[Federal Register Volume 59, Number 245 (Thursday, December 22, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-31441]


[[Page Unknown]]

[Federal Register: December 22, 1994]


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FEDERAL RESERVE SYSTEM

12 CFR Parts 208 and 225

[Regulations H and Y; Docket No. R-0795]

 

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 or 
Federal Reserve) is revising its capital adequacy guidelines for state 
member banks and bank holding companies to establish a limitation on 
the amount of certain deferred tax assets that may be included in (that 
is, not deducted from) Tier 1 capital for risk-based and leverage 
capital purposes. The capital rule was developed in response to the 
Financial Accounting Standards Board's (FASB) issuance of Statement No. 
109, ``Accounting for Income Taxes'' (FAS 109). Under the final rule, 
deferred tax assets that can only be realized if an institution earns 
taxable income in the future are limited for regulatory capital 
purposes to the amount that the institution expects to realize within 
one year of the quarter-end report date--based on its projection of 
taxable income--or 10 percent of Tier 1 capital, whichever is less.

EFFECTIVE DATE: April 1, 1995.

FOR FURTHER INFORMATION CONTACT: Charles H. Holm, Project Manager, 
(202) 452-3502; Nancy J. Rawlings, Senior Financial Analyst, (202) 452-
3059, Regulatory Reporting and Accounting Issues Section; Barbara J. 
Bouchard, Supervisory Financial Analyst, (202) 452-3072, Policy 
Development Section, Division of Banking Supervision and Regulation, 
Board of Governors of the Federal Reserve System. For the hearing 
impaired only, Telecommunication Device for the Deaf (TDD), Dorothea 
Thompson (202) 452-3544.

SUPPLEMENTARY INFORMATION:

I. Background

A. Characteristics of Deferred Tax Assets

    Deferred tax assets are assets that reflect, for financial 
reporting purposes, benefits of certain aspects of tax laws and rules. 
Deferred tax assets may arise because of specific limitations under tax 
laws of different tax jurisdictions that require that certain net 
operating losses (e.g., when, for tax purposes, expenses exceed 
revenues) or tax credits be carried forward if they cannot be used to 
recover taxes previously paid. These ``carryforwards'' are realized 
only if the institution generates sufficient future taxable income 
during the carryforward period.
    Deferred tax assets may also arise from the tax effects of certain 
events that have been recognized in one period for financial statement 
purposes but will result in deductible amounts in a future period for 
tax purposes, i.e., the tax effects of ``deductible temporary 
differences.'' For example, many depository institutions and bank 
holding companies may report higher income to taxing authorities than 
they reflect in their regulatory reports1 because their loan loss 
provisions are expensed for reporting purposes but are not deducted for 
tax purposes until the loans are charged off.
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    \1\State member banks are required to file quarterly 
Consolidated Reports of Condition and Income (Call Reports) with the 
Federal Reserve. Bank holding companies with total consolidated 
assets of $150 million or more file quarterly Consolidated Financial 
Statements for Bank Holding Companies (FR Y-9C reports) with the 
Federal Reserve.
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    Deferred tax assets arising from an organization's deductible 
temporary differences may or may not exceed the amount of taxes 
previously paid that the organization could recover if the 
organization's temporary differences fully reversed at the report date. 
Some of these deferred tax assets may theoretically be ``carried back'' 
and recovered from taxes previously paid. On the other hand, when 
deferred tax assets arising from deductible temporary differences 
exceed such previously paid tax amounts, they will be realized only if 
there is sufficient future taxable income during the carryforward 
period. Such deferred tax assets, and deferred tax assets arising from 
net operating loss and tax credit carryforwards, are hereafter referred 
to as ``deferred tax assets that are dependent upon future taxable 
income.''

B. Summary of FAS 109

    In February 1992, the FASB issued Statement No. 109, ``Accounting 
for Income Taxes'' which supersedes Accounting Principles Board Opinion 
No. 11 and FASB Statement No. 96. FAS 109 provides guidance on many 
aspects of accounting for income taxes, including the accounting for 
deferred tax assets. FAS 109 potentially allows some state member banks 
and bank holding companies to record significantly higher deferred tax 
assets than previously permitted under generally accepted accounting 
principles (GAAP) and the federal banking agencies' prior reporting 
policies.2 Unlike the general practice under previous standards, 
FAS 109 permits the reporting of deferred tax assets that are dependent 
upon future taxable income. However, FAS 109 requires the establishment 
of a valuation allowance to reduce the net deferred tax asset to an 
amount that is more likely than not (i.e., a greater than 50 percent 
likelihood) to be realized.
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    \2\The federal banking agencies consist of the Federal Reserve 
Board (Board), the Federal Deposit Insurance Corporation (FDIC), the 
Office of the Comptroller of the Currency (OCC), and the Office of 
Thrift Supervision (OTS) (hereafter, the ``agencies''.)
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    FAS 109 became effective for fiscal years beginning on or after 
December 15, 1992. The adoption of this standard has resulted in the 
reporting of additional deferred tax assets in Call Reports and FR Y-9C 
reports that directly increase institutions' undivided profits 
(retained earnings) and Tier 1 capital.

