Capital Adequacy: Net Unrealized Holding Gains and Losses on Available-For-Sale Securities

DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Part 3

[Docket No. 94-20]

RIN 1557-AB14

Capital Adequacy: Net Unrealized Holding Gains and Losses on

Available-For-Sale Securities

AGENCY: Office of the Comptroller of the Currency, Treasury.

ACTION: Final rule.

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SUMMARY: The Office of the Comptroller of the Currency (OCC) has

determined not to adopt its proposal to include the Statement of

Financial Accounting Standard No. 115, ``Accounting for Certain

Investments in Debt and Equity Securities'' (FAS 115), adjustment for

net unrealized holding gains and losses on available-for-sale

securities in Tier 1 capital. Based upon analysis of the comments

received and having considered the potential consequences of including

the FAS 115 adjustment in Tier 1 capital, the OCC, in consultation with

the Federal Reserve Board, the Federal Deposit Insurance Corporation,

and the Office of Thrift Supervision (Federal banking agencies),

determined not to amend the definition of Tier 1 capital as previously

proposed.

The OCC also decided to maintain the current requirement that

national banks deduct net unrealized losses on equity securities when

calculating Tier 1 capital. However, because FAS 115 changed the names

and requirements of the security classifications in the investment

portfolio, this final rule amends the definition of common

stockholders' equity to reflect the revised classifications used for

equity securities that are not in the trading account.

EFFECTIVE DATE: December 27, 1994.

FOR FURTHER INFORMATION CONTACT: Thomas G. Rees, Professional

Accounting Fellow, (202) 874-5180; J. Ray Diggs, National Bank Examiner

(202) 874-5070; Roger Tufts, Senior Economic Advisor, Office of the

Chief National Bank Examiner, (202) 874-5070; Ronald Shimabukuro,

Senior Attorney, or William W. Templeton, Senior Attorney, Legislative

and Regulatory Activities Division, (202) 874-5060, Office of the

Comptroller of the Currency, Washington, D.C. 20219.

SUPPLEMENTARY INFORMATION:

Background

Under the current OCC minimum capital requirements (leverage ratio)

and the risk-based capital guidelines set forth at 12 CFR part 3

appendix A, section 1(c)(7), a major component of Tier 1 capital is

common stockholders' equity. Common stockholders' equity currently

includes:

(1) common stock,

(2) common stock surplus,

(3) undivided profits,

(4) capital reserves,

(5) adjustments for the cumulative effect of foreign currency

translation, and

(6) net unrealized losses on noncurrent marketable equity

securities. The net unrealized losses are those recorded under

Statement of Financial Accounting Standards No. 12, ``Accounting for

Certain Marketable Securities'' (FAS 12).

FAS 115

In May 1993, the Financial Accounting Standards Board (FASB) issued

FAS 115. This statement superseded FAS 12. FAS 115 required that all

securities be grouped into one of three classifications: held-to-

maturity, trading, or available-for-sale. Most significantly, FAS 115

established net unrealized holding gains and losses on available-for-

sale securities as a new component of common stockholders' equity.

FAS 115 defines available-for-sale securities as those securities

that a bank does not have the positive intent and ability to hold to

maturity, and does not intend to trade actively as part of its trading

account. FAS 115 increases the number of securities that banks must

account for at market value. Consequently, numerous securities

previously reported by banks at amortized cost will now be reported at

their market value. In August 1993, the Federal Financial Institutions

Examination Council (FFIEC) announced the adoption of FAS 115 for

regulatory reporting purposes, effective January 1, 1994. Accordingly,

all national banks follow FAS 115 for reporting purposes.

Proposal

On April 18, 1994, the OCC proposed to adopt FAS 115 for regulatory

capital purposes (59 FR 18328, April 18, 1994). The other Federal

banking agencies published similar proposals to adopt FAS 115 for

regulatory capital purposes. See 58 FR 68563 (December 28, 1993)

(Federal Reserve Board); 58 FR 68781 (December 29, 1993) (Federal

Deposit Insurance Corporation); 59 FR 32143 (June 22, 1994) (Office of

Thrift Supervision). The OCC issued the proposal to promote greater

consistency of regulatory capital rules with generally accepted

accounting principles (GAAP). At the same time, the OCC wanted to

understand the industry sentiment regarding the costs and benefits of

adopting FAS 115, and to determine banks' assessment of their ability

to manage the potential volatility in regulatory capital.

