[Federal Register Volume 65, Number 60 (Tuesday, March 28, 2000)]
[Proposed Rules]
[Pages 16480-16483]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-7148]



  Federal Register / Vol. 65, No. 60 / Tuesday, March 28, 2000 / 
Proposed Rules  

[[Page 16480]]


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FEDERAL RESERVE SYSTEM

12 CFR Part 225

Regulation Y; Docket No. R-1067


Bank Holding Companies and Change in Bank Control

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Proposed rule with request for public comments.

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SUMMARY: The Board of Governors of the Federal Reserve System, in 
consultation with the Secretary of the Treasury, solicits comment on a 
proposal that would govern the regulatory capital treatment of certain 
investments in nonfinancial companies by bank holding companies. This 
proposal would amend the Board's consolidated capital guidelines for 
bank holding companies to apply a 50 percent capital charge to all 
investments made, directly or indirectly, by a bank holding company in 
nonfinancial companies under the merchant banking authority of the Bank 
Holding Company Act (BHC Act), in nonfinancial companies under the 
Board's Regulation K, under the Federal Deposit Insurance Act, through 
small business investment companies (whether controlled by the bank 
holding company or by a subsidiary depository institution), or under 
the BHC Act in less than 5 percent of the shares of a nonfinancial 
company.
    This proposal is a supplement to an interim rule (with request for 
public comment) that governs merchant banking investments made by 
financial holding companies. That interim rule is published separately 
and implements provisions of the recently enacted Gramm-Leach-Bliley 
Act (GLB Act) that permit financial holding companies to make 
investments in nonfinancial companies as part of a bona fide securities 
underwriting or merchant or investment banking activity. The capital 
proposal described below is being published for comment and, unlike the 
interim rule on merchant banking investments, is not being made 
effective on an interim basis. During the comment period, the Board and 
the Secretary will discuss issues raised by this proposal with the 
other Federal banking agencies and with other appropriate functional 
regulators.
    Comment is invited on all aspects of the proposed rule, and the 
Board will revise the final rule as appropriate in response to comments 
received. The Board expects to complete this rulemaking on capital 
treatment expeditiously.

DATES: Comments must be received on the capital proposal by May 22, 
2000.

ADDRESSES: Comments should refer to docket number R-1067 and should be 
sent to Ms. Jennifer J. Johnson, Secretary, Board of Governors of the 
Federal Reserve System, 20th Street and Constitution Avenue, N.W., 
Washington, D.C. 20551 (or mailed electronically to 
[email protected]). Comments addressed to Ms. Johnson 
also may be delivered to the Board's mail room between the hours of 
8:45 a.m. and 5:15 p.m. and, outside of those hours, to the Board's 
security control room. Both the mail room and the security control room 
are accessible from the Eccles Building courtyard entrance, located on 
20th Street between Constitution Avenue and C Street, N.W. Members of 
the public may inspect comments in Room MP-500 of the Martin Building 
between 9:00 a.m. and 5:00 p.m. on weekdays.

FOR FURTHER INFORMATION CONTACT: Scott G. Alvarez, Associate General 
Counsel (202/452-3583), Kieran J. Fallon, Senior Counsel (202/452-
5270), or Camille M. Caesar, Senior Attorney (202/452-3513), Legal 
Division; Jean Nellie Liang, Chief, Capital Markets (202/452-2918), 
Division of Research & Statistics; Michael G. Martinson, Deputy 
Associate Director (202/452-3640) or James A. Embersit, Manager, 
Capital Markets (202/452-5249), Division of Banking Supervision and 
Regulation; Norah M. Barger, Assistant Director, Supervisory Policies 
and Procedures, Division of Banking Supervision and Regulation; Board 
of Governors of the Federal Reserve System, 20th Street and 
Constitution Avenue, N.W., Washington, D.C. 20551. Users of 
Telecommunications Device for the Deaf (TDD) only contact Janice Simms 
at (202) 872-4984.

