Funding and Fiscal Affairs, Loan Policies and Operations, and Funding Operations; General Provisions; Disclosure to Shareholders; Capital Adequacy

SUMMARY: The Farm Credit Administration (FCA), by the FCA Board

(Board), proposes amendments to FCA capital regulations for Farm Credit

System (Farm Credit or System) institutions to add unallocated surplus

and total surplus standards for banks and associations; add a

collateral ratio for banks; add procedures for the establishment of

individual institution capital standards and for the issuance of

capital directives; remove outdated provisions; and make other

technical, clarifying, and conforming changes. The regulation would

require that each institution maintain at least a minimum level of

unallocated surplus and total surplus capital, and that banks maintain

at least a minimum collateral ratio. In addition, the regulations would

specify procedures for setting higher individual capital standards when

warranted by higher risk and issuing capital directives.

DATES: Written comments must be received on or before October 25, 1995.

ADDRESSES: Comments should be submitted in writing to Patricia W.

DiMuzio, Associate Director, Regulation Development, Office of

Examination, Farm Credit Administration, McLean, Virginia 22102-5090.

Copies of all communications received will be available for examination

by interested parties in the Office of Examination, Farm Credit

Administration.

FOR FURTHER INFORMATION CONTACT:

Dennis K. Carpenter, Senior Policy Analyst, Office of Examination, Farm

Credit Administration, McLean, VA 22102-5090, (703) 883-4498, TDD (703)

883-4444, or

Rebecca S. Orlich, Senior Attorney, Office of General Counsel, Farm

Credit Administration, McLean, VA 22102-5090, (703) 883-4020, TDD (703)

883-4444.

SUPPLEMENTARY INFORMATION:

I. Summary of Proposed Surplus and Collateral Requirements

System banks and associations should hold sufficient capital to

operate in a safe and sound manner, provide a foundation for future

viability, and provide a reasonable level of protection to shareholders

who must purchase equity in a System institution as a condition of

receiving a loan. The FCA proposes to require System banks and

associations to maintain the following capital standards in addition to

the existing risk-adjusted permanent capital standards:

A ratio of at least 7 percent of total surplus to risk-

weighted assets; and

A ratio of at least 3.5 percent of unallocated surplus to

risk-weighted assets.

For purposes of the total surplus computation, institutions would

be permitted to treat the following as surplus: stock held by non-

borrowers, allocated stock, and stock held by borrowers that was not

purchased as a condition of receiving a loan, provided that all of such

stock can only be retired pursuant to a discretionary revolvement plan

of at least 5 years or a similar retirement plan. Perpetual stock held

by non-borrowers could also be included in the unallocated surplus

computations. For the purposes of the total surplus computation, the

double counting of association investments in their affiliated banks

would be eliminated according to the permanent capital allotment

agreements. However, the unallocated surplus measurement for an

association would be net of the association's investment in the bank.

In addition, banks would also be required to maintain a collateral

ratio of at least 104 percent of eligible assets (as defined by

Sec. 615.5050 of existing FCA regulations) to liabilities, net of any

bank equities that are being counted as permanent capital of

associations.

The existing permanent capital requirements would continue

unchanged. An institution that falls below its permanent capital ratio

is statutorily prohibited from further retirement of borrower stock,

but noncompliance with the proposed surplus and collateral standards

would not result in the same prohibition. However, as proposed by these

regulations, noncompliance with the surplus or collateral ratios would

prohibit the board of directors of an institution from delegating the

decision to retire stock to management.

Institutions that do not satisfy the proposed surplus and

collateral standards would be required to develop and implement a plan

approved by the FCA for building surplus to attain the standards within

a reasonable time. An association that does not meet the unallocated

surplus standard would have the option, as part of its capital plan, of

entering into a risk-sharing agreement with its affiliated bank. Under

such a risk-sharing agreement, the bank would share association losses

up to an amount not to exceed the amount of bank equities counted as

association permanent capital. Institutions meeting the goals of plans

approved by the FCA would be considered to be in compliance with their

applicable surplus and collateral ratios.

II. Background

Since 1986, the Farm Credit Act of 1971, as amended (Act), 12

U.S.C. 2001 et seq., has required the FCA to ``cause institutions to

achieve and maintain adequate capital by establishing minimum levels of

capital for such System institutions and by using such other methods as

the [FCA] deems appropriate.'' Section 4.3(a) of the Act. Provisions of

the Agricultural Credit Act of 1987 (1987 Act), Pub. L. 100-233, added

a requirement that the FCA promulgate regulations establishing minimum

standards of ``permanent capital'' as defined in the statute. These

standards were required to be based on financial statements prepared in

accordance with generally accepted accounting principles (GAAP) and to

take into consideration relative risk factors as determined by the FCA.

Most of the FCA's existing capital regulations were adopted in

1988, in order to implement the permanent capital provisions of the

1987 Act. Those regulations: (1) Established a minimum permanent

capital standard for both banks and associations of 7

[[Page 38522]]

percent of risk-weighted assets, after elimination of intra-System

reciprocal investments; and (2) prohibited the double counting of

capital invested by associations in their affiliated banks. Such

capital was to be counted as permanent capital by only one institution,

and the regulation specified that eventually only the bank could count

it. In October 1992, the statutory definition of ``permanent capital''

was amended by Congress to permit banks and associations to specify by

mutual agreement the amount of allocated equities that would be

considered bank or association equity for the purpose of calculating

the permanent capital ratio. In July 1994, the FCA amended the

regulations to implement the statutory change.

The 1992 statutory change was a response to concerns raised by the

System that the 1988 regulatory provisions would have resulted in

additional tax liabilities for Farm Credit associations. The

associations' investments in their respective banks resulted over a

period of many years and largely consisted of allocated equities--that

is, earnings that tax-exempt banks distributed to their owner

associations in the form of stock or allocated surplus rather than

cash. When earnings were distributed in the form of equities, taxes did

not have to be paid by the associations.

III. Purposes of Capital

The capital structure of a System institution, at a minimum, needs

to fulfill three broad purposes:

A. To provide a cushion that will allow an institution to remain

financially viable during periods of adversity, thereby protecting the

System institutions, investors, and taxpayers;

B. To provide a source of funds to help stabilize earnings and

finance growth; and

C. To denote and protect the ownership, investment, and rights of

shareholders.

There are several categories of capital in the System that, in

combination, achieve one or more of these fundamental purposes of

capital. These categories are: borrower stock; participation

certificates; preferred stock; allocated equities; and unallocated

surplus. Borrower stock is common shareholder equity purchased as a

condition of obtaining a loan with a System institution.1

Participation certificates are similar to borrower stock and arise from

authorized lending relationships with entities and individuals

ineligible to own borrower stock.2 Preferred stock may be sold to

individuals separate from the lending relationship and provides

preferential treatment, such as the payment of fixed dividends or

preference over common shareholders upon liquidation. Allocated

equities, including allocated surplus and allocated borrower stock,

result from a patronage allocation of an institution's earnings to its

active members. Finally, unallocated surplus is the unallocated

retained earnings of an institution.

\1\ Institutions are authorized to issue common stock to non-

borrowers, but no such stock has been issued.

\2\ For the remainder of the preamble, further references to

borrower stock will include participation certificates, as

applicable. Participation certificates are considered to be similar

to borrower stock from a financial perspective, even though voting

rights differ.

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IV. FCA Review and Concerns

The FCA has been engaged in a comprehensive review of its capital

regulations to determine whether they create appropriate incentives for

the accumulation of adequate amounts of various components of capital,

in light of risks undertaken by the System. The FCA has also reviewed

the principles of the 1988 international framework for capital

standards, known as the Basle Accord, and capital regulations imposed

by Federal banking agencies on commercial banks and thrifts, as well as

a publication evaluating the adequacy of those regulations by staff of

the Federal Deposit Insurance Corporation (FDIC), for information that

may be relevant to determining the adequacy of System capital. As a

result of this review, the FCA has concluded that the proposed minimum

surplus and net collateral ratios would generate an additional level of

protection for both borrower/shareholders and investors in the System's

debt instruments.

A. Regulatory Requirements Need To Ensure Sufficient Capital

The FCA believes that a mixture of capital components is necessary

to achieve a sound capital structure, and that each institution should

have a minimum amount of secure capital that is not at risk at another

System institution. As a result, the FCA has the following concerns.

1. Long-term Stability for Associations Requires a More Stable Capital

Base Than Just Borrower Stock and Should Provide Some Cushion for

Borrower Investments

Under existing regulations, it is possible for an institution to

rely solely on borrower stock to meet its minimum capital standards, by

establishing a stock purchase requirement of 7 percent or more of the

loan amount. An institution may then be in compliance but have little

or no surplus to cushion the investment of a shareholder. While the

shareholder's investment is at risk and provides some protection to the

institution, the Agency believes that it is imprudent to make such

investments vulnerable to even modest levels of adversity, given the

cooperative structure of the System.

