[Federal Register Volume 60, Number 29 (Monday, February 13, 1995)]
[Rules and Regulations]
[Pages 8177-8182]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-3469]
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FEDERAL RESERVE SYSTEM
12 CFR Parts 208 and 225
[Regulations H and Y; Docket No. R-0835]
Capital; Capital Adequacy Guidelines
AGENCY: Board of Governors of the Federal Reserve System.
ACTION: Final rule.
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SUMMARY: The Board of Governors of the Federal Reserve System (Board)
is amending its risk-based capital guidelines for state member banks
and bank holding companies (banking organizations) to implement section
350 of the Riegle Community Development and Regulatory Improvement Act
of 1994 (Riegle Act). Section 350 states that the amount of risk-based
capital required to be maintained by any insured depository
institution, with respect to assets transferred with recourse, may not
exceed the maximum amount of recourse for which the institution is
contractually liable under the recourse agreement. This rule will have
the effect of correcting the anomaly that currently exists in the risk-
based capital treatment of recourse transactions under which an
institution could be required to hold capital in excess of the maximum
amount of loss possible under the contractual terms of the recourse
obligation.
EFFECTIVE DATE: March 22, 1995.
FOR FURTHER INFORMATION CONTACT: Rhoger H Pugh, Assistant Director
(202/728-5883), Thomas R. Boemio, Supervisory Financial Analyst (202/
452-2982), or David Elkes (202/452-5218), Senior Financial Analyst,
Policy Development, Division of Banking Supervision and Regulation. For
the hearing impaired only, Telecommunication Device for the Deaf (TDD),
Dorothea Thompson (202/452-3544), Board of Governors of the Federal
Reserve System, 20th and C Streets NW., Washington, DC 20551.
SUPPLEMENTARY INFORMATION:
Background
The Board's current regulatory capital guidelines are intended to
ensure that banking organizations that transfer assets and retain the
credit risk inherent in the assets maintain adequate capital to support
that risk. For banks, this is generally accomplished by requiring that
assets transferred with recourse continue to be reported on the balance
sheet in regulatory reports. These amounts are thus included in the
calculation of banks' risk-based and leverage capital ratios. For bank
holding companies, transfers of assets with recourse are reported in
accordance with generally accepted accounting principles (GAAP), which
treats most such transactions as sales, allowing the assets to be
removed from the balance sheet.1 For purposes of calculating bank
[[Page 8178]] holding companies' risk-based capital ratios, however,
assets sold with recourse that have been removed from the balance sheet
in accordance with GAAP are included in risk-weighted assets.
Consequently, both banks and bank holding companies generally are
required to maintain capital against the full risk-weighted amount of
assets transferred with recourse.
\1\The GAAP treatment focuses on the transfer of benefits rather
than the retention of risk and, thus, allows a transfer of
receivables with recourse to be accounted for as a sale if the
transferor: (1) surrenders control of the future economic benefits
of the assets; (2) is able to reasonably estimate its obligations
under the recourse provision; and (3) is not obligated to repurchase
the assets except pursuant to the recourse provision. In addition,
the transferor must establish a separate liability account equal to
the estimated probable losses under the recourse provision (GAAP
recourse liability account).
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In cases where an institution retains a low level of recourse, the
amount of capital required under the Board's risk-based capital
guidelines could exceed the institution's maximum contractual liability
under the recourse agreement. This can occur in transactions in which a
banking organization contractually limits its recourse exposure to less
than the full effective risk-based capital requirement for the assets
transferred--generally, 4 percent for mortgage assets and 8 percent for
most other assets.
The Federal Reserve and the other federal banking agencies have
long recognized this anomaly in the risk-based capital guidelines. On
May 25, 1994, the banking agencies, under the auspices of the Federal
Financial Institutions Examination Council (FFIEC), issued a Notice of
Proposed Rulemaking (NPR) (59 FR 27116) that was aimed principally at
amending the risk-based capital guidelines to limit the capital charge
in low level recourse transactions to an institution's maximum
contractual recourse liability. The proposal for these types of
transactions would effectively result in a dollar capital charge for
each dollar of low level recourse exposure, up to the full effective
risk-based capital requirement on the underlying assets.
