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Financial Institution Letters


[Federal Register: December 28, 1994]


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FEDERAL DEPOSIT INSURANCE CORPORATION
12 CFR Part 325

RIN 3064-AB29

 
Capital Maintenance

AGENCY: Federal Deposit Insurance Corporation (FDIC).

ACTION: Final rule.

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SUMMARY: The FDIC has decided not to proceed with its proposal to 
include net unrealized holding gains (losses) on available-for-sale 
securities in Tier 1 capital. Instead, the FDIC is adopting only 
technical wording changes to conform the language in its leverage and 
risk-based capital standards with the terminology used in Statement of 
Financial Accounting Standards No. 115, ``Accounting for Certain 
Investments in Debt and Equity Securities'' (FASB 115). For regulatory 
capital purposes, this FDIC final rule requires net unrealized holding 
losses on available-for-sale equity securities with readily 
determinable fair values to be deducted in determining the amount of 
Tier 1 capital. All other net unrealized holding gains (losses) on 
available-for-sale securities are excluded from the definition of Tier 
1 capital. However, for purposes of the quarterly Reports of Condition 
and Income (Call Reports) filed by FDIC-supervised institutions, the 
Federal Financial Institutions Examination Council (FFIEC) requires net 
unrealized gains (losses) on all available-for-sale securities to be 
reported as a separate component of stockholders' equity, in accordance 
with FASB 115.

EFFECTIVE DATE: January 27, 1995.

FOR FURTHER INFORMATION CONTACT: For supervisory purposes, Stephen G. 
Pfeifer, Examination Specialist (202/898-8904), or Robert F. Storch, 
Section Chief (202/898-8906), Accounting Section, Division of 
Supervision; for legal issues, Cristeena G. Naser, Attorney, Legal 
Division (202/898-3587).

SUPPLEMENTARY INFORMATION:

I. Background

    The FDIC's leverage and risk-based capital standards (12 CFR part 
325--subpart A and appendix A to part 325) set forth a definition of 
Tier 1 capital that includes common stockholders' equity. The capital 
definitions (12 CFR 325.2(d) and section 1.A.1. of appendix A) further 
explain that common stockholders' equity includes common stock and any 
related surplus, undivided profits, disclosed capital reserves that 
represent a segregation of undivided profits, and foreign currency 
translation adjustments, less net unrealized losses on marketable 
equity securities.
    In May 1993, the Financial Accounting Standards Board (FASB) issued 
FASB 115 which, in effect, changes the composition of stockholders' 
equity in financial statements prepared in accordance with generally 
accepted accounting principles (GAAP) by including as a separate 
component of equity the amount of net unrealized holding gains and 
losses on debt and equity securities that are deemed to be available-
for-sale. The FFIEC has notified all banks that they must adopt the new 
FASB 115 accounting standard for purposes of their Call Reports as of 
January 1, 1994, or the beginning of their first fiscal year 
thereafter, if later. Early adoption of this standard was also 
permitted in Call Reports to the extent allowable under FASB 115.
    Prior to the adoption of FASB 115, Call Report instructions 
required banks to report a separate capital component for the net 
unrealized loss on marketable equity securities, consistent with the 
provisions of Statement of Financial Accounting Standards No. 12, 
``Accounting for Certain Marketable Securities'' (FASB 12). FASB 115, 
which supersedes FASB 12, broadens the scope of this separate component 
of stockholders' equity in that the FASB 115 capital component includes 
unrealized gains and losses on all securities that are available-for-
sale (debt as well as equity), rather than just the net unrealized 
losses on marketable equity securities.
    This new GAAP accounting standard and the conforming Call Report 
guidance raised the question of how the FASB 115 capital component for 
net unrealized holding gains and losses on available-for-sale 
securities should be treated for purposes of calculating the amount of 
an institution's regulatory capital under part 325.