For most corporations, common equity capital is generally a

permanent source of funds. Once the equity shares are issued, the

company permanently retains the proceeds. The stock may trade among

investors, but an individual shareholder may not demand that the

company retire the stock. Unlike corporate equity capital, System

borrower stock may be, and often is, retired upon repayment of a

borrower's loan at the board's discretion. If pending losses threaten

the value of an association's stock, borrower/shareholders can obtain

financing elsewhere, pay down their loan and request retirement of

their stock. As a practical matter, in a situation in which the

institution still meets its permanent capital requirements, the degree

to which borrower stock acts as a buffer for absorbing loss depends on

the extent to which the association refrains from retiring stock.

For an association to use this authority in a way that makes

borrower stock a meaningful buffer, the association has to recognize

potential losses in a timely manner and be willing to withhold proceeds

from stock retirement requests. However, such actions can signal

problems to existing and potential borrowers at the association. Thus,

an association might continue to make retirements until the evidence of

serious adverse financial conditions is abundantly clear. By then, the

stock of many members may have been retired, and remaining members

would bear the loss. Therefore, despite the fact that borrower stock is

an at-risk investment like any common equity stock, it is less able to

absorb losses than common equity capital. By contrast, a minimum

surplus requirement would provide a more permanent source of capital

that is capable of absorbing losses and of providing protection to the

investments of borrower/shareholders.

Another concern is that an institution can grow in an unbounded

manner if each new loan is fully capitalized by borrower stock.

Similarly, the institution's capital base can fluctuate significantly

when borrowers repay or prepay loans and their stock is retired.

[[Page 38523]]

In addition, the most frequent source of an association's financial

stress is borrower adversity, whether it is the result of widespread

adverse financial conditions (as it was in the mid-1980s), or the

result of troubled conditions in a region or industry in which an

association has a concentration of loans. As occurred in the mid-1980s,

when an institution is unable to retire borrower stock because of

financial stress, the institution's business and its borrower/

shareholders are adversely affected.

2. ``Local'' Unallocated Retained Earnings (URE) Are Important to

Institutions During Periods of Economic Adversity

Over a number of years, most associations in the System accumulated

URE, in part, through non-cash earnings distributions from their

affiliated banks. Since these non-cash distributions have seldom been

retired, some portion of these distributions has resulted in an

increase to URE on the associations' balance sheets and yet has

continued to be reported as allocated equities on the bank's financial

statements. Certain associations have little or no URE that is not also

included in the bank's GAAP capital. This group of associations is

particularly vulnerable to financial adversity at their affiliated

banks because most of their capital other than borrower stock is at

risk in both the bank and the association. When a bank sustains losses,

all of the bank's capital is available to absorb losses, regardless of

whether it is being counted as permanent capital at the association. It

follows that such capital will not be available to absorb association

losses, which can create a domino effect in troubled times, since

adversity in one institution can cause adversity in many or all

institutions in the district.

The FCA conducted a study of production credit associations (PCAs)

that became financially stressed during the 1980s. The sample used

represented a comparable set of financially stressed and healthy

institutions. Although the number of institutions and quarters of

historical financial data were limited, the FCA was able to make

inferences regarding capital levels and long-term viability. The

healthy associations, which had unallocated surplus net of their

investments in their affiliated banks, were better able to withstand

adversity and stay financially viable without assistance. However,

associations with no or low surplus, after deducting the investment in

the bank, generally could not independently withstand an adverse

economic environment without assistance or other action to address

their financial deterioration.3

\3\ In fact, the stressed PCAs in the study generally had no

``local'' URE. The median value was actually below zero. These PCAs

were subsequently merged or provided financial assistance.

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A URE cushion that does not include the association's

interdependent investment in its affiliated bank provides optimum

protection for borrower/shareholders. Losses at the affiliated bank

stemming from adversity in other associations or from risks borne by

the bank (funding, investment, operational, etc.) could impair the

investment in the bank and deplete association capital. Consequently,

an association with a large URE and a high permanent capital ratio may

not be adequately insulated from adversity if it relies heavily on

capital that is invested in its affiliated bank. Strong local URE

allows the association to remain viable even if the investment in the

bank becomes impaired. The likelihood of the bank and associations

sustaining losses simultaneously greatly amplifies the need for a local

URE standard.

3. A Sufficient Level of Eligible Collateral Is Needed To Protect

Investors in the System's Debt Instruments

The basis for funding banks within the System is the maintenance of

sufficient eligible collateral. Performing agricultural loans make up

the bulk of eligible collateral,4 followed by marketable

securities and cash. Nonperforming loans and acquired property also

provide eligible collateral, after deducting for losses. During the

1980s, the collateral positions of the Farm Credit banks were a

critical measure of survival. As an example, the collateral of one bank

was exhausted, and the bank lost its ability to independently obtain

funding from the marketplace before its capital was depleted.5

\4\ Such loans consist of loans made directly by the bank or, in

the case of a bank's wholesale lending activities, the loans made by

the direct lender associations which are pledged as security for the

associations' direct loans from the bank (up to the amount of the

direct loan).

\5\ The bank was able to maintain access to the funding markets

only after certain other System banks agreed to pledge excess

collateral to the troubled bank.

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Farm Credit banks have long used a collateral ratio as a principal

indicator of financial strength. Both the Market Access Agreement and

the Contractual Interbank Performance Agreement (CIPA) 6 use a

collateral ratio as a critical measure of bank financial viability and

survivability. A bank failure within the System would have grave

consequences not only for that bank and its affiliated associations,

but also for the other System banks because of joint and several

liability and the market perception of the System as a single entity

seeking funding.

\6\ These are self-monitoring agreements among the Federal Farm

Credit Banks Funding Corporation (Funding Corporation) and System

banks that specify levels of bank financial performance, as well as

the consequences of a bank's falling below such levels.

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The FCA believes that a bank could be shut out of the securities

markets if its collateral ratio (as defined in Sec. 615.5050 of the

regulations) dropped below 100 percent. Thus, a margin of safety above

this level is reasonable, in order to protect investors and allow

sufficient time for corrective action to be implemented prior to a

funding crisis at an individual bank, and thus district, level. Also,

the FCA believes that the net collateral position of a bank, net of its

equities counted by associations as part of their permanent capital,

affords better protection for both investors and shareholders.

Both the statute and the FCA's capital regulations require a

permanent capital calculation that eliminates the double counting of

capital shared by System institutions through the allotment agreements.

Similarly, the FCA believes a collateral ratio adjusted for the

allotment agreements is another appropriate measure of financial

safety. This would help ensure that the bank has sufficient capital,

net of any capital counted as association permanent capital, to protect

investors and shareholders. Specifically, it prevents a bank from

placing such equities at risk for investor protection at the same time

that associations are placing them at risk for credit and other

purposes.

B. Basle Accord and Capital Regulations of Other Regulators

As a part of its review, the FCA has re-examined the 1988 Basle

Accord agreed to by the Committee on Banking Regulations and

Supervisory Practices, which meets under the auspices of the Bank for

International Settlements in Basle, Switzerland. In the existing

capital regulations, the FCA incorporated the Basle Accord principles

of weighting assets, including off-balance-sheet items, according to

categories of risk. However, the FCA did not incorporate in the

regulations the two-tiered approach of the Basle Accord, which requires

that each institution have at least a minimum amount of ``core

capital'' (primarily stable equity capital), which must constitute at

least 50 percent of the required capital of the institution. Rather,

the FCA treated all types of capital meeting the statutory definition

of permanent capital as if they were of

[[Page 38524]]

equal value to the institution to absorb losses.

The Federal regulatory agencies for commercial banks and thrifts in

this country--the Federal Deposit Insurance Corporation (FDIC), the

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

Supervision, and the Board of Governors of the Federal Reserve System--

have all adopted capital regulations that are consistent with the Basle

Accord framework. In each agency's two-tiered capital system, core or

Tier 1 capital is mainly composed of common stock, surplus,

noncumulative perpetual preferred stock, and minority interests in

consolidated subsidiaries. Supplementary or Tier 2 capital is composed

of a portion of the allowance for loan losses and all other kinds of

capital and capital-like instruments, up to an amount equal to the

amount of Tier 1 capital. The minimum capital requirement is 8 percent.

Commercial banks and thrifts also have a minimum leverage requirement,

calculated as the ratio of Tier 1 capital to total (i.e., not risk-

adjusted) assets, to protect against risks other than credit risk.

Common shareholders' equity in commercial banks and thrifts is the

most stable, permanent form of capital because it is fully paid and is

rarely retired. By contrast, nearly all of the common equity capital of

System associations is borrower stock, which lacks the characteristic

of permanence because it is retired in the ordinary course of business

of the associations.

