Publication of the December 2002 update to the Bank Holding Company Supervision Manual - Announcements

Federal Reserve Bulletin, March, 2003

The December 2002 update to the Bank Holding Company Supervision Manual, Supplement No. 23, has been published and is now available. The Manual comprises the Federal Reserve System's regulatory, supervisory, and inspection guidance for bank holding companies. The new supplement includes the following subjects:

1. Capital Adequacy. The revised sections on the assessment of capital adequacy include various rule changes, clarifying interpretations, an advisory, and other supervisory guidance. They include

a. A change to Regulation Y (12 CFR 225, appendix A) that was approved by the Board on November 8, 2001 (effective January 1, 2002) and issued in a joint interagency press release dated November 29, 2001. The revised rule addresses the risk-based capital treatment for recourse obligations, residual interests (except credit-enhancing I/Os), direct-credit substitutes, and senior subordinated securities in asset securitizations that expose banking organizations (including bank holding companies) primarily to credit risk. New standards are added for the treatment of residual interests, as well as a concentration limit for credit-enhancing I/O strips. Credit ratings from rating agencies and certain limited alternative-credit-rating approaches are used to match more closely the risk-based capital requirement for these banking organizations to their relative risk of loss for certain positions in asset securitizations.

b. A change to Regulation Y that was approved by the Board on January 8, 2002 (effective April 1, 2002). This revised rule established special minimum risk-based capital requirements for equity investments in nonfinancial companies. The requirements impose a series of marginal capital charges on authorized covered equity investments that increase with the level of a bank's overall exposure to equity investments relative to its tier 1 capital. The highest marginal capital charge requires a 25 percent deduction from tier 1 capital for authorized covered investments that aggregate more than 25 percent of a bank holding company's tier 1 capital. (See SR letter 02-4.)

c. The Board's approval of a limited risk-based capital change to Regulation Y on March 27, 2002, effective July 1, 2002. (See the Federal Reserve's joint press release of April 9, 2002, and its attachment.) The change lowered, from 100 percent to 20 percent, the risk weight that is applied to certain securities claims on, or guaranteed by, a qualifying securities firm in the United States and in other countries that are members of the Organization for Economic Cooperation and Development.

d. The May 17, 2002, interagency advisory on the risk-based capital treatment of accrued interest receivables (AIR) related to credit card securitizations. The AIR asset typically represents a subordinated retained interest in the transferred assets. The asset therefore meets the definition of a "residual interest" that requires dollar-for-dollar capital, even if the amount exceeds the fully equivalent risk-based capital charge on the transferred assets under the November 2001 Regulation Y amendment. When accounting under FAS 140, "Accounting for Transfers and Servicing of Financial Assets and the Extinguishment of Liabilities," for the securitization and sale of credit card receivables, and in computing the gain or loss on sale, a banking organization (seller) should report the AIR asset on the date of transfer, at adjusted cost, based on its relative fair (market) value. (See SR letters 02-12 and 02-22.)

e. The joint September 5, 2002, interagency interpretive guidance discussing the appropriate applications of the November 2001, joint final rule on the treatment of recourse obligations, direct-credit substitutes, and residual interests in asset securitizations. The guidance addresses the risk-based capital treatment for (1) split or partially rated instruments, (2) nonqualification of corporate bonds or other securities for the ratings-based approach, (3) spread accounts that function as credit-enhancing interest-only strips, (4) audits of internal credit risk rating systems, and (5) cleanup calls. (See SR letter 02-16.)

f. The Federal Reserve's March 23, 2002, supervisory guidance on derivative contracts hedging trust preferred stock as to the inclusion of such trust preferred stock in tier 1 capital. In order for an issuing bank holding company to include the stock in tier 1 capital, it must have the ability to defer payments for at least 20 consecutive quarters without giving rise to an event of default. Such a deferral feature, which typically is cumulative in trust preferred stock, is essential in a tier 1 instrument because it allows the issuer to conserve its cash resources at a time when its financial condition is deteriorating. Issues of trust preferred stock may not be included in tier 1 capital if they are covered by a derivative contract that defeats the cash-conserving purpose of the deferral mechanism on the trust preferred stock. (See SR letter 02-10.)