The proposal requested specific comment on whether an institution
should be able to use the balance of the GAAP recourse liability
account to reduce the dollar-for-dollar capital charge for the recourse
exposure on assets transferred with low level recourse in a transaction
recognized as a sale both under GAAP and for regulatory reporting
purposes. In addition, the proposal indicated that the capital
requirement for an exposure to low level recourse retained in a
transaction associated with a swap of mortgage loans for mortgage-
related securities would be the lower of the capital charge for the
swapped mortgages or the combined capital charge for the low level
recourse exposure and the mortgage-related securities, adjusted for any
double counting.
The NPR also addressed other issues related to recourse
transactions, including equivalent capital treatment of recourse
arrangements and direct credit substitutes that provide first dollar
loss protection and definitions for ``recourse'' and associated terms
such as ``standard representations and warranties.'' The NPR was issued
in conjunction with an Advance Notice of Proposed Rulemaking (ANPR)
that outlined a possible alternative approach to deal comprehensively
with the capital treatment of recourse transactions and
securitizations. The comment period for the NPR and ANPR ended on July
25, 1994.
During the agencies' review of the comments received, the Riegle
Act was signed into law on September 23, 1994. Section 350 of the Act
requires the federal banking agencies to issue regulations limiting, as
of March 22, 1995, the amount of risk-based capital an insured
depository institution is required to hold for assets transferred with
recourse to the maximum amount of recourse for which the institution is
contractually liable. In order to meet the statutory requirements of
section 350, the Federal Reserve is now issuing a rule that puts into
final form only those portions of the NPR dealing with low level
recourse transactions.
Comments Received
In response to the NPR and ANPR, the Federal Reserve Board received
letters from 36 public commenters. Of these respondents, 27 addressed
issues related to the NPR's proposed low level recourse capital
treatment. These commenters included 13 banking organizations,
including 11 multinational and regional banking organizations, one
community banking organization, and one foreign banking organization;
eight trade associations; two law firms; one government-sponsored
agency; and three other commenters. Of these 27 respondents, 23
specifically provided a favorable overall assessment of the low level
recourse proposal. In general, these respondents viewed the low level
proposal as a way of rationally correcting an anomaly in the existing
risk-based capital rules so that institutions would not be required to
hold capital in excess of their contractual liability.
Ten of the commenters stated that, while the proposed low level
recourse capital treatment was a positive step, it still would result
in too high of a capital requirement for assets sold with limited
recourse. These respondents, which included eight of the thirteen
banking organizations and two of the eight trade associations,
expressed the view that the banking agencies should adopt the GAAP
treatment of assets sold with recourse for purposes of calculating the
regulatory capital ratios. These commenters maintained that the GAAP
recourse liability account provides adequate protection against the
risk of loss on assets sold with recourse, obviating the need for
additional capital.
The NPR specifically sought comment on five issues related to the
proposed capital treatment of low level recourse transactions. Thirteen
of the 27 respondents commented on the first issue, which concerned the
treatment of the GAAP recourse liability account established for assets
sold with recourse reported as sales for regulatory reporting purposes.
These 13 commenters favored reducing the capital requirement for low
level recourse transactions by the balance of its GAAP recourse
liability account--which would continue to be excluded from an
institution's regulatory capital. In their view, not taking this
account into consideration would result in double coverage of the
portion of the risk provided for in that account.
Fourteen commenters, including five banking organizations and five
trade associations, responded to the second issue, which sought comment
on whether a dollar-for-dollar capital requirement would be too high
for low level recourse transactions. Eleven commenters indicated that
such a capital charge would be too high since it was unlikely that an
institution would incur losses up to its maximum contractual liability.
Two others responded that whether the capital treatment was too high
depended upon the credit quality of the underlying asset pool and the
structure of the securitization. One commenter stated that the dollar-
for-dollar capital charge would not be too onerous.
