Author: Timothy Sullivan

Summary
On March 1, 2005, the Federal Reserve Board approved final rules which allow the continued inclusion of outstanding and prospective issuances of trust preferred securities in the tier 1 capital of bank holding companies (“BHCs”).

The Board also revised the quantitative limits applied to the aggregate amount of cumulative perpetual preferred stock, trust preferred securities, and minority interests in the equity accounts of most consolidated subsidiaries (collectively, restricted core capital elements) which may be included in the tier 1 capital of BHCs.

The Board limited the total of all “restricted core capital elements” to 25% of core capital elements, net of goodwill (less any associated deferred tax liability).

The quantitative limits will become effective on March 31, 2009.

On March 1, 2005, the Board also revised qualitative standards for capital instruments included in regulatory capital to bring them in line with longstanding Board policies.

Click on Download PDF at the bottom of this page for a copy of the final rules.

Background
The Board’s current risk-based capital guidelines allow BHCs to include in their tier 1 capital the following core (or tier 1) capital elements:

• common stockholders’ equity;
• qualifying noncumulative perpetual preferred stock (including related surplus); 
• qualifying cumulative perpetual preferred stock (including related surplus); and
• minority interest in the equity accounts of consolidated subsidiaries.

Tier 1 capital generally is defined as the sum of core capital elements less deductions for all, or a portion of, goodwill, other intangible assets, credit-enhancing interest-only strips receivable, deferred tax assets, non-financial equity investments, and certain other items required to be deducted in computing tier 1 capital.

In 1996, the Board approved the inclusion of trust preferred securities in BHCs’ tier 1 capital.  Trust preferred securities are cumulative preferred securities issued by a special purpose entity (SPE), usually in the form of a trust, in which a BHC owns all of the common securities.  The trust preferred securities are generally callable at the option of the issuer within 5-10 years of issuance and must be redeemed 30 years after issuance.

The SPE’s sole asset is a junior subordinated note issued by the BHC.  The subordinated note, which is senior only to a BHC’s common and preferred stock, has terms that generally mirror those of the trust preferred securities and has a fixed maturity of at least 30 years. 

The terms of the trust preferred securities allow dividends to be deferred for at least a twenty-consecutive-quarter period without creating an event of default or acceleration.  After the deferral of dividends for this twenty-quarter period, if the BHC fails to pay the cumulative dividend amount owed to investors, an event of default and accelerations occurs, giving investors the right to take the subordinated notes.  At the same time, the BHC’s obligation to pay principal and interest on the underlying junior subordinated note accelerates and the note becomes immediately due and payable. 

Probably the most important feature of the trust preferred securities is the tax treatment of its dividends.  For tax purposes the dividends paid on trust preferred securities, unlike those paid on directly issued preferred stock, are tax deductible as interest expense. 

Because the dividends on trust preferred securities are cumulative, these securities have been limited since their inclusion in tier 1 capital in 1996, together with a BHC’s directly issued cumulative perpetual preferred stock, to no more than 25% of a BHC’s core capital elements.

The first pooled issuance of trust preferred securities came to market in 2000.  In a pool a group of BHCs issue trust preferred securities to a pooling entity that issues to the market asset-backed securities representing an interest in the BHC’s pooled trust preferred securities.  Such pooling arrangements, which have become increasingly popular, have made the issuance of trust preferred securities possible for even very small BHCs, most of which had not previously enjoyed capital market access for raising tier 1 capital.

In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN 46”), causing BHCs to wrestle with the application of FIN 46 to the consolidation by BHCs of trusts issuing trust preferred securities.

In December 2003, FASB concluded that such trusts must be deconsolidated in financial statements under GAAP and issued a revised version of FIN 46 (FIN 46R).  Under FIN 46 and FIN 46R, trust preferred securities generally continue to be accounted for as equity at the level of the trust that issues them, but the instruments may no longer be treated as minority interests in the equity accounts of a consolidated subsidiary on a BHC’s consolidated balance sheet.  Therefore, a BHC may no longer reflect on its balance sheet the trust preferred securities issued out of the SPE, but rather must reflect the subordinated note the BHC issued to the deconsolidated SPE.

