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SRC Insights: Fourth Quarter 2004

Understanding the Proposed Capital Treatment of Trust Preferred Securities

by Vincent J. Poppa, Supervising Examiner

In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities. 1 FIN 46 changed the rules for consolidating “variable interest entities,” also known as “special purpose entities” (SPE), from voting majority to concentration of risk.

Almost immediately, the accounting industry and bank holding companies (BHCs) began to wrestle with the application of FIN 46 to the then-current practice of consolidating trusts issuing trust preferred securities (TPS) with the BHC. In late December 2003, FASB issued a revised version of FIN 46. 2 In that guidance, the accounting authorities generally concluded that such trusts must be deconsolidated in financial statements prepared under GAAP.

Since the majority of the risks inherent in a TPS-issuing trust are borne by the TPS holders rather than the BHC, FIN 46 will not allow the trust to be consolidated with the BHC. As a result, the BHC's consolidated balance sheet will no longer reflect TPS in minority interest, but rather will reflect the subordinated debt issued to the deconsolidated trust. The subordinated debt will be reported in other liabilities and the equity investment in the SPE will be reported in investments in unconsolidated subsidiaries on the balance sheet. This change in accounting rules raised the question of whether the Federal Reserve would change its capital guidelines with respect to TPS, because the subordinated debt shown on the balance sheet would ordinarily only qualify as tier 2 capital.

On May 6, 2004, the Federal Reserve Board issued for comment a proposed rule that would continue to allow TPS to be counted in tier 1 capital of BHCs, subject to stricter quantitative limits. There were several reasons why the Board proposed to continue the tier 1 capital treatment for TPS. First, while the accounting designation has changed, the structure and substance of the securities have not. TPS continue to offer BHCs significant equity-like features—long lives, deferral rights, and loss absorbency. They also do not affect the BHC's liquidity position, are easier and more cost-efficient to issue and manage, and are more transparent and better understood by the market Since their introduction in the year 2000, pools of TPS have given small BHCs access to the capital markets for tier 1 capital. The Board is also aware that foreign banks have issued similar tax-efficient tier 1 capital instruments, so large U.S. BHCs could have a competitive disadvantage if they were unable to count TPS in tier 1 capital.

The regulatory reporting of TPS will reflect GAAP accounting requirements. However, the Federal Reserve is not bound by GAAP accounting in its definition of tier 1 or tier 2 capital, because these are regulatory constructs designed to ensure the safety and soundness of banking organizations.

The proposed rule would apply the 25 percent of tier 1 capital limit after deducting goodwill. Previously the limit was 25 percent of tier 1 capital before deducting goodwill. Deducting goodwill from core capital elements will help ensure that a BHC is not unduly leveraging its tangible equity. This will mean that many BHCs carrying goodwill on their balance sheets may count less of their TPS in tier 1 capital.

Also, capital elements to be included in determining the limit would include minority interest that is not in the form of common or noncumulative preferred stock issued directly by a subsidiary bank or thrift. An example of the type of minority interest to be limited would be REIT preferred securities. To further guard against potential over-reliance on TPS and other non-equity elements within a BHC's capital structure, amounts of TPS and minority interest in consolidated non-depository institution subsidiaries in excess of the 25 percent limit would be included in tier 2 capital, subject, together with subordinated debt and limited-life preferred stock, to a 50 percent of tier 1 limit.

The proposal also provides that in the last five years before the subordinated debt matures, TPS would be excluded from tier 1 capital and counted only as tier 2 capital, subject to the 50 percent of tier 1 limit. During those last five years, the TPS would be amortized out of tier 2 capital by one-fifth each year and excluded totally during the last year. That is the same haircut applied to subordinated debt and limited life preferred stock.

The proposed rule notes that internationally active BHCs would "generally be expected" to adhere to a 15 percent limit, which comes from the 1998 international Basel guideline.

As proposed, the new limits would become fully effective on March 31, 2007, after a three-year transition period that would start on March 31, 2004. However, the Board of Governors did receive 36 comments on the proposal and is considering whether any amendments to the proposal appear to be warranted. After considering the comments, the Board anticipates issuing the final rule by year-end 2004 or early 2005. 3

Based upon the June 30, 2004 regulatory report filings, only three institutions in the Third District could be affected by the proposed change. However, given the amount of time to comply with the stricter limits, these institutions may not be impacted at all by the end of the phase-in period.

If you have any questions concerning the proposed capital treatment or regulatory reporting of trust preferred securities, please contact Supervising Examiner Vincent J. Poppa at (215) 574-6492.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.