FEDERAL RESERVE SYSTEM 12 CFR Parts 208 and 225

[Regulations H and Y; Docket No. R-0823]

Capital; Capital Adequacy Guidelines

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Proposed rule with request for comments.

SUMMARY: The Board of Governors of the Federal Reserve System is proposing to
amend its risk-based and leverage capital guidelines for State member banks
and bank holding companies to include in Tier 1 capital the net unrealized
changes in the value of securities available for sale for purposes of
calculating the risk-based and leverage ratios. The proposal is in response to
the recently adopted Financial Accounting Standards Board (FASB) Statement
Number 115, Accounting for Certain Investments in Debt and Equity Securities,
which establishes "net unrealized holding gains and losses on securities
available for sale'' as a new component of common stockholders' equity.
Although the Board's capital guidelines indicate that common stockholders'
equity is included in Tier 1 capital, they do not specifically address this
new equity account. This proposed rule addresses the treatment of the new
account.

DATES: All comments regarding the proposed changes must be submitted on or
before January 21, 1994.

ADDRESSES: Comments should refer to Docket No. R-0823 and may be addressed to
Mr. William W. Wiles, Secretary, Board of Governors of the Federal Reserve
System, 20th and Constitution Avenue, NW, Washington, DC 20551, or delivered
to room B-2223, Eccles Building, between 8:45 a.m. and 5:15 p.m. Comments may
be inspected in room MP-500, Martin Building, between 9:00 a.m. and 5:00 p.m.
weekdays, except as provided in Section 261.8(a) of the Board's Rules
Regarding Availability of Information, 12 CFR 261.8(a).

FOR FURTHER INFORMATION CONTACT: Rhoger H Pugh, Assistant Director
(202/728-5883), Arleen E. Lustig, Supervisory Financial Analyst
(202/452-2987), and John M. Frech, Supervisory Financial Analyst
(202/452-2275), Division of Banking Supervision and Regulation, Board of
Governors of the Federal Reserve System. For the hearing impaired only,
Telecommunication Device for the Deaf (TDD), Dorothea Thompson (202/452-3544),
Board of Governors of the Federal Reserve System, 20th and C Streets, NW,
Washington, DC 20551.

SUPPLEMENTARY INFORMATION:

Background

The risk-based capital guidelines adopted by the Federal Reserve Board®1¯  set
forth a definition of Tier 1 capital that includes common stockholders'
equity. The Board's risk-based capital guidelines for State member banks and
bank holding companies further state that common stockholders' equity includes
(1) common stock, (2) related surplus, and (3) retained earnings, including
capital reserves and adjustments for the cumulative effect of foreign currency
translation, net of treasury stock. On May 31, 1993, FASB issued a new
accounting standard, FASB Statement Number 115 (FASB 115), Accounting for
Certain Investments in Debt and Equity Securities, which, in essence, adds a
new element to common stockholders' equity by including net unrealized gains
and losses on certain securities. The Federal banking agencies have agreed to
adopt FASB 115 for regulatory reporting purposes.®2¯  The adoption of this new
accounting standard for regulatory reporting has raised the question whether
the Board should include the new component of common stockholders' equity in
Tier 1 capital for purposes of calculating risk-based and leverage capital
ratios.

®1¯ The Board's guidelines implement, for State member banks and bank holding
companies, the international bank capital standards as set forth in the Basle
Accord. The Basle Accord is a risk-based capital framework that was proposed
by the Basle Committee on Banking Regulations and Supervisory Practices and
endorsed by the central bank governors of the Group of Ten (G-10) countries in
July 1988. The Committee is comprised of representatives of the central banks
and supervisory authorities from the G-10 countries (Belgium, Canada, France,
Germany, Italy, Japan, Netherlands, Sweden, Switzerland, the United Kingdom,
and the United States) and Luxembourg.

®2¯  All banking organizations should adopt the new FASB 115 accounting
standard, both for GAAP and regulatory reporting purposes, as of January 1,
1994, or the beginning of their first fiscal year thereafter, if later. Early
adoption of this standard is also permitted to the extent allowable under FASB
115.

