdings of equity securities valued on the
balance sheet at the historic cost of acquisition.

Latent

revaluation reserves consist of the difference between the
historic cost book value and market value of such securities.
Either form of revaluation reserve may be included in
Tier 2 capital provided that the bank's national supervisory
authority recognizes such reserves in capital and considers such
reserves to be prudently valued, fully reflecting the possibility
of price fluctuations and forced sale.

In this connection,

latent revaluation reserves associated with holdings of equity
securities must be discounted by 55 percent to reflect the

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potential volatility of this form of unrealized capital and the
notional tax charge on it.

General provisions/general loan loss reserves

This item includes provisions or loan loss reserves,
which are held against future and presently unidentified losses
and are freely available to meet losses that may subsequently
materialize.

This definition excludes provisions ascribed to the

impairment of particular assets or known liabilities.

The amount

of such general provisions or general loan loss reserves
permissible in Tier 2 capital is generally limited to 1.25
percent of risk-weighted assets.

Hybrid (debt/equity} capital instruments

These instruments combine characteristics of equity
capital and of debt.

Their precise specifications differ from

country to country, but they should meet the following
requirements:

they are unsecured, subordinated and fully paid-

up; they are not redeemable at the initiative of the holder or
without the prior consent of the supervisory authority; they are
available to participate in losses without the bank being obliged
to cease trading (unlike conventional subordinated debt); and
they should allow service obligations to be deferred where the
profitability of the bank would not support payment.

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The most widely known form of hybrid capital instrument
5

is cumulative perpetual preferred stock.

The Basle Accord notes

that a number of instruments that are largely unique to
individual countries may also qualify as hybrid capital
instruments, such as U.S. mandatory convertible securities and
U.K. perpetual debt instruments.

Subordinated term debt

Subordinated term debt includes conventional unsecured
subordinated debt capital instruments and limited life preferred
stock.

To be included in capital, such instruments must have a

minimum original maturity of five years.

During the last five

years to maturity, a cumulative discount (or amortization) factor
of 20 percent per year is applied to the amount of such
instruments to reflect the diminishing value as a continuing
source of strength to the banks.

Unlike instruments included in

item (d) above, these instruments normally are not available to
participate in the losses of a bank which continues trading.

For

this reason, the amount of such instruments permitted in Tier 2
capital is limited to a maximum of 50 percent of Tier 1 capital.

Deductions from Capital

The following deductions should be made from the
capital base for the purpose of calculating the risk-weighted
capital ratio.

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The deductions consist of:

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goodwill, an intangible asset which is
deducted from Tier 1 capital elements;

investments in unconsolidated subsidiaries
engaged in banking and financial activities.
Normally such subsidiaries should be
consolidated for the purpose of assessing the
capital adequacy of banking groups.

Where

this is not done, deduction is essential to
prevent the multiple use of the same capital
resources in different parts of the banking
group.

The deduction for such investments is

made against the total capital base.

The

assets representing the investments in
subsidiary companies whose capital has been
deducted from the parent's capital is not
included in total assets for the purposes of
computing the risk-based capital ratio;

at national supervisory discretion, banks'
holdings of capital issued by other banks or
deposit-taking institutions, whether in the
form of equity or of other capital
instruments, may be required to be deducted
from the total capital base.

As a general

matter, reciprocal cross-holdings of bank
7

capital designed to inflate artificially the
capital position of the banks concerned
should be deducted from organizations' total
capital base.

Framework for Risk Categories

The risk-based framework relates capital to different
categories of assets, weighted according to broad categories of
relative riskiness, in assessing the capital adequacy of banks.
The resulting risk ratio has three key advantages over the
simpler gearing or leverage ratio, which relates capital to total
assets:

1) it provides a fairer basis for making international

comparisons between banking systems whose structures may differ:
2) it allows off-balance sheet exposures to be incorporated more
easily into the capital calculations: and 3) it does not deter
banks from holding liquid or other assets which carry low risk.
The framework of weights employs only five riskweighted categories

o, 10, 20, 50 and 100 percent -- to which

all claims, including on-balance sheet assets and credit
equivalent amounts of off-balance sheet items, are assigned.

The

100 percent risk weight is considered the standard risk weight to
which the bulk of a bank's assets or off-balance sheet items
normally is assigned.

