Title: PROPOSED RULE--Funding and Fiscal Affairs, Loan Policies and Operations, and Funding Operations; General Provisions--12 CFR Parts 615 and 618
Issue Date: 05/12/1988
Agency: FCA
Federal Register Cite: 53 FR 16948
___________________________________________________________________________
FARM CREDIT ADMINISTRATION

12 CFR Parts 615 and 618

Funding and Fiscal Affairs, Loan Policies and Operations, and Funding Operations; General Provisions


ACTION: Proposed rule.

SUMMARY: The Farm Credit Administration (FCA) proposes for comment an amendment to 12 CFR Part 615, Subpart H that establishes minimum permanent capital standards for Farm Credit System (System) institutions. The amendment implements section 301(a) of the Agricultural Credit Act of 1987, which directs the FCA to issue regulations under section 4.3(a) of the Farm Credit Act of 1971, establishing minimum permanent capital standards expressed as a ratio of capital to assets that takes into account relative risk factors. The regulation provides for a relative weighting of assets on the basis of risk and establishes a minimum ratio of permanent capital to weighted assets that would be phased in over 5 years. The proposed regulation also sets forth the factors that should be considered in developing plans to achieve capital adequacy for each Farm Credit System institution. The FCA proposes to remove existing 615.5210 and add it to Part 618 as 618.8440. The FCA also proposes to remove and reserve 615.5220 and 615.5240 of Subpart I, which set forth debt to capital ratios required under prior law. The FCA withdraws capital adequacy regulations that were published for comment on July 23, 1986 (51 FR 26402), prior to the enactment of the 1987 Act. These proposed regulations would have the effect of requiring System institutions to meet the minimum permanent capital adequacy levels specified in the regulations.

DATES: Comments must be submitted on or before June 10, 1988. A public hearing is scheduled for June 9, 1988. See the "Final Notice of Hearings" published elsewhere in this issue of the Federal Register.

ADDRESSES: Comments and requests to testify may be mailed (in triplicate) to Anne E. Dewey, General Counsel, Farm Credit Administration, 1501 Farm Credit Drive, McLean, VA 22102-5090. Copies of all communications received will be available for examination by interested parties in the Office of General Counsel, Farm Credit Administration. For address of public hearings see the "Final Notice of Hearings" published elsewhere in this issue of the Federal Register.

FOR FURTHER INFORMATION CONTACT:

William G. Dunn, Chief, Financial Analysis and Standards Division, Farm Credit Administration, 1501 Farm Credit Drive, McLean, VA 22102-5090, (703) 883-4402,
or
Dorothy J. Acosta, Senior Attorney, Office of General Counsel, Farm Credit Administration, 1501 Farm Credit Drive, McLean, VA 22102-5090, (703) 883-4020, TDD (703) 883-4444.

TEXT: SUPPLEMENTARY INFORMATION: On July 23, 1986, the Farm Credit Administration (FCA) published for comment proposed regulations (51 FR 26402) relating to capital adequacy and minimum capital for Farm Credit System (System) institutions pursuant to section 4.3(a) of the Farm Credit Act of 1971 (1971 Act), 12 U.S.C. 2154. The proposed regulation would have established regulatory zones based on capital levels, within which System institutions would have been authorized to take a number of actions that previously required FCA approval. Such actions included the establishment of interest rates, payment of dividends and distribution of earnings. On October 16, 1986, the FCA published for comment proposed conforming amendments to Parts 614 and 615 (capital adequacy related regulations) (51 FR 36824).

On January 6, 1988, the Agricultural Credit Act of 1987, Pub. L. 100-233 (1987 Act) was enacted, amending the 1971 Act to alter significantly the capital structure of Farm Credit banks and associations and to delete many previously required prior approvals by the FCA. System banks and associations have greater flexibility to determine their capital structure and develop sources of "at-risk" capital than they previously had. In addition, the 1987 Act makes significant structural changes in the System, requiring mergers among the Federal land banks (FLBs) and the Federal intermediate credit banks (FICBs) in each district and permitting mergers among all banks within a district, among banks for cooperatives (BCs), among production credit associations (PCAs), and Federal land bank associations (FLBAs) within a district, and between certain institutions in different districts. In addition, Federal land bank associations may become direct lenders.

As a result of these statutory changes, described more fully below, the FCA has determined that the capital adequacy regulations proposed for comment on July 23, 1986, are no longer appropriate and hereby withdraws them. The capital adequacy related regulations are similarly affected and the FCA will determine in the near future what adjustments need to be made in the current regulations and the proposed amendments.

I. Agricultural Credit Act of 1987 (1987 Act)

The 1987 Act makes significant changes in the capital structure of Farm Credit banks and associations (collectively "institutions"). New capitalization bylaws are required to be developed implementing the statutory changes. See section 301(b) of the 1987 Act. The bylaws do not require FCA prior approval, but must enable the institution to meet the minimum capital adequacy standards established by the FCA and must have majority stockholder approval.

The statutory requirement to purchase stock is reduced from 5 percent to 2 percent of $1,000, whichever is less, although the institution may require more under its bylaws. Such stock need not be retired upon repayment of the loan or otherwise at the option of the borrower; retirement must be solely at the discretion of the board of directors. No retirement can be made unless the institution meets the minimum capital adequacy standards established by the FCA under section 4.3(a) of the 1971 Act. Voting stock may only be held by borrowers who are farmers, ranchers, producers or harvesters of aquatic products, and eligible cooperatives; nonvoting stock may be issued to non-borrowers. Voting stock must be converted to nonvoting stock within 2 years of loan repayment. All stock is freely transferable.

A distinction is made between the new "at-risk" stock and "eligible borrower stock," which is protected from impairment. Section 201 of the 1987 Act amends the 1971 Act to add a new section 4.9A, which requires the institution to retire such protected "eligible borrower stock" at par value upon repayment of the loan, whether or not such stock is impaired. Section 201 also provides for such impairments to be cured with Federal financial assistance, which is exchanged for preferred stock issued to the Farm Credit System Assistance Corporation, an entity created by the 1987 Act. "Eligible borrower stock" is defined as stock, participation certificates and allocated equities, issued or allocated to persons other than Farm Credit System institutions, and which was outstanding on the date of enactment or issued after enactment as a condition of obtaining a loan but before the earlier of 9 months from enactment or the date the institution adopts capitalization bylaws under the 1987 Act. The bylaws must require holders of eligible borrower stock to exchange a portion of it for new, at-risk stock.

Section 4.3(a) of the 1971 Act, added in 1985, requires the FCA to adopt minimum capital standards for Farm Credit System institutions and empowers the FCA to issue directives to institutions that fail to maintain capital at or above the minimum standard, in addition to any other enforcement powers available to the FCA. Such directives may require the institution to develop and adhere to a plan that would enable the minimum capital standard to be met. In addition, the FCA is allowed, in its discretion, to consider such a failure an unsafe and unsound condition and to consider the institution's progress toward meeting the standard when considering whether to give prior approvals required under the 1971 Act to any proposal to divert earnings or otherwise impede the institution's progress in meeting its minimum capital level. Section 4.3(b)(3); 12 U.S.C. 2154.

While the 1987 Act eliminated many required prior approvals by the FCA, the provisions of section 4.3(a) of the 1971 Act were not changed. However, section 301(a) of the 1987 Act directs the FCA to issue regulations under section 4.3(a) establishing for Farm Credit System institutions minimum "permanent capital" standards that specify fixed percentages representing the ratio of permanent capital of the institution to the assets of the institution, taking into consideration relative risk factors, as determined by the FCA. Minimum permanent capital standards are required to be phased in over a 5-year period and must be based on financial statements of the institutions prepared in accordance with generally accepted accounting principles (GAAP).

"Permanent capital" is defined as "current year retained earnings, allocated and unallocated earnings, all surplus (less allowances for losses), and stock issued by a System institution, except stock that --

(A) May be retired by the holder thereof on repayment of the holder's loan, or otherwise at the option or request of the holder; or

(B) Is protected under section 4.9A or is otherwise not at risk."

Section 4.3A(a)(1) of the 1971 Act, added by section 301(b) of the 1987 Act. "Stock" is defined to mean "voting and nonvoting stock (including preferred stock), equivalent contributions to a guaranty fund, participation certificates, allocated equities, and other forms and types of equities." Section 4.3A(a)(2) of the 1971 Act, as amended.

The effect of these definitions is to include within permanent capital all capital in System institutions except that which is protected under section 4.9A of the 1971 Act, as amended, or is otherwise not at risk, and that which must be retired upon repayment of the loan or otherwise at the option of the borrower.

In response to the statutory directive to issue regulations under section 4.3(a) of the 1971 Act establishing minimum permanent capital standards, the FCA issued an Advance Notice of Proposed Rulemaking (ANPRM) on February 17, 1988 (53 FR 4642), requesting comment on a proposed approach that would be similar to the risk-adjusted capital proposals of other Federal bank regulatory agencies and on a number of related issues. The comment period closed on March 1, 1988.

Comments were received from the Farm Credit Corporation of America (FCCA) on behalf of the 37 Farm Credit banks, several individual Farm Credit districts, a number of production credit associations and Federal land bank associations, the American Bankers Association, the United States League of Savings Institutions, and the National Farmers Union. A summary of the issues raised in the ANPRM and the comments received follows.

II. Summary of Comments

A. Level of Required Minimum Permanent Capital

The FCA stated in the ANPRM that capital must be sufficient to protect investors, minimize the risk of insolvency and provide for current and future needs, including protection against risks inherent in concentrated, single-industry lending in fixed geographic territories, and that minimum capital ratios should generally be higher than those set or proposed for more diversified financial institutions.
Two Farm Credit districts, the American Bankers Association and the United States League of Savings Institutions supported the FCA's contention that capital levels should be generally higher for single-industry lenders with a lack of geographic diversification. One Farm Credit district asserted that capital levels even far in excess of those now proposed for diversified financial institutions would not have been adequate to allow a number of System institutions to survive without assistance from inside and outside the System.

