Nonaccrual Loans and Restructured Debt (Accounting, Reporting, and

Nonaccrual Loans and Restructured Debt(Accounting, Reporting, and Disclosure Issues) Section 2065.1

Working with borrowers who are experiencingfinancial difficulties may involve formallyrestructuring their loans and taking other mea-sures to conform the repayment terms to theborrowers’ ability to repay. Such actions, ifdone in a way that is consistent with prudentlending principles and supervisory practices, canimprove the prospects for collection. Generallyaccepted accounting principles (GAAP) andregulatory reporting requirements provide aframework for reporting that may alleviate cer-tain concerns that lenders may have about work-ing constructively with borrowers who are hav-ing financial difficulties.

Interagency policy statements and guidance,issued on March 1, 1991; March 10, 1993; andJune 10, 1993, clarified supervisory policiesregarding nonaccrual assets, restructured loans,and collateral valuation (additional clarificationguidance may be found in SR-95-38 and in theglossary of the reporting instructions for thebank call report and the FR-Y-9C, the consoli-dated bank holding company report). When cer-tain criteria1 are met, (1) interest payments onnonaccrual assets can be recognized as incomeon a cash basis without first recovering anyprior partial charge-offs; (2) nonaccrual assetscan be restored to accrual status when subject toformal restructurings, according to FinancialAccounting Standards Board (FASB) StatementNos. 15 and 114, ‘‘Accounting by Debtors andCreditors for Troubled Debt Restructurings’’(FAS 15) and ‘‘Accounting by Creditors forImpairment of a Loan’’ (FAS 114); and (3) re-structurings that specify a market rate of interestwould not have to be included in restructuredloan amounts reported in the years after the yearof the restructuring. These supervisory policiesapply to federally supervised financial institu-tions. The board of directors and managementof bank holding companies should therefore in-corporate these policies into the supervision oftheir federally supervised financial institutionsubsidiaries.

2065.1.1 CASH-BASIS INCOMERECOGNITION ON NONACCRUALASSETS

Current regulatory reporting requirements donot preclude the cash-basis recognition of

income on nonaccrual assets (including loansthat have been partially charged off), if theremaining book balance of the loan is deemedfully collectible. Interest income recognized ona cash basis should be limited to that whichwould have been accrued on the recorded bal-ance at the contractual rate. Any cash interestreceived over this limit should be recorded asrecoveries of prior charge-offs until thesecharge-offs have been fully recovered.

2065.1.2 NONACCRUAL ASSETSSUBJECT TO FAS 15 AND FAS 114RESTRUCTURINGS

A loan or other debt instrument that has beenformally restructured to ensure repayment andperformance need not be maintained in non-accrual status. When the asset is returned toaccrual status, payment performance that hadbeen sustained for a reasonable time before therestructuring may be considered. For example, aloan may have been restructured, in part, toreduce the amount of the borrower’s contractualpayments. It may be that the amount and fre-quency of payments under the restructuredterms do not exceed those of the payments thatthe borrower had made over a sustained period,within a reasonable time before the restruc-turing. In this situation, if the lender is reason-ably assured of repayment and performanceaccording to the modified terms, the loan can beimmediately restored to accrual status.

Clearly, a period of sustained performance,whether before or after the date of the restructur-ing, is very important in determining whetherthere is reasonable assurance of repaymentand performance. In certain circumstances, otherinformation may be sufficient to demonstrate animprovement in the borrower’s condition or ineconomic conditions that may affect the bor-rower’s ability to repay. Such information mayreduce the need to rely on the borrower’s perfor-mance to date in assessing repayment prospects.For example, if the borrower has obtained sub-stantial and reliable sales, lease, or rental con-tracts or if other important developments areexpected to significantly increase the borrow-er’s cash flow and debt-service capacity andstrength, then the borrower’s commitment torepay may be sufficient. A preponderance ofsuch evidence may be sufficient to warrant

1. A discussion of the criteria is found within the corre-sponding subsections that follow.

BHC Supervision Manual December 2002Page 1

returning a restructured loan to accrual status.The restructured terms must reasonably ensureperformance and full repayment.

It is imperative that the reasons for restoringrestructured debt to accrual status be docu-mented. A restoration should be supported bya current, well-documented evaluation of theborrower’s financial condition and prospectsfor repayment. This documentation will bereviewed by examiners.

The formal restructuring of a loan or otherdebt instrument should be undertaken in waysthat will improve the likelihood that the creditwill be repaid in full in accordance with reason-ably restructured repayment terms.2 Regulatoryreporting requirements and GAAP do notrequire a banking organization that restructuresa loan to grant excessive concessions, forgiveprincipal, or take other steps not commensuratewith the borrower’s ability to repay in order touse the reporting treatment specified in FAS 15.Furthermore, the restructured terms may includeprudent contingent payment provisions that per-mit an institution to obtain appropriate recoveryof concessions granted in the restructuring, ifthe borrower’s condition substantially improves.

2065.1.3 RESTRUCTURINGSRESULTING IN A MARKETINTEREST RATE

A FAS 114 restructuring that specifies an effec-tive interest rate that is equal to or greater thanthe rate the lending banking organization is will-ing to accept at the time of the restructuring, fora new loan with comparable risk (assuming theloan is not impaired by the restructuring agree-ment), does not have to be reported asa troubled-debt restructuring after the year ofrestructuring.

2065.l.4 NONACCRUAL TREATMENTOF MULTIPLE LOANS TO ONEBORROWER

As a general principle, whether to place an assetin nonaccrual status should be determined by anassessment of the individual asset’s collect-

ibility. One loan to a borrower being placedin nonaccrual status does not automatically haveto result in all other extensions of credit to thatborrower being placed in nonaccrual status.When a single borrower has multiple extensionsof credit outstanding and one meets the criteriafor nonaccrual status, the lender should evalu-ate the others to determine whether one or moreof them should also be placed in nonaccrualstatus.

2065.1.4.1 Troubled-DebtRestructuring—Returning a Multiple-NoteStructure to Accrual Status

On June 10, 1993, interagency guidance wasissued to clarify a March 10, 1993, interagencypolicy statement on credit availability. The guid-ance addresses a troubled-debt restructuring(TDR) that involves multiple notes (some-times referred to as A/B note structures). Anexample of a multiple-note structure is whenthe first, or A, note would represent the portionof the original-loan principal amount that wouldbe expected to be fully collected along withcontractual interest. The second part of therestructured loan, or B note, represents the por-tion of the original loan that has been chargedoff.

Such TDRs generally may take any of threeforms: (1) In certain TDRs, the B note may be acontingent receivable that is payable only ifcertain conditions are met (for example, if thereis sufficient cash flow from the property).(2) For other TDRs, the B note may becontingency-forgiven (note B is forgiven if noteA is paid in full). (3) In other instances, aninstitution would have granted a concession (forexample, a rate reduction) to the troubled bor-rower but the B note would remain a contractualobligation of the borrower. Because the B noteis not reflected as an asset on the institution’sbooks and is unlikely to be collected, the B noteis viewed as a contingent receivable for report-ing purposes.

Financial institutions may return the A noteto accrual status provided the following condi-tions are met:

1. The restructuring qualifies as a TDR asdefined by FAS 15, and there is economicsubstance to the restructuring. (Under FAS15, a restructuring of debt is considered aTDR if ‘‘the creditor for economic or legalreasons related to the debtor’s financial diffi-culties grants a concession to the debtor thatit would not otherwise consider.’’)

2. A restructured loan may not be restored to accrual statusunless there is reasonable assurance of repayment and perfor-mance under its modified terms in accordance with a reason-able repayment schedule.

Nonaccrual Loans and Restructured Debt 2065.1


2. The portion of the original loan representedby the B note has been charged off. Thecharge-off must be supported by a current,well-documented evaluation of the borrow-er’s financial condition and prospects forrepayment under the revised terms. Thecharge-off must be recorded before or at thetime of the restructuring.

3. The institution is reasonably assured ofrepayment of the A note and of performancein accordance with the modified terms.

4. In general, the borrower must have demon-strated sustained repayment performance(either immediately before or after therestructuring) in accordance with the modi-fied terms for a reasonable period before thedate on which the A note is returned toaccrual status. Sustained payment perfor-mance generally would be for a minimum ofsix months and involve payments in the formof cash or cash equivalents.

The A note would be initially disclosed as aTDR. However, if the A note yields a marketrate of interest and performs in accordance withthe restructured terms, the note would not haveto be disclosed as a TDR in the year after therestructuring. To be considered a market rate ofinterest, the interest rate on the A note at thetime of the restructuring must be equal to orgreater than the rate that the institution is will-ing to accept for a new receivable with compa-rable risk. (See SR-93-30.)

2065.1.4.2 Nonaccrual Loans That HaveDemonstrated Sustained ContractualPerformance

Certain borrowers have resumed paying the fullamount of scheduled contractual interest andprincipal payments on loans that are past dueand in nonaccrual status. Although prior arrear-ages may not have been eliminated by paymentsfrom the borrowers, some borrowers have dem-onstrated sustained performance over a time inaccordance with contractual terms. The inter-agency guidance of June 10, 1993, announcedthat such loans may henceforth be returned toaccrual status, even though the loans have notbeen brought fully current. They may bereturned to accrual status if (1) there is reason-able assurance of repayment of all principal andinterest amounts contractually due (includingarrearages) within a reasonable period and(2) the borrower has made payments of cash orcash equivalents over a sustained period (gener-ally a minimum of six months) in accordance

with the contractual terms. When the federalfinancial institution regulatory reporting criteriafor restoration to accrual status are met, previ-ous charge-offs taken would not have to be fullyrecovered before such loans are returned toaccrual status. Loans that meet this criteriashould continue to be disclosed as past due asappropriate (for example, 90 days past due andstill accruing) until they have been brought fullycurrent. (See SR-93-30.)

2065.1.5 ACQUISITION OFNONACCRUAL ASSETS

Banking organizations (or the receiver of afailed institution) may sell loans or debt securi-ties maintained in nonaccrual status. Such loansor debt securities that have been acquired froman unaffiliated third party should be reported bythe purchaser in accordance with AICPA Prac-tice Bulletin No. 6. When the criteria specifiedin this bulletin are met, these assets may beplaced in nonaccrual status.3

2065.1.6 TREATMENT OFNONACCRUAL LOANS WITHPARTIAL CHARGE-OFFS

Whether partial charge-offs associated with anonaccrual loan that has not been formallyrestructured must first be fully recovered beforethe loan can be restored to accrual status is anissue that has not been explicitly addressed byGAAP and bank regulatory reporting require-ments. In accordance with the instructions forthe bank call report and the bank holding com-pany reports (FR-Y series), restoration toaccrual status is permitted when (1) the loan hasbeen brought fully current with respect to princi-pal and interest and (2) it is expected that thefull contractual balance of the loan (includingany amounts charged off) plus interest will befully collectible under the terms of the loan.4

3. AICPA Practice Bulletin No. 6, ‘‘Amortization of Dis-counts on Certain Acquired Loans,’’ American Institute ofCertified Public Accountants, August 1989.

4. The instructions for the call reports and FR-Y reportsdiscuss the criteria for restoration to accrual status in theglossary entries for ‘‘nonaccrual status.’’ This guidance alsopermits restoration to accrual status for nonaccrual assets thatare both well secured and in the process of collection. Inaddition, this guidance permits restoration to accrual status,when certain criteria are met, of formally restructured debtand acquired nonaccrual assets.



Thus, in determining whether a partiallycharged-off loan that has been brought fullycurrent can be returned to accrual status, it isimportant to determine whether the bankingorganization expects to receive the full amountof principal and interest called for by the termsof the loan.

When a loan has been brought fully currentwith respect to contractual principal and inter-est, and when the borrower’s financial conditionand economic conditions that could affect theborrower’s ability to repay have improved to thepoint that repayment of the full amount of con-tractual principal (including any amountscharged off) and interest is expected, the loanmay be restored to accrual status even if thecharge-off has not been recovered. However,this treatment would not be appropriate if thecharge-off reflects continuing doubt about thecollectibility of principal or interest. Becauseloans or other assets are required to be placed innonaccrual status when full repayment of princi-pal or interest is not expected, such loans couldnot be restored to accrual status.

It is imperative that the reasons for the resto-ration of a partially charged-off loan to accrualstatus be supported by a current, well-documented evaluation of the borrower’s finan-cial condition and prospects for full repaymentof contractual principal (including any amountscharged off) and interest. This documentationwill be subject to review by examiners.

A nonaccrual loan or debt instrument mayhave been formally restructured in accordancewith FAS 15 so that it meets the criteria forrestoration to accrual status presented in section2065.1.2 addressing restructured loans. UnderGAAP, when a charge-off was taken before thedate of the restructuring, it does not have tobe recovered before the restructured loan canbe restored to accrual status. When a charge-offoccurs after the date of the restructuring, theconsiderations and treatments discussed earlierin this section are applicable.

2065.1.7 IN-SUBSTANCEFORECLOSURES

FAS 114 addresses the accounting for impairedloans and clarifies existing accounting guidancefor in-substance foreclosures. Under the impair-ment standard and related amendments to FAS

15, a collateral-dependent real estate loan5

would be reported as ‘‘other real estate owned’’(OREO) only if the lender had taken possessionof the collateral. For other collateral-dependentreal estate loans, loss recognition would bebased on the fair value of the collateral if fore-closure is probable.6 Such loans would remainin the loan category and would not be reportedas OREO. For depository institution examina-tions, any portion of the loan balance on acollateral-dependent loan that exceeds the fairvalue of the collateral and that can be identifiedas uncollectible would generally be classified asa loss and be promptly charged off against theALLL.

A collateralized loan that becomes impairedis not considered ‘‘collateral dependent’’ ifrepayment is available from reliable sourcesother than the collateral. Any impairment onsuch a loan may, at the depository institution’soption, be determined based on the present valueof the expected future cash flows discounted atthe loan’s effective interest rate or, as a practicalexpedient, based on the loan’s observable mar-ket price. (See SR-95-38.)

Losses must be recognized on real estateloans that meet the in-substance foreclosurecriteria with the collateral being valued accord-ing to its fair value. Such loans do not have tobe reported as OREO unless possession of theunderlying collateral has been obtained. (SeeSR-93-30.)

2065.1.8 LIQUIDATION VALUES OFREAL ESTATE LOANS

In accordance with the March 10, 1993, inter-agency policy statement Credit Availability,loans secured by real estate should be based onthe borrower’s ability to pay over time, ratherthan on a presumption of immediate liquidation.Interagency guidance issued on June 10, 1993,emphasizes that it is not regulatory policy tovalue collateral that underlies real estate loanson a liquidation basis. (See SR-93-30.)

5. A collateral-dependent real estate loan is a loan forwhich repayment is expected to be provided solely by theunderlying collateral and there are no other available andreliable sources of repayment.

6. The fair value of the assets transferred is the amount thatthe debtor could reasonably expect to receive for them in acurrent sale between a willing buyer and a willing seller, otherthan in a forced or liquidation sale.



Determining an Adequate Level for the Allowance for Loan and LeaseLosses (Accounting, Reporting, and Disclosure Issues) Section 2065.2

The adequacy of a banking organization’sallowance for loan and lease losses (ALLL)(including amounts based on an analysis of thecommercial real estate portfolio) must be basedon a careful, well-documented, and consistentlyapplied analysis of the loan and lease portfolio.1

The determination of the adequacy of the ALLLshould be based on management’s considerationof all current significant conditions that mightaffect the ability of borrowers (or guarantors, ifany) to fulfill their obligations to the institution.While historical loss experience provides a rea-sonable starting point, historical losses or evenrecent trends in losses are not sufficient, withoutfurther analysis, to produce a reliable estimateof anticipated loss.

In determining the adequacy of the ALLL,management should consider factors such aschanges in the nature and volume of the port-folio; the experience, ability, and depth of lend-ing management and staff; changes in creditstandards; collection policies and historical col-lection experience; concentrations of credit risk;trends in the volume and severity of past-dueand classified loans; and trends in the volume ofnonaccrual loans, specific problem loans, andcommitments. In addition, this analysis shouldconsider the quality of the organization’s sys-tems and management in identifying, monitor-ing, and addressing asset-quality problems. Fur-thermore, management should consider externalfactors such as local and national economicconditions and developments, competition, andlegal and regulatory requirements, as well asreasonably foreseeable events that are likely toaffect the collectibility of the loan portfolio.

Management should adequately document thefactors that were considered, the methodologyand process that were used in determining theadequacy of the ALLL, and the range of pos-sible credit losses estimated by this process. Thecomplexity and scope of this analysis must beappropriate to the size and nature of the organi-zation and provide for sufficient flexibility toaccommodate changing circumstances.

Examiners will evaluate the methodology andprocess that management has followed in arriv-ing at an overall estimate of the ALLL to ensurethat all of the relevant factors affecting thecollectibility of the portfolio have been appro-priately considered. In addition, the overall esti-mate of the ALLL and the range of possiblecredit losses estimated by management will bereviewed for reasonableness in view of thesefactors. The examiner’s analysis will also con-sider the quality of the organization’s systemsand management in identifying, monitoring, andaddressing asset-quality problems. (See sections2065.3, 2065.4, and 2128.08.)

The value of the collateral will be consideredby examiners in reviewing and classifying acommercial real estate loan. However, for aperforming commercial real estate loan, thesupervisory policies of the agencies do notrequire automatic increases to the ALLL solelybecause the value of the collateral has declinedto an amount that is less than the loan balance.

In assessing the ALLL, it is important torecognize that management’s process, method-ology, and underlying assumptions require asubstantial degree of judgment. Even whenan organization maintains sound loan-administration and -collection procedures andeffective internal systems and controls, the esti-mation of losses may not be precise due to thewide range of factors that must be considered.Further, the ability to estimate losses on specificloans and categories of loans improves overtime as substantive information accumulatesregarding the factors affecting repayment pros-pects. When management has (1) maintainedeffective systems and controls for identifying,monitoring, and addressing asset-quality prob-lems and (2) analyzed all significant factorsaffecting the collectibility of the portfolio,examiners should give considerable weight tomanagement’s estimates in assessing theadequacy of the overall ALLL.

Examiners and bank holding company man-agement should consider the impact of theFinancial Accounting Standards Board’s(FASB) Statement No. 114, ‘‘Accounting byCreditors for Impairment of a Loan’’ (FAS 114)(as amended by FASB Statement No. 118,‘‘Accounting by Creditors for Impairment of aLoan—Income Recognition and Disclosures’’),on the ALLL-estimating process. FAS 114 setsforth guidance for estimating the impairment of

1. The estimation process described in this section permitsa more accurate estimate of anticipated losses than could beachieved by assessing the loan portfolio solely on an aggre-gate basis. However, it is only an estimation process and doesnot imply that any part of the ALLL is segregated for, orallocated to, any particular asset or group of assets. TheALLL is available to absorb overall credit losses originatingfrom the loan and lease portfolio. The balance of the ALLL ismanagement’s estimation of potential credit losses, synony-mous with its determination as to the adequacy of theoverallALLL.


a loan for general financial reporting purposes.Under FAS 114, a loan is impaired when, basedon current information and events, it is probablethat a creditor will be unable to collect allamounts due (principal and interest) accordingto the contractual terms of the loan agreement.

When a creditor has determined that a loan isimpaired, FAS 114 requires that an allowancebe established based on the present value of theexpected future cash flows of the loan dis-counted at the loan’s effective interest rate (thatis, the contract rate, as adjusted for any netdeferred loan fees or costs, premiums, or dis-counts) or, as a practical expedient, at the loan’sobservable market price or at the fair value ofthe collateral if the loan is collateral dependent.Since the allowances under FAS 114 apply onlyto a subset of loans,2 FAS 114 does not addressthe adequacy of a creditor’s overall ALLL orhow the creditor should assess the adequacy ofits ALLL. Examiners should not focus undulyon the adequacy of this or any other portion ofthe ALLL established for a subset of loans.Bank holding companies are required to followFAS 114 (as amended by FAS 118) when report-ing in the FR Y-9C report for the holding com-pany on a consolidated basis.

2065.2.1 INSPECTION OBJECTIVES

1. To evaluate the methodology and processthat management employs in compiling anoverall estimate of the ALLL.

2. To understand and evaluate the nature of theexternal (economic and social climate, theextent of competition) and internal (creditstrategies, levels of acceptable credit risk,and lending policies and procedures) lendingenvironment and how they might influencemanagement’s estimate of the ALLL.

3. To determine the accuracy and reasonable-ness of management’s estimate of the overallALLL.

4. To evaluate the quality of the BHC’s systemsand management performance in identifying,monitoring, and resolving asset-qualityproblems.

2065.2.2 INSPECTION PROCEDURES

1. Determine whether the banking organizationhas carefully documented and applied anaccurate and consistent method of analysisfor estimating the overall ALLL. When mak-ing such a determination, ascertainwhether—a. management has considered all significant

factors and conditions that might affectthe collectibility of the loan, including theborrower’s repayment practices, the valueof accessible underlying collateral, andother factors (that is, those factors listedin this section);

b. management has documented all factorsthat were considered and the methodologyand process that were used to evaluate theadequacy of the allowance; and

c. the complexity and scope of the analysisare appropriate for the size and nature ofthe organization.

2. Evaluate the methodology and process thatmanagement has followed in arriving at anoverall estimate of the ALLL.

3. Determine the reasonableness of manage-ment’s consolidated estimate of the ALLL,including the range of possible credit losses.Determine whether management has prop-erly evaluated the overall composition of theloan portfolio at all organizational levelsby—a. identifying potential problem loans,

including loans classified by all bankregulatory agencies;

b. determining trends with respect to loanvolume (growth (in particular, rapidgrowth), levels of delinquencies, nonac-cruals, and nonperforming loans);

c. considering the previous loss and recoveryexperience including the timeliness ofcharge-offs;

d. evaluating the performance of concentra-tions of credit (related interests, geo-graphic regions, industries, lesser-developed countries (LDCs), highlyleveraged loans, and the size of creditexposures (few large loans versus numer-ous small loans));

e. determining the amount of loans andproblem loans (delinquent, nonaccrual,and nonperforming) by lending officer orcommittee; and

f. evaluating the levels and performance ofloans involving related parties.

