Capital; Capital Adequacy Guidelines

Federal RegisterDec 22, 1994

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FEDERAL RESERVE SYSTEM

12 CFR Parts 208 and 225

[Regulations H and Y; Docket No. R-0795]

Capital; Capital Adequacy Guidelines

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Final rule.

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SUMMARY: The Board of Governors of the Federal Reserve System (Board or

Federal Reserve) is revising its capital adequacy guidelines for state

member banks and bank holding companies to establish a limitation on

the amount of certain deferred tax assets that may be included in (that

is, not deducted from) Tier 1 capital for risk-based and leverage

capital purposes. The capital rule was developed in response to the

Financial Accounting Standards Board's (FASB) issuance of Statement No.

109, ``Accounting for Income Taxes'' (FAS 109). Under the final rule,

deferred tax assets that can only be realized if an institution earns

taxable income in the future are limited for regulatory capital

purposes to the amount that the institution expects to realize within

one year of the quarter-end report date--based on its projection of

taxable income--or 10 percent of Tier 1 capital, whichever is less.

EFFECTIVE DATE: April 1, 1995.

FOR FURTHER INFORMATION CONTACT: Charles H. Holm, Project Manager,

(202) 452-3502; Nancy J. Rawlings, Senior Financial Analyst, (202) 452-

3059, Regulatory Reporting and Accounting Issues Section; Barbara J.

Bouchard, Supervisory Financial Analyst, (202) 452-3072, Policy

Development Section, 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.

SUPPLEMENTARY INFORMATION:

I. Background

A. Characteristics of Deferred Tax Assets

Deferred tax assets are assets that reflect, for financial

reporting purposes, benefits of certain aspects of tax laws and rules.

Deferred tax assets may arise because of specific limitations under tax

laws of different tax jurisdictions that require that certain net

operating losses (e.g., when, for tax purposes, expenses exceed

revenues) or tax credits be carried forward if they cannot be used to

recover taxes previously paid. These ``carryforwards'' are realized

only if the institution generates sufficient future taxable income

during the carryforward period.

Deferred tax assets may also arise from the tax effects of certain

events that have been recognized in one period for financial statement

purposes but will result in deductible amounts in a future period for

tax purposes, i.e., the tax effects of ``deductible temporary

differences.'' For example, many depository institutions and bank

holding companies may report higher income to taxing authorities than

they reflect in their regulatory reports1 because their loan loss

provisions are expensed for reporting purposes but are not deducted for

tax purposes until the loans are charged off.

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\1\State member banks are required to file quarterly

Consolidated Reports of Condition and Income (Call Reports) with the

Federal Reserve. Bank holding companies with total consolidated

assets of $150 million or more file quarterly Consolidated Financial

Statements for Bank Holding Companies (FR Y-9C reports) with the

Federal Reserve.

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Deferred tax assets arising from an organization's deductible

temporary differences may or may not exceed the amount of taxes

previously paid that the organization could recover if the

organization's temporary differences fully reversed at the report date.

Some of these deferred tax assets may theoretically be ``carried back''

and recovered from taxes previously paid. On the other hand, when

deferred tax assets arising from deductible temporary differences

exceed such previously paid tax amounts, they will be realized only if

there is sufficient future taxable income during the carryforward

period. Such deferred tax assets, and deferred tax assets arising from

net operating loss and tax credit carryforwards, are hereafter referred

to as ``deferred tax assets that are dependent upon future taxable

income.''

B. Summary of FAS 109

In February 1992, the FASB issued Statement No. 109, ``Accounting

for Income Taxes'' which supersedes Accounting Principles Board Opinion

No. 11 and FASB Statement No. 96. FAS 109 provides guidance on many

aspects of accounting for income taxes, including the accounting for

deferred tax assets. FAS 109 potentially allows some state member banks

and bank holding companies to record significantly higher deferred tax

assets than previously permitted under generally accepted accounting

principles (GAAP) and the federal banking agencies' prior reporting

policies.2 Unlike the general practice under previous standards,

FAS 109 permits the reporting of deferred tax assets that are dependent

upon future taxable income. However, FAS 109 requires the establishment

of a valuation allowance to reduce the net deferred tax asset to an

amount that is more likely than not (i.e., a greater than 50 percent

likelihood) to be realized.

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\2\The federal banking agencies consist of the Federal Reserve

Board (Board), the Federal Deposit Insurance Corporation (FDIC), the

Office of the Comptroller of the Currency (OCC), and the Office of

Thrift Supervision (OTS) (hereafter, the ``agencies''.)

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FAS 109 became effective for fiscal years beginning on or after

December 15, 1992. The adoption of this standard has resulted in the

reporting of additional deferred tax assets in Call Reports and FR Y-9C

reports that directly increase institutions' undivided profits

(retained earnings) and Tier 1 capital.

C. Concerns Regarding Deferred Tax Assets That Are Dependent Upon

Future Taxable Income

The Federal Reserve has certain concerns about including in capital

deferred tax assets that are dependent upon future taxable income.

Realization of such assets depends on whether a banking organization

has sufficient future taxable income during the carryforward period.