The National Farmers Union agreed that single-industry lending in fixed geographical territories poses greater risk that those faced by diversified financial institutions, but voiced concern that higher capital standards would result in higher interest rates to borrowers, which would result in borrower flight from the System.

The FCCA did not agree that capital standards for Farm Credit institutions should be higher than for commercial banks. The FCCA argued that System institutions have less liquidity risk than commercial banks because of the System's status as a "sponsored" agency with access to the financial markets not available to commercial banks, the protection afforded debtholders by joint and several liability, the active secondary market in System debt issues, the easier access to liquidity through Federal Reserve purchase of debt issues, and the absence of demand deposits. In addition, the FCCA argued that commercial banks have more payment system risk, more country risk, more single borrower lending concentrations and a lower percentage of collateralized loans. The FCCA pointed out that other "sponsored" agencies, such as the Federal National Mortgage Association, are capitalized at lower rates than commercial banks because of their limited liquidity risks and that the Farm Credit System Insurance Corporation (created by section 302 of the 1987 Act) will provide greater protection for "insured" System liabilities than do Federal Deposit Insurance Corporation assets for insured commercial deposits. (After January 6, 1989, System debt issuances will be considered "insured" pursuant to section 302 of the 1987 Act.)

The FCCA also argued that the need to be competitive imposes a practical limit on the amount of permanent capital that can be accumulated, inasmuch as the cost of accumulating new capital would either be passed on to borrowers in the form of higher interest rates or would reduce capital that could otherwise be accumulated, or both. Finally, the FCCA asserted that the agricultural industry is extremely diversified with a broad variety of products, market factors and economic conditions. Several commentors stated that the mergers of the Federal land banks and the Federal intermediate credit banks would result in wider diversification in the resulting Farm Credit banks than has existed heretofore.

The FCCA suggested that a minimum permanent capital standard in the range of 3 to 4 percent be established for all System banks and associations. One Farm Credit district suggested that institutions be expected to achieve a 3 percent ratio by the end of the second year of the phase-in period and 4 percent by the fifth year. Another believed that the rate should be higher than the 4 percent core capital ratio proposed by the other regulators. An association suggested that 5 1/2 percent would be an appropriate ratio.

Several commentors urged the FCA not to respond to the System's single-industry lending status and the adversity of the last 4 years with excessive capital requirements in the belief that the System could have weathered the recent adversity had its capital levels been high enough. To do so, it was argued, would be self-defeating to the System in its attempt to obtain new capital, in that institutions would be unable to pay a return to providers of capital and would be forced to charge uncompetitive rates to borrowers.

Several commentors stated that the FCA must take into account the fact that the allowance for losses is excluded from the statutory definition of permanent capital in the 1987 Act, while other regulators include the general portion of the allowance in the capital base. One commentor stated that Farm Credit System institutions should be allowed to do the same in order to be competitive with commercial banks. One commentor asserted that, if the risks in the loan portfolio are properly identified and the allowance for losses is adequate, System institutions carry proportionately fewer risk assets on their balance sheets than do more diversified institutions, since the remainder of the PCA's assets are invested in the FICB and in facilities and equipment used in the operation of the business.

One commentor opined that there should be local participation in establishing minimum permanent capital ratios. The commentor believed that local markets and the risk associated with specific commodities should be considered.

B. Single or Multiple Standards

In the ANPRM, the FCA invited comment on whether there should be a single standard for all System institutions or different standards that reflect the different levels of risk inherent in the operations of different types of institutions.

The FCCA favored a single standard in view of the potential complexity of the prospective System structure. The FCCA believed that the differences in risk could be addressed by risk-adjusting the assets and establishing the allowance for losses at an appropriate level.

Several other commentors supported the idea of using one standard for all institutions and accounting for the differences in the risk-weighting of the assets. One commentor suggested developing extensive and sophisticated asset risk-weighting categories that are reflective of the structural nature of the System as it evolves under the provisions of the 1987 Act and the collateral type and quality of the loan.

On the other hand, some commentors believed that the risk-weighting of assets would not adequately address the differences in risk evidenced by the historical loss records of the various institutions. One commentor noted that the recent stress in the agricultural sector impacted different institutions in the same district differently and that differential minimum permanent capital standards should be established after the differences have been quantified and studied.

A number of associations urged the FCA to consider the relationship between the associations and their district banks in setting capital standards. Several commentors noted that the association's ability to meet capitalization requirements depends on the actions of the district banks in setting interest rates, passing operating and other costs to the association, establishing the required investment in the bank and approving interest rates and operating budgets. These commentors urged the FCA to issue regulations that would insure that the associations have the same opportunity to meet capitalization standards as do district banks.

Another commentor suggested that the regulations impose restrictions on the transfer of capital between a Farm Credit bank and its associations, which would have the effect of requiring the bank to raise capital from outside sources rather than through raising the cost of funds to the associations. The commentor also urged that FCA merger regulations require the merged association to meet a specific capital adequacy standard upon chartering, to prevent nonviable associations from merging and utilizing capital which would be better utilized by viable associations, and that Farm Credit banks be prohibited from distributing capital to merging associations that cannot meet the capital adequacy standards.

One commentor noted that the capital adequacy ratios should logically depend in large part upon what the FCA and System institutions envision the future functions of bank and associations to be. The commentor stated that the Congressional intent evident in the new legislation to decentralize more responsibility to associations is likely to result in System institutions that are not as closely tied together as vertically integrated financial intermediaries as they have been in the past. The commentor, therefore, suggested that a flexible treatment of capital necessary to offset risks involved in asset liability management may be needed, as well as higher levels of capital to compensate for the loss of the protective supervision of Farm Credit banks. These changes, the commentor suggested, argue for differential capital levels. An association that if fully involved in asset liability management may need more stringent liquidity policies and procedures, and also more capital, than the association that simply discounts most of its assets with an intermediary wholesaler such as a Farm Credit bank.

One commentor urged the FCA to require disclosure of the current year's ratio of income to capital as well as the three previous year's ratios and projections for the next 3 years.

3. Risk-Based Capital Approach

In the ANPRM, the FCA stated its intention to consider the adoption of a risk-based approach similar to the proposed Interagency Guidelines published on March 15, 1988, by the Board of Governors of the Federal Reserve System (Federal Reserve), the Comptroller of the Currency (Comptroller) and the Federal Deposit Insurance Corporation (FDIC), (53 FR 8550) modified to reflect the relative risk factors inherent in the System institutions and the unique nature of permanent capital, as defined by the 1987 Act. The Interagency Guidelines are based on several years of study and are intended to promote the stability of the banking system and bring some degree of uniformity to capital standards so that there is competitive equity among institutions subject to the oversight of different regulators.

Under the Interagency Guidelines, assets would be assigned to categories ranging from 0 to 100 percent according to the risk inherent in the particular type of asset. Assets assigned to the 0 percent category would be deemed to present no risk and would be excluded from the asset base altogether for the purpose of determining the institution's permanent capital ratio. Assets having the greatest risk would be assigned to the 100 percent category and the full face amount of the asset would be included in the asset base. Assets having intermediate degrees of inherent risk would be assigned to intermediate percentage risk categories and the face amount of the asset included in the asset base to the extent of the assigned percentage. The institution's permanent capital would then be divided by the institution's risk-adjusted asset base to arrive at the permanent capital ratio, which would be expressed as a percentage.

The Interagency Guidelines utilize two measures for commercial banks: (1) "tier one," core capital; and (2) "tier two," total capital, which includes core capital plus certain elements of supplementary capital. Core capital consists of stockholder's equity (common stock, surplus, and retained earnings -- including disclosed capital reserves that represent an appropriation of retained earnings, net of Treasury stock and foreign currency translation adjustments); minority interest in common stockholder's equity accounts of unconsolidated subsidiaries; and, during the transition period, certain supplementary capital elements. Supplementary capital consists of the general allowance for losses on loans and leases; perpetual and long-term preferred stock (original maturity of at least 20 years); hybrid capital instruments -- including perpetual debt, mandatory convertible securities and subordinated debt; and intermediate term preferred stock (original maturity of 7 years or more).

Many commentors supported the use of risk-adjusted capital standards similar to those used by other regulators. The FCCA noted that the substantive research, discussion, and agreement among Federal banking regulators make it an appropriate model for the System and that such an approach is consistent with the Congressional intent underlying section 301. The FCCA proposed a risk-weighting of assets that is similar to that used in the Interagency Guidelines, with some modifications for assets unique to the System. For example, the FCCA proposed that investments in System institutions be risk-weighted at 0 percent and that loans to System be risk-weighted at 75 percent. The FCCA argued that such assets have less exposure to loss than loans and assets generally by reason of the unique protective devices available currently and prospectively to System institutions, such as joint and several liability, the availability of financial assistance through the Farm Credit System Assistance Board, and the protection to be provided through the Farm Credit System Insurance Corporation.

The FCCA favored a single measure of minimum capital over the two-tier approach of the Interagency Guideline. One Farm Credit district urged the FCA not to use a standard based on a ratio of unallocated surplus to assets. However, several commentors suggested that the regulatory standards developed by the FCA be treated as minimum guidelines and that the institution be held accountable for maintaining "appropriate levels" of capital, which may be in excess of the regulatory minimum.

The American Bankers Association (ABA) urged the FCA to monitor the progress of the risk-based capital proposals of the other regulators to ensure that the regulations adopted by FCA at least meet the standards for commercial banks and included its comments on the risk-based capital proposals of the other regulators. The ABA's comments were generally critical of the proposals of the other regulators as a mandatory approach and urged the other regulators to allow the industry to develop risk-based capital guidelines.

D. Off-Balance-Sheet Items

In the ANPRM, the FCA stated its intention to require capital support for certain off-balance-sheet items, such as undisbursed commitments, letters of credit, and similar obligations that have some risk, by assigning them some weight for inclusion in the risk-adjusted asset base.

Comments received on weighting off-balance-sheet items were generally supportive. One commentor favored including undisbursed commitments only if they cannot be withdrawn. The FCCA stated that the weighting of off-balance-sheet items should be consistent with the Interagency Guidelines, but that only amount-specific commitments should be risk-weighted. For example, commitments under joint and several liability and loss sharing agreements or guarantees should be specifically excluded until such time as events occur that define the amount, as determined under GAAP, of the commitments.