On May 6, 2004, the Federal Reserve Board proposed rules to address the supervisory concerns, competitive equity considerations and changes in generally accepted accounting principles.  The Board observed in its May 6, 2004 release that: “BHCs should, for both accounting and regulatory reporting purposes, determine the appropriate application of GAAP (including FIN 46 and FIN 46R) to their trusts issuing trust preferred securities. Accordingly, there should be no substantive difference in the treatment of such trusts for purposes of regulatory reporting and GAAP accounting.”

Regulatory Capital Treatment of Trust Preferred Securities
Under the final rules, the Board will continue to permit BHCs to include outstanding and prospective issuances of trust preferred securities in their tier 1 capital, subject to stricter quantitative limits, which would apply to a broader range of capital instruments issued by BHCs.

The Board will continue subjecting cumulative perpetual preferred stock and trust preferred securities to a common limit, while requiring other capital elements in the form of minority interest in the equity accounts of consolidated subsidiaries to be subject to that same limit.

Tier 1 Components
Under the final rules, the elements qualifying for inclusion in the tier 1 component (core capital elements) of an institution’s total qualifying capital would be:

• common stockholders’ equity;
• qualifying noncumulative perpetual preferred stock (including related surplus); 
• minority interest related to qualifying common or noncumulative perpetual preferred stock directly issued by a consolidated U.S. depository institution or foreign bank subsidiary (Class A minority interest); and
• restricted core capital elements.

Restricted Core Capital Elements
Restricted core elements are defined to include:

• qualifying cumulative perpetual preferred stock (including related surplus);
• minority interests related to qualifying cumulative perpetual preferred stock directly issued by a consolidated U.S. depository institution or foreign bank subsidiary (Class B minority interest);
• minority interests in the form of qualifying common stockholders’ equity or qualifying perpetual preferred stock (and related surplus) in a consolidated subsidiary that is neither a U.S. depository institution nor a foreign bank (Class C minority interest); and
• qualifying trust preferred securities.

Restricted Core Capital Limits
The limit the Board approved for the aggregate amount of a BHC’s restricted core capital elements is 25% of core capital elements (including the restricted core capital elements), net of goodwill (less associated deferred tax liability), thereby tightening the current 25% limit, which currently is determined on a basis that does not deduct goodwill.  Stated differently, the aggregate amount of restricted core capital elements is limited to one-third of the sum of core capital elements, excluding restricted core capital elements, net of goodwill less any associated deferred tax liability.

Amounts of qualifying trust preferred securities and Class C minority interests in excess of the 25% limit would be included in tier 2 capital but would be limited, together with subordinated debt and limited-life preferred stock, to 50% of tier 1 capital.

A BHC would be free to attribute its excess amounts of restricted core capital elements first to any qualifying cumulative perpetual preferred stock or to Class B minority interest, and second to qualifying trust preferred securities or Class C minority interest, which are subject to the tier 2 sublimit.

Qualifying cumulative perpetual preferred stock and Class B minority interest in excess of the 25% limit would be includable in tier 2 capital with no sublimit.

Transition Period
BHCs will have until March 31, 2009 to meet the new, stricter limitations.

During the interim, BHCs with restricted core capital elements in excess of these limits must consult with the Federal Reserve on a plan for ensuring that the banking organization is not unduly relying upon these elements in its capital base and, where appropriate, for reducing such reliance.

Until March 31, 2009, BHCs generally must comply with the current tier 1 capital limits and should calculate their tier 1 capital on a basis that limits the aggregate amount of qualifying cumulative perpetual preferred stock (including related surplus) and qualifying trust preferred securities to 25% of the sum of qualifying common stockholders’ equity, qualifying noncumulative and cumulative perpetual preferred stock (including related surplus), qualifying minority interest in the equity accounts of consolidated subsidiaries, and qualifying trust preferred securities.

Amounts of qualifying cumulative perpetual preferred stock and qualifying trust preferred securities in excess of this limit may be included in tier 2 capital.

