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June 28, 1S89 To the Addressee: As indicated in our notice of June 7, which was sent to you with revised pamphlets on Regulations E (Official Staff Commentary), H, and Y, the Board of Governors of the Federal Reserve System has issued a new regulatory pamphlet entitled "Capital Adequacy Guidelines." The new pamphlet, which is enclosed, contains Appendix A to the Board’s Regulation H (Capital Adequacy Guidelines for State Member Banks: Risk-Based Measure), Appendix A to the Board’s Regulation Y (Capital Adequacy Guidelines for Bank Holding Companies: Risk-Based Measure), and Appendix B to Regulation Y (Capital Adequacy Guidelines for Bank Holding Companies and State Member Banks: Leverage Measure). You may now discard the previous printing of Regulation Y (dated February 3, 1984) and the Federal Register notice of January 27, 1989 (which was sent to you with our Circular No. 10286); you should not discard your current copies of Regulation H (as amended effective April 1, 1989) or Regulation Y (revised effective March 15, 1989), both of which were sent to you on June 7. Questions regarding the Capital Adequacy Guidelines may be directed to our Bank Analysis Department (Tel. No. 212-720-7962 or 6710). Circulars Division FEDERAL RESERVE BANK OF NEW YORK 2870C Board of Governors of the Federal Reserve System ■ l O Capital Adequacy Guidelines 12 CFR 208, appendix A; 12 CFR 225 appendixes A and B; effective March 15, 1989 2) £ > '~ j Any inquiry relating to these guidelines should be addressed to the Federal Reserve Bank of the Federal Reserve District in which the inquiry arises. March 1989 Contents Page Capital Adequacy Guidelines for State Member Banks: Risk-Based Measure (Regulation H, Appendix A ) .............. Capital Adequacy Guidelines for Bank Holding Companies: Risk-Based Measure (Regulation Y, Appendix A) . 1 Page Capital Adequacy Guidelines for Bank Holding Companies and State Member Banks: Leverage Measure (Regulation Y, Appendix B ) .................................... 55 27 i Capital Adequacy Guidelines for State Member Banks: Risk-Based Measure R eg u la tio n H (1 2 C F R 2 0 8 ), A p p en d ix A I. Overview The Board of Governors of the Federal Re serve System has adopted a risk-based capital measure to assist in the assessment of the cap ital adequacy of state member banks.1 The principal objectives of this measure are to (i) make regulatory capital requirements more sensitive to differences in risk profiles among banks; (ii) factor off-balance-sheet exposures into the assessment of capital adequacy; (iii) minimize disincentives to holding liquid, lowrisk assets; and (iv) achieve greater consisten cy in the evaluation of the capital adequacy of major banks throughout the world.2 The risk-based capital guidelines include both a definition of capital and a framework for calculating weighted-risk assets by assign ing assets and off-balance-sheet items to broad risk categories. A bank’s risk-based capital ra tio is calculated by dividing its qualifying capital (the numerator of the ratio) by its weighted-risk assets (the denominator).3 The definition of “qualifying capital” is outlined below in section II, and the procedures for calculating weighted-risk assets are discussed in section III. Attachment I illustrates a sam ple calculation of weighted-risk assets and the risk-based capital ratio. The risk-based capital guidelines also estab lish a schedule for achieving a minimum su pervisory standard for the ratio of qualifying 1 Supervisory ratios that relate capital to total assets for state member banks are outlined in appendix B to part 225 of the Federal Reserve’s Regulation Y, 12 CFR 225 (page 55). 2 The risk-based capital measure is based upon a frame work developed jointly by supervisory authorities from the countries represented on the Basle Committee on Banking Regulations and Supervisory Practices (Basle Supervisors’ Committee) and endorsed by the Group of Ten Central Bank Governors. The framework is described in a paper prepared by the BSC entitled “International Convergence of Capital Measurement,” July 1988. 3 Banks will initially be expected to utilize period-end amounts in calculating their risk-based capital ratios. When necessary and appropriate, ratios based on average balances may also be calculated on a case-by-case basis. Moreover, to the extent banks have data on average balances that can be used to calculate risk-based ratios, the Federal Reserve will take such data into account. capital to weighted-risk assets and provide for transitional arrangements during a phase-in period to facilitate adoption and implementa tion of the measure at the end of 1992. These interim standards and transitional arrange ments are set forth in section IV. The risk-based guidelines apply to all state member banks on a consolidated basis. They are to be used in the examination and supervi sory process as well as in the analysis of appli cations acted upon by the Federal Reserve. Thus, in considering an application filed by a state member bank, the Federal Reserve will take into account the bank’s risk-based capital ratio, the reasonableness of its capital plans, and the degree of progress it has demonstrat ed toward meeting the interim and final riskbased capital standards. The risk-based capital ratio focuses princi pally on broad categories of credit risk, al though the framework for assigning assets and off-balance-sheet items to risk categories does incorporate elements of transfer risk, as well as limited instances of interest-rate and mar ket risk. The risk-based ratio does not, howev er, incorporate other factors that can affect a bank’s financial condition. These factors in clude overall interest-rate exposure; liquidity, funding and market risks; the quality and lev el of earnings; investment or loan-portfolio concentrations; the quality of loans and in vestments; the effectiveness of loan and invest ment policies; and management’s ability to monitor and control financial and operating risks. In addition to evaluating capital ratios, an overall assessment of capital adequacy must take account of these other factors, including, in particular, the level and severity of problem and classified assets. For this reason, the final supervisory judgment on a bank’s capital ade quacy may differ significantly from conclu sions that might be drawn solely from the lev el of its risk-based capital ratio. The risk-based capital guidelines establish minimum ratios of capital to weighted-risk assets. In light of the considerations just dis- 1 Regulation H, Appendix A cussed, banks generally are expected to oper ate well above the minimum risk-based ratios. In particular, banks contemplating significant expansion proposals are expected to maintain strong capital levels substantially above the minimum ratios and should not allow signifi cant diminution of financial strength below these strong levels to fund their expansion plans. Institutions with high or inordinate lev els of risk are also expected to operate well above minimum capital standards. In all cas es, institutions should hold capital commensu rate with the level and nature of the risks to which they are exposed. Banks that do not meet the minimum risk-based standard, or that are otherwise considered to be inade quately capitalized, are expected to develop and implement plans acceptable to the Feder al Reserve for achieving adequate levels of capital within a reasonable period of time. The Board will monitor the implementation and effect of these guidelines in relation to do mestic and international developments in the banking industry. When necessary and appro priate, the Board will consider the need to modify the guidelines in light of any signifi cant changes in the economy, financial mar kets, banking practices, or other relevant factors. II. Definition of Qualifying Capital for the Risk-Based Capital Ratio A bank’s qualifying total capital consists of two types of capital components: “core capital elements” (comprising tier 1 capital) and “supplementary capital elements” (compris ing tier 2 capital). These capital elements and the various limits, restrictions, and deductions to which they are subject, are discussed below and are set forth in attachment II. To qualify as an element of tier 1 or tier 2 capital, a capital instrument may not contain or be covered by any covenants, terms, or re strictions that are inconsistent with safe and sound banking practices. Redemptions of permanent equity or other capital instruments before stated maturity could have a significant impact on a bank’s overall capital structure. Consequently, a bank considering such a step should consult 2 Capital Adequacy Guidelines with the Federal Reserve before redeeming any equity or debt capital instrument (prior to maturity) if such redemption could have a material effect on the level or composition of the institution’s capital base.4 A. The Components o f Qualifying Capital 1. Core capital elements (tier 1 capital). The tier 1 component of a bank’s qualifying capital must represent at least 50 percent of qualify ing total capital and may consist of the follow ing items that are defined as core capital elements: i. common stockholders’ equity ii. qualifying noncumulative perpetual pre ferred stock (including related surplus) iii. minority interest in the equity accounts of consolidated subsidiaries Tier 1 capital is generally defined as the sum of the core capital elements less goodwill.5* (See section 11(B) below for a more detailed discussion of the treatment of goodwill, including an explanation of certain limited grandfathering arrangements.) a. Common stockholders' equity. Common stockholders’ equity includes common stock; related surplus; and retained earn ings, including capital reserves and adjust ments for the cumulative effect of foreign currency translation, net of any treasury stock. b. Perpetual preferred stock. Perpetual pre ferred stock is defined as preferred stock that does not have a maturity date, that cannot be redeemed at the option of the holder of the instrument, and that has no other provisions that will require future re demption of the issue. In general, preferred stock will qualify for inclusion in capital only if it can absorb losses while the issuer operates as a going concern (a fundamental characteristic of equity capital) and only if 4 Consultation would not ordinarily be necessary if an instrument were redeemed with the proceeds of, or re placed by, a like amount of a similar or higher-quality capi tal instrument and the organization’s capital position is considered fully adequate by the Federal Reserve. 5 During the transition period and subject to certain limi tations set forth in section IV below, tier 1 capital may also include items defined as supplementary capital elements. Capital Adequacy Guidelines Regulation H, Appendix A i. allowance for loan and lease losses (sub the issuer has the ability and legal right to ject to limitations discussed below) defer or eliminate preferred dividends. ii. perpetual preferred stock and related sur The only form of perpetual preferred plus (subject to conditions discussed stock that state member banks may consid below) er as an element of tier 1 capital is noncumulative perpetual preferred. While the iii. hybrid capital instruments (as defined be low) and mandatory convertible debt guidelines allow for the inclusion of noncusecurities mulative perpetual preferred stock in tier 1, it is desirable from a supervisory standpoint iv. term subordinated debt and intermediateterm preferred stock, including related that voting common stockholders’ equity surplus (subject to limitations discussed remain the dominant form of tier 1 capital. below) Thus, state member banks should avoid ov erreliance on preferred stock or nonvoting equity elements within tier l.6 The maximum amount of tier 2 capital that Perpetual preferred stock in which the may be included in a bank’s qualifying total dividend is reset periodically based, in capital is limited to 100 percent of tier 1 capi whole or in part, upon the bank’s current tal (net of goodwill). credit standing (that is, auction rate perpet The elements of supplementary capital are ual preferred stock, including so-called discussed in greater detail below.8 Dutch auction, money market, and remarka. Allowance for loan and lease losses. Al etable preferred) will not qualify for inclu lowances for loan and lease losses are re sion in tier 1 capital.7 Such instruments, serves that have been established through a however, qualify for inclusion in tier 2 charge against earnings to absorb future capital. losses on loans or lease financing receiv c. Minority interest in equity accounts o f ables. Allowances for loan and lease losses consolidated subsidiaries. This element is in exclude “allocated transfer risk reserves,”9 cluded in tier 1 because, as a general rule, it and reserves created against identified represents equity that is freely available to losses. absorb losses in operating subsidiaries. During the transition period, the riskWhile not subject to an explicit sublimit based capital guidelines provide for reduc within tier 1, banks are expected to avoid ing the amount of this allowance that may using minority interest in the equity ac be included in an institution’s total capital. counts of consolidated subsidiaries as an av Initially, it is unlimited. However, by yearenue for introducing into their capital end 1990, the amount of the allowance for structures elements that might not other loan and lease losses that will qualify as wise qualify as tier 1 capital or that would, capital will be limited to 1.5 percent of an in effect, result in an excessive reliance on institution’s weighted risk assets. By the preferred stock within tier 1. 2. Supplementary capital elements (tier 2 capi tal). The tier 2 component of a bank’s qualify ing total capital may consist of the following items that are defined as supplementary capi tal elements: 6 The Federal Reserve’s capital guidelines for bank hold ing companies limit the amount of perpetual preferred stock that may be included in tier 1 to 25 percent o f tier 1. (See 12 CFR 225, appendix A, page 27.) 7 Adjustable-rate noncumulative perpetual preferred stock (that is, perpetual preferred stock in which the divi dend rate is not affected by the issuer’s credit standing or financial condition but is adjusted periodically according to a formula based solely on general market interest rates) may be included in tier 1. 8 The Basle capital framework also provides for the in clusion of “undisclosed reserves” in tier 2. As defined in the framework, undisclosed reserves represent accumulated af ter-tax retained earnings that are not disclosed on the bal ance sheet of a bank. Apart from the fact that these re serves are not disclosed publicly, they are essentially of the same quality and character as retained earnings, and, to be included in capital, such reserves must be accepted by the bank’s home supervisor. Although such undisclosed re serves are common in some countries, under generally ac cepted accounting principles (G A A P ) and long-standing supervisory practice, these types of reserves are not recog nized for state member banks. 9 Allocated transfer risk reserves are reserves that have been established in accordance with section 905(a) of the International Lending Supervision Act of 1983, 12 USC 3904(a), against certain assets whose value U.S. superviso ry authorities have found to be significantly impaired by protracted transfer risk problems. 3 Regulation H, Appendix A end of the transition period, the amount of the allowance qualifying for inclusion in tier 2 capital may not exceed 1.25 percent of weighted risk assets.10 b. Perpetual preferred stock. Perpetual pre ferred stock, as noted above, is defined as preferred stock that has no maturity date, that cannot be redeemed at the option of the holder, and that has no other provisions that will require future redemption of the issue. Such instruments are eligible for in clusion in tier 2 capital without limit.1 * 1 c. Hybrid capital instruments and manda tory convertible debt securities. Hybrid capi tal instruments include instruments that are essentially permanent in nature and that have certain characteristics of both equity and debt. Such instruments may be includ ed in tier 2 without limit. The general crite ria hybrid capital instruments must meet in order to qualify for inclusion in tier 2 capi tal are listed below: 1. The instrument must be unsecured; fully paid up; and subordinated to general creditors and must also be subordinated to claims of depositors. 2. The instrument must not be redeemable at the option of the holder prior to matu rity, except with the prior approval of the Federal Reserve. (Consistent with the Board’s criteria for perpetual debt and mandatory convertible securities, this requirement implies that holders of such instruments may not accelerate the payment of principal except in the event of bankruptcy, insolvency, or reorganization.) 10 The amount of the allowance for loan and lease losses that may be included in tier 2 capital is based on a percent age of gross weighted-risk assets. A bank may deduct re serves for loan and lease losses in excess of the amount permitted to be included in tier 2 capital, as well as allocat ed transfer risk reserves, from the sum o f gross weightedrisk assets and use the resulting net sum of weighted-risk assets in computing the denominator of the risk-based capi tal ratio. 11 Long-term preferred stock with an original maturity of 20 years or more (including related surplus) will also qualify in this category as an element of tier 2. If the holder of such an instrument has a right to require the issuer to redeem, repay, or repurchase the instrument prior to the original stated maturity, maturity would be defined, for risk-based capital purposes, as the earliest possible date on which the holder can put the instrument back to the issuing bank. 4 Capital Adequacy Guidelines 3. The instrument must be available to participate in losses while the issuer is operating as a going concern. (Term subordinated debt would not meet this requirement.) To satisfy this require ment, the instrument must convert to common or perpetual preferred stock in the event that the accumulated losses ex ceed the sum of the retained earnings and capital surplus accounts of the issuer. 4. The instrument must provide the option for the issuer to defer interest payments if (a) the issuer does not report a profit in the preceding annual period (defined as combined profits for the most recent four quarters) and (b) the issuer elimi nates cash dividends on common and preferred stock. Mandatory convertible debt securities in the form of equity contract notes that meet the criteria set forth in 12 CFR 225, appen dix B (page 55) also qualify as unlimited elements of tier 2 capital. In accordance with that appendix, equity commitment notes issued prior to May 15, 1985, also qualify for inclusion in tier 2. d. Subordinated debt and intermediateterm preferred stock. The aggregate amount of term subordinated debt (excluding man datory convertible debt) and intermediateterm preferred stock that may be treated as supplementary capital is limited to 50 per cent of tier 1 capital (net of goodwill). Amounts in excess of these limits may be issued and, while not included in the ratio calculation, will be taken into account in the overall assessment of a bank’s funding and financial condition. Subordinated debt and intermediate-term preferred stock must have an original weighted average maturity of at least five years to qualify as supplementary capital. (If the holder has the option to require the issuer to redeem, repay, or repurchase the instrument prior to the original stated ma turity, maturity would be defined, for riskbased capital purposes, as the earliest possi ble date on which the holder can put the instrument back to the issuing bank.) In the case of subordinated debt, the in strument must be unsecured and must Regulation H, Appendix A Capital Adequacy Guidelines clearly state on its face that it is not a depos it and is not insured by a federal agency. To qualify as capital in banks, debt must be subordinated to general creditors and claims of depositors. Consistent with cur rent regulatory requirements, if a state member bank wishes to redeem subordinat ed debt before the stated maturity, it must receive prior approval of the Federal Reserve. e. Discount o f supplementary capital instru ments. As a limited-life capital instrument approaches maturity it begins to take on characteristics of a short-term obligation. For this reason, the outstanding amount of term subordinated debt and any long- or in termediate-life, or term, preferred stock eli gible for inclusion in tier 2 is reduced, or discounted, as these instruments approach maturity: one-fifth of the original amount, less any redemptions, is excluded each year during the instrument’s last five years be fore maturity.12 f. Revaluation reserves. Such reserves re flect the formal balance sheet restatement or revaluation for capital purposes of asset carrying values to reflect current market values. In the United States, banks, for the most part, follow GAAP when preparing their financial statements, and GAAP gen erally does not permit the use of marketvalue accounting. For this and other rea sons, the federal banking agencies generally have not included unrealized asset values in capital ratio calculations, although they have long taken such values into account as a separate factor in assessing the overall fi nancial strength of a bank. Consistent with long-standing superviso ry practice, the excess of market values over book values for assets held by state member B. Deductions from Capital and Other Adjustments Certain assets are deducted from a bank’s cap ital for the purpose of calculating the riskbased capital ratio.13 These assets include— i. goodwill—deducted from the sum of core capital elements ii. investments in banking and finance sub sidiaries that are not consolidated for ac counting or supervisory purposes and, on a case-by-case basis, investments in other designated subsidiaries or associated com panies at the discretion of the Federal Re serve—deducted from total capital components iii. reciprocal holdings of capital instruments of banking organizations—deducted from total capital components 1. Goodwill and other intangible assets a. Goodwill. Goodwill is an intangible asset that represents the excess of the purchase price over the fair market value of identifia ble assets acquired less liabilities assumed in acquisitions accounted for under the pur chase method of accounting. State member banks generally have not been allowed to include goodwill in regulatory capital under current supervisory policies. Consistent with this policy, all goodwill in state mem ber banks will be deducted from tier 1 instru capital.14 12 For example, outstanding amounts o f these ments that count as supplementary capital include 100 per cent o f the outstanding amounts with remaining maturities of more than five years; 80 percent of outstanding amounts with remaining maturities of four to five years; 60 percent of outstanding amounts with remaining maturities o f three to four years; 40 percent o f outstanding amounts with re maining maturities of two to three years; 20 percent of out standing amounts with remaining maturities o f one to two years; and 0 percent of outstanding amounts with remain ing maturities of less than one year. Such instruments with a remaining maturity of less than one year are excluded from tier 2 capital. banks will generally not be recognized in supplementary capital or in the calculation of the risk-based capital ratio. However, all banks are encouraged to disclose their equivalent of premises (building) and equi ty revaluation reserves. Such values will be taken into account as additional considera tions in assessing overall capital strength and financial condition. 13 Any assets deducted from capital in computing the numerator of the ratio are not included in weighted-risk assets in computing the denominator of the ratio. 14 An exception is made for those state member banks that have acquired goodwill in connection with supervisory mergers with troubled or failed depository institutions and that were given explicit authority to include such goodwill in capital under the then-existing capital policy. Consistent with this approach, state member banks will be allowed to include such goodwill in tier 1 capital for risk-based capital purposes. 5 Regulation H, Appendix A b. Other intangible assets. The Federal Re serve is not proposing, as a matter of gener al policy, to deduct automatically any other intangible assets from the capital of state member banks. The Federal Reserve, how ever, will continue to monitor closely the level and quality of other intangible as sets—including purchased mortgage-servic ing rights, leaseholds, and core deposit value—and take them into account in as sessing the capital adequacy and overall as set quality of banks. Generally, banks should review all intan gible assets at least quarterly and, if neces sary, make appropriate reductions in their carrying values. In addition, in order to conform with prudent banking practice, an institution should reassess such values dur ing its annual audit. Banks should use ap propriate amortization methods and assign prudent amortization periods for intangible assets. Examiners will review the carrying value of these assets, together with support ing documentation, as well as the appropri ateness of including particular intangible assets in a bank’s capital calculation. In making such evaluations, examiners will consider a number of factors, including— 1. the reliability and predictability of any cash flows associated with the asset and the degree of certainty that can be achieved in periodically determining the asset’s useful life and value; 2. the existence of an active and liquid mar ket for the asset; and 3. the feasibility of selling the asset apart from the bank or from the bulk of its assets. While all intangible assets will be moni tored, intangible assets (other than good will) in excess of 25 percent of tier 1 capital (which is defined net of goodwill) will be subject to particularly close scrutiny, both through the examination process and by other appropriate means. Whenever necessary—in particular, when assessing applications to expand or to engage in other activities that could entail unusual or higher-than-normal risks—the Board will, on a case-by-case basis, continue to consid er the level of an individual bank’s tangible 6 Capital Adequacy Guidelines capital ratios (after deducting all intangible assets), together with the quality and value of the bank’s tangible and intangible assets, in making an overall assessment of capital adequacy. Consistent with long-standing Board pol icy, banks experiencing substantial growth, whether internally or by acquisition, are ex pected to maintain strong capital positions substantially above minimum supervisory levels, without significant reliance on intan gible assets. 2. Investments in certain subsidiaries. The ag gregate amount of investments in banking or finance subsidiaries15 whose financial state ments are not consolidated for accounting or bank regulatory reporting purposes will be de ducted from a bank’s total capital com ponents.16* Generally, investments for this purpose are defined as equity and debt capital investments and any other instruments that are deemed to be capital in the particular subsidiary. Advances (that is, loans, extensions of credit, guarantees, commitments, or any other forms of credit exposure) to the subsidiary that are not deemed to be capital will general ly not be deducted from a bank’s capital. Rather, such advances generally will be in cluded in the bank’s consolidated assets and be assigned to the 100 percent risk category, unless such obligations are backed by recog nized collateral or guarantees, in which case they will be assigned to the risk category ap propriate to such collateral or guarantees. These advances may, however, also be deduct ed from the bank’s capital if, in the judgment of the Federal Reserve, the risks stemming from such advances are comparable to the risks associated with capital investments or if the advances involve other risk factors that warrant such an adjustment to capital for su 15 For this purpose, a banking and finance subsidiary generally is defined as any company engaged in banking or finance in which the parent institution holds directly or indirectly more than 50 percent of the outstanding voting stock, or which is otherwise controlled or capable of being controlled by the parent institution. 