The assignment of various types of assets

to particular risk-weight categories inevitably entails broad-

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brush judgments. Consequently, the risk category to which a claim
is assigned should not be regarded as a substitute for commercial
judgment for purposes of market pricing of that asset or offbalance sheet item.
Total risk-weighted assets are calculated by first
multiplying the face amount of each asset or the credit
equivalent amount of each off-balance sheet item by the riskweight percentage of the risk category to which the claim is
assigned.

The resulting amounts are then added together to

arrive at total risk-weighted assets.

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Risk-Weight categories

Cash

Claims on, or guaranteed by, central
governments and central banks
denominated in national currency and
funded in that currency

Other claims on, or guaranteed by,

OECD 1 central governments and central
banks

Claims collateralized by cash or OECD
central-government securities.

0, 10,

Claims on domestic public sector

20,50%

entities 2 and loans guaranteed by such
entities

(at national discretion)

20%

Claims on multilateral lending
institutions and regional development
banks and claims guaranteed by, or

1
In the context of the Basle Accord, OECD countries
include all full members of the Organization for Economic
Cooperation and Development (OECD), as well as all countries that
have concluded special lending arrangements with the
International Monetary Fund (IMF) associated with the Fund's
General Arrangements to Borrow. The OECD includes the following
countries: Australia, Austria, Belgium, Canada, Denmark, the
Federal Republic of Germany, Finland, France, Greece, Iceland,
Ireland, Italy, Japan, Luxembourg, Netherlands, New Zealand,
Norway, Portugal, Spain, Sweden, Switzerland, Turkey, the United
Kingdom, and the United States. Sa.udi Arabia has concluded
special lending arrangements with the IMF associated with the
Fund's General Arrangements to Borrow.

2
Public sector entities are those entities below the level
of the central government, for example, states and local
authorities. A separate category was created for such entities
in view of their special character and varying creditworthiness
in different member countries. Such entities do not include
commercial companies owned by the public sector, which are
instead assigned a 100 percent risk weight to avoid competitive
inequality vis-a-vis similar private sector commercial
enterprises.

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collateralized by securities issued by,
such entities

Claims on banks incorporated in the OECD
countries and loans guaranteed by such
banks

Claims on, or guaranteed by, banks
incorporated in countries outside the
OECD with a remaining maturity of one
year or less.

Claims on, or guaranteed by, nondomestic
OECD public sector entities

Cash items in process of collection

50%

Loans fully secured by mortgages on
residential property that is, or will
be, occupied by the borrower or that is
rented

100%

Claims on the private sector

Claims on, or guaranteed by, banks
incorporated outside the OECD with a
11

remaining maturity of over one year

Claims on, or guaranteed by, central
governments outside the OECD that are
not denominated in the local currency
and funded in that currency

Claims on commercial companies owned by
the public sector

Premises, plant, and equipment and other
fixed assets

Real estate and other investments

Capital instruments issued by other
banks (unless deducted from capital)

All other assets

Off-Balance Sheet Activities

The Basle Committee considered that it was also of
great importance that all off-balance sheet activity should be
captured within the capital adequacy framework.

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It was also

recognized, however, that there was only limited experience in
assessing the risks associated with some of the activities and
that, for some countries, a complex analytical approach and
detailed reporting systems could not easily be justified because
the amounts of such business, particularly in the newer, more
innovative instruments, were small.
The approach that was adopted is comprehensive in that
all categories of off-balance sheet activities, including recent
innovations, are converted to credit risk equivalents by
multiplying the nominal principal amounts by a credit conversion
factor with the resulting amounts then being weighted according
to the nature of the counterparty.

The different off-balance

sheet activities are divided into five broad categories, which
are as follows:
1. those which substitute for loans (for example, general
guarantees for indebtedness, bank acceptance guarantees, and
standby letters of credit serving as financial guarantees for
loans and securities).

This particular category will carry a 100

percent credit risk conversion factor;
2. certain transaction-related contingencies {for example,
performance bonds, bid bonds, warrants and standby letters of
credit relating to particular transactions).

A 50 percent credit

risk conversion factor will be applied to this category;
3. short-term, self-liquidating, trade-related contingent
liabilities arising from the movement of goods {for example,
documentary credits collateralized by the underlying shipments).