FASB 115

Under current Generally Accepted Accounting Principles (GAAP), there are three
categories of securities, each of which is subject to a different accounting
treatment: (1) "securities held for investment,'' (2) "trading securities,''
and (3) "securities held for sale.'' Under FASB 115, securities held by
banking organizations will be divided among three categories: (1) securities
held to maturity, a new category that replaces the securities
held-for-investment category; (2) the trading securities category, which
remains unchanged; and (3) securities available for sale, a new category that
replaces the securities held-for-sale category.

Under FASB 115, trading securities continue to be defined as those securities
that an institution buys and holds principally for the purpose of selling in
the near term. As before, these securities are to be reported at fair value
(i.e., generally at market value), with net unrealized changes in their value
reported directly in the income statement as part of an institution's
earnings.

Traditionally, securities held for investment have been recorded at amortized
cost. Under FASB 115, this treatment will continue to be applied to securities
held to maturity. However, FASB 115 states that a banking organization may
include a security in the held-to-maturity category only if management has
expressed "the positive intent and ability to hold the security to maturity.''

Under current GAAP, securities held for sale are carried at the lower of cost
or market value. Unrealized losses on such securities are reported through
earnings and reduce Tier 1 capital. Securities meeting the definition of the
new available-for-sale category, (i.e., securities that the institution does
not have both a positive intent and ability to hold to maturity, yet does not
intend to trade actively as part of its trading account), will be reported at
fair value. However, changes in the fair value of securities available for
sale will not be included in the income statement, but will be reported, net
of tax effects, directly in a separate, newly-established component of common
stockholders' equity. Consequently, any unrealized appreciation or
depreciation in the value of securities in the available-for-sale category
will have no impact on the reported earnings of an institution, but will
affect its capital position.

The available-for-sale category is likely to include more securities than are
included in the current held-for-sale account. This is because institutions
previously could include in the held-for-investment category securities that
banking organizations intended to hold for long-term investment purposes, but
not necessarily to maturity. Many such securities are now likely to be held in
the available-for-sale category, and the new standard describes specific
circumstances under which a debt security should be reported in the
available-for-sale or trading accounts rather than in the held-to-maturity
category. For example, securities that would be sold in response to changes in
market interest rates or prepayment rates, or to provide liquidity to meet
deposit withdrawal or increased loan demand, would have to be included in the
available-for-sale or trading account; they would not be eligible for the
held-to-maturity category.

FASB 115 does acknowledge that there may be events that are "isolated,
nonrecurring, and unusual'' in nature that could not have been reasonably
anticipated by management and, thus, would permit the sale or transfer of a
held-to-maturity security without necessarily calling into question the
institution's intent to hold to maturity other securities carried in this
category. FASB 115 notes that such unforeseen events might include certain
changes in industry capital requirements, certain changes in tax laws, and
evidence of a significant deterioration in the issuer's creditworthiness that
would appear to permit sales or transfers without tainting other securities in
the held-to-maturity category.

Proposal

The Board is proposing to amend the capital adequacy guidelines for State
member banks and bank holding companies to include in Tier 1 capital the new
component of common stockholders' equity created by FASB 115. Under this
proposed amendment, the net amount of unrealized gains and losses, adjusted
for income taxes, from securities held in the available-for-sale account would
be included in Tier 1 capital for purposes of calculating both the leverage
and risk-based capital ratios.

The Board believes that this proposal is consistent with the intent of section
121 of the Federal Deposit Insurance Corporation Improvement Act of 1991
(FDICIA), which stipulates, consistent with the long-standing policy of the
banking agencies, that regulatory accounting standards be no less stringent
than GAAP and result in financial reports that accurately reflect the capital
of depository institutions. In this regard, the effect on institutions of
including net gains and losses on securities available for sale in Tier 1 can
perhaps best be evaluated in an economic environment in which banking
organizations generally have experienced losses on their securities holdings,
rather than gains as is the situation for most institutions at the present
time.

The Board also believes that if unrealized gains and losses on securities
available for sale were excluded from Tier 1 capital, an incentive could be
created for banking organizations to sell their securities that have
appreciated to increase Tier 1 capital, while continuing to hold securities
that have depreciated without incurring a reduction in Tier 1 capital. An
organization engaging in such a practice potentially could overstate its
capital and, accordingly, could be subject to examiner criticism.

