View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.


July 1993




News and Views
for the Eighth District


Grandfather Clause for Interlocking
Directors Expires

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.


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
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)

(cxmtinued from front page)

a greater percentage of that
class of voting securities or
if the company is registered
with the SEC.

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

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
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.


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
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
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
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.
. . - - . ·- - ~ - -


--- -~ ...

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
For banks with total assets
less than 1 billion, the preceding list will ensure accurate
completion of Schedule RC-R.

On the FR Y-9C, completing
Additional Details on Capital
Components (Schedule HCIC) and the Memoranda items
on Risked-Based Capital



- - --









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
• Goodwill and other di allowed intangible assets
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

Call Report and
Confu ing the difference
between the credit conversion
factor (CCF) and the ri kweighting factor (RWF) both
of which are used in comput-


ing risk-weighted assets, is a
common error made on both
the Call Report and the FR
• 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
bankers may
want to review existing disclosures to avoid potential problems. The following takes a
look at three specific issues
with consumer lending.


Required Deposit
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-
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
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-


. l\"'\ \)l

0 (\~



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,

Examining Eighth District Net Interest
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


Net Interest Margin
Peer Group Comparison

S.0- - - - - - - - - - - - - - - - - ~
Federal Reserve Bank of St. Louis

Comparative Margin Analysis
Eighth District States
Ranked by Descending Interest Margin






Interest Income

Interest Ex ense
4.1 3%

• 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
want to know we are meeting
your expectations with this
Please take a few minutes to
complete the enclosed survey

and drop it in the mail. We
appreciate you taking the time
to respond.


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.
Federal Reserve Bank of St. Louis

A Supervisory

eral regulator. Institutions that
report data to the Federal
Reserve Bank of St. Louis
should call Bob Dowling at

(314) 444-8532.



Postage Will Be Paid by Addressee

Editor, Supervisory Issues
Banking Supervision and Regulation
Federal Reserve Bank of St. Louis
Post Office Box 442
St. Louis, MO 63166-0442
Federal Reserve Bank of St. Louis



Dear Reader:
We would like to know if Supervisory Issues is meeting your supervisory and regulatory infonnational needs. Please take a few minutes to answer the following questions
and drop this card in the mail. Thank you.
1. How many people in your organization read Supervisory Issues?
(Please check one.)
:J Subscriber only
0 2-4 individuals
0 5-10 individuals
0 11 or more individuals
2. Does Supervisory' Issues meet your need for guidance on the following?
(Check all that apply.)
0 Examination/inspection expectations
0 Safety and soundness regulations
0 Consumer regulations
0 Applications processing
0 Eighth District bank perfonnance
CJ Financial reporting (for example, Call Reports and Yreports)
0 Other _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __
3. How does Supervisory' Issues meet your expectations? (Check all that apply.)
□ Articles provide specific guidance
□ Topics covered are relevant
:::J Articles are easy to understand
□ Infonnation is timely
□ Other _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __
Federal Reserve Bank of St. Louis

4. How does Supervisory• Issues fall short of your expectations?
(Check all that apply.)
0 Articles do not provide enough detail
□ Articles provide too much detail
0 Articles do not provide specific guidance
0 Topics covered are not relevant
0 Articles are not timely
0 Other_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __
5. What suggestions do you have for improving Supervisory•Issues?

6. Who would you like to add to the Supervisory· Issues mailing list?
ame:_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __
Address:_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __

If you have additional comments on Superzifsory· Issues, please call Dawn C. Ligibel,
Banking Supervision and Regulation Division, Federal Reserve Bank of St. Louis, at
(800) 333-0810 extension 8909 or (314) 444-8909.