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FEDERAL RESERVE BANK OF NEW YORK i fi-T /JoXS2 5 February 21, 1979 B A N K HOLDING COM PANY RATING SYSTEM To All Bank Holding Companies in the Second Federal Reserve District: Following is the text of a statement issued by the Board of Governors of the Federal Reserve System announcing the adoption of a rating system for evaluating the performance and financial condition of bank holding companies: The Federal Reserve Board today [F e b r u a r y 7] adopted a system for appraising and rating the performance and financial condition of bank holding companies. The bank holding company rating system extends a program of intensified supervision of bank holding companies the Federal Reserve put into effect at the beginning of 1978. That program includes requirements for annual on-the-spot inspections of most bank holding companies with consolidated assets greater than $300 million as well as the application to such companies of standardized examination criteria. Building on this supervisory program, the Board adopted a system that will be used nationwide by the Federal Reserve to rate the strengths and weaknesses of parent bank holding companies, their bank and nonbank subsidiaries, and to assess certain operational characteristics such as the organization’s earnings, the adequacy of its capital and its management. Each of these component aspects of the holding company will be given a rating of one to five, with one representing the best rating and five the lowest. The component ratings will then be combined into an overall financial composite rating, also on a scale of one (best) to five (lowest). In addition, holding companies will be given a separate rating on the ability and competence of the company’s management. The bank holding company rating system adopted by the Board is similar in concept to the uniform interagency system for rating banks adopted by the Federal Reserve, Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation in May 1978. Enclosed for bank holding companies is a copy of a description of the rating system. Any questions regarding the system may be directed to George Juncker, Chief, Bank Analysis Division (Tel. No. 212791-6710). P aul A. Volcker, President. INTRODUCTION AND SUMMARY The bank holding company rating system is a management Information and supervisory tool which defines the condition of bank holding companies in a systematic way. approach by: The system adopts the "componentM (1) evaluating the financial condition and risk characteristics of each major component of the bank holding company; (2) assessing the important interrelationships among the components; and (3) analyzing the strength and significance of key consolidated financial and operating performance characteristics. This approach is particularly appropriate since holding companies are to be a source of financial and managerial strength to their bank subsidiaries. In order to arrive at an overall assessment of financial condition, the following, elements of the bank holding company are evaluated and rated on a scale of one through five in descending order of performance quality: Bank Subsidiaries Other (Nonbank) Subsidiaries Parent Company Earnings - Consolidated Capital Adequacy - Consolidated The first three elements of the rating, i.e., the bank, other subsidiaries, and parent company, reflect the contribution of each to the fundamental financial soundness of the holding company. The rating of consolidated earnings and capital recognizes the importance that regulators place on these factors and therr crucial role in maintaining the financial strength and supporting the risk characteristics of the entire organization. The ability and competence of holding company management bear tantly on eve r y aspect of holding company operations and, consequently, impor is included as a major factor in the evaluation of each of the five principal elements of the bank holding company rating, as well as in the assignment of an overall holding company rating. In addition to the individual elements described above, each company is accorded an overall or composite rating, comprising both a financial and managerial component. The financial composite rating is predicated upon - an overall evaluation of the ratings of each of the five principal elements of the holding company’s operations as defined above. The financial composite rating is also based upon a scale of one through five in descending order of performance quality. Thus, one degree of supervisory concern. represents the lowest and five the highest The managerial composite is predicated upon a comprehensive evaluation of holding company management as reflected in the conduct of the affairs of the bank and nonbank subsidiaries and the parent company. "F", or "U” The managerial composite is indicated by the assignment of " S " , for, respectively, management that is found to be satisfactory, fair or unsatisfactory. The complete rating represents a summary evaluation of the bank holding company in the form of a rating "fraction." The "numerator" re flects the condition of the principal components of the holding company and assessments of certain key