4. For each level of the organization, determinethe percentage of past-due loans to the loanportfolio and compare it with prior periods.

2. The guidance on impairment in FAS 114 does not applyto ‘‘ large groups of smaller balance homogeneous loans thatare collectively evaluated for impairment,’’ loans that aremeasured at fair value or at the lower of cost or fair value, orleases and debt securities as defined in FAS 115, ‘‘Accountingfor Certain Investments in Debt and Equity Securities.’’FAS 114 does apply to loans that are restructured in atroubled-debt restructuring involving a modification of terms.

Determining an Adequate Level for the Allowance for Loan and Lease Losses 2065.2


The examiner may find it beneficial to com-pute the ratio for groups of loans by type,size, or risk levels.

5. Compare the loans classified during reg-ulatory examinations or BHC inspectionswith the previous examinations or inspec-tions and also with those classified by man-agement before the regulatory examinationsor inspections. Investigate the current statusof previously classified loans.

6. Compute the percentage of the ALLL toaverage outstanding loans and compare thoseresults with those of the previous inspection.Investigate the reasons for variationsbetween those periods.

7. Assess the quality of the organization’s sys-tems and internal controls in identifying,monitoring, and addressing asset-qualityproblems.

Determining an Adequate Level for the Allowance for Loan and Lease Losses 2065.2


Maintenance of an Appropriate Allowance for Loan and Lease Losses(Accounting, Reporting, and Disclosure Issues) Section 2065.3

WHAT’S NEW IN THIS REVISEDSECTION

This section has been fully revised to set forththe 2006 Interagency Policy Statement on theAllowance for Loan and Lease Losses (ALLL),which was issued on December 13, 2006, by thefederal bank and thrift regulatory agencies (thebanking agencies.) (See SR-06-17.) This guid-ance updates and replaces the 1993 policy state-ment. The policy was revised to ensure consis-tency with generally accepted accountingprinciples (GAAP) and recent supervisory guid-ance. The Federal Reserve believes the guid-ance is broadly applicable to bank holding com-panies. Accordingly, examiners should apply thepolicy, as appropriate, during inspections ofbank holding companies and their nonbanksubsidiaries.

2065.3.0 OVERVIEW OF THE ALLLPOLICY STATEMENT

The 2006 policy statement discusses the natureand purpose of the allowance for loan and leaselosses (ALLL); the responsibilities of boards ofdirectors, the institution’s management, and theexaminers of banking organizations regardingthe ALLL; factors to be considered in the esti-mation of the ALLL; and the objectives andelements of an effective loan review system,including a sound credit grading system. Thestatement states that it is the responsibility ofthe board of directors and management of eachinstitution to maintain the ALLL at an appropri-ate level. Each institution is responsible fordeveloping, maintaining, and documenting acomprehensive, systematic, and consistentlyapplied process for determining the amounts ofthe ALLL and the provision for loan and leaselosses. To fulfill this responsibility, each institu-tion should ensure that controls are in place toconsistently determine the ALLL in accordancewith GAAP, the institution’s stated policies andprocedures, management’s best judgment, andrelevant supervisory guidance. The policy state-ment also discusses the analysis of the loan andlease portfolio, factors to consider in estimatingcredit losses, and the characteristics of an effec-tive loan-review system.

The policy statement continues the policythat Federal Reserve examiners will generallyaccept bank management’s estimates in theirassessment of the appropriateness of the ALLLwhen management has (1) maintained effective

loan review systems and controls for identify-ing, monitoring, and addressing asset-qualityproblems in a timely manner; (2) analyzed allsignificant environmental factors that affect thecollectibility of the portfolio as of the evaluationdate in a reasonable manner; (3) established anacceptable ALLL-evaluation process for bothindividual loans and groups loans that meets theobjectives for an appropriate ALLL; and(4) incorporated reasonable and properly sup-ported assumptions, valuations, and judgmentsinto the evaluation process.

The policy also reiterates the points of agree-ment between the Securities and ExchangeCommission and the banking agencies since1999: (1) the need for management to exercisesignificant judgment when estimating theALLL, (2) the concept of a range of losses, and(3) the appropriateness of a properly developedand documented ALLL. Accordingly, the policyemphasizes that an institution should providereasonable support and documentation of itsALLL estimates, including adjustments to theallowance for qualitative or environmental fac-tors and unallocated portions of the allowance.This emphasis on support and documentationsupplements, but does not replace, the guidancein the 2001 Interagency Policy Statement on theAllowance for Loan and Lease Losses Method-ologies and Documentation for Banks and Sav-ings Institutions (see SR-01-17).

Additionally, institutions are reminded thatthe allowance is an institution-specific estimateand generally should not be based solely on a‘‘standard percentage’’ of loans. While peergroup or other benchmark averages are anappropriate tool to evaluate the reasonablenessof the allowance, it is the institution’s responsi-bility to analyze the collectibility of the loanportfolio to estimate the allowance. To that end,the policy statement does not reference stan-dardized loss estimates (that is, 15 percent forloans classified as substandard and 50 percentfor loans classified as doubtful).

The policy statement also includes guidanceon SFAS 114, ‘‘Accounting by Creditors forImpairment of a Loan,’’ which describes theevaluation and measurement of impairment forloans that are impaired on an individual basis,and SFAS 5, ‘‘Accounting for Contingencies,’’which describes the same for pools of loansgrouped according to risk factors. The relation-ship between the two standards is described as

BHC Supervision Manual July 2007Page 1

well as the application of each standard in esti-mating the ALLL. Lastly, the policy remindsinstitutions that allowances related to off-balance-sheet financial instruments such as loancommitments or letters of credit should not bereported as part of the ALLL. Any allowancefor these types of instruments is recorded as an‘‘other liability.’’

This policy statement applies to all deposi-tory institutions supervised by the banking agen-cies, except for U.S. branches and agencies offoreign banks. In addition, the Federal Reservebelieves the guidance is broadly applicable tobank holding companies as well. Accordingly,examiners should apply the policy, as appropri-ate, during inspections of bank holding compa-nies and their nonbank subsidiaries, in additionto the examination of state member banks.

Although the policy statement discusses keyconcepts and requirements in GAAP and exist-ing supervisory guidance on the ALLL, thebanking agencies recognized that institutionsmay not have had sufficient time to completeany enhancements needed to bring their ALLLprocesses and documentation into full compli-ance with the revised guidance for year-end2006 reporting purposes. Nevertheless, suchenhancements were to be completed and effec-tive in the subsequent near term.

The text of the interagency policy statementfollows. (See also sections 2065.1, 2065.2, and2065.4.)

2065.3.1 2006 INTERAGENCY POLICYSTATEMENT ON THE ALLOWANCEFOR LOAN AND LEASE LOSSES

This 2006 interagency policy statement1 revisesand replaces the 1993 policy statement on theALLL. It reiterates key concepts and require-ments included in generally accepted account-ing principles (GAAP) and existing ALLLsupervisory guidance.2 The principal sources of

guidance on accounting for impairment in aloan portfolio under GAAP are Statement ofFinancial Accounting Standards No. 5,‘‘Accounting for Contingencies’’ (FAS 5) andStatement of Financial Accounting StandardsNo. 114, ‘‘Accounting by Creditors for Impair-ment of a Loan’’ (FAS 114). In addition, theFinancial Accounting Standards Board View-points article that is included in Emerging IssuesTask Force Topic D-80 (EITF D-80), ‘‘Applica-tion of FASB Statements No. 5 and No. 114 to aLoan Portfolio,’’ presents questions and answersthat provide specific guidance on the interactionbetween these two FASB statements and may behelpful in applying them.

In July 1999, the banking agencies and theSecurities and Exchange Commission (SEC)issued a Joint Interagency Letter to FinancialInstitutions. The letter stated that the bankingagencies and the SEC agreed on the followingimportant aspects of loan loss allowancepractices:

• Arriving at an appropriate allowance involvesa high degree of management judgment andresults in a range of estimated losses.

• Prudent, conservative—but not excessive—loan loss allowances that fall within an accept-able range of estimated losses are appropriate.In accordance with GAAP, an institutionshould record its best estimate within therange of credit losses, including when man-agement’s best estimate is at the high end ofthe range.

• Determining the allowance for loan losses isinevitably imprecise, and an appropriateallowance falls within a range of estimatedlosses.

• An ‘‘unallocated’’ loan loss allowance isappropriate when it reflects an estimate ofprobable losses, determined in accordancewith GAAP, and is properly supported.

• Allowance estimates should be based on acomprehensive, well-documented, and consis-tently applied analysis of the loan portfolio.

• The loan loss allowance should take into con-sideration all available information existing asof the financial statement date, including envi-ronmental factors such as industry, geographi-cal, economic, and political factors.

In July 2001, the banking agencies issued thePolicy Statement on Allowance for Loan and

1. The policy statement was adopted by, and applies to, alldepository institutions (institutions), except U.S. branches andagencies of foreign banks, that are supervised by the Board ofGovernors of the Federal Reserve System, the Office of theComptroller of the Currency, the Federal Deposit InsuranceCorporation, the Office of Thrift Supervision (the bankingagencies), and to institutions insured and supervised by theNational Credit Union Administration (NCUA) (collectively,the agencies). U.S. branches and agencies of foreign bankscontinue to be subject to any separate guidance that has beenissued by their primary supervisory agency.

2. As discussed more fully below in the ‘‘Nature andPurpose of the ALLL’’ within this section, this policy state-ment and the ALLL generally do not address loans carried atfair value or loans held for sale. In addition, this policystatement provides only limited guidance on ‘‘purchasedimpaired loans.’’

Maintenance of an Appropriate Allowance for Loan and Lease Losses 2065.3


Lease Losses Methodologies and Documenta-tion for Banks and Savings Institutions (2001policy statement). The policy statement isdesigned to assist institutions in establishing asound process for determining an appropriateALLL and documenting that process in accor-dance with GAAP.3 (See section 2065.4.1.)

In March 2004, the agencies also issued theUpdate on Accounting for Loan and LeaseLosses. This guidance provided reminders oflongstanding supervisory guidance as well as alisting of the existing allowance guidance thatinstitutions should continue to apply.

2065.3.1.1 Nature and Purpose of theALLL

The ALLL represents one of the most signifi-cant estimates in an institution’s financial state-ments and regulatory reports. Because of itssignificance, each institution has a responsibilityfor developing, maintaining, and documenting acomprehensive, systematic, and consistentlyapplied process for determining the amounts ofthe ALLL and the provision for loan and leaselosses (PLLL). To fulfill this responsibility, eachinstitution should ensure controls are in place toconsistently determine the ALLL in accordancewith GAAP, the institution’s stated policies andprocedures, management’s best judgment, andrelevant supervisory guidance. As of the end ofeach quarter, or more frequently if warranted,each institution must analyze the collectibilityof its loans and leases held for investment4(hereafter referred to as loans) and maintain anALLL at a level that is appropriate and deter-mined in accordance with GAAP. An appropri-ate ALLL covers estimated credit losses on indi-vidually evaluated loans that are determined tobe impaired as well as estimated credit lossesinherent in the remainder of the loan and leaseportfolio. The ALLL does not apply, however,to loans carried at fair value, loans held for

sale,5 off-balance-sheet credit exposures6 (forexample, financial instruments such as off-balance-sheet loan commitments, standby let-ters of credit, and guarantees), or general orunspecified business risks.

For purposes of this policy statement, theterm estimated credit losses means an estimateof the current amount of loans that it is probablethe institution will be unable to collect givenfacts and circumstances since the evaluationdate. Thus, estimated credit losses represent netcharge-offs that are likely to be realized for aloan or group of loans. These estimated creditlosses should meet the criteria for accrual of aloss contingency (that is, through a provision tothe ALLL) set forth in GAAP.7 When availableinformation confirms that specific loans, or por-tions thereof, are uncollectible, these amountsshould be promptly charged off against theALLL.

For ‘‘purchased impaired loans,’’8 GAAP pro-

3. See section 2065.4.1 for the 2001 policy statement. TheSEC staff issued parallel guidance in July 2001, which isfound in Staff Accounting Bulletin No. 10, ‘‘Selected LoanLoss Allowance Methodology and Documentation Issues’’(SAB 102), which has been codified as Topic 6.L. in theSEC’s Codification of Staff Accounting Bulletins. Both SAB102 and the codification are available on the SEC’s web site.

4. Consistent with the American Institute of Certified Pub-lic Accountants’ (AICPA) Statement of Position 01-6,‘‘Accounting by Certain Entities (Including Entities WithTrade Receivables) That Lend to or Finance the Activities ofOthers,’’ loans and leases held for investment are those loansand leases that the institution has the intent and ability to holdfor the foreseeable future or until maturity or payoff.

5. See ‘‘Interagency Guidance on Certain Loans Held forSale’’ (March 26, 2001) for the appropriate accounting andreporting treatment for certain loans that are sold directlyfrom the loan portfolio or transferred to a held-for-saleaccount. Loans held for sale are reported at the lower of costor fair value. Declines in value occurring after the transfer of aloan to the held-for-sale portfolio are accounted for as adjust-ments to a valuation allowance for held-for-sale loans and notas adjustments to the ALLL.

6. Credit losses on off-balance-sheet credit exposuresshould be estimated in accordance with FAS 5. Any allow-ance for credit losses on off-balance-sheet exposures shouldbe reported on the balance sheet as an ‘‘other liability,’’ andnot as part of the ALLL.

7. FAS 5 requires the accrual of a loss contingency wheninformation available prior to the issuance of the financialstatements indicates it is probable that an asset has beenimpaired at the date of the financial statements and the amountof loss can be reasonably estimated. These conditions may beconsidered in relation to individual loans or in relation togroups of similar types of loans. If the conditions are met,accrual should be made even though the particular loans thatare uncollectible may not be identifiable. Under FAS 114, anindividual loan is impaired when, based on current informa-tion and events, it is probable that a creditor will be unable tocollect all amounts due according to the contractual terms ofthe loan agreement. It is implicit in these conditions that itmust be probable that one or more future events will occurconfirming the fact of the loss. Thus, under GAAP, the pur-pose of the ALLL is not to absorb all of the risk in the loanportfolio, but to cover probable credit losses that have alreadybeen incurred.

8. A purchased impaired loan is defined as a loan that aninstitution has purchased, including a loan acquired in apurchase business combination, that has evidence of deteriora-tion of credit quality since its origination and for which it isprobable, at the purchase date, that the institution will beunable to collect all contractually required payments. Whenreviewing the appropriateness of the reported ALLL of aninstitution with purchased impaired loans, examiners shouldconsider the credit losses factored into the initial investment



hibits ‘‘carrying over’’ or creating an ALLL inthe initial recording of these loans. However, if,upon evaluation subsequent to acquisition, it isprobable that the institution will be unable tocollect all cash flows expected at acquisition ona purchased impaired loan (an estimate thatconsiders both timing and amount), the loanshould be considered impaired for purposes ofapplying the measurement and other provisionsof FAS 5 or, if applicable, FAS 114.

Estimates of credit losses should reflect con-sideration of all significant factors that affect thecollectibility of the portfolio as of the evaluationdate. For loans within the scope of FAS 114 thatare individually evaluated and determined to beimpaired,9 these estimates should reflect consid-eration of one of the standard’s three impair-ment measurement methods as of the evaluationdate: (1) the present value of expected futurecash flows discounted at the loan’s effectiveinterest rate,10 (2) the loan’s observable marketprice, or (3) the fair value of the collateral if theloan is collateral dependent.

An institution may choose the appropriateFAS 114 measurement method on a loan-by-loan basis for an individually impaired loan,except for an impaired collateral-dependentloan. The agencies require impairment of acollateral-dependent loan to be measured usingthe fair value of collateral method. As defined inFAS 114, a loan is collateral dependent if repay-ment of the loan is expected to be providedsolely by the underlying collateral. In general,any portion of the recorded investment in acollateral-dependent loan (including any capital-ized accrued interest, net deferred loan fees or

costs, and unamortized premium or discount) inexcess of the fair value of the collateral that canbe identified as uncollectible, and is thereforedeemed a confirmed loss, should be promptlycharged off against the ALLL.11

All other loans, including individually evalu-ated loans determined not to be impaired underFAS 114, should be included in a group of loansthat is evaluated for impairment under FAS 5.12

While an institution may segment its loan port-folio into groups of loans based on a variety offactors, the loans within each group should havesimilar risk characteristics. For example, a loanthat is fully collateralized with risk-free assetsshould not be grouped with uncollateralizedloans. When estimating credit losses on eachgroup of loans with similar risk characteristics,an institution should consider its historical lossexperience on the group, adjusted for changesin trends, conditions, and other relevant factorsthat affect repayment of the loans as of theevaluation date.

For analytical purposes, an institution shouldattribute portions of the ALLL to loans that itevaluates and determines to be impaired underFAS 114 and to groups of loans that it evaluatescollectively under FAS 5. However, the ALLLis available to cover all charge-offs that arisefrom the loan portfolio.

2065.3.1.2 Responsibilities of the Boardof Directors and Management

2065.3.1.2.1 Appropriate ALLL Level

Each institution’s management is responsiblefor maintaining the ALLL at an appropriatelevel and for documenting its analysis accordingto the standards set forth in the 2001 policystatement. Thus, management should evaluatethe ALLL reported on the balance sheet as ofthe end of each quarter or more frequently ifwarranted, and charge or credit the PLLL tobring the ALLL to an appropriate level as ofeach evaluation date. The determination of theamounts of the ALLL and the PLLL should bebased on management’s current judgmentsabout the credit quality of the loan portfolio, and

in these loans when determining whether further deterioration(for example, decreases in cash flows expected to be col-lected) has occurred since the loans were purchased. Thebank’s Consolidated Report of Condition and Income (CallReport) and/or the Consolidated Financial Statement for BankHolding Companies (such as the FR Y-9C), and the disclo-sures in the bank’s financial statements may provide usefulinformation for examiners in reviewing these loans. Refer tothe AICPA’s Statement of Position 03-3, ‘‘Accounting forCertain Loans or Debt Securities Acquired in a Transfer,’’ forfurther guidance on the appropriate accounting.

9. FAS 114 does not specify how an institution shouldidentify loans that are to be evaluated for collectibility nordoes it specify how an institution should determine that a loanis impaired. An institution should apply its normal loan reviewprocedures in making those judgments. Refer to the ALLLinterpretations for further guidance.

10. The effective ‘‘interest rate’’ on a loan is the rate ofreturn implicit in the loan (that is, the contractual interest rateadjusted for any net deferred loan fees or costs and anypremium or discount existing at the origination or acquisitionof the loan).

11. For further information, refer to the illustration inappendix B of the 2001 policy statement (see the appendix insection 2065.4.1.8).

12. An individually evaluated loan that is determined notto be impaired under FAS 114 should be evaluated under FAS5 when specific characteristics of the loan indicate that it isprobable there would be estimated credit losses in a group ofloans with those characteristics. For further guidance, refer tothe frequently asked questions that were distributed with thispolicy statement.



should consider all known relevant internal andexternal factors that affect loan collectibility asof the evaluation date. Management’s evalua-tion is subject to review by examiners. An insti-tution’s failure to analyze the collectibility ofthe loan portfolio and maintain and support anappropriate ALLL in accordance with GAAPand supervisory guidance is generally an unsafeand unsound practice.

In carrying out its responsibility for maintain-ing an appropriate ALLL, management isexpected to adopt and adhere to written policiesand procedures that are appropriate to the sizeof the institution and the nature, scope, and riskof its lending activities. At a minimum, thesepolicies and procedures should ensure the fol-lowing:

• The institution’s process for determining anappropriate level for the ALLL is based on acomprehensive, well-documented, and consis-tently applied analysis of its loan portfolio.13

The analysis should consider all significantfactors that affect the collectibility of the port-folio and should support the credit losses esti-mated by this process. The institution has aneffective loan review system and controls(including an effective loan classification orcredit grading system) that identify, monitor,and address asset quality problems in an accu-rate and timely manner.14 To be effective, theinstitution’s loan review system and controlsmust be responsive to changes in internal andexternal factors affecting the level of creditrisk in the portfolio.

• The institution has adequate data capture andreporting systems to supply the informationnecessary to support and document its esti-mate of an appropriate ALLL.

• The institution evaluates any loss estimationmodels before they are employed and modi-fies the models’ assumptions, as needed, to

ensure that the resulting loss estimates areconsistent with GAAP. To demonstrate thisconsistency, the institution should documentits evaluations and conclusions regarding theappropriateness of estimating credit losseswith the models or other estimation tools. Theinstitution should also document and supportany adjustments made to the models or to theoutput of the models in determining the esti-mated credit losses.

• The institution promptly charges off loans, orportions of loans, that available informationconfirms to be uncollectible.

• The institution periodically validates theALLL methodology. This validation processshould include procedures for a review, by aparty who is independent of the institution’scredit approval and ALLL estimation pro-cesses, of the ALLL methodology and itsapplication in order to confirm its effective-ness. A party who is independent of theseprocesses could be the internal audit staff, arisk management unit of the institution, anexternal auditor (subject to applicable auditorindependence standards), or another con-tracted third party from outside the institution.One party need not perform the entire analy-sis, as the validation can be divided amongvarious independent parties.

The board of directors is responsible for over-seeing management’s significant judgments andestimates pertaining to the determination of anappropriate ALLL. This oversight shouldinclude but is not limited to—

• reviewing and approving the institution’swritten ALLL policies and procedures at leastannually;

• reviewing management’s assessment and jus-tification that the loan review system is soundand appropriate for the size and complexity ofthe institution;

• reviewing management’s assessment and jus-tification for the amounts estimated andreported each period for the PLLL and theALLL; and

• requiring management to periodically validateand, when appropriate, revise the ALLL meth-odology.

