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FEDERAL RESERVE BANK OF NEW YORK [ Circular No. 10574 "1 September 21, 1992 J ISSUANCE OF SUBORDINATED DEBT AS CAPITAL — Interpretation of the Capital Adequacy Appendices to Regulations H and Y — Technical Amendments to Regulation D and the Rules Regarding Delegation of Authority To A ll State Member Banks and Bank Holding Companies in the Second Federal Reserve District, and Others Concerned: Following is the text of a statement issued by the Board of Governors of the Federal Reserve System: The Federal Reserve Board has announced its approval of the elimination of the requirement that State member banks obtain the Board’s prior approval before issuing subordinated debt in order to treat that debt as capital rather than as a deposit. Accordingly, the Board is issuing an interpretation of the capital adequacy appendices to Regulations H and Y which provides general guidance on the criteria that subordinated debt and mandatory convertible debt issued by State member banks and bank holding companies must meet to be included in capital. In connection with this action, the Board also is making technical amendments to its Regulation D and its Rules Regarding Delegation of Authority. These actions are effective September 4, 1992. Enclosed is a copy of the text of the Board’s notice in this matter, which has been reprinted from the Federal Register of September 4. Questions may be directed to our Banking Applications Department (Tel. No. 212-720-5861). E. G e r a l d C o r r ig a n , President. Board of Governors of the Federal Reserve System ISSUANCE OF SUBORDINATED DEBT AS CAPITAL — Technical Amendments to Regulation D — Interpretation of the Capital Adequacy Appendices to Regulations H and Y — Technical Amendment to the Rules Regarding Delegation of A uthority (Effective September 4, 1992) FEDERAL RESERVE SYSTEM 12 CFR Parts 204,250, and 265 [Regulation D; Docket No. R-0774] Reserve Requirements of Depository institutions, Miscellaneous interpretations, and Rules Regarding Delegation of Authority Board of Governors of the Federal Reserve System. a c t i o n : Final rule; technical amendments. AGENCY: The Board is eliminating the requirement that state member banks obtain the Board’s prior approval before issuing subordinated debt in order to treat that debt as capital rather than as a deposit and is issuing an interpretation of the capital adequacy appendices to Regulations H and Y which provides general guidance on the criteria that subordinated debt and mandatory convertible debt must meet to be included in capital. The purpose of the interpretation is to clarify these criteria. In connection with this action, the Board is making a technical amendment to its Regulation D and its Rules Regarding Delegation of Authority. The amendment to Regulation D conforms a reference regarding the minimum maturity of subordinated debt to the minimum maturity set in the capital guidelines (changing “seven” years to "five” years). The amendment to the Rules Regarding Delegation of Authority eliminates the authority of Reserve Banks to approve the issuance of subordinated debt and mandatory convertible debt as such approval is no longer required. The Board also is rescinding an interpretation of Regulation D concerning subordinated debt that is no longer necessary. EFFECTIVE DATE: September 4,1992. sum m ary: In connection with this action, the Board also is making a technical amendment to its Regulation D (12 CFR part 204) and its Rules Regarding Delegation of Authority (12 CFR part 265). The amendment to Regulation D conforms a reference regarding the minimum maturity of subordinated debt that would not be considered a deposit under that Regulation to the minimum maturity set in the capital guidelines (changing “seven” years to "five” years). The Board is amending its Rules Regarding Delegation of Authority to SUPPLEMENTARY INFORMATION: The eliminate the authority of Reserve Banks Board is eliminating the requirement to approve the issuance of subordinated that state member banks obtain the debt and mandatory convertible debt as Board’s approval before issuing subordinated debt in order to treat that such approval is no longer required. In addition, the Board is rescinding an debt as Tier 2 capital rather than as a interpretation of Regulation D deposit. However, in order to ensure concerning subordinated debt which is that state member banks and bank holding companies fully understand the no longer necessary. requirements for subordinated debt and Notice and Public Participation; mandatory convertible debt that may be Effective Date considered Tier 2 capital, the Board is The provisions of 5 U.S.C. 553(b) issuing an interpretation of its riskbased capital guidelines in Regulations relating to notice and public H (12 CFR part 208, appendix A) and Y participation have not been followed in (12 CFR part 225, appendix A). connection with the adoption of these Under the Board's risk-based capital amendments because the amendments are interpretative and are related to guidelines, state member banks and bank holding companies may include in agency procedure and practice, and Tier 2 capital long-term subordinated section 553(b) does not apply to such debt and mandatory convertible debt rules. Further, the Board finds that securities that meet certain criteria. The notice and public procedure