Review of Comments

The comment period for the OCC's proposal closed on May 18, 1994.

Among the 69 commenters, 61 were banks, thrifts or holding companies;

five were financial institution trade groups; one was a public

accounting firm; one was an investment banking firm, and one was a

clearinghouse association. Fifty-five of the commenters opposed the

proposal to include net unrealized holding gains on available-for-sale

securities in Tier 1 capital.

Opposition to the proposal focused on the belief that including the

net unrealized holding gains and losses on available-for-sale

securities in regulatory capital would result in excessive volatility

in regulatory capital levels. Many commenters observed that temporary

market conditions could cause banks to change capital levels. Although

an interest rate change causing a change in a security's market value

may be temporary, the fluctuation in Tier 1 capital could trigger more

permanent regulatory provisions and sanctions tied to a bank's level of

capitalization. For example, a change in capital could limit a bank's

ability to acquire brokered deposits or increase a bank's deposit

insurance premiums. In an extreme case, a bank could be subject to

prompt corrective action restrictions, sanctions, and penalties.

A few commenters were critical of the market value accounting

approach. These commenters believe that recognizing unrealized gains

and losses directly in capital would present a misleading report of a

bank's financial condition. Although these unrealized gains and losses

may reflect market value, banks may never realize the dollar values of

these unrealized gains and losses. Several commenters believe that FAS

115 is not consistent in its approach because it requires banks to

account for certain assets at fair market value while liabilities are

valued at cost. These commenters believe that by focusing only on

certain assets, FAS 115 does not properly consider the effects of

market changes on other components of bank balance sheets.

Several commenters opposed this proposal because of another recent

OCC notice of proposed rulemaking to link the lending limits on loans

to one borrower to the capital adequacy rules (59 FR 6593, February 11,

1994). These commenters observed that if the OCC adopts both proposals,

an unacceptable level of volatility would be introduced to bank lending

limits. As a result, the capital rules could restrain a bank's ability

to lend to a single borrower in times of rising interest rates.

Of the ten commenters favoring the proposal, eight believe that the

OCC should make its capital adequacy rules consistent with GAAP.

Several of these commenters indicated that they would incur additional

recordkeeping expenses if the regulatory definition of capital differs

from the GAAP definition. These commenters believe that the regulatory

burden would be increased by excluding the FAS 115 adjustment from Tier

1 capital. However, several commenters from smaller banks contradicted

this view. These commenters stated that adoption of the proposal to

include net unrealized holding gains and losses in stockholders' equity

would increase regulatory burden because they would have to change

their investment and portfolio management procedures.

A few commenters believe that adoption of the proposed rule would

be consistent with the Federal Deposit Insurance Corporation

Improvement Act of 1991 (FDICIA), Pub. L. 102-242 (1991). Specifically,

the commenters refer to section 121 of FDICIA which requires that the

Federal banking agency regulatory accounting policy, applicable to

reports or statements filed with Federal banking agencies, be no less

stringent than GAAP.

Several commenters indicated that they did not see any benefit from

implementing FAS 115 for regulatory capital purposes. They believe that

the costs of implementing the proposal would exceed any benefits

obtained. These commenters believe adoption of the proposal would

reduce bank profitability. These commenters also believe that greater

volatility in the investment portfolio would translate into greater

volatility in bank capital.

Several commenters believe that banks may change their investment

strategies to avoid the potential adverse consequences of volatility in

capital levels. These commenters predict that banks would attempt to

manage the volatility by purchasing lower-yielding securities of

shorter duration. Banks would shorten the duration of their securities

to minimize the potential for depreciation due to increases in interest

rates. Banks could also limit the types of securities acquired to those

with less interest rate risk. Portfolios with lower volatility risk

would produce lower yields, resulting in smaller profit margins.

A few commenters observed that to avoid volatility in regulatory

capital, bank management may pay more attention to the short-term

impacts of portfolio decisions instead of emphasizing long-term

investment management strategies. The proposal could result in a

reduction of a portfolio manager's flexibility to respond to changing

market conditions.