Since a banking organization that is in a net operating loss

carryforward position is often experiencing financial difficulties, its

prospects for generating sufficient taxable income in the future are

uncertain. In addition, the condition of and future prospects for an

organization often can and do change very rapidly in the banking

environment. This raises concerns about the realizability of deferred

tax assets that are dependent upon future taxable income, even when an

organization may be sound and well-managed. Thus, for many

organizations such deferred tax assets may not be realized, and for

other organizations there is a high degree of subjectivity in

determining the realizability of this asset. Furthermore, while many

organizations may be able to make reasonable projections of taxable

income for relatively short periods and actually realize this income,

beyond a short time period, the reliability of the projections tends to

decrease significantly. In addition, unlike many other assets, banking

organizations generally cannot obtain the value of deferred tax assets

by selling them.

Moreover, as an organization's condition deteriorates, it is less

likely that deferred tax assets that are dependent upon future taxable

income will be realized. Therefore, the organization is required under

FAS 109 to reduce its deferred tax assets through increases to the

asset's valuation allowance. Additions to this allowance would reduce

the organization's regulatory capital at precisely the time it needs

capital support the most. Thus, the inclusion in capital of deferred

tax assets that are dependent upon future taxable income raises

supervisory concerns.

Because of these concerns, the agencies, under the auspices of the

Federal Financial Institutions Examination Council (FFIEC), considered

whether it would be appropriate to adopt FAS 109 for regulatory

reporting purposes. On August 3, 1992, the FFIEC requested public

comment on this matter, and on December 23, 1992, after consideration

of the comments received, the FFIEC decided that banks and savings

associations should adopt FAS 109 for reporting purposes in Call

Reports and Thrift Financial Reports (TFRs) beginning in the first

quarter of 1993 (or the beginning of their first fiscal year

thereafter, if later). Furthermore, the Board decided that bank holding

companies should adopt FAS 109 in FR Y-9C Reports at the same time.

D. Proposal for the Treatment of Deferred Tax Assets

The FFIEC, in reaching its decision on regulatory reporting, also

recommended that each of the agencies amend its regulatory capital

standards to limit the amount of deferred tax assets that can be

included in regulatory capital. In response to the FFIEC's

recommendation, on February 11, 1993, the Board issued for public

comment a proposal to adopt the recommendation of the FFIEC in full, as

summarized below (54 FR 8007, February 11, 1993). The FFIEC recommended

that the agencies limit the amount of deferred tax assets that are

dependent upon future taxable income that can be included in regulatory

capital to the lesser of:

i. the amount of such deferred tax assets that the institution

expects to realize within one year of the quarter-end report date,

based on its projection of taxable income (exclusive of net operating

loss or tax credit carryforwards and reversals of existing temporary

differences), or

ii. 10 percent of Tier 1 capital, net of goodwill and all

identifiable intangible assets other than purchased mortgage servicing

rights and purchased credit card relationships (and before any

disallowed deferred tax assets are deducted). Deferred tax assets that

can be realized from taxes paid in prior carryback years and from

future reversals of existing taxable temporary differences would

generally not be limited under the proposal.

II. Public Comments on the Proposal

The comment period for the Board's proposal ended on March 15,

1993. The Board received nineteen comment letters including ten from

multinational and large regional banking organizations, and three

community banks. In addition, the Board received four comment letters

from bank trade associations and two from finance companies. Sixteen

commenters offered support for the Board's proposal to require banking

organizations to report, for regulatory purposes, deferred tax assets

in accordance with FAS 109. In addition, fifteen commenters indicated

that it would be preferable for the Board to place no limit on the

amount of deferred tax assets allowable in capital. These commenters

indicated that, in their view, embracing FAS 109 in its entirety would

achieve consistency between regulatory standards and GAAP as well as

maintain consistency with the intent of Section 121 of the Federal

Deposit Insurance Corporation Improvement Act (FDICIA) of 1991.

Commenters asserted that the criteria set forth in FAS 109 to recognize

and value deferred tax assets is sufficiently conservative to limit any

exposure to the bank insurance fund and that an arbitrary or mechanical

formula, such as the ones proposed, would not provide a more accurate

or reliable result.

While preferring no capital limit on deferred tax assets, some

commenters noted that the proposal represented a compromise and a step

forward from prior regulatory policies that permitted little or no

inclusion in regulatory reports or capital of deferred tax assets that

are dependent upon future taxable income. Two commenters generally

supported the proposal or expressed their understanding of the

regulator's concern regarding the realizability of deferred tax assets

and one commenter indicated the capital treatment should be consistent

with the capital treatment for identifiable intangible assets.

A. Responses to the Board's Questions

Question 1: (Gross-up of Intangible Assets) Nine commenters

responded to the Board's first question regarding whether certain

identifiable intangible assets acquired in a nontaxable business

combination accounted for as a purchase should be adjusted for the tax

effect of the difference between the market or appraised value of the

asset and its tax basis. Under FAS 109, this tax effect is recorded

separately in a deferred tax liability account, whereas under

preexisting GAAP, this tax effect reduced the amount of the intangible

asset. This change in treatment could cause a large increase (i.e.,

gross-up) in the reported amount of certain identifiable intangible

assets, such as core deposit intangibles, which are deducted for

purposes of computing regulatory capital.

Seven commenters indicated that banking organizations should be

permitted to deduct the net after-tax amount of the intangible asset

from capital, not the gross amount of the intangible asset. These

commenters argued that FAS 109 will create artificially high values for

intangible assets and the related deferred tax liability when a banking

organization acquires the assets with a carryover basis for tax

purposes but revalues the asset for financial reporting purposes. The

commenters generally indicated that, under FAS 109, the balance sheet

will not accurately reflect the value paid for the intangibles.

