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Federal R eser v e Bank OF DALLAS W IL L IA M H . W ALLACE DALLAS, TEXAS 7 5 2 2 2 FIRST V IC E P R ES ID EN T AND CH IEF O PER ATING O FFIC E R MdTCh 3, 1987 C i r c u l a r 87-18 TO: The Chief Executive O f f i c e r o f a l l f i n a n c i a l i n s t i t u t i o n s in t he Eleventh Federal Reserve D i s t r i c t SUBJECT Proposed r isk -b a sed c a p ita l framework fo r banks and bank holding companies DETAILS On February 12, 1987, t h e Federal Reserve Board r e q u e s t e d comment on a proposed r i s k - b a s e d c a p i t a l framework f o r banks and bank holding companies. The Boar d' s r i s k - b a s e d c a p i t a l proposal i s based on a proposed United S t a t e s / U n i t e d Kingdom Agreement on primary c a p i t a l and c a p i t a l adequacy a s s e ss m en t. This proposed Agreement i s t h e r e s u l t o f d i s c u s s i o n s between t he Federal Reserve Board, t he O f f i c e o f t h e C omptroll er o f t he Currency, t he Federal Deposit In sura nce Corp ora ti on and t he Bank o f England. The proposal encompasses a common d e f i n i t i o n o f primary c a p i t a l and r i s k c a t e g o r i e s aimed a t b r i n g i n g t o g e t h e r t he assessment o f c a p i t a l adequacy and t he e s t a b l i s h m e n t o f minimum c a p i t a l s t a n d a r d s on an i n t e r n a t i o n a l b a s i s . A 70-page document d e t a i l i n g t h i s i s s u e has been given l i m i t e d d i s t r i b u t i o n by t he Federal Reserve Bank o f D a l l a s . I f you would l i k e t o r e c e i v e a copy, p l e a s e c o n t a c t t he P ub li c A f f a i r s Department a t (214) 651-6289. ATTACHMENTS Attached i s a news r e l e a s e which summarizes t h e t e x t o f t he p r o p o s a l . MORE INFORMATION For more i n f or m at i o n on t h i s t o p i c , p l e a s e c o n t a c t Robert Hankins a t (214) 651-6120. Sincerely yours, For additional copies of any circular please contact the Public Affairs Department at (214) 651-6289. Banks and others are encouraged to use the following incoming WATS numbers in contacting this Bank (800) 442-7140 (intrastate) and (800) 527-9200 (interstate). This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org) Comptroller of the Currency_________ Federal Deposit Insurance Corporation Federal Reserve Board Joint News Release For immediate r e l e a s e The U.S. bank r e g u l a t o r y a g enc ie s and t h e Bank of England have agreed t o r e q u e s t p u b l i c comment on a proposed r i s k - b a s e d c a p i t a l framework f o r banks and bank holding companies t h a t has been developed j o i n t l y by t h e O f f i c e of t h e C o m pt r ol l e r of t h e Cu rrency, t h e Federal Deposit I ns ur ance C o r p o r a t i o n , t h e Federal Reserve Board, and t h e Bank of England. The proposal i s t h e r e s u l t of d i s c u s s i o n s between t h e U.S. bank r e g u l a t o r y a ge nc i es and t h e Bank of England, and r e p r e s e n t s an i mpor tant s tep toward b r i n g i n g t o g e t h e r t h e a ssessment of c a p i t a l adequacy and t h e e s t a b l i s h m e n t of minimum c a p i t a l s t a n d a r d s on an i n t e r n a t i o n a l b a s i s , e s p e c i a l l y in view of t h e i n c r e a s i n g t r e n d toward global banking c o m p e t i t i o n . S p e c i f i c goals of t h e proposal i n c l u d e : • making r e g u l a t o r y c a p i t a l re q ui re me n ts more s e n s i t i v e t o d i f f e r e n c e s in t h e r i s k of banking i n s t i t u t i o n s ; • a s s e s s i n g a c a p i t a l re qu ire me nt a g a i n