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F ederal reserve Ba n k DALLAS, TEXAS of Dallas 75222 Circular No. 81-144 July 16, 1981 FEDERAL FINANCIAL INSTITUTIONS EXAMINATION COUNCIL Proposed Definition of Bank Capital to be used in Determining Capital Adequacy TO ALL STATE MEMBER BANKS, AND BANK HOLDING COMPANIES IN THE ELEVENTH FEDERAL RESERVE DISTRICT: The Federal Financial Institutions Examination Council is pro posing a revised definition of capital for use by the Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency for the purposes of evaluating bank capital for supervisory purposes. This action is being considered in order to promote uniformity in supervisory policies among the bank regu latory agencies. The Council is seeking public comment on the proposal and is requesting that comments be received by the Executive Secretary, Federal Financial Institutions Examination Council, 490 L'Enfant Plaza, SW, Washington, D.C. 20219, (202) 447-0939, by August 31, 1981. Enclosed are copies of the Council's notice and press release which more fully detail its views. Any questions relating to the proposal should be directed to Marvin C. McCoy, Extension 6657, or Uzziah Anderson, Extension 6275, of the Bank Supervision and Regulations Department of this Bank. Sincerely yours, William H. Wallace First Vice President Enclosure Banks and others are encouraged lo 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. Thispublication was digitized and made available by the Federal Reserve Hank of Dallas' Historical Library (FedHistory@dal.frb.org) Federal Financial Institutions Examination Council, W ashington, D.C. 20219 ^ _____________________________________________________________________ Press Release For immediate release June 17, 1981 The Federal Financial Institutions Examination Council today proposed a broadened definition of bank capital for the use of the three Federal bank regulatory agencies— ^ in determining the adequacy of capital in the banks they supervise. The Council requested comment by August 31, 1981. The Council made its proposal to promote uniformity among the Federal bank regulators. The Council proposed that bank capital should be defined as con sisting of two elements — primary and secondary capital. Under the Council's proposal primary capital would consist of common and perpetual preferred stock, surplus and undivided profits, con tingency and other capital reserves, mandatory convertible instruments and 100 percent of the allowances for possible loan losses. The Council proposed that secondary capital consist of limitedlife preferred stock and subordinated notes and debentures. As proposed, secondary capital would: — — 1/ Amount to no more than 50 percent of the amount of primary capital, and Financing instruments in secondary capital would be phased out of the bank's capital as they approached maturity. The Comptroller of the Currency (supervisor of national banks), the Federal Reserve (supervisor of State chartered banks that are members of the Federal Reserve System), and the Federal Deposit Insurance Corporation (supervisor of insured State nonmember banks). Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Federal Home Loan Bank Board, National Credit Union A dministration, Office of the Comptroller of the Currency -2 The Council noted that the agencies would continue to stress the importance of an adequate level of primary capital for the safe and sound operation of banks. Limited-life preferred stock and subordinated notes and debentures were viewed by the Council as having some, but not all, of the characteristics of capital and thus would be considered eligible for consideration as second capital if: 1. These instruments have an original final maturity of at least 10 years and an original weighted average maturity of at least 7 years; 2. Any serial of installment repayments, once begun, are made at least annually, with each payment no less than the previous one; 3. Together, such financing equals no more than half of the amount of primary capital; and 4. The percent of such issues considered as capital declines by a fifth each year when their maturity is less than five years distant. This would