[Federal Register Volume 59, Number 226 (Friday, November 25, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-29110]
[[Page Unknown]]
[Federal Register: November 25, 1994]
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DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
12 CFR Part 3
[Docket No. 94-20]
RIN 1557-AB14
Capital Adequacy: Net Unrealized Holding Gains and Losses on
Available-For-Sale Securities
AGENCY: Office of the Comptroller of the Currency, Treasury.
ACTION: Final rule.
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SUMMARY: The Office of the Comptroller of the Currency (OCC) has
determined not to adopt its proposal to include the Statement of
Financial Accounting Standard No. 115, ``Accounting for Certain
Investments in Debt and Equity Securities'' (FAS 115), adjustment for
net unrealized holding gains and losses on available-for-sale
securities in Tier 1 capital. Based upon analysis of the comments
received and having considered the potential consequences of including
the FAS 115 adjustment in Tier 1 capital, the OCC, in consultation with
the Federal Reserve Board, the Federal Deposit Insurance Corporation,
and the Office of Thrift Supervision (Federal banking agencies),
determined not to amend the definition of Tier 1 capital as previously
proposed.
The OCC also decided to maintain the current requirement that
national banks deduct net unrealized losses on equity securities when
calculating Tier 1 capital. However, because FAS 115 changed the names
and requirements of the security classifications in the investment
portfolio, this final rule amends the definition of common
stockholders' equity to reflect the revised classifications used for
equity securities that are not in the trading account.
EFFECTIVE DATE: December 27, 1994.
FOR FURTHER INFORMATION CONTACT: Thomas G. Rees, Professional
Accounting Fellow, (202) 874-5180; J. Ray Diggs, National Bank Examiner
(202) 874-5070; Roger Tufts, Senior Economic Advisor, Office of the
Chief National Bank Examiner, (202) 874-5070; Ronald Shimabukuro,
Senior Attorney, or William W. Templeton, Senior Attorney, Legislative
and Regulatory Activities Division, (202) 874-5060, Office of the
Comptroller of the Currency, Washington, D.C. 20219.
SUPPLEMENTARY INFORMATION:
Background
Under the current OCC minimum capital requirements (leverage ratio)
and the risk-based capital guidelines set forth at 12 CFR part 3
appendix A, section 1(c)(7), a major component of Tier 1 capital is
common stockholders' equity. Common stockholders' equity currently
includes:
(1) common stock,
(2) common stock surplus,
(3) undivided profits,
(4) capital reserves,
(5) adjustments for the cumulative effect of foreign currency
translation, and
(6) net unrealized losses on noncurrent marketable equity
securities. The net unrealized losses are those recorded under
Statement of Financial Accounting Standards No. 12, ``Accounting for
Certain Marketable Securities'' (FAS 12).
FAS 115
In May 1993, the Financial Accounting Standards Board (FASB) issued
FAS 115. This statement superseded FAS 12. FAS 115 required that all
securities be grouped into one of three classifications: held-to-
maturity, trading, or available-for-sale. Most significantly, FAS 115
established net unrealized holding gains and losses on available-for-
sale securities as a new component of common stockholders' equity.
FAS 115 defines available-for-sale securities as those securities
that a bank does not have the positive intent and ability to hold to
maturity, and does not intend to trade actively as part of its trading
account. FAS 115 increases the number of securities that banks must
account for at market value. Consequently, numerous securities
previously reported by banks at amortized cost will now be reported at
their market value. In August 1993, the Federal Financial Institutions
Examination Council (FFIEC) announced the adoption of FAS 115 for
regulatory reporting purposes, effective January 1, 1994. Accordingly,
all national banks follow FAS 115 for reporting purposes.
Proposal
On April 18, 1994, the OCC proposed to adopt FAS 115 for regulatory
capital purposes (59 FR 18328, April 18, 1994). The other Federal
banking agencies published similar proposals to adopt FAS 115 for
regulatory capital purposes. See 58 FR 68563 (December 28, 1993)
(Federal Reserve Board); 58 FR 68781 (December 29, 1993) (Federal
Deposit Insurance Corporation); 59 FR 32143 (June 22, 1994) (Office of
Thrift Supervision). The OCC issued the proposal to promote greater
consistency of regulatory capital rules with generally accepted
accounting principles (GAAP). At the same time, the OCC wanted to
understand the industry sentiment regarding the costs and benefits of
adopting FAS 115, and to determine banks' assessment of their ability
to manage the potential volatility in regulatory capital.