II. December 1993 Proposal

    In view of this FASB 115 issue, the FDIC issued a proposal (58 FR 
68781, December 29, 1993) to amend its leverage and risk-based capital 
standards to explicitly recognize net unrealized holding gains and 
losses on available-for-sale securities in determining the amount of an 
institution's Tier 1 capital. Accordingly, the FDIC requested specific 
comments on the following:
    (1) Recognition of FASB 115 Capital Adjustments for Regulatory 
Capital Purposes. Given the provisions of section 37 of the Federal 
Deposit Insurance Act (FDI Act) and the other issues discussed in the 
proposal's preamble, should the FASB 115 capital adjustments that 
institutions are required to reflect for GAAP and Call Report purposes 
also be taken into consideration for purposes of determining an 
institution's Tier 1 capital under the FDIC's leverage and risk-based 
capital standards? If not, what regulatory capital treatment should be 
applied?
    (2) Effect of FASB 115 Adjustments on Other Capital-Based 
Regulations. If the FASB 115 capital adjustments are recognized for 
purposes of calculating an institution's leverage and risk-based 
capital ratios, these adjustments may also have an effect on certain 
other laws and regulations that are based, in part, on regulatory 
capital levels, including the prompt corrective action rules (12 CFR 
part 325--subpart B), the risk-related insurance premium system (12 CFR 
part 327), the brokered deposit restrictions (12 CFR 337.6), and the 
restrictions on activities and investments of insured state banks (12 
CFR part 362), such as the limitations in Sec. 362.3(d)(4) on the book 
value of certain equity investments as a percent of Tier 1 capital. If 
the FASB 115 capital adjustments are recognized in calculating an 
institution's compliance with the minimum leverage and risk-based 
capital standards, should these adjustments also be recognized for 
purposes of the other rules noted above that are based, in part, on an 
institution's regulatory capital levels? If not, what treatment should 
be used for these other regulations?
    (3) Appropriateness of Recognizing FASB 115 Net Appreciation for 
Regulatory Capital Purposes. In determining the amount of any FASB 115 
adjustment to stockholders' equity for changes in the fair value of 
available-for-sale securities, FASB 115 as well as the conforming Call 
Report guidance take into consideration all changes in the fair value 
of these securities, regardless of whether these changes represent net 
appreciation or net depreciation. Under the accounting rules that were 
applicable prior to the adoption of FASB 115, an institution's capital 
for GAAP and Call Report purposes could not be increased by the amount 
of any net unrealized appreciation on securities held for sale. Should 
the regulatory capital treatment for changes in the fair value of 
securities held in the FASB 115 available-for-sale category differ, 
depending upon whether the change represents net appreciation or net 
depreciation? If so, what treatment is appropriate?

