FEDERAL DEPOSIT INSURANCE CORPORATION 12 CFR Part 325 RIN 3064ÄAB29 Capital Maintenance AGENCY: Federal Deposit Insurance Corporation (FDIC). ACTION: Proposed rule. SUMMARY: The FDIC is proposing to amend its leverage and risk-based capital standards to conform with the recently-issued Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities'' (FASB 115), which requires banks to explicitly recognize net unrealized holding gains and losses on available-for-sale securities in determining the amount of an institution's common stockholders' equity. Since Tier 1 capital is defined to include common stockholders' equity, this proposal, if adopted, would also affect the calculation of Tier 1 capital. The proposal is consistent with recent Call Report guidance issued by the Federal Financial Institutions Examination Council (FFIEC) that requires banks to adopt FASB 115 for Call Report purposes. In addition, the proposed changes would appear to be consistent with the intent of section 37 of the Federal Deposit Insurance Act, which provides that accounting principles applicable to depository institutions should be no less stringent than generally accepted accounting principles (GAAP). Because institutions must adopt FASB 115 for Call Report purposes, recognizing the FASB 115 adjustments for regulatory capital purposes will avoid a regulatory burden that would otherwise arise if the treatment of these unrealized gains and losses for regulatory capital purposes were to differ from the method required for GAAP and Call Report purposes. DATES: Comments on the proposal must be received by January 28, 1994. ADDRESSES: All comments should be submitted to Hoyle L. Robinson, Executive Secretary, Attention: Room FÄ400, Federal Deposit Insurance Corporation, 550 17th Street NW., Washington, DC 20429 or delivered to room FÄ400, 1776 F Street, NW., between the hours of 9 a.m. and 5 p.m. on business days. Comments will be available for inspection in room 7118, 550 17th Street, NW., Washington, DC between 9 a.m. and 4:30 p.m. on business days. FOR FURTHER INFORMATION CONTACT: For supervisory purposes, Stephen G. Pfeifer, Examination Specialist (202/898Ä8904), or Robert F. Storch, Section Chief (202/898Ä8906), Accounting Section, Division of Supervision; for legal issues, Cristeena G. Naser, Attorney, Legal Division (202/898Ä3587). SUPPLEMENTARY INFORMATION: I. Background The FDIC's leverage and risk-based capital standards (12 CFR part 325 subpart A and appendix A to part 325) set forth a definition of Tier 1 capital that includes common stockholders' equity. The capital definitions (12 CFR 325.2(d) and section 1.A.1. of appendix A) further explain that common stockholders' equity includes common stock and any related surplus, undivided profits, disclosed capital reserves that represent a segregation of undivided profits, and foreign currency translation adjustments, less unrealized losses on marketable equity securities. In May 1993, the Financial Accounting Standards Board (FASB) issued FASB 115 which, in effect, changes the calculation of stockholders' equity in financial statements prepared in accordance with GAAP by including as a separate component of equity the amount of net unrealized holding gains and losses on debt and equity securities that are deemed to be available-for-sale. In addition, in materials accompanying the September 1993 Call Report forms, the FFIEC notified all banks that they must adopt the new FASB 115 accounting standard 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. Call Report instructions that apply prior to the adoption of FASB 115 require a separate capital component only for the net unrealized loss on marketable equity securities, consistent with the provisions of Statement of Financial Accounting Standards No. 12, "Accounting for Certain Marketable Securities'' (FASB 12). FASB 115, which supersedes FASB 12, broadens the scope of this separate component of stockholders' equity in that the FASB 115 capital component will include unrealized gains and losses on all securities that are available-for-sale (debt as well as equity), rather than just the net unrealized losses on marketable equity securities. This new GAAP accounting standard and the conforming Call Report guidance raise the question of how the FASB 115 capital component for unrealized gains and losses on available-for-sale securities should be treated in determining the amount of an institution's regulatory capital under part 325. As a result, the FDIC is proposing to amend its leverage and risk-based capital standards to explicitly recognize net unrealized holding gains and losses on available-for-sale securities in determining the amount of an institution's common stockholders' equity. This proposed regulatory capital treatment is consistent with the manner in which the FASB 115 capital component will be handled for financial reporting purposes under GAAP and for regulatory reporting purposes in the Call Reports that are filed by banks in accordance with the instructions issued by the FFIEC. Since Tier 1 capital under the FDIC's capital standards is defined to include common stockholders' equity, this proposal, if adopted, would also affect the calculation of Tier 1 capital. II. Summary of FASB 115 Accounting Requirements Under the GAAP rules and the Call Report instructions that apply to banks prior to the adoption of FASB 115, the basis of accounting for securities differs, depending on whether the securities are held for investment, held for trading, or held for sale. FASB 115 revises the categories among which depository institutions