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A 20 percent credit risk conversion factor will be applied to
this category;
4. commitments with an original majority exceeding one year
and all Note Issuance Facilities (NIFs) and Revolving
Underwriting Facilities (RUFs).

A 50 percent credit risk

conversion factor will be applied to this category; and
5. interest and exchange-rate related items (for example,
swaps, options, futures).
With regard to the last item above, the Basle Committee
felt that special treatment was needed for such off-balance sheet
items due to the fact that banks are not exposed to credit risk
for the full notional amount of the contracts involved but rather
only to the replacement costs associated with the contracts if a
counterparty defaults.

The Accord permits members to choose one

of two methods to calculate replacement cost.

Under the first

method, the current replacement cost is calculated by marking to
market the relevant contracts and adding a factor to represent
potential exposure during the remaining life of the contract.
The alternative approach is to use conversion factors based upon
the notional principal sum underlying each contract according to
its type and maturity.

Target Standard Ratio
The Basle Accord establishes a target minimum ratio of

total capital to total risk-weighted assets that international
banks generally are expected to achieve by the end of the

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transitional period, that is, by year-end 1992.

The standard has

been set at a level that is deemed to be consistent with the
objective of securing, over time, soundly-based and consistent
capital ratios for all international banks.

Accordingly, the

target standard ratio of total capital to total risk-weighted
assets has been set at eight percent, of which at least half, or
four percent, should be in the form of Tier 1 capital.

The

transitional period to the end of 1992 (March 1993 for Japanese
banks as this is their fiscal year end for 1992) is intended to
allow time for progressive steps toward adjustment by banks that
may need to build up to the eight percent minimum level and to
obviate any requirement for such banks to take immediate or
precipitous action.

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Risk-Based Capital Accord: Summary of Areas in which
National Discretion is Permitted in G-7 Countries
United
States

Japan

Germany'

Canada

United
Kingdom

Non-Cumulative Perpetual Preferred
Stock

Permitted

Permitted;
however
none issued
to date

Permitted

Issues not
permitted in
domestic
market

Permitted

Current-Year Profit (or Loss)

Profits may
be included;
losses must
be deducted

Profits may
not be
included;
losses do
not have to
be deducted

Profits may
be included;
losses must
be deducted

Profits
included
only if
published 2;
losses must
be deducted

Profits may
be included;
losses must
be deducted

Profits must
be included;
losses must
be deducted

Required
with
exception of
Purchased
Mortgage
Servicing
Rights
(PMSRs)
and
Purchased
Credit Card
Receivables
(PCCRs)

Not
permitted by
local
accounting
principles

Not
required;
OIA
permitted by
local
accounting
principles
only in
exceptional
cases

Not
permitted by
local
accounting
principles

Required
with
exception of
U.S.
PMSRs

Required
with
exception of
lease
renewal
rights

Required

France

Italy

TIER 1 (Core Capital):

.....
O'I

Deductions from Tier l Capital

•

Deduction of Intangible Assets
Other than Goodwill (OIA)

NOTE:
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This table was compiled based upon various sources, including information supplied by central bank officials from the respective
countries. Because the table is a summary, it cannot encompass the full complexity of the topics ai.ldressed.

United
States

Japan

Germany1

Canada

Undisclosed Reserves

Not
permitted by
local
accounting
principles

Allowed
only if such
reserves
have been
taxed and
audited

Not
permitted by
local
accounting
principles

Hybrid Capital Instruments (including
cumulative perpetual preferred stock)

Permitted

Permitted,
but not
prevalent

Permitted
(up to 25
percent of
total capital)

United
Kingdom

France

Italy

Not
permitted to
commercial
banks

Not
permitted by
local
accounting
principles

Not permitted
by local
accounting
principles

Permitted

Permitted,
but not
prevalent

TIER 2 (Supplementary Capital):

Term Instruments (up to 50 percent
of Tier 1)
I-'

......