The rationale put forward by FASB for requiring the marking to market of
securities available for sale is that it provides a more realistic and
conservative presentation of the value of these securities than would
recording them at historical cost. The premise of valuing securities at
historical cost is based on the expectation that the securities will be held
to maturity, at which time the institution would realize the par value of the
securities. Since securities available for sale, like trading securities, are
not intended to be held to maturity, valuing them at historical cost would not
be as appropriate as marking them to market. Therefore, including the
unrealized losses, as well as the unrealized gains, on securities available
for sale in Tier 1 capital, is viewed overall as more conservative than not
recognizing these changes in value by continuing to carry these securities on
a historical cost basis.

The Board notes that in view of the agencies' adoption of FASB 115 for
regulatory reporting purposes, additional regulatory burden would be avoided
by including the new equity account in capital. Furthermore, if net unrealized
changes in the fair value of securities available for sale are included in
capital, the asset base used in the calculation of capital ratios would not
have to be adjusted to eliminate changes in the fair value of these
securities.

It also should be noted that including unrealized changes in the value of
securities available for sale in Tier 1 capital, as proposed, would affect the
calculation of capital for purposes of a number of laws and regulations that
are based, in part, on the institution's capital levels. Such laws and
regulations include prompt corrective action (12 CFR, part 208, subpart B),
brokered deposit restrictions (12 CFR 337.6), and the risk-related insurance
premium system (12 CFR part 327).

Consistency With the Basle Accord

The Basle capital treatment for changes in the value of assets that are marked
to market is well-established in the case of the unrealized changes in the
value of trading securities, which are included in Tier 1, and in the cases of
the on-balance sheet revaluation reserves of bank premises and the off-balance
sheet revaluation reserves of equity securities, both of which are included in
Tier 2. The Board believes that including the unrealized changes in the value
of securities available for sale in Tier 1 is consistent with international
capital standards, as set forth in the Basle Accord.

The principle of marking-to-market securities in the trading account and
including the net unrealized changes in value in Tier 1 capital is applied in
many countries and has been considered consistent with the Accord since its
adoption in 1988. The on-balance sheet revaluation of bank premises is
practiced in some countries that have experienced periods of high rates of
inflation. Accordingly, accounting standards in many of these countries
require all companies, including banks, to revalue their premises on the
balance sheet formally and periodically. The Basle Accord includes the
associated revaluation reserve in Tier 2 capital. Banking organizations in the
U.S. are not permitted to record their bank premises at market value under
U.S. accounting standards and, thus, revaluation reserves associated with bank
premises are not an issue for U.S. banking organizations.

The Basle Accord also includes in Tier 2 capital securities revaluation
reserves that arise from a off-balance sheet addition to capital of hidden
values and that pertain to "those banks whose balance sheets traditionally
include very substantial amounts of equities held in their portfolio at
historical cost.'' Many believe that Tier 2 capital treatment is appropriate
for equity and premises revaluation reserves and was adopted for these
reserves in part to reflect concerns about a banking organization's ability to
recognize the indicated market price for securities or other assets for which
there are not highly liquid markets.

The Board believes that its proposed Tier 1 capital treatment for unrealized
changes in the value of securities available for sale can be viewed as an
extension of the capital treatment currently applied to trading securities.
Moreover, the Board also notes that, like other elements of Tier 1 capital
under the Basle Accord, the net unrealized gains and losses on these
securities is separately disclosed as part of common stockholders' equity on
an institution's financial statements on an after-tax basis. However, the
Board recognizes the importance of maintaining the consistent application of
the Basle capital standards and invites comment on this issue.

Request for Public Comment

The Board invites comments on all aspects of this proposed change. In
particular, the Board seeks the comments from interested parties on the
following:

(1) The extent to which FASB 115 may permit an institution to sell securities
from the held-to-maturity account without calling into question the
institution's intent or ability to continue to hold other securities reported
in that account.

(2) Examples of isolated, nonrecurring, and unusual events involving demands
for liquidity that would permit the sale or transfer of held-to-maturity
securities.

(3) Alternatives to including net unrealized changes in the value of
securities available for sale in Tier 1 capital by:

(a) Excluding all such changes from capital, which would have the same effect
as valuing these securities on a historical cost basis;

(b) Including only losses in Tier 1 capital, while not recognizing any gains
for capital purposes, which would have the effect of valuing securities
available for sale on lower of cost or market basis -- the same treatment that
currently pertains to securities held for sale;

(c) Including both the gains and losses in Tier 2 capital; and

(d) Including losses in Tier 1 capital, while including gains in Tier 2
capital.

