Full text of District Notices (Federal Reserve Bank of Dallas) : Final Amendments to the Capital Adequacy Guidelines, Notice 95-23

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F ederal R e ser v e Bank
OF DALLAS
ROBERT

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

DALLAS, TEXAS

PRESIDENT
AND CHIEF EXECUTIVE O F F IC E R

February 15, 1995

75265-5906

Notice 95-23

TO:

The Chief Executive Officer of each
member bank and others concerned in
the Eleventh Federal Reserve District

SUBJECT
Final Amendments to the
Capital Adequacy Guidelines
DETAILS

The Federal Reserve Board has issued amendments to its capital adequacy
guidelines for state member banks and bank holding companies to establish a limitation
on the amount of certain deferred tax assets that may be included in (that is, not
deducted from) Tier 1 capital for risk-based and leverage capital purposes.
The capital rule was developed in response to the Financial Accounting
Standards Board’s issuance of Statement No. 109, "Accounting for Income Taxes."
Under the new rule, deferred tax assets that can only be realized if an
institution earns taxable income in the future are limited for regulatory capital purposes
to the amount that the institution expects to realize within one year of the quarter-end
report date—based on its projection of taxable income—or 10 percent of Tier 1 capital,
whichever is less. Deferred tax assets that can be realized from taxes paid in prior
carryback years would generally not be limited.
The amendments are effective April 1, 1995.
ATTACHMENT

A copy of the Board’s notice as it appears on pages 65920-27, Vol. 59, No.
245, of the Federal Register dated December 22, 1994, is attached.

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

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

MORE INFORMATION
For more information, please contact Dorsey Davis at (214) 922-6051. For
additional copies of this Bank’s notice, please contact the Public Affairs Department at
(214) 922-5254.
Sincerely yours,

FEDERAL RESERVE BANK OF DALLAS
NOTICE 95-23

Final Amendments
to the
Capital Adequacy Guidelines
(Docket No. R-0795)

65920 Federal Register / Vol. 59, No. 245 / Thursday, December 22, 1994 / Rules and Regulations
Regulatory Reporting and Accounting
Issues Section; Barbara J. Bouchard,
Supervisory Financial Analyst, (202)
452-3072, Policy Development Section,
Division of Banking Supervision and
Regulation, Board of Governors of the
Federal Reserve System. For the hearing
impaired only. Telecommunication
Device for the Deaf (TDD), Dorothea
Thompson (202) 452-3544.
SUPPLEMENTARY INFORMATION:

I. Background

FEDERAL RESERVE SYSTEM
12CFR Parts 208 and 225
[Regulations H and Y; Docket No. R -0795]

Capital; Capital Adequacy Guidelines

Board of Governors of the
Federal Reserve System,
ACTION: Final rule.
AGENCY:

The Board of Governors of the
Federal Reserve System (Board or
Federal Reserve) is revising its capital
adequacy guidelines for state member
banks and bank holding companies to
establish a limitation on the amount of
certain deferred tax assets that may be
included in (that is, not deducted from)
Tier 1 capital for risk-based and leverage
capital purposes. The capital rule was
developed in response to the Financial
Accounting Standards Board’s (FASB)
issuance of Statement No. 109,
“Accounting for Income Taxes” (FAS
109). Under the final rule, deferred tax
assets that can only be realized if an
institution earns taxable income in the
future are limited for regulatory capital
purposes to the amount that the
institution expects to realize within one
year of the quarter-end report date—
based on its projection of taxable
income—or 10 percent of Tier 1 capital,
whichever is less.
EFFECTIVE DATE: April 1, 1995
SUMMARY:

FOR FURTHER INFORMATION CONTACT:

Charles H. Holm, Project Manager, (202)
452-3502; Nancy J. Rawlings, Senior
Financial Analyst, (202) 452-3059,

income during the carryforward period.
Such deferred tax assets, and deferred
tax assets arising from net operating loss
and tax credit carryforwards, are
hereafter referred to as “deferred tax
assets that are dependent upon future
taxable income.”
B. Sum m ary o f F AS 109
In February 1992, the FASB issued
Statement No. 109, "Accounting for
Income Taxes” which supersedes
Accounting Principles Board Opinion
No. 11 and FASB Statement No. 96. FAS
109 provides guidance on many aspects
of accounting for income taxes,
including the accounting for deferred
tax assets. FAS 109 potentially allows
some state member banks and bank
holding companies to record
significantly higher deferred tax assets
than previously permitted under
generally accepted accounting
principles (GAAP) and the federal
banking agencies’ prior reporting
policies.2 Unlike the general practice
under previous standards, FAS 109
permits the reporting of deferred tax
assets that are dependent upon future
taxable income. However, FAS 109
requires the establishment of a valuation
allowance to reduce the net deferred tax
asset to an amount that is more likely
than not (i.e., a greater than 50 percent
likelihood) to be realized.
FAS 109 became effective for fiscal
years beginning on or after December
15,1992. The adoption of this standard
has resulted in the reporting of
additional deferred tax assets in Call
Reports and FR Y-9C reports that
directly increase institutions’ undivided
profits (retained earnings) and Tier 1
capital.