The third issue dealt with ways of demonstrating that the dollar-
for-dollar capital requirement might be too high and possible methods
for reducing this requirement without jeopardizing safety and
soundness. The eight commenters on this issue indicated that historical
analysis, examiner review, and ``depression scenario'' stress testing
would show whether the capital requirement would be too high relative
to historical losses.
The fourth issue concerned ways the banking agencies could handle
the increased probability of loss to the insurance fund if less than
dollar-for-dollar capital is maintained against low [[Page 8179]] level
recourse transactions. The eight commenters on this issue stated that
as long as the amount of required capital held against the low level
recourse transactions was prudently assessed based upon expected
losses, actual losses would seldom, if ever, exceed the capital
requirement. Thus, the insurance funds would not likely experience
losses.
The fifth issue sought comment on whether the proposed low level
recourse capital treatment would reduce transaction costs or otherwise
help to facilitate the sale or securitization of banking organizations'
assets. The eight commenters that responded to this issue were all of
the opinion that the low level capital treatment generally would help
lower transaction costs and help facilitate securitization.
Final Rule
After consideration of the comments received and further
deliberation on the issues involved, particularly the requirements of
section 350 of the Riegle Act, the Board is adopting a final rule
amending the risk-based capital guidelines with respect to the
treatment of low level recourse transactions. Specifically, the final
amendments implement section 350 by reducing the capital requirements
for all recourse transactions in which a state member bank
contractually limits its recourse exposure to less than the full,
effective risk-based capital requirement for the assets transferred.
Although section 350 explicitly extends only to depository
institutions, the Board, consistent with its proposal, is also issuing
a parallel final amendment to its risk-based capital guidelines for
bank holding companies.2
\2\In addition to amending the risk-based capital guidelines to
reduce the capital requirement for low level recourse transactions
(see paragraph g of section III.D.1. of the guidelines), the Board
is also making some technical, nonsubstantive changes to that
section of the guidelines by identifying each paragraph in the
section with a letter designation.
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The final rule applies to low level recourse transactions involving
all types of assets, including small business loans, commercial loans,
and residential mortgages. In this regard, the Board notes that
previously under the risk-based capital guidelines residential mortgage
loans transferred with recourse were excluded from risk-weighted assets
if the institution did not retain significant risk of loss. As
proposed, this treatment would no longer apply and the low level
recourse capital treatment the Board is now issuing would extend to
these types of mortgage loan transfers.
Under the low level recourse rule, a banking organization that
contractually limits its maximum recourse obligation to less than the
full effective risk-based capital requirement for the transferred
assets would be required to hold risk-based capital equal to the
contractual maximum amount of its recourse obligation. This requirement
limits to one dollar the capital charge for each dollar of low-level
recourse exposure. Under this dollar-for-dollar capital requirement,
the capital charge for a 100 percent risk-weighted asset transferred
with 3 percent recourse would be 3 percent of the value of the
transferred assets, rather than the 8 percent previously required.
Thus, a banking organization's capital requirement on a low level
recourse transaction would not exceed the contractual maximum amount it
could lose under the recourse obligation.
Under the final rule, an institution may reduce the dollar-for-
dollar capital charge held against the recourse exposure on assets
transferred with low level recourse for a transaction recognized as a
sale under GAAP and for regulatory reporting purposes by the balance of
any associated non-capital GAAP recourse liability account. In adopting
this aspect of the final rule, the Board concurs with commenters that
indicated that nonrecognition of the liability account would result in
double coverage of the portion of the credit risk provided for in that
account.
In applying the final rule, the Board will, as proposed, limit the
capital requirement for an exposure to low level recourse retained in a
transaction associated with a swap of mortgage loans for mortgage-
related securities to the lower of the capital charge for the swapped
mortgages or the combined capital charge for the low level recourse
exposure and the mortgage-related securities, adjusted for any double
counting.