SUPPLEMENTARY INFORMATION:  

A. Background

    Section 103(a) of the GLB Act (Pub. L. 106-102, 113 Stat. 1338 
(1999)) added a new section 4(k)(4)(H) to the BHC Act (12 U.S.C. 
1843(k)(4)(H)) that authorizes financial holding companies to acquire 
or control shares, assets or ownership interests of any nonfinancial 
company as part of a bona fide underwriting or merchant or investment 
banking activity (merchant banking investments).

Interviews With Securities Firms and Bank Holding Companies

    In order to gather information about how firms currently reserve 
capital against merchant banking investments, staff of the Federal 
Reserve System and the Department of the Treasury conducted interviews 
with a number of securities firms that currently make in merchant 
banking investments. System staff and Treasury staff also interviewed 
several bank holding companies that engage in more limited types of 
investment activities under existing authority. The attached rule 
reflects information collected in these interviews and the experience 
of the System staff and Treasury staff in supervising the more limited 
types of investment activities permissible for bank holding companies.
    Securities firms and bank holding companies uniformly indicated 
that they apply higher internal capital charges against merchant 
banking investments than are applied to many other types of activities. 
The industry practice regarding the appropriate internal measures of 
capital required to support merchant banking activities reflects the 
greater risks associated with these investments, including the 
volatility and illiquidity of many investments and the higher leverage 
often associated with companies in which such investments are made. 
Firms that make merchant banking investments impose internal capital 
charges that differ by firm and, in some cases, by type of investment. 
These capital charges range from 25 percent to 100 percent of the 
investment. Firms typically record investments initially at the lower 
of cost or market. Investments may be assigned an adjusted carrying 
value if a significant event occurs (such as an initial public 
offering, follow-up financing, or secondary capital raising events), 
subject to a discount that reflects the size of the firm's holding, the 
liquidity of the market for the shares held, the volatility of the 
market and other factors and that is applied prior to recognizing any 
unrealized gains on the investment.
    The proposal reflects industry practices in conducting merchant 
banking activities. The information about industry practice collected 
during the interviews is discussed more fully in connection with the 
interim rule implementing the merchant banking investment authority.
    The Board and the Secretary view this capital proposal as a 
precaution that is necessary to prevent the buildup within banking 
organizations of excessive risk from merchant banking and other 
investment activities. In developing this proposal, they have 
considered the effect of the proposal on the existing activities of 
bank holding companies.
    The Board welcomes comments on all aspects of the proposed rule. 
These

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comments will be carefully considered before promulgation of a final 
rule.