Review of Comments
The comment period for the OCC's proposal closed on May 18, 1994.
Among the 69 commenters, 61 were banks, thrifts or holding companies;
five were financial institution trade groups; one was a public
accounting firm; one was an investment banking firm, and one was a
clearinghouse association. Fifty-five of the commenters opposed the
proposal to include net unrealized holding gains on available-for-sale
securities in Tier 1 capital.
Opposition to the proposal focused on the belief that including the
net unrealized holding gains and losses on available-for-sale
securities in regulatory capital would result in excessive volatility
in regulatory capital levels. Many commenters observed that temporary
market conditions could cause banks to change capital levels. Although
an interest rate change causing a change in a security's market value
may be temporary, the fluctuation in Tier 1 capital could trigger more
permanent regulatory provisions and sanctions tied to a bank's level of
capitalization. For example, a change in capital could limit a bank's
ability to acquire brokered deposits or increase a bank's deposit
insurance premiums. In an extreme case, a bank could be subject to
prompt corrective action restrictions, sanctions, and penalties.
A few commenters were critical of the market value accounting
approach. These commenters believe that recognizing unrealized gains
and losses directly in capital would present a misleading report of a
bank's financial condition. Although these unrealized gains and losses
may reflect market value, banks may never realize the dollar values of
these unrealized gains and losses. Several commenters believe that FAS
115 is not consistent in its approach because it requires banks to
account for certain assets at fair market value while liabilities are
valued at cost. These commenters believe that by focusing only on
certain assets, FAS 115 does not properly consider the effects of
market changes on other components of bank balance sheets.
Several commenters opposed this proposal because of another recent
OCC notice of proposed rulemaking to link the lending limits on loans
to one borrower to the capital adequacy rules (59 FR 6593, February 11,
1994). These commenters observed that if the OCC adopts both proposals,
an unacceptable level of volatility would be introduced to bank lending
limits. As a result, the capital rules could restrain a bank's ability
to lend to a single borrower in times of rising interest rates.
Of the ten commenters favoring the proposal, eight believe that the
OCC should make its capital adequacy rules consistent with GAAP.
Several of these commenters indicated that they would incur additional
recordkeeping expenses if the regulatory definition of capital differs
from the GAAP definition. These commenters believe that the regulatory
burden would be increased by excluding the FAS 115 adjustment from Tier
1 capital. However, several commenters from smaller banks contradicted
this view. These commenters stated that adoption of the proposal to
include net unrealized holding gains and losses in stockholders' equity
would increase regulatory burden because they would have to change
their investment and portfolio management procedures.
A few commenters believe that adoption of the proposed rule would
be consistent with the Federal Deposit Insurance Corporation
Improvement Act of 1991 (FDICIA), Pub. L. 102-242 (1991). Specifically,
the commenters refer to section 121 of FDICIA which requires that the
Federal banking agency regulatory accounting policy, applicable to
reports or statements filed with Federal banking agencies, be no less
stringent than GAAP.
Several commenters indicated that they did not see any benefit from
implementing FAS 115 for regulatory capital purposes. They believe that
the costs of implementing the proposal would exceed any benefits
obtained. These commenters believe adoption of the proposal would
reduce bank profitability. These commenters also believe that greater
volatility in the investment portfolio would translate into greater
volatility in bank capital.
Several commenters believe that banks may change their investment
strategies to avoid the potential adverse consequences of volatility in
capital levels. These commenters predict that banks would attempt to
manage the volatility by purchasing lower-yielding securities of
shorter duration. Banks would shorten the duration of their securities
to minimize the potential for depreciation due to increases in interest
rates. Banks could also limit the types of securities acquired to those
with less interest rate risk. Portfolios with lower volatility risk
would produce lower yields, resulting in smaller profit margins.
A few commenters observed that to avoid volatility in regulatory
capital, bank management may pay more attention to the short-term
impacts of portfolio decisions instead of emphasizing long-term
investment management strategies. The proposal could result in a
reduction of a portfolio manager's flexibility to respond to changing
market conditions.