The FCA also reviewed an FDIC staff study published in 1993 that

compared the risk-based standards for commercial banks to the primary

and secondary capital constraints they had replaced.7 The previous

standards differed from the current 8-percent standard in two important

ways: the assets were not risk weighted, and all of the allowance for

losses (ALL) was included in capital. The study concluded that the

risk-based standard was a better predictor of the potential failure of

a bank than the previous standards for two reasons: (1) The exclusion

of ALL from Tier 1 and its only limited inclusion in Tier 2 improved

the quality of the capital measure; and (2) the risk-based measure was

more sensitive to credit risk.8 But the study also concluded that

using both the risk-based standard and the new Tier 1 capital-to-total-

assets leverage ratio together was a better predictor of failure than

either one separately, because in many cases the leverage ratio, which

addressed risks other than credit risk, provided a more stringent test

of capital adequacy.

\7\ John P. O'Keefe, ``Risk-Based Capital Standards for

Commercial Banks: Improved Capital-Adequacy Standards?'' published

in the FDIC Banking Review, Spring-Summer 1993.

\8\ ALL is already excluded from the permanent capital measure

for System institutions; so the FDIC staff finding is not directly

relevant with respect to the inclusion of ALL. However, the finding

is important because it shows the necessity of assuring at least a

minimum amount of the highest quality of capital.

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C. Farm Credit System Observations

In May 1993, the System's Presidents Planning Committee appointed a

capital adequacy work group (System group) with the charge of reviewing

the FCA's capital adequacy regulations and making recommendations for

improvements. As a result of this effort, in November 1993 the System

group provided the FCA with a report of its findings and suggestions.

The System group refined this report with a supplemental document

submitted to the FCA in April 1994. The System group informed the FCA

that the group had consulted with all the banks and a number of

associations in developing its final report.

The final report recognized concerns with existing regulatory

requirements similar to those identified by the FCA. The System report

supported a requirement to build unallocated surplus and allocated

surplus to buffer borrower stock from potential losses and to insulate

an institution's capital position from the potentially volatile nature

of borrower stock. The report noted the important role borrower stock

plays in obtaining new loans and retaining quality business, given the

cooperative structure of the System. The report also acknowledged the

need to protect investors in System securities.

The System group recommended that the FCA establish regulatory

standards requiring all institutions to build unallocated surplus and

total surplus (i.e., allocated equities and unallocated surplus) by

annually retaining a portion of earnings. The System group's proposed

goals of 3.5-percent unallocated surplus and 7-percent total surplus

were proposed to be achieved by retaining at least 10 percent of net

earnings after taxes in unallocated surplus and at least 50 percent of

net earnings in unallocated and allocated equities. These objectives

were based on the regulatory permanent capital framework and used risk-

adjusted assets as the ratios' denominators.

The System group's report also recognized the need to protect

investors in System securities. The System recommended that each bank

begin reporting to the Funding Corporation its collateral position net

of bank equities being counted at associations for permanent capital

purposes. The System group stated that its recommendation ``effectively

prevents the bank from placing such equities at risk for investor

protection at the same time that associations are putting them at risk

for credit and other purposes pursuant to an allotment agreement,'' and

further that ``[i]t gives tangible recognition to the spirit and intent

of the . . . 1992 legislation.''

Similarities and differences between the FCA's proposed regulation

and the System group's suggestions are discussed below in section C of

part V.

V. FCA Conclusions and Proposals for Surplus and Collateral Ratios

The FCA makes the following proposals:

A. Surplus and Collateral Requirements

Each Farm Credit institution 9 should have some minimum amount

of capital in the form of unallocated surplus, allocated equities or

stock not required to be purchased as a condition of obtaining a loan,

in order to protect against losses. Part of the surplus should be

unallocated surplus that provides a cushion for borrower stock and

allocated equities and that does not also support risks in another

System institution. The FCA believes that this unallocated surplus

would better enable an institution to withstand its own losses and also

insulate both the institution and its borrowers from adversities

suffered by related System institutions.

\9\ ``Institution'' includes each System bank, System

association, and the Farm Credit Leasing Services Corporation. It

does not include other System entities, such as other service

corporations. The surplus ratios for the Leasing Corporation are

calculated the same way as the surplus ratios for banks. However,

the Leasing Corporation would not have to maintain a net collateral

standard.

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1. Unallocated Surplus Requirement

The FCA proposes that institutions have unallocated surplus of at

least 3.5 percent of risk-weighted assets. For this purpose,

unallocated surplus would include common stock and noncumulative

perpetual preferred stock held by non-borrowers, provided that the

institution adheres to a policy of not retiring such stock. For

associations, the net investment in its affiliated bank--that is, the

total investment less reciprocal investments, pass-through stock, and

investments related to loan participations--would be subtracted from

the unallocated surplus. For both banks and associations, the risk-

weighted asset base would be calculated as it is for the institution's

permanent capital requirement, except

[[Page 38525]]

that an association's assets would be reduced by the net investment in

the bank. The unallocated surplus ratio would be calculated as follows:

[GRAPHIC][TIFF OMITTED]TP27JY95.000

If this proposed regulation is enacted, the existing requirement in

Sec. 615.5330 for banks for cooperatives to add a percentage of

earnings to unallocated surplus annually would be replaced by the new

requirement.

The FCA believes this minimum unallocated surplus requirement is

needed to provide a source of permanent at-risk capital that does not

depend on the financial condition of the bank and that protects against

the suspension of stock retirements when problems emerge.

2. Total Surplus Requirement

The FCA proposes a requirement that each institution hold total

surplus (adjusted according to the permanent capital allotment

agreement, or according to the allotment regulation if there is no

agreement) equal to 7 percent of risk-weighted assets. The total

surplus would consist of the capital treated as unallocated surplus for

the purposes of the unallocated surplus ratio (prior to any deductions

for investments in the banks), as well as certain allocated equities

and other stock. Allocated equities would consist of allocated surplus

and allocated stock subject to a discretionary revolvement plan of 5

years or more, or not projected to be retired under the institution's

capital adequacy plan. Other stock included in total surplus would be

stock other than stock that has been purchased as a requirement of

obtaining a loan and would be either perpetual stock or, if term stock,

have an original maturity of at least 5 years; furthermore, the

institution must adhere to a policy of not retiring the perpetual stock

and of not retiring the term stock prior to its maturity. The amount of

such term stock that is eligible to be included in total surplus would

be reduced by 20 percent in each of the last 5 years of the life of the

instrument.10 The risk-weighted asset base would be the base as

calculated for the institution's permanent capital ratio. The total

surplus ratio would be calculated as follows:

\10\ Thus, for example, in the first year after its issuance,

term stock with a 5-year maturity would count in surplus in an

amount equal to 80 percent of its value; in the fifth year, none of

the stock would be counted in surplus.

[GRAPHIC][TIFF OMITTED]TP27JY95.001

3. Net Collateral Requirement

The FCA proposes that all System banks should also maintain a net

collateral ratio of at least 104 percent of eligible assets (which are

defined by Sec. 615.5050), exclusive of any amounts counted as

association permanent capital, divided by total liabilities. This

measure would differ from the measure of eligible collateral that is

required by section 4.3(c) of the Act in that it would eliminate any

double-leveraged capital by ``netting out'' the capital counted as

association permanent capital pursuant to the allotment

agreements.11 A 104-percent minimum net collateral ratio affords

an added measure of protection should market forces cause a decline in

the underlying value of collateral.

\11\ This net collateral position would not replace the

collateral requirement of section 4.3(c) of the Act and, indeed,

could not do so without a statutory amendment. The FCA is not

considering proposing such a statutory change.

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This ratio would also provide the overall protection against other

risks that a leverage (i.e., total assets) ratio is intended to address

and that ratios based on risk-adjusted assets do not fully provide for.

For example, it would provide important information on a bank's ability

to withstand losses associated with management and operational risks.

Management and operational risks are not readily measurable, but they

are often serious sources of risk in a financial institution.

B. Compliance

1. Capital Plans

Institutions that are below any applicable minimum surplus or

collateral standards on the effective date of the regulations, or that

fall below the minimum standards after the effective date, would be

required to develop and submit a capital plan acceptable to the FCA for

achieving the minimum standards.12 The plan would include an

explanation of how the institution will build surplus, realistic

projections and goals for increasing the pertinent ratios, and a

reasonable timeframe for achieving the minimum capital standards. An

association that proposes a long timeframe for achieving its minimum

unallocated surplus standard would generally be expected to have a

Risk-Sharing Agreement, as described below, as part of its capital

plan; however, determination of the appropriateness of having a Risk-

Sharing Agreement would be made on a case-by-case basis. An institution

that is meeting the goals of its approved plan would be deemed by the

FCA to be in compliance with the surplus and collateral standards.

\12\ Such a plan would supplement or amend the capital adequacy

plan required by Sec. 615.5200 of the regulations.

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2. Risk-Sharing Agreements

a. Noncompliance on the Effective Date. Associations that are below

their unallocated surplus standard on the effective date of the surplus

requirements would have the option of including a Risk-Sharing

Agreement with their affiliated bank as a part of their capital plan.

Under such a Risk-Sharing Agreement, the affiliated bank could agree to

share specified association losses. The maximum amount of such

specified losses may not be greater than the amount of the

association's investment in the bank counted as association permanent

capital during the term of the Risk-Sharing Agreement. While the

agreement is in effect, the bank would have to defer sharing in losses

when it is below its own minimum capital standards, or when doing so

would cause it to fall below them.