B. Proposed Rule

    As discussed above, many firms that make merchant banking 
investments and engage in other types of investment activities 
internally allocate capital to these investments in amounts that are 
higher than the amounts of capital allocated to most banking assets due 
to the greater risk, illiquidity and volatility of merchant banking and 
similar investments and the higher leverage that often is associated 
with portfolio companies. The internal capital allocation for these 
investments is generally many multiples of the current regulatory 
capital charge.
    After consideration of the industry practice, the Board, in 
consultation with the Secretary, is proposing to modify the methods of 
calculating the risk-weighted and leverage capital ratios for bank 
holding companies to reflect the risk profiles of these investment 
activities. The Board is authorized by the BHC Act and other provisions 
of law to promulgate rules, including capital standards, consistent 
with the requirements and purposes of the BHC Act and other provisions.
    Under the proposal, a bank holding company would be required to 
deduct from its Tier 1 regulatory capital an amount equal to 50 percent 
of the total carrying value, as reflected on consolidated financial 
statements of the bank holding company, of all merchant banking 
investments held by the bank holding company. The total carrying value 
of any merchant banking investment subject to this capital deduction is 
excluded from the bank holding company's assets for purposes of 
calculating the asset denominator of the risk-based and leverage 
capital ratios.\1\
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    \1\ Some investments are booked using ``available for sale'' 
(AFS) accounting. Under this accounting treatment, unrealized gains 
are not recognized as net income and flow to a special segregated 
equity account that is not recognized as Tier 1 capital by the 
regulatory agencies. Under the current bank holding company rules, 
45 percent of the gain on AFS equity securities may be included in 
Tier 2 capital. This proposal would continue this treatment but 
further require deduction from Tier 1 capital of 50 percent of the 
reported cost (or fair value if lower for equity securities) of 
merchant banking investments recorded as AFS. The reported cost or 
fair value of these investments would be deducted from risk-weighted 
and average consolidated assets.
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    The capital charge applies to all investments that would be 
considered to be equity of the nonfinancial company and all debt 
instruments that are convertible into equity. It also applies to all 
debt extended by a bank holding company to a nonfinancial company in 
which the financial holding company owns 15 percent or more of the 
total equity. The proposal contains exceptions for short-term secured 
loans for working capital purposes; for debt if at least 50 percent of 
the initial principal balance has been syndicated to third parties; for 
loans that are guaranteed by the United States government; and for 
extensions of credit by an insured depository institution controlled by 
the financial holding company that are collateralized in accordance 
with the requirements of section 23A of the Federal Reserve Act (12 
U.S.C. 371c) and that meet the other requirements of that section.
    The proposal would also apply the same capital treatment to 
investments held in nonfinancial companies under Regulation K, in less 
than 5% of the shares of any company under section 4(c)(6) or 4(c)(7) 
of the BHC Act, through a small business investment company (SBIC) that 
is controlled by the bank holding company or a subsidiary depository 
institution, or held by a state bank subsidiary in accordance with 
section 24 of the Federal Deposit Insurance Act. This capital treatment 
would not apply to investments that are held in a trading account in 
accordance with applicable accounting principles and that are part of 
an underwriting, market making or dealing activity.
    The proposal applies this capital treatment to nonfinancial 
investment activities described above for several reasons. Importantly, 
the risks associated with these investment activities do not vary 
according to the authority used to conduct the activity. Thus, similar 
investment activities should be given the same capital treatment 
regardless of the source of legal authority to make the investment. 
Moreover, current regulatory capital treatment, which applies an 8% 
minimum capital charge to these investments, was developed at a time 
when the investment activities of banking organizations were relatively 
small. In recent years, some bank holding companies have greatly 
expanded the level of their investment activities. The proposal 
reflects the judgment that it is appropriate at this time, when the 
investment authority of banking organizations has also been greatly 
expanded, to revisit and revise regulatory capital treatment for all 
investment activities.
    The Board and the Secretary view this capital proposal as a 
precaution that is necessary to prevent the development within banking 
organizations of excessive risk from merchant banking and other 
investment activities. In developing this proposal, they have 
considered the effect of the proposal on the existing activities of 
bank holding companies. The Board and the Secretary also note that the 
proposed capital treatment is similar to the approach to capital 
sufficiency that the Federal Deposit Insurance Corporation has adopted 
under section 24 of the Federal Deposit Insurance Act for investments 
in subsidiaries that engage in principal activities that are not 
permissible for a national bank.
    As an initial matter, adoption of the capital proposal would not 
prevent any holding company from becoming or remaining a financial 
holding company or from taking advantage of the new powers granted 
under the GLB Act. The capital charge would be applied only at the 
holding company level on the consolidated organization. Consequently, 
the capital proposal would not affect the capital levels of any 
depository institution--which, under the GLB Act, determine whether a 
company qualifies to be a financial holding company--controlled by a 
bank holding company.
    In addition, the Board and the Secretary have reviewed a sampling 
of call reports of bank holding companies engaged currently in 
significant investment activities, including companies that are likely 
to seek to become financial holding companies. This review indicates 
that, with virtually no exception, bank holding companies would remain 
well capitalized on a consolidated basis even after applying the 
proposed capital charge to all of the investments currently made by 
these companies. Moreover, nearly all of these companies would be able 
to increase significantly their level of investment activity and 
continue to be well capitalized on a consolidated basis after applying 
the proposed capital charge.
    For these reasons, the capital proposal is not expected to have a 
significant effect on the level of investment activities conducted by 
bank holding companies. The capital proposal would, however, help to 
limit the potential harm to bank holding companies and depository 
institutions controlled by bank holding companies from the risks 
associated with investment activities.
    The capital charge would not be applied to investments made by 
insurance company subsidiaries of financial holding companies held in 
accordance with section 4(k)(4)(I) of the BHC Act. The Board expects 
soon to seek comments on a proposal to de-consolidate functionally 
regulated insurance underwriting companies from the financial holding 
company for purposes of applying the Board's