consolidated financial and operating factors. The "denominator" represents the composite rating, as defined in greater de tail below, including both its financial and managerial components. While the elements in the "numerator" represent the essential foundation upon which the composite rating is based, the composite need not reflect a simple arith metic mean or rigid formula weighting of the individual performance dimensions. Any kind of formula could be misleading and inappropriate. Rather, the com-. posite should reflect the rater's judgment of the overall condition of the bank holding company based upon his knowledge and experience with the company. Thus, the complete rating is displayed as follows: Bank(s) Other - Parent - Earnings - Capital ___________Subsidiaries________________________ ________ Financial Managerial Composite Composite The bank holding company rating system parallels the uniform interagency bank rating system to some degree by utilizing similar rating scales and performance definitions to evaluate both the individual elements and the summary or overall condition of the holding company. This framework will provide for consistency and facilitate the adoption and use of the holding company rating system. The rating system is also sufficiently flexible to allow for appropriate differences in appraising shell bank holding companies. Since shell bank holding companies comprise the majority of supervised companies, and involve a substantial volume of banking assets, they must also be addressed by the rating system. The procedure would be similar to that so far described; however, the other (nonbank) subsidiaries, consolidated earnings, and consolidated capital ratings would be dropped since these components have little relevance for the shell company. This leaves the parent (with emphasis on cash flow and debt servicing ability), bank and composite (both financial and managerial) as remaining elements of the shell bank holding company rating. -4 - FISANCLAL COMPOSITE RAT HI G The five composite ratings are defined and distinguished as follows: Composite 1 Bank holding companies in this group are sound in almost every respect; any negative findings are basically of a minor nature and can be handled in a routine manner. Such holding Qompanies and their subsidiaries are resistant to external economic and financial disturbances and readily generate cash flow which is more than adequate to service their debt and other fixed obliga^ tions with no harm to subsidiaries. Composite 2 3ank holding companies in this group are also fundamentally sound but may reflect modest weaknesses correctable in the normal course of business. Such holding companies and their subsidiaries generate cash flow which is adequate to service their obligations; however, areas of weakness could develop into conditions of greater concern. To the extent that the minor adjustments are handled in the normal course of business, the supervisory response is limited. Composite 3 Bank holding companies in this group exhibit a combination of weaknesses ranging from fair to moderately severe. Such holding companies and their subsidiaries are less resistant to the onset of adverse business conditions and could likely deteriorate if concerted action is not effective in correcting the areas of weakness. The company’s cash flow is sufficient to meet immediate obligations but, unless action is taken to -5 - correct weaknesses, parent cash flow needs could adversely affect the financial condition of the subsidiaries. Conse quently, such bank holding companies are vulnerable and require more than normal supervision. Overall strength and financial capacity, however, are still such as to pose only a remote threat to the viability of the company. Composite 4 Bank holding companies and their subsidiaries in this group have an immoderate volume of asset weaknesses, or a combination of other conditions that are less than satisfactory. An additional weakness may be that: the holding company's cash flow needs are met only by upstreaming imprudent dividends and/or fees from its subsidiaries. Unless prompt action is taken to correct these conditions, they could impair future viability. 3ank holding cotiq>anies in this category require close supervisory attention and increased financial surveillance. Composite 5 The volume and character of the weaknesses of bank holding companies in this category are so critical as to require urgent from shareholders or other sources to prevent insolvency. The imminent inability of such companies to service their fimed obligations and/or prevent capital depletion from severe operating losses places their viability seriously in doubt. Such companies require immediate corrective action and constant supervisory a t tention. MB -6 - m a n a g s m e :i T composite hating The management rating is intended Co reflect an overall evaluation of the capabilities and competence of che m an a gement of the parent company and senior management of the bank(s) and nonbanks subsidiaries. The assessment of management must taka place within the contemn of the situation and circumstances surrounding the individual holding company under evaluation. Since business complexities