Trust Preferred Criteria
The Board also approved revisions to its capital guidelines to specify the criteria trust preferred securities must meet to be eligible for inclusion in tier 1 capital. Under these revised criteria:

• A BHC must consult with the Federal Reserve before issuing trust preferred securities. Such
   consultation would normally be undertaken with the BHC’s District Reserve Bank.
• Qualifying trust preferred securities must be undated and provide for a minimum of twenty consecutive quarters of dividend deferral.  The notice of the dividend deferral must be reasonably short and no more than 15 business days prior to the dividend payment date.
• The final rules do not require that the securities include a call at the BHC’s option. Call options are not prohibited, however.
• The sole asset of the trust must be a subordinated note issued by the BHC, which must have a minimum maturity of thirty years and must be subordinated with regard to both liquidation and priority of periodic payments to all senior and subordinated debt of the BHC. 
• Terms of junior subordinated debt must mirror those of the trust preferred securities.
• Junior subordinated debt may be pari passu with obligations to trade creditors and other junior subordinated notes underlying other trust preferred securities. The junior subordinated debt may also provide that it may be senior or pari passu with deeply subordinated capital instruments that the Board may authorize in the future for
   inclusion in tier 1 capital.
• The terms of the subordinated note must conform to the requirements of the Board’s subordinated debt policy statement, 12 CFR250.166.  The note may become due and payable upon (a) default following the deferral of dividends for more than 20 consecutive quarters, or (b) termination of the trust without redemption of the
   trust preferred securities.

Trust preferred securities issued before April 15, 2005 for which the underlying subordinated debt does not comply with 12 CFR 250.166 may continue to be included in tier 1 capital provided the noncomplying terms:

• have been commonly used by banking organizations, 
• do not provide an unreasonably high degree of protection to the holder in circumstances other than bankruptcy, and
• do not effectively allow the holder in due course of the note to stand ahead of senior or subordinated debt holders in the event of bankruptcy.
  

Purchase of Pool Securities
With regard to trust preferred securities issued by a BHC to a pool, the rules provide (as part of the longstanding Board policy) that the BHC may not purchase a security issued by that same pool. If the BHC holds such a security (for example, through an acquisition of another banking organization), the notional amount of that security must be deducted from the amount of trust preferred securities qualifying for inclusion in regulatory capital.  The trust preferred documents usually permit the BHC to redeem trust preferred securities (and an equivalent amount of the note) when the BHC acquires trust preferred securities.

Capital Treatment of Trust Preferred Securities During Last Five Years
The final rules also require that in the last five years before the underlying subordinated note matures, the associated trust preferred securities must be treated as limited-life preferred stock, with the outstanding amount of trust preferred securities being excluded from tier 1 capital and included in tier 2 capital, subject, together with subordinated debt and other limited-life preferred stock, to a limit of 50% of tier 1 capital.  The trust preferred securities will then be amortized out of tier 2 capital by one-fifth of the original amount (less redemptions) each year and excluded totally from tier 2 capital during the last year of life of the underlying note.

Other Revisions
The Board also approved a number of revisions to its capital guidelines relating to its longstanding policies with regard to the terms and features of qualifying capital instruments, including the following:

• Where a BHC has directly or indirectly funded the purchase of an instrument, the instrument generally is excluded from regulatory capital. This provision is intended to capture intentional arrangements that undermine the concept that instruments included in regulatory capital must be fully paid up. 
• Common stockholder’s equity may not have terms or features that create investor preferences (e.g., stated maturity date; liquidation preference; incentives to encourage redemption) and voting common equity should be the dominant form of tier 1 capital.  Banking organizations should avoid over-reliance on preferred stock and nonvoting elements within tier 1 capital. However, such nonvoting elements can include portions of common stockholders’ equity where, for example, a banking organization has a class of nonvoting common equity, or a class of voting common equity that has substantially fewer voting rights per share than another class of voting common equity.
• A BHC should have the unrestricted ability to defer or waive preferred dividends. The Board expects that such dividends will be deferred or waived when a BHC is in weakened condition.
• These revisions also clarify the distinction between cumulative and noncumulative preferred stock. Perpetual preferred stock that is noncumulative may not permit the accumulation or payment of unpaid dividends in any form, including in the form of common stock.
• Preferred instruments with dividend rate step-ups or so-called market value conversion features whereby the holder must or can convert the preferred instrument into common stock at the market price prevailing at the time of the conversion are excluded from tier 1 capital. Perpetual preferred stock that has a credit-sensitive dividend feature—that is, a dividend rate that is reset periodically based, in whole or in part, on the banking organization’s current credit standing—generally does not qualify for inclusion in tier 1 capital. Similarly, perpetual preferred stock that has a dividend rate step-up or a market value conversion feature—that is, a feature whereby the holder must or can convert the preferred stock into common stock at the market price prevailing at the time of conversion—generally does not qualify for inclusion in tier 1 capital. Perpetual preferred stock that does not qualify for inclusion in tier 1 capital generally will qualify for inclusion in tier 2 capital.
• The guidelines for subordinated debt have been incorporated into these rules by a reference to the Federal Reserve’s subordinated debt policy statement set forth in 12 CFR 250.166, which outlines a number of technical requirements that subordinated debt must meet in order to be included in regulatory capital. The final rules also incorporates some clarifications of that policy with regard to subordination and acceleration.
  

