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4000 - Advisory Opinions

Exclusion from Definitions of Extension of Credit Under Regulation O


February 7, 1983

Pamela E. F. LeCren, Senior Attorney

The following is in response to your request in connection with * * * for input as to the scope of section 215.3(b)(4)(ii) of Regulation O which excludes from the definition of extension of credit "any indebtedness to a bank for the purpose of protecting the bank against loss or of giving financial assistance to it." According to your request and the additional information provided to this office by you, the bank has had poor earnings stemming at least partially from the bank's heavy investment in fixed assets and its high volume of low yield mortgage loans and U.S. Government agency bonds which cannot offset the bank's higher cost of deposits and repurchase agreements. The bank has been criticized in the examination report for its lack of earnings.

* * * is proposing to increase its earnings by making several extensions of credit to certain related interests of the bank's chairman of the board. The loans would be on non- preferential terms; secured by productive real estate with a two-to-one ratio of value to debt; and approved in advance by the bank's board of directors. The bank has argued that these extensions of credit would be for the purposes of "giving financial assistance to it" and therefore would not be covered by Regulation O.

The Washington Office has not had occasion to construe the language of this exception. Staff at the Washington Office of the Federal Reserve Board indicated that the exception has never to their knowledge been an issue in the context of Regulation O. The wording of the exception was taken directly from language found in section 22(g) of the Federal Reserve Act (12 U.S.C. 375a) Nothing in the legislative history for section 22(g) provides any guidance as to what circumstances are encompassed by the language nor does any case law concerning section 22(g) deal with the exception.

We discovered only one published Federal Reserve Board opinion concerning section 22(g) and the relevant language. (See Federal Reserve Looseleaf Service, § 3860.10 at 3862.) The opinion provides little guidance, however, as it concerns a fact situation more clearly falling within the portion of the exception dealing with indebtedness to a bank for the purpose of protecting the bank against loss. The facts of that opinion are as follows: the bank had made a loan to a certain individual supported by a real estate mortgage upon which interest was long overdue. Taxes on the property were in arrears and foreclosure was probable. The property was sold to the vice-president of the bank who paid a certain amount in cash and assumed the mortgage. In response to a question put to the Federal Reserve Board as to the application of the relevant language in section 22(g), the Board observed that whether or not a particular indebtedness to a bank comes within the exception depends upon the purpose for which the indebtedness was incurred. The Board concluded that the facts as described offered some indication that the particular indebtedness was incurred for the purpose of protecting the bank against loss or for giving financial assistance to it but that those facts standing alone did not necessarily show that the indebtedness was incurred for one of those purposes. The opinion concludes by stating that, in the absence of full information showing the purpose for which the indebtedness was incurred, the Board was not able to advise the bank as to the application of the exception.

The question put forth by the bank thus appears to be one of first impression not only for the FDIC but the Federal Reserve Board as well. We have tried to identify a fact situation or situations which would encompass an extension of credit by a bank to a bank director, bank officer, or bank principal shareholder for the purpose of somehow providing financial assistance to the bank. We are somewhat at a loss to do so other than to agree with * * * proposition that an arm's length, non-preferential extension of credit to a creditworthy bank insider may fall within the exception when the purpose of the loan is to increase the bank's earnings.

Inasmuch as any loan made at or above current interest rates would add to a bank's earnings, a broad reading of section 215.3(b)(4)(ii) could totally undercut the safeguards otherwise provided by the regulation. We therefore would be willing to consider an extension of credit to be for the purpose of giving financial assistance to the bank and thus excepted from Regulation O by 215.3(b)(4)(ii) only if the following conditions are met: (1) The FDIC has identified the bank's lack of earnings as a serious problem; (2) the bank's overall condition is poor; (3) the bank has unsuccessfully attempted to increase earnings by other means; (4) the bank has been unable to attract sufficient loan business from non-related borrowers; (5) the loan is necessary in order to provide the bank with any positive earnings; and (6) the loan is at or above current market rates, is fully secured, is approved in advance by the Board of Directors, and fully comports with applicable state law.

Although the loans under consideration by * * * are stated to be non-preferential and secured by productive real estate appraised at a two-to-one ratio of value to debt (therefore substantially meeting the last item) the bank's overall condition (2-2-2-4-2/2) does not appear to warrant use of the exception. Correspondence from the bank to Regional Director Sarsfield indicates that the bank itself expects to enjoy a more positive earnings spread viz-a-viz its cost of funds and interest expense; its low yield investments will have matured by 1985; its deposit growth has been favorable; and positive earnings are projected for 1983. Although the examiner may not be as optimistic about the bank's earning picture ("While the 8.6 percent adjusted capital ratio which includes subordinated debentures, is considered satisfactory, the capital accounts may have to be realigned so as to provide for operating funds") we are still of the opinion that the bank's condition does not yet warrant the extraordinary measure of permitting insider loans in excess of the loan ceiling established by Regulation O.

It would seem incumbent upon bank management to rely upon other measures to increase the bank's earnings, at least initially, and appropriate for the FDIC to utilize section 215.3(b)(4)(ii) only as an extraordinary measure. Furthermore, the bank expects additional earnings from other sources and there is no indication that other corporate loan customers cannot be located. Absent some indication that * * * would not be able to move the loans to the related interest of the bank insider into the bank at a later date, we will assume that the bank is in a position to tap that source of earnings should the other measures prove unsuccessful and the need for the loans is more immediate.

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