[Federal Register Volume 75, Number 130 (Thursday, July 8, 2010)]
[Proposed Rules]
[Pages 39392-39411]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2010-16457]



[[Page 39391]]

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Part IV





Farm Credit Administration





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12 CFR Part 615



Funding, Fiscal Affairs, Loan Policies and Funding Operations; Proposed 
Rule

  Federal Register / Vol. 75, No. 130 / Thursday, July 8, 2010 / 
Proposed Rules  

[[Page 39392]]


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FARM CREDIT ADMINISTRATION

12 CFR Part 615

RIN 3052-AC61


Funding and Fiscal Affairs, Loan Policies and Operations, and 
Funding Operations; Capital Adequacy; Capital Components--Basel Accord 
Tier 1 and Tier 2

AGENCY: Farm Credit Administration.

ACTION: Advance notice of proposed rulemaking.

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SUMMARY: The Farm Credit Administration (FCA or we) is considering the 
promulgation of Tier 1 and Tier 2 capital standards for Farm Credit 
System (FCS or System) institutions. The Tier 1/Tier 2 capital 
structure would be similar to the capital tiers delineated in the Basel 
Accord that the other Federal financial regulatory agencies have 
adopted for the banking organizations they regulate. We are seeking 
comments to facilitate the development of this regulatory capital 
framework, including new minimum risk-based and leverage ratio capital 
requirements that take into consideration both the System's cooperative 
structure of primarily wholesale banks owned by retail lender 
associations that are, in turn, owned by their member borrowers, and 
the System's status as a Government-sponsored enterprise.

DATES: You may send comments on or before November 5, 2010.

ADDRESSES: There are several methods for you to submit your comments. 
For accuracy and efficiency reasons, commenters are encouraged to 
submit comments by e-mail or through the FCA's Web site. As facsimiles 
(faxes) are difficult for us to process and achieve compliance with 
section 508 of the Rehabilitation Act (29 U.S.C. 794d), we are no 
longer accepting comments submitted by fax. Regardless of the method 
you use, please do not submit your comment multiple times via different 
methods. You may submit comments by any of the following methods:
     E-mail: Send us an e-mail at [email protected].
     FCA Web site: http://www.fca.gov. Select ``Public 
Commenters,'' then ``Public Comments,'' and follow the directions for 
``Submitting a Comment.''
     Federal E-Rulemaking Web site: http://www.regulations.gov. 
Follow the instructions for submitting comments.
     Mail: Send mail to Gary K. Van Meter, Deputy Director, 
Office of Regulatory Policy, Farm Credit Administration, 1501 Farm 
Credit Drive, McLean, VA 22102-5090.
    You may review copies of comments we receive at our office in 
McLean, Virginia, or on our Web site at http://www.fca.gov. Once you 
are in the Web site, select ``Public Commenters,'' then ``Public 
Comments,'' and follow the directions for ``Reading Submitted Public 
Comments.'' We will show your comments as submitted, but for technical 
reasons we may omit items such as logos and special characters. 
Identifying information that you provide, such as phone numbers and 
addresses, will be publicly available. However, we will attempt to 
remove e-mail addresses to help reduce Internet spam.

FOR FURTHER INFORMATION CONTACT:
Laurie Rea, Associate Director, Office of Regulatory Policy, Farm 
Credit Administration, McLean, VA 22102-5090, (703) 883-4232, TTY (703) 
883-4434, or
Chris Wilson, Policy Analyst, Office of Regulatory Policy, Farm Credit 
Administration, McLean, VA 22102-5090, (703) 883-4204, TTY (703) 883-
4434, or
Rebecca S. Orlich, Senior Counsel, Office of General Counsel, Farm 
Credit Administration, McLean, VA 22102-5090, (703) 883-4020, TTY (703) 
883-4020.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Objective
II. Summary and List of Questions
    A. Introduction
    B. The Farm Credit System
    C. The FCA's Current Capital Regulations
    D. List of Questions
III. The Tier 1/Tier 2 Capital Framework Under Consideration by the 
FCA and Associated Questions
    A. The Tier 1/Tier 2 Capital Structure Within a Broader Context
    1. Discussion of Bank and Association Differences
    2. Limits and Minimums
    3. The Permanent Capital Standard
    B. The Individual Components of Tier 1 and Tier 2 Capital
    1. Tier 1 Capital Components
    2. Tier 2 Capital Components
    C. Regulatory Adjustments
IV. Additional Background
    A. The October 2007 ANPRM
    B. Description of FCA's Current Capital Requirements
    C. Overview of the Tier 1/Tier 2 Capital Framework
    1. The Current Tier 1/Tier 2 Capital Framework
    2. Proposed Changes to the Current Tier 1/Tier 2 Framework

I. Objective

    The objective of this advance notice of proposed rulemaking (ANPRM) 
is to seek public comments to help us formulate proposed regulations 
that would:
    1. Promote safe and sound banking practices and a prudent level of 
regulatory capital for System institutions;
    2. Minimize differences, to the extent appropriate, in regulatory 
capital requirements between System institutions \1\ and federally 
regulated banking organizations; \2\
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    \1\ For the purposes of this ANPRM, ``System institutions'' 
include System banks and associations but do not include service 
organizations or the Federal Agricultural Mortgage Corporation 
(Farmer Mac).
    \2\ Banking organizations include commercial banks, savings 
associations, and their respective holding companies.
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    3. Improve the transparency of System capital for System 
stockholders, investors, and the public; and
    4. Foster economic growth in agriculture and rural America through 
the effective allocation of System capital.

II. Summary and List of Questions

A. Introduction

    In October 2007, the FCA published an ANPRM on the risk weighting 
of assets--the denominator in our risk-based core surplus, total 
surplus, and permanent capital ratios; a possible leverage ratio, and a 
possible early intervention framework (October 2007 ANPRM).\3\ The 
comment letter we received in December 2008 from the Federal Farm 
Credit Banks Funding Corporation on behalf of the System (System 
Comment Letter) focused primarily on the numerators of those regulatory 
capital ratios.\4\ The System urged us to replace the core surplus and 
total surplus capital standards with a ``Tier 1/Tier 2'' capital 
framework consistent with the Basel Accord (Basel I) and the other 
Federal financial regulatory agencies' (FFRAs \5\) guidelines to help 
provide a level playing field for the System in competing with 
commercial banks in accessing the capital markets. Furthermore, the 
System recommended that we replace our net collateral ratio (NCR), 
which is applicable only to

[[Page 39393]]

banks, with a non-risk-based leverage ratio applicable to all System 
institutions. We have responded to a number of issues and comments 
raised in the System Comment Letter in drafting this ANPRM.
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    \3\ 72 FR 61568 (October 31, 2007).
    \4\ Comment letter dated December 19, 2008, from Jamie Stewart, 
President and CEO, Federal Farm Credit Banks Funding Corporation, on 
behalf of the System. This letter and its attachments are available 
in the ``Public Comments'' section under ``Capital Adequacy--Basel 
Accord--ANPRM'' at http://www.fca.gov.
    \5\ We refer collectively to the Office of the Comptroller of 
the Currency (OCC), the Board of Governors of the Federal Reserve 
System (FRB), the Federal Deposit Insurance Corporation (FDIC), and 
the Office of Thrift Supervision (OTS) as the other ``Federal 
financial regulatory agencies'' or FFRAs.
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    Basel I is a two-tiered capital framework for measuring capital 
adequacy that was first published in 1988 by the Basel Committee on 
Banking Supervision.\6\ Tier 1 capital, or core capital, consists of 
the highest quality capital elements that are permanent, stable, and 
immediately available to absorb losses and includes common stock, 
noncumulative perpetual stock, and retained earnings. Tier 2 capital, 
or supplementary capital, includes general loan-loss reserves, hybrid 
instruments such as cumulative stock and perpetual debt, and 
subordinated debt. Basel I established a minimum 4-percent Tier 1 risk-
based capital ratio and an 8-percent total risk-based capital ratio 
(Tier 1 + Tier 2).
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    \6\ Basel I has been updated several times since 1988. The Basel 
Committee's documents are available at http://www.bis.org/bcbs/index/htm.
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    In December 2009, the Basel Committee published a consultative 
document (Basel Consultative Proposal) that proposes fundamental 
reforms to the current Tier 1/Tier 2 capital framework.\7\ The Basel 
Committee's primary aims are to improve the banking sector's ability to 
absorb shocks arising from financial and economic stress, to mitigate 
spillover risk from the financial sector to the broader economy, and to 
increase bank transparency and disclosures. The Basel Committee intends 
to develop a set of new capital and liquidity standards by the end of 
2010 to be phased in by the end of 2012. Although the FFRAs have 
discretion whether or not to adopt the new standards, they are members 
of the Basel Committee and have encouraged the public to review and 
comment on the Basel Committee's proposals. Consequently, we believe it 
is important for the FCA to consider the Basel Consultative Proposal in 
formulating new capital standards for System institutions, and we 
encourage commenters on our ANPRM also to review and consider the Basel 
Committee's proposals.
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    \7\ ``Basel Consultative Proposals to Strengthen the Resilience 
of the Banking Sector,'' December 17, 2009. The document is 
available at http://www.bis.org/publ/bcbs164.htm.
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B. The Farm Credit System

    The Farm Credit System (FCS or System) is a federally chartered 
network of borrower-owned lending cooperatives and related service 
organizations. Cooperatives are organizations that are owned and 
controlled by their members who use the cooperatives' products or 
services. The System was created by Congress in 1916 as a farm real 
estate lender and was the first Government-sponsored enterprise (GSE); 
in subsequent years, Congress expanded the System to include production 
credit, cooperative, rural housing, and other types of lending. The 
mission of the FCS is to provide sound and dependable credit to its 
member borrowers, who are American farmers, ranchers, producers or 
harvesters of aquatic products, their cooperatives, and certain farm-
related businesses and rural utility cooperatives. The FCA is the 
System's independent Federal regulator that examines and regulates 
System institutions for safety and soundness and mission compliance. 
The System's enabling statute is the Farm Credit Act of 1971, as 
amended (Act).\8\
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    \8\ 12 U.S.C. 2001-2279cc. The Act is available at http://www.fca.gov under ``FCA Handbook.''
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    The System is composed of 88 associations that are direct retail 
lenders; four Farm Credit Banks that are primarily wholesale lenders to 
the associations; an Agricultural Credit Bank (CoBank, ACB) that makes 
retail loans to cooperatives as well as wholesale loans to 
associations; and a few service organizations.\9\ Each System bank has 
a district, or lending territory, which includes the territories of the 
affiliated associations that it funds; CoBank, in addition, lends to 
cooperatives nationwide. There are currently two types of System 
association structures: Agricultural credit associations (ACAs) that 
are holding companies with subsidiary production credit associations 
(PCAs) and Federal land credit associations (FLCAs), and stand-alone 
FLCAs. PCAs make short- and intermediate-term operating or production 
or rural housing loans, and FLCAs make real estate mortgage loans and 
long-term rural housing loans. ACAs have the authorities of both PCAs 
and FLCAs.
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    \9\ This is the System's structure as of April 30, 2010. Farmer 
Mac, which is a corporation and federally chartered instrumentality, 
is also an institution in the System. The FCA has a separate set of 
capital regulations that apply to Farmer Mac, and the questions in 
this ANPRM do not pertain to Farmer Mac's regulations.
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    The five banks collectively own the Federal Farm Credit Banks 
Funding Corporation (Funding Corporation), which is the fiscal agent 
for the System banks and is responsible for issuing and marketing 
Systemwide debt securities in domestic and global capital markets. The 
proceeds from the securities are used by the banks to fund their 
lending and other operations, and the banks are jointly and severally 
liable on the debt.

C. The FCA's Current Capital Regulations

    The FCA currently has three risk-based minimum capital standards: A 
3.5-percent core surplus ratio (CSR), a 7-percent total surplus ratio 
(TSR), and a 7-percent permanent capital ratio (PCR).\10\ Congress 
added a definition of ``permanent capital'' to the Act in 1988 and 
required the FCA to adopt risk-based permanent capital standards for 
System institutions. The FCA adopted permanent capital regulations in 
1988 and, in 1997, added core surplus and total surplus capital 
standards for banks and associations, as well as a non-risk-based net 
collateral ratio (NCR) for banks.\11\ Since then, we have made only 
minor changes to these regulations.
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    \10\ See 12 CFR 615.5201-5216 and 615.5301-5336.
    \11\ See 53 FR 39229 (October 6, 1988) and 63 FR 39229 (July 22, 
1998).
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    Permanent capital is defined primarily by statute and includes 
current earnings, unallocated and allocated earnings, stock (other than 
stock retirable on repayment of the holder's loan or at the discretion 
of the holder, and certain stock issued before October 1988), surplus 
less allowance for losses, and other debt or equity instruments that 
the FCA determines appropriate to be considered permanent capital. Core 
surplus contains the highest quality capital, similar (but not 
identical) to Basel I's Tier 1 capital and generally consists of 
unallocated retained earnings, certain allocated surplus, and 
noncumulative perpetual preferred stock less, for associations, the 
association's net investment in its affiliated bank. Total surplus 
generally contains most of the components of permanent capital but 
excludes stock held by borrowers as a condition of obtaining a loan and 
certain other instruments that are routinely and frequently retired by 
institutions.
    Section IV of this ANPRM provides more detailed information for 
readers who are not familiar with our regulatory capital requirements; 
the FCA's October 2007 ANPRM and comments; and Basel I and the Basel 
Consultative Proposal.

D. List of Questions

    This ANPRM poses questions on the possible promulgation of 
regulatory capital standards based on Basel I and the FFRAs' guidelines 
while keeping in mind the reforms being proposed by the Basel 
Committee. It is tailored to account for the member-owner cooperative 
structure and GSE mission of the System. The questions are listed

[[Page 39394]]

below and followed by a full discussion in Section III.
    1. We seek comments on the different ways System banks and 
associations retain and distribute capital, how their borrowers 
influence the System institution's retention and distribution of 
capital, and how such differences should be captured in a new 
regulatory capital framework. Should we adopt separate and tailored 
regulatory capital standards for banks and associations? Why or why 
not?
    2. We seek comments on ways to address bank and association 
interdependent relationships in the new regulatory capital framework. 
Should we establish an upper Tier 1 minimum standard for banks and 
associations? Why or why not? If so, what capital items should be 
included in upper Tier 1, and should bank requirements differ from 
association requirements?
    3. We seek comments on ways to ensure that the majority of Tier 1 
and total capital is retained earnings and capital held by or allocated 
to an institution's borrowers. Should we establish specific regulatory 
restrictions on third-party capital? Why or why not? If so, should 
there be different restrictions for banks and associations?
    4. We seek comments on the role that permanent capital will play in 
a new regulatory capital framework. Should we replace any regulatory 
limits and/or restrictions based on permanent capital with a new limit 
based on Tier 1 or total capital? If so, what should the new limits 
and/or restrictions be? Also, we ask for comments on how, or whether, 
to reconcile the sum of Tier 1 and Tier 2 (e.g., total capital) with 
permanent capital.
    5. We seek comments on other types of allocated surplus or stock in 
the System that could be considered unallocated retained earnings (URE) 
equivalents under a new regulatory capital framework. We ask commenters 
to explain how these other types of allocated surplus or stock are 
equivalent to URE.
    6. We seek comments on ways to limit reliance on noncumulative 
perpetual preferred stock (NPPS) as a component included in Tier 1 
capital while avoiding the downward spiral effect that can occur when 
other elements of Tier 1 capital decrease.
    7. We seek comments to help us develop a capital regulatory 
mechanism that would allow System institutions to include allocated 
surplus and member stock in Tier 1 capital. Using the table titled 
``System Institutions Capital Distributions Restrictions and Reporting 
Requirements'' as an example, what risk metrics would be appropriate to 
classify a System institution as Category 1, Category 2, or Category 3? 
What percentage ranges would be appropriate for each risk metric under 
each category? We also seek comments on the increased restrictions and/
or reporting requirements listed in Category 2 and Category 3.
    8. We seek comments on whether the FCA should count a portion of 
the allowance for loan losses (ALL) as regulatory capital. We also seek 
information on how losses for unfunded commitments equate to ALL and 
why they should be included as regulatory capital. We ask commenters to 
take into consideration the Basel Consultative Proposal and any recent 
changes to FFRA regulations in relation to the amount or percentage of 
ALL includible in Tier 2 capital.
    9. We seek comments on the treatment of cumulative perpetual and 
term-preferred stock as Tier 2 capital subject to the same conditions 
imposed by the FFRAs.
    10. We seek comments on authorizing System institutions to include 
a portion of unrealized holding gains on available-for-sale (AFS) 
equity securities as regulatory capital. We ask commenters to provide 
specific examples of how this component of Tier 2 capital would be 
applicable to System institutions.
    11. We seek comments on the treatment of intermediate-term 
preferred stock and subordinated debt as Tier 2 capital and conditions 
for their inclusion in Tier 2 capital.
    12. We seek comments on how to develop a regulatory mechanism to 
make a type of perpetual preferred stock that can be continually 
redeemed (referred to as H stock by most associations that have issued 
it) more permanent and stable so that the stock may qualify as Tier 2 
capital.
    13. We seek comments on the regulatory adjustments in our current 
regulations that we expect to incorporate into the new regulatory 
capital framework. We also seek comments on the regulatory capital 
treatment for positions in securitizations that are downgraded and are 
no longer eligible for the ratings-based approach under the new 
regulatory capital framework.