Small BHCs
In the May 6, 2004, release, the Board sought comment on the treatment of qualifying trust preferred securities issued by small BHCs (BHCs with consolidated assets of $150 million or less) under the Small Bank Holding Company Policy Statement, which generally exempts small BHCs from the Board’s risk-based capital and leverage capital guidelines. Instead, small BHCs generally apply the risk-based capital and leverage capital guidelines on a bank-only basis and must only meet a debt-to-equity ration at the parent BHC level.

One approach discussed by the Board in the May 6, 2004 release was to treat the subordinated debt associated with trust preferred securities issued by small BHCs as debt for most purposes under the Small BHC Policy Statement (other than the 12-year debt reduction and 25-year debt retirement standards), except that an amount of subordinated debt up to 25% of a small BHC’s GAAP total stockholders’ equity, net of goodwill, would be considered as neither debt nor equity. In the Board’s view, this would result in a treatment for trust preferred securities issued by BHCs subject to the Small BHC Policy Statement that would be more in line with the treatment of these securities that the Board finalized for larger BHCs subject to the Federal Reserve’s risk-based capital guidelines.

The Board intends to issue supervisory guidance on this in the near future.

Internationally Active BHCs
The Board also amended its capital guidelines to make explicit the Board’s general expectation that internationally active BHCs limit the amount of restricted core capital elements to 15% of the sum of core capital elements, including restricted core capital elements, net of goodwill.  An internationally active BHC is a BHC that:

• as of its most recent year-end FR Y-9C report has total consolidated assets equal to $250 billion or more, or
• on a consolidated basis, reports total on-balance sheet foreign exposure of $10 billion or more on its filings of the most recent year-end FFIEC 009 Country Exposure Report. 

This definition closely approximates the definition proposed for mandatory advanced AIRB banking organizations in the Advance Notice of Proposed Rulemaking to implement the Mid-year Text, which was issued on August 4, 2003.  Thus, the 15% limit would not apply to banking organizations that opt-in to the AIRB.  In arriving at this definition of internationally active, the Board took into account the possible effects of the proposed application on the 15% limitation on the capital-raising efforts of moderate-sized BHCs that may opt in to the AIRB approach in the future.

The Board also decided to turn the 15 percent general supervisory expectation into a regulatory limitation to ensure the soundness of the capital base of the largest U.S. banking organizations and to formalize the application of the Sydney Agreement to such banking organizations by regulation.  The Board will generally expect and strongly encourage opt-in AIRB BHCs to plan for, and come into compliance with, the 15 percent limit on restricted core capital elements as they approach the criteria for internationally active BHCs.

Part 225 - BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL (REGULATION Y)

APPENDIX A to PART 225 – CAPITAL ADEQUACY GUIDELINES FOR BANK HOLDING COMPANIES: RISK-BASED MEASURE
* * * * *
II. Definition of Qualifying Capital for the Risk-Based Capital Ratio

