Risk-Based Capital Standards: Unrealized Holding Gains on Certain Equity Securities

Federal RegisterSep 1, 1998

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[Federal Register Volume 63, Number 169 (Tuesday, September 1, 1998)]

[Rules and Regulations]

[Pages 46518-46524]

From the Federal Register Online via the Government Publishing Office [www.gpo.gov]

[FR Doc No: 98-23379]

[[Page 46517]]

_______________________________________________________________________

Part III

Department of the Treasury

Office of the Comptroller of the Currency

12 CFR Part 3

Federal Reserve System

12 CFR Parts 208 and 225

Federal Deposit Insurance Corporation

12 CFR Part 325

Department of the Treasury

Office of Thrift Supervision

_______________________________________________________________________

12 CFR Part 567

Risk-Based Capital Standards: Unrealized Holding Gains on Certain

Equity Securities; Final Rule

Federal Register / Vol. 63, No. 169 / Tuesday, September 1, 1998 /

Rules and Regulations

[[Page 46518]]

DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Part 3

[Docket No. 98-12]

RIN 1557-AB14

FEDERAL RESERVE SYSTEM

12 CFR Parts 208 and 225

[Regulations H and Y; Docket No. R-0982]

FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Part 325

RIN 3064-AC11

DEPARTMENT OF THE TREASURY

Office of Thrift Supervision

12 CFR Part 567

[Docket No. 98-75]

RIN 1550-AB11

Risk-Based Capital Standards: Unrealized Holding Gains on Certain

Equity Securities

AGENCIES: Office of the Comptroller of the Currency, Treasury; Board of

Governors of the Federal Reserve System; Federal Deposit Insurance

Corporation; and Office of Thrift Supervision, Treasury.

ACTION: Final rule.

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SUMMARY: The Office of the Comptroller of the Currency (OCC), the Board

of Governors of the Federal Reserve System (Board), the Federal Deposit

Insurance Corporation (FDIC), and the Office of Thrift Supervision

(OTS) (collectively, the Agencies) are amending their respective risk-

based capital standards for banks, bank holding companies, and thrifts

(institutions) with regard to the regulatory capital treatment of

unrealized holding gains on certain equity securities. These gains are

reported as a component of equity capital under U.S. generally accepted

accounting principles (GAAP), but have not been included in regulatory

capital under the Agencies' capital standards. This final rule permits

institutions to include in supplementary (Tier 2) capital up to 45

percent of the pretax net unrealized holding gains on certain

available-for-sale (AFS) equity securities. The final rule is intended

to make the regulatory capital treatment of these unrealized gains

consistent with the international standards of the Basle Accord.

DATES: This final rule is effective October 1, 1998. The Agencies will

not object if an institution wishes to apply the provisions of this

final rule beginning on September 1, 1998.

FOR FURTHER INFORMATION CONTACT: OCC: Roger Tufts, Senior Economic

Advisor (202/874-5070), Amrit Sekhon, Examiner (202/874-5070), Capital

Policy Division; or Ronald Shimabukuro, Senior Attorney (202/874-5090),

Legislative and Regulatory Activities Division, Office of the

Comptroller of the Currency, 250 E Street, SW, Washington, DC 20219.

Board: Norah Barger, Assistant Director (202/452-2402), Barbara

Bouchard, Manager (202/452-3072), John F. Connolly, Supervisory

Financial Analyst (202/452-3621), Division of Banking Supervision and

Regulation; or Mark E. Van Der Weide, Staff Attorney (202/452-2263),

Legal Division. For the hearing impaired only, Telecommunication Device

for the Deaf (TDD), Diane Jenkins (202/452-3544), Board of Governors of

the Federal Reserve System, 20th and C Streets, NW, Washington, DC

20551.

FDIC: For supervisory issues, Stephen G. Pfeifer, Examination

Specialist (202/898-8904) or Carol L. Liquori, Examination Specialist

(202/898-7289), Accounting Section, Division of Supervision; for legal

issues, Jamey Basham, Counsel, Legal Division (202/898-7265), Federal

Deposit Insurance Corporation, 550 17th Street, NW, Washington, DC

20429.

