Title: FINAL RULE--Funding and Fiscal Affairs, Loan Policies and Operations, and Funding Operations; General Provisions--12 CFR Parts 615 and 618
Issue Date: 10/06/1988
Federal Register Cite: 53 FR 39229
FARM CREDIT ADMINISTRATION
12 CFR Parts 615 and 618
Funding and Fiscal Affairs, Loan Policies and Operations, and Funding Operations; General Provisions
ACTION: Final rule.
SUMMARY: The Farm Credit Administration (FCA) adopts final regulations amending 12 CFR Part 615, Subpart H, and Part 618, Subpart J. The regulations amending Subpart H of Part 615 establish minimum permanent capital standards for Farm Credit System ("System") institutions and require them to adopt capital adequacy plans that enable them to meet such standards. The amendment to Subpart H implements section 301(a) of the Agricultural Credit Act of 1987 (1987 Act), Pub. L. 100-233, which directs the FCA to issue regulations under section 4.3(a) of the Farm Credit Act of 1971 (1971 Act), 12 U.S.C. 2001 et seq., establishing minimum permanent capital standards, expressed as a ratio of capital to assets, that take 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 risk-weighted assets of 7 percent, to be achieved by 1993. The standard is phased in through a series of interim permanent capital standards that are determined by reference to each institution's permanent capital ratio on June 30, 1988. Double counting of capital between related institutions is eliminated by subtracting the investment in another System institution from both the capital and assets of the investing institution before computing the permanent capital ratio. This method of eliminating double counting between Farm Credit Banks (FCBs) and direct lender associations is phased in over a 10-year period. For institutions that are unable to meet their interim standards, the regulation provides a "safe harbor" from certain regulatory enforcement actions if forbearance criteria are met. Forbearance criteria are based on specified increases in institutions' permanent capital ratios. The regulation also sets forth factors that should be considered in developing plans to achieve capital adequacy for each System institution engaged in lending or leasing. The regulation amending Part 618, Subpart J, sets forth minimum requirements for an operational and strategic business plan that will be required of all System institutions.
The effect of the regulations amending Part 615 is to require System institutions that engage in lending and leasing activities to achieve a minimum permanent capital level of 7 percent of risk-adjusted assets by the beginning of 1993 and to develop capital adequacy plans for meeting such a standard. The effect of the regulations amending Part 618 is to require System institutions to develop strategic and operational plans for a minimum 3-year period that meet certain minimum requirements.
EFFECTIVE DATE: The regulation shall become effective upon the expiration of 30 days after this publication during which either or both houses of Congress is in session. Notice of effective date will be published.
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
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.
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 System institutions pursuant to section 4.3(a) of the Farm Credit Act of 1971 (1971 Act), 12 U.S.C. 2154. 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 provisions relating to capitalization of System institutions. Section 301 of the 1987 Act directed the FCA to adopt minimum permanent capital standards for System institutions that take into account risk factors. On February 17, 1988, the FCA published an Advance Notice of Proposed Rulemaking (ANPR) soliciting comments on a proposed approach to the risk-based minimum permanent capital standard (53 FR 4642). On April 5, 1988, the FCA adopted proposed capital adequacy regulations, which were published for comment on May 12, 1988 (53 FR 16948), and withdrew the July 23, 1986 proposed capital adequacy standards. On June 9, 1988, the FCA held a public hearing on the proposed regulation. The comment period closed on June 10, 1988.
Comments were received from 143 organizations and individuals, including the Farm Credit Corporation of America (FCCA), the Federal land banks (FLBs), Federal intermediate credit banks (FICBs), and bank for cooperatives (BCs) in 9 districts, 57 Federal land bank associations (FLBAs), 48 production credit associations (PCAs), the Central Bank for Cooperatives, Federal Farm Credit Banks Funding Corporation (Funding Corporation), The Farm Credit Council, National Council of Farmer Cooperatives, American Bankers Association (ABA), the Independent Bankers Association of America (IBAA), National Association of Wheat Growers, First Boston Corporation, American Farm Bureau Federation, Iowa Institute of Cooperation, National Grange, GROWMARK, Nebraska Cooperative Council, Farm Credit System Audit Committee, Texas Federation of PCAs, 6 individual borrowers and 7 Federal legislators.
After considering the comments, the FCA solicited additional comments on August 10, 1988, (53 FR 30071) on two issues: Alternative methods for eliminating double counting of capital and a regulatory forbearance plan under consideration for incorporation in the final rule. The comment period closed on August 31, 1988.
Forty-seven comment letters were received, some representing the views of two or more institutions. Thirty PCAs, 20 FLBAs, 9 Farm Credit Banks formed from the mergers of FLBs and FICBs (FCBs), 4 BCs, and 1 FICB commented. Comments were also received from the FCCA, the Funding Corporation, the ABA, and the St. Paul District Federation on behalf of all PCAs and FLBAs in the St. Paul District.
The comments received during the initial comment period, testimony received at the public hearing, and the comments received in response to the resolicitation are summarized below along with the FCA's response and an explanation of changes to the proposed rule made in the final rule.
A. Minimum Permanent Capital Standards
The FCA proposed for comment a minimum permanent capital standard of 7 percent, to be achieved by 1993 through a series of annual interim standards that would increase in annual increments equal to 20 percent of the difference between the permanent capital ratio of each institution on December 31, 1987 and 7 percent.
1. Summary of Comments
Almost all of the respondents in the initial comment period commented on the 7 percent requirement. A few respondents, including the ABA, the IBAA, and the National Association of Wheat Growers, supported the 7 percent requirement. The ABA and the IBAA noted that commercial banks are required to meet an 8 percent standard by 1992. The ABA suggested that the 7 percent level be increased to 8 percent in the interest of competitive equality and made reference to the FCA's assertion in the preamble of the proposed regulation that a capital level of at least 10 percent would have been required of System institutions to weather the last few years of economic stress. The ABA witness at the public hearing also noted that agricultural banks had average capital of 9.73 percent at year-end 1987 without taking into account the allowance for losses.
Several System institutions supported the 7 percent rate, some noting that it is hard to argue with 7 percent as an appropriate rate when System institutions have historically maintained capital at levels higher than 7 percent. A number of the respondents and witnesses at the public hearing stated that 7 percent would be an acceptable level, but thought a 5-year phase-in would be too short, requiring an unrealistic return on assets to achieve. Several of these respondents suggested alternative phase-in plans, which are discussed later in this document.
The majority of the respondents, most of which were System institutions, objected to the requirement as too high. Many of these respondents argued that the 7 percent rate phased in over 5 years would require raising borrower interest rates by 1 to 4 percent to uncompetitive levels, thereby making currently viable institutions nonviable because such a rate increase would result in accrual loans becoming nonaccrual loans and borrowers being driven away from the System. The respondents asserted that this would increase the need for Federal assistance or the likelihood of forced merger or liquidation. Many respondents looked to borrowers as the only realistic source of additional capital. They argued that nonvoting stock on which no dividend can be paid until permanent capital standards are met would not be attractive to the investment community. They thought this would be especially true for those System institutions with negative or very low levels of "permanent capital" as that term is defined in the regulation. They pointed out that since equities protected by section 4.9A of the 1971 Act, as amended, are excluded from the statutory definition of permanent capital, the only remaining component of permanent capital is earned net worth, which is at very low levels in many institutions.
A number of respondents perceived the 7 percent requirement to be a higher capital standard than the 8 percent that would be imposed upon commercial banks by uniform guidelines that have been proposed by other Federal bank regulatory agencies (Interagency Guidelines). These respondents argued that the 7 percent "permanent capital" requirement should be compared with the 4 percent "core" capital requirement proposed by the other regulators. These respondents noted that commercial banks are allowed to count subordinated debt and the general portion of the allowance for losses toward their regulatory capital requirement, whereas the allowance for losses is statutorily excluded from the definition of "permanent capital" and System institutions are unable to augment their permanent capital by issuing subordinated debt. n1
n 1 One such respondent inaccurately asserted that core capital would include the general portion of the allowance for losses, up to 1.25 percent of assets. In fact, core (tier one) capital under the proposed Interagency Guidelines would consist essentially of common stockholder's equity (common stock, surplus, retained earnings including capital reserves that represent an appropriation or segregation of retained or undivided earnings, and perpetual preferred stock). The remainder of the 8 percent requirement could be met by supplementary (tier two) capital, primarily the general portion of the allowance for losses up to 1.25 percent of risk-adjusted assets; long-term and convertible preferred stock; subordinated debt; and hybrid capital instruments that meet specified criteria.
One respondent thought that the FCA had arrived at 7 percent by reference to the 8 percent required of commercial banks by counting each additional $1.00 in tier two of the commercial bank requirement as $.75 for the FCA requirement and stated that the FCA should more thoroughly discuss and defend its assumptions.
A number of respondents, including some System institutions, agreed with the FCA's assertion that the System's single industry lending is inherently more risky than the more diversified lending of commercial banks. Some did not agree and argued that the agricultural industry itself is diverse, citing the diversity of commodities and geographic areas financed by the System. Some respondents opined that third world loans and energy loans pose a far greater risk to commercial banks than agricultural lending does to System institutions. The respondents also noted that other Federal bank regulators do not prescribe higher capital requirements for agricultural banks than for commercial banks generally.
Some respondents, including the FCCA, asserted that capital levels should be lower for System institutions than commercial banks because of the following System characteristics: Preferred access to capital markets due to sponsored agency status; joint and several liability; lower liquidity risks due to a lack of demand deposits, the existence of a secondary market for debt issues, and the authority of the Federal Reserve Board to purchase System obligations in the open market; lower country risk; lower payment risk; the greater percentage of collateralized loans in System institutions; and the greater protection for debtholders provided by the Farm Credit System Insurance Corporation than the FDIC provides for commercial banks. Several respondents noted that the required capital for the Federal National Mortgage Association (FNMA), a sponsored agency, is 2 percent.
For one or more of these reasons, many respondents asserted that the minimum permanent capital standard should be in the 3 to 4 percent range, although some respondents thought 5 or 6 percent would be acceptable, or even 7 percent with a longer phase-in period.
2. FCA Response
The FCA did not derive the proposed 7 percent requirement primarily from the 8 percent required of commercial banks. The FCA arrived at 7 percent after a review of levels of capital historically maintained by System institutions, previous statutory and regulatory capital requirements for the System and System-developed capital standards. The FCA also estimated the levels of permanent capital that would have been required by various System institutions to survive the stress of the last 5 years and still be able to generate positive earnings in 1992 without Federal financial assistance. The FCA determined that a 7 percent risk-adjusted ratio is an appropriate level in view of System experience. The FCA then compared the historical System data and the proposed requirement with historical data for commercial banks and current and proposed capital requirements for commercial banks and concluded that such a level is also appropriate when compared to the requirements for commercial banks.
Historic System Experience
Prior to 1987, the 1971 Act required certain System institutions that are primary lenders to maintain statutory debt-to-capital ratios. PCAs were required to maintain a debt-to-capital ratio of 10 to 1. (See 12 U.S.C. 2074(c) (1980 Ed.), repealed by the 1987 Act.) This translates to a total-capital-to-total-asset ratio of 9.1. The issuance of debt obligations was subject to a Systemwide statutory limitation of 20 to 1 total-capital-to-total-asset ratio. (See 12 U.S.C. 2154 (1980 Ed.), repealed by the 1987 Act.) The 1971 Act, after its amendment by the 1987 Act, contains no Systemwide limits, but limits individual bank participation to limits on individual indebtedness. FCA regulations that are repealed by this regulation required debt-to-capital ratios of 20 to 1 for System banks individually. A 20-to-1 debt-to-capital ratio translates into a 4.8 percent total-capital-to-total-asset ratio. The FCA also looked at monitoring standards developed by the System in 1982 in support of its capital preservation and other loss-sharing agreements. These standards required total capital as a percentage of total assets at levels of about 1.5 percent for FICBs, 4 percent for FLBs, 7 percent for PCAs and 7 percent for BCs. In 1984, the System capital standard for banks was 7.5 percent of total assets.
These ratios are not directly comparable to the proposed standard because the asset base is not risk-adjusted. The effect of risk adjusting an institution's asset base is to require less capital since some assets are included in the asset base at less than 100 percent of the principal amount. Precise equivalence can only be determined on an institution-by-institution basis because the composition of the asset base varies from institution to institution. However, generally, a 7 percent capital-to-total-asset ratio is a higher standard than a 7 percent capital-to-risk-adjusted-asset ratio.
Of course, the exclusion of protected stock and the elimination of double-duty capital decreases the capital available to meet the standard. The exclusion of protected stock is a temporary problem, since all borrower stock issued after October 5, 1988, must have the characteristics of permanent capital, and protected borrower stock will gradually be retired in the ordinary course of business. The phase-in of the capital standard in the final regulation is designed to deal with the effect of the exclusion of protected stock on the institution's ability to meet prudent capital standards in the early years. The effect may be ameliorated in a particular institution by a transfer of some of the double-duty capital between the direct lender and its funding bank during the phase-in period.