and operating problems vary with the sine and type of holding company activity, management that is competent to effectively discharge responsibilities under one set of conditions may be less competent as these conditions change. Management perfor mance must be evaluated against virtually all factors necessary to operate the holding company's activities in a sound and prudent manner. In addition to objective operating results, important subjective con siderations in assessing management performance 1. Technical competence, include the following: leadership, administrative ability, management depth and succession; 2, Knowledge of and compliance with the 3ank Holding Company Act and related regulations, and all other relevant laws and regulations; 3. History of serving the banking needs of the ccccauaity; 4.. Ability to plan and respond to changing circumstances; 5 . Ability of parent management to monitor and direct subsidiary operations in order to insure prudent operation and compliance with established holding company policies; S. Adequacy and scope of internal audit systems and controls and evaluation of them as contained in audit reports; and 7. Attitude toward risk as indicated by resou rces any undue r e l i a n c e on o f s u b s id ia r y bank(s).. to support: nonbank activities. A rating of satisfactory (S) 13 indicative of management that is fully effective with respect to almost all factors and exhibits a respon siveness and ability to cope successfully with existing and foreseeable problems that may arise in the conduct of the pare n t ’s, or subsidiaries' affairs. Management rated satisfactory is knowledgeable concerning rele vant lav3 and regulations, and has demonstrated an understanding of the need to insulate the subsidiary bank(s) with nonbank activities. from any undue risk associated A rating of fair (7) reflects performance that is lacking in some measure of ability desirable to meet responsibilitiesof the situation in which management is found. Either it is characterized by modest talent when above-average abilities are called for, or it is distinctly below average for the type and size of organization in which it operates. Thus, its responsiveness or ability to correct less than satisractory conditions may be lacking. Moreover, such management may 3- reflect a less than satisfactory understanding-of relevant holding com pany laws and regulations. A rating of unsatisfactory (U)is indicative of a management that is demonstrably inferior or incompetent in relation to the responsibilities or problems it faces. This rating may also be indicative of management that has demonstrated an inclination to subject the subsidiary bank(s) to excessive or unwarranted risk as a result of the activities of the nonbank suipsidiaries. In these cases, problems resulting from management weakness are of such severity that management must be strengthened or replaced before sound conditions can be brought about. PERFORMANCE EVALUATION The five components of holding company operations— bank subsid iaries, nonbank subsidiaries, parent only, consolidated earnings and capital— are to be evaluated on a scale of one to five. Following is a description of the gradations to be utilized in assigning performance ratings r Rating No. 1 - indicates strong performance. It is the highest rating, and is indicative of performance that is significantly higher than average and obviates the need for supervisory con cern. Rating No . 2 - reflects satisfactory performance. performance that is average or above; It reflects it includes performance that adequately provides for the safe and sound operation of the bank holding company and its subsidiaries. -9 - Rating N o . 3 - represents performance that is flawed to seme degree; as such, is considered fair. It is neither satisfac tory nor marginal but is characterized by performance of below average* quality. Such performance requires management Reten tion due to the distinct possibility of further deterioration. Rating No. A - represents marginal performance which is signif icantly below average; if left unchecked, such performance might evolve into weaknesses or conditions that could threaten the viability of the institution. Rating N o . 5 - is considered unsatisfactory. It is the lowest rating and is indicative of performance that is critically de ficient and in need of immediate remedial attention. Such per formance by itself, or in combination with other weaknesses, could threaten the viability of the institution. BANK CONDITION The bank condition component is intended to reflect the overall condition of the banking subsidiary or subsidiaries. For this purpose, use is made of the subsidiary bank CAMEL composite rating(s). In the case of multibank companies, each bank's.composite rating should be weighted according to its asset size to arrive at an average bank composite rating. Weighting implies that, in most cases, the bank 4 -1 0 - condition component in the holding company rating system w ill usually r e fle c t the lead bank's composite according to the bank rating system (CAMEL). To highlight the presence of one or more problem bank(s) in a multibaak holding company whose bank condition component, based