16 An exception to this deduction would be made in the case o f shares acquired in the regular course of securing or collecting a debt previously contracted in good faith. The requirements for consolidation are spelled out in the in structions to the commercial bank Consolidated Reports of Condition and Income (call report). Capital Adequacy Guidelines pervisory purposes. These other factors could include, for example, the absence of collateral support. Inasmuch as the assets of unconsolidated banking and finance subsidiaries are not fully reflected in a bank’s consolidated total assets, such assets may be viewed as the equivalent of olF-balance-sheet exposures since the opera tions of an unconsolidated subsidiary could expose the bank to considerable risk. For this reason, it is generally appropriate to view the capital resources invested in these unconsoli dated entities as primarily supporting the risks inherent in these off-balance-sheet assets, and not generally available to support risks or ab sorb losses elsewhere in the bank. The Federal Reserve may, on a case-by-case basis, also deduct from a bank’s capital, in vestments in certain other subsidiaries in or der to determine if the consolidated bank meets minimum supervisory capital require ments without reliance on the resources in vested in such subsidiaries. The Federal Reserve will not automatically deduct investments in other unconsolidated subsidiaries or investments in joint ventures and associated companies.17 Nonetheless, the resources invested in these entities, like invest ments in unconsolidated banking and finance subsidiaries, support assets not consolidated with the rest of the bank’s activities and, therefore, may not be generally available to support additional leverage or absorb losses elsewhere in the bank. Moreover, experience has shown that banks stand behind the losses of affiliated institutions, such as joint ventures and associated companies, in order to protect the reputation of the organization as a whole. In some cases, this has led to losses that have exceeded the investments in such organizations. For this reason, the Federal Reserve will monitor the level and nature of such invest ments for individual banks and on a case-by case basis may, for risk-based capital purpos es, deduct such investments from total capital components, apply an appropriate risk17 The definition o f such entities is contained in the structions to the commercial bank call report. Under regu latory reporting procedures, associated companies and joint ventures generally are defined as companies in which the bank owns 20 to 50 percent o f the voting stock. Regulation H, Appendix A weighted capital charge against the bank’s proportionate share of the assets of its associ ated companies, require a line-by-line consoli dation of the entity (in the event that the bank’s control over the entity makes it the functional equivalent of a subsidiary), or oth erwise require the bank to operate with a riskbased capital ratio above the minimum. In considering the appropriateness of such adjustments or actions, the Federal Reserve will generally take into account whether— 1. the bank has significant influence over the financial or managerial policies or opera tions of the subsidiary, joint venture, or as sociated company; 2. the bank is the largest investor in the affili ated company; or 3. other circumstances prevail that appear to closely tie the activities of the affiliated company to the bank. 3. Reciprocal holdings o f banking organiza tions' capital instruments. Reciprocal holdings of banking organizations’ capital instruments (that is, instruments that qualify as tier 1 or tier 2 capital)18 will be deducted from a bank’s total capital components for the pur pose of determining the numerator of the riskbased capital ratio. Reciprocal holdings are cross-holdings re sulting from formal or informal arrangements in which two or more banking organizations swap, exchange, or otherwise agree to hold each other’s capital instruments. Generally, deductions will be limited to intentional cross holdings. At present, the Board does not in tend to require banks to deduct nonreciprocal holdings of such capital instruments.19* 20 18 See 12 CFR 225, appendix A (page 27) for instru ments that qualify as tier 1 and tier 2 capital for bank holding companies. 19 Deductions of holdings of capital securities also would not be made in the case of interstate “stake out” invest ments that comply with the Board’s policy statement on nonvoting equity investments, 12 CFR 225.143 ( F e d e ra l R e se rv e R e g u la to r y S ervic e 4-172.1; 1982 F e d e r a l R e se rv e B u lle tin 413.). In addition, holdings of capital instruments issued by other banking organizations but taken in satisfac tion of debts previously contracted would be exempt from any deduction from capital. in 20 The Board intends to monitor nonreciprocal holdings o f other banking organizations’ capital instruments and to provide information on such holdings to the Basle Supervi sors’ Committee as callled for under the Basle capital framework. 7 Regulation H, Appendix A III. Procedures for Computing Weighted-Risk Assets and Off-Balance-Sheet Items A. Procedures Assets and credit-equivalent amounts of offbalance-sheet items of state member banks are assigned to one of several broad risk catego ries, according to the obligor, or, if relevant, the guarantor or the nature of the collateral. The aggregate dollar value of the amount in each category is then multiplied by the risk weight associated with that category. The re sulting weighted values from each of the risk categories are added together, and this sum is the bank’s total weighted-risk assets that com prise the denominator of the risk-based capital ratio. Attachment I provides a sample calculation. Risk weights for all off-balance-sheet items are determined by a two-step process. First, the “credit-equivalent amount” of off-balancesheet items is determined, in most cases by multiplying the off-balance-sheet item by a credit conversion factor. Second, the creditequivalent amount is treated like any balancesheet asset and generally is assigned to the appropriate risk category according to the ob ligor, or, if relevant, the guarantor or the na ture of the collateral. In general, if a particular item qualifies for placement in more than one risk category, it is assigned to the category that has the lowest risk weight. A holding of a U.S. municipal revenue bond that is fully guaranteed by a U.S. bank, for example, would be assigned the 20 percent risk weight appropriate to claims guaranteed by U.S. banks, rather than the 50 percent risk weight appropriate to U.S. mu nicipal revenue bonds.21 Capital Adequacy Guidelines The terms “claims” and “securities” used in the context of the discussion of risk weights, unless otherwise specified, refer to loans or debt obligations of the entity on whom the claim is held. Assets in the form of stock or equity holdings in commercial or fi nancial firms are assigned to the 100 percent risk category, unless some other treatment is explicitly permitted. B. Collateral, Guarantees, and Other Considerations 1. Collateral. The only forms of collateral that are formally recognized by the risk-based capital framework are cash on deposit in the bank; securities issued or guaranteed by the central governments of the OECD-based group of countries,22 U.S. government agen cies, or U.S. government-sponsored agencies; and securities issued by multilateral lending institutions or regional development banks. Claims fully secured by such collateral are as signed to the 20 percent risk-weight category. The extent to which qualifying securities are recognized as collateral is determined by at any particular time. Shares in a fund that may invest only in U.S. Treasury securities would generally be as signed to the 20 percent risk category. If, in order to main tain a necessary degree of short-term liquidity, a fund is permitted to hold an insignificant amount of its assets in short-term, highly liquid securities of superior credit quali ty that do not qualify for a preferential risk weight, such securities will generally not be taken into account in deter mining the risk category into which the bank’s holding in the overall fund should be assigned. Regardless of the com position of the fund’s securities, if the fund engages in any activities that appear speculative in nature (for example, use of futures, forwards, or option contracts for purposes other than to reduce interest-rate risk) or has any other characteristics that are inconsistent with the preferential risk weighting assigned to the fund’s investments, holdings in the fund will be assigned to the 100 percent risk catego ry. During the examination process, the treatment of shares in such funds that are assigned to a lower risk weight will be subject to examiner review to ensure that they have been assigned an appropriate risk weight. 22 The OECD-based group of countries comprises all full 21 An investment in shares of a fund whose portfolio members of the Organization for Economic Cooperation and Development (OECD), as well as countries that have consists solely o f various securities or money market instru concluded special lending arrangements with the Interna ments that, if held separately, would be assigned to differ tional Monetary Fund (IM F) associated with the Fund’s ent risk categories, is generally assigned to the risk category General Arrangements to Borrow. The OECD includes the appropriate to the highest risk-weighted security or instru following countries: Australia, Austria, Belgium, Canada, ment that the fund is permitted to hold in accordance with Denmark, the Federal Republic of Germany, Finland, its stated investment objectives. However, in no case will France, Greece, Iceland, Ireland, Italy, Japan, Luxem indirect holdings through shares in such funds be assigned bourg, Netherlands, New Zealand, Norway, Portugal, to the zero percent risk category. For example, if a fund is Spain, Sweden, Switzerland, Turkey, the United Kingdom, permitted to hold U.S. Treasuries and commercial paper, and the United States. Saudi Arabia has concluded special shares in that fund would generally be assigned the 100 lending arrangements with the IMF associated with the percent risk weight appropriate to commercial paper, re Fund’s General Arrangements to Borrow. gardless of the actual composition of the fund’s investments 8 Capital Adequacy Guidelines their current market value. If a claim is only partially secured, that is, the market value of the pledged securities is less than the face amount of a balance-sheet asset or an offbalance-sheet item, the portion that is covered by the market value of the qualifying collater al is assigned to the 20 percent risk category, and the portion of the claim that is not cov ered by collateral in the form of cash or a qualifying security is assigned to the risk cate gory appropriate to the obligor or, if relevant, the guarantor. For example, to the extent that a claim on a private-sector obligor is collater alized by the current market value of U.S. government securities, it would be placed in the 20 percent risk category, and the balance would be assigned to the 100 percent risk category. 2. Guarantees. Guarantees of the OECD and non-OECD central governments, U.S. govern ment agencies, U.S. government-sponsored agencies, state and local governments of the OECD-based group of countries, multilateral lending institutions and regional development banks, U.S. depository institutions, and for eign banks are also recognized. If a claim is partially guaranteed, that is, coverage of the guarantee is less than the face amount of a balance-sheet asset or an off-balance-sheet item, the portion that is not fully covered by the guarantee is assigned to the risk category appropriate to the obligor or, if relevant, to any collateral. The face amount of a claim covered by two types of guarantees that have different risk weights, such as a U.S. govern ment guarantee and a state guarantee, is to be apportioned between the two risk categories appropriate to the guarantors. The existence of other forms of collateral or guarantees that the risk-based capital frame work does not formally recognize may be tak en into consideration in evaluating the risks inherent in a bank’s loan portfolio—which, in turn, would affect the overall supervisory as sessment of the bank’s capital adequacy. 3. Mortgage-backed securities. Mortgagebacked securities, including pass-throughs and collateralized mortgage obligations (but not stripped mortgage-backed securities), that are issued or guaranteed by a U.S. government agency or U.S. government-sponsored agency Regulation H, Appendix A are assigned to the risk-weight category ap propriate to the issuer or guarantor. Generally, a privately issued mortgage-backed security meeting certain criteria set forth in the accompanying footnote23*is treated as es sentially an indirect holding of the underlying assets, and assigned to the same risk category as the underlying assets, but in no case to the zero percent risk category. Privately issued mortgage-backed securities whose structures do not qualify them to be regarded as indirect holdings of the underlying assets are assigned to the 100 percent risk category. During the examination process, privately issued mort gage-backed securities that are assigned to a lower risk-weight category will be subject to examiner review to ensure that they meet the appropriate criteria. While the risk category to which mortgagebacked securities are assigned will generally be based upon the issuer or guarantor or, in the case of privately issued mortgage-backed securities, the assets underlying the security, any class of a mortgage-backed security that can absorb more than its pro rata share of loss without the whole issue being in default (for example, a so-called subordinated class or re sidual interest), is assigned to the 100 percent risk category. Furthermore, all stripped mort gage-backed securities, including interest-only strips (IOs), principal-only strips (POs), and similar instruments are also assigned to the 23 A privately issued mortgage-backed security may be treated as an indirect holding of the underlying assets pro vided that (1) the underlying assets are held by an inde pendent trustee and the trustee has a first priority, perfect ed security interest in the underlying assets on behalf of the holders of the security; (2 ) either the holder of the security has an undivided pro rata ownership interest in the under lying mortgage assets or the trust or single-purpose entity (or conduit) that issues the security has no liabilities unre lated to the issued securities; (3) the security is structured such that the cash flow from the underlying assets in all cases fully meets the cash flow requirements of the security without undue reliance on any reinvestment income; and (4) there is no material reinvestment risk associated with any funds awaiting distribution to the holders of the securi ty. In addition, if the underlying assets of a mortgagebacked security are composed of more than one type of asset, for example, U.S. government-sponsored agency se curities and privately issued pass-through securities that qualify for the 50 percent risk category, the entire mort gage-backed security is generally assigned to the category appropriate to the highest risk-weighted asset underlying the issue. Thus, in this example, the security would receive the 50 percent risk weight appropriate to the privately is sued pass-through securities. 9 Regulation H, Appendix A Capital Adequacy Guidelines 100 percent risk-weight category, regardless tries and U.S. government agencies,27 as well of the issuer or guarantor. as all direct local currency claims on, and the portions of local currency claims that are di 4. Maturity. Maturity is generally not a factor rectly and unconditionally guaranteed by, the in assigning items to risk categories with the central governments of non-OECD countries, exception of claims on non-OECD banks, to the extent that the bank has liabilities commitments, and interest-rate and foreignbooked in that currency. A claim is not con exchange-rate contracts. Except for commit sidered to be unconditionally guaranteed by a ments, short-term is defined as one year or central government if the validity of the guar less remaining maturity and long-term is de antee is dependent upon some affirmative ac fined as over one year remaining maturity. In tion by the holder or a third party. Generally, the case of commitments, short-term is de securities guaranteed by the U.S. government fined as one year or less original maturity and or its agencies that are actively traded in fi long-term is defined as over one year original nancial markets, such as GNMA securities, maturity.24 are considered to be unconditionally guaranteed. C. Risk Weights Attachment III contains a listing of the risk categories, a summary of the types of assets assigned to each category and the weight asso ciated with each category, that is, 0 percent, 20 percent, 50 percent, and 100 percent. A brief explanation of the components of each category follows. 2. Category 2: 20 percent. This category in cludes cash items in the process of collection, both foreign and domestic; short-term claims (including demand deposits) on, and the por tions of short-term claims that are guaranteed28 by, U.S. depository insti tutions29 and foreign banks;30*and long-term 1. Category 1: zero percent This category in cludes cash (domestic and foreign) owned and held in all offices of the bank or in transit and gold bullion held in the bank’s own vaults or in another bank’s vaults on an allocated basis, to the extent it is offset by gold bullion liabilities.25 The category also includes all di rect claims (including securities, loans, and leases) on, and the portions of claims that are directly and unconditionally guaranteed by, the central governments26 of the OECD coun- as central governments of countries that do not belong to the OECD-based group of countries. 27 A U.S. government agency is defined as an instrumen tality o f the U.S. government whose obligations are fully and explicitly guaranteed as to the timely payment of prin cipal and interest by the full faith and credit of the U.S. government. Such agencies include the Government Na tional Mortgage Association (G N M A ), the Veterans Ad ministration (V A ), the Federal Housing Administration (F H A ), the Export-Import Bank (Exim Bank), the Over seas Private Investment Corporation (OPIC), the Com modity Credit Corporation (CCC), and the Small Business Administration (SBA). 28 Claims guaranteed by U.S. depository institutions and foreign banks include risk participations in both banker’s acceptances and standby letters of credit, as well as partici pations in commitments, that are conveyed to other U.S. depository institutions or foreign banks. 29 U.S. depository institutions are defined to include branches (foreign and domestic) of federally insured banks and depository institutions chartered and headquartered in the 50 states of the United States, the District of Columbia, Puerto Rico, and U.S. territories and possessions. The defi nition encompasses banks, mutual or stock savings banks, savings or building and loan associations, cooperative banks, credit unions, and international banking facilities of domestic banks. U.S.-chartered depository institutions owned by foreigners are also included in the definition. However, branches and agencies of foreign banks located in the U.S., as well as all bank holding companies, are excluded. 30 Foreign banks are distinguished as either OECD banks or non-OECD banks. OECD banks include banks and their branches (foreign and domestic) organized under the laws of countries (other than the U.S.) that belong to the OECD-based group of countries. Non-OECD banks inContinued 24 Through year-end 1992, remaining, rather than origi nal, maturity may be used for determining the maturity of commitments. 25 All other holdings of bullion are assigned to the 100 percent risk category. 26 A central government is defined to include depart ments and ministries, including the central bank, of the central government. The U.S. central bank includes the 12 Federal Reserve Banks, and the stock held in these banks as a condition o f membership is assigned to the zero per cent risk category. The definition of central government does not include state, provincial, or local governments; or commercial enterprises owned by the central government. In addition, it does not include local government entities or commercial enterprises whose obligations are guaranteed by the central government, although any claims on such entities guaranteed by central governments are placed in the same general risk category as other claims guaranteed by central governments. OECD central governments are defined as central governments of the OECD-based group of countries; non-OECD central governments are defined 10 Capital Adequacy Guidelines claims on, and the portions of long-term claims that are guaranteed by, U.S. depository institutions and OECD banks.31 This category also includes the portions of claims that are conditionally guaranteed by OECD central governments and U.S. govern ment agencies, as well as the portions of local currency claims that are conditionally guaran teed by non-OECD central governments, to the extent that the bank has liabilities booked in that currency. In addition, this category also includes claims on, and the portions of claims that are guaranteed by, U.S. government-sponsored32 agencies and claims on, and the portions of claims guaranteed by, the International Bank for Reconstruction and Development (World Bank), the Interamerican Development Bank, the Asian De velopment Bank, the African Development Bank, the European Investment Bank, and other multilateral lending institutions or re gional development banks in which the U.S. government is a shareholder or contributing member. General obligation claims on, or por tions of claims guaranteed by the full faith and credit of, states or other political subdiviContinued elude banks and their branches (foreign and domestic) or ganized under the laws of countries that do not belong to the OECD-based group of countries. For this purpose, a bank is defined as an institution that engages in the business o f banking; is recognized as a bank by the bank supervisory or monetary authorities of the country of its organization or principal banking operations; receives deposits to a sub stantial extent in the regular course of business; and has the power to accept demand deposits. Claims on, and the por tions o f claims that are guaranteed by, a non-OECD central bank are treated as claims on, or guaranteed by, a nonOECD bank, except for local-currency claims on, and the portions of local-currency claims that are guaranteed by, a non-OECD central bank that are funded in local-currency liabilities. The latter claims are assigned to the zero percent risk category. 31 Long-term claims on, or guaranteed by, non-OECD banks and all claims on bank holding companies are as signed to the 100 percent risk category, as are holdings of bank-issued securities that qualify as capital of the issuing banks. 32 For this purpose, U.S. government-sponsored agen cies are defined as agencies originally established or char tered by the federal government to serve public purposes specified by the U.S. Congress but whose obligations are n o t e x p lic itly guaranteed by the full faith and credit o f the U.S. government. These agencies include the Federal Home Loan Mortgage Corporation (FHLM C), the Federal Na tional Mortgage Association (F N M A ), the Farm Credit System, the Federal Home Loan Bank System, and the Stu dent Loan Marketing Association (SLM A). Claims on U.S. government-sponsored agencies include capital stock in a Federal Home Loan Bank that is held as a condition of membership in that Bank. Regulation H, Appendix A sions of the United States or other countries of the OECD-based group are also assigned to this category.33 This category also includes the portions of claims (including repurchase agreements) collateralized by cash on deposit in the bank; by securities issued or guaranteed by OECD central governments, U.S. government agen cies, or U.S. government-sponsored agencies; or by securities issued by multilateral lending institutions or regional development banks in which the U.S. government is a shareholder or contributing member. 3. Category 3: 50 percent. This category in cludes loans fully secured by first liens34 on one- to four-family residential properties,35 ei ther owner-occupied or rented, provided that such loans have been made in accordance with prudent underwriting standards, includ ing a conservative loan-to-value ratio;36 are performing in accordance with their original terms; and are not 90 days or more past due or carried in nonaccrual status.37 Also includ ed in this category are privately issued mort gage-backed securities provided that (1) the structure of the security meets the criteria de scribed in section 111(B)(3) above; (2) if the security is backed by a pool of conventional mortgages, each underlying mortgage meets the criteria described above in this section for eligibility for the 50 percent risk-weight cate gory at the time the pool is originated; and (3) if the security is backed by privately is sued mortgage-backed securities, each under lying security qualifies for the 50 percent risk 33 Claims on, or guaranteed by, states or other political subdivisions of countries that do not belong to the OECDbased group of countries are placed in the 100 percent risk category. 34 If a bank holds the first and junior lien(s) on a resi dential property and no other party holds an intervening lien, the transaction is treated as a single loan secured by a first lien for the purpose of determining the loan-to-value ratio. 35 The types of properties that qualify as one- to fourfamily residences are listed in the instructions to the com mercial bank call report. 36 The loan-to-value ratio is based upon the most current appraised value of the property. All appraisals must be made in a manner consistent with the federal banking agen cies’ real estate appraisal guidelines and with the bank’s own appraisal guidelines. 37 Residential property loans that do not meet all the specified criteria or that are made for the purpose of specu lative property development are placed in the 100 percent risk category. 11 Regulation H, Appendix A category. Privately issued mortgage-backed securities that do not meet these criteria or that do not qualify for a lower risk weight are generally assigned to the 100 percent riskweight category. Also assigned to this category are revenue (nongeneral obligation) bonds or similar obli gations, including loans and leases, that are obligations of states or other political subdivi sions of the U.S. (for example, municipal rev enue bonds) or other countries of the OECDbased group, but for which the government entity is committed to repay the debt with rev enues from the specific projects financed, rath er than from general tax funds. Credit-equivalent amounts of interest-rate and foreign-exchange-rate contracts involving standard risk obligors (that is, obligors whose loans or debt securities would be assigned to the 100 percent risk category) are included in the 50 percent category, unless they are backed by collateral or guarantees that allow them to be placed in a lower risk category. 4. Category 4: 100 percent. All assets not in cluded in the categories above are assigned to this category, which comprises standard risk assets. The bulk of the assets typically found in a loan portfolio would be assigned to the 100 percent category. This category includes long-term claims on, or guaranteed by, non-OECD banks, and all claims on non-OECD central governments that entail some degree of transfer risk.38 This category also includes all claims on foreign and domestic private-sector obligors not in cluded in the categories above (including loans to nondepository financial institutions and bank holding companies); claims on com mercial firms owned by the public sector; cus tomer liabilities to the bank on acceptances outstanding involving standard risk claims;39 38 Such assets include all nonlocal currency claims on, or guaranteed by, non-OECD central governments and those portions o f local currency claims on, or guaranteed by, non-OECD central governments that exceed the local cur rency liabilities held by the bank. 39 Customer liabilities on acceptances outstanding in volving nonstandard risk claims, such as claims on U.S. depository institutions, are assigned to the risk category appropriate to the identity of the obligor or, if relevant, the nature of the collateral or guarantees backing the claims. Portions o f acceptances conveyed as risk participations to U.S. depository institutions or foreign banks are assigned to the 20 percent risk category appropriate to short-term 12 Capital Adequacy Guidelines investments in fixed assets, premises, and oth er real estate owned; common and preferred stock of corporations, including stock ac quired for debts previously contracted; commercial and consumer loans (except those assigned to lower risk categories due to recog nized guarantees or collateral and loans for residential property that qualify for a lower risk weight); mortgage-backed securities that do not meet criteria for assignment to a lower risk weight (including any classes of mort gage-backed securities that can absorb more than their pro rata share of loss without the whole issue being in default); and all stripped mortgage-backed and similar securities. Also included in this category are industrial development bonds and similar obligations is sued under the auspices of states or political subdivisions of the OECD-based group of countries for the benefit of a private party or enterprise where that party or enterprise, not the government entity, is obligated to pay the principal and interest, and all obligations of states or political subdivisions of countries that do not belong to the OECD-based group. The following assets also are assigned a risk weight of 100 percent if they have not been deducted from capital: investments in uncon solidated companies, joint ventures, or associ ated companies; instruments that qualify as capital issued by other banking organizations; and any intangibles, including grandfathered goodwill. D. Off-Balance-Sheet Items The face amount of an off-balance-sheet item is incorporated into the risk-based capital ra tio by multiplying it by a credit conversion factor. The resultant credit-equivalent amount is assigned to the appropriate risk category ac cording to the obligor, or, if relevant, the guarantor or the nature of the collateral.40* At- claims guaranteed by U.S. depository institutions and for eign banks. 