A Characteristics o f Deferred Tax
Assets
Deferred tax assets are assets that
reflect, for financial reporting purposes*
benefits of certain aspects of tax laws
and rules. Deferred tax assets may arise
because of specific limitations under tax
laws of different tax jurisdictions that
require that certain net operating losses
(e.g., when, for tax purposes, expenses
exceed revenues) or tax credits be
carried forward if they cannot be used
to recover taxes previously paid. These
“carryforwards” are realized only if the
institution generates sufficient future
taxable income during the carryforward
period.
Deferred tax assets may also arise
from the tax effects of certain events that
have been recognized in one period for
financial statement purposes but will
result in deductible amounts in a future
period for tax purposes, i.e., the tax
effects of “deductible temporary
differences.” For example, many
depository institutions and bank
holding companies may report higher
income to taxing authorities than they
reflect in their regulatory reports 1
because their loan loss provisions are
expensed for reporting purposes but are
C. Concerns Regarding Deferred Tax
not deducted for tax purposes until the
Assets That Are Dependent Upon
loans are charged off.
Future Taxable Income
Deferred tax assets arising from an
The Federal Reserve has certain
organization’s deductible temporary
concerns about including in capital
differences may or may not exceed the
amount of taxes previously paid that the deferred tax assets that are dependent
upon future taxable income. Realization
organization could recover if the
of such assets depends on whether a
organization's temporary differences
banking organization has sufficient
fully reversed at the report date. Some
future taxable income during the
of these deferred tax assets may
carryforward period. Since a banking
theoretically be “carried back” and
organization that is in a net operating
recovered from taxes previously paid.
loss carryforward position is often
On the other hand, when deferred tax
assets arising from deductible temporary experiencing financial difficulties, its
differences exceed such previously paid prospects for generating sufficient
taxable income in the future are
tax amounts, they will be realized only
uncertain. In addition, the condition of
if there is sufficient future taxable
and future prospects for an organization
1 State member banks are required to file quarterly
Consolidated Reports of Condition and Income (Call
Reports) with the Federal Reserve Bank holding
companies with total consolidated assets of $150
million or more file quarterly Consolidated
Financial Statements for Bank Holding Companies
(FR Y-9C reports) w ith the Federal Reserve

2 The federal banking agencies consist of the
Federal Reserve Board (Board), the Federal Deposit
Insurance corporation (FDIC), the Office of the
Comptrolle of the Currency (OCC1. and the Office
of Thrift Supervision (OTS) (hereafter the
“agencies” '

Federal Register / Vol. 59, No. 245 / Thursday, December 22, 1994 / Rules and Regulations 65921
often can and do change very rapidly in
the banking environment. This raises
concerns about the realizability of
deferred tax assets that are dependent
upon future taxable income, even when
an organization may be sound and wellmanaged. Thus, for many organizations
such deferred tax assets may not be
realized, and for other organizations
there is a high degree of subjectivity in
determining the realizability of this
asset. Furthermore, while many
organizations may be able to make
reasonable projections of taxable income
for relatively short periods and actually
realize this income, beyond a short time
period, the reliability of the projections
tends to decrease significantly. In
addition, unlike many other assets,
banking organizations generally cannot
obtain the value of deferred tax assets by
selling them.
Moreover, as an organization’s
condition deteriorates, it is less likely
that deferred tax assets that are
dependent upon future taxable income
will be realized. Therefore, the
organization is required under FAS 109
to reduce its deferred tax assets through
increases to the asset’s valuation
allowance. Additions to this allowance
would reduce the organization’s
regulatory capital at precisely the time
it needs capital support the most. Thus,
the inclusion in capital of deferred tax
assets that are dependent upon future
taxable income raises supervisory
concerns.
Because of these concerns, th
agencies, under the auspices of the
Federal Financial Institutions
Examination Council (FFIEC),
considered whether it would be
appropriate to adopt FAS 109 for
regulatory reporting purposes. On
August 3, 1992, the FFIEC requested
public comment on this matter, and on
December 23,1992, after consideration
of the comments received, the FFIEC
decided that banks and savings
associations should adopt FAS 109 for
reporting purposes in Call Reports and
Thrift Financial Reports (TFKs)
beginning in the first quarter of 1993 (or
the beginning of their first fiscal year
thereafter, if later). Furthermore, the
Board decided that bank holding
companies should adopt FAS 109 in FR
Y-9C Reports at the same time.
D. Proposal for the Treatment o f
Deferred Tax Assets
The FFIEC, in reaching its decisii \ on
regulatory reporting, also recommended
that each of the agencies amend its
regulatory capital standards to limit the
amount of deferred tax assets that can be
included in regulatory capital. In
response to the FFIEC’s

recommendation, on February 11,1993.
the Board issued for public comment a
proposal to adopt the recommendation
of the FFIEC in full, as summarized
below (54 FR 8007, February 11,1993).
The FFIEC recommended that the
agencies limit the amount of deferred
tax assets that are dependent upon
future taxable income that can be
included in regulatory capital to the
lesser of:
i. the amount of such deferred tax
assets that the institution expects to
realize within one year of the quarter-end report date, based on its projection
of taxable income (exclusive of net
operating loss or tax credit
carryforwards and reversals of existing
temporary differences), or
ii. 10 percent of Tier 1 capital, net of
goodwill and all identifiable intangible
assets other than purchased mortgage
servicing rights and purchased credit
card relationships (and before any
disallowed deferred tax assets are
deducted). Deferred tax assets that can
be realized from taxes paid in prior
carryback years and from future
reversals of existing taxable temporary
differences would generally not be
limited under the proposal.

noted that the proposal represented a
compromise and a step forward from
prior regulatory policies that permitted
little or no inclusion in regulatory
reports or capital of deferred tax assets
that are dependent upon future taxable
income. Two commentersgenerally
supported the proposal or expressed
their understanding of the regulator’s
concern regarding the realizability of
deferred tax assets and one commenter
indicated the capital treatment should
be consistent with the capital treatment
for identifiable intangible assets.
A. Responses to the Board’s Questions