•

Subordinated Term Debt

Permitted

Not
permitted

Permitted

•

Limited Life Redeemable
Preference Shares

Permitted
and issued

Permitted,
but not
issued

Not
permitted

Permitted
and issued

Permitted,
but not
issued

Permitted,
but only for
Italian
subsidiaries
of foreign
banks

Fixed Asset Revaluation Reserves
(On-balance sheet)

Not allowed
by local
accounting
principles

Permitted

Permitted
periodically,
when allowed
by special
legislation

"Latent" Revaluation Reserves (with
55 percent discount on equities in
investment portfolio)

Excluded

Included

Excluded

General Loan Loss Reserves (up to
1.25 percent)

Included

Excluded

Included

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United
States

Japan

Required,
only if sole
purpose is
to raise
capital ratio

Germany'

Canada

United
Kingdom

France

Italy

Only if in
excess of a
specific
percent of
investor's or
investee's
capital

Deductions from Total Capital

•

I-'

Investments in the capital of
other banks and financial
institutions

Not
Required

Required, if
in excess of
IO percent
of voting
shares or if
sole purpose
is to raise
capital ratio

Required,
but with a
market
making
exemption
(up to a
specific
percent of
investor's or
investee's
capital)

l. Major changes to the German Banking Law implementing the EC Capital Directives are expected by year-end 1992.

2. Profits must also be verified by the auditors.

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APPENDIX C

CAPITAL STANDARDS IN THE EUROPEAN COMMUNITY

Seven of the twelve members of the Basle Committee on
Banking Supervision are also member states of the European
Community.!'

There is, therefore, a great deal of comparability

between the Basle Accord and the EC capital standards set out in
relevant EC Directives.

The two primary Directives addressing

capital standards are the own Funds and Solvency Ratio
Directives, which were adopted in April 1989 and December 1989,
respectively, following the adoption of the Basle Accord in July
1988.

These Directives are part of the harmonization exercise

underlying the development of a single market in financial
services in the European Community.
These Directives establish a common definition of
capital, as well as minimum standards for capital adequacy for
credit institutions.

Implementation by EC member states was

required by January 1991; however, credit institutions are not
required to meet the minimum eight percent standard until
January 1, 1993.

These transitional arrangements correspond

closely to those included in the Basle Accord.
Whereas the Basle framework is non-compulsory and
applies only to internationally active banks, the EC Directives
have the force of law within the EC and, therefore, establish
mandatory minimum standards.

These standards apply to all credit

institutions incorporated in the member states rather than only
!/ The twelve member states of the European Community are
Belgium, Denmark, France, Germany, Greece, Ireland, Italy,
Luxembourg, the Netherlands, Portugal, Spain and the United
Kingdom.

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If the treaty establishing the

to internationally active banks.

European Economic Area (EEA) is ratified, these directives also
will have the force of law within the seven countries of the
European Free Trade Association (EFTA).Z1
The EC capital standard, like the Basle Accord, is
based on a minimum eight percent risk-weighted capital ratio.
Similar to the Basle Accord, EC member states have national
discretion to impose capital standards which are more stringent
than the minimum established in the Directives.
The EC Directives, however, in some respects depart
from the provisions of the Basle Accord.

Some departures from

the Accord are minor in nature and were necessary in order to
accommodate the differences in banking structures and financial
markets within the European Community and to accomplish
harmonization of minimum capital standards within EC member
states prior to the establishment of a single market in 1993.
Other differences are more significant and, for the most part,
remove some of the flexibility permitted by the Accord regarding
the components of Tier 1 and Tier 2 capita1,i1
capital, and risk weightings.

deductions from

These differences are discussed

below.
i i The seven EFTA countries are Austria, Finland, Iceland,
Liechtenstein, Norway, Sweden and Switzerland.

Al It should be noted that the E.C. Directives refer to
"original own funds" and "additional own funds" rather than to
Tier 1 (core) capital and Tier 2 (supplementary) capital which
are the terms used in the Basle Accord. These differences in
terminology have no substantive effect and, therefore, for
purposes of this report, the Basle terminology will be used.

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Tier 1 Capital

Under the Basle Accord, all current year profits may be
included in Tier 1 at national discretion.

Under the EC

standards, however, current year profits may only be included in
Tier 1 if those profits have been verified by auditors.
The EC Directives also establish a "Fund for General
Banking Risks" which will be included in Tier 1 capital, subject
to certain limitations discussed below.

The European Community

provided for the establishment of this Fund in the Bank Accounts
Directive (which must also be implemented by member states by
January 1993) in order to facilitate the gradual phasing out of
so-called "hidden" reserves.

These reserves constitute

shareholders' funds and, although not published or disclosed
other than to supervisory authorities, are permitted by the
accounting practices in a few member states.