E. Phase-In Period

In the ANPRM, the FCA stated its intention to propose interim target ratios which would be greater each year until the fifth year when the minimum permanent capital standard must be met and to prohibit the payment of dividends and patronage until the fifth year standard is met.

The FCCA noted that during the first 5 years certain System banks and associations may need to rely upon retained earnings as the primary method of accumulating permanent capital to meet minimum capital adequacy standards and that a number of institutions may be unable to accumulate sufficient permanent capital within the next 5 years to meet the standard, even if they are well managed. The FCCA suggested that the FCA periodically conduct an institution-by-institution evaluation of progress in meeting the capital adequacy standard and establish regulatory oversight accordingly, giving considerable weight to the trend in accumulation of capital in addition to the absolute level attained. The FCCA recognized that regulatory enforcement action is both necessary and appropriate where the standard has not been met during the phase-in period and cannot be realistically projected in a sound business plan, but suggested that no regulatory action be taken against an institution that is effectively managed and has a total capital (including protected stock) of greater than 3 percent of weighted risk assets and a positive trend in the accumulation of permanent capital, even though the minimum permanent capital standard has not yet been met. This approach contemplates that the FCA and each institution would negotiate a trend line (not necessarily linear) with the objective of meeting the capital adequacy standard, even if doing so requires longer than a 5-year period.

The FCCA and a number of other commentors urged the FCA to reconsider its intention to prohibit the payment of patronage refunds or dividends until the final minimum standard is met. It was argued that such a prohibition will make it difficult for Farm Credit System institutions to develop sources of capital other than required borrower capital and, to the extent borrowers have anticipated such distributions as a reduction of their borrowing costs, may cause borrower flight from System institutions. The FCCA proposed an alternative by which a System institution is allowed to pay patronage refunds and dividends as long as the interim targets negotiated between the institution and the FCA are met. Several commentors agreed with this proposal. One commentor noted that the association might be able to get borrowers to convert protected stock to new, at-risk stock if the customers were assured of getting a return on their investment.

One Farm Credit district urged that phase-in regulations be specific enough to avoid subjective judgments by the FCA, with quantifiable measures and standards established through regulation, and that the institution's capital management not be hampered by an "all or none" philosophy for payment of dividends and patronage except in circumstances where there is a safety and soundness issue.

Several associations requested that the FCA, in establishing interim standards, take into account nonrecurring events that temporarily distort the capital on an institution, such as the significant adverse impact of the Tax Reform Act of 1986 on production credit associations that had substantial loan loss reserves.

Commentors were generally supportive of requiring a plan during the phase-in period to achieve the minimum permanent capital standard. One commentor noted that such plans should address dividends and endorsed the components of the financial plan that was required in the capital adequacy regulations proposed by the FCA on July 23, 1986. One commentor believed that plans would be particularly helpful "during the interim period in which FCA prohibited from taking certain regulatory actions solely because of the failure of institutions to meet minimum adequacy standards." This commentor believed that the requirement should be lifted when the minimum capital requirement is met and as long as it is maintained.

F. Treatment of Equities

In the ANPRM, the FCA stated its intention to eliminate "double duty dollars" in the computation of the permanent capital ratio. "Double duty dollars" is a term that refers to the use of one dollar of real capital to support two credit risks.

The FCCA encouraged the continued use of "double duty dollars," stating that such continuation would be consistent with the requirements under section 301(a)(1)(b) of the 1987 Act and GAAP. The FCCA stated that the use of double duty capital encourages the generation of earnings at the discount lenders level, with benefits passed to the direct lenders through the cooperative patronage refund process, thus providing an equity base at the bank level to support its potential obligations under joint and several liability, as well as any secondary risk in its discount lending operation. The FCCA stated, however, that if there were to be an adjustment for double duty dollars to the extent that capital is counted only once, the capital should support those assets to which the primary risk applies and that the assets to which a secondary risk applies (i.e. the bank's loan to the association) should be risk-weighted at 0 percent.

Two districts and one association favored eliminating the double duty dollar. One district cited analogies to the treatment of unconsolidated subsidiaries and reciprocal holdings by the Interagency Group. Another district suggested that elimination of the double duty dollar might be accomplished by looking at a Farm Credit bank and its related associations as a combined entity for the purpose of determining the capital requirements, since it may be difficult to allocate the capital between the bank and association. An association suggested that the Farm Credit banks pay out any future earnings distribution in cash, noting the tax consequences of such a change, but also noting that such a method would eliminate the current complicated accounting practice. All of the commentors who commented on the issue favored concentrating the capital at the direct lender level where the primary risk resides.
In the ANPRM, the FCA also stated that equities that will be paid to borrowers in accordance with revolvement policies that entitle the shareholder to a specific payout at a specific time should not be considered as permanent capital.

The FCCA stated its belief that the only allocated equities that should be excluded from the determination of permanent capital are "allocated equities that were outstanding of the date of enactment of the 1987 Act and 'protected' under section 4.9A of the 1971 Act, as amended by the 1987 Act, and allocated equities (in a specific dollar amount) that will be retired on a date certain by reason of a specific action of the board of directors of the System institution authorizing such specific retirement." The FCCA stated that until such time as a board of directors establishes a date certain claim against allocated equities, such equities are at risk and should be considered permanent capital.

One Farm Credit district opined that the statute means for certain allocated equities that were revolved only by unilateral action of the System institution's board of directors to be considered at risk and therefore "permanent capital."

Several commentors, including the FCCA, urged the FCA to allow institutions to count certain elements that are not considered permanent capital under the 1987 Act, such as the allowance for losses and protected equities, in computing their permanent capital ratios, at least during the phase-in period. One commentor suggested that protected equities might be discounted in some manner to reflect their "demand character."

G. Average Daily Balances

In the ANPRM, the FCA stated its expectation that the standards would be applied on the basis of daily average balances of the relevant accounts for each calendar quarter.

Most commentors believed that it would be difficult and costly for many institutions to close their books on a daily basis in order to comply, and that the cost would outweigh the benefits to be achieved. The FCCA noted that the seasonal variation and other loan volume trends of System institutions may cause a significant distortion in the amount of capital required, even on a quarterly basis, and that such distortions may cause overstatements in some cases and understatements in others of capital required against risk-adjusted assets. The FCCA proposed that the permanent capital ratios of System institutions be calculated as of the last day of each calendar quarter.
One district suggested that the standards be applied on the basis of a 12-month rolling average of month-end figures if 12-month daily averages are not considered feasible. One association indicated that daily averages would presently be a burdensome requirement, but that if given sufficient time, the capacity to obtain daily average balances could be acquired.

H. Public Hearing

The FCA invited comment on whether a public hearing would contribute to the thorough airing of issues related to capital adequacy. The response to this invitation was positive. One commentor suggested that hearings should be held in different parts of the country. Another suggested that a two-way discussion format be used for the hearing. Another requested that the full range of capital-adequacy-related issues be addressed.

I. Other Comments

The FCCA noted that section 6.9(e)(3)(D) [probably intended to be (B)] of the 1971 Act, added by section 201 of the 1987 Act, requires a treatment of the third quarter 1986 capital preservation assistance liabilities that is inconsistent with GAAP and requested a clarification that the term "GAAP" as used in section 301(a)(1)(B) means GAAP as adjusted for many exceptions in accordance with section 6.9(e)(3)(D) [probably B].

III. Response To Comments

A. Capital Adequacy

After careful consideration of the comments, the FCA proposes for comment a capital adequacy regulation that establishes a single risk-adjusted minimum permanent capital standard as a baseline for capital adequacy for all Farm Credit System institutions engaged in lending or leasing. The proposed regulation is modeled after the Interagency Guidelines proposed by the other Federal regulators. The FCA believes the Interagency Guidelines are an appropriate model for risk-weighting assets, even though Farm Credit System institutions are cooperatively organized, inasmuch as the risks associated with various types of assets are the same regardless of the organizational form of the institution that holds them (although rates should generally be higher for single-industry lenders).

The proposed minimum permanent capital standard is primarily designed to protect against credit or counterparty risk that is inherent in the investment, servicing, lending, and leasing operations of System institutions, and which is not accounted for by the allowance for losses. Other types of risk, such as interest rate, liquidity, funding, and operational risks are not fully taken into account by the minimum standard. Such risks arising from management decisions made in the normal course of operations vary significantly among institutions and will require capital levels greater than those required by the proposed minimum permanent capital standard.

Establishment of a minimum permanent capital standard does not relieve the boards of directors and managements of System institutions from their obligation to evaluate and determine an adequate level of total capital. Overall capital adequacy should be set at a level to provide a base for required growth and a buffer to protect the institution's owners and creditors from future adversity. It should also provide for risks not taken into account by the minimum standard. An institution's overall capital requirements can only be determined after careful review of specific circumstances in each individual institution, such as: quality of policies, procedures, and internal controls; capability and experience of management, quantity and quality of earnings; adequacy of the allowance for credit losses; adequacy of liquid funds; needs of the institution's customer base; and any other risk-oriented activities requiring additional capital.

A final assessment of overall capital adequacy must take into account each of these conditions including, in particular, the level and severity of problem and classified assets. The minimum permanent capital ratio proposed by the FCA is but one element in the determination of overall capital adequacy, which determination may differ significantly from conclusions that might be drawn solely from the institution's risk-based capital ratio.

B. Single Standard for All Institutions

The proposed regulation adopts a single standard for all System institutions rather than multiple rates reflective of the different levels of risk inherent in the lending and leasing operations of the various Farm Credit System institutions. The FCA is well aware that the historical loss experience of different types of Farm Credit System institutions varies widely and that capital needs among institutions of the same type may differ greatly from institution to institution. However, the minimum standard is intended to provide for risks inherent in and common to lending institutions whether or not they are organized as cooperatives. In this regard, the risk-weighting of assets allows for the single rate to have a differential impact on an institution-by-institution basis, inasmuch as institutions with proportionately more high risk assets would be required to have more capital even though the rate is the same.