Commenter Alternatives
Several commenters suggested alternative methods of adopting FAS
115 for regulatory capital. A few commenters suggested revising the
regulatory capital rules to include the net unrealized holding gains
and losses on available-for-sale securities in Tier 2 capital. However,
the OCC believes that adoption of this alternative would increase the
complexity of the risk-based capital calculations. In addition, because
FAS 115 significantly increased the number of securities subject to
market valuation, including the unrealized gains and losses in Tier 2
capital may not prevent volatility in regulatory capital levels.
Several commenters suggested that other balance sheet accounts,
particularly liabilities, should be reported at their market values.
These commenters argue that regulatory capital could then include the
net unrealized holding gains and losses on these other balance sheet
accounts. This would result in a more consistent treatment of assets
and liabilities. The OCC agrees that a more consistent method of
applying market values to assets and liabilities would result in a
better approach. However, since the FASB was unable to identify a
workable approach for valuing liabilities when it developed FAS 115,
the OCC concluded that this modification would require considerably
more research. Therefore, the OCC concluded that it could not implement
this suggestion at this time.
Another commenter suggested that the OCC include net unrealized
holding gains and losses on available-for-sale securities in regulatory
capital, but exclude the adjustment from capital calculations that are
tied to other regulations such as prompt corrective action or FDIC
insurance premiums. This approach would also be complex and burdensome
and essentially require a bank to maintain yet another set of capital
calculations. Accordingly, the OCC determined not to implement this
alternative.
Another commenter suggested that banks disclose market values but
exclude them from regulatory capital. Since the OCC has adopted FAS 115
for regulatory reporting, but will not adopt it for regulatory capital
purposes, in effect, the OCC is implementing this suggestion.
The Final Rule
After considering all the comments received, the OCC, in
consultation with the other Federal banking agencies, decided not to
adopt the proposal to include the net unrealized holding gains and
losses on available-for-sale securities in the definition of common
stockholders' equity. The significant changes in market interest rates
that occurred during the first two quarters of 1994 demonstrated that
bank capital levels could be significantly more volatile if the
definition of common stockholders' equity included the FAS 115
adjustment for net unrealized holding gains and losses. This is
especially true for smaller banks that tend to have more of their
assets in marketable securities. Additionally, smaller banks may lack
the financial resources to establish a portfolio management function
dedicated to hedging interest rate risks.
Based on the comment letters received, the OCC determined that
including the FAS 115 adjustment in capital could have consequences
that may adversely impact the banking industry. For example, market-
driven fluctuations in interest rates could cause temporary changes in
regulatory capital levels, which in turn could trigger inappropriate
regulatory intervention. In addition, industry profitability could
decline due to higher expenses and lower investment yields, simply due
to the accounting implications of FAS 115. The OCC is concerned that
adoption of the proposal would encourage management to place excessive
weight on the accounting implications of their decisions, rather than
on their long-term economic impacts.
Additionally, the OCC is concerned that the lack of consistent
application of market valuation for assets and liabilities would
present a misleading report of a bank's regulatory capital. Since FAS
115 only requires market value accounting for certain segments of the
investment portfolio, only one side of the balance sheet reflects the
impact of interest rate changes. The OCC believes it would be
inappropriate to take regulatory action without evaluating the impact
of rate changes on both sides of the balance sheet.
The OCC, considered the comments received regarding FDICIA's
requirement that regulatory accounting policy be no less stringent than
GAAP. In fact, section 121 of FDICIA (12 U.S.C. 1831n) requires that
policies applicable to reports and statements filed with the Federal
banking agencies conform to GAAP. The section does not require the
calculation of an institution's regulatory capital or the components of
regulatory capital to conform to GAAP, and the legislative history of
the section indicates that was not the intent of Congress. By adopting
FAS 115 for regulatory reporting purposes, the OCC's policy conforms to
the section 121 requirement.
Although the OCC and other Federal regulatory agencies attempt to
conform to GAAP when formulating regulatory policy, it is not always
appropriate. When formulating GAAP, the accounting policy makers do not
focus on the unique capital adequacy requirements of banks. Moreover,
the bank regulators' framework of bank supervision is being linked
increasingly to capital levels. Therefore, it is logical to expect some
differences between GAAP and bank regulatory policy in appropriate
circumstances. In fact, the definition of capital in the capital
adequacy rules already differs from the GAAP definition. For example,
the regulatory definition includes a limited amount of the allowance
for loan and lease losses (ALLL) in Tier 2 capital, while the GAAP
definition of capital does not include any amount of ALLL. By adopting
FAS 115 for regulatory reporting, the agencies minimized the difference
between the Reports of Condition and Income (Call Reports) and
financial reports issued under GAAP.
