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Publication of the December 2002 update to the Bank Holding Company Supervision Manual. (Announcements).

The December 2002 update to the Bank Holding Company Supervision Manual, Supplement No. 23, has been published and is now available. The Manual comprises the Federal Reserve System's regulatory, supervisory, and inspection guidance for bank holding companies. The new supplement includes the following subjects:

1. Capital Adequacy. The revised sections on the assessment of capital adequacy include various rule changes, clarifying interpretations, an advisory, and other supervisory guidance. They include

a. A change to Regulation Y (12 CFR 225, appendix A) that was approved by the Board on November 8, 2001 (effective January 1, 2002) and issued in a joint interagency press release dated November 29, 2001. The revised rule addresses the risk-based capital treatment for recourse obligations, residual interests (except credit-enhancing I/Os), direct-credit substitutes, and senior subordinated securities in asset securitizations that expose banking organizations (including bank holding companies) primarily to credit risk. New standards are added for the treatment of residual interests, as well as a concentration limit for credit-enhancing I/O strips. Credit ratings from rating agencies and certain limited alternative-credit-rating approaches are used to match more closely the risk-based capital requirement for these banking organizations to their relative risk of loss for certain positions in asset securitizations.

b. A change to Regulation Y that was approved by the Board on January 8, 2002 (effective April 1, 2002). This revised rule established special minimum risk-based capital requirements for equity investments in nonfinancial companies. The requirements impose a series of marginal capital charges on authorized covered equity investments that increase with the level of a bank's overall exposure to equity investments relative to its tier 1 capital. The highest marginal capital charge requires a 25 percent deduction from tier 1 capital for authorized covered investments that aggregate more than 25 percent of a bank holding company's tier 1 capital. (See SR letter 02-4.)

c. The Board's approval of a limited risk-based capital change to Regulation Y on March 27, 2002, effective July 1, 2002. (See the Federal Reserve's joint press release of April 9, 2002, and its attachment.) The change lowered, from 100 percent to 20 percent, the risk weight that is applied to certain securities claims on, or guaranteed by, a qualifying securities firm in the United States and in other countries that are members of the Organization for Economic Cooperation and Development.

d. The May 17, 2002, interagency advisory on the risk-based capital treatment of accrued interest receivables (AIR) related to credit card securitizations. The AIR asset typically represents a subordinated retained interest in the transferred assets. The asset therefore meets the definition of a "residual interest" that requires dollar-for-dollar capital, even if the amount exceeds the fully equivalent risk-based capital charge on the transferred assets under the November 2001 Regulation Y amendment. When accounting under FAS 140, "Accounting for Transfers and Servicing of Financial Assets and the Extinguishment of Liabilities," for the securitization and sale of credit card receivables, and in computing the gain or loss on sale, a banking organization (seller) should report the AIR asset on the date of transfer, at adjusted cost, based on its relative fair (market) value. (See SR letters 02-12 and 02-22.)

e. The joint September 5, 2002, interagency interpretive guidance discussing the appropriate applications of the November 2001, joint final rule on the treatment of recourse obligations, direct-credit substitutes, and residual interests in asset securitizations. The guidance addresses the risk-based capital treatment for (1) split or partially rated instruments, (2) nonqualification of corporate bonds or other securities for the ratings-based approach, (3) spread accounts that function as credit-enhancing interest-only strips, (4) audits of internal credit risk rating systems, and (5) cleanup calls. (See SR letter 02-16.)

f. The Federal Reserve's March 23, 2002, supervisory guidance on derivative contracts hedging trust preferred stock as to the inclusion of such trust preferred stock in tier 1 capital. In order for an issuing bank holding company to include the stock in tier 1 capital, it must have the ability to defer payments for at least 20 consecutive quarters without giving rise to an event of default. Such a deferral feature, which typically is cumulative in trust preferred stock, is essential in a tier 1 instrument because it allows the issuer to conserve its cash resources at a time when its financial condition is deteriorating. Issues of trust preferred stock may not be included in tier 1 capital if they are covered by a derivative contract that defeats the cash-conserving purpose of the deferral mechanism on the trust preferred stock. (See SR letter 02-10.)

g. The revised Regulation Y (12 CFR 225, appendix D) that was approved by the Board on November 8, 2001 (effective January 1, 2002), which amended the tier 1 leverage measure of the capital adequacy guidelines for bank holding companies for agreements involving recourse, direct-credit substitutes, and residual interests. Also included is the Regulation Y revision for non financial equity investments, approved by the Board on January 7, 2002 (effective April 1, 2002). (See the January 8, 2002, joint interagency press release and SR letter 02-4.)