C. Concerns Regarding Deferred Tax Assets That Are Dependent Upon 
Future Taxable Income

    The Federal Reserve has certain concerns about including in capital 
deferred tax assets that are dependent upon future taxable income. 
Realization of such assets depends on whether a banking organization 
has sufficient future taxable income during the carryforward period. 
Since a banking organization that is in a net operating loss 
carryforward position is often experiencing financial difficulties, its 
prospects for generating sufficient taxable income in the future are 
uncertain. In addition, the condition of and future prospects for an 
organization often can and do change very rapidly in the banking 
environment. This raises concerns about the realizability of deferred 
tax assets that are dependent upon future taxable income, even when an 
organization may be sound and well-managed. Thus, for many 
organizations such deferred tax assets may not be realized, and for 
other organizations there is a high degree of subjectivity in 
determining the realizability of this asset. Furthermore, while many 
organizations may be able to make reasonable projections of taxable 
income for relatively short periods and actually realize this income, 
beyond a short time period, the reliability of the projections tends to 
decrease significantly. In addition, unlike many other assets, banking 
organizations generally cannot obtain the value of deferred tax assets 
by selling them.
    Moreover, as an organization's condition deteriorates, it is less 
likely that deferred tax assets that are dependent upon future taxable 
income will be realized. Therefore, the organization is required under 
FAS 109 to reduce its deferred tax assets through increases to the 
asset's valuation allowance. Additions to this allowance would reduce 
the organization's regulatory capital at precisely the time it needs 
capital support the most. Thus, the inclusion in capital of deferred 
tax assets that are dependent upon future taxable income raises 
supervisory concerns.
    Because of these concerns, the agencies, under the auspices of the 
Federal Financial Institutions Examination Council (FFIEC), considered 
whether it would be appropriate to adopt FAS 109 for regulatory 
reporting purposes. On August 3, 1992, the FFIEC requested public 
comment on this matter, and on December 23, 1992, after consideration 
of the comments received, the FFIEC decided that banks and savings 
associations should adopt FAS 109 for reporting purposes in Call 
Reports and Thrift Financial Reports (TFRs) beginning in the first 
quarter of 1993 (or the beginning of their first fiscal year 
thereafter, if later). Furthermore, the Board decided that bank holding 
companies should adopt FAS 109 in FR Y-9C Reports at the same time.

D. Proposal for the Treatment of Deferred Tax Assets

    The FFIEC, in reaching its decision on regulatory reporting, also 
recommended that each of the agencies amend its regulatory capital 
standards to limit the amount of deferred tax assets that can be 
included in regulatory capital. In response to the FFIEC's 
recommendation, on February 11, 1993, the Board issued for public 
comment a proposal to adopt the recommendation of the FFIEC in full, as 
summarized below (54 FR 8007, February 11, 1993). The FFIEC recommended 
that the agencies limit the amount of deferred tax assets that are 
dependent upon future taxable income that can be included in regulatory 
capital to the lesser of:
    i. the amount of such deferred tax assets that the institution 
expects to realize within one year of the quarter-end report date, 
based on its projection of taxable income (exclusive of net operating 
loss or tax credit carryforwards and reversals of existing temporary 
differences), or
    ii. 10 percent of Tier 1 capital, net of goodwill and all 
identifiable intangible assets other than purchased mortgage servicing 
rights and purchased credit card relationships (and before any 
disallowed deferred tax assets are deducted). Deferred tax assets that 
can be realized from taxes paid in prior carryback years and from 
future reversals of existing taxable temporary differences would 
generally not be limited under the proposal.

II. Public Comments on the Proposal

    The comment period for the Board's proposal ended on March 15, 
1993. The Board received nineteen comment letters including ten from 
multinational and large regional banking organizations, and three 
community banks. In addition, the Board received four comment letters 
from bank trade associations and two from finance companies. Sixteen 
commenters offered support for the Board's proposal to require banking 
organizations to report, for regulatory purposes, deferred tax assets 
in accordance with FAS 109. In addition, fifteen commenters indicated 
that it would be preferable for the Board to place no limit on the 
amount of deferred tax assets allowable in capital. These commenters 
indicated that, in their view, embracing FAS 109 in its entirety would 
achieve consistency between regulatory standards and GAAP as well as 
maintain consistency with the intent of Section 121 of the Federal 
Deposit Insurance Corporation Improvement Act (FDICIA) of 1991. 
Commenters asserted that the criteria set forth in FAS 109 to recognize 
and value deferred tax assets is sufficiently conservative to limit any 
exposure to the bank insurance fund and that an arbitrary or mechanical 
formula, such as the ones proposed, would not provide a more accurate 
or reliable result.
    While preferring no capital limit on deferred tax assets, some 
commenters noted that the proposal represented a compromise and a step 
forward from prior regulatory policies that permitted little or no 
inclusion in regulatory reports or capital of deferred tax assets that 
are dependent upon future taxable income. Two commenters generally 
supported the proposal or expressed their understanding of the 
regulator's concern regarding the realizability of deferred tax assets 
and one commenter indicated the capital treatment should be consistent 
with the capital treatment for identifiable intangible assets.