• A banking organization’s qualifying total capital consists of two types of capital components: “core capital elements” (tier 1 capital elements) and “supplementary capital elements” (tier 2 capital elements). These capital elements and the various limits, restrictions, and deductions to which they are subject, are discussed below. To qualify as an element of tier 1 or tier 2 capital, an instrument must be fully paid up and effectively unsecured. Accordingly, if a banking organization has purchased, or has directly or indirectly funded the purchase of, its own capital instrument, that instrument generally is disqualified from inclusion in regulatory capital. A qualifying tier 1 or tier 2 capital instrument must be subordinated to all senior indebtedness of the organization. If issued by a bank, it also must be subordinated to claims of depositors. In addition, the instrument must not contain or be covered by any covenants, terms, or restrictions that are inconsistent with safe and sound banking practices.
• On a case-by-case basis, the Federal Reserve may determine whether, and to what extent, any instrument that does not fit wholly within the terms of a capital element set forth below, or that does not have the characteristics or the ability to absorb losses commensurate with the capital treatment specified below, will qualify as an element of tier 1 or tier 2 capital. In making such a determination, the Federal Reserve will consider the similarity of the instrument to instruments explicitly addressed in the guidelines; the ability of the instrument to absorb losses, particularly while the organization operates as a going concern; the maturity and redemption features of the instrument; and other relevant terms and factors. 
•  The redemption of capital instruments before stated maturity could have a significant impact on an organization’s overall capital structure. Consequently, an organization should consult with the Federal Reserve before redeeming any equity or other capital instrument included in tier 1 or tier 2 capital prior to stated maturity if such redemption could have a material effect on the level or composition of the organization’s capital base. Such consultation generally would not be necessary when the instrument is to be redeemed with the proceeds of, or replaced by, a like amount of a capital instrument that is of equal or higher quality with regard to terms and maturity and the Federal Reserve considers the organization’s capital position to be fully sufficient.

A. The Definition and Components of Qualifying Capital

Tier 1 capital. Tier 1 capital generally is defined as the sum of core capital elements less any amounts of goodwill, other intangible assets, interest-only strips receivables, deferred tax assets, nonfinancial equity investments, and other items that are required to be deducted in accordance with section II.B. of this appendix. Tier 1 capital must represent at least 50 percent of qualifying total capital.

a. Core capital elements (tier 1 capital elements). The elements qualifying for inclusion in the tier 1 component of a banking organization’s qualifying total capital are:

i. Qualifying common stockholders’ equity;

ii. Qualifying noncumulative perpetual preferred stock (including related surplus);

iii. Minority interest related to qualifying common or noncumulative perpetual preferred stock directly issued by a consolidated U.S. depository institution or foreign bank subsidiary (Class A minority interest); and

iv. Restricted core capital elements. The aggregate of these items is limited within tier 1 capital as set forth in section II.A.1.b. of this appendix. These elements are defined to include:

(1) Qualifying cumulative perpetual preferred stock (including related surplus);

(2) Minority interest related to qualifying cumulative perpetual preferred stock directly issued by a consolidated U.S. depository institution or foreign bank subsidiary (Class B minority interest);

(3) Minority interest related to qualifying common stockholders’ equity or perpetual preferred stock issued by a consolidated subsidiary that is neither a U.S. depository institution nor a foreign bank (Class C minority interest); and

(4) Qualifying trust preferred securities.

b. Limits on restricted core capital elements--i. Limits. (1) The aggregate amount of restricted core capital elements that may be included in the tier 1 capital of a banking organization must not exceed 25 percent of the sum of all core capital elements, including restricted core capital elements, net of goodwill less any associated deferred tax liability. Stated differently, the aggregate amount of restricted core capital elements is limited to one-third of the sum of core capital elements, excluding restricted core capital elements, net of goodwill less any associated deferred tax liability.

(2) In addition, the aggregate amount of restricted core capital elements (other than qualifying mandatory convertible preferred securities ) that may be included in the tier 1 capital of an internationally active banking organization ) must not exceed 15 percent of the sum of all core capital elements, including restricted core capital elements, net of goodwill less any associated deferred tax liability.

(3) Amounts of restricted core capital elements in excess of this limit generally may be included in tier 2 capital. The excess amounts of restricted core capital elements that are in the form of Class C minority interest and qualifying trust preferred securities are subject to further limitation within tier 2 capital in accordance with section II.A.2.d.iv. of this appendix. A banking organization may attribute excess amounts of restricted core capital elements first to any qualifying cumulative perpetual preferred stock or to Class B minority interest, and second to qualifying trust preferred securities or to Class C minority interest, which are subject to a tier 2 sublimit.

ii. Transition.

(1) The quantitative limits for restricted core capital elements set forth in sections II.A.1.b.i. and II.A.2.d.iv. of this appendix become effective on March 31, 2009. Prior to that time, a banking organization with restricted core capital elements in amounts that cause it to exceed these limits must consult with the Federal Reserve on a plan for ensuring that the banking organization is not unduly relying on these elements in its capital base and, where appropriate, for reducing such reliance to ensure that the organization complies with these limits as of March 31, 2009.