In setting forth this final rule, the Board has considered the
arguments that several commenters made for adopting for regulatory
capital purposes the GAAP treatment for all assets sold with recourse,
including those sold with low levels of recourse. Under such a
treatment, assets sold with recourse in accordance with GAAP would have
no capital requirement, but the GAAP recourse liability account would
provide some level of protection against losses.
The Board continues to believe it would not be appropriate to adopt
for regulatory capital purposes the GAAP treatment of recourse
transactions, even if the transferring bank retains only a low level of
recourse. In the Board's view, the GAAP recourse liability account
would be an inadequate substitute for maintaining capital at a level
commensurate with the risks. One of the principal purposes of
regulatory capital is to provide a cushion against unexpected losses.
In contrast, the GAAP recourse liability account is, in effect, a
specific reserve that is intended to cover only an institution's
probable expected losses under the recourse provision. In this regard,
the Board notes that the capital guidelines explicitly state that
specific reserves may not be included in regulatory capital.
In addition, the amount of credit risk that is typically retained
in a recourse transaction greatly exceeds the normal expected losses
associated with the transferred assets. Thus, even though a
transferring institution may reduce its exposure to potential
catastrophic losses by limiting the amount of recourse it provides, it
may still retain, in many cases, the bulk of the risk inherent in the
assets. For example, an institution transferring high quality assets
with a reasonably estimated expected loss rate of one percent that
retains ten percent recourse in the normal course of business will
sustain the same amount of losses it would have had the assets not been
transferred. This occurs because the amount of exposure under the
recourse provision is very high relative to the amount of expected
losses. The Board believes that in such transactions the transferor has
not significantly reduced its risk for purposes of assessing regulatory
capital and should continue to be assessed regulatory capital as though
the assets had not been transferred.
The GAAP reliance on reasonable estimates of all probable credit
losses over the life of the receivables transferred poses additional
concerns to the Board. While it may be possible to make such estimates
for pools of consumer loans or residential mortgages, the Board is of
the view that it is currently difficult to do so for other types of
loans. Even if it is possible to make a reasonable estimate of probable
credit losses at the time an asset or asset pool is transferred, the
ability of an institution to make a reasonable estimate may change over
the life of the transferred assets.
Finally, the Board is concerned that an institution transferring
assets with recourse might estimate that it would not have any losses
under the recourse provision, in which case it would not establish any
GAAP recourse liability account for the exposure. If the transferor
recorded either no liability or only a nominal liability in the GAAP
[[Page 8180]] recourse liability account for a succession of asset
transfers, it could accumulate large amounts of credit risk that would
not be reflected, or would be only partially reflected, on the balance
sheet.
The Board is issuing this final rule now in order to implement
section 350 of the Riegle Act in accordance with the statutory
deadline. Consequently, the rule deals with only those portions of the
NPR concerned with low level recourse transactions. The Board will
continue to consider, on an interagency basis, the other aspects of the
NPR, as well as all aspects of the ANPR that was issued in conjunction
with the NPR.
Regulatory Flexibility Act
The purpose of this final rule is to reduce the risk-based capital
requirement on transfers of assets with low levels of recourse.
Therefore, pursuant to section 605(b) of the Regulatory Flexibility
Act, the Board hereby certifies that this rule will have a beneficial
economic impact on small business entities (in this case, small banking
organizations) that sell assets with low levels of recourse. The risk-
based capital guidelines generally do not apply to bank holding
companies with consolidated assets of less than $150 million; thus,
this rule will not affect such companies.
Paperwork Reduction Act and Regulatory Burden
The Board has determined that this final rule will not increase the
regulatory paperwork burden of banking organizations pursuant to the
provisions of the Paperwork Reduction Act (44 U.S.C. 3501 et seq.).
Section 302 requires that new regulations take effect on the first
day of the calendar quarter following publication of the rule, unless,
inter alia, the regulation, pursuant to any other Act of Congress, is
required to take effect on a date other than the date determined under
section 302. Section 350 of the Riegle Act requires that before the end
of the 180-day period beginning on the date of enactment of the Act, or
in this case no later than March 22, 1995, the amount of risk-based
capital required to be maintained, under regulations prescribed by the
appropriate Federal banking agency, by any insured depository
institution transferring assets with recourse be limited to the maximum
amount of recourse for which such institution is contractually liable
under the recourse agreement. Accordingly, the Board has determined
that an effective date of March 22, 1995 is appropriate.