Furthermore, commenters indicated that the increased value of the

intangible posed no risk to institutions, because a reduction in the

value of the asset would effectively extinguish the related deferred

tax liability.

On the other hand, two commenters indicated that the pretax (gross)

value of intangible assets should be deducted for regulatory capital

purposes in this situation. This organization contended that intangible

assets should be treated similarly to other assets, which are not

reduced by any related liability.

Question 2: The Board's second question inquired about (i) the

potential burden associated with the proposal and whether a limitation

based on projections of taxable income would be difficult to implement,

and (ii) the appropriateness of the separate entity method for deferred

tax assets and tax sharing agreements in general.

i. Methodology Based on Income Projections. The Board received

eleven letters from commenters who responded directly to this aspect of

the question. Four commenters supported using income projections and

stated that calculating deferred tax asset limitations for capital

purposes based on projected taxable income would not be difficult to

implement and would not impose an additional burden because many

banking organizations already forecast taxable income in order to

recognize their deferred tax assets. One commenter added that these

calculations should not pose any problems, provided they are done on a

consolidated basis. In addition, one commenter suggested that the Board

clarify the term ``realized within one year'' so that readers

understand that the phrase means the amount of deferred tax assets that

could be used to offset income taxes generated in the next 12 months,

and not the amount of deferred tax assets that actually will be used.

Four commenters specifically opposed an income approach, citing the

additional burden that would be created by the detailed calculations.

One commenter specifically favored implementing the percentage of

capital method since it is certain and exact and does not involve as

many estimations or fluctuations as the income approach.

Five commenters supported an approach based on the financial

condition of the institution, some of whom also offered support or

opposition to the income or percentage of capital approach. One

commenter suggested that ``healthy'' institutions be permitted to

include deferred tax assets in regulatory capital in an amount based on

a specified percentage of Tier 1 capital. Another commenter supported

an approach that excluded ``well capitalized'' banks from the

limitation. On the other hand, one commenter did not support using an

approach for calculating the capital limitation based upon the

perceived ``health'' of the institution, stating that this method could

lead to arbitrary and inconsistent measures of capital adequacy.

ii. Separate Entity Approach. Twelve commenters specifically

addressed this part of the question. Under the Board's proposal, the

capital limit for deferred tax assets would be determined on a separate

entity basis for each state member bank so that a bank that is a

subsidiary of a holding company would be treated as a separate taxpayer

rather than as part of the consolidated entity. All of the commenters

opposed the separate entity approach. They argued that the separate

entity approach is artificial and that tax-sharing agreements between

financially capable bank holding companies and bank subsidiaries should

be considered when evaluating the recognition of deferred tax assets

for regulatory capital purposes. Commenters also stated that the

separate entity method is unnecessarily restrictive and that any

systematic and rational method should be permitted for the calculation

of the limitation for each bank.

One commenter based its opposition for the separate entity approach

on the view that the limitation is not consistent with the Board's 1987

``Policy Statement on the Responsibility of Bank Holding Companies to

Act as Sources of Strength to Their Subsidiary Banks'' which, in some

respects, treats a controlled group as one entity. Another commenter

contended that the effect of a separate entity calculation would be to

reduce bank capital which is needed for future lending which would be

inconsistent with the March 10, 1993, ``Interagency Policy Statement on

Credit Availability''. The same commenter also noted that the

regulatory burden and cost of calculating the deferred tax asset on a

separate entity basis would be substantial for both bankers and

regulators.

Question 3: The Board's third question addressed three specific

provisions of the proposal. These provisions included (i) requiring tax

planning strategies to be part of an institution's projection of

taxable income for the next year, (ii) requiring organizations to

assume that all temporary differences fully reverse at the report date,

and (iii) permitting the grandfathering of amounts previously reported

if they were in excess of the proposed limitation.

i. Inclusion of Tax Planning Strategies. Two commenters addressed

this issue. Both commenters stated that they support including tax

planning strategies in an institution's projection of taxable income.

One commenter stated that the proposal should be modified to permit

institutions to consider strategies that would ensure realization of

deferred tax assets within the one-year time frame. The proposal

provided that organizations should consider tax planning strategies

that would realize tax carryforwards or net operating losses that would

otherwise expire during that time frame.

ii. Temporary Differences. Four commenters specifically addressed

this aspect of the question, and all agreed that it is appropriate to

require the assumption that all temporary differences fully reverse as

of the report date. One commenter noted that this assumption would

eliminate the burden of scheduling the ``turnaround'' of temporary

differences.

iii. Grandfathering. Five commenters discussed the proposal's

provision on grandfathering which would allow the amount of any

deferred tax assets reported as of September 1992 in excess of the

limit to be phased out over a two year period ending in 1994. Four

commenters offered support for grandfathering but argued that excess

deferred tax assets should be grandfathered until the underlying

temporary differences reversed, rather than be phased out over two

years. The other commenter disagreed with the grandfathering proposal

and stated that such provisions would be inconsistent with the

proposal's capital adequacy objectives.