Such balances would

have been included in Tier 1 capital if published, like, e.g.,
retained earnings; however, because of their lack of transparency
they were included in Tier 2, or supplementary, capital under the
Basle Accord.
Limitations which apply to the Fund are:

1) amounts

can only be transferred to or from the Fund via the post-tax
balance on the profit and loss account, i.e., losses may not be
directly charged to the Fund but must be taken through the profit
and loss account; 2) the Fund must be disclosed separately in the
bank's published accounts; and 3) the Fund must be freely
available to a bank to meet losses as soon as they occur. The

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Basle Committee has agreed that balances in such accounts are
properly part of core capital and should be included in Tier 1;
funds with the same characteristics in the accounts of non-EC
countries will be entitled to similar treatment.

The Committee

will keep this area under review to ensure that the desired
effect of further convergence and improved quality of capital is
achieved.
2. Tier 2 Capital
Although the Basle Accord permits the inclusion of
undisclosed reserves in Tier 2 capital without limit, under the
terms of the relevant EC Directives, the portion of these
reserves which may remain undisclosed (and continue to count as
Tier 2 capital) is limited to four percent of designated assets.
Any excess over the permitted four percent, in order to be
included in capital, must qualify for inclusion in the Fund for
general banking risk, discussed above, by being disclosed, taxed
and passed through the statement of profit and loss.
The EC capital standards also deny to its member states
the use of the latent revaluation reserves which are permitted
under the Accord.

Consequently, the EC does not allow 45 percent

of latent revaluation reserves to be included in Tier 2
supplementary capital.

The EC Directives only permit disclosed

revaluation reserves (those formally recognized in financial
statements) to be included in Tier 2 capital.
With regard to general loan loss reserves, the EC
Directives place such reserves in the "other items" category for

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which there is no separate limit in Tier 2 capital.

The Basle

Accord restricts general loan loss reserves in Tier 2 to 1.25
percent of risk-based assets.
3. Deductions from Capital
The Basle Accord grants national discretion to
supervisory authorities to either require deduction (in whole or
in part) or a 100 percent risk weighting of all holdings of
capital of other banks and financial institutions.

The EC

Directives, however, require investments in capital of other
banks and financial institutions to be deducted from capital when
such investments are in excess of 10 percent of the investee
institutions capital.

In such cases, the entire amount of the

investment is deducted.

If investments in the capital of other

banks and financial institutions are in excess of 10 percent of
the reporting institution's own funds, the excess amount only is
required to be deducted.
4. Risk Weightings
Some minor differences also exist between risk
weightings included in the Basle Accord and the EC Directives.
For example, EC member states may, at national discretion, apply
a 10 percent weighting to claims on institutions specializing in
the interbank and public debt markets.

These assets were not

categorized separately in the Basle framework.

Second, a more

extensive allowance for collateral applies under the EC
directives than under the Basle framework as member states are
permitted to weight assets collateralized by securities issued by

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OECD regional governments or local authorities or by deposits
with, or certificates of deposits issued by, OECD banks at 20
percent.

Conversion Factors

The capital framework established by the EC Directives
also encompasses off-balance sheet activities, which are broadly
divided into two groups: (1) interest rate and foreign exchange
risks; and (2) all other off-balance sheet activities.
Generally, with regard to interest rate and foreign exchange
contracts, banks may choose either the marking to market (or
current replacement cost) approach or the original exposure (or
residual maturity) approach to measure the risks associated with
these transactions.

With regard to other off-balance sheet

activities, they are first classified and valued according to the
risk characteristics of the activities.

The off-balance sheet

values for these activities are then multiplied by the risk
weightings attributable to the relevant counterparties.

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APPENDIX D

U.S. CAPITAL STANDARDS -- IMPLEMENTATION OF THE
BASLE ACCORD

INTRODUCTION

Banks and bank holding companies in the United States
have been required to follow risk-based capital guidelines since
early 1989.

The guidelines were issued by the three federal

banking agencies following discussions at the Basle Committee and
opportunity for public comment.

The risk-based capital

guidelines of the three federal banking agencies are very similar
and closely follow the requirements of the Basle Accord.

These

guidelines are subject to ongoing review as part of the efforts
of the Basle Committee to further refine the Accord.
While the Basle Accord is specifically directed towards
internationally active banks, the three federal banking agencies
extend the application of the risk-based capital framework to all
U.S. banks under their jurisdiction. 1

The Board also applies the

broad principles of the risk-based capital framework to U.S. bank
holding companies on a consolidated basis.