must divide their securities holdings to held-to-maturity, trading, and available-for-sale, and provides a different accounting treatment for each category. Held-to-Maturity The held-to-maturity category supplants the current held-for-investment category, but the accounting basis (i.e., amortized cost) remains the same. FASB 115 permits an institution to include a security in the held-to-maturity category only if the institution has "the positive intent and ability to hold the security to maturity''. Trading Securities The accounting treatment for trading securities remains unchanged. Trading securities are those debt and equity securities that an institution buys and holds principally for the purpose of selling in the near term. Trading securities will continue to be reported at fair value (i.e., generally market value) with unrealized changes in value (appreciation and depreciation) reported directly in the income statement as a part of the institution's earnings. Available-for-Sale Securities in the available-for-sale category are those securities for which the institution does not have the positive intent and ability to hold to maturity, yet does not intend to trade actively as part of its trading account. Under GAAP that exists prior to the adoption of FASB 115, debt securities held for sale have been carried at the lower of cost or fair value, with the offsetting entry reported directly in the income statement. However, securities meeting the new FASB 115 definition of available-for-sale will be reported at fair value, but any changes in the fair value of available-for-sale securities will not be included in the bank's income statement. Rather, the unrealized holding gains and losses on these securities, net of any applicable tax effect, will be reported directly as a separate component of stockholders' equity. Consequently, any unrealized appreciation or depreciation in the value of securities in the available-for-sale category, after adjusting for any applicable tax effects, will increase or decrease an institution's equity capital, respectively, but will have no immediate effect on the reported earnings of the institution. The available-for-sale category is likely to include more securities than are included in the held-for-sale category it replaces. This is because institutions previously could include in the held-for-investment category securities that banks intended to hold for long-term investment purposes, but for which they may not necessarily have possessed the positive intent and ability to hold to maturity. Under FASB 115, however, a security should not be reported in the held-to-maturity category if, for example, the security may be sold in response to: (1) Changes in market interest rates and related changes in prepayment risk; (2) liquidity needs; (3) changes in the availability of and the yield on alternative investments; (4) changes in funding sources and terms; or (5) changes in foreign currency risk (FASB 115, 9). FASB 115 indicates that certain changes in circumstances may cause an institution to sell or transfer a held-to-maturity security without necessarily calling into question the institution's intent to hold to maturity other securities carried in this category. Such changes in circumstances include, for example, evidence of a significant deterioration in the issuer's creditworthiness, a change in regulatory requirements significantly modifying what constitutes a permissible investment or the maximum level of investments in certain securities, a significant increase in the industry's capital requirements, and a significant increase in the risk weights of debt securities used for risk-based capital purposes. In addition, FASB 115 states that there may be other events that are "isolated, nonrecurring, and unusual'' in nature that could not have been reasonably anticipated by management that may cause an institution to sell or transfer securities from the held-to-maturity category without tainting other securities that remain in that category (FASB 115, 8). III. Impact of FASB 115 for Regulatory Capital Purposes As discussed above, FASB 115 will restrict the circumstances under which securities may be reported at amortized cost. Thus, a greater proportion of an institution's securities may need to be carried at amounts that consider their fair value than in the past. Although the FDIC's proposal to adopt FASB 115 for part 325 capital purposes will not affect reported earnings, it may result in more volatility in the amount of regulatory capital as the net appreciation or depreciation figure for securities in the available-for-sale category changes over time. Because of the interest rate environment over the past several years, the fair value of many institutions' securities portfolios may exceed book value. Consequently, this proposal, if adopted, would result in an immediate increase in Tier 1 capital for those institutions that have net appreciation in the securities they will designate as available-for-sale when FASB 115 is adopted. Nonetheless, as the interest rate environment changes over time, some institutions may find that the impact of this proposal could result in lower regulatory capital and possibly additional regulatory restrictions under the prompt corrective action rules (12 CFR part 325 subpart B) and under various other laws and regulations that are based, in part, on the institutions' capital levels.1 ®1¯ Some of the laws and regulations that may be affected if the proposed revisions are adopted include those dealing with the risk-related insurance premium system (12 CFR