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consolidated capital rules. The proposal would take account of the 
different accounting standards, business practices, and capital and 
supervisory regimes that apply to insurance underwriting companies.
    The Board and the Secretary recognize that the new authority 
accorded financial holding companies under the GLB Act may raise the 
possibility of arbitrage between an insurance company and its financial 
holding company affiliates designed to avoid the capital charges 
proposed for merchant banking and other investments. The Board and the 
Secretary seek comment on whether provisions should be included in the 
final capital rule that would apply to investments made through an 
insurance company the same capital charge at the holding company level 
as would be applied to merchant banking and other investments if the 
Board finds that such arbitrage is occurring within a particular 
holding company. The Board and the Secretary also invite comment on 
whether there are other mechanisms that would prevent such arbitrage.
    During the period prior to adoption of a final capital rule, 
financial holding companies that engage in merchant banking activities 
will be expected to adopt and implement internal capital and accounting 
policies that reflect the liquidity, market and other risks associated 
with the company's investment activities. An initial criterion for 
these internal capital and accounting policies is that they be capable 
of enabling the financial holding company to meet the terms of the 
proposed capital rule on its effective date with minimal adjustment and 
remain in compliance with applicable regulatory capital standards. 
Moreover, the Board and the Secretary do not intend to encourage 
behavior that is different than conservative industry practice and 
expect to monitor capital treatment of merchant banking activities 
carefully.
    Comment is invited on all aspects of the capital charge, including 
the appropriateness of a separate capital charge for investment 
activities under different authorities, the amount of the charge, and 
whether the charge should apply to the exclusions outlined. In 
particular, comment is invited on how, if at all, the charge differs 
from the internal capital charges imposed on investment activities by 
firms that conduct merchant banking and other investment activities. In 
addition, comment is sought on whether a different approach to the 
capital treatment would more accurately reserve for the risks of 
merchant banking and other investment activities. Moreover, comment is 
invited on the interaction between the capital sufficiency proposal and 
the investment thresholds for aggregate merchant banking activities 
discussed in the related interim rule governing merchant banking 
investments.
    Comment also is invited on the manner in which the capital charge 
is applied to debt extended to portfolio companies in which a financial 
holding company has made investments. In addition, comment is requested 
on whether other methods would be more appropriate for assuring that an 
organization does not use an extension of credit that functions like 
equity as a means of evading the capital charge.
    Comment is requested on whether an exclusion from the proposed 
capital treatment, or a lesser capital charge, should be established 
for investments in less than 5 percent of the securities or assets of a 
nonfinancial company that is publicly held and in which there is a 
ready market. In addition, the Board seeks comment on whether the 
proposed capital treatment or a lesser capital charge should apply to 
merchant banking investments that do not result in a financial holding 
company's control of the merchant banking investment.

Regulatory Flexibility Act Analysis

    In accordance with section 3(a) of the Regulatory Flexibility Act 
(5 U.S.C. 603(a)), the Board must publish an initial regulatory 
flexibility analysis with this rulemaking. The rule proposes and 
requests comment on amendments to the Board's consolidated risk-based 
and Tier 1 leverage capital adequacy guidelines for bank holding 
companies (Part 225, Appendix A and D). These amendments would 
establish the regulatory capital requirements applicable to the 
merchant banking investments of financial holding companies and similar 
investment activities of bank holding companies. The proposed capital 
amendments generally would not apply to financial or bank holding 
companies with consolidated assets of less than $150 million and, thus, 
are not likely to have a significant economic impact on a substantial 
number of small entities (i.e., holding companies with less than $100 
million in assets). The Board believes the proposed amendments to its 
capital guidelines are necessary and appropriate to ensure that bank 
holding companies maintain capital commensurate with the level of risks 
associated with their activities and that the investment activities of 
bank holding companies do not pose an undue risk to the safety and 
soundness of affiliated insured depository institutions.
    The Board specifically seeks comment on the likely burden that the 
proposed rule will impose on bank holding companies.