III. Summary and Analysis of Comment Letters Received

    The FDIC received 61 responses to its request for comment, 
including 41 from banks, 11 from multibank holding companies, four from 
financial institution trade associations, three from state banking 
regulators, and two from banking consultants. Nearly three-fourths of 
the respondents were opposed to the proposal to include net unrealized 
holding gains (losses) on available-for-sale securities in Tier 1 
capital. Many of the 41 letters from banks were from community banks 
and 37 of these respondents were against the proposal. The 11 responses 
from multibank holding companies were generally mixed, with six 
appearing to favor the proposed rule and the remaining five opposed to 
it.
    Three of the four financial institution trade associations that 
responded to the proposal at least cautiously supported the proposal; 
however, one of the associations in favor of the proposal did so 
partially out of a concern that, if the proposal were not adopted, an 
even more restrictive lower-of-cost-or-market (LOCOM) approach might be 
required where only net depreciation (but not net appreciation) on 
available-for-sale securities would be recognized for Tier 1 capital 
purposes. The responses from the three state banking regulators and the 
two banking consultants were mixed.
    Common arguments raised by many of the respondents opposing the 
proposal included: (1) The additional capital volatility arising from 
marking-to-market the available-for-sale securities, which may cause 
banks to shorten maturities, sacrifice yield and thus realize less net 
income; (2) the distortive effect that the piecemeal application of 
market value accounting may have on a bank's financial statements, 
particularly when interest rates rise but offsetting changes in the 
value of the bank's deposit base cannot be recognized; (3) the adverse 
impact that these market fluctuations may have on other capital-based 
rules, such as prompt corrective action and risk-related insurance 
premiums; and (4) the potential for more banks to fail simply because 
of market value changes in securities that may be temporary and that 
may exist on available-for-sale securities which the bank does not have 
the current intent to sell.
    The most common alternative to the FDIC's proposed treatment of the 
FASB 115 net unrealized gains (losses) on available-for-sale 
securities, which was expressed by 37 of the commenters, was to exclude 
the FASB 115 unrealized gains and losses from Tier 1 capital. However, 
if the FASB 115 adjustments were to be included in regulatory capital, 
12 commenters indicated that net appreciation and depreciation on 
available-for-sale securities should be treated consistently (otherwise 
a LOCOM approach could result for regulatory capital purposes). 
Additionally, seven of the respondents specifically mentioned that FASB 
115 net unrealized gains (losses) on available-for-sale securities 
should only be included in Tier 2 (or total risk-based capital) rather 
than in Tier 1 capital. Several respondents also indicated that, even 
if these net unrealized gains (losses) are recognized for purposes of 
calculating supervisory capital ratios, they should be ignored in 
determining capital for purposes of prompt corrective action, risk-
related insurance premiums, applicable lending limits, Federal Reserve 
Board Regulation O, and section 23A of the Federal Reserve Act.
    Some of the reasons given by the minority of the commenters who 
favored the proposal included the following: (1) The proposal to 
recognize net unrealized holding gains (losses) on available-for-sale 
securities in Tier 1 capital is consistent with the requirements under 
GAAP and the Call Report instructions that these unrealized gains 
(losses) be recognized as a component of stockholders' equity; (2) the 
proposal is consistent with section 37 of the FDI Act, which generally 
provides that accounting principles applicable to depository 
institutions for regulatory reporting purposes should be no less 
stringent than GAAP; and (3) the proposal would minimize the reporting 
and systems burden that might otherwise exist if the FASB 115 capital 
component is treated differently for regulatory capital purposes than 
it is for regulatory reporting and GAAP purposes.
    The FDIC has considered the comments raised by those responding to 
the request for comment. After carefully evaluating the merits of the 
proposed rule and consulting with the other federal banking agencies, 
the FDIC has decided not to proceed with its proposal but rather to 
retain the existing regulatory capital treatment. As a result, net 
unrealized holding losses on available-for-sale equity securities with 
readily determinable fair values should continue to be deducted in 
determining the amount of Tier 1 capital. However, all other net 
unrealized holding gains (losses) on available-for-sale securities will 
be excluded from the definition of Tier 1 capital.
    In addition, for regulatory reporting (as opposed to regulatory 
capital) purposes, FDIC-supervised institutions will continue to 
reflect FASB 115 net unrealized gains (losses) on available-for-sale 
securities as a separate component of equity capital in the Call 
Reports they file with the FDIC on a quarterly basis. This reporting 
treatment is consistent with the provisions of section 37 of the FDI 
Act.
    Although section 37 generally requires that accounting principles 
applicable to depository institutions for regulatory reporting purposes 
must be consistent with or no less stringent than GAAP, the FDIC 
believes that the requirements of section 37 do not extend to the 
federal banking agencies' definitions of regulatory capital. It is well 
established that the calculation of regulatory capital for supervisory 
purposes can differ from the measurement of equity capital for 
financial reporting purposes. For example, statutory restrictions 
against the recognition of goodwill for regulatory capital purposes may 
lead to differences between the reported amount of equity capital and 
the regulatory capital calculation for Tier 1 capital. Other types of 
intangible assets are also subject to limitations under the agencies' 
regulatory capital rules. In addition, subordinated debt and the 
allowance for loan and lease losses are examples of items where the 
regulatory reporting and the regulatory capital treatments differ.
    The FDIC acknowledges that unrealized gains and losses on all 
securities, regardless of whether they are in the held-to-maturity, 
available-for-sale, or trading accounts, should be taken into 
consideration in the overall qualitative evaluation of an institution's 