are purpose of the interpretation is to clarify impracticable and contrary to the public these criteria. The interpretation interest because the amendments make clarifies the criteria that subordinated technical corrections and relieve a debt and mandatory convertible debt restriction by eliminating an application issues must meet to be included in requirement. capital including treatment of The provisions of 5 U.S.C. 553(d) acceleration clauses, provisions generally prescribing 30 days’ prior inconsistent with safe and sound notice of the effective date of a rule banking practices, credit sensitive features, and limitations on the amounl have not been followed in connection with the adoption of these amendments. of such instruments includable in Section 553(d) provides that such prior capital. FOR FURTHER INFORMATION CONTACT: Norah Barger, Supervisory Financial Analyst, Division of Banking Supervision and Regulation (202/4522402), or Patrick J. McDivitt, Attorney (202/452-3818), Legal Division, Board of Governors of the Federal Reserve System. For the hearing impaired only, Telecommunication Device for the Deaf (TDD), Dorothea Thompson (202/4523544); Board of Governors of the Federal Reserve System, 20th and C Streets, NW., Washington, DC 20551. PRINTED IN NEW YORK, FROM FEDERAL REGISTER, VOL. 57, NO. 173, PR 40597-40600 [Enc. Cir. No. 10574] notice is not necessary whenever a rule relieves a restriction or there is good cause for finding that such notice is contrary to the public interest. This rule relieves such a restriction, and the Board has determined that delaying the effectiveness of that relief is contrary to the public interest. Regulatory Flexibility Act Analysis Pursuant to section 605(b) of the Regulatory Flexibility Act (Pub. L. 96354, 5 U.S.C. 601 et seq.), the Board certifies that the proposed amendments will not have a significant adverse economic impact on a substantial number of small entities. The proposed amendments reduce certain regulatory burdens for all depository institutions, including small depository institutions, and have no particular adverse effect on other small entities. list of Subjects 12 CFR Part 204 Banks, banking. Federal Reserve System, Reporting and recordkeeping requirements. 12 CFR Part 250 Federal Reserve System. 12 CFR Part 265 Authority delegations (Government agencies), Federal Reserve System. For the reasons set forth in the preamble, the Board is amending 12 CFR parts 204, 250, and 265 as follows: PART 204— RESERVE REQUIREMENTS OF DEPOSITORY INSTITUTIONS 1. The authority citation for part 204 continues to read as follows: Authority: S ectio n s 11(a). 11(c), 19, 25, 25(a) o f the F ederal R eserve A ct (12 U.S.C. 248(a). 248(c). 371a. 371b, 461. 601. 611): se ctio n 7 of the International Banking A ct o f 1978 (12 U.S.C. 3105); and se ctio n 411 o f the G am -St G erm ain D ep ository Institutions A ct o f 1982 (12 U.S.C. 461). § 204.2 [Amended] 2. Section 204.2(a)(l)(vii)(C) is amended by removing the word “seven” and adding the word “five” in its place. § 204.129 [Removed] 3. Section 204.129 is removed. PART 250— MISCELLANEOUS INTERPRETATIONS 1. The authority citation for part 250 continues to read as follows: Authority: 12 U.S.C. 248(i). 2. A new § 250.166 is added to read asupon the occurrence of certain events, which could happen at any time after follows: the instrument is issued, subordinated debt that includes provisions permitting § 250.166 Treatment of mandatory convertible debt and subordinated notes of acceleration upon events other than state member banks and bank holding bankruptcy or reorganization under companies as “capital”. Chapters 7 (Liquidation) and 11 (a) General Under the Board’s risk(Reorganization) of the Bankruptcy based capital guidelines, state member Code, in the case of a bank holding banks and bank holding companies may company, or insolvency—i.e., the include in Tier 2 capital subordinated appointment of a receiver—in the case debt and mandatory convertible debt of a state member bank, does not qualify that meets certain criteria. The purpose for inclusion in Tier 2 capital. of this interpretation is to clarify these (ii) Further, subordinated debt whose criteria. This interpretation should be terms provide for acceleration upon the read with those guidelines, particularly occurrence of events other than with paragraphs U.c. through II.e. of bankruptcy or the appointment of a appendix A of 12 CFR part 208 if the receiver does not qualify as Tier 2 issuer is a state member bank and with capital. For example, the terms of some paragraphs II.A.2.C. and II.A.2.d. of subordinated debt issues would permit appendix A of 12 CFR part 225 if the debtholders to accelerate repayment if issuer is a bank holding company. the issuer failed to pay principal or (b) Criteria for subordinated debt interest on the subordinated debt issue included in capital—(1) Characteristics. when due (or within a certain timeframe after the due date), failed to make To be included in Tier 2 capital under the Board’s risk-based capital guidelines mandatory sinking fund deposits, defaulted on any other debt, failed to for state member banks and bank honor covenants, or if an institution holding companies, subordinated debt affiliated with the issuer entered into must be subordinated in right of bankruptcy or receivership. Some payment to the claims of the issuer’s general