**Application of Regulation O to Formula for
Calculation of Interest Rate
**

FDIC-82-15

August 4, 1982

Pamela E. F. LeCren, Senior Attorney

At your request, I have reviewed the attached June 22, 1982 opinion
concerning *** written by Honors Attorney Robert Feldman in which you
concurred. The opinion concerns a formula used by *** to calculate
interest on loans. The formula, which is used for loans to all bank
customers, establishes a sliding scale that lowers the interest rate on
a loan in proportion to the size of the customer's compensating
balance. For example, if customer X has no compensating balance, the
interest rate on X's loan is prime plus five percent. Prime equals the
money market certificate rate plus 31/2 percent. The scale tops
off at a 150 percent compensating balance which carries an interest
rate of prime minus 12 percent. The bank has established a minimum rate
of 71/2 percent. A customer's compensating balance is equal to
the sum total of that customer's demand deposits, the total book value
of his or her stock in the bank, and 50 percent of his or her savings
deposits held by the bank.

Attorney Feldman concluded that although the same formula was used
to calculate the interest rate on loans to all bank customers, use of
the formula would entail a violation of section 215.4(a) of Regulation
O which requires that loans to bank insiders be made on substantially
the same terms (including interest rate and collateral) as those made
available to persons not employed by the bank or covered by Regulation
O. After reviewing Mr. Feldman's memorandum and the regulation, we are
in agreement with the conclusion expressed in that memorandum.

The formula necessarily treats similarly creditworthy individuals
differently based upon their stock ownership in the lending bank. For
example, customer X who has the same demand deposits and savings
accounts as customer Y but who holds stock in *** will be accorded a
better interest rate on a loan than Y who holds stock of equal book
value in another institution but holds no stock in ***. The formula
thus may result in an extension of credit to a principal shareholder
that is not made on substantially the same terms as those made
available for comparable transactions with persons not subject to the
regulation.

Our conclusion is not altered by the fact that it may be possible
under the formula for a nonshareholder to obtain as good a rate or a
better rate than a shareholder who has no demand deposits or savings
accounts. The fact that the formula places a premium on shareholder
status and does not treat shareholder status within the broader context
of creditworthiness (*i.e., *the customer's overall financial
status) causes us to conclude that the formula is improper. Where the
formula results in terms more favorable to principal shareholders of
the bank, the loans to the principal shareholders will be in violation
of section 215.4(a).

Not only do we find to include book value of a customer's stock as
part of a formula to determine the interest rate on loans to present a
problem under § 215.4(a), we find it somewhat incongruous that ***
would consider stock ownership to have some function as a compensating
balance.