s t c e r t a i n o f f - b a l a n c e s h ee t exp os ur e s; • r e c o g n i z i n g t h a t hold in g low r i s k , r e l a t i v e l y l i q u i d a s s e t s r e q u i r e s less c a p ita l; • and moving t h e c a p i t a l adequacy p o l i c i e s of t h e U.S. and o t h e r major in d u s tr ia l countries in to c lo s e r alignment. The U.S./U.K. proposal encompasses a common d e f i n i t i o n of primary c a p i t a l and r i s k c a t e g o r i e s . The framework i s i nt e n d e d t o e n s u r e t h a t banking o r g a n i z a t i o n s t h a t t a k e on a d d i t i o n a l r i s k s s u p po r t t h e s e a c t i v i t i e s with additional c a p ita l. The primary c a p i t a l of U.S. banking o r g a n i z a t i o n s would i n c l u d e w i t h o u t l i m i t , as i t does now, common s t o c k h o l d e r s ' e q u i t y , t h e general - 2- r e s e r v e f o r loan l o s s e s , and m i n o r i t y i n t e r e s t in t h e e q u i t y a ccounts of consolidated su b sid iaries. The d e f i n i t i o n of primary c a p i t a l would a l s o i n c l u d e t h e foll owi ng components on a l i m i t e d b a s i s : p e r p e t u a l p r e f e r r e d s t o c k , l ong-t er m (25 y e a r s o r more o r i g i n a l m a t u r i t y ) l i m i t e d - l i f e p r e f e r r e d s t o c k , and c e r t a i n debt i n s t r u m e n t s ( i n c l u d i n g p e r p e t u a l d e b t ) with p r o v i s i o n s t h a t e nsur e t h e i r permanence and a b i l i t y t o absorb l o s s e s . F i n a l l y , t h e U.S./U.K. proposal p ro v id e s f o r c e r t a i n d e du ct i on s from primary c a p i t a l t o c a l c u l a t e a d j u s t e d primary c a p i t a l and a s s e s s c a p i t a l adequacy. The proposal e s t a b l i s h e s f i v e r i s k c a t e g o r i e s f o r t h e purpose of c a l c u l a t i n g weighted r i s k a s s e t s . 0, 10, 25, 50, and 100 p e r c e n t . The c a t e g o r i e s a r e a ss i g n e d weights of The proposed measure would a c h i ev e convergence between U.S. and U.K. s u p e r v i s o r y a u t h o r i t i e s with r e s p e c t t o c a p i t a l r e qu ir e me n ts f o r major c a t e g o r i e s of a s s e t s and o f f - b a l a n c e s h e e t it e ms . I nc lu de d among t h e s e c a t e g o r i e s a r e : - cash and c la ims on domestic c e n t r a l bank, - c laims on domestic d e p o s i t o r y i n s t i t u t i o n s , - claims on f o r e i g n banks, i n c l u d i n g f o r e i g n c e n t r a l - c laims on domestic c e n t r a l government and claims c o l l a t e r a l i z e d banks, by c e n t r a l government d e b t , - c la ims on f o r e i g n governments; and - c la ims on p r i v a t e s e c t o r e n t i t i e s . Weights a s s i g n e d t o o f f - b a l a n c e s h e e t items a r e determined through a c o n v er s i on formula t h a t t r a n s l a t e s o f f - b a l a n c e s h e e t e xposures i n t o a rough on-balance sheet equivalent. - 3- The c o nv er s ion f a c t o r s f o r o f f - b a l a n c e s h e e t items a r e summarized as fo ll ows : Direct c r e d it s u b s ti t u te s ( f i n a n c i a l g u a r a n t e e s and standby l e t t e r s of c r e d i t s e r v i n g t h e same purpose) - 100 p e r c e n t c r e d i t conver sio n f a c t o r . T rad e -rela te d contingencies (commercial l e t t e r s of c r e d i t , bid and performance bonds and performance standby l e t t e r s of c r e d i t ) - 50 p e r c en t c r e d i t c o nv e r s i o n f a c t o r . Sa le and r e pur ch ase agreements and a s s e t s a l e s with r e c o u r s e , i f not a l r e a d y in cl ud e d on t h e balance