Paperwork Reduction Act

    In accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
3506; 5 CFR 1320 App. A.1), the Board reviewed the proposed rule under 
the authority delegated to the Board by the Office of Management and 
Budget. No collections of information pursuant to the Paperwork 
Reduction Act are contained in the proposed rule.

List of Subjects in 12 CFR Part 225

    Administrative practice and procedure, Banks, banking, Federal 
Reserve System, Holding companies, Reporting and recordkeeping 
requirements, Securities.

    For the reasons set out in the preamble, the Board amends 12 CFR 
part 225 as follows:

PART 225--BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL 
(REGULATION Y)

    1. The authority citation for part 225 is revised to read as 
follows:

    Authority: 12 U.S.C. 1817(j)(13), 1818, 1828(o), 1831i, 1831p-1, 
1843(c)(8), 1843(k), 1844(b), 1972(l), 3106, 3108, 3310, 3331-3351, 
3907, and 3909.

    2. In Appendix A to part 225:
    a. In section II.B., a new paragraph (v) is added at the end of the 
introductory paragraph and a new paragraph 5 is added at the end of 
section II.B; and
    b. In sections III. and IV., footnotes 24 through 57 are 
redesignated as footnotes 26 through 59.

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

* * * * *
    II. * * *
    B. * * *

    (v) Portfolio investments--deducted from the sum of core capital 
elements in the manner described below.
* * * * *
    5. Portfolio investments. a. Fifty percent (50%) of the value of 
all portfolio investments made by the parent bank holding company or 
by its direct or indirect subsidiaries must be deducted from the 
consolidated parent banking organization's core capital components.
    b. A portfolio investment is any merchant banking investment 
made directly or indirectly by the bank holding company pursuant to 
section 4(k)(4)(H) of the Bank Holding Company (BHC) Act and subpart 
J of Regulation Y, and any investment made