An association would be able to count in its unallocated surplus

the amount its bank agrees to cover in the event of loss.

[[Page 38526]]

Any association losses actually absorbed by the bank (which would

probably be reflected by a reduction of the amount of the association's

direct loan) would then have to be allocated back to the association by

the bank, which would result in a reduction of the association's

investment in the bank.

The FCA notes that an association with a Risk-Sharing Agreement

must continue to build unallocated surplus net of the investment in the

bank during the time period of its capital plan, so that the

association will have achieved at least the minimum standard when the

Agreement terminates.

The risk-sharing arrangement would have two potential benefits for

the associations. First, an association would be able to report a

higher unallocated surplus ratio without directly generating the

earnings itself or causing a taxable event. Second, in the event that

the association does sustain losses, the sharing of the losses by the

bank would mitigate the effect of the losses on the association's

loanable funds position. ``Loanable funds position'' refers to the

association's levels of interest-earning assets and interest-bearing

liabilities. A positive loanable funds position means that interest-

earning assets exceed interest-bearing liabilities.

There is also a benefit for the bank and the other associations in

the district. That is, the allocation of losses by the bank back to the

association would mean that the bank's unallocated surplus would not be

reduced by the association's losses shared in by the bank, and the

interest rates on direct loans to the other associations should not be

affected.13 Without a loss-allocation requirement, the Risk-

Sharing Agreement would require a bank to come to the assistance of an

association without ultimately holding the association accountable for

that assistance.

\13\ Most wholesale banks in the System currently do not require

equalization of associations' investments in the bank; instead the

banks compensate their affiliated associations based on the relative

size of the association's investment in the bank. The risk-sharing

arrangement would work under these circumstances. If the district's

associations are required to equalize their relative investments in

the bank on a regular basis, risk sharing might not be a viable

option.

b. Subsequent Noncompliance

An association that falls below the unallocated surplus standard

subsequent to the effective date of the regulations could propose a

Risk-Sharing Agreement with its affiliated bank as part of its capital

plan, but the FCA would approve it only under appropriate

circumstances. Factors the FCA would consider would include: (1) The

causes of the decline in the association's surplus ratio; (2) the

present and projected financial health of the affiliated bank and other

associations in the district; (3) the bank's continued ability to meet

its own capital ratios under risk sharing; and (4) the likelihood that

the association will sustain significant losses in the near term.

An example of a circumstance in which risk sharing may be

appropriate would be a temporary decrease in an association's

unallocated surplus ratio due to a significant and immediate growth in

assets. There may also be times when an association is experiencing

losses, but the affiliated bank is very well capitalized and the other

associations in the district are healthy. In this situation, the

prospects are very high that a bank would be able to share an

association's losses when needed, without causing undue stress on the

bank or other associations in the district. Therefore, a Risk-Sharing

Agreement may be appropriate.

3. Other Considerations

In the development of these proposed regulations, the FCA

considered making the Risk-Sharing Agreement a permanent means of

association compliance with the unallocated surplus standard. If the

Agreement were a permanent method of compliance, an association with an

Agreement would not be required to build unallocated surplus to at

least 3.5 percent net of its investment in the bank. Arguments in favor

of doing so are that this approach would better reflect the value to

the association of an important intra-System asset and that it would

not limit the discretion of an association and its affiliated bank to

accumulate earnings at the bank in order to minimize taxes. However,

permitting a Risk-Sharing Agreement to, in effect, substitute for

unallocated surplus net of the investment in the bank would fail to

address an important safety and soundness concern--that is, the concern

that institutions have a minimum amount of capital in excess of

borrower-owned equities that is not at risk in other Farm Credit

institutions. It is only by having unallocated surplus net of its

investment in the bank that an association will be insulated from

problems that may be suffered by the bank (due, in most cases, to

problems at other associations).

As stated above, a Risk-Sharing Agreement would not permit the bank

to share association losses if the bank is not meeting all of its

capital requirements, including the surplus and collateral

requirements.14 Consequently, in a time of widespread financial

stress for Farm Credit institutions, associations with Risk-Sharing

Agreements would not be sufficiently insulated from the problems of

other Farm Credit institutions, because the bank may be unable to

perform under the Risk-Sharing Agreement.15

\14\ The FCA recognizes that sharing association losses under

the Agreement would not reduce the permanent capital or total

surplus ratios of the bank and would only temporarily reduce the

unallocated surplus and collateral ratios, until losses are

allocated back to the association. However, the risk sharing would

result in a reduction of total bank capital, which could eventually

expose System investors to greater risk.

\15\ The FCA notes that there were complaints from certain

System managers during the late 1980s, and even as recently as 1994,

about bank assistance to weaker associations. During the 1980s,

certain financially strong direct lender associations in some

districts expressed reservations about their district bank's

provision of assistance to other, weaker associations in the

district. The managers of the stronger associations complained that

the weaker associations were being given assistance without any

requirements to repay, and that the funds were coming from the

unallocated surplus of the bank, which, in the view of some, should

be used to keep the cost of all direct loans to associations at the

lowest level possible.

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The FCA has, therefore, provided in the proposed regulations that

Risk-Sharing Agreements may be used only temporarily as a means of

complying with the unallocated surplus requirement and that

associations must eventually meet the minimum standard on their own.

However, the FCA specifically invites comments and suggestions on the

use of the Risk-Sharing Agreements to meet the unallocated surplus

requirements on a permanent basis, as well as any alternative methods

of ensuring that associations have sufficient surplus that is not at

risk in other Farm Credit institutions.

4. Terms and Conditions of the Risk-Sharing Agreement

The term ``Risk-Sharing Agreement'' has been chosen to distinguish

the arrangement from the loss-sharing agreements previously entered

into by some Farm Credit institutions. Unlike the previous loss-sharing

agreements, which obligated one institution to use funds that it had

earned to absorb losses at another institution that otherwise had no

claim on the funds, the Risk-Sharing Agreement covers only funds earned

(albeit allocated from the bank) by an association and accumulated at

the bank to absorb losses at that association.

The basic terms and conditions of a Risk-Sharing Agreement would

limit the amount of exposure to the bank. Restrictions on such an

arrangement, which are intended to protect both parties, would be as

follows:

[[Page 38527]]

a. The maximum dollar amount of losses the bank could participate

in would be specified by the Agreement and could not be greater than

the amount allocated to the association by the bank that is counted as

permanent capital of the association. Such amount would be counted in

the 3.5-percent unallocated surplus capital of the association.

b. The bank's participation in association losses must begin on or

before the point when losses of the association exceed the

association's current year's earnings.

c. The percentage of bank participation in a loss could not be less

than 25 percent and would automatically increase to 100 percent when

the association's unallocated surplus, net of the investment in the

bank, is exhausted. In other words, the bank would share losses up to

the maximum amount specified in the Agreement before other association

capital is charged.

d. The amount committed to risk sharing by a bank could not be

reduced, except by payment to the association, until the association's

unallocated surplus ratio net of its investment in the bank is in

excess of 3.5 percent. The association and the bank may, of course,

agree that the bank will share losses of the association even when the

association's unallocated surplus ratio exceeds the minimum requirement

without counting the amount covered by the Risk-Sharing Agreement.

e. A bank would be prohibited from sharing any association losses

under the Agreement when the bank's permanent capital ratio, surplus

ratios, or net collateral ratio is below any of the minimum standards,

or if sharing in the losses would cause it to fall below any of the

standards.

f. A bank would be required to allocate any losses shared pursuant

to the Risk-Sharing Agreement back to the association where the loss

was incurred. The allocation of losses back to the association, which

may be implemented under general cooperative practices in the System,

is essential to hold the association fully accountable for losses

incurred.16

\16\ The allocation of losses back to the association could be

a book entry only, without the actual physical movement of assets.

At the association level, capital would decrease because the

investment in the bank would decrease. The allocation of losses by

the bank would decrease the bank's allocated surplus and restore its

unallocated surplus to the level prior to the losses taken under the

Risk-Sharing Agreement.

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C. Comparison of FCA Proposed Regulations and System Group's Proposal

The FCA's proposed regulations are broadly similar to the System

group's suggested approach for establishing unallocated and total

surplus standards. However, the FCA's proposed regulations differ with

respect to achieving the standards, because the FCA believes that the

System's proposal to require that a percentage of earnings be retained

annually until the standards are met would not ensure that an

institution experiencing growth, making cash distributions, or

allocating equities would ever achieve the minimum surplus standards.

The FCA proposes instead to require institutions not meeting the

standards to submit a capital plan to achieve such standards. The FCA

believes that achieving the standards over time is a complex planning

issue with many considerations that are best addressed in a

comprehensive capital plan. An institution that does not submit, or

does not meet the goals of, an acceptable capital plan would not be in

compliance with the capital requirements.