For purposes of the Consolidated Reports ofCondition and Income (Call Report) and/or theConsolidated Financial Statement for BankHolding Companies (such as the FR Y-9C) an

13. As noted in the 2001 policy statement, an institutionwith less complex lending activities and products may find itmore efficient to combine a number of procedures whilecontinuing to ensure that the institution has a consistent andappropriate ALLL methodology. Thus, much of the support-ing documentation required for an institution with more com-plex products or portfolios may be combined into fewersupporting documents in an institution with less complexproducts or portfolios.

14. Loan review and loan classification or credit gradingsystems are discussed in attachment 1 of this policy statement.In addition, state member banks and savings associationsshould refer to the asset quality standards in the InteragencyGuidelines Establishing Standards for Safety and Soundness,which were adopted by the Federal Reserve Board (see appen-dix D-1, 12 C.F.R. 208). For national banks, see appendix Ato Part 30; for state nonmember banks, appendix A to Part364; and for savings associations, appendix A to Part 570.



appropriate ALLL (after deducting all loans andportions of loans confirmed loss) should consistonly of the following components (as appli-cable),15 the amounts of which take into accountall relevant facts and circumstances as of theevaluation date:

• For loans within the scope of FAS 114 that areindividually evaluated and found to beimpaired, the associated ALLL should bebased upon one of the three impairment mea-surement methods specified in FAS 114.16

• For all other loans, including individuallyevaluated loans determined not to be impairedunder FAS 114,17 the associated ALLL shouldbe measured under FAS 5 and should providefor all estimated credit losses that have beenincurred on groups of loans with similar riskcharacteristics.

• For estimated credit losses from transfer riskon cross-border loans, the impact to the ALLLshould be evaluated individually for impairedloans under FAS 114 or evaluated on a groupbasis under FAS 5. See this policy statement’sattachment 2 for further guidance on consider-ations of transfer risk on cross-border loans.

• For estimated credit losses on accrued interestand fees on loans that have been reported aspart of the respective loan balances on theinstitution’s balance sheet, the associatedALLL should be evaluated under FAS 114 orFAS 5 as appropriate, if not already includedin one of the preceding components.

Because deposit accounts that are overdrawn(that is, overdrafts) must be reclassified as loanson the balance sheet, overdrawn accounts shouldbe included in one of the first two componentsabove, as appropriate, and evaluated for esti-mated credit losses.

Determining the appropriate level for theALLL is inevitably imprecise and requires ahigh degree of management judgment. Manage-ment’s analysis should reflect a prudent, conser-vative, but not excessive ALLL that falls withinan acceptable range of estimated credit losses.When a range of losses is determined, institu-

tions should maintain appropriate documenta-tion to support the identified range and the ratio-nale used for determining the best estimate fromwithin the range of loan losses.

As discussed more fully in attachment 1 ofthis policy statement, it is essential that institu-tions maintain effective loan review systems.An effective loan review system should work toensure the accuracy of internal credit classifica-tion or grading systems and, thus, the quality ofthe information used to assess the appropriate-ness of the ALLL. The complexity and scope ofan institution’s ALLL evaluation process, loanreview system, and other relevant controlsshould be appropriate for the size of the institu-tion and the nature of its lending activities. Theevaluation process should also provide for suffi-cient flexibility to respond to changes in thefactors that affect the collectibility of theportfolio.

Credit losses that arise from the transfer riskassociated with an institution’s cross-borderlending activities require special consideration.In particular, for banks with cross-border lend-ing exposure, management should determinethat the ALLL is appropriate to cover estimatedlosses from transfer risk associated with thisexposure over and above any minimum amountthat the Interagency Country Exposure ReviewCommittee requires to be provided in the Allo-cated Transfer Risk Reserve (or charged offagainst the ALLL). These estimated lossesshould meet the criteria for accrual of a losscontingency set forth in GAAP. (See attachment2 for factors to consider.)

2065.3.1.2.2 Factors to Consider in theEstimation of Credit Losses

Estimated credit losses should reflect consider-ation of all significant factors that affect thecollectibility of the portfolio as of the evaluationdate. Normally, an institution should determinethe historical loss rate for each group of loanswith similar risk characteristics in its portfoliobased on its own loss experience for loans inthat group. While historical loss experience pro-vides a reasonable starting point for the institu-tion’s analysis, historical losses—or even recenttrends in losses—do not by themselves form asufficient basis to determine the appropriatelevel for the ALLL. Management also shouldconsider those qualitative or environmental fac-tors that are likely to cause estimated creditlosses associated with the institution’s existingportfolio to differ from historical loss experi-ence, including but not limited to—

15. A component of the ALLL that is labeled ‘‘unallo-cated’’ is appropriate when it reflects estimated credit lossesdetermined in accordance with GAAP and is properly sup-ported and documented.

16. As previously noted, the use of the fair value of collat-eral method is required for an individually evaluated loan thatis impaired if the loan is collateral dependent.

17. See footnote 12.



• changes in lending policies and procedures,including changes in underwriting standardsand collection, charge-off, and recovery prac-tices not considered elsewhere in estimatingcredit losses;

• changes in international, national, regional,and local economic and business conditionsand developments that affect the collectibilityof the portfolio, including the condition ofvarious market segments;18

• changes in the nature and volume of the port-folio and in the terms of loans;

• changes in the experience, ability, and depthof lending management and other relevantstaff;

• changes in the volume and severity of pastdue loans, the volume of nonaccrual loans,and the volume and severity of adversely clas-sified or graded loans;19

• changes in the quality of the institution’s loanreview system;

• changes in the value of underlying collateralfor collateral-dependent loans;

• the existence and effect of any concentrationsof credit, and changes in the level of suchconcentrations; and

• the effect of other external factors such ascompetition and legal and regulatory require-ments on the level of estimated credit lossesin the institution’s existing portfolio.

In addition, changes in the level of the ALLLshould be directionally consistent with changesin the factors, taken as a whole, that evidencecredit losses, keeping in mind the characteristicsof an institution’s loan portfolio. For example, ifdeclining credit quality trends relevant to thetypes of loans in an institution’s portfolio areevident, the ALLL level as a percentage of theportfolio should generally increase, barringunusual charge-off activity. Similarly, if improv-ing credit quality trends are evident, the ALLLlevel as a percentage of the portfolio shouldgenerally decrease.

2065.3.1.2.3 Measurement of EstimatedCredit Losses

FAS 5. When measuring estimated credit losses

on groups of loans with similar risk characteris-tics in accordance with FAS 5, a widely usedmethod is based on each group’s historical netcharge-off rate adjusted for the effects of thequalitative or environmental factors discussedpreviously. As the first step in applying thismethod, management generally bases the his-torical net charge-off rates on the ‘‘annualized’’historical gross loan charge-offs, less recoveries,recorded by the institution on loans in eachgroup.

Methodologies for determining the historicalnet charge-off rate on a group of loans withsimilar risk characteristics under FAS 5 canrange from the simple average of, or a determi-nation of the range of, an institution’s annual netcharge-off experience to more complex tech-niques, such as migration analysis and modelsthat estimate credit losses.20 Generally, institu-tions should use at least an ‘‘annualized’’ or12-month average net charge-off rate that willbe applied to the groups of loans when estimat-ing credit losses. However, this rate could vary.For example, loans with effective lives longerthan 12 months often have workout periods overan extended period of time, which may indicatethat the estimated credit losses should be greaterthan that calculated based solely on the annual-ized net charge-off rate for such loans. Thesegroups may include certain commercial loans aswell as groups of adversely classified loans.Other groups of loans may have effective livesshorter than 12 months, which may indicate thatthe estimated credit losses should be less thanthat calculated based on the annualized netcharge-off rate.

Regardless of the method used, institutionsshould maintain supporting documentation for

18. Credit loss and recovery experience may vary signifi-cantly depending upon the stage of the business cycle. Forexample, an overreliance on credit loss experience during aperiod of economic growth will not result in realistic esti-mates of credit losses during a period of economic downturn.

19. For banks and savings associations, adversely classi-fied or graded loans are loans rated ‘‘substandard’’ (or itsequivalent) or worse under its loan classification system.

20. Annual charge-off rates are calculated over a specifiedtime period (for example, three years or five years), which canvary based on a number of factors including the relevance ofpast periods’ experience to the current period or point in thecredit cycle. Also, some institutions remove loans that becomeadversely classified or graded from a group of nonclassified ornongraded loans with similar risk characteristics in order toevaluate the removed loans individually under FAS 114 (ifdeemed impaired) or collectively in a group of adverselyclassified or graded loans with similar risk characteristicsunder FAS 5. In this situation, the net charge-off experienceon the adversely classified or graded loans that have beenremoved from the group of nonclassified or nongraded loansshould be included in the historical loss rates for that group ofloans. Even though the net charge-off experience on adverselyclassified or graded loans is included in the estimation of thehistorical loss rates that will be applied to the group ofnonclassified or nongraded loans, the adversely classified orgraded loans themselves are no longer included in that groupfor purposes of estimating credit losses on the group.



the techniques used to develop the historicalloss rate for each group of loans. If a range ofhistorical loss rates is developed instead for agroup of loans, institutions should maintaindocumentation to support the identified rangeand the rationale for determining which rate isthe best estimate within the range of loss rates.The rationale should be based on management’sassessment of which rate is most reflective ofthe estimated credit losses in the current loanportfolio.

After determining the appropriate historicalloss rate for each group of loans with similarrisk characteristics, management should con-sider those current qualitative or environmentalfactors that are likely to cause estimated creditlosses as of the evaluation date to differ from thegroup’s historical loss experience. Institutionstypically reflect the overall effect of these fac-tors on a loan group as an adjustment that, asappropriate, increases or decreases the historicalloss rate applied to the loan group. Alterna-tively, the effect of these factors may bereflected through separate stand-alone adjust-ments within the FAS 5 component of theALLL.21 Both methods are consistent withGAAP, provided the adjustments for qualitativeor environmental factors are reasonably andconsistently determined, are adequately docu-mented, and represent estimated credit losses.For each group of loans, an institution shouldapply its adjusted historical loss rate, or itshistorical loss rate and separate stand-aloneadjustments, to the recorded investment in thegroup when determining its estimated creditlosses.

Management must exercise significant judg-ment when evaluating the effect of qualitativefactors on the amount of the ALLL because datamay not be reasonably available or directlyapplicable for management to determine the pre-cise impact of a factor on the collectibility of theinstitution’s loan portfolio as of the evaluationdate. Accordingly, institutions should supportadjustments to historical loss rates and explainhow the adjustments reflect current information,events, circumstances, and conditions in the lossmeasurements. Management should maintainreasonable documentation to support which fac-

tors affected the analysis and the impact of thosefactors on the loss measurement. Support anddocumentation includes descriptions of eachfactor, management’s analysis of how each fac-tor has changed over time, which loan groups’loss rates have been adjusted, the amount bywhich loss estimates have been adjusted forchanges in conditions, an explanation of howmanagement estimated the impact, and otheravailable data that supports the reasonablenessof the adjustments. Examples of underlying sup-porting evidence could include, but are not lim-ited to, relevant articles from newspapers andother publications that describe economic eventsaffecting a particular geographic area, economicreports and data, and notes from discussionswith borrowers.

There may be times when an institution doesnot have its own historical loss experience uponwhich to base its estimate of the credit losses ina group of loans with similar risk characteris-tics. This may occur when an institution offers anew loan product or when it is a newly estab-lished (that is, de novo) institution. If an institu-tion has no experience of its own for a loangroup, reference to the experience of otherenterprises in the same lending business may beappropriate, provided the institution demon-strates that the attributes of the group of loans inits portfolio are similar to those of the loangroup in the portfolio providing the loss experi-ence. An institution should only use anotherenterprise’s experience on a short-term basisuntil it has developed its own loss experiencefor a particular group of loans.

FAS 114. When determining the FAS 114 com-ponent of the ALLL for an individuallyimpaired loan,22 an institution should considerestimated costs to sell the loan’s collateral, ifany, on a discounted basis, in the measurementof impairment if those costs are expected toreduce the cash flows available to repay orotherwise satisfy the loan. If the institution basesits measure of loan impairment on the presentvalue of expected future cash flows discountedat the loan’s effective interest rate, the estimatesof these cash flows should be the institution’sbest estimate based on reasonable and support-

21. An overall adjustment to a portion of the ALLL that isnot attributed to specific segments of the loan portfolio isoften labeled ‘‘unallocated.’’ Regardless of what a componentof the ALLL is labeled, it is appropriate when it reflectsestimated credit losses determined in accordance with GAAPand is properly supported.

22. As noted in FAS 114, some individually impairedloans have risk characteristics that are unique to an individualborrower and the institution will apply the measurement meth-ods on a loan-by-loan basis. However, some impaired loansmay have risk characteristics in common with other impairedloans. An institution may aggregate those loans and may usehistorical statistics, such as average recovery period and aver-age amount recovered, along with a composite effective inter-est rate as a means of measuring impairment of those loans.



able assumptions and projections. All availableevidence should be considered in developing theestimate of expected future cash flows. Theweight given to the evidence should be com-mensurate with the extent to which the evidencecan be verified objectively. The likelihood of thepossible outcomes should be considered indetermining the best estimate of expected futurecash flows.

2065.3.1.2.4 Analyzing the OverallMeasurement of the ALLL

Institutions also are encouraged to use ratioanalysis as a supplemental tool for evaluatingthe overall reasonableness of the ALLL. Ratioanalysis can be useful in identifying divergenttrends (compared with an institution’s peergroup and its own historical experience) in therelationship of the ALLL to adversely classifiedor graded loans, past due and nonaccrual loans,total loans, and historical gross and net charge-offs. Based on such analysis, an institution mayidentify additional issues or factors that previ-ously had not been considered in the ALLLestimation process, which may warrant adjust-ments to estimated credit losses. Such adjust-ments should be appropriately supported anddocumented.

While ratio analysis, when used prudently,can be helpful as a supplemental check on thereasonableness of management’s assumptionsand analyses, it is not a sufficient basis fordetermining the appropriate amount for theALLL. In particular, because an appropriateALLL is an institution-specific amount, suchcomparisons do not obviate the need for a com-prehensive analysis of the loan portfolio and thefactors affecting its collectibility. Furthermore,it is inappropriate for the board of directors ormanagement to make adjustments to the ALLLwhen it has been properly computed and sup-ported under the institution’s methodology forthe sole purpose of reporting an ALLL thatcorresponds to the peer group median, a targetratio, or a budgeted amount. Institutions thathave high levels of risk in the loan portfolio orare uncertain about the effect of possible futureevents on the collectibility of the portfolioshould address these concerns by maintaininghigher equity capital and not by arbitrarilyincreasing the ALLL in excess of amounts sup-ported under GAAP.23

2065.3.1.2.5 Estimated Credit Losses inCredit-Related Accounts

Typically, institutions evaluate and estimatecredit losses for off-balance-sheet credit expo-sures at the same time that they estimate creditlosses for loans. While a similar process shouldbe followed to support loss estimates related tooff-balance-sheet exposures, these estimatedcredit losses are not recorded as part of theALLL. When the conditions for accrual of a lossunder FAS 5 are met, an institution should main-tain and report as a separate liability account, anallowance that is appropriate to cover estimatedcredit losses on off-balance-sheet loan commit-ments, standby letters of credit, and guarantees.In addition, recourse liability accounts (thatarise from recourse obligations on any transfersof loans that are reported as sales in accordancewith GAAP) should be reported in regulatoryreports as liabilities that are separate and dis-tinct from both the ALLL and the allowance forcredit losses on off-balance-sheet creditexposures.

When accrued interest and fees are reportedseparately on an institution’s balance sheet fromthe related loan balances (that is, as otherassets), the institution should maintain an appro-priate valuation allowance, determined in accor-dance with GAAP, for amounts that are notlikely to be collected unless management hasplaced the underlying loans in nonaccrual statusand reversed previously accrued interest andfees.24

2065.3.1.3 Examiner Responsibilities

Examiners should assess the credit quality of aninstitution’s loan portfolio, the appropriatenessof its ALLL methodology and documentation,and the appropriateness of the reported ALLL in

23. It is inappropriate to use a ‘‘standard percentage’’ asthe sole determinant for the amount to be reported as theALLL on the balance sheet. Moreover, an institution should

not simply default to a peer ratio or a ‘‘standard percentage’’after determining an appropriate level of ALLL under itsmethodology. However, there may be circumstances when aninstitution’s ALLL methodology and credit risk identificationsystems are not reliable. Absent reliable data of its own,management may seek data that could be used as a short-termproxy for the unavailable information (for example, an indus-try average loss rate for loans with similar risk characteris-tics). This is only appropriate as a short-term remedy until theinstitution creates a viable system for estimating credit losseswithin its loan portfolio.

24. See instructions for the Call Report or the ConsolidatedFinancial Statement for Bank Holding Companies (such asthe FR Y- 9C) for further guidance on placing a loan innonaccrual status.



the institution’s regulatory reports. In theirreview and classification or grading of the loanportfolio, examiners should consider all signifi-cant factors that affect the collectibility of theportfolio, including the value of any collateral.In reviewing the appropriateness of the ALLL,examiners should do the following:

• Consider the effectiveness of board oversightas well as the quality of the institution’s loanreview system and management in identify-ing, monitoring, and addressing asset qualityproblems. This will include a review of theinstitution’s loan review function and creditgrading system. Typically, this will involvetesting a sample of the institution’s loans. Thesample size generally varies and will dependon the nature or purpose of the examination.25

• Evaluate the institution’s ALLL policies andprocedures and assess the methodology thatmanagement uses to arrive at an overall esti-mate of the ALLL, including whether man-agement’s assumptions, valuations, and judg-ments appear reasonable and are properlysupported. If a range of credit losses has beenestimated by management, evaluate the rea-sonableness of the range and management’sbest estimate within the range. In makingthese evaluations, examiners should ensurethat the institution’s historical loss experienceand all significant qualitative or environmen-tal factors that affect the collectibility of theportfolio (including changes in the quality ofthe institution’s loan review function and theother factors previously discussed) have beenappropriately considered and that manage-ment has appropriately applied GAAP, includ-ing FAS 114 and FAS 5.

• Review management’s use of loss estimationmodels or other loss estimation tools to ensurethat the resulting estimated credit losses are inconformity with GAAP.

• Review the appropriateness and reasonable-

ness of the overall level of the ALLL. In someinstances this may include a quantitativeanalysis (for example, using the types of ratioanalysis previously discussed) as a prelimi-nary check on the reasonableness of theALLL. This quantitative analysis should dem-onstrate whether changes in the key ratiosfrom prior periods are reasonable based on theexaminer’s knowledge of the collectibility ofloans at the institution and its currentenvironment.

• Review the ALLL amount reported in theinstitution’s regulatory reports and financialstatements and ensure these amounts recon-cile to its ALLL analyses. There should be nomaterial differences between the consolidatedloss estimate, as determined by the ALLLmethodology, and the final ALLL balancereported in the financial statements. Inquireabout reasons for any material differencesbetween the results of the institution’s ALLLanalyses and the institution’s reported ALLLto determine whether the differences can besatisfactorily explained.

• Review the adequacy of the documentationand controls maintained by management tosupport the appropriateness of the ALLL.

• Review the interest and fee income accountsassociated with the lending process to ensurethat the institution’s net income is not materi-ally misstated.26

As noted in the ‘‘Responsibilities of the Boardof Directors and Management’’ section of thispolicy statement, when assessing the appropri-ateness of the ALLL, it is important to recog-nize that the related process, methodology, andunderlying assumptions require a substantialdegree of management judgment. Even when aninstitution maintains sound loan administrationand collection procedures and an effective loanreview system and controls, its estimate of creditlosses is not a single precise amount due to thewide range of qualitative or environmental fac-tors that must be considered.

An institution’s ability to estimate creditlosses on specific loans and groups of loansshould improve over time as substantive infor-mation accumulates regarding the factors affect-ing repayment prospects. Therefore, examinersshould generally accept management’s estimates

25. In an examiner’s review of an institution’s loan reviewsystem, the examiner’s loan classifications or credit gradesmay differ from those of the institution’s loan review system.If the examiner’s evaluation of these differences indicatesproblems with the loan review system, especially when theloan classification or credit grades assigned by the institutionare more liberal than those assigned by the examiner, theinstitution would be expected to make appropriate adjust-ments to the assignment of its loan classifications or creditgrades to the loan portfolio and to its estimated credit losses.Furthermore, the institution would be expected to improve itsloan review system. (This policy statement’s attachment 1discusses effective loan review systems.)

26. As noted previously, accrued interest and fees on loansthat have been reported as part of the respective loan balanceson the institution’s balance sheet should be evaluated forestimated credit losses. The accrual of the interest and feeincome should also be considered. Refer to GAAP and theagencies’ regulatory reporting instructions for further guid-ance on income recognition.



when assessing the appropriateness of the insti-tution’s reported ALLL, and not seek adjust-ments to the ALLL, when management has—

• maintained effective loan review systems andcontrols for identifying, monitoring, andaddressing asset quality problems in a timelymanner;

• analyzed all significant qualitative or environ-mental factors that affect the collectibility ofthe portfolio as of the evaluation date in areasonable manner;

• established an acceptable ALLL evaluationprocess for both individual loans and groupsof loans that meets the GAAP requirementsfor an appropriate ALLL; and

• incorporated reasonable and properly sup-ported assumptions, valuations, and judg-ments into the evaluation process.

If the examiner concludes that the reportedALLL level is not appropriate or determinesthat the ALLL evaluation process is based onthe results of an unreliable loan review systemor is otherwise deficient, recommendations forcorrecting these deficiencies, including anyexaminer concerns regarding an appropriatelevel for the ALLL, should be noted in thereport of examination. The examiner’s com-ments should cite any departures from GAAPand any contraventions of this policy statementand the 2001 policy statement, as applicable.Additional supervisory action may also be takenbased on the magnitude of the observed short-comings in the ALLL process, including themateriality of any error in the reported amountof the ALLL.