The FCA believes that the standard should be set at a level that is appropriate for the safe and sound operation of the institution rather than set on the basis of what institutions can easily meet. The FCA recognizes that the exclusion of protected stock from the statutory definition of permanent capital makes it difficult for many institutions to attain the 7 percent standard in the early years and has taken that fact into account in setting interim standards that are based upon the institution's beginning permanent capital ratio and in incorporating a regulatory forbearance plan in the final regulation.
The FCA estimated the levels of capital that would have been required by various System institutions to survive the stress of the last 5 years and still be able to generate positive earnings in 1992 without Federal financial assistance. These 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 have needed somewhat less, while many individual PCAs would have needed substantially more. The FCA recognized that minimum standards based on what would be necessary to survive a historic downturn in the agricultural economy could be considered an overly conservative approach. The FCA therefore considered what would have been needed by four FLBs that experienced less than average stress, as measured by annual chargeoffs, year-end nonaccrual loans, and year-end allowance for loan losses, all taken as a percentage of gross loans for the period 1985 to 1987. These FLBs would have needed capital of about 7 percent of risk-weighted assets at the beginning of the stress period to continue generating positive earnings. The FCA has also looked at permanent capital ratios for the FLBs able to maintain positive net operating incomes during the years 1985 to 1987. After the double counting of capital was eliminated, the ratios of the banks' remaining capital to risk-adjusted assets ranged from 8.5 percent to 11.2 percent, averaging about 9.7 percent. The FCA has concluded that very few, if any, institutions desiring to generate consistent net positive earnings throughout periods of stress could operate with much less than 8 percent risk-adjusted capital.
Commercial Bank Standards
While the FCA did not arrive at the 7 percent standard by reference to the 8 percent standard proposed by other Federal regulators, it has compared the two. The proposed 7 percent standard may be considered roughly equivalent to the 8 percent standard proposed by other Federal regulators when the general allowance for losses (up to 1.25 percent of risk-adjusted assets) and other components of capital not available to System institutions are taken into account. The FCA was persuaded by the argument that System institutions should be compared for this purpose with agricultural banks. Most of these banks do not have access to subordinated debt and other sources of capital that qualify as tier-two capital for commercial banks and consequently will have to meet the 8 percent standard primarily through the use of core capital. (Components of tier-two capital that are available to commercial banks but not available to System institutions, exclusive of the allowance for losses, constituted less than one-tenth of one percent (.10 percent) of total assets for all U.S. banks with above average proportions of farm loans in their portfolios from 1984 to 1987.)
The FCA has also compared the 7 percent risk-adjusted rate with the capital ratios currently required by other Federal regulators and with the average primary and equity capital ratios maintained by U.S. commercial banks generally and U.S. agricultural commercial banks for 1985 and 1986. In order to compare the 7 percent risk-adjusted rate with the total-capital-to-total-asset ratios currently required by other Federal regulators, it was necessary to convert the 7 percent risk-adjusted ratio to a permanent-capital-to-total-asset ratio. To accomplish the conversion, the FCA computed the amount of permanent capital that would have been required in each System bank for the years 1984 to 1987 had the 7 percent risk-adjusted standard been in effect and divided the result by total assets to derive a permanent-capital-to-total-asset ratio. Because the amount of permanent capital required under the risk-adjusted standard is affected by the composition of each institution's assets, the permanent-capital-to-total-asset ratios vary from institution to institution.
After the conversion, the risk adjusted ratio of 7 percent translated to ratios that ranged from 4.3 percent to 6 percent for combined FLBs/FICBs. By comparison, commercial banks were required to have total capital levels of at least 6 percent of total assets over this period, of which 5.5 percent was required to be "primary capital." "Primary capital" includes essentially stockholders equity and the allowance for losses. Stockholder's equity is essentially stock (common and perpetual preferred), paid-in surplus, and retained earnings. The primary capital ratio for commercial banks is derived by dividing the bank's primary capital by total assets plus the allowance for losses.
This comparison is inexact because of the different treatment of the allowance for losses. Commercial banks are allowed to count the allowance for losses as primary capital, but are required to add back the allowance for losses to the asset base, whereas Farm Credit institutions are not permitted to count the allowance as capital but are allowed to deduct the allowance from the asset base. While the inclusion of the allowance for losses on both the capital and the asset sides of the ratio gives commercial banks a slight advantage in meeting their capital requirements, the exclusion of the allowance from permanent capital is not as great a disadvantage as many respondents appeared to believe, because the allowance is also deducted from the asset base. When an adjustment is made to the primary capital ratio to account for the inclusion of the allowance for losses, the adjusted ratio for commercial banks is 4.7 percent. The adjustment is made by subtracting from the required primary capital percentage an amount equal to the average actual allowance for loss stated as a percentage of assets for all commercial banks, which for 1985 and 1986 was 0.8 percent.
In addition, the FCA has compared the 7 percent risk-adjusted rate, converted to a permanent-capital-to-total-asset ratio as described above, to the average primary capital and equity capital as a percentage of total assets of all U.S. commercial banks and all U.S. agricultural commercial banks (banks in which at least 25 percent of the loan portfolio consists of loans to agricultural enterprises) for 1985 and 1986. Over this period, U.S. agricultural commercial banks held even more equity capital than commercial banks in general. Commercial banks in general held average equity capital of 9.2 percent and 8.9 percent of total assets in 1985 and 1986, respectively, while agricultural commercial banks held average equity capital of 10.2 percent and 9.3 percent of total assets in 1985 and 1986, respectively. Thus, on the average, commercial banks possessed substantially more equity capital than either the amount required of them or the amount that would have been required of System banks had the proposed standard been in effect in 1985 and 1986.
The FCA does not agree with the arguments put forth by the FCCA and others that System institutions should have a lower capital requirement than commercial banks. The FCA believes that Farm Credit institutions should be operated as self-sustaining businesses with as little reliance upon Federal assistance as possible. As such, they should be subject to the same standards of safety and soundness and prudent lending as other lenders. The existence of joint and several liability on consolidated Systemwide obligations makes prudent capital standards more rather than less necessary, inasmuch as joint and several liability imposes potential obligations on System institutions as well as conferring potential benefits. Furthermore, joint and several liability is an advantage to investors only if it is supported by adequately capitalized institutions.
Nor does the FCA believe that greater protection offered to System investors by the Farm Credit System Insurance Corporation (FCSIC) should necessarily result in a lower capital standard for Farm Credit institutions than for commercial banks, inasmuch as there are countervailing considerations that argue for a higher rate, such as single-industry lending. Moreover, the actual level of reserves in the insurance corporation during the 5-year-start-up period will be insufficient to assist any single large institution in the System in a material way. Furthermore, it is doubtful that even a fully funded insurance corporation could have provided sufficient assistance to the weaker institutions to avert the need for Federal assistance during the 1980s. The situation in which the savings and loan industry currently finds itself, in which insolvent institutions cannot be liquidated because there are insufficient reserves in the insurance fund to pay off depositors, should be ample evidence of the folly of relying too heavily upon the existence of insurance. Also, it should be noted that the "Cabinet Council Recommendations for Change in the Federal Deposit Insurance System" published in January 1985 and cited in the report of the General Accounting Office on Federal deposit insurance, stated that notwithstanding the existence of Federal deposit insurance, insured institutions should have capital in the range of 8 to 10 percent of assets.
The FCCA asserted that System institutions should have a lower capital standard than commercial banks because they have less liquidity risk, less funding risk, less payment risk and less country risk. The FCCA pointed out that the Federal Reserve Board is able to purchase Farm Credit securities in the open market and that there is an active secondary market in Farm Credit securities that enhances their marketability and lessens liquidity risk. The FCCA also pointed out that Farm Credit institutions do not take demand deposits.
The FCA finds it difficult to differentiate in any quantifiable fashion between the liquidity risks posed to commercial banks from their funding sources and the liquidity risks posed to the System from its principal funding source. Liquidity for the System is measured primarily by the ease with which System banks can access the agency market to sell their notes and bonds. The major factor in market access is public confidence that the System will repay the notes and bonds in a timely manner when they mature. Public confidence is also a principal factor determining the stability of the demand deposit base of commercial banks. One of the key indicators that the public will look to in assessing whether to make funds available to financial institutions (commercial banks and Farm Credit institutions alike) is the level of capital that the financial institutions have as a cushion against loss.
The FCA also continues to believe that single-industry lending is inherently more risky than diversified lending despite the diversity that exists within agriculture. The widespread distress in the Farm Credit System during the recent downturn in the agricultural economy provides ample evidence. Few districts were unscathed. The FCA agrees that commercial banks that have concentrated their lending in third world debt or energy related loans are also engaged in high-risk lending. The difference between Farm Credit banks and commercial banks is that Farm Credit banks are legally restricted in the degree to which they can diversify, whereas a commercial bank that has concentrations of energy loans or third world debt can elect to diversify. The fact that the other Federal regulators have not established a separate standard for agricultural banks or other banks with single industry concentrations could be due to the difficulty and impracticality of attempting to design such a sensitive standard where concentrations occur as a matter of choice and can fluctuate in the discretion of the bank rather than being required as a matter of law.
In addition, the FCA does not believe that the System's "sponsored" status should necessarily result in lower capital requirements to support their lending operations. While there appears to be a public perception that the United States Government stands behind institutions that sell securities in the agency securities market, there is no explicit guarantee by the United States Government and there is no guarantee that Federal assistance would be forthcoming in the event of default. Also, there is a similar perception with respect to institutions whose deposits are Federally insured, even though the deposit insurance corporations have no explicit guarantee of Federal assistance should their funds be depleted. In both cases, the level of capital continues to be a matter of concern to investors.
The operations of System institutions are not analogous to the operations of FNMA, as the reference to its required capital levels would suggest, inasmuch as FNMA is a secondary market intermediary and System institutions are not. System institutions play an important role in the primary mortgage market as direct loan originators. They do not have the characteristics of a secondary market participant, nor are they active at present in the secondary market. The FCB does not function as a true intermediary in the same way as FNMA does and bears substantially more risk. Despite this greater risk, the minimum permanent capital standard adopted in the final regulation, had it been in effect, would have required System FICBs to maintain an average permanent capital-to-total asset ratio over the 1984 to 1987 period of about 1.4 percent, a lower rate than the comparable capital-to-total asset rate required of FNMA of 2 percent.
After carefully gathering and analyzing all of the above information and considering the comments, the FCA has concluded that the proposed minimum capital standard of 7 percent is appropriate as a minimum standard for the safe and sound operation of well managed System institutions during normal business cycles and adopts such a standard in the final regulation. Many institutions will require more.
1. Summary of Comments
Many of the System institutions that commented asserted that they would be unable to reach the standard by 1993, citing interest rate increases and returns on assets that would be required and that were deemed to be uncompetitive and unrealistic. Many respondents suggested that the phase-in should be longer and/or nonlinear and/or more flexible, since the starting point is an historic low and the minimum permanent capital standard higher than that for their competitors, commercial lenders. Many respondents pointed out factors that would make reaching even the interim standards difficult in the early years: (1) One-time events occurring in 1988, such as the required stock purchase in the FAC, reallocation of loss-sharing accruals for some institutions, and PCA allowance for loss adjustments required by tax law changes; (2) continued high average System debt costs and the lingering effects of nonaccrual loans; (3) the high percentage of statutorily protected borrower stock in the early years; and (4) the requirement for banks to record a pro rata share of FAC bonds. A nonlinear phase-in was often suggested to take into account these factors and to allow for the compounding effect of earnings. Several legislators who commented asserted that Congress did not intend standards to be so high that most institutions would be in violation the first year.
A number of alternative phase-in plans were suggested. A back-loaded, nonlinear phase-in, which requires little or no increase in capital during the first and second year and increasing in the third through the fifth year was the alternative most often suggested. However, a number of respondents suggested extending the phase-in over a longer period, from 10 to 15 years. Several respondents suggested requiring 3 to 5 percent by 1992, with some higher figures, 6 to 7 percent, to be achieved in 10 to 15 years. One respondent suggested that institutions be allowed to set their own phase-in standards. Another suggested that the FCA establish regulatory oversight on the basis of an institution-by-institution evaluation. Establishing subcategories of institutions by financial condition, with appropriate interim standards for each was also suggested.
FCA enforcement of its capital standards during the phase-in period appeared to be a primary concern of those who commented on the phase-in. While some respondents supported enforcement during the phase-in period, two senators wrote in opposition to enforcement during the phase-in period, although the 1987 Act appears to contemplate it. Other respondents proposed that FCA develop a formal regulatory forbearance plan that would provide a "safe harbor" for institutions that are making reasonable progress toward meeting their minimum permanent capital standards. Some suggested that the granting of forbearance be based on a specified minimum return on assets and others, on a specified increase in the permanent capital ratio. Several respondents expressed concern that a failure to attain the interim standard would automatically result in enforcement action, including draconian measures such as forced merger and liquidation, despite the FCA's assurance in the preamble of the proposed regulation that it would take into account the good faith efforts and reasonable progress of System institutions in determining whether an enforcement action is appropriate. Other respondents, while not expressing such a concern, appeared to assume such a result.