capital adequacy. Further, if an institution has established a 
securities trading account in which it buys and holds securities 
principally for the purpose of selling those assets in the near term, 
it is appropriate for such an institution to reflect the amount of any 
net unrealized gains (losses) on these trading account assets in both 
net income and the calculation of Tier 1 capital. However, for debt 
securities that are placed in the held-to-maturity or available-for-
sale categories, the FDIC does not believe that market value 
fluctuations should automatically be factored into the quantitative 
calculations for regulatory capital, but rather these unrealized gains 
(losses) generally should be qualitatively considered in assessing 
capital adequacy.
    Under the final rule, FDIC-supervised institutions will continue to 
reflect net unrealized holding gains (losses) on available-for-sale 
securities as a separate capital component for regulatory reporting 
purposes, consistent with the Call Report instructions issued by the 
FFIEC. However, because unrealized holding gains (losses) on available-
for-sale securities will not be included in the determination of 
regulatory capital (other than for net unrealized holding losses on 
available-for-sale equity securities with readily determinable fair 
values), institutions' capital levels under the FDIC's leverage and 
risk-based capital standards will not be adversely affected by 
temporary fluctuations in the fair value of these securities that may 
give rise to net unrealized holding losses. Similarly, if banks have 
net unrealized holding gains on available-for-sale securities, these 
gains, which also may be temporary in nature, will be excluded from the 
calculation of Tier 1 capital.
    The FDIC is concerned that if unrealized losses on all available-
for-sale securities are deducted in the Tier 1 capital calculation, but 
unrealized gains are not included, an inequitable treatment would exist 
in that institutions would reflect the full impact of any net 
unrealized losses in their regulatory capital calculations without 
receiving the benefit of net unrealized gains.
    The FDIC believes that both net appreciation and net depreciation 
on available-for-sale debt securities should be treated consistently 
for regulatory capital purposes and that it is more appropriate to 
exclude these unrealized gains and losses from the calculation of 
regulatory capital than it is to include both in Tier 1 capital, 
particularly since Tier 1 capital generally is expected to be comprised 
of the most permanent forms of capital. In this regard, the FDIC 
considers it more appropriate to qualitatively evaluate the impact of 
these FASB 115 net unrealized gains (losses) on a case-by-case basis 
(e.g., in conjunction with the overall assessment of the institution's 
interest rate risk exposure), rather than to automatically incorporate 
these amounts into the quantitative calculation of Tier 1 capital.
    This approach is deemed proper in view of the potential volatility 
in the amount of net unrealized gains (losses) on available-for-sale 
debt securities as interest rates change, particularly where these 
changes may be temporary in nature, and the effect that these 
unrealized gains and losses could otherwise have on an institution's 
capital category for purposes of the FDIC's prompt corrective action, 
risk-related insurance premiums, brokered deposit, and other capital-
based rules if these unrealized gains (losses) were included in Tier 1 
capital. In addition, because of the piecemeal application of market 
value accounting mandated by FASB 115, the FDIC believes it is 
inappropriate to explicitly recognize in regulatory capital all 
unrealized gains (losses) on available-for-sale securities when 
offsetting gains (losses) in the value of an institution's other assets 
and liabilities are not similarly recognized.
    The FDIC, however, retains the authority to require institutions to 
maintain more capital than the minimums set forth in part 325.1 
This enables the FDIC to take appropriate action against an institution 
where, for example, the institution is deemed to have an excessive 
amount of net unrealized losses on available-for-sale securities in 
relation to the institution's overall capital structure.
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    \1\ For example, in discussing the minimum leverage ratio 
requirement, Sec. 325.3(a) of the FDIC's regulations states, in 
part, that
    Banks must maintain at least the minimum leverage capital 
requirement set forth in this section. The capital standards in this 
part are the minimum acceptable for banks whose overall financial 
condition is fundamentally sound, which are well-managed and which 
have no material or significant financial weaknesses. Thus, the FDIC 
is not precluded from requiring an institution to maintain a higher 
capital level based on the institution's particular risk profile.
    Also, in discussing the FDIC's minimum risk-based capital 
guidelines, the fifth paragraph in the FDIC's Statement of Policy on 
Risk-Based Capital (Appendix A to Part 325) states that
    The risk-based capital ratio focuses principally on broad 
categories of credit risk; however, the ratio does not take account 
of many other factors that can affect a bank's financial condition. 
These factors include overall interest rate risk exposure; 
liquidity, funding and market risks; the quality and level of 
earnings; investment or loan portfolio concentrations; the quality 
of loans and investments; the effectiveness of loan and investment 
policies; and management's overall ability to monitor and control 
financial and operating risks. In addition to evaluating capital 
ratios, an overall assessment of capital adequacy must take account 
of each of these other factors, including, in particular, the level 
and severity of problem and adversely classified assets. For this 
reason, the final supervisory judgment on a bank's capital adequacy 
may differ significantly from the conclusions that might be drawn 
solely from the absolute level of the bank's risk-based capital 
ratio.
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    With respect to the impact that FASB 115 may have on how capital is 
determined for purposes of legal lending limits, Federal Reserve Board 
Regulation O and section 23A of the Federal Reserve Act, the FDIC notes 
that many borrower lending limits for FDIC-supervised state-chartered 
banks are established by the institutions' appropriate state regulatory 
authorities and that the issuance of interpretive guidance pertaining 
to Regulation O and section 23A is generally within the purview of the 
Federal Reserve Board.