The FCA does not propose to weight assets on the basis of the condition or classification of the loan. These differences will be reflected in the allowance for losses, which, though not included in the computation of the permanent capital ratio, will affect the determination of the overall capital adequacy of an institution. Nor does the FCA propose to attempt to weight assets on the basis of type of commodity or geographic area or local markets. The difficulty of making such numerous, sophisticated judgment on these dynamic relative risk factors makes this an impracticable approach. Differences in risk exposure resulting from these factors, as well as other risks which may vary from institution to institution, such as interest rate, liquidity, and operational risks, must be determined and provided for by the board of directors in determining the overall capital requirements for each institution. The adoption of a single minimum standard for all System institutions would be consistent with Interagency Guidelines on risk-adjusted capital proposed by the Federal Reserve, the Comptroller, and the FDIC (collectively, the Interagency Group).

The FCA proposes to make the Farm Credit Leasing Corporation (Leasing Corporation) subject to the proposed minimum permanent capital standards. The Leasing Corporation is exposed to risks similar to those encountered by Farm Credit banks and associations, inasmuch as leasing is a functional equivalent of lending. If lessees fail to perform in accordance with their lease terms, the Leasing Corporation may be left holding depreciated assets of little or no value. Because the risks are similar, the FCA proposes that the Leasing Corporation be subject to the same minimum permanent capital standards as System banks and associations.

The proposed regulation does not establish a minimum permanent capital standard for the Federal Farm Credit Funding Corporation, the FCCA, the Federal Agricultural Mortgage Corporation, or the Financial Assistance Corporation, all of which are Farm Credit System institutions. Capital standards for these institutions must be approached differently since they are not primarily engaged in lending and leasing operations. The FCA is considering what standards are appropriate for such institutions.

C. Asset Risk Weights

After a careful review of the asset risk-weights proposed by the Interagency Group and comments received on the ANPRM, the FCA has determined to propose for comment the asset risk-weight categories developed by the Interagency Group of 0, 10, 20, 50 and 100 percent. The proposed weight categories for risk assets are determined primarily on the basis of the type of instrument and the type of obligor. The only forms of collateral that are formally considered by the risk asset framework are obligations of the U.S. Government and its agencies and obligations of U.S. Government-sponsored agencies. The only guarantees that are recognized for weighting purposes are guarantees of the U.S Government, U.S. Government-sponsored agencies, and domestic State and local governments. However, other forms of collateral or guarantees would be taken into account in evaluating the adequacy of an institution's allowance for losses to properly value the credit portfolio. The allowance for losses is expressly excluded from the statutory definition of permanent capital in the 1987 Act. However, the adequacy of the allowance for losses must be addressed by the board, and management of each institution (and examined by the FCA for adequacy) in determining the overall capital requirements of the institution.

The FCA does not agree with the FCCA that System loans and investments should carry a lower risk-weight because of unique System protective devices, especially Federal financial assistance. The FCA believes that the System and the FCA have an obligation to make every effort to minimize the reliance on Federal assistance. Furthermore, the proposed regulation would establish a standard that the FCA believes, based on the information currently available, would be appropriate when financial assistance is terminated. Also, while "unique System protective devices" such as joint and several liability may provide risk protection to outside investors, for Farm Credit institutions, joint and several liability is an additional risk as well as a protective device. For the purpose of establishing internal capital standards, the proposed regulation considers Farm Credit System institutions as independent, stand-alone, but related entities. Accordingly, the FCA did not accept the FCCA's suggestion to weight investments in System institutions at 0 and loans to System institutions at 75. If the FCA were to accept the FCCA's suggestion to continue to double-count capital, the FCA would propose to risk-weight intra-System loans at 100 percent.

The FCA also did not accept the FCCA's suggestion that, if double counting of capital were to be eliminated, the direct loan from banks to associations should be risk-weighted at 0. Such a risk-weighting would undermine the effect of eliminating double counting of capital, since the objectionable feature of double-counted capital is that one dollar of real capital supports two units of risk. While the FCA recognizes that to some extent the risk of default on the direct loan and the risk of default by borrowers are the same risk, the FCA also believes that there is a secondary level of risk posed by the possibility that some associations may default for reasons other than or in addition to the direct passthrough of loan losses and that some cushion is needed to provide for the possibility that not all associations will be adequately capitalized. To provide for these risks, the FCA proposes to risk-weight direct loans to and investments in other Farm Credit System institutions at 20 percent.

The treatment of off-balance-sheet items in the proposed regulation is consistent with the Interagency Guidelines. Off-balance-sheet items would first be converted to a credit equivalent by the application of credit conversion factors that are also risk-based. For example, off-balance-sheet items that are direct credit substitutes have a credit conversion factor of 100 percent, because the institution is subject to essentially the same credit risk as if it had made a direct loan to the obligor or account party. Transaction-related contingencies, i.e., instruments backing the performance of nonfinancial or commercial contracts or undertakings and undisbursed commitments with original maturity exceeding 1 year, are subject to a 50-percent conversion factor. Short-term, self-liquidating, trade-related contingencies that arise from the movement of goods, such as commercial and documentary letters of credit collateralized by the underlying shipments, are subject to a credit conversion factor of 20 percent. Unused commitments with an original maturity of 1 year or less are deemed to involve little risk and are subject to a 0-percent credit conversion factor, which results in their requiring no capitalization at all. After applying the credit equivalent factor, the resulting amount is assigned to a risk-weight category or the same bases as the balance sheet assets-type of obligor or guarantor or type of collateral.

The treatment of goodwill is also consistent with the Interagency Guidelines. Goodwill acquired after the date of publication of this proposed regulation and all goodwill on the books of the institution after January 1, 1993, would be deducted from permanent capital (and the asset base) before computing the permanent capital ratio. This treatment is proposed because of the uncertainty of the future benefits of such an intangible asset, inasmuch as it does not involve a contractual right to receive a definite income stream for a specified or certain period. In the event an institution experiences financial difficulties, goodwill may not provide the degree of support provided by other assets because goodwill cannot be sold separately and because the entity whose acquisition gave rise to the goodwill may not be readily marketable. However, goodwill acquired before the date of publication of the proposed regulation would be "grandfathered." Until 1993, such goodwill would not be deducted from permanent capital, but would be risk-weighted in the asset base at 100 percent.
The proposed rule does not make any adjustments for intangible assets other than goodwill. Except for goodwill, there is no uniformity among the Interagency Group on the treatment of intangible assets. The Federal Reserve generally evaluates intangible assets on a case-by-case basis and makes appropriate adjustments when the level or recorded value of these intangibles is inconsistent with the organization's overall financial condition. The FDIC and the Comptroller permit purchased mortgage servicing rights to be considered in the computation but allow other intangibles only on a case-by-case basis. The FCA invites comment on the appropriate treatment of intangible assets in the computation of the permanent capital ratio.

Differences from Interagency Guidelines: There are, however, several differences between the proposed regulation and the Interagency Group's proposed asset-risk weights:

(1) The Interagency Group weights cash items in process of collection in the 20-percent category; the proposed regulation assigns them to the 10-percent category. System institutions with these items have very low loss experience.

(2) The proposed regulation makes no distinction between the U.S. Government or U.S. Government-agency securities with less than 90 days to maturity and those with longer maturities, as the Interagency Group does. The FCA assigns all such securities to the 10-percent category rather than the 0-percent category, because short-term securities remain subject to some degree of interest rate and market risk.

D. Single Measure of Permanent Capital Adequacy

The proposed regulation does not incorporate a two-tier approach similar to the Interagency Group proposal. The Interagency Guidelines include in tier two, or total capital, elements that would not fall within the statutory definition of permanent capital, such as the general allowance for losses, hybrid debt-equity instruments and subordinated debt. The Interagency Guidelines also limit such supplementary capital that can be counted toward the capital ratio to 100 percent of the core capital. Although the proposed regulation does not adopt a similar two-tier approach, the FCA emphasizes that the minimum permanent capital standard is a minimum and does not fully take into account all of the risks a particular institution may need to provide for in determining an overall adequate level of capital. Also, while the proposed rule does not distinguish between various elements of permanent capital, the FCA encourages the accumulation of capital that is not subject to revolvement.

E. Treatment of Certain Equities

1. Allocated equities: The FCA regards all allocated equities that can be retired only in the discretion of the board (provided minimum standards are met) as permanent capital, as defined in the statute. However, the FCA wishes to encourage the accumulation of capital which both the institution and the holder understand at the outset is not subject to revolvement (except in the absolute discretion of the board), as the FCA understands this to be the intent of Congress in enacting the new capitalization provisions of the 1987 Act. Therefore, the proposed regulation would not count capital subject to revolvement as permanent capital unless (1) the bylaws state that such capital can be retired only at the discretion of the board and that there is no express or implied right granted to the borrower to have the capital retired at the end of the revolvement cycle or at any other time; and (2) the notice of allocation contains a similar statement.

The effect of this treatment would be to exclude from permanent capital all allocated equities presently outstanding, since they would not have been issued under such a bylaw, with such notice to the borrower. However, all of these equities are already excluded from permanent capital under section 4.9A of the 1971 Act, as amended by the 1987 Act.