2065.3.1.4 ALLL Level Reflected inRegulatory Reports

The agencies believe that an ALLL establishedin accordance with this policy statement and the2001 policy statement, as applicable, falls withinthe range of acceptable estimates determined inaccordance with GAAP. When the reportedamount of an institution’s ALLL is not appropri-ate, the institution will be required to adjust itsALLL by an amount sufficient to bring theALLL reported on its Call Report and/or Con-solidated Financial Statement for Bank HoldingCompanies (such as the FR Y-9C) to an appro-priate level as of the evaluation date. Thisadjustment should be reflected in the currentperiod provision or through the restatement ofprior period provisions, as appropriate in thecircumstances.

2065.3.1.5 Appendix 1—Loan ReviewSystems

The nature of loan review systems may varybased on an institution’s size, complexity, loantypes, and management practices.27 Forexample, a loan review system may includecomponents of a traditional loan review func-tion that is independent of the lending function,or it may place some reliance on loan officers.In addition, the use of the term loan reviewsystem can refer to various responsibilitiesassigned to credit administration, loan adminis-tration, a problem loan workout group, or otherareas of an institution. These responsibilitiesmay range from administering the internal prob-lem loan reporting process to maintaining theintegrity of the loan classification or credit grad-ing process (for example, ensuring that timelyand appropriate changes are made to the loanclassifications or credit grades assigned to loans)and coordinating the gathering of the informa-tion necessary to assess the appropriateness ofthe ALLL. Additionally, some or all of thisfunction may be outsourced to a qualified exter-nal loan reviewer. Regardless of the structure ofthe loan review system in an institution, aneffective loan review system should have, at aminimum, the following objectives:

• promptly identify loans with potential creditweaknesses;

• appropriately grade or adversely classifyloans, especially those with well-definedcredit weaknesses that jeopardize repayment,so that timely action can be taken and creditlosses can be minimized;

• identify relevant trends that affect the collect-ibility of the portfolio and isolate segments ofthe portfolio that are potential problem areas;

27. The loan review function is not intended to be per-formed by an institution’s internal audit function. However, asdiscussed in the banking agencies’ March 2003 InteragencyPolicy Statement on the Internal Audit Function and Its Out-sourcing, some institutions seek to coordinate the internalaudit function with several risk-monitoring functions such asloan review. The policy statement notes that coordination ofloan review with the internal audit function can facilitate thereporting of material risk and control issues to the auditcommittee, increase the overall effectiveness of these monitor-ing functions, better utilize available resources, and enhancethe institution’s ability to comprehensively manage risk. How-ever, the internal audit function should maintain the ability toindependently audit other risk-monitoring functions, includ-ing loan review, without impairing its independence withrespect to these other functions.



• assess the adequacy of and adherence to inter-nal credit policies and loan administrationprocedures and monitor compliance with rel-evant laws and regulations;

• evaluate the activities of lending personnelincluding their compliance with lending poli-cies and the quality of their loan approval,monitoring, and risk assessment;

• provide senior management and the board ofdirectors with an objective and timely assess-ment of the overall quality of the loan portfo-lio; and

• provide management with accurate and timelycredit quality information for financial andregulatory reporting purposes, including thedetermination of an appropriate ALLL.

2065.3.1.5.1 Loan Classification orCredit Grading Systems

The foundation for any loan review system isaccurate and timely loan classification or creditgrading, which involves an assessment of creditquality and leads to the identification of prob-lem loans. An effective loan classification orcredit grading system provides important infor-mation on the collectibility of the portfolio foruse in the determination of an appropriate levelfor the ALLL.

Regardless of the type of loan review systememployed, an effective loan classification orcredit grading framework generally places pri-mary reliance on the institution’s lending staffto identify emerging loan problems. However,given the importance and subjective nature ofloan classification or credit grading, the judg-ment of an institution’s lending staff regardingthe assignment of particular classification orgrades to loans should be subject to review by(1) peers, superiors, or loan committee(s); (2) anindependent, qualified part-time or full-timeemployee(s); (3) an internal department staffedwith credit review specialists; or (4) qualifiedoutside credit review consultants. A loan classi-fication or credit grading review that is indepen-dent of the lending function is preferred becauseit typically provides a more objective assess-ment of credit quality. Because accurate andtimely loan classification or credit grading is acritical component of an effective loan reviewsystem, each institution should ensure that itsloan review system includes the followingattributes:

• a formal loan classification or credit gradingsystem in which loan classifications or creditgrades reflect the risk of default and creditlosses and for which a written description ismaintained, including a discussion of the fac-tors used to assign appropriate classificationsor credit grades to loans;28

• an identification or grouping of loans thatwarrant the special attention of management29

or other designated ‘‘watch lists’’ of loans thatmanagement is more closely monitoring;

• documentation supporting the reasons whyparticular loans merit special attention orreceived a specific adverse classification orcredit grade and management’s adherence toapproved workout plans;

• a mechanism for direct, periodic, and timelyreporting to senior management and the boardof directors on the status of loans identified asmeriting special attention or adversely classi-fied or graded and the actions taken by man-agement; and

• appropriate documentation of the institution’shistorical loss experience for each of thegroups of loans with similar risk characteris-tics into which it has segmented its loanportfolio.30

2065.3.1.5.2 Elements of Loan-ReviewSystems

Each institution should have a written policythat is reviewed and approved at least annuallyby the board of directors to evidence its supportof and commitment to maintaining an effectiveloan review system. The loan review policyshould address the following elements that aredescribed in more detail below: the qualifica-tions and independence of loan review person-nel; the frequency, scope and depth of reviews;

28. A bank or savings association may have a loan classifi-cation or credit grading system that differs from the frame-work used by the banking agencies. However, each institutionthat maintains a loan classification or credit grading systemthat differs from the banking agencies’ framework shouldmaintain documentation that translates its system into theframework used by the banking agencies. This documentationshould be sufficient to enable examiners to reconcile the totalsfor the various loan classifications or credit grades under theinstitution’s system to the banking agencies’ categories.

29. For banks and savings associations, loans that havepotential weaknesses that deserve management’s close atten-tion are designated ‘‘special mention’’ loans.

30. In particular, institutions with large and complex loanportfolios are encouraged to maintain records of their histori-cal loss experience for credits in each of the categories in theirloan classification or credit grading framework. For banks,these categories should be (1) those used by or (2) categoriesthat can be translated into those used by, the banking agencies.



the review of findings and follow-up; and work-paper and report distribution.

Qualifications of loan review personnel. Personsinvolved in the loan review or credit gradingfunction should be qualified based on their levelof education, experience, and extent of formalcredit training. They should be knowledgeablein both sound lending practices and the institu-tion’s lending guidelines for the types of loansoffered by the institution. In addition, theyshould be knowledgeable of relevant laws andregulations affecting lending activities.

Independence of loan review personnel. Aneffective loan review system uses both the ini-tial identification of emerging problem loans byloan officers and other line staff, and the creditreview of loans by individuals independent ofthe credit approval process. An importantrequirement for an effective system is to placeresponsibility on loan officers and line staff forcontinuous portfolio analysis and prompt identi-fication and reporting of problem loans. Becauseof frequent contact with borrowers, loan officersand line staff can usually identify potential prob-lems before they become apparent to others.However, institutions should be careful to avoidoverreliance upon loan officers and line staff foridentification of problem loans. Institutionsshould ensure that loans are also reviewed byindividuals who do not have control over theloans they review and who are not part of, andare not influenced by anyone associated with,the loan approval process.

While larger institutions typically establish aseparate department staffed with credit reviewspecialists, cost and volume considerations maynot justify such a system in smaller institutions.In some smaller institutions, an independentcommittee of outside directors may fill this role.Whether or not the institution has an indepen-dent loan review department, the loan reviewfunction should report directly to the board ofdirectors or a committee thereof (althoughsenior management may be responsible forappropriate administrative functions so long asthey do not compromise the independence ofthe loan review function).

Some institutions may choose to outsourcethe credit review function to an independentoutside party. However, the responsibility formaintaining a sound loan review process cannotbe delegated to an outside party. Therefore,institution personnel who are independent of thelending function should assess control risks,develop the credit review plan, and ensureappropriate follow-up of findings. Furthermore,

the institution should be mindful of specialrequirements concerning independence should itconsider outsourcing the credit review functionto its external auditor.

Frequency of reviews. Loan review personnelshould review significant credits31 at least annu-ally, upon renewal, or more frequently wheninternal or external factors indicate a potentialfor deteriorating credit quality in a particularloan, loan product, or group of loans. Optimally,the loan review function can be used to provideuseful continual feedback on the effectivenessof the lending process in order to identify anyemerging problems. A system of ongoing orperiodic portfolio reviews is particularly impor-tant to the ALLL determination process becausethis process is dependent on the accurate andtimely identification of problem loans.

Scope of reviews. Reviews by loan review per-sonnel should cover all loans that are significantand other loans that meet certain criteria. Man-agement should document the scope of itsreviews and ensure that the percentage of theportfolio selected for review provides reason-able assurance that the results of the reviewhave identified any credit quality deteriorationand other unfavorable trends in the portfolio andreflect its quality as a whole. Managementshould also consider industry standards for loanreview coverage consistent with the size andcomplexity of its loan portfolio and lendingoperations to verify that the scope of its reviewsis appropriate. The institution’s board of direc-tors should approve the scope of loan reviewson an annual basis or when any significantinterim changes to the scope of reviews aremade. Reviews typically include—

• loans over a predetermined size;• a sufficient sample of smaller loans;• past due, nonaccrual, renewed, and restruc-

tured loans;• loans previously adversely classified or

graded and loans designated as warranting thespecial attention of management32 by theinstitution or its examiners;

• insider loans; and• loans constituting concentrations of credit risk

31. Significant credits in this context may or may not beloans individually evaluated for impairment under FAS 114.

32. See footnote 29.



and other loans affected by common repay-ment factors.

Depth of reviews. Reviews should analyze anumber of important aspects of the loansselected for review, including—

• credit quality, including underwriting and bor-rower performance;

• sufficiency of credit and collateral documenta-tion;

• proper lien perfection;• proper approval by the loan officer and loan

committee(s);• adherence to any loan agreement covenants;• compliance with internal policies and proce-

dures (such as aging, nonaccrual, and classifi-cation or grading policies) and laws and regu-lations; and

• appropriate identification of individuallyimpaired loans, measurement of estimatedloan impairment, and timeliness of charge-offs.

Furthermore, these reviews should consider theappropriateness and timeliness of the identifica-tion of problem loans by loan officers.

Review of findings and follow-up. Loan reviewpersonnel should discuss all noted deficienciesand identified weaknesses and any existing orplanned corrective actions, including timeframes for correction, with appropriate loanofficers and department managers. Loan reviewpersonnel should then review these findings andcorrective actions with members of senior man-agement. All noted deficiencies and identifiedweaknesses that remain unresolved beyond thescheduled time frames for correction should bepromptly reported to senior management andthe board of directors.

Credit classification or grading differencesbetween loan officers and loan review personnelshould be resolved according to a prearrangedprocess. That process may include formalappeals procedures and arbitration by an inde-pendent party or may require default to theassigned classification or grade that indicateslower credit quality. If an outsourced creditreview concludes that a borrower is less credit-worthy than is perceived by the institution, thelower credit quality classification or gradeshould prevail unless internal parties identifyadditional information sufficient to obtain theconcurrence of the outside reviewer or arbiter

on the higher credit quality classification orgrade.

Workpaper and report distribution. The loanreview function should prepare a list of all loansreviewed (including the date of the review) anddocumentation (including a summary analysis)that substantiates the grades or classificationsassigned to the loans reviewed. A report thatsummarizes the results of the loan review shouldbe submitted to the board of directors at leastquarterly.33 In addition to reporting currentcredit quality findings, comparative trends canbe presented to the board of directors that iden-tify significant changes in the overall quality ofthe portfolio. Findings should also address theadequacy of and adherence to internal policiesand procedures, as well as compliance with lawsand regulations, in order to facilitate timelycorrection of any noted deficiencies.

2065.3.1.6 Appendix 2—InternationalTransfer Risk Considerations

With respect to international transfer risk, aninstitution with cross-border exposures shouldsupport its determination of the appropriatenessof its ALLL by performing an analysis of thetransfer risk, commensurate with the size andcomposition of the institution’s exposure to eachcountry. Such analyses should take into consid-eration the following factors, as appropriate:

• the institution’s loan portfolio mix for eachcountry (for example, types of borrowers, loanmaturities, collateral, guarantees, specialcredit facilities, and other distinguishingfactors);

• the institution’s business strategy and its debt-management plans for each country;

• each country’s balance of payments position;• each country’s level of international reserves;• each country’s established payment perfor-

mance record and its future debt-servicingprospects;

• each country’s sociopolitical situation and itseffect on the adoption or implementation ofeconomic reforms, in particular those affect-ing debt servicing capacity;

• each country’s current standing with multilat-eral and official creditors;

• the status of each country’s relationships withother creditors, including institutions; and

33. The board of directors should be informed more fre-quently than quarterly when material adverse trends are noted.



• the most recent evaluations distributed by thebanking agencies’ Interagency Country Expo-sure Review Committee.



ALLL Methodologies and Documentation(Accounting, Reporting, and Disclosure Issues) Section 2065.4


Effective July 2012, this section has beenrevised to delete a reference to SR-04-5, ‘‘Inter-agency Update on Accounting for Loan andLease Losses,’’ deemed inactive by SR-12-6.Also, certain accounting references have beenupdated for the Financial Accounting StandardsBoard’s (FASB’s) Accounting Standards Codifi-cation (ASC) numbering and referencing system.

A supplemental interagency Policy Statementon Allowance for Loan and Lease Losses(ALLL) Methodologies and Documentation forBanks and Savings Institutions1 was issued bythe Federal Financial Institutions ExaminationCouncil (FFIEC) on July 2, 2001.2 The policystatement clarifies the agencies’ expectations fordocumentation that supports the ALLL method-ology. Additionally, the statement emphasizesthe need for appropriate ALLL policies andprocedures, which should include an effectiveloan-review system. The guidance also providesexamples of appropriate supporting documenta-tion, as well as illustrations on how to imple-ment this guidance. (See SR-01-17.) While thispolicy statement, by its terms, applies only todepository institutions insured by the FederalDeposit Insurance Corporation (which includesstate member banks), the Federal Reservebelieves this guidance is broadly applicable tobank holding companies. Accordingly, examin-ers should apply the policy, as appropriate, intheir inspections of bank holding companies andtheir nonbank subsidiaries. This policy, how-ever, does not apply to federally insuredbranches and agencies of foreign banks. Feder-ally insured branches and agencies of foreignbanks continue to be subject to separate guid-ance issued by their primary supervisory agency.

The guidance requires that a financial institu-tion’s ALLL methodology be in accordancewith generally accepted accounting principles(GAAP) and all outstanding supervisory guid-ance. An ALLL methodology should be system-atic, consistently applied, and auditable. Themethodology should be validated periodicallyand modified to incorporate new events or find-ings, as needed. The guidance specifies thatmanagement, under the direction of the board of

directors, should implement appropriate proce-dures and controls to ensure compliance withthe institution’s ALLL policies and procedures.Institution management should (1) segment theportfolio to evaluate credit risks; (2) select lossrates that best reflect the probable loss; and(3) be responsive to changes in the organization,the economy, or the lending environment bychanging the methodology, when appropriate.Furthermore, supporting information should beincluded on summary schedules, whenever fea-sible. Under this policy, institutions with less-complex loan products or portfolios, such ascommunity banks, may use a more streamlinedapproach to implement this guidance.

The policy statement is consistent with theFederal Reserve’s long-standing policy to pro-mote strong internal controls over an institu-tion’s ALLL process. In this regard, the policystatement recognizes that determining an appro-priate allowance involves a high degree of man-agement judgment and is inevitably imprecise.Accordingly, an institution may determine thatthe amount of loss falls within a range. In accor-dance with GAAP, an institution should recordits best estimate within the range of creditlosses. (See also sections 2065.2 and 2065.3.)

The policy statement is provided below.Some wording has been slightly modified forthis manual, as indicated by asterisks or textenclosed in brackets. Some footnotes have alsobeen renumbered.

2065.4.1 2001 POLICY STATEMENTON ALLL METHODOLOGIES ANDDOCUMENTATION

Boards of directors of banks * * * are respon-sible for ensuring that their institutions havecontrols in place to consistently determine theallowance for loan and lease losses (ALLL) inaccordance with the institutions’ stated policiesand procedures, GAAP, and ALLL supervisoryguidance.3 To fulfill this responsibility, boardsof directors instruct management to develop andmaintain an appropriate, systematic, and consis-

1. See 66 Fed. Reg. 35,629–35,639 (July 6, 2001).2. The guidance was developed in consultation with Secu-

rities and Exchange Commission (SEC) staff, who issuedparallel guidance in the form of Staff Accounting Bulletin No.102.

3. [The actual policy statement includes a bibliography]that lists applicable ALLL GAAP guidance, interagency state-ments, and other reference materials that may assist in under-standing and implementing an ALLL in accordance withGAAP. See [the appendix] for additional information onapplying GAAP to determine the ALLL.


tently applied process to determine the amountsof the ALLL and provisions for loan losses.Management should create and implement suit-able policies and procedures to communicatethe ALLL process internally to all applicablepersonnel. Regardless of who develops andimplements these policies, procedures, andunderlying controls, the board of directorsshould assure themselves that the policies spe-cifically address the institution’s unique goals,systems, risk profile, personnel, and otherresources before approving them. Additionally,by creating an environment that encourages per-sonnel to follow these policies and procedures,management improves procedural discipline andcompliance.

The determination of the amounts of theALLL and provisions for loan and lease lossesshould be based on management’s current judg-ments about the credit quality of the loan port-folio, and should consider all known relevantinternal and external factors that affect loancollectibility as of the reporting date. Theamounts reported each period for the provisionfor loan and lease losses and the ALLL shouldbe reviewed and approved by the board of direc-tors. To ensure the methodology remains appro-priate for the institution, the board of directorsshould have the methodology periodically vali-dated and, if appropriate, revised. Further, theaudit committee4 should oversee and monitorthe internal controls over the ALLL-determination process.5

The [Federal Reserve and other] bankingagencies6 have long-standing examination poli-cies that call for examiners to review an institu-tion’s lending and loan-review functions andrecommend improvements, if needed. Addition-ally, in 1995 and 1996, the banking agenciesadopted interagency guidelines establishingstandards for safety and soundness, pursuant tosection 39 of the Federal Deposit Insurance Act

(FDI Act).7 The interagency asset-quality guide-lines and [this guidance will assist] an institu-tion in estimating and establishing a sufficientALLL supported by adequate documentation, asrequired under the FDI Act. Additionally, theguidelines require operational and managerialstandards that are appropriate for an institution’ssize and the nature and scope of its activities.

For financial-reporting purposes, includingregulatory reporting, the provision for loan andlease losses and the ALLL must be determinedin accordance with GAAP. GAAP requires thatallowances be well documented, with clearexplanations of the supporting analyses andrationale.8 This [2001] policy statementdescribes but does not increase the documenta-tion requirements already existing withinGAAP. Failure to maintain, analyze, or supportan adequate ALLL in accordance with GAAPand supervisory guidance is generally an unsafeand unsound banking practice.9

This guidance [the 2001 policy statement]applies equally to all institutions, regardless ofthe size. However, institutions with less-complex lending activities and products mayfind it more efficient to combine a number ofprocedures (for example, information gathering,documentation, and internal-approval processes)while continuing to ensure the institution has aconsistent and appropriate methodology. Thus,much of the supporting documentation requiredfor an institution with more-complex productsor portfolios may be combined into fewer sup-porting documents in an institution with less-complex products or portfolios. For example,simplified documentation can include spread-sheets, checklists, and other summary docu-

4. All institutions are encouraged to establish audit com-mittees; however, at small institutions without audit commit-tees, the board of directors retains this responsibility.

5. Institutions and their auditors should refer to Statementon Auditing Standards No. 61, ‘‘Communication with AuditCommittees’’ (as amended by Statement on Auditing Stan-dards No. 90, ‘‘Audit Committee Communications’’), whichrequires certain discussions between the auditor and the auditcommittee. These discussions should include items, such asaccounting policies and estimates, judgments, and uncertain-ties that have a significant impact on the accounting informa-tion included in the financial statements.

6. The [other] banking agencies are the Federal DepositInsurance Corporation, the Office of the Comptroller of theCurrency, and the Office of Thrift Supervision.

7. Institutions should refer to the guidelines *** for statemember banks, appendix D to part 208***.

8. The documentation guidance within this 2001 policystatement is predominantly based upon the GAAP guidancefrom FASB’s ASC section 450-20-25, Contingencies - LossContingencies - Recognition (formerly Statement of FinancialAccounting Standards No. 5, ‘‘Accounting for Contingen-cies’’); ASC Subtopic 310-10-05, Receivables - Overall (for-merly Statement of Financial Accounting Standards No. 114,‘‘Accounting by Creditors for Impairment of a Loan’’);Emerging Issues Task Force Topic No. D-80 (EITF TopicD-80 and attachments), ‘‘Application of FASB Statements No.5 and No. 114 to a Loan Portfolio’’ (which includes theViewpoints article—an article issued in 1999 by FASB staffproviding guidance on certain issues regarding the ALLL,particularly on the application of FAS 5 and FAS 114 and howthese statements interrelate); Chapter 9, ‘‘Credit Losses,’’ theAmerican Institute of Certified Public Accountants’ (AIC-PA’s) Audit and Accounting Guide, Depository and LendingInstitutions: Banks and Savings Institutions, Credit Unions,Finance Companies and Mortgage Companies, 2008 update;and the SEC’s Financial Reporting Release No. 28 (FRR 28).

9. Failure to maintain adequate supporting documentationdoes not relieve an institution of its obligation to record anappropriate ALLL.

ALLL Methodologies and Documentation 2065.4


ments that many institutions currently use. Illus-trations A and C provide specific examples ofhow less-complex institutions may determineand document portions of their loan-lossallowance.