Additionally, the OCC and the other Federal banking agencies
recognize that the net unrealized holding gains and losses recorded
under FAS 115 are often temporary.
Therefore, because Tier 1 capital, or ``core capital,'' is intended
to be permanent in nature, the OCC believes the definition of Tier 1
capital should not include these unrealized gains and losses. Such
treatment would be inconsistent with the capital measurement and
standards provisions of the Basle Accord, an international agreement of
the central banks and supervisory authorities of ten countries.
Change to Common Stockholders' Equity
In addressing the issues raised by the commenters on the merits of
including unrealized gains and losses in regulatory capital, the OCC
considered eliminating the requirement to deduct unrealized losses on
noncurrent marketable equity securities. However, the OCC believes the
use of amortized cost is relevant for debt securities but not for
equities. Absent the default of the issuer, a debt security will
realize its face amount. However, an equity security does not have a
maturity value. Consequently, the market value of an equity security
represents the best measure of its worth.
The OCC believes market value is the appropriate method of valuing
equities, but does not believe it is appropriate to include unrealized
gains in regulatory capital. The OCC and the other Federal agencies
have a long-standing policy of excluding all unrealized gains from Tier
1 capital and do not believe it is appropriate to deviate from this
policy. Accordingly, the OCC decided to retain the requirement to
deduct unrealized losses on equity securities. This final rule
clarifies the description of the deduction and revises the definition
of common stockholders' equity to reflect the new security
classification specified under FAS 115. Accordingly, banks must adjust
Tier 1 capital for net unrealized holding losses on equity securities
with readily determinable fair values held in the available-for-sale
portfolio.
Other Issues
To ensure regulators do not ignore significant unrealized
depreciation in the market value of securities when assessing a bank's
safety and soundness, examiners will consider both unrealized gains and
losses in their evaluation of the adequacy of a bank's regulatory
capital. When unrealized losses could threaten a bank's financial
condition, other regulatory actions that are based on regulatory
capital may be initiated.
Examiners will use their discretion to determine if a national bank
has taken an investment approach that is inconsistent with the OCC's
description of suitable investment practices. If it appears that an
institution is artificially manipulating security classifications to
increase regulatory capital, examiners may require banks to account for
securities at market values instead of amortized cost. The OCC plans to
issue additional guidance that will describe how unrealized gains and
losses will be considered and what actions examiners will take when
they detect gains trading and other unsafe practices.
Regulatory Flexibility Act
Pursuant to section 605(b) of the Regulatory Flexibility Act, it is
hereby certified that this final rule will not have a significant
economic impact on a substantial number of small entities. Accordingly,
a regulatory flexibility analysis is not required. This final rule will
not increase the number of banks that do not meet regulatory capital
standards. The effect on capital will be minimal regardless of bank
size.
Executive Order 12866
The OCC has determined that this final rule is not a significant
regulatory action under Executive Order 12866.
List of Subjects in 12 CFR Part 3
Administrative practice and procedure, National banks, Reporting
and recordkeeping requirements.
Authority and Issuance
For the reasons set out in the preamble, part 3 of title 12,
chapter I, of the Code of Federal Regulations is amended as set forth
below.
PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES
1. The authority of citation for part 3 is revised to read as
follows:
Authority: 12 U.S.C. 93a, 161, 1818, 1828(n), 1828 note, 1831(n)
note, 3907, and 3909.
2. In appendix A to part 3, paragraph (c)(7) of section 1 is
revised to read as follows:
Appendix A to Part 3--Risk-Based Capital Guidelines
Section 1. Purpose, Applicability of Guidelines, and
Definitions.
* * * * *
(c) * * *
(7) Common stockholders' equity means common stock, common stock
surplus, undivided profits, capital reserves, and adjustments for
the cumulative effect of foreign currency translation, less net
unrealized holding losses on available-for-sale equity securities
with readily determinable fair values.
* * * * *
Dated: November 8, 1994.
Eugene A. Ludwig,
Comptroller of the Currency.
[FR Doc. 94-29110 Filed 11-23-94; 8:45 am]
BILLING CODE 4810-33-P