The FCA's proposed regulations also differ from the System group's

proposal in how the unallocated surplus standard is calculated. The FCA

is proposing that URE be reduced by an association's net investment in

its bank. This approach would ensure that an association has a level of

unallocated surplus to provide for financial strength that is

independent of its bank affiliation. The FCA notes that, because the

proposed surplus standards are separate requirements apart from the

permanent capital standard, the failure to meet the minimum surplus

standards would not alone trigger the statutory prohibition on the

retirement of borrower stock.

The net collateral ratio for banks is proposed by the FCA to be

calculated as recommended by the System group. However, the FCA is

proposing that an enforceable minimum regulatory standard be set in

lieu of the requirement to report the net collateral position to the

Funding Corporation. The FCA concluded that a minimum net collateral

standard is key to ensuring the building of capital at the bank to

protect investors in System securities and to ensure an early warning

mechanism for market access to funding, which is a critical safety and

soundness issue.

VI. Retirement of Borrower Stock

As long as an institution's 17 unallocated and total surplus

ratios meet or exceed applicable minimum standards, and the permanent

capital position is at least 9 percent, the retirement of borrower

stock may be delegated by its board of directors to management within

certain parameters.

\17\ While this provision of the regulation addresses all

institutions it is recognized that the delegation restriction would

have a limited impact on most banks.

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This provision clarifies what kind of delegations may be made by

the board to management, consistent with the statutory mandate that

stock is retirable only at the board's discretion. If an institution is

meeting or exceeding its minimum surplus standards and, if applicable,

collateral standard, the board may delegate the decision to retire

borrower stock to management provided that the institution's permanent

capital will remain at 9 percent or greater after the retirement.

Management may make such retirements only in accordance with the

institution's retirement policy and must report the aggregate amount of

the retirements and their impact on the institution's capital position

to the board every quarter. If an institution's surplus and collateral

standards are less than the minimum requirements, or if its permanent

capital would be less than 9 percent after the retirement, the

institution's board of directors must specifically consider and approve

each retirement of borrower stock prior to actual cash retirement or

payout of the stock.

This proposed regulation is similar to a suggestion made by the

System group. The System group recommended that stock retirements be

delegable to management when an institution's permanent capital ratio

is greater than 8 percent after the retirement, or when the institution

had reached the surplus requirements (or, if not, had been applying the

required proportion of earnings to surplus). The proposed regulation

would set a higher permanent capital standard for delegations and would

require the institution also to be in compliance with the surplus and

collateral standards.

VII. Individual Institution Capital Ratios and Capital Directives

The FCA proposes regulations providing procedures to implement its

statutory authorities: (1) To establish individual capital ratios for a

single institution, and (2) to issue a capital directive to an

institution that is below its minimum capital requirements (including

individual institution standards, if any), or to the board of directors

of an institution to prohibit the board from reducing the capital of

the institution. These authorities would apply with respect to the

proposed

[[Page 38528]]

surplus and collateral ratios as well as to the permanent capital

ratio. They provide another regulatory tool to the FCA to take

appropriate action when an institution's capital is insufficient. The

authorities differ from a cease and desist order in that a full hearing

(as mandated by section 5.25 of the Act) is not required; therefore,

the FCA may respond more quickly in order to minimize further

deterioration of an institution's capital position.

These powers were granted to the FCA in 1986, at the same time the

Agency was directed to set capital standards for System institutions.

The FCA was authorized to ``establish such minimum level of capital for

a System institution as the [FCA], in its discretion, deems to be

necessary or appropriate in light of the particular circumstances of

the System institution.'' Section 4.3(a) of the Act. The FCA was

further authorized to issue a capital directive to any System

institution failing to maintain capital at or above the required level,

including any individual minimum standard. Such a capital directive

may, among other things, require the System to submit and adhere to a

plan acceptable to the FCA describing how the institution will achieve

its minimum capital requirements. Section 4.3(b)(2) and (3) of the Act.

The 1987 Act, which added permanent capital provisions to the Act,

prohibited System institutions from reducing the permanent capital of

an institution through the payment of patronage refunds or dividends,

or the retirement of stock, if the permanent capital of the institution

failed, or would fail, to meet the minimum capital adequacy standards

established under section 4.3(a) of the Act, including the permanent

capital standards. In addition, the FCA was authorized, pursuant to

section 4.3A(e), to issue a capital directive to the board of directors

of an institution to comply with such prohibitions if the board has

failed to do so.

The issuance of a capital directive would be at the discretion of

the FCA. Section 5.31 of the Act, as amended by the 1987 Act, provides

that a capital directive ``shall be treated as an effective and

outstanding order enforceable in the appropriate United States district

court in the same manner and to the same extent as a final cease and

desist order issued under section 5.25.'' In addition, civil money

penalties may be imposed for violation of a capital directive pursuant

to section 5.32. A capital directive could be issued in lieu of, in

conjunction with, or in addition to other enforcement actions available

to the FCA. Furthermore, the FCA could take any available enforcement

action in lieu of issuing a capital directive.

These proposed regulations contain procedures for the establishment

by the FCA of a permanent capital ratio, surplus ratios and, if

applicable, a collateral ratio for an individual institution, as well

as for the issuance of capital directives. The regulations are similar

to the regulations of the OCC and the FDIC, which have nearly identical

authority to the FCA's with respect to individual capital ratios and

capital directives. See 12 U.S.C. 3907.

For the establishment of individual institution capital ratios, the

procedures provide for notice to the institution setting forth the

proposed individual capital ratio or ratios, the reasons the FCA has

determined that such ratio or ratios are appropriate for the

institution, and a statement that the institution has 30 days within

which to comment in writing on the proposal. The 30-day time period may

be shortened or lengthened in the discretion of the FCA, with proper

notice of its action to the institution. The institution has the

opportunity to agree to or object to the FCA's proposals and to state

the reasons therefor, to propose modifications to the proposal, and to

provide documentation or other relevant information, including

information about any mitigating circumstances.

For the issuance of capital directives, the procedures are

similar--notification to the institution of the proposed capital

directive, a 30-day period for the institution to respond, an

evaluation of the institution's response, and a determination to issue

the capital directive as proposed, to modify it, or not to issue the

capital directive at all.

VIII. Other Proposed Changes

A. Exclusion of Impact of FASB 115

The FCA has concluded that unrealized gains and losses should not

be reflected in the permanent capital, surplus, or collateral ratios.

The FCA is considering the implementation of interest rate risk

requirements that would ensure that System institutions have sufficient

capital to cover the level of risk taken for interest rates. The

current requirements of the Financial Accounting Standards Board's

(FASB) Statement No. 115 would include unrealized gains or losses based

largely on the shifts in interest rates. Such a requirement may

duplicate the efforts of an interest rate risk standard. The FCA notes

that the other Federal bank regulators have now eliminated the

unrealized gains and losses requirements of FASB Statement No. 115 from

their capital standards.

B. Technical and Conforming Changes

The following amendments are being proposed to add new terms to the

capital regulations, to remove obsolete terms and provisions, and to

make conforming changes in other parts of the regulations:

Section 615.5201 is proposed to be amended to include the terms

``Federal land credit association'' and ``agricultural credit bank'' in

the definition of ``institution.'' Changes would also be made to

Sec. 615.5220(d) and (e) to include such terms.

Section 615.5216, which granted forbearance to institutions that

were below the minimum permanent capital standards when those standards

became effective in 1988, is proposed to be deleted from the

regulations because all institutions are now in excess of the minimum

standard. References to the interim standards would also be deleted in

Secs. 615.5205, 615.5220(f), 615.5240(a), 615.5250(a)(4)(ii) and (iii),

615.5250(c)(3), and 615.5270(b).

Section 615.5230(b)(1) is proposed to be amended to eliminate the

reference to preferred stock issued to the Financial Assistance

Corporation. All such stock has been retired.

Section 615.5250(c), which pertains to the mandatory exchange of

eligible borrower stock, is proposed to be deleted because all

mandatory exchanges have been completed. A related provision in

Sec. 615.5260(a) would also be deleted.

Section 615.5260(d), which requires FCA approval of eligible

borrower stock retirements other than in the ordinary course of

business, is proposed to be deleted. The FCA has determined that it no

longer has significant safety and soundness concerns regarding such

retirements, because there is only a small amount of eligible borrower

stock outstanding, and the FCA has not received an approval request

since 1990.

IX. Regulatory Impact and FCA Regulatory Philosophy

These proposed regulations are consistent with the FCA Board's

Policy Statement on Regulatory Philosophy and achieve the Board's

objective of creating an environment that promotes the confidence of

borrower/shareholders, investors and the public in the System's

financial strength, and future viability. See 60 FR 26034, May 16,

1995.

The objective of the revisions to the capital regulations is to

establish standards that encourage the building of a sound capital

structure in System

[[Page 38529]]

institutions. The FCA expects the building of a sound capital structure

at each institution to improve the likelihood of an institution's

survival during periods of economic stress and thereby improve the

safety and soundness of the System as a whole. Additionally, the

regulations reflect the importance of capital structure to business

viability for System institutions. The FCA believes that regulations

implementing these goals must provide a meaningful measurement of

capital adequacy and be appropriate for all System institutions.

