Seal of the Board of Governors of the Federal Reserve System BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM

WASHINGTON, D. C.  20551
DIVISION OF BANKING
SUPERVISION AND REGULATION
SR 02-4
March 4, 2002

TO THE  OFFICER IN CHARGE OF SUPERVISION
AT EACH FEDERAL RESERVE BANK

SUBJECT:   Final Capital Rules for Nonfinancial Equity Investments

                      On January 25, 2002, the Federal Reserve Board (Board), the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) jointly published in the Federal Register a rule establishing special minimum regulatory capital requirements for equity investments in nonfinancial companies, effective on April 1, 2002.1  This SR letter summarizes the key provisions of the new capital rule and attaches the text of the interagency preamble and the rules promulgated by the Board for state member banks and bank holding companies.2  As noted in the preamble, these rules are designed as an interim step or "bridge" to the ongoing comprehensive review and revision of the Basel Capital Accord, which is expected to include provisions addressing equity investment activities.

                      It is important to note that these capital requirements are minimum regulatory requirements.  Consistent with the rule and in accordance with existing guidance, banking organizations conducting material equity investment activities should have internal methods for allocating adequate economic capital based on the risk inherent in these activities.3  Organizations substantially engaged in equity investment activities generally allocate economic capital to these activities in amounts in excess of regulatory minimums.

                      Reserve Banks should distribute this letter and the attachment to the appropriate banking organizations under their jurisdiction.  Reserve Banks should also ensure that all central points of contact, examiners, and other staff involved in the supervision of banking organizations' investment activities review the final capital rules and become familiar with SR letters 99-18 and 00-9.  The Spring 2002 revisions to the Trading and Capital Markets Activities Manual will reflect the new capital rule.

Summary of the Final Capital Rules for Nonfinancial Equity Investments

                      Investments Covered by the Rule.  Examiners should be aware that the new capital requirements apply symmetrically to banks and bank holding companies (BHCs) and impose a series of marginal capital charges on covered equity investments that increase with the level of a banking organization's overall exposure to equity investments relative to Tier 1 capital.  The capital rules apply to equity investments made under:

  • The merchant banking authority of section 4(k)(4)(H) of the Bank Holding Company Act (BHC Act) (12 U.S.C. 1843(k)(4)(H)) and subpart J of the Board's Regulation Y.

  • The authority to acquire up to 5 percent of the voting shares of any company under section 4(c)(6) or 4(c)(7) of the BHC Act (12 U.S.C. 1843(c)(6) and (c)(7)).

  • The authority to invest in small business investment corporations (SBICs) under section 302(b) of the Small Business Investment Act of 1958 (15 U.S.C. 682(b)).

  • The portfolio investment provisions of Regulation K (12 C.F.R. 211.8(c)(3)), including the authority to make portfolio investments through Edge and Agreement corporations.

  • The authority to make investments under section 24 of the Federal Deposit Insurance Act (FDI Act) (other than under section 24(f)) (12 U.S.C. 1831a).

Other than equity investments held in connection with securities underwriting, dealing, and trading activities, or as hedges to derivatives transactions, the aforementioned are the only authorities under which banking organizations are expected to hold any substantial amount of equity investments.

                      An equity investment includes the purchase, acquisition or retention of any equity instrument (including common stock, preferred stock, partnership interests, interests in limited liability companies, trust certificates, and warrants and call options that give the holder the right to purchase an equity instrument), any equity feature of a debt instrument (such as a warrant or call option), and any debt instrument that is convertible into equity.  The rule generally does not apply to investments in nonconvertible senior or subordinated debt.  Examiners should note, however, that the agencies may impose the rule's higher charges on any instrument if the agency, based on a case-by-case review of the instrument in the supervisory process, determines that the instrument serves as the functional equivalent of equity or exposes the banking organization to essentially the same risks as an equity investment.

                      The capital charge applies to investments held directly or indirectly in "nonfinancial companies" under one of the authorities listed above.  A nonfinancial company is defined as an entity that engages in any activity that has not been determined to be financial in nature or incidental to financial activities under section 4(k) of the BHC Act.  For investments held directly or indirectly by a bank, the term "nonfinancial company" also does not include a company that engages only in activities that are permissible for the parent bank to conduct directly.

                      Schedule of Capital Charges.  The marginal capital charges are applied by making a deduction from the banking organization's Tier 1 capital.  Examiners should note that the final rule adopts a "stairstep" approach under which each tier of capital charges applies, on a marginal basis, to the adjusted carrying value of the banking organization's aggregate nonfinancial equity investment portfolio that falls within the specified range of the organization's Tier 1 capital.  The stairstep approach reflects the fact that the financial risks to a banking organization from equity investment activities increases as the level of these activities account for a larger portion of the organization's capital, earnings, and activities.  The Federal Register preamble to the final rule contains examples of the application of the capital charges.

                      An 8 percent charge applies to that portion of the total portfolio that amounts to less than 15 percent of the banking organization's Tier 1 capital.  A 12 percent charge applies to that portion of the total portfolio that amounts to between 15 to 24.99 percent of the banking organization's Tier 1 capital.  A 25 percent charge applies to that portion of the portfolio that amounts to 25 percent or more of the organization's Tier 1 capital.

                      The adjusted carrying value of an investment is the value at which the investment is recorded on the balance sheet of the banking organization, reduced by (i) net unrealized gains that are included in carrying value but have not been included in Tier 1 capital; and (ii) associated deferred tax liabilities.

                      Consistent with the treatment of other assets deducted from capital, the total adjusted carrying value of a banking organization's nonfinancial equity investments that is subject to a deduction from Tier 1 capital is excluded from the organization's risk-weighted assets and from average total consolidated assets.