List of Subjects
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.
For the reasons set forth in the preamble, the Board amends 12 CFR
parts 208 and 225 as set forth below:
PART 208--MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE FEDERAL
RESERVE SYSTEM (REGULATION H)
1. The authority citation for part 208 continues to read as
follows:
Authority: 12 U.S.C. 36, 248(a), 248(c), 321-338a, 371d, 461,
481-486, 601, 611, 1814, 1823(j), 1828(o), 1831o, 1831p-1, 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.
2. In Part 208, Appendix A, section III.D.1. is revised to read as
follows:
Appendix A to Part 208--Capital Adequacy Guidelines for State
Member Banks: Risk-Based Measure
* * * * *
III. * * *
D. * * *
1. Items with a 100 percent conversion factor.
a. A 100 percent conversion factor applies to direct credit
substitutes, which include guarantees, or equivalent instruments,
backing financial claims, such as outstanding securities, loans, and
other financial liabilities, or that back off-balance sheet items
that require capital under the risk-based capital framework. Direct
credit substitutes include, for example, financial standby letters
of credit, or other equivalent irrevocable undertakings or surety
arrangements, that guarantee repayment of financial obligations such
as: commercial paper, tax-exempt securities, commercial or
individual loans or debt obligations, or standby or commercial
letters of credit. Direct credit substitutes also include the
acquisition of risk participations in bankers acceptances and
standby letters of credit, since both of these transactions, in
effect, constitute a guarantee by the acquiring bank that the
underlying account party (obligor) will repay its obligation to the
originating, or issuing, institution.\41\ (Standby letters of credit
that are performance-related are discussed below and have a credit
conversion factor of 50 percent.)
\41\Credit equivalent amounts of acquisitions of risk
participations are assigned to the risk category appropriate to the
account party obligor, or, if relevant, the nature of the collateral
or guarantees.
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b. The full amount of a direct credit substitute is converted at
100 percent and the resulting credit equivalent amount is assigned
to the risk category appropriate to the obligor or, if relevant, the
guarantor or the nature of the collateral. In the case of a direct
credit substitute in which a risk participation\42\ has been
conveyed, the full amount is still converted at 100 percent.
However, the credit equivalent amount that has been conveyed is
assigned to whichever risk category is lower: the risk category
appropriate to the obligor, after giving effect to any relevant
guarantees or collateral, or the risk category appropriate to the
institution acquiring the participation. Any remainder is assigned
to the risk category appropriate to the obligor, guarantor, or
collateral. For example, the portion of a direct credit substitute
conveyed as a risk participation to a U.S. domestic depository
institution or foreign bank is assigned to the risk category
appropriate to claims guaranteed by those institutions, that is, the
20 percent risk category.\43\ This approach recognizes that such
conveyances replace the originating bank's exposure to the obligor
with an exposure to the institutions acquiring the risk
participations.\44\
\42\That is, a participation in which the originating bank
remains liable to the beneficiary for the full amount of the direct
credit substitute if the party that has acquired the participation
fails to pay when the instrument is drawn.
\43\Risk participations with a remaining maturity of over one
year that are conveyed to non-OECD banks are to be assigned to the
100 percent risk category, unless a lower risk category is
appropriate to the obligor, guarantor, or collateral.
\44\A risk participation in bankers acceptances conveyed to
other institutions is also assigned to the risk category appropriate
to the institution acquiring the participation or, if relevant, the
guarantor or nature of the collateral.