III. The Tier 1/Tier 2 Capital Framework Under Consideration by the FCA 
and Associated Questions

    The table below displays the possible treatment of the System's 
capital components under a framework that is consistent with the FFRAs' 
current Tier 1/Tier 2 capital framework. We anticipate that the Basel 
Consultative Proposal could lead to significant changes to this 
framework, and we ask commenters to take the Basel Committee's 
proposals into consideration when answering the questions in this 
ANPRM.

------------------------------------------------------------------------
       Capital element                          Comments
------------------------------------------------------------------------
                             Tier 1 Capital
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URE & URE Equivalents........  We may create the term ``URE
                                equivalents'' and ask commenters to help
                                us identify types of allocated surplus
                                and/or stock that would constitute URE
                                equivalents.
Noncumulative Perpetual        We may limit NPPS to an amount less than
 Preferred Stock (NPPS).        50 percent of Tier 1 capital. We seek
                                comments on ways to limit NPPS as Tier 1
                                capital while avoiding the downward
                                spiral effect that can occur when other
                                elements of Tier 1 capital decrease.
Allocated Surplus and Member   We may treat most forms of allocated
 Stock.                         surplus and member stock as Tier 1
                                capital, provided System institutions
                                are subject to a regulatory mechanism
                                that would give the FCA the additional
                                ability to effectively monitor and, if
                                necessary, take actions that would
                                restrict, suspend, or prohibit capital
                                distributions before a System
                                institution reaches its regulatory
                                capital minimums. We ask commenters to
                                help us develop this mechanism.
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                             Tier 2 Capital
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Association's Excess           We may treat the amount of an
 Investment in the Bank.        association's investment that is in
                                excess of its bank requirement, whether
                                counted by the bank or the association,
                                as Tier 2 capital.
Allowance for Loan Losses      We have not determined whether any
 (ALL).                         portion of ALL should be treated as Tier
                                2 capital. We seek comments as to why
                                the FCA should count a portion of ALL as
                                regulatory capital.

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Cumulative Perpetual           We may adopt the definitions, criteria
 Preferred Stock and Long-      and/or limits consistent with future
 Term Preferred Stock.          revisions to the Basel Accord and FFRA
                                guidelines. We also may adopt aggregate
                                third-party capital limits that are
                                unique to the System.
Unrealized Holding Gains on    This element is currently addressed in
 AFS Securities.                the FFRAs' guidelines but is subject to
                                change. We seek comment on the
                                appropriate treatment of this element
                                and specific examples of how this
                                application would affect System
                                institutions.
Intermediate-term Preferred    We may adopt the definitions, criteria
 Stock and Subordinated Debt.   and/or limits consistent with future
                                revisions to the Basel Accord and FFRA
                                guidelines. We also may adopt aggregate
                                third-party capital limits that are
                                unique to the System.
Association Continuously       We view this element as a 1-day term
 Redeemable Preferred Stock.    instrument that would not currently
                                qualify as Tier 1 or Tier 2 capital. We
                                seek comments to help us develop a
                                regulatory mechanism that would make the
                                stock sufficiently permanent to be
                                included in Tier 2 capital.
------------------------------------------------------------------------
                         Regulatory Adjustments
------------------------------------------------------------------------
We may apply most of the deductions currently in our egulations to the
 new regulatory capital ratios. However, in view of the Basel
 Consultative Proposal, we are considering reflecting the net effect of
 accumulated other comprehensive income in the new regulatory capital
 ratios..
------------------------------------------------------------------------

A. The Tier 1/Tier 2 Capital Structure Within a Broader Context

1. Discussion of Bank and Association Differences
    We established core surplus and total surplus standards in 1997 to 
ensure System institutions would have a more stable capital cushion 
that would provide some protection to System institutions, investors, 
and taxpayers; reduce the volatility of capital in relation to borrower 
stock retirements; and ensure that the institutions always maintain a 
sufficient amount of URE to absorb losses. Our determinations were 
influenced, in part, by what we learned in the 1980s when the System 
experienced severe financial problems.\12\ At that time, the System was 
employing an average-cost pricing strategy that caused System loans to 
be priced below rates offered by other lenders when interest rates were 
high (e.g., in the early 1980s) and above rates offered by other 
lenders when interest rates fell (e.g., in the mid-1980s). When the 
System's rates were no longer competitive, many higher quality 
borrowers who could easily find credit elsewhere began to leave the 
System. Those who left early in the crisis were able to have the 
institution retire their stock at par, which at that time was around 5 
to 10 percent of the loan (or some borrowers simply paid down their 
loans to an amount equal to their stock), causing capital and loan 
portfolio quality to drop sharply at many associations.
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    \12\ This discussion presents a simplified explanation of the 
System's financial problems in the 1980s. See 60 FR 38521 (July 27, 
1995) and 61 FR 42092 (August 13, 1996) for a more comprehensive 
discussion. These Federal Register documents are available at http://www.fca.gov. To find them, go to the home page and click on ``Law & 
Regulations,'' then ``FCA Regulations,'' then ``Public Comments,'' 
then ``View Federal Register Documents.''
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    Some association boards had the legal discretion to suspend stock 
retirements but did not do so, perhaps to help their borrowers in times 
of distress but also to avoid sending a message to remaining and 
potential borrowers that borrower stock was risky. The result was that, 
in many cases, these actions left remaining stockholders bearing the 
brunt of more severe association losses. We concluded from these events 
that associations needed to build surplus cushions to be able to 
continue retiring borrower stock on a routine basis and to reduce the 
volatility associated with borrower stock retirements, and our 1997 
regulations have effectively required associations to establish such 
cushions. System banks and associations retain and distribute capital 
differently. For this reason, we will consider whether to establish 
separate and tailored regulatory capital standards for banks and for 
associations as we construct a new regulatory capital framework.
    System banks do not routinely retire their stock in the ordinary 
course of business or revolve surplus in the same manner as 
associations. At the present time, each bank has established a 
``required investment,'' \13\ which may consist of both purchased stock 
and allocated surplus, for each of its affiliated associations.\14\ 
This required investment, which is generally a percentage of the 
association's direct loan outstanding from the bank, can fluctuate 
within a bank board's established range depending upon the bank's 
capital needs. The bank's bylaws usually require an association that 
falls short of the required investment to purchase additional stock in 
the bank.\15\ In most cases, the banks make little distinction between 
purchased stock and allocated surplus.
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    \13\ See Section III.B.1.c. for a more detailed discussion of 
the bank's required investment.
    \14\ We are generalizing about how banks retain and distribute 
capital. In practice, each bank has its own unique policies and 
practices for retaining and distributing capital. For example, one 
bank distributes patronage to its associations in the form of either 
cash or stock, and the associations' investments consist only of 
bank stock. This bank retires its stock over a long period of time, 
depending upon its capital needs.
    \15\ See Section III.B.2.a. for a more detailed discussion of 
the excess investment.
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    Associations make a greater distinction between borrower stock and 
the surplus they allocate to borrowers.\16\ Borrower stock held by 
retail borrowers as a condition of obtaining a loan is routinely 
retired by the association at par when the borrower pays off or pays 
down the loan. Some associations allocate earnings, and others do not. 
Some associations do not have allocated equity revolvement plans and 
distribute patronage only in the form of cash on an annual basis.\17\ 
Other associations do not have allocated equity revolvement plans but 
distribute some patronage in the form of nonqualified or qualified 
allocated equities on a regular basis; they generally determine how 
such equity will be distributed on an ad hoc or annual basis after 
assessing market conditions. Still other associations have equity 
revolvement plans and distribute earnings as either cash or 
nonqualified or qualified allocated equities consistent with the plan; 
however, they have the power to withhold or suspend cash distributions 
to respond to changing economic and financial conditions.
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    \16\ See Section III.B.1.c. for a more detailed discussion of 
association borrower stock and allocated surplus.
    \17\ All associations are required to have capital plans, but 
these plans may or may not include regular allocated equity 
revolvement plans.
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    The cooperative structure and operations of System associations are 
significantly different from a typical corporate structure in that a 
borrower's

[[Page 39396]]

expectation of patronage distributions can and does influence the 
permanency and stability of association stock and allocated surplus. In 
addition, a System bank's retention and distribution of bank stock and 
bank surplus are different from those of associations for a number of 
reasons, including the tax implications and the fact that an 
association cannot easily find debt financing from sources other than 
the bank. We are asking commenters to consider the unique structure and 
practices of System banks and associations, the characteristics and 
expectations of their borrowers, and how such characteristics and 
expectations can impact the stability and permanency of stock and 
surplus.
    Question 1: We seek comments on the different ways System banks and 
associations retain and distribute capital, how their borrowers 
influence the System institution's retention and distribution of 
capital, and how such differences should be captured in a new 
regulatory capital framework. Should we adopt separate and tailored 
regulatory capital standards for banks and associations? Why or why 
not?
2. Limits and Minimums
    The current regulatory capital minimums imposed by the FFRAs 
include a 4-percent Tier 1 risk-based capital ratio, an 8-percent 
minimum total risk-based capital ratio with the amount of Tier 2 
components limited to the amount of Tier 1, and a 4-percent minimum 
Tier 1 non-risk-based leverage ratio. These standards could change as a 
result of efforts to revise the risk-based capital ratios and introduce 
a non-risk-based leverage ratio that may integrate off-balance sheet 
items as outlined in the Basel Consultative Proposal. We are also 
considering an ``upper Tier 1'' minimum consistent with the Basel 
Committee's proposed common equity standard. An upper Tier 1 minimum 
would ensure that the predominant form of a System institution's Tier 1 
capital consists of the highest quality capital elements. Finally, we 
are studying third-party capital limits that take into consideration 
the System's GSE charter and cooperative form of organization.\18\ 
These limits and/or minimums for System banks may differ from the 
limits and minimums for associations.
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    \18\ Third-party capital is capital issued to parties who are 
not borrowers of the System institution and are not other System 
institutions. Existing third-party regulatory capital in System 
institutions includes both preferred stock and subordinated debt.
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a. Upper Tier 1 Minimum
    Upper Tier 1 in a commercial banking context is typically referred 
to as ``tangible common equity''; it is the highest quality portion of 
a commercial bank's Tier 1 capital and consists of common stockholder's 
equity and retained earnings. A commercial bank's upper Tier 1 capital, 
or tangible common equity, is the most permanent and stable capital 
available to absorb losses to ensure it continues as a going concern. 
The FRB's and FDIC's regulatory guidelines state that the dominant form 
of Tier 1 capital should consist of common stockholder's equity and 
retained earnings.\19\ Upper Tier 1 in a System lending institution 
context would not necessarily have the equivalent components of 
tangible common equity at a commercial bank. The FCA's position has 
been that borrower stock and many forms of allocated surplus are 
generally less permanent, stable and available to absorb losses than 
URE and URE equivalents \20\ because suspension of patronage 
distributions and stock retirements can have negative effects on the 
institution's relationship with its existing and prospective customers. 
We currently restrict all forms of allocated equities includible in 
core surplus to 2 percentage points \21\ of the 3.5-percent CSR unless 
a System institution has at least 1.5 percent of uncommitted, 
unallocated surplus and noncumulative perpetual preferred stock.\22\
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    \19\ FRB guidelines for state member banks are in 12 CFR part 
208, App. A, II.A.1. FRB guidelines for bank holding companies 
(BHCs) are in 12 CFR part 225, App. A, II.A.1.c(3). FDIC guidelines 
for state non-member banks are in 12 CFR part 325, App. A, I.A.1(b).
    \20\ URE is earnings not allocated as stock or distributed 
through patronage refunds or dividends. URE equivalents are other 
forms of surplus that have the same or very similar characteristics 
of permanence (i.e., low expectation of redemption), stability and 
availability to absorb losses as URE.
    \21\ In other words, if an institution has at least 1.5 percent 
of uncommitted, unallocated surplus and noncumulative perpetual 
preferred stock, it may include qualifying allocated equities in 
core surplus in excess of 2 percentage points.
    \22\ The NCUA has taken a similar position as it considers 
adopting a Tier 1/Tier 2 regulatory capital framework for the 
institutions it regulates. The NCUA has also proposed a retained 
earnings minimum for corporate credit unions to help prevent the 
downstreaming of the losses to the credit unions they serve. See 74 
FR 65209 (December 9, 2009).
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    As noted above, the Basel Committee is considering establishing a 
new common equity standard \23\ and has described the characteristics 
that instruments must have to qualify as common equity. Instruments 
such as member stock and surplus in cooperative financial institutions 
must also have these characteristics to be included in common equity. 
The FCA will take into account these characteristics as it considers an 
upper Tier 1 standard for System institutions.
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    \23\ See paragraph 87 of the Basel Consultative Proposal.
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    We are also considering an upper Tier 1 minimum to address 
interdependency risk within the System. Because of their financial and 
operational interdependence, financial problems at one System 
institution can spread to other System institutions. An upper Tier 1 
capital requirement could help moderate these interdependent 
relationships if it contains uncommitted, high quality, loss-absorbing 
capital that protects the investors of a System institution from its 
own financial problems as well as from the financial problems of other 
System institutions.
    A commercial bank that needs additional upper Tier 1 capital may 
have the ability to issue additional common stock to investors without 
any direct impact on its customers. System institutions have fewer 
options to increase their highest quality capital, and exercising these 
options could have negative effects on their member borrowers in 
adverse situations. For example, if a System bank suffers severe losses 
and needs to replenish capital, its only options might be to reduce or 
suspend patronage distributions to its affiliated associations or to 
increase its associations' minimum required investments in the bank, or 
both. Since an association depends, to some extent, on the earnings 
distributions it receives from its bank, the association would have 
less income to purchase additional capital to support its struggling 
bank. The association might have to use its earnings from its own 
operations to recapitalize the bank instead of making cash patronage 
distributions to its borrowers or capitalizing new loans. The bank's 
financial weakness could spur the association to try to reaffiliate 
with another System bank; however, as the System Comment Letter points 
out,\24\ associations cannot easily reaffiliate with another funding 
bank or voluntarily liquidate or terminate System status under a 
stressed bank financial scenario. A sufficient amount of upper Tier 1 
capital at the bank that consists of unallocated capital would help 
cushion the bank losses that can negatively impact the associations and 
their borrowers. It would protect the association's investment and 
reduce the likelihood that the bank will raise the association's 
capital requirement at a

[[Page 39397]]

time when the association is least able to afford it.
---------------------------------------------------------------------------

    \24\ See footnote 4 above.
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    Upper Tier 1 requirements at associations would also protect the 
borrowers' investments in the institution. Associations with financial 
problems might not have additional capital to meet the bank's required 
investment, and the bank might, in turn, try to obtain additional 
capital from healthier associations to ensure the bank remains 
adequately capitalized. Because of these interdependent relationships, 
it is possible that weaker associations could pull down healthier 
associations. An adequate amount of upper Tier 1 capital at the 
associations would help protect the borrower's investment from losses 
resulting from these interdependent relationships.
    If the FCA determines that borrower stock and allocated surplus can 
be treated in part or in whole as Tier 1 capital (depending upon 
appropriate regulatory mechanisms as discussed below), we may establish 
an upper Tier 1 minimum at both the banks and the associations to 
protect against systemic risks outside the control of the System 
institution. The upper Tier 1 requirement for System banks might be 
different from the requirement for associations. For example, an upper 
Tier 1 minimum at the banks might include only URE and URE equivalents 
to protect the associations' required investments in the bank. An upper 
Tier 1 minimum at the associations might include some forms of 
allocated surplus but exclude other forms of allocated surplus and most 
or all borrower stock.\25\
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    \25\ We discuss the individual components of System capital in 
more detail below in Section III.B.
---------------------------------------------------------------------------