2. FCA Response
The FCA recognizes that the statutory exclusion of protected equities may make it difficult for some institutions to meet the standard in the early years. However, the FCA believes it important to set a standard that will continue to be appropriate when protected stock is phased out and all borrower equities are at-risk. Since that statute requires a 5-year phase-in period, the FCA cannot extend the phase-in period beyond 5 years. However, the FCA was persuaded by the arguments of the respondents that some formal assurance should be given to institutions that enforcement actions will not be taken against institutions that are making a good faith effort to reach the standard and are improving their capital ratios by at least a reasonable amount. Therefore, the FCA solicited additional comment on a forbearance plan, which is discussed later in this document. Because of the many extraordinary expenses in 1988, the FCA asked respondents to the resolicitation to assume that the permanent capital ratio as of December 31, 1987, would be the interim standard for 1989. The FCA concluded that such a delay in requiring an increase in the permanent capital ratio would be appropriate because some of the extraordinary events to which the respondents referred were related to the transfer of funds between Farm Credit System institutions required by the 1987 Act, such as the requirement to purchase stock in the Farm Credit System Financial Assistance Corporation (FAC) and loss sharing reversals.
Respondents to the resolicitation asserted that many institutions would have difficulty even maintaining the December 31, 1987 ratio in 1988, because none of the one-time events required by the 1987 Act would have been recorded as of December 31, 1987. Since the extraordinary events referred to above were recorded in the first half of 1988, the FCA concluded that the simplest way to make allowance for these events would be to use the permanent capital ratio as of June 30, 1988, as the beginning permanent capital ratio and the interim standard for 1989 and reflected this change in the final regulation.
The final regulation does not attempt to make any additional adjustment for the effect of the recent change in the Federal tax laws relative to the allowance for losses beyond that which would result from using the June 30, 1988 permanent capital ratio as a beginning permanent capital ratio. However, some flexibility in managing the effect of such increased tax liabilities on the direct lender association's ability to meet its minimum capital standards may be afforded by the manner in which the elimination of the double counting of capital between direct lender associations and their funding banks is phased in the final regulation. (See discussion of "Double duty dollar adjustments" below.)
The FCA considered the effect of a nonlinear, back-loaded phase-in as well and concluded that it would have the effect of requiring institutions to achieve a pronounced increase in their permanent capital at the end of the phase-in period, which would be difficult for many institutions to achieve in a single year. If interim standards are to easily attainable in the early years, institutions could be lulled into a false sense of security, only to be faced with a steep increase in the requirement at the end of the phase-in. Since the final regulation provides for a forbearance plan and delays any required increase in the interim permanent capital ratios until January 1, 1990, the FAC concluded that a linear phase-in would be preferable to avoid such an effect in the last year of the phase-in. In addition, most institutions will achieve some increase in permanent capital in 1988 and 1989 as result of the statutorily mandated conversion of some portion of protected stock to at-risk stock and the issuance of new at-risk stock after October 5, 1988. This increase alone will permit many institutions to meet their interim permanent capital standards in 1990. Therefore, the final regulation retains a linear phase-in of the 7 percent standard.
The interim standards of the final regulation are based on a percentage of the difference between the institution's permanent capital as of June 30, 1988, and 7 percent. However, since no increase in the permanent capital ratio is required for 1989, instead of requiring an incremental 20 percent of the shortfall to be achieved in each of the 5 phase-in years, the final regulation requires a 25 percent increment to be achieved in each of the 4 remaining years of the phase-in, beginning in 1990.
C. Forbearance Plan
1. Summary of Comments
In the resolicitation of comments published on August 10, 1988, the FCA invited comment on a forbearance plan developed in response to comments on the original May 12, 1988 proposal. Under the plan, an institution would be exempt from regulatory enforcement action imposed solely for failure to meet its minimum permanent capital standard during any year from 1989 through 1993 in which it maintains its permanent capital ratio at or above the average permanent capital ratio for the previous year plus the increase specified below:
Increase in Permanent Capital Ratio Over the Average of the Previous Year's Closing Capital Ratios.
The previous year's average permanent capital ratio for an institution would be computed by summing the adjusted permanent capital balances computed from each closing statement for that year (numerator) and dividing by the total of the risk-adjusted assets (denominator) computed from each closing statement for that year. For the purpose of commenting, respondents were instructed to assume that until 1991, the average would be computed using averages of monthend balances, and that beginning in 1991, the average would be computed using averages of daily balances. Under the plan, if an institution were to maintain its permanent capital ratio throughout a given year at or above its prior year's average plus the forbearance increment, it would be exempt from enforcement action taken solely for failure to meet its interim minimum permanent capital standard for that year. The plan proposed on August 10, 1988, would require the institution to meet the criterion at all times during the year.
The ABA opposed regulatory forbearance for Farm Credit institutions altogether, opining that the statutory phase-in period is already a forbearance plan. The ABA also asserted that any extension of the forbearance plan beyond 5-year period would in fact constitute a direct contravention of the statute. The ABA suggested that the FCA delay implementation of forbearance until capital standards have been finalized so that some estimate of the effect of the forbearance plan can be determined.
Most of the respondents to the resolicitation supported the forbearance plan, but thought that it should be extended beyond 5 years. One respondent thought that either the period should be extended or the criteria lowered. Some respondents thought that any extension of the forbearance should be limited to 3 to 5 years beyond 1993, but others thought that it should be open ended until 7 percent is reached. A number of respondents suggested that increments of 100 basis points in the permanent capital ratio should be required to qualify for forbearance in the extended period. A few respondents asserted that forbearance should be negotiated with each institution in order to take into account the particular circumstances of that institution. Two respondents favored regulatory forbearance, a nonlinear phase-in and a lower minimum capital requirement within 5 years and a higher level within 7 to 10 years. These respondents asserted that the weakened position in which many Farm Credit institutions started, with declining accruing loans, high costs due to borrower rights compliance, insurance fund implementation and repayment of financial assistance, warrant such an approach. Otherwise, the respondents assert, institutions could price themselves out of the market.
Several respondents, including the FCCA, suggested that the forbearance plan should have a cumulative provision which would provide a safe harbor for an institution that meets the lesser of the required annual forbearance increment or the cumulative annual forbearance increments. These respondents asserted that such a provision would encourage the retention of earnings above the amount needed to meet the forbearance standard in the early years.
Most of the respondents who commented on the forbearance plan asserted that the institution should be able to pay dividends and retire stock when the forbearance criteria are met. In support of this position, the respondents argue that the ability to retire stock is essential to enable the institution to remain competitive and to retain accruing loan volume. One respondent asserted that the institutions' inability to retire stock will be perceived by borrowers as a stock freeze. A few respondents suggested that institutions be allowed to retire stock if the cumulative forbearance standard were met even if interim permanent standards are not met. Only a few respondents appeared to recognize that this would require the FCA to characterize the forbearance criteria as a minimum permanent capital standard to avoid the statutory prohibition on the payment of dividends and the retirement of stock when permanent capital standards are not met. (See section 4.3A(d) of the 1971 Act, as amended.) The FCCA also suggested that the regulation provide temporary forbearance to an institution that achieves its annual increment despite not doing so previously. A few respondents requested that the FCA make provision for unforeseen occurrences, such as having to record a pro rata share of the bonds of the FAC and the cost of liquidating other institutions.
A number of respondents objected to the manner in which the FCA proposed to compute and apply the regulatory forbearance criteria. Several thought that the institution should not be required to maintain the increment throughout the year but that the institution's satisfaction of its criteria should be measured once a year. These respondents pointed to the seasonality of their business and short term uncertainties in their loan portfolios in support of their views. Many respondents objected to having to compute the criteria on an average daily balance after 1990. Some suggested the use of a 13-month rolling average instead.
2. FCA Response
The FCA does not agree with the ABA that the statutory phase-in period is intended to operate as a regulatory forbearance plan. Rather, the FCA notes that the statute requires the rate, which is based on safety and soundness concerns and not on an institution's progress, to be phased in. Such a phase-in is necessary because of the stock protection provisions of the 1987 Act and the statutory definition of permanent capital, which makes most of the equity in Farm Credit institutions unavailable for meeting the capital requirements the FCA is required to establish. Nor does the FCA believe that extending regulatory forbearance beyond 1993 contravenes the 1987 Act. Capital requirements are not relaxed by the forbearance plan. The institutions must still meet the capital requirements in order to be able to retire stock or distribute earnings. The regulatory forbearance plan merely provides a mechanism for the FCA to communicate to Farm Credit institutions in a way that gives some level of comfort that the FCA will not initiate enforcement actions against institutions solely for failure to meet minimum permanent capital standards when they are making a good faith effort to meet these standards and are achieving reasonable progress in meeting their requirements.
The final regulation incorporates a forbearance plan similar to the plan published for comment on August 10, 1988, and extends the forbearance beyond 1993 for institutions that increase their permanent capital ratios by 100 basis points each year until they reach 7 percent. In the final regulation the forbearance plan operates cumulatively and cumulatively only. Under the final regulation, the forbearance criteria for each year is determined by adding the cumulative total of the annual basis point increments for prior years and the current years, as published in the resolicitation, to the beginning permanent capital ratio, calculated as of June 30, 1988, as illustrated below:
|Beginning ratio plus 50 basis points. |
Beginning ratio plus 125 basis points.
Beginning ratio plus 200 basis points.
Beginning ratio plus 300 basis points.
1933 ratio plus 100 basis points each year, cumulatively, until 7 percent is reached.
Any institution that meets the cumulative criteria in any year is eligible for forbearance despite failing to meet it previously, which eliminates the need to provide for "temporary forbearance."
The final regulation does not make any adjustments in the criteria for unforeseen occurrences, as suggested by the respondents. There does not appear to be any practicable way to take into account unforeseen occurrences in establishing objective criteria. Since the criteria are objective and the effect of meeting the standards is to preclude enforcement action for failure to meet the standard, the FCA believes that the criteria should be rigorous. As always, the FCA will take into account individual circumstances and extenuating circumstances (including unforeseen occurrences) in determining whether enforcement action is appropriate and useful. The FCA notes, however, that the recording of FAC bonds is not an unforeseen occurrence, as it occurs at maturity, and institutions should consider that event in their capital planning.
The final regulation requires forbearance criteria to be met at all times during the year, rather than at the end of the year as several respondents suggested. The FCA believes that to require the forbearance criteria to be met only at the end of the year is too lenient a standard for a provision that establishes a "safe harbor" from enforcement action for failure to meet minimum permanent capital standards. Providing a guarantee of forbearance if an institution meets a certain target at previous year-end could effectively prevent the FCA from taking appropriate action in a deteriorating permanent capital institution until after the next year-end. This might encourage System institutions to adopt policies and practices intended solely to ensure that the forbearance criteria are met at one point in time but not on an ongoing basis. Institutions that are making significant progress toward their permanent capital requirements, but fail to meet the forbearance criteria on one or a few days during the year, are not likely to face enforcement action solely for that failure.
The FCA continues to believe that, for purposes of computing an institution's permanent capital requirements and determining whether forbearance is available, average daily balances are the fairest and most accurate means available. However, the FCA was persuaded that allowing an institution to average its available permanent capital as well as assets would provide significant additional flexibility with little additional risk so long as the period used was reasonably short. Consequently, the final regulation continues to require the computation of permanent capital ratios using average daily balances, but provides that both permanent capital and assets are to be averaged for the most recent 3 months.
The final regulation does not permit the retirement of stock or distribution of earnings when the forbearance criteria is met but the interim standard is not. If the FCA were to characterize the forbearance criteria as a minimum capital adequacy standard within the meaning of section 4.3A(d) of the Act, as the respondents suggested, the forbearance standard would merely be a relaxation of the interim standards. Furthermore, if the FCA were to interpret the forbearance standard as an alternate minimum interim standard, so as to permit the retirement of stock and the payment of dividends, the FCA would be unable to extend the forbearance plan beyond 1993, as Congress has clearly limited the phase-in period to 5 years. Therefore, the final regulation does not permit the retirement of stock or the payment of dividends unless the institution will continue to meet its interim percent capital standard after the action is taken.