part 327), brokered deposit restrictions (12 CFR part 337.6), and restrictions on activities and investments of insured state banks (12 CFR part 362). For example, under  362.3(d)(4) of the FDIC's regulations, certain equity investments are subject to a maximum permissible investment limitation as a percent of Tier 1 capital. If the FASB 115 adjustments for available-for-sale securities are recognized for regulatory capital purposes, as is being proposed, this would affect the calculation of the amount of additional investments, if any, an insured state bank can make under this limitation. The book value of equity investments and Tier 1 capital are used in computing this amount. The FDIC recognizes that banks whose equity investments under part 362 are already at the maximum may have to adjust their holdings if FASB 115 is adopted for regulatory capital purposes since any upward adjustment to the book value of these securities for unrealized holding gains will be based on the gross amount of unrealized appreciation before considering applicable tax effects whereas the actual increase in Tier 1 capital for this unrealized appreciation will be net of applicable tax effects. In addition, the FDIC notes that state-chartered banks will need to consult with their respective state banking authorities to determine the impact, if any, that FASB 115 may have on the application of state laws and regulations, including legal lending limits. The volatility arising from changes in the fair value of available-for-sale securities may be minimized if, for example, the institution employs effective asset/liability and interest rate risk management techniques that reduce a bank's exposure to movements in interest rates and related market risks. Further, many institutions maintain capital cushions over and above the minimum capital standards and therefore will be better able to absorb any adverse fluctuations in capital levels that may arise from FASB 115 fair value adjustments. The proposed changes to the FDIC's capital standards would conform the part 325 capital definitions with the new FASB 115 accounting standard and with the recent notification to banks about the applicability of this standard for Call Report purposes. In addition, the proposed changes would appear to be consistent with the intent of section 37 of the Federal Deposit Insurance Act (12 U.S.C. 1831n), which provides that accounting principles applicable to depository institutions should be no less stringent than GAAP and should: (a) Result in financial statements and reports of condition that accurately reflect the capital of such institutions, (b) facilitate effective supervision of the institutions, and (c) facilitate prompt corrective action at the least cost to the insurance funds. Section 37 also promotes uniformity among the agencies in the accounting standards used to determine compliance with regulatory requirements applicable to depository institutions, including regulatory capital requirements. This proposal has been developed in consultation with the other federal banking agencies to ensure uniformity in the application of FASB 115 for regulatory capital purposes. Since institutions must adopt FASB 115 for Call Report purposes, recognizing the FASB 115 adjustments for regulatory capital purposes will avoid a regulatory burden that would otherwise arise if the treatment of these unrealized gains and losses for regulatory capital purposes were to differ from the method required for GAAP and Call Report purposes. The FDIC notes that the decision to propose the adoption of FASB 115 for regulatory capital purposes should not be viewed as an endorsement of a wider application of market value accounting. The FDIC's longstanding concerns that market valuations of many assets are highly subjective and that market value accounting could produce undesirable volatility in earnings are somewhat mitigated in the case of FASB 115, since this accounting standard applies only to certain investment securities having a readily discernible fair value and since unrealized holding gains and losses on available-for-sale securities are reflected directly in capital without affecting reported earnings. If the proposed part 325 revisions are adopted, FDIC examiners will continue to consider the quality and not just the level of a bank's capital in evaluating capital adequacy. Institutions with available-for-sale securities possessing net unrealized holding gains that comprise a disproportionately large portion of Tier 1 capital may possibly be exposed to excessive levels of interest rate or market risk. These institutions will be expected to maintain capital levels above the minimum regulatory capital standards and commensurate with the institutions' particular risk profiles. After the federal banking agencies take final action on this proposal, the FDIC intends to consult with the Office of the Comptroller of the Currency, the Federal Reserve Board, and the Conference of State Bank Supervisors concerning the need, if any, for revisions to the "Uniform Agreement on the Classification of Assets and Appraisal of Securities Held by Banks''. The FDIC and the other federal and state bank supervisors last revised this joint statement in May 1979. The statement contains guidance on the appraisal of securities in bank examinations, including the effect of appreciation and depreciation in investment securities on regulatory capital. IV. Issues for Specific Comment The FDIC invites comments on all aspects of this proposed regulatory capital rule. In addition to other comments that respondents