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Federal r e s e r v e Ba n k o f D allas
DALLAS, TEXAS

75222
Circular No. 82-64
June 4, 1982

CAPITAL ADEQUACY
Criteria for Mandatory Convertible Debt Securities

TO ALL STATE MEMBER BANKS AND
BANK HOLDING COMPANIES IN THE
ELEVENTH FEDERAL RESERVE DISTRICT:
The Board of Governors of the Federal Reserve System and the Office of
the Comptroller of the Currency have adopted criteria for determining whether
mandatory convertible debt securities can qualify as primary capital in assessing
capital adequacy.
Although these criteria will be effective immediately, the Board has
requested comment on the criteria to be submitted by June 24, 1982, to the
Secretary, Board of Governors of the Federal Reserve System, Washington, D. C.
20551.
Printed on the reverse of this circular is a copy of the Board's press
release and enclosed is the policy statem ent of the criteria for assessing mandatory
convertible issues. Questions from state member banks should be directed to Marvin
C. McCoy of our Bank Supervision and Regulations Department, Ext. 6657 and bank
holding companies should contact Basil J. Asaro of our Holding Company Supervision
Department, Ext. 4345.
Additional copies of this circular will be furnished upon request to the
Department of Communications, Financial and Community Affairs, Ext. 6289.
Sincerely yours,

William H. Wallace
First Vice President
Enclosure

Banks and others are encouraged to use the following incoming W A T S numbers in contacting this Bank:
1-800-442-7140 (intrastate) and 1-800-527-9200 (interstate). For calls placed locally, please use 651 plus the
extension referred to above.

This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)

FEDERAL RESERVE press release
For immediate

The

release

May 26, 1982

Federal Reserve

Board today made public criteriafor determining

whether debt securities issued by State member banks and bank holding companies
with a mandatory requirement for future conversion to equity can qualify as
primary capital in assessing capital adequacy.
The

Board will begin immediately to apply these criteria

adoptedfor national banks by
—

the Office of the Comptroller of

—

also

the Currency

to mandatory convertible issues of State member banks and bank holding

companies.

However, the Board asked for comment on the criteria, to be

submitted to the Secretary of the Board by June 24, 1982.

Any changes

subsequently made in the criteria would apply to securities issued after the
revision.
The Board, and the Comptroller, earlier adopted guidelines for
assessing bank and bank holding company capital adequacy to be used by the
two agencies in the examination and supervision of financial institutions
they supervise.

The guidelines recognized as primary capital common stock,

perpetual preferred stock, capital surplus, undivided profits, reserves for
contingencies and other capital reserves, the allowance for possible loan
losses and mandatory convertible instruments.

The criteria now issued are

meant to clarify the characteristics mandatory convertible issues must have
if they are to be included in primary capital.
The Board stressed that any organization that now has a capital
deficiency should regard the sale of mandatory convertible securities as
making up for the deficiency and not as the basis for additional leverage.
The criteria for assessing mandatory convertible issues are attached.

ATTACHMENT

FEDERAL RESERVE BOARD
OFFICE OF THE COMPTROLLER OF THE CURRENCY

CRITERIA FOR DETERMINING PRIMARY CAPITAL STATUS OF
________ MANDATORY CONVERTIBLE SECURITIES_________

On December 17, 1981, the Federal Reserve and the Office of
the Comptroller of the Currency issued capital adequacy guidelines that
are now being used by these agencies in assessing the capital of well
managed national banks, state member banks and bank holding companies.
In implementing this capital program, the agencies are using two prin­
cipal capital measurements:

(1) primary capital, and (2) total capital.

Primary capital consists of common stock, perpetual preferred stock,
capital surplus, undivided profits, reserves for contingencies and other
capital reserves, mandatory convertible instruments and the allowance for
possible loan losses.

Total capital includes the primary capital com­

ponents plus limited life preferred stock and qualifying subordinated
notes and debentures.
As indicated, one of the components of primary capital is man­
datory convertible securities.

Historically, banking organizations have

issued mandatory convertible securities only on rare occasions.