A. Responses to the Board's Questions

    Question 1: (Gross-up of Intangible Assets) Nine commenters 
responded to the Board's first question regarding whether certain 
identifiable intangible assets acquired in a nontaxable business 
combination accounted for as a purchase should be adjusted for the tax 
effect of the difference between the market or appraised value of the 
asset and its tax basis. Under FAS 109, this tax effect is recorded 
separately in a deferred tax liability account, whereas under 
preexisting GAAP, this tax effect reduced the amount of the intangible 
asset. This change in treatment could cause a large increase (i.e., 
gross-up) in the reported amount of certain identifiable intangible 
assets, such as core deposit intangibles, which are deducted for 
purposes of computing regulatory capital.
    Seven commenters indicated that banking organizations should be 
permitted to deduct the net after-tax amount of the intangible asset 
from capital, not the gross amount of the intangible asset. These 
commenters argued that FAS 109 will create artificially high values for 
intangible assets and the related deferred tax liability when a banking 
organization acquires the assets with a carryover basis for tax 
purposes but revalues the asset for financial reporting purposes. The 
commenters generally indicated that, under FAS 109, the balance sheet 
will not accurately reflect the value paid for the intangibles. 
Furthermore, commenters indicated that the increased value of the 
intangible posed no risk to institutions, because a reduction in the 
value of the asset would effectively extinguish the related deferred 
tax liability.
    On the other hand, two commenters indicated that the pretax (gross) 
value of intangible assets should be deducted for regulatory capital 
purposes in this situation. This organization contended that intangible 
assets should be treated similarly to other assets, which are not 
reduced by any related liability.
    Question 2: The Board's second question inquired about (i) the 
potential burden associated with the proposal and whether a limitation 
based on projections of taxable income would be difficult to implement, 
and (ii) the appropriateness of the separate entity method for deferred 
tax assets and tax sharing agreements in general.
    i. Methodology Based on Income Projections. The Board received 
eleven letters from commenters who responded directly to this aspect of 
the question. Four commenters supported using income projections and 
stated that calculating deferred tax asset limitations for capital 
purposes based on projected taxable income would not be difficult to 
implement and would not impose an additional burden because many 
banking organizations already forecast taxable income in order to 
recognize their deferred tax assets. One commenter added that these 
calculations should not pose any problems, provided they are done on a 
consolidated basis. In addition, one commenter suggested that the Board 
clarify the term ``realized within one year'' so that readers 
understand that the phrase means the amount of deferred tax assets that 
could be used to offset income taxes generated in the next 12 months, 
and not the amount of deferred tax assets that actually will be used.
    Four commenters specifically opposed an income approach, citing the 
additional burden that would be created by the detailed calculations. 
One commenter specifically favored implementing the percentage of 
capital method since it is certain and exact and does not involve as 
many estimations or fluctuations as the income approach.
    Five commenters supported an approach based on the financial 
condition of the institution, some of whom also offered support or 
opposition to the income or percentage of capital approach. One 
commenter suggested that ``healthy'' institutions be permitted to 
include deferred tax assets in regulatory capital in an amount based on 
a specified percentage of Tier 1 capital. Another commenter supported 
an approach that excluded ``well capitalized'' banks from the 
limitation. On the other hand, one commenter did not support using an 
approach for calculating the capital limitation based upon the 
perceived ``health'' of the institution, stating that this method could 
lead to arbitrary and inconsistent measures of capital adequacy.
    ii. Separate Entity Approach. Twelve commenters specifically 
addressed this part of the question. Under the Board's proposal, the 
capital limit for deferred tax assets would be determined on a separate 
entity basis for each state member bank so that a bank that is a 
subsidiary of a holding company would be treated as a separate taxpayer 
rather than as part of the consolidated entity. All of the commenters 
opposed the separate entity approach. They argued that the separate 
entity approach is artificial and that tax-sharing agreements between 
financially capable bank holding companies and bank subsidiaries should 
be considered when evaluating the recognition of deferred tax assets 
for regulatory capital purposes. Commenters also stated that the 
separate entity method is unnecessarily restrictive and that any 
systematic and rational method should be permitted for the calculation 
of the limitation for each bank.
    One commenter based its opposition for the separate entity approach 
on the view that the limitation is not consistent with the Board's 1987 
``Policy Statement on the Responsibility of Bank Holding Companies to 
Act as Sources of Strength to Their Subsidiary Banks'' which, in some 
respects, treats a controlled group as one entity. Another commenter 
contended that the effect of a separate entity calculation would be to 
reduce bank capital which is needed for future lending which would be 
inconsistent with the March 10, 1993, ``Interagency Policy Statement on 
Credit Availability''. The same commenter also noted that the 
regulatory burden and cost of calculating the deferred tax asset on a 
separate entity basis would be substantial for both bankers and 
regulators.
    Question 3: The Board's third question addressed three specific 
provisions of the proposal. These provisions included (i) requiring tax 
planning strategies to be part of an institution's projection of 
taxable income for the next year, (ii) requiring organizations to 
assume that all temporary differences fully reverse at the report date, 
and (iii) permitting the grandfathering of amounts previously reported 
if they were in excess of the proposed limitation.
    i. Inclusion of Tax Planning Strategies. Two commenters addressed 
this issue. Both commenters stated that they support including tax 
planning strategies in an institution's projection of taxable income. 
One commenter stated that the proposal should be modified to permit 
institutions to consider strategies that would ensure realization of 
deferred tax assets within the one-year time frame. The proposal 
provided that organizations should consider tax planning strategies 
that would realize tax carryforwards or net operating losses that would 
otherwise expire during that time frame.
    ii. Temporary Differences. Four commenters specifically addressed 
this aspect of the question, and all agreed that it is appropriate to 
require the assumption that all temporary differences fully reverse as 
of the report date. One commenter noted that this assumption would 
eliminate the burden of scheduling the ``turnaround'' of temporary 
differences.
    iii. Grandfathering. Five commenters discussed the proposal's 
provision on grandfathering which would allow the amount of any 
deferred tax assets reported as of September 1992 in excess of the 
limit to be phased out over a two year period ending in 1994. Four 
commenters offered support for grandfathering but argued that excess 
deferred tax assets should be grandfathered until the underlying 
temporary differences reversed, rather than be phased out over two 
years. The other commenter disagreed with the grandfathering proposal 
and stated that such provisions would be inconsistent with the 
proposal's capital adequacy objectives.