to this proposal may wish to provide, the FDIC requests specific comments on the following: (1) Recognition of FASB 115 Capital Adjustments for Regulatory Capital Purposes. Given the provisions of section 37 of the FDI Act and the other issues discussed in this preamble, should the FASB 115 capital adjustments that institutions are required to reflect for GAAP and Call Report purposes also be taken into consideration for purposes of determining an institution's Tier 1 capital under the FDIC's leverage and risk-based capital standards? If not, what regulatory capital treatment should be applied? (2) Effect of FASB 115 Adjustments on Other Capital-Based Regulations. If the FASB 115 capital adjustments are recognized for purposes of calculating an institution's leverage and risk-based capital ratios, these adjustments may also have an effect on certain other laws and regulations that are based, in part, on regulatory capital levels, including the prompt corrective action rules (12 CFR part 325 subpart B), the risk-related insurance premium system (12 CFR part 327), the brokered deposit restrictions (12 CFR 337.6), and the restrictions on activities and investments of insured state banks (12 CFR part 362), such as the limitations in  362.3(d)(4) on the book value of certain equity investments as a percent of Tier 1 capital. If the FASB 115 capital adjustments are recognized in calculating an institution's compliance with the minimum leverage and risk-based capital standards, should these adjustments also be recognized for purposes of the other rules noted above that are based, in part, on an institution's regulatory capital levels? If not, what treatment should be used for these other regulations? (3) Appropriateness of Recognizing FASB 115 Net Appreciation for Regulatory Capital Purposes. In determining the amount of any FASB 115 adjustment to stockholders' equity for changes in the fair value of available-for-sale securities, FASB 115 as well as the conforming Call Report guidance take into consideration all changes in the fair value of these securities, regardless of whether these changes represent net appreciation or net depreciation. Under the accounting rules that are applicable prior to the adoption of FASB 115, an institution's capital for GAAP and Call Report purposes could not be increased by the amount of any net unrealized appreciation on securities held for sale. Should the regulatory capital treatment for changes in the fair value of securities held in the FASB 115 available-for-sale category differ, depending upon whether the change represents net appreciation or net depreciation? If so, what treatment is appropriate? V. Regulatory Flexibility Act Statement The Board of Directors of the FDIC hereby certifies that these amendments to part 325 will not have a significant economic impact on a substantial number of small business entities within the meaning of the Regulatory Flexibility Act (5 U.S.C. 601 et seq). These amendments will not necessitate the development of sophisticated recordkeeping or reporting systems by small institutions nor will small institutions need to seek out the expertise of specialized accountants, lawyers or managers to comply with the regulation. In light of this certification, the Regulatory Flexibility Act requirements (at 5 U.S.C. 603, 604) to prepare initial and final regulatory flexibility analyses do not apply. VI. Paperwork Reduction Act No collections of information pursuant to section 3504(h) of the Paperwork Reduction Act (44 U.S.C. 3501 et seq.) are contained in this notice. Consequently, no information has been submitted to the Office of Management and Budget for review. List of Subjects in 12 CFR Part 325 Bank deposit insurance, Banks, Banking, Capital adequacy, Reporting and recordkeeping requirements, State nonmember banks, Savings associations. For the reasons set forth in the preamble, the Board of Directors of the Federal Deposit Insurance Corporation proposes to amend part 325 of title 12 of the Code of Federal Regulations as follows: PART 325 CAPITAL MAINTENANCE 1. The authority citation for part 325 continues to read as follows: Authority: 12 U.S.C. 1815(a), 1815(b), 1816, 1818(a), 1818(b), 1818(c), 1818(t), 1819(Tenth), 1828(c), 1828(d), 1828(i), 1828(n), 1828(o), 1831o, 3907, 3909; Public Law 102Ä233, 105 Stat. 1761, 1789, 1790 (12 U.S.C. 1831n note); Public Law 102Ä242, 105 Stat. 2236, 2355, 2386 (12 U.S.C. 1828 note). 2. Section 325.2(d) is revised to read as follows:  325.2 Definitions. * * * * * (d) Common stockholders' equity means the sum of common stock and related surplus, undivided profits, disclosed capital reserves that represent a segregation of undivided profits, foreign currency translation adjustments, and net unrealized holding gains and losses on available-for-sale securities. * * * * * 3. In appendix A to part 325, the definition of common stockholders' equity in section I.A.1. is revised to read as follows: Appendix A to Part 325 Statement of Policy on Risk-Based Capital I. * * * A. * * * 1. * * * Common stockholders' equity capital (includes common stock and related surplus, undivided profits, disclosed capital reserves that represent a segregation of undivided profits, foreign currency translation adjustments, and net unrealized holding gains and losses on available-for-sale securities); * * * * * By order of the Board of Directors. Dated at Washington, D.C. this 14th day of December, 1993. Federal Deposit Insurance Corporation. Robert E. Feldman, Deputy Executive Secretary. [FR Doc. 93Ä31656 Filed 12Ä28Ä93; 8:45 am] BILLING CODE 6714Ä01ÄP