2065.4.1.1 Documentation Standards

Appropriate written supporting documentationfor the loan-loss provision and allowance facili-


BHC Supervision Manual July 2012Page 2.1

tates review of the ALLL process and reportedamounts, builds discipline and consistency intothe ALLL-determination process, and improvesthe process for estimating loan and lease lossesby helping to ensure that all relevant factors areappropriately considered in the ALLL analysis.An institution should document the relationshipbetween the findings of its detailed review ofthe loan portfolio and the amount of the ALLLand the provision for loan and lease lossesreported in each period.10

At a minimum, institutions should maintainwritten supporting documentation for the fol-lowing decisions, strategies, and processes:

• policies and procedures—— over the systems and controls that main-

tain an appropriate ALLL and— over the ALLL methodology

• loan-grading system or process• summary or consolidation of the ALLL

balance• validation of the ALLL methodology• periodic adjustments to the ALLL process

2065.4.1.2 Policies and Procedures

Financial institutions utilize a wide range ofpolicies, procedures, and control systems in theirALLL process. Sound policies should be appro-priately tailored to the size and complexity ofthe institution and its loan portfolio.

In order for an institution’s ALLL methodol-ogy to be effective, the institution’s written poli-cies and procedures for the systems and controlsthat maintain an appropriate ALLL shouldaddress but not be limited to—

• the roles and responsibilities of the institu-tion’s departments and personnel (includingthe lending function, credit review, financialreporting, internal audit, senior management,audit committee, board of directors, and oth-ers, as applicable) who determine, or review,as applicable, the ALLL to be reported in thefinancial statements;

• the institution’s accounting policies for loans,[leases, and their loan losses], including thepolicies for charge-offs and recoveries and forestimating the fair value of collateral, whereapplicable;

• the description of the institution’s systematicmethodology, which should be consistent withthe institution’s accounting policies for deter-mining its ALLL;11 and

• the system of internal controls used to ensurethat the ALLL process is maintained in accor-dance with GAAP and supervisory guidance.

An internal-control system for the ALLL-estimation process should—

• include measures to provide assurance regard-ing the reliability and integrity of informationand compliance with laws, regulations, andinternal policies and procedures;

• reasonably assure that the institution’s finan-cial statements (including regulatory reports)are prepared in accordance with GAAP andALLL supervisory guidance;12 and

• include a well-defined loan-review processcontaining—— an effective loan-grading system that is

consistently applied, identifies differingrisk characteristics and loan-quality prob-lems accurately and in a timely manner,and prompts appropriate administrativeactions;

— sufficient internal controls to ensure thatall relevant loan-review information isappropriately considered in estimatinglosses. This includes maintaining appro-priate reports, details of reviews per-formed, and identification of personnelinvolved; and

— clear formal communication and coordina-tion between an institution’s credit-administration function, financial-reporting group, management, board ofdirectors, and others who are involved in

10. This position is fully described in the SEC’s FRR 28,in which the SEC indicates that the books and records ofpublic companies engaged in lending activities should includedocumentation of the rationale supporting each period’s deter-mination that the ALLL and provision amounts reported wereadequate.

11. Further explanation is presented in the ‘‘Methodology’’section that appears below.

12. In addition to the supporting documentation require-ments for financial institutions, as described in interagencyasset-quality guidelines, public companies are required tocomply with the books and records provisions of the Securi-ties Exchange Act of 1934 (Exchange Act). Under sections13(b)(2)–(7) of the Exchange Act, registrants must make andkeep books, records, and accounts, which, in reasonabledetail, accurately and fairly reflect the transactions and dispo-sitions of assets of the registrant. Registrants also must main-tain internal accounting controls that are sufficient to providereasonable assurances that, among other things, transactionsare recorded as necessary to permit the preparation of finan-cial statements in conformity with GAAP. See also SEC StaffAccounting Bulletin No. 99, Materiality.



the ALLL-determination or -review pro-cess, as applicable (e.g., written policiesand procedures, management reports,audit programs, and committee minutes).

2065.4.1.3 Methodology

An ALLL methodology is a system that aninstitution designs and implements to reason-ably estimate loan and lease losses as of thefinancial statement date. It is critical that ALLLmethodologies incorporate management’s cur-rent judgments about the credit quality of theloan portfolio through a disciplined and consis-tently applied process.

An institution’s ALLL methodology is influ-enced by institution-specific factors, such as aninstitution’s size, organizational structure, busi-ness environment and strategy, managementstyle, loan-portfolio characteristics, loan-administration procedures, and managementinformation systems. However, there are certaincommon elements an institution should incorpo-rate in its ALLL methodology. A summaryof common elements is provided in [theappendix].13

2065.4.1.3.1 Documentation of ALLLMethodology in Written Policies andProcedures

An institution’s written policies and proceduresshould describe the primary elements of theinstitution’s ALLL methodology, includingportfolio segmentation and impairment mea-surement. In order for an institution’s ALLLmethodology to be effective, the institution’swritten policies and procedures should describethe methodology—

• for segmenting the portfolio:— how the segmentation process is per-

formed (i.e., by loan type, industry, riskrates, etc.),

— when a loan-grading system is used tosegment the portfolio:• the definitions of each loan grade,• a reconciliation of the internal loan

grades to supervisory loan grades, and• the delineation of responsibilities for the

loan-grading system.

• for determining and measuring impairmentunder FAS 114:— the methods used to identify loans to be

analyzed individually;— for individually reviewed loans that are

impaired, how the amount of any impair-ment is determined and measured,including—• procedures describing the impairment-

measurement techniques available and• steps performed to determine which

technique is most appropriate in a givensituation.

— the methods used to determine whetherand how loans individually evaluatedunder FAS 114, but not considered to beindividually impaired, should be groupedwith other loans that share common char-acteristics for impairment evaluationunder FAS 5.

• for determining and measuring impairmentunder FAS 5—— how loans with similar characteristics are

grouped to be evaluated for loan collect-ibility (such as loan type, past-due status,and risk);

— how loss rates are determined (e.g., his-torical loss rates adjusted for environmen-tal factors or migration analysis) and whatfactors are considered when establishingappropriate time frames over which toevaluate loss experience; and

— descriptions of qualitative factors (e.g.,industry, geographical, economic, andpolitical factors) that may affect loss ratesor other loss measurements.

The supporting documents for the ALLL maybe integrated in an institution’s credit files, loan-review reports or worksheets, board of direc-tors’ and committee meeting minutes, computerreports, or other appropriate documents andfiles.

2065.4.1.4 ALLL Under FAS 114

An institution’s ALLL methodology related toFAS 114 loans begins with the use of its normalloan-review procedures to identify whether aloan is impaired as defined by the accountingstandard. Institutions should document—

• the method and process for identifying loansto be evaluated under FAS 114 and

• the analysis that resulted in an impairmentdecision for each loan and the determinationof the impairment-measurement method to be

13. Also, refer to paragraph 7.05 of the AICPA AuditGuide.



used (i.e., present value of expected futurecash flows, fair value of collateral less costs tosell, or the loan’s observable market price).

Once an institution has determined which ofthe three available measurement methods to usefor an impaired loan under FAS 114, it shouldmaintain supporting documentation as follows:

• When using the present-value-of-expected-future-cash-flows method—— the amount and timing of cash flows,— the effective interest rate used to discount

the cash flows, and— the basis for the determination of cash

flows, including consideration of currentenvironmental factors and other informa-tion reflecting past events and currentconditions.

• When using the fair-value-of-collateralmethod—— how fair value was determined, including

the use of appraisals, valuation assump-tions, and calculations,

— the supporting rationale for adjustments toappraised values, if any,

— the determination of costs to sell, if appli-cable, and

— appraisal quality, and the expertise andindependence of the appraiser.

• When using the observable-market-price-of-a-loan method—— the amount, source, and date of the

observable market price.

Illustration A describes a practice used by asmall financial institution to document its FAS114 measurement of impairment using a com-prehensive worksheet.14 [Examples 1 and 2 pro-vide examples of applying and documentingimpairment-measurement methods under FAS114. Some loans that are evauluated individu-ally for impairment under FAS 114 may be fullycollateralized and therefore require no ALLL.Example 3 presents an institution whose loanportfolio includes fully collateralized loans. Itdescribes the documentation maintained by thatinstitution to support its conclusion that noALLL was needed for those loans.]

Illustration A

Documenting an ALLL UnderFAS 114

Comprehensive worksheet for the impairment-measurement process

A small institution utilizes a comprehensiveworksheet for each loan being reviewed indi-vidually under FAS 114. Each worksheetincludes a description of why the loan wasselected for individual review, the impairment-measurement technique used, the measurementcalculation, a comparison to the current loanbalance, and the amount of the ALLL for thatloan. The rationale for the impairment-measurement technique used (e.g., present valueof expected future cash flows, observable mar-ket price of the loan, fair value of the collateral)is also described on the worksheet.

Example 1: ALLL Under FAS 114—Measuring and Documenting Impairment

Facts. Approximately one-third of InstitutionA’s commercial loan portfolio consists of large-balance, nonhomogeneous loans. Due to theirlarge individual balances, these loans meet thecriteria under Institution A’s policies and proce-dures for individual review for impairmentunder FAS 114. Upon review of the large-balance loans, Institution A determines that cer-tain of the loans are impaired as defined by FAS114.

Analysis. For the commercial loans reviewedunder FAS 114 that are individually impaired,Institution A should measure and document theimpairment on those loans. For those loans thatare reviewed individually under FAS 114 andconsidered individually impaired, Institution Amust use one of the methods for measuringimpairment that is specified by FAS 114 (that is,the present value of expected future cash flows,

14. The [referenced] illustrations are presented to assistinstitutions in evaluating how to implement the guidanceprovided in this document. The methods described in theillustrations may not be suitable for all institutions and are notconsidered required processes or actions. For additionaldescriptions of key aspects of ALLL guidance, a series of[numbered examples is provided. These examples wereincluded in appendix A of the policy statement as questionsand answers. The wording of the examples has been slightlymodified for this format.]



the loan’s observable market price, or the fairvalue of collateral).

An impairment-measurement method otherthan the methods allowed by FAS 114 cannot beused. For the loans considered individuallyimpaired under FAS 114, under the circum-stances described above, it would not be appro-priate for Institution A to choose a measurementmethod not prescribed by FAS 114. For exam-ple, it would not be appropriate to measure loanimpairment by applying a loss rate to each loanbased on the average historical loss percentagefor all of its commercial loans for the past fiveyears.

Institution A should maintain, as sufficient,objective evidence, written documentation tosupport its measurement of loan impairmentunder FAS 114. If it uses the present value ofexpected future cash flows to measure impair-ment of a loan, it should document (1) theamount and timing of cash flows, (2) the effec-tive interest rate used to discount the cash flows,and (3) the basis for the determination of cashflows, including consideration of current envi-ronmental factors15 and other informationreflecting past events and current conditions. IfInstitution A uses the fair value of collateral tomeasure impairment, it should document(1) how it determined the fair value, includingthe use of appraisals, valuation assumptions andcalculations; (2) the supporting rationale for ad-justments to appraised values, if any, and thedetermination of costs to sell, if applicable;(3) appraisal quality; and (4) the expertise andindependence of the appraiser. Similarly, Institu-tion A should document the amount, source, anddate of the observable market price of a loan, ifthat method of measuring loan impairment isused.

Example 2: ALLL Under FAS 114—Measuring Impairment for aCollateral-Dependent Loan

Facts. Institution B has a $10 million loan out-standing to Company X that is secured by realestate, which Institution B individually evalu-ates under FAS 114 due to the loan’s size.Company X is delinquent in its loan paymentsunder the terms of the loan agreement. Accord-

ingly, Institution B determines that its loan toCompany X is impaired, as defined by FAS 114.Because the loan is collateral dependent, Institu-tion B measures impairment of the loan basedon the fair value of the collateral. Institution Bdetermines that the most recent valuation of thecollateral was performed by an appraiser 18months ago and, at that time, the estimatedvalue of the collateral (fair value less costs tosell) was $12 million.

Institution B believes that certain of theassumptions that were used to value the collat-eral 18 months ago do not reflect current marketconditions and, therefore, the appraiser’s valua-tion does not approximate current fair value ofthe collateral. Several buildings, which are com-parable to the real estate collateral, wererecently completed in the area, increasing va-cancy rates, decreasing lease rates, and attract-ing several tenants away from the borrower.Accordingly, credit-review personnel at Institu-tion B adjust certain of the valuation assump-tions to better reflect the current market condi-tions as they relate to the loan’s collateral.16

After adjusting the collateral-valuation assump-tions, the credit-review department determinesthat the current estimated fair value of the collat-eral, less costs to sell, is $8 million. Given thatthe recorded investment in the loan is $10 mil-lion, Institution B concludes that the loan isimpaired by $2 million and records an allow-ance for loan losses of $2 million.

Analysis. Institution B should maintain docu-mentation to support its determination of theallowance for loan losses of $2 million for theloan to Company X. It should document that itmeasured impairment of the loan to Company Xby using the fair value of the loan’s collateral,less costs to sell, which it estimated to be$8 million. This documentation should include(1) the institution’s rationale and basis for the$8 million valuation, including the revised valu-ation assumptions it used; (2) the valuation cal-culation; and (3) the determination of costs tosell, if applicable. Because Institution B arrivedat the valuation of $8 million by modifying anearlier appraisal, it should document its ratio-nale and basis for the changes it made to thevaluation assumptions that resulted in the collat-eral value declining from $12 million 18 monthsago to $8 million in the current period.17

15. Question 16 in Exhibit D-80A of EITF Topic D-80 and[its] attachments indicates that environmental factors includeexisting industry, geographical, economic, and politicalfactors.

16. When reviewing collateral-dependent loans, InstitutionB may often find it more appropriate to obtain an updatedappraisal to estimate the effect of current market conditionson the appraised value instead of internally estimating anadjustment.

17. In accordance with the FFIEC’s Federal Register



Example 3: ALLL Under FAS 114—FullyCollateralized Loans

Facts. Institution C has $10 million in loans thatare fully collateralized by highly rated debt se-curities with readily determinable market val-ues. The loan agreement for each of these loansrequires the borrower to provide qualifying col-lateral sufficient to maintain a loan-to-value ratiowith sufficient margin to absorb volatility in thesecurities’ market prices. Institution C’s collat-eral department has physical control of the debtsecurities through safekeeping arrangements. Inaddition, Institution C perfected its securityinterest in the collateral when the funds wereoriginally distributed. On a quarterly basis, Insti-tution C’s credit-administration functiondetermines the market value of the collateral foreach loan using two independent market quotesand compares the collateral value to the loancarrying value. If there are any collateral defi-ciencies, Institution C notifies the borrower andrequests that the borrower immediately remedythe deficiency. Due in part to its efficient opera-tion, Institution C has historically not incurredany material losses on these loans. Institution Cbelieves these loans are fully collateralized andtherefore does not maintain any ALLL balancefor these loans.

Analysis. To adequately support its determina-tion that no allowance is needed for this group

of loans, Institution C must maintain the follow-ing documentation:

• The management summary of the ALLL mustinclude documentation indicating that, inaccordance with the institution’s ALLL pol-icy, (1) Institution C has verified the collateralprotection on these loans, (2) no probable losshas been incurred, and (3) no ALLL isnecessary.

• The documentation in Institution C’s loan filesmust include (1) the two independent marketquotes obtained each quarter for each loan’scollateral amount, (2) the documents evidenc-ing the perfection of the security interest inthe collateral and other relevant supportingdocuments, and (3) Institution C’s ALLL pol-icy, including guidance for determining whena loan is considered ‘‘fully collateralized,’’which would not require an ALLL. InstitutionC’s policy should require the following fac-tors to be considered and fully documented:— volatility of the market value of the

collateral— recency and reliability of the appraisal or

other valuation— recency of the institution’s or third party’s

inspection of the collateral— historical losses on similar loans— confidence in the institution’s lien or

security position including appropriate—• type of security perfection (e.g., physi-

cal possession of collateral or securedfiling);

• filing of security perfection (i.e., correctdocuments and with the appropriateofficials);

• relationship to other liens; and• other factors as appropriate for the loan

type.

2065.4.1.5 ALLL Under FAS 5

2065.4.1.5.1 Segmenting the Portfolio

For loans evaluated on a group basis under FAS5, management should segment the loan port-folio by identifying risk characteristics that arecommon to groups of loans. Institutions typi-cally decide how to segment their loan port-folios based on many factors, which vary withtheir business strategies as well as their informa-tion system capabilities. Smaller institutions thatare involved in less complex activities oftensegment the portfolio into broad loan categories.This method of segmenting the portfolio islikely to be appropriate in only small institu-

tions offering a narrow range of loan products.Larger institutions typically offer a more diverseand complex mix of loan products. Such institu-tions may start by segmenting the portfolio intomajor loan types but typically have moredetailed information available that allows themto further segregate the portfolio into product-line segments based on the risk characteristicsof each portfolio segment. Regardless of thesegmentation method used, an institution shouldmaintain documentation to support its conclu-sion that the loans in each segment have similarattributes or characteristics.

notice, Implementation Issues Arising from FASB No. 114,‘‘Accounting by Creditors for Impairment of a Loan,’’ pub-lished February 10, 1995 (60 Fed. Reg. 7966), impaired,collateral-dependent loans must be reported at the fair valueof collateral, less costs to sell, in regulatory reports. Thistreatment is to be applied to all collateral-dependent loans,regardless of type of collateral.



As economic and other business conditionschange, institutions often modify their businessstrategies, which may result in adjustments tothe way in which they segment their loan port-folio for purposes of estimating loan losses.

Illustration B presents an example in which aninstitution refined its segmentation method tomore effectively consider risk factors and main-tains documentation to support this change.

Illustration B

Documenting Segmenting Practices

Documenting a refinement in a segmentationmethod

An institution with a significant portfolio ofconsumer loans performed a review of its ALLLmethodology. The institution had determined itsALLL based upon historical loss rates in theoverall consumer portfolio. The ALLL method-ology was validated by comparing actual lossrates (charge-offs) for the past two years to theestimated loss rates. During this process, the

institution decided to evaluate loss rates on anindividual-product basis (e.g., auto loans, unse-cured loans, or home equity loans). This analy-sis disclosed significant differences in the lossrates on different products. With this additionalinformation, the methodology was amended inthe current period to segment the portfolio byproduct, resulting in a better estimation of theloan losses associated with the portfolio. Tosupport this change in segmentation practice,the credit-review committee records contain theanalysis that was used as a basis for the changeand the written report describing the need forthe change.

Institutions use a variety of documents tosupport the segmentation of their portfolios.Some of these documents include—

• loan trial balances by categories and types ofloans,

• management reports about the mix of loans inthe portfolio,

• delinquency and nonaccrual reports, and• a summary presentation of the results of an

internal or external loan-grading review.

Reports generated to assess the profitability of aloan-product line may be useful in identifyingareas in which to further segment the portfolio.

2065.4.1.5.2 Estimating Loss on Groupsof Loans

Based on the segmentation of the loan portfolio,an institution should estimate the FAS 5 portionof its ALLL. For those segments that require anALLL,18 the institution should estimate the loanand lease losses, on at least a quarterly basis,based upon its ongoing loan-review processand analysis of loan performance. The institu-tion should follow a systematic and consistentlyapplied approach to select the most appropriate

loss-measurement methods and support its con-clusions and rationale with written documenta-tion. Regardless of the methods used to measurelosses, an institution should demonstrate anddocument that the loss-measurement methodsused to estimate the ALLL for each segment aredetermined in accordance with GAAP as of thefinancial statement date.19

One method of estimating loan losses forgroups of loans is through the application ofloss rates to the groups’ aggregate loan bal-ances. Such loss rates typically reflect the insti-tution’s historical loan-loss experience for eachgroup of loans, adjusted for relevant environ-mental factors (e.g., industry, geographical, eco-nomic, and political factors) over a definedperiod of time. If an institution does not haveloss experience of its own, it may be appropriateto reference the loss experience of other institu-tions, provided that the institution demonstratesthat the attributes of the loans in its portfoliosegment are similar to those of the loansincluded in the portfolio of the institution pro-viding the loss experience.20 Institutions shouldmaintain supporting documentation for the tech-nique used to develop their loss rates, includingthe period of time over which the losses wereincurred. If a range of loss is determined, institu-tions should maintain documentation to supportthe identified range and the rationale used fordetermining which estimate is the best estimatewithin the range of loan losses. An example of

18. An example of a loan segment that does not generallyrequire an ALLL is loans that are fully secured by depositsmaintained at the lending institution.

19. Refer to paragraph 8(b) of FAS 5***.20. Refer to paragraph 23 of FAS 5.



how a small institution performs a comprehen-sive historical loss analysis is provided as thefirst item in illustration C.

Before employing a loss-estimation model,an institution should evaluate and modify, asneeded, the model’s assumptions to ensure thatthe resulting loss estimate is consistent withGAAP. In order to demonstrate consistency withGAAP, institutions that use loss-estimationmodels typically document the evaluation, theconclusions regarding the appropriateness ofestimating loan losses with a model or otherloss-estimation tool, and the support for adjust-ments to the model or its results.

In developing loss measurements, institutionsshould consider the impact of current environ-mental factors and then document which factorswere used in the analysis and how those factorsaffected the loss measurements. Factors thatshould be considered in developing loss mea-surements include the following:21

• levels of and trends in delinquencies andimpaired loans

• levels of and trends in charge-offs andrecoveries

• trends in volume and terms of loans• effects of any changes in risk-selection and

underwriting standards, and other changes in

lending policies, procedures, and practices• experience, ability, and depth of lending man-

agement and other relevant staff• national and local economic trends and

conditions• industry conditions• effects of changes in credit concentrations

For any adjustment of loss measurementsfor environmental factors, the institution shouldmaintain sufficient, objective evidence tosupport the amount of the adjustment and toexplain why the adjustment is necessary toreflect current information, events, circum-stances, and conditions in the lossmeasurements.