III. Final Amendment to the Capital Adequacy Guidelines

A. Limitation on Deferred Tax Assets

    Consistent with the FFIEC's recommendation and the Board's 
proposal, the Board is limiting in regulatory capital deferred tax 
assets that are dependent on future taxable income to the lesser of:
    i. The amount of such deferred tax assets that the institution 
expects to realize within one year of the quarter-end report date, 
based on its projection of taxable income (exclusive of net operating 
loss or tax credit carryforwards and reversals of existing temporary 
differences), or
    ii. 10 percent of Tier 1 capital, net of goodwill and all 
identifiable intangible assets other than purchased mortgage servicing 
rights and purchased credit card relationships (and before any 
disallowed deferred tax assets are deducted).
    Deferred tax assets that can be realized from taxes paid in prior 
carryback years and from future reversals of existing taxable temporary 
differences are generally not limited under the final rule. The 
reported amount of deferred tax assets, net of its valuation allowance, 
in excess of the limitation would be deducted from Tier 1 capital for 
purposes of calculating both the risk-based and leverage capital 
ratios. Banking organizations should not include the amount of 
disallowed deferred tax assets in weighted-risk assets in the risk-
based capital ratio and should deduct the amount of disallowed deferred 
tax assets from average total assets in the leverage capital ratio. 
Deferred tax assets included in capital continue to be assigned a risk 
weight of 100 percent.
    To determine the limit, a banking organization should assume that 
all existing temporary differences fully reverse as of the report date. 
Also, estimates of taxable income for the next year should include the 
effect of tax planning strategies the organization is planning to 
implement to realize net operating losses or tax credit carryforwards 
that will otherwise expire during the year. Consistent with FAS 109, 
the Board believes tax planning strategies are carried out to prevent 
the expiration of such carryforwards. Both of these requirements are 
consistent with the proposal.
    The capital limitation is intended to balance the Board's continued 
concerns about deferred tax assets that are dependent upon future 
taxable income against the fact that such assets will, in many cases, 
be realized. This approach generally permits full inclusion of deferred 
tax assets potentially recoverable from carrybacks, since these amounts 
will generally be realized. This approach also includes those deferred 
tax assets that are dependent upon future taxable income, if they can 
be recovered from projected taxable income during the next year. The 
Board is limiting projections of future taxable income to one year 
because, in general, the Board believes that organizations are 
generally capable of making projections of taxable income for the 
following twelve month period that have a reasonably good probability 
of being achieved. However, the reliability of projections tends to 
decrease significantly beyond that time period. Deferred tax assets 
that are dependent upon future taxable income are further limited to 10 
percent of Tier 1 capital, since the Board believes such assets should 
not comprise a large portion of an organization's capital base given 
the uncertainty of realization associated with these assets and the 
difficulty in selling these assets apart from the organization. 
Furthermore, a 10% capital limit also reduces the risk that an overly 
optimistic estimate of future taxable income will cause the bank to 
significantly overstate the value of deferred tax assets.
    Banking organizations already follow FAS 109 for regulatory reports 
and accordingly, are making projections of taxable income. Banking 
organizations already report in regulatory reports the amount of 
deferred tax assets that would be disallowed under the proposal. In 
addition, the 10 percent calculation of Tier 1 capital is 
straightforward. Therefore, the Board believes that banking 
organizations will have little difficulty implementing this final rule.