    Question 2: We seek comments on ways to address bank and 
association interdependent relationships in the new regulatory capital 
framework. Should we establish an upper Tier 1 minimum for banks and 
associations? Why or why not? If so, what capital items should be 
included in upper Tier 1, and should bank requirements differ from 
association requirements?
b. Third-Party Capital Limits
    System institutions capitalize themselves primarily with member 
stock and surplus. System institutions are also authorized to raise 
capital from third-party investors who are not borrowers of the System. 
Third-party capital may include various kinds of hybrid capital 
instruments such as preferred stock and subordinated debt. While 
diverse sources of capital improve a System institution's risk-bearing 
capacity and, to a certain extent, improve corporate governance through 
increased market discipline, the FCA believes that too much third-party 
capital would compromise the cooperative nature and GSE status of the 
System. Consequently, we have imposed limits on the amount of third-
party capital that is includible in a System institution's regulatory 
capital.\26\
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    \26\ The FCA currently limits NPPS to 25 percent of core surplus 
outstanding and imposes aggregate third-party regulatory capital 
limits of the lesser of 40 percent of permanent capital outstanding 
or 100 percent of core surplus outstanding. We also limit the 
inclusion of term preferred stock and subordinated debt to 50 
percent of core surplus outstanding. (Institutions can issue third-
party stock or subordinated debt in excess of these limits but 
cannot count it in their regulatory capital.)
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    The FCA agrees with the position of the Basel Committee that the 
predominant form of capital should be stable, permanent, and of the 
highest quality. While NPPS provides loss absorbency in a going 
concern, it absorbs losses only after member stock and surplus have 
been depleted. Since member stock and surplus rank junior to NPPS, it 
is more difficult for a System institution to raise additional capital 
from its patrons during periods of adversity if it holds a significant 
amount of NPPS. Furthermore, while dividends can be waived and do not 
accumulate to future periods, System bank issuers of NPPS, like 
commercial banks, appear to have strong economic incentives not to 
waive dividends since doing so would send adverse signals to the 
market.\27\ Additionally, unlike customers of commercial banks, the 
customers of System institutions are impacted when System institutions 
are prohibited from paying patronage because they skipped dividends on 
preferred stock. For these reasons, we are considering maintaining 
limits on third-party capital in both Tier 1 and total capital to 
ensure that member stock and surplus remain the predominant form of 
System capital.\28\
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    \27\ Market analysts might perceive a financial institution to 
be in worse financial condition when it waives preferred stock 
dividends, because it implies that the institution has previously 
eliminated its common stock dividends (or, in the case of a 
cooperative, its patronage).
    \28\ See also the discussion in Section III.B.1.b.
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    Question 3: We seek comments on ways we can ensure that the 
majority of Tier 1 and total capital is retained earnings and capital 
held by or allocated to an institution's borrowers. Should we establish 
specific regulatory restrictions on third-party capital? Why or why 
not? If so, should there be different restrictions for banks and 
associations?
3. The Permanent Capital Standard
    Permanent capital is defined by statute to include stock issued to 
System borrowers and others, allocated surplus, URE, and other types of 
debt or equity instruments that the FCA determines is appropriate to be 
considered permanent capital, but expressly excludes ALL.\29\ The Act 
imposes a permanent capital requirement and, therefore, it will remain 
part of the System's regulatory capital framework. The FCA will 
continue to enforce any restrictions or other requirements prescribed 
in the Act relating to the permanent capital standard. (One such 
restriction prohibits a System institution from distributing patronage 
or paying dividends (with specific exceptions) or retiring stock if the 
institution fails to meet its minimum permanent capital standard.) \30\
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    \29\ Section 4.3A(a) of the Act (12 U.S.C. 2154a(a)).
    \30\ Section 4.3A(d) of the Act (12 U.S.C. 2154a(d)). Any System 
institution subject to Federal income tax may pay patronage refunds 
partially in cash as long as the cash portion of the refund is the 
minimum amount required to qualify the refund as a deductible 
patronage distribution for Federal income tax purposes and the 
remaining portion of the refund paid qualifies as permanent capital.
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    Several existing FCA regulations refer to measurements of permanent 
capital outstanding or PCR minimums.\31\ For example, Sec.  614.4351 
sets a lending and leasing base for a System institution equal to the 
amount of the institution's permanent capital outstanding, with certain 
adjustments. Section 615.5270 permits a System institution's board of 
directors to delegate authority to management to retire stock as long 
as the PCR of the institution is in excess of 9 percent after any such 
retirements. Section 627.2710 sets forth the grounds for the 
appointment of a conservator or receiver for System institutions and 
defines a System institution as unsafe and unsound if its PCR is less 
than one-half of the minimum required level (3.5 percent). We could 
retain these regulations in their current form, but it may be more 
appropriate to change any or all of them to fit the new regulatory 
capital framework.
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    \31\ The FCA's regulations are set forth in chapter VI, title 12 
of the Code of Federal Regulations and available on the FCA's Web 
site under ``Laws & Regulations.''
---------------------------------------------------------------------------

    Question 4: We seek comments on the role that permanent capital 
will play in the new regulatory capital framework. Should we replace 
any regulatory limits and/or restrictions based on permanent capital 
with a new limit based on Tier 1 or total capital? If so, what should 
the new limits and/or restrictions be? Also, we ask for comments on 
how, or whether, to reconcile the sum of Tier 1 and Tier 2 (e.g., total 
capital) with permanent capital.

[[Page 39398]]

B. The Individual Components of Tier 1 and Tier 2 Capital

1. Tier 1 Capital Components
    We ask commenters to consider the Basel Consultative Proposal when 
addressing questions 5 through 7 below. The Basel Committee's proposed 
Tier 1 capital would include two basic components: Common equity 
(including current and retained earnings) and additional going-concern 
capital. Common equity must be the predominant form of Tier 1 capital. 
Common equity is, among other things, the highest quality of capital 
that represents the most subordinated claim in liquidation of a bank 
and takes the first and, proportionately, greatest share of losses as 
they occur. The instrument's principal must be perpetual, and the bank 
must do nothing to create an expectation at issuance that the 
instrument will be bought back, redeemed, or canceled. Additional 
going-concern capital is capital that is, among other things, 
subordinated to depositors and/or creditors, has fully discretionary 
noncumulative dividends or coupons, has no maturity date, and has no 
incentive to redeem.\32\
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    \32\ See paragraph 89 of the Basel Consultative Proposal.
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a. URE and URE Equivalents
    URE is current and retained earnings not allocated as stock or 
distributed through patronage refunds or dividends. It is free from any 
specific ownership claim or expectation of allocation, it absorbs 
losses before other forms of surplus and stock, and it represents the 
most subordinated claim in liquidation of a System institution. The FCA 
expects to propose to treat URE as Tier 1 capital under the new 
regulatory capital framework.
    URE equivalents are other forms of surplus that have the same or 
very similar characteristics of permanence (i.e., low expectation of 
redemption) and loss absorption as URE. For example, the System Comment 
Letter recommends treating association and bank nonqualified allocated 
surplus not subject to revolvement (NQNSR) as Tier 1 capital.\33\ In 
the comment letter, the System characterizes NQNSR as allocated equity 
on which the institution is liable for taxes in the year of allocation 
and which the institution does not anticipate redeeming. In addition, 
the institution has not revolved NQNSR outside of the context of 
liquidation, termination, or dissolution. The System explains that the 
``member [is] aware that his ownership interest in the [institution] 
has increased such that, in the event of liquidation of the 
[institution], the member has a larger claim on the excess of assets 
over liabilities.'' The FCA will likely consider such NQNSR to be the 
equivalent of URE and expects to propose to treat it as Tier 1 capital 
under a new regulatory capital framework.
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    \33\ The associations refer to NQNSR in various ways such as 
``nonqualified retained earnings'' or ``nonqualified retained 
surplus.'' The System Comment Letter refers to bank NQNSR as 
``nonqualified allocated stock to cooperatives not subject to 
revolvement.''
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    The System recommends that the FCA treat ``Paid-In Capital 
Surplus'' resulting from an acquisition in a business combination as 
Tier 1 capital. Current accounting guidance for business combinations 
under U.S. generally accepted accounting principles (U.S. GAAP) \34\ 
requires the acquirer in a business combination to use the acquisition 
method of accounting. This accounting guidance applies to System 
institutions and became effective for all business combinations 
occurring on or after January 1, 2009. For transactions accounted for 
under the acquisition method, the acquirer must recognize assets 
acquired, the liabilities assumed and any non-controlling interest in 
the acquired business measured at their fair value at the acquisition 
date. For mutual entities such as System institutions, the acquirer 
must recognize the acquiree's net assets as a direct addition to 
capital or equity in its statement of financial position, not as an 
addition to retained earnings.\35\
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    \34\ On June 30, 2009, the Financial Accounting Standards Board 
(FASB) established the FASB Accounting Standards Codification\TM\ 
(FASB Codification or ASC) as the single source of authoritative 
nongovernmental U.S. GAAP. In doing so, the FASB Codification 
reorganized existing U.S. accounting and reporting standards issued 
by the FASB and other related private-sector standard setters. More 
information about the FASB Codification is available at http://asc.fasb.org/home.
    \35\ This guidance was formerly included in pre-codification 
reference Statement of Financial Accounting Standards (SFAS) No. 
141(R), Business Combinations, and is now incorporated into the FASB 
Codification at ASC Topic 805, Business Combinations.
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    The System provided the FCA with three examples of potential 
acquisitions under FASB guidance on business combinations. In each 
example, the retained earnings of the acquiree are transferred to the 
acquirer as Paid-In Capital Surplus.\36\ Under these three scenarios, 
Paid-In Capital Surplus functions similarly to URE and would likely be 
treated as Tier 1 capital under a new regulatory capital framework. 
However, it is equally plausible that under other scenarios, as part of 
the terms of the acquisition, the acquirer might allocate some or all 
of the acquiree's retained earnings subject to some plan or practice of 
revolvement or retirement. Under such scenarios, the allocated portion 
may or may not qualify as Tier 1 capital. The FCA would likely look at 
the specific acquisition before determining whether the capital 
transferred in the acquisition would be Tier 1 or Tier 2 capital.
---------------------------------------------------------------------------

    \36\ Since the System submitted its comment letter in December 
2008, there have been several System mergers that were accounted for 
under the acquisition method and resulted in recording additional 
paid-in capital similar to the System's examples.
---------------------------------------------------------------------------

    Question 5: We seek comments on other types of allocated surplus or 
stock in the System that could be considered URE equivalents under a 
new regulatory capital framework. We ask commenters to explain how 
these other types of allocated surplus or stock are equivalent to URE.
b. Noncumulative Perpetual Preferred Stock
    NPPS is perpetual preferred stock that does not accumulate 
dividends from one dividend period to the next and has no maturity 
date. The noncumulative feature means that the System institution 
issuer has the option to skip dividends. Undeclared dividends are not 
carried over to subsequent dividend periods, they do not accumulate to 
future periods, and they do not represent a contingent claim on the 
System institution issuer. The perpetual feature means that the stock 
has no maturity date, cannot be redeemed at the option of the holder, 
and has no other provisions that will require future redemption of the 
issue.
    The FFRAs treat some, but not all, forms of NPPS as Tier 1 capital. 
For example, the FRB emphasizes that NPPS with credit-sensitive 
dividend features generally would not qualify as Tier 1 capital.\37\ 
The FDIC views certain NPPS where the dividend rate escalates 
excessively as having more in common with limited life preferred stock 
than with Tier 1 capital instruments.\38\ Furthermore, the OCC, FRB, 
and FDIC do not include NPPS in Tier 1 capital

[[Page 39399]]

if an issuer is required to pay dividends other than cash (e.g., stock) 
when cash dividends are not or cannot be paid, and the issuer does not 
have the option to waive or eliminate dividends.\39\
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    \37\ See 12 CFR part 225, App. A, II.A.1.c.ii(2) for BHCs and 
Part 208, App. A, II.A.1.b for state member banks. If the dividend 
rate is reset periodically based, in whole or in part, on the 
institution's current credit standing, it is not treated as Tier 1 
capital. However, adjustable rate NPPS where the dividend rate is 
not affected by the issuer's credit standing or financial condition 
but is adjusted periodically according to a formula based solely on 
general market interest rates may be included in Tier 1 capital.
    \38\ See 12 CFR part 325, App. B, IV.B. This is an issuance with 
a low initial rate that is scheduled to escalate to much higher 
rates in subsequent periods and become so onerous that the bank is 
effectively forced to call the issue.
    \39\ The OTS may allow this type of NPPS to qualify as Tier 1. 
See 73 FR 50326 (August 26, 2008), ``Joint Report: Differences in 
Accounting and Capital Standards Among the Federal Banking Agencies; 
Report to the Congressional Basel Committees.''
---------------------------------------------------------------------------

    As noted above, the Basel Committee is proposing to establish a set 
of criteria for including ``additional going-concern capital'' such as 
NPPS in Tier 1 capital.\40\ We will consider these criteria in a future 
proposed rulemaking.
---------------------------------------------------------------------------

    \40\ See paragraphs 88 and 89 of the Basel Consultative 
Proposal.
---------------------------------------------------------------------------

    Consistent with the Basel Committee's position, the FCA believes 
that high quality member stock and surplus should be the predominant 
form of Tier 1 capital. We are seeking comments on how to ensure that 
NPPS remains the minority of Tier 1 capital under most circumstances. 
We note that a specific limit on the amount of NPPS that is includible 
in Tier 1 capital may create a downward spiral effect in adverse 
situations where decreases in high quality member stock and surplus 
also decrease the amount of NPPS includible in Tier 1 capital.
    One option would be to establish a hard limit that is something 
less than 50 percent of Tier 1 capital at the time of issuance. If this 
limit is subsequently breached due to adverse circumstances, the System 
institution would be required to submit a capital restoration plan to 
the FCA that includes increasing surplus through earnings in order to 
bring the percentage of NPPS in Tier 1 capital back below the limit 
that is imposed at the time of issuance. During such adversity, the 
System institution may be limited in its ability to issue additional 
NPPS that would qualify for Tier 1 regulatory capital treatment.
    Question 6: We seek comments on ways to limit reliance on NPPS as a 
component of Tier 1 capital while avoiding the downward spiral effect 
that can occur in adverse situations as described above.
c. Allocated Surplus and Member Stock
i. Overview of System Bank and Association Allocated Surplus and Member 
Stock
    Each System bank provides its affiliated associations with a line 
of credit, referred to as a direct note, as the primary source of 
funding their operations. Each association, in turn, is required to 
purchase a minimum amount of equity in its affiliated bank. This 
required investment minimum is generally a percentage of its direct 
note outstanding.\41\ For example, suppose a bank that has a required 
investment range of 2 percent to 6 percent, as set forth in its bylaws, 
establishes a current required investment minimum of 3 percent of an 
association's direct note outstanding.\42\ If the association falls 
short of the 3-percent minimum, it would be required to purchase 
additional stock in the bank. If the association's investment is over 
the 3-percent minimum, the bank would distribute (sometimes over a long 
period of time through a revolvement plan) or allot, for regulatory 
capital purposes, the ``excess investment'' back to the association.
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    \41\ The minimum may not be lower than the statutory minimum 
stock purchase requirement of $1,000 or 2 percent of the loan 
amount, whichever is less (section 4.3A(c)(1)(E) of the Act). The 
banks also have other programs in which associations and other 
lenders participate that require investment in the bank. We 
collectively refer to these investments as the bank's required 
minimum investment.
    \42\ The bank board may increase or decrease this minimum within 
the required investment range from time to time, depending upon the 
capital needs of the bank.
---------------------------------------------------------------------------

    CoBank, ACB makes direct loans to System associations and is also a 
retail lender to agricultural cooperatives, rural energy, 
communications and water companies and other eligible entities. CoBank 
builds equity for its retail business using a ``target equity level'' 
that is similar to the required investment minimum described above.\43\ 
The target equity level includes the statutory minimum initial borrower 
investment of $1,000 or 2 percent of the loan amount, whichever is 
less,\44\ and equity that is built up over time through patronage 
distributions. The CoBank board annually determines an appropriate 
targeted equity level based on economic capital and strategic needs, 
internal capital ratio targets, financial and economic conditions, 
market expectations and other factors. CoBank does not automatically or 
immediately pay off the borrower's stock after the loan is paid in 
full. Rather, it retires the stock over a long period of time.\45\
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    \43\ For more detail on CoBank's target equity level, see 
CoBank's 2008 Annual Report. This document is available at http://www.cobank.com.
    \44\ Section 4.3A(c)(1)(E) of the Act (12 U.S.C. 
2154a(c)(1)(E)).
    \45\ CoBank stated in its 2008 annual report that the target 
equity level is expected to be 8 percent of the 10-year historical 
average loan volume for 2009 and remain at that level thereafter.
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    Borrowers from System associations are statutorily required to 
purchase association stock as a condition of obtaining a loan. The 
purchase requirement is set by the association's board and, by statute, 
must be at least $1,000 or 2 percent of the loan amount, whichever is 
less. In practice over the past two decades, association boards have 
set the member stock (or participation certificates for individuals or 
entities that cannot hold voting stock) purchase requirement at the 
statutory minimum and routinely retire the purchased stock when the 
borrower pays off his or her loan.\46\ Consequently, the borrower has a 
high expectation of stock retirement when his or her loan is paid off. 
Currently, member stock is not includible in core surplus or total 
surplus and makes up only a small portion of the association's capital 
base.
---------------------------------------------------------------------------