III. Final Amendment to the Capital Adequacy Guidelines

A. Limitation on Deferred Tax Assets

Consistent with the FFIEC's recommendation and the Board's

proposal, the Board is limiting in regulatory capital deferred tax

assets that are dependent on future taxable income to the lesser of:

i. The amount of such deferred tax assets that the institution

expects to realize within one year of the quarter-end report date,

based on its projection of taxable income (exclusive of net operating

loss or tax credit carryforwards and reversals of existing temporary

differences), or

ii. 10 percent of Tier 1 capital, net of goodwill and all

identifiable intangible assets other than purchased mortgage servicing

rights and purchased credit card relationships (and before any

disallowed deferred tax assets are deducted).

Deferred tax assets that can be realized from taxes paid in prior

carryback years and from future reversals of existing taxable temporary

differences are generally not limited under the final rule. The

reported amount of deferred tax assets, net of its valuation allowance,

in excess of the limitation would be deducted from Tier 1 capital for

purposes of calculating both the risk-based and leverage capital

ratios. Banking organizations should not include the amount of

disallowed deferred tax assets in weighted-risk assets in the risk-

based capital ratio and should deduct the amount of disallowed deferred

tax assets from average total assets in the leverage capital ratio.

Deferred tax assets included in capital continue to be assigned a risk

weight of 100 percent.

To determine the limit, a banking organization should assume that

all existing temporary differences fully reverse as of the report date.

Also, estimates of taxable income for the next year should include the

effect of tax planning strategies the organization is planning to

implement to realize net operating losses or tax credit carryforwards

that will otherwise expire during the year. Consistent with FAS 109,

the Board believes tax planning strategies are carried out to prevent

the expiration of such carryforwards. Both of these requirements are

consistent with the proposal.

The capital limitation is intended to balance the Board's continued

concerns about deferred tax assets that are dependent upon future

taxable income against the fact that such assets will, in many cases,

be realized. This approach generally permits full inclusion of deferred

tax assets potentially recoverable from carrybacks, since these amounts

will generally be realized. This approach also includes those deferred

tax assets that are dependent upon future taxable income, if they can

be recovered from projected taxable income during the next year. The

Board is limiting projections of future taxable income to one year

because, in general, the Board believes that organizations are

generally capable of making projections of taxable income for the

following twelve month period that have a reasonably good probability

of being achieved. However, the reliability of projections tends to

decrease significantly beyond that time period. Deferred tax assets

that are dependent upon future taxable income are further limited to 10

percent of Tier 1 capital, since the Board believes such assets should

not comprise a large portion of an organization's capital base given

the uncertainty of realization associated with these assets and the

difficulty in selling these assets apart from the organization.

Furthermore, a 10% capital limit also reduces the risk that an overly

optimistic estimate of future taxable income will cause the bank to

significantly overstate the value of deferred tax assets.

Banking organizations already follow FAS 109 for regulatory reports

and accordingly, are making projections of taxable income. Banking

organizations already report in regulatory reports the amount of

deferred tax assets that would be disallowed under the proposal. In

addition, the 10 percent calculation of Tier 1 capital is

straightforward. Therefore, the Board believes that banking

organizations will have little difficulty implementing this final rule.

B. Guidance on Specific Implementation Issues

In response to the comments received and after discussions with the

other agencies, the Board is providing the following guidance.

Originating Temporary Differences--Consistent with the Board's

proposal, the final rule does not specify how the provision for loan

and lease losses and other originating temporary differences should be

treated for purposes of projecting taxable income for the next year.

Banking organizations routinely prepare income forecasts for future

periods and, in theory, income forecasts for book income should be

adjusted for originating temporary differences in arriving at a

projection of taxable income. On the other hand, requiring such

adjustments adds complexity to the final rule. Furthermore, deductible

originating temporary differences, such as the provision for loan and

lease losses, generally would lead to additional deferred tax assets.

Thus, arguably, such temporary differences should not be added back to

book income in determining the amount of deferred tax assets that will

be realized. Accordingly, the Board is permitting each institution to

decide whether or not to adjust projected book income for originating

temporary differences. While the Board is not specifying a single

treatment on originating temporary differences in the final rule,

institutions should follow a reasonable and consistent approach.

Gross-up of Intangibles--As noted above, FAS 109 could lead to a

large increase (i.e., gross-up) in the reported amount of certain

intangible assets, such as core deposit intangibles, which are deducted

for purposes of computing regulatory capital. Commenters stated that

the increased value of an intangible posed no risk to institutions,

because a reduction in the value of the asset would effectively

extinguish the related deferred tax liability. The Board concurs with

this position and, consequently, will permit, for capital adequacy

purposes, netting of deferred tax liabilities arising from this gross-

up effect against related intangible assets. To ensure this benefit is

not double counted, a deferred tax liability netted in this manner

could not also be netted against deferred tax assets when determining

the amount of deferred tax assets that are dependent upon future

taxable income. Netting will not be permitted against purchased

mortgage servicing rights (PMSRs) and purchased credit card

relationships (PCCRs), since only the portion of these assets that

exceed specified capital limits are deducted for capital adequacy

purposes.

Leveraged Leases--While not expected to significantly affect many

banking organizations, one commenter stated that future net tax

liabilities related to leveraged leases acquired in a purchase business

combination are included in the valuation of the leveraged lease and

are not shown on the balance sheet as deferred tax liabilities. This

artificially increases the amount of deferred tax assets for those

institutions that acquire a leveraged lease portfolio. Thus, this

commenter continued, the future taxes payable included in the valuation

of a leveraged lease portfolio in a purchase business combination

should be treated as a taxable temporary difference whose reversal

would support the recognition of deferred tax assets, if applicable.

