July 2005 update to the Bank Holding Company Supervision Manual.

The July 2005 update to the Bank Holding Company Supervision Manual has been published (supplement no. 28). The Manual comprises the Federal Reserve System's regulatory, supervisory, and inspection guidance for bank holding companies (BHCs). The new supplement includes guidance on the following subjects:

1. Interagency Credit Risk Management Guidance for Home-Equity Lending. The section on "Supervision of Subsidiaries--Loan Administration and Lending Standards" has been revised to include this May 16, 2005, guidance that was issued by the federal supervisory agencies to promote greater focus on sound risk-management practices at banking organizations that have home-equity lending programs. The guidance highlights the sound risk-management practices that a banking organization should follow to align the growth and risk within its home-equity portfolio. See SR letter 05-11 and its attachment. The inspection objectives and procedures were revised to incorporate the interagency guidance.

2. Continued Limited Inclusion of Trust Preferred Securities in the Tier 1 Capital of Bank Holding Companies. The section "Consolidated Capital--Examiner's Guidelines for Assessing the Capital Adequacy of BHCs" and the section "Consolidated Capital--Leverage Measure" were revised to incorporate the February 28, 2005 (published March 10, 2005), revision of the definition of tier 1 capital under the Board's risk-based and leverage capital rules for BHCs. The revised rules allow the continued inclusion of outstanding and prospective issuances of trust preferred securities in BHCs' tier 1 capital and impose new quantitative limits and qualitative standards on the components of tier 1 capital. The Board adopted revised quantitative limits on the aggregate amount of cumulative perpetual preferred and trust preferred securities, and minority interests in the equity accounts of most consolidated subsidiaries (collectively, restricted core capital elements) included in BHCs' tier 1 capital. The revised rule limits restricted core capital elements as of March 31, 2009, to 25 percent of all core capital elements, net of goodwill less any associated deferred tax liability. Internationally active BHCs, defined as those with consolidated assets greater than $250 billion or on-balance-sheet foreign exposure greater than $10 billion, will be subject to a 15 percent limit. They may, however, include qualifying mandatory convertible preferred securities up to the generally applicable 25 percent limit. Amounts of restricted core capital elements in excess of these limits generally may be included in tier 2 capital, subject to the limit that the aggregate amount of subordinated debt and restricted core capital elements (other than cumulative perpetual preferred securities) included in tier 2 capital may not exceed 50 percent of tier 1 capital. A transition period, ending March 31, 2009, is provided for the application of the quantitative limits.

The revised rule addresses supervisory concerns, competitive equity considerations, and the changes in the treatment of trust preferred securities under generally accepted accounting principles. In addition, it strengthens the definition of regulatory capital by incorporating longstanding Board policies regarding the acceptable terms of capital instruments included in BHCs' tier 1 or tier 2 capital. These strengthened standards include a requirement that junior subordinated notes underlying trust preferred securities generally comply with the Board's subordinated debt policy statement. See 12 CFR 250.166. Updated inspection objectives and procedures are also included. The Board's Regulation Y, appendix A (12 CFR 225, appendix A) includes the risk-based capital role and the rule's appendix D (12 CFR 225, appendix D) sets forth the tier 1 leverage measure rule.

3. The Bank Holding Company RFI/C (D) Rating System. The "BHC Rating System" section has been updated to replace the BOPEC bank holding company rating system with the RFI/C (D) rating system that was approved by the Board on December 1, 2004 (effective January 1, 2005), and described in SR letter 04-18. Under this new system, each BHC is assigned a "C" composite rating, which is based on an evaluation and rating of the BHC's managerial and financial condition and an assessment of future potential risk to its subsidiary depository institution(s). The other main components of the rating system are: Risk management (R); Financial condition (F); and potential Impact (I) of the parent company and nondepository subsidiaries (collectively, nondepository entities) on the subsidiary depository institution(s). The Depository institution(s) (D), will generally mirror the primary regulator's assessment of the subsidiary depository institution(s). Several component ratings have subcomponent ratings. The composite, component, and subcomponent ratings are assigned to BHCs on the basis of a numeric scale. A "1" is the highest rating; a "5" is the lowest. Ali of the BHC's numeric ratings, including the composite, component, and subcomponent ratings, should be presented in the inspection report in accordance with Federal Reserve supervisory practices. Many of the manual's sections that involve supervisory risk-management-assessments during a BHC inspection have been revised to incorporate, or reference, the RFI/C (D) rating system.

4. Interagency Advisory on the Confidentiality of the Supervisory Rating and Other Non-Public Supervisory Information. A new section incorporates the February 28, 2005, interagency advisory that reminds banking organizations of the statutory prohibitions on the disclosure of supervisory ratings and other confidential supervisory ratings to third parties. See SR letter 05-4.

5. Board Orders and Board Staff Interpretations Involving Nonbanking Activities. A new section, "Credit Card Bank Exemption from the Definition of Bank," discusses the February 18, 2005, Board staff interpretation involving the credit card bank exemption under section 2(c)(2)(F) of the BHC Act. This statutory provision and the interpretation set forth the criteria that an institution must meet to qualify for the so-called credit card bank exemption.

The section for "Section 4(c)(4) of the BHC Act--Interests in Nonbanking Organizations" has been revised to include a qualifying foreign banking organization's (FBO's) November 24, 2004, request for a Board staff determination, which is based on section 4(c)(4) of the BHC Act and on the availability of a fiduciary exemption that is found in the Board's Regulation K, section 211.23(f)(4) (12 CFR 211.23(f)(4)) and in Regulation Y, section 225.22(d)(3) (12 CFR 225.22(d)(3)). Two of the FBO's asset-management subsidiaries proposed to serve as trustee for foreign-based investment trusts that would invest in U.S. real estate. As part of this asset-management activity, the two subsidiaries would take title to U.S. real estate on behalf of the investment trusts and for the benefit of the investors in the trusts.

The section "Permissible Activities for FHCs (section 4(k) of the BHC Act)" and the section "Limited Physical-Commodity Trading Activities (section 4(k) of the BHC Act)" were revised for additional Board orders (see 2004 Federal Reserve Bulletin, pp. 215 and 511) that authorized engaging in limited amounts and types of commodity trading activities that complement the financial activity of acting regularly as principal in BHC-permissible commodity derivatives based on a particular commodity. A financial holding company must submit, through the filing of a notice under section 4 of the BHC Act, a written request to the Federal Reserve Board to engage in a complementary activity.

A more detailed summary of changes is included with the update package. Copies of the new supplement were shipped directly by the publisher to the Reserve Banks for their distribution to examiners and other System staff. The public may obtain the Manual and the updates (including pricing information) from Publications Fulfillment, Mail Stop 127, Board of Governors of the Federal Reserve System, 20th and C Streets, N.W., Washington, DC 20551; telephone [phone]; or send a facsimile to [phone]. The Manual is also available on the Board's public web site at www.federalreserve.gov/ boarddocs/supmanual/.