    \46\ Under section 4.3A(c)(1)(I) of the Act (12 U.S.C. 
2154a(c)(1)(I)), this stock is retired at the discretion of the 
association.
---------------------------------------------------------------------------

    The majority of an association's regulatory capital base comes 
through retained earnings as either allocated surplus or URE. Allocated 
surplus is earnings that are distributed as patronage to an individual 
borrower but retained by the association as part of the member's equity 
in the institution. We do not consider allocated surplus that is 
subject to revolvement to be a URE equivalent, because the borrower has 
an expectation of distribution at some future point in time through a 
System association's equity revolvement program. These revolvement 
programs vary depending upon the unique circumstances of the 
association. Currently, allocated surplus that is subject to 
revolvement is a small part of the capital base of most associations.
ii. The System Comment Letter and FCA's Responses to Treating Allocated 
Surplus and Member Stock as Tier 1 Capital
    The System Comment Letter recommends that all at-risk allocated 
surplus and member stock be Tier 1 capital. We have categorized the 
System's comments into broad arguments. We respond below after each 
broad argument.
    The System's first argument is that various systems and agreements 
are in place to ensure the stability and permanency of allocated 
surplus and borrower stock. For example, while a regular practice or 
plan of retirement may give rise to an expectation of equity 
retirement, borrowers do not have the legal right to demand retirement. 
A System institution board has the sole discretion to suspend or stop 
equity distributions at any time if warranted by changing economic and 
financial conditions. Moreover, an institution's bylaws and capital 
plans put some restraints on capital distributions under certain 
conditions. The System also comments that the System banks and

[[Page 39400]]

the Funding Corporation have entered into a Contractual Interbank 
Performance Agreement and a Market Access Agreement, which provide 
early and quick enforcement triggers to protect against a bank's 
weakening capital position. In addition, each bank has a General 
Financing Agreement (GFA) with its affiliated associations. The GFA 
requires each association to maintain a satisfactory borrowing base, 
which is a measure of capital adequacy. Third-party capital issuances 
(e.g., preferred stock and subordinated debt) have terms that prohibit 
the payment of outsized cash patronage dividends and stock retirements 
if regulatory capital ratios are breached.
    In our 1997 final rule on System regulatory capital, we addressed 
similar arguments and observed that internal systems and agreements 
alone do not ensure that System institutions consistently maintain 
sufficient amounts of high quality capital.\47\ At the time, we decided 
to exclude member stock from core surplus and limit the inclusion of 
allocated surplus to ensure that System institutions had an adequate 
amount of uncommitted, unallocated surplus that was not at risk at 
another institution and not subject to borrower expectations of 
retirement or revolvement. However, as we discuss below, in developing 
the new regulatory capital framework, the FCA is considering what 
regulatory mechanisms could be put into place to make allocated surplus 
and member stock more permanent and stable so as to qualify as Tier 1 
capital.
---------------------------------------------------------------------------

    \47\ 62 FR 4429 (January 30, 1997).
---------------------------------------------------------------------------

    The System's second argument is that other banking organizations 
can treat similar equities as Tier 1 capital. For example, a Federal 
Home Loan Bank (FHLB) is permitted to include as ``permanent capital'' 
certain stock issued to commercial banks that is redeemable in cash 5 
years after a commercial bank provides written notice to its FHLB.\48\ 
In addition, Subchapter S commercial bank corporation (Subchapter S 
corporation) investors have expectations of regular dividend 
distributions that are similar to those of System borrowers, and FFRAs 
permit Subchapter S corporations to treat their equities as Tier 1 
capital.\49\
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    \48\ The System indicates in its comment that it views FHLB 
``permanent capital'' as the equivalent of Tier 1 capital.
    \49\ The System also noted that the FASB has recognized 
cooperative capital as equity even if a portion of it is redeemable. 
While this is true, it does not support the argument that allocated 
surplus and member stock should be treated as Tier 1 capital rather 
than Tier 2 capital.
---------------------------------------------------------------------------

    In response to the second argument, while the FHLBs are not 
directly comparable to System institutions, we are open to suggestions 
on how to apply a 5-year or other time horizon to allocated surplus and 
member stock retirements. We note, however, that the inclusion of such 
stock in a FHLB's capital is mandated by statute and was not a safety 
and soundness determination made by the FHLB's regulator.\50\ As for 
Subchapter S corporation investors, while they may have expectations of 
equity distributions that may be similar to those of System borrowers, 
Subchapter S corporations do not depend on their investors to make up 
the customer base of the institution. Consequently, the borrowers' 
influence on the System institution's retention and distribution of its 
stock and surplus may be different from the investors' influence on 
Subchapter S corporation's retention and distribution of its stock and 
surplus.
---------------------------------------------------------------------------

    \50\ See 12 U.S.C. 1426.
---------------------------------------------------------------------------

    The System's third argument is that no distinction should be made 
between allocated surplus and URE based on cooperative principles. The 
System believes that cooperatives should be funded to the extent 
possible by current patrons on the basis of patronage. The System 
asserts that, if we require the majority of Tier 1 capital to be URE, 
the burden of capitalizing the institution is borne disproportionately 
by patrons who have repaid their loans and have ceased to use the 
credit services of the institution. The result is that current patrons 
enjoy the benefit the URE affords without bearing a substantial part of 
the burden of accumulating it. The System also contends that, from a 
tax perspective, retention of earnings as allocated surplus is a more 
efficient and less costly method of capital accumulation than URE. The 
single tax treatment under Subchapter T enables the cooperative to 
capitalize its operations from retention of patronage-sourced earnings 
and allows such earnings to be returned to its members without 
additional taxation. The result is that more of the earnings derived 
from the patron can be utilized to capitalize the cooperative's 
business at a lesser cost over time to the member. The System also 
states its belief that limits and/or exclusions of allocated surplus 
from Tier 1 capital would arbitrarily discourage System institutions 
from operating on a cooperative basis, unduly devalue allocated 
surplus, and prevent System institutions from maximizing non-cash 
patronage distributions as a component of capital management. The 
investment that borrowers hold in the institution would tend to remain 
relatively small, and without a material ownership stake in the 
institution, members are more likely to become disengaged from the 
processes of corporate governance and their crucial role in holding 
boards of directors accountable for poor performance. The System 
believes that the FCA should include all allocated surplus as Tier 1 
capital.
    In response to this third argument, we agree with the System that 
it is important to consider cooperative principles in developing the 
new regulatory capital framework. However, as noted above, allocated 
surplus that is regularly revolved is less stable and permanent than 
URE because of the borrower's reasonable expectation of equity 
distributions. In the current regulatory capital framework, we have 
striven to balance cooperative principles with FCA's safety and 
soundness objectives by treating only certain longer-term allocated 
equities as core surplus and requiring that at least 1.5 percent of 
core surplus be composed of elements other than allocated surplus. We 
continue to believe that certain regulatory mechanisms are needed to 
ensure that allocated equities subject to revolvement qualify as Tier 1 
capital. We are willing to consider approaches other than time element 
restrictions. Association capital retention and distribution practices 
have changed over time and will continue to evolve. Our regulations 
should be flexible enough to encompass the myriad of institutions' 
revolvement plans without unduly hindering patronage distribution 
practices.
    Five System associations also submitted individual comments 
recommending the FCA treat all association allocated surplus as Tier 1 
capital. The five commenters assert that borrower expectations of 
patronage distributions have little or no effect on the stability and 
permanency of allocated surplus. In summary, they state that extensions 
of established revolvement cycles or reductions or suspensions of 
patronage distributions have not had a negative effect on marketing 
efforts, growth, or income at their associations. The associations 
state that they price their loans to market and provide high quality 
service, and they say there is little or no pressure from borrowers 
when scheduled patronage distributions are suspended or withheld.
    While borrower expectations of patronage distributions do not 
appear to have had a material effect on the stability and permanency of 
allocated surplus under current conditions, we

[[Page 39401]]

are not certain that this would be the case under other scenarios. 
Since 1997, from the time core surplus and total surplus requirements 
were established, the System has, for the most part, enjoyed strong 
growth and earnings as a result of favorable agricultural and wider 
macroeconomic conditions. Only recently have System institutions had to 
extend or suspend revolvement periods for allocations and reduce cash 
payments in response to the current economic downturn. Prior to this 
downturn, System institutions have not had recent experience with the 
trough of a credit cycle where very adverse credit conditions require 
boards to make hard decisions. Consequently, it is difficult to 
evaluate the efficacy of our capital requirements in times of severe 
stress.
    Currently, the predominant form of System association capital is 
URE. Most associations distribute the majority of their patronage in 
cash. Consequently, most borrowers do not have a significant amount of 
direct ownership in the form of allocated surplus in their respective 
associations. However, it is possible that the associations could at 
some future point be primarily capitalized by their current patrons, 
and the majority of the association's capital base could be allocated 
surplus that is subject to regular revolvement. The borrower's direct 
capital investment would probably have to be significantly higher, and 
distributions that come from scheduled revolvement plans could be large 
and could possibly be material to a borrower's cash flows. Under this 
scenario, associations could have more difficulty suspending or 
withholding patronage distributions during periods of adversity, 
especially if the borrowers are stressed and are depending on scheduled 
patronage distributions to meet maturing financial obligations or to 
remain solvent. This possible scenario is the reason why the FCA's 
existing regulations require associations to hold a minimum amount of 
URE and other high quality equity that is not allocated equity. URE 
provides a capital cushion that enables the association to continue 
making routine borrower stock retirements as well as orderly planned 
distributions, which are especially important in situations where 
borrowers need those distributions to meet their own financial 
obligations.
    The System Comment Letter asserts that association borrower stock 
should be treated as Tier 1 capital, pointing out that, while 
association borrower stock is commonly retired in conjunction with loan 
pay-offs, such retirement is always at risk and subject to association 
board discretion. Moreover, association boards commonly delegate to 
management and/or approve ongoing retirement programs only as long as 
such actions do not compromise the associations' capital adequacy. 
Finally, the System notes that borrower stock is of nominal amounts.
    The FCA believes that, under the current regulatory framework, 
there is an important difference between borrower stock issued by 
associations and common stock issued by commercial banks. The investors 
who purchase an association's borrower stock are also customers of the 
association, whereas investors who purchase commercial bank common 
stock generally are not customers of the commercial bank. This 
customer/investor relationship of System borrowers to their 
associations makes borrower stock intrinsically different from 
commercial bank common stock. Since associations routinely retire 
borrower stock, suspension of stock retirements can have negative 
effects on the association's relationships with its customers, 
prospective customers, and its investors. The effect of a suspension of 
stock retirements may not be material today because borrower stock is 
presently nominal in amount, but stock retirements can become an issue 
when borrower stock makes up a larger portion of association capital. 
For instance, if associations increased their stock purchase 
requirement to 5 percent or 10 percent of the loan amount (as was the 
case up until the end of the 1980s) and then suspended the retirements, 
the borrowers would be more likely to be materially affected. In 
addition, the suspension of such stock retirements could undermine an 
association's efforts to attract new borrowers.
    Second, borrower stock is routinely retired when the borrower pays 
off his or her loan. Commercial bank common stock is rarely retired 
once it is issued and generally requires notice to or the prior 
approval of the regulator.\51\ The stock may trade among investors, but 
an individual shareholder would have little or no success in demanding 
that the commercial bank retire its stock in the absence of a 
retirement or exchange affecting the entire class of stock. In 
addition, commercial bank stock buy-backs are not analogous to stock 
retirements in connection with the paying off of loans and are not 
``routine'' in the way association borrower stock retirements are 
routine.
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    \51\ U.S. commercial banks and savings associations must, in 
many cases, notify or seek the prior approval of their primary FFRA 
before making a capital distribution (stock retirements or dividends 
in the form of cash). The notification requirements and/or 
restrictions enhance the permanence and stability of Tier 1 capital 
elements for such entities. For national banks, see 12 U.S.C. 59, 
60; 12 CFR 5.46, 5.60-5.67. For state banks, see 12 CFR 208.5; 12 
U.S.C. 1828(i), 12 CFR 303.203, 303.241. For savings associations, 
see 12 U.S.C. 1467a(f); 12 CFR 563.140-563.146.
---------------------------------------------------------------------------

    Third, System borrowers generally do not pay cash for association 
stock. Rather, the par value of the stock is added to the principal 
amount of a borrower's obligation, and the association retains a first 
lien on the stock. From a practical standpoint, the borrower could 
simply pay down a loan to the par value of the stock and cease making 
any further payments. In such cases, it is usually easier and less 
costly for the association simply to offset the amount of the stock 
against the remaining loan balance than it is to take other legal 
measures (such as foreclosure) against a borrower. By contrast, 
commercial bank investors pay cash for their stock. Since their stock 
must be paid in full, the stockholder has no easy opportunity to use 
the stock to offset a debt obligation.
    The System has also commented that association allocated surplus 
and borrower stock are equivalent in permanency and stability and 
should be treated the same way under the new regulatory framework. The 
System states that both types of equities are at risk and can be 
redeemed only at the discretion of the association's board and also 
claims that no distinction is made from the borrower's perspective. As 
we have explained throughout this ANPRM, we believe a distinction can 
be made from a safety and soundness perspective. The very fact that 
association borrower stock is routinely retired when a borrower pays 
off a loan makes borrower stock less permanent and stable than any form 
of surplus.
iii. FCA's Consideration of a Proposal To Treat Allocated Surplus and 
Member Stock as Tier 1 Capital
    After evaluating the comments above, the FCA has begun to formulate 
a regulatory mechanism that would permit: (1) System associations to 
treat their allocated equities subject to revolvement and borrower 
stock as Tier 1 capital, (2) System banks to treat their associations' 
required minimum investment as Tier 1 capital, and (3) CoBank to treat 
its retail customers' stock and surplus as Tier 1 capital. This program 
would give us the ability to monitor, and if necessary, take actions 
that would restrict, suspend or prohibit capital distributions before a 
System institution reaches its regulatory capital minimums. An 
objective of the program would be to ensure that the FCA has some 
control over a System institution's capital distributions when it 
begins to experience financial stress. In this way, we believe that 
allocated surplus and

[[Page 39402]]

member stock could qualify as Tier 1 capital.
    The regulatory mechanism we may propose would operate differently 
from the FFRAs' Prompt Corrective Action framework.\52\ The Prompt 
Corrective Action framework was designed, in part, to protect the 
Federal deposit insurance fund by requiring the FFRAs to take specific 
corrective actions against depository institutions as soon as they fall 
below minimum capital standards. In contrast, the purpose of our 
program would be to ensure the quality, permanence and stability of 
allocated surplus and member stock.
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    \52\ Congress established the Prompt Corrective Action framework 
in the Federal Deposit Insurance Corporation Improvement Act 
(FDICIA) of 1991 with the objective to prevent a reoccurrence of the 
large-scale failures of bank and thrift institutions that depleted 
the Federal deposit insurance funds in the 1980s. For information 
about the use and effectiveness of the Prompt Corrective Action 
framework see GAO, Bank and Thrift Regulation: Implementation of 
FDICIA's Prompt Regulatory Action Provisions, GAO/GGD-97-18 
(Washington, DC: Nov. 21, 1996), and GAO, Deposit Insurance: 
Assessment of Regulators Use of Prompt Corrective Action Provisions 
and FDIC's New Deposit Insurance System, GAO-07-242 (Washington DC: 
February 2007).
---------------------------------------------------------------------------