creditors11and, for banks, to the banking organizations have also issued, or proposed to issue, subordinated debt claims of depositors as well; must be unsecured: must state clearly on its face that would allow debtholders to that it is not a deposit and is not insured accelerate repayment if, for example, the banking organization failed to by a federal agency; must have a maintain certain prescribed minimum minimum average maturity of five years;2 must not contain provisions that capital ratios or rates of return, or if the amount of nonperforming assets or permit debtholders to accelerate charge-offs of the banking organization payment of principal prior to maturity except in the event of bankruptcy of or exceeded a certain level. (iii) These and other similar the appointment of a receiver for the issuing organization; must not contain or acceleration clauses raise significant be covered by any covenants, terms, or supervisory concerns because repayment of the debt could be restrictions that are inconsistent with accelerated at a time when an safe and sound banking practice; and organization may be experiencing must not be credit sensitive. (2) Acceleration clauses.—(i) In orderfinancial difficulties. Acceleration of the debt could restrict the ability of the to be included in Tier 2 capital, the organization to resolve its problems in appendices provide that subordinated debt instruments must have an original the normal course of business and could cause the organization involuntarily to weighted average maturity of at least five years. For this purpose, maturity is enter into bankruptcy or receivership. defined as the earliest possible date on Furthermore, since such acceleration which the holder can put the instrument clauses could allow the holders of subordinated debt to be paid ahead of back to the issuing banking organization. Since acceleration clauses general creditors or depositors, their inclusion in a debt issue throws into permit the holder to put the debt back question whether the debt is, in fact, subordinated. 1 The risk-based capital guidelines for bank (iv) Subordinated debt issues whose holding companies state that bank holding company terms state that the debtholders may debt must be subordinated to all senior accelerate the repayment of principal indebtedness of the company To meet this requirement, the debt should be subordinated to all only in the event of bankruptcy or general creditors. receivership of the issuer do not permit 2 The "average maturity" of an obligation or issue the holders of the debt to be paid before repayable in scheduled periodic payments shall be general creditors or depositors and do the weighted average of the maturities of all such not raise supervisory concerns because scheduled payments. 2 o the acceleration does not occur until the debt.3 the minimum maturity requirement.6* (4) Credit sensitive features. Credit institution has failed. Accordingly, debt Since mandatory convertible debt sensitive subordinated debt (including eventually converts to an equity issues that permit acceleration of mandatory convertible securities) where principal only in the event of bankruptcy instrument, it has no minimum maturity payments are tied to the financial (liquidation or reorganization) in the requirement. Such debt, however, is condition of the borrower generally do subject to a maximum maturity case of bank holding companies and not qualify for inclusion in capital. receivership in the case of banks may Interest rate payments may be linked to requirement of 12 years. generally be classified as capital. (d) Previously issued subordinated (3) Provisions inconsistent with safethe financial condition of an institution debt. Subordinated debt including through various ways, such as through and sound banking practices—(i) The mandatory convertible debt that has risk-based capital guidelines state that an auction rate mechanism, a preset instruments included in capital may not schedule that either mandates interest been issued prior to the date of this contain or be covered by any covenants, rate increases as the credit rating of the interpretation and that contains provisions permitting acceleration for institution declines or automatically terms, or restrictions that are reasons other than bankruptcy or increases them over the passage of inconsistent with safe and sound time,4 or that raises the interest rate if receivership of the issuing institution: banking practice. As a general matter, includes other questionable terms or capital instruments should not contain payment is not made in a timely fashion.5 As the financial condition of conditions; or that is credit sensitive will terms that could adversely affect an organization declines, it is faced with not automatically be excluded from liquidity or unduly restrict higher and higher payments on its credit capital. Rather, such debt will be management’s flexibility to run the considered on a case-by-case basis to organization, particularly in times of sensitive subordinated debt at a time determine whether it qualifies as Tier 2 financial difficulty, or that could limit when it most needs to conserve its capital. As a general matter, the regulator’s ability to resolve problem resources. Thus, credit sensitive debt bank situations. For example, some does not provide the support expected subordinated debt issued prior to the