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■ July 1993 UPERVISORY I ssu E Supervisory News and Views for the Eighth District s Grandfather Clause for Interlocking Directors Expires ESOPs Receive Increased Attention https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Officers and directors of depository institutions should review their status if they are serving under the grandfather clause in Regulation L- "Management Official Interlocks." This clause is scheduled to expire November 10, 1993, at which time all prohibited management interlocks must be severed. The Depository Institutions Management Interlocks Act, enacted on ovember 10, 1978, permitted otherwi e prohibited management interlocks to management officials between continue for ten years if they nonaffiliated organizations, existed before that date. A1988 regardless of where they are located, if one organization amendment extended this exception an additional five has total assets over $1 billion years. That extension ends and the other has total assets over $500 million. An affiliate November 10, 1993. The Act prohibits executive organization is one of which officers or directors of deposi25 percent or more is comtory institutions from simultamonly owned. neously serving as executives or directors of other nonaffiliated ~ - - - - - - - depository institutions in the same market or community. It also prohibits interlocking n employee stock ownership plan (ESOP) is a tax-qualified employee benefit plan invested primarily in employer stock. ESOPs are designed and administered for the benefit of employee participants. Additionally, they are subject to the Employee Retirement Income and Security Act of 1974 (ERISA) and applicable Department of Labor (DOL) regulations. As the use of ESOPs has increased among Eighth District banking organizations, more and more bankers have questions concerning the status of ESOPs under the Bank Holding Company Act and the supervisory treatment of transactions between ESOPs and bank holding companies. A Status of ESOPs Under the Bank Holding Company Act An ESOP is a company for purposes of the Bank Holding Company Act. Therefore transactions by which an ESOP will acquire 25 percent or more of any class of voting securities of a bank or holding company are subject to prior approval from the Federal Reserve System. In addition, an ESOP is considered aperson under the Change in Bank Control Act. Therefore an ESOP acquiring 10 percent or more of any class of voting securities of a bank or bank holding company must file a Change in Bank Control notice if no other person owns (continued on next page) ESOPs (cxmtinued from front page) a greater percentage of that class of voting securities or if the company is registered with the SEC. Application Considerations An ESOP filing an application for prior approval under Section 3of the Bank Holding Company Act or a notice under the Change in Bank Control Act will be asked to respond to inquiries designed to determine compliance with DOL regulations. For instance, the Reserve Bank will request a copy of the plan and trust agreements governing the ESOP and the IRS determination letter verifying the plan's tax exempt status under Section 401 of the Internal Revenue Code. In addition, if a pension or profit sharing plan was terminated to establish the ESOP, the applicant will be asked to provide evidence of the Pension Benefit Guaranty Corporation's approval of plan termination. Financial Effect of ESOP Transactions ESOP debt is generally serviced with tax deductible contributions by a sponsoring employer. As such, the ESOP's sponsoring employer may guarantee the ESOP's debt or commit to make sufficient future contributions to ensure the ESOP's ability to repay its debt. The Federal Reserve System generally permits bank holding companies to guarantee the debt of an affiliated ESOP consistent with safe and sound banking practices. If debt incurred to acquire https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis employer securities is accompanied by an underlying guarantee or commitment by the employer bank holding company, the Generally Accepted Accounting Principles (GAAP) require adjustments to a bank holding company's balance sheet. Because this guarantee or commitment is in substance, a liability of the employer bank holding company, the company must record a liability account for the amount of the ESOP debt and offset that entry by reducing shareholders' equity. company's balance sheet. Likewise, when an ESOP acquires employer bank holding company stock without debt, the ESOP is treated like any other shareholder and no adjusting entries are made to the employer bank holding company's balance sheet. 1 The Federal Reserve generally permits bank holding companies to guarantee the debt of an aff1liated ESOP. As the ESOP makes payments on its debt, the liability recorded by the employer bank holding company is reduced accordingly. The resulting additional debt burden and corresponding reduction in shareholders' equity produced by this accounting treatment will be analyzed by the Federal Reserve System to ensure compliance with regulations and standards regarding parent company debt and capital adequacy. When an ESOP incurs debt to fund the acquisition of employer stock with no guarantee or commitment from the employer bank holding company, the ESOP is treated like any other shareholder and no adjusting entries are made to the employer bank holding Supervisory Concerns ESOPs generally avoid borrowing from affiliated banks or having their affiliated banks guarantee their debt to escape the restrictions of Section 23A of the Federal Reserve Act. Section 23A states that the securities issued by an affiliate of the bank shall not be acceptable as collateral for a guarantee issued on behalf of that or any other affiliate. Because ESOPs invest primarily in employer company securities they generally will not have