The Board agrees with this commenter and, therefore, banking

organizations may use the deferred tax liabilities that are embedded in

the carrying value of a leveraged lease to reduce the amount of

deferred tax assets subject to the capital limit.

Tax Jurisdictions--Unlike the proposal, the final rule does not

require an institution to determine its limitation on deferred tax

assets on a jurisdiction-by-jurisdiction basis. While such an approach

may theoretically be more accurate, the Board does not believe the

greater precision that would be achieved in mandating such an approach

outweighs the complexities involved and its inherent cost to

institutions. Thus, banking organizations may make projections of their

taxable income on an organization-wide basis and use a combined tax

rate for purposes of calculating the one-year limitation.

Timing--Institutions may use the future taxable income projections

for their current fiscal year (adjusted for any significant changes

that have occurred or are expected to occur) when applying the capital

limit at an interim report date rather than preparing a new projection

each quarter. Several commenters requested this treatment because it

reduces the frequency with which banking organizations are required to

revise their estimate of future taxable income.

Available for Sale Securities--Under FASB Statement No. 115,

``Accounting for Certain Investments in Debt and Equity Securities''

(FAS 115), ``available-for-sale'' securities are reported in regulatory

reports at market value, and unrealized gains and losses on such

securities are included, net of tax effects, in a separate component of

stockholders equity. These tax effects may increase or decrease the

amount of deferred tax assets an institution reports.

The Board has recently decided to exclude from regulatory capital

the amount of net unrealized gains and losses on available for sale

securities (except net unrealized losses of available-for-sale equity

securities with readily determinable fair values) (59 FR 63241,

December 8, 1994). Thus, excluding for capital adequacy purposes

deferred tax effects arising from reporting unrealized holding gains

and losses on available-for-sale securities is consistent with the

regulatory capital treatment for such gains and losses. On the other

hand, requiring the exclusion of such deferred tax effects would add

significant complexity to the capital guidelines and in most cases

would not have a significant impact on regulatory capital ratios.

Therefore, when determining the capital limit for deferred tax

assets, the Board has decided to permit, but not require, institutions

to adjust the reported amount of deferred tax assets for any deferred

tax assets and liabilities arising from marking-to-market available-

for-sale debt securities for regulatory reporting purposes. This choice

will reduce implementation burden for institutions not wanting to

contend with the complexity arising from such adjustments, while

permitting those institutions that want to achieve greater precision to

make such adjustments. Institutions must follow a consistent approach

with respect to such adjustments.

Separate Entity Method--The proposed capital limit was to be

determined on a separate entity basis for each state member bank. Use

of a separate entity approach on income tax sharing agreements

(including intercompany tax payments and current and deferred taxes) is

generally required by the Board's 1978 Policy Statement on

Intercorporate Income Tax Accounting Transactions of Bank Holding

Companies and State Member Banks, and similar policies are followed by

the other banking agencies. Thus, any change to the separate entity

approach for deferred tax assets would also need to consider changes to

this policy statement, which is outside the scope of this rulemaking.

The Board notes that regulatory reports of banks are generally required

to be filed using a separate entity approach and consistency between

the reports would be reduced if the Board permitted institutions to use

other methods for calculating deferred tax assets in addition to a

separate entity approach. Thus, while a number of the commenters

suggested that the Board consider permitting other approaches, the

Board will generally require the separate entity approach.\3\

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\3\State member banks should project taxable income for the

bank, generally on a consolidated basis including subsidiaries of

the bank. Bank holding companies should project taxable income for

the holding company, generally on a consolidated basis including

bank and non-bank subsidiaries of the holding company.

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As proposed, the final rule contains an exception to the separate

entity approach when a state member bank's parent holding company does

not have the financial capability to reimburse the bank for tax

benefits derived from the bank's carryback of net operating losses or

tax credits. In these cases, the amount of carryback potential the bank

may consider in calculating the capital limit on deferred tax assets is

limited to the lesser amount which it could reasonably expect to have

refunded by its parent.

Grandfathering--The proposal would grandfather any deferred tax

assets reported as of September 1992 in excess of the proposed limit,

but would require that such excess amounts be phased out over a two

year period ending in 1994. Since all grandfathered amounts are now

fully amortized, the Board's final rule does not include any

grandfathering provision.

IV. Regulatory Flexibility Act Analysis

The Board does not believe that the adoption of this final rule

will have a significant economic impact on a substantial number of

small business entities (in this case, small banking organizations), in

accordance with the spirit and purposes of the Regulatory Flexibility

Act (5 U.S.C. 601 et seq.). In this regard, the vast majority of small

banking organizations currently have very limited amounts of net

deferred tax assets, which are the subject of this proposal, as a

component of their capital structures. In addition, this final rule, in

combination with the adoption by the Board of FAS 109 for regulatory

reporting purposes, allows many organizations to increase the amount of

deferred tax assets they include in regulatory capital. Moreover,

because the risk-based and leverage 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. The Board

did not receive any comment letters specifically addressing regulatory

flexibility concerns, and therefore, no alternatives to the proposal

were considered to address regulatory flexibility.

V. Paperwork Reduction Act and Regulatory Burden

The Board has determined that this final rule will not increase the

regulatory paperwork burden of banking organizations pursuant to the

provisions of the Paperwork Reduction Act (44 U.S.C. 3501 et seq.).