    Because the Prompt Corrective Action framework relies almost 
exclusively on regulatory capital ratios, most corrective actions are 
not triggered until a depository institution falls below regulatory 
minimum capital requirements. The program we are considering proposing 
would have trigger points well above regulatory capital minimum 
requirements that, when breached, would require System institutions to 
take certain actions. We also expect to include other financial 
measures along with the capital ratios in the program to provide 
earlier indicators to a System institution's financial condition and 
performance.
    The regulatory mechanism we may propose would conceivably 
incorporate many of the Treasury's principles for reforming regulatory 
capital frameworks.\53\ For example, the Treasury has noted that the 
capital ratios in the Prompt Corrective Action framework have often 
acted as lagging indicators of financial distress and ``ha[ve] resulted 
in far too many banking firms going from well-capitalized status 
directly to failure.'' The Treasury has recommended that the FFRAs 
consider improving their Prompt Corrective Action frameworks by adding 
supplemental triggers such as measures of non-performing loans or 
liquidity measures.
---------------------------------------------------------------------------

    \53\ ``Principles for Reforming the U.S. and International 
Regulatory Capital Framework for Banking Firms'' (September 3, 
2009). This document is available at http://www.ustreas.gov/.
---------------------------------------------------------------------------

    We also note that the Prompt Corrective Action framework is 
mandated for all depository institutions regulated by the FFRAs. The 
capital regulatory mechanism we are developing would apply only to 
those System institutions that elect to treat their allocated surplus 
and/or member stock as Tier 1 capital. System institutions that choose 
not to participate in the regulatory program would treat their 
allocated surplus and/or member stock as Tier 2 capital. The following 
chart sets forth the broad parameters of the program we are 
considering:

   System Institution Capital Distribution Restrictions and Reporting
                              Requirements
------------------------------------------------------------------------
                                                 Regulatory Requirements
                              Risk Metrics *         (e.g., periodic
    System Institution        (e.g. capital,        reporting, prior
         Category               asset, and             approval on
                            liquidity metrics)    distributions, etc.)
------------------------------------------------------------------------
Category 1...............  Capital Ratios =      No additional
                            high.                requirements.
                           Asset Quality =
                            strong.
                           Asset Growth = low.
                           Liquidity = high...
Category 2...............  Capital Ratios =      Notification to
                            adequate.            FCA of any capital
                           Asset Quality =       distributions at least
                            fair..               30 days before
                           Asset Growth =        declaration of
                            high..               distribution.
                           Liquidity =           Institution
                            adequate..           must report all capital
                                                 ratios to the FCA on a
                                                 monthly basis and
                                                 explain how asset
                                                 quality, asset growth
                                                 and liquidity have
                                                 impacted the ratios.
Category 3...............  Capital Ratios =      FCA prior
                            low.                 approval of any capital
                           Asset Quality =       distributions.
                            poor..               Possible
                                                 restrictions on capital
                                                 distributions.**
                                                 Reporting
                                                 requirements of
                                                 Category 2, and the FCA
                                                 may increase the scope
                                                 and intensity of a
                                                 specific institution-
                                                 related issue on more
                                                 than a monthly basis.
                           Liquidity = low
------------------------------------------------------------------------
   The Capital Ratio thresholds for Category 3 would be the Regulatory
                            Capital Minimums.
------------------------------------------------------------------------
If a System institution does not meet one or more of the regulatory
 minimum capital requirements, the FCA could take one or more
 supervisory actions under its existing authorities, such as conditions
 imposed in writing on transactions that require FCA approval; requiring
 a capital restoration plan; issuing supervisory letters, cease and
 desist orders, or capital directives; or placing the institution in
 conservatorship or receivership when there are grounds for doing so.
------------------------------------------------------------------------
* After the proposed capital distribution.
** This includes potential restrictions on patronage distributions,
  dividends, stock retirements, callable debt, and interest payments on
  third-party capital instruments.

    The table above outlining the program we are considering displays 
categories we might use to determine whether or when to restrict or 
prohibit a System institution's capital distributions. Each 
participating System institution that has capital levels at or above 
the regulatory minimums would be assigned to one of three categories 
(e.g., the best performing System institutions would be assigned to 
Category 1 and so forth). FCA would place institutions in categories 
based on a variety of measures of capital adequacy, asset quality, 
asset growth and liquidity. These measures would have specific 
thresholds that would act as trigger points to require additional 
reporting or other action by the institution. Taken as a whole, the 
regulatory mechanism we are considering would assist the FCA in 
determining whether or when to intervene to limit or prevent a System 
institution's capital distributions in order to ensure the permanence 
and loss absorption capacity of allocated surplus and member stock.
    The capital ratios we expect to use would include a Tier 1 risk-
based capital ratio, a total (Tier 1 + Tier 2)

[[Page 39403]]

risk-based capital ratio, and a Tier 1 non-risk-based leverage ratio. 
We are also considering a Tier 1 risk-based capital ratio or Tier 1 
non-risked-based leverage ratio that includes the effects of other 
comprehensive income.\54\ Minimum category 1 capital ratio thresholds 
would significantly exceed the new regulatory minimum capital 
requirements. Minimum category 2 capital ratio thresholds would exceed 
the new regulatory minimum capital requirements. Minimum category 3 
capital ratio thresholds would be equal to the regulatory minimum 
capital requirements. For a System institution that does not meet at 
least one of the regulatory minimum capital requirements, the FCA could 
take one or more supervisory actions under our existing supervisory and 
enforcement authorities. As noted above, we also expect to use other 
financial ratios in conjunction with the regulatory capital ratios to 
provide earlier indicators of a System institution's financial 
condition and performance. We ask commenters to help us determine these 
other ratios and develop the thresholds.
---------------------------------------------------------------------------

    \54\ Other comprehensive income (OCI) is the difference between 
net income and comprehensive income and represents certain gains and 
losses of an enterprise. OCI generally refers to revenues, expenses, 
gains, and losses that under U.S. GAAP are included in comprehensive 
income but excluded from net income. For System institutions, the 
most common items in OCI have recently been pension liability 
adjustments, unrealized gains or losses on available-for-sale 
securities, and other-than-temporary impairment on investments 
available-for-sale. The accumulated balances of those items are 
required by those respective standards to be reported in a separate 
component of equity in a company's balance sheet. The principal 
source of guidance on comprehensive income and OCI under U.S. GAAP 
is at ASC Topic 220, Comprehensive Income.
---------------------------------------------------------------------------

    The financial measures of the regulatory mechanism would need to 
reflect accurately a System institution's financial position and have 
appropriate thresholds to trigger a regulatory requirement so that the 
FCA can monitor and/or intervene to restrict capital distributions in a 
timely manner. For example, if a System institution dropped to Category 
2, it would have to submit additional information to the FCA each month 
and give us prior notification of any capital distributions (as 
described in the table above). We are also considering requiring 
Category 2 institutions to submit a capital restoration plan. If a 
System institution drops to Category 3, it would need the FCA's prior 
approval of any capital distributions.\55\
---------------------------------------------------------------------------

    \55\ We note that the Basel Consultative Proposal has a similar 
concept to limit capital distributions, including limits on dividend 
payments and share buybacks, to ensure that banking organizations 
hold higher amounts of high quality capital during good economic 
situations so as to be drawn down during periods of stress. See 
paragraphs 39 and 40 of the Basel Consultative Proposal.
---------------------------------------------------------------------------

    Finally, the FCA would reserve the right to place a System 
institution in a different category if warranted by the particular 
circumstances of the institution and the current economic environment. 
We would monitor this program primarily through our examination 
function.
    Question 7: We seek comments to help us develop a capital 
regulatory mechanism that would allow System institutions to include 
allocated surplus and member stock in Tier 1 capital. Using the table 
titled ``System Institutions Capital Distributions Restrictions and 
Reporting Requirements'' as an example, what risk metrics would be 
appropriate to classify a System institution as Category 1, Category 2, 
or Category 3? What percentage ranges of specific financial ratios 
would be appropriate for each risk metric under each category? We also 
seek comments on the increased restrictions and/or reporting 
requirements listed in Category 2 and Category 3.
2. Tier 2 Capital Components
    As aforementioned, the Basel Committee is proposing changes, and we 
ask commenters to consider the changes to Tier 2 capital when 
responding to questions 8 through 12 below. At a minimum, the Basel 
Committee is proposing that Tier 2 capital be subordinated to 
depositors and general creditors and have a maturity of at least 5 
years; recognition in regulatory capital will be amortized on a 
straight line basis during the final 5 years of maturity.\56\
---------------------------------------------------------------------------

    \56\ The Basel Committee will determine the amount of allowance 
for loan losses to be included in Tier 2 capital after conducting 
its mid-year 2010 impact assessment.
---------------------------------------------------------------------------

a. The Association's Investment in the Bank
    As explained above, each System association must maintain a minimum 
investment in its affiliated bank. The required investment is generally 
a percentage of the association's direct loan from the bank and may 
consist of both purchased stock and allocated surplus. If an 
association falls short of the required investment, it is generally 
required to purchase additional stock in the bank. Many associations 
have investments in their banks that are in excess of the bank's 
requirements.
    Under our current capital regulations, an association's investment 
in its bank may be counted in whole or in part in either the bank's 
total surplus and permanent capital, or in the association's total 
surplus and permanent capital, but it may not count in both 
institutions' regulatory capital. This avoids the ``double-duty'' 
dollar situation of using the same dollar of capital to support risk-
bearing capacity at both institutions. A capital allotment agreement 
between a System bank and a System association specifies which of the 
institutions will include the investment in its regulatory capital.\57\ 
Even though the association is permitted to include part or all of its 
investment in the bank in its permanent capital and total surplus, the 
association's investment is retained at the bank, at risk at the bank, 
included on the bank's balance sheet, and retired only at the 
discretion of the bank board. Moreover, if the bank were to fail or to 
be required to make payments under its statutory joint and several 
liability,\58\ the association might lose part or all of its 
investment.
---------------------------------------------------------------------------

    \57\ See 12 CFR 615.5207-5208.
    \58\ See section 4.4(a)(2)(A) of the Act (12 U.S.C. 
2155(a)(2)(A)).
---------------------------------------------------------------------------

    One System institution commenter recommended that the FCA treat an 
association's investment in the bank in excess of the minimum required 
investment, whether counted at the bank or the association, as Tier 1 
capital. The commenter stated that the capital allotment agreement 
reflects a shared understanding between the System bank and System 
association that the excess amount allotted to the association is 
``owned'' by the association and should not be leveraged by the bank. 
While the commenter provides many arguments as to why the excess 
investment is regulatory capital, in our view the excess investment 
does not have the attributes of Tier 1 capital at the association 
level. As the commenter points out, the association cannot legally 
compel the bank to retire the stock or otherwise liquidate it to pay 
down the association's debt at a moment's notice, and the bank board 
retains the sole discretion as to when the stock can be retired.
b. Allowance for Loan Losses
    Section 621.5(a) of our regulations requires System institutions to 
maintain ALL in accordance with GAAP. ALL must be adequate to absorb 
all probable and estimable losses that may reasonably be expected to 
exist in a System institution's loan portfolio. ALL is expressly 
excluded from the statutory definition of permanent capital in the Act 
\59\ and will continue to be excluded

[[Page 39404]]

from the permanent capital standard. The FCA does not currently treat 
any portion of ALL as either core surplus or total surplus.
---------------------------------------------------------------------------

    \59\ Section 4.3A(a)(1)(C) of the Act (12 U.S.C. 2154a(a)(1)(C).
---------------------------------------------------------------------------

    Basel I defines ALL (referred to as general loan loss reserves) as 
reserves created against the possibility of losses not yet identified. 
The FFRAs, in general, define ALL as reserves to absorb future losses 
on loans and lease receivables. Currently, ALL can be included in Tier 
2 capital up to 1.25 percent \60\ of a banking organization's risk-
adjusted asset base provided the institution is subject to capital 
rules that are based on either Basel I or the Basel II standardized 
approach.\61\ Provisions or reserves that have been created against 
identified losses are not included in Tier 2 capital. Any excess amount 
of ALL may be deducted from the net sum of risk-weighted assets in 
computing the denominator of the risk-based capital ratio.
---------------------------------------------------------------------------

    \60\ The Basel Committee may remove or modify this percentage 
after conducting its mid-year 2010 impact assessment.
    \61\ The more advanced approaches of Basel II have a different 
formula for determining the amount of general loan loss reserves 
that can be included in Tier 2 capital. Basel II is discussed 
briefly in Section IV of this document.
---------------------------------------------------------------------------

    In the System Comment Letter, the System recommended that the FCA 
include ALL, including reserves for losses on unfunded commitments, as 
Tier 2 capital under the new regulatory capital framework consistent 
with the Basel I standards and FFRA guidelines. The FCA acknowledges 
that ALL is a front line defense for absorbing credit losses before 
capital but also believes that it may not be as loss absorbing as other 
components of capital because it is tied only to credit-related losses.
    Question 8: We seek comments on whether the FCA should count a 
portion of the allowance for loan losses (ALL) as regulatory capital. 
We also seek information on how losses for unfunded commitments equate 
to ALL and why they should be included as regulatory capital. We ask 
commenters to take into consideration the Basel Consultative Proposal 
and any recent changes to FFRA regulations in relation to the amount or 
percentage of ALL includible in Tier 2 capital.
c. Cumulative Perpetual and Long-Term Preferred Stock
    Cumulative perpetual preferred stock is preferred stock that 
accumulates dividends from one dividend period to the next but has no 
maturity date and cannot be redeemed at the option of the holder. Basel 
I and the FFRAs currently treat cumulative perpetual preferred stock as 
Tier 2 capital without limit (other than the general limitation that 
Tier 2 capital cannot exceed 100 percent of Tier 1 capital). The FCA 
expects to consider cumulative perpetual preferred stock as Tier 2 
capital, provided the instrument does not have a significant step-up 
(as defined in Basel I) that has the practical effect of a maturity 
date.\62\
---------------------------------------------------------------------------

    \62\ For descriptions of cumulative perpetual preferred stock 
and long-term stock, see the OCC's guidelines at 12 CFR part 3, App. 
A, 1(c)(26) and 2(b)(2). See the FRB's guidelines at 12 CFR part 
225, App. A, II.A.2.b and 12 CFR part 208, App. A, II.A.2.b. See the 
FDIC's guidelines at 12 CFR part 325, App. A, I.A.2.ii and I.A.2.b. 
See the OTS's guidelines (for cumulative perpetual preferred stock) 
at 12 CFR 567.5(b)(1).
---------------------------------------------------------------------------

    FCA regulations do not currently distinguish between long-term and 
intermediate-term preferred stock.\63\ The FFRAs define long-term 
preferred stock as preferred stock with an original maturity of 20 
years or more. Long-term preferred stock is Tier 2 capital subject to 
the same aggregate limits as cumulative perpetual preferred stock. In 
addition, the amount of long-term preferred stock that is eligible to 
be included as Tier 2 capital is reduced by 20 percent of the original 
amount of the instrument (net of redemptions) at the beginning of each 
of the last 5 years of the life of the instrument. The FCA is 
considering adopting the FFRAs' definition of long-term preferred stock 
and treating it as Tier 2 capital with similar conditions.
---------------------------------------------------------------------------

    \63\ FCA defines ``term preferred stock'' in Sec.  615.5201 as 
stock with an original maturity date of at least 5 years and on 
which, if cumulative, the board of directors has the option to defer 
dividends, provided that, at the beginning of each of the last 5 
years of the term of the stock, the amount that is eligible to be 
counted as permanent capital is reduced by 20 percent of the 
original amount of the stock (net of redemptions).
---------------------------------------------------------------------------

    Question 9: We seek comments on the treatment of cumulative 
perpetual and term-preferred stock as Tier 2 capital subject to the 
same conditions imposed by the FFRAs.
d. Unrealized Holding Gains on Available-For-Sale (AFS) Equity 
Securities
    The FCA does not currently treat any portion of a System 
institution's unrealized holding gains on AFS equity securities as 
regulatory capital. The FFRAs began treating unrealized holding gains 
on AFS equity securities as regulatory capital after the implementation 
of SFAS No. 115, which requires institutions to fair-value their AFS 
equity securities and reflect any changes in accumulated other 
comprehensive income as a separate component of equity capital.\64\ 
This is comparable to Basel I treatment, which includes ``revaluation 
reserves'' in Tier 2 capital provided the reserves are revalued at 
their current value rather than at historic cost.
---------------------------------------------------------------------------

    \64\ Pre-codification reference: SFAS No. 115, Accounting for 
Certain Investments in Debt and Equity Securities, was issued in May 
1993 and effective for fiscal years beginning after December 15, 
1993. This statement is now incorporated into ASC Topic 320, 
Investments--Debt and Equity Securities. See 63 FR 46518 (September 
1, 1998).
---------------------------------------------------------------------------

    Basel I specifies that a bank must discount any unrealized gains by 
55 percent to reflect the potential volatility of this form of 
unrealized capital, as well as the tax liability charges that would 
generally be incurred if the unrealized gains were realized. 
Consequently, the FFRAs treat up to 45 percent of the pretax net 
unrealized holding gains on AFS equity securities with readily 
determinable fair values as Tier 2 capital. Unrealized gains on other 
types of assets, such as bank premises and AFS debt securities, are not 
included in Tier 2 capital, though the FFRAs may take these unrealized 
gains into consideration when assessing a bank's overall capital 
adequacy. In addition, the FFRAs' guidelines reserve the right to 
exclude all or a portion of unrealized gains from Tier 2 capital if 
they determine that the equity securities are not prudently valued.\65\
---------------------------------------------------------------------------

    \65\ See the OCC's guidelines at 12 CFR part 3, App. A, 2.b.5. 
See the FRB's guidelines at 12 CFR part 225, App. A, II.A.2(v) and 
II.A.e; and 12 CFR part 208, App. A, II.A.2(v) and II.A.e. See the 
FDIC's guidelines at 12 CFR part 325, App. A, I.A.2(iv) and I.A.2.f. 
See the OTS's guidelines at 12 CFR 567.5(b)(5).
---------------------------------------------------------------------------

    It is important to note that Basel I and the FFRAs' guidelines 
require all unrealized losses on AFS equity securities to be deducted 
from Tier 1 capital.
    Question 10: We seek comments on authorizing System institutions to 
include a portion of unrealized holding gains on AFS equity securities 
as regulatory capital. We ask commenters to provide specific examples 
of how this component of Tier 2 capital would be applicable to System 
institutions.
e. Intermediate-Term Preferred Stock and Subordinated Debt
    The FFRAs define intermediate-term preferred stock as preferred 
stock with an original maturity of at least 5 years but less than 20 
years. Subordinated debt is generally defined as debt that is lower in 
priority than other debt to claims on assets or earnings. The FCA 
currently treats subordinated debt as regulatory capital provided it 
meets certain criteria.\66\
---------------------------------------------------------------------------

    \66\ See the OCC's guidelines at 12 CFR part 3, App. A, 2.b.5. 
See the FRB's guidelines at 12 CFR part 225, App. A, II.A.2(iv) and 
II.A.2.d; and 12 CFR part 208, App. A, II.A.2(iv) and II.A.2.d. See 
the FDIC's guidelines at 12 CFR part 325, App. A, I.A.2(v) and 
I.A.2.d. See the OTS's guidelines at 12 CFR 567.5(b)(1)(vi) and 
(b)(2)(ii).

