|BOARD OF GOVERNORS
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 20551
|DIVISION OF BANKING
SUPERVISION AND REGULATION
November 9, 2001
Over the past several years, a number of banking organizations have engaged in various types of forward transactions relating to the repurchase of their common stock. In these transactions, the banking organization enters into an arrangement with a counterparty, usually an investment bank or another commercial bank, under which common shares of the banking organization are purchased by the counterparty, either in the open market or directly from the institution itself, with the agreement that the banking organization will repurchase those shares at an agreed-upon forward price at a later date (typically three years or less from the execution date of the agreement). These transactions are used to "lock in" stock repurchases at price levels that are perceived to be advantageous and also as a means of managing regulatory capital ratios.
Banking organizations have generally continued to treat shares under such arrangements as Tier 1 capital. However, because these transactions can impair the permanence of the shares and typically have certain features that are undesirable from a supervisory point of view, shares covered by these arrangements have qualities that are inconsistent with Tier 1 capital status.1 Accordingly, any common stock covered by forward equity transactions entered into after issuance of this letter will be excluded from Tier 1 capital.2
Banking organizations have engaged in two main types of forward transactions: forward equity sales transactions and forward purchase contracts.
Forward Equity Sales Transactions
In a forward equity sales transaction, a banking organization purchases its own common shares in the open market, generally as part of a stock buyback program, and then issues these shares to a counterparty at a specified price that approximates the then-current market value. Simultaneously, the banking organization enters into a forward contract with the same counterparty to repurchase the shares at the same price plus a premium (the forward price).
Forward Purchase Contracts
Forward purchase contracts differ from forward equity sales transactions in that the counterparty purchases the shares to be covered under the contract directly in the open market. The banking organization agrees to purchase the shares from the counterparty at a future date at the forward price.
Forward equity sales transactions and forward purchase contracts can generally be settled in one of three ways, typically at the option of the banking organization:
While shares covered under such agreements retain certain characteristics of Tier 1 capital, the shares are nonetheless under contractual agreements that can limit their availability to absorb future losses. Specifically, under the gross physical settlement method, the shares have the potential to be retired in a relatively short period of time. Therefore, the forward equity transaction impairs the permanence of those shares.
In addition, the net settlement options described above depend on the future market price of the common stock. In a stress scenario, this could lead to undesirable results from a supervisory point of view. For example, if an institution has entered into a forward equity transaction and subsequently experiences financial deterioration, it is likely that the institution's share price would reflect this stress and would have declined to a price lower than the forward price fixed in the agreement. In order to settle the forward transaction, it is likely that the institution, in exercising its flexibility to choose the settlement method, would eschew share settlement to avoid dilution and would choose instead to settle the transaction through an expenditure of cash. Moreover, the further the stock price declines, the more cash the banking organization would need to settle the transaction, resulting in a greater drain of resources for an institution that is already distressed. Aside from the potentially negative financial effects that could result from such a scenario, the net settlement options in these transactions attach to a Tier 1 capital instrument what is essentially a market value conversion feature that could weaken a stressed institution. The Federal Reserve's examination manuals state that market-rate convertible preferred stock must be excluded from Tier 1 capital.4 The policy reasons for excluding market-rate convertible preferred apply with equal force to common shares subject to a forward equity transaction.
Due to these concerns, the Federal Reserve has determined that shares covered by forward equity arrangements should not be included in the Tier 1 capital of a bank holding company or a state member bank. The amount to be excluded would be equal to the common stock, surplus, and retained earnings associated with the shares. Banking organizations that currently have common stock covered under forward equity transactions may continue to treat those shares as Tier 1 capital, but shares covered by any future forward equity transactions, other than those specified for deferred compensation or other employee benefit plans, must be excluded, even if executed under a currently existing master agreement.
Reserve Banks are asked to distribute this letter to banking organizations in their district and to supervisory staff. Questions may be addressed to Norah Barger, Deputy Associate Director, (202) 452-2402, or Dave Adkins, Supervisory Financial Analyst, (202) 452-5259.
SR letters | 2001