These proposed regulations will affect all System banks,

associations, and the Leasing Corporation because all such institutions

will be required to adhere to the standards. However, less than 10

percent of the institutions would be below the standards, if the

standards were in effect today, and those institutions will be required

to build capital. As of the quarter ending March 31, 1995, 90 percent

of the direct lender associations would have met the proposed surplus

requirements had the requirements been in place on that date. All of

the Federal land bank associations would have met the proposed surplus

standards. Of the direct lender associations that would not have been

in compliance, two associations would not have met either the total

surplus or unallocated surplus ratios, nine additional associations

would not have met the unallocated surplus ratio, and four additional

associations would not have met the total surplus requirements.

However, in most of those associations both types of surplus have been

increasing steadily during the past 5 years, and the FCA estimates that

most, if not all, of the associations would achieve the minimum

standards in 7 years or less if these trends continue.

As of the quarter ending March 31, 1995, all eight banks would have

been above the 7-percent total surplus standard.18 In addition,

five of the eight banks would have been above the proposed unallocated

surplus ratio and the net collateral ratio. Of those that would not

have met the proposed requirements, two banks would have been below the

minimum unallocated surplus standard and one bank would have been below

the net collateral standard. All banks have been building allocated and

unallocated surplus over the past several years, although in some cases

the ratios have not increased because assets have also grown.

\18\ The FCB of Columbia and the FCB of Baltimore, which merged

on April 1, 1995, to form AgFirst, FCB, are treated here as a single

bank.

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The FCA has determined that the proposed regulations would not have

a significant effect upon the general economy. In addition, the

proposed regulations pertain only to System institutions and,

therefore, would not present a conflict with the rules and regulations

of other financial regulatory agencies. Due to the nature of the

regulations, it is not anticipated that the regulations will have any

material impact upon governmental entitlements, grants, user fees, or

loan programs.

List of Subjects

12 CFR Part 615

Accounting, Agriculture, Banks, banking, Government securities,

Investments, Rural areas.

12 CFR Part 618

Agriculture, Archives and records, Banks, banking, Insurance,

Reporting and recordkeeping requirements, Rural areas, Technical

assistance.

12 CFR Part 620

Accounting, Agriculture, Banks, banking, Reporting and

recordkeeping requirements, Rural areas.

For reasons stated in the preamble, parts 615, 618, and 620 of

chapter VI, title 12 of the Code of Federal Regulations are proposed to

be amended to read as follows:

PART 615--FUNDING AND FISCAL AFFAIRS, LOAN POLICIES AND OPERATIONS,

AND FUNDING OPERATIONS

1. The authority citation for part 615 is revised to read as

follows:

Authority: Secs. 1.5, 1.7, 1.10, 1.11, 1.12, 2.2, 2.3, 2.4, 2.5,

2.12, 3.1, 3.7, 3.11, 3.25, 4.3, 4.3A, 4.9, 4.14B, 4.25, 5.9, 5.17,

6.20, 6.26, 8.0, 8.4, 8.6, 8.7, 8.8, 8.10, 8.12 of the Farm Credit

Act (12 U.S.C. 2013, 2015, 2018, 2019, 2020, 2073, 2074, 2075, 2076,

2093, 2122, 2128, 2132, 2146, 2154, 2154a, 2160, 2202b, 2211, 2243,

2252, 2278b, 2278b-6, 2279aa, 2279aa-4, 2279aa-6, 2279aa-7, 2279aa-

8, 2279aa-10, 2279aa-12); sec. 301(a) of Pub. L. 100-233, 101 Stat.

1568, 1608.

Subpart H--Capital Adequacy

Sec. 615.5201 [Amended]

2. Section 615.5201 is amended by adding the words ``Federal land

credit association,'' after the words ``Federal land bank

association,''; and by removing the words ``National Bank for

Cooperatives,'' and adding in their place, the words ``agricultural

credit bank,'' in paragraph (g).

3. Section 615.5205 is revised to read as follows:

Sec. 615.5205 Minimum permanent capital standards.

Each Farm Credit System institution shall at all times maintain

permanent capital at a level of at least 7 percent of its risk-adjusted

assets.

4. Section 615.5210 is amended by removing paragraphs (f)(2)(i)(D)

and (f)(2)(v)(D); redesignating paragraph (f)(2)(v)(E) as new paragraph

(f)(2)(v)(D); adding a new paragraph (e)(2)(ii)(G)(10); and revising

paragraphs (e)(2)(ii)(G)(7) and (f)(2)(i)(C) to read as follows:

Sec. 615.5210 Computation of the permanent capital ratio.

* * * * *

(e) * * *

(2) * * *

(ii) * * *

(G) * * *

(7) Each institution shall deduct from its total capital an amount

equal to any goodwill.

* * * * *

(10) The permanent capital of an institution shall exclude any

impact from unrealized holding gains or losses for available-for-sale

securities.

(f) * * *

(2) * * *

(i) * * *

(C) Goodwill.

* * * * *

Sec. 615.5216 [Removed and reserved]

5. Section 615.5216 is removed and reserved.

Subpart I--Issuance of Equities

Sec. 615.5220 [Amended]

6. Section 615.5220 is amended by removing paragraph (f),

redesignating paragraphs (g), (h), and (i) as paragraphs (f), (g), and

(h), respectively; removing the words ``may be more than, but'' each

place they appear in paragraphs (d) and (e); by adding the words ``,

agricultural credit banks (with respect to loans other than to

cooperatives),'' after the words ``For Farm Credit Banks'' in paragraph

(d); by adding the words ``and agricultural credit banks (with respect

to loans to cooperatives)'' after the words ``For banks for

cooperatives'' in paragraph (e); and by removing the words ``(including

interim standards)'' in newly designated paragraph (f).

Sec. 615.5230 [Amended]

7. Section 615.5230 is amended by removing the words ``preferred

stock to be issued to the Farm Credit System Financial Assistance

Corporation and'' in paragraph (b)(1).

8. Section 615.5240 is amended by removing paragraph (b);

redesignating the introductory paragraph and

[[Page 38530]]

paragraph (a) introductory text as paragraphs (a) and (b) introductory

text, respectively; adding a new paragraph (c); and revising newly

designated paragraph (a) to read as follows:

Sec. 615.5240 Permanent capital requirements.

(a) The capitalization bylaws shall enable the institution to meet

the minimum permanent capital adequacy standards established under

subpart H of this part and the total capital requirements established

by the board of directors of the institution.

* * * * *

(c) An institution's board of directors may delegate to management

the decision whether to retire borrower stock, provided that:

(1) The institution's permanent capital ratio will be in excess of

9 percent after any such retirements;

(2) The institution meets and maintains all applicable minimum

surplus and collateral standards;

(3) Any such retirements are in accordance with the institution's

capital plan; and

(4) The aggregate amount of stock purchases, retirements, and the

net effect of such activities are reported to the board of directors on

a quarterly basis.

Sec. 615.5250 [Amended]

9. Section 615.5250 is amended by removing paragraph (c);

redesignating paragraphs (d) and (e) as paragraphs (c) and (d)

respectively; by removing the words ``(including interim standards)''

in paragraphs (a)(4)(ii) and newly designated (c)(3); and by removing

the words ``, including interim standards'' in paragraph (a)(4)(iii).

Subpart J--Retirement of Equities

Sec. 615.5260 [Amended]

10. Section 615.5260 is amended by removing ``; or'' at the end of

paragraph (a)(2)(ii) and inserting a period in its place and by

removing paragraphs (a)(2)(iii) and (d).

Sec. 615.5270 [Amended]

11. Section 615.5270 is amended by removing the words ``(including

interim standards)'' in paragraph (b).

12. Subpart K is revised to read as follows:

Subpart K--Surplus and Collateral Requirements

Sec.

615.5301 Definitions.

615.5330 Minimum surplus ratios.

615.5335 Bank net collateral ratio requirements.

615.5336 Compliance.

Subpart K--Surplus and Collateral Requirements

Sec. 615.5301 Definitions.

For the purposes of this subpart, the following definitions shall

apply:

(a) The terms institution, permanent capital, risk-adjusted asset

base, and total capital shall have the meanings set forth in

Sec. 615.5201.

(b) Net collateral ratio means a bank's collateral position as

defined by Sec. 615.5050, less an amount equal to that portion of the

allocated investments of affiliated associations that is not counted as

permanent capital of the bank, divided by the bank's total liabilities.

(c) Net investment in the bank means the total investment by an

association in its affiliated bank, less reciprocal investments and

investments resulting from a loan originating/service agency

relationship, including participations.

(d) Risk-Sharing Agreement means a binding contract between a bank

and its affiliated association, under which a bank agrees to share

losses that the affiliated association may incur and which specifies at

least the following:

(1) The maximum dollar amount of association losses to be shared by

the bank shall be specified and shall not be greater than the amount of

the association's allocated investment in the bank that is counted as

association permanent capital.