2. FLB passthrough equities: The proposed rule would also exclude from the definition of permanent capital equities of the Federal land banks (FLBs) held by the Federal land bank associations (FLBAs) that were purchased in connection with loans supported by stock that is retireable upon repayment of the borrower's loan. The FCA believes that Congress intended such equities to be considered retireable upon repayment of the borrower's loan and therefore excluded from the statutory definition of "permanent capital." Such equities represent a direct, dollar-for-dollar passthrough of capital purchased by the borrower in the FLBA required by the 1971 Act prior to its amendment in 1987. Title I of the 1971 Act, prior to its replacement by the new Title I in the 1987 Act (which takes effect July 5, 1988), requires FLBA stock to be retired upon repayment of the loan. Section 1.16 of the 1971 Act, 12 U.S.C. 2033. It has long been the practice of FLBs to retire its FLBA-owned equities issued in connection with a particular loan when the loan is paid off, in order to permit the FLBA to fulfill its statutory obligation to retire its borrower-owned equities. Indeed, most FLBAs would be unable to retire their protected stock without stock impairment if the FLB did not retire the corresponding FLB stock, as most FLBAs have few earning assets and little earned net worth. If such FLB equities were to be treated as permanent capital, the statutory prohibition against the reduction of permanent capital through the payment of dividends or patronage or the retirement of stock if minimum permanent capital standards are not met (see new section 4.3A(d), added by section 301(b) of the 1987 Act) would effectively preclude the retirement of protected stock if the FLB did not meet the minimum permanent capital standards. This could lead to the anomalous result of FLBAs in relatively healthy districts seeking Federal Financial assistance, and facing insolvency if it were denied, while the FLB materially improves its capital position (since it no longer has the asset to support by retains the supporting capital).

The FCA believes the 1987 Act need not and should not be interpreted to yield such an unintended result. The 1987 Act excluded from the definition of permanent capital two categories of equities: (1) Equities protected under section 4.9A of the Act or otherwise not at risk; and (2) stock that must be retired upon repayment of the loan or otherwise at the option of the borrower. All borrower stock outstanding on the date of enactment and all stock issued as a condition for obtaining a loan until the earlier of the adoption of the new capitalization bylaws or 9 months from enactment is protected and included in Category 1. Under the new bylaws, no stock will be retireable at the option of the holder. Therefore, there are no FLBA equities that could fall into Category 2 that are not protected and, therefore, included in Category 1. The FCA has concluded that Congress must have considered FLB equities issued to FLBAs in connection with loans supported by protected stock to be retireable upon repayment of the loan or otherwise at the request of the holder and, therefore, excluded from the definition of "permanent capital." To treat such equities as permanent capital would render Category 2 a nullity and would produce a result inconsistent with the Federal financial assistance framework set forth in the 1987 Act.

3. Preferred Stock: Preferred stock is included within the statutory definition of permanent capital. However, the proposed rule would consider preferred stock issued to the Financial Assistance Corporation to be permanent capital only to the extent it is not used to offset impairment of protected equities. To the extent it offsets such an impairment (so that all protected equities can be retired at par in accordance with the 1987 Act), it is not available to absorb risk. To treat such stock as permanent capital would undermine the clear intent of Congress to include in permanent capital only that capital which is available to absorb risk.

F. Double Duty Dollars

The proposed regulation would eliminate "double duty dollars" for the purpose of computing the permanent capital ratio. Double counting of capital in related institutions having a direct lending or discount relationship would be eliminated by excluding from permanent capital of the funding institution the direct lender's stock investment in the funding institution. Double counting of capital between institutions having a participation relationship would be eliminated in the following manner: Where an institution is required to invest in another institution in order to capitalize the participation interest of such other institution, the amount of such investment would be deducted from the permanent capital of the investing institution. For the purpose of eliminating double counting of capital only, the FLB and the FLBA would be considered to have a participation relationship. That is, the FLB would be considered to be the participating institution and the FLBA the investing institution. Double counting of capital between the Leasing Corporation and its owners would be eliminated by reducing the permanent capital of the owners of the Leasing Corporation by an amount equal to their investment in the Leasing Corporation.

The proposed regulation would also disregard any reciprocal or cross-holdings of stock or participation certificates in the computation of permanent capital in both institutions. These holdings are relatively rare, occurring primarily because of FICB financial assistance to PCAs in the form of capital investment. In some cases, such capital may not satisfy the definition of permanent capital because it can be retired at the option of the holder or because it was issued with a definite retirement date. Where these holdings do qualify as permanent capital, they would be deducted from both the permanent capital and the asset base of each institution prior to the computation of the permanent capital ratio and prior to the deductions required to eliminate "double duty dollars."

The proposed approach to "double duty dollars" is consistent with the Interagency Guidelines. While the concept of "double duty dollars" has no direct application in commercial banks, their proposed elimination would be analogous to the practice of the Interagency Group of eliminating related company transactions and reciprocal equity holdings between commercial banks prior to computing risk-adjusted capital ratios. The Interagency Guidelines eliminate related company transactions either through consolidation or by deducting investments in unconsolidated subsidiaries from the institution's capital before computing the minimum capital ratio. The rationale for such treatment of unconsolidated subsidiaries is that the assets of an unconsolidated subsidiary are not fully reflected in the parent's assets and "may be viewed as the equivalent of off-balance-sheet exposures since the operations of an unconsolidated subsidiary could expose the parent organization * * * to considerable risk." The Interagency Group views the capital invested in these entities as primarily supporting the risk inherent in the off-balance-sheet assets and not generally available to support risks or additional leverage elsewhere in the organization.

Reciprocal holdings are also deducted from the capital bases of both institutions under the Interagency Guidelines. In addition, the Interagency Group further considered whether to require the deduction of all holdings in other banks since these do not represent additional capital to the banking system as a whole and could increase the possibility that problems could be transmitted from one institution to another. While the Interagency Group decided not to restrict non-reciprocal holdings of capital, it was not addressing relationships between related entities. Based on these actions and comments, it is clear that the Interagency Group would not permit the use of the same capital twice in two related entities.

The FCA shares the concerns of the Interagency Group as they apply to System institutions and believes it is necessary to eliminate "double duty dollars" in order to obtain an accurate picture of the System's capital position and to assure that capital levels of all System institutions are adequate. Were "double duty dollars" not to be eliminated, the minimum standard would need to be established at higher levels to compensate for the double counting, since one dollar of capital supports both the primary and secondary lending risk. Also, loans to System institutions would then be risk-weighted at 100 percent.

The FCA believes that eliminating "double duty dollars" is not inconsistent with section 301 of the 1987 Act or GAAP. The proposed elimination would not reduce or not count permanent capital; it would merely avoid double counting the real capital that is there. Furthermore, eliminating the "double duty dollars" by treating the bank and the association as a combined entity, as suggested by one Farm Credit district, would be consistent with GAAP. Financial Accounting Standards Board Statement 12 states:

There are circumstances, however, where combined financial statements (as distinguished from consolidated statements) of commonly controlled enterprises are likely to be more meaningful than their separate statements. For example, combined financial statements would be useful if one individual owns a controlling interest in several enterprises that are related in their operations. Combined statements also would be used to present the financial position and the results of operations of a group of unconsolidated subsidiaries. They also might be used to combine the financial statements of enterprises under common management. If combined statements are prepared for a group of related enterprises, such as a group of unconsolidated subsidiaries or a group of commonly controlled enterprises, intercompany transactions and profits or losses shall be eliminated, and if there are problems in connection with such matters as minority interests, foreign operations, different fiscal periods or income taxes, they shall be treated in the same manner as in consolidated statements.

While the ownership structure is inverted in the Farm Credit System, the same principles apply. Combined statements of the bank and the association are required in reports to shareholders by 12 CFR Part 620 and are used in Reports to Investors, both of which are required to be prepared in accordance with GAAP. Furthermore, the FCA believes that the primary purpose of the Congressional directive to base the minimum permanent capital standards on financial statements prepared in accordance with GAAP was to assure that capital standards would not be based on the regulatory accounting procedures permitted under section 5.9 of the 1971 Act, 12 U.S.C. 2254.

While using a combined balance sheet as a basis for computing permanent capital ratios would eliminate "double duty dollars," the FCA does not want to obscure the fact that the institutions are independent entities. Therefore, the proposed regulation is drafted to accomplish the elimination directly and to count the capital at the direct lender level, where the primary risk resides.

The FCA considered other methods of eliminating (for the purpose of computing permanent capital ratios) the double counting of capital and/or assets between institutions having a lending/investing relationship. Among the methods considered were the following:

One method considered would have eliminated double-counted assets and capital and apportioned them 75 percent to the direct lender and 25 percent to the funding institution (the "75/25" approach). The assets of the funding institution would be reduced by an amount equal to 75 percent of the loan (or discount) to the direct lender and the assets of the direct lender would be reduced by 25 percent of its indebtedness to the funding institution. Similarly, when counting capital, the funding institution would reduce its permanent capital by an amount equal to 75 percent of the direct lender's investment in the funding institution and the direct lender would reduce its permanent capital and assets by an amount equal to 25 percent of its investment in the funding institution. Adjustments having a similar effect would be made for the BC/CBC system and for the Leasing Corporation.

A second method considered would have eliminated double-counted capital and assets by excluding them from consideration by the investing institution (the "owned funds" approach). The investing institution, when computing its permanent capital ratio, would have been required to exclude from its assets and its capital an amount equal to its investment in its funding institution. The funding institution would be permitted to include all its otherwise eligible capital.

The FCA invites comments on these alternatives to the proposed approach, or others, that would eliminate double-counted dollars between institutions having a lending/investing relationship.

G. The Minimum Permanent Capital Standard

The FCA proposes to require that System institutions maintain at all times permanent capital that is adequate for their institution, but in no case less than 7 percent of their risk-adjusted assets. After reviewing the comments submitted, the FCA continues to believe that concentrated, single-industry lending within limited geographic areas is inherently riskier than is the more diversified multi-industry lending that is typical of many commercial banks. The FCA rejects the FCCA's argument that System institutions have less risk from single borrower lending concentrations than commercial banks; few commercial banks are as dependent on the well-being of a few borrowers as are many Farm Credit System institutions.

Historically, the Farm Credit System has maintained high levels of capital relative to commercial lending institutions. For instance, until 1971, the BCs were prohibited from exceeding debt-to-capital ratios of 13 to 1 (7.1 percent). In 1982, before the magnitude of the current crisis was fully understood, the Farm Credit System developed monitoring standards in support of capital preservation and other loss-sharing agreements, which set capital as a percent of total assets for Farm Credit System institutions at levels of about 1.5 percent for FICBs, 4 percent for FLBs, 7 percent for PCAs, and 7 percent for BCs. After risk-adjusting total assets and eliminating "double duty dollars" in these institutions, the proposed standards are not substantially different.