mean that such instruments would have no capital value when they have a maturity of less than a year. The Council made clear that although its proposal was aimed at promoting uniformity among the Federal bank regulators, the individual agencies have the flexibility to depart from the guidelines when the circumstances of a particular case warrant it. The Council's views are set forth in more detail in the attached notice. The Council welcomes comment on all aspects of its proposal, but would particularly like to receive comment on questions noted on pages 8 and 9 of the attached notice. Attachment FEDERAL FINANCIAL INSTITUTIONS EXAMINATION COUNCIL Proposed D e f i n i t i o n of Bank Capital to be used in Determining Capital Adequacy AGENCY: -FEDERAL FINANCIAL INSTITUTIONS EXAM INATION COUNCIL ACTION: Proposed D e f in itio n o f Bank Capital f o r Determining Capital Adequacy; r eq u est f o r comments SUM ARY: The Federal F inancial I n s t i t u t i o n s Examination Council i s proposing M to recommend a uniform d e f i n i t i o n of c a p i t a l f o r use by the th re e federa l bank supervisory agencies (Board o f Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and O ffice of the Comptroller of the Currency) f o r purposes o f determining the adequacy of bank c a p i t a l f o r supervisory purposes. The Examination Council i s taking t h i s a c tio n in o rder to promote uniform ity in supervis ory p o l i c i e s among the bank r e g u lato ry agencies. Extensive a n a ly s is of the proper r o l e of bank c a p i t a l and the a p p r o p ri a t e components of bank c a p i t a l has been c a r r i e d out by the Examination Council and i t s interagency S t a f f Task Force on Supervision. This a n a ly s is placed sp ecial emphasis on the types of f i n a n c i a l instruments t h a t should be considered components of bank c a p i t a l as well as a p p ro p riate r e s t r i c t i o n s to be applied to the use of p a r t i c u l a r types of f i n a n c i a l instruments. A major conclusion of t h i s a n a l y s i s i s t h a t bank c a p i t a l should be divided in to two components, primary and secondary, f o r purposes of definin g bank c a p i t a l f o r making supervisory determ inations regarding c a p i t a l adequacy. The primary components are c h a r a c t e r i z e d p r i n c i p a l l y by t h e i r permanence and include common and perpetual p r e fe r r e d stoc k, s u r p lu s , undivided p r o f i t s , contingency and o th e r c a p i t a l r e s e r v e s , mandatory c o n v e r t i b l e instrum ents, and 100 percent o f the allowance f o r p o ss ib le loan l o s s e s . The secondary components of c a p i t a l include l i m i t e d - l i f e p r e fe r r e d stock and subordinated notes and debentures. These f i n a n c i a l instruments possess c e r t a i n f e a t u r e s of c a p i t a l , but they lack permanence because they have m a tu rity or redemption d a te s . Furthermore, in the case of subordinated debt instrum ents, any d e f a u l t on r equ ire d i n t e r e s t payments could r e s u l t in a c c e l e r a t i n g the m atu rity date. I t i s recognized t h a t p r e fe r r e d stock c a r r i e s a co ntractua l o b lig a t i o n to pay dividends; but so long as omission of such payments does not mandate r e t i r e m e n t of the is s u e in the case of perpetual p r e f e r r e d , or a c c e l e r a t i o n o f the redemption date in the case of l i m i t e d - l i f e p r e f e r r e d , such co ntractu al o b l i g a t i o n s should not be considered in making the d i s t i n c t i o n between primary and secondary components of c a p i t a l . The Examination Council seeks public comment on the proposed d e f i n i t i o n of bank c a p i t a l to be used in determining c a p i t a l adequacy and on the various issu es r e l a t e d to t h i s d e f i n i t i o n and the implementation of the proposed d e f i n i t i o n by the federal bank supervisory agencies. EFFECTIVE DATE: Comments on the proposed d e f i n i t i o n of bank c a p i t a l must be received on or before August 31, 1981. - 2 - ADDRESS: Comments should be s e n t to Executive S e c r e t a r y , Federal Financial I n s t i t u t i o n s Examination Council, 490 L'Enfant P la z a , SW, Washington, D 20219, C (202)447-0939. Comments w ill be a v a i l a b l e f o r public in sp e ctio n and photocopying. FOR FURTHER INFORMATION CONTACT: David K. Schweitzer, Deputy Executive S e c r e t a r y , Federal F inancial I n s t i t u t i o n s Examination Council, 490 L'Enfant Plaza, SW Washington, D 20219, (202)287-4206. , C DRAFTING INFORMATION: The p r i n c i p a l d r a f t e r of t h i s document was Robert J . Lawrence, Executive S e c r e t a r y , Federal Financial I n s t i t u t i o n s Examination Council. SUPPLEM ENTARY INFORMATION: The Federal F inancial I n s t i t u t i o n s Examination Council proposes to recommend a d e f i n i t i o n of bank c a p i t a l f o r use by the t h r e e fe d e ra l bank r e g u l a t o r y agencies in determining the adequacy of bank c a p i t a l f o r supervisory purposes. Functions of Bank Capital The primary fu n ctio n s of bank c a p i t a l are to: 1) help ensure t h a t the bank can continue i t s o perations during periods when i t experiences low earnings or l o s s e s ; 2) provide p r o t e c t i o n f o r uninsured d e p osito rs and unsecured c r e d i t o r s of a bank; 3) help ensure t h a t the in h e ren t r i s k s in banking ar e a p p r o p r i a t e l y d i s t r i b u t e d between the public and p r i v a t e s e c t o r s ; 4) help maintain public confidence in individual banks and in the banking system; and 5) provide a source of funds f o r banking o p era tio n s. The p r i n c i p a l f e a t u r e s of bank c a p i t a l t h a t enable i t to serve these fu n ctio n s are: i t s permanence; the absence of co ntractua l payments t h a t , i f o m itted, could a c c e l e r a t e the m atu rity date of an i s s u e ; and the s t a t u s of i t s holders as re sid u a l claimants to the a s s e t s of the bank. Fin ancial instrum ents t h a t have evolved in f i n a n c i a l markets have these t h r e e f e a t u r e s in widely varying degrees. Consequently, d e l i n e a t i n g a l l f i n a n c i a l instruments as e i t h e r c a p i t a l or non-capital instruments would be overly a r b i t r a r y because i t would f a i l to provide f o r some g radation in the c a p i t a l - l i k e q u a l i t i e s found among the myriad f i n a n c ia l instruments a v a i l a b l e in the markets. The Examination Council b e l i e v e s , t h e r e f o r e , i t i s d e s i r a b l e to allow f o r two c a t e g o r i e s of c a p i t a l in banks; these ar e r e f e r r e d to in the proposed d e f i n i t i o n as the primary components and secondary components of bank c a p i t a l . Primary Components of Capital The components t h a t the Council regards as being in the primary category a re those having a l l or v i r t u a l l y a l l of the three f e a t u r e s of c a p i t a l . C l e a r l y , common and perpetual p r e fe r r e d sto c k, s u r p l u s , and undivided p r o f i t s possess these f e a t u r e s . Mandatory c o n v e r t i b l e instrum ents, i . e . , those with covenants mandating conversion i n to common or perpetual p r e f e r r e d s to c k , u l t i m a t e l y w ill possess them, though f o r an in terim period t h e r e may be some required c o n trac tu al payments which make them s l i g h t l y l e s s p e r f e c t as c a p i t a l instruments than, say, common stock. With the c a p i t a l - 3 - re se r v e s ( o t h e r than contingency reserv es) and allowance f o r p o s s ib le loan l o s s e s , t h e r e i s some lack o f permanence because the reserve s or allowances a r e e s t a b l i s h e d with the ex p ecta tio n t h a t th e r e w ill be some drawings on them in the normal course of a bank's o p e r a tio n s . Generally, however, the loan l o ss and o t h e r c a p i t a l reserv e s a re quickly r e b u i l t because of the close s c r u t i n y -paid to such m atters in f i n a n c i a l markets and by the supervisory agencies. Thus, such re serv es and allowances tend in r e a l i t y to have a high degree of permanence, which j u s t i f i e s t h e i r in c lu sio n as a primary component o f c a p i t a l . In the case o f contingency r e s e r v e s , they are e s t a b l i s h e d out of undivided p r o f i t s f o r p o s s ib le l i a b i l i t i e s . Generally, the p r o b a b i l i t y t h a t such reserv e s w ill be drawn down i s not known; hence, t h e i r in c lu sio n in primary c a p i t a l i s warranted. Secondary Components of Capital The secondary components o f c a p i t a l included in the proposed d e f i n i t i o n , i . e . , l i m i t e d - l i f e p r e fe r r e d stock and subordinated notes and debentures, possess some of the f e a t u r e s of bank c a p i t a l , but in one or more r e s p e c ts f a l l below those encompassed in the primary components. Both subordinated debt and l i m i t e d - l i f e p r e fe r r e d stock lack permanence and subordinated debt involves req u ired i n t e r e s t payments as well. On the o t h e r hand, they possess to a con sid erab le degree some of the important a t t r i b u t e s of c a p i t a l . Although they stand ahead of common stock holders in t h e i r claim on the bank's a s s e t s , t h e i r su bordinate p o s itio n to deposito rs and o th e r c r e d i t o r s of a bank provides important p r o t e c t i o n to those p a r t i e s . Also, while the two secondary components are not permanent, they provide r e l a t i v e l y long-term p r o t e c t i o n to d ep o s ito rs and o th e r c r e d i t o r s i f the m a t u r i ty , redemption or payment dates are several years or more in the f u tu re . Because the secondary components do not have the f e a t u r e s of bank c a p i t a l to the degree t h a t the primary components do, the Examination Council b e lie v e s t h a t four r e s t r i c t i o n s should be placed upon the use of such f i n a n c i a l instruments in order f o r them to be counted as c a p i t a l in determining c a p i t a l adequacy. F i r s t , to provide a s u f f i c i e n t degree of continuance to a secondary c a p i t a l instrum ent, any issuance must have an o r i g in a l f i n a l m aturity of a t l e a s t ten y ears and an o r i g i n a l , weighted average m a tu rity of a t l e a s t seven y e a r s . Second, to help ensure t h a t the desired continuance i s achieved, the Council proposes to r e q u i r e - - i n the case of an o b l i g a t i o n or iss u e t h a t provides f o r any type of scheduled repayments of p r i n c i p a l - - t h a t once repayment begins, a l l repayments s h a ll be made a t l e a s t annually and the amount repaid each year s h a ll be no l e s s than in the previous year. Third, the Council b eliev es t h e r e should be an upper l i m i t on the amount of secondary components t h a t can be counted as c a p i t a l and i s proposing a l i m i t equal to 50 percent o f the amount of primary c a p i t a l . Fourth, the Council believes t h a t as the secondary components approach m a tu rity , or interim payments become due, there must be c l e a r reco g n itio n of the p ro gressiv e lo ss of the "permanence" aspect of the instrument. The Council proposes to take t h i s f a c t o r in to account by amortizing secondary components with a remaining l i f e of l e s s than 5 y ears. S p e c i f i c a l l y , the Council proposes to count f u l l y the secondary components as c a p i t a l as long as t h e i r m a t u r i ty , redemption or payment dates are 5 years or more away. Below 5 y e a r s , the q u a lif y in g balance of secondary c a p i t a l i n s t r u ments approaching m a t u r i ty , redemption or payment would be reduced by 20 - 4 - percentage p o in ts per y e a r ; f o r example, only 80 percent of the amount of the secondary components maturing or due f o r payment between 4 and 5 years would be counted as c a p i t a l , 60 percent between years 3 and 4, and so f o r t h , with those maturing or due in l e s s than one y ear not counted as c a p i t a l a t a l l . Supervisory Agency F l e x i b i l i t y The d e f i n i t i o n being proposed by the Examination Council has, as one of i t s purposes, promoting uniform ity in supervisory p o l i c i e s among the fed era l banking agencies represented on the Council. The in dividual super v isory ag en cie