The second item in illustration C provides anexample of how an institution adjusts its com-mercial real estate historical loss rates forchanges in local economic conditions. Example4 provides an example of maintaining support-ing documentation for adjustments to portfolio-segment loss rates for an environmental factorrelated to an economic downturn in the bor-rower’s primary industry. Example 5 describesone institution’s process for determining anddocumenting an ALLL for loans that are notindividually impaired but have character-istics indicating there are loan losses on a groupbasis.

Illustration C

Documenting the Setting of LossRates

Comprehensive loss analysis in a smallinstitution

A small institution determines its loss ratesbased on loss rates over a three-year historicalperiod. The analysis is conducted by type ofloan and is further segmented by originatingbranch office. The analysis considers charge-offs and recoveries in determining the loss rate.The institution also considers the loss rates foreach loan grade and compares them to historicallosses on similarly rated loans in arriving at thehistorical loss factor. The institution maintainssupporting documentation for its loss-factoranalysis, including historical losses by type ofloan, originating branch office, and loan gradefor the three-year period.

Adjustment of loss rates for changes in localeconomic conditions

An institution develops a factor to adjust lossrates for its assessment of the impact of changesin the local economy. For example, when ana-lyzing the loss rate on commercial real estateloans, the assessment identifies changes inrecent commercial building occupancy rates.The institution generally finds the occupancystatistics to be a good indicator of probablelosses on these types of loans. The institutionmaintains documentation that summarizes therelationship between current occupancy ratesand its loss experience.

Example 4: ALLL Under FAS 5—Adjusting Loss Rates

Facts. Institution D’s lending area includes ametropolitan area that is financially dependent

21. Refer to paragraph 7.13 in the AICPA Audit Guide.



upon the profitability of a number of manufac-turing businesses. These businesses use highlyspecialized equipment and significant quantitiesof rare metals in the manufacturing process.Due to increased low-cost foreign competition,several of the parts suppliers servicing thesemanufacturing firms declared bankruptcy. Theforeign suppliers have subsequently increasedprices, and the manufacturing firms have suf-fered from increased equipment maintenancecosts and smaller profit margins. Additionally,the cost of the rare metals used in the manufac-turing process increased and has now stabilizedat double last year’s price. Due to these events,the manufacturing businesses are experiencingfinancial difficulties and have recentlyannounced downsizing plans.

Although Institution D has yet to confirm anincrease in its loss experience as a result ofthese events, management knows that it lends toa significant number of businesses and individu-als whose repayment ability depends upon thelong-term viability of the manufacturing busi-nesses. Institution D’s management has identi-fied particular segments of its commercial andconsumer customer bases that include borrow-ers highly dependent upon sales or salary fromthe manufacturing businesses. Institution D’smanagement performs an analysis of theaffected portfolio segments to adjust its histori-cal loss rates used to determine the ALLL. Inthis particular case, Institution D has experi-enced similar business and lending conditionsin the past that it can compare to currentconditions.

Analysis. Institution D should document its sup-port for the loss-rate adjustments that resultfrom considering these manufacturing firms’financial downturns. It should document itsidentification of the particular segments of itscommercial and consumer loan portfolio forwhich it is probable that the manufacturing busi-ness’ financial downturn has resulted in loanlosses. In addition, it should document its analy-sis that resulted in the adjustments to the lossrates for the affected portfolio segments. As partof its documentation, Institution D should main-tain copies of the documents supporting theanalysis, including relevant newspaper articles,economic reports, economic data, and notesfrom discussions with individual borrowers.

Since Institution D has had similar situationsin the past, its supporting documentation shouldalso include an analysis of how the currentconditions compare to its previous loss experi-

ences in similar circumstances. As part of itseffective ALLL methodology, a summaryshould be created of the amount and rationalefor the adjustment factor, which managementpresents to the audit committee and board fortheir review and approval prior to the issuanceof the financial statements.

Example 5: ALLL Under FAS 5—Estimating Losses on Loans IndividuallyReviewed for Impairment but NotConsidered Individually Impaired

Facts. Institution E has outstanding loans of$2 million to Company Y and $1 million toCompany Z, both of which are paying as agreedupon in the loan documents. The institution’sALLL policy specifies that all loans greater than$750,000 must be individually reviewed for im-pairment under FAS 114. Company Y’s finan-cial statements reflect a strong net worth, goodprofits, and ongoing ability to meet debt-servicerequirements. In contrast, recent informationindicates Company Z’s profitability is decliningand its cash flow is tight. Accordingly, this loanis rated substandard under the institution’s loan-grading system. Despite its concern, manage-ment believes Company Z will resolve its prob-lems and determines that neither loan isindividually impaired as defined by FAS 114.

Institution E segments its loan portfolio toestimate loan losses under FAS 5. Two of itsloan portfolio segments are Segment 1 and Seg-ment 2. The loan to Company Y has risk charac-teristics similar to the loans included in Seg-ment 1, and the loan to Company Z has riskcharacteristics similar to the loans included inSegment 2.22

In its determination of the ALLL under FAS5, Institution E includes its loans to Company Yand Company Z in the groups of loans withsimilar characteristics (i.e., Segment 1 for Com-pany Y’s loan and Segment 2 for Company Z’sloan). Management’s analyses of Segment 1 andSegment 2 indicate that it is probable that eachsegment includes some losses, even though thelosses cannot be identified to one or more spe-cific loans. Management estimates that the useof its historical loss rates for these two seg-ments, with adjustments for changes inenvironmental factors, provides a reasonableestimate of the institution’s probable loan lossesin these segments.

22. These groups of loans do not include any loans thathave been individually reviewed for impairment under FAS114 and determined to be impaired as defined by FAS 114.



Analysis. Institution E should adequately docu-ment an ALLL under FAS 5 for these loans thatwere individually reviewed for impairment butare not considered individually impaired. Aspart of its effective ALLL methodology, Institu-tion E documents the decision to include itsloans to Company Y and Company Z in itsdetermination of its ALLL under FAS 5. Itshould also document the specific characteris-tics of the loans that were the basis for grouping

these loans with other loans in Segment 1 andSegment 2, respectively. Institution E maintainsdocumentation to support its method of estimat-ing loan losses for Segment 1 and Segment 2,including the average loss rate used, the analysisof historical losses by loan type and by internalrisk rating, and support for any adjustments toits historical loss rates. The institution alsomaintains copies of the economic and otherreports that provided source data.

2065.4.1.6 Consolidating the LossEstimates

To verify that ALLL balances are presentedfairly in accordance with GAAP and are audit-able, management should prepare a documentthat summarizes the amount to be reported inthe financial statements for the ALLL. Theboard of directors should review and approvethis summary.

Common elements in such summariesinclude—

• the estimate of the probable loss or range ofloss incurred for each category evaluated (e.g.,individually evaluated impaired loans, homo-geneous pools, and other groups of loans thatare collectively evaluated for impairment);

• the aggregate probable loss estimated usingthe institution’s methodology;

• a summary of the current ALLL balance;• the amount, if any, by which the ALLL is to

be adjusted;23 and• depending on the level of detail that supports

the ALLL analysis, detailed subschedules ofloss estimates that reconcile to the summaryschedule.

Illustration D describes how an institution docu-ments its estimated ALLL by adding compre-hensive explanations to its summary schedule.

Generally, an institution’s review andapproval process for the ALLL relies upon thedata provided in these consolidated summaries.There may be instances in which individuals orcommittees that review the ALLL methodologyand resulting allowance balance identify adjust-ments that need to be made to the loss estimatesto provide a better estimate of loan losses. Thesechanges may be due to information not knownat the time of the initial loss estimate (e.g.,information that surfaces after determining andadjusting, as necessary, historical loss rates, ora recent decline in the marketability of propertyafter conducting a FAS 114 valuation basedupon the fair value of collateral). It is impor-tant that these adjustments are consistent withGAAP and are reviewed and approved byappropriate personnel. Additionally, the sum-mary should provide each subsequent reviewerwith an understanding of the support behindthese adjustments. Therefore, managementshould document the nature of any adjustmentsand the underlying rationale for making thechanges. This documentation should be pro-vided to those making the final determinationof the ALLL amount. Example 6 addressesthe documentation of the final amount of theALLL.

23. Subsequent to adjustments, there should be no materialdifferences between the consolidated loss estimate, as deter-mined by the methodology, and the final ALLL balancereported in the financial statements.



Illustration D

Summarizing Loss Estimates

Descriptive comments added to the consolidatedALLL summary schedule

To simplify the supporting documentation pro-cess and to eliminate redundancy, an institutionadds detailed supporting information to its sum-mary schedule. For example, this institution’sboard of directors receives, within the body ofthe ALLL summary schedule, a brief descrip-tion of the institution’s policy for selecting loansfor evaluation under FAS 114. Additionally, theinstitution identifies which FAS 114impairment-measurement method was used foreach individually reviewed impaired loan. Otheritems on the schedule include a brief descriptionof the loss factors for each segment of the loanportfolio, the basis for adjustments to loss rates,and explanations of changes in ALLL amountsfrom period to period, including cross-references to more detailed supportingdocuments.

Example 6: Consolidating the LossEstimates—Documenting the ReportedALLL

Facts. Institution F determines its ALLL usingan established systematic process. At the end ofeach period, the accounting department preparesa summary schedule that includes the amount ofeach of the components of the ALLL, as well asthe total ALLL amount, for review by seniormanagement, the credit committee, and, ulti-mately, the board of directors. Members ofsenior management and the credit committeemeet to discuss the ALLL. During these discus-sions, they identify changes that are required byGAAP to be made to certain of the ALLL

estimates. As a result of the adjustments madeby senior management, the total amount of theALLL changes. However, senior management(or its designee) does not update the ALLLsummary schedule to reflect the adjustments orreasons for the adjustments. When performingtheir audit of the financial statements, the inde-pendent accountants are provided with the origi-nal ALLL summary schedule that was reviewedby senior management and the credit commit-tee, as well as a verbal explanation of thechanges made by senior management and thecredit committee when they met to discuss theloan-loss allowance.

Analysis. Institution F’s documentation prac-tices supporting the balance of its loan-loss al-lowance, as reported in its financial statements,are not in compliance with existing documenta-tion guidance. An institution must maintain sup-porting documentation for the loan-loss allow-ance amount reported in its financial statements.As illustrated above, there may be instances inwhich ALLL reviewers identify adjustments thatneed to be made to the loan-loss estimates. Thenature of the adjustments, how they were mea-sured or determined, and the underlying ratio-nale for making the changes to the ALLL bal-ance should be documented. Appropriatedocumentation of the adjustments should beprovided to the board of directors (or its desig-nee) for review of the final ALLL amount to bereported in the financial statements. For institu-tions subject to external audit, this documenta-tion should also be made available to the inde-pendent accountants. If changes frequentlyoccur during management or credit committeereviews of the ALLL, management may find itappropriate to analyze the reasons for the fre-quent changes and to reassess the methodologythe institution uses.

2065.4.1.7 Validating the ALLLMethodology

An institution’s ALLL methodology is consid-ered valid when it accurately estimates theamount of loss contained in the portfolio. Thus,the institution’s methodology should includeprocedures that adjust loss-estimation methodsto reduce differences between estimated lossesand actual subsequent charge-offs, as necessary.

To verify that the ALLL methodology is validand conforms to GAAP and supervisory guid-ance, an institution’s directors should establishinternal-control policies, appropriate for the sizeof the institution and the type and complexity ofits loan products. These policies should includeprocedures for a review, by a party who isindependent of the ALLL-estimation process, ofthe ALLL methodology and its application inorder to confirm its effectiveness.

In practice, financial institutions employnumerous procedures when validating the rea-sonableness of their ALLL methodology and



determining whether there may be deficienciesin their overall methodology or loan-gradingprocess. Examples are—

• a review of trends in loan volume, delinquen-cies, restructurings, and concentrations;

• a review of previous charge-off and recoveryhistory, including an evaluation of the timeli-ness of the entries to record both the charge-offs and the recoveries;

• a review by a party that is independent of theALLL-estimation process (this often involvesthe independent party reviewing, on a testbasis, source documents and underlyingassumptions to determine that the establishedmethodology develops reasonable lossestimates); and

• an evaluation of the appraisal process of theunderlying collateral. (This may be accom-plished by periodically comparing theappraised value to the actual sales price onselected properties sold.)

2065.4.1.7.1 Supporting Documentationfor the Validation Process

Management usually supports the validationprocess with the workpapers from the ALLL-review function. Additional documentationoften includes the summary findings of the inde-pendent reviewer. The institution’s board ofdirectors, or its designee, reviews the findingsand acknowledges its review in its meeting min-utes. If the methodology is changed based uponthe findings of the validation process, documen-tation that describes and supports the changesshould be maintained.

2065.4.1.8 Appendix—Application ofGAAP

[This appendix was designated appendix B inthe policy statement.] An ALLL recorded pursu-ant to GAAP is an institution’s best estimate ofthe probable amount of loans and lease-financing receivables that it will be unable tocollect based on current information andevents.24 A creditor should record an ALLL

when the criteria for accrual of a loss contin-gency as set forth in GAAP have been met.Estimating the amount of an ALLL involves ahigh degree of management judgment and isinevitably imprecise. Accordingly, an institutionmay determine that the amount of loss fallswithin a range. An institution should record itsbest estimate within the range of loan losses.25

Under GAAP, Statement of FinancialAccounting Standards No. 5, ‘‘Accounting forContingencies’’ (FAS 5), provides the basicguidance for recognition of a loss contingency,such as the collectibility of loans (receivables),when it is probable that a loss has been incurredand the amount can be reasonably estimated.Statement of Financial Accounting StandardsNo. 114, ‘‘Accounting by Creditors for Impair-ment of a Loan’’ (FAS 114) provides morespecific guidance about the measurement anddisclosure of impairment for certain types ofloans.26 Specifically, FAS 114 applies to loansthat are identified for evaluation on an indi-vidual basis. Loans are considered impairedwhen, based on current information and events,it is probable that the creditor will be unable tocollect all interest and principal payments dueaccording to the contractual terms of the loanagreement.

For individually impaired loans, FAS 114provides guidance on the acceptable methods tomeasure impairment. Specifically, FAS 114states that when a loan is impaired, a creditorshould measure impairment based on the presentvalue of expected future principal and interestcash flows discounted at the loan’s effectiveinterest rate, except that as a practical expedient,a creditor may measure impairment based on aloan’s observable market price or the fair valueof collateral, if the loan is collateral dependent.When developing the estimate of expectedfuture cash flows for a loan, an institution shouldconsider all available information reflecting pastevents and current conditions, including the

24. This appendix provides guidance on the ALLL anddoes not address allowances for credit losses for off-balance-sheet instruments (e.g., loan commitments, guarantees, andstandby letters of credit). Institutions should record liabilitiesfor these exposures in accordance with GAAP. Further guid-ance on this topic is presented in the American Institute ofCertified Public Accountants’ Audit and Accounting Guide,Banks and Savings Institutions, 2000 edition (AICPA AuditGuide). Additionally, this appendix does not address allow-

ances or accounting for assets or portions of assets sold withrecourse, which is described in Statement of FinancialAccounting Standards No. 140, ‘‘Accounting for Transfersand Servicing of Financial Assets and Extinguishments ofLiabilities—a Replacement of FASB Statement No. 125’’(FAS 140).

25. Refer to FASB Interpretation No. 14, ‘‘ReasonableEstimation of the Amount of a Loss,’’ and Emerging IssuesTask Force Topic No. D-80, ‘‘Application of FASB State-ments No. 5 and No. 114 to a Loan Portfolio’’ (EITF TopicD-80).

26. EITF Topic D-80 includes additional guidance on therequirements of FAS 5 and FAS 114 and how they relate toeach other.***



effect of existing environmental factors. Thefollowing illustration provides an example of an

institution estimating a loan’s impairment whenthe loan has been partially charged off.

Illustration

Interaction of FAS 114 with anAdversely Classified Loan, PartialCharge-Off, and the Overall ALLL

An institution determined that a collateral-dependent loan, which it identified for evalua-tion, was impaired. In accordance with FAS114, the institution established an ALLL for theamount that the recorded investment in the loanexceeded the fair value of the underlying collat-eral, less costs to sell.

Consistent with relevant regulatory guidance,the institution classified as ‘‘Loss,’’ the portion

of the recorded investment deemed to be theconfirmed loss and classified the remainingrecorded investment as ‘‘Substandard.’’ For thisloan, the amount classified ‘‘Loss’’ was lessthan the impairment amount (as determinedunder FAS 114). The institution charged off the‘‘Loss’’ portion of the loan. After the charge-off,the portion of the ALLL related to this ‘‘Sub-standard’’ loan (1) reflects an appropriate mea-sure of impairment under FAS 114, and (2) isincluded in the aggregate FAS 114 ALLL for allloans that were identified for evaluation andindividually considered impaired. The aggre-gate FAS 114 ALLL is included in the institu-tion’s overall ALLL.

Large groups of smaller-balance homoge-neous loans that are collectively evaluated forimpairment are not included in the scope of FAS114.27 Such groups of loans may include, butare not limited to, credit card, residential mort-gage, and consumer installment loans. FAS 5addresses the accounting for impairment ofthese loans. Also, FAS 5 provides the account-ing guidance for impairment of loans that arenot identified for evaluation on an individualbasis and loans that are individually evaluatedbut are not individually considered impaired.Institutions should ensure that they do not layertheir loan-loss allowances. Layering is the inap-propriate practice of recording in the ALLLmore than one amount for the same probableloan loss. Layering can happen when an institu-tion includes a loan in one segment, determinesits best estimate of loss for that loan eitherindividually or on a group basis (after takinginto account all appropriate environmental fac-tors, conditions, and events), and then includesthe loan in another group, which receives anadditional ALLL amount.28

While different institutions may use differentmethods, there are certain common elementsthat should be included in any loan-loss allow-ance methodology. Generally, an institution’smethodology should—

• include a detailed analysis of the loan port-folio, performed on a regular basis;

• consider all loans (whether on an individualor group basis);

• identify loans to be evaluated for impairmenton an individual basis under FAS 114 andsegment the remainder of the portfolio intogroups of loans with similar risk charac-teristics for evaluation and analysis underFAS 5;

• consider all known relevant internal andexternal factors that may affect loancollectibility;

• be applied consistently but, when appropriate,be modified for new factors affectingcollectibility;

• consider the particular risks inherent in differ-ent kinds of lending;

• consider current collateral values (less coststo sell), where applicable;

• require that analyses, estimates, reviews, andother ALLL methodology functions beperformed by competent and well-trainedpersonnel;

• be based on current and reliable data;• be well documented, in writing, with clear

explanations of the supporting analyses andrationale; and

• include a systematic and logical method toconsolidate the loss estimates and ensure the

27. In addition, FAS 114 does not apply to loans measuredat fair value or at the lower of cost or fair value, leases, ordebt securities.

28. According to the Federal Financial Institutions Exami-nation Council’s Federal Register notice, ImplementationIssues Arising from FASB Statement No. 114, ‘‘Accountingby Creditors for Impairment of a Loan,’’ published February10, 1995, institution-specific issues should be reviewed whenestimating loan losses under FAS 114. This analysis should beconducted as part of the evaluation of each individual loanreviewed under FAS 114 to avoid potential ALLL layering.



ALLL balance is recorded in accordance withGAAP.29

A systematic methodology that is properlydesigned and implemented should result in aninstitution’s best estimate of the ALLL. Accord-ingly, institutions should adjust their ALLL bal-ance, either upward or downward, in eachperiod for differences between the results of thesystematic determination process and the unad-justed ALLL balance in the general ledger.30


1. To evaluate internal controls over the loan-loss estimation process by evaluating theALLL written policy and the process used tocreate and maintain the policy, loan-gradingsystems, and other associated internal con-trols over credit risk.

2. To determine the existence of an ALLL bal-ance and review the summary schedule sup-porting it.

3. To analyze and review the evaluation forStatement of Financial Accounting StandardsNo. 114 (FAS 114) (for individually listedloans).

4. To analyze and review the evaluation forStatement of Financial Accounting StandardsNo. 5 (FAS 5) (for groups of loans).

5. To determine if the BHC has adequatelydeveloped a range of loss and a margin forimprecision.

6. To determine that the ALLL reflects esti-mated credit losses for specifically identifiedloans (or groups of loans) and any estimatedprobable credit losses inherent in the remain-der of the loan portfolio at the balance-sheetdate.

7. To analyze and review the ALLL-documentation support.

8. To determine the adequacy of the BHC’sprocess to evaluate the ALLL methodologyand to adjust the methodology, as needed.


1. Determine if the board of directors hasdeveloped and maintained an appropriate,systematic, and consistently applied processto determine the amounts of the ALLL andprovision for loan losses, or if it hasinstructed management to do so. Determineif the ALLL policies specifically address theBHC’s goals, risk profile, personnel, andother resources.

2. Determine if the board of directors hasapproved the written ALLL policy.

3. Determine if the BHC’s loan-loss estimate,in accordance with its methodology, is con-sistent with generally accepted accountingprinciples and supervisory guidance. Addi-tionally, ensure that the BHC’s loan-loss esti-mate is materially consistent with thereported balance of the BHC’s ALLLaccount.

4. Determine if the ALLL methodology is peri-odically validated by an independent partyand, if appropriate, revised.

5. Ascertain whether the audit committee isoverseeing and monitoring the internal con-trols over the ALLL-documentation process.

6. Ascertain that the BHC maintains adequatewritten documentation of its ALLL, includ-ing clear explanations of the supportinganalyses and rationale. The documentationshould consist of—• policies and procedures over the systems

and controls that maintain an appropriateALLL and over the ALLL methodology,

• the loan-grading system or process,• a summary or consolidation (including

losses) of the ALLL balance,• a validation of the ALLL methodology,

and• periodic adjustments to the ALLL process.

7. Determine if the amount reported for theALLL for each period and the provisions forloan and leases losses are reviewed andapproved by the board of directors.

29. Refer to paragraph 7.05 of the AICPA Audit Guide.30. Institutions should refer to the guidance on materiality

in SEC Staff Accounting Bulletin No. 99, Materiality.