(2) The participation in losses shall begin on or before the point

when losses of the association exceed its current year's earnings, net

of non-cash allocated earnings allocated to the association from the

affiliated bank.

(3) The percentage of bank participation in a loss shall be not

less than 25 percent and shall automatically increase to 100 percent

when the association's unallocated surplus less the net investment in

the bank is zero.

(4) The dollar amount committed to risk sharing by the bank under

the agreement shall not be reduced except by payment to the

association, unless the association has an unallocated surplus ratio in

excess of 3.5 percent, net of the net investment in the bank.

(5) At any time a bank's permanent capital ratio, surplus ratios,

or net collateral ratio is less than the minimum applicable standards

or would fall below upon payment, the bank shall defer its payments

under the agreement until such time as the payments do not result in

the bank's failure to meet its minimum standards.

(6) The bank shall allocate any and all losses shared under the

agreement back to the association where the loss was incurred.

(e)(1) Total surplus means:

(i) Unallocated retained earnings;

(ii) Allocated equities, including allocated surplus and stock

which, if subject to revolvement, have a revolvement of not less than 5

years and are eligible to be included in permanent capital pursuant to

Sec. 615.5201(j)(4)(iv); and

(iii) Stock that is not purchased as a condition of obtaining a

loan, provided that it is either perpetual stock or term stock with an

original maturity of at least 5 years, and provided that the

institution has and adheres to a policy of not retiring such perpetual

stock and of not retiring such term stock prior to its stated maturity.

The amount of term stock that is eligible to be included in total

surplus shall be reduced by 20 percent in each of the last 5 years of

the life of the instrument.

(2)The surplus of an institution shall exclude any impact from

unrealized holding gains or losses for available-for-sale securities.

(f) Unallocated surplus means unallocated retained earnings and any

common or non-cumulative perpetual preferred stock held by non-

borrowers, provided that the institution has and adheres to a policy of

not retiring the stock. Any impact from unrealized holding gains or

losses for available-for-sale securities shall be excluded from

unallocated surplus.

Sec. 615.5330 Minimum surplus ratios.

(a) Total surplus. Each institution shall achieve and maintain a

ratio of at least 7 percent of total surplus to risk-adjusted assets.

(b) Unallocated surplus. (1) Each institution shall achieve and

maintain a ratio of unallocated surplus to risk-adjusted assets of at

least 3.5 percent.

(2) Each association shall compute its unallocated surplus ratio by

deducting an amount equal to the net investment in its affiliated Farm

Credit bank from which it has received allocated equities from both its

unallocated surplus and its risk-adjusted asset base, except that the

amount specified as the maximum amount of losses to be shared by the

bank in a Risk-Sharing Agreement that is in effect shall not be

deducted from the unallocated surplus or risk-adjusted asset base.

(c) An institution's total and unallocated surplus ratios shall be

computed as of the end of each month.

Sec. 615.5335 Bank net collateral ratio requirements.

(a) Each bank shall achieve and maintain a net collateral ratio of

at least 104 percent of net collateral to total liabilities.

[[Page 38531]]

(b) A bank's net collateral ratio shall be computed as of the end

of each month.

Sec. 615.5336 Compliance.

(a) Association compliance requirements. (1) Each association that

fails to satisfy either or both of its minimum surplus ratios shall

submit a plan for achieving and maintaining the standards, with

appropriate annual progress toward meeting the goal, to the Farm Credit

Administration within 60 days of the month-end in which the failure

occurred. If the capital plan is not approved by the Farm Credit

Administration, the association shall submit a revised capital plan

within the time specified by the Farm Credit Administration.

(2) An association whose unallocated surplus ratio is less than the

minimum requirement on [the effective date of the final rule] shall

have the option to include a Risk-Sharing Agreement with its affiliated

bank in the capital plan, provided that the capital plan also

incorporates provisions for achieving and maintaining the unallocated

surplus standard exclusive of the Risk-Sharing Agreement.

(3) An association whose unallocated surplus ratio is less than the

minimum requirement subsequent to [the effective date of the final

rule] may include a Risk-Sharing Agreement in its capital plan only if

the Farm Credit Administration approves such inclusion.

(b) Bank compliance requirements. A bank that fails to meet its

minimum applicable unallocated or total surplus standard or net

collateral standard shall submit a plan for achieving and maintaining

the standards to the Farm Credit Administration within 60 days of the

month-end when the failure occurred for meeting the standard. If such

plan is not acceptable to the Farm Credit Administration, the bank

shall submit a revised capital plan within the time specified by the

Farm Credit Administration.

(c) Compliance with the use of a capital plan. An institution that

is adhering to a capital plan that has been submitted to the Farm

Credit Administration under this subpart and that has been approved by

the Agency shall be deemed to be in compliance with the requirements of

this subpart.

13. Subparts L and M are added to read as follows:

Subpart L--Establishment of Minimum Capital Ratios for an Individual

Institution

Sec.

615.5350 General--Applicability.

615.5351 Standards for determination of appropriate individual

institution minimum capital ratios.

615.5352 Procedures.

615.5353 Relation to other actions.

615.5354 Enforcement.

Subpart M--Issuance of a Capital Directive

615.5355 Purpose and scope.

615.5356 Notice of intent to issue a capital directive.

615.5357 Response to notice.

615.5358 Decision.

615.5359 Issuance of a capital directive.

615.5360 Reconsideration based on change in circumstances.

615.5361 Relation to other administrative actions.

Subpart L--Establishment of Minimum Capital Ratios for an

Individual Institution

Sec. 615.5350 General--Applicability.

(a) The rules and procedures specified in this subpart are

applicable to a proceeding to establish required minimum capital ratios

that would otherwise be applicable to an institution under

Secs. 615.5205, 615.5330, and 615.5335. The Farm Credit Administration

is authorized to establish such minimum capital requirements for an

institution as the Farm Credit Administration, in its discretion, deems

to be necessary or appropriate in light of the particular circumstances

of the institution. Proceedings under this subpart also may be

initiated to require an institution having capital ratios greater than

those set forth in Secs. 615.5205, 615.5330, or 615.5335 to continue to

maintain those higher ratios.

(b) The Farm Credit Administration may require higher minimum

capital ratios for an individual institution in view of its

circumstances. For example, higher capital ratios may be appropriate

for:

(1) An institution receiving special supervisory attention;

(2) An institution that has, or is expected to have, losses

resulting in capital inadequacy;

(3) An institution with significant exposure due to operational

risk; interest rate risk; the risks from concentrations of credit;

certain risks arising from other products, services, or related

activities; or management's overall inability to monitor and control

financial risks presented by concentrations of credit and related

services activities;

(4) An institution exposed to a high volume of, or particularly

severe, problem loans;

(5) An institution that is growing rapidly; or

(6) An institution that may be adversely affected by the activities

or condition of System institutions with which it has significant

business relationships or in which it has significant investments.

Sec. 615.5351 Standards for determination of appropriate individual

institution minimum capital ratios.

The appropriate minimum capital ratios for an individual

institution cannot be determined solely through the application of a

rigid mathematical formula or wholly objective criteria. The decision

is necessarily based in part on subjective judgment grounded in Agency

expertise. The factors to be considered in the determination will vary

in each case and may include, for example:

(a) The conditions or circumstances leading to the Farm Credit

Administration's determination that higher minimum capital ratios are

appropriate or necessary for the institution;

(b) The exigency of those circumstances or potential problems;

(c) The overall condition, management strength, and future

prospects of the institution and, if applicable, affiliated

institutions;

(d) The institution's capital, risk asset and other ratios compared

to the ratios of its peers or industry norms; and

(e) The views of the institution's directors and senior management.

Sec. 615.5352 Procedures.

(a) Notice. When the Farm Credit Administration determines that

minimum capital ratios greater than those set forth in Secs. 615.5205,

615.5330, or 615.5335 are necessary or appropriate for a particular

institution, the Farm Credit Administration will notify the institution

in writing of the proposed minimum capital ratios and the date by which

they should be reached (if applicable) and will provide an explanation

of why the ratios proposed are considered necessary or appropriate for

the institution.

(b) Response. (1) The institution may respond to any or all of the

items in the notice. The response should include any matters which the

institution would have the Farm Credit Administration consider in

deciding whether individual minimum capital ratios should be

established for the institution, what those capital ratios should be,

and, if applicable, when they should be

[[Page 38532]]

achieved. The response must be in writing and delivered to the

designated Farm Credit Administration official within 30 days after the

date on which the institution received the notice. In its discretion,

the Farm Credit Administration may extend the time period for good

cause. The Farm Credit Administration may shorten the time period with

the consent of the institution or when, in the opinion of the Farm

Credit Administration, the condition of the institution so requires,

provided that the institution is informed promptly of the new time

period.

(2) Failure to respond within 30 days or such other time period as

may be specified by the Farm Credit Administration shall constitute a

waiver of any objections to the proposed minimum capital ratios or the

deadline for their achievement.