40 The sufficiency of collateral and guarantees for off-balance-sheet items is determined by the market value of the collateral or the amount of the guarantee in relation to the face amount of the item, except for interest- and foreign-exchange-rate contracts, for which this determination is made in relation to the credit equivalent amount. Collateral and guarantees are subject to the same provisions noted under section III(B ). Capital Adequacy Guidelines tachment IV sets forth the conversion factors for various types of off-balance-sheet items. 1. Items with a 100 percent conversion fac tor. A 100 percent conversion factor applies to direct credit substitutes, which include guarantees, or equivalent instruments, back ing financial claims, such as outstanding secu rities, loans, and other financial liabilities, or that back off-balance-sheet items that require capital under the risk-based capital frame work. Direct credit substitutes include, for ex ample, financial standby letters of credit, or other equivalent irrevocable undertakings or surety arrangements, that guarantee repay ment of financial obligations such as commer cial paper, tax-exempt securities, commercial or individual loans or debt obligations, or standby or commercial letters of credit. Direct credit substitutes also include the acquisition of risk participations in banker’s acceptances and standby letters of credit, since both of these transactions, in effect, constitute a guar antee by the acquiring bank that the underly ing account party (obligor) will repay its obli gation to the originating, or issuing, institution.41 (Standby letters of credit that are performance-related are discussed below and have a credit conversion factor of 50 percent.) The full amount of a direct credit substitute is converted at 100 percent and the resulting credit-equivalent amount is assigned to the risk category appropriate to the obligor or, if relevant, the guarantor or the nature of the collateral. In the case of a direct credit substi tute in which a risk participation42 has been conveyed, the full amount is still converted at 100 percent. However, the credit-equivalent amount that has been conveyed is assigned to whichever risk category is lower: the risk cate gory appropriate to the obligor, after giving effect to any relevant guarantees or collateral, or the risk category appropriate to the institu tion acquiring the participation. Any remain41 Credit-equivalent amounts of acquisitions o f risk par ticipations are assigned to the risk category appropriate to the account-party obligor, or, if relevant, the nature of the collateral or guarantees. 42 That is, a participation in which the originating bank remains liable to the beneficiary for the full amount of the direct credit substitute if the party that has acquired the participation fails to pay when the instrument is drawn. Regulation H, Appendix A der is assigned to the risk category appropri ate to the obligor, guarantor, or collateral. For example, the portion of a direct credit substi tute conveyed as a risk participation to a U.S. domestic depository institution or foreign bank is assigned to the risk category appropri ate to claims guaranteed by those institutions, that is, the 20 percent risk category.43 This approach recognizes that such conveyances replace the originating bank’s exposure to the obligor with an exposure to the institutions acquiring the risk participations.44* In the case of direct credit substitutes that take the form of a syndication as defined in the instructions to the commercial bank call report, that is, where each bank is obligated only for its pro rata share of the risk and there is no recourse to the originating bank, each bank will only include its pro rata share of the direct credit substitute in its risk-based capital calculation. Financial standby letters of credit are dis tinguished from loan commitments (discussed below) in that standbys are irrevocable obli gations of the bank to pay a third-party bene ficiary when a customer (account party) fails to repay an outstanding loan or debt instru ment (direct credit substitute). Performance standby letters of credit (performance bonds) are irrevocable obligations of the bank to pay a third-party beneficiary when a customer (account party) fails to perform some other contractual nonfinancial obligation. The distinguishing characteristic of a stand by letter of credit for risk-based capital pur poses is the combination of irrevocability with the fact that funding is triggered by some fail ure to repay or perform an obligation. Thus, any commitment (by whatever name) that in volves an irrevocable obligation to make a payment to the customer or to a third party in the event the customer fails to repay an out standing debt obligation or fails to perform a contractual obligation is treated, for risk43 Risk participations with a remaining maturity of over one year that are conveyed to non-OECD banks are to be assigned to the 100 percent risk category, unless a lower risk category is appropriate to the obligor, guarantor, or collateral. 44 A risk participation in banker’s acceptances conveyed to other institutions is also assigned to the risk category appropriate to the institution acquiring the participation or, if relevant, the guarantor or nature of the collateral. 13 Regulation H, Appendix A based capital purposes, as respectively, a fi nancial guarantee standby letter of credit or a performance standby. A loan commitment, on the other hand, in volves an obligation (with or without a mate rial adverse change or similar clause) of the bank to fund its customer in the normal course of business should the customer seek to draw down the commitment. Sale and repurchase agreements and asset sales with recourse (to the extent not included on the balance sheet) and forward agreements also are converted at 100 percent. The riskbased capital definition of the sale of assets with recourse, including the sale of one- to four-family residential mortgages, is the same as the definition contained in the instructions to the commercial bank call report. So-called loan strips (that is, short-term advances sold under long-term commitments without direct recourse) are defined in the instructions to the commercial bank call report and for riskbased capital purposes as assets sold with recourse. Forward agreements are legally binding contractual obligations to purchase assets with certain drawdown at a specified future date. Such obligations include forward pur chases, forward forward deposits placed,45 and partly paid shares and securities; they do not include commitments to make residential mortgage loans or forward foreign-exchange contracts. Securities lent by a bank are treated in one of two ways, depending upon whether the lender is at risk of loss. If a bank, as agent for a customer, lends the customer’s securities and does not indemnify the customer against loss, then the transaction is excluded from the risk-based capital calculation. If, alternatively, a bank lends its own securities or, acting as agent for a customer, lends the customer’s se curities and indemnifies the customer against loss, the transaction is converted at 100 per cent and assigned to the risk-weight category appropriate to the obligor, to any collateral delivered to the lending bank, or, if applicable, to the independent custodian acting on the lender’s behalf. Capital Adequacy Guidelines 2. Items with a 50 percent conversion factor. Transaction-related contingencies are converted at 50 percent. Such contingencies include bid bonds, performance bonds, war ranties, standby letters of credit related to par ticular transactions, and performance standby letters of credit, as well as acquisitions of risk participations in performance standby letters of credit. Performance standby letters of cred it represent obligations backing the perform ance of nonfinancial or commercial contracts or undertakings. To the extent permitted by law or regulation, performance standby letters of credit include arrangements backing, among other things, subcontractors’ and sup pliers’ performance, labor and materials con tracts, and construction bids. The unused portion of commitments with an original maturity exceeding one year,46 in cluding underwriting commitments, and com mercial and consumer credit commitments also are converted at 50 percent. Original ma turity is defined as the length of time between the date the commitment is issued and the earliest date on which (1) the bank can, at its option, unconditionally (without cause) can cel the commitment47 and (2) the bank is scheduled to (and as a normal practice actual ly does) review the facility to determine whether or not it should be extended. Such reviews must continue to be conducted at least annually for such a facility to qualify as a short-term commitment. Commitments are defined as any legally binding arrangements that obligate a bank to extend credit in the form of loans or leases; to purchase loans, securities, or other assets; or to participate in loans and leases. They also include overdraft facilities, revolving credit, home equity and mortgage lines of credit, and similar transactions. Normally, commitments involve a written contract or agreement and a commitment fee, or some other form of con 46 Through year-end 1992, remaining maturity may be used for determining the maturity of off-balance-sheet loan commitments; thereafter, original maturity must be used. 47 In the case of consumer home equity or mortgage lines o f credit secured by hens on one- to four-family residential properties, the bank is deemed able to unconditionally can cel the commitment for the purpose of this criterion if, at its option, it can prohibit additional extensions of credit, 45 Forward forward deposits accepted are treated as inreduce the credit line, and terminate the commitment to the full extent permitted by relevant federal law. terest-rate contracts. 14 Capital Adequacy Guidelines sideration. Commitments are included in weighted-risk assets regardless of whether they contain “material adverse change” claus es or other provisions that are intended to re lieve the issuer of its funding obligation under certain conditions. In the case of commit ments structured as syndications, where the bank is obligated solely for its pro rata share, only the bank’s proportional share of the syn dicated commitment is taken into account in calculating the risk-based capital ratio. Facilities that are unconditionally cancella ble (without cause) at any time by the bank are not deemed to be commitments, provided the bank makes a separate credit decision be fore each drawing under the facility. Commit ments with an original maturity of one year or less are deemed to involve low risk and, there fore, are not assessed a capital charge. Such short-term commitments are defined to in clude the unused portion of lines of credit on retail credit cards and related plans (as de fined in the instructions to the commercial bank call report) if the bank has the uncondi tional right to cancel the line of credit at any time, in accordance with applicable law. Once a commitment has been converted at 50 percent, any portion that has been con veyed to U.S. depository institutions or OECD banks as participations in which the originating bank retains the full obligation to the borrower if the participating bank fails to pay when the instrument is drawn, is assigned to the 20 percent risk category. This treatment is analogous to that accorded to conveyances of risk participations in standby letters of credit. The acquisition of a participation in a commitment by a bank is converted at 50 per cent and assigned to the risk category appro priate to the account-party obligor or, if rele vant, the nature of the collateral or guarantees. Revolving underwriting facilities (RUFs), note issuance facilities (N IFs), and other sim ilar arrangements also are converted at 50 percent regardless of maturity. These are fa cilities under which a borrower can issue on a revolving basis short-term paper in its own name, but for which the underwriting banks have a legally binding commitment either to purchase any notes the borrower is unable to Regulation H, Appendix A sell by the roll-over date or to advance funds to the borrower. 3. Items with a 20 percent conversion factor. Short-term, self-liquidating trade-re lated contingencies which arise from the movement of goods are converted at 20 per cent. Such contingencies generally include commercial letters of credit and other docu mentary letters of credit collateralized by the underlying shipments. 4. Items with a zero percent conversion fac tor. These include unused portions of com mitments with an original maturity of one year or less,48*or which are unconditionally cancellable at any time, provided a separate credit decision is made before each drawing under the facility. Unused portions of lines of credit on retail credit cards and related plans are deemed to be short-term commitments if the bank has the unconditional right to cancel the line of credit at any time, in accordance with applicable law. E. Interest-Rate and Foreign-Exchange-Rate Contracts 1. Scope. Credit equivalent amounts are com puted for each of the following off-balancesheet interest-rate and foreign-exchange-rate instruments: I. Interest-Rate Contracts A. Single-currency interest-rate swaps B. Basis swaps C. Forward-rate agreements D. Interest-rate options purchased (in cluding caps, collars, and floors purchased) E. Any other instrument that gives rise to similar credit risks (including when-issued securities and forward forward deposits accepted) II. Exchange-Rate Contracts A. Cross-currency interest-rate swaps B. Forward foreign-exchange contracts C. Currency options purchased D. Any other instrument that gives rise to similar credit risks 48 Through year-end 1992, remaining maturity may be used for determining term to maturity for off-balance-sheet loan commitments; thereafter, original maturity must be used. 15 Regulation H, Appendix A Capital Adequacy Guidelines Exchange-rate contracts with an original ma turity of 14 calendar days or less and instru ments traded on exchanges that require daily payment of variation margin are excluded from the risk-based ratio calculation. Overthe-counter options purchased, however, are included and treated in the same way as the other interest-rate and exchange-rate contracts. 2. Calculation o f credit-equivalent amounts. Credit-equivalent amounts are calculated for each individual contract of the types listed above. To calculate the credit-equivalent amount of its off-balance-sheet interest-rate and exchange-rate instruments, a bank sums these amounts: 1. the mark-to-market value49 (positive val ues only) of each contract (that is, the cur rent exposure) and 2. an estimate of the potential future credit exposure over the remaining life of each contract. The potential future credit exposure on a contract, including contracts with negative mark-to-market values, is estimated by multi plying the notional principal amount by one of the following credit conversion factors, as appropriate: Rem aining m aturity Interestrate contracts Exchangerate contracts One year or less Over one year -0 0.5% 1.0% 5.0% Examples of the calculation of credit-equiva lent amounts for these instruments are con tained in attachment V. Because exchange-rate contracts involve an exchange of principal upon maturity, and ex change rates are generally more volatile than interest rates, higher conversion factors have been established for foreign-exchange con tracts than for interest-rate contracts. No potential future credit exposure is calcu lated for single-currency interest-rate swaps in which payments are made based upon two floating rate indices, so-called floating/float- ing or basis swaps; the credit exposure on these contracts is evaluated solely on the basis of their mark-to-market values. 3. Risk weights. Once the credit-equivalent amount for interest-rate and exchange-rate in struments has been determined, that amount is assigned to the risk-weight category appro priate to the counterparty, or, if relevant, the nature of any collateral or guarantees.50 How ever, the maximum weight that will be applied to the credit-equivalent amount of such in struments is 50 percent. 4. Avoidance o f double-counting. In certain cases, credit exposures arising from the inter est-rate and exchange instruments covered by these guidelines may already be reflected, in part, on the balance sheet. To avoid double counting such exposures in the assessment of capital adequacy and, perhaps, assigning inap propriate risk weights, counterparty credit ex posures arising from the types of instruments covered by these guidelines may need to be excluded from balance-sheet assets in calcu lating banks’ risk-based capital ratios. 5. Netting. Netting of swaps and similar con tracts is recognized for purposes of calculating the risk-based capital ratio only when accom plished through netting by novation.51 While the Federal Reserve encourages any reason able arrangements designed to reduce the risks inherent in these transactions, other types of netting arrangements are not recog nized for purposes of calculating the riskbased ratio at this time. IV. Minimum Supervisory Ratios and Standards The interim and final supervisory standards set forth below specify minimum supervisory 50 For interest- and exchange-rate contracts, sufficiency of collateral or guarantees is determined by the market val ue of the collateral or the amount of the guarantee in rela tion to the credit-equivalent amount. Collateral and guar antees are subject to the same provisions noted under sec tion III(B ). 51 Netting by novation, for this purpose, is a written bi lateral contract between two counterparties under which 49 Mark-to-market values are measured in dollars, reany obligation to each other to deliver a given currency on a given date is automatically amalgamated with all other gardless of the currency or currencies specified in the con obligations for the same currency and value date, le g a lly tract, and should reflect changes in both interest rates and substituting one single net amount for the previous gross counterparty credit quality. obligations. 16 Capital Adequacy Guidelines ratios based primarily on broad credit-risk considerations. As noted above, the risk-based ratio does not take explicit account of the quality of individual asset portfolios or the range of other types of risks to which banks may be exposed, such as interest-rate, liquidi ty, market, or operational risks. For this rea son, banks are generally expected to operate with capital positions above the minimum ra tios. This is particularly true for institutions that are undertaking significant expansion or that are exposed to high or unusual levels of risk. Upon adoption of the risk-based frame work, any bank that does not meet the interim or final supervisory ratios, or whose capital is otherwise considered inadequate, is expected to develop and implement a plan acceptable to the Federal Reserve for achieving an adequate level of capital consistent with the provisions of these guidelines or with the special circum stances affecting the individual institution. In addition, such banks should avoid any ac tions, including increased risk-taking or un warranted expansion, that would lower or fur ther erode their capital positions. A. Minimum Risk-Based Ratio After Transition Period As reflected in attachment VI, by year-end 1992, all state member banks should meet a minimum ratio of qualifying total capital to weighted-risk assets of 8 percent, of which at least 4.0 percentage points should be in the form of tier 1 capital net of goodwill. (Section II above contains detailed definitions of capi tal and related terms used in this section.) The maximum amount of supplementary cap ital elements that qualifies as tier 2 capital is limited to 100 percent of tier 1 capital net of goodwill. In addition, the combined maxi mum amount of subordinated debt and inter mediate-term preferred stock that qualifies as tier 2 capital is limited to 50 percent of tier 1 capital. The maximum amount of the allow ance for loan and lease losses that qualifies as tier 2 capital is limited to 1.25 percent of gross weighted-risk assets. Allowances for loan and lease losses in excess of this limit may, of course, be maintained, but would not be in cluded in a bank’s total capital. The Federal Regulation H, Appendix A Reserve will continue to require banks to maintain reserves at levels fully sufficient to cover losses inherent in their loan portfolios. Qualifying total capital is calculated by adding tier 1 capital and tier 2 capital (limited to 100 percent of tier 1 capital) and then de ducting from this sum certain investments in banking or finance subsidiaries that are not consolidated for accounting or supervisory purposes, reciprocal holdings of banking orga nization capital securities, or other items at the direction of the Federal Reserve. These deductions are discussed above in section 11(B). B. Transition Arrangements The transition period for implementing the risk-based capital standard ends on December 31, 1992.52 Initially, the risk-based capital guidelines do not establish a minimum level of capital. However, by year-end 1990, banks are expected to meet a minimum interim target ratio for qualifying total capital to weightedrisk assets of 7.25 percent, at least one-half of which should be in the form of tier 1 capital. For purposes of meeting the 1990 interim tar get, the amount of loan-loss reserves that may be included in capital is limited to 1.5 percent of weighted-risk assets and up to 10 percent of a bank’s tier 1 capital may consist of supple52 The Basle capital framework does not establish an ini tial minimum standard for the risk-based capital ratio be fore the end of 1990. However, for the purpose of calculat ing a risk-based capital ratio prior to year-end 1990, no sublimit is placed on the amount of the allowance for loan and lease losses includable in tier 2. In addition, this frame work permits, under temporary transition arrangements, a certain percentage of a bank’s tier 1 capital to be made up of supplementary capital elements. In particular, supple mentary elements may constitute 25 percent of a bank’s tier 1 capital (before the deduction of goodwill) up to the end o f 1990; from year-end 1990 up to the end of 1992, this allowable percentage of supplementary elements in tier 1 declines to 10 percent of tier 1 (before the deduction of goodwill). Beginning on December 31, 1992, supplemen tary elements may not be included in tier 1. The amount of subordinated debt and intermediate-term preferred stock temporarily included in tier 1 under these arrangements will not be subject to the sublimit on the amount of such instruments includable in tier 2 capital. Goodwill must be deducted from the sum of a bank’s permanent core capital elements (that is, common equity, noncumulative perpetu al preferred stock, and minority interest in the equity of unconsolidated subsidiaries) plus supplementary items that may temporarily qualify as tier 1 elements for the purpose of calculating tier 1 (net of goodwill), tier 2, and total capital. 17 Regulation H, Appendix A mentary capital elements. Thus, the 7.25 per cent interim target ratio implies a minimum ratio of tier 1 capital to weighted-risk assets of 3.6 percent (one-half of 7.25) and a minimum ratio of core capital elements to weighted-risk assets ratio of 3.25 percent (nine-tenths of the tier 1 capital ratio). 18 Capital Adequacy Guidelines Capital Adequacy Guidelines Regulation H, Appendix A Attachment I— Sample Calculation of Risk-Based Capital Ratio for State Member Banks Example of a bank with $6,000 in total capital and the following assets and off-balance-sheet items. Balance-sheet assets Cash $ 5,000 U.S. Treasuries Balances at domestic banks Loans secured by first liens on 1- to 4-family residential properties 20,000 5,000 Loans to private corporations 65,000 5,000 Total Balance-Sheet Assets $100,000 Off-balance-sheet items Standby letters of credit (SLCs) backing generalobligation debt issues of U.S. municipalities (GOs) Long-term legally binding commitments to private corporations $ 10,000 Total Off-Balance-Sheet Items $ 30,000 20,000 This bank’s total capital to total assets (leverage) ratio would be: ($ 6,000/ $ 100,000 ) = 6 .00 % . To compute the bank’s weighted-risk assets— 1. Compute the credit-equivalent amount of each off-balance-sheet (OBS) item. OBS item SLCs backing municipal GOs Long-term commitments to private corporations Conversion factor Face value $10,000 $20,000 X X 1.00 0.50 Creditequivalent am ount = = $10,000 $10,000 Attachment I continued, next page 19 Capital Adequacy Guidelines Regulation H, Appendix A Attachment I continued 2. Multiply each balance-sheet asset and the credit-equivalent amount o f each OBS item by the appropriate risk weight. OBS item Conversion fa cto r Face value Creditequivalent am ount 0 % category Cash U.S. Treasuries $ 5,000 20,000 X 0 = 0 $15,000 X 0.20 = $ 3,000 $ 5,000 X 0.50 = $ 2,500 X 1.00 = $75,000 $25,000 2 0 % category Balances at domestic banks Credit-equivalent amounts of SLCs backing GOs of U.S. municipalities $ 5,000 10,000 5 0% category Loans secured by first liens on 1- to 4-family residential properties 100% category Loans to private corporations Credit-equivalent amounts of long-term commit ments to private corporations $65,000 10,000 $75,000 Total Risk-Weighted Assets $80,500 This bank’s ratio of total capital to weighted-risk assets (risk-based capital ratio) would be: ($6,000/580,500) = 7.45% 20 Capital Adequacy Guidelines Regulation H, Appendix A A ttachm ent II— Sum m ary Definition of Qualifying Capital for State M em ber Banks* Using the Year-End 1992 Standards Components CORE CAPITAL (tier 1) Common stockholders’ equity Qualifying noncumulative perpetual preferred stock Minority interest in equity accounts of consolidated subsidiaries M inim um requirements after transition period Must equal or exceed 4% of weighted-risk assets No limit No limit; banks should avoid undue reliance on preferred stock in tier 1 Banks should avoid using minority interests to introduce elements not otherwise qualifying for tier 1 capital Less: Goodwill1 SUPPLEMENTARY CAPITAL (tier 2) Allowance for loan and lease losses Perpetual preferred stock Hybrid capital instruments and equity-contract notes Subordinated debt and intermediate-term preferred stock (original weighted average maturity of 5 years or more) Revaluation reserves (equity and building) DEDUCTIONS (from sum of tier 1 and tier 2) Investments in unconsolidated subsidiaries Reciprocal holdings of banking organizations’ capital securities Other deductions (such as other subsidiaries or joint ventures) as determined by supervisory authority Total of tier 2 is limited to 100% of tier l 2 Limited to 1.25% of weighted-risk assets2 No limit within tier 2 No limit within tier 2 Subordinated debt and intermediate-term preferred stock are limited to 50% of tier l;3 amortized for capital purposes as they approach maturity Not included; banks encouraged to disclose; may be evaluated on a case-by-case basis for international comparisons; and taken into account in making an overall assessment of capital On a case-by-case basis or as a matter of policy after formal rulemaking TOTAL CAPITAL (tier 1 + tier 2 — Deductions) Must equal or exceed 8% of weighted-risk assets * See discussion in section II o f the guidelines for a com plete description of the requirements for, and the limita tions on, the components of qualifying capital. 1 All goodwill, except previously grandfathered goodwill approved in supervisory mergers, is deducted immediately. 2 Amounts in excess of limitations are permitted but do not qualify as capital. 3 Amounts in excess of limitations are permitted but do not qualify as capital. 4 A proportionately greater amount may be deducted from tier 1 capital if the risks associated with the subsidiary so warrant. 