Question 1. (Gross-up of Intangible
Assets) Nine commenters responded to
the Board’s first question regarding
whether certain identifiable intangible
assets acquired in a nontaxable business
combination accounted for as a
purchase should be adjusted for the tax
effect of the difference between the
market or appraised value of the asset
and its tax basis. Under FAS 109, this
tax effect is recorded separately in a
deferred tax liability account, whereas
under preexisting GAAP, this tax effect
reduced the amount of the intangible
asset. This change in treatment could
cause a large increase (i.e.. gross-up) in.
II. Public Comments on the Proposal
the reported amount of certain
The comment period for the Board’s
identifiable intangible assets, such as
proposal ended on March 15,1993. The
core deposit intangibles, which are
Board received nineteen comment
letters including ten from multinational ' deducted for purposes of computing
regulatory capital.
and large regional banking
Seven commenters indicated that
organizations, and three community
banking organizations should be
banks. In addition, the Board received
permitted to deduct the net after-tax
four comment letters from bank trade
amount of the intangible asset from
associations and two from finance
companies. Sixteen commenters offered capital, not the gross amount of the
intangible asset. These commenters
support for the Board’s proposal to
argued that FAS 109 will create
require banking organizations to report,
artificially high values for intangible
for regulatory purposes, deferred tax
assets and the related deferred tax
assets in accordance with FAS 109. In
liability when a banking organization
addition, fifteen commenters indicated
that it would be preferable for the Board acquires the assets with a carryover
basis for tax purposes but revalues the
to place no limit on the amount of
asset for financial reporting purposes.
deferred tax assets allowable in capital.
The commenters generally indicated
These commenters indicated that, in
that, under FAS 109, the balance sheet
their view, embracing FAS 109 in its
will not accurately reflect the value paid
entirety would achieve consistency
between regulatory standards and GAAP for the intangibles. Furthermore,
as well as maintain consistency with the commenters indicated that the increased
value of the intangible posed no risk to
intent of Section 121 of the Federal
institutions, because a reduction in the
Deposit Insurance Corporation
value of the asset would effectively
Improvement Act (FDICIA) of 1991.
Commenters asserted that the criteria set extinguish the related deferred tax
liability.
forth in FAS 109 to recognize and value
On the other hand, two commenters
deferred tax assets is sufficiently
indicated that the pretax (gross) value of
conservative to limit any exposure to
intangible assets should be deducted for
the bank insurance fund and that an
arbitrary or mechanical formula, such as regulatory capital purposes in this
the ones proposed, would not provide a situation. This organization contended
that intangible assets should be treated
more Accurate or reliable result.
similarly to other assets, which are not
While preferring no capital limit on
reduced by any related liability.
defe#ed tax assets, some commenters

65922 Federal Register / Vol. 59, No. 245 / Thursday, December 22, 1994 / Rules and Regulations
Question 2: The Board’s second
question inquired about (i) the potential
burden associated with the proposal and
whether a limitation based on
projections of taxable income would be
difficult to implement, and (ii) the
appropriateness of the separate entity
method for deferred tax assets and tax
sharing agreements in general.
i. Methodology Based on Income
Projections. The Board received eleven
letters from commenters who responded
directly to this aspect of the question.
Four commenters supported using
income projections and stated that
calculating deferred tax asset limitations
for capital purposes based on projected
taxable income would not be difficult to
implement and would not impose an
additional burden because many
banking organizations already forecast
taxable income in order to recognize
their deferred tax assets. One
commenter added that these
calculations should not pose any
problems, provided they are done on a
consolidated basis. In addition, one
commenter suggested that the Board
clarify the term “realized within one
year” so that readers understand that
the phrase means the amount of
deferred tax assets that could be used to
offset income taxes generated in the
next 12 months, and not the amount of
deferred tax assets that actually will be
used.
Four commenters specifically
opposed an income approach, citing the
additional burden that would be created
by the detailed calculations. One
commenter specifically favored
implementing the percentage of capital
method since it is certain and exact and
does not involve as many estimations or
fluctuations as the income approach.
Five commenters supported an
approach based on the financial
condition of the institution, some of
whom also offered support or
opposition to the income or percentage
of capital approach. One commenter
suggested that “healthy” institutions be
permitted to include deferred tax assets
in regulatory capital in an amount based
on a specified percentage of Tier 1
capital. Another commenter supported
an approach that excluded “well
capitalized” banks from the limitation.
On the other hand, one commenter did
not support using an approach for
calculating the capital limitation based
upon the perceived “health” of the
institution, stating that this method
could lead to arbitrary and inconsistent
measures of capital adequacy.
ii. Separate Entity Approach. Twelve
commenters specifically addressed this
part of the question. Under the Board’s
proposal, the capital limit for deferred

tax assets would be determined on a
separate entity basis for each state
member bank so that a bank that is a
subsidiary of a holding company would
be treated as a separate taxpayer rather
than as part of the consolidated entity.
All of the commenters opposed the
separate entity approach. They argued
that the separate entity approach is
artificial and that tax-sharing
agreements between financially capable
bank holding companies and bank
subsidiaries should be considered when
evaluating the recognition of deferred
tax assets for regulatory capital
purposes. Commenters also stated that
the separate entity method is
unnecessarily restrictive and that any
systematic and rational method should
be permitted for the calculation of the
limitation for each bank.
One commenter based its opposition
for the separate entity approach on the
view that the limitation is not consistent
with the Board’s 1987 “Policy Statement
on the Responsibility of Bank Holding
Companies to Act as Sources of Strength
to Their Subsidiary Banks” which, in
some respects, treats a controlled group
as one entity. Another commenter
contended that the effect of a separate
entity calculation would be to reduce
bank capital which is needed for future
lending which would be inconsistent
with the March 10,1993, “Interagency
Policy Statement on Credit
Availability”. The same commenter also
noted that the regulatory burden and
cost of calculating the deferred tax asset
on a separate entity basis would be
substantial for both bankers and
regulators.
Question 3: The Board’s third
question addressed three specific
provisions of the proposal. These
provisions included (i) requiring tax
planning strategies to be part of an
institution’s projection of taxable
income for the next year, (ii) requiring
organizations to assume that all
temporary differences fully reverse at
the report date, and (iii) permitting the
grandfathering of amounts previously
reported if they were in excess of the
proposed limitation.
i. Inclusion o f Tax Planning
Strategies. Two commenters addressed
this issue. Both commenters stated that
they support including tax planning
strategies in an institution’s projection
of taxable income. One commenter
stated that the proposal should be
modified to permit institutions to
consider strategies that would ensure
realization of deferred tax assets within
the one-year time frame. The proposal
provided that organizations should <
consider tax planning strategies that
would realize tax carryforwards or m t