on weighted averages, might not otherwise reveal their presence ( i . e . , bank condition ratings of 1, 2 or 3 ) , a problem id e n tifie r , " P , " would be attached to the bank condition rating ( e . g . , IP, 2?, 3?). Thus, 2? would indicate that, while on balance the banking subsidiaries are rated sa tisfactory, there exists a problem bank (composite 4 or 5) among the banking subsidiaries. The problem id e n tifie r »is unnecessary when the bank condition component is rated 4 or 5 . Although the bank condition component is a weighted average, i t can be adjusted for sub je c tiv e , judgmental reasons at the-discretion of the rater. QT5EP QTONBANK) SUBSIDIARIES The other subsidiaries rating is designed to assess the condition of the nonbank subsidiaries in the context of their overall impact on the financial condition of the holding company and the subsidiary bank(s). In so doing, emphasis must be placed on the asset quality of credit-extending subsidiaries and the p r o fita b ility and operating soundness of noncredit extending subsidiaries. The evaluation of other subsidiaries should concentrate on the quality and condition of nonbank assets defined a s : 1. The underlying assets of credit-extending nonbank subsidiaries; and -1 1 - 2. The parent' 3 Investment in and advances to noncredit-extending subsidiaries. The inclusion of No. 2 in the d efin ition recognises the fact that poorly run. servicing or. other noncredit-extending subsidiaries, can pose significant risk exposure to the holding company which should be e x p lic itly reflected in the racing. Such exposure might r e su lt, for example, from operating losses or'off-balan ce sheet items such as guarantees. In many cases, since noncredit-extending subsidiaries are not heavy borrowers from external sources, the parent's investments in and advances to such com panies w ill serve as a proxy for the magnitude of their operations. The degree o f risk associated with the noncredit-extending subsidiaries may be quantified for the purpose of analyzing nonbank asset quality by c la s sifying the parent’ s investments in and advances, to such subsidiaries where appropriate. However, to the extent that the potential l i a b i l i t y may be in excess of the parent’ s investments and advances, this fact should be recognized. In assessing the investment in or advance to a noncredit-extending subsidiary, the analysis should p a ra llel that for any asset appraisal, with particular attention given to the subsidiary's purpose and operating e fficien cy, management reporting procedures and p r o fita b ility . A lso, foreign subsidiaries should be assessed in a manner similar to that for the company's domestic nonbank investments. The degree of risk associated with credit-extending subsidiaries is determined by the c la ssifica tio n of the underlying assets of the sub sid ia rie s. The severity of both problem investments and c la ssifie d assets should be reflected by using the following weights: 100 per cent of loss, -12 - 50 per cant of doubtful, and 20 per cant of substandard, A major stap in rating nonbank a c tiv itie s is f ir s t to appraise their significance to the company's overall financial performance. The appraisal should focus on the potential loss exposure these a c tiv itie s posa to the bank holding company. One way of estimating this exposure is to compare tota l nonbank assets as defined above, plus any additional exposure not reflected in to ta l a sse ts, to to ta l consolidated c a p ita l. As a general ru le, other subsidiaries should be rated whenever nonbank assets exceed 5 per cent of consolidated capital or $10 m illion , which ever is lower. I f neither of these conditions is met, a "0 ” should be entered for the rating of other su b sid iaries. Other subsidiary, assets that do not meet the significance conditions may be rated i f , in the opinion of the rater, not to do so would sig n ifica n tly misrepresent the condition of the holding company. When a rating is assigned to nonbank a sse ts, considerations should include: 1. The relationship of problem investments in and advances to noncxedit-extending subsidiaries plus c la ssifie d assets in the credit-extending nonbank subsidiaries to tota l nonbank assets as defined above; 2. The relationship of problem investments and advances plus c la ssifie d assets to the sum of parent company and nonbank valuation reserves and ex-bank consolidated equity ca p ital, or to any more appropriate or refined c a ;it a l index or measure, i f warranted; -13 - 3. The a b ility of nonbank management to supervise and exercise overall control over nonbank subsidiary operations in order to insure prudent operation, sound asset administration, and compliance with established holding company p o licies and r e le vant laws and regulations; and 4. Management attitudes toward risk as indicated by any undue reliance on resources of affiliated bank(s) to support non bank subsidiar ies. The sp e cific delineation of the above considerations is not meant to preclude taking into account other relevant factors such as p r o fita b ility , operating e fficien cy, management controls, reporting procedures and any other relevant