(c) Decision. After the close of the institution's response period,

the Farm Credit Administration will decide, based on a review of the

institution's response and other information concerning the

institution, whether individual minimum capital ratios should be

established for the institution and, if so, the ratios and the date the

requirements will become effective. The institution will be notified of

the decision in writing. The notice will include an explanation of the

decision, except for a decision not to establish individual minimum

capital requirements for the institution.

(d) Submission of plan. The decision may require the institution to

develop and submit to the Farm Credit Administration, within a time

period specified, an acceptable plan to reach the minimum capital

ratios established for the institution by the date required.

(e) Reconsideration based on change in circumstances. If, after the

Farm Credit Administration's decision in paragraph (c) of this section,

there is a change in the circumstances affecting the institution's

capital adequacy or its ability to reach the required minimum capital

ratios by the specified date, either the institution or the Farm Credit

Administration may propose a change in the minimum capital ratios for

the institution, the date when the minimums must be achieved, or the

institution's plan (if applicable). The Farm Credit Administration may

decline to consider proposals that are not based on a significant

change in circumstances or are repetitive or frivolous. Pending a

decision on reconsideration, the Farm Credit Administration's original

decision and any plan required under that decision shall continue in

full force and effect.

Sec. 615.5353 Relation to other actions.

In lieu of, or in addition to, the procedures in this subpart, the

required minimum capital ratios for an institution may be established

or revised through a written agreement or cease and desist proceedings

under part C of title V of the Act, or as a condition for approval of

an application.

Sec. 615.5354 Enforcement.

An institution that does not have or maintain the minimum capital

ratios applicable to it, whether required in subparts H and K of this

part, in a decision pursuant to this subpart, in a written agreement or

temporary or final order under part C of title V of the Act, or in a

condition for approval of an application, or an institution that has

failed to submit or comply with an acceptable plan to attain those

ratios, will be subject to such administrative action or sanctions as

the Farm Credit Administration considers appropriate. These sanctions

may include the issuance of a capital directive pursuant to subpart M

of this part or other enforcement action, assessment of civil money

penalties, and/or the denial or condition of applications.

Subpart M--Issuance of a Capital Directive

Sec. 615.5355 Purpose and scope.

(a)(1) This subpart is applicable to proceedings by the Farm Credit

Administration to issue a capital directive under sections 4.3(b) and

4.3A(e) of the Act. A capital directive is an order issued to an

institution that does not have or maintain capital at or greater than

the minimum ratios set forth in Secs. 615.5205, 615.5330, and 615.5335;

or established for the institution under subpart L, by a written

agreement under part C of title V of the Act, or as a condition for

approval of an application. A capital directive may order the

institution to:

(i) Achieve the minimum capital ratios applicable to it by a

specified date;

(ii) Adhere to a previously submitted plan to achieve the

applicable capital ratios;

(iii) Submit and adhere to a plan acceptable to the Farm Credit

Administration describing the means and time schedule by which the

institution shall achieve the applicable capital ratios;

(iv) Take other action, such as reduction of assets or the rate of

growth of assets, restrictions on the payment of dividends or

patronage, or restrictions on the retirement of stock, to achieve the

applicable capital ratios; or

(v) A combination of any of these or similar actions.

(2) A capital directive may also be issued to the board of

directors of an institution, requiring such board to comply with the

requirements of section 4.3A(d) of the Act prohibiting the reduction of

permanent capital.

(b) A capital directive issued under this subpart, including a plan

submitted under a capital directive, is enforceable in the same manner

and to the same extent as an effective and outstanding cease and desist

order which has become final as defined in section 5.25 of the Act.

Violation of a capital directive may result in assessment of civil

money penalties in accordance with section 5.32 of the Act.

Sec. 615.5356 Notice of intent to issue a capital directive.

The Farm Credit Administration will notify an institution in

writing of its intention to issue a capital directive. The notice will

state:

(a) The reasons for issuance of the capital directive;

(b) The proposed contents of the capital directive, including the

proposed date for achieving the minimum capital requirement; and

(c) Any other relevant information concerning the decision to issue

a capital directive.

Sec. 615.5357 Response to notice.

(a) An institution may respond to the notice by stating why a

capital directive should not be issued and/or by proposing alternative

contents for the capital directive or seeking other appropriate relief.

The response shall include any information, mitigating circumstances,

documentation, or other relevant evidence that supports its position.

The response may include a plan for achieving the minimum capital

ratios applicable to the institution. The response must be in writing

and delivered to the Farm Credit Administration within 30 days after

the date on which the institution received the notice. In its

discretion, the Farm Credit Administration may extend the time period

for good cause. The Farm Credit Administration may shorten the 30-day

time period:

(1) When, in the opinion of the Farm Credit Administration, the

condition of the institution so requires, provided that the institution

shall be informed promptly of the new time period;

(2) With the consent of the institution; or

(3) When the institution already has advised the Farm Credit

Administration that it cannot or will not achieve its applicable

minimum capital ratios.

[[Page 38533]]

(b) Failure to respond within 30 days or such other time period as

may be specified by the Farm Credit Administration shall constitute a

waiver of any objections to the proposed capital directive.

Sec. 615.5358 Decision.

After the closing date of the institution's response period, or

receipt of the institution's response, if earlier, the Farm Credit

Administration may seek additional information or clarification of the

response. Thereafter, the Farm Credit Administration will determine

whether or not to issue a capital directive, and if one is to be

issued, whether it should be as originally proposed or in modified

form.

Sec. 615.5359 Issuance of a capital directive.

(a) A capital directive will be served by delivery to the

institution. It will include or be accompanied by a statement of

reasons for its issuance.

(b) A capital directive is effective immediately upon its receipt

by the institution, or upon such later date as may be specified

therein, and shall remain effective and enforceable until it is stayed,

modified, or terminated by the Farm Credit Administration.

Sec. 615.5360 Reconsideration based on change in circumstances.

Upon a change in circumstances, an institution may request the Farm

Credit Administration to reconsider the terms of its capital directive

or may propose changes in the plan to achieve the institution's

applicable minimum capital ratios. The Farm Credit Administration also

may take such action on its own motion. The Farm Credit Administration

may decline to consider requests or proposals that are not based on a

significant change in circumstances or are repetitive or frivolous.

Pending a decision on reconsideration, the capital directive and plan

shall continue in full force and effect.

Sec. 615.5361 Relation to other administrative actions.

A capital directive may be issued in addition to, or in lieu of,

any other action authorized by law, including cease and desist

proceedings, civil money penalties, or the conditioning or denial of

applications. The Farm Credit Administration also may, in its

discretion, take any action authorized by law, in lieu of a capital

directive, in response to an institution's failure to achieve or

maintain the applicable minimum capital ratios.

PART 618--GENERAL PROVISIONS

14. The authority citation for part 618 continues to read as

follows:

Authority: Secs. 1.5, 1.11, 1.12, 2.2, 2.4, 2.5, 2.12, 3.1, 3.7,

4.12, 4.13A, 4.25, 4.29, 5.9, 5.10, 5.17, of the Farm Credit Act (12

U.S.C. 2013, 2019, 2020, 2073, 2075, 2076, 2093, 2122, 2128, 2183,

2200, 2211, 2218, 2243, 2244, 2252).

Subpart J--Internal Controls

Sec. 618.8440 [Amended]

15. Section 618.8440 is amended by removing the reference

``Sec. 615.5200(b)'' and adding in its place, the references

``Secs. 615.5200(b), 615.5330 (c) or (d), and 615.5335(b)'' in

paragraph (b)(6).

PART 620--DISCLOSURE TO SHAREHOLDERS

16. The authority citation for part 620 continues to read as

follows:

Authority: Secs. 5.17, 5.19, 8.11 of the Farm Credit Act (12

U.S.C. 2252, 2254, 2279aa-11); sec. 424 of Pub. L. 100-233, 101

Stat. 1568, 1656.

Subpart B--Annual Report to Shareholders

17. Section 620.5 is amended by revising paragraphs (d)(1)(ix) and

(g)(4)(ii) to read as follows:

Sec. 620.5 Contents of the annual report to shareholders.

* * * * *

(d) * * *

(1) * * *

(ix) The statutory and regulatory restriction regarding retirement

of stock and distribution of earnings pursuant to Sec. 615.5215, and

any requirements to add capital under a plan approved by the Farm

Credit Administration pursuant to Secs. 615.5330, 615.5335, 615.5351,

or 615.5357.

* * * * *

(g) * * *

(4) * * *

(ii) Describe any material trends or changes in the mix and cost of

debt and capital resources. The discussion shall consider changes in

protected borrower capital, permanent capital, surplus requirements and

collateral position, debt, risk-sharing agreements, and any off-

balance-sheet financing arrangements.

* * * * *

Dated: July 20, 1995.

Floyd Fithian,

Secretary, Farm Credit Administration Board.

[FR Doc. 95-18323 Filed 7-26-95; 8:45 am]

BILLING CODE 6705-01-P