OTS: Michael D. Solomon, Senior Program Manager for Capital Policy

(202/906-5654), Supervision Policy; or Vern McKinley, Senior Attorney

(202/906-6241), Regulations and Legislation Division, Office of the

Chief Counsel, Office of Thrift Supervision, 1700 G Street, NW,

Washington, DC 20552.

SUPPLEMENTARY INFORMATION:

Background

The Agencies' risk-based capital standards implementing the

International Convergence of Capital Measurement and Capital Standards

(the Basle Accord) 1 include definitions for core (Tier 1)

capital and supplementary (Tier 2) capital.2 Under the

Agencies' capital standards, Tier 1 capital generally includes common

stockholders' equity, noncumulative perpetual preferred stock, and

minority interests in the equity accounts of consolidated

subsidiaries.3 The common stockholders' equity component is

defined to include common stock; related surplus; and retained earnings

(including capital reserves and adjustments for the cumulative effect

of foreign currency translation); less net unrealized holding losses on

AFS equity securities with readily determinable fair values. Net

unrealized holding gains on such equity securities and net unrealized

holding gains and losses on AFS debt securities are not included in the

Agencies' regulatory capital definition of common stockholders'

equity.4 Tier 2 capital includes, subject to certain

limitations and conditions, the allowance for loan and lease losses;

cumulative perpetual preferred stock and related surplus; and certain

other maturing or redeemable capital instruments.

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\1\ The Basle Accord is a risk-based capital framework developed

by the Basle Committee on Banking Regulations and Supervisory

Practices and endorsed by the central bank governors of the Group of

Ten (G-10) countries in July 1988. The Basle Committee is comprised

of the central banks and supervisory authorities from the G-10

countries (Belgium, Canada, France, Germany, Italy, Japan, the

Netherlands, Sweden, Switzerland, the United Kingdom, and the United

States) and Luxembourg.

\2\ Each Agency's risk-based capital standards contain more

detailed descriptions of core and supplementary capital. See 12 CFR

Part 3, Appendix A, for national banks; 12 CFR Part 208, Appendix A,

for state member banks; 12 CFR Part 225, Appendix A, for bank

holding

\3\ Bank holding companies may also include limited amounts of

cumulative perpetual preferred stock in Tier 1 capital.

\4\ For regulatory reporting purposes, institutions record net

unrealized gains and losses on AFS securities (debt and equity) in

accordance with Statement of Financial Accounting Standards (SFAS)

No. 115, ``Accounting for Certain Investments in Debt and Equity

Securities.'' AFS securities are all debt securities not held for

trading that an institution does not have the positive intent and

ability to hold to maturity and equity securities with readily

determinable fair values not held for trading. AFS securities must

be reported at fair value with unrealized holding gains or losses

(i.e., the amount by which fair value exceeds or falls below cost)

reported, net of tax, directly in a separate component of common

stockholders' equity.

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The Basle Accord also permits institutions to include up to 45

percent of the pretax net unrealized gains on equity securities in

supplementary capital. As explained in the Basle Accord, the 55 percent

discount is applied to the unrealized gains to reflect the potential

volatility of this form of unrealized capital, as well as the tax

liability charges that generally would be incurred if the unrealized

gain were realized or otherwise taxed currently. When the Agencies

implemented the Basle Accord by issuing their respective risk-based

capital standards in 1989, they decided not to include unrealized gains

on AFS equity securities in Tier 2 capital.

[[Page 46519]]

Proposed Rule

The Agencies believe that it is appropriate to continue the

existing regulatory capital treatment of net unrealized holding gains

and losses on AFS debt securities and net unrealized holding losses on

AFS equity securities. However, for institutions that have net

unrealized holding gains on AFS equity securities, the Agencies decided

to consider whether to include at least a portion of the unrealized

gains on such securities in regulatory capital. Accordingly, on October

27, 1997, the Agencies published a joint proposal to amend their

respective risk-based capital standards for institutions (62 FR 55682).