B. Guidance on Specific Implementation Issues

    In response to the comments received and after discussions with the 
other agencies, the Board is providing the following guidance.
    Originating Temporary Differences--Consistent with the Board's 
proposal, the final rule does not specify how the provision for loan 
and lease losses and other originating temporary differences should be 
treated for purposes of projecting taxable income for the next year. 
Banking organizations routinely prepare income forecasts for future 
periods and, in theory, income forecasts for book income should be 
adjusted for originating temporary differences in arriving at a 
projection of taxable income. On the other hand, requiring such 
adjustments adds complexity to the final rule. Furthermore, deductible 
originating temporary differences, such as the provision for loan and 
lease losses, generally would lead to additional deferred tax assets. 
Thus, arguably, such temporary differences should not be added back to 
book income in determining the amount of deferred tax assets that will 
be realized. Accordingly, the Board is permitting each institution to 
decide whether or not to adjust projected book income for originating 
temporary differences. While the Board is not specifying a single 
treatment on originating temporary differences in the final rule, 
institutions should follow a reasonable and consistent approach.
    Gross-up of Intangibles--As noted above, FAS 109 could lead to a 
large increase (i.e., gross-up) in the reported amount of certain 
intangible assets, such as core deposit intangibles, which are deducted 
for purposes of computing regulatory capital. Commenters stated that 
the increased value of an intangible posed no risk to institutions, 
because a reduction in the value of the asset would effectively 
extinguish the related deferred tax liability. The Board concurs with 
this position and, consequently, will permit, for capital adequacy 
purposes, netting of deferred tax liabilities arising from this gross-
up effect against related intangible assets. To ensure this benefit is 
not double counted, a deferred tax liability netted in this manner 
could not also be netted against deferred tax assets when determining 
the amount of deferred tax assets that are dependent upon future 
taxable income. Netting will not be permitted against purchased 
mortgage servicing rights (PMSRs) and purchased credit card 
relationships (PCCRs), since only the portion of these assets that 
exceed specified capital limits are deducted for capital adequacy 
purposes.
    Leveraged Leases--While not expected to significantly affect many 
banking organizations, one commenter stated that future net tax 
liabilities related to leveraged leases acquired in a purchase business 
combination are included in the valuation of the leveraged lease and 
are not shown on the balance sheet as deferred tax liabilities. This 
artificially increases the amount of deferred tax assets for those 
institutions that acquire a leveraged lease portfolio. Thus, this 
commenter continued, the future taxes payable included in the valuation 
of a leveraged lease portfolio in a purchase business combination 
should be treated as a taxable temporary difference whose reversal 
would support the recognition of deferred tax assets, if applicable. 
The Board agrees with this commenter and, therefore, banking 
organizations may use the deferred tax liabilities that are embedded in 
the carrying value of a leveraged lease to reduce the amount of 
deferred tax assets subject to the capital limit.
    Tax Jurisdictions--Unlike the proposal, the final rule does not 
require an institution to determine its limitation on deferred tax 
assets on a jurisdiction-by-jurisdiction basis. While such an approach 
may theoretically be more accurate, the Board does not believe the 
greater precision that would be achieved in mandating such an approach 
outweighs the complexities involved and its inherent cost to 
institutions. Thus, banking organizations may make projections of their 
taxable income on an organization-wide basis and use a combined tax 
rate for purposes of calculating the one-year limitation.
    Timing--Institutions may use the future taxable income projections 
for their current fiscal year (adjusted for any significant changes 
that have occurred or are expected to occur) when applying the capital 
limit at an interim report date rather than preparing a new projection 
each quarter. Several commenters requested this treatment because it 
reduces the frequency with which banking organizations are required to 
revise their estimate of future taxable income.
    Available for Sale Securities--Under FASB Statement No. 115, 
``Accounting for Certain Investments in Debt and Equity Securities'' 
(FAS 115), ``available-for-sale'' securities are reported in regulatory 
reports at market value, and unrealized gains and losses on such 
securities are included, net of tax effects, in a separate component of 
stockholders equity. These tax effects may increase or decrease the 
amount of deferred tax assets an institution reports.
    The Board has recently decided to exclude from regulatory capital 
the amount of net unrealized gains and losses on available for sale 
securities (except net unrealized losses of available-for-sale equity 
securities with readily determinable fair values) (59 FR 63241, 
December 8, 1994). Thus, excluding for capital adequacy purposes 
deferred tax effects arising from reporting unrealized holding gains 
and losses on available-for-sale securities is consistent with the 
regulatory capital treatment for such gains and losses. On the other 
hand, requiring the exclusion of such deferred tax effects would add 
significant complexity to the capital guidelines and in most cases 
would not have a significant impact on regulatory capital ratios.
    Therefore, when determining the capital limit for deferred tax 
assets, the Board has decided to permit, but not require, institutions 
to adjust the reported amount of deferred tax assets for any deferred 
tax assets and liabilities arising from marking-to-market available-
for-sale debt securities for regulatory reporting purposes. This choice 
will reduce implementation burden for institutions not wanting to 
contend with the complexity arising from such adjustments, while 
permitting those institutions that want to achieve greater precision to 
make such adjustments. Institutions must follow a consistent approach 
with respect to such adjustments.
    Separate Entity Method--The proposed capital limit was to be 
determined on a separate entity basis for each state member bank. Use 
of a separate entity approach on income tax sharing agreements 
(including intercompany tax payments and current and deferred taxes) is 
generally required by the Board's 1978 Policy Statement on 
Intercorporate Income Tax Accounting Transactions of Bank Holding 
Companies and State Member Banks, and similar policies are followed by 
the other banking agencies. Thus, any change to the separate entity 
approach for deferred tax assets would also need to consider changes to 
this policy statement, which is outside the scope of this rulemaking. 
The Board notes that regulatory reports of banks are generally required 
to be filed using a separate entity approach and consistency between 
the reports would be reduced if the Board permitted institutions to use 
other methods for calculating deferred tax assets in addition to a 
separate entity approach. Thus, while a number of the commenters 
suggested that the Board consider permitting other approaches, the 
Board will generally require the separate entity approach.\3\
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    \3\State member banks should project taxable income for the 
bank, generally on a consolidated basis including subsidiaries of 
the bank. Bank holding companies should project taxable income for 
the holding company, generally on a consolidated basis including 
bank and non-bank subsidiaries of the holding company.
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    As proposed, the final rule contains an exception to the separate 
entity approach when a state member bank's parent holding company does 
not have the financial capability to reimburse the bank for tax 
benefits derived from the bank's carryback of net operating losses or 
tax credits. In these cases, the amount of carryback potential the bank 
may consider in calculating the capital limit on deferred tax assets is 
limited to the lesser amount which it could reasonably expect to have 
refunded by its parent.
    Grandfathering--The proposal would grandfather any deferred tax 
assets reported as of September 1992 in excess of the proposed limit, 
but would require that such excess amounts be phased out over a two 
year period ending in 1994. Since all grandfathered amounts are now 
fully amortized, the Board's final rule does not include any 
grandfathering provision.

IV. Regulatory Flexibility Act Analysis

    The Board does not believe that the adoption of this final rule 
will have a significant economic impact on a substantial number of 
small business entities (in this case, small banking organizations), in 
accordance with the spirit and purposes of the Regulatory Flexibility 
Act (5 U.S.C. 601 et seq.). In this regard, the vast majority of small 
banking organizations currently have very limited amounts of net 
deferred tax assets, which are the subject of this proposal, as a 
component of their capital structures. In addition, this final rule, in 
combination with the adoption by the Board of FAS 109 for regulatory 
reporting purposes, allows many organizations to increase the amount of 
deferred tax assets they include in regulatory capital. Moreover, 
because the risk-based and leverage capital guidelines generally do not 
apply to bank holding companies with consolidated assets of less than 
$150 million, this proposal will not affect such companies. The Board 
did not receive any comment letters specifically addressing regulatory 
flexibility concerns, and therefore, no alternatives to the proposal 
were considered to address regulatory flexibility.

V. 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 of the Riegle Community Development and Regulatory 
Improvement Act of 1994 (Pub. L. 103-325, 108 Stat. 2160) provides that 
the federal banking agencies must consider the administrative burdens 
and benefits of any new regulation that impose additional requirements 
on insured depository institutions. Section 302 also requires such a 
rule to take effect on the first day of the calendar quarter following 
final publication of the rule, unless the agency, for good cause, 
determines an earlier effective date 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 is amending 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), 321-338, 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-l, and 78w; 31 U.S.C. 5318.