factors that, in the judgment of the rater, are necessary •to accurately assess the condition of the nonbank subsidiaries. An asset quality rating of 1 obviates the need for supervisory concern due to the existence of sound, well-managed nonbank operations, investments and loan p o rtfo lio s. A2 rating may indicate the existence of some asset problems or other minor operational weaknesses, but s t i l l represents fundamentally sound, well-managed asset conditions warranting minimal supervisory concern. A2 may also r e fle c t asset problems that are clearly of l i t t l e supervisory concern, given their unlikely impact on -thfc, bank(s) and the size and overall strength of the holding company. Problems associated with a course of business. A3 2 rating can readily be resolved in the normal rating represents the existence of deficiencies such as a sign ifican t upward trend in c la ssific a tio n s, management control weaknesses or other problems that, i f le f t unchecked, could cause sub- -1 4 - sta n tia l deterioration and have an adverse inpact on the banking subsidiaries. A 4 rating represents an increased need for supervisory surveillance and concern due to any ccabination of poor operations, weak management or severe asset problems that are currently having a serious impact on the holding company or the banking subsidiaries. A 5 rating applies to a c r it ic a l le v e l o f nonbank problems. PARENT CCMPA3Y The parent company rating r e fle c ts the financial condition of the parent company by focusing on: (1) it s a b ility to readily service it s debt and other fixed obligations; and (2) the quality of direct parent credit extensions to en titie s that are not subsidiaries of the holding company. (Investments in and advances to holding company subsidiaries are treated above in connection with the evaluation of the nonbank sub sid ia ries .) In analyzing the parent company, consideration should be given to its a b ility to generate adequate cash flow from its on-going opera tions and the liq u idity of its a sse ts. Potential sources of cash flew to the parent include, for example, bank and aonbank dividends, loan repayments, management and service fees, tax b en efits, interest income and liquidation of a ssets; while cash needs would include interest and operating expenses, debt retirement and preferred and common stock dividends. The analysis should also take into account the capacity of the parent company to safely obtain liq u id ity from its subsidiaries by, for example, the prudent upstreaming of additional subsidiary d iv idends. -15 Factors.which should be incorporated in the analysis of the parent company include: 1. Volume and composition of parent company debt, and cash flow needs deriving therefrom; 2* Comparison of the maturities of parent company borrowings with the maturities of the investments which they fund; 3. Quality of credits to n on affiliated companies; 4. A b ility to readily convert assets to cash without incurring serious loss or adversely affecting the banking subsidiaries; 5. A b ility of management to plan for liq u id ity and cash flew needs and respond to changing conditions in "the markets fo r short-term funds; 6. A b ility of the company to obtain long and short-term funds on reasonable terms, and the existence of firm back up lines o f cred it; 7* Reasonableness of any bank management or service fees paid to the parent; 3* Demonstrated performance in meeting past and current servicing requirements; and 9. A b ility of parent management to supervise and exercise overall control over subsidiary and parent operations in order to insure prudent operation, sound asset administration, and compliance with established holding company p o licie s and relevant laws and regulations. -16 - r->._i.sc importance, but treated elsewhere/ are the use of oarent debt to rund equity investments in subsidiaries/ the adequacy of the com pany's capital and capital plans and the strength of corporate earnings. The 3 h sll company would be appraised in a manner sim ilar to that outlined above. Cash flow to service parent company debt would be the major aspect of the analysis, with attention focused on its e ffec ts on the subsidiary bank's capital position.' In addition, the amount of parent company debt should be compared to the parent's pro portionate interest in the subsidiary bank's equity ca p ita l. This serves as a good estimate of the company's a b ility to carry existing debt or borrow additional funds should an unexpected need arise . A parent company rating of 1 indicates that the holding company can readily generate cash flow which is more than adequate to service it s debt obligations and other cash flow needs and provide for the smooth rollover of debt without adverse a ffe c t on its subsidiaries. The rating also re fle c ts good management and the absence of s ig n i f i cant asset problems. A 2 rating, while reflectin g a fundamentally sound situation, indicates a possible trend toward tighter liq u id ity due to lower earnings, asset quality, or other relevant operating indices. A rating of 3 represents a decidedly tig h t, but s t i l l manage able, cash flow situation. The company w ill lik