sufficient other assets to pledge as collateral to satisfy the requirements of Section 23A. Accordingly, ESOP debt is generally obtained from unaffiliated lenders to avoid these restrictions and potential violations. ESOPs should be designed and administered for the benefit of the participants. ESOPs receive tax benefits that may result in banking organizations viewing ESOP purchases as an important contributor to capital growth. For example, employer contributions to ESOP that are applied to the repayment of ESOP debt generally qualify as tax-deductible for the employer, and dividends paid on shares of employer stock owned by an ESOP may qualify as a tax-deductible expense for the employer. Transactions between an employer company and the ESOP, however, must always be in the best interest of the participants. For that reason, it is inappropriate for an employer company to view an ESOP as a market maker for its own stock or as a funding vehicle for the holding company. Thus Eighth District banks considering establishing an ESOP should remember that ERISA and DOL regulations require that an ESOP be designed and administered for the primary benefit of its participants. It is also important to remember that depending on the ESOP's percentage of ownership of employer bank or bank holding company stock, the ESOP may be subject to federal banking rules and regulations. Reflect Your Capital Position Correctly apital is receiving additional emphasis as a measure of institutional condition. With this increased focus, it is more important for institutions to ensure that the reports on which they record capital are complete and accurate. An analysis of the Call Report and the FR Y-9C shows that risk-based capital schedules are often completed incorrectly. Many reporters appear to be using the same set of instructions for both reports, when in fact, the capital schedules in the FR Y-9C differ from capital schedules in the Call Report. . . - - . ·- - ~ - - C --- -~ ... should be subtracted when computing tier 1capital. • As of December 31, 1992 the amount of allowance for loan losses qualifying for tier 2 capital was limited to 1.25 percent of risk-weighted assets. For banks with total assets less than 1 billion, the preceding list will ensure accurate completion of Schedule RC-R. FR Y·9C On the FR Y-9C, completing Additional Details on Capital Components (Schedule HCIC) and the Memoranda items on Risked-Based Capital - ' - - -- ' -- ;-~--;=-, I 1: I ----=--~--------...;,_________ il \:: .. __ . The following gives specific guidance for avoiding the mo t common errors. Call Report When completing the RiskBased Capital section (Schedule RC-R) of the Call Report, be sure to review the definition and components of adjusted total assets and total qualifying capital allowable under the risk-based capital guidelines. Keep the following in mind: • Goodwill and other di allowed intangible assets https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis (Schedule HC-1) accurately is critical to computing tier 1 capital and total capital for bank holding companies. These schedules determine the risk category to which the particular capital component belongs and the value ultimately assigned to that component. Call Report and FR Y·9C Confu ing the difference between the credit conversion factor (CCF) and the ri kweighting factor (RWF) both of which are used in comput- I ing risk-weighted assets, is a common error made on both the Call Report and the FR Y-9C. • The CCF converts an offbalance sheet item to a credit equivalent amount, which is then treated as an on-balance sheet asset. (Be sure to show the credit equivalent amounts of offbalance sheet items in the appropriate fields for both Call Report and FR Y9C schedules.) Failing to report the credit equivalent amounts has frequently resulted in an overstatement of ri k-weighted assets on the FR Y-9C. • The RWF converts all onbalance sheet assets to riskweighted assets. Before submitting either report, ensure that all data are accurate. Be sure line items correspond with supporting chedules and memoranda items. Once these reports are completed accurately, keep a full set of workpapers for examiners to review. If you have questions about risk-based capital schedules or any other regulatory reports, call Jim Mack in the Statistics Section at 314-444-8599 or Rita Rauba in the Banking Supervision and Regulation Division at 314-444-8850. Take a Closer Look at Consumer Lending hile new consumer laws are being implemented, bankers may want to review existing disclosures to avoid potential problems. The following takes a look at three specific issues with consumer lending. W Required Deposit Balance Now that interest rates have declined substantially, banks may be required to make an additional disclosure to credit customers as stated in Section _226.18(r) of Regulation Z. If a creditor must maintain a deposit as a condition in a loan agreement and the de- https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis tor to disclose whether a security interest in the property will be acquired. Unfortunately, many form vendors and inhouse computer programs are automatically marking boxes on disclosure forms to indicate security interests. In some cases, such disclosures can violate Regulation Z. Such a violation can occur if a creditor attempts to disclose a right of set-off by checking the box indicating a security interest in "my deposit account and other rights I may have to the payment of money from you." Because a bank's right of set-off arises by operation of law, it should not be included with the disclosures required under Section posit earns less than 5percent, the customer must be informed that the quoted annual percentage rate does not reflect the effect of the required deposit. This notice can be accomplished by simply adding a standard clause to the disclosure statement. The model clause in Appendix Hreads, "The annual