Recently,

there has been a sizable amount of securities sold that were designed to
qualify as mandatory convertible securities.

A number of banking organi­

zations have expressed interest in marketing similar securities and have
inquired as to whether the terms and conditions of their proposals would
qualify the issue for regulatory treatment as part of the institution's
primary capital.

In view of this interest, the Federal Reserve and the

Office of the Comptroller of the Currency have developed a set of cri­
teria that will be applied in determining whether a particular issue

-2 -

qualifies as primary capital.

In developing the criteria, the Agencies

wish to stress that the principal determinant is the permanence of the
funds and the certainty with which the debt issue will be replaced by
permanent equity.

In this respect, there have thus far been two basic

approaches to the concept of mandatory convertible securities.

The

first is a so-called "equity note" which obligates the holder of the
note to purchase a like amount of stock in the issuing institution.
The second involves a note which obligates the issuer to sell stock in
sufficient amounts to replace the debt obligation.

In determining

whether securities qualify as primary capital, the following criteria
will be applied.

Securities with mandatory stock purchase contracts
a.

The securities must mature in 12 years or less.

b.

A stock purchase contract can be separated from a security
and held separately only if the fo l d e r of the contract
provides sufficient collateral— ' to the issuer, or to an
independent trustee for the benefit of the issuer, to
assure performance under the contract.

1/ Collateral is defined as:
a.

cash or certificates of deposit;

b.

U.S. government securities that will mature prior to maturity
of the equity contract and that have a par or maturity value
at least equal to the amount of the holder's obligation under
the stock purchase contract;

c.

standby letters of credit issued by a U.S. bank that is not
an affiliate of the issuer; or

d.

other collateral as may be designated from time to time by the
regulators.

-3 -

Securities payable from sale of common or perpetual preferred stock
a.

The securities must mature in 12 years or less.

b.

The securities indenture must contain the following pro­
visions :

c.

1.

The issuer of the securities will establish a fund
(identifiable from the records of the bank or with
a separate trustee) solely from the sale of common
or perpetual preferred stock.
This fund will be
the sole source of repayment of the securities.

2.

By the time that one-third of the life of the securi­
ties has run, the issuer must have paid into the fund
from the sale of common or perpetual preferred stock
an amount equal to one-third of the original princi­
pal of the securities.
By the time that two-thirds
of the life of the securities has run, the issuer
must have paid into the fund from the sale of common
or perpetual preferred stock an amount equal to twothirds of the original principal of the securities.
The issuer must have paid into the fund from the
sale of common or perpetual preferred stock an amount
equal to the final one-third of principal of the secur­
ities at least 60 days prior to the maturity of the
securities.

If a security is issued by a subsidiary of a bank or bank holding
company, any guaranty of the principal by that subsidiary's parent
bank or bank holding company must be subordinate to the same degree
as the issue and limited to repayment of the principal amount of
the note at its final maturity.

The funded portions of the securities will be deducted
capital to avoid double counting.
If the issuer fails
of these periodic funding requirements, its supervisor
will cease to treat the unfunded securities as primary

from primary
to meet any
immediately
capital.

General provisions applicable to any type of mandatory convertible issues
a.

The aggregate amount of mandatory convertible securities must
not exceed 20 percent of primary capital other than mandatory
convertible securities.

b.

The issuer may redeem securities prior to maturity only with
the proceeds of the sale of common or perpetual preferred stock
of the bank or bank holding company or with the approval of
its primary supervisor.

I

- 4-

c.

The holder of the security cannot accelerate the payment of
principal except in the event of bankruptcy, insolvency or
reorganization.

d.

The security must be subordinate in right of payment to all
senior indebtedness of the issuer.
In the event that the
proceeds of the security are reloaned to an affiliate, the
loan must be subordinated to the same degree as the original
issue.

Any questions on the above criteria for determining the primary
capital status of mandatory convertible securities should be directed to
Samuel H. Talley (202-452-3354) or Anthony G. C o m y n

(202-452-3450) of

the Board's Division of Banking Supervision and Regulation.