subordinated debt includes covenants of a capital instrument to an institution release of this interpretation and containing such provisions or features that would not allow the banking whose financial condition is organization to make additional secured deteriorating: rather, the credit sensitive may qualify as Tier 2 capital so long as or senior borrowings. Other covenants feature can accelerate depletion of the these terms: (1) have been commonly used by would prohibit a banking organization institution’s resources and increase the banking organizations, from disposing of a major subsidiary or likelihood of default on the debt. (2) do not provide an unreasonably undergoing a change in control. Such (c) Criteria for mandatory convertible high degree of protection to the holder in covenants could restrict the banking cases not involving bankruptcy or organization's ability to raise funds to debt included in capital. Mandatory convertible debt included in capital receivership, and meet its liquidity needs. In addition, such terms or conditions limit the ability must meet all the criteria cited above for (3) do not effectively allow the holder of bank supervisors to resolve problem subordinated debt with the exception of to stand ahead of the general creditors of the issuing institution in cases of bank situations through a change in 3 This notice does not attempt to list or address control. all clauses included in subordinated debt; rather, it bankruptcy or receivership. Subordinated debt containing provisions (ii) Certain other provisions found in is intended to give general supervisory guidance regarding the types of clauses that could raise that permit the holders of the debt to subordinated debt may provide concerns. Issuers of subordinated debt accelerate payment of principal when protection to investors in subordinated supervisory may need to consult further with Federal Reserve the banking organization begins to debt without adversely affecting the staff about other subordinated debt provisions not overall benefits of the instrument to the specifically discussed above to determine whether experience difficulties, for example, such provisions are appropriate in a debt capital when it fails to meet certain financial organization. For example, some ratios, such as capital ratios or rates of instruments include covenants that may instrument. 4 Although payments on debt whose interest rate return, does not meet these three require the banking organization to: increases over time on the surface may not appear (A) Maintain an office or agency to be directly linked to the financial condition of the criteria. Consequently, subordinated issuing organization, such debt (sometimes referred debt issued prior to the release of this where securities may be presented, (B) Hold payments on the securities in to as expanding or exploding rate debt) has a strong interpretation containing such potential to be credit sensitive in substance. provisions may not be included within trust. whose financial condition has Tier 2 capital. (C) Preserve the rights and franchises Organizations strengthened are more likely to be able to refinance (e) Limitations on the amount of of the company, the debt at a rate lower than that mandated by the (D) Pay taxes and assessments before preset increase, whereas institutions whose subordinated debt in capital—(1) Basic condition has deteriorated are less likely to be able limitation. The amount of subordinated they become delinquent, to do so. Moreover, just when these latter (E) Provide an annual statement of debt an institution may include in Tier 2 institutions would be in the most need of conserving compliance on whether the company capital is limited to 50 percent of the capital, they would be under strong pressure to has observed all conditions of the debt redeem the debt as an alternative to paying higher amount of the institution’s Tier 1 capital. rates and. thus, would accelerate depletion of their The amount of a subordinated debt agreement, or resources. (F) Maintain its properties in good issue that may be included in Tier 2 5 While such terms may be acceptable in condition. Such covenants, as long as capital is discounted as it approaches perpetual preferred stock qualifying as Tier 2 they do not unduly restrict the activity capital, it would be inconsistent with safe and maturity: one-fifth of the original amount of the banking organization, generally sound banking practice to include debt with such terms in Tier 2 capital. The organization does not would be acceptable in qualifying 6 Mandatory convertible debt is subordinated the option, as it does with auction rate subordinated debt, provided that failure have debt that contains provisions committing the issuing preferred stock issues, of eliminating the higher to meet them does not give the holders payments on the subordinated debt without going brganization to repay the principal from the proceeds of future equity issues. of the debt the right to accelerate the into default. 