s, however, may approve issuances t h a t do not f u l l y conform to th e d e f i n i t i o n or may i n s i s t on more s t r i n g e n t conditions than those proposed i f the circumstances of a p a r t i c u l a r case warrant such a c t i o n . In p a r t i c u l a r , because the secondary c a p i t a l components do not possess the c h a r a c t e r i s t i c s o f c a p i t a l to the e x t e n t t h a t the primary components do, the agencies will continue to s t r e s s the importance of an adequate level of primary c a p i t a l f o r the safe and sound o peration of banks. In reviewing a p p l i c a t i o n s by banks to issue secondary c a p i t a l in stru m en ts, the t h r e e fed eral bank supervisory agencies will continue to tak e i n to account, among o th e r t h i n g s , the following f a c t o r s : 1) the ov erall co n ditio n o f the bank, includin g trends in t h a t c o n d itio n , with p a r t i c u l a r s c r u t i n y accorded to problem banks; 2) the a b i l i t y of the bank to meet a l l p r i n c i p a l and i n t e r e s t payments on the f in a n c i a l instrument; 3) i f an a p p l i c a n t bank i s a s u b s id ia r y of a holding company, the o v erall condition of the conso lid ated o r g a n i z a t i o n , e s p e c i a l l y i t s consolid a te d level of debt and c a p i t a l ; and 4) any p rov isio n s of the f i n a n c i a l instrum ent, such as the imposition of operating r e s t r a i n t s on the bank, t h a t would impair the bank's o r the supervisory agency's f l e x i b i l i t y to deal with changed circumstances. I t should be noted t h a t , in the event of l i q u i d a t i o n of a bank, th e claims of the holders of secondary c a p i t a l instruments are subordinated to any claims of the Federal Deposit Insurance Corporation a r i s i n g out of th e d e p o s i t o r s ' subrogation of t h e i r claims to the FDIC, or are subordinated t o claims of the FDIC a g a i n s t any of the a s s e t s of the bank a s soc iate d with a merger or purchase and assumption t r a n s a c t i o n pursuant to Section 13(e) of the Federal Deposit Insurance Act. S p e c if ic Requests f o r Public Comment The Examination Council welcomes comment on any aspect of i t s p roposal. The Council would, however, a p p r e c ia te s p e c i f i c comments on the following q uestio ns and is s u e s . 1) Should l i m i t e d - l i f e p re fe rre d stock be regarded as primary r a t h e r than secondary c a p i t a l ? In the proposed d e f i n i t i o n , both l i m i t e d - l i f e p r e f e r r e d stock and subordinated notes and debentures are regarded as secondary c a p i t a l components. Both types of f i n a n c i a l instruments lack permanence, and, t h e r e f o r e , would in any event be amortized as they approach t h e i r redemption or m aturity dates in accordance with the am ortization schedule f o r the secondary c a p i t a l components. There is a d i f f e r e n c e , however, in t h a t subordinated debt i s a l i a b i l i t y and p re fe rre d stock i s an equity instrument. Also, subordinated debt involves i n t e r e s t payments, while p re fe rre d stock - 5 - does n o t; and any d e f a u l t on required i n t e r e s t payments could r e s u l t in a c c e l e r a t i n g the m atu rity d ate of the subordinated debt instrum ents. Are the d i f f e r e n c e s in the two types of instruments of s u f f i c i e n t importance to warrant counting the e l i g i b l e amount of l i m i t e d - l i f e p r e fe rred stock as "primary" c a p i t a l ; o r , as the Examination Council i s proposing, should the lack of permanence be the c o n t r o l l i n g f a c t o r in the decision on whether a f in a n c ia l instrum ent i s considered a primary or secondary component of bank c a p i t a l ? 