ALLL Estimation Practices for Loans Secured by Junior LiensSection 2065.5

The federal banking agencies1 issued, in Janu-ary 2012, ‘‘Interagency Supervisory Guidanceon Allowance for Loan and Lease Losses Esti-mation Practices for Loans and Lines of CreditSecured by Junior Liens on 1–4 Family Resi-dential Properties.’’ The guidance applies to allbanking organizations with junior-lien loans. Itwas issued to address the allowance for loan andlease losses (ALLL) estimation practices forjunior-lien loans and lines of credit (collec-tively, junior liens). (See SR-12-3.)

Domestic banking organizations that aresupervised by the Federal Reserve are remindedto consider all credit quality indicators relevantto their junior liens. Generally, this informationshould include the delinquency status of seniorliens associated with the institution’s junior liensand whether the senior lien has been modified.Institutions should ensure that during the ALLLestimation process, sufficient information isgathered to adequately assess the probable lossincurred within junior-lien portfolios.

This 2012 ALLL guidance applies to institu-tions of all sizes. The guidance states that aninstitution should use reasonably available toolsto determine the payment status of senior liensassociated with its junior liens, such as creditreports, third-party services, or, in certain cases,a proxy. It is expected that large, complex insti-tutions would find most tools reasonably avail-able and would use proxies in limitedcircumstances.

The guidance does not add or modify existingregulatory reporting requirements issued by theagencies or current generally accepted account-ing principles (GAAP). This guidance reiterateskey concepts included in GAAP and existingsupervisory guidance related to the ALLL. (See,for example, SR-06-17 (section 2065.3) andSR-01-17 (section 2065.4) and theirattachments.

Institutions also are reminded to followappropriate risk-management principles in man-aging junior-lien loans and lines of credit,including the May 2005 ‘‘Interagency CreditRisk Management Guidance for Home EquityLending.’’ (See SR-05-11 and section 2010.2.4.)

2065.5.1 ALLL ESTIMATIONPRACTICES FOR LOANS AND LINESOF CREDIT SECURED BY JUNIORLIENS ON 1–4 FAMILY RESIDENTIALPROPERTIES

Amidst continued uncertainty in the economyand the housing market, federally regulatedfinancial institutions are reminded to monitor allcredit quality indicators relevant to credit port-folios, including junior liens. While the follow-ing guidance specifically addresses junior liens,it contains principles that apply to estimatingthe ALLL for all types of loans. Institutions alsoare reminded to follow appropriate risk-management principles in managing junior-lienloans and lines of credit, including those in theMay 2005 guidance.

The December 2006 ‘‘Interagency PolicyStatement on the Allowance for Loan and LeaseLosses’’ (IPS) states: ‘‘Estimates of credit lossesshould reflect consideration of the significantfactors that affect the collectibility of the port-folio as of the evaluation date.’’ (See section2065.3.)

The ‘‘Interagency Credit Risk ManagementGuidance for Home Equity Lending’’ states:‘‘Financial institutions should establish anappropriate ALLL and hold capital commensu-rate with the riskiness of portfolios. In determin-ing the ALLL adequacy, an institution shouldconsider how the interest-only and draw fea-tures of home equity lines of credit (HELOCs)during the lines’ revolving periods could affectthe loss curves for the HELOC portfolio. Thoseinstitutions engaging in programmatic subprimehome equity lending or institutions that havehigher risk products are expected to recognizethe elevated risk of the activity when assessingcapital and ALLL adequacy.’’

While the 2012 ALLL guidance specificallyaddresses junior liens, it contains principles thatapply to estimating the ALLL for all types ofloans.

1. The federal banking agencies are the Board of Gover-nors of the Federal Reserve System (Federal Reserve Board),the Federal Deposit Insurance Corporation (FDIC), the Officeof the Comptroller of the Currency (OCC), and the NationalCredit Union Administration (NCUA).


2065.5.1.1 Responsibilities ofManagement

2065.5.1.1.1 Consideration of AllSignificant Factors

Institutions should ensure that during the ALLLestimation process sufficient information is gath-ered to adequately assess the probable lossincurred within junior-lien portfolios. Generally,this information should include the delinquencystatus of senior liens associated with the institu-tion’s junior liens and whether the senior-lienloan has been modified. Institutions with signifi-cant holdings of junior liens should gather andanalyze data on the associated senior-lien loansit owns or services. When an institution does notown or service the associated senior-lien loans,it should use reasonably available tools to deter-mine the payment status of the senior-lien loans.Such tools include obtaining credit reports ordata from third-party services to assist in match-ing an institution’s junior liens with its associ-ated senior liens. Additionally, an institutionmay, as a proxy, use the relevant performancedata on similar senior liens it owns or services.An institution with an insignificant volume ofjunior-lien loans and lines of credit may usejudgment when determining what informationabout associated senior liens not owned or ser-viced is reasonably available.

Institutions with significant holdings of juniorliens should also periodically refresh othercredit quality indicators the organization hasdeemed relevant about the collectibility of itsjunior liens, such as borrower credit scores andcombined loan-to-value ratios (CLTVs), whichinclude both the senior and junior liens. Aninstitution should refresh relevant credit qual-ity indicators as often as necessary consideringeconomic and housing market conditions thataffect the institution’s junior-lien portfolio. Asnoted in SR-06-17, ‘‘changes in the level of theALLL should be directionally consistent withchanges in the factors, taken as a whole, thatevidence credit losses.’’ For example, if declin-ing credit quality trends in the factors relevantto either junior liens or their associated senior-lien loans are evident, the ALLL level as apercentage of the junior-lien portfolio shouldgenerally increase, barring unusual charge-offactivity. Similarly, if improving credit qualitytrends are evident, the ALLL level as a percent-age of the junior-lien portfolio should gener-ally decrease.

Institutions routinely gather information forcredit-risk management purposes, but some maynot fully use that information in the allowanceestimation process. Institutions should considerall reasonably available and relevant informa-tion in the allowance estimation process, includ-ing information obtained for credit-risk manage-ment purposes. Financial Accounting StandardsBoard Accounting Standards Codification(ASC) Topic 450 states that losses should beaccrued by a charge to income if informationavailable prior to issuance of the financial state-ments indicates that it is probable that an assethas been impaired. The 2006 IPS states, ‘‘...esti-mates of credit losses should reflect consider-ation of all significant factors.’’ (See SR-06-17and its attachment.) Consequently, it is consid-ered inconsistent with both GAAP and supervi-sory guidance to fail to gather and considerreasonably available and relevant informationthat would significantly affect management’sjudgment about the collectibility of theportfolio.2

2065.5.1.1.2 Adequate Segmentation

Institutions normally segment their loan port-folio into groups of loans based on risk charac-teristics as part of the ALLL estimation pro-cess. Institutions with significant holdings ofjunior liens should ensure adequate segmenta-tion within their junior-lien portfolio to appro-priately estimate the allowance for high-risksegments within this portfolio. A lack of seg-mentation can result in an allowance estab-lished for the entire junior-lien portfolio that islower than what the allowance would be ifhigh-risk loans were segregated and groupedtogether for evaluation in one or more separatesegments. The following credit quality indica-tors may be appropriate for use in identifyinghigh-risk junior-lien portfolio segments:

• delinquency and modification status of aninstitution’s junior liens

• delinquency and modification status of senior-lien loans associated with an institution’sjunior liens

2. ‘‘Portfolio’’ refers to loans collectively evaluated forimpairment under ASC Topic 450; this supervisory guidancemay also be applicable to junior-lien loans that are subject tomeasurement for impairment under ASC Subtopic 310-10,Receivables - Overall (formerly Statement of FinancialAccounting Standards No. 114, Accounting by Creditors forImpairment of a Loan) and ASC Subtopic 310-30, Loans andDebt Securities Acquired with Deteriorated Credit Quality(formerly AICPA Statement of Position 03-3, Accounting forCertain Loans or Debt Securities Acquired in a Transfer).

ALLL Estimation Practices for Loans Secured by Junior Liens 2065.5


• current borrower credit score• current CLTV• origination channel• documentation type• property type (for example, investor owned or

owner-occupied)• geographic location of property• origination vintage• HELOCs where the borrower is making only

the minimum payment due• HELOCs where current information and con-

ditions indicate that the borrower will be sub-ject to payment shock

In particular, institutions should ensure theirALLL methodology adequately incorporates theelevated borrower default risk associated withpayment shocks due to (1) rising interest ratesfor adjustable rate junior liens, includingHELOCs,3 or (2) HELOCs converting frominterest-only to amortizing loans. If the defaultrate of junior liens that have experienced pay-ment shock is higher than the default rate ofjunior liens that have not experienced paymentshock, an institution should determine whetherit has a significant number of junior liensapproaching their conversion to amortizingloans or approaching an interest rate adjustmentdate. If so, to ensure the institution’s estimate ofcredit losses is not understated, it would benecessary to adjust historical default rates onthese junior liens to incorporate the effect ofpayment shocks that, based on current informa-tion and conditions, are likely to occur.

Adequate segmentation of the junior-lienportfolio by risk factors should facilitate aninstitution’s ability to track default rates andloss severity for high-risk segments and its abil-ity to appropriately incorporate these data intothe allowance estimation process.

2065.5.1.1.3 Qualitative orEnvironmental Factor Adjustments

As noted in SR-06-17, institutions should adjusta loan group’s historical loss rate for the effectof qualitative or environmental factors that arelikely to cause estimated credit losses as of theevaluation date to differ from the group’s his-torical loss experience. Institutions typicallyreflect the overall effect of these factors on aloan group as an adjustment that, as appropriate,

increases or decreases the historical loss rateapplied to the loan group. Alternatively, theeffect of these factors may be reflected throughseparate standalone adjustments within the ASCSubtopic 450-20 component of the ALLL.

When an institution uses qualitative or envi-ronmental factors to estimate probable lossesrelated to individual high-risk segments withinthe junior-lien portfolio, any adjustment to thehistorical loss rate or any separate standaloneadjustment should be supported by an analysisthat relates the adjustment to the characteristicsof and trends in the individual risk segments. Inaddition, changes in the allowance allocation forjunior liens should be directionally consistentwith changes in the factors taken as a whole thatevidence credit losses on junior liens, keeping inmind the characteristics of the institution’sjunior-lien portfolio.

2065.5.1.1.4 Charge-Off and NonaccrualPolicies

Banking institutions should ensure that theircharge-off policy on junior liens is in accor-dance with the June 2000 Uniform Retail CreditClassification and Account Management Policy.(See SR-00-8 and the appendix of section2241.0.1.) As stated in SR-06-17, ‘‘when avail-able information confirms that specific loans, orportions thereof, are uncollectible, theseamounts should be promptly charged off againstthe ALLL.’’

Institutions also should ensure that income-recognition practices related to junior liens areappropriate. Consistent with GAAP and regula-tory guidance, institutions are expected to haverevenue recognition practices that do not resultin overstating income. Placing a junior lien onnonaccrual, including a current junior lien, whenpayment of principal or interest in full is notexpected is one appropriate method to ensurethat income is not overstated. An institution’sincome-recognition policy should incorporatemanagement’s consideration of all reasonablyavailable information including, for junior liens,the performance of the associated senior liens aswell as trends in other credit quality indicators.The policy should require that consideration ofthese factors takes place before foreclosure onthe senior lien or delinquency of the junior lien.The policy should also explain how manage-ment’s consideration of these factors affectsincome recognition prior to foreclosure on the3. Forecasts of future interest rate increases should not be

included in the determination of the ALLL. However, if rateshave risen since the last rate adjustment, the effect of theincrease on the amount of the payment at the next rateadjustment should be considered.



senior lien or delinquency of the junior lien toensure income is not overstated.

2065.5.1.1.5 Responsibilities ofExaminers

To the extent an institution has significant hold-ings of junior liens, examiners should assess theappropriateness of the institution’s ALLL meth-odology and documentation related to theseloans, and the appropriateness of the level of theALLL established for this portfolio. As noted inSR-06-17, for analytical purposes, an institutionshould attribute portions of the ALLL to loansthat it individually evaluates and determines tobe impaired under ASC Subtopic 310-10 and togroups of loans that it evaluates collectivelyunder ASC Subtopic 450-20. However, theALLL is available to cover all charge-offs thatarise from the loan portfolio.

Consistent with SR-06-17, in their review ofthe junior-lien portfolio, examiners should con-sider all significant factors that affect the collect-ability of the portfolio. Examiners should takethe following steps when reviewing the appro-priateness of an institution’s allowance that isestablished for junior liens:

• Evaluate the institution’s ALLL policies andprocedures and assess the methodology thatmanagement uses to arrive at an overall esti-mate of the ALLL for junior liens. This shouldinclude whether all significant qualitative orenvironmental factors that affect the collect-ability of the portfolio (including those factorspreviously discussed) have been appropriatelyconsidered in accordance with GAAP.

• Review management’s use of loss-estimationmodels or other loss estimation tools to ensurethat the resulting estimated credit losses are inconformity with GAAP.

• Review management’s support for any quali-tative or environmental factor adjustments tothe allowance related to junior liens. Examin-ers should ensure that all relevant qualitativeor environmental factors were considered andadjustments to historical loss rates for specificrisk segments within the junior-lien portfolioare supported by an analysis that relates theadjustments to the characteristics of andtrends in the individual risk segments.

• Review the interest income accounts associ-ated with junior liens to ensure that the institu-tion’s net income is not overstated.

If the examiner concludes that the reportedALLL for junior liens is not appropriate ordetermines that the ALLL evaluation process isdeficient, recommendations for correcting thesedeficiencies, including any examiner concernsregarding an appropriate level for the ALLL,should be noted in the inspection report. Exam-iners should cite any departures from GAAPand regulatory guidance, as applicable. Addi-tional supervisory action may also be takenbased on the magnitude of the observed short-comings in the ALLL process.


The inspection objectives for an institution thathas significant holdings of loans secured byjunior liens are as follows:

1. To evaluate the appropriateness of the institu-tion’s methodology and documentation ofthe ALLL related to these loans.

2. To ascertain whether the institution’s poli-cies, practices, procedures, and internal con-trols regarding the ALLL estimation prac-tices for loans secured by junior liens aresufficient.

3. To determine whether the level of the ALLLis reasonable and adequate for the institu-tion’s volume of such loans outstanding.

4. To evaluate if the institution has fully consid-ered and accounted for all significant qualita-tive or environmental factors that affect thecollectability of such loans.

5. To ascertain whether the portfolio has beenproperly accounted in accordance withGAAP and whether all applicable supervi-sory and regulatory guidance, as well asstatutory and regulatory requirements, havebeen adhered to.


1. To the extent an institution has significantholdings of loans secured by junior liens,assess the appropriateness of the institution’sa. ALLL methodology and documentation

related to these loans, andb. ALLL level established for this portfolio.

2. During the inspection’s review of the of thejunior-lien portfolio, consider all significantqualitative or environmental factors thataffect the collectibility of the junior-lienportfolio and whether they have beenappropriately considered in accordance withGAAP.



3. Perform the following steps when reviewingthe appropriateness of the institution’s ALLLthat is established for junior liens:a. Evaluate the institution’s ALLL policies

and procedures and assess the methodol-ogy that management uses to arrive at anoverall estimate of the ALLL for juniorliens.

b. Review management’s use of loss-estimation models or other loss-estimationtools to ensure that the resulting estimatedcredit losses are in conformity withGAAP.

c. Review management’s support for anyqualitative or environmental factor adjust-ments to the ALLL related to junior liens.Ensure that all relevant qualitative orenvironmental factors were considered

and adjustments to historical loss rates forspecific risk segments within the junior-lien portfolio are supported by an analysisthat relates the adjustment to the charac-teristics of and trends in the individualrisk segments.

d. Review the interest income accounts asso-ciated with junior liens to ensure that theinstitution’s net income is not overstated.

4. Provide comments in the inspection reportwhen the ALLL for junior liens is not appro-priate or if the ALLL evaluation process isdeficient. Include recommendations for cor-recting these deficiencies and any concernsregarding an appropriate level for the ALLL.

5. Cite in the inspection report any departuresfrom GAAP and regulatory guidance, asapplicable.



Sound Incentive Compensation PoliciesSection 2068.0

Incentive compensation practices in the finan-cial industry were one of many factors thatcontributed to the financial crisis that began inmid-2007. Banking organizations too oftenrewarded employees for increasing the organiza-tion’s revenue or short-term profit withoutadequate recognition of the risks the employees’activities posed to the organization.1 These prac-tices exacerbated the risks and losses at a num-ber of banking organizations and resulted in themisalignment of the interests of employees withthe long-term well-being and safety and sound-ness of their organizations. This section pro-vides guidance on sound incentive compensa-tion practices to banking organizationssupervised by the Federal Reserve (also theOffice of the Comptroller of the Currency, theFederal Deposit Insurance Corporation, and theOffice of Thrift Supervision (collectively, the‘‘Agencies’’)).2 This guidance is intended toassist banking organizations in designing andimplementing incentive compensation arrange-ments and related policies and procedures thateffectively consider potential risks and riskoutcomes.3

Alignment of incentives provided to employ-ees with the interests of shareholders of theorganization often also benefits safety andsoundness. However, aligning employee incen-tives with the interests of shareholders is notalways sufficient to address safety-and-soundness concerns. Because of the presence ofthe federal safety net, (including the ability ofinsured depository institutions to raise insureddeposits and access the discount window andpayment services of the Federal Reserve), share-holders of a banking organization in some casesmay be willing to tolerate a degree of risk that isinconsistent with the organization’s safety and

soundness. Accordingly, the Federal Reserveexpects banking organizations to maintainincentive compensation practices that are con-sistent with safety and soundness, even whenthese practices go beyond those needed to alignshareholder and employee interests.

To be consistent with safety and soundness,incentive compensation arrangements4 at abanking organization should:

1. Provide employees incentives that appropri-ately balance risk and reward;

2. Be compatible with effective controls andrisk-management; and

3. Be supported by strong corporate gover-nance, including active and effective over-sight by the organization’s board of directors.

These principles, and the types of policies, pro-cedures, and systems that banking organiza-tions should have to help ensure compliancewith them, are discussed later in this guidance.

The Federal Reserve expects banking organi-zations to regularly review their incentive com-pensation arrangements for all executive andnon-executive employees who, either individu-ally or as part of a group, have the ability toexpose the organization to material amounts ofrisk, as well as to regularly review the risk-management, control, and corporate governanceprocesses related to these arrangements. Bank-ing organizations should immediately addressany identified deficiencies in these arrangementsor processes that are inconsistent with safetyand soundness. Banking organizations areresponsible for ensuring that their incentivecompensation arrangements are consistent withthe principles described in this guidance andthat they do not encourage employees to exposethe organization to imprudent risks that maypose a threat to the safety and soundness of theorganization.1. Examples of risks that may present a threat to the

organization’s safety and soundness include credit, market,liquidity, operational, legal, compliance, and reputationalrisks.

2. As used in this guidance, the term ‘‘banking organiza-tion’’ includes national banks, state member banks, statenonmember banks, savings associations, U.S. bank holdingcompanies, savings and loan holding companies, Edge andagreement corporations, and the U.S. operations of foreignbanking organizations (FBOs) with a branch, agency, or com-mercial lending company in the United States. If the FederalReserve is referenced, the reference is intended to also includethe other supervisory Agencies.

3. This guidance (see 75 Fed. Reg. 36395, June 25, 2010,for the entire text) and the principles reflected herein areconsistent with the Principles for Sound Compensation Prac-tices issued by the Financial Stability Board (FSB) in April2009, and with the FSB’s Implementation Standards for thoseprinciples, issued in September 2009.

4. In this guidance, the term ‘‘incentive compensation’’refers to that portion of an employee’s current or potentialcompensation that is tied to achievement of one or morespecific metrics (e.g., a level of sales, revenue, or income).Incentive compensation does not include compensation that isawarded solely for, and the payment of which is solely tied to,continued employment (e.g., salary). In addition, the termdoes not include compensation arrangements that are deter-mined based solely on the employee’s level of compensationand does not vary based on one or more performance metrics(e.g., a 401(k) plan under which the organization contributes aset percentage of an employee’s salary).


The Federal Reserve recognizes that incen-tive compensation arrangements often seek toserve several important and worthy objectives.For example, incentive compensation arrange-ments may be used to help attract skilled staff,induce better organization-wide and employeeperformance, promote employee retention, pro-vide retirement security to employees, or allowcompensation expenses to vary with revenue onan organization-wide basis. Moreover, theanalysis and methods for ensuring that incentivecompensation arrangements take appropriateaccount of risk should be tailored to the size,complexity, business strategy, and risk toleranceof each organization. The resources requiredwill depend upon the complexity of the firm andits use of incentive compensation arrangements.For some, the task of designing and implement-ing compensation arrangements that properlyoffer incentives for executive and non-executiveemployees to pursue the organization’s long-term well-being and that do not encourageimprudent risk-taking is a complex task that willrequire the commitment of adequate resources.

While issues related to designing and imple-menting incentive compensation arrangementsare complex, the Federal Reserve is committedto ensuring that banking organizations moveforward in incorporating the principlesdescribed in this guidance into their incentivecompensation practices.5

As discussed further below, because of thesize and complexity of their operations, Largecomplex banking organizations (LCBOs)6

should have and adhere to systematic and for-

malized policies, procedures, and processes.These are considered important in ensuring thatincentive compensation arrangements for allcovered employees are identified and reviewedby appropriate levels of management (includingthe board of directors where appropriate andcontrol units), and that they appropriately bal-ance risks and rewards. In several places, thisguidance specifically highlights the types ofpolicies, procedures, and systems that LCBOsshould have and maintain, but that generally arenot expected of smaller, less complex organiza-tions. LCBOs warrant the most intensive super-visory attention because they are significantusers of incentive compensation arrangementsand because flawed approaches at these organi-zations are more likely to have adverse effectson the broader financial system. The FederalReserve will work with LCBOs as necessarythrough the supervisory process to ensure thatthey promptly correct any deficiencies that maybe inconsistent with the safety and soundness ofthe organization.