---------------------------------------------------------------------------

[[Page 39405]]

    Intermediate-term preferred stock and subordinated debt are 
currently considered to be ``lower Tier 2'' capital by the FFRAs and 
are limited to an amount not to exceed 50 percent of Tier 1 capital 
after deductions. In addition, the amount of intermediate-term 
preferred stock and subordinated debt that is eligible to be included 
as Tier 2 capital is reduced by 20 percent of the original amount of 
the instrument (net of redemptions) at the beginning of each of the 
last 5 years of the life of the instrument. The Basel Consultative 
Proposal indicates that the Basel Committee may remove the limits on 
how much of these components may count as Tier 2 capital, but the 
phase-out period will be retained. The FCA is considering treating 
intermediate-term preferred stock and subordinated debt as Tier 2 
capital with an aggregate limit of 50 percent of Tier 1 capital after 
deductions consistent with FFRA regulations.
    Question 11: We seek comments on the treatment of intermediate-term 
preferred stock and subordinated debt as Tier 2 capital and conditions 
for their inclusion in Tier 2 capital.
f. Association-Issued Continuously Redeemable Cumulative Perpetual 
Preferred Stock
    Some associations have issued continuously redeemable cumulative 
perpetual preferred stock (designated as H Stock by most associations) 
to existing borrowers to invest and participate in their cooperative 
beyond the minimum borrower stock purchases. H Stock is an ``at-risk'' 
investment and can be redeemed only at the discretion of the 
association's board. H Stock has some similarity to a deposit or money 
market account in operation, but holders of H Stock do not have an 
enforceable right to demand payment. The FCA has previously determined 
that H Stock qualifies as permanent capital because it is at risk and 
is redeemable solely at the discretion of the association's board. 
However, the H Stock is not includible in core surplus or total surplus 
because of the association's announced intention to redeem the stock 
upon the request of the holder, provided minimum regulatory capital 
ratios are met.
    The System Comment Letter recommends treating H stock as Tier 2 
capital because of its temporary nature. The System states that 
disclaimers inform H Stock stockholders that retirement is subordinate 
to debt instruments and subject to board discretion. However, the 
holders have a high expectation that such stock will be retired. Also, 
the members' investment horizons are relatively short; so the capital 
would be viewed as temporary.
    We agree with the System that H Stock is temporary in nature. In 
essence, the FCA views the H Stock that is currently outstanding as 
similar to a 1-day term instrument because of the associations' express 
willingness to retire it at the request of the holder. Consequently, 
the FCA believes that, without some enhancement that would improve the 
stock's stability and permanency, H Stock could not qualify as Tier 2 
capital.
    Question 12: We seek comments on how to develop a regulatory 
mechanism to make H Stock more permanent and stable so that the stock 
may qualify as Tier 2 capital.

C. Regulatory Adjustments

    The FCA expects to apply many of the regulatory adjustments 
currently in our regulations to Tier 1 and total capital. For example, 
we expect to require System institutions to: (1) Eliminate the double-
duty dollars associated with reciprocal holdings with other System 
institutions, (2) deduct the amount of investments in associations that 
capitalize loan participations, (3) deduct amounts equal to all 
goodwill, whenever acquired, (4) deduct investments in the Leasing 
Corporation, (5) make necessary adjustments for loss-sharing agreements 
and deferred-tax assets and (6) exclude the net effect of all 
transactions covered by the definition of other comprehensive income 
contained in the FASB Codification. We expect to require System 
associations to deduct their net investments in their affiliated banks 
from both the numerator and denominator when computing their Tier 1 
risk-based capital ratio and non-risk-based leverage ratio. We believe 
this is consistent with the current Basel I's requirement for 
unconsolidated financial entities to deduct their investments from 
regulatory capital to prevent the multiple use of the same capital 
resource and to gauge the capital adequacy of individual institutions 
on a stand-alone basis. However, for the purposes of computing the 
total risk-based capital ratio, a System association could count some 
or all of its investment in its affiliated bank in accordance with the 
terms and conditions of bank-association capital allotment agreements. 
We also may require System institutions to make other deductions from 
Tier 1 capital or total capital consistent with FFRA guidelines.\67\ 
Finally, we expect to revise Sec.  615.5210(c)(3) prescribing how 
positions in securitizations that do not qualify for the ratings-based 
approach affect the numerator of the new regulatory capital ratios.
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    \67\ See the OCC's guidelines at 12 CFR part 3, App. A, 2.c. See 
the FRB's guidelines at 12 CFR part 225, App. A, II.B. and 12 CFR 
part 208, App. A, II.B. See the FDIC's guidelines at 12 CFR part 
325, App. A, I.B. See the OTS's guidelines at 12 CFR 567.5(a)(2).
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    We are also considering proposing some of the significant new 
regulatory adjustments that are discussed in the Basel Consultative 
Proposal. For example, financial institutions may be required to adjust 
the capital ratios for unrealized losses on debt and equity 
instruments, loans and receivables, equities, own-use properties and 
investment properties in our new regulatory capital ratios. The Basel 
Committee also proposes to deduct pension fund assets as well as fully 
recognize liabilities that arise from these funds. We expect to 
consider these regulatory adjustments in our future proposed 
rulemaking.
    Question 13: We seek comments on the regulatory adjustments in our 
current regulations that we expect to incorporate into the new 
regulatory capital framework. We also seek comments on the regulatory 
capital treatment for positions in securitizations that are downgraded 
and are no longer eligible for the ratings-based approach under a new 
regulatory capital framework.

IV. Additional Background

A. The October 2007 ANPRM

    In our October 2007 ANPRM, we solicited comments on the development 
of a proposed rule to amend our capital regulations.\68\ Most of the 
questions posed in the October 2007 ANPRM related to the method for 
calculating the risk-adjusted asset base that serves as the denominator 
for FCA's risk-based capital ratios. The questions were designed to 
help us develop a risk-weighting framework consistent with the 
standardized approach for credit risk \69\ as described in the 
``International

[[Page 39406]]

Convergence of Capital Measurement and Capital Standards: A Revised 
Framework'' \70\ (Basel II).\71\ We intend to propose new risk-
weighting regulations in a future rulemaking.\72\
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    \68\ See 72 FR 61568 (October 31, 2007). The original comment 
period of 150 days was later extended to December 31, 2008. We note 
that, in the October 2007 ANPRM, FCA withdrew a previous ANPRM 
published in June 2007 (72 FR 34191, June 21, 2007) in which we had 
sought comments to questions based on a proposed regulatory capital 
rulemaking (referred to as Basel IA) published by the FFRAs in 
December 2006. The FFRAs later withdrew the Basel IA proposal. For 
that reason, we withdrew the June 2007 ANPRM and published the 
October 2007 ANPRM. The FFRAs replaced the Basel 1A rulemaking with 
the July 2008 proposal based on the Basel II standardized approach.
    \69\ We also asked for comments on what approach we should 
consider in determining a risk-based capital charge for operational 
risk.
    \70\ See http://www.bis.org/publ/bcbsca.htm for the 2004 Basel 
II Accord as well as updates in 2005 and 2006.
    \71\ The Basel Committee on Banking Supervision was established 
in 1974 by central banks with bank supervisory authorities in major 
industrialized countries. The Basel Committee formulates standards 
and guidelines related to banking and recommends them for adoption 
by member countries and others. All Basel Committee documents are 
available at http://www.bis.org.
    \72\ The FFRAs are in the process of implementing multiple sets 
of capital rules for the financial institutions they regulate. In 
December 2007, the FFRAs adopted a regulatory capital framework 
consistent with the advanced approaches of Basel II that is 
applicable to only a few internationally active banking 
organizations. See 72 FR 69288 (December 7, 2007). In July 2008, the 
FFRAs proposed a regulatory capital framework consistent with the 
standardized approach for credit risk and basic indicator approach 
for operational risk under Basel II to help minimize the potential 
differences in the regulatory minimum capital requirements of those 
banks applying the advanced approaches and those banks applying the 
more simplified approaches. See 73 FR 43982 (July 29, 2008). The 
FFRAs have not yet acted on this proposal.
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    Other questions posed in our October 2007 ANPRM related to other 
aspects of our risk-based regulatory capital framework. For example, we 
sought comments on a non-risk-based leverage ratio that would apply to 
all FCS institutions. We also sought comments on an early intervention 
framework with financial thresholds, such as capital ratios or other 
risk measures that, when breached, would trigger an FCA capital 
directive or enforcement action. Of the issues we raised in the October 
2007 ANPRM, we reference only the potential addition of a non-risk-
based leverage ratio in this ANPRM.
    The System Comment Letter submitted in December 2008 recommended, 
among other things, that we replace our core surplus and total surplus 
standards with a ``Tier 1/Tier 2 structure'' consistent with Basel I 
and FFRA regulations.\73\ The letter asserted the System's belief that 
such revisions would enable the System to operate on a level playing 
field with commercial banks in accessing the capital markets.\74\ The 
System recommended that the FCA adopt a regulatory capital framework 
with a 4-percent Tier 1 risk-based capital ratio and an 8-percent total 
(Tier 1 + Tier 2) risk-based capital ratio. The System also recommended 
that the FCA replace its net collateral ratio (NCR), which is 
applicable only to System banks, with a Tier 1 non-risk-based leverage 
ratio that would be applicable to all System institutions.\75\ The 
System Comment Letter stated that, ``because the System's growth has 
required the use of external equity capital, the System is in regular 
contact with the financial community, including rating agencies and 
investors. Obtaining capital at competitive terms, conditions, and 
rates requires these parties [to] understand the System's and 
individual institution's financial position, making consistency with 
approaches used by other regulators, rating agencies, and investment 
firms a requirement to enhance the capacity of the System to achieve 
its mission * * *. For the System to achieve its mission, the System 
must be able to compete with other lenders. Therefore, FCA's capital 
regulations must result in a regulatory framework that provides for a 
level playing field, in addition to safe and sound operations.''
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    \73\ See footnote 4 above.
    \74\ The FCA also received six comment letters from individual 
System institutions pertaining to the treatment of certain capital 
components as Tier 1 capital. We address these comments below.
    \75\ The System also recommended many changes to our risk-
weighting regulations, which we will address in a future rulemaking.
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    The FCA believes that adoption of a Tier 1/Tier 2 capital structure 
(including minimum risk-based and leverage ratios), tailored to the 
System's structure, could improve the transparency of System capital, 
could reduce the costs of accessing the capital markets, could reduce 
the negative effects that can result from differences in regulatory 
capital standards, and could enhance the safety and soundness of the 
System.

B. Description of FCA's Current Capital Requirements

    In 1985, Congress amended the Act to require the FCA to ``cause 
System institutions to achieve and maintain adequate capital by 
establishing minimum levels of capital for such System institutions and 
by using such other methods as the [FCA] deems appropriate.'' \76\ 
Congress also authorized the FCA to impose capital directives on System 
institutions.\77\ In the Agricultural Credit Act of 1987 (1987 Act), 
Congress added a definition of ``permanent capital'' to the Act and 
required FCA to adopt minimum risk-based permanent capital adequacy 
standards for System institutions.\78\ In 1988, FCA adopted a new 
regulatory capital framework \79\ that established a minimum permanent 
capital standard for System institutions that, among other things, 
prohibited the double counting of capital invested by associations in 
their affiliated banks (i.e., shared System capital).\80\
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    \76\ Section 4.3(a) of the Act (12 U.S.C. 2154(a)).
    \77\ Section 4.3(b) of the Act (12 U.S.C. 2154(b)). This 
provision is nearly identical to legislation enacted in 1983 with 
respect to the other FFRAs. See 12 U.S.C. 3097.
    \78\ Section 4.3A of the Act; section 301(a) of Public Law 100-
233, as amended by the Agricultural Credit Technical Corrections Act 
of 1988, Public Law 100-399, title III, section 301(a), August 17, 
1988, 102 Stat. 93.
    \79\ See 53 FR 39229 (October 6, 1988). The FCA's objective at 
this time was to develop a permanent capital standard consistent 
with the statute. We determined not to adopt the two-tiered capital 
structure of Basel I because of significant differences between 
statutory permanent capital and Tier 2 capital.
    \80\ The 1988 regulation required an association to deduct the 
full amount of its investment in its affiliated bank before 
computing its PCR. This requirement had a phase-in period that was 
to begin in 1993. In 1992, Congress amended the statutory definition 
of permanent capital to permit System banks and associations to 
specify by mutual agreement the amount of allocated equities that 
would be considered bank or association equity for the purpose of 
calculating the PCR. In July 1994, the FCA amended the regulations 
to implement this statutory change. See 59 FR 37400 (July 22, 1994).
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    Section 4.3A of the Act \81\ defines permanent capital to include 
stock (other than stock issued to System borrowers that is not 
considered to be at risk),\82\ allocated surplus,\83\ URE, and other 
types of debt or equity instruments that the FCA determines are 
appropriate to be considered permanent capital. The Act explicitly 
excludes ALL from permanent capital. Our regulations require each 
System institution to maintain a ratio of at least 7 percent of 
permanent capital to its risk-adjusted asset base.\84\ The method for 
calculating