21 Regulation H, Appendix A Attachment III—Summary of Risk Weights and Risk Categories for State Member Banks Category 1: Zero Percent 1. Cash (domestic and foreign) held in the bank or in transit 2. Balances due from Federal Reserve Banks (including Federal Reserve Bank stock) and central banks in other OECD countries 3. Direct claims on, and the portions of claims that are unconditionally guaranteed by, the U.S. Treasury and U.S. government agencies1 and the central governments of oth er OECD countries, and local currency claims on, and the portions of local currency claims that are unconditionally guaranteed by, the central governments of non-OECD countries (including the central banks of non-OECD countries), to the extent that the bank has lia bilities booked in that currency 4. Gold bullion held in the bank’s vaults or in another’s vaults on an allocated basis, to the extent offset by gold bullion liabilities Category 2: 20 Percent 1. Cash items in the process of collection 2. All claims (long- or short-term) on, and the portions of claims (long- or short-term) that are guaranteed by, U.S. depository insti tutions and OECD banks 3. Short-term claims (remaining maturity of one year or less) on, and the portions of short term claims that are guaranteed by, nonOECD banks 4. The portions of claims that are condition ally guaranteed by the central governments of OECD countries and U.S. government agen cies, and the portions of local currency claims that are conditionally guaranteed by the cen tral governments of non-OECD countries, to 1 For the purpose of calculating the risk-based capital ratio, a U.S. government agency is defined as an instrumen tality of the U.S. government whose obligations are fully and explicitly guaranteed as to the timely payment of prin cipal and interest by the full faith and credit o f the U.S. government. 22 Capital Adequacy Guidelines the extent that the bank has liabilities booked in that currency 5. Claims on, and the portions of claims that are guaranteed by, U.S. governmentsponsored agencies2 6. General obligation claims on, and the por tions of claims that are guaranteed by the full faith and credit of, local governments and po litical subdivisions of the U.S. and other OECD local governments 7. Claims on, and the portions of claims that are guaranteed by, official multilateral lending institutions or regional development banks 8. The portions of claims that are collateralized3 by securities issued or guaran teed by the U.S. Treasury, the central govern ments of other OECD countries, U.S. govern ment agencies, U.S. government-sponsored agencies, or by cash on deposit in the bank 9. The portions of claims that are collateralized3 by securities issued by official multilateral lending institutions or regional development banks 10. Certain privately issued securities repre senting indirect ownership of mortgagebacked U.S. government agency or U.S. gov ernment-sponsored agency securities 11. Investments in shares of a fund whose portfolio is permitted to hold only securities that would qualify for the zero or 20 percent risk categories Category 3: 50 Percent 1. Loans fully secured by first liens on one- to four-family residential properties that have been made in accordance with prudent under writing standards, that are performing in ac cordance with their original terms, and are not past due or in nonaccrual status, and cer tain privately issued mortgage-backed securi ties representing indirect ownership of such 2 For the purpose of calculating the risk-based capital ratio, a U.S. government-sponsored agency is defined as an agency originally established or chartered to serve public purposes specified by the U.S. Congress but whose obliga tions are not e x p lic itly guaranteed by the full faith and credit of the U.S. government. 3 The extent of collateralization is determined by current market value. Capital Adequacy Guidelines Regulation H, Appendix A loans (Loans made for speculative purposes are excluded.) all claims on non-OECD state or local governments 2. Revenue bonds or similar claims that are obligations of U.S. state or local governments, or other OECD local governments, but for which the government entity is committed to repay the debt only out of revenues from the facilities financed 4. Obligations issued by U.S. state or local governments, or other OECD local govern ments (including industrial-development au thorities and similar entities), repayable solely by a private party or enterprise 3. Credit-equivalent amounts of interest rateand foreign exchange rate-related contracts, except for those assigned to a lower risk category Category 4: 100 Percent 1. All other claims on private obligors 2. Claims on, or guaranteed by, non-OECD foreign banks with a remaining maturity ex ceeding one year 3. Claims on, or guaranteed by, non-OECD central governments that are not included in item 3 of category 1 or item 4 of category 2; 5. Premises, plant, and equipment; other fixed assets; and other real estate owned 6. Investments in any unconsolidated subsidi aries, joint ventures, or associated compa nies—if not deducted from capital 7. Instruments issued by other banking orga nizations that qualify as capital—if not de ducted from capital 8. Claims on commercial firms owned by a government 9. All other assets, including any intangible assets that are not deducted from capital 23 Regulation H, Appendix A Attachment IV—Credit-Conversion Factors for Off-Balance-Sheet Items for State Member Banks 100 Percent Conversion Factor 1. Direct credit substitutes (These include general guarantees of indebtedness and all guarantee-type instruments, including stand by letters of credit backing the financial obli gations of other parties.) 2. Risk participations in banker’s acceptances and direct credit substitutes, such as standby letters of credit 3. Sale and repurchase agreements and assets sold with recourse that are not included on the balance sheet 4. Forward agreements to purchase assets, in cluding financing facilities, on which draw down is certain 5. Securities lent for which the bank is at risk Capital Adequacy Guidelines 20 Percent Conversion Factor 1. Short-term, self-liquidating, trade-related contingencies, including commercial letters of credit Zero Percent Conversion Factor 1. Unused portions of commitments with an original maturity1 of one year or less, or which are unconditionally cancellable at any time, provided a separate credit decision is made before each drawing Credit Conversion for Interest-Rate and Foreign-Exchange Contracts The total replacement cost of contracts (ob tained by summing the positive mark-to-mar ket values of contracts) is added to a measure of future potential increases in credit expo sure. This future potential exposure measure is calculated by multiplying the total notional value of contracts by one of the following credit-conversion factors, as appropriate: R em aining m atu rity 50 Percent Conversion Factor 1. Transaction-related contingencies (These include bid bonds, performance bonds, war ranties, and standby letters of credit backing the nonfinancial performance of other parties.) 2. Unused portions of commitments with an original maturity1 exceeding one year, includ ing underwriting commitments and commer cial credit lines 3. Revolving underwriting facilities (RUFs), note-issuance facilities (NIFs), and similar arrangements 24 One year or less Over one year Interest-rate contracts Exchange-rate contracts 0 0.5% 1.0% 5.0% No potential exposure is calculated for sin gle-currency interest-rate swaps in which pay ments are made based upon two floating rate indices, that is, so-called floating/floating or basis swaps. The credit exposure on these con tracts is evaluated solely on the basis of their mark-to-market value. Exchange-rate con tracts with an original maturity of 14 days or less are excluded. Instruments traded on ex changes that require daily payment of varia tion margin are also excluded. The only form of netting recognized is netting by novation. 1 Remaining maturity may be used until year-end 1992. Capital Adequacy Guidelines Regulation H, Appendix A Attachment V—Calculation of Credit-Equivalent Amounts Interest Rate- and Foreign Exchange Rate-Related Transactions for State Member Banks + Potential Exposure Type o f contract (remaining m aturity) (1) 120-day forward foreign exchange (2) 120-day forward foreign exchange Notional principal (dollars) Potentialexposure Potential conversion exposure X factor = (dollars) Current Exposure Replace m ent cost1 CreditEquivalent Am ount = (dollars) Current exposure (dollars)2 5,000,000 .01 50,000 100,000 100,000 150,000 6,000,000 .01 60,000 -120,000 -0 - 60,000 (3) 3-year single-currency fixed/floating 10,000,000 interest-rate swap (4) 3-year single-currency fixed/floating 10,000,000 interest-rate swap .005 50,000 200,000 200,000 250,000 .005 50,000 -250,000 -0 - 50,000 (5) 7-year cross-currency floating/floating interest-rate swap .05 1,000,000 -1,300,000 -0 - TOTAL 20,000,000 $51,000,000 1,000,000 $1,510,000 1 These numbers are purely for illustration. 2 The larger of zero or a positive mark-to-market value. 25 Regulation H, Appendix A A ttachm ent VI Capital Adequacy Guidelines SUMMARY OF: Transitional Arrangements fo r State M em ber Banks Final Arrangement Initial 1. Minimum standard of total capital to weighted-risk assets 2. Definition of tier 1 capital 3. Minimum standard of tier 1 capital to weighted-risk assets 4. Minimum standard of stockholders’ equity to weighted-risk assets 5. Limitations on sup plementary capital elements a. Allowance for loan and lease losses b. Qualifying perpet ual preferred stock c. Hybrid capital in struments and eq uity contract notes d. Subordinated debt and intermediateterm preferred stock c. Total qualifying tier 2 capital 6. Definition of total capital Year-end 1990 Year-end 1992 None 7.25% 8.0% Common equity, qualifying noncumulative perpetual preferred stock, minority interests, plus supplementary elements1 less goodwill Common equity, qualifying noncumulative perpetual preferred stock, minority interests, plus supplementary elements2 less goodwill Common equity, qualifying noncumulative perpetual preferred stock, and minority interests less goodwill None 3.625% 4.0% None 3.25% 4.0% No limit within tier 2 1.5% of weighted-risk assets 1.25% of weighted-risk assets No limit within tier 2 No limit within tier 2 No limit within tier 2 No limit within tier 2 No limit within tier 2 No limit within tier 2 Combined maximum of 50% of tier 1 Combined maximum of 50% of tier 1 Combined maximum of 50% of tier 1 May not exceed tier 1 capital May not exceed tier 1 capital May not exceed tier 1 capital Tier 1plu s tier 2 less: • reciprocal holdings of banking organizations’ capital instruments • investments in unconsolidated subsidiaries Tier 1plus tier 2 less: • reciprocal holdings of banking organizations’ capital instruments • investments in unconsolidated subsidiaries Tier 1plus tier 2 less: • reciprocal holdings of banking organizations’ capital instruments • investments in unconsolidated subsidiaries 1 Supplementary elements may be included in tier 1 up to 25% of the sum of tier 1 plus goodwill. 2 Supplementary elements may be included in tier 1 up to 10% of the sum of tier 1 plus goodwill. 26 Capital Adequacy Guidelines for Bank Holding Companies: Risk-Based Measure Regulation Y (12 CFR 225), Appendix A capital to weighted-risk assets and provide for transitional arrangements during a phase-in The Board of Governors of the Federal Re period to facilitate adoption and implementa serve System has adopted a risk-based capital tion of the measure at the end of 1992. These measure to assist in the assessment of the cap interim standards and transitional arrange ital adequacy of bank holding companies ments are set forth in section IV. ( “banking organizations” ) .1 The principal The risk-based guidelines apply on a con objectives of this measure are to (i) make reg solidated basis to bank holding companies ulatory capital requirements more sensitive to with consolidated assets of $150 million or differences in risk profiles among banking or more. For bank holding companies with less ganizations; (ii) factor off-balance-sheet expo than $150 million in consolidated assets, the sures into the assessment of capital adequacy; guidelines will be applied on a bank-only basis (iii) minimize disincentives to holding liquid, unless (a) the parent bank holding company low-risk assets; and (iv) achieve greater con is engaged in nonbank activity involving sig sistency in the evaluation of the capital ade nificant leverage;4 or (b) the parent company quacy of major banking organizations has a significant amount of outstanding debt throughout the world.2 that is held by the general public. The risk-based capital guidelines include The risk-based guidelines are to be used in both a definition of capital and a framework the inspection and supervisory process as well for calculating weighted-risk assets by assign as in the analysis of applications acted upon ing assets and off-balance-sheet items to broad by the Federal Reserve. Thus, in considering risk categories. An institution’s risk-based an application filed by a bank holding compa capital ratio is calculated by dividing its quali ny, the Federal Reserve will take into account fying capital (the numerator of the ratio) by the organization’s risk-based capital ratio, the its weighted-risk assets (the denominator).3 reasonableness of its capital plans, and the de The definition of “qualifying capital” is out gree of progress it has demonstrated toward lined below in section II, and the procedures meeting the interim and final risk-based capi for calculating weighted-risk assets are dis tal standards. cussed in section III. Attachment I illustrates The risk-based capital ratio focuses princi a sample calculation of weighted-risk assets pally on broad categories of credit risk, al and the risk-based capital ratio. though the framework for assigning assets and The risk-based capital guidelines also estab off-balance-sheet items to risk categories does lish a schedule for achieving a minimum su incorporate elements of transfer risk, as well pervisory standard for the ratio of qualifying as limited instances of interest-rate and mar ket risk. The risk-based ratio does not, howev 1 Supervisory ratios that relate capital to total assets for bank holding companies are outlined in appendix B of Reg er, incorporate other factors that can affect an ulation Y (page 55). organization’s financial condition. These fac 2 The risk-based capital measure is based upon a frame work developed jointly by supervisory authorities from the tors include overall interest-rate exposure; li countries represented on the Basle Committee on Banking quidity, funding, and market risks; the quality Regulations and Supervisory Practices (Basle Supervisors’ and level of earnings; investment or loan port Committee) and endorsed by the Group of Ten Central Bank Governors. The framework is described in a paper folio concentrations; the quality of loans and prepared by the BSC entitled “International Convergence investments; the effectiveness of loan and in of Capital Measurement,” July 1988. vestment policies; and management’s ability 3 Banking organizations will initially be expected to uti lize period-end amounts in calculating their risk-based cap to monitor and control financial and operating ital ratios. When necessary and appropriate, ratios based on risks. average balances may also be calculated on a case-by-case I. Overview basis. Moreover, to the extent banking organizations have data on average balances that can be used to calculate riskbased ratios, the Federal Reserve will take such data into account. 4 A parent company that is engaged in significant off-bal ance-sheet activities would generally be deemed to be en gaged in activities that involve significant leverage. 27 Regulation Y, Appendix A In addition to evaluating capital ratios, an overall assessment of capital adequacy must take account of these other factors, including, in particular, the level and severity of problem and classified assets. For this reason, the final supervisory judgment on an organization’s capital adequacy may differ significantly from conclusions that might be drawn solely from the level of the organization’s risk-based capi tal ratio. The risk-based capital guidelines establish minimum ratios of capital to weighted-risk as sets. In light of the considerations just dis cussed, banking organizations generally are expected to operate well above the minimum risk-based ratios. In particular, banking orga nizations contemplating significant expansion proposals are expected to maintain strong capital levels substantially above the mini mum ratios and should not allow significant diminution of financial strength below these strong levels to fund their expansion plans. In stitutions with high or inordinate levels of risk are also expected to operate above minimum capital standards. In all cases, institutions should hold capital commensurate with the level and nature of the risks to which they are exposed. Banking organizations that do not meet the minimum risk-based standard, or that are otherwise considered to be inade quately capitalized, are expected to develop and implement plans acceptable to the Feder al Reserve for achieving adequate levels of capital within a reasonable period of time. The Board will monitor the implementation and effect of these guidelines in relation to do mestic and international developments in the banking industry. When necessary and appro priate, the Board will consider the need to modify the guidelines in light of any signifi cant changes in the economy, financial mar kets, banking practices, or other relevant factors. II. Definition of Qualifying Capital for the Risk-Based Capital Ratio An institution’s qualifying total capital con sists of two types of capital components: “core capital elements” (comprising tier 1 capital) and “supplementary capital elements” (com28 Capital Adequacy Guidelines prising tier 2 capital). These capital elements and the various limits, restrictions, and deduc tions to which they are subject, are discussed below and are set forth in attachment II. To qualify as an element of tier 1 or tier 2 capital, a capital instrument may not contain or be covered by any covenants, terms, or re strictions that are inconsistent with safe and sound banking practices. Redemptions of permanent equity or other capital instruments before stated maturity could have a significant impact on an organi zation’s overall capital structure. Consequent ly, an organization considering such a step should consult with the Federal Reserve be fore redeeming any equity or debt capital in strument (prior to maturity) if such redemp tion could have a material effect on the level or composition of the organization’s capital base.5 A. The Components o f Qualifying Capital 1. Core capital elements (tier 1 capital). The tier 1 component of an institution’s qualifying capital must represent at least 50 percent of qualifying total capital and may consist of the following items that are defined as core capital elements: i. common stockholders’ equity ii. qualifying perpetual preferred stock (in cluding related surplus), subject to certain limitations described below iii. minority interest in the equity accounts of consolidated subsidiaries Tier 1 capital is generally defined as the sum of the core capital elements less goodwill.6* (See section 11(B) below for a more detailed discussion of the treatment of goodwill, including an explanation of certain limited grandfathering arrangements.) a. Common stockholders' equity. Common stockholders’ equity includes: common 5 Consultation would not ordinarily be necessary if an instrument were redeemed with the proceeds of, or re placed by, a like amount of a similar or higher-quality capi tal instrument and the organization’s capital position is considered fully adequate by the Federal Reserve. In the case of limited-life tier 2 instruments, consultation would generally be obviated if the new security is of equal or greater maturity than the one it replaces. 6 During the transition period and subject to certain limi tations set forth in section IV below, tier 1 capital may also include items defined as supplementary capital elements. Capital Adequacy Guidelines stock; related surplus; and retained earn ings, including capital reserves and adjust ments for the cumulative effect of foreign currency translation, net of any treasury stock. b. Perpetual preferred stock. Perpetual pre ferred stock is defined as preferred stock that does not have a maturity date, that cannot be redeemed at the option of the holder of the instrument, and that has no other provisions that will require future re demption of the issue. In general, preferred stock will qualify for inclusion in capital only if it can absorb losses while the issuer operates as a going concern (a fundamental characteristic of equity capital) and only if the issuer has the ability and legal right to defer or eliminate preferred dividends. Perpetual preferred stock in which the dividend is reset periodically based, in whole or in part, upon the banking organi zation’s current credit standing (that is, auction rate perpetual preferred stock, in cluding so-called Dutch auction, money market, and remarketable preferred) will not qualify for inclusion in tier 1 capital.7 Such instruments, however, qualify for in clusion in tier 2 capital. For bank holding companies, both cumu lative and noncumulative perpetual pre ferred stock qualify for inclusion in tier 1. However, the aggregate amount of such stock (whether cumulative or noncumula tive) that may be included in a holding company’s tier 1 is limited to one-third of the sum of core capital elements, excluding the perpetual preferred stock (that is, items i and iii above). Stated differently, the ag gregate amount may not exceed 25 percent of the sum of all core capital elements, in cluding perpetual preferred stock (that is, items i, ii and iii above). Any perpetual pre ferred stock outstanding in excess of this limit may be included in tier 2 capital with out any sublimits within that tier (see dis cussion below). The limits on preferred stock are consis- Regulation Y, Appendix A tent with the Board’s long-standing view that common equity should remain the dominant form of a banking organization’s capital structure. In addition to these limits, the Board believes that, in general, banking organizations should avoid overreliance on other nonvoting equity instruments in their tier 1 capital. c. Minority interest in equity accounts o f consolidated subsidiaries. This element is in cluded in tier 1 because, as a general rule, it represents equity that is freely available to absorb losses in operating subsidiaries. While not subject to an explicit sublimit within tier 1, banking organizations are ex pected to avoid using minority interest in the equity accounts of consolidated subsidi aries as an avenue for introducing into their capital structures elements that might not otherwise qualify as tier 1 capital or that would, in effect, result in an excessive reli ance on preferred stock within tier 1. 2. Supplementary capital elements (tier 2 capi tal). The tier 2 component of an institution’s qualifying total capital may consist of the fol lowing items that are defined as supplemen tary capital elements: i. Allowance for loan and lease losses (sub ject to limitations discussed below) ii. Perpetual preferred stock and related sur plus (subject to conditions discussed below) iii. Hybrid capital instruments (as defined be low), perpetual debt, and mandatory con vertible debt securities iv. Term subordinated debt and intermediateterm preferred stock, including related surplus (subject to limitations discussed below) The maximum amount of tier 2 capital that may be included in an organization’s qualify ing total capital is limited to 100 percent of tier 1 capital (net of goodwill). The elements of supplementary capital are discussed in greater detail below.8 8 The Basle capital framework also provides for the in 7 Adjustable-rate perpetual preferred stock (that is, perclusion of “undisclosed reserves” in tier 2. As defined in the petual preferred stock in which the dividend rate is not framework, undisclosed reserves represent accumulated af affected by the issuer’s credit standing or financial condi ter-tax retained earnings that are not disclosed on the bal ance sheet of a banking organization. Apart from the fact tion but is adjusted periodically according to a formula that these reserves are not disclosed publicly, they are es based solely on general market interest rates) may be in sentially of the same quality and character as retained earncluded in tier 1 up to the limits specified for perpetual pre ferred stock. Continued 29 Regulation Y, Appendix A a. Allowance for loan and lease losses. Al lowances for loan and lease losses are re serves that have been established through a charge against earnings to absorb future losses on loans or lease-financing receiv ables. Allowances for loan and lease losses exclude “allocated transfer risk reserves,”* 9 and reserves created against identified losses. During the transition period, the riskbased capital guidelines provide for reduc ing the amount of this allowance that may be included in an institution’s total capital. Initially, it is unlimited. However, by yearend 1990, the amount of the allowance for loan and lease losses that will qualify as capital will be limited to 1.5 percent of an institution’s weighted-risk assets. By the end of the transition period, the amount of the allowance qualifying for inclusion in tier 2 capital may not exceed 1.25 percent of weighted-risk assets.10 b. Perpetual preferred stock. Perpetual pre ferred stock, as noted above, is defined as preferred stock that has no maturity date, that cannot be redeemed at the option of the holder, and that has no other provisions that will require future redemption of the issue. Such instruments are eligible for in clusion in tier 2 capital without limit.1 * 1 Continued ings, and, to be included in capital, such reserves must be accepted by the banking organization’s home supervisor. Although such undisclosed reserves are common in some countries, under generally accepted accounting principles (G A A P) and long-standing supervisory practice, these types of reserves are not recognized for banking organiza tions in the United States. Foreign banking organizations seeking to make acquisitions or conduct business in the United States would generally be expected to disclose pub licly at least the degree of reliance on such reserves in meet ing supervisory capital requirements. 9 Allocated transfer risk reserves are reserves that have been established in accordance with section 905(a) of the International Lending Supervision Act of 1983, 12 USC 3904(a), against certain assets whose value U.S. superviso ry authorities have found to be significantly impaired by protracted transfer risk problems. 10 The amount o f the allowance for loan and lease losses that may be included in tier 2 capital is based on a percent age of gross weighted-risk assets. A banking organization may deduct reserves for loan and lease losses in excess of the amount permitted to be included in tier 2 capital, as well as allocated transfer risk reserves, from the sum of gross weighted-risk assets and use the resulting net sum of weighted-risk assets in computing the denominator of the risk-based capital ratio. 11 Long-term preferred stock with an original maturity of 20 years or more (including related surplus) will also 30 Capital Adequacy Guidelines c. Hybrid capital instruments, perpetual debt, and mandatory convertible debt securi ties. Hybrid capital instruments include in struments that are essentially permanent in nature and that have certain characteristics of both equity and debt. Such instruments may be included in tier 2 without limit. The general criteria hybrid capital instruments must meet in order to qualify for inclusion in tier 2 capital are listed below: 1. The instrument must be unsecured; fully paid up; and subordinated to general creditors. If issued by a bank, it must also be subordinated to claims of depositors. 2. The instrument must not be redeemable at the option of the holder prior to matu rity, except with the prior approval of the Federal Reserve. (Consistent with the Board’s criteria for perpetual debt and mandatory convertible securities, this requirement implies that holders of such instruments may not accelerate the payment of principal except in the event of bankruptcy, insolvency, or reorganization.) 3. The instrument must be available to par ticipate in losses while the issuer is operating as a going concern. (Term subordinated debt would not meet this requirement.) To satisfy this require ment, the instrument must convert to common or perpetual preferred stock in the event that the accumulated losses ex ceed the sum of the retained earnings and capital surplus accounts of the issuer. 