While the FCA concurs that retaining accruing loan volume is critical to the attainment of capital standards for many institutions, certain legislative judgments about the operation of the Farm Credit System were made by the 1987 Act which the FCA is not free to ignore. The 1987 Act has clearly changed the manner in which Farm Credit institutions are to be capitalized and these changes result in a change in the relationship of the institutions with their borrower/shareholders. No longer is there an obligation to retire stock upon repayment of the loan without regard to the capital position of the institution. Rather, the 1987 Act shifts the focus from capitalizing the loan to capitalizing the institution. While this may be viewed as a change adverse to borrowers, the 1987 Act conferred a substantial benefit on existing borrowers by providing protection for outstanding stock. The Act also allows institutions more flexibility in meeting capital standards, including lowering minimum stock purchase requirements and tapping outside sources of capital. While the weakened condition of many Farm Credit institutions may presently limit the availability of outside capital, this option will ultimately benefit Farm Credit borrowers. Nevertheless, the 1987 Act did not change the cooperative nature of the System, and the primary means of capitalization, at least for the present, is likely to continue to be the borrower/shareholder. If borrowers are unwilling to capitalize the institution they own and choose to borrow elsewhere to avoid capitalizing the institution, Farm Credit institutions will undoubtedly suffer. The Farm Credit System was established to meet a perceived need for a reliable source of credit in good times and bad. If borrowers are unwilling to assume the risk of ownership to capitalize the institutions, the continued need for a special purpose lending institution owned and managed by agricultural producers is called into question. Borrowers with foresight should be willing to temporarily forego the payment of dividends and the retirement of stock upon repayment of the loan if they understand the benefits they derive from the long-term viability of the institution.
The forbearance plan provides a safe harbor only from enforcement action for failure to meet minimum permanent capital standards established by the FCA, and only until an institution reaches 7 percent. It does not foreclose FCA enforcement action for other unsafe and unsound conditions, including failure to maintain adequate total capital. Nor is it available to an institution that satisfies one or more of the statutory conditions for liquidation or conservatorship.
D. Computation Issues
A number of comments were received on the adjustments to permanent capital and assets required by the proposed regulation prior to risk-weighting, as well as other computation issues, such as the use of average daily balances and statutory modifications of GAAP. These comments and the FCA responses are discussed below under topical headings.
1. Adjustments to Permanent Capital
The proposed regulation defined permanent capital as all capital except: (1) Stock and other equities that are protected under section 4.9A of the Act or is otherwise not at risk; or (2) stock and other equities that may be retired on the repayment of the holder's loan or otherwise at the option of the holder. It expressly excluded certain equities deemed not to be at risk. In addition, certain adjustments were made to eliminate double counting of capital between related institutions. Comments were received on a number of these adjustments.
a. Preferred Stock Issued to the FAC
The proposed regulation excluded preferred stock issued to the FAC to the extent such stock is issued to offset an impairment of equities protected under section 4.9A of the Act. A few respondents took issue with this exclusion, arguing that preferred stock issued by the FAC is available to absorb risk even though it cures an impairment of borrower stock, which must be retired at par.
The FCA continues to believe that preferred stock should be excluded from permanent capital to the extent it is issued to offset an impairment of protected stock. In effect, such stock substitutes for the impaired portion of eligible borrower stock, which must be retired at par, and such preferred stock is at risk only to the extent eligible borrower stock is at risk. The 1987 Act appears to contemplate that the ability to retire stock at book value even when book value is below par is an essential ingredient of at-risk stock. In addition, the FCA notes that, to the extent such preferred stock is not retireable at the option of the institution's board, it would not be permanent capital at all regardless of how it is used. The regulatory exclusion is intended to make clear that even if such preferred stock would otherwise be considered permanent capital, it must be excluded if it replaces capital that is not permanent capital. Therefore, the final regulation, like the proposed regulation, excludes preferred stock that is issued to offset an impairment of protected stock.
b. FLB Pass-through Equities
One Farm Credit district opposed the exclusion from permanent capital of FLB (now FCB) pass-through equities that support protected borrower stock in the FLBA, challenging the rationale and legal analysis supporting the exclusion. Pass-through equities are equities of the FLB that were purchased by the FLBA in connection with a loan in an amount corresponding to the amount of FLBA equities the borrower is required to purchase in connection with a loan.
In the preamble to the proposed regulation, the FCA contended that pass-through equities should be excluded because they represent a statutorily required, direct, dollar-for-dollar pass-through of FLBA equities purchased by the borrower. FLBA equities purchased by the borrower in connection with a loan were required by the 1971 Act prior to amendment in 1987 to be retired upon repayment of the loan. It has long been the practice of the FLB to retire the pass-through stock when the loan is repaid in order to permit the FLBA to retire the borrower's stock. Indeed, most FLBAs are unable to retire such stock unless the pass-through investment in the FLB is retired, since the FLBA has historically acted in an agency-like capacity for the FLB, which is the contractual creditor. An FLBA that acts in this capacity carries no loan assets on its books and receives its income pursuant to a compensation agreement with the FLB, which may or may not bear a direct relationship to the income generated from the loans originated by the FLBA. For these reasons, the FCA contended that the FLB pass-through equities should be considered retireable upon repayment of the loan for the purpose of determining permanent capital.
In addition, the FCA concluded that the 1987 Act could be read to require such a result using well accepted principles of statutory construction, which require that a statute be construed where possible, to give meaning to all of its terms. The FCA noted that Congress excluded two categories of equities from permanent capital: (1) Equities protected under section 4.9A or otherwise not at risk; and (2) equities that must be retired upon repayment of the loan or otherwise at the option of the borrower. The FCA contended that there are no equities that could fall within category (2) that are not already included in category (1), except FLB pass-through equities, since under the new capitalization bylaws required by section 4.3A(c) of the 1971 Act, as amended, no stock may be issued that is retireable upon repayment of the loan. To consider the pass-through equities as permanent capital would thus render category (2) a nullity and could thwart the statutory scheme for the protection of borrower stock, since most FLBAs would be unable to retire borrower stock unless the FCB retired the pass-through stock. This would allow FLBAs with impaired stock to seek Federal assistance even though the FCB may be overcapitalized.
The respondent stated that a number of FLBAs in two districts have substantial net worth and are not dependent upon the retirement of FLB stock to retire borrower stock. In addition, the respondent challenged the assertion that no stock retireable upon repayment of the loan may be issued under the new capitalization bylaws, citing language prohibiting such issuance that was deleted from S.B. 1665 before its incorporation in the 1987 Act. This, the respondent argued, created an inference that such issuance is allowed, although it is excluded from permanent capital. The respondent also argued that protected stock that is required to be exchanged for new stock issued under the bylaws continues to be retireable upon repayment of the loan even though it loses its protection under section 4.9A and that this stock could be included in category (2). In addition, the respondent noted that it is conceivable that the FCB could issue other types of equities that would be retireable upon repayment of the loan or otherwise at the option of the holder. The existence of these possibilities, the respondent asserted, undercuts the FCA's argument that Congress must have considered such equities to be retireable upon repayment of the loan. The respondent suggested that FCB pass-through equities be permitted to be included in permanent capital if the bylaws make clear that such equities are retireable only in the discretion of the board of the bank and that there is no right, express or implied, for such capital to be retired upon loan repayment or at any other time.
2. FCA Response
The FCA disagrees with the respondent's legal analysis and continues to believe it appropriate to exclude FLB pass-through equities that support protected stock in the FLBAs. Furthermore, the FCA believes that the effect of the capitalization provisions of the 1987 Act is to require that all equities issued after October 5, 1988 be permanent capital. Not only does the statute clearly state that the capitalization bylaws shall permit the stock to be retired at the discretion of the board, the Conference Report described the effect of incorporating the provisions of S.B. 1665 relating to the capitalization bylaws in the 1987 Act as follows:
The Senate amendment will prohibit after the adoption of the new bylaws, the issuance by FCS institutions of stock that can be retired by the holder when he repays his loan, or otherwise at the option or request of the holder. (Sec. 4.3A(c)(1)(A)).
H.R. Rep. No. 490, 100th Cong, 1st Sess. 247 (1988). The language of the Conference Report clearly overrides any negative inference that may be raised by the deletions in S.B. 1665 prior to its incorporation in the 1987 Act. Such language also indicates that when stock is exchanged for new stock issued under the new bylaws, such new stock is not retireable upon repayment of the loan. Stock issued under the 1971 Act is issued subject to the terms of the 1971 Act as it may be amended from time to time. The provision requiring the borrower to exchange protected stock for new stock issued under the bylaws operates as a modification of the contract between the bank and the stockholder with respect to such stock. The final regulation, like the proposed regulation, excludes pass-through equities that support protected stock from permanent capital.
c. "Double-duty dollar" Adjustments
Offset against protected stock. The proposed regulation required the deduction from permanent capital of an amount equal to the institution's investment in another System institution to eliminate the double counting of capital. A number of respondents pointed out that when the investment amount is offset by protected stock (which can not be counted as permanent capital), a double deduction results if the investment amount is not first reduced by the amount of protected stock before a deduction is made from permanent capital.
The double deduction that results from the failure to offset the institution's protected stock against the amount of investment in another System institution before deducting such amount from permanent capital is an unintended result. Section 615.5210(d) (2) and (3) of the proposed regulation have been revised in the final regulation to require protected stock to be deducted from total capital, which includes protected stock. "Total capital" is defined in the final rule to mean assets less liabilities, determined in accordance with GAAP, except that eligible borrower stock is counted as capital even though there is an obligation to retire the stock at par. This change has the effect of allowing an offset of the investment against protected stock before a deduction from permanent capital is made.
Investment exclusion. The regulation proposed on May 12, 1988, would have eliminated double-counted capital between the FCB and its direct-lender owners by deducting an amount equal to the direct lender's investment in the FCB from the FCB's permanent capital; between institutions having a participation relationship, by requiring an amount equal to the investment required to capitalize the participation to be deducted from the permanent capital of the investing institution (for this purpose, FLBAs that are not direct lenders are considered to be an investing institution having a participation relationship with the FCB); and between the Leasing Corporation and its owners, by deducting from the permanent capital of its owners an amount equal to their investment in the Leasing Corporation.
A number of respondents noted that the proposed regulation makes no provision for the deletion of the investment from the asset base when a corresponding amount is deducted from capital. Where the deduction from capital is made from the investing institution, the result is to require the institution to capitalize the investment even though the offsetting amount of capital has been deducted, resulting in an effective capitalization rate of more than 100 percent. This situation occurred under the proposed regulation for the owners of the Leasing Corporation and for the investing institution in a participation relationship. These respondents argued that the investment should be excluded from the asset base as well. Some respondents argued that a similar exclusion should be made in the elimination of the double counting of capital between the FCB and its direct-lender owners, even though the capital deduction is not made in the investing institution.
The FCA agrees that where a deduction of an investment amount from capital is required in the owner institution to eliminate double counting of capital, it is appropriate to exclude the investment from the assets of the owner institution, to avoid the result described above. The final regulation allows such an exclusion. This exclusion applies in the elimination of the double counting of capital between the Leasing Corporation and its owners, between participating institutions (including FLBAs that are not direct lenders and the FCB) and between direct lenders and their funding banks to the extent, and only to the extent, a deduction is required to be made from the direct lender's capital for its investment in the bank. That is to say, where the FCB is required to deduct the association's investment from its capital, there is no offsetting entry on the asset side to deduct. Rather, the investment is reflected in the assets of the owner institution (direct lender). The FCA believes that to the extent the association is not required to deduct an amount equal to this investment from its capital, the investment should be capitalized, as it represents a separate risk to the association. The final regulation weights such an asset in the 20 percent category.
Elimination options. In the preamble to the proposed regulation, the FCA invited comment on two alternative options for eliminating the double counting of capital between institutions having a lending/investing relationship, such as the FCB and the direct-lender associations. One was to eliminate 75 percent of the association's investment in the bank from the bank's capital and an amount equal to 25 percent of the association's investment in the bank from the association's capital. This approach would have the effect of counting 25 percent of the double-duty capital at the bank level and 75 percent at the direct lender level. The second option was to eliminate the double-counting of capital at the direct lender level by deducting from the direct lender's capital the amount of its investment in the funding bank (owned funds approach).
Only four comments were received. Two PCAs supported the approach set forth in the proposed regulation. The reasons cited were: (1) All asset risk to the association's equity lies in the farmer's debt; (2) the borrower's stock relies directly on the association's investment in the FCB to maintain its value; (3) if PCAs were not permitted to have value for their investment in the FCB, all capital would have to be built from the farmer's pocket in the form of higher interest rates, which would drive away the best customers; (4) the farmer paid for the association's investment in the FCB and should be permitted to directly utilize the benefit through counting such investment as permanent capital; and (5) the direct lender is the level of primary risk and should utilize the investment as permanent capital.
A Farm Credit service center (a jointly managed branch office of a PCA and FLBA) and a PCA supported the elimination of the capital at the association level. Two reasons were given. First, the recent one-time purchase FAC stock demonstrated that such a requirement can be very damaging when an institution carries capital on its books to which it has no access. Second, the bank and the association should each have capital which each is free to use as necessary to protect its respective operational interests. The PCA that supported the elimination of the double counted capital at the association level believed that this would encourage the accumulation of a surplus account made up of "good hard cash."