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c. In the case of direct credit substitutes that take the form
of a syndication as defined in the instructions to the commercial
bank Call Report, that is, where each bank is obligated only for its
pro rata share of the risk and there is no recourse to the
originating bank, each bank will only include its pro rata share of
the direct credit substitute in its risk-based capital calculation.
d. Financial standby letters of credit are distinguished from
loan commitments (discussed below) in that standbys are irrevocable
obligations of the bank to pay a third-party beneficiary when a
customer (account party) fails to repay an outstanding loan or debt
instrument (direct credit substitute). Performance standby letters
of credit (performance bonds) are irrevocable obligations of the
bank to pay a third-party beneficiary when a customer (account
party) fails to perform some other contractual non-financial
obligation.
e. The distinguishing characteristic of a standby letter of
credit for risk-based capital purposes is the combination of
irrevocability with the fact that funding is triggered by some
failure to repay or perform an obligation. Thus, any commitment (by
[[Page 8181]] whatever name) that involves an irrevocable obligation
to make a payment to the customer or to a third party in the event
the customer fails to repay an outstanding debt obligation or fails
to perform a contractual obligation is treated, for risk-based
capital purposes, as respectively, a financial guarantee standby
letter of credit or a performance standby.
f. A loan commitment, on the other hand, involves an obligation
(with or without a material adverse change or similar clause) of the
bank to fund its customer in the normal course of business should
the customer seek to draw down the commitment.
g. Sale and repurchase agreements and asset sales with recourse
(to the extent not included on the balance sheet) and forward
agreements also are converted at 100 percent. The risk-based capital
definition of the sale of assets with recourse, including the sale
of 1- to 4-family residential mortgages, is the same as the
definition contained in the instructions to the commercial bank Call
Report. Accordingly, the entire amount of any assets transferred
with recourse that are not already included on the balance sheet,
including pools of 1- to 4-family residential mortgages, are to be
converted at 100 percent and assigned to the risk weight appropriate
to the obligor, or if relevant, the nature of any collateral or
guarantees. The terms of a transfer of assets with recourse may
contractually limit the amount of the institution's liability to an
amount less than the effective risk-based capital requirement for
the assets being transferred with recourse. If such a transaction
(including one that is reported as a financing, i.e., the assets are
not removed from the balance sheet) meets the criteria for sales
treatment under GAAP, the amount of total capital required is equal
to the maximum amount of loss possible under the recourse provision.
If the transaction is also treated as a sale for regulatory
reporting purposes, then the required amount of capital may be
reduced by the balance of any associated non-capital liability
account established pursuant to GAAP to cover estimated probable
losses under the recourse provision. So-called ``loan strips'' (that
is, short-term advances sold under long-term commitments without
direct recourse) are defined in the instructions to the commercial
bank Call Report and for risk-based capital purposes as assets sold
with recourse.
h. Forward agreements are legally binding contractual
obligations to purchase assets with certain drawdown at a specified
future date. Such obligations include forward purchases, forward
forward deposits placed,\45\ and partly-paid shares and securities;
they do not include commitments to make residential mortgage loans
or forward foreign exchange contracts.
\45\Forward forward deposits accepted are treated as interest
rate contracts.
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i. Securities lent by a bank are treated in one of two ways,
depending upon whether the lender is at risk of loss. If a bank, as
agent for a customer, lends the customer's securities and does not
indemnify the customer against loss, then the transaction is
excluded from the risk-based capital calculation. If, alternatively,
a bank lends its own securities or, acting as agent for a customer,
lends the customer's securities and indemnifies the customer against
loss, the transaction is converted at 100 percent and assigned to
the risk weight category appropriate to the obligor, to any
collateral delivered to the lending bank, or, if applicable, to the
independent custodian acting on the lender's behalf. Where a bank is
acting as agent for a customer in a transaction involving the
lending or sale of securities that is collateralized by cash
delivered to the bank, the transaction is deemed to be
collateralized by cash on deposit in the bank for purposes of
determining the appropriate risk-weight category, provided that any
indemnification is limited to no more than the difference between
the market value of the securities and the cash collateral received
and any reinvestment risk associated with that cash collateral is
borne by the customer.