2) Should s e c u r i t i e s t h a t are c o n v e r t i b l e , but do not have a mandatory c o n v e r t i b l e f e a t u r e , be t r e a t e d d i f f e r e n t l y from n on-convertible s e c u r i t i e s ? The proposed d e f i n i t i o n draws no d i s t i n c t i o n , but the f a c t t h a t a debt instrument might be converted to common stock could make such an instrum ent more akin to c a p i t a l than a debt instrument without a provision f o r c o n v e r t i b i l i t y . The Examination Council req u ests comment on the f a c t o r s t h a t should be taken i n t o account, o th e r than simply the c o n v e r t i b i l i t y f e a t u r e , i f such a d i s t i n c t i o n were to be made. 3) Federal Reserve Regulations D and Q and FDIC Regulation 329.10 c u r r e n t l y impose a minimum s i z e of $500 on subordinated debt issu es i f they a re to be exempt from r e se r v e requirements and i n t e r e s t r a t e l i m i t a t i o n s . Should th e r e be a h ig h er, more r e s t r i c t i v e , minimum s i z e , f o r example $25,000? A higher minimum s i z e would help ensure t h a t such issu es are not confused by t h e i r purchasers with insured d e p o s i t instruments. 4) Should t h e r e be a l i m i t placed on the amount of subordinated debt t h a t a bank can s e l l to o th e r banks, such as $5 m illio n ? When one bank s e l l s i t s subordinated debt to o th e r banks, the increase in c a p i t a l o f the issu in g bank does not r e s u l t in any real in crease in c a p i t a l f o r the banking system. I t may be d e s i r a b l e , t h e r e f o r e , to impose some type of l i m i t on the amount an in dividual bank can s e l l to o th e r banks. The C o u n c il's proposed d e f i n i t i o n of bank c a p i t a l , issued pursuant to the a u t h o r i t y o f s e c t i o n 1006 o f the Financial I n s t i t u t i o n s Regulatory and I n t e r e s t Rate Control Act of 1978 (12 U.S.C. s e c tio n 3305), follows. - 6 - PROPOSED DEFINITION OF BANK CAPITAL TO BE USED IN DETERMINING CAPITAL ADEQUACY Primary Components of Bank Capital The fe d era l bank r e g u l a t o r y agencies consider the primary components of bank c a p i t a l to be: • • • • common stock perpetual p r e f e r r e d stock surplus undivided p r o f i t s t contingency and o t h e r c a p i t a l reserves • mandatory c o n v e r t i b l e instruments ( c a p i t a l instruments with covenants mandating conversion i n to common or perpetual p r e fe r r e d s t o c k .) • allowance f o r p o s s i b l e loan lo sses Secondary Components of Bank Capital The agencies recognize t h a t o th e r f i n a n c i a l instruments can, with c e r t a i n r e s t r i c t i o n s , be considered as p a r t of bank c a p i t a l because they possess some, though not a l l , of the f e a t u r e s of c a p i t a l . These instruments are: • L i m i t e d - l i f e p r e f e r r e d stock • Subordinated notes and debentures R e s t r i c t i o n s Relating to Secondary Components The agencies w ill consid er the secondary components as bank c a p i t a l under the c o n d itio ns l i s t e d below. • The issue must have an o r i g in a l f i n a l m atu rity of a t l e a s t ten y ears and an o r i g i n a l , weighted average m aturity a t l e a s t seven y e a r s. • I f the is s u e has a s e r i a l or in sta lm en t repayment program, a l l scheduled repayments sh a ll be made a t l e a s t an n u ally , once c o n tra ctu al repayment of p r in c ip a l begins, and the amount repaid in a given year sh a ll be no le s s than the amount repaid in the previous year. ■ The aggregate amount of l i m i t e d - l i f e p r e ferre d stock and subordinated debt q u a lif y in g as secondary c a p i t a l may not exceed 50 p ercen t of the amount of primary c a p i t a l . • As the secondary components approach m a t u r i ty , redemption or payment, the outstanding balance of a l l such instruments including those with s e r i a l note payments, sinking fund p r o v i s i o n s , or an am ortization schedule - - will be amortized in accordance with th e following schedule: - 7 - Years to Maturity Greate r than or equal to Less than 5 but g r e a t e r Less- than 4 but g r e a t e r Less than 3 but g r e a t e r Less than 2 but g r e a t e r Less than 1 Considered Capital 5 than than than than or or or or equal equal equal equal to to to to 4 3 2 1 TO O 80 60 40 20 -0- (No adjustment in the book amount of the issu e i s required or expected by t h i s schedule. Adjustment w ill be made by a memorandum account.)
@FedFRASER