Instruments Eligible for Inclusion in Tier 1 Capital

To All State Member Banks, Bank Holding Companies, and Branches and Agencies of Foreign Banks, in the Second Federal Reserve District:

The following is from a statement by the Board of Governors of the Federal Reserve System:

The Basle Committee on Banking Supervision (Basle Committee) has issued an interpretation of the Basle framework for capital adequacy (Basle Accord) regarding instruments eligible for inclusion in Tier 1 capital.

The Committee noted that the interpretation will be subject to review as part of a broader effort already underway to reassess the present framework for evaluating banks' capital adequacy.

The governors of the central banks of the G-10 countries endorsed the Basle Accord, which applies to internationally active banks, in 1988.

The interpretation reaffirms that the common shareholders' equity is the key element of capital and should be the predominant form of a bank's Tier 1 capital under the Basle Accord. The interpretation emphasizes the important role public disclosure plays in ensuring that the integrity of capital is maintained.

In this regard, the Committee notes the need for banks to publicly disclose each component of Tier 1 capital and its main features. Such disclosure is consistent with a report entitled "Enhancing Bank Transparency," which the Basle Committee released in September 1998.

The interpretation states that the Committee has determined that minority interest in equity accounts of consolidated subsidiaries that take the form of special purpose vehicles may be included in Tier 1 provided they meet certain minimum criteria. These criteria include permanence, deferability of distributions on a noncumulative basis, and ability to absorb losses within the bank on a going concern basis.

Further, the Committee has determined that moderate step-ups after a minimum of ten years are an acceptable feature in a Tier 1 instrument. Issuances of instruments with such a feature, however, are limited to 15 percent of Tier 1 capital in order to avoid undue reliance on innovative noncommon instruments in Tier 1.

The Federal Reserve will make a determination as to how to implement the Basle interpretation with regard to U.S. banks after consulting with other federal financial institutions regulatory agencies.

With regard to bank holding companies, the Federal Reserve notes that by its terms, the Basle Accord applies to internationally active banks but states that ownership structures should not be allowed to weaken capital positions of banks.

Since the inception of the Basle Accord, U.S. bank holding companies, entities which are legally separate from banks, have been subject to a risk-based capital regime that is identical to the Basle Accord, with the exception that holding companies are allowed to include cumulative preferred stock in Tier 1 on a limited basis.

Consistent with the principles that common equity should be the predominant component of Tier 1 capital and that ownership structures should not weaken bank capital positions, state member banks and bank holding companies generally have been expected to maintain risk-based capital ratios above Basle minimums, without reliance on preferred stock.

State member banks and bank holding companies disclose the components of their capital positions in sufficient detail to allow analysts and supervisors to calculate capital ratios on many different bases, including the Basle capital standard.

The Federal Reserve has no plans to change these policies and practices.

The Basle Committee's interpretation is in the form of a press release. Its report on Enhancing Bank Transparency was sent to you with our Circular No. 11097.