3 of the instrument, less any redemptions, Regulation Y. Accordingly, if a banking mandatory convertible debt included in is excluded each year from Tier 2 capital organization, with the agreement of its capital are required to receive prior during the last five years prior to debtholders, seeks Federal Reserve Federal Reserve approval, unless the maturity. If the instrument has a serial approval to eliminate such a fund, redemption is effected with the proceeds redemption feature such that, for approval normally would be given from the sale or common or perpetual example, half matures in seven years unless supervisory concerns warrant preferred stock. An organization and half matures in ten years, the otherwise. planning to effect such a redemption issuing organization should begin (f) Redemption of subordinated debt with the proceeds from the sale of discounting the seven-year portion after prior to maturity—(1) By state member common or perpetual preferred stock is two years and the ten-year portion after banks. State member banks must obtain five years. approval from the appropriate Reserve advised to consult informally with its (2) Treatment of debt with dedicated Bank prior to redeeming before maturity Reserve Bank in order to avoid the possibility of taking an action that could proceeds. If a banking organization has subordinated debt or mandatory issued common or preferred stock and convertible debt included in capital.7 A result in weakening its capital position. A Reserve Bank will not approve the dedicated the proceeds to the Reserve Bank will not approve such redemption of mandatory convertible redemption of a mandatory convertible early redemption unless it is satisfied debt security, that portion of the security that the capital position of the bank will securities, or acquiesce in such a redemption effected with the sale of covered by the amount of the proceeds be adequate after the proposed common or perpetual preferred stock, so dedicated is considered to be redemption. ordinary subordinated debt for capital (2) By bank holding companies. While unless it is satisfied that the capital purposes, provided the proceeds are not bank holding companies are not position of the bank holding company placed in a sinking fund, trust fund, or formally required to obtain approval will be satisfactory after the similar segregated account or are not prior to redeeming subordinated debt, redemption.18 the risk-based capital guidelines state used in the interim for some other purpose. Thus, dedicated portions of that bank holding companies should PART 265— RULES REGARDING mandatory convertible debt securities consult with the Federal Reserve before DELEGATION OF AUTHORITY are subject, like other subordinated redeeming any capital instruments prior debt, to the 50 percent sublimit within to stated maturity. This also applies to 1. The authority citation for part 265 is Tier 2 capital, as well as to discounting any redemption of mandatory revised to read as follows: in the last five years of life. Undedicated convertible debt with proceeds of an Authority: 1 2 U.S.C. 248(i) and (k). portions of mandatory convertible debt equity issuance that were dedicated to the redemption of that debt. may be included in Tier 2 capital §265.11 [Amended] without any sublimit and are not subject Accordingly, a bank holding company should consult with its Reserve Bank to discounting. 2. In § 265.11, paragraph (e )(ll) is (3) Treatment of debt with segregated prior to redeeming subordinated debt or removed, and paragraph (e)(12) is funds. In some cases, the provisions in dedicated portions of mandatory redesignated as (e)(ll). mandatory convertible debt issues may convertible debt included in capital. A * * * * * require the issuing banking organization Reserve Bank generally will not acquiesce to such a redemption unless it to set up a sinking fund, trust fund, or By order o f the Board o f G overn ors o f the is satisfied that the capital position of similar segregated account to hold the F ederal R eserve S ystem , A ugust 2 8 ,1 9 9 2 . the bank holding company would be proceeds from the sale of equity adequate after the proposed redemption. Jennifer J. Johnson, securities dedicated to pay off the Associate Secretary o f the Board. principal of the mandatory convertible (3) Special concerns involving debt at maturity. The portion of mandatory convertible debt. Consistent [FR Doc. 9 2 - 2 1 2 0 4 F iled 9-2-92; 8 4 5 am ) mandatory convertibles covered by the with appendix B to Regulation^, bank BILLING CODE 6210-01-F amount of proceeds deposited in such a holding companies wishing to redeem segregated fund is considered secured before maturity undedicated portions of 8 The guidance contained in this paragraph and, thus, may not be included in capital applies to mandatory convertible debt issued prior at all, let alone be treated as 1 Some agreements governing mandatory to the risk-based capital guidelines that state that subordinated debt that is subject to the convertible debt issued prior to the risk-based the banking organization may redeem the note9 if capital guidelines provide that the bank may 50 percent sublimit within Tier 2 capital. they no longer count as primary capital a9 defined redeem the notes if they no longer count as primary The maintenance of such separate in Appendix B to Regulation Y. Such provisions do capital as defined in appendix B to Regulation Y. segregated funds for the redemption of' Such a provision does not obviate the requirement not obviate the need to consult with, or obtain mandatory convertible debt exceeds the to receive Federal Reserve approval prior to approval from, the Federal Reserve prior to redemption. redemption of the debt. requirements of appendix B to