4. The instrument must provide the option for the issuer to defer interest payments if (a) the issuer does not report a profit in the preceding annual period (defined as combined profits for the most recent four quarters) and (b) the issuer elimi nates cash dividends on common and preferred stock. Perpetual debt and mandatory convert ible debt securities that meet the criteria set qualify in this category as an element of tier 2. If the holder of such an instrument has a right to require the issuer to redeem, repay, or repurchase the instrument prior to the original stated maturity, maturity would be defined, for risk-based capital purposes, as the earliest possible date on which the holder can put the instrument back to the issuing banking organization. Capital Adequacy Guidelines forth in 12 CFR 225, appendix B (page 55), also qualify as unlimited elements of tier 2 capital for bank holding companies. d. Subordinated debt and intermediateterm preferred stock. The aggregate amount of term subordinated debt (excluding man datory convertible debt) and intermediateterm preferred stock that may be treated as supplementary capital is limited to 50 per cent of tier 1 capital (net of goodwill). Amounts in excess of these limits may be issued and, while not included in the ratio calculation, will be taken into account in the overall assessment of an organization’s funding and financial condition. Subordinated debt and intermediate-term preferred stock must have an original weighted average maturity of at least five years to qualify as supplementary capital.12 (If the holder has the option to require the issuer to redeem, repay, or repurchase the instrument prior to the original stated ma turity, maturity would be defined, for riskbased capital purposes, as the earliest possi ble date on which the holder can put the instrument back to the issuing banking organization.) In the case of subordinated debt, the in strument must be unsecured and must clearly state on its face that it is not a depo sit and is not insured by a federal agency. Bank holding company debt must be subor dinated in right of payment to all senior in debtedness of the company. e. Discount o f supplementary capital instru ments. As a limited-life capital instrument approaches maturity it begins to take on characteristics of a short-term obligation. For this reason, the outstanding amount of term subordinated debt and any long- or in termediate-life, or term, preferred stock eli gible for inclusion in tier 2 is reduced, or discounted, as these instruments approach maturity: one-fifth of the original amount, less any redemptions, is excluded each year Regulation Y, Appendix A during the instrument’s last five years be fore maturity.13 f. Revaluation reserves. Such reserves re flect the formal balance-sheet restatement or revaluation for capital purposes of asset carrying values to reflect current market values. In the United States, banking orga nizations, for the most part, follow GAAP when preparing their financial statements, and GAAP generally does not permit the use of market-value accounting. For this and other reasons, the federal banking agencies generally have not included un realized asset values in capital-ratio calcula tions, although they have long taken such values into account as a separate factor in assessing the overall financial strength of a banking organization. Consistent with long-standing superviso ry practice, the excess of market values over book values for assets held by bank holding companies will generally not be recognized in supplementary capital or in the calcula tion of the risk-based capital ratio. Howev er, all banking organizations are encour aged to disclose their equivalent of premises (building) and equity revaluation reserves. Such values will be taken into account as additional considerations in assessing over all capital strength and financial condition. B. Deductions from Capital and Other Adjustments Certain assets are deducted from an organiza tion’s capital for the purpose of calculating the risk-based capital ratio.14 These assets in clude— 13 For example, outstanding amounts of these instru ments that count as supplementary capital include 100 per cent o f the outstanding amounts with remaining maturities of more than five years; 80 percent of outstanding amounts with remaining maturities of four to five years; 60 percent of outstanding amounts with remaining maturities of three to four years; 40 percent of outstanding amounts with re maining maturities of two to three years; 20 percent of out 12 Unsecured term debt issued by bank holding compastanding amounts with remaining maturities of one to two nies prior to March 12, 1988, and qualifying as secondary years; and 0 percent of outstanding amounts with remain capital at the time o f issuance would continue to qualify as ing maturities of less than one year. Such instruments with an element of supplementary capital under the risk-based a remaining maturity of less than one year are excluded framework, subject to the 50 percent o f tier 1 capital limita from tier 2 capital. tion. Bank holding company term debt issued on or after 14 Any assets deducted from capital in computing the March 12, 1988, must be subordinated in order to qualify numerator of the ratio are not included in weighted-risk as capital. assets in computing the denominator of the ratio. 31 Regulation Y, Appendix A i. goodwill—deducted from the sum of core capital elements (See discussion below of limited grandfathering of bank holding company goodwill during the transition period.) ii. investments in banking and finance sub sidiaries that are not consolidated for ac counting or supervisory purposes, and in vestments in other designated subsidiaries or associated companies at the discretion of the Federal Reserve—deducted from total capital components (as described in greater detail below) iii. reciprocal holdings of capital instruments of banking organizations—deducted from total capital components 1. Goodwill and other intangible assets. a. Goodwill. Goodwill is an intangible asset that represents the excess of the purchase price over the fair market value of identifia ble assets acquired less liabilities assumed in acquisitions accounted for under the pur chase method of accounting. Any goodwill carried on the balance sheet of a bank hold ing company after December 31, 1992, will be deducted from the sum of core capital elements in determining tier 1 capital for ratio-calculation purposes. Any goodwill in existence before March 12, 1988, is grand fathered during the transition period and is not deducted from core capital elements un til after December 31, 1992. However, bank holding company goodwill acquired as a re sult of a merger or acquisition that was con summated on or after March 12, 1988, is deducted immediately.15 b. Other intangible assets. The Federal Re serve is not proposing, as a matter of gener al policy, to deduct automatically any other intangible assets from the capital of bank holding companies. The Federal Reserve, however, will continue to monitor closely the level and quality of other intangible assets—including purchased mortgage-serv icing rights, leaseholds, and core deposit value—and take them into account in as15 Goodwill acquired by a subsidiary bank in connection with a merger with a troubled or failed depository institu tion that regulatory authorities have specifically allowed the bank to include in its capital will generally not be de ducted from the core capital elements of its parent bank holding company. 32 Capital Adequacy Guidelines sessing the capital adequacy and overall as set quality of banking institutions. Generally, banking organizations should review all intangible assets at least quarterly and, if necessary, make appropriate reduc tions in their carrying values. In addition, in order to conform with prudent banking practice, an organization should reassess such values during its annual audit. Bank ing organizations should use appropriate amortization methods and assign prudent amortization periods for intangible assets. Examiners will review the carrying value of these assets, together with supporting docu mentation, as well as the appropriateness of including particular intangible assets in a banking organization’s capital calculation. In making such evaluations, examiners will consider a number of factors, including— 1. the reliability and predictability of any cash flows associated with the asset and the degree of certainty that can be achieved in periodically determining the asset’s useful life and value; 2. the existence of an active and liquid mar ket for the asset; and 3. the feasibility of selling the asset apart from the banking organization or from the bulk of its assets. While all intangible assets will be moni tored, intangible assets (other than good will) in excess of 25 percent of tier 1 capital (which is defined net of goodwill) will be subject to particularly close scrutiny, both through the inspection process and by other appropriate means. Whenever necessary— in particular, when assessing applications to expand or to engage in other activities that could entail unusual or higher-than-normal risks—the Board will, on a case-by-case ba sis, continue to consider the level of an indi vidual organization’s tangible capital ratios (after deducting all intangible assets), to gether with the quality and value of the or ganization’s tangible and intangible assets, in making an overall assessment of capital adequacy. Consistent with long-standing Board pol icy, banking organizations experiencing substantial growth, whether internally or by acquisition, are expected to maintain Capital Adequacy Guidelines strong capital positions substantially above minimum supervisory levels, without signif icant reliance on intangible assets. 2. Investments in certain subsidiaries. a. Unconsolidated banking or finance sub sidiaries. The aggregate amount of invest ments in banking or finance subsidiaries16 whose financial statements are not consoli dated for accounting or regulatory-report ing purposes, regardless of whether the investment is made by the parent bank holding company or its direct or indirect subsidiaries, will be deducted from the con solidated parent banking organization’s to tal capital components.17 Generally, invest ments for this purpose are defined as equity and debt capital investments and any other instruments that are deemed to be capital in the particular subsidiary. Advances (that is, loans, extensions of credit, guarantees, commitments, or any other forms of credit exposure) to the sub sidiary that are not deemed to be capital will generally not be deducted from an or ganization’s capital. Rather, such advances generally will be included in the parent banking organization’s consolidated assets and be assigned to the 100 percent risk cate gory, unless such obligations are backed by recognized collateral or guarantees, in which case they will be assigned to the risk category appropriate to such collateral or guarantees. These advances may, however, also be deducted from the consolidated par ent banking organization’s capital if, in the judgment of the Federal Reserve, the risks stemming from such advances are compara ble to the risks associated with capital in vestments or if the advances involve other risk factors that warrant such an adjust ment to capital for supervisory purposes. These other factors could include, for ex ample, the absence of collateral support. 16 For this purpose, a banking and finance subsidiary generally is defined as any company engaged in banking or finance in which the parent institution holds directly or indirectly more than 50 percent o f the outstanding voting stock, or which is otherwise controlled or capable o f being controlled by the parent institution. 17 An exception to this deduction would be made in the case o f shares acquired in the regular course of securing or collecting a debt previously contracted in good faith. The requirements for consolidation are spelled out in the in structions to the Consolidated Financial Statements for Bank Holding Companies (FR Y-9C Report). Regulation Y, Appendix A Inasmuch as the assets of unconsolidated banking and finance subsidiaries are not ful ly reflected in a banking organization’s con solidated total assets, such assets may be viewed as the equivalent of off-balancesheet exposures since the operations of an unconsolidated subsidiary could expose the parent organization and its affiliates to con siderable risk. For this reason, it is general ly appropriate to view the capital resources invested in these unconsolidated entities as primarily supporting the risks inherent in these off-balance-sheet assets, and not gen erally available to support risks or absorb losses elsewhere in the organization, b. Other subsidiaries and investments. The deduction of investments, regardless of whether they are made by the parent bank holding company or by its direct or indirect subsidiaries, from a consolidated banking organization’s capital will also be applied in the case of any subsidiaries, that, while con solidated for accounting purposes, are not consolidated for certain specified superviso ry or regulatory purposes, such as to facili tate functional regulation. For this purpose, aggregate capital investments (that is, the sum of any equity or debt instruments that are deemed to be capital) in these subsidiar ies will be deducted from the consolidated parent banking organization’s total capital components.18 Advances (that is, loans, extensions of credit, guarantees, commitments, or any other forms of credit exposure) to such sub sidiaries that are not deemed to be capital will generally not be deducted from capital. Rather, such advances will normally be in cluded in the parent banking organization’s consolidated assets and assigned to the 100 percent risk category, unless such obliga tions are backed by recognized collateral or 18 Investments in unconsolidated subsidiaries will be de ducted from both tier 1 and tier 2 capital. As a general rule, one-half (50 percent) of the aggregate amount of capital investments will be deducted from the bank holding com pany’s tier 1 capital and one-half (50 percent) from its tier 2 capital. However, the Federal Reserve may, on a case-bycase basis, deduct a proportionately greater amount from tier 1 if the risks associated with the subsidiary so warrant. If the amount deductible from tier 2 capital exceeds actual tier 2 capital, the excess would be deducted from tier 1 capital. Bank holding companies’ risk-based capital ratios, net of these deductions, must exceed the minimum stan dards set forth in section IV. 33 Regulation Y, Appendix A guarantees, in which case they will be as signed to the risk category appropriate to such collateral or guarantees. These ad vances may, however, be deducted from the consolidated parent banking organization’s capital if, in the judgment of the Federal Reserve, the risks stemming from such ad vances are comparable to the risks associat ed with capital investments or if such ad vances involve other risk factors that warrant such an adjustment to capital for supervisory purposes. These other factors could include, for example, the absence of collateral support.19 In general, when investments in a consol idated subsidiary are deducted from a con solidated parent banking organization’s capital, the subsidiary’s assets will also be excluded from the consolidated assets of the parent banking organization in order to as sess the latter’s capital adequacy.20 The Federal Reserve may also deduct from a banking organization’s capital, on a case-by-case basis, investments in certain other subsidiaries in order to determine if the consolidated banking organization meets minimum supervisory capital re quirements without reliance on the resourc es invested in such subsidiaries. The Federal Reserve will not automati cally deduct investments in other unconsol idated subsidiaries or investments in joint ventures and associated companies.21 Nonetheless, the resources invested in these entities, like investments in unconsolidated banking and finance subsidiaries, support assets not consolidated with the rest of the banking organization’s activities and, there 19 In assessing the overall capital adequacy of a banking organization, the Federal Reserve may also consider the organization’s fully consolidated capital position. 20 If the subsidiary’s assets are consolidated with the par ent banking organization for financial-reporting purposes, this adjustment will involve excluding the subsidiary’s as sets on a line-by-line basis from the consolidated parent organization’s assets. The parent banking organization’s capital ratio will then be calculated on a consolidated basis with the exception that the assets of the excluded subsidi ary will not be consolidated with the remainder o f the par ent banking organization. 21 The definition of such entities is contained in the in structions to the Consolidated Financial Statements for Bank Holding Companies. Under regulatory-reporting pro cedures, associated companies and joint ventures generally are defined as companies in which the banking organization owns 20 to 50 percent of the voting stock. 34 Capital Adequacy Guidelines fore, may not be generally available to sup port additional leverage or absorb losses elsewhere in the banking organization. Moreover, experience has shown that bank ing organizations stand behind the losses of affiliated institutions, such as joint ventures and associated companies, in order to pro tect the reputation of the organization as a whole. In some cases, this has led to losses that have exceeded the investments in such organizations. For this reason, the Federal Reserve will monitor the level and nature of such invest ments for individual banking organizations and may, on a case-by-case basis, deduct such investments from total capital compo nents, apply an appropriate risk-weighted capital charge against the organization’s proportionate share of the assets of its asso ciated companies, require a line-by-line consolidation of the entity (in the event that the parent’s control over the entity makes it the functional equivalent of a sub sidiary), or otherwise require the organiza tion to operate with a risk-based capital ra tio above the minimum. In considering the appropriateness of such adjustments or actions, the Federal Reserve will generally take into account whether— 1. the parent banking organization has sig nificant influence over the financial or managerial policies or operations of the subsidiary, joint venture, or associated company; 2. the banking organization is the largest investor in the affiliated company; or 3. other circumstances prevail that appear to closely tie the activities of the affiliat ed company to the parent banking organization. 3. Reciprocal holdings o f banking organiza tions' capital instruments. Reciprocal holdings of banking organizations’ capital instruments (that is, instruments that qualify as tier 1 or tier 2 capital) will be deducted from an orga nization’s total capital components for the purpose of determining the numerator of the risk-based capital ratio. Reciprocal holdings are cross-holdings re sulting from formal or informal arrangements Capital Adequacy Guidelines in which two or more banking organizations swap, exchange, or otherwise agree to hold each other’s capital instruments. Generally, deductions will be limited to intentional cross holdings. At present, the Board does not in tend to require banking organizations to de duct nonreciprocal holdings of such capital instruments.22- 23 III. Procedures for Computing Weighted-Risk Assets and Off-Balance-Sheet Items A. Procedures Assets and credit-equivalent amounts of offbalance-sheet items of bank holding compa nies are assigned to one of several broad risk categories, according to the obligor, or, if rele vant, the guarantor or the nature of the collat eral. The aggregate dollar value of the amount in each category is then multiplied by the risk weight associated with that category. The re sulting weighted values from each of the risk categories are added together, and this sum is the banking organization’s total weighted-risk assets that comprise the denominator of the risk-based capital ratio. Attachment I pro vides a sample calculation. Risk weights for all off-balance-sheet items are determined by a two-step process. First, the “credit equivalent amount” of off-balancesheet items is determined, in most cases, by multiplying the off-balance-sheet item by a credit conversion factor. Second, the creditequivalent amount is treated like any balancesheet asset and generally is assigned to the appropriate risk category according to the ob ligor, or, if relevant, the guarantor or the na ture of the collateral. 22 Deductions of holdings o f capital securities also would not be made in the case of interstate “stake out” invest ments that comply with the Board’s policy statement on nonvoting equity investments, 12 CFR 225.143 ( F e d e ra l R e se rv e R e g u la to r y S ervic e 4— 172.1; 1982 F e d e ra l R e se rv e B u lle tin 413). In addition, holdings of capital instruments issued by other banking organizations but taken in satisfac tion of debts previously contracted would be exempt from any deduction from capital. 23 The Board intends to monitor nonreciprocal holdings of other banking organizations’ capital instruments and to provide information on such holdings to the Basle Supervi sors’ Committee as called for under the Basle capital framework. Regulation Y, Appendix A In general, if a particular item qualifies for placement in more than one risk category, it is assigned to the category that has the lowest risk weight. A holding of a U.S. municipal revenue bond that is fully guaranteed by a U.S. bank, for example, would be assigned the 20 percent risk weight appropriate to claims guaranteed by U.S. banks, rather than the 50 percent risk weight appropriate to U.S. mu nicipal revenue bonds.24* The terms “claims” and “securities” used in the context of the discussion of risk weights, unless otherwise specified, refer to loans or debt obligations of the entity on whom the claim is held. Assets in the form of stock or equity holdings in commercial or fi nancial firms are assigned to the 100 percent risk category, unless some other treatment is explicitly permitted. B. Collateral, Guarantees, and Other Considerations 1. Collateral. The only forms of collateral that are formally recognized by the risk-based capital framework are cash on deposit in a 24 An investment in shares of a fund whose portfolio consists solely of various securities or money market instru ments that, if held separately, would be assigned to differ ent risk categories, is generally assigned to the risk category a p p ro p riate to th e highest risk-w eighted secu rity o r in stru ment that the fund is permitted to hold in accordance with its stated investment objectives. However, in no case will indirect holdings through shares in such funds be assigned to the zero percent risk category. For example, if a fund is permitted to hold U.S. Treasuries and commercial paper, shares in that fund would generally be assigned the 100 percent risk weight appropriate to commercial paper, re gardless of the actual composition of the fund’s investments at any particular time. Shares in a fund that may invest only in U.S. Treasury securities would generally be as signed to the 20 percent risk category. If, in order to main tain a necessary degree of short-term liquidity, a fund is permitted to hold an insignificant amount of its assets in short-term, highly liquid securities of superior credit quali ty that do not qualify for a preferential risk weight, such securities will generally not be taken into account in deter mining the risk category into which the banking organiza tion’s holding in the overall fund should be assigned. Re gardless of the composition of the fund’s securities, if the fund engages in any activities that appear speculative in nature (for example, use of futures, forwards, or option contracts for purposes other than to reduce interest rate risk) or has any other characteristics that are inconsistent with the preferential risk weighting assigned to the fund’s investments, holdings in the fund willl be assigned to the 100 percent risk category. During the examination process, the treatment of shares in such funds that are assigned to a lower risk weight will be subject to examiner review to en sure that they have been assigned an appropriate risk weight. 35 Regulation Y, Appendix A subsidiary lending institution; securities issued or guaranteed by the central governments of the OECD-based group of countries,25 U.S. government agencies, or U.S. governmentsponsored agencies; and securities issued by multilateral lending institutions or regional development banks. Claims fully secured by such collateral are assigned to the 20 percent risk category. The extent to which qualifying securities are recognized as collateral is determined by their current market value. If a claim is only partially secured, that is, the market value of the pledged securities is less than the face amount of a balance-sheet asset or an offbalance-sheet item, the portion that is covered by the market value of qualifying collateral is assigned to the 20 percent risk category, and the portion of the claim that is not covered by collateral in the form of cash or a qualifying security is assigned to the risk category appro priate to the obligor or, if relevant, the guar antor. For example, to the extent that a claim on a private-sector obligor is collateralized by the current market value of U.S. government securities, it would be placed in the 20 percent risk category and the balance would be as signed to the 100 percent risk category. 2. Guarantees. Guarantees of the OECD and non-OECD central governments, U.S. govern ment agencies, U.S. government-sponsored agencies, state and local governments of the OECD-based group of countries, multilateral lending institutions and regional development banks, U.S. depository institutions, and for eign banks are also recognized. If a claim is partially guaranteed, that is, coverage of the guarantee is less than the face amount of a balance-sheet asset or an off-balance-sheet item, the portion that is not fully covered by Capital Adequacy Guidelines the guarantee is assigned to the risk category appropriate to the obligor or, if relevant, to any collateral. The face amount of a claim covered by two types of guarantees that have different risk weights, such as a U.S. govern ment guarantee and a state guarantee, is to be apportioned between the two risk categories appropriate to the guarantors. The existence of other forms of collateral or guarantees that the risk-based capital frame work does not formally recognize may be tak en into consideration in evaluating the risks inherent in an organization’s loan portfolio— which, in turn, would affect the overall super visory assessment of the organization’s capital adequacy. 3. Mortgage-backed securities. Mortgagebacked securities, including pass-throughs and collateralized mortgage obligations (but not stripped mortgage-backed securities), that are issued or guaranteed by a U.S. government agency or U.S. government-sponsored agency are assigned to the risk-weight category appropriate to the issuer or guarantor. Gener ally, a privately issued mortgage-backed secu rity meeting certain criteria set forth in the accompanying footnote26*is treated as essen tially an indirect holding of the underlying as sets, and is assigned to the same risk category as the underlying assets, but in no case to the zero percent risk category. Privately issued mortgage-backed securities whose structures 26 A privately issued mortgage-backed security may be treated as an indirect holding of the underlying assets pro vided that (1) the underlying assets are held by an inde pendent trustee and the trustee has a first priority, perfect ed security interest in the underlying assets on behalf of the holders of the security; (2) either the holder of the security has an undivided pro rata ownership interest in the under lying mortgage assets or the trust or single-purpose entity (or conduit) that issues the security has no liabilities unre lated to the issued securities; (3) the security is structured such that the cash flow from the underlying assets in all cases fully meets the cash-flow requirements of the security 25 The OECD-based group of countries comprises all full without undue reliance on any reinvestment income; and members of the Organization for Economic Cooperation (4) there is no material reinvestment risk associated with any funds awaiting distribution to the holders of the securi and Development (OECD), as well as countries that have ty. In addition, if the underlying assets of a mortgageconcluded special lending arrangements with the Interna tional Monetary Fund (IM F) associated with the Fund’s backed security are composed of more than one type of asset, for example, U.S. government-sponsored agency se General Arrangements to Borrow. The OECD includes the curities and privately issued pass-through securities that following countries: Australia, Austria, Belgium, Canada, qualify for the 50 percent risk weight category, the entire Denmark, the Federal Republic of Germany, Finland, mortgage-backed security is generally assigned to the cate France, Greece, Iceland, Ireland, Italy, Japan, Luxem gory appropriate to the highest risk-weighted asset underly bourg, Netherlands, New Zealand, Norway, Portugal, ing the issue, but in no case to the zero percent risk catego Spain, Sweden, Switzerland, Turkey, the United Kingdom, ry. Thus, in this example, the security would receive the 50 and the United States. Saudi Arabia has concluded special percent risk weight appropriate to the privately issued pass lending arrangements with the IMF associated with the Fund’s General Arrangements to Borrow. through securities. 