The policies, procedures, and systems ofsmaller banking organizations that use incentivecompensation arrangements7 are expected to beless extensive, formalized, and detailed thanthose of LCBOs. Supervisory reviews of incen-tive compensation arrangements at smaller, less-complex banking organizations will be con-ducted by the Federal Reserve as part of theevaluation of those organizations’ risk-management, internal controls, and corporategovernance during the regular, risk-focusedexamination process. These reviews will be tai-lored to reflect the scope and complexity of anorganization’s activities, as well as the preva-lence and scope of its incentive compensationarrangements. Little, if any, additional examina-tion work is expected for smaller banking orga-nizations that do not use, to a significant extent,incentive compensation arrangements.8

For all banking organizations, supervisoryfindings related to incentive compensation willbe communicated to the organization andincluded in the relevant report of examination orinspection. In addition, these findings will beincorporated, as appropriate, into the organiza-

5. In December 2009 the Federal Reserve, working withthe other Agencies, initiated a special horizontal review ofincentive compensation arrangements and related risk-management, control, and corporate governance practices oflarge banking organizations (LBOs). This initiative wasdesigned to spur and monitor the industry’s progress towardsthe implementation of safe and sound incentive compensationarrangements, identify emerging best practices, and advancethe state of practice more generally in the industry.

6. For supervisory purposes, the Federal Reserve (as wellas the other federal bank regulatory agencies) segments theorganizations it supervises into different supervisory port-folios based on, among other things, size, complexity, and riskprofile. For purposes of this guidance, the LBOs referred to inthe guidance are identified in this section as large complexbanking organizations to be consistent with the FederalReserve’s other supervisory policies. LBOs are designated by(1) the OCC as the largest and most complex national banksas defined in the Large Bank Supervision booklet of theComptroller’s Handbook; (2) the FDIC, large, complexinsured depository institutions (IDIs); and (3) the OTS, thelargest and most complex savings associations and savingsand loan holding companies.

7. This guidance does not apply to banking organizationsthat do not use incentive compensation.

8. To facilitate these reviews, where appropriate, a smallerbanking organization should review its compensation arrange-ments to determine whether it uses incentive compensationarrangements to a significant extent in its business operations.A smaller banking organization will not be considered asignificant user of incentive compensation arrangements sim-ply because the organization has a firm-wide profit-sharing orbonus plan that is based on the bank’s profitability, even if theplan covers all or most of the organization’s employees.

Sound Incentive Compensation Policies 2068.0


tion’s rating component(s) and subcomponent(s)relating to risk-management, internal controls,and corporate governance under the relevantsupervisory rating system, as well as the organi-zation’s overall supervisory rating.

The Federal Reserve (or the organization’sappropriate federal supervisor) may takeenforcement action against a banking organiza-tion if its incentive compensation arrangementsor related risk-management, control, or gover-nance processes pose a risk to the safety andsoundness of the organization, particularly whenthe organization is not taking prompt and effec-tive measures to correct the deficiencies. Forexample, the appropriate federal supervisor maytake an enforcement action if material deficien-cies are found to exist in the organization’sincentive compensation arrangements or relatedrisk-management, control, or governance pro-cesses, or the organization fails to promptlydevelop, submit, or adhere to an effective plandesigned to ensure that its incentive compensa-tion arrangements do not encourage imprudentrisk-taking and are consistent with principles ofsafety and soundness. As provided under sec-tion 8 of the Federal Deposit Insurance Act (12U.S.C. 1818), an enforcement action may,among other things, require an organization totake affirmative action, such as developing acorrective action plan that is acceptable to theappropriate federal supervisor to rectify safety-and-soundness deficiencies in its incentive com-pensation arrangements or related processes.Where warranted, the appropriate federal super-visor may require the organization to take addi-tional affirmative action to correct or remedydeficiencies related to the organization’s incen-tive compensation practices.

Effective and balanced incentive compensa-tion practices are likely to evolve significantlyin the coming years, spurred by the efforts ofbanking organizations, supervisors, and otherstakeholders. The Federal Reserve will reviewand update this guidance as appropriate to incor-porate best practices that emerge from theseefforts.

2068.0.1 SCOPE OF APPLICATION

The incentive compensation arrangements andrelated policies and procedures of banking orga-nizations should be consistent with principles ofsafety and soundness.9 Incentive compensation

arrangements for executive officers as well asfor non-executive personnel who have the abil-ity to expose a banking organization to materialamounts of risk may, if not properly structured,pose a threat to the organization’s safety andsoundness. Accordingly, this guidance appliesto incentive compensation arrangements for:

1. Senior executives and others who are respon-sible for oversight of the organization’s firm-wide activities or material business lines;10

2. Individual employees, including non-executive employees, whose activities mayexpose the organization to material amountsof risk (e.g., traders with large position limitsrelative to the organization’s overall risk tol-erance); and

3. Groups of employees who are subject to thesame or similar incentive compensationarrangements and who, in the aggregate, mayexpose the organization to material amountsof risk, even if no individual employee islikely to expose the organization to materialrisk (e.g., loan officers who, as a group,originate loans that account for a materialamount of the organization’s credit risk).

For ease of reference, these executive andnon-executive employees are collectivelyreferred to hereafter as ‘‘covered employees’’ or‘‘employees.’’ Depending on the facts and cir-cumstances of the individual organization, thetypes of employees or categories of employeesthat are outside the scope of this guidancebecause they do not have the ability to exposethe organization to material risks would likelyinclude, for example, tellers, bookkeepers, cou-riers, or data processing personnel.

In determining whether an employee, orgroup of employees, may expose a bankingorganization to material risk, the organization

9. In the case of the U.S. operations of FBOs, the organiza-tion’s policies, including management, review, and approvalrequirements for its U.S. operations, should be coordinated

with the FBO’s group-wide policies developed in accordancewith the rules of the FBO’s home country supervisor. Thepolicies of the FBO’s U.S. operations should also be consis-tent with the FBO’s overall corporate and management struc-ture, as well as its framework for risk-management and inter-nal controls. In addition, the policies for the U.S. operations ofFBOs should be consistent with this guidance.

10. Senior executives include, at a minimum, ‘‘executiveofficers’’ within the meaning of the Federal Reserve’s Regula-tion O (see 12 CFR 215.2(e)(1)) and, for publicly tradedcompanies, ‘‘named officers’’ within the meaning of the Secu-rities and Exchange Commission’s rules on disclosure ofexecutive compensation (see 17 CFR 229.402(a)(3)). Savingsassociations should also refer to OTS’s rule on loans bysaving associations to their executive officers, directors, andprincipal shareholders. (12 CFR 563.43).



should consider the full range of inherent risksarising from, or generated by, the employee’sactivities, even if the organization uses risk-management processes or controls to limit therisks such activities ultimately may pose to theorganization. Moreover, risks should be consid-ered to be material for purposes of this guidanceif they are material to the organization, or arematerial to a business line or operating unit thatis itself material to the organization.11

For purposes of illustration, assume that abanking organization has a structured-financeunit that is material to the organization. A groupof employees within that unit who originatestructured-finance transactions that may exposethe unit to material risks should be considered‘‘covered employees’’ for purposes of this guid-ance even if those transactions must beapproved by an independent risk function priorto consummation, or the organization uses otherprocesses or methods to limit the risk that suchtransactions may present to the organization.

Strong and effective risk-management andinternal control functions are critical to thesafety and soundness of banking organizations.However, irrespective of the quality of thesefunctions, poorly designed or managed incen-tive compensation arrangements can themselvesbe a source of risk to a banking organization.For example, incentive compensation arrange-ments that provide employees strong incentivesto increase the organization’s short-term rev-enues or profits, without regard to the short- orlong-term risk associated with such business,can place substantial strain on the risk-management and internal control functions ofeven well-managed organizations.

Moreover, poorly balanced incentive compen-sation arrangements can encourage employeesto take affirmative actions to weaken or circum-vent the organization’s risk-management orinternal control functions, such as by providinginaccurate or incomplete information to thesefunctions, to boost the employee’s personalcompensation. Accordingly, sound compensa-tion practices are an integral part of strong risk-management and internal control functions. Akey goal of this guidance is to encourage bank-ing organizations to incorporate the risks relatedto incentive compensation into their broaderrisk-management framework. Risk-management

procedures and risk controls that ordinarily limitrisk-taking do not obviate the need for incentivecompensation arrangements to properly balancerisk-taking incentives.

2068.0.2 PRINCIPLES OF A SOUNDINCENTIVE COMPENSATIONSYSTEM

2068.0.2.1 Principle 1: BalancedRisk-Taking Incentives

Incentive compensation arrangements shouldbalance risk and financial results in a mannerthat does not encourage employees to exposetheir organizations to imprudent risks.

Incentive compensation arrangements typicallyattempt to encourage actions that result ingreater revenue or profit for the organization.However, short-run revenue or profit can oftendiverge sharply from actual long-run profitbecause risk outcomes may become clear onlyover time. Activities that carry higher risk typi-cally yield higher short-term revenue, and anemployee who is given incentives to increaseshort-term revenue or profit, without regard torisk, will naturally be attracted to opportunitiesto expose the organization to more risk.

An incentive compensation arrangement isbalanced when the amounts paid to an employeeappropriately take into account the risks (includ-ing compliance risks), as well as the financialbenefits, from the employee’s activities and theimpact of those activities on the organization’ssafety and soundness. As an example, under abalanced incentive compensation arrangement,two employees who generate the same amountof short-term revenue or profit for an organiza-tion should not receive the same amount ofincentive compensation if the risks taken by theemployees in generating that revenue or profitdiffer materially. The employee whose activitiescreate materially larger risks for the organiza-tion should receive less than the other employee,all else being equal.

The performance measures used in an incen-tive compensation arrangement have an impor-tant effect on the incentives provided employeesand, thus, the potential for the arrangement toencourage imprudent risk-taking. For example,if an employee’s incentive compensation pay-ments are closely tied to short-term revenue orprofit of business generated by the employee,without any adjustments for the risks associatedwith the business generated, the potential for thearrangement to encourage imprudent risk-taking

11. Thus, risks may be material to an organization even ifthey are not large enough themselves to threaten the solvencyof the organization.



may be quite strong. Similarly, traders whowork with positions that close at year-end couldhave an incentive to take large risks toward theend of a year if there is no mechanism forfactoring how such positions perform over alonger period of time. The same result couldensue if the performance measures themselveslack integrity or can be manipulated inappropri-ately by the employees receiving incentivecompensation.

On the other hand, if an employee’s incentivecompensation payments are determined basedon performance measures that are only distantlylinked to the employee’s activities (e.g., formost employees, organization-wide profit), thepotential for the arrangement to encourage theemployee to take imprudent risks on behalf ofthe organization may be weak. For this reason,plans that provide for awards based solely onoverall organization-wide performance areunlikely to provide employees, other than seniorexecutives and individuals who have the abilityto materially affect the organization’s overallrisk profile, with unbalanced risk-takingincentives.

Incentive compensation arrangements shouldnot only be balanced in design, they also shouldbe implemented so that actual payments varybased on risks or risk outcomes. If, for example,employees are paid substantially all of theirpotential incentive compensation even when riskor risk outcomes are materially worse thanexpected, employees have less incentive toavoid activities with substantial risk.

• Banking organizations should consider thefull range of risks associated with an employ-ee’s activities, as well as the time horizonover which those risks may be realized, inassessing whether incentive compensationarrangements are balanced.

The activities of employees may create a widerange of risks for a banking organization, suchas credit, market, liquidity, operational, legal,compliance, and reputational risks, as well asother risks to the viability or operation of theorganization. Some of these risks may be real-ized in the short term, while others may becomeapparent only over the long term. For example,future revenues that are booked as currentincome may not materialize, and short-termprofit-and-loss measures may not appropriatelyreflect differences in the risks associated withthe revenue derived from different activities(e.g., the higher credit or compliance risk associ-

ated with subprime loans versus prime loans).12

In addition, some risks (or combinations of riskystrategies and positions) may have a low prob-ability of being realized, but would have highlyadverse effects on the organization if they wereto be realized (‘‘bad tail risks’’). While share-holders may have less incentive to guard againstbad tail risks because of the infrequency of theirrealization and the existence of the federalsafety net, these risks warrant special attentionfor safety-and-soundness reasons given thethreat they pose to the organization’s solvencyand the federal safety net.

Banking organizations should consider thefull range of current and potential risks associ-ated with the activities of covered employees,including the cost and amount of capital andliquidity needed to support those risks, in devel-oping balanced incentive compensation arrange-ments. Reliable quantitative measures of riskand risk outcomes (‘‘quantitative measures’’),where available, may be particularly useful indeveloping balanced compensation arrange-ments and in assessing the extent to whicharrangements are properly balanced. However,reliable quantitative measures may not be avail-able for all types of risk or for all activities, andtheir utility for use in compensation arrange-ments varies across business lines and employ-ees. The absence of reliable quantitative mea-sures for certain types of risks or outcomes doesnot mean that banking organizations shouldignore such risks or outcomes for purposes ofassessing whether an incentive compensationarrangement achieves balance. For example,while reliable quantitative measures may notexist for many bad-tail risks, it is important thatsuch risks be considered given their potentialeffect on safety and soundness. As in otherrisk-management areas, banking organizationsshould rely on informed judgments, supportedby available data, to estimate risks and riskoutcomes in the absence of reliable quantitativerisk measures.

Large complex banking organizations. Indesigning and modifying incentive compensa-tion arrangements, LCBOs should assess inadvance of implementation whether such

12. Importantly, the time horizon over which a risk out-come may be realized is not necessarily the same as the statedmaturity of an exposure. For example, the ongoing reinvest-ment of funds by a cash management unit in commercialpaper with a one-day maturity not only exposes the organiza-tion to one-day credit risk, but also exposes the organizationto liquidity risk that may be realized only infrequently.



arrangements are likely to provide balancedrisk-taking incentives. Simulation analysis ofincentive compensation arrangements is oneway of doing so. Such analysis uses forward-looking projections of incentive compensationawards and payments based on a range of per-formance levels, risk outcomes, and levels ofrisks taken. This type of analysis, or other analy-sis that results in assessments of likely effective-ness, can help an LCBO assess whether incen-tive compensation awards and payments to anemployee are likely to be reduced appropriatelyas the risks to the organization from the employ-ee’s activities increase.

• An unbalanced arrangement can be movedtoward balance by adding or modifying fea-tures that cause the amounts ultimatelyreceived by employees to appropriately reflectrisk and risk outcomes.

If an incentive compensation arrangementmay encourage employees to expose their bank-ing organization to imprudent risks, the organi-zation should modify the arrangement as neededto ensure that it is consistent with safety andsoundness. Four methods are often used to makecompensation more sensitive to risk. Thesemethods are:

1. Risk Adjustment of Awards: The amount ofan incentive compensation award for anemployee is adjusted based on measures thattake into account the risk the employee’sactivities may pose to the organization. Suchmeasures may be quantitative, or the size ofa risk adjustment may be set judgmentally,subject to appropriate oversight.

2. Deferral of Payment: The actual payout ofan award to an employee is delayed signifi-cantly beyond the end of the performanceperiod, and the amounts paid are adjusted foractual losses or other aspects of performancethat are realized or become better knownonly during the deferral period.13 Deferredpayouts may be altered according to risk

outcomes either formulaically or judgmen-tally, subject to appropriate oversight. To bemost effective, the deferral period should besufficiently long to allow for the realizationof a substantial portion of the risks fromemployee activities, and the measures of lossshould be clearly explained to employeesand closely tied to their activities during therelevant performance period.

3. Longer Performance Periods: The timeperiod covered by the performance measuresused in determining an employee’s award isextended (for example, from one year to twoor more years). Longer performance periodsand deferral of payment are related in thatboth methods allow awards or payments tobe made after some or all risk outcomes arerealized or better known.

4. Reduced Sensitivity to Short-Term Perfor-mance: The banking organization reducesthe rate at which awards increase as anemployee achieves higher levels of the rel-evant performance measure(s). Rather thanoffsetting risk-taking incentives associatedwith the use of short-term performance mea-sures, this method reduces the magnitude ofsuch incentives. This method also caninclude improving the quality and reliabilityof performance measures in taking intoaccount both short-term and long-term risks,for example improving the reliability andaccuracy of estimates of revenues and long-term profits upon which performance mea-sures depend.14

These methods for achieving balance are notexclusive, and additional methods or variationsmay exist or be developed. Moreover, eachmethod has its own advantages and disadvan-tages. For example, where reliable risk mea-sures exist, risk adjustment of awards may bemore effective than deferral of payment inreducing incentives for imprudent risk-taking.This is because risk adjustment potentially cantake account of the full range and time horizonof risks, rather than just those risk outcomes thatoccur or become more evident during the defer-ral period. On the other hand, deferral of pay-ment may be more effective than risk adjust-ment in mitigating incentives to take hard-to-measure risks (such as the risks of new activities

13. The deferral-of-payment method is sometimes referredto in the industry as a ‘‘clawback.’’ The term ‘‘clawback’’ alsomay refer specifically to an arrangement under which anemployee must return incentive compensation payments pre-viously received by the employee (and not just deferred) ifcertain risk outcomes occur. Section 304 of the Sarbanes-Oxley Act of 2002 (15 U.S.C. 7243), which applies to chiefexecutive officers and chief financial officers of public bank-ing organizations, is an example of this more specific type of‘‘clawback’’ requirement.

14. Performance targets may have a material effect onrisk-taking incentives. Such targets may offer employeesgreater rewards for increments of performance that are abovethe target or may provide that awards will be granted only if atarget is met or exceeded. Employees may be particularlymotivated to take imprudent risk in order to reach perfor-mance targets that are aggressive, but potentially achievable.



or products, or certain risks such as reputationalor operational risk that may be difficult to mea-sure with respect to particular activities), espe-cially if such risks are likely to be realizedduring the deferral period. Accordingly, in somecases two or more methods may be needed incombination for an incentive compensationarrangement to be balanced.

The greater the potential incentives anarrangement creates for an employee to increasethe risks associated with the employee’s activi-ties, the stronger the effect should be of themethods applied to achieve balance. Thus, forexample, risk adjustments used to counteract amaterially unbalanced compensation arrange-ment should have a similarly material impact onthe incentive compensation paid under thearrangement. Further, improvements in the qual-ity and reliability of performance measuresthemselves, for example improving the relia-bility and accuracy of estimates of revenues andprofits upon which performance measuresdepend, can significantly improve the degree ofbalance in risk-taking incentives.

Where judgment plays a significant role inthe design or operation of an incentive compen-sation arrangement, strong policies and proce-dures, internal controls, and ex post monitoringof incentive compensation payments relative toactual risk outcomes are particularly importantto help ensure that the arrangements as imple-mented are balanced and do not encourageimprudent risk-taking. For example, if a bank-ing organization relies to a significant degree onthe judgment of one or more managers to ensurethat the incentive compensation awards toemployees are appropriately risk-adjusted, theorganization should have policies and proce-dures that describe how managers are expectedto exercise that judgment to achieve balance andthat provide for the manager(s) to receive appro-priate available information about the employ-ee’s risk-taking activities to make informedjudgments.

Large complex banking organizations. Meth-ods and practices for making compensation sen-sitive to risk are likely to evolve rapidly duringthe next few years, driven in part by the effortsof supervisors and other stakeholders. LCBOsshould actively monitor developments in thefield and should incorporate into their incentivecompensation systems new or emerging meth-ods or practices that are likely to improve theorganization’s long-term financial well-beingand safety and soundness.

• The manner in which a banking organizationseeks to achieve balanced incentive compen-

sation arrangements should be tailored toaccount for the differences betweenemployees—including the substantial differ-ences between senior executives and otheremployees—as well as between bankingorganizations.

Activities and risks may vary significantlyboth across banking organizations and acrossemployees within a particular banking organiza-tion. For example, activities, risks, and incentivecompensation practices may differ materiallyamong banking organizations based on, amongother things, the scope or complexity of activi-ties conducted and the business strategies pur-sued by the organizations. These differencesmean that methods for achieving balanced com-pensation arrangements at one organization maynot be effective in restraining incentives toengage in imprudent risk-taking at another orga-nization. Each organization is responsible forensuring that its incentive compensationarrangements are consistent with the safety andsoundness of the organization.

Moreover, the risks associated with the activi-ties of one group of non-executive employees(e.g., loan originators) within a banking organi-zation may differ significantly from those ofanother group of non-executive employees (e.g.,spot foreign exchange traders) within the orga-nization. In addition, reliable quantitative mea-sures of risk and risk outcomes are unlikely tobe available for a banking organization as awhole, particularly a large, complex organiza-tion. This factor can make it difficult for bank-ing organizations to achieve balanced compen-sation arrangements for senior executives whohave responsibility for managing risks on anorganization-wide basis solely through use ofthe risk-adjustment-of-award method.

Furthermore, the payment of deferred incen-tive compensation in equity (such as restrictedstock of the organization) or equity-based instru-ments (such as options to acquire the organiza-tion’s stock) may be helpful in restraining therisk-taking incentives of senior executives andother covered employees whose activities mayhave a material effect on the overall financialperformance of the organization. However,equity-related deferred compensation may notbe as effective in restraining the incentives oflower-level covered employees (particularly atlarge organizations) to take risks because suchemployees are unlikely to believe that their



actions will materially affect the organization’sstock price.

Banking organizations should take account ofthese differences when constructing balancedcompensation arrangements. For most bankingorganizations, the use of a single, formulaicapproach to making employee incentive com-pensation arrangements appropriately risk-sensitive is likely to result in arrangements thatare unbalanced at least with respect to someemployees.15

Large complex banking organizations. Incen-tive compensation arrangements for seniorexecutives at LCBOs are likely to be betterbalanced if they involve deferral of a substantialportion of the executives’ incentive compensa-tion over a multi-year period in a way thatreduces the amount received in the event ofpoor performance, substantial use of multi-yearperformance periods, or both. Similarly, thecompensation arrangements for senior execu-tives at LCBOs are likely to be better balancedif a significant portion of