The Interagency Group has proposed a 1992 minimum capital standard with two components -- a core capital (essentially, common stockholders' equity) standard of 4 percent, and a "second-tier" standard, which considers other forms of capital (including the allowance for losses) in addition to core capital, of 8 percent. These standards are intended to apply to all financial institutions in the United States and, basically, represent the minimum standards agreed to by 10 Western industrialized countries. (The United Kingdom, for comparison, has proposed minimum standards for core capital of 8 percent for its institutions.)

The FCA estimated the levels of permanent capital that would have been required by various System institutions in order to have survived the stress of the last 5 years without Federal assistance and still be able to generate positive earnings in 1992. The studies showed that the combined FLB/FLBA system would have needed permanent capital of about 10 percent of weighted assets -- with some districts needing up to 16 percent. The FICB/PCA and BC systems were estimated to need somewhat less, while many individual PCAs appear to need substantially more.

The FCA also computed the year-end 1987 permanent capital ratios for several districts with the best operating results. After combining the FLB and FICB in each district, the resulting total capital ratios ranged from 9.2 percent to 15.5 percent, averaging about 12.5 percent. After double-counted capital was eliminated, the combined banks' total capital ratios ranged from 6.3 percent to 9.6 percent, averaging about 8 percent. The FCA concluded that very few, if any, institutions desiring to generate consistent net positive earnings could operate with much less than 8 percent risk-adjusted capital. While these calculations included stock that is now protected under the 1987 Act and is not permanent, eventually permanent capital will comprise all of the institution's capital, as protected stock is replaced by new at-risk stock.

After considering the proposals of the other financial regulators and the experience of Farm Credit System institutions over the last 5 years, the FCA has concluded that 7 percent is an appropriate minimum level for all Farm Credit lending and leasing institutions. The elimination of "double duty dollars" and the risk adjusting of the assets will, of course, cause the rate to have a differential impact on the various types of institutions.

The FCA believes that even with levels of permanent capital at 7 percent of weighted assets, many institutions may be undercapitalized if there are substantial weaknesses, in their management, the terms and conditions of their existing loans, or in the general economic condition of their service area. Without significant changes in their operating practices, these institutions may not be viable independent entities and may need to consider merger with stronger entities in order to continue to service their territory and minimize the need for financial assistance.

H. Phase-In

While many institutions do not presently meet the proposed standard, the FCA believes that standards should be set, on a normative basis, at a level appropriate to provide for the risks, with reasonable provision for a gradual phase-in.

The proposed regulation would provide, for institutions that are unable to meet the standard in the first year, for the standard to be phased in over a 5-year period, as required by the 1987 Act. This would be achieved through a series of annual interim minimum permanent capital standards (interim standards) that are determined by reference to the existing permanent capital ratio in the institution on December 31, 1987, and to the 1993 standard of 7 percent. That is, the difference between the institution's ratio on December 31, 1987, and 7 percent would be divided by five to determine the annual increments by which the interim permanent capital standard for that institution would increase each year. This approach provides for a measure of customization of the interim standards to the circumstances of a particular institution. The FCA invites comment on alternative methods for determining appropriate increments for the annual interim minimum capital standards.

The FCA rejects the FCCA suggestion to negotiate trend lines with each institution as a substitute for interim standards, but anticipates that such a process may in fact occur in the process of determining what regulatory enforcement actions are appropriate. The FCA believes that the institution's good faith efforts to meet the standard and reasonable progress in doing so should be factors in determining whether regulatory enforcement action is appropriate for an institution that does not meet the standard. The FCA will not be inclined to bring enforcement actions against institutions that are making a good faith effort to meet minimum standards and are making reasonable progress in doing so. What constitutes reasonable progress and good faith efforts must be determined on an institution-by-institution basis during the course of the examination process and may in fact amount to a negotiated trend line.

On the other hand, meeting the minimum capital standard does not necessarily ensure that an institution has adequate overall capital for safe and sound operation. Where safety and soundness considerations require, enforcement actions may be appropriate even though the minimum permanent capital standard is met.

The FCA wishes to clarify the statutory constraints under which the FCA may take enforcement actions during the phase-in period, since some comments reflect an apparent misunderstanding of these provisions. The statute does not prohibit enforcement actions against institutions based solely on capital adequacy during the phase-in period. It merely requires the concurrence of the Farm Credit System Assistance Board for such enforcement actions against institutions authorized to issue preferred stock to the Assistance Board (i.e., institutions authorized to receive Federal financial assistance).

I. Distribution of Earnings

The comments received on the distribution of earnings during the phase-in period were also carefully considered. A majority of the commentors urged the FCA to reconsider its announced intention to prohibit the payment of dividends and patronage refunds until the fifth year minimum permanent capital standard is met.

The FCA is sympathetic with the need to offer some incentive to providers of capital in order to attract new permanent capital. On the other hand, the FCA feels an obligations to discourage the dissipation of capital if the effect would be to increase the need for Federal financial assistance. The FCA believes that the System has a similar obligation to minimize the need for Federal financial assistance. However, the need to accumulate sufficient permanent capital in Farm Credit System institutions at the end of the 5-year Federal financial assistance period and the need to develop sources of permanent capital (other than borrower stock required to be purchased as a condition for the loan) have caused the FCA to reconsider its initial position on the distribution of earnings during the phase-in period. Therefore, the proposed regulation would permit the payment of dividends and patronage in any year in which the interim standard is met, provided such distribution is consistent with the capital adequacy plan developed by the institution. However, even if the interim standard is met, no distributions should be made (except those permitted under section 4.3A(d)(2) of the 1971 Act, as amended by section 301(b) of the 1987 Act) unless it appears reasonably probable that the institution will be able to meet its interim standard for the next year after the distribution is made. The FCA expects institutions to balance carefully the need to attract new capital and prevent borrower flight against the impact of the distribution upon the institution's capital levels, to assure that the net effect of the action on the institution's capital levels will be positive.

J. Average Daily Balance

The proposed regulation adopts the suggestion of one Farm Credit district that the standard be applied on the basis of a 12-month rolling average of month-end figures during the phase-in period, but applies the standard on an average daily balance after December 31, 1989. This would give institutions a reasonable time to develop the capacity to close their books on a daily basis, as do commercial banks.

K. Clarifications

The FCCA requested two clarifications. First, the FCCA requested that the FCA clarify that the reference to "surplus (less the allowance for losses)" in the definition of permanent capital in the 1987 Act is intended to exclude the allowance for losses from the definition of permanent capital, not require it to be subtracted from the surplus. The confusion arises because, under GAAP, the allowance for losses is not included in the surplus account, as the statutory language would suggest, but is shown as an offset to asset accounts. The FCA believes that the phrase "surplus (less the allowance for losses) should be read as "surplus (exclusive of the allowance for losses)."

Second, the FCCA requested that the section 301(a)(1)(B) requirement to establish minimum permanent standards based on GAAP be interpreted to mean "GAAP as adjusted by any exception in accordance with section 6.9(e)(3)(D)" [probably intended by FCCA to be B], which requires a treatment of third quarter 1986 capital preservation assistance liabilities that is inconsistent with GAAP. Since there is no provision in the 1987 Act indicating that section 6.9(e)(3)(B) overrides section 301, a strict interpretation of section 301(a)(1)(B) would preclude the clarification sought by the FCCA. However, as noted above, the FCA believes that section 301(a)(1)(B) was primarily intended to assure that minimum permanent capital standards would not be based on regulatory accounting procedures established by the 1986 Act, Pub. L. 99-509, codified at 12 U.S.C. 2159, and in the absence of an express override provision in section 301, will not interpret section 301(a)(1)(B) so strictly as to yield unintended results.

L. Public Hearing

The FCA invited comment on whether a public hearing would be a useful means of assuring that the issues related to capital adequacy are thoroughly aired. The commentors who responded to this invitation agreed that it would. Accordingly, it is expected that a public hearing will be scheduled for June 9, 1988, in the Washington, DC, area.

IV. Proposed Regulation.

The FCA proposes to amend Subpart H of 12 CFR Part 615 by removing 615.5210 and adding it to Subpart J of Part 618 as 618.8440, and removing the remaining sections (615.5200 and 615.5215) in Subpart H and all sections of Subpart I in their entirety. The deleted sections of Subpart H, except 615.5210, are inconsistent with the proposed regulation. The deleted sections of Subpart I set forth debt-to-equity ratios required of Farm Credit System institutions under prior law. The FCA invites comment on whether some debt-to-equity standard should be required during the phase-in period or until experience with the risk-adjusted capital approach demonstrates that it will provide an adequate control on leverage.

The following new sections would be added to Subpart H:

A. Proposed 615.5200 would require a Farm Credit System institution to determine the level of capital needed to assure its continued financial viability and to provide for growth necessary to meet the needs of its borrowers. Each institution would be required to establish a formal, written capital adequacy plan that, if followed, would enable the institution to achieve its operating goals as well as the minimum permanent capital standard. The plan would be required to address projected earnings distributions and stock retirements and to take into account the capability of management, the quality and quantity of earnings, the quality of its assets and the adequacy of the allowance for losses, the sufficiency of liquid funds, the needs of an institution's customer base, and any other risk-oriented activities, such as funding and interest rate risks, contingent and off-balance-sheet liabilities, and other conditions warranting additional capital.

B. Proposed 615.5201 sets forth definitions of terms used in the subpart. "Institution" is defined to include all Farm Credit banks and associations and the Farm Credit Leasing Corporation. "Permanent capital" is defined to include all capital except stock and other equities that may be retired on the repayment of the holder's loan or otherwise at the option of the holder or are protected under section 4.9A of the 1971 Act, as amended, or are otherwise not at risk. Excluded under this definition of permanent capital would be: (1) Preferred stock issued to the Financial Assistance Corporation to the extent it offsets an impairment of protected equities; (2) FLB equities required to be purchased by the FLBA in connection with a loan supported by stock protected under section 4.9A of the Act; and (3) capital subject to revolvement unless the institution's bylaws clearly provide that such capital can be retired at the sole discretion of the board and 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, and the notice of allocation includes a similar statement. The section also defines other terms used in the computation of permanent capital ratios.