Consideration of these comments stimulated additional discussion within the FCA of the various options for eliminating the double counting of capital between direct lenders and their funding banks. As a result of these discussions and in view of the small number of comments received, the FCA determined that it would be useful to solicit additional comment on the options as well as on the regulatory forbearance plan discussed above, resulting in the resolicitation published on August 10, 1988. In particular, the FCA solicited comments on the "owned funds" option described in the proposed regulation and invited comment on whether an allocation based on the distinction between purchased equities and equities received as a distribution of earnings would be appropriate.
Many respondents supported the owned funds approach in theory but expressed reservations about whether the funding banks would be willing (and in some cases able) to downstream the "good hard cash" to the association and about the short-term effect on the association's ability to reach its capital standards. One respondent expressed support for the owned funds approach provided it were coupled with a retirement of equities received as distributions of earnings from the Farm Credit Bank and noted that now is an ideal time to retire such equities because the one-time purchase of FCA stock would more than offset the tax liability created by such a retirement This association noted that the increased earnings from the funds downstreamed from the bank through retirement of bank equities would allow the reduction of its minimum capitalization requirement to 2 percent, which would help increase volume and still meet the 7 percent requirement. The respondent asserted that a further advantage would be to give the association stockholder some control of FCB funding, which would, the respondent asserted, ensure that FCBs would operate in an efficient manner and be more accountable than in the past. The respondent believed that this would result in reducing the FCBs to a discount and contract services agency requiring little capitalization and that investors would have adequate protection in an adequate allowance for losses, the insurance fund, and joint and several liability, under which banks could assess the associations. Another respondent supported the owned funds approach provided some portion of the investment of the direct lender in the bank could be counted at the association. Yet another respondent suggested that the capital should be counted at the bank level until the bank meets the minimum permanent capital adequacy standards established by the FCA and the total capital requirements set by its board and only subsequently should the balance be allowed to be counted at the association level. This approach was viewed as more consistent with cooperative principles, which require the patrons of the cooperative to capitalize it, than the owned funds approach, which the respondent asserted would force the bank to capitalize itself through earnings, which would mean higher interest rates to associations. Also, the respondent feared that returning all bank equities to the association would weaken the financial structure of the bank, weaken the combined bank/association financial position due to the major tax liabilities that would result and further work against the bank as it attempts to prepare for the retirement of the preferred stock owned by the FAC. One respondent supported the philosophy of the owned funds approach, believing it to be most consistent with the 1987 Act, but suggested that it be phased in, to allow for flexibility in managing the tax liability that would result from the retirement of bank equities. The respondent suggested that the investment be counted at the direct lender level for a specified period of time and the allocation then shifted from the association to the bank over a period of 5 to 10 years on an incremental basis, giving the bank an opportunity to retire the equities representing excess capital to assist the association in meeting its capital requirements.
Many respondents opposed the owned funds approach. Some opposed any approach that would cause earnings to be accumulated in taxable institutions rather than in nontaxable ones, arguing that such an approach would convert potential capital dollars into tax liabilities. Some opposed it because they feared it would renew and invigorate disputes between the PCA borrowers and the FLB borrowers that arose during the mandatory mergers of the FLBs and the FICBs and possibly lead to more litigation over the use of FICB surplus to capitalize FLB borrowers. As noted above, some agreed in theory with the owned funds approach, but objected primarily to the immediate impact on associations, some of which would start with negative permanent capital positions. Several respondents noted that the owned funds approach would require too rapid a transfer at the expense of not effectively managing the tax consequences that would result. One noted that having to meet forbearance criteria would further reduce the flexibility of the association in managing the tax liability. One respondent argued that the cost of retiring distributed equities is too high unless equities could be converted in a tax-free transaction to a form of redeemable preferred stock or unsecured obligation that would give the association immediate access and pay a reasonable return on the investments.
One respondent asserted that it is not necessary to have the good hard capital at the direct lender level in order to have strong primary lenders. Another asserted that mutual dependence will continue, regardless of where the "good hard cash" is, as the banks must continue to be capitalized, either through association investments or earnings, and the associations will continue to own the bank and influence its action through the election of directors.
A number of respondents agreed with the FCA that accessibility of association capital is a problem, but believed that it is primarily a problem of liquidity, which should be addressed outside the capital regulations. Other respondents took issue with the FCA's assertion that the owned funds approach would best promote the autonomy of the associations, arguing that the associations would be dependent on the banks' willingness to retire equities to meet their capital requirements and that banks would be unwilling and in some cases unable to downstream capital. This would result, these respondents argued, in greater rather than less dependence on the bank and a centralization of capital at the bank level. This, some asserted, is a disguised loss sharing agreement, which is inconsistent with the message they believe was sent by the 1987 Act, that strong associations should not be assessed to the point of non-viability. One respondent asserted that the owned funds approach would lead to unsafe and unsound practices on the part of the associations, but offered no examples. Another respondent rejected the notion that the bank should be reduced to a discounter in order for associations to become more independent, noting that the Stenholm amendment, which would have accomplished that, was rejected and that Congress reaffirmed the banks' role as the primary lender for the associations.
One respondent argued that the capital should be counted where the direct obligation lies and where stockholder/borrowers can most directly influence System operations and prohibit the further accumulation of double-counted capital by requiring banks to pay a portion of their patronage in cash and revolve their equities like banks for cooperatives. Another stated that the owned funds approach would require associations to "regressively rebuild" equity through earnings, which would be tantamount to requesting the borrower to capitalize the association twice. This respondent also argued (somewhat inconsistently) that direct lenders should have access to the investment in the FCB and the FCB should be able, if it needed additional capital, to require all institutions in the district to contribute, either through stock or earnings to an equitable capitalization. One respondent argued that the owned funds approach is in direct conflict with the risk weightings, which weight borrower loans (that are not guaranteed) at 100 percent and weight the bank's direct loan to the association at 20 percent.
Respondents who opposed the owned funds approach found little solace in the proposed regulatory forbearance plan, primarily because even if forbearance criteria were met, stock could not be retired or earnings distributed unless the interim minimum permanent capital standard is met. Many respondents especially associations, view the ability to retire stock in the ordinary course of business as critical to their marketing efforts and hence key to continued viability and autonomy.
The Funding Corporation pointed out that System obligations are sold on the strength of the combined financial strength of the banks and associations, which is made possible by the interdependence of the banks and associations. The investment of association surplus in bank capital, the Funding Corporation asserted, is a significant factor of that interdependence. Also, the Funding Corporation opined that the statutory authority for regulations allowing capital calls on associations is not at all clear and that in any event it would be premature to rely on a regulation that is not yet final. However, the Funding Corporation noted that if there were contractual arrangements with associations to respond to the bank's capital needs, there would be less concern with the owned funds approach.
Many of the respondents who opposed the owned funds approach supported the original proposal, citing some of the advantages referred by the FCA in the preamble to the resolicitation, such as the need to maintain a strong capital position to enhance investor confidence and to enable the FCB to assist troubled associations. Also, some respondents reiterated the premise of the original proposal, that the capital should be counted at the direct lender level where the primary risk resides. One respondent asserted that association stockholders have paid for the association's investment in the bank and should be entitled to count it at the association so that they are not penalized in the form of higher interest rates to correct past ills. Some respondents emphasized the importance of being able to retire borrower stock at the association level to retain borrower confidence and loan volume. Other respondents noted that concentrating capital at the bank level increases the cost of delivery of credit to the borrowers and discourages mergers of FLBAs and PCAs because of the tax consequences of accumulating the earnings in taxable entities.
Regulatory allocation of the double-counted capital between the FCB and its associations was favored by a number of respondents, some as a first choice an others as a second choice to allocation by agreement. One respondent thought the purchased versus distributed allocation would be a very workable alternative if clear provision were made for FLBAs that are not direct lenders. This approach was viewed by the respondent as offering the most flexibility and encouraging downstreaming while allowing the funding bank to maintain adequate permanent capital. The ABA expressed no real preference for any method of eliminating double-duty dollars, as long as they are eliminated but noted that the purchased versus distributed alternative would create a more business-like incentive mechanism. Several respondents indicated that this would be an acceptable approach if allocation by agreement is not to be allowed, but a few respondents affirmatively opposed the approach. One of these opposed it because the level of purchased equities varies considerably between associations in the same district. Several respondents stated that it would have an especially negative impact when combined with a proposed district reallocation and county transfer program.
The 75/25 allocation was affirmatively opposed by a few respondents. One asserted that the formula appeared arbitrary. Another stated that although the approach appropriately recognizes the need to reasonably allocate capital between direct lender associations and the funding bank, it is too rigid and does not accommodate different kinds of relationships that might exist between the funding bank and direct lenders. A number of respondents favored some kind of regulatory allocation as an equitable, balanced approach that allows each entity optimal control and flexibility, but for some of these respondents, regulatory allocation was a second choice to allocation by agreement. Several respondents favored an 80/20 allocation and one urged that the sum of permanent capital of the Bank and the associations should be equal to the permanent capital of the district combined.
For some respondents, the original proposal or the owned funds approach or one of the allocation approaches was a second choice to allowing the banks and associations to enter into binding agreements allocating the double-counted capital as they see fit, for the purpose of determining capital ratios. The FCCA and a number of banks supported this approach. The FICB of Jackson noted that although there is sufficient combined capital to meet a 7 percent requirement for both the FICB and the associations, the original proposal would require the FICB to generate a substantial amount of additional capital to meet its 7 percent standard. Allocation by agreement, they assert, would eliminate the need for unwarranted charges or income manipulation between entities to actually transfer capital.
The FCA weighed carefully the many thoughtful comments on this complicated issue in light of the provisions of the 1987 Act and its legislative history and arrived at the following conclusions. The clear thrust of the 1987 Act is to promote greater autonomy for System associations and strengthen local management and control. However, the Act did not change the fundamental cooperative nature of the System, the funding mechanism, or the funding relationship between the banks and associations. The 1987 Act shifts the focus from capitalization of loans to capitalization of institutions, and requires System institutions to develop sufficient permanent capital to meet standards established by the Farm Credit Administration. The 1987 Act also provides institutions with considerable flexibility in determining their capital structures. At the same time, there is a clear direction to the System from the Congress to streamline for more efficient operation. The decision of how best to achieve greater efficiency is generally left to System institutions and ample authorities for different combinations and configurations are provided. The challenge to the FCA in determining how the double counting of capital should be eliminated between direct lender and funding bank has been to balance the diverse and sometimes conflicting interests of the various Farm Credit institutions that currently exist and potentially may exist under the 1987 Act in a manner consistent with the thrust of that Act.
As the FCA grappled with the many complex issues involved in developing this regulation, both substantive and technical, the owned funds approach emerged as the most logical and internally consistent method. Using the owned funds approach between direct lender associations and their funding banks is consistent with the methods used for participating institutions and for FLBAs that are not direct lenders. It is consistent with the accepted accounting eliminations used to combine the financial statements of parents and subsidiaries, and most importantly from a regulatory perspective, it provides the clearest picture of where capital is actually located in the Farm Credit System. The owned funds approach also contributes to achieving the objectives of the 1987 Act by creating incentives to accumulate accessible capital in each institution to replace the double duty capital, thereby promoting greater autonomy for the direct lender associations. Therefore, the final regulation incorporates the owned funds approach to eliminating double counting of capital between direct lender associations and their banks. The premise of this approach is that the double-duty capital should be counted where it is located, that is, where it is accessible to the institution's board of directors.
The FCA considered the comments of respondents who believed that earnings should be accumulated at the bank level rather than at the association to avoid tax liabilities that would further increase the cost of capital. The FCA concluded that the determination of how to eliminate double counting of capital between direct lender associations and their funding banks should be driven by regulatory concerns for safety and soundness and for the creation of an environment in which each institution must assume responsibility and accountability for its performance and an environment which will facilitate the FCA's evaluation of each institution's performance. The FCA does not believe that tax avoidance is an appropriate goal of regulatory policy and concluded that the owned funds approach should not be rejected merely because of its tax consequences if it were the most coherent and logical approach to the elimination of double counting of capital.
The FCA recognizes that accessible capital at the direct lender association level may cause an increase in tax liability, particularly if the associations rely on retained earnings to provide the bulk of their permanent capital requirements. However, associations may choose to issue "at risk" stock which would assist them in meeting their permanent capital requirements rather than relying solely on retained earnings. Application of the "owned funds" method will require that for retained earnings to qualify as permanent capital they must be in cash or invested in earning assets rather than in bank equities, which are illiquid and inaccessible to the association without bank agreement.
The FCA was not persuaded by the argument that the owned funds approach should be rejected because it would require PCA borrowers to subsidize borrowers from FLBAs that are not direct lenders. To the extent that such a result occurs, it occurs because of the mergers between the FLB and the FICB mandated by Congress and because FLBAs are allowed to continue their agency-like role. This may be an appropriate consideration for bank management in pricing and funding the various segments of its business, but should not be the decisive factor in adopting regulatory capital standards.