    2. Appendix A to part 208 is amended by adding a new paragraph (iv) 
to the introductory text of Section II.B. to read as follows:

Appendix A to Part 208--Capital Adequacy Guidelines for State Member 
Banks: Risk-Based Measure

* * * * *
    II. * * *
    B. * * *
    (iv) Deferred tax assets--portions are deducted from the sum of 
core capital elements in accordance with section II.B.4. of this 
Appendix A.
* * * * *
    3. Appendix A to Part 208 is amended by:
    a. Revising footnote 19 in section II.B.3.;
    b. Removing footnote 20 from the end of section II.B.3.; and
    c. Adding section II.B.4.
    The additions and revisions read as follows:

* * * * *
    II. * * *
    B. * * *
    3. * * *\19\* * *
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    \1\9Deductions of holdings of capital securities also would not 
be made in the case of interstate ``stake out'' investments that 
comply with the Board's Policy Statement on Nonvoting Equity 
Investments, 12 CFR 225.143 (Federal Reserve Regulatory Service 4-
172.1; 68 Federal Reserve Bulletin 413 (1982)). In addition, 
holdings of capital instruments issued by other banking 
organizations but taken in satisfaction of debts previously 
contracted would be exempt from any deduction from capital. The 
Board intends to monitor nonreciprocal holdings of other banking 
organizations' capital instruments and to provide information on 
such holdings to the Basle Supervisors' Committee as called for 
under the Basle capital framework.
---------------------------------------------------------------------------

    4. Deferred tax assets. The amount of deferred tax assets that 
are dependent upon future taxable income, net of the valuation 
allowance for deferred tax assets, that may be included in, that is, 
not deducted from, a bank's capital may not exceed the lesser of: 
(i) the amount of these deferred tax assets that the bank is 
expected to realize within one year of the calendar quarter-end 
date, based on its projections of future taxable income for that 
year,\20\ or (ii) 10 percent of tier 1 capital. For purposes of 
calculating this limitation, Tier 1 capital is defined as the sum of 
core capital elements, net of goodwill and all identifiable 
intangible assets other than purchased mortgage servicing rights and 
purchased credit card relationships (and before any disallowed 
deferred tax assets are deducted). The amount of deferred tax assets 
that can be realized from taxes paid in prior carryback years and 
from future reversals of existing taxable temporary differences and 
that do not exceed the amount which the bank could reasonably expect 
to have refunded by its parent (if applicable) generally are not 
limited. The reported amount of deferred tax assets, net of any 
valuation allowance for deferred tax assets, in excess of these 
amounts is to be deducted from a bank's core capital elements in 
determining tier 1 capital.
---------------------------------------------------------------------------

    \20\Projected future taxable income should not include net 
operating loss carryforwards to be used during that year or the 
amount of existing temporary differences a bank expects to reverse 
within the year. Such projections should include the estimated 
effect of tax planning strategies that the organization expects to 
implement to realize net operating losses or tax credit 
carryforwards that would otherwise expire during the year. 
Institutions may use the future taxable income projections for their 
current fiscal year (adjusted for any significant changes that have 
occurred or are expected to occur) when applying the capital limit 
at an interim report date rather than preparing a new projection 
each quarter. To determine the limit, an institution should assume 
that all existing temporary differences fully reverse as of the 
report date.
---------------------------------------------------------------------------

* * * * *
    4. Appendix B to part 208 is revised to read as follows:

Appendix B to Part 208--Capital Adequacy Guidelines for State Member 
Banks: Tier 1 Leverage Measure

I. Overview

    a. The Board of Governors of the Federal Reserve System has 
adopted a minimum ratio of tier 1 capital to total assets to assist 
in the assessment of the capital adequacy of state member banks.\1\ 
The principal objective of this measure is to place a constraint on 
the maximum degree to which a state member bank can leverage its 
equity capital base. It is intended to be used as a supplement to 
the risk-based capital measure.
---------------------------------------------------------------------------

    \1\Supervisory risk-based capital ratios that related capital to 
weighted-risk assets for state member banks are outlined in Appendix 
A to this part.
---------------------------------------------------------------------------

    b. The guidelines apply to all state member banks on a 
consolidated basis and are to be used in the examination and 
supervisory process as well as in the analysis of applications acted 
upon by the Federal Reserve. The Board will review the guidelines 
from time to time and will consider the need for possible 
adjustments in light of any significant changes in the economy, 
financial markets, and banking practices.

II. The Tier 1 Leverage Ratio

    a. The Board has established a minimum level of tier 1 capital 
to total assets of 3 percent. An institution operating at or near 
these levels is expected to have well-diversified risk, including no 
undue interest-rate risk exposure; excellent asset quality; high 
liquidity; and good earnings; and in general be considered a strong 
banking organization, rated composite 1 under CAMEL rating system of 
banks. Institutions not meeting these characteristics, as well as 
institutions with supervisory, financial, or operational weaknesses, 
are expected to operate well above minimum capital standards. 
Institutions experiencing or anticipating significant growth also 
are expected to maintain capital ratios, including tangible capital 
positions, well above the minimum levels. For example, most such 
banks generally have operated at capital levels ranging from 100 to 
200 basis points above the stated minimums. Higher capital ratios 
could be required if warranted by the particular circumstances or 
risk profiles of individual banks. Thus for all but the most highly 
rated banks meeting the conditions set forth above, the minimum tier 
1 leverage ratio is to be 3 percent plus an additional cushion of a 
least 100 to 200 basis points. In all cases, banking institutions 
should hold capital commensurate with the level and nature of all 
risks, including the volume and severity of problem loans, to which 
they are exposed.
    b. A bank's tier 1 leverage ratio is calculated by dividing its 
tier 1 capital (the numerator of the ratio) by its average total 
consolidated assets (the denominator of the ratio). The ratio will 
also be calculated using period-end assets whenever necessary, on a 
case-by-case basis. For the purpose of this leverage ratio, the 
definition of tier 1 capital for year-end 1992 as set forth in the 
risk-based capital guidelines contained in Appendix A of this part 
will be used.\2\ As a general matter, average total consolidated 
assets are defined as the quarterly average total assets (defined 
net of the allowance for loan and lease losses) reported on the 
bank's Reports of Condition and Income (Call Report), less goodwill; 
amounts of purchased mortgage servicing rights and purchased credit 
card relationships that, in the aggregate, are in excess of 50 
percent of tier 1 capital; amounts of purchased credit card 
relationships in excess of 25 percent of tier 1 capital; all other 
intangible assets; any investments in subsidiaries or associated 
companies that the Federal Reserve determines should be deducted 
from tier 1 capital; and deferred tax assets that are dependent upon 
future taxable income, net of their valuation allowance, in excess 
of the limitation set forth in section II.B.4 of this Appendix A.\3\
---------------------------------------------------------------------------