ely have l i t t l e or no liq u id ity in its asset p ortfolio and/or be overly dependent on poten t ia lly harmful dividends and fees from its subsidiaries. Weak earnings -17 - night also be expected to complicate such a situation- The 3 rating would r e fle c t increasing d iffic u lty for .the parent company in obtaining short-term funds on favorable terns. A rating of 4 .indicates serious cash flow problems caused or exacerbated by severe asset deterioration or poor or no corporate earnings. Companies so rated may be seriously draining funds from bank subsidiaries to service cash flow needs and may be completely unable to .serve as a source of funds or financial strength to their subsidiaries.. A rating of 5 may represent an in a b ility to enter money markets. Moreover, the problems represented by a rating of 5 would r e fle c t an imminent danger of default or in solvency of the parent company. EARNINGS - CONSOLIDATED The rating of earnings is based on the assessment of fully consolidated profitability. This approach is appropriate since con- -13- Pro l i t a b ility has two dimensions, quantity and quality, both of which must be incorporated in the evaluation of earnings. Quantity refers to the absolute le v e l of net income and it s adequacy in relation to the considerations listed below. The appraisal of quality is an attempt to determine the strength of operating earnings ( i . e . , the a b ility to generate on-going revenues and hold down expenses), and the degree to which earnings r e fle c t the impact of unusually large securities gains or lo sse s, unusual tax items ( i . e . , cred its, carry forwards, e t c .) , or other large, nonrecurring, extraordinary gains or lo sse s. Quality of earnings also refers to the e ffe c t on net income of adequately providing additions to the loan loss reserve in order to properly-recognize the impact of poor, overstated or loss assets carried on the balance sheet. « Other things equal, consolidated net income that r e lie s unduly on unusually large, nonrecurring gains or that f a ils to r e fle c t adequate loan loss provisions is of lower qual it y than net income of equal magnitude that re fle c ts strong operations and adequate loss provisions. ity "works both wavs." On the other hand, the concept of dual While care must be taken to avoid attempting to predict the future, net income that otherwise appears somewhat low maybe of high quality and, consequently, suggests stronger future net income. This would especially be the case i f current earnings re flected a level of charge-offs that was not expected to recur, given the re la tiv e ly high quality of the company's a ssets. -1 9 - Generally, consolidated earnings since the prior inspection ■sill be rated with emphasis' given to the most recent year1s te rro rnance* In lig h t or the above discussion, earnings w ill be rated with respect to the following considerations: 1* ‘ The a b ility to adequately cover charge-offs, maintain public confidence, and provide for the safe on-going operation of the company; 2. Return on consolidated a ssets, h isto r ic a l earnings trends, and peer group comparisons; 3* Quality of earnings as reflected by: (i) extent of reliance on nonrecurring gains or losses or unusual tax e ffe c ts , and (ii) the sufficiency of loss provisions in view of the con d ition o f the asset p o rtfo lio and the adequacy of the loan loss reserves; 4. A b ility of management to plan and devise r e a lis tic earnings projections in light of the risk structure and quality of a s s e ts ; 5* Outlook for earnings as implied by the current risk structure and quality of assets; and 6* A b ility of earnings to provide for the growth of capital in lig h t of recent and planned asset growth. 20 Inclusion o r N o. 5 is not meant to suggest that the level or adequacy of current capital determines the rating for earnings; capital per se is treated elsewhere. I t simply recognizes that retained earnings is a primary source of ca p ita l. Should a company opt tor rapid growth, i t s earnings must enable i t to raise the necessary capital either through retention or by permitting ease of entry into the capital markets. While this notion must be kept in mind in evaluating a company’ s p r o fita b ility , i t is quite possible for a company to s i multaneously have low capital and good earnings or vice versa. Earnings rated 1 are su ffic ie n t to make f u ll provision for the absorption of losses and accretion of capital when due consideration ±3 given to asset quality and bank holding company growth. Generally, holding companies so rated w ill have earnings w ell above peer group averages. A company whose earnings are re la tiv e ly sta tic or even moving downward may receive a 2 rating provided it s level of earnings is adequate in view of the considerations discussed above. Normally, companies so rated w ill have earnings that are in line with or slig h tly above peer group norms. A 3 should be accorded earnings that are not fu lly adequate to make su fficie n t provisions for the absorption of losses and the accretion of capital in relation to company growth. The earnings pictures of such companies may be further clouded by sta tic or inconsistent earnings trends, chronically in su fficien t earnings, or less than satisfactory asset quality. Earnings of such -2 1 - companies are generally below peer group averages. Earnings rated 4 , while generally p o sitive, are clearly not adequate to make f u ll pro vision for losses and the necessary accretion of ca p ita l. Companies with earnings rated 4 may be characterised by erratic fluctuations in net income, poor earnings and the likelihood of the development o f a further downward trend, intermittent lo sse s, chronically depressed earnings, or a substantial drop from the previous year. Earnings of such companies are ordinarily substantially below peer group averages. 