The FCA was persuaded by the many comments suggesting that an immediate implementation of the "owned funds" proposal would be too disruptive to System associations. Therefore, the final regulation provides for a phase-in of the "owned funds" method over a 10-year period. Until 1993, which coincides with the phase-in of the 7 percent rate, FCBs may agree with their direct lender associations on a districtwide plan, which may be amended annually, on how the associations' investments in the bank are to be allocated between the bank and the associations for the purpose of computing permanent capital ratios. If it is not possible to agree, the final regulation requires that the direct lender association's investment in the bank be allocated 20 percent to the bank and 80 percent to the association. In 1993 and thereafter, the purchased portion of the direct lender association's investment in the bank must be counted at the bank level and a corresponding amount deducted from the association's capital. In 1993, all of the direct lender association's investment in the bank that was allocated to the association as a distribution of earnings must be counted at the association and deducted from the bank's capital. In each year after 1993, the portion of the distributed investment that can be counted by the association decreases in 20 percent increments until 1998, when all the association's investment in the bank must be counted at the bank level and deducted from the association's capital and assets prior to computing the permanent capital ratio. As a result, beginning in 1998, capital in direct lender associations, as in other investing institutions in the System, will be measured by the ratio of the association's "owned funds" to its risk-adjusted assets exclusive of its investment in the bank. The phase-in is illustrated graphically as follows:
Method of allocation of investment in FCB
|Until 1993...........................................|| Agreement between FCB and direct lender associations. |
1998 and ..........................
|100% of purchased investment |
100% of purchased
20% of distributed
100% of purchased
40% of distributed
100% of purchased
60% of distributed
100% of purchased
80% of distributed
100% of purchased
100% of distributed
|100% of distributed investment. |
0% of purchase.
80% of distributed.
0% of purchased.
60% of distributed.
0% of purchased.
40% of distributed.
0% of purchased.
20% of distributed.
0% of purchased.
0% of distributed.
Many associations that commented supported the philosophy of the "owned funds" approach but feared the immediate impact of implementation. Some associations were skeptical of the bank's ability and willingness to downstream capital. The FAC believes that such associations may underestimate their influence as owners to elect their bank's board of directors or otherwise to influence bank policy. The phase-in of the owned funds approach will give the bank and associations a sufficient period of time for any necessary downstreaming to occur without undue disruption and will allow more flexibility in managing tax liabilities that might arise. The FCA further believes that the phase-in of the "owned funds" method will provide a reasonable period of time for institutions to achieve the efficiencies contemplated by the 1987 Act, and will not be an impediment to restructuring and merger activity.
The FCA does not intend this approach to encourage the retirement of all bank equities outstanding to associations. The FCA believes it appropriate that some portion of the banks capitalization should be in the form of equity owned by the associations. Further, the FCA wishes to emphasize that System institutions are cooperative in nature and that associations have an obligation to assure that the banks are adequately capitalized. Furthermore, both the bank and the associations need sufficient accessible capital to support their respective risks (including potential calls under joint and several liability) and to thrive. Banks must determine their required levels of capital and allocate their requirements among their associations in an equitable manner, equalizing them periodically to assure that all shareholders bear their fair share of the capital burden.
The FCA considered the comments of the Funding Corporation and other respondents that the FCA should take care not to undermine the basis for the use of combined financial statements to sell System securities. The question of the continued appropriateness of combined financial statements after the 1987 Act is a broader question than whether the surplus of the associations is invested in bank equities. It is a question that must certainly be addressed as the 1987 Act is implemented and as the System restructures itself under its provisions. However, the FCA believes that the ability of the bank to access capital in the associations in support of joint and several liability is as important, if not more important, than whether the association's surplus is invested in bank equities. Whether the surplus is invested in bank equities is not likely to be decisive of the question, and in any event associations will continue to be free to invest their surplus in bank equities. Therefore, the FCA has concluded that the decision on where to count double-duty capital is a regulatory judgment that should be driven by safety and soundness concerns and the need to create an environment that will promote the autonomy and accountability of each institution. The FCA has concluded that the owned-funds method best accomplishes those goals and provides the clearest picture of the capital position of each institution.
The FCA agrees with the implicit assumption of the Funding Corporation that if there is no authority for the bank to make capital calls and there are no contractual agreements in place obligating associations to respond to such calls, the banks would need to have more capital than the minimum 7 percent of risk-adjusted assets to support joint and several obligations, especially in view of the risk-weighting of loans to associations at 20 percent rather than 100 percent. In § 615.5200 of the final regulation, the FCA has clarified that joint and several liability risks as they may be evaluated from time to time are to be taken into account in determining the level of total capital that is appropriate by adding potential obligations under joint and several liability. The FCA's authority to promulgate a regulation authorizing banks to make capital call on associations will be more fully addressed in the adoption of the capital adequacy related regulations after consideration of comments on this issue received in the public comment period. However, if there were no such regulation and no such agreements in place in a particular district, the FCA would encourage banks to consider the absence of such agreements in determining their total capital requirements and in making decisions on the downstreaming of capital to associations. If the associations are unwilling to adequately capitalize the bank or otherwise provide necessary support for joint and several liability, it is the associations and their borrowers that have the most to lose from the loss of its advantages.
d. Minority Interest in Unconsolidated Subsidiaries
The FCCA requested that the proposed regulation allow minority investments in unconsolidated subsidiaries to be included in the permanent capital of the investing institution and noted that such a requirement would be consistent with the Interagency Guidelines proposed by the other Federal regulators.
The proposed regulation would allow investments in unconsolidated subsidiaries to count as permanent capital unless such subsidiaries are System institutions. This position is consistent with the proposed Interagency Guidelines of the other Federal regulators, whose regulations require the elimination of related party transactions and do not contemplate that such minority investments would be between related entities. Those proposed guidelines also state, "[a]ny equity or debt capital investments in banking or finance subsidiaries that are not consolidated under regulatory reporting requirements are to be deducted from an organization's total capital base * * *."
e. Allowance for Losses
A few respondents objected to the exclusion of the allowance for losses from permanent capital since its very function is to absorb loss. Some of the respondents appeared to be unaware that the allowance is statutorily excluded from permanent capital. Others suggested that a legislative solution is needed. In addition, a few respondents urged that the excess of the statutory 3 1/2 reserve required of PCAs over a GAAP allowance be permitted to be included in permanent capital.
The 1971 Act, as amended, requires that the minimum permanent capital standards be applied on the basis of financial statements prepared in accordance with GAAP. Compliance with that statutory requirement would have the effect of including in permanent capital any excess of the statutorily required reserve over a GAAP reserve. No adjustment to the regulation is necessary.
2. Adjustments to Asset Base
a. Allowance for Losses
A number of respondents urged that the allowance for loan and lease losses and other reserves be deducted from the asset base before weighting the assets. These respondents noted that such an exclusion would be consistent with GAAP and not inconsistent with the statute.
The FCA believes it appropriate to calculate the institution's permanent capital ratio on the basis of assets adjusted for any allowance for losses as required by GAAP. No adjustment to the regulation is necessary.
b. Protected Stock
One respondent suggested that the regulation allow the deduction of protected stock from loan assets prior to weighting the assets, on the theory that the stock will be retired when the loan is paid off and the loan minus the stock amount is the net asset that should be weighted. In many institutions the last payment on a loan is made by netting the outstanding stock against the loan balance.
The FCA regards protected stock retired under these circumstances as closely analogous to a compensating balance. GAAP does not permit the netting of compensating balances against the loan balance in presenting the loans outstanding on financial statements. Since the minimum permanent capital standard is required to be applied to financial statements prepared in accordance with GAAP, the final regulation does not permit the netting of protected stock against the loan balances to determine capital requirements.
Several respondents asked for a clarification concerning whether depreciation could be deducted from assets prior to weighting, as permitted by GAAP. The FCA believes it appropriate to calculate the institution's permanent capital ratio or the basis of assets adjusted for any associated depreciation as required by GAAP, but does not believe that any adjustment to the proposed regulation is necessary.
d. Advance Conditional Payments
A few respondents suggested that advance conditional payments be deducted from the loan balance prior to risk-weighting. Advance conditional payments are loan payments which are made in advance and draw interest until they are applied, but which can be withdrawn for any purpose for which a loan could be made. The FCA does not believe that advance conditional payments should be permitted to be deducted from the loan balance prior to risk weighting, because such payments can be withdrawn upon the borrower's demand for an appropriate purpose and may never be applied to the loan balance.
e. FLB-FLBA Loss Sharing Agreements
The banks in one district and one Federal legislator, pointed out that the proposed regulation does not take into account the fact that in a few districts the FLB (now the FCB) and the FLBAs have entered into agreements to share, in a specified proportion, losses on loans originated by the FLBAs. Under the proposed regulation, the FCBs in these districts would be required to capitalize all of these assets, even though they may bear only a portion of the risk. Since a portion of the allowance for loss established for these loans is reflected on the books of the FLBA rather than the FCB and the asset amounts used in computing the permanent capital are net of the allowance for loss, the FCB's permanent capital ratio would appear artificially low. This effect would make such loss-sharing arrangements unattractive and would thus restrict the flexibility of districts in establishing relationships with the FLBAs.
The FCA recognized that some provision should be made for districts having such loss sharing agreements with FLBAs so as not to impose regulatory requirements that would restrict the flexibility of districts in establishing these relationships. Therefore, where an FCB and an FLBA have an enforceable, written agreement to share losses on loans originated by the FLBA on a predetermined, quantifiable basis, the final regulation would require the institutions, for the purpose of determining permanent capital ratios, to apportion the assets subject to the agreement between them in the same proportion as they have agreed to share the losses.
3. Average Daily Balance
Several respondents objected to the proposed requirement to use the average daily balance even with a phase-in period. Some respondents asserted that the cost of implementing procedures to allow its computation outweighs the benefits to be derived. One respondent noted that the effect of using the average daily balance is to overstate capital ratios when volume is increasing and understate them when volume is decreasing. Also, the FCA was asked to clarify whether only assets were to be calculated on the basis of average daily balances or whether capital is to be similarly calculated.
The FCA continues to believe that, for the purpose of computing an institution's permanent capital requirements, average daily balances are the fairest and most accurate means available. The FCA also continues to believe that daily closings impose a desirable discipline on financial institutions and facilitate the timely identification of problems and that these benefits outweigh the cost. As noted earlier, the final regulation has been changed from the proposed regulation to allow both permanent capital and assets to be averaged over the most recent 3-month period.
4. Statutory Modification of GAAP
Several respondents pointed out that section 6.9(e)(3)(d) of the 1971 Act, as amended, which provides that obligations of the FAC shall not be considered an obligation of System banks for all financial reporting purposes until such obligation reaches maturity, is inconsistent with GAAP, which would require System banks to include these and other liabilities of FAC on their books because the banks are ultimately responsible for obligations issued by the FAC. The respondents requested that the FCA read this statutory modification of GAAP into the statutory requirement to apply the minimum permanent capital standard to financial statements based upon GAAP, which would have the effect of increasing the institution's permanent capital by a corresponding amount.
The FCA believes that such a reading is the correct reading and the proposed regulation has been revised in the final regulation to clarify that the requirement to base the computation of the permanent capital ratio on the basis of GAAP-prepared statements is qualified by the statutory exclusion of obligations of the FAC from the bank's liabilities before maturity.
5. Entities Created After 12/31/87
One respondent requested that the FCA clarify the starting reference point from which the interim standards will be derived for entities that are created after 12/31/87. In the resolicitation, the FCA indicated that for entities merged or consolidated with other entities after 12/31/87, the FCA would consider pro forma capital and assets of the institutions as if they had been merged on 12/31/87. A few commentors requested additional guidance on these matters.
The final regulation provides that such pro formas should be as of June 30, 1988, the date of beginning permanent capital ratios for other institutions. The final regulation also provides that the interim minimum permanent capital standards for a new association that results from a special reconsideration under section 7.9(i) of the 1971 Act shall be the same standards as those of the association of which it was formerly a part. Since the FCA will not charter organizing entities that are inadequately capitalized, the issue is not likely to be present for newly organized entities. The FCA will provide any additional guidance on these matters that may be needed in another format.
D. Risk Weighting Assets
While respondents generally expressed support for establishing risk weights that are consistent with those of other regulators, a number of comments were made on specific risk weights. These comments and the FCA response are discussed below under topical headings.
1. Loans to System Institutions
Next to comments on the 7 percent rate, the most frequently made comment by System institutions related to the risk-weighting of loans to System institutions in the 20 percent category. While this is a low risk category, System institutions believed that these loans should have been weighted in the 0 percent category because of the elimination of double counting of capital. These comments appear to be based on the assumption that the risk in the direct loan and the risk in the direct lender's loans is identical and hence such risk is also double counted. These respondents disputed the FCA's contention that there is a secondary level of risk at the funding level that is distinct from the pass-through risk of the direct lender's loans and asserted that there is no secondary risk if associations maintain GAAP allowances for losses. Also, these comments appear to have been based on a view of the funding bank and the direct lender as a combined lending unit; indeed, a few respondents urged that the capital requirements be applied to the banks and associations on a combined basis. These assumptions evidently led the respondents to conclude that an 8.4 percent effective rate of capitalization is required for loans through a direct lender: 7 percent for the direct lender and 1.4 percent for the funding bank. As a result, the respondents argued, there is a disincentive for an FLBA to become a direct lender or to merge with a PCA. Also, some respondents noted that the result is a higher requirement for the association/bank lending operation than for the BC lending operation.