IV. Final Rule

    After considering the comments received and consulting with the 
other federal banking agencies, the FDIC has decided not to proceed 
with its proposal to include net unrealized gains (losses) on 
available-for-sale securities in Tier 1 capital. Instead, the FDIC is 
adopting only technical wording changes to its existing capital rules. 
The FDIC's consultations with the other agencies included participating 
in the deliberations of the FFIEC's Task Force on Supervision. The 
regulatory capital treatment of net unrealized gains (losses) in this 
final rule is consistent with the treatment that the Task Force on 
Supervision has recommended to the agencies.
    The definitions under the FDIC's leverage and risk-based capital 
standards indicate that Tier 1 capital includes, among other items, 
``common stockholders' equity.'' In this regard, the FDIC is revising 
Sec. 325.2(d) of its regulations and section I.A.1. of Appendix A to 
Part 325 to indicate that, for regulatory capital purposes, common 
stockholders' equity includes common stock and related surplus, 
undivided profits, disclosed capital reserves that represent a 
segregation of undivided profits, and foreign currency translation 
adjustments, less net unrealized holding losses on available-for-sale 
equity securities with readily determinable fair values.
    Thus, although FASB 115 net unrealized losses on available-for-sale 
equity securities are deducted in determining the amount of Tier 1 
capital, all other net unrealized holding gains (losses) on available-
for-sale securities generally will be excluded (i.e., ignored) in these 
regulatory capital calculations.
    This final rule refers to deducting the ``net unrealized holding 
losses'' on ``equity securities'' with ``readily determinable fair 
values''. The captioned phrases are consistent with the terms defined 
in FASB 115 and in the Call Report guidance issued by the FFIEC. This 
language replaces the existing phrase in the FDIC's leverage and risk-
based capital rules, ``net unrealized losses on marketable equity 
securities'', which was based on terminology included in the FASB 12 
accounting standard that has now been superseded by FASB 115.
    This final rule is also consistent with the interim regulatory 
capital guidance that was jointly issued on December 21, 1993, by the 
FDIC, the Federal Reserve Board, and the Office of the Comptroller of 
the Currency after the issuance of FASB 115.2 Accordingly, the 
amortized cost rather than fair value of available-for-sale debt 
securities generally will continue to be used for purposes of 
calculating both the numerator and the denominator for the leverage and 
risk-based capital ratios. The amortized cost of available-for-sale 
debt securities will also continue to be used in determining the amount 
of average total assets reported on the Call Report schedule for 
quarterly averages and the amount of risk-weighted assets reflected on 
the Call Report's risk-based capital schedule.3
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    \2\See FIL-91-93, which is available upon request from the 
FDIC's Office of Corporate Communications (202/898-6996). This 
interim guidance had provided that, until the federal banking 
agencies can complete any necessary amendments to their respective 
capital rules, net unrealized losses on marketable equity securities 
should continue to be deducted when computing Tier 1 capital and 
that other net unrealized gains or losses on available-for-sale 
securities resulting from the adoption of FASB 115 should be 
excluded from the computation of Tier 1 capital.
    \3\For further information, refer to the Call Report 
instructions issued by the FFIEC.
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V. Regulatory Flexibility Act Statement