Commenter Alternatives

Several commenters suggested alternative methods of adopting FAS

115 for regulatory capital. A few commenters suggested revising the

regulatory capital rules to include the net unrealized holding gains

and losses on available-for-sale securities in Tier 2 capital. However,

the OCC believes that adoption of this alternative would increase the

complexity of the risk-based capital calculations. In addition, because

FAS 115 significantly increased the number of securities subject to

market valuation, including the unrealized gains and losses in Tier 2

capital may not prevent volatility in regulatory capital levels.

Several commenters suggested that other balance sheet accounts,

particularly liabilities, should be reported at their market values.

These commenters argue that regulatory capital could then include the

net unrealized holding gains and losses on these other balance sheet

accounts. This would result in a more consistent treatment of assets

and liabilities. The OCC agrees that a more consistent method of

applying market values to assets and liabilities would result in a

better approach. However, since the FASB was unable to identify a

workable approach for valuing liabilities when it developed FAS 115,

the OCC concluded that this modification would require considerably

more research. Therefore, the OCC concluded that it could not implement

this suggestion at this time.

Another commenter suggested that the OCC include net unrealized

holding gains and losses on available-for-sale securities in regulatory

capital, but exclude the adjustment from capital calculations that are

tied to other regulations such as prompt corrective action or FDIC

insurance premiums. This approach would also be complex and burdensome

and essentially require a bank to maintain yet another set of capital

calculations. Accordingly, the OCC determined not to implement this

alternative.

Another commenter suggested that banks disclose market values but

exclude them from regulatory capital. Since the OCC has adopted FAS 115

for regulatory reporting, but will not adopt it for regulatory capital

purposes, in effect, the OCC is implementing this suggestion.

The Final Rule

After considering all the comments received, the OCC, in

consultation with the other Federal banking agencies, decided not to

adopt the proposal to include the net unrealized holding gains and

losses on available-for-sale securities in the definition of common

stockholders' equity. The significant changes in market interest rates

that occurred during the first two quarters of 1994 demonstrated that

bank capital levels could be significantly more volatile if the

definition of common stockholders' equity included the FAS 115

adjustment for net unrealized holding gains and losses. This is

especially true for smaller banks that tend to have more of their

assets in marketable securities. Additionally, smaller banks may lack

the financial resources to establish a portfolio management function

dedicated to hedging interest rate risks.

Based on the comment letters received, the OCC determined that

including the FAS 115 adjustment in capital could have consequences

that may adversely impact the banking industry. For example, market-

driven fluctuations in interest rates could cause temporary changes in

regulatory capital levels, which in turn could trigger inappropriate

regulatory intervention. In addition, industry profitability could

decline due to higher expenses and lower investment yields, simply due

to the accounting implications of FAS 115. The OCC is concerned that

adoption of the proposal would encourage management to place excessive

weight on the accounting implications of their decisions, rather than

on their long-term economic impacts.

Additionally, the OCC is concerned that the lack of consistent

application of market valuation for assets and liabilities would

present a misleading report of a bank's regulatory capital. Since FAS

115 only requires market value accounting for certain segments of the

investment portfolio, only one side of the balance sheet reflects the

impact of interest rate changes. The OCC believes it would be

inappropriate to take regulatory action without evaluating the impact

of rate changes on both sides of the balance sheet.

The OCC, considered the comments received regarding FDICIA's

requirement that regulatory accounting policy be no less stringent than

GAAP. In fact, section 121 of FDICIA (12 U.S.C. 1831n) requires that

policies applicable to reports and statements filed with the Federal

banking agencies conform to GAAP. The section does not require the

calculation of an institution's regulatory capital or the components of

regulatory capital to conform to GAAP, and the legislative history of

the section indicates that was not the intent of Congress. By adopting

FAS 115 for regulatory reporting purposes, the OCC's policy conforms to

the section 121 requirement.

Although the OCC and other Federal regulatory agencies attempt to

conform to GAAP when formulating regulatory policy, it is not always

appropriate. When formulating GAAP, the accounting policy makers do not

focus on the unique capital adequacy requirements of banks. Moreover,

the bank regulators' framework of bank supervision is being linked

increasingly to capital levels. Therefore, it is logical to expect some

differences between GAAP and bank regulatory policy in appropriate

circumstances. In fact, the definition of capital in the capital

adequacy rules already differs from the GAAP definition. For example,

the regulatory definition includes a limited amount of the allowance

for loan and lease losses (ALLL) in Tier 2 capital, while the GAAP

definition of capital does not include any amount of ALLL. By adopting

FAS 115 for regulatory reporting, the agencies minimized the difference

between the Reports of Condition and Income (Call Reports) and

financial reports issued under GAAP.