While the FCA views the bank and its associations as related organizations and believes that eliminating the double counting of capital is therefore appropriate, it does not view the bank and association as a combined unit for the purpose of determining adequate capital standards. Therefore, the FCA disputes the appropriateness of comparing the 8.4 percent rate, constructed by combining the individual institutions' capital requirements, with the 7 percent used to compute the individual capital requirements imposed on each institution. Such a comparison obscures both the levels of capital actually required of the institutions and the focus of the capital requirements, which is the credit and other general risks inherent in each institution's operations.
The FCA views each institution as a separate entity and attempts to evaluate its capital needs based on the risk inherent in its assets. Since the direct loan comprises a significant portion of the funding bank's assets, weighting the loan at 0 percent would result in very low levels of capital, even with a 7 percent standard. The FCA believes that there is a level of secondary risk even if the associations maintain GAAP allowances for losses. Banks have risks other than the pass-through risk on the direct loans. In addition to direct loan risks, there are risks due to their joint and several liability on consolidated systemwide obligations. Also, bank assistance has been a first line of defense for associations in financial difficulty, which difficulty can result from factors other than loan losses. The Farm Credit System Insurance Corporation will have limited resources in the near term and will be unable to assist in a material way for some period of time. The banks must have some institutional capacity to absorb losses. In addition, banks may incur interest rate risks. The average cost of funds may at times be higher than can reasonably be passed on to the direct lender, and the bank may need to absorb the excess cost for a period of time. And even when the capital is not needed to absorb specific risks, it is still fully employed to keep the interest rates to borrowers competitive, since it will enable the bank to charge the direct lender a rate that represents a narrower spread over the bank's cost of funds than would otherwise be the case.
The FCA does not believe that risk-weighting the direct loan at 20 percent would operate as any more of a disincentive to merge or to become a direct lender than the previous statutory and regulatory capital requirements would have. It is true that direct lenders are required to have more capital than FLBAs that are not direct lenders, but that result is unavoidable. An institution that carries risk assets on its books must capitalize them and this is true whether the proposed capital standard is applied or whether the former debt-to-equity standards are applied. Since this is the case, the argument that the 20 percent weighting is a disincentive to become a direct lender or to merge with a direct lender, while superficially attractive, is not convincing.
The FCA was not persuaded by the argument that risk-weighting the direct loan at 20 percent causes the PCA borrower to subsidize the FLBA borrower. Under the final regulation, the FCB will have some assets risk-weighted at 20 percent (loans to associations) and some assets that will be risk-weighted at 100 percent (loans to borrowers) on its books. After determining its capital requirements, the FCB will then determine how to allocate its capital requirements among its owners. Since there is no longer any statutory requirement to retire stock upon repayment of long term real estate loans and no longer any requirement for FLBAs to purchase stock in the FCB in an amount corresponding to the stock purchased by the borrower, the FCB would appear to be free to allocate its capital requirements among its owners in any manner which equitably distributes the burden of capitalizing the institution. Thus, this issue is an appropriate consideration for bank management in determining how to allocate its capital requirements and price its products, but the FCA's decision on how to risk-weight assets must be driven by safety and soundness concerns. Therefore, the final regulation continues to risk-weight the direct loans to associations at 20 percent.
2. Claims on Foreign Governments
One respondent suggested that claims of foreign governments should be included along with claims on foreign banks in each appropriate maturity category.
The proposed regulation is revised in the final regulation to risk-weight the claims of foreign governments in a manner consistent with the proposed Interagency Guidelines. Claims in the local currency of the foreign central government would be risk-weighted in the 20 percent category to the extent the System institution has local currency liabilities in that country. Any amount of such claims that exceed the amount of the institution's local currency liabilities are assigned to the 100 percent risk-weight category. All nonlocal currency claims on foreign central governments are assigned to the 100 percent risk-weight category.
3. FHMA-Guaranteed Loans
One respondent requested that the FCA clarify that loans guaranteed by the Farmer's Home Administration are among the "other claims" referred to in Category 2, which is weighted at 10 percent.
The FCA considers "other claims" to include all loans and portions of loans guaranteed by the U.S. Government or its agencies. However, only that portion of such loans that is guaranteed by a U.S. Government agency is included in the 10-percent category. The remainder is assigned to the risk category otherwise appropriate to the obligor(s).
4. State-Guaranteed Claims
One respondent suggested that securities and other claims guaranteed by State governments and agencies should be included in Category 3, which is weighted at 20 percent.
The final regulation includes all loans and portions of loans guaranteed by the full faith and credit of State governments or their agencies in the 20 percent category. However, only that portion of such loans that is guaranteed by a State government or agency is included in this category. The remainder is assigned to the risk-weight category otherwise appropriate to the obligor(s).
5. Rural Residence Loans
The proposed regulation made no distinction between rural residence loans and other loans in assigning risk weights and weighted these loans in the 100 percent category. At the time of the May 12, 1988 proposal, this was consistent with the Interagency Guidelines. At the urging of commercial banks that commented on the Interagency Guidelines, other Federal regulators have indicated their intention to assign residential mortgage loans to the 50 percent category because these loans are deemed to have less risk than commercial loans. Therefore, the final regulation assigns rural residence loans made under the authority of the Act and 12 CFR 613.3040 to the 50 percent risk-weighting category.
6. Letters of Credit
One System district asserted that the method of converting standby letters of credit to their balance-sheet equivalent before risk weighting would place its bank for cooperatives at a competitive disadvantage relative to other domestic and international commercial banks. The respondent suggested that the conversion factor for trade-related standby letters of credit be changed to a 0 percent conversion factor.
The FCA reviewed the types of off-balance-sheet risk exposure to System institutions, and concluded that System institutions are exposed to many of the same types of off-balance-sheet risk as commercial banks. Off-balance-sheet risk exposure includes letters of credit (standby and commercial), direct credit substitutes, loan commitments and interest rate swaps. Therefore, the FCA adopted the conversion factors set forth in the proposed Interagency Guidelines. The effect of this approach is to ensure that such contingent risk is recognized and capitalized and that System institutions are not placed at a competitive disadvantage relative to commercial banks.
The final rule provides additional guidance in applying conversion factors to certain off-balance-sheet items, including letters of credit other than commercial letters of credit. Commercial letters of credit, like other trade-related contingencies, would be subject to a conversion factor of 20 percent. Standby letters of credit, which operate as guarantees, would be subject to two different conversion factors, depending on whether they guarantee financial claims such as loans and securities, or whether they guarantee the performance of nonfinancial or commercial undertakings. Standby letters of credit that operate as guarantees of financial claims would be considered to be direct credit substitutes and would be subject to a conversion factor of 100 percent. Performance-based standby letters of credit would be subject to a conversion factor of 50 percent. The final regulation adds definitions of standby letters of credit and performance-based standby letters of credit.
For purpose of applying the proposed regulation, standby letters of credit are distinguished from loan commitments in that standby letters of credit are irrevocable obligations of the financial institution to pay a third-party beneficiary when a customer fails to repay an outstanding loan or debt instrument or fails to perform some other contractual obligation. A loan commitment, on the other hand, involves an obligation (with or without a material adverse change clause) of the financial institution to provide funds to its customer in the normal course of business should the customer seek to draw down the commitments. Therefore, the distinguishing characteristic of a standby letter of credit is the combination of irrevocability with the notion that funding is triggered by some failure to repay or perform on an obligation. Thus, any commitment (by whatever name) that involves an irrevocable obligation to make a payment to the customer or to a third party in the event the customer fails to repay an outstanding debt obligation or fails to perform on a contractual obligation would be treated, for the purposes of the proposed regulation, as a standby letter of credit.
The final regulation adds to the 0 percent credit conversion category, unused commitments with an original maturity of greater than 1 year if they are unconditionally cancellable by the institution and the institution has the contractual right to, and in fact does, make a separate credit decision based upon the borrower's current financial condition before each drawing under the lending arrangement. The second sentence in the definition of "commitment" in the proposed regulation excluded from the definition of commitment, lending, or leasing arrangements that are unconditionally cancellable at any time at the option of the institution provided the institution makes a separate credit decision based upon the borrower's current financial condition before each advance of funds or other credit under the arrangement. The effect of this exclusion was the same as placing such "commitments" in the 0 percent category. With the addition of such commitments to the 0 percent category in § 615.5210(e)(ii)(A), the exclusion in the definition of commitment is unnecessary and is deleted in the final regulation.
The final regulation is changed from the proposed regulation to clarify that the face amount of a direct credit substitute is to be netted against any participations sold in that item before applying the credit conversion factor and assigning it to a risk-weight category. The final regulation has also been expanded to describe the essential characteristics of revolving underwriting facilities, note issuance facilities and other similar arrangements that are subject to a conversion factor of 50 percent.
7. Differences From Proposed Interagency Guidelines
Several respondents suggested that the two differences between the proposed FCA rule and the Interagency Guidelines should be eliminated. The proposed rule risk-weighted cash items in the process of collection in the 10 percent category; the Interagency Guidelines' risk weight is 20 percent. The proposed rule also risk-weighted U.S. Government and U.S. Government-agency securities in the 10 percent category; the Interagency Guidelines distinguish between U.S. Government and U.S. Government-agency securities maturing in 90 days or less (risk-weighted at 0 percent) and those securities maturing after 90 days (risk-weighted at 10 percent). The respondents suggested that the differences were unnecessary, but provided no further rationale in support their position.
The FCA continues to believe that cash items in the process of collection pose less risk to System institutions than to commercial banks and therefore warrant a lower risk weighting of 10 percent. The FCA also believes that short-term Treasury securities (those with maturities less than 91 days) remain subject to some degree of interest rate and market risk and continue to warrant a 10 percent risk weight. Therefore no changes have been made in the final rule for these differences.
E. Distribution of Earnings
One respondent suggested that the regulation provide for the FCA, in limited circumstances, to waive the prohibition against distributing earnings when the interim capital standard is not met in order to enable institutions to sell stock. Another respondent suggested that the regulation allow distributions even if the standards are not met if the prior approval of the FCA is obtained. Another respondent objected to the FCA's statement that the institution should ascertain that it is reasonably probable that the institution will be able to meet the interim standard at the end of the next year even if interim standards are met.
Since the regulatory prohibition reflects a statutory prohibition, the FCA is unable to provide a waiver, no matter how compelling the circumstances. By establishing interim standards based on the institution's beginning permanent capital ratio, the FCA has tried to strike an appropriate balance between the need for each institution to achieve the minimum permanent capital standard of 7 percent and the institution's need to offer dividends to attract capital from outside sources. Also, by phasing in the owned funds approach the regulation will give institutions some flexibility in allocating double-duty capital during the phase-in of minimum permanent capital standards so as to strike this balance in the most effective way. The FCA continues to believe that each institution should ascertain that it is reasonably probable, based on reasonable projections of earnings and losses, to meet its interim standard for the next year before distributing earnings. Until the minimum permanent capital standard is met, each System institution should distribute earnings only when it concludes that such a distribution will promote progress toward the capital goal either by retaining borrowers or attracting new capital.
The FCCA requested the FCA to clarify whether noncash patronage refunds from nontaxable institutions must qualify as permanent capital at the distributing institution only in order to qualify for the exemption from the statutory limitation on the distribution of earnings that applies when the minimum permanent capital standards are met, or whether the refund must also qualify as permanent capital at the receiving institution.
The FCA interprets the statute to mean that the refund must qualify as permanent capital at the distributing institution only. The FCA does not believe that the statute should be interpreted to require the capital of the receiving institution that is offset by the asset to be permanent capital before the distribution can be made without violating the statutory prohibition. The statutory prohibition appears to be directed at conserving the capital of the distributing institution. The final regulation has been clarified accordingly.
The FCA reemphasizes that the forbearance criteria are not interim permanent standards and that the prohibitions set forth in this regulation apply when the interim standards determined in accordance with § 615.5205 are not met, whether or not forbearance criteria are met.
A number of comments were received in relation to §§ 615.5200(b) and 618.8440 of the proposed regulations regarding the planning requirements. The most frequent comment was that the requirements of these regulations were inappropriate for an arms-length regulator and were not consistent with the requirements of other Federal financial regulators. One respondent commented that the proposed regulations addressed practices that were consistent with sound business practices but feared that the enforcement of the regulation could infringe upon management prerogatives. Others thought that the regulation dictated operational methodology and did not recognize the varying needs of differing institutions.
