[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