[[Page 39407]]

risk-adjusted assets (which includes both on- and off-balance sheet 
exposures) is based largely on Basel I and is generally consistent with 
the FFRAs' Basel I-based risk-weighting categories.\85\ From 1988 to 
1997, the only regulatory capital requirement imposed on all System 
banks and associations was the permanent capital standard.
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    \81\ Section 4.3A(a)(1) of the Act (12 U.S.C. 2154a(a)(1)).
    \82\ Borrower stock is common shareholder equity that is 
purchased as a condition of obtaining a loan with a System 
institution. We include in this category participation certificates, 
which are a form of equity issued to persons or entities that are 
ineligible to own borrower voting stock, such as rural home 
borrowers. To be counted as permanent capital, stock must be at risk 
and retireable only at the discretion of an institution's board of 
directors. Any stock that may be retired by the holder of the stock 
on repayment of the holder's loan, or otherwise at the option or 
request of the holder, or stock that is protected under section 4.9A 
of the Act or is otherwise not at risk, is excluded from permanent 
capital. Stock protected by section 4.9A of the Act was issued prior 
to October 1988, and nearly all such stock has been retired.
    \83\ Allocated surplus is earnings allocated but not paid in 
cash to a System institution borrower. Allocated surplus is counted 
as permanent capital provided the bylaws of a System institution 
clearly specify that there is no express or implied right for such 
capital to be retired at the end of the revolvement cycle or at any 
other time. In addition, the institution must clearly state in the 
notice of allocation that such capital may be retired only at the 
sole discretion of the board of directors in accordance with 
statutory and regulatory requirements and that no express or implied 
right to have such capital retired at the end of the revolvement 
cycle or at any other time is thereby granted.
    \84\ See Sec.  615.5205. Before making this computation, each 
System institution is required to make certain adjustments and/or 
deductions to permanent capital and/or the risk-adjusted asset base.
    \85\ See Sec. Sec.  615.5211-615.5212. Under the current 
framework, each on- and off-balance sheet credit exposure is 
assigned to one of five broad risk-weighting categories (0, 20, 50, 
100, and 200 percent) or dollar-for-dollar deduction to determine 
the risk-adjusted asset base, which is the denominator for all of 
FCA's risk-based capital ratios.
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    In the mid-1990s, the FCA engaged in a rulemaking to ensure that 
System institutions held adequate capital in light of the risks 
undertaken. A feature of the cooperative structure of the System is 
retail borrowers' expectations of patronage distributions, as well as 
the expectation that borrower stock will generally be retired when a 
loan is paid down or paid off. These expectations can influence the 
permanency and stability of borrower stock and allocated surplus. The 
FCA was concerned that System associations did not have enough high 
quality surplus both to maintain and grow operations and at the same 
time to meet these borrower expectations of stock retirement. The FCA 
was also concerned that System associations did not have a sufficient 
level of surplus to buffer borrower stock from unexpected losses and to 
insulate such institutions from the volatility associated with 
recurring borrower stock retirements. It was possible for a System 
association to meet its permanent capital requirements solely with 
borrower stock. For example, it could establish a stock purchase 
requirement of 7 percent or more of the borrower's loan amount to meet 
the minimum permanent capital requirement with little or no surplus to 
absorb association losses.\86\ Furthermore, as noted above, since 
borrower stock in a cooperative is generally retired in the ordinary 
course of business upon repayment of a borrower's loan, if the majority 
of association capital consists of borrower stock, then its capital 
base is not sufficiently permanent if stock is commonly retired when 
loans are repaid. The FCA concluded that a minimum surplus requirement 
was necessary to provide a cushion to protect the borrower's investment 
in the System association and also to ensure that the institution had a 
more stable capital base that was not subject to borrowers' 
expectations of retirement.\87\
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    \86\ Before the 1987 Act took effect, the FLBAs had authority to 
set a borrower stock requirement of not less than 5 percent nor more 
than 10 percent of the amount of the loan, and the associations were 
required to retire the stock upon full repayment of the loan. The 
PCAs had a statutory minimum borrower stock requirement of 5 
percent, and such stock could be canceled or retired on repayment of 
the loan as provided by the association's bylaws; in addition, an 
association could also require borrowers to purchase stock or 
provide an equity reserve in an amount up to another 5 percent of 
the loan. The 1987 Act changed these provisions by eliminating the 
mandatory stock retirements when long-term real estate loans were 
repaid and by allowing System institutions to choose their stock 
purchase requirement as long as it was not below the lesser of 
$1,000 or 2 percent of the loan.
    \87\ At the time, the System generally supported the FCA's 
position and recommended that we establish regulatory standards 
requiring all System institutions to build unallocated surplus and 
total surplus (e.g., both allocated and unallocated surplus). To 
meet these new standards, the FCS suggested that each System 
institution retain a portion of its net earnings after taxes to 
achieve and maintain at least 3.5 percent in unallocated surplus and 
7.0 percent in total surplus of the institution's risk-adjusted 
assets. The FCA chose instead to establish fixed minimums but 
permitted institutions with capital below the minimums to achieve 
compliance initially by submitting capital restoration plans.
---------------------------------------------------------------------------

    The FCA was also concerned that System associations did not have a 
sufficient amount of what the Agency viewed as ``local'' surplus--that 
is, surplus that was completely under the control of the association 
and immediately available to absorb losses only at the association. 
Under the 1992 amendments to the Act,\88\ a System bank and each of its 
affiliated associations can determine through a ``capital allotment 
agreement'' whether allocated surplus retained at the bank is counted 
as permanent capital at the bank or at the association for the purposes 
of computing the permanent capital ratio.\89\ Over the years, many 
System associations had accumulated URE, in part, through non-cash 
surplus allocations from the bank that were retained by the bank, 
included in the bank's balance sheet capital, and retired only at the 
discretion of the bank board. The FCA was concerned that this allocated 
surplus under the bank's control and at risk at the bank would not 
always be accessible to the association if either the bank or the 
association (or both) were to incur losses.\90\ The FCA determined that 
a minimum surplus requirement, which excluded a System association's 
investment in its affiliated bank, was necessary to: (1) Ensure that 
each association had a minimum amount of accessible surplus that was 
not at risk at the bank or at any other System institution, (2) 
immediately absorb losses and enable the association to continue as a 
going concern during periods of economic stress, and (3) improve the 
safety and soundness of the System as a whole.
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    \88\ Farm Credit Banks and Associations Safety and Soundness Act 
of 1992, Public Law 102-552, 106 Stat. 4102 (October 28, 1992).
    \89\ See Sec. Sec.  615.5207(b)(2) and 615.5208 for the 
provisions regarding the capital allotment agreements.
    \90\ It is important to distinguish the terms ``allocated 
surplus'' and ``allotted surplus.'' From a bank perspective, 
allocated surplus is earnings allocated to an association and 
retained at the bank. It is counted in either the bank's regulatory 
capital or the association's regulatory capital. ``Allotted 
surplus'' is the term we use to describe how the allocated surplus 
is counted according to an allotment agreement when calculating 
regulatory capital ratios. We describe the System banks' retention 
and distribution of capital in Section III.A.1. and Section 
III.B.1.c.
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    In 1995, the FCA proposed minimum ``surplus'' standards to ensure 
that System institutions had an appropriate mixture of capital 
components other than borrower stock, such as URE, allocated equities 
and other types of stock,\91\ to achieve a sound capital structure.\92\ 
We initially proposed ``unallocated surplus'' and ``total surplus'' 
standards.\93\ The unallocated surplus standard was designed to ensure 
that System institutions held a sufficient amount of URE that was not 
available to absorb losses at another System institution. Total surplus 
was designed to ensure that System institutions held a sufficient 
amount of capital other than borrower stock so that institutions could 
fulfill borrower expectations of stock retirements while continuing to 
hold sufficient capital to operate and grow.\94\ Most comments to the 
1995 proposed rule centered on the proposed unallocated surplus 
standard. Respondents were concerned that a high quality minimum 
surplus requirement that excluded allocated surplus would: (1) Convey 
the wrong message that allocated surplus was of lower quality

[[Page 39408]]

than unallocated surplus, (2) create a bias against cooperative 
principles, and (3) result in lower patronage distributions, which 
could create a competitive disadvantage with non-cooperative 
agricultural lenders. The FCA considered commenters' views and 
subsequently published a reproposed rule that replaced the URE standard 
with a ``core surplus'' requirement.\95\
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    \91\ This is stock that is not required to be purchased as a 
condition of obtaining a loan and that is not routinely retired.
    \92\ We also proposed a minimum NCR requirement (a type of 
leverage ratio) for System banks above the statutory minimum 
collateral requirement to protect investors and allow sufficient 
time for corrective action to be implemented prior to a funding 
crisis at an individual bank (see below). See 60 FR 38521 (July 27, 
1995).
    \93\ The proposed definition of unallocated surplus included URE 
and common and noncumulative perpetual preferred stock held by non-
borrowers but excluded allocated surplus, borrower stock and ALL. 
System associations also had to deduct their net investments in 
their affiliated bank before computing the unallocated surplus 
ratio. The proposed definition of total surplus included both 
unallocated and allocated surplus, including allotted surplus, as 
well as various types of common and preferred stock, but excluded 
borrower stock and ALL.
    \94\ In the final rule, adopted in 1997, the total surplus 
requirement remained mostly unchanged from what was originally 
proposed. See 62 FR 4429 (January 30, 1997).
    \95\ See 61 FR 42092 (August 13, 1996).
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    As proposed, core surplus included the unallocated surplus (URE and 
certain perpetual preferred stock but not borrower stock) and 
NQNSR.\96\ Since NQNSR has no financial impact on the borrower (e.g., 
the borrower does not pay tax on the allocation) and the notice sent to 
the borrower clearly indicates no plan of redemption, the risk-bearing 
capacity of NQNSR is very similar to that of URE. Respondents to the 
1996 proposed rule supported the addition of NQNSR to core surplus but 
asserted that the definition was still too restrictive. In addition to 
the reasons described above, they argued that, while System 
associations typically establish allocated equity revolvement cycles as 
a matter of capital planning, the retirements are not automatic and can 
be reduced or withheld at any time at the board's discretion. The FCA 
was persuaded that certain allocated equities that are subject to 
revolvement, while generally not perpetual in nature, do provide 
important capital protection for as long as they are held. In the final 
rule, adopted in 1997, the FCA included certain longer-term System 
association qualified allocated equities in core surplus on the ground 
that they would help an association build a high quality capital base 
without discouraging patronage distribution practices.\97\
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    \96\ NQNSR (nonqualified allocated equities not subject to 
revolvement) is equity retained by a cooperative institution from 
after-tax earnings. The System institution pays the tax on earnings 
and issues a notice of allocation to its members specifying the 
amount that has been earmarked for potential distribution. The 
``non-revolvement'' feature indicates that no redemption is 
anticipated in the near future.
    \97\ See 62 FR 4429 (January 30, 1997). We determined at the 
time not to include System bank allocated equities in core surplus. 
This primarily affected CoBank, which operates a significant retail 
operation (the other System banks are primarily wholesale 
operations). However, since March 2008, we have temporarily 
permitted CoBank to include a portion of its allocated equities in 
core surplus consistent with our treatment of association allocated 
equities until this issue could be addressed through a rulemaking.
---------------------------------------------------------------------------

    Respondents also objected to the proposed requirement that an 
association deduct its net investment in its affiliated bank in its 
core surplus calculation. We did not change this requirement from what 
was originally proposed. We emphasized that a measurement of capital 
not subject to the borrower's expectation of retirement and not 
available to absorb losses at another System institution was needed to 
ensure an association could survive independently of its funding bank.
    The FCA adopted minimum ``core surplus'' and ``total surplus'' 
standards in 1997.\98\ Since that time, the FCA has made only minor 
changes to the regulatory definitions of core surplus, total surplus 
and permanent capital.\99\ Under existing regulations, core surplus 
\100\ is the highest quality of System capital and includes the 
following:
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    \98\ See 62 FR 4429 (January 30, 1997).
    \99\ In 1998 we made minor wording changes to the total surplus 
and core surplus definitions to clarify certain terms and phrases. 
See 63 FR 39219 (July 22, 1998). In 2003, we changed the definition 
of permanent capital to reflect a 1992 statutory change to section 
4.3A of the Act and added a restriction to the amount of term 
preferred stock includible in total surplus. See 68 FR 18532 (April 
16, 2003).
    \100\ Core surplus is defined in Sec.  615.5301(b).
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    (1) URE,
    (2) NQNSR,\101\
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    \101\ In the event that NQNSR are distributed, other than as 
required by section 4.14B of the Act (statutory restructuring of a 
loan), or in connection with a loan default or the death of an 
equityholder whose loan has been repaid (to the extent provided for 
in the institution's capital adequacy plan), any remaining NQNSR 
that were allocated in the same year will be excluded from core 
surplus.
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    (3) Perpetual common \102\ (excluding borrower stock) or 
noncumulative perpetual preferred stock,
---------------------------------------------------------------------------

    \102\ Certain classes of common stock issued by System 
institutions are typically never retired except in the event of 
liquidation or merger. However, there is only a small amount of 
these classes of stock currently outstanding. In the event that such 
stock is retired, other than as required by section 4.14B of the 
Act, or in connection with a loan default to the extent provided for 
in the institution's capital adequacy plan, any remaining common 
stock of the same class or series has to be excluded from core 
surplus.
---------------------------------------------------------------------------

    (4) Other functional equivalents of core surplus,\103\ and
---------------------------------------------------------------------------

    \103\ The FCA may permit an institution to include all or a 
portion of any instrument, entry, or account it deems to be the 
functional equivalent of core surplus, permanently or on a temporary 
basis.
---------------------------------------------------------------------------

    (5) For associations, certain allocated equities that are subject 
to a plan or practice of revolvement or retirement, provided the 
equities are includible in total surplus and are not intended to be 
revolved or retired during the next 3 years.\104\
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    \104\ We explained in the 1997 final rule our belief that 3 
years should be sufficient time for a System association 
experiencing adversity to adjust its allocation plans and take other 
protective measures while continuing to be able to make planned 
patronage distributions. The rule further provides that, in the 
event that such allocated equities included in core surplus are 
retired, other than in connection with a loan default or 
restructuring or the death of an equityholder whose loan has been 
repaid (to the extent provided for in the institution's capital 
adequacy plan), any remaining such allocated equities that were 
allocated in the same year must be excluded from core surplus.
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    In calculating their core surplus ratio, System associations must 
deduct their net investment in their affiliated bank.\105\ Each System 
institution must maintain a ratio of at least 3.5 percent of core 
surplus to its risk-adjusted asset base.\106\ Furthermore, allocated 
equities, including NQNSR, may constitute up to 2 percentage points of 
the 3.5-percent CSR minimum. This means that at least 1.5 percent of 
core surplus to risk-adjusted assets must consist of components other 
than allocated equities.
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    \105\ System banks cannot include their affiliated associations' 
investments in core surplus. The net investment is the total 
investment by an association in its affiliated bank, less reciprocal 
investments and investments resulting from a loan originating/
service agency relationship, such as participation loans. See Sec.  
615.5301(e).
    \106\ Each System institution is also required to make certain 
other deductions and/or adjustments before computing its core 
surplus ratio. See 12 CFR 615.5301(e).
---------------------------------------------------------------------------

    Total surplus is the next highest form of System institution 
capital.\107\ It includes the following:
---------------------------------------------------------------------------

    \107\ Total surplus is defined in Sec.  615.5301(i).
---------------------------------------------------------------------------

    (1) Core surplus,
    (2) Allocated equities (including allocated surplus and stock), 
other than those equities subject to a plan or practice of revolvement 
of 5 years or less,
    (3) Common and perpetual preferred stock that is not purchased or 
held as a condition of obtaining a loan, provided that the institution 
has no established plan or practice of retiring such stock,
    (4) Term preferred stock with an original term of at least 5 
years,\108\ and
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    \108\ Term preferred stock is limited to a maximum of 25 percent 
of the institution's permanent capital (as calculated after 
deductions required in the PCR computation). The amount of 
includible term stock must be reduced by 20 percent (net of 
redemptions) at the beginning of each of the last 5 years of the 
term of the instrument.
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    (5) Any other capital instrument, balance sheet entry, or account 
the FCA determines to be the functional equivalent of total 
surplus.\109\
---------------------------------------------------------------------------

    \109\ The FCA may permit one or more institutions to include all 
or a portion of such instrument, entry, or account as total surplus, 
permanently or on a temporary basis.
---------------------------------------------------------------------------

    Total surplus excludes ALL as well as stock purchased or held by 
borrowers as a condition of obtaining a loan. Each System institution 
must maintain a ratio of at least 7 percent of total surplus to its 
risk-adjusted asset base.\110\ The FCA's purpose for adopting the total 
surplus requirement was to ensure that System institutions, 
particularly associations, do not rely heavily on borrower stock as a 
capital cushion.