Specifically, the Agencies proposed, consistent with the Basle

Accord, to permit institutions that legally hold equity securities to

include up to 45 percent of the pretax net unrealized holding gains

(that is, the excess amount, if any, of fair value over historical

cost) on AFS equity securities in Tier 2 capital. The proposed rule

required that equity securities be valued in accordance with GAAP and

have readily determinable fair values,5 and institutions

should be able to substantiate those values. In the event that an

Agency determines that an institution's AFS equity securities are not

prudently valued in accordance with GAAP, the institution may be

precluded from including all or a portion of the 45 percent of pretax

net unrealized holding gains on those securities in Tier 2 capital.

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\5\ The Agencies intend to rely on the guidance set forth in

SFAS 115 for purposes of determining whether equity securities have

fair values that are ``readily determinable.'' Under SFAS 115, the

fair value of an equity security is readily determinable if sales

prices or bid-and-ask quotations are currently available on a

securities exchange registered with the Securities and Exchange

Commission or in the over-the-counter market, provided that those

prices or quotations for the over-the-counter market are publicly

reported by the National Association of Securities Dealers Automated

Quotations System or by the National Quotations Bureau. Restricted

stock does not meet this definition. The fair value of an equity

security traded only in a foreign market is readily determinable if

that foreign market is of a breadth and scope comparable to one of

the U.S. markets referred to previously. The fair value of an

investment in a mutual fund is readily determinable if the fair

value per share (unit) is determined and published and is the basis

for current transactions.

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Comments Received

The Agencies received eleven comments on the proposal, six from

financial institutions and five from banking trade associations. Seven

commenters expressed support for the proposal; the remaining four

respondents were opposed.

Respondents supporting the proposal included three institutions and

four trade associations. These commenters generally believe that

convergence with the Basle Accord will result in greater uniformity

with foreign capital standards, and will mitigate a source of

competitive inequality arising from continuing differences in

supervisory capital requirements across countries. Three commenters

representing trade associations further emphasized that the proposed

rule would treat net unrealized holding gains on AFS equity securities

more consistently with the current treatment of net unrealized holding

losses since the latter are already deducted from Tier 1 capital.

Another commenter observed that including net unrealized holding gains

in Tier 2 capital is more comparable to the GAAP treatment of such

gains as a component of equity capital.

Opponents of the proposal, three financial institutions and one

banking trade association, expressed varying concerns. The financial

institution representatives generally stated that the proposed rule

would place an additional burden on small community banks. The

remaining opponent of the proposed rule expressed opposition to the

fair value treatment of debt and equity securities for regulatory

capital calculations (an opinion expressed by two other trade

associations, despite their support for the proposal). This commenter

noted that market fluctuations could have a significant impact on

capital levels if the unrealized equity gains are included and the

proposed discount may be insufficient to absorb the potential

volatility in the value of these assets. This commenter also disagreed

with the timing of the proposal, indicating that the currently strong

market could create equity holding gains that may not be sustained if

the economy weakens. In such an event, the commenter was concerned that

institutions unduly relying on unrealized holding gains in their

portfolios may find their capital levels falling below regulatory

minimums due to an adverse change in market conditions.

Several commenters made suggestions for improvements or requests

for clarification. Two supporters of the proposal recommended that the

Agencies further amend the risk-based capital guidelines to eliminate

the Tier 1 capital deduction for net unrealized losses on AFS equity

securities in favor of a deduction from Tier 2 capital, thereby

providing parallel treatment of both unrealized gains and losses on AFS

equity securities. Others, claiming that AFS debt securities are as

liquid and marketable as AFS equity holdings, recommended that the

Agencies work with the Basle Committee to allow unrealized holding

gains on debt securities to be treated as supplementary capital.

Two commenters, each with a different overall opinion of the

proposed rule, questioned the proposed 55 percent discount applied to

the amount permitted to be recognized for regulatory capital purposes.

One stated that the discount was excessive and suggested the Agencies

consider eliminating or reducing the discount. While generally in favor

of the proposal, this commenter noted that a comparable discount was

not required by GAAP and pointed out that unrealized losses were not

similarly discounted. The other commenter believed unrealized equity

gains should either be fully recognized in capital or be entirely

disallowed. Since the commenter expected a discount to be included in

the final rule, the commenter voiced overall opposition to the

proposal.

The Agencies were also asked to clarify that the proposal applies

to equity securities held in subsidiaries of financial institutions.