36 Capital Adequacy Guidelines do not qualify them to be regarded as indirect holdings of the underlying assets are assigned to the 100 percent risk category. During the inspection process, privately issued mortgagebacked securities that are assigned to a lower risk-weight category will be subject to examin er review to ensure that they meet the appro priate criteria. While the risk category to which mortgagebacked securities are assigned will generally be based upon the issuer or guarantor or, in the case of privately issued mortgage-backed securities, the assets underlying the security, any class of a mortgage-backed security that can absorb more than its pro rata share of loss without the whole issue being in default (for example, a so-called subordinated class or re sidual interest), is assigned to the 100 percent risk category. Furthermore, all stripped mort gage-backed securities, including interest-only strips (IOs), principal-only strips (POs), and similar instruments, are also assigned to the 100 percent risk-weight category, regardless of the issuer or guarantor. 4. Maturity. Maturity is generally not a factor in assigning items to risk categories with the exception of claims on non-OECD banks, commitments, and interest-rate and foreignexchange-rate contracts. Except for commit ments, short-term is defined as one year or less remaining maturity and long-term is de fined as over one year remaining maturity. In the case of commitments, short-term is de fined as one year or less original maturity and long-term is defined as over one year original maturity.27 Regulation Y, Appendix A institutions or in transit and gold bullion held in either a subsidiary depository institution’s own vaults or in another’s vaults on an allo cated basis, to the extent it is offset by gold bullion liabilities.28 The category also includes all direct claims (including securities, loans, and leases) on, and the portions of claims that are directly and unconditionally guaranteed by, the central governments29 of the OECD countries and U.S. government agencies,30 as well as all direct local currency claims on, and the portions of local currency claims that are directly and unconditionally guaranteed by, the central governments of non-OECD coun tries, to the extent that subsidiary depository institutions have liabilities booked in that cur rency. A claim is not considered to be uncon ditionally guaranteed by a central government if the validity of the guarantee is dependent upon some affirmative action by the holder or a third party. Generally, securities guaranteed by the U.S. government or its agencies that are actively traded in financial markets, such as GNMA securities, are considered to be un conditionally guaranteed. 2. Category 2: 20 percent. This category in cludes cash items in the process of collection, both foreign and domestic; short-term claims (including demand deposits) on, and the por 28 All other holdings of bullion are assigned to the 100 percent risk category. 29 A central government is defined to include depart ments and ministries, including the central bank, of the central government. The U.S. central bank includes the 12 Federal Reserve Banks, and stock held in these banks as a condition of membership is assigned to the zero percent risk category. The definition of central government does not include state, provincial, or local governments; or com mercial enterprises owned by the central government. In addition, it does not include local government entities or C. Risk Weights commercial enterprises whose obligations are guaranteed by the central government, although any claims on such Attachment III contains a listing of the risk entities guaranteed by central governments are placed in categories, a summary of the types of assets the same general risk category as other claims guaranteed by central governments. OECD central governments are assigned to each category and the risk weight defined as central governments of the OECD-based group associated with each category, that is, 0 per o f countries; non-OECD central governments are defined cent, 20 percent, 50 percent, and 100 percent. as central governments of countries that do not belong to the OECD-based group of countries. A brief explanation of the components of each 30 A U.S. government agency is defined as an instrumen tality of the U.S. government whose obligations are fully category follows. and explicitly guaranteed as to the timely payment of prin 1. Category 1: zero percent. This category in cipal and interest by the full faith and credit of the U.S. cludes cash (domestic and foreign) owned government. Such agencies include the Government Na tional Mortgage Association (G N M A ), the Veterans Ad and held in all offices of subsidiary depository ministration (V A ), the Federal Housing Administration (F H A ), the Export-Import Bank (Exim Bank), the Over 27 Through year-end 1992, remaining, rather than origiseas Private Investment Corporation (OPIC), the Com nal, maturity may be used for determining the maturity of modity Credit Corporation (CCC), and the Small Business commitments. Administration (SBA). 37 Regulation Y, Appendix A tions of short-term claims that are guaranteed by,31 U.S. depository institutions32 and for eign banks;33 and long-term claims on, and the portions of long-term claims that are guar anteed by, U.S. depository institutions and OECD banks.34 This category also includes the portions of claims that are conditionally guaranteed by OECD central governments and U.S. govern ment agencies, as well as the portions of local currency claims that are conditionally guaran teed by non-OECD central governments, to the extent that subsidiary depository institu tions have liabilities booked in that currency. In addition, this category also includes claims on, and the portions of claims that are guaran teed by, U.S. government-sponsored agen cies35 and claims on, and the portions of 31 Claims guaranteed by U.S. depository institutions and foreign banks include risk participations in both banker’s acceptances and standby letters of credit, as well as partici pations in commitments, that are conveyed to U.S. deposi tory institutions or foreign banks. 32 U.S. depository institutions are defined to include branches (foreign and domestic) of federally insured banks and depository institutions chartered and headquartered in the 50 states of the United States, the District of Columbia, Puerto Rico, and U.S. territories and possessions. The defi nition encompasses banks, mutual or stock savings banks, savings or building and loan associations, cooperative banks, credit unions, and international banking facilities of domestic banks. U.S.-chartered depository institutions owned by foreigners are also included in the definition. However, branches and agencies of foreign banks located in the U.S., as well as all bank holding companies, are excluded. 33 Foreign banks are distinguished as either OECD banks or non-OECD banks. OECD banks include banks and their branches (foreign and domestic) organized under the laws o f countries (other than the U .S.) that belong to the OECD-based group of countries. Non-OECD banks in clude banks and their branches (foreign and domestic) or ganized under the laws of countries that do not belong to the OECD-based group of countries. For this purpose, a bank is defined as an institution that engages in the business of banking; is recognized as a bank by the bank supervisory or monetary authorities of the country of its organization or principal banking operations; receives deposits to a sub stantial extent in the regular course o f business; and has the power to accept demand deposits. Claims on, and the por tions o f claims that are guaranteed by, a non-OECD central bank are treated as claims on, or guaranteed by, a nonOECD bank, except for local currency claims on, and the portions o f local currency claims that are guaranteed by, a non-OECD central bank that are funded in local-currency liabilities. The latter claims are assigned to the zero percent risk category. 34 Long-term claims on, or guaranteed by, non-OECD banks and all claims on bank holding companies are as signed to the 100 percent risk category, as are holdings of bank-issued securities that qualify as capital o f the issuing banks. 35 For this purpose, U.S. government-sponsored agen cies are defined as agencies originally established or char- 38 Capital Adequacy Guidelines claims guaranteed by, the International Bank for Reconstruction and Development (World Bank), the Interamerican Development Bank, the Asian Development Bank, the African Development Bank, the European Investment Bank, and other multilateral lending institu tions or regional development banks in which the U.S. government is a shareholder or con tributing member. General obligation claims on, or portions of claims guaranteed by the full faith and credit of, states or other political subdivisions of the United States or other countries of the OECD-based group are also assigned to this category.36 This category also includes the portions of claims (including repurchase agreements) collateralized by cash on deposit in the subsid iary lending institution; by securities issued or guaranteed by OECD central governments, U.S. government agencies or U.S. govern ment-sponsored agencies; or by securities is sued by multilateral lending institutions or re gional development banks in which the U.S. government is a shareholder or contributing member. 3. Category 3: 50 percent. This category in cludes loans fully secured by first liens37 on one- to four-family residential properties,38 ei ther owner-occupied or rented, provided that such loans have been made in accordance with prudent underwriting standards, includ ing a conservative loan-to-value ratio;39 are tered by the federal government to serve public purposes specified by the U.S. Congress but whose obligations are n o t e x p lic itly guaranteed by the full faith and credit of the U.S. government. These agencies include the Federal Home Loan Mortgage Corporation (FHLM C), the Federal Na tional Mortgage Association (F N M A ), the Farm Credit System, the Federal Home Loan Bank System, and the Stu dent Loan Marketing Association (SLM A). Claims on U.S. government-sponsored agencies include capital stock in a Federal Home Loan Bank that is held as a condition of membership in that Bank. 36 Claims on, or guaranteed by, states or other political subdivisions of countries that do not belong to the OECDbased group of countries are placed in the 100 percent risk category. 37 If a banking organization holds the first and junior lien(s) on a residential property and no other party holds an intervening lien, the transaction is treated as a single loan secured by a first lien for the purpose of determining the loan-to-value ratio. 38 The types of properties that qualify as one- to fourfamily residences are listed in the instructions to the FR Y9C Report. 39 The loan-to-value ratio is based upon the most current appraised value of the property. All the appraisals must be made in a manner consistent with the federal banking agen cies’ real estate appraisal guidelines and with the banking organization’s own appraisal guidelines. Capital Adequacy Guidelines performing in accordance with their original terms; and are not 90 days or more past due or carried in nonaccrual status.40 Also includ ed in this category are privately issued mort gage-backed securities provided that (1) the structure of the security meets the criteria de scribed in section 111(B)(3) above; (2) if the security is backed by a pool of conventional mortgages, each underlying mortgage meets the criteria described above in this section for eligibility for the 50 percent risk-weight cate gory at the time the pool is originated; and (3) if the security is backed by privately is sued mortgage-backed securities, each under lying security qualifies for the 50 percent risk category. Privately issued mortgage-backed securities that do not meet these criteria or that do not qualify for a lower risk weight are generally assigned to the 100 percent riskweight category. Also assigned to this category are revenue (nongeneral obligation) bonds or similar obli gations, including loans and leases, that are obligations of states or other political subdivi sions of the United States (for example, mu nicipal revenue bonds) or other countries of the OECD-based group, but for which the government entity is committed to repay the debt with revenues from the specific projects financed, rather than from general tax funds. Credit-equivalent amounts of interest-rate and foreign-exchange-rate contracts involving standard risk obligors (that is, obligors whose loans or debt securities would be assigned to the 100 percent risk category) are included in the 50 percent category, unless they are backed by collateral or guarantees that allow them to be placed in a lower risk category. Regulation Y, Appendix A claims on non-OECD central governments that entail some degree of transfer risk.41 This category also includes all claims on foreign and domestic private-sector obligors not in cluded in the categories above (including loans to nondepository financial institutions and bank holding companies); claims on com mercial firms owned by the public sector; cus tomer liabilities to the bank on acceptances outstanding involving standard risk claims;42* investments in fixed assets, premises, and oth er real estate owned; common and preferred stock of corporations, including stock ac quired for debts previously contracted; commercial and consumer loans (except those assigned to lower risk categories due to recog nized guarantees or collateral and loans for residential property that qualify for a lower risk weight); mortgage-backed securities that do not meet criteria for assignment to a lower risk weight (including any classes of mort gage-backed securities that can absorb more than their pro rata share of loss without the whole issue being in default); and all stripped mortgage-backed and similar securities. Also included in this category are industri al-development bonds and similar obligations issued under the auspices of states or political subdivisions of the OECD-based group of countries for the benefit of a private party or enterprise where that party or enterprise, not the government entity, is obligated to pay the principal and interest, and all obligations of states or political subdivisions of countries that do not belong to the OECD-based group. The following assets also are assigned a risk weight of 100 percent if they have not been deducted from capital: investments in uncon solidated companies, joint ventures, or associ- 4. Category 4: 100 percent. All assets not in cluded in the categories above are assigned to this category, which comprises standard risk assets. The bulk of the assets typically found in a loan portfolio would be assigned to the 100 percent category. This category includes long-term claims on, and the portions of long-term claims that are guaranteed by, non-OECD banks, and all 41 Such assets include all nonlocal-currency claims on, and the portions of claims that are guaranteed by, nonOECD central governments and those portions of localcurrency claims on, or guaranteed by, non-OECD central governments that exceed the local-currency liabilities held by subsidiary depository institutions. 42 Customer liabilities on acceptances outstanding in volving nonstandard risk claims, such as claims on U.S. depository institutions, are assigned to the risk category appropriate to the identity of the obligor or, if relevant, the nature of the collateral or guarantees backing the claims. Portions of acceptances conveyed as risk participations to 40 Residential property loans that do not meet all theU.S. depository institutions or foreign banks are assigned to the 20 percent risk category appropriate to short-term specified criteria or that are made for the purpose of specu claims guaranteed by U.S. depository institutions and for lative property development are placed in the 100 percent risk category. eign banks. 39 Regulation Y, Appendix A ated companies; instruments that qualify as capital issued by other banking organizations; and any intangibles, including grandfathered goodwill. D. Off-Balance-Sheet Items The face amount of an off-balance-sheet item is incorporated into the risk-based capital ra tio by multiplying it by a credit-conversion factor. The resultant credit-equivalent amount is assigned to the appropriate risk category ac cording to the obligor, or, if relevant, the guarantor or the nature of the collateral.43 At tachment IV sets forth the conversion factors for various types of off-balance-sheet items. 1. Items with a 100 percent conversion factor. A 100 percent conversion factor applies to di rect credit substitutes, which include guaran tees, or equivalent instruments, backing finan cial claims, such as outstanding securities, loans, and other financial liabilities, or that back off-balance-sheet items that require capi tal under the risk-based capital framework. Direct credit substitutes include, for example, financial standby letters of credit, or other equivalent irrevocable undertakings or surety arrangements, that guarantee repayment of fi nancial obligations such as commercial paper, tax-exempt securities, commercial or individ ual loans or debt obligations, or standby or commercial letters of credit. Direct credit sub stitutes also include the acquisition of risk participations in banker’s acceptances and standby letters of credit, since both of these transactions, in effect, constitute a guarantee by the acquiring banking organization that the underlying account party (obligor) will repay its obligation to the originating, or issu ing, institution.44 (Standby letters of credit that are performance-related are discussed be low and have a credit-conversion factor of 50 percent.) 43 The sufficiency of collateral and guarantees for offbalance-sheet items is determined by the market value of the collateral or the amount of the guarantee in relation to the face amount of the item, except for interest- and for eign-exchange-rate contracts, for which this determination is made in relation to the credit-equivalent amount. Collat eral and guarantees are subject to the same provisions not ed under section III(B ). 44 Credit-equivalent amounts of acquisitions of risk par ticipations are assigned to the risk category appropriate to the account-party obligor, or, if relevant, the nature of the collateral or guarantees. 40 Capital Adequacy Guidelines The full amount of a direct credit substitute is converted at 100 percent and the resulting credit-equivalent amount is assigned to the risk category appropriate to the obligor or, if relevant, the guarantor or the nature of the collateral. In the case of a direct credit substi tute in which a risk participation45 has been conveyed, the full amount is still converted at 100 percent. However, the credit-equivalent amount that has been conveyed is assigned to whichever risk category is lower: the risk cate gory appropriate to the obligor, after giving effect to any relevant guarantees or collateral, or the risk category appropriate to the institu tion acquiring the participation. Any remain der is assigned to the risk category appropri ate to the obligor, guarantor, or collateral. For example, the portion of a direct credit substi tute conveyed as a risk participation to a U.S. domestic depository institution or foreign bank is assigned to the risk category appropri ate to claims guaranteed by those institutions, that is, the 20 percent risk category.46 This approach recognizes that such conveyances replace the originating banking organization’s exposure to the obligor with an exposure to the institutions acquiring the risk participations.47* In the case of direct credit substitutes that take the form of a syndication, that is, where each banking organization is obligated only for its pro rata share of the risk and there is no recourse to the originating banking organiza tion, each banking organization will only in clude its pro rata share of the direct credit substitute in its risk-based capital calculation. Financial standby letters of credit are dis tinguished from loan commitments (discussed below) in that standbys are irrevocable obli gations of the banking organization to pay a third-party beneficiary when a customer (ac 45 That is, a participation in which the originating bank ing organization remains liable to the beneficiary for the full amount of the direct credit substitute if the party that has acquired the participation fails to pay when the instru ment is drawn. 46 Risk participations with a remaining maturity of over one year that are conveyed to non-OECD banks are to be assigned to the 100 percent risk category, unless a lower risk category is appropriate to the obligor, guarantor, or collateral. 47 A risk participation in banker’s acceptances conveyed to other institutions is also assigned to the risk category appropriate to the institution acquiring the participation or, if relevant, the guarantor or nature of the collateral. Capital Adequacy Guidelines count party) fails to repay an outstanding loan or debt instrument (direct credit substitute). Performance standby letters of credit (per formance bonds) are irrevocable obligations of the banking organization to pay a thirdparty beneficiary when a customer (account party) fails to perform some other contractual nonfinancial obligation. The distinguishing characteristic of a stand by letter of credit for risk-based capital pur poses is the combination of irrevocability with the fact that funding is triggered by some fail ure to repay or perform an obligation. Thus, any commitment (by whatever name) that in volves an irrevocable obligation to make a payment to the customer or to a third party in the event the customer fails to repay an out standing debt obligation or fails to perform a contractual obligation is treated, for riskbased capital purposes, as respectively, a fi nancial guarantee standby letter of credit or a performance standby. A loan commitment, on the other hand, in volves an obligation (with or without a mate rial adverse change or similar clause) of the banking organization to fund its customer in the normal course of business should the cus tomer seek to draw down the commitment. Sale and repurchase agreements and asset sales with recourse (to the extent not included on the balance sheet) and forward agreements also are converted at 100 percent.48 So-called “loan strips” (that is, short-term advances sold under long-term commitments without direct recourse) are treated for risk-based capital purposes as assets sold with recourse and, accordingly, are also converted at 100 percent. Forward agreements are legally binding contractual obligations to purchase assets with certain drawdown at a specified future date. Such obligations include forward pur Regulation Y, Appendix A chases, forward forward deposits placed,* 49 0 1 and partly paid shares and securities; they do not include commitments to make residential mortgage loans or forward foreign-exchange contracts. Securities lent by a banking organization are treated in one of two ways, depending upon whether the lender is at risk of loss. If a banking organization, as agent for a customer, lends the customer’s securities and does not indemnify the customer against loss, then the transaction is excluded from the risk-based capital calculation. If, alternatively, a banking organization lends its own securities or, acting as agent for a customer, lends the customer’s securities and indemnifies the customer against loss, the transaction is converted at 100 percent and assigned to the risk-weight category appropriate to the obligor, to any collateral delivered to the lending banking or ganization, or, if applicable, to the indepen dent custodian acting on the lender’s behalf. 2. Items with a 50 percent conversion factor. Transaction-related contingencies are convert ed at 50 percent. Such contingencies include bid bonds, performance bonds, warranties, standby letters of credit related to particular transactions, and performance standby letters of credit, as well as acquisitions of risk partici pations in performance standby letters of credit. Performance standby letters of credit represent obligations backing the performance of nonfinancial or commercial contracts or undertakings. To the extent permitted by law or regulation, performance standby letters of credit include arrangements backing, among other things, subcontractors’ and suppliers’ performance, labor and materials contracts, and construction bids. The unused portion of commitments with an original maturity exceeding one year,50*in cluding underwriting commitments, and com mercial and consumer credit commitments also are converted at 50 percent. Original ma turity is defined as the length of time between the date the commitment is issued and the 48 In regulatory reports and under GAAP, bank holding companies are permitted to treat some asset sales with re course as “true” sales. For risk-based capital purposes, however, such assets sold with recourse and reported as “true” sales by bank holding companies are converted at 100 percent and assigned to the risk category appropriate to the underlying obligor, or, if relevant, the guarantor or 49 Forward forward deposits accepted are treated as nature of the collateral, provided that the transactions meet interest-rate contracts. the definition of assets sold with recourse, including the sale 50 Through year-end 1992, remaining maturity may be of one- to four-family residential mortgages, that is con used for determining the maturity of off-balance-sheet loan tained in the instructions to the commercial bank Consoli commitments; thereafter, original maturity must be used. dated Reports of Condition and Income (call report). 41 Regulation Y, Appendix A earliest date on which (1) the banking organi zation can, at its option, unconditionally (without cause) cancel the commitment51 and (2) the banking organization is scheduled to (and as a normal practice actually does) review the facility to determine whether or not it should be extended. Such reviews must continue to be conducted at least annually for such a facility to qualify as a short-term commitment. Commitments are defined as any legally binding arrangements that obligate a banking organization to extend credit in the form of loans or leases; to purchase loans, securities, or other assets; or to participate in loans and leases. They also include overdraft facilities, revolving credit, home equity and mortgage lines of credit, and similar transactions. Nor mally, commitments involve a written con tract or agreement and a commitment fee, or some other form of consideration. Commit ments are included in weighted-risk assets re gardless of whether they contain “material ad verse change” clauses or other provisions that are intended to relieve the issuer of its funding obligation under certain conditions. In the case of commitments structured as syndica tions, where the banking organization is obli gated solely for its pro rata share, only the banking organization’s proportional share of the syndicated commitment is taken into ac count in calculating the risk-based capital ratio. Facilities that are unconditionally cancella ble (without cause) at any time by the bank ing organization are not deemed to be com mitments, provided the banking organization makes a separate credit decision before each drawing under the facility. Commitments with an original maturity of one year or less are deemed to involve low risk and, therefore, are not assessed a capital charge. Such short term commitments are defined to include the unused portion of lines of credit on retail credit cards and related plans (as defined in the instructions to the FR Y-9C Report) if Capital Adequacy Guidelines the banking organization has the uncondition al right to cancel the line of credit at any time, in accordance with applicable law. Once a commitment has been converted at 50 percent, any portion that has been con veyed to U.S. depository institutions or OECD banks as participations in which the originating banking organization retains the full obligation to the borrower if the partici pating bank fails to pay when the instrument is drawn, is assigned to the 20 percent risk category. This treatment is analogous to that accorded to conveyances of risk participations in standby letters of credit. The acquisition of a participation in a commitment by a banking organization is converted at 50 percent and assigned to the risk category appropriate to the account-party obligor or, if relevant, the nature of the collateral or guarantees. Revolving underwriting facilities (RUFs), note-issuance facilities (NIFs), and other similar arrangements also are converted at 50 percent regardless of maturity. These are fa cilities under which a borrower can issue on a revolving basis short-term paper in its own name, but for which the underwriting organi zations have a legally binding commitment ei ther to purchase any notes the borrower is un able to sell by the roll-over date or to advance funds to the borrower. 