operating losses that would otherwise
expire during that time frame.
ii. Temporary Differences. Four
commenters specifically addressed this
aspect of the question, and all agreed
that it is appropriate to require the
assumption that all temporary
differences fully reverse as of the report
date. One commenter noted that this
assumption would eliminate the burden
of scheduling the “turnaround” of
temporary differences.
iii. Grandfathering. Five commenters
discussed the proposal’s provision on
grandfathering which would allow the
amount of any deferred tax assets
reported as of September 1992 in excess
of the limit to be phased out over a two
year period ending in 1994. Four
commenters offered support for
grandfathering but argued that excess
deferred tax assets should be
grandfathered until the underlying
temporary differences reversed, rather
than be phased out over two years. The
other commenter disagreed with the
grandfathering proposal and stated that
such provisions would be inconsistent
with the proposal's capital adequacy
objectives.
III. Final Amendment to the Capital
Adequacy Guidelines
A. Limitation on Deferred Tax Assets
Consistent with the FFIEC’s
recommendation and the Board’s
proposal, the Board is limiting in
regulatory capital deferred tax assets
that are dependent on future taxable
income to the lesser of:
i. The amount of such deferred tax
assets that the institution expects to
realize within one year of the quarterend report date, based on its projection
of taxable income (exclusive of net
operating loss or tax credit
carryforwards and reversals of existing
temporary differences), or
ii. 10 percent of Tier 1 capital, net of
goodwill and all identifiable intangible
assets other than purchased mortgage
servicing rights and purchased credit
card relationships (and before any
disallowed deferred tax assets are
deducted).
Deferred tax assets that can be
realized from taxes paid in prior
carryback years and from future
reversals of existing taxable temporary
differences are generally not limited
under the final rule. The reported
amount of deferred tax assets, net of its
valuation allowance, in excess of the
limitation would be deducted from Tier
1 capital for purposes of calculating
both the risk-based and leverage capital
ratios. Banking organizations should not
include the amount of disallowed

Federal Register / Vol. 59, No. 245 / Thursday, December 22, 1994 / Rules and Regulations 65923
deferred tax assets in weighted-risk
assets in the risk-based capital ratio and
should deduct the amount of disallowed
deferred tax assets from average total
assets in the leverage capital ratio.
Deferred tax assets included in capital
continue to be assigned a risk weight of
100 percent.
To determine the limit, a banking
organization should assume that all
existing temporary differences fully
reverse as of the report date. Also,
estimates of taxable income for the next
year should include the effect of tax
planning strategies the organization is
planning to implement to realize net
operating losses or tax credit
carryforwards that will otherwise expire
during the year. Consistent with FAS
109, the Board believes tax planning
strategies are carried out to prevent the
expiration of such carryforwards. Both
of these requirements are consistent
with the proposal.
The capital limitation is intended to
balance the Board’s continued concerns
about deferred tax assets that are
dependent upon future taxable income
against the fact that such assets will, in
many cases, be realized. This approach
generally permits full inclusion of
deferred tax assets potentially
recoverable from carrybacks, since these
amounts will generally be realized. This
approach also includes those deferred
tax assets that are dependent upon
future taxable income, if they can be
recovered from projected taxable
income during the next year. The Board
is limiting projections of future taxable
income to one year because, in general,
the Board believes that organizations are
generally capable of making projections
of taxable income for the following
twelve month period that have a
reasonably good probability of being
achieved. However, the reliability of
projections tends to decrease
significantly beyond that time period.
Deferred tax assets that are dependent
upon future taxable income are further
limited to 10 percent of Tier 1 capital,
since the Board believes such assets
should not comprise a large portion of
an organization’s capital base given the
uncertainty of realization associated
with these assets and the difficulty in
selling these assets apart from the
organization. Furthermore, a 10%
capital limit also reduces the risk that
an overly optimistic estimate of future
taxable income will cause the bank to
significantly overstate the value of
deferred tax assets.
Banking organizations already follow
FAS 109 for regulatory reports and
accordingly, are making projections of
taxable income. Banking organizations
already report in regulatory reports the

amount of deferred tax assets that would
be disallowed under the proposal. In
addition, the 10 percent calculation of
Tier 1 capital is straightforward.
Therefore, the Board believes that
banking organizations will have little
difficulty implementing this final rule.
B. Guidance on Specific Im plem entation
Issues
In response to the comments received
and after discussions with the other
agencies, the Board is providing the
following guidance.
Originating Temporary Differences—
Consistent with the Board’s proposal,
the final rule does not specify how the
provision for loan and lease losses and
other originating temporary differences
should be treated for purposes of
projecting taxable income for the next
year. Banking organizations routinely
prepare income forecasts for future
periods and, in theory, income forecasts
for book income should be adjusted for
originating temporary differences in
arriving at a projection of taxable
income. On the other hand, requiring
such adjustments adds complexity to
the final rule. Furthermore, deductible
originating temporary differences, such
as the provision for loan and lease
losses, generally would lead to
additional deferred tax assets. Thus,
arguably, such temporary differences
should not be added back to book
income in determining the amount of
deferred tax assets that will be realized.
Accordingly, the Board is permitting
each institution to decide whether or
not to adjust projected book income for
originating temporary differences. While
the Board is not specifying a single
treatment on originating temporary
differences in the final rule, institutions
should follow a reasonable and
consistent approach.
Gross-up of Intangibles—As noted
above, FAS 109 could lead to a large
increase (i.e., gross-up) in the reported
amount of certain intangible assets, such
as core deposit intangibles, which are
deducted for purposes of computing
regulatory capital. Commenters stated
that the increased value of an intangible
posed no risk to institutions, because a
reduction in the value of the asset
would effectively extinguish the related
deferred tax liability. The Board concurs
with this position and, consequently,
will permit, for capital adequacy
purposes, netting of deferred tax
liabilities arising from this gross-up
effect against related intangible assets.
To ensure this benefit is not double
counted, a deferred tax liability netted
in this m anner could not also be netted
against deferred tax assets when
determining the amount of deferred tax