(2) Until March 31, 2009, the aggregate amount of qualifying cumulative perpetual preferred stock (including related surplus) and qualifying trust preferred securities that a banking organization may include in tier 1 capital is limited to 25 percent of the sum of the following core capital elements: qualifying common stockholders’ equity, qualifying noncumulative and cumulative perpetual preferred stock (including related surplus), qualifying minority interest in the equity accounts of consolidated subsidiaries, and qualifying trust preferred securities. Amounts of qualifying cumulative perpetual preferred stock (including related surplus) and qualifying trust preferred securities in excess of this limit may be included in tier 2 capital.

(3) Until March 31, 2009, internationally active banking organizations generally are expected to limit the amount of qualifying cumulative perpetual preferred stock (including related surplus) and qualifying trust preferred securities included in tier 1 capital to 15 percent of the sum of core capital elements set forth in section II.A.1.b.ii.2. of this appendix.

c. Definitions and requirements for core capital elements--i. Qualifying common stockholders’ equity.

(1) Definition. Qualifying common stockholders’ equity is limited to common stock; related surplus; and retained earnings, including capital reserves and adjustments for the cumulative effect of foreign currency translation, net of any treasury stock, less net unrealized holding losses on available-for-sale equity securities with readily determinable fair values. For this purpose, net unrealized holding gains on such equity securities and net unrealized holding gains (losses) on available-for-sale debt securities are not included in qualifying common stockholders’ equity.

(2) Restrictions on terms and features. A capital instrument that has a stated maturity date or that has a preference with regard to liquidation or the payment of dividends is not deemed to be a component of qualifying common stockholders’ equity, regardless of whether or not it is called common equity. Terms or features that grant other preferences also may call into question whether the capital instrument would be deemed to be qualifying common stockholders’ equity. Features that require, or provide significant incentives for, the issuer to redeem the instrument for cash or cash equivalents will render the instrument ineligible as a component of qualifying common stockholders’ equity.

(3) Reliance on voting common stockholders’ equity. Although section II.A.1. of this appendix allows for the inclusion of elements other than common stockholders’ equity within tier 1 capital, voting common stockholders’ equity, which is the most desirable capital element from a supervisory standpoint, generally should be the dominant element within tier 1 capital. Thus, banking organizations should avoid over-reliance on preferred stock and nonvoting elements within tier 1 capital. Such nonvoting elements can include portions of common stockholders’ equity where, for example, a banking organization has a class of nonvoting common equity, or a class of voting common equity that has substantially fewer voting rights per share than another class of voting common equity. Where a banking organization relies excessively on nonvoting elements within tier 1 capital, the Federal Reserve generally will require the banking organization to allocate a portion of the nonvoting elements to tier 2 capital.

ii. Qualifying perpetual preferred stock.

(1) Qualifying requirements. Perpetual preferred stock qualifying for inclusion in tier 1 capital has no maturity date and cannot be redeemed at the option of the holder. Perpetual preferred stock will qualify for inclusion in tier 1 capital only if it can absorb losses while the issuer operates as a going concern.

(2) Restrictions on terms and features. Perpetual preferred stock included in tier 1 capital may not have any provisions restricting the banking organization’s ability or legal right to defer or waive dividends, other than provisions requiring prior or concurrent deferral or waiver of payments on more junior instruments, which the Federal Reserve generally expects in such instruments consistent with the notion that the most junior capital elements should absorb losses first. Dividend deferrals or waivers for preferred stock, which the Federal Reserve expects will occur either voluntarily or at its direction when an organization is in a weakened condition, must not be subject to arrangements that would diminish the ability of the deferral to shore up the banking organization’s resources. Any perpetual preferred stock with a feature permitting redemption at the option of the issuer may qualify as tier 1 capital only if the redemption is subject to prior approval of the Federal Reserve. Features that require, or create significant incentives for the issuer to redeem the instrument for cash or cash equivalents will render the instrument ineligible for inclusion in tier 1 capital. For example, perpetual preferred stock that has a credit-sensitive dividend feature—that is, a dividend rate that is reset periodically based, in whole or in part, on the banking organization’s current credit standing—generally does not qualify for inclusion in tier 1 capital.  Similarly, perpetual preferred stock that has a dividend rate step-up or a market value conversion feature — that is, a feature whereby the holder must or can convert the preferred stock into common stock at the market price prevailing at the time of conversion — generally does not qualify for inclusion in tier 1 capital.  Perpetual preferred stock that does not qualify for inclusion in tier 1 capital generally will qualify for inclusion in tier 2 capital.