C. Proposed 615.5205 requires System institutions, beginning in 1993, to maintain at all times permanent capital at a level of at least 7 percent of its risk-adjusted assets. The section also sets forth the method for determining the annual interim minimum permanent capital standard for each institution. The difference between the institution's permanent capital ratio on December 31, 1987, and the 7 percent standard applicable in 1993 is divided by 5 to arrive at the annual increment by which the beginning capital ratio must increase each year in order to reach 7 percent by 1993. The interim minimum permanent capital standard for 1989 is determined by adding the increment to the beginning permanent capital ratio. The interim minimum permanent capital standard for each year between 1989 and 1993 is determined by adding the annual increment to the prior year's interim standard.

D. Proposed 615.5210 sets forth the proposed method for computing an institution's permanent capital ratio. The institution's permanent capital, (adjusted to eliminate reciprocal equity holdings between institutions, double counting of capital, and goodwill) is divided by its assets, (also adjusted to eliminate reciprocal holdings between institutions, and goodwill).

Adjustments to permanent capital. Before the ratio is computed, certain adjustments to the permanent capital and the asset base would be required. First, reciprocal holdings of equities between institutions would be eliminated to the extent of the offset in both institutions. If the investments are equal in amount, the elimination would be accomplished in each institution by deducting from permanent capital issued to another Farm Credit System institution an amount equal to any investment in such institution and reducing assets by an equal amount. If the investments are not equal in amount, the permanent capital and assets of each institution would be reduced by an amount equal to the smaller investment.

Second, double counting of capital between institutions having a direct loan or discount lending relationship would be eliminated by reducing the permanent capital of the funding institution by an amount equal to the direct lender's investment remaining after the elimination or reciprocal holdings, if any.

Third, double counting of capital between institutions having a participation relationship would be eliminated by deducting the investment required to capitalize the participation from the permanent capital of the investing institution.

Fourth, double counting of capital would be eliminated between the Leasing Corporation and its owners by reducing the permanent capital of the owner institutions by an amount equal to their investment in the Leasing Corporation.

Fifth, the section would require institutions to reduce their permanent capital by the amount of any goodwill reflected on the balance sheet, but would "grandfather" until 1993 goodwill acquired before the date of publication of the proposed regulation. That is, goodwill acquired before the date of publication of the proposed regulation would be considered as an asset weighted in the 100 percent category until 1933, after which it would be deducted from permanent capital. Goodwill acquired after the date of publication of the proposed regulation would be deducted from permanent capital (and assets).

Risk-weight categories. Risk-weight categories would be defined primarily on the basis of the type of asset and type of obligor or guarantor. Cash and claims on Federal Reserve banks would be assigned to Category 1, which is risk-weighted at 0 percent. Securities of the United States Government and explicitly guaranteed United States agency securities, cash items in process of collection, portions of loans and other assets collateralized by securities of the United States Government or its agencies, and securities and other claims guaranteed by the United States Government or its agencies (including portions of claims guaranteed) are assigned to Category 2, which is risk-weighted at 10 percent. Loans and other assets collateralized by United States Government-sponsored agency securities, investments in foreign banks with an original maturity of 1 year or less, all investments in domestic banks, investments in general obligations of State and local government, claims on official multinational lending institutions, or regional development institutions in which the United States Government is a shareholder or contributor are assigned to Category 3, which is risk-weighted at 20 percent. All other investment securities with maturities under 1 year are assigned to Category 4, which is risk-weighted at 50 percent. All other claims on private obligors, claims on foreign banks with an original maturity exceeding 1 year, loans and investments in Farm Credit institutions, and all other assets, including but not limited to fixed assets and receivables, are assigned to Category 5, which is risk-weighted at 100 percent. "Goodwill" grandfathered under 615.5201 is risk-weighted in the 100-percent category until 1993, at which time it would be deducted from permanent capital and risk-weighted in the 0-percent category.

Off-balance-sheet items. Off-balance-sheet items would be risk-weighted in a two-step process. First, a credit equivalent would be obtained by multiplying the face amount of the item by the appropriate credit conversion factor set forth in the regulation. The resulting amount would then be risk-weighted in the same manner as balance sheet assets.

Proposed credit conversion factors are set forth in the regulation. A credit conversion factor of 0 percent would be applied to unused commitments with an original maturity of 1 year or less. A credit conversion factor of 20 percent would be applied to commercial letters of credit. A credit conversion factor of 50 percent would be applied to transaction-related contingencies (i.e. bid bonds, performance bonds, warranties, and standby letters of credit related to a particular transaction), commitments with an original maturity exceeding 1 year, revolving underwriting facilities, note issuance facilities and other similar arrangements. A credit conversion factor of 100 percent would be applied to direct credit substitutes (general guarantees of indebtedness, including standby letters of credit serving as financial guarantees for loans and securities); acquisitions of risk participations in bankers acceptance, and participations in direct credit substitutes; sale and repurchase agreements and asset sales with recourse, if not already included on the balance sheet; and forward agreements to purchase assets.

Interest rate contracts and foreign exchange contracts would require special treatment to arrive at a credit equivalent amount. The institution would add the current exposure, i.e. total replacement cost (obtained by marking to market) of all its contracts with a positive value and an estimate of the potential future credit exposure, determined by multiplying the notional principal amount by one of the following credit conversion factors, as appropriate:

Remaining maturity Interest Exchange
rate rate
contracts contracts
Less that 1 year 0 1.0
One year and over 0.5 5.0

No potential credit exposure would be calculated for single currency floating/floating interest rate swaps. The credit exposure on these contracts would be evaluated solely on the basis of their mark-to-market value.

List of Subjects in 12 CFR Parts 615 and 618

Accounting, Agriculture, Banks, Banking, Government securities, Investments, Archives and records, Insurance, Reporting and recordkeeping requirements, Technical assistance.

For the reasons stated in the preamble, Parts 615 and 618 of Chapter VI, Title 12, of the Code of Federal Regulations are proposed to be amended as follows:

PART 615 -- FUNDING AND FISCAL AFFAIRS, LOAN POLICIES AND OPERATIONS, AND FUNDING OPERATIONS

1. The authority citation for Part 615 is revised to read as follows:

Authority: 12 U.S.C. 2154, 2243, 2252, Section 301(a) of Pub. L. 100-233.

2. Subpart H is revised to read as follows:

Subpart H -- Capital Adequacy

Sec.

615.5200 General.

615.5201 Definitions.

615.5205 Minimum permanent capital standards.

615.5210 Computation of the permanent capital ratio.

615.5215 Distribution of earnings.

Subpart H -- Capital Adequacy

615.5200 General.

(a) The Board of Directors of each Farm Credit System institution shall determine the amount of capital needed to assure the institution's continued financial viability and to provide for growth necessary to meet the needs of its borrowers. The minimum permanent capital standard prescribed in 615.5205 is not meant to be adopted as the optimum capital level in the institution's capital adequacy plan. Rather, the standard is intended to serve as a minimum level of permanent capital that each institution must maintain to protect against the credit and other general risks inherent in its operations.

(b) The Board of Directors shall establish and maintain a formal written capital adequacy plan as a part of the financial plan required by 618.8440. The plan shall include the capital targets that are necessary to achieve the institution's capital adequacy goals as well as the minimum permanent capital standards. The plan shall address any projected dividends, patronage distribution, equity retirements, or other action that may decrease the institution's permanent capital. In addition to factors that must be considered in meeting the minimum standards, the Board of Directors shall also consider at least the following factors in developing the capital adequacy plan:

(1) Capability of management;

(2) Quality of operating policies, procedures, and internal controls;

(3) Quality and quantity of earnings;

(4) Asset quality and the adequacy of the allowance for losses to absorb potential loss within the loan and lease portfolios;

(5) Sufficiency of liquid funds;

(6) Needs of an institution's customer base; and

(7) Any other risk-oriented activities, such as funding and interest rate risks, contingent and off-balance-sheet liabilities or other conditions warranting additional capital.

615.5201 Definitions.

For the purpose of this subpart, the following definitions shall apply:

(a) "Commitment" means any arrangement that legally obligates an institution to purchase loans or securities, to participate in loans or leases, to extend credit in the form of loans or leases, to pay the obligation of another, to provide overdraft, revolving credit or underwriting facilities, or to participate in similar transactions. Lending or leasing arrangements that are unconditionally cancellable at any time at the option of the institution shall not be considered to be commitments, provided the institution makes a separate credit decision based upon the borrower's current financial conditions before each advance of funds or other credit under the arrangement.

(b) "Credit conversion factor" means that number by which an off-balance-sheet item shall be multiplied to obtain a credit equivalent before placing the item in a risk-weight category.

(c) "Direct lender institution" means an institution that extends credit in the form of loans or leases to eligible borrowers in its own right and carries such loan or lease assets on its books.

(d) "Government agency" means an agency of the United States Government whose obligations are explicitly guaranteed by the United States Government or their successors.

(e) "Government-sponsored agency" means agencies or instrumentalities charted by the United States Congress to serve a public purpose whose debt obligations are not explicitly guaranteed by the United States Government.

(f) "Institution" means a Farm Credit bank, Federal land bank association, production credit association, Farm Credit association, Farm Credit Leasing Corporation, bank for cooperatives, and Central Bank for Cooperatives, and their successors.

(g) "Permanent capital" means all capital except stock and other equities that may be retired on the repayment of the holder's loan or otherwise at the option of the holder, or is protected under section 4.9A of the Act, or is otherwise not at risk. For the purpose of computing the permanent capital ratio, permanent capital shall not include:

(1) Preferred stock issued to the Financial Assistance Corporation to the extent it is used to offset an impairment of equities protected under section 40.9A or the Act;

(2) FLB equities required to be purchased by FLBAs in connection with stock issued to borrowers that is protected under section 4.9A of the Act;

(3) Capital subject to revolvement, unless:

(A) The bylaws of the institution clearly provide that there is no express or implied right for such capital to be retired at the end of the revolvement cycle or at any time; and

(B) The institution clearly states in the notice of allocation that such capital may only be retired at the sole discretion of the board 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.