s h e e t - 100 p e r c e n t c r e d i t c onver sion f a c t o r . Other commitments, i n c l u d i n g r e v o l v i n g u n d e r w r i t i n g f a c i l i t i e s , u n d e r w r i t i n g commitments, commercial and consumer c r e d i t l i n e s . The c r e d i t c on v e r s i o n f a c t o r s a r e : 10 p e r c e n t - one y e a r and l e s s o r i g i n a l m a t u r i t y 25 p e r c e n t - over one t o f i v e y e a r s o r i g i n a l m a t u r i t y 50 p e r c e n t - over f i v e y e a r s o r i g i n a l m a t u r i t y M at u r i t y i s d e f i ne d as t h e e a r l i e s t p o s s i b l e time a t which t h e bank may u n c o n d i t i o n a l l y cancel t h e commitment. Calculation The weighted r i s k a s s e t base e qual s t h e sum of t h e a g gr e g a t e d o l l a r v alue of t h e a s s e t s and t h e conver ted o f f - b a l a n c e s h e e t items in each c at egor y m u l t i p l i e d by t h e weight a ss i g n e d t o t h a t c a t e g o r y . The r i s k a s s e t r a t i o i s then c a l c u l a t e d by d i v i d i n g primary c a p i t a l by t h e weighted r i s k a s s e t b as e, as* f ol l o ws : Adjusted Primary C a p i t a l = -f- Weighted Risk Asset Base Risk Asset R at i o - 4- The U. S./U.K. proposal p r o vi de s t h a t t h e banking a u t h o r i t i e s w il l e s t a b l i s h a common minimum r i s k a s s e t r a t i o f o r banking o r g a n i z a t i o n s under t h e i r s u p e r v i s i o n , a lt ho ug h such a minimum i s not being e s t a b l i s h e d a t t h i s t i me . Most i n s t i t u t i o n s w i l l be e xpec te d t o ma in ta in t h e i r r a t i o s above t h i s mi nimum. For p r a c t i c a l reasons t h e proposed c a p i t a l measure i s not i ntended t o c a p t u r e a l l of t h e r i s k s faced by banking i n s t i t u t i o n s . focus i s on c r e d i t r i s k . I n s t e a d , t h e primary The U.S./U.K. proposal i n d i c a t e s a commitment on t h e p a r t of t h e a g e nc i es t o develop t e c h n i q u e s f o r f a c t o r i n g i n t e r e s t r a t e swap and f o r e i g n exchange t r a d i n g r i s k s i n t o t h e r a t i o in t h e f u t u r e . The proposal a l s o r e f l e c t s an i n t e n t i o n t o develop a more d i r e c t measure of o v e r a l l i n t e r e s t r a t e r i sk. In a s s e s s i n g c a p i t a l adequacy, t h e U.S./U.K. proposal i n d i c a t e s t h a t t h e banking a u t h o r i t i e s w i ll emphasize t h e r i s k a s s e t r a t i o . However, t h e a u t h o r i t i e s w i l l r e t a i n f l e x i b i l i t y t o c o n t i n u e t o u t i l i z e o t h e r measures of c a p i t a l adequacy, i n c l u d i n g c a p i t a l t o t o t a l a s s e t r a t i o s . All p a r t i e s re co gn ize t h a t t h e c a l c u l a t i o n of a r i s k a s s e t or o t h e r c a p i t a l r a t i o i s but one s t e p in t h e e v a l u a t i o n of c a p i t a l and t h a t many o t h e r f a c t o r s must be t ake n i n t o account b e f o r e an o v e r a l l d e t e r m i n a t i o n of c a p i t a l adequacy can be made. loan p o r t f o l i o ; These f a c t o r s i n c l u d e t h e q u a l i t y and d i v e r s i t y of t h e t h e q u a l i t y , t r e n d and v a r i a b i l i t y of e a r n i n g s ; payout r a t i o and t h e l e v e l and t r e n d of r e t a i n e d e a r n i n g s ; s t r u c t u r e of l i a b i l i t i e s ; t h e dividend l i q u i d i t y and t h e t h e e f f e c t i v e n e s s of loan and i nvest ment p o l i c i e s ; and, management's o v e r a l l a b i l i t y t o monitor and c o n t r o l r i s k s . - 0-
@FedFRASER