3. Items with a 20 percent conversion factor. Short-term, self-liquidating, trade-related con tingencies which arise from the movement of goods are converted at 20 percent. Such con tingencies generally include commercial let ters of credit and other documentary letters of credit collateralized by the underlying shipments. 4. Items with a zero percent conversion factor. These include unused portions of commit ments with an original maturity of one year or less,52*or which are unconditionally cancella ble at any time, provided a separate credit de cision is made before each drawing under the facility. Unused portions of lines of credit on retail credit cards and related plans are 51 In the case of consumer home equity or mortgage lines deemed to be short-term commitments if the of credit secured by liens on one- to four-family residential properties, the bank is deemed able to unconditionally can cel the commitment for the purpose o f this criterion if, at its option, it can prohibit additional extensions of credit, reduce the credit line, and terminate the commitment to the full extent permitted by relevant federal law. 42 52 Through year-end 1992, remaining maturity may be used for determining term to maturity for off-balance-sheet loan commitments; thereafter, original maturity must be used. Regulation Y, Appendix A Capital Adequacy Guidelines banking organization has the unconditional right to cancel the line of credit at any time, in accordance with applicable law. E. Interest-Rate and Foreign-Exchange-Rate Contracts 1. Scope. Credit-equivalent amounts are com puted for each of the following off-balancesheet interest-rate and foreign-exchange-rate instruments: I. Interest-rate contracts A. Single-currency interest-rate swaps B. Basis swaps C. Forward-rate agreements D. Interest-rate options purchased (in cluding caps, collars, and floors purchased) E. Any other instrument that gives rise to similar credit risks (including whenissued securities and forward forward deposits accepted) II. Exchange-rate contracts A. Cross-currency interest rate swaps B. Forward foreign-exchange contracts C. Currency options purchased D. Any other instrument that gives rise to similar credit risks Exchange-rate contracts with an original ma turity of 14 calendar days or less and instru ments traded on exchanges that require daily payment of variation margin are excluded from the risk-based ratio calculation. Overthe-counter options purchased, however, are included and treated in the same way as the other interest-rate and exchange-rate contracts. 2. Calculation o f credit-equivalent amounts. Credit-equivalent amounts are calculated for each individual contract of the types listed above. To calculate the credit-equivalent amount of its off-balance-sheet interest-rate and exchange-rate instruments, a banking or ganization sums these amounts: 2. an estimate of the potential future credit exposure over the remaining life of each contract. The potential future credit exposure on a contract, including contracts with negative mark-to-market values, is estimated by multi plying the notional principal amount by one of the following credit conversion factors, as appropriate: Remaining maturity One year or less Over one year Interest-rate contracts -0 0.5% Exchange-rate contracts 1.0% 5.0% Examples of the calculation of credit-equiva lent amounts for these instruments are con tained in attachment V. Because exchange-rate contracts involve an exchange of principal upon maturity, and ex change rates are generally more volatile than interest rates, higher conversion factors have been established for foreign-exchange con tracts than for interest-rate contracts. No potential future credit exposure is calcu lated for single-currency interest-rate swaps in which payments are made based upon two floating rate indices, so-called floating/floating or basis swaps; the credit exposure on these contracts is evaluated solely on the basis of their mark-to-market values. 3. Risk weights. Once the credit-equivalent amount for interest-rate and exchange-rate in struments has been determined, that amount is assigned to the risk-weight category appro priate to the counterparty, or, if relevant, the nature of any collateral or guarantees.54* How ever, the maximum weight that will be applied to the credit-equivalent amount of such in struments is 50 percent. 4. Avoidance o f double-counting. In certain cases, credit exposures arising from the inter est-rate and exchange instruments covered by these guidelines may already be reflected, in part, on the balance sheet. To avoid double counting such exposures in the assessment of 1. the mark-to-market value53 (positive val capital adequacy and, perhaps, assigning inap ues only) of each contract (that is, the cur rent exposure); and 54 For interest- and exchange-rate contracts, sufficiency o f collateral or guarantees is determined by the market 53 Mark-to-market values are measured in dollars, revalue of the collateral or the amount of the guarantee in relation to the credit-equivalent amount. Collateral and gardless o f the currency or currencies specified in the con guarantees are subject to the same provisions noted under tract, and should reflect changes in both interest rates and section III(B ). counterparty credit quality. 43 Regulation Y, Appendix A propriate risk weights, counterparty credit ex posures arising from the types of instruments covered by these guidelines may need to be excluded from balance-sheet assets in calcu lating banking organizations’ risk-based capi tal ratios. Capital Adequacy Guidelines organization. In addition, such organizations should avoid any actions, including increased risk-taking or unwarranted expansion, that would lower or further erode their capital positions. A. Minimum Risk-Based Ratio After 5. Netting. Netting of swaps and similar Transition Period contracts is recognized for purposes of calcu lating the risk-based capital ratio only when As reflected in attachment VI, by year-end accomplished through netting by novation.55 1992, all bank holding companies56 should While the Federal Reserve encourages any meet a minimum ratio of qualifying total capi reasonable arrangements designed to reduce tal to weighted-risk assets of 8 percent, of the risks inherent in these transactions, other which at least 4.0 percentage points should be types of netting arrangements are not recog in the form of tier 1 capital. (Section II above nized for purposes of calculating the risk- contains detailed definitions of capital and re lated terms used in this section.) The maxi based ratio at this time. mum amount of supplementary capital ele ments that qualifies as tier 2 capital is limited to 100 percent of tier 1 capital net of goodwill. IV. Minimum Supervisory Ratios and In addition, the combined maximum amount Standards of subordinated debt and intermediate-term The interim and final supervisory standards preferred stock that qualifies as tier 2 capital set forth below specify minimum supervisory is limited to 50 percent of tier 1 capital net of ratios based primarily on broad credit-risk goodwill. The maximum amount of the allow considerations. As noted above, the risk-based ance for loan and lease losses that qualifies as ratio does not take explicit account of the tier 2 capital is limited to 1.25 percent of gross quality of individual asset portfolios or the weighted-risk assets. Allowances for loan and range of other types of risks to which banking lease losses in excess of this limit may, of organizations may be exposed, such as inter course, be maintained, but would not be in est-rate, liquidity, market, or operational cluded in an organization’s total capital. The risks. For this reason, banking organizations Federal Reserve will continue to require bank are generally expected to operate with capital holding companies to maintain reserves at lev positions well above the minimum ratios. This els fully sufficient to cover losses inherent in is particularly true for institutions that are un their loan portfolios. dertaking significant expansion or that are ex Qualifying total capital is calculated by posed to high or unusual levels of risk. adding tier 1 capital and tier 2 capital (limited Upon adoption of the risk-based frame to 100 percent of tier 1 capital) and then de work, any organization that does not meet the ducting from this sum certain investments in interim or final supervisory ratios, or whose banking or finance subsidiaries that are not capital is otherwise considered inadequate, is consolidated for accounting or supervisory expected to develop and implement a plan ac purposes, reciprocal holdings of banking orga ceptable to the Federal Reserve for achieving nizations’ capital securities, or other items at an adequate level of capital consistent with the direction of the Federal Reserve. The con the provisions of these guidelines or with the ditions under which these deductions are to be special circumstances affecting the individual made and the procedures for making the de ductions are discussed above in section II(B ). 55 Netting by novation, for this purpose, is a written bi lateral contract between two counterparties under which any obligation to each other to deliver a given currency on 56 As noted in section I above, bank holding companies a given date is automatically amalgamated with all other with less than $150 million in consolidated assets would generally be exempt from the calculation and analysis of obligations for the same currency and value date, le g a lly substituting one single net amount for the previous gross risk-based ratios on a consolidated holding company basis, subject to certain terms and conditions. obligations. 44 Capital Adequacy Guidelines Regulation Y, Appendix A B. Transition Arrangements The transition period for implementing the risk-based capital standard ends on December 31, 1992.57 Initially, the risk-based capital guidelines do not establish a minimum level of capital. However, by year-end 1990, banking organizations are expected to meet a mini mum interim target ratio for qualifying total capital to weighted-risk assets of 7.25 percent, at least one-half of which should be in the form of tier 1 capital. For purposes of meeting the 1990 interim target, the amount of loanloss reserves that may be included in capital is limited to 1.5 percent of weighted-risk assets and up to 10 percent of an organization’s tier 1 capital may consist of supplementary capital elements. Thus, the 7.25 percent interim tar get ratio implies a minimum ratio of tier 1 capital to weighted-risk assets of 3.6 percent (one-half of 7.25) and a minimum ratio of core capital elements to weighted-risk assets ratio of 3.25 percent (nine-tenths of the tier 1 capital ratio). 57 The Basle capital framework does not establish an ini tial minimum standard for the risk-based capital ratio be fore the end of 1990. However, for the purpose of calculat ing a risk-based capital ratio prior to year-end 1990, no sublimit is placed on the amount of the allowance for loan and lease losses includable in tier 2. In addition, this frame work permits, under temporary transition arrangements, a certain percentage o f an organization’s tier 1 capital to be made up of supplementary capital elements. In particular, supplementary elements may constitute 25 percent o f an organization’s tier 1 capital (before the deduction of good will) up to the end of 1990; from year-end 1990 up to the end of 1992, this allowable percentage of supplementary elements in tier 1 declines to 10 percent of tier 1 (before the deduction of goodwill). Beginning on December 31, 1992, supplementary elements may not be included in tier 1. The amount of subordinated debt and intermediate-term pre ferred stock temporarily included in tier 1 under these ar rangements will not be subject to the sublimit on the amount of such instruments includable in tier 2 capital. While the transitional arrangements allow an organization to include supplementary elements in tier 1 on a temporary basis, the amount of perpetual preferred stock that may be included in a bank holding company’s tier 1— both during and after the transition period—is, as described in section 11(A), based solely upon a specified percentage o f the orga nization’s permanent core capital elements (that is, com mon equity, perpetual preferred stock, and minority inter est in the equity o f consolidated subsidiaries), not upon total tier 1 elements that temporarily include tier 2 items. Once the amount of supplementary items that may tempo rarily qualify as tier 1 elements is determined, goodwill must be deducted from the sum of this amount and the amount of the organization’s permanent core capital ele ments for the purpose o f calculating tier 1 (net o f good will), tier 2, and total capital. 45 Regulation Y, Appendix A Capital Adequacy Guidelines Attachment I—Sample Calculation of Risk-Based Capital Ratio for Bank Holding Companies Example of a banking organization with $6,000 in total capital and the following assets and off-balance-sheet items: Balance-sheet assets Cash U.S. Treasuries Balances at domestic banks $ 5,000 20,000 5,000 Loans secured by first liens on 1- to 4-family residential properties Loans to private corporations 5,000 65,000 Total Balance-Sheet Assets $ 100,000 Off-balance-sheet items Standby letters of credit (SLCs) backing generalobligation debt issues of U.S. municipalities (GOs) $ 10,000 Long-term legally binding commitments to private corporations 20,000 Total Off-Balance-Sheet Items $ 30,000 This bank holding company’s total capital to total assets (leverage ratio would be: ($6,000/5100,000) = 6.00%. To compute the bank holding company’s weighted-risk assets: 1. Compute the credit-equivalent amount of each off-balance-sheet (OBS) item. OBS item Conversion factor Face value Creditequivalent amount SLCs backing municipal GOs $10,000 X 1.00 = $10,000 Long-term commitments to private corporations $20,000 X 0.50 = $10,000 Table continued 46 Capital Adequacy Guidelines Regulation Y, Appendix A 2. Multiply each balance-sheet asset and the credit-equivalent amount of each OBS item by the appropriate risk weight. OBS item 0% category Cash U.S. Treasuries Conversion factor Face value Creditequivalent amount $ 5,000 20,000 $25,000 Credit-equivalent amounts of SLCs backing GOs of U.S. municipalities 0 = 0 $15,000 20% category Balances at domestic banks X X 0.20 = $ 3,000 $ 5,000 X 0.50 = $ 2,500 X 1.00 = $75,000 $ 5,000 10,000 50% category Loans secured by first liens on 1- to 4-family residential properties 100% category Loans to private corporations Credit-equivalent amounts of long-term commitments to private corporations $65,000 10,000 $75,000 Total Risk-Weighted Assets $80,500 This bank holding company’s ratio of total capital to weighted-risk assets (risk-based capital ratio) would be: ($6,000/580,500) = 7.45% 47 Regulation Y, Appendix A Capital Adequacy Guidelines Attachment II— Summary Definition of Qualifying Capital for Bank Holding Companies* Using the Year-End 1992 Standards Components CORE CAPITAL (tier 1) Common stockholders’ equity Qualifying cumulative and noncumulative perpetual preferred stock Minority interest in equity accounts of consolidated subsidiaries M inim um requirements after transition period Must equal or exceed 4% of weighted-risk assets No limit Limited to 25% of the sum of common stock, minority interests, and qualifying perpetual preferred stock Organizations should avoid using minority interests to introduce elements not otherwise qualifying for tier 1 capital Less: Goodwill1 SUPPLEMENTARY CAPITAL (tier 2) Allowance for loan and lease losses Total of tier 2 is limited to 100% of tier l 2 Limited to 1.25% of weighted-risk assets2 Perpetual preferred stock No limit within tier 2 Hybrid capital instruments, perpetual debt, and mandatory convertible securities Subordinated debt and intermediate-term pre ferred stock (original weighted average maturity of 5 years or more) No limit within tier 2 Revaluation reserves (equity and building) Not included; organizations encouraged to disclose; may be evaluated on a case-by-case basis for international comparisons; and taken into account in making an overall assessment of capital DEDUCTIONS (from sum of tier 1 and tier 2) Investments in unconsolidated subsidiaries Reciprocal holdings of banking organizations’ capital securities Other deductions (such as other subsidiaries or joint ventures) as determined by supervisory authority Subordinated debt and intermediate-term preferred stock are limited to 50% of tier 1;3 amortized for capital purposes as they approach maturity As a general rule, one-half of the aggregate investments will be deducted from tier 1 capital and one-half from tier 2 capital4 On a case-by-case basis or as a matter of policy after formal rulemaking TOTAL CAPITAL (tier 1 + tier 2 — Deductions) Must equal or exceed 8% of weighted-risk assets * See discussion in section II of the guidelines for a com plete description of the requirements for, and the limita tions on, the components of qualifying capital. 1 Goodwill on books of bank holding companies before March 12, 1988, would be “grandfathered” for the tran sition period. 2 Amounts in excess of limitations are permitted but do not qualify as capital. 3 Amounts in excess of limitations are permitted but do not qualify as capital. 4 A proportionately greater amount may be deducted from tier 1 capital if the risks associated with the subsidiary so warrant. 48 Capital Adequacy Guidelines Attachment III—Summary of Risk Weights and Risk Categories for Bank Holding Companies Category 1: Zero Percent 1. Cash (domestic and foreign) held in sub sidiary depository institutions or in transit 2. Balances due from Federal Reserve Banks (including Federal Reserve Bank stock) and central banks in other OECD countries Regulation Y, Appendix A the extent that subsidiary depository institu tions have liabilities booked in that currency 5. Claims on, and the portions of claims that are guaranteed by, U.S. governmentsponsored agencies2 6. General obligation claims on, and the por tions of claims that are guaranteed by the full faith and credit of, local governments and po litical subdivisions of the U.S. and other OECD local governments 3. Direct claims on, and the portions of claims that are unconditionally guaranteed by, the U.S. Treasury and U.S. government agencies1 and the central governments of oth er OECD countries, and local currency claims on, and the portions of local currency claims that are unconditionally guaranteed by, the central governments of non-OECD countries (including the central banks of non-OECD countries), to the extent that subsidiary de pository institutions have liabilities booked in that currency 8. The portions of claims that are collateralized3 by securities issued or guaran teed by the U.S. Treasury, the central govern ments of other OECD countries, U.S. govern ment agencies, U.S. government-sponsored agencies, or by cash on deposit in the subsidi ary depository institution 4. Gold bullion held in the vaults of a subsidi ary depository institution or in another’s vaults on an allocated basis, to the extent off set by gold bullion liabilities 9. The portions of claims that are collateralized3 by securities issued by official multilateral lending institutions or regional development banks Category 2:20 Percent 10. Certain privately issued securities repre senting indirect ownership of mortgagebacked U.S. government agency or U.S. gov ernment-sponsored agency securities 1. Cash items in the process of collection 2. All claims (long- or short-term) on, and the portions of claims (long- or short-term) that are guaranteed by, U.S. depository insti tutions and OECD banks 3. Short-term claims (remaining maturity of one year or less) on, and the portions of short term claims that are guaranteed by, nonOECD banks 4. The portions of claims that are condition ally guaranteed by the central governments of OECD countries and U.S. government agen cies, and the portions of local currency claims that are conditionally guaranteed by the cen tral governments of non-OECD countries, to 7. Claims on, and the portions of claims that are guaranteed by, official multilateral lending institutions or regional development banks 11. Investments in shares of a fund whose portfolio is permitted to hold only securities that would qualify for the zero or 20 percent risk categories Category 3:50 Percent 1. Loans fully secured by first liens on one- to four-family residential properties that have been made in accordance with prudent under writing standards, that are performing in ac cordance with their original terms, and are 2 For the purpose of calculating the risk-based capital ratio, a U.S. government-sponsored agency is defined as an 1 For the purpose o f calculating the risk-based capitalagency originally established or chartered to serve public ratio, a U.S. government agency is defined as an instrumen purposes specified by the U.S. Congress but whose obliga tality of the U.S. government whose obligations are fully tions are not e x p lic itly guaranteed by the full faith and and explicitly guaranteed as to the timely payment o f prin credit of the U.S. government. cipal and interest by the full faith and credit of the U.S. 3 The extent of collateralization is determined by current government. market value. 49 Regulation Y, Appendix A not past due or in nonaccrual status, and cer tain privately issued mortgage-backed securi ties representing indirect ownership of such loans (Loans made for speculative purposes are excluded.) 2. Revenue bonds or similar claims that are obligations of U.S. state or local governments, or other OECD local governments, but for which the government entity is committed to repay the debt only out of revenues from the facilities financed 3. Credit-equivalent amounts of interest rateand foreign exchange rate-related contracts, except for those assigned to a lower risk category Category 4:100 Percent 1. All other claims on private obligors Capital Adequacy Guidelines item 3 of category 1 or item 4 of category 2; all claims on non-OECD state or local governments 4. Obligations issued by U.S. state or local governments, or other OECD local govern ments (including industrial-development au thorities and similar entities), repayable solely by a private party or enterprise 5. Premises, plant, and equipment; other fixed assets; and other real estate owned 6. Investments in any unconsolidated subsidi aries, joint ventures, or associated compa nies—if not deducted from capital 7. Instruments issued by other banking orga nizations that qualify as capital—if not de ducted from capital 2. Claims on, or guaranteed by, non-OECD foreign banks with a remaining maturity ex ceeding one year 8. Claims on commercial firms owned by a government 3. Claims on, or guaranteed by, non-OECD central governments that are not included in 9. All other assets, including any intangible assets that are not deducted from capital 50 Capital Adequacy Guidelines Attachment IV—Credit-Conversion Factors for Off-Balance-Sheet Items for Bank Holding Companies 100 Percent Conversion Factor 1. Direct credit substitutes (These include general guarantees of indebtedness and all guarantee-type instruments, including stand by letters of credit backing the financial obli gations of other parties.) 2. Risk participations in banker’s acceptances and direct credit substitutes, such as standby letters of credit 3. Sale and repurchase agreements and assets sold with recourse that are not included on the balance sheet 4. Forward agreements to purchase assets, in cluding financing facilities, on which draw down is certain 5. Securities lent for which the banking orga nization is at risk Regulation Y, Appendix A 20 Percent Conversion Factor 1. Short-term, self-liquidating, trade-related contingences, including commercial letters of credit Zero Percent Conversion Factor 1. Unused portions of commitments with an original maturity1 of one year or less, or which are unconditionally cancellable at any time, provided a separate credit decision is made before each drawing Credit Conversion for Interest-Rate and Foreign-Exchange Contracts The total replacement cost of contracts (ob tained by summing the positive mark-to-mar ket values of contracts) is added to a measure of future potential increases in credit expo sure. This future potential exposure measure is calculated by multiplying the total notional value of contracts by one of the following credit conversion factors, as appropriate: R em aining m aturity Interest-rate contracts Exchange-rate contracts One year or less 0 1.0% 50 Percent Conversion Factor Over one year 0.5% 5.0% 1. Transaction-related contingencies (These include bid bonds, performance bonds, war ranties, and standby letters of credit backing the nonfinancial performance of other parties.) No potential exposure is calculated for sin gle-currency interest-rate swaps in which pay ments are made based upon two floating rate indices, that is, so-called floating/floating or basis swaps. The credit exposure on these con tracts is evaluated solely on the basis of their mark-to-market value. Exchange-rate con tracts with an original maturity of 14 days or less are excluded. Instruments traded on ex changes that require daily payment of varia tion margin are also excluded. The only form of netting recognized is netting by novation. 2. Unused portions of commitments with an original maturity1 exceeding one year, includ ing underwriting commitments and commer cial credit lines 3. Revolving underwriting facilities (RUFs), note issuance facilities (NIFs), and similar arrangements 1 Remaining maturity may be used until year-end 1992. 51 Regulation Y, Appendix A Capital Adequacy Guidelines Attachment V—Calculation of Credit-Equivalent Amounts Interest Rate- and Foreign Exchange Rate-Related Transactions for Bank Holding Companies + Potential Exposure Type of contract (remaining maturity) PotentialNotional exposure Potential conversion exposure principal (dollars) X factor = (dollars) (1) 120-day forward foreign exchange 5,000,000 (2 ) 120-day forward 6,000,000 foreign exchange (3) 3-year single-currency fixed/floating 10,000,000 interest-rate swap (4) 3-year single-currency fixed/floating 10,000,000 interest-rate swap (5) 7-year cross-currency floating/floating 20,000,000 interest-rate swap TOTAL Replace ment cost1 Current exposure (dollars)2 .01 50,000 100,000 100,000 150,000 .01 60,000 -120,000 -0 - 60,000 .005 50,000 200,000 200,000 250,000 .005 50,000 -250,000 -0 - 50,000 1,000,000 -1,300,000 -0 - .05 $51,000,000 1 These numbers are purely for illustration. 2 The larger o f zero or a positive mark-to-market value. 52 Current Exposure CreditEquivalent Amount — (dollars) 1,000,000 $1,510,000 Capital Adequacy Guidelines Attachment VI Regulation Y, Appendix A SUMMARY OF: Transitional Arrangements for Bank Holding Companies Final Arrangement Initial Year-end 1990 Year-end 1992 1. Minimum standard of total capital to weighted-risk assets None 2. Definition of tier 1 capital Common equity, qualifying cumulative and noncumulative perpetual preferred stock,1 and minority interests, plus supplementary elements,2 less goodwill3 7.25% 8.0% Common equity, qualifying cumulative and noncumulative perpetual preferred stock,1 and minority interests, plus supplementary elements,4 less goodwill3 Common equity, qualifying cumulative and noncumulative perpetual preferred stock,1 and minority interests, less goodwill3 3. Minimum standards of tier 1 capital to weighted-risk assets 3.625% 4.0% 3.25% 4.0% None 4. Minimum standard of stockholders’ equity to weighted-risk None assets 5. Limitations on sup plementary capital elements a. Allowance for loan and lease losses No limit within tier 2 1.5% of weighted-risk assets 1.25% of weighted-risk assets b. Perpetual pre ferred stock No limit within tier 2 No limit within tier 2 No limit within tier 2 No limit within tier 2 No limit within tier 2 No limit within tier 2 Combined maximum of 50% of tier 1 Combined maximum of 50% of tier 1 Combined maximum of 50% of tier 1 May not exceed tier 1 capital May not exceed tier 1 capital May not exceed tier 1 capital Tier 1plus tier 2 less: • reciprocal holdings of banking organizations’ capital instruments • investments in unconsolidated subsidiaries5 Tier 1plus tier 2 less: • reciprocal holdings of banking organizations’ capital instruments • investments in unconsolidated subsidiaries5 Tier 1plus tier 2 less: • reciprocal holdings of banking organizations’ capital instruments • investments in unconsolidated subsidiaries5 c. Hybrid capital in struments, perpet ual debt, and man datory convertibles d. Subordinated debt and intermediateterm preferred stock c. Total qualifying tier 2 capital 6. Definition of total capital 1 Perpetual preferred stock is limited within tier 1 to 25% of the sum o f common stockholders’ equity, qualify ing perpetual preferred stock, and minority interests. 2 Supplementary elements may be included in tier 1 up to 25% of the sum o f tier 1 plus goodwill. 3 See the guidelines for discussion o f relevant definitions and grandfathering arrangements for goodwill. 