assets that are dependent upon future
taxable income. Netting will not be
permitted against purchased mortgage
servicing rights (PMSRs) and purchased
credit card relationships (PCCRs), since
only the portion of these assets that
exceed specified capital limits are
deducted for capital adequacy purposes.
Leveraged Leases—While not
expected to significantly affect many
banking organizations, one commenter
stated that future net tax liabilities
related to leveraged leases acquired in a
purchase business combination are
included in the valuation of the
leveraged lease and are not shown on
the balance sheet as deferred tax
liabilities. This artificially increases the
amount of deferred tax assets for those
institutions that acquire a leveraged
lease portfolio. Thus, this commenter
continued, the future taxes payable
included in the valuation of a leveraged
lease portfolio in a purchase business
combination should be treated as a
taxable temporary difference whose
reversal would support the recognition
of deferred tax assets, if applicable. The
Board agrees with this commenter and,
therefore, banking organizations may
use the deferred tax liabilities that are
embedded in the carrying value of a
leveraged lease to reduce the amount of
deferred tax assets subject to the capital
limit.
Tax Jurisdictions—Unlike the
proposal, the final rule does not require
an institution to determine its limitation
on deferred tax assets on a jurisdiction
by-jurisdiction basis. While such an
approach may theoretically be more
accurate, the Board does not believe the
greater precision that would be achieved
in mandating such an approach
outweighs the complexities involved
and its inherent cost to institutions.
Thus, banking organizations may make
projections of their taxable income on
an organization-wide basis and use a
combined tax rate for purposes of
calculating the one-year limitation.
Timing—Institutions may use the
future taxable income projections for
their current fiscal year (adjusted for
any significant changes that have
occurred or are expected to occur) when
applying the capital limit at an interim
report date rather than preparing a new
projection each quarter. Several
commenters requested this treatment
because it reduces the frequency with
which banking organizations are
required to revise their estimate of
future taxable income.
Available for Sale Securities—Under
FASB Statement No. 115, "Accounting
for Certain Investments in Debt and
Equity Securities” (FAS 115),
"available-for-sale” securities are

65924 Federal Register / Vol. 59, No. 245 / Thursday, December 22, 1994 / Rules and Regulations
reported in regulatory reports at market
value, and unrealized gains and losses
on such securities are included, net of
tax effects, in a separate component of
stockholders equity. These tax effects
may increase or decrease the amount of
deferred tax assets an institution
reports.
The Board has recently decided to
exclude from regulatory capital the
amount of net unrealized gains and
losses on available for sale securities
(except net unrealized losses of
available-for-sale equity securities with
readily determinable fair values) (59 FR
63241. December 8,1994). Thus,
excluding for capital adequacy purposes
deferred tax effects arising from
reporting unrealized holding gains and
losses on available-for-sale securities is
consistent with the regulatory capital
treatment for such gains and losses. On
the other hand, requiring the exclusion
of such deferred tax effects would add
significant complexity to the capital -guidelines and in most cases would not
have a significant impact on regulatory
capital ratios.
Therefore, when determining the
capital limit for deferred tax assets, the
Board has decided to permit, but not
require, institutions to adjust the
reported amount of deferred tax assets
for any deferred tax assets and liabilities
arising from marking-to-market
available-for-sale debt securities for
regulatory reporting purposes. This
choice will reduce implementation
burden for institutions not wanting to
contend with the complexity arising
from such adjustments, while
permitting those institutions that want
to achieve greater precision to make
such adjustments. Institutions must
follow a consistent approach with
respect to such adjustments.
Separate Entity Method—The
proposed capital limit was to be
determined on a separate entity basis for
each state member bank. Use of a
separate entity approach on income tax
sharing agreements (including
intercompany tax payments and current
and deferred taxes) is generally required
by the Board’s 1978 Policy Statement on
Intercorporate Income Tax Accounting
Transactions of Bank Holding
Companies and State Member Banks,
and similar policies are followed by the
other banking agencies. Thus, any
change to the separate entity approach
for deferral tax assets would also need
to consider changes to this policy
statement, which is outside the scope of
this rulemaking. The Board notes that
regulatory reports of banks are generally
required to be filed using a separate;
entity approach and consistency
Detween the reports w o u ld h e reduced -

if the Board permitted institutions to
use other methods for calculating
deferred tax assets in addition to a
separate entity approach. Thus, while a
number of the commenters suggested
that the Board consider permitting other
approaches, the Board will generally
require the separate entity approach.3
As proposed, the final rule contains
an exception to the separate entity
approach when a state member bank’s
parent holding company does not have
the financial capability to reimburse the
bank for tax benefits derived from the
bank’s carryback of net operating losses
or tax credits. In these cases, the amount
of carryback potential the bank may
consider in calculating the capital limit
on deferred tax assets is limited to the
lesser amount which it could reasonably
expect to have refunded by its parent.
Grandfathering—The proposal would
grandfather any deferred tax assets
reported as of September 1992 in excess
of the proposed limit, but would require
that such excess amounts be phased out
over a two year period ending in 1994.
Since all grandfathered amounts are
now fully amortized, the Board’s final
rule does not include any
grandfathering provision.
IV. Regulatory Flexibility Act Analysis
The Board does not believe that the
adoption of this final rule will have a
significant economic impact on a
substantial num ber of small business
entities (in this case, small banking
organizations),.in accordance with t h e '
spirit and purposes of the Regulatory
Flexibility Act (5 U.S.C. 601 et seq.). In
this regard, the vast majority of small
banking organizations currently have
very limited amounts of net deferred tax
assets, which are the subject of this
proposal, as a component of their
capital structures. In addition, this final
rule, in combination w ith the adoption
by the Board of FAS 109 for regulatory
reporting purposes, allows many
organizations to increase the amount of
deferred tax assets they include in
regulatory capital. Moreover, because
the risk-based and leverage capital
guidelines generally do not apply to
bank holding companies with
consolidated assets of less than $150
million, this proposal will not affect
such companies. The Board did not
receive any comment letters specifically
addressing regulatory flexibility
concerns, and therefore, no alternatives
3 State member banks should project taxable
income for the bank, generally on a consolidated
basis including subsidiaries of the bank Bank
holding companies should project taxable income
for the holding company generally on a
consolidated basis including bank and non-bank
subsidiaries of the holding company