percentage rate does not take into account your required deposit." Security Interests Computerized loan processing systems and preprinted disclosure forms are causing compliance problems with Section 226.18(m) of Regulation Z, which requires a credi- t . l\"'\ \)l 0 (\~ l se°'-o\~ 226.18(m). The bank may, however, state this right elsewhere in the contract and invoke and enforce the right in accordance with state law. As this example shows, bank personnel should consider each specific situation when determining appropriate disclosures required by Regulation Z. Rule of 78s Assessing compliance with the provisions of Section 933 of the Housing and Community Development Act of 1992 will become part of ongoing consumer compliance examinations for state member banks. Specifically, Section 933 (1) requires prompt refunds of unearned interest payments, (2) prohibits the use of the Rule of 78s rebate method for transactions that are consummated after September 30, 1993, and with terms that exceed 61 months, and (3) requires a statement of the prepayment amount to be given on request. Though the prohibition of the Rule of 78s becomes effective for loans consummated after September 30, 1993, the other provisions became effective when the Housing and Community Development Act was signed on October 28, 1992. BANK PERFORMANCE Examining Eighth District Net Interest Margin or some time, we have reported that District banks' return on average assets (ROA) has been above their national peers, while at the same time their net interest earnings have been lower. Reviewing yearend District data by peer group size and state illustrates two interesting points. While all asset size groups and six of the seven District states have average net interest margins below national peers, this difference is most pronounced in large banks and in Kentucky and Missouri. The District's 16 largest banks, all with assets over $1 billion, trail the national peer interest margin significantlyby 62 basis points. These banks hold 35 percent of District banking assets and thus have considerable influence on the District margin. I F Net Interest Margin Peer Group Comparison Percent S.0- - - - - - - - - - - - - - - - - ~ 4.8 4.6 4.4 4.2 4.0 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Comparative Margin Analysis Eighth District States Ranked by Descending Interest Margin State NIM* Mississippi Tennessee 5.08% 4.62% 4.61% 4.61% 4.57% 4.28% 4.27% Illinois Arkansas Indiana Kentucky Missouri Interest Income 8.69% 8.11% 8.64% 8.05% 8.70% 8.09% 7.84% Interest Ex ense 3.61% 3.49% 4.03% 3.44% 4.1 3% 3.81% 3.57% • Net Interest Margin Additionally, more than 60 percent of these assets are located in the Louisville and St. Louis banking markets. An average of 58 percent of the loans in the portfolios of these banks consist of commercial and industrial loans, and loans secured by commercial real estate - excluding residential mortgages (1-4 family) and home equity loans. The average yield on the commercial and industrial loans is 6.8 percent. While the average real estate loan yield is 8.4 percent, this reflects the influence of the residential mortgages and home equity loans. By comparison, these banks average only 20 percent of their portfolios in consumer, installment, and credit card loans which have yields of 8.5 percent and above. As the chart to the left shows, both Kentucky and Missouri have the lowest net interest margins due to the combined effects of the large banks influence and the loan mix and yields previously described. The lower yields coupled with a higher interest expense in these states produce the lower net interest margin. To assess this effect further, data for the largest banks from the Louisville and St. Louis markets were isolated. With these seven banks removed, the District average net interest margin climbs 12 points to 4.60 percent. Relatively, this accounts for 30 percent of the total difference between the District and U.S. peer. The effect of removing the largest banks is even greater on the state averages. For Kentucky, removing the three largest banks increases the margin by 14 basis points to 4. 42 percent. In Missouri, the margin increases 21 basis points to 4. 49 percent. These increases would bring both states in line with the District average. 1 The District, peer group, and state interest margin averages are calculated on a weighted basis. Thus the relative size ofa bank or group of banks has a proportionate effect on the ratio. HMDA Time Frames Shortened emember that the Housing and Community Development Act of 1992 changed the timing requirements for Home Mortgage Disclosure Act (HMDA) disclosure statements. After financial institutions receive their disclosure statements from the Federal Financial Institutions Examination Council (FFIEC), they must make them available to the public within three days at home offices and within ten days at appropriate branch offices. Institutions will still have 30 days, however, to review the statements for accuracy and content. Questions about HMDA disclosure statements should be directed to the appropriate fed- t the one-year anniversary of we want to know we are meeting your expectations with this newsletter. Please take a few minutes to complete the enclosed survey and drop it in the mail. We appreciate you taking the time to respond. R Supervisory Issues Enters Second Year ■ Post Office Box 442 St. Louis, Mi ouri 63166 Supervisory Issues is published bimonthly by the Banking Supervision and Regulation Division of the Federal Reserve Bank of St. Louis. Views expressed are not necessarily official opinions of the Federal Reserve S tern or the Federal Reserve Bank of St. Louis. Questions regarding this publication should be directed to Dawn C. Ligibel, editor, 314-444-8909. https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Issues, A Supervisory if eral regulator. 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