Finally, two commenters supported a reexamination of the whole risk-

based capital framework, contending that the framework is too complex

for small, traditional institutions and the current risk weight

categories are too broad.

Response to Comments

After carefully considering the comments received, the Agencies are

adopting the final rule substantially as proposed. The Agencies agree

that adopting this rule will result in more consistency with the

capital standards applied to financial institutions in other countries

that have adopted the treatment permitted in the Basle Accord. Although

limited to a supplementary capital item, recognizing unrealized gains

on AFS equity securities in Tier 2 capital is more consistent with the

treatment of unrealized losses on such equity securities and is also

more comparable to the GAAP treatment of such gains as a component of

equity capital.

Under the final rule an institution is permitted, but not required,

to recognize up to 45 percent of pretax net unrealized holding gains on

AFS equity securities in Tier 2 capital. The information the

institution must assemble in support of such treatment is the same as

that already used by the institution when it prepares its

[[Page 46520]]

regulatory reports 6 in accordance with GAAP and there are

no new capital restrictions or limitations imposed. Consequently, the

Agencies find no reason to believe that this final rule places an

additional burden on institutions of any size, including small

community banks.

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\6\ These reports are the Consolidated Reports of Condition and

Income for banks supervised by the OCC, the Board, or the FDIC; the

Thrift Financial Report for thrift institutions supervised by the

OTS; and the FR Y-9C Report for bank holding companies supervised by

the Board.

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Unrealized gains and losses on many financial assets, including AFS

debt securities and most loans, are ignored for purposes of calculating

capital under the Agencies' leverage and risk-based capital standards.

However, the Agencies do not agree with the argument raised in some of

the comment letters that, for regulatory capital purposes, historical

cost (rather than fair value) should be used for equity securities. To

the contrary, the Agencies believe that the fair value of equity

securities is relevant when evaluating regulatory capital.

At the time the risk-based capital guidelines were promulgated in

1989, GAAP and the regulatory reporting rules generally required equity

investments to be valued at the lower of cost or market (LOCOM) with

any net unrealized losses on these investments deducted from equity

capital.7 Consistent with this LOCOM accounting approach,

the Agencies did not include net unrealized gains on equity securities

in Tier 2 capital. However, in 1993, SFAS 115 was adopted. This

accounting standard, which applies fair value accounting to many equity

securities and requires institutions to reflect changes in the fair

value of their AFS equity securities as a component of equity capital,

was also adopted by the Agencies for regulatory reporting purposes.

Although SFAS 115 further requires AFS debt securities to be carried at

fair value, the unrealized holding gains and losses on these securities

generally are more temporary in nature because the fair values of these

debt instruments, over time, tend to approach their respective face

values. Thus, any unrealized gains and losses on these debt instruments

generally diminish as the instruments draw closer to their maturity

dates. As a result, the Agencies continue to believe that unrealized

gains and losses on AFS debt instruments are appropriately excluded

from regulatory capital. However, the Agencies now believe it is

appropriate, subject to prudential supervisory limitations, to include

in Tier 2 capital at least a portion of an institution's net unrealized

holding gains on AFS equity securities. Consistent with current

supervisory policy, to the extent that unrealized gains and losses on

AFS debt securities and other assets are not formally recognized for

regulatory capital purposes, the Agencies will continue to consider the

impact of any appreciation or depreciation on these assets when

evaluating an institution's capital adequacy.

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\7\ This LOCOM accounting approach for equity securities was

required by SFAS No. 12, ``Accounting for Certain Marketable

Securities.''

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This final rule does not revise the treatment of net unrealized

losses on AFS equity securities. The Agencies believe any measure of

potential loss must be reflected in Tier 1 capital so as to provide an

adequate cushion against risk. Therefore, in accordance with the

Agencies' existing capital standards, these net unrealized losses will

continue to be deducted in determining Tier 1 capital.

The Agencies agree with the concerns of the commenter that market

fluctuations could have a significant impact on capital levels if net

unrealized holding gains on equity securities are included in Tier 2

capital. Thus, as a prudent supervisory constraint, and consistent with

the Basle Accord, it appears appropriate to limit the amount of net

appreciation on AFS equity securities that may be included in Tier 2

capital to no more than 45 percent of the pretax net unrealized holding

gains on these securities. Although not required by GAAP, this discount

will help minimize supervisory concerns about market volatility, forced

sale risk, and possible tax charges.