    \2\At the end of 1992, Tier 1 capital for state member banks 
includes common equity, minority interest in the equity accounts of 
consolidated subsidiaries, and qualifying noncumulative perpetual 
preferred stock. In addition, as a general matter, Tier 1 capital 
excludes goodwill; amounts of purchased mortgage servicing rights 
and purchased credit card relationships that, in the aggregate, 
exceed 50 percent of Tier 1 capital; amounts of purchased credit 
card relationships that exceed 25 percent of Tier 1 capital; all 
other intangible assets; and deferred tax assets that are dependent 
upon future taxable income, net of their valuation allowance, in 
excess of certain limitations. The Federal Reserve may exclude 
certain investments in subsidiaries or associated companies as 
appropriate.
    \3\Deductions from Tier 1 capital and other adjustments are 
discussed more fully in section II.B. in Appendix A of this part.
---------------------------------------------------------------------------

    c. Whenever appropriate, including when a bank is undertaking 
expansion, seeking to engage in new activities or otherwise facing 
unusual or abnormal risks, the Board will continue to consider the 
level of an individual bank's tangible tier 1 leverage ratio (after 
deducting all intangibles) in making an overall assessment of 
capital adequacy. This is consistent with the Federal Reserve's 
risk-based capital guidelines an long-standing Board policy and 
practice with regard to leverage guidelines. Banks experiencing 
growth, whether internally or by acquisition, are expected to 
maintain strong capital position substantially above minimum 
supervisory levels, without significant reliance on intangible 
assets.

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(i), 3106, 3108, 3310, 3331-3351, 3907, and 
3909.
    2. Appendix A to part 225 is amended by adding a new paragraph (iv) 
to the introductory text of section II.B. to read as follows:

Appendix A to Part 225--Capital Adequacy Guidelines for Bank Holding 
Companies: Risk-Based Measure

* * * * *
    II. * * *
    B. * * *
    (iv) Deferred tax assets--portions are deducted from the sum of 
core capital elements in accordance with section II.B.4. of this 
Appendix A.
* * * * *
    3. Appendix A to part 225 is amended by:
    a. Revising footnote 22 in section II.B.3.;
    b. Removing footnote 23 from the end of section II.B.3. and;
    c. Adding section II.B.4.
    The revisions and additions read as follows:
* * * * *
    II. * * *
    B. * * *
    3. * * *\22\* * *
---------------------------------------------------------------------------

    \22\Deductions of holdings of capital securities also would not 
be made in the case of interstate ``stake out'' investments that 
comply with the Board's Policy Statement on Nonvoting Equity 
Investments, 12 CFR 225.143 (Federal Reserve Regulatory Service 4-
172.1; 68 Federal Reserve Bulletin 413 (1982)). In addition, 
holdings of capital instruments issued by other banking 
organizations but taken in satisfaction of debts previously 
contracted would be exempt from any deduction from capital. The 
Board intends to monitor nonreciprocal holdings of other banking 
organizations' capital instruments and to provide information on 
such holdings to the Basle Supervisors' Committee as called for 
under the Basle capital framework.
---------------------------------------------------------------------------

    4. Deferred tax assets. The amount of deferred tax assets that 
are dependent upon future taxable income, net of the valuation 
allowance for deferred tax assets, that may be included in, that is, 
not deducted from, a banking organization's capital may not exceed 
the lesser of: (i) the amount of these deferred tax assets that the 
banking organization is expected to realize within one year of the 
calendar quarter-end date, based on its projections of future 
taxable income for that year,\23\ or (ii) 10 percent of tier 1 
capital. For purposes of calculating this limitation, tier 1 capital 
is defined as the sum of core capital elements, net of goodwill and 
all identifiable intangible assets other than purchased mortgage 
servicing rights and purchased credit card relationships (and before 
any disallowed deferred tax assets are deducted). The amount of 
deferred tax assets that can be realized from taxes paid in prior 
carryback years and from future reversals of existing taxable 
temporary differences generally are not limited. The reported amount 
of deferred tax assets, net of any valuation allowance for deferred 
tax assets, in excess of these amounts is to be deducted from a 
banking organization's core capital elements in determining tier 1 
capital.
---------------------------------------------------------------------------

    \23\Projected future taxable income should not include net 
operating loss carryforwards to be used during that year or the 
amount of existing temporary differences a bank holding company 
expects to reverse within the year. Such projections should include 
the estimated effect of tax planning strategies that the 
organization expects to implement to realize net operating loss or 
tax credit carryforwards that will otherwise expire during the year. 
Banking organizations may use the future taxable income projections 
for their current fiscal year (adjusted for any significant changes 
that have occurred or are expected to occur) when applying the 
capital limit at an interim report date rather than preparing a new 
projection each quarter. To determine the limit, a banking 
organization should assume that all existing temporary differences 
fully reverse as of the report date.
---------------------------------------------------------------------------

* * * * *
    4. Appendix D to part 225 is revised to read as follows:

Appendix D to Part 225--Capital Adequacy Guidelines for Bank Holding 
Companies: Tier 1 Leverage Measure

I. Overview

    a. The Board of Governors of the Federal Reserve System has 
adopted a minimum ratio of tier 1 capital to total assets to assist 
in the assessment of the capital adequacy of bank holding companies 
(banking organizations).\1\ The principal objectives of this measure 
is to place a constraint on the maximum degree to which a banking 
organization can leverage its equity capital base. It is intended to 
be used as a supplement to the risk-based capital measure.
---------------------------------------------------------------------------

    \1\Supervisory ratios that related capital to total assets for 
state member banks are outlined in Appendix B of this part.
---------------------------------------------------------------------------

    b. The guidelines apply to consolidated basis to banking holding 
companies with consolidated assets of $150 million or more. For bank 
holding companies with less that $150 million in consolidated 
assets, the guidelines will be applied on a bank-only basis unless 
(i) the parent bank holding company is engaged in nonbank activity 
involving significant leverage\2\ or (ii) the parent company has a 
significant amount of outstanding debt that is held by the general 
public.
---------------------------------------------------------------------------

    \2\A parent company that is engaged is significant off balance 
sheet activities would generally be deemed to be engaged in 
activities that involve significant leverage.
---------------------------------------------------------------------------

    c. The tier 1 leverage guidelines are to be used in the 
inspection and supervisory process as well as in the analysis of 
applications acted upon by the Federal Reserve. The Board will 
review the guidelines from time to time and will consider the need 
for possible adjustments in light of any significant changes in the 
economy, financial markets, and banking practices.

II. The Tier 1 Leverage Ratio

    a. The Board has established a minimum level of tier 1 capital 
to total assets of 3 percent. A banking organization operating at or 
near these levels is expected to have well-diversified risk, 
including no undue interest-rate risk exposure; excellent asset 
quality; high liquidity; and good earnings; and in general be 
considered a strong banking organization, rated composite 1 under 
BOPEC rating system of bank holding companies. Organizations not 
meeting these characteristics, as well as institutions with 
supervisory, financial, or operational weaknesses, are expected to 
operate well above minimum capital standards. Organizations 
experiencing or anticipating significant growth also are expected to 
maintain capital ratios, including tangible capital positions, well 
above the minimum levels. For example, most such banks generally 
have operated at capital levels ranging from 100 to 200 basis points 
above the stated minimums. Higher capital ratios could be required 
if warranted by the particular circumstances or risk profiles of 
individual banking organizations. Thus for all but the most highly 
rated banks meeting the conditions set forth above, the minimum tier 
1 leverage ratio is to be 3 percent plus an additional cushion of a 
least 100 to 200 basis points. In all cases, banking organizations 
should hold capital commensurate with the level and nature of all 
risks, including the volume and severity of problem loans, to which 
they are exposed.
    b. A banking organization's tier 1 leverage ratio is calculated 
by dividing its tier 1 capital (the numerator of the ratio) by its 
average total consolidated assets (the denominator of the ratio). 
The ratio will also be calculated using period-end assets whenever 
necessary, on a case-by-case basis. For the purpose of this leverage 
ratio, the definition of tier 1 capital for year-end 1992 as set 
forth in the risk-based capital guidelines contained in Appendix A 
of this part will be used.\3\ As a general matter, average total 
consolidated assets are defined as the quarterly average total 
assets (defined net of the allowance for loan and lease losses) 
reported on the organization's Consolidated Financial Statements (FR 
Y-9C Report), less goodwill; amounts of purchased mortgage servicing 
rights and purchased credit card relationships that, in the 
aggregate, are in excess of 50 percent of tier 1 capital; amounts of 
purchased credit card relationships in excess of 25 percent of tier 
1 capital; all other intangible assets; any investments in 
subsidiaries or associated companies that the Federal Reserve 
determines should be deducted from tier 1 capital; and deferred tax 
assets that are dependent upon future taxable income, net of their 
valuation allowance, in excess of the limitation set forth in 
section II.B.4 of this Appendix A.\4\
---------------------------------------------------------------------------

    \3\At the end of 1992, Tier 1 capital for state member banks 
includes common equity, minority interest in the equity accounts of 
consolidated subsidiaries, and qualifying noncumulative perpetual 
preferred stock. In addition, as a general matter, Tier 1 capital 
excludes goodwill; amounts of purchased mortgage servicing rights 
and purchased credit card relationships that, in the aggregate, 
exceed 50 percent of Tier 1 capital; amounts of purchased credit 
card relationships that exceed 25 percent of Tier 1 capital; all 
other intangible assets; and deferred tax assets that are dependent 
upon future taxable income, net of their valuation allowance, in 
excess of certain limitations. The Federal Reserve may exclude 
certain investments in subsidiaries or associated companies as 
appropriate.
    \4\Deductions from Tier 1 capital and other adjustments are 
discussed more fully in section II.B. in Appendix A of this part.
---------------------------------------------------------------------------

    c. Whenever appropriate, including when an organization is 
undertaking expansion, seeking to engage in new activities or 
otherwise facing unusual or abnormal risks, the Board will continue 
to consider the level of an individual organization's tangible tier 
1 leverage ratio (after deducting all intangibles) in making an 
overall assessment of capital adequacy. This is consistent with the 
Federal Reserve's risk-based capital guidelines an long-standing 
Board policy and practice with regard to leverage guidelines. 
Organizations experiencing growth, whether internally or by 
acquisition, are expected to maintain strong capital position 
substantially above minimum supervisory levels, without significant 
reliance on intangible assets.

    By order of the Board of Governors of the Federal Reserve 
System, December 16, 1994.
William W. Wiles,
Secretary of the Board
[FR Doc. 94-31441 Filed 12-21-94; 8:45 am]
BILLING CODE 6210-01-P