3ank holding companies with earnings accorded a 5 rating should be experiencing losses or reflecting a le v e l of earnings that is worse than defined in rating 4 above. Such lo sse s, i f not reversed, could represent a d istin ct threat to the holding company's solvency through the erosion o f ca p ita l. CAPITAL ADEQUACY - CONSOLIDATED Capital is to be evaluated with regard to the volume and risk of the operations of the consolidated corporation. Emphasis on capital from the standpoint of the consolidated entity is appropriate since holding company management exercises some discretion with respect to the allocation of capital resources within the corporation. -2 2 - Thus, it is the holding company's capital on a consolidated basis that must serve as the ultimate source of support and strength to the entire corporation. To be considered adequate, holding company capital must: (a) support the volume and risk characteristics of a l l parent and •subsidiary a c t iv itie s ; (b) provide a su fficie n t cushion to absorb unanticipated losses arising from. holding company and subsidiary a c t iv it ie s ; (c) support the level and composition of corporate and subsidiary borrowing; and (d) serve a3 a source of strength by providing an adequate base for the growth of risk assets and permitting entry into the capital markets as the need arises. An e ssen tia l step in the analysis of capital is the assessment of the risk characteristics and cap ital requirements deriving from the lending a c tiv itie s and operations of the parent and each of the operating subsidiaries.. The analysis of capital should incorporate the following considerations: 1* The relationship of consolidated capital to consolidated assets as reflected in (i) the ratio of equity to con solidated assets, and ( i i ) the ratio of equity plus long-term subordinated notes aad debentures to consol idated assets; p -23- 2. Capital requirements that derive from the asset quality and risk associated with each holding company a c tiv ity ; 3. Relationship of consolidated debt to equity; 4. Extent o f reliance on.long-term debt in the capital structure as indicated by the ratio of long-term debt to the sum of long-term debt plus equity; 5» Extent of the use of debt at tiie parent level to fund equity investments in subsidiaries; 6* Trends of indices of capital adequacy and peer group ratio comparisons; 7. Management’ s a b ility to devise adequate capital plans and retention policies in lig h t of any capital deficiency and/or planned expansion of risk a ssets; and 8. Capacity to enter capital markets or tap other sources of long-term debt and equity. As suggested in Nos. 1 and 4 above, long-term debt has certain of the characteristics of equity capital and can be used to some degree to correct a capital deficiency or strengthen the existing capital base. Over-reliance on long-term debt, however, can weaken the capital struc ture and severely restrict management options for raising additional capital funds. Other things equal, the lover the level of earrings and the higher the current le v e l of long-term debt, the less accept able is the inclusion of long-term debt in the capital structure for purposes of the analysis of cap ital adequacy. 3ank holding companies with cap ital rated 1 or 2 are considered to have adequate ca p ital, although the r a tio s , strength of support, and ratio trends of the former w ill generally r e fle c t a more favorable situation than the la tte r . Capital rated 3, while marginally s u f f i cient to support the volume and risk associated with current operations, would quickly become inadequate in the event of further asset d e te ri oration. Eolding companies with 3 rated capital generally have capital ratios below peer group norms and typ ically above-average levels of debt. Moreover, such companies could find themselves rorced to pay premiums in order to successfully tap the capital markets. Companies with ratings of 4 and 5 are clearly inadequately cap italised . A 4 capital rating implies ratios well below peer group norms and s ig n if icant d iffic u lty in entering the capital markets. The subsidiaries o f such companies may also be undercapitalised because or the need to upstream substantial fees and dividends to the parent. A 5 rating represent3 a situation of such gravity as to threaten v ia b ility and requires urgent assistance from shareholders or other external sources of financial support.
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