Furthermore, to prevent undue reliance on such gains to meet

minimum capital requirements, unrealized gains on AFS equity securities

are not included in the calculation of Tier 1 capital under the

Agencies' leverage and risk-based capital ratios. Although up to 45

percent of these net unrealized holding gains may be included in

calculating total risk-based capital, the allowable portion of these

gains is only included in Tier 2 capital, which, in turn, is limited

under the Agencies' risk-based capital standards to no more than 100

percent of Tier 1 capital.

The proposed rulemaking did not address how unrealized gains on

equity securities that are held by an institution's subsidiaries should

be treated in those cases where the institution's investment in the

subsidiary itself is required to be deducted from regulatory capital.

If an institution's investment in a subsidiary is deducted for

regulatory capital purposes, any unrealized gains on equity securities

held by the subsidiary will not be included in the institution's Tier 2

capital. On September 12, 1997, the FDIC published a request for

comments regarding proposed changes to the rules regarding the

activities of insured state banks and insured state savings

associations (62 FR 47969). If this rule is adopted as proposed by the

FDIC, a state institution's investment in a subsidiary which, in turn,

invests in listed equity securities or shares of investment companies

of a type not permitted for a national bank or federal savings

association, as authorized by the proposed rule in the case of well-

capitalized institutions, would be deducted from Tier 1 capital for

regulatory capital purposes.

Finally, the Agencies have considered the commenters' concern that

the current risk-based capital rules are too complex for small

traditional institutions and that the current risk weight categories

are too broad. Although the Agencies are sympathetic to this concern

and will continue to seek ways to reduce burden on banks wherever

appropriate, a broad-based reexamination of the risk-based capital

framework is outside the scope of this rulemaking.

Final Rule

After careful consideration of all the comments received, the

Agencies have decided to adopt the final rule with only minor technical

modifications. Under the final rule, institutions that legally hold

equity securities are permitted to include up to 45 percent of the

pretax net unrealized holding gains on AFS equity securities in Tier 2

capital. Revisions from the original proposal have been limited to

minor changes in the regulatory text to ensure consistency among the

rules issued by each Agency.

Institutions need to be aware that, although including a portion of

unrealized gains on AFS equity securities in Tier 2 capital may

increase their total risk-based capital ratio, it may reduce their Tier

1 risk-based capital ratio.8 Such decreases could occur

because an institution's total risk-weighted assets (the denominator

for both the Tier 1 and total risk-based capital ratios) would increase

by the amount of pretax net unrealized holding gains on AFS equity

securities included in Tier 2 capital. However, none of these gains

would be included in Tier 1

[[Page 46521]]

capital, thereby potentially decreasing an institution's Tier 1 risk-

based capital ratio. For this reason, institutions should weigh the

effects on both their total risk-based capital ratio and Tier 1 risk-

based capital ratio when determining the amount of unrealized gains on

AFS equity securities, if any, to include in Tier 2 capital.

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\8\ The leverage ratio will not be affected because the

unrealized gains on AFS equity securities are not included in the

numerator (Tier 1 capital) nor the denominator (total assets as

defined in the agencies' capital standards) when computing the

leverage ratio.

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Early Compliance

Subject to certain exceptions, 12 U.S.C. 4802(b) provides that new

regulations and amendments to regulations prescribed by a Federal

banking agency which impose additional reporting, disclosures, or other

new requirements on an insured depository institution shall take effect

on the first day of a calendar quarter which begins on or after the

date on which the regulations are published in final form. However,

section 4802(b) also permits persons who are subject to such

regulations to comply with the regulation before its effective date.

Accordingly, the Agencies will not object if an institution wishes to

apply the provisions of this final rule beginning with the date it is

published in the Federal Register.