(3) Noncumulative and cumulative features. Perpetual preferred stock that is noncumulative generally may not permit the accumulation or payment of unpaid dividends in any form, including in the form of common stock. Perpetual preferred stock that provides for the accumulation or future payment of unpaid dividends is deemed to be cumulative, regardless of whether or not it is called noncumulative.

iii. Qualifying minority interest. Minority interest in the common and preferred stockholders’ equity accounts of a consolidated subsidiary (minority interest) represents stockholders’ equity associated with common or preferred equity instruments issued by a banking organization’s consolidated subsidiary that are held by investors other than the banking organization. Minority interest is included in tier 1 capital because, as a general rule, it represents equity that is freely available to absorb losses in the issuing subsidiary. Nonetheless, minority interest typically is not available to absorb losses in the banking organization as a whole, a feature that is a particular concern when the minority interest is issued by a subsidiary that is neither a U.S. depository institution nor a foreign bank. For this reason, this appendix distinguishes among three types of qualifying minority interest. Class A minority interest is minority interest related to qualifying common and noncumulative perpetual preferred equity instruments issued directly (that is, not through a subsidiary) by a consolidated U.S. depository institution  or foreign bank  subsidiary of a banking organization. Class A minority interest is not subject to a formal limitation within tier 1 capital. Class B minority interest is minority interest related to qualifying cumulative perpetual preferred equity instruments issued directly by a consolidated U.S. depository institution or foreign bank subsidiary of a banking organization. Class B minority interest is a restricted core capital element subject to the limitations set forth in section II.A.1.b.i. of this appendix, but is not subject to a tier 2 sub-limit. Class C minority interest is minority interest related to qualifying common or perpetual preferred stock issued by a banking organization’s consolidated subsidiary that is neither a U.S. depository institution nor a foreign bank. Class C minority interest is eligible for inclusion in tier 1 capital as a restricted core capital element and is subject to the limitations set forth in sections II.A.1.b.i. and II.A.2.d.iv. of this appendix. Minority interest in small business investment companies, investment funds that hold nonfinancial equity investments (as defined in section II.B.5.b. of this appendix), and subsidiaries engaged in nonfinancial activities are not included in the banking organization’s tier 1 or total capital if the banking organization’s interest in the company or fund is held under one of the legal authorities listed in section II.B.5.b. of this appendix. In addition, minority interest in consolidated asset-backed commercial paper programs (ABCP) (as defined in section III.B.6. of this appendix) that are sponsored by a banking organization are not included in the organization’s tier 1 or total capital if the organization excludes the consolidated assets of such programs from risk-weighted assets pursuant to section III.B.6. of this appendix.

iv. Qualifying trust preferred securities.

(1) A banking organization that wishes to issue trust preferred securities and include them in tier 1 capital must first consult with the Federal Reserve. Trust preferred securities are defined as undated preferred securities issued by a trust or similar entity sponsored (but generally not consolidated) by a banking organization that is the sole common equity holder of the trust. Qualifying trust preferred securities must allow for dividends to be deferred for at least twenty consecutive quarters without an event of default, unless an event of default leading to acceleration permitted under section II.A.1.c.iv.(2) has occurred. The required notification period for such deferral must be reasonably short, no more than 15 business days prior to the payment date. Qualifying trust preferred securities are otherwise subject to the same restrictions on terms and features as qualifying perpetual preferred stock under section II.A.1.c.ii.(2) of this appendix.

(2) The sole asset of the trust must be a junior subordinated note issued by the sponsoring banking organization that has a minimum maturity of thirty years, is subordinated with regard to both liquidation and priority of periodic payments to all senior and subordinated debt of the sponsoring banking organization (other than other junior subordinated notes underlying trust preferred securities). Otherwise the terms of a junior subordinated note must mirror those of the preferred securities issued by the trust.  The note must comply with section II.A.2.d. of this appendix and the Federal Reserve’s subordinated debt policy statement set forth in 12 CFR 250.166  except that the note may provide for an event of default and the acceleration of principal and accrued interest upon (a) nonpayment of interest for 20 or more consecutive quarters or (b) termination of the trust without redemption of the trust preferred securities, distribution of the notes to investors, or assumption of the obligation by a successor to the banking organization.