* * * * *
PART 225--BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL
(REGULATION Y)
1. The authority citation for part 225 continues to read as
follows:
Authority: 12 U.S.C. 1817(j)(13), 1818, 1831i, 1831p-1,
1843(c)(8), 1844(b), 1972(l), 3106, 3108, 3310, 3331-3351, 3907, and
3909.
2. In Part 225, Appendix A, section III.D.1. is revised to read as
follows:
Appendix A to Part 225--Capital Adequacy Guidelines for Bank
Holding Companies: Risked-Based Measure
* * * * *
III. * * *
D. * * *
1. Items with a 100 percent conversion factor.
a. A 100 percent conversion factor applies to direct credit
substitutes, which include guarantees, or equivalent instruments,
backing financial claims, such as outstanding securities, loans, and
other financial liabilities, or that back off-balance sheet items
that require capital under the risk-based capital framework. Direct
credit substitutes include, for example, financial standby letters
of credit, or other equivalent irrevocable undertakings or surety
arrangements, that guarantee repayment of financial obligations such
as: commercial paper, tax-exempt securities, commercial or
individual loans or debt obligations, or standby or commercial
letters of credit. Direct credit substitutes also include the
acquisition of risk participations in bankers acceptances and
standby letters of credit, since both of these transactions, in
effect, constitute a guarantee by the acquiring banking organization
that the underlying account party (obligor) will repay its
obligation to the originating, or issuing, institution.44
(Standby letters of credit that are performance-related are
discussed below and have a credit conversion factor of 50 percent.)
\44\Credit equivalent amounts of acquisitions of risk
participations are assigned to the risk category appropriate to the
account party obligor, or, if relevant, the nature of the collateral
or guarantees.
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b. The full amount of a direct credit substitute is converted at
100 percent and the resulting credit equivalent amount is assigned
to the risk category appropriate to the obligor or, if relevant, the
guarantor or the nature of the collateral. In the case of a direct
credit substitute in which a risk participation45 has been
conveyed, the full amount is still converted at 100 percent.
However, the credit equivalent amount that has been conveyed is
assigned to whichever risk category is lower: the risk category
appropriate to the obligor, after giving effect to any relevant
guarantees or collateral, or the risk category appropriate to the
institution acquiring the participation. Any remainder is assigned
to the risk category appropriate to the obligor, guarantor, or
collateral. For example, the portion of a direct credit substitute
conveyed as a risk participation to a U.S. domestic depository
institution or foreign bank is assigned to the risk category
appropriate to claims guaranteed by those institutions, that is, the
20 percent risk category.46 This approach recognizes that such
conveyances replace the originating banking organization's exposure
to the obligor with an exposure to the institutions acquiring the
risk participations.47
\45\That is, a participation in which the originating banking
organization remains liable to the beneficiary for the full amount
of the direct credit substitute if the party that has acquired the
participation fails to pay when the instrument is drawn.
\46\Risk participations with a remaining maturity of over one
year that are conveyed to non-OECD banks are to be assigned to the
100 percent risk category, unless a lower risk category is
appropriate to the obligor, guarantor, or collateral.
\47\A risk participation in bankers acceptances conveyed to
other institutions is also assigned to the risk category appropriate
to the institution acquiring the participation or, if relevant, the
guarantor or nature of the collateral.
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c. In the case of direct credit substitutes that take the form
of a syndication, that is, where each banking organization if
obligated only for its pro rata share of the risk and there is no
recourse to the originating banking organization, each banking
organization will only include its pro rata share of the direct
credit substitute in its risk-based capital calculation.
d. Financial standby letters of credit are distinguished from
loan commitments (discussed below) in that standbys are irrevocable
obligations of the banking organization to pay a third-party
beneficiary when a customer (account party) fails to repay an
outstanding loan or debt instrument (direct credit substitute).