Regulatory Flexibility Act Analysis

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

Agencies have determined that this final rule will not have a

significant economic impact on a substantial number of small entities

in accordance with the spirit and purposes of the Regulatory

Flexibility Act (5 U.S.C. 601 et seq.). The final rule will permit, but

not obligate, institutions to include up to 45 percent of the pretax

net unrealized holding gains on AFS equity securities in Tier 2

capital. The information which an institution must assemble in support

of such treatment is the same as that already created when it prepares

its regulatory reports in accordance with GAAP. For those institutions

choosing to utilize the final rule, the effect would be to increase

immediately the amount of Tier 2 capital held by institutions,

including small institutions, by the amount of their qualifying pretax

net unrealized holding gains on such securities subject to the existing

limit on Tier 2 capital. Thereafter, the amount of Tier 2 capital will

increase or decrease as the fair value of the institution's holdings of

AFS equity securities changes. The Agencies have concluded that the

increase and changes in Tier 2 capital will not have a significant

impact on the amount of total capital held by institutions, regardless

of size.

Paperwork Reduction Act

The Agencies have determined that the final rule does not involve a

collection of information pursuant to the provisions of the Paperwork

Reduction Act of 1995 (44 U.S.C. 3501 et seq.).

Small Business Regulatory Enforcement Fairness Act

The Small Business Regulatory Enforcement Fairness Act of 1996

(SBREFA) (Title II, Pub. L. 1004-121) provides generally for agencies

to report rules to Congress for review. The reporting requirement is

triggered when a federal agency issues a final rule. Accordingly, the

Agencies will file the appropriate reports with Congress as required by

SBREFA.

The Office of Management and Budget has determined that this final

rule does not constitute a ``major rule'' as defined by SBREFA.

OCC and OTS Executive Order 12866 Determination

The OCC and the OTS have determined that the final rule does not

constitute a ``significant regulatory action'' for the purposes of

Executive Order 12866.

OCC and OTS Unfunded Mandates Reform Act of 1995 Determinations

Section 202 of the Unfunded Mandates Reform Act of 1995, Pub. L.

104-4 (Unfunded Mandates Act) requires that an agency prepare a

budgetary impact statement before promulgating a rule that includes a

Federal mandate that may result in expenditure by State, local, and

tribal governments, in the aggregate, or by the private sector, of $100

million or more in any one year. If a budgetary impact statement is

required, section 205 of the Unfunded Mandates Act also requires an

agency to identify and consider a reasonable number of regulatory

alternatives before promulgating a rule. As discussed in the preamble,

this rule will permit institutions to include up to 45 percent of

pretax net unrealized holding gains on AFS equity securities in Tier 2

capital under the Agencies' risk-based capital rules. The final rule

will reduce regulatory burden by increasing the amount of supplementary

capital held by certain institutions. The OCC and the OTS have

therefore determined that the overall effect of the rule on national

banks and thrifts will not result in aggregate expenditures by State,

local, or tribal governments or by the private sector of $100 million

or more. Accordingly, the OCC and the OTS have not prepared a budgetary

impact statement or specifically addressed the regulatory alternatives

considered.

List of Subjects

12 CFR Part 3

Administrative practice and procedure, Capital, National banks,

Reporting and recordkeeping requirements, Risk.

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.

12 CFR Part 325

Administrative practice and procedure, Banks, banking, Capital

adequacy, Reporting and recordkeeping requirements, Savings

associations, State non-member banks.

12 CFR Part 567

Capital, Reporting and recordkeeping requirements, Savings

associations.

Authority and Issuance

Office of the Comptroller of the Currency

12 CFR Chapter I

For the reasons set out in the joint preamble, part 3 of chapter I

of title 12 of the Code of Federal Regulations is amended as follows:

PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES

1. The authority citation for part 3 continues to read as follows:

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

note, 1835, 3907, and 3909.

2. In appendix A to part 3, section 2. is amended by adding a new

paragraph (b)(5) including footnote 5 to read as follows:

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

* * * * *

Section 2. Components of Capital.

* * * * *

(b) * * *

(5) Up to 45 percent of the pretax net unrealized holding gains

(that is, the excess, if any, of the fair value over historical

cost) on available-for-sale equity securities with

[[Page 46522]]

readily determinable fair values.5 Unrealized gains

(losses) on other types of assets, such as bank premises and

available-for-sale debt securities, are not included in Tier 2

capital, but the OCC may take these unrealized gains (losses) into

account as additional factors when assessing a bank's overall

capital adequacy.