    The Board of Directors of the FDIC hereby certifies that these 
amendments to part 325 will not have a significant economic impact on a 
substantial number of small business entities within the meaning of the 
Regulatory Flexibility Act (5 U.S.C. 601 et seq). These amendments will 
not necessitate the development of sophisticated recordkeeping or 
reporting systems by small institutions nor will small institutions 
need to seek out the expertise of specialized accountants, lawyers or 
managers to comply with the regulation. In light of this certification, 
the Regulatory Flexibility Act requirements (at 5 U.S.C. 603, 604) to 
prepare initial and final regulatory flexibility analyses do not apply.

VI. Paperwork Reduction Act and Regulatory Burden

    No collections of information pursuant to section 3504(h) of the 
Paperwork Reduction Act (44 U.S.C. 3501 et seq.) are contained in this 
notice. Consequently, no information has been submitted to the Office 
of Management and Budget for review.
    Section 302 of the Riegle Community Development and Regulatory 
Improvement Act of 1994 (Pub. Law 103-325, 108 Stat. 2160) provides 
that the federal banking agencies must consider the administrative 
burdens and benefits of any new regulations that impose additional 
requirements on insured depository institutions. Section 302 also 
requires such a rule to take effect on the first day of the calendar 
quarter following final publication of the rule, unless the agency, for 
good cause, determines an earlier effective date is appropriate. The 
new capital rule does not impose any new requirements on depository 
institutions for purposes of calculating their risk-based and leverage 
capital ratios. The amended rule clarifies the regulatory capital 
treatment of a new common equity component (i.e., net unrealized 
holding gains (losses) on available-for-sale securities) created by 
FASB 115, but does not change the current treatment. For these reasons, 
the FDIC has determined that an effective date 30 days from the date of 
this rule's publication in the Federal Register is appropriate.

List of Subjects in 12 CFR Part 325

    Bank deposit insurance, Banks, Banking, Capital adequacy, Reporting 
and recordkeeping requirements, State nonmember banks, Savings 
associations.

    For the reasons set forth in the preamble, the Board of Directors 
of the Federal Deposit Insurance Corporation is amending part 325 of 
title 12 of the Code of Federal Regulations as follows:

PART 325--CAPITAL MAINTENANCE

    1. The authority citation for part 325 continues to read as 
follows:

    Authority: 12 U.S.C. 1815(a), 1815(b), 1816, 1818(a), 1818(b), 
1818(c), 1818(t), 1819(Tenth), 1828(c), 1828(d), 1828(i), 1828(n), 
1828(o), 1831o, 3907, 3909; Pub. L. 102-233, 105 Stat. 1761, 1789, 
1790 (12 U.S.C. 1831n note); Pub. L. 102-242, 105 Stat. 2236, 2355, 
2386 (12 U.S.C. 1828 note).

    2. Section 325.2(d) is revised to read as follows:


Sec. 325.2  Definitions.

* * * * *
    (d) Common stockholders' equity means the sum of common stock and 
related surplus, undivided profits, disclosed capital reserves that 
represent a segregation of undivided profits, and foreign currency 
translation adjustments, less net unrealized holding losses on 
available-for-sale equity securities with readily determinable fair 
values.
* * * * *
    3. In appendix A to part 325, the definition of common 
stockholders' equity in the first paragraph in section I.A.1. is 
revised to read as follows:

Appendix A to Part 325--Statement of Policy on Risk-Based Capital

* * * * *
    I. * * *
    A. * * *
    1. * * *

--Common stockholders' equity capital (includes common stock and 
related surplus, undivided profits, disclosed capital reserves that 
represent a segregation of undivided profits, and foreign currency 
translation adjustments, less net unrealized holding losses on 
available-for-sale equity securities with readily determinable fair 
values);
* * * * *
    By order of the Board of Directors.

    Dated at Washington, D.C. this 20th day of December, 1994.

Federal Deposit Insurance Corporation.
Robert E. Feldman,
Acting Executive Secretary.
[FR Doc. 94-31725 Filed 12-27-94; 8:45 am]
BILLING CODE 6714-01-P
Last Updated 07/17/1999 communications@fdic.gov