2. Asset Securitization. This revised section addresses the following issues:

a. The asset securitization process and credit enhancements. The guidance is expanded and also includes a general discussion of the November 2001 changes to the risk-based capital rule for bank holding companies in Regulation Y. The revised rule provides for a multilevel, ratings-based approach for agreements involving recourse, direct credit substitutes, and residual interests.

b. Implicit recourse provided to asset securitizations. The interagency guidance, issued May 23, 2002, on implicit recourse is addressed. Implicit recourse occurs when a banking organization (including a bank holding company) provides post-sale credit support beyond its contractual obligation to one or more of its securitizations. Implicit recourse demonstrates that the securitizing banking organization is re-assuming risk associated with the securitized asset--risk that it initially transferred to the marketplace. Illustrative examples are provided and several supervisory actions are discussed that the Federal Reserve may take upon a determination that a banking organization has provided implicit recourse. (See SR letter 02-15.)

c. Covenants in asset-securitization contracts that are linked to supervisory thresholds or adverse supervisory actions that are triggers for early amortization events or the transfer of servicing. An interagency advisory, dated May 23, 2002, discusses these covenants, which are considered unsafe and unsound banking practices that undermine the objective of supervisory actions. A banking organization's board of directors and senior management are encouraged to amend, modify, or remove these types of covenants in existing transactions. Such covenants could create or exacerbate any liquidity and earnings problems for a banking organization, possibly leading to a further deterioration in its financial condition. (See SR letter 02-14.)

3. BHC surveillance program. The discussion on the Federal Reserve System's surveillance program is amended so that it applies only to those bank holding companies that have $1 billion or more in consolidated assets. The section recognizes the separate surveillance program for BHCs with consolidated assets of less than $1 billion. (See SR letter 02-01.)

4. International-country risk. The country risk section is substantially revised to include the February 22, 2002, interagency supervisory and examination guidance on an effective country-risk management process for banking organizations (including bank holding companies). Country risk is the risk that economic, social, or political conditions in a foreign country might adversely affect an organization's financial condition, primarily through impaired credit quality or transfer risk (a subset of country risk). The examiner's responsibilities are discussed with regard to ensuring that a banking organization's management of country risks is appropriately addressed during the bank holding company inspection process. Inspection objectives and procedures are included. (See SR letter 02-5.)

5. Formal corrective actions. Various statutory provisions are discussed in a revised section on formal corrective actions, including actions that must be taken by the Federal Reserve. Also discussed are the Federal Reserve's supervisory concerns and guidance that focus on the FDIC's regulations on indemnification agreements and payments. (See SR letter 02-17.)

6. Allowance for loan and lease losses (ALLL). A new section contains supervisory guidance on ALLL methodologies and documentation practices. (See the July 2, 2001, FFIEC policy statement.) Although this policy statement, by its terms, applies only to federally insured depository institutions, the Federal Reserve believes the guidance it contains is broadly applicable to bank holding companies. A banking organization's board of directors is responsible for ensuring that controls are in place to determine the appropriate level of the ALLL. The banking organization should maintain and support the ALLL with documentation that is consistent with its stated policies and procedures, generally accepted accounting principles (GAAP), and applicable supervisory guidance. The ALLL methodology must be a thorough, disciplined, and consistently applied process that incorporates management's current judgment about the credit quality of the loan portfolio. (See SR letter 01-17.)

7. Supplemental subprime-lending interagency guidance. The subprime-lending section was revised to include the January 2001 guidance that is directed primarily to banking organizations that have subprime-lending programs that equal or exceed 25 percent of tier 1 regulatory capital. Banking organizations are expected to recognize that the elevated levels of credit and other risks arising from these activities require more intensive risk management and, often, additional capital. Questions and answers pertaining to the January 2001 guidance are included in an appendix. Revised inspection objectives and procedures are provided. (See SR letter 01-4.)

A more detailed summary of changes is included with the update package. The Manual and updates, including pricing information, are available from Publications Fulfillment, Mail Stop 127, Board of Governors of the Federal Reserve System, Washington, DC 20551 (or charge by facsimile: 202-728-5886). The Manual is also available on the Board's public web site at www.federalreserve.gov/ boarddocs/supmanual/.
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Publication:Federal Reserve Bulletin
Geographic Code:1USA
Date:Mar 1, 2003
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