                      Exemptions from the Rule; Investments Not Covered by the Rule.  Examiners should be aware that there are a number of exemptions from the rule, one or more of which may apply to the banking organizations for which they have supervisory responsibility.  The adjusted carrying value of exempted investments is included for purposes of calculating the marginal capital charge applicable to equity investments covered by the rule.  Other investments are not subject to the rule; the adjusted carrying value of these investments is not included for purposes of calculating the marginal capital charge under the rule.

                      The rule exempts from the additional regulatory capital charge on SBIC investments held directly or indirectly by a bank to the extent that the aggregate adjusted carrying value of all such investments does not exceed 15 percent of the Tier 1 capital of the bank.  For BHCs, no additional regulatory capital charge is imposed on SBIC investments held directly or indirectly by the holding company to the extent the aggregate adjusted carrying value of all such investments does not exceed 15 percent of the aggregate of the holding company's pro rata interests in the Tier 1 capital of its subsidiary banks.  However, the adjusted carrying value of all SBIC investments must be included in determining the total amount of nonfinancial equity investments held by the banking organization in relation to its Tier 1 capital, and thus, the marginal capital charge that applies to the organization's covered equity investments. 

                      A grandfather provision exempts from the higher capital charges any individual investment made by a bank or BHC before March 13, 2000, or made after such date pursuant to a binding written commitment entered into prior to March 13, 2000.  An investment qualifies for grandfather rights only if the banking organization has continuously held the investment since March 13, 2000 (or the date the investment was acquired if it was acquired after March 13, 2000 pursuant to a binding written commitment entered into prior to such date).  For example, if the banking organization sold 40 shares of a grandfathered investment in Company X on March 15, 2000 and purchased another 40 shares of Company X on December 31, 2000, the 40 shares would be ineligible for grandfathered status and the adjusted carrying value of those 40 shares would be subject to the new charge.  Shares or other interests received by a banking organization through a stock split or stock dividend on a grandfathered investment are not considered new investments if the banking organization does not provide any consideration for the shares or interests and the transaction does not materially increase the organization's proportional interest in the portfolio company.

                      The adjusted carrying value of all grandfathered investments must be included in determining the total amount of nonfinancial equity investments held by the banking organization in relation to its Tier 1 capital, and thus, the marginal capital charge that applies to the organization's covered equity investments. 

                      The rule does not apply to investments made by a state bank under the authority contained in section 24(f) of the FDI Act.  The rule also does not apply the higher capital charges to equity securities acquired and held by a bank or BHC as a bona fide hedge of an equity derivatives transaction lawfully entered into by the institution.  The adjusted carrying value of these investments is not included in determining the total amount of nonfinancial equity investments held by the banking organization.

                      The rule does not apply to investments made in community development corporations under 12 U.S.C. 24 (Eleventh), or to equity securities that are acquired in satisfaction of a debt previously contracted and that are held and divested in accordance with applicable law.  The rule also does not apply to equity investments made under section 4(k)(4)(I) of the BHCA by an insurance underwriting affiliate of a financial holding company.  The adjusted carrying value of these investments is not included in determining the total amount of nonfinancial equity investments held by the banking organization.

                      Rules Establish Minimum Levels of Capital Pending Revision of Basel Capital Accord.  The capital requirements established by the rule are minimum levels of capital for a banking organization's equity investment activities.  The rule requires banking organizations to at all times maintain capital that is commensurate with the level and nature of the risks to which they are exposed, including the risks of private equity and merchant banking investments.  Consistent with the guidelines identified in SR letter  99-18, institutions conducting material equity investment activities are expected to have internal methods for allocating capital based on the inherent risk and control environment of these activities.  These methodologies should identify material risks and their potential impact on the safety and soundness of the consolidated entity.  Examiners should review the internal capital methodologies of banking organizations engaged in significant equity investment activities in addition to reviewing for compliance with the capital requirements established by the rule.

                      The Board, the OCC and the FDIC are participating actively in the ongoing comprehensive review and revision of the Basel Capital Accord, which is expected to include provisions addressing equity investment activities.  The Board believes that the final rule is consistent with the efforts of the Basel Committee to develop a minimum regulatory capital requirement that is more risk-sensitive than the current 100 percent risk-weighting.  The capital rules for nonfinancial equity investments are an interim step or "bridge" to the revised Accord.  The Board anticipates revisiting the capital charge applicable to equity investments once the Basel Capital Accord is revised, in order to determine what, if any, revisions to the rules should be adopted in light of the final revised Accord.

                      Questions and Further Information.  Questions regarding the rules may be directed to Mary Frances Monroe, Senior Supervisory Financial Analyst (202/452-5231), or Michael J. Schoenfeld, Senior Supervisory Financial Analyst (202/452-2836), Market and Liquidity Risk Section.

 

Richard Spillenkothen
Director

 

Attachment

Cross-reference: SR letters 00-9 and 99-18

 



Note:

  1. Refer to 67 FR 3784 (January 25, 2002).  Return to text

  2. The Board’s press release announcing the new rule and the Federal Register notice can be found at www.federalreserve.gov/boarddocs/press/boardacts/2002/20020108/.  Return  to text

  3. Refer to SR letter 00-9, Supervisory Guidance on Equity Investment and Merchant Banking Activities (June 22, 2000), and SR letter 99-18, Assessing Capital Adequacy in Relation to Risk at Large Banking Organizations and Others with Complex Risk Profiles (July 1, 1999)  Return to text


SR letters | 2002