to the proposal were considered to
address regulatory flexibility.
V, Paperwork Reduction Act and
Regulatory Burden
The Board has determined that this
final rule will not increase the
regulatory paperwork burden of banking
organizations pursuant to the provisions
of the Paperwork Reduction Act (44
U.S.C. 3501 et seq.).
Section 302 of the Riegle Community
Development and Regulatory
Improvement Act of 1994 (Pub. L. 103325,108 Stat. 2160) provides that the
federal banking agencies must consider
the administrative burdens and benefits
of any new regulation that impose
additional requirements on insured
depository institutions. Section 302 also
requires such a rule to take effect on the
first day of the calendar quarter
following final publication o fth e rule,
unless the agency, for good cause,
determines an earlier effective date is
appropriate.
List of Subjects
12 CFR Part 208
Accounting, Agriculture, Banks,
banking, Confidential business
information, Crime* Currency, Federal
Reserve System, Mortgages, Reporting
and recordkeeping requirements.
Securities.
12 CFR Part 225
Administrative practice and
procedure. Banks, banking, Federal
Reserve System, Holding companies,
Reporting and recordkeeping
requirements, Securities.
For the reasons set forth in the
preamble, the Board is amending 12
CFR parts 208 and 225 as set forth
below:
PART 208—MEMBERSHIP OF STATE
BANKING INSTITUTIONS IN THE
FEDERAL RESERVE SYSTEM
(REGULATION H)
1. The authority citation for part 208
continues to read as follows:
Authority: 12 U.S.C. 36, 248(a), 248(c),
321-338, 3 7 ld , 461, 481-486, 601, 611, 1814
1823(j), 1828(o), 1 8 3 1 0 ,18,31p-l, 3105, 3310,
3331-3351 and 3906-3909: 15 U S.C. 78b,
781(b), 781(g). 78l(i), 78o-4(c) (5), 78q, 78q1. and 78w; 31 U.S.C. 5318.

2. Appendix A to part 208 is amended
by adding a new paragraph (iv) to the
introductory text of Section II.B. to read
as follows:
Appendix A to Part 208—Capital
Adequacy Guidelines for State Member
Banks: Risk-Based Measure

Federal Register / Vol. 59, No. 245 / Thursday, December 22, 1994 / Rules and Regulations 65925
II. * * *
B. * * *
(iv) Deferred tax assets— portions are
deducted from the sum o f core capital
elements in accordance with section II.B.4. of
this Appendix A.

*

*
*
*
*
3. Appendix A to Part 208 is amended
by:
a. Revising footnote 19 in section
I1.B.3.;
b. Removing footnote 20 from the end
of section H.B.3.; and
c. Adding section n.B.4.
The additions and revisions read as
follows:
*

★

*

it

*

II. * * *
B. * * *
2

*

*

*

19

*

*

*

4. Deferred tax assets. The amount of
deferred tax assets that are dependent upon
future taxable income, net of the valuation
allowance for deferred tax assets, that may be
included in, that is, not deducted from, a
bank’s capital may not exceed the lesser of:
(i) the amount of these deferred tax assets
that the bank is expected to realize within
one year of the calendar quarter-end date,
based on its projections of future taxable
incom e for that year,20 or (ii) 10 percent of
tier 1 capital. For purposes of calculating this
limitation, Tier 1 capital is defined as the
sum of core capital elements, net of goodwill
and all identifiable intangible assets other
than purchased mortgage servicing rights and
purchased credit card relationships (and
before any disallowed deferred tax assets are
deducted). The amount o f deferred tax assets
that can be realized from taxes paid in prior
carryback years and from future reversals of
existing taxable temporary differences and
that do not exceed the amount w hich the
bank could reasonably expect to have
19Deductions of holdings of capital securities also
would not be made in the case of interstate "stake
out" investments that comply with the Board’s
Policy Statement on Nonvoting Equity Investments,
12 CFR 225.143 (Federal Reserve Regulatory Service
4-172.1; 68 Federal Reserve Bulletin 413 (1982)). In
addition, holdings of capital instruments issued by
other banking organizations but taken in
satisfaction of debts previously contracted would be
exempt from any deduction from capital. The Board
intends to m onitor nonreciprocal holdings of other
banking organizations' capital instruments and to
provide information on such holdings to the Basle
Supervisors' Committee as called for under the
Basle capital framework.
?°Projected future taxable income sliould not
include net operating loss carryforwards to be used
during that year or the am ount of existing
temporary differences a bank expects to reverse
w ithin the year. Such projections should include
the estimated effect of tax planning strategies that
the organization expects to implement to realize net
operating losses or tax credit carryforwards that
would otherwise expire during the year. Institutions
may use the future taxable income projections for
their current fiscal year (adjusted for any significant
changes that have occurred or are expected to
occur) when applying the capital limit at an interim
report date rather than preparing a new projection
each quarter. To determine the limit, an institution
should assume that all existing temporary
differences fully reverse as of the report date.

refunded by its parent (if applicable)
generally are not limited. The reported
amount of deferred tax assets, net o f any
valuation allowance for deferred tax assets,
in excess of these amounts is to be deducted
from a bank’s core capital elem ents in
determining tier 1 capital.
*

*

*

*

4r

4. A p p e n d ix B to part 2 0 8 is r e v ise d
to read as fo llo w s:

Appendix B to Part 208—Capital
Adequacy Guidelines for State Member
Banks: Tier 1 Leverage Measure
I. O verview
a. The Board of Governors of the Federal
Reserve System has adopted a minimum ratio
of tier 1 capital to total assets to assist in the
assessm ent of the capital adequacy of state
member banks.1 The principal objective o f
this measure is to place a constraint on the
maximum degree to w h ich a state member
bank can leverage its equity capital base. It
is intended to be used as a supplement to the
risk-based capital measure.
b. The guidelines apply to all state member
banks on a consolidated basis and are to be
used in the examination and supervisory
process as w ell as in the analysis of
applications acted upon by the Federal
Reserve. The Board w ill review the
guidelines from time to time and w ill
consider the need for possible adjustments in
light of any significant changes in the
econom y, financial markets, and banking
practices.
II. The Tier 1 Leverage Ratio
a.
The Board has established a m in im u m
level o f tier 1 capital to total assets o f 3
percent. An institution operating at or near
these levels is expected to have welldiversified risk, including no undue interestrate risk exposure; excellent asset quality;
high liquidity; and good earnings; and in
general be considered a strong banking
organization, rated com posite 1 under
CAMEL rating system of banks. Institutions
not meeting these characteristics, as w ell as
institutions with supervisory, financial, or
operational weaknesses, are expected to
operate w ell above minim um capital
standards. Institutions experiencing or
anticipating significant growth also are
expected to maintain capital ratios, including
tangible capital positions, well above the
minimum levels. For example, most such
banks generally have operated at capital
levels ranging from 100 to 200 basis points
above the stated minimums. Higher capital
ratios could be required if warranted by the
particular circumstances or risk profiles of
individual banks. Thus for all but the most
highly rated banks meeting the conditions set
forth above, the minimum tier 1 leverage
ratio is to be 3 percent plus an additional
cushion of a least 100 to 200 basis points. In
all cases, banking institutions should hold
capital commensurate with the level and
nature of all risks, including the volume and
severity of problem loans, to which they are
exposed.