Section 302 of the Riegle Community Development and Regulatory

Improvement Act of 1994 (Pub. L. 103-325, 108 Stat. 2160) provides that

the federal banking agencies must consider the administrative burdens

and benefits of any new regulation that impose additional requirements

on insured depository institutions. Section 302 also requires such a

rule to take effect on the first day of the calendar quarter following

final publication of the rule, unless the agency, for good cause,

determines an earlier effective date is appropriate.

List of Subjects

12 CFR Part 208

Accounting, Agriculture, Banks, banking, Confidential business

information, Crime, Currency, Federal Reserve System, Mortgages,

Reporting and recordkeeping requirements, Securities.

12 CFR Part 225

Administrative practice and procedure, Banks, banking, Federal

Reserve System, Holding companies, Reporting and recordkeeping

requirements, Securities.

For the reasons set forth in the preamble, the Board is amending 12

CFR parts 208 and 225 as set forth below:

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), 248(c), 321-338, 371d, 461,

481-486, 601, 611, 1814, 1823(j), 1828(o), 1831o, 1831p-1, 3105,

3310, 3331-3351 and 3906-3909; 15 U.S.C. 78b, 78l(b), 78l(g),

78l(i), 78o-4(c) (5), 78q, 78q-l, and 78w; 31 U.S.C. 5318.

2. Appendix A to part 208 is amended by adding a new paragraph (iv)

to the introductory text of Section II.B. to read as follows:

Appendix A to Part 208--Capital Adequacy Guidelines for State Member

Banks: Risk-Based Measure

* * * * *

II. * * *

B. * * *

(iv) Deferred tax assets--portions are deducted from the sum of

core capital elements in accordance with section II.B.4. of this

Appendix A.

* * * * *

3. Appendix A to Part 208 is amended by:

a. Revising footnote 19 in section II.B.3.;

b. Removing footnote 20 from the end of section II.B.3.; and

c. Adding section II.B.4.

The additions and revisions read as follows:

* * * * *

II. * * *

B. * * *

3. * * *\19\* * *

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\1\9Deductions of holdings of capital securities also would not

be made in the case of interstate ``stake out'' investments that

comply with the Board's Policy Statement on Nonvoting Equity

Investments, 12 CFR 225.143 (Federal Reserve Regulatory Service 4-

172.1; 68 Federal Reserve Bulletin 413 (1982)). In addition,

holdings of capital instruments issued by other banking

organizations but taken in satisfaction of debts previously

contracted would be exempt from any deduction from capital. The

Board intends to monitor nonreciprocal holdings of other banking

organizations' capital instruments and to provide information on

such holdings to the Basle Supervisors' Committee as called for

under the Basle capital framework.

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4. Deferred tax assets. The amount of deferred tax assets that

are dependent upon future taxable income, net of the valuation

allowance for deferred tax assets, that may be included in, that is,

not deducted from, a bank's capital may not exceed the lesser of:

(i) the amount of these deferred tax assets that the bank is

expected to realize within one year of the calendar quarter-end

date, based on its projections of future taxable income for that

year,\20\ or (ii) 10 percent of tier 1 capital. For purposes of

calculating this limitation, Tier 1 capital is defined as the sum of

core capital elements, net of goodwill and all identifiable

intangible assets other than purchased mortgage servicing rights and

purchased credit card relationships (and before any disallowed

deferred tax assets are deducted). The amount of deferred tax assets

that can be realized from taxes paid in prior carryback years and

from future reversals of existing taxable temporary differences and

that do not exceed the amount which the bank could reasonably expect

to have refunded by its parent (if applicable) generally are not

limited. The reported amount of deferred tax assets, net of any

valuation allowance for deferred tax assets, in excess of these

amounts is to be deducted from a bank's core capital elements in

determining tier 1 capital.

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\20\Projected future taxable income should not include net

operating loss carryforwards to be used during that year or the

amount of existing temporary differences a bank expects to reverse

within the year. Such projections should include the estimated

effect of tax planning strategies that the organization expects to

implement to realize net operating losses or tax credit

carryforwards that would otherwise expire during the year.

Institutions may use the future taxable income projections for their

current fiscal year (adjusted for any significant changes that have

occurred or are expected to occur) when applying the capital limit

at an interim report date rather than preparing a new projection

each quarter. To determine the limit, an institution should assume

that all existing temporary differences fully reverse as of the

report date.

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* * * * *

4. Appendix B to part 208 is revised to read as follows:

Appendix B to Part 208--Capital Adequacy Guidelines for State Member

Banks: Tier 1 Leverage Measure

I. Overview

a. The Board of Governors of the Federal Reserve System has

adopted a minimum ratio of tier 1 capital to total assets to assist

in the assessment of the capital adequacy of state member banks.\1\

The principal objective of this measure is to place a constraint on

the maximum degree to which a state member bank can leverage its

equity capital base. It is intended to be used as a supplement to

the risk-based capital measure.

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\1\Supervisory risk-based capital ratios that related capital to

weighted-risk assets for state member banks are outlined in Appendix

A to this part.

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b. The guidelines apply to all state member banks on a

consolidated basis and are to be used in the examination and

supervisory process as well as in the analysis of applications acted

upon by the Federal Reserve. The Board will review the guidelines

from time to time and will consider the need for possible

adjustments in light of any significant changes in the economy,

financial markets, and banking practices.