Office of Thrift Supervision also employs a risk-based
framework for assessing the capital adequacy of savings
associations under its jurisdiction. The regulation implementing
this framework was issued in October 1989. This regulation
parallels the risk-based capital guidelines for banks but
contains some differences meant to accommodate thrifts' large
involvement in mortgage-related transactions.

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1The

II.

U.S. APPLICATION OF THE RISK-BASED CAPITAL FRAMEWORK

As permitted by the Basle Accord, U.S. regulators
exercise national discretion with regard to the inclusion of
certain categories of capital, as well as various risk weights of
assets.

The U.S. approach to the components of Tier 1 and Tier 2

capital, deductions from total capital and risk weights of assets
is described below.

Tier 1 Capital

U.S. regulators define Tier 1 capital as paid-up share
capital, retained earnings, minority interests and current year
profits (or losses).

In addition, banks may include any non-

cumulative perpetual preferred stock that has been issued.
Goodwill is deducted from Tier 1, as required by the Accord.

The

U.S. guidelines also require the deduction of other intangible
assets with the exception of limited amounts of purchased
mortgage servicing rights and purchased credit card receivables.
In applying the risk-based capital framework to holding
companies, the Board adopted a definition of Tier 1 capital that
differs somewhat from the definition contained in the Basle
Accord for international banks.

This difference involves the

inclusion of cumulative perpetual preferred stock in Tier 1
capital, which the Basle Accord restricts to Tier 2 capital.
Under the U.S. risk-based capital guidelines, bank holding
companies (but not banks) are allowed to include cumulative

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perpetual preferred stock in Tier 1 capital up to 25 percent of
Tier 1 capital.

Tier 2 Capital

Under the Basle Accord, national discretion is applied
to all categories of capital permitted in Tier 2.

U.S.

regulators define Tier 2 as general loan loss reserves (up to
1.25 percent of risk-weighted assets), hybrid capital instruments
and term instruments such as subordinated term debt and limited
life redeemable preferred stock.

The term instruments are

limited to 50 percent of Tier 1 capital.

U.S. regulators permit

the inclusion of country risk reserves in general loan loss
reserves.
U.S. banks are prohibited by generally accepted
accounting principles from maintaining undisclosed equity
reserves.

Full disclosure by U.S. banks means that all equity

reserves are included in Tier 1 capital.

U.S. banks are also

prohibited by accounting principles from revaluing fixed assets
or marking investment portfolios to market.

Deductions from Total Capital

Under the Basle Accord and U.S. guidelines, the
aggregate amount of investments in unconsolidated banking or
finance subsidiaries are deducted from a bank's total capital
base.

The Accord also states that national supervisors, at their

discretion, may require banks to deduct holdings of capital

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instruments issued by other banks or financial institutions from
their total capital.

The U.S. guidelines generally require

deduction of reciprocal holdings of capital instruments of other
banking organizations only if these cross-holdings are
intentional.

Risk Weights

The U.S. guidelines regarding the risk weights for
assets closely follow those specified in the Accord except in a
few minor respects.

The Basle Accord allows claims

collateralized by cash or OECD government securities to be
assigned a zero percent risk weight.

The U.S. guidelines,

however, weight these claims at 20 percent in order to limit the
amount of assets in the zero percent risk category, as well as to
address concerns regarding the operational risks of maintaining
and liquidating collateral.

The Board is proposing to lower the

risk weight from 20 percent to zero percent for certain low-risk
collateralized transactions.
The Basle Accord allows national discretion to weight
claims on, or guaranteed by, domestic public sector entities
(PSEs) in the zero, 10, 20, or 50 percent risk category.

PSEs

are defined in the Accord as entities "below the level of central
government (e.g., states, local authorities, etc.)."
considers state and local governments to be PSEs.

The U.S.

However, the

risk weight assigned to PSEs under U.S. guidelines depends on the
type of claim.

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A 20 percent risk weight is assigned to general
4

obligation claims and a 50 percent risk weight is assigned to
revenue obligation claims on such entities.

Industrial

development bonds issued by state and local governments are
assigned to the 100 percent risk category.

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Full text of Capital Equivalency Report

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