b. A bank’s tier 1 leverage ratio is
calculated by dividing its tier 1 capital (the
numerator of the ratio) by its average total
consolidated assets (the denominator of the
ratio). The ratio w ill also be calculated using
period-end assets whenever necessary, on a
case-by-case basis. For the purpose of this
leverage ratio, the definition o f tier 1 capital
for year-end 1992 as set forth in the riskbased capital guidelines contained in
Appendix A of this part w ill be used.2 As a
general matter, average total consolidated
assets are defined as the quarterly average
total assets (defined net of the allowance for
loan and lease losses) reported on the bank’s
Reports of Condition and Income (Call
Report), less goodwill; amounts of purchased
mortgage servicing rights and purchased
credit card relationships that, in the
aggregate, are in excess of 50 percent of tier
1 capital; amounts of purchased credit card
relationships in excess of 25 percent of tier
1 capital; all other intangible assets; any
investments in subsidiaries or associated
companies that the Federal Reserve
determines should be deducted from tier 1
capital; and deferred tax assets that are
dependent upon future taxable income, net of
their valuation allowance, in excess of the
limitation set forth in section II.B.4 of this
Appendix A.3
c. Whenever appropriate, including when
a bank is undertaking expansion, seeking to
engage in new activities or otherwise facing
unusual or abnormal risks, the Board will
continue to consider the level of an
individual bank’s tangible tier 1 leverage
ratio (after deducting all intangibles) in
making an overall assessm ent of capital
adequacy. This is consistent with the Federal
Reserve’s risk-based capital guidelines an
long-standing Board policy and practice with
regard to leverage guidelines. Banks
experiencing growth, whether internally or
by acquisition, are expected to maintain
strong capital position substantially above
minim um supervisory levels, without
significant reliance on intangible assets.

PART 225— BANK HOLDING
COMPANIES AND CHANGE IN BANK
CONTROL (REGULATION Y)
1. T h e a u th o rity c ita tio n for part 2 2 5
c o n t in u e s to read as fo llo w s:'
Authority: 12 U.S.C. 1817(j)(13), 1818,
1831i, 1 8 3 1 p -l, 1843(c)(8), 1844(b), 1972(i),

2 At the end of 1992, Tier 1 capital for state
member banks includes common equity, minority
interest in the equity accounts of consolidated
subsidiaries, and qualifying noncumulative
perpetual preferred stock. In addition, as a general
matter, Tier 1 capital excludes goodwill; amounts
of purchased mortgage servicing rights and
purchased credit card relationships that, in the
aggregate, exceed 50 percent of Tier 1 capital;
am ounts of purchased credit card relationships that
exceed 25 percent of Tier 1 capital: all other
intangible assets; and deferred tax assets that are
dependent upon future taxable income, net of their
valuation allowance, in excess of certain
limitations. The Federal Reserve may exclude
certain investments in subsidiaries or associated
com panies as appropriate.
3 Deductions from Tier 1 capital and other
1 Supervisory risk-based capital ratios that related
adjustments are discussed more fully in section 1I.B
capital to weighted-risk assets for state member
in Appendix A of this part.
banks are outlined in Appendix A to this part.

65926 Federal Register / Vol. 59, No. 245 / Thursday, December 22, 1994 / Rules and Regulations
3106, 3108, 3310, 3331-3351, 3907, and
3909.
2. Appendix A to part 225 is amended
by adding a new paragraph (iv) to the
introductory text of section II.B. to read
as follows:
Appendix A to Part 225—Capital
Adequacy Guidelines for Bank Holding
Companies:. Risk-Based Measure
*

*.

*

* v

*

II. * * *
B

*

*

*

(iv) Deferred tax assets—portions are
deducted from the sum of core capital
elements m accordance with section II.B.4. of
this Appendix A.
*
*
*
*
*
3. Appendix A to part 225 is amended
by:
a. Revising footnote 22 in section
II.B.3.;
b. Removing footnote 23 from the end
of scction II.B.3. and; ■
c. Adding section II.B.4.
The revisions and additions read as
follows:
*
*
*
*
*
11

*

*

*

B. * * *
g * * *

2 2 * * *

4. Deferred tax assets. The amount of

deferred tax assets that are dependent upon
future taxable income, net of the valuation
allowance for deferred tax assets, that may be
included in, that is, not deducted from, a
banking organization’s capital may not
exceed the lesser of: (i) the amount o f these
deterred tax assets that the banking
organization is expected to realize within one
year of the calendar quarter-end date, based
on its projections o f future taxable income for
that year,23 or (ii) 10 percent of tier 1 capital.
22 Deductions of holdings of capital securities also
would not be made in the case of interstate “stake
out” investments that comply with the Board’s
Policy Statement on Nonvoting Equity Investments,
12 CFR 225.143 (Federal Reserve Regulatory Service
4-172.1; 68 Federal Reserve Bulletin 413 (1982)). In
addition, holdings of capital instruments issued by
other banking organizations but taken in
satisfaction of debts previously contracted would be
exempt from any deduction from capital. The Board
intends to monitor nonreciprocal holdings of other
banking organizations’ capital instruments and to
provide information on such holdings to the Basle
Supervisors’ Committee as called for under the
Basle capital framework.
23 Projected future taxable income should not
include net operating loss carryforwards to be used
during that year or the amount of existing
temporary differences a bank holding company
expects to reverse within the year. Such projections
should include the estimated effect of tax planning
strategies that the organization expects to
implement to realize net operating loss or tax credit
carryforwards that w ill otherwise expire during the
year. Banking organizations may use the future
taxable income projections for their current fiscal
year (adjusted for any significant changes that have
occurred or are expected to occur) when applying
the capital limit at an interim report date rather
than preparing a new projection each quarter, To
determine the limit, a banking organization should
assume that ail existing temporary differences fully
reverse as of the report date.