II. The Tier 1 Leverage Ratio

a. The Board has established a minimum level of tier 1 capital

to total assets of 3 percent. An institution operating at or near

these levels is expected to have well-diversified risk, including no

undue interest-rate risk exposure; excellent asset quality; high

liquidity; and good earnings; and in general be considered a strong

banking organization, rated composite 1 under CAMEL rating system of

banks. Institutions not meeting these characteristics, as well as

institutions with supervisory, financial, or operational weaknesses,

are expected to operate well above minimum capital standards.

Institutions experiencing or anticipating significant growth also

are expected to maintain capital ratios, including tangible capital

positions, well above the minimum levels. For example, most such

banks generally have operated at capital levels ranging from 100 to

200 basis points above the stated minimums. Higher capital ratios

could be required if warranted by the particular circumstances or

risk profiles of individual banks. Thus for all but the most highly

rated banks meeting the conditions set forth above, the minimum tier

1 leverage ratio is to be 3 percent plus an additional cushion of a

least 100 to 200 basis points. In all cases, banking institutions

should hold capital commensurate with the level and nature of all

risks, including the volume and severity of problem loans, to which

they are exposed.

b. A bank's tier 1 leverage ratio is calculated by dividing its

tier 1 capital (the numerator of the ratio) by its average total

consolidated assets (the denominator of the ratio). The ratio will

also be calculated using period-end assets whenever necessary, on a

case-by-case basis. For the purpose of this leverage ratio, the

definition of tier 1 capital for year-end 1992 as set forth in the

risk-based capital guidelines contained in Appendix A of this part

will be used.\2\ As a general matter, average total consolidated

assets are defined as the quarterly average total assets (defined

net of the allowance for loan and lease losses) reported on the

bank's Reports of Condition and Income (Call Report), less goodwill;

amounts of purchased mortgage servicing rights and purchased credit

card relationships that, in the aggregate, are in excess of 50

percent of tier 1 capital; amounts of purchased credit card

relationships in excess of 25 percent of tier 1 capital; all other

intangible assets; any investments in subsidiaries or associated

companies that the Federal Reserve determines should be deducted

from tier 1 capital; and deferred tax assets that are dependent upon

future taxable income, net of their valuation allowance, in excess

of the limitation set forth in section II.B.4 of this Appendix A.\3\

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\2\At the end of 1992, Tier 1 capital for state member banks

includes common equity, minority interest in the equity accounts of

consolidated subsidiaries, and qualifying noncumulative perpetual

preferred stock. In addition, as a general matter, Tier 1 capital

excludes goodwill; amounts of purchased mortgage servicing rights

and purchased credit card relationships that, in the aggregate,

exceed 50 percent of Tier 1 capital; amounts of purchased credit

card relationships that exceed 25 percent of Tier 1 capital; all

other intangible assets; and deferred tax assets that are dependent

upon future taxable income, net of their valuation allowance, in

excess of certain limitations. The Federal Reserve may exclude

certain investments in subsidiaries or associated companies as

appropriate.

\3\Deductions from Tier 1 capital and other adjustments are

discussed more fully in section II.B. in Appendix A of this part.

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c. Whenever appropriate, including when a bank is undertaking

expansion, seeking to engage in new activities or otherwise facing

unusual or abnormal risks, the Board will continue to consider the

level of an individual bank's tangible tier 1 leverage ratio (after

deducting all intangibles) in making an overall assessment of

capital adequacy. This is consistent with the Federal Reserve's

risk-based capital guidelines an long-standing Board policy and

practice with regard to leverage guidelines. Banks experiencing

growth, whether internally or by acquisition, are expected to

maintain strong capital position substantially above minimum

supervisory levels, without significant reliance on intangible

assets.

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(i), 3106, 3108, 3310, 3331-3351, 3907, and

3909.

2. Appendix A to part 225 is amended by adding a new paragraph (iv)

to the introductory text of section II.B. to read as follows:

Appendix A to Part 225--Capital Adequacy Guidelines for Bank Holding

Companies: Risk-Based Measure

* * * * *

II. * * *

B. * * *

(iv) Deferred tax assets--portions are deducted from the sum of

core capital elements in accordance with section II.B.4. of this

Appendix A.

* * * * *

3. Appendix A to part 225 is amended by:

a. Revising footnote 22 in section II.B.3.;

b. Removing footnote 23 from the end of section II.B.3. and;

c. Adding section II.B.4.

The revisions and additions read as follows:

* * * * *

II. * * *

B. * * *

3. * * *\22\* * *

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\22\Deductions of holdings of capital securities also would not

be made in the case of interstate ``stake out'' investments that

comply with the Board's Policy Statement on Nonvoting Equity

Investments, 12 CFR 225.143 (Federal Reserve Regulatory Service 4-

172.1; 68 Federal Reserve Bulletin 413 (1982)). In addition,

holdings of capital instruments issued by other banking

organizations but taken in satisfaction of debts previously

contracted would be exempt from any deduction from capital. The

Board intends to monitor nonreciprocal holdings of other banking

organizations' capital instruments and to provide information on

such holdings to the Basle Supervisors' Committee as called for

under the Basle capital framework.