(3) In the last five years before the maturity of the note, the outstanding amount of the associated trust preferred securities is excluded from tier 1 capital and included in tier 2 capital, where the trust preferred securities are subject to the amortization provisions and quantitative restrictions set forth in sections II.A.2.d.iii. and iv. of this appendix as if the trust preferred securities were limited-life preferred stock.

2. Supplementary capital elements (tier 2 capital elements) * * * * * * * *

b. Perpetual preferred stock. Perpetual preferred stock (and related surplus) that meets the requirements set forth in section II.A.1.c.ii.(1) of this appendix is eligible for inclusion in tier 2 capital without limit.
* * * * *

d. Subordinated debt and intermediate-term preferred stock--i. Five-year minimum maturity. Subordinated debt and intermediate-term preferred stock must have an original weighted average maturity of at least five years to qualify as tier 2 capital. If the holder has the option to require the issuer to redeem, repay, or repurchase the instrument prior to the original stated maturity, maturity would be defined, for risk-based capital purposes, as the earliest possible date on which the holder can put the instrument back to the issuing banking organization.

ii. Other restrictions on subordinated debt. Subordinated debt included in tier 2 capital must comply with the Federal Reserve’s subordinated debt policy statement set forth in 12 CFR 250.166.  Accordingly, such subordinated debt must meet the following requirements:

(1) The subordinated debt must be unsecured.

(2) The subordinated debt must clearly state on its face that it is not a deposit and is not insured by a Federal agency.

(3) The subordinated debt must not have credit-sensitive features or other provisions that are inconsistent with safe and sound banking practice.

(4) Subordinated debt issued by a subsidiary U.S. depository institution or foreign bank of a bank holding company must be subordinated in right of payment to the claims of all the institution’s general creditors and depositors, and generally must not contain provisions permitting debt holders to accelerate payment of principal or interest upon the occurrence of any event other than receivership of the institution. Subordinated debt issued by a bank holding company or its subsidiaries that are neither U.S. depository institutions nor foreign banks must be subordinated to all senior indebtedness of the issuer; that is, the debt must be subordinated at a minimum to all borrowed money, similar obligations arising from off-balance sheet guarantees and direct credit substitutes, and obligations associated with derivative products such as interest rate and foreign exchange contracts, commodity contracts, and similar arrangements. Subordinated debt issued by a bank holding company or any of its subsidiaries that is not a U.S. depository institution or foreign bank must not contain provisions permitting debt holders to accelerate the payment of principal or interest upon the occurrence of any event other than the bankruptcy of the bank holding company or the receivership of a major subsidiary depository institution. Thus, a provision permitting acceleration in the event that any other affiliate of the bank holding company issuer enters into bankruptcy or receivership makes the instrument ineligible for inclusion in tier 2 capital.

iii. Discounting in last five years. As a limited-life capital instrument approaches maturity, it begins to take on characteristics of a short-term obligation. For this reason, the outstanding amount of term subordinated debt and limited-life preferred stock eligible for inclusion in tier 2 capital is reduced, or discounted, as these instruments approach maturity: one-fifth of the outstanding amount is excluded each year during the instrument’s last five years before maturity. When remaining maturity is less than one year, the instrument is excluded from tier 2 capital.

iv. Limits. The aggregate amount of term subordinated debt (excluding mandatory convertible debt) and limited-life preferred stock as well as, beginning March 31, 2009, qualifying trust preferred securities and Class C minority interest in excess of the limits set forth in section II.A.1.b.i. of this appendix that may be included in tier 2 capital is limited to 50 percent of tier 1 capital (net of goodwill and other intangible assets required to be deducted in accordance with section II.B.1.b. of this appendix). Amounts of these instruments in excess of this limit, although not included in tier 2 capital, will be taken into account
by the Federal Reserve in its overall assessment of a banking organization’s funding and financial condition.

B. * * *
2. * * *
a. *** The aggregate amount of investments in banking or finance subsidiaries * * *
* * * * *
III.* * *
C. * * *
2. * * *
a. * * * U.S. depository institutions  and foreign banks ;* * * * * * * *

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