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directly or indirectly by the bank holding company in a nonfinancial 
company pursuant to section 4(c)(6) or 4(c)(7) of the BHC Act, 
Sec. 211.5(b)(1)(iii) of the Board's Regulation K, or section 302(b) 
of the Small Business Investment Act of 1958, or in accordance with 
section 24 of the Federal Deposit Insurance Act.\24\ A nonfinancial 
company is an entity that engages in any activity that has not been 
determined to be financial in nature or incidental to financial 
activities under section 4(k) of the Bank Holding Company Act.
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    \24\ See 12 U.S.C. 1843(c)(6), (c)(7) and (k)(4)(H); 12 CFR 
211.5(b)(1)(iii); 15 U.S.C. 682(b); 12 U.S.C. 1831a.
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    c. The deduction applies to all merchant banking investments 
made under section 4(k)(4)(H) of the BHC Act and all investments 
made in nonfinancial companies under the other authorities listed 
above, regardless of whether the investment is held by the bank 
holding company, a depository institution subsidiary of the bank 
holding company, or a direct or indirect subsidiary of either. For 
example, a portfolio investment includes any investment in a private 
equity fund under section 4(k)(4)(H) of the BHC Act, any 
nonfinancial investment made by a small business investment company 
(SBIC) subsidiary of the bank holding company, and any nonfinancial 
investment made by an Edge or Agreement Corporation subsidiary of 
the holding company under Sec. 211.5(b)(1)(iii) of the Board's 
Regulation K.
    d. For this purpose, an investment includes any equity 
instrument and any debt instrument with equity features (such as 
conversion rights, warrants or call options). If the bank holding 
company owns or controls 15 percent or more of the company's total 
equity, the term also includes any other debt instrument held by the 
bank holding company or any subsidiary, except for any short-term, 
secured extension of credit provided for working capital purposes, 
any extension of credit by an insured depository institution that is 
collateralized in accordance with the requirements of section 23A of 
the Federal Reserve Act (12 U.S.C. 371c) and that meets the other 
requirements of that section; any extension of credit at least 50 
percent of which is sold or participated out to unaffiliated persons 
on the same terms and conditions that applied to the initial credit, 
and any extension of credit that is guaranteed by the U.S. 
government.
    This provision does not apply to investments that are held in 
the trading account in accordance with applicable accounting 
principles and that are held as part of an underwriting, market 
making or dealing activity.
    f. For portfolio investments that are reported at cost, under 
the equity method, or at fair value with unrealized gains (or 
losses) included in earnings, the deduction is equal to 50 percent 
of the carrying value of the investment. For available-for-sale 
portfolio investments reported at fair value with unrealized gains 
(or losses) included in other comprehensive income, the amount of 
the deduction is equal to 50 percent of the reported cost of the 
investment.\25\ Any unrealized gains on available-for-sale 
investments are not to be included in core capital, but may be 
included in supplementary capital to the extent permitted under 
section II.A.2.e of this Appendix.
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    \25\ For available-for-sale equity investments where fair value 
is less than historical cost, the amount of the deduction is equal 
to 50 percent of reported fair value. The unrealized losses on such 
investments are deducted from core capital in accordance with 
section II.A.1.a of this Appendix.
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    g. For portfolio investments in a company that is consolidated 
for accounting purposes, the deduction is equal to 50 percent of the 
parent banking organization's investment in the company as 
determined under the equity method of accounting (net of any 
intangibles associated with the investment that are deducted from 
the consolidated bank holding company's core capital in accordance 
with section II.B.1 of this Appendix). The company remains fully 
consolidated for purposes of determining the banking organization's 
risk-weighted assets.
    h. The value of any portfolio investment subject to the 
deduction described in this paragraph that is not consolidated for 
accounting purposes is excluded from the bank holding company's 
weighted risk assets for purposes of computing the denominator of 
the company's risk-based capital ratio. For available-for-sale 
portfolio investments, this exclusion applies to the investment's 
reported cost or, in the case of equity investments when fair value 
is less than historical cost, reported fair value.
* * * * *
    3. In Appendix D to part 225, in section II.b., footnote 3 is 
revised and the fourth sentence of section II.b. is revised to read as 
follows:

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

* * * * *
    II. * * *

    b. * * * \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 mortgage servicing assets, nonmortgage 
servicing assets, and purchased credit card relationships that, in 
the aggregate, are in excess of 100 percent of Tier 1 capital; 
amounts of nonmortgage servicing assets and purchased credit card 
relationships that, in the aggregate, are in excess of 25 percent of 
Tier 1 capital; all other identifiable intangible assets; deferred 
tax assets that are dependent upon future taxable income, net of 
their valuation allowance, in excess of the limitations set forth in 
section II.B.4 of Appendix A of this part; portfolio investments; 
and other investments in subsidiaries or associated companies that 
the Federal Reserve determines should be deducted from Tier 1 
capital.

    \3\ Tier 1 capital for banking organizations includes common 
equity, minority interest in the equity accounts of consolidated 
subsidiaries, qualifying noncumulative perpetual preferred stock, 
and qualifying cumulative perpetual preferred stock. (Cumulative 
perpetual preferred stock is limited to 25 percent of Tier 1 
capital.) In addition, as a general matter, Tier 1 capital excludes 
goodwill; amounts of mortgage servicing assets, nonmortgage 
servicing assets, and purchased credit card relationships that, in 
the aggregate, exceed 100 percent of Tier 1 capital; nonmortgage 
servicing assets and purchased credit card relationships that, in 
the aggregate, exceed 25 percent of Tier 1 capital; all other 
identifiable intangible assets; deferred tax assets that are 
dependent upon future taxable income, net of their valuation 
allowance, in excess of certain limitations; and 50 percent of the 
value of portfolio investments. The Federal Reserve may exclude 
certain other investments in subsidiaries or associated companies as 
appropriate.

    By order of the Board of Governors of the Federal Reserve 
System, March 17, 2000.
Robert deV. Frierson,
Associate Secretary of the Board.
[FR Doc. 00-7148 Filed 3-27-00; 8:45 am]
BILLING CODE 6210-01-U