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4. Deferred tax assets. The amount of deferred tax assets that

are dependent upon future taxable income, net of the valuation

allowance for deferred tax assets, that may be included in, that is,

not deducted from, a banking organization's capital may not exceed

the lesser of: (i) the amount of these deferred tax assets that the

banking organization is expected to realize within one year of the

calendar quarter-end date, based on its projections of future

taxable income for that year,\23\ or (ii) 10 percent of tier 1

capital. For purposes of calculating this limitation, tier 1 capital

is defined as the sum of core capital elements, net of goodwill and

all identifiable intangible assets other than purchased mortgage

servicing rights and purchased credit card relationships (and before

any disallowed deferred tax assets are deducted). The amount of

deferred tax assets that can be realized from taxes paid in prior

carryback years and from future reversals of existing taxable

temporary differences generally are not limited. The reported amount

of deferred tax assets, net of any valuation allowance for deferred

tax assets, in excess of these amounts is to be deducted from a

banking organization's core capital elements in determining tier 1

capital.

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\23\Projected future taxable income should not include net

operating loss carryforwards to be used during that year or the

amount of existing temporary differences a bank holding company

expects to reverse within the year. Such projections should include

the estimated effect of tax planning strategies that the

organization expects to implement to realize net operating loss or

tax credit carryforwards that will otherwise expire during the year.

Banking organizations may use the future taxable income projections

for their current fiscal year (adjusted for any significant changes

that have occurred or are expected to occur) when applying the

capital limit at an interim report date rather than preparing a new

projection each quarter. To determine the limit, a banking

organization should assume that all existing temporary differences

fully reverse as of the report date.

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* * * * *

4. Appendix D to part 225 is revised to read as follows:

Appendix D to Part 225--Capital Adequacy Guidelines for Bank Holding

Companies: Tier 1 Leverage Measure

I. Overview

a. The Board of Governors of the Federal Reserve System has

adopted a minimum ratio of tier 1 capital to total assets to assist

in the assessment of the capital adequacy of bank holding companies

(banking organizations).\1\ The principal objectives of this measure

is to place a constraint on the maximum degree to which a banking

organization can leverage its equity capital base. It is intended to

be used as a supplement to the risk-based capital measure.

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\1\Supervisory ratios that related capital to total assets for

state member banks are outlined in Appendix B of this part.

---------------------------------------------------------------------------

b. The guidelines apply to consolidated basis to banking holding

companies with consolidated assets of $150 million or more. For bank

holding companies with less that $150 million in consolidated

assets, the guidelines will be applied on a bank-only basis unless

(i) the parent bank holding company is engaged in nonbank activity

involving significant leverage\2\ or (ii) the parent company has a

significant amount of outstanding debt that is held by the general

public.

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\2\A parent company that is engaged is significant off balance

sheet activities would generally be deemed to be engaged in

activities that involve significant leverage.

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c. The tier 1 leverage guidelines are to be used in the

inspection and supervisory process as well as in the analysis of

applications acted upon by the Federal Reserve. The Board will

review the guidelines from time to time and will consider the need

for possible adjustments in light of any significant changes in the

economy, financial markets, and banking practices.

II. The Tier 1 Leverage Ratio

a. The Board has established a minimum level of tier 1 capital

to total assets of 3 percent. A banking organization operating at or

near these levels is expected to have well-diversified risk,

including no undue interest-rate risk exposure; excellent asset

quality; high liquidity; and good earnings; and in general be

considered a strong banking organization, rated composite 1 under

BOPEC rating system of bank holding companies. Organizations not

meeting these characteristics, as well as institutions with

supervisory, financial, or operational weaknesses, are expected to

operate well above minimum capital standards. Organizations

experiencing or anticipating significant growth also are expected to

maintain capital ratios, including tangible capital positions, well

above the minimum levels. For example, most such banks generally

have operated at capital levels ranging from 100 to 200 basis points

above the stated minimums. Higher capital ratios could be required

if warranted by the particular circumstances or risk profiles of

individual banking organizations. Thus for all but the most highly

rated banks meeting the conditions set forth above, the minimum tier

1 leverage ratio is to be 3 percent plus an additional cushion of a

least 100 to 200 basis points. In all cases, banking organizations

should hold capital commensurate with the level and nature of all

risks, including the volume and severity of problem loans, to which

they are exposed.

b. A banking organization's tier 1 leverage ratio is calculated

by dividing its tier 1 capital (the numerator of the ratio) by its

average total consolidated assets (the denominator of the ratio).

The ratio will also be calculated using period-end assets whenever

necessary, on a case-by-case basis. For the purpose of this leverage

ratio, the definition of tier 1 capital for year-end 1992 as set

forth in the risk-based capital guidelines contained in Appendix A

of this part will be used.\3\ As a general matter, average total

consolidated assets are defined as the quarterly average total

assets (defined net of the allowance for loan and lease losses)

reported on the organization's Consolidated Financial Statements (FR

Y-9C Report), less goodwill; amounts of purchased mortgage servicing

rights and purchased credit card relationships that, in the

aggregate, are in excess of 50 percent of tier 1 capital; amounts of

purchased credit card relationships in excess of 25 percent of tier

1 capital; all other intangible assets; any investments in

subsidiaries or associated companies that the Federal Reserve

determines should be deducted from tier 1 capital; and deferred tax

assets that are dependent upon future taxable income, net of their

valuation allowance, in excess of the limitation set forth in

section II.B.4 of this Appendix A.\4\

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\3\At the end of 1992, Tier 1 capital for state member banks