4 Supplementary elements may be included in tier 1 up to 10% o f the sum of tier 1 plus goodwill. 5 As a general rule, one-half (50% ) of the aggregate amount of investments will be deducted from tier 1 capital and one-half (50% ) from tier 2 capital. A proportionally greater amount may be deducted from tier 1 capital if the risks associated with the subsidiary so warrant. 53 Capital Adequacy Guidelines for Bank Holding Companies and State Member Banks: Leverage Measure Regulation Y (12 CFR 225), Appendix B The Board of Governors of the Federal Re serve System has adopted minimum capital ratios and guidelines to provide a framework for assessing the adequacy of the capital of bank holding companies and state member banks (collectively “banking organizations” ). The guidelines generally apply to all state member banks and bank holding companies regardless of size and are to be used in the examination and supervisory process as well as in the analysis of applications acted upon by the Federal Reserve. The Board of Gover nors will review the guidelines from time to time for possible adjustments commensurate with changes in the economy, financial mar kets, and banking practices. Two principal measurements of capital are used—the primary capital ratio and the total capital ratio. The definitions of primary and total capital for banks and bank holding com panies and formulas for calculating the capital ratios are set forth below in the definitional sections of these guidelines. Capital Guidelines The Board has established a minimum level of primary capital to total assets of 5.5 percent and a minimum level of total capital to total assets of 6.0 percent. Generally, banking or ganizations are expected to operate above the minimum primary and total capital levels. Those organizations whose operations involve or are exposed to high or inordinate degrees of risk will be expected to hold additional capital to compensate for these risks. In addition, the Board has established the following three zones for total capital for banking organizations of all sizes: Zone 1 Zone 2 Zone 3 Total Capital Ratio Above 7.0% 6.0% to 7.0% Below 6.0% The capital guidelines assume adequate li quidity and a moderate amount of risk in the loan and investment portfolios and in off-balance-sheet activities. The Board is. concerned that some banking organizations may attempt to comply with the guidelines in ways that reduce their liquidity or increase risk. Bank ing organizations should avoid the practice of attempting to meet the guidelines by decreas ing the level of liquid assets in relation to total assets. In assessing compliance with the guide lines, the Federal Reserve will take into ac count liquidity and the overall degree of risk associated with an organization’s operations, including the volume of assets exposed to risk. The Federal Reserve will also take into ac count the sale of loans or other assets with recourse and the volume and nature of all offbalance-sheet risk. Particularly close attention will be directed to risks associated with stand by letters of credit and participation in jointventure activities. The Federal Reserve will review the relationship of all on- and off-bal ance-sheet risks to capital and will require those institutions with high or inordinate lev els of risk to hold additional primary capital. In addition, the Federal Reserve will continue to review the need for more explicit proce dures for factoring on- and off-balance-sheet risks into the assessment of capital adequacy. The capital guidelines apply to both banks and bank holding companies on a consolidat ed basis.1 Some banking organizations are en gaged in significant nonbanking activities that typically require capital ratios higher thanthose of commercial banks alone. The Board believes that, as a matter of both safety and soundness and competitive equity, the degree of leverage common in banking should not au tomatically extend to nonbanking activities. Consequently, in evaluating the consolidated capital positions of banking organizations, the Board is placing greater weight on the build 1 The guidelines will apply to bank holding companies with less than $150 million in consolidated assets on a bank-only basis unless (1 ) the holding company or any nonbank subsidiary is engaged directly or indirectly in any nonbank activity involving significant leverage or (2) the holding company or any nonbank subsidiary has outstand ing significant debt held by the general public. Debt held by the general public is defined to mean debt held by parties other than financial institutions, officers, directors, and principal shareholders of the banking organization or their related interests. 55 Regulation Y, Appendix B ing-block approach for assessing capital re quirements. This approach generally provides that nonbank subsidiaries of a banking organi zation should maintain levels of capital consistent with the levels that have been es tablished by industry norms or standards, by federal or state regulatory agencies for similar firms that are not affiliated with banking orga nizations, or that may be established by the Board after taking into account risk factors of a particular industry. The assessment of an organization’s consolidated capital adequacy must take into account the amount and nature of all nonbank activities, and an institution’s consolidated capital position should at least equal the sum of the capital requirements of the organization’s bank and nonbank subsidi aries as well as those of the parent company. Supervisory Action The nature and intensity of supervisory action will be determined by an organization’s com pliance with the required minimum primary capital ratio as well as by the zone in which the company’s total capital ratio falls. Banks and bank holding companies with primary capital ratios below the 5.5 percent minimum will be considered undercapitalized unless they can demonstrate clear extenuating cir cumstances. Such banking organizations will be required to submit an acceptable plan for achieving compliance with the capital guide lines and will be subject to denial of applica tions and appropriate supervisory enforce ment actions. The zone into which an organization’s total capital ratio falls will normally trigger the fol lowing supervisory responses, subject to quali tative analysis: • • For institutions operating in zone 1, the Federal Reserve will consider that capital is generally adequate if the primary capital ratio is acceptable to the Federal Reserve and is above the 5.5 percent minimum. For institutions operating in zone 2, the Federal Reserve will pay particular atten tion to financial factors, such as asset qual ity, liquidity, off-balance-sheet risk, and interest rate risk, as they relate to the ade quacy of capital. If these areas are deficient and the Federal Reserve concludes capital 56 Capital Adequacy Guidelines is not fully adequate, the Federal Reserve will intensify its monitoring and take ap propriate supervisory action. • For institutions operating in zone 3, the Federal Reserve will— —consider that the institution is under capitalized, absent clear extenuating circumstances; —require the institution to submit a com prehensive capital plan, acceptable to the Federal Reserve, that includes a pro gram for achieving compliance with the required minimum ratios within a rea sonable time period; and —institute appropriate supervisory and/or administrative enforcement action, which may include the issuance of a capital directive or denial of applica tions, unless a capital plan acceptable to the Federal Reserve has been adopted by the institution. Treatment of Intangible Assets for Purpose of Assessing Capital Adequacy In considering the treatment of intangible as sets for the purpose of assessing capital ade quacy, the Federal Reserve recognizes that the determination of the future benefits and useful lives of certain intangible assets may in volve a degree of uncertainty that is not nor mally associated with other banking assets. Supervisory concern over intangible assets de rives from this uncertainty and from the pos sibility that, in the event an organization expe riences financial difficulties, such assets may not provide the degree of support generally associated with other assets. For this reason, the Federal Reserve will carefully review the level and specific character of intangible assets in evaluating the capital adequacy of state member banks and bank holding companies. The Federal Reserve recognizes that intan gible assets may differ with respect to predict ability of any income stream directly associat ed with a particular asset, the existence of a market for the asset, the ability to sell the as set, or the reliability of any estimate of the asset’s useful life. Certain intangible assets have predictable income streams and objec tively verifiable values and may contribute to an organization’s profitability and overall fi Capital Adequacy Guidelines nancial strength. The value of other intangi bles, such as goodwill, may involve a number of assumptions and may be more subject to changes in general economic circumstances or to changes in an individual institution’s future prospects. Consequently, the value of such in tangible assets may be difficult to ascertain. Consistent with prudent banking practices and the principle of the diversification of risks, banking organizations should avoid excessive balance-sheet concentration in any category or related categories of intangible assets. Bank Holding Companies While the Federal Reserve will consider the amount and nature of all intangible assets, those holding companies with aggregate intangible assets in excess of 25 percent of tan gible primary capital (i.e., stated primary cap ital less all intangible assets) or those institu tions with lesser, although still significant, amounts of goodwill will be subject to close scrutiny. For the purpose of assessing capital adequacy, the Federal Reserve may, on a case-by-case basis, make adjustments to an or ganization’s capital ratios based upon the amount of intangible assets in excess of the 25 percent threshold level or upon the specific character of the organization’s intangible as sets in relation to its overall financial condi tion. Such adjustments may require some or ganizations to raise additional capital. The Board expects banking organizations (including state member banks) contemplat ing expansion proposals to ensure that pro forma capital ratios exceed the minimum cap ital levels without significant reliance on in tangibles, particularly goodwill. Consequent ly, in reviewing acquisition proposals, the Board will take into consideration both the stated primary capital ratio (that is, the ratio without any adjustment for intangible assets) and the primary capital ratio after deducting intangibles. In acting on applications, the Board will take into account the nature and amount of intangible assets and will, as appro priate, adjust capital ratios to include certain intangible assets on a case-by-case basis. Regulation Y, Appendix B tal will be subject to close scrutiny. In addi tion, for the purpose of calculating capital ratios of state member banks, the Federal Re serve will deduct goodwill from primary capi tal and total capital. The Federal Reserve may, on a case-by-case basis, make further ad justments to a bank’s capital ratios based on the amount of intangible assets (aside from goodwill) in excess of the 25 percent thresh old level or on the specific character of the bank’s intangible assets in relation to its over all financial condition. Such adjustments may require some banks to raise additional capital. In addition, state member banks and bank holding companies are expected to review pe riodically the value at which intangible assets are carried on their balance sheets to deter mine whether there has been any impairment of value or whether changing circumstances warrant a shortening of amortization periods. Institutions should make appropriate reduc tions in carrying values and amortization peri ods in light of this review, and examiners will evaluate the treatment of intangible assets during on-site examinations. Definition of Capital to Be Used in Determining Capital Adequacy Primary Capital Components The components of primary capital are— • common stock, • perpetual preferred stock (preferred stock that does not have a stated maturity date and that may not be redeemed at the option of the holder), • surplus (excluding surplus relating to limit ed-life preferred stock), • undivided profits, • contingency and other capital reserves, • mandatory convertible instruments,2 • allowance for possible loan and lease losses (exclusive of allocated transfer risk re serves), • minority interest in equity accounts of con solidated subsidiaries, and • perpetual debt instruments (for bank hold ing companies but not for state member banks). State Member Banks State member banks with intangible assets in excess of 25 percent of tangible primary capi 2 See the definitional section below that lists the criteria for mandatory convertible instruments to qualify as pri mary capital. 57 Regulation Y, Appendix B Limits on Certain Forms o f Primary Capital Capital Adequacy Guidelines they meet the requirements of secondary capi tal instruments. Bank holding companies. The maximum composite amount of mandatory convertible Secondary Capital Components securities, perpetual debt, and perpetual pre The components of secondary capital are— ferred stock that may be counted as primary capital for bank holding companies is limited to • limited-life preferred stock (including relat ed surplus) and 33.3 percent of all primary capital, including these instruments. Perpetual preferred stock • bank subordinated notes and debentures issued prior to November 20, 1985, (or deter and unsecured long-term debt of the parent company and its nonbank subsidiaries. mined by the Federal Reserve to be in the pro cess of being issued prior to that date) shall Restrictions Relating to Capital Components continue to be included as primary capital. The maximum composite amount of man To qualify as primary or secondary capital, a datory convertible securities and perpetual capital instrument should not contain or be debt that may be counted as primary capital covered by any covenants, terms, or restric for bank holding companies is limited to 20 tions that are inconsistent with safe and sound percent of all primary capital, including these banking practices. Examples of such terms are instruments. The maximum amount of equity those regarded as unduly interfering with the commitment notes (a form of mandatory con ability of the bank or holding company to vertible securities) that may be counted as conduct normal banking operations or those primary capital for a bank holding company is resulting in significantly higher dividends or limited to 10 percent of all primary capital, interest payments in the event of a deteriora including mandatory convertible securities. tion in the financial condition of the issuer. Amounts outstanding in excess of these limi The secondary components must meet the tations may be counted as secondary capital following conditions to qualify as capital: provided they meet the requirements of sec ondary capital instruments. • The instrument must have an original weighted-average maturity of at least seven State member banks. The composite limita years. tions on the amount of mandatory convertible • The instrument must be unsecured. securities and perpetual preferred stock (per • The instrument must clearly state on its petual debt is not primary capital for state face that it is not a deposit and is not in member banks) that may serve as primary sured by a federal agency. capital for bank holding companies shall not • Bank debt instruments must be subordinat be applied formally to state member banks, ed to claims of depositors. although the Board shall determine appropri • For banks only, the aggregate amount of limited-life preferred stock and subordinate ate limits for these forms of primary capital debt qualifying as capital may not exceed 50 on a case-by-case basis. The maximum amount of mandatory con percent of the amount of the bank’s primary vertible securities that may be counted as pri capital.* mary capital for state member banks is limited As secondary capital components approach to 16§ percent of all primary capital, includ maturity, the banking organization must plan ing mandatory convertible securities. Equity to redeem or replace the instruments while commitment notes, one form of mandatory maintaining an adequate overall capital posi convertible securities, shall not be included as tion. Thus, the remaining maturity of second primary capital for state member banks except ary capital components will be an important that notes issued by state member banks prior consideration in assessing the adequacy of to to May 15, 1985, will continue to be included tal capital. in primary capital. Amounts of mandatory convertible securities in excess of these limita * See also 12 C FR 204.129 ( F e d e ra l R e se rv e R e g u la to ry tions may be counted as secondary capital if S ervic e 2-260.56; 1988 F e d e r a l R e s e r v e B u lle tin 124). 58 Capital Adequacy Guidelines Capital Ratios The primary and total capital ratios for bank holding companies are computed as follows: Primary capital ratio: __________Primary capital components_________ Total assets + Allowance for loan and lease losses (exclusive of allocated transfer risk reserves) Total capital ratio: Primary capital components + Secondary capital ________________ components________________ Total assets + Allowance for loan and lease losses (exclusive of allocated transfer risk reserves) The primary and total capital ratios for state member banks are computed as follows: Primary capital ratio: Primary capital components — Goodwill Average total assets + Allowance for loan and lease losses (exclusive of allocated transfer risk reserves) — Goodwill Total capital ratio: Primary capital components -f Secondary capital ___________ components—Goodwill___________ Average total assets + Allowance for loan and lease losses (exclusive of allocated transfer risk reserves) —Goodwill Generally, period-end amounts will be used to calculate bank holding company ratios. However, the Federal Reserve will discourage temporary balance-sheet adjustments or any other “window dressing” practices designed to achieve transitory compliance with the guidelines. Banking organizations are expect ed to maintain adequate capital positions at all times. Thus, the Federal Reserve will, on a case-by-case basis, use average total assets in the calculation of bank holding company capi tal ratios whenever this approach provides a more meaningful indication of an individual holding company’s capital position. For the calculation of bank capital ratios, “average total assets” will generally be defined as the quarterly average total assets figure re ported on the bank’s Report of Condition. If warranted, however, the Federal Reserve may calculate bank capital ratios based upon total Regulation Y, Appendix B assets as of period-end. All other components of the bank’s capital ratios will be based upon period-end balances. Criteria for Determining Primary Capital Status of Mandatory Convertible Securities Mandatory convertible securities are subordi nated debt instruments that are eventually transformed into common or perpetual pre ferred stock within a specified period of time, not to exceed 12 years. To be counted as pri mary capital, mandatory convertible securities must meet the criteria set forth below. These criteria cover the two basic types of mandato ry convertible securities: equity contract notes (securities that obligate the holder to take common or perpetual preferred stock of the issuer in lieu of cash for repayment of princi pal) and equity commitment notes (securities that are redeemable only with the proceeds from the sale of common or perpetual pre ferred stock). Both equity commitment notes and equity contract notes qualify as primary capital for bank holding companies, but only equity contract notes qualify as primary capi tal for banks. Criteria Applicable to Both Types o f Mandatory Convertible Securities a. The securities must mature in 12 years or less. b. The issuer may redeem securities prior to maturity only with the proceeds from the sale of common or perpetual preferred stock of the bank or bank holding company. Any excep tion to this rule must be approved by the Fed eral Reserve. The securities may not be re deemed with the proceeds of another issue of mandatory convertible securities. Nor may the issuer repurchase or acquire its own man datory convertible securities for resale or reissuance. c. Holders of the securities may not acceler ate the payment of principal except in the event of bankruptcy, insolvency, or reorganization. d. The securities must be subordinate in right of payment to all senior indebtedness of the 59 Regulation Y, Appendix B issuer. In the event that the proceeds of the securities are reloaned to an affiliate, the loan must be subordinated to the same degree as the original issue. e. An issuer that intends to dedicate the pro ceeds of an issue of common or perpetual pre ferred stock to satisfy the funding require ments of an issue of mandatory convertible securities (i.e. the requirement to retire or re deem the notes with the proceeds from the issuance of common or perpetual preferred stock) generally must make such a dedication during the quarter in which the new common or preferred stock is issued.3 As a general rule, if the dedication is not made within the prescribed period, then the securities issued may not at a later date be dedicated to the retirement or redemption of the mandatory convertible securities.4 Additional Criteria Applicable to Equity Contract Notes a. The note must contain a contractual provi sion (or must be issued with a mandatory stock purchase contract) that requires the holder of the instrument to take the common or perpetual stock of the issuer in lieu of cash in satisfaction of the claim for principal repay ment. The obligation of the holder to take the common or perpetual preferred stock of the issuer may be waived if, and to the extent that, prior to the maturity date of the obligation, the issuer sells new common or perpetual pre 3 Common or perpetual preferred stock issued under div idend reinvestment plans or issued to finance acquisitions, including acquisitions of business entities, may be dedicated to the retirement or redemption of the mandatory convert ible securities. Documentation certified by an authorized agent of the issuer showing the amount of common stock or perpetual preferred stock issued, the dates of issue, and amounts of such issues dedicated to the retirement or re demption o f mandatory convertible securities will satisfy the dedication requirement. 4 The dedication procedure is necessary to ensure that the primary capital of the issuer is not overstated. For each dollar of common or perpetual preferred proceeds dedicat ed to the retirement or redemption of the notes, there is a corresponding reduction in the amount of outstanding mandatory securities that may qualify as primary capital. De minimis amounts (in relation to primary capital) of common or perpetual preferred stock issued under arrange ments in which the amount of stock issued is not predict able, such as dividend reinvestment plans and employee stock option plans (but excluding public stock offerings and stock issued in connection with acquisitions), should be dedicated by no later than the company’s fiscal year-end. 60 Capital Adequacy Guidelines ferred stock and dedicates the proceeds to the retirement or redemption of the notes. The dedication generally must be made during the quarter in which the new common or pre ferred stock is issued. b. A stock purchase contract may be separat ed from a security only if (1) the holder of the contract provides sufficient collateral5 to the issuer, or to an independent trustee for the benefit of the issuer, to ensure performance under the contract and (2) the stock purchase contract requires the purchase of common or perpetual preferred stock. Additional Criteria Applicable to Equity Commitment Notes a. The indenture or note agreement must con tain the following two provisions: 1. The proceeds of the sale of common or perpetual preferred stock will be the sole source of repayment for the notes, and the issuer must dedicate the proceeds for the purpose of repaying the notes. (Documen tation certified by an authorized agent of the issuer showing the amount of common or perpetual preferred stock issued, the dates of issue, and amounts of such issues dedicated to the retirement or redemption of mandatory convertible securities will sat isfy the dedication requirement.) 2. By the time that one-third of the life of the securities has run, the issuer must have raised and dedicated an amount equal to one-third of the original principal of the se curities. By the time that two-thirds of the life of the securities has run, the issuer must have raised and dedicated an amount equal to two-thirds of the original principal of the securities. At least 60 days prior to the ma turity of the securities, the issuer must have raised and dedicated an amount equal to the entire original principal of the securi ties. Proceeds dedicated to redemption or retirement of the notes must come only 5 Collateral is defined as (1) cash or certificates of depo sit; (2 ) U.S. government securities that will mature prior to or simultaneous with the maturity of the equity contract and that have a par or maturity value at least equal to the amount of the holder’s obligation under the stock purchase contract; (3 ) standby letters of credit issued by an insured U.S. bank that is not an affiliate of the issuer; or (4) other collateral as may be designated from time to time by the Federal Reserve. Capital Adequacy Guidelines from the sale of common or perpetual pre ferred stock.6 b. If the issuer fails to meet any of these peri odic funding requirements, the Federal Re serve immediately will cease to treat the un funded securities as primary capital and will take appropriate supervisory action. In addi tion, failure to meet the funding requirements will be viewed as a breach of a regulatory commitment and will be taken into consid eration by the Board in acting on statutory applications. c. If a security is issued by a subsidiary of a bank or bank holding company, any guaran tee of the principal by that subsidiary’s parent bank or bank holding company must be sub ordinate to the same degree as the security issued by the subsidiary and limited to repay ment of the principal amount of the security at its final maturity. Criteria for Determining the Primary Capital Status o f Perpetual Debt Instruments o f Bank Holding Companies a. The instrument must be unsecured and, if issued by a bank, must be subordinated to the claims of depositors. b. The instrument may not provide the note holder with the right to demand repayment of principal except in the event of bankruptcy, insolvency, or reorganization. The instrument must provide that nonpayment of interest shall not trigger repayment of the principal of the perpetual debt note or any other obliga tion of the issuer, nor shall it constitute prima facie evidence of insolvency or bankruptcy. 6 The funded portions o f the securities will be deducted from primary capital to avoid double counting. Regulation Y, Appendix B c. The issuer shall not voluntarily redeem the debt issue without prior approval of the Fed eral Reserve, except when the debt is convert ed to, exchanged for, or simultaneously re placed in like amount by an issue of common or perpetual preferred stock of the issuer or the issuer’s parent company. d. If issued by a bank holding company, a bank subsidiary, or a subsidiary with substan tial operations, the instrument must contain a provision that allows the issuer to defer inter est payments on the perpetual debt in the event of, and at the same time as the elimina tion of dividends on all outstanding common or preferred stock of the isssuer (or in the case of a guarantee by a parent company at the same time as the elimination of the divi dends of the parent company’s common and preferred stock). In the case of a nonoperat ing subsidiary (a funding subsidiary or one formed to issue securities), the deferral of in terest payments must be triggered by elimina tion of dividends by the parent company. e. If issued by a bank holding company or a subsidiary with substantial operations, the in strument must convert automatically to com mon or perpetual preferred stock of the issuer when the issuer’s retained earnings and sur plus accounts become negative. If an operat ing subsidiary’s perpetual debt is guaranteed by its parent, the debt may convert to the shares of the issuer or guarantor and such conversion may be triggered when the issuer’s or parent’s retained earnings and surplus ac counts become negative. If issued by a nonop erating subsidiary of a bank holding company or bank, the instrument must convert auto matically to common or preferrred stock of the issuer’s parent when the retained earnings and surplus accounts of the issuer’s parent be come negative. 61
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