[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