Additionally, the OCC and the other Federal banking agencies

recognize that the net unrealized holding gains and losses recorded

under FAS 115 are often temporary.

Therefore, because Tier 1 capital, or ``core capital,'' is intended

to be permanent in nature, the OCC believes the definition of Tier 1

capital should not include these unrealized gains and losses. Such

treatment would be inconsistent with the capital measurement and

standards provisions of the Basle Accord, an international agreement of

the central banks and supervisory authorities of ten countries.

Change to Common Stockholders' Equity

In addressing the issues raised by the commenters on the merits of

including unrealized gains and losses in regulatory capital, the OCC

considered eliminating the requirement to deduct unrealized losses on

noncurrent marketable equity securities. However, the OCC believes the

use of amortized cost is relevant for debt securities but not for

equities. Absent the default of the issuer, a debt security will

realize its face amount. However, an equity security does not have a

maturity value. Consequently, the market value of an equity security

represents the best measure of its worth.

The OCC believes market value is the appropriate method of valuing

equities, but does not believe it is appropriate to include unrealized

gains in regulatory capital. The OCC and the other Federal agencies

have a long-standing policy of excluding all unrealized gains from Tier

1 capital and do not believe it is appropriate to deviate from this

policy. Accordingly, the OCC decided to retain the requirement to

deduct unrealized losses on equity securities. This final rule

clarifies the description of the deduction and revises the definition

of common stockholders' equity to reflect the new security

classification specified under FAS 115. Accordingly, banks must adjust

Tier 1 capital for net unrealized holding losses on equity securities

with readily determinable fair values held in the available-for-sale

portfolio.

Other Issues

To ensure regulators do not ignore significant unrealized

depreciation in the market value of securities when assessing a bank's

safety and soundness, examiners will consider both unrealized gains and

losses in their evaluation of the adequacy of a bank's regulatory

capital. When unrealized losses could threaten a bank's financial

condition, other regulatory actions that are based on regulatory

capital may be initiated.

Examiners will use their discretion to determine if a national bank

has taken an investment approach that is inconsistent with the OCC's

description of suitable investment practices. If it appears that an

institution is artificially manipulating security classifications to

increase regulatory capital, examiners may require banks to account for

securities at market values instead of amortized cost. The OCC plans to

issue additional guidance that will describe how unrealized gains and

losses will be considered and what actions examiners will take when

they detect gains trading and other unsafe practices.

Regulatory Flexibility Act

Pursuant to section 605(b) of the Regulatory Flexibility Act, it is

hereby certified that this final rule will not have a significant

economic impact on a substantial number of small entities. Accordingly,

a regulatory flexibility analysis is not required. This final rule will

not increase the number of banks that do not meet regulatory capital

standards. The effect on capital will be minimal regardless of bank

size.

Executive Order 12866

The OCC has determined that this final rule is not a significant

regulatory action under Executive Order 12866.

List of Subjects in 12 CFR Part 3

Administrative practice and procedure, National banks, Reporting

and recordkeeping requirements.

Authority and Issuance

For the reasons set out in the preamble, part 3 of title 12,

chapter I, of the Code of Federal Regulations is amended as set forth

below.

PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES

1. The authority of citation for part 3 is revised to read as

follows:

Authority: 12 U.S.C. 93a, 161, 1818, 1828(n), 1828 note, 1831(n)

note, 3907, and 3909.

2. In appendix A to part 3, paragraph (c)(7) of section 1 is

revised to read as follows:

Appendix A to Part 3--Risk-Based Capital Guidelines

Section 1. Purpose, Applicability of Guidelines, and

Definitions.

* * * * *

(c) * * *

(7) Common stockholders' equity means common stock, common stock

surplus, undivided profits, capital reserves, and adjustments for

the cumulative effect of foreign currency translation, less net

unrealized holding losses on available-for-sale equity securities

with readily determinable fair values.

* * * * *

Dated: November 8, 1994.

Eugene A. Ludwig,

Comptroller of the Currency.

[FR Doc. 94-29110 Filed 11-23-94; 8:45 am]

BILLING CODE 4810-33-P