Performance standby letters of credit (performance bonds) are
irrevocable obligations of the banking organization to pay a third-
party beneficiary when a customer (account party) fails to perform
some other contractual non-financial obligation.
e. The distinguishing characteristic of a standby letter of
credit for risk-based capital purposes is the combination of
irrevocability with the fact that funding is triggered by some
failure to repay or perform an obligation. Thus, any commitment (by
whatever name) that involves an irrevocable [[Page 8182]] obligation
to make a payment to the customer or to a third party in the event
the customer fails to repay an outstanding debt obligation or fails
to perform a contractual obligation is treated, for risk-based
capital purposes, as respectively, a financial guarantee standby
letter of credit or a performance standby.
f. A loan commitment, on the other hand, involves an obligation
(with or without a material adverse change or similar clause) of the
banking organization to fund its customer in the normal course of
business should the customer seek to draw down the commitment.
g. Sale and repurchase agreements and asset sales with recourse
(to the extent not included on the balance sheet) and forward
agreements also are converted at 100 percent.48 So-called
``loan strips'' (that is, short-term advances sold under long-term
commitments without direct recourse) are treated for risk-based
capital purposes as assets sold with recourse and, accordingly, are
also converted at 100 percent.
\48\In regulatory reports and under GAAP, bank holding companies
are permitted to treat some asset sales with recourse as ``true''
sales. For risk-based capital purposes, however, such assets sold
with recourse and reported as ``true'' sales by bank holding
companies are converted at 100 percent and assigned to the risk
category appropriate to the underlying obligor or, if relevant, the
guarantor or nature of the collateral, provided that the
transactions meet the definition of assets sold with recourse
(including assets sold subject to pro rata and other loss sharing
arrangements), that is contained in the instructions to the
commercial bank Consolidated Reports of Condition and Income (Call
Report). This treatment applies to any assets, including the sale of
1- to 4-family and multifamily residential mortgages, sold with
recourse. Accordingly, the entire amount of any assets transferred
with recourse that are not already included on the balance sheet,
including pools of 1- to 4-family residential mortgages, are to be
converted at 100 percent and assigned to the risk category
appropriate to the obligor, or if relevant, the nature of any
collateral or guarantees. The terms of a transfer of assets with
recourse may contractually limit the amount of the institution's
liability to an amount less than the effective risk-based capital
requirement for the assets being transferred with recourse. If such
a transaction is recognized as a sale under GAAP, the amount of
total capital required is equal to the maximum amount of loss
possible under the recourse provision, less any amount held in an
associated non-capital liability account established pursuant to
GAAP to cover estimated probable losses under the recourse
provision.
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h. Forward agreements are legally binding contractual
obligations to purchase assets with certain drawdown at a specified
future date. Such obligations include forward purchases, forward
forward deposits placed,49 and partly-paid shares and
securities; they do not include commitments to make residential
mortgage loans or forward foreign exchange contracts.
\49\Forward forward deposits accepted are treated as interest
rate contracts.
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i. Securities lent by a banking organization are treated in one
of two ways, depending upon whether the lender is at risk of loss.
If a banking organization, as agent for a customer, lends the
customer's securities and does not indemnify the customer against
loss, then the transaction is excluded from the risk-based capital
calculation. If, alternatively, a banking organization lends its own
securities or, acting as agent for a customer, lends the customer's
securities and indemnifies the customer against loss, the
transaction is converted at 100 percent and assigned to the risk
weight category appropriate to the obligor, to any collateral
delivered to the lending banking organization, or, if applicable, to
the independent custodian acting on the lender's behalf. Where a
banking organization is acting as agent for a customer in a
transaction involving the lending or sale of securities that is
collateralized by cash delivered to the banking organization, the
transaction is deemed to be collateralized by cash on deposit in a
subsidiary lending institution for purposes of determining the
appropriate risk-weight category, provided that any indemnification
is limited to no more than the difference between the market value
of the securities and the cash collateral received and any
reinvestment risk associated with that cash collateral is borne by
the customer.
* * * * *
By order of the Board of Governors of the Federal By Reserve
System, February 7, 1995.
William W. Wiles,
Secretary of the Board.
[FR Doc. 95-3469 Filed 2-10-95; 8:45 am]
BILLING CODE 6210-01-P