(4) The extent to which the above alternatives may create an incentive for
banking organizations to sell securities that have appreciated to realize the
gains in Tier 1 capital, while holding securities that have depreciated to
avoid reductions in Tier 1 capital.

(5) The manner for maintaining an Allocated Transfer Risk Reserve (ATRR) for
certain foreign debt securities (e.g. "Brady Bonds'') held as securities
available for sale.

In seeking comments, the Board notes that its decision to propose adoption of
FASB 115 for regulatory capital purposes should not be viewed as an
endorsement of a wider application of market value accounting. The Board has
long had concerns that market valuations of many assets are highly subjective
and that market value accounting could produce undesirable volatility in
earnings. The Board believes that these concerns are mitigated in the case of
FASB 115 because the standard applies only to certain investment securities
having a readily discernable fair value and because unrealized changes in the
fair value of securities available for sale are reflected directly in capital
without affecting reported earnings.

Regulatory Flexibility Act Analysis

The Federal Reserve Board does not believe adoption of this proposal would
have a significant economic impact on a substantial number of small business
entities (in this case, small banking organizations), in accord with the
spirit and purposes of the Regulatory Flexibility Act (5 U.S.C. 601 et seq.).
In addition, because the risk-based capital guidelines generally do not apply
to bank holding companies with consolidated assets of less than $150 million,
this proposal will not affect such companies.

List of Subjects

12 CFR Part 208

Accounting, Agriculture, Banks, banking, Confidential business information,
Currency, Reporting and recordkeeping requirements, Securities.

12 CFR Part 225

Administrative practice and procedure, Banks, banking, Holding companies,
Reporting and recordkeeping requirements, Securities.

For the reasons set forth in the preamble, the Board is proposing to amend 12
CFR parts 208 and 225 as follows:

PART 208 MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE FEDERAL RESERVE
SYSTEM (REGULATION H)

1. The authority citation for part 208 continues to read as follows:

Authority: 12 U.S.C. 36, 248(a) and (c), 321-338, 461, 481-486, 601, and 611,
1814, 1823(j), 1831o, 1831p-1, 3906-3909, 3310, 3331-3351; 15 U.S.C. 78b,
78o-4(c)(5), 78q, 78q-1, 78w, 781(b), 781(i), and 1781(q).

2. Appendix A to part 208 is amended by revising section II.A.1.a, to read as
follows:

Appendix A to Part 208 Capital Adequacy Guidelines for State Member Banks:
Risk-Based Measure

                                  * * * * *

II. Definition of Qualifying Capital for the Risk-Based Capital Ratio

                                  * * * * *

A. * * *

1. * * *

a. Common stockholders' equity. Common stockholders' equity includes: common
stock; related surplus; net unrealized holding gains and losses on securities
available for sale; and retained earnings, including capital reserves and
adjustments for the cumulative effect of foreign currency translation, net of
any treasury stock.

                                  * * * * *

PART 225 BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL (REGULATION Y)

1. The authority citation for part 225 continues to read as follows:

Authority: 12 U.S.C. 1817(j)(13), 1818, 1831i, 1831p-1, 1843(c)(8), 1844(b),
1972(l), 3106, 3108, 3907, 3909, 3310, and 3331-3351.

2. Appendix A to part 225 is amended by revising section II.A.1.a, to read as
follows:

Appendix A to Part 225 Capital Adequacy Guidelines for Bank Holding Companies:
Risk-Based Measure

                                  * * * * *

II. Definition of Qualifying Capital for the Risk-Based Capitol Ratio

                                  * * * * *

A. * * *

1. * * *

a. Common stockholders' equity. Common stockholders' equity includes: common
stock; related surplus; net unrealized holding gains and losses on securities
available for sale; and retained earnings, including capital reserves and
adjustments for the cumulative effect of foreign currency translation, net of
any treasury stock.

                                  * * * * *

Board of Governors of the Federal Reserve System, December 17, 1993.

William W. Wiles,

Secretary of the Board.

[FR Doc. 93-31339 Filed 12-27-93; 8:45 am]

BILLING CODE 6210-01-F