(h) "Risk-adjusted asset base" means the total dollar amount of the institution's assets adjusted in accordance with 615.5210(d) weighted on the basis of risk in accordance with 615.5210(e).

(i) "Stock" means stock and participation certificates.

615.5205 Minimum permanent capital standards.

(a) Beginning on January 1, 1993, each Farm Credit System institution shall at all times maintain permanent capital at a level of at least 7 percent of its risk-adjusted assets.

(b)(1) During each year beginning on January 1, 1988, through January 1, 1993, each institution that does not meet the minimum permanent capital standard established in paragraph (a) of this section shall maintain a level of permanent capital at all times during such year at a level that is not less than the interim minimum capital standard for such year:

(2) The annual interim minimum permanent capital standards shall be determined for each institution in the following manner: A beginning permanent capital ratio shall be determined as of December 31, 1987. The difference between the institution's beginning ratio expressed as a percentage and 7 percent shall be divided by five. The resulting number shall be the annual increment to be used to determine the interim minimum permanent capital standard for each of the years between 1988 and 1993. The interim minimum permanent capital standard for each of the following years shall be equal to:

For 1988 -- the beginning capital ratio;

1989 -- the beginning capital ratio plus the increment;

1990 -- the beginning capital ratio plus (2 times the increment);

1991 -- the beginning capital ratio plus (3 times the increment);

1992 -- the beginning capital ratio plus (4 times the increment);

1993 -- 7 percent.

615.5210 Computation of the permanent capital ratio.

(a) The institution's permanent capital ratio shall be determined on the basis of the financial statements of the institution prepared in accordance with generally accepted accounting principles.

(b) Through December 31, 1989, the institution's assets may be computed using the average of the most recent 12 months' balances. Thereafter, the institution's asset base shall be computed using currently daily balances.

(c) The institution's permanent capital ratio shall be calculated by dividing the institution's permanent capital, adjusted in accordance with paragraph (d) of this section (the numerator), by the risk-adjusted asset base (the denominator), to derive a ratio expressed as a percentage.

(d) For the sole purpose of computing the institution's permanent capital ratio, the following adjustments shall be made prior to assigning assets to risk-weight categories and computing the ratio:

(1) Where two Farm Credit System institutions have stock investments in each other, such reciprocal holdings shall be eliminated to the extent of the offset. If the investments are equal in amount, each institution shall deduct from its assets and its permanent capital an amount equal to the investment. If the investment are not equal in amount, each institution shall deduct from its permanent capital and its assets an amount equal to the smaller investment.

(2) Where an institution (except the Leasing Corporation or the Central Bank for Cooperatives) is owned by another Farm Credit System institution that is a direct lender, the double counting of capital shall be eliminated by deducting from the permanent capital of the owned institution any investment of the direct lender not eliminated pursuant to paragraph (d)(1) of this section.

(3) Where an institution invests in another institution to capitalize a participation interest purchased by such other institution, the investing institution shall deduct from its permanent capital an amount equal to its investment in the participating institution. For the purpose of computing the minimum permanent capital ratio, the FLB shall be considered a participating institution and the FLBA shall be considered an investing institution.

(4) The double counting of capital between the Leasing Corporation and its owner institutions shall be eliminated by reducing the permanent capital of the owner institutions by 100 percent of their investment in the Leasing Corporation.

(5) Each institution shall deduct from its permanent capital an amount equal to any goodwill acquired after May 12, 1988. Beginning on January 1, 1993, each institution shall deduct from its permanent capital all goodwill, whenever acquired.

(e) The risk-adjusted assets base (denominator) shall be determined in the following manner:

(1) Each asset on the institution's balance sheet and each off-balance-sheet item, adjusted by the appropriate credit conversion factor in paragraph (e)(3) of this section, shall be assigned to one of five risk categories in accordance with this section. The aggregate dollar value of the assets in each category shall be multiplied by the percentage weight assigned to that category. The sum of the weighted dollar values from each of the five risk categories shall comprise the denominator for computation of the permanent capital ratio.

(2) Balance sheet assets shall be assigned to the percentage risk categories as follows:

(i) Category 1: 0 Percent. (A) Cash on hand and demand balances held in domestic and foreign banks.

(B) Claims on Federal Reserve Banks.

(C) Goodwill acquired after May 12, 1988.

(D) Beginning 1993, all goodwill, whenever acquired.

(ii) Category 2: 10 percent. (A) All securities issued by the U.S. Government and Government agencies.

(B) Cash items in the process of collection.

(C) Portions of loans and other assets collateralized by securities of the U.S Government or Government agencies.

(D) Securities and other claims guaranteed by the U.S. Government or Government agencies (including portions of claims guaranteed).

(iii) Category 3: 20 percent. (A) Loans and other assets collateralized by U.S. Government-sponsored agency securities.

(B) Claims on foreign banks with an original maturity of 1 year or less.

(C) Claims on domestic banks (exclusive of demand balances).

(D) Investments in State and local government obligations backed by the "full faith and credit of State or local government."

(E) Claims on official multinational lending institutions or regional development institutions in which the U.S. Government is a shareholder or contributor.

(F) Obligations of and investments in Farm Credit institutions.

(iv) Category 4: 50 percent. (A) All other investment securities with maturities under 1 year.

(v) Category 5: 100 percent. (A) All other claims on private obligors.

(B) Claims on foreign banks with original maturity greater than 1 year.

(C) All other assets not specified above, including but not limited to, leases, fixed assets, and receivables.

(D) Until 1993, goodwill acquired before May 12, 1988.

(3) Off-Balance-Sheet Items.

(i) The dollar amount of off-balance-sheet items that shall be assigned to a risk-weight category for inclusion in the denominator shall be determined by multiplying the face amount of the item by the appropriate credit conversion factor set forth in paragraph

(b) of this section. The resulting amount shall be then assigned to the appropriate risk-weight category described in paragraph (e)(2) of this section on the basis of the type of obligor.

(ii) Credit conversion factors shall be applied to off-balance-sheet items as follows:

(A) 0 Percent. (1) Unused commitments with an original maturity of 1 year or less.

(B) 20 Percent. (1) Short-term, self-liquidating, trade-related contingencies, including but not limited to, commercial letters of credit.

(C) 50 Percent. (1) Transaction-related contingencies (e.g. bid bonds, performance bonds, warranties, and standby letters of credit related to a particular transaction).

(2) Unused commitments with an original maturity exceeding 1 year, including underwriting commitments and commercial credit lines.

(3) revolving underwriting facilities (RUFs), note issuance facilities (NIFs) and other similar arrangements.

(D) 100 Percent. (1) Direct credit substitutes (general guarantees of indebtedness, including standby letters of credit serving as financial guarantees for loans and securities).

(2) Acquisitions of risk participations in bankers acceptances and participations in direct credit substitutes (e.g. standby letters of credit).

(3) Sale and repurchase agreements and asset sales with recourse, if not already included on the balance sheet.

(4) Forward agreements (i.e., contractual obligations) to purchase assets, including financing facilities with certain drawdown.

(iii) Credit equivalents of interest rate contracts and foreign exchange contracts (except single currency floating/floating interest rate swaps) shall be determined by adding the replacement cost (mark-to-market value, if positive) to the potential future credit exposure, determined by multiplying the national principal amount by the following credit conversion factors as appropriate.

Remaining maturity Interest Exchange
rate rate
contracts contracts
Less than 1-year 01.0
1 Year and over 0.5 5.0

(iv) Credit equivalents of single currency floating/floating interest rate swaps shall be determined by their replacement cost (mark-to-market).

615.5215 Distribution of earnings.

The boards of directors of System institutions may not reduce the permanent capital of the institution through the payment of patronage refunds or dividends, or the retirement of stock or allocated equities if, after or due to the action, the permanent capital of the institution would fail to meet the minimum permanent capital adequacy standard established under regulation 615.5210 for that period. This limitation shall not apply to the payment of noncash patronage refunds by any institution exempt from Federal income tax if the entire refund paid qualifies as permanent capital. Any System institution subject to Federal income tax may pay patronage refunds partially in cash if 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.

Subpart I -- [Removed and Reserved]

3. Subpart I, 615.5220 to 615.5240, is removed and reserved.

PART 618 -- GENERAL PROVISIONS

4. The authority citation for Part 618 continues to read as follows:

Authority: 12 U.S.C. 2183, 2243, 2244, 2252.

Subpart J -- Internal Controls

5. Subpart J is amended by adding a new 618.8440 to read as follows:

618.8440 Annual budgets and projections.

(a) The board of directors of each Farm Credit System institution shall adopt and approve an operational and strategic business plan, completed not later than 30 days after the commencement of each calendar year.

(b) The plan, at a minimum, shall address the operations of the institution for a minimum of 3 years and shall cover a minimum of the following areas:

(1) A mission statement, which describes how the institution intends to meet the long-term needs of its customers, creditors, stockholders, and employees.

(2) A review of the internal and external factors which are likely to effect the institution during the planning horizon.

(3) The establishment of quantifiable goals and objectives which must address, at a minimum, the areas of capitalization, asset quality, loan volume, profitability, operating expenses, marketing, human resources, liquidity, and, where applicable, interest rate risk.

(4) Action plans which evidence how goals are planned to be achieved. These action plans must include, at a minimum, a description of the proposed actions, a cost/benefit analysis, specific implementation schedules, and an assignment of individual responsibilities.

(c) Each plan will include pro forma financial statements for each year of the plan and a detailed monthly operating budget for the first year of the plan.

(d) Each System institution shall have a board of directors approved policy which outlines the steps and process for completing the plan. This policy must include, at a minimum, the establishing of overall timetables for developing the plan, the assignment of accountability for the overall planning process, and the establishment of monitoring, control, and reporting processes for measuring performance under the plan.

Dated: May 4, 1988.

David A. Hill,

Secretary Farm Credit Administration Board

[FR Doc. 88-10185 Filed 5-11-88; 8:45 am]

BILLING CODE 6705-01-M