For purposes of calculating this limitation,
tier 1 capital is defined as the sum of core
capital elements, net o f goodw ill and all
identifiable intangible assets other than
purchased mortgage servicing rights and
purchased credit card relationships (and
before any disallowed deferred tax assets are
deducted). The amount of deferred tax assets
that can be realized from taxes paid in prior
carryback years and from future reversals of
existing taxable temporary differences
generally are not limited. The reported
amount of deferred tax assets, net of any
valuation allowance for deferred tax assets,
in excess of these amounts is to be deducted
from a banking organization’s core capital
elements in determining tier 1 capital.
*

*

*

*

*

4. Appendix D to part 225 is revised
to read as follows:
Appendix D to Part 225—Capital
Adequacy Guidelines for Bank Holding
Companies: Tier 1 Leverage Measure
I. O verview
a. The Board of Governors o f the Federal
Reserve System has adopted a minimum ratio
of tier 1 capital to total assets to assist in the
assessment of the capital adequacy o f bank
holding companies (banking organizations).1
The principal objectives of this measure is to
place a constraint on the maximum degree to
which a banking organization can leverage its
equity capital base. It is intended to be used
as a supplement to the risk-based capital
measure.
b. The guidelines apply ^ c o n so lid a te d
basis to banking holding companies with
consolidated assets of $150 m illion or more.
For bank holding companies with less that
$150 million in consolidated assets, the
guidelines w ill be applied on a bank-only
basis unless (i) the parent bank holding
company is engaged in nonbank activity
involving significant leverage2 or (ii) the
parent company has a significant amount of
outstanding debt that is held by the general
public.
c. The tier 1 leverage guidelines are to be
used in the inspection and supervisory
process as w ell as in the analysis of
applications acted upon by the Federal
Reserve. The Board w ill review the
guidelines from time to time and will
consider the need for possible adjustments in
light of any significant changes in the
economy, financial markets, and banking
practices.
II. The Tier 1 Leverage Ratio
a.
The Board has established a m in im u m
level of tier 1 capital to total assets of 3
percent. A banking organization operating at
or near these levels is expected to have welldiversified risk, including no Undue interestrate risk exposure; excellent asset quality;
high liquidity; and good earnings; and in
1Supervisory ratios that related capital to total
assets for state member banks are outlined in
Appendix B of this part.
1A parent company that is engaged is significant
off balance sheet activities would generally be
(leerued to be engaged in activities that involve
significant leverage.

general be considered a strong banking
organization, rated com posite 1 under
BOPEC rating system o f bank holding
companies. Organizations not meeting these
characteristics, as w ell as institutions with
supervisory, financial, or operational
weaknesses, are expected to operate well
above minimum capital standards.
Organizations experiencing or anticipating
significant growth also are expected to
maintain capital ratios, including tangible
capital positions, w ell above the minimum
levels. For example, most such banks
generally have operated at capital levels
ranging from 100 to 200 basis points above
the stated minim um s. Higher capital ratios
could be required if warranted by the
particular circumstances or risk profiles of
individual banking organizations. Thus for
all but the most highly rated banks meeting
the conditions set forth above, the m inim um
tier 1 leverage ratio is to be 3 percent plus
an additional cushion of a least 100 to 200
basis points. In all cases, banking
organizations should hold capital
commensurate with the level and nature of
all risks, including the volum e and severity
of problem loans, to which they are exposed.
b. A banking organization's tier 1 leverage
ratio is calculated by dividing its tier 1
capital (the numerator of the ratio) by its
average total consolidated assets (the
denominator of the ratio). The ratio w ill also
be calculated using period-end assets
whenever necessary, on a case-by-case basis.
For the purpose o f this leverage ratio, the
definition o f tier 1 capital for year-end 1992
as set forth in the risk-based capital
guidelines contained in Appendix A of this
part w ill be used.3 As a general matter,,
average total consolidated assets are defined
as the quarterly average total assets (defined
net of the allow ance for loan and lease losses)
reported on the organization’s Consolidated
Financial Statements (FR Y-9C Report), less .
goodwill; amounts o f purchased mortgage
servicing rights and purchased credit card
relationships that, in the aggregate, are in
excess of 50 percent o f tier 1 capital; amounts
of purchased credit card relationships in
excess of 25 percent of tier 1 capital; all other
intangible assets: any investments in
subsidiaries or associated companies that the
Federal Reserve determines should be
deducted from tier 1 capital: and deferred tax
assets that are dependent upon future taxable
income, net o f their valuation allowance, in
3 At the end of 1992, Tier 1 capital for state
member banks includes common equity, minority
interest in the equity accounts of consolidated
subsidiaries, and qualifying noncumulative
perpetual preferred stock. In addition, as a general
matter, Tier 1 capital excludes goodwill; amounts
of purchased mortgage servicing rights and
purchased credit card relationships that, in th(
aggregate, exceed 50 percent of Tier 1 capital;
amounts of purchased credit card relationships that
exceed 25 percent of Tier 1 capital; all other
intangible assets; and deferred tax assets that are
dependent upon future taxable income, net of their
valuation allowance, in'excess of certain
limitations. T he Federal Reserve may exclude
certain investments in subsidiaries or associated
companies as appropriate.

Federal Register / Vol. 59, No. 245 / Thursday, December 22, 1994 /' Rules and Regulations 65927
excess of the limitation set forth in section
II.B.4 of this Appendix A.4
c.
Whenever appropriate, including w hen
an organization is undertaking expansion,
seeking to engage in new activities or
otherwise facing unusual or abnormal risks,
the Board w ill continue to consider the level
o f an individual organization’s tangible tier 1
leverage ratio (after deducting all intangibles)
in making an overall assessment o f capital
adequacy. This is consistent with the Federal
Reserve’s risk-based capital guidelines an
long-standing Board policy and practice with
regard to leverage guidelines. Organizations
experiencing growth, whether internally or
by acquisition, are expected to maintain
strong capital position substantially above
minimum supervisory levels, without
significant reliance on intangible assets.
By order of the Board of Governors of the
Federal Reserve System, December 16,1994.
W illiam W. W iles,
Secretary o f the Board
[FR Doc. 94-31441 Filed 12-21-94; 8:45 am]
B ILLING C O D E 6 2 1 0 - 0 1 - P