The requirement of § 615.5200(b) to develop a capital plan that will enable the institution to meet the minimum permanent capital standards established by the FCA is a new requirement. The FCA believes it entirely appropriate to require such a plan by regulation and to enumerate the matters that should be addressed. The regulation does not attempt to do the planning for the institution, which would be inappropriate, but it does have the effect of putting institutions on notice that the FCA considers such a plan essential and sets forth the examination standard by which the planning effort would be judged.
On the other hand, the plan required by proposed § 618.8440, is a proposed revision of an existing requirement. The FCA has reviewed the comments made in relation to § 618.8440 and continues to believe that requiring institutions to develop annual operating and strategic plans and budgets is consistent with the FCA's responsibility to promote the safe and sound operation of System institutions. Other Federal regulators do frequently comment upon the need for planning in the examination process and occasionally suggest specific matters that such plans should address. However, in response to the comments, the requirements contained in the proposed regulation have been modified in the final regulation to remove many of the specific subcomponents of the planning process which were objectionable to the respondents. The FCA was persuaded by the argument that the proposed regulation may have been too rigid to take into account the varying needs of different institutions. The final regulation has been revised to permit institutions more flexibility in the implementation of their planning processes.
G. General Comments.
Several other comments of a general nature were received.
1. One respondent recommended that even though the proposed regulation focuses only on credit risk, the FCA should encourage institutions to study all other risks. The FCA does encourage institutions to study other risks and make provision for them in setting their total capital goals under § 615.5200. Some of these risks are alluded to in § 615.5200(b), which sets forth factors that should be taken into account in developing a total capital adequacy plan.
2. One district asserted that the regulation is not consistent with the emphasis on local control that is evident in the 1987 Act. The FCA did not understand this comment, since no specific inconsistencies were cited. However, the FCA believes its insistence on viewing System institutions as separate entities with separate capital needs even though they are related entities is consistent with the central thrust of the 1987 Act, which the FCA views as providing for greater autonomy for direct lenders and allowing every Farm Credit association to become a direct lender.
3. A few respondents suggest that the FCA consider keying the regulation to the proposed Interagency Guidelines as they may be issued from time to time. The FCA believes that consistency with the Interagency Guidelines generally is a desirable goal and will carefully monitor any development in the adoption or amendment of those Guidelines, but declines to adopt a regulation that is automatically adjusted as the Interagency Guidelines are amended, without making its own judgment that the changes are appropriate for System institutions.
H. Final Regulation
For the reasons stated in the preamble, the following changes to the proposed rule are made in the final rule.
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 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: Secs. 4.3, 4.9, 4.14B, 5.9, 5.17, 6.20, 6.26; 12 U.S.C. 2154, 2160, 2202b, 2243, 2252, 2278b, 2278b-6; Sec. 301(a) of Pub. L. 100-233.
2. Subpart H is revised to read as follows:
Subpart H -- Capital Adequacy
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 total 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, potential obligations under joint and several liability, 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.
(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 is 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 of 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 chartered 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 intermediate credit bank, Federal land bank association, production credit association, agricultural credit association, Farm Credit Leasing Corporation, bank for cooperatives, National Bank for Cooperatives, and their successors.
(g) "Performance-based standby letter of credit" means any letter of credit or similar arrangement that represents an irrevocable obligation to be beneficiary on the part of the issuer to make payment on any default by the account party in the performance of a nonfinancial or commercial obligation.
(h) "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 a risk. For the purpose of computing the permanent capital ratio, permanent capital shall not include:
(1) Preferred stock issued to the Farm Credit System Financial Assistance Corporation to the extent it is issued to offset an impairment of equities protected under section 4.9A of the Act;
(2) Federal Land Bank equities required to be purchased by Federal land bank associations in connection with stock issued to borrowers that is protected under section 4.9A of the Act;
(3) Capital subject to revolvement, unless:
(i) 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 other time; and
(ii) 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.
(i) "Risk-adjusted asset base" means the total dollar amount of the institution's assets adjusted in accordance with § 615.5210(d) and weighted on the basis of risk in accordance with § 615.5210(e).
(j) "Standby letter of credit" means any letter of credit or similar arrangement that represents an irrevocable obligation to the beneficiary on the part of the issuer:
(1) To repay money borrowed by or advanced to or for the account of the account party; or
(2) To make payment on account of any indebtedness undertaken by the account party, in the event the account party fails to fulfill its obligation to the beneficiary.
(k) "Stock" means stock and participation certificates.
(l) "Total capital" means assets minus liabilities, valued in accordance with generally accepted accounting principles (GAAP), except that liabilities shall not include obligations to retire stock protected under section 4.9A of the Act.
§ 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, 1989, 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 of all times during such year at a level that is not less than its interim minimum permanent capital standard for such year, determined in accordance with paragraph (b)(2) of this section.
(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 June 30, 1988. For institutions merged or consolidated after June 30, 1988, the beginning permanent capital ratio shall be determined on the basis of pro forma financial statements as of June 30, 1988. For each year between January 1, 1989 and 1993, the interim minimum permanent capital standard shall be the beginning permanent capital ratio plus the specified percentage of the difference (shortfall) between the beginning permanent capital ratio and the minimum permanent capital standard of 7 percent. During each of the following years each institution shall maintain its permanent capital at a level equal to or greater than its interim minimum permanent capital standard, determined in accordance with the percentage of its shortfall specified below:
Year Beginning -- Interim Minimum Permanent Capital Standard
January 1, 1989 -- Beginning permanent capital ratio
January 1, 1990 -- beginning permanent capital ratio plus 25 percent of shortfall
January 1, 1991 -- beginning permanent capital ratio plus 50 percent of shortfall
January 1, 1992 -- beginning permanent capital ratio plus 75 percent of shortfall
January 1, 1993 -- the minimum permanent capital ratios shall be and thereafter 7 percent.
The interim minimum permanent capital standards for a new association that results from a special reconsideration under section 7.9(i) of the Act shall be the same standards as those for the association of which it was formerly a part.
§ 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 except that the obligations of the Farm Credit System Financial Assistance Corporation shall not be considered obligations of any institution subject to this regulation prior to their maturity.
(b) Through December 31, 1989, the institution's assets and permanent capital may be computed using the average of the most recent 3 months' balances. Thereafter, the institution's asset base and permanent capital shall be computed using average daily balances for the most recent 3 months.
(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 total capital an amount equal to the investment. If the investments are not equal in amount, each institution shall deduct from its total capital and its assets an amount equal to the smaller investment.
(2) Where a Farm Credit Bank is owned by one or more Farm Credit System institutions that are direct lenders, the double counting of capital shall be eliminated in the following manner:
(i) For each year, until January 1, 1993, each Farm Credit Bank and Federal intermediate credit bank shall, with the agreement of a majority of its related direct lender associations, adopt a districtwide plan specifying, for the purpose of computing the permanent capital ratio only, a percentage allocation of a direct lender association's investment in the bank between the bank and the direct lender association, which may be amended annually. The plan and any amendments thereto shall be forwarded to the office of the Farm Credit Administration responsible for examining the institution along with evidence of approval by the bank and a majority of its direct lender associations. If it is not possible to reach agreement, the direct lender's investment in the bank shall be allocated 20 percent to the bank and 80 percent to the association.
(ii) Beginning January 1, 1993 and in each year thereafter, all equities of a Farm Credit Bank and a Federal intermediate credit bank that have been purchased by direct lender associations shall be allocated to the bank.
(iii) Beginning January 1, 1993, all equities of the bank that have been distributed by the bank to the direct lender associations rather than purchased shall be allocated between the bank and its direct lender associations in the following manner:
Allocation of Equities Distributed
1998 and thereafter......................
(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 total capital an amount equal to its investment in the participating institution. For the purpose of computing the permanent capital ratio, the Federal land bank association that is not a direct lender shall be considered an investing institution and the Farm Credit Bank shall be considered a participating institution with respect to that Federal land bank association.
(4) The double counting of capital between the Leasing Corporation and its owner institutions shall be eliminated by deducting an amount equal to their investment in the Leasing Corporation from their total capital.
(5) Each institution shall deduct from its total capital an amount equal to any goodwill acquired after May 12, 1988. Beginning on January 1, 1993, each institution shall deduct from its total capital all goodwill, whenever acquired.
(6) To the extent an institution has deducted its investment in another Farm Credit institution from its total capital, the investment may be eliminated from its asset base.
(7) Where a Farm Credit Bank and an association have an enforceable written agreement to share losses on specifically identified assets on a predetermined quantifiable basis, such assets shall be counted in each institution's risk-adjusted asset base in the same proportion as the institutions have agreed to share the loss.
(e) The risk-adjusted asset 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 United States Government and Government agencies.
(B) Cash items in the process of collection.
(C) Portions of loans and other assets collateralized by securities of the United States Government or Government agencies.
(D) Securities and other claims guaranteed by the United States Government or Government agencies or portions of such claims (but only to the extent guaranteed).
(iii) Category 3: 20 Percent
(A) Loans and other assets collateralized by United States 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." Other claims (including loans) and portions of claims guaranteed by the full faith and credit of a State government (but only to the extent guaranteed).
(E) Claims on official multinational lending institutions or regional development institutions in which the United States Government is a shareholder or contributor.
(F) Loans and other obligations of and investments in Farm Credit institutions.
(G) Local currency claims on foreign central governments to the extent that the Farm Credit institution has local liabilities in that country.
(iv) Category 4: 50 Percent
(A) All other investment securities with maturities under 1 year.
(B) Rural housing loans secured by first lien mortgages or deeds of trust.
(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.
(E) All nonlocal currency claims on foreign central governments, as well as local currency claims on foreign central governments that are not included in category 3 (G).
(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 (e)(3)(ii) 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;
(2) Unused commitments with an original maturity of greater than 1 year if;
(i) They are unconditionally cancellable by the institution; and
(ii) The institution has the contractual right to, and in fact does, make a separate credit decision based upon the borrower's current financial condition before each drawing under the lending arrangement.
(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 performance-based standby letters of credit related to a particular transaction).
(2) Unused loan 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 pursuant to which the institution's customer can issue short-term debt obligations in its own name, but for which the institution has a legally binding commitment to either:
(i) Purchase the obligations the customer is unable to sell by a stated date; or
(ii) Advance funds to its customer if the obligations cannot be sold.
(D) 100 Percent
(1) Direct credit substitutes including financial-guarantee-type standby letters of credit that support financial claims on the account party. The face amount of a direct credit substitute shall be netted against any participations sold in that item. The amount not so sold shall be assigned to a risk-weight category using the criteria of § 615.5210(e)(2).
(2) Acquisitions of risk participations in bankers acceptances and participations in direct credit substitutes.
(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 notional principal amount by the following credit conversion factors as appropriate.
Interest rate contracts
Exchange rate contracts
|Less than 1-year.....................................|
1 year and over ......................................
(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 § 615.5205 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 at the issuing institution. 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.
§ 615.5216 Regulatory forbearance.
(a) During 1989, no institution shall be subject to a regulatory enforcement action solely for failure to meet its interim minimum permanent standard so long as it maintains its permanent capital ratio at or above the beginning permanent capital ratio of June 30, 1988. For each year thereafter no institution shall be subject to regulatory enforcement action solely for failure to meet its minimum permanent capital standard so long as it maintains its permanent capital ratio at or above the beginning permanent capital ratio plus the forbearance increment specified in this paragraph.
|Beginning ratio plus 50 basis points. |
Beginning ratio plus 125 basis points.
Beginning ratio plus 200 basis points.
Beginning ratio plus 300 basis points.
1993 ratio plus 100 basis points each year, cumulatively, until 7 percent is reached.
(b) The provisions of paragraph (a) of this section shall not apply to any institution that meets one or more of the conditions specified in 12 CFR 611.1156 for the appointment of a conservator or receiver.
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 is revised to read as follows:
Authority: Secs. 1.5, 1.11, 1.12, 2.2, 2.4, 2.5, 2.12, 3.1, 3.7, 4.12, 4.13A, 4.25, 4.29, 5.9, 5.10, 5.17; 12 U.S.C. 2013, 2019, 2020, 2073, 2075, 2076, 2093, 2122, 2128, 2183, 2200, 2211, 2218, 2243, 2244, 2252.
Subpart J -- Internal Controls
5. Subpart J is amended by adding a new § 618.8440 to read as follows:
§ 618.8440 Planning.
(a) No later than 30 days after the commencement of each calendar year, the board of directors of each Farm Credit System institution shall adopt an operational and strategic business plan for at least the succeeding 3 years.
(b) The plan shall include, at a minimum, the following:
(1) A mission statement.
(2) A review of the internal and external factors that are likely to affect the institution during the planning period.
(3) Quantifiable goals and objectives.
(4) Pro forma financial statements for each year of the plan.
(5) A detailed operating budget for the first year of the plan.
(6) The capital adequacy plan adopted pursuant to § 615.5200(b).
Dated: September 28, 1988.
David A. Hill,
Secretary, Farm Credit Administration Board.
[FR Doc. 88-22862 Filed 10-5-88; 8:45 am]
BILLING CODE 6705-01-M