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\5\ The OCC reserves the authority to exclude all or a portion

of unrealized gains from Tier 2 capital if the OCC determines that

the equity securities are not prudently valued.

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* * * * *

Dated: August 12, 1998.

Julie L. Williams,

Acting Comptroller of the Currency.

Federal Reserve System

12 CFR Chapter II

For the reasons set forth in the joint preamble, parts 208 and 225

of chapter II of title 12 of the Code of Federal Regulations are

amended as follows:

PART 208--MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE FEDERAL

RESERVE SYSTEM (REGULATION H)

1. The authority citation for part 208 is revised to read as

follows:

Authority: 12 U.S.C. 24, 36, 92(a), 93(a), 248(a), 248(c), 321-

338a, 371d, 461, 481-486, 601, 611, 1814, 1816, 1818, 1820(d)(9),

1823(j), 1828(o), 1831, 1831o, 1831p-1, 1831r-1, 1835a, 1882, 2901-

2907, 3105, 3310, 3331-3351, and 3906-3909; 15 U.S.C. 78b, 78l(b),

78l(g), 78l(i), 78o-4(c)(5), 78q, 78q-1, and 78w; 31 U.S.C. 5318; 42

U.S.C. 4012a, 4104a, 4104b, 4106, and 4128.

2. In appendix A to part 208, the introductory paragraphs in

section II.A.2. are revised and footnote 8 is removed and reserved to

read as follows:

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

Banks: Risk-Based Measure

* * * * *

II. * * *

A. * * *

2. Supplementary capital elements (Tier 2 capital). The Tier 2

component of a bank's qualifying total capital may consist of the

following items that are defined as supplementary capital elements:

(i) Allowance for loan and lease losses (subject to limitations

discussed below);

(ii) Perpetual preferred stock and related surplus (subject to

conditions discussed below);

(iii) Hybrid capital instruments (as defined below) and

mandatory convertible debt securities;

(iv) Term subordinated debt and intermediate-term preferred

stock, including related surplus (subject to limitations discussed

below);

(v) Unrealized holding gains on equity securities (subject to

limitations discussed in section II.A.2.e. of this appendix).

The maximum amount of Tier 2 capital that may be included in a

bank's qualifying total capital is limited to 100 percent of Tier 1

capital (net of goodwill and other intangible assets required to be

deducted in accordance with section II.B.1.b. of this appendix).

The elements of supplementary capital are discussed in greater

detail below.

* * * * *

3. In appendix A to part 208, section II.A.2., paragraphs d. and e.

are revised to read as follows:

* * * * *

II. * * *

A. * * *

2. * * *

d. Subordinated debt and intermediate term preferred stock. (i)

The aggregate amount of term subordinated debt (excluding mandatory

convertible debt) and intermediate-term preferred stock that may be

treated as supplementary capital is limited to 50 percent of Tier 1

capital (net of goodwill and other intangible assets required to be

deducted in accordance with section II.B.1.b. of this appendix).

Amounts in excess of these limits may be issued and, while not

included in the ratio calculation, will be taken into account in the

overall assessment of a bank's funding and financial condition.

(ii) Subordinated debt and intermediate-term preferred stock

must have an original weighted average maturity of at least five

years to qualify as supplementary capital. (If the holder has the

option to require the issuer to redeem, repay, or repurchase the

instrument prior to the original stated maturity, maturity would be

defined, for risk-based capital purposes, as the earliest possible

date on which the holder can put the instrument back to the issuing

bank.) 12 In the case of subordinated debt, the

instrument must be unsecured and must clearly state on its face that

it is not a deposit and is not insured by a Federal agency. To

qualify as capital in banks, debt must be subordinated to general

creditors and claims of depositors. Consistent with current

regulatory requirements, if a state member bank wishes to redeem

subordinated debt before the stated maturity, it must receive prior

approval of the Federal Reserve.

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\12\ As a limited-life capital instrument approaches maturity it

begins to take on characteristics of a short-term obligation. For

this reason, the outstanding amount of term subordinated debt and

limited-life preferred stock eligible for inclusion in Tier 2 is

reduced, or discounted, as these instruments approach maturity: one-

fifth of the original amount (less redemptions) is excluded each

year during the instrument's last five years before maturity. When

the remaining maturity is less than one year, the instrument is

excluded from Tier 2 capital.