[[Page 39409]]

Associations have continued their practice of retiring borrower stock 
when the borrower's loan is repaid.
---------------------------------------------------------------------------

    \110\ As with the other capital ratios, each System institution 
is also required to make certain other deductions and/or adjustments 
before computing its total surplus ratio.
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    Each System bank must maintain a 103-percent minimum NCR 
requirement that functions as a leverage ratio.\111\ The NCR is, 
generally, available collateral as defined in Sec.  615.5050, less an 
amount equal to the portion of affiliated associations' investments in 
the bank that is not counted in the bank's permanent capital, divided 
by total liabilities. Total liabilities are GAAP liabilities with 
certain specified adjustments.\112\
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    \111\ See Sec.  615.5301(c) and (d) and Sec.  615.5335.
    \112\ See Sec.  615.5301(j).
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C. Overview of the Tier 1/Tier 2 Capital Framework

    In 1988, the Basel Committee published Basel I, a two-tiered 
capital framework for measuring capital adequacy at internationally 
active banking organizations.\113\ Tier 1 capital, or core capital, is 
composed primarily of equity capital and disclosed reserves (i.e., 
retained earnings), the highest quality capital elements that are 
permanent and stable. Tier 2 capital, or supplementary capital, 
comprises less secure sources of capital and hybrid or debt 
instruments.\114\ Basel I established two minimum risk-based capital 
ratios: a 4-percent Tier 1 risk-based capital ratio and an 8-percent 
total (Tier 1 + Tier 2) risk-based capital ratio. For discussion 
purposes, FCA's core surplus is more similar to Tier 1 capital, whereas 
total surplus is more similar to total capital. (FCA regulations do not 
include a ratio similar to Tier 2 capital.)
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    \113\ In 1996, the Basel Committee added a third capital tier to 
support market risk, commodities risk and foreign currency risk in 
relation to trading book activities. However, in the Basel 
Consultative Proposal, the Basel Committee has proposed to abolish 
Tier 3 to ensure that market risks are supported by the same quality 
of capital as credit and operational risk.
    \114\ Total capital is the sum of Tier 1 and Tier 2 capital. 
Currently, Tier 2 capital may not account for more than 50 percent 
of a commercial bank's total capital.
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    The Basel Consultative Proposal published in December 2009 proposes 
many significant changes to the current Tier 1/Tier 2 capital 
framework.\115\ The changes are intended to strengthen global capital 
regulations with the goal of promoting a more resilient banking sector. 
The Basel Committee also announced a plan to conduct an impact 
assessment on the proposed changes in the first half of 2010 and 
develop a fully calibrated set of standards by the end of 2010. These 
changes will be phased in as financial conditions improve and the 
economic recovery is assured, with the aim of full implementation by 
the end of 2012. We describe the current Tier 1/Tier 2 capital 
framework and summarize the Basel Committee's proposed changes below.
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    \115\ See footnote 7 above.
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1. The Current Tier 1/Tier 2 Capital Framework
    Tier 1 capital in Basel I consists primarily of equity capital and 
disclosed reserves. Equity capital is issued and fully paid ordinary 
shares of common stock and noncumulative perpetual preferred stock. 
Disclosed reserves are primarily reserves created or increased by 
appropriations of retained earnings.\116\ Disclosed reserves also 
include general funds that must meet the following criteria: (1) 
Allocations to the funds must be made out of post-tax retained earnings 
or out of pre-tax earnings adjusted for all potential liabilities; (2) 
the funds, including movements into or out of the funds, must be 
disclosed separately in the bank's published accounts; (3) the funds 
must be unrestricted and accessible and immediately available to absorb 
losses; and (4) losses cannot be charged directly to the funds but must 
be taken through the profit and loss account. In October 1998, the 
Basel Committee determined that up to 15 percent of Tier 1 capital 
could include ``innovative instruments,'' provided such instruments met 
certain criteria.\117\
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    \116\ The Basel Committee has emphasized over the years that the 
predominant form of Tier 1 capital should be voting common 
stockholder's equity and disclosed reserves. Common shareholders' 
funds allow a bank to absorb losses on an ongoing basis and are 
permanently available for this purpose. It best allows banks to 
conserve resources when they are under stress because it provides a 
bank with full discretion as to the amount and timing of 
distributions. It is also the basis on which most market judgments 
of capital adequacy are made. The voting rights attached to common 
stock provide an important source of market discipline over a 
commercial bank's management.
    \117\ The Basel Committee determined that all Tier 1 capital 
elements, including these instruments, must have the following 
characteristics: (1) Issued and fully paid, (2) noncumulative, (3) 
able to absorb losses within a bank on a going-concern basis, (4) 
junior to depositors, general creditors, and subordinated debt of 
the bank, (5) permanent, (6) neither be secured nor covered by a 
guarantee of the issuer or related entity or other arrangement that 
legally or economically enhances the seniority of the claim vis-
[agrave]-vis bank creditors and (7) callable at the initiative of 
the issuer only after a minimum of 5 years with supervisory approval 
and under the condition that it will be replaced with capital of the 
same or better quality unless the supervisor determines that the 
bank has capital that is more than adequate to its risks. See 
``Instruments eligible for inclusion in Tier 1 capital'' (October 
27, 1998). This document is available at http://www.bis.org.
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    Tier 2 capital is undisclosed reserves,\118\ revaluation reserves, 
general loan loss reserves, hybrid capital instruments and subordinated 
debt. Revaluation reserves are reserves that are revalued at their 
current value (or closer to the current value) rather than at historic 
cost. The bank must discount any unrealized gains by 55 percent to 
reflect the potential volatility of this form of unrealized capital, as 
well as the tax liability charges that would generally be incurred if 
the unrealized gains were realized. General loan loss reserves are 
reserves created against the possibility of losses not yet identified. 
General loan loss reserves can be included in Tier 2 capital up to 1.25 
percentage points of risk-weighted assets.\119\ Hybrid capital 
instruments are instruments that have certain characteristics of both 
equity and debt, such as cumulative preferred stock, and must meet 
certain criteria to be treated as Tier 2 capital. Subordinated debt and 
term preferred stock must also meet certain criteria to be treated as 
Tier 2 capital. This last category is also referred to as ``lower Tier 
2'' capital since subordinated debt and term preferred stock are not 
normally available to participate in the losses of a bank and are 
therefore limited to an aggregate amount not to exceed 50 percent of 
Tier 1 capital (after deductions).
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    \118\ Although Basel I includes them in Tier 2 capital, the FCA 
would likely not recognize undisclosed reserves as Tier 2 capital 
under a new regulatory capital framework.
    \119\ This is applicable to capital rules that are based on 
either Basel I or the Basel II standardized approach. The advanced 
approaches of Basel II have a different formula for determining the 
amount of general loan loss reserves in Tier 2 capital.
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    Goodwill and any increases in equity capital resulting from a 
securitization exposure must be deducted from Tier 1 capital prior to 
computing the Tier 1 risk-based capital ratio. Investments in 
unconsolidated financial entities must also be deducted from regulatory 
capital (as well as from assets): 50 percent from Tier 1 capital and 50 
percent from Tier 2 capital. Such deductions prevent multiple uses of 
the same capital resources by entities that are not consolidated (based 
on national accounting and/or regulatory systems) and to gauge the 
capital adequacy of individual institutions on a stand-alone basis. The 
Basel Committee explained that such deductions are necessary to prevent 
the double gearing (or double-leveraging) of capital, which can have 
negative systemic effects for the banking system by making it more 
vulnerable to the rapid transmission of problems from one institution 
to another.
    In 1989, the FFRAs adopted the Basel I Tier 1 and Tier 2 capital 
framework with some variations to correspond to the characteristics of 
the financial institutions they regulate. All FFRAs treat common 
stockholders' equity

[[Page 39410]]

(including retained earnings), noncumulative perpetual preferred stock 
and certain minority interests in equity accounts of subsidiaries \120\ 
as Tier 1 capital.\121\ The FRB and FDIC also emphasize in their 
guidelines that common stockholders' equity should be the predominant 
form of Tier 1 capital. Tier 2 capital includes a certain portion of 
qualifying ALL and unrealized holding gains of available-for-sale 
equity securities, cumulative perpetual and term preferred stock, 
subordinated debt and other kinds of hybrid capital instruments.\122\ 
Tier 2 capital is limited to 100 percent of Tier 1 capital. Certain 
Tier 2 capital elements, such as intermediate-term preferred stock and 
subordinated debt, are limited to 50 percent of Tier 1 capital. The 
FFRAs' regulations include a 4-percent Tier 1 risk-based capital ratio, 
an 8-percent total risk-based capital ratio and a 3- or 4-percent 
minimum leverage ratio requirement.\123\ The FFRAs also require certain 
deductions to be made prior to computing the risk-based capital ratios.
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    \120\ Minority interests in equity accounts of subsidiaries 
represent stockholders' equity associated with common or 
noncumulative perpetual preferred equity instruments issued by an 
institution's consolidated subsidiary that are held by investors 
other than the institution. They typically are not available to 
absorb losses in the consolidated institution as a whole, but they 
are included in Tier 1 capital because they represent equity that is 
freely available to absorb losses in the issuing subsidiary. Some of 
the FFRAs restrict these minority interests to 25 percent of Tier 1 
capital.
    \121\ The OTS and FRB have additional elements in Tier 1 
capital. For example, the OTS permits some of its institutions to 
include nonwithdrawable accounts and pledged deposits in Tier 1 
capital to the extent that such accounts have no fixed maturity 
date, cannot be withdrawn at the option of the accountholder and do 
not earn interest that carries over to subsequent periods. The FRB 
permits certain BHCs to treat certain ``restricted core capital 
elements'' (restricted elements) as Tier 1 capital. Restricted 
elements include qualifying cumulative perpetual preferred stock and 
cumulative trust preferred securities, which are limited to 25 
percent of Tier 1 capital. The FRB has recently decreased this limit 
to 15 percent of Tier 1 capital for certain internationally active 
BHCs but has delayed the effective date to March 31, 2011. See 70 FR 
11827 (March 10, 2005) and 74 FR 12076 (March 23, 2009).
    \122\ The FFRA's elements of Tier 2 capital are discussed in 
more detail below.
    \123\ The minimum leverage ratio requirement depends on the type 
of institution and a regulatory assessment of the strength of its 
management and controls. Banks holding the highest supervisory 
rating and not growing significantly have a minimum leverage ratio 
of 3 percent; all other banks must meet a leverage ratio of at least 
4 percent.
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2. Proposed Changes to the Current Tier 1/Tier 2 Framework
    In December 2009, the Basel Committee described a number of 
possible fundamental reforms to the Tier 1/Tier 2 capital framework in 
its Basel Consultative Proposal. The reforms proposed in the Basel 
Consultative Proposal would strengthen bank-level, or micro-prudential, 
regulation, which will help increase the resilience of individual 
banking institutions during periods of stress. The Basel Committee is 
also considering a macro-prudential overlay to address procyclicality 
and systemic risk. The objective of the reforms is to improve the 
banking sector's ability to absorb shocks arising from financial and 
economic stress and reduce the risk of spillover from the financial 
sector to the real economy. The Basel Committee also aims to improve 
risk management and governance as well as strengthen banks' 
transparency and disclosures.
    The Basel Committee proposes to improve the quality and consistency 
of Tier 1 capital. The new standards would place greater emphasis on 
common equity as the predominant form of Tier 1 capital. Common equity 
means common shares plus retained earnings and other comprehensive 
income, net of the regulatory adjustments (which can be 
significant).\124\ The Basel Committee has also identified a Tier 1 
element it calls ``additional going-concern capital,'' which would be 
all capital included in Tier 1 that is not common equity.\125\ Certain 
instruments with innovative features that do not meet the criteria of 
common equity and additional going-concern capital would be phased out 
of Tier 1 capital over time.
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    \124\ Common shares must meet a set of criteria to be included 
in Tier 1 capital. See paragraph 87 of the Basel Consultative 
Proposal.
    \125\ Additional going concern capital must meet a set of 
criteria to be included in Tier 1 capital. See paragraphs 88 and 89 
of the Basel Consultative Proposal.
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    The Basel Consultative Proposal defines Tier 2 capital as capital 
that provides loss absorption on a gone-concern basis.\126\ The 
criteria that instruments must meet for inclusion in Tier 2 capital 
would be simplified from the Basel I criteria. All limits and 
subcategories related to Tier 2 capital would be removed.
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    \126\ Instruments must meet or exceed a set of criteria to be 
included in Tier 2 capital. See paragraph 90 of the Basel 
Consultative Proposal.
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    The Basel Committee plans to revise the Tier 1 risk-based and total 
risk-based capital ratios. Since common equity would be the predominant 
form of Tier 1 capital, the Basel Committee would establish a common 
equity risk-based minimum to ensure that it equates to a greater 
portion of Tier 1 capital. The data collected in the impact assessment 
will be used to calibrate the new minimum required levels and ensure a 
consistent interpretation of the predominant standard. The regulatory 
adjustments that are applied to capital, including the new common 
equity component, would also change.\127\
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    \127\ A description of the regulatory adjustments can be found 
in paragraphs 93 through 108 of the Basel Consultative Proposal.
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    The Basel Committee is also introducing a non-risk-based leverage 
ratio as a supplementary ``backstop'' measure based on gross 
exposure.\128\ A Tier 1 and/or common equity leverage ratio will be 
considered as possible measures. The leverage ratio would be harmonized 
internationally, fully adjusting for material differences in 
accounting, and, unlike the current leverage ratios of the FFRAs, would 
appropriately integrate off-balance sheet items.
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    \128\ See paragraphs 202 through 207 of the Basel Consultative 
Proposal.
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    The Basel Committee has included a proposal for capital 
conservation standards that would reduce the discretion of banks to 
distribute earnings in certain situations.\129\ A Tier 1 capital buffer 
range would be established above the regulatory minimum capital 
requirement. When the Tier 1 capital level falls within this range, a 
bank would be required to conserve a certain percentage of its earnings 
in the subsequent financial year. Regulators would have the discretion 
to impose time limits on banks operating within the buffer range on a 
case-by-case basis. The Basel Committee will use the impact assessment 
to calibrate the buffer and restrictions of this regulatory capital 
conservation framework.
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    \129\ See paragraphs 247 through 259 of the Basel Consultative 
Proposal.
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    Finally, the Basel Committee proposes to improve the transparency 
of capital. Banks would be required to: (1) Reconcile all regulatory 
capital elements back to the balance sheet in the audited financial 
statements; (2) separately disclose all regulatory adjustments; (3) 
describe all limits and minimums, identifying the positive and negative 
elements of capital to which the limits and minimums apply; (4) 
describe the main features of capital instruments issued; and (5) 
comprehensively explain how the capital ratios are calculated. In 
addition to the above, banks would be required to make available on 
their Web sites the full terms and conditions of all instruments 
included in regulatory capital.\130\
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    \130\ See paragraphs 80 and 81 of the Basel Consultative 
Proposal.
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    The FFRAs have not yet announced or proposed these recommended 
changes to their regulatory capital frameworks. However, we note that 
the FFRAs used higher capital standards consistent with

[[Page 39411]]

the Basel Consultative Proposal in their ``Supervisory Capital 
Assessment Program'' (SCAP) conducted between February and April 2009 
to assess the capital adequacy of 19 of the largest U.S. bank holding 
companies.\131\ We also note that the U.S. Treasury's core principles 
for reforming the U.S. and international regulatory capital framework 
are consistent with the Basel Committee's recent proposal.\132\ 
Finally, we note that the National Credit Union Administration (NCUA) 
issued a proposed rule to propose changes to its regulation that would 
improve the quality of capital at corporate credit unions.\133\ Among 
the regulations the NCUA is proposing is a retained earnings minimum to 
ensure that a corporate credit union's capital base does not consist of 
entirely contributed capital. This should provide a cushion to protect 
against the downstreaming of corporate credit union losses to its 
natural person credit unions when those institutions could least afford 
those losses.\134\
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    \131\ A detailed white paper on the SCAP data and methodology 
was published in April 2009, and the results were published in May 
2009. See ``The Supervisory Capital Assessment Program: Design and 
Implementation'' (April 24, 2009) and ``The Supervisory Capital 
Assessment Program: Overview of Results'' (May 7, 2009). These 
documents are available at http://www.federalreserve.gov.
    \132\ See ``Principles for Reforming the U.S. and International 
Regulatory Capital Framework for Banking Firms,'' (September 3, 
2009). This document is available at http://www.ustreas.gov.
    \133\ See 74 FR 65209 (December 9, 2009).
    \134\ See also Statement of Michael E. Fryzel, Chairman of NCUA, 
on ``H.R. 2351: The Credit Union Share Insurance Stabilization Act'' 
before the U.S. House of Representatives, Basel Committee on 
Financial Services, SubBasel Committee on Financial Institutions and 
Consumer Credit (May 20, 2009). This document is available at: 
http://www.ncua.gov.
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    The comment period for the Basel Consultative Proposal closed on 
April 16, 2010. As noted above, the Basel Committee has indicated it 
plans to issue a ``fully calibrated, comprehensive set of proposals'' 
covering all elements discussed in the consultative document. It is 
expected that Basel Committee member countries will phase in the new 
standards as their economies improve, with an aim of full 
implementation by the end of 2012.

    Dated: June 30, 2010.
Roland E. Smith,
Secretary, Farm Credit Administration Board.
[FR Doc. 2010-16457 Filed 7-7-10; 8:45 am]
BILLING CODE 6705-01-P