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e. Unrealized gains on equity securities and unrealized gains

(losses) on other assets. Up to 45 percent of pretax net unrealized

holding gains (that is, the excess, if any, of the fair value over

historical cost) on available-for-sale equity securities with

readily determinable fair values may be included in supplementary

capital. However, the Federal Reserve may exclude all or a portion

of these unrealized gains from Tier 2 capital if the Federal Reserve

determines that the equity securities are not prudently valued.

Unrealized gains (losses) on other types of assets, such as bank

premises and available-for-sale debt securities, are not included in

supplementary capital, but the Federal Reserve may take these

unrealized gains (losses) into account as additional factors when

assessing a bank's overall capital adequacy.

* * * * *

PART 225--BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL

(REGULATION Y)

1. The authority citation for part 225 is revised to read as

follows:

Authority: 12 U.S.C. 1817(j)(13), 1818, 1828(o), 1831i, 1831p-1,

1843(c)(8), 1844(b), 1972(1), 3106, 3108, 3310, 3331-3351, 3907, and

3909.

2. In appendix A to part 225, the introductory paragraphs of

section II.A.2. are revised and footnote 8 is removed and reserved to

read as follows:

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

Companies: Risk-Based Measure

* * * * *

II. * * *

A. * * *

2. Supplementary capital elements (Tier 2 capital). The Tier 2

component of an institution's qualifying total capital may consist

of the following items that are defined as supplementary capital

elements:

(i) Allowance for loan and lease losses (subject to limitations

discussed below);

(ii) Perpetual preferred stock and related surplus (subject to

conditions discussed below);

(iii) Hybrid capital instruments (as defined below), perpetual

debt and mandatory convertible debt securities;

(iv) Term subordinated debt and intermediate-term preferred

stock, including related surplus (subject to limitations discussed

below);

(v) Unrealized holding gains on equity securities (subject to

limitations discussed in section II.A.2.e. of this appendix).

The maximum amount of Tier 2 capital that may be included in an

organization's qualifying total capital is limited to 100 percent of

Tier 1 capital (net of goodwill and other intangible assets required

to be deducted in accordance with section II.B.1.b. of this

appendix).

The elements of supplementary capital are discussed in greater

detail below.

* * * * *

3. In appendix A to part 225, section II.A.2., paragraphs d and e

are revised to read as follows:

* * * * *

II. * * *

A. * * *

2. * * *

d. Subordinated debt and intermediate-term preferred stock. (i)

The aggregate

[[Page 46523]]

amount of term subordinated debt (excluding mandatory convertible

debt) and intermediate-term preferred stock that may be treated as

supplementary capital is limited to 50 percent of Tier 1 capital

(net of goodwill and other intangible assets required to be deducted

in accordance with section II.B.1.b. of this appendix). Amounts in

excess of these limits may be issued and, while not included in the

ratio calculation, will be taken into account in the overall

assessment of an organization's funding and financial condition.

(ii) Subordinated debt and intermediate-term preferred stock

must have an original weighted average maturity of at least five

years to qualify as supplementary capital.12 (If the

holder has the option to require the issuer to redeem, repay, or

repurchase the instrument prior to the stated maturity, maturity

would be defined, for risk-based capital purposes, as the earliest

possible date on which the holder can put the instrument back to the

issuing banking organization.) 13 In the case of

subordinated debt, the instrument must be unsecured and must clearly

state on its face that it is not a deposit and is not insured by a

Federal agency. Bank holding company debt must be subordinated in

the right of payment to all senior indebtedness of the company.

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\12\ Unsecured term debt issued by bank holding companies prior

to March 12, 1988, and qualifying as secondary capital at the time

of issuance continues to qualify as an element of supplementary

capital under the risk-based framework, subject to the 50 percent of

Tier 1 capital limitation. Bank holding company term debt issued on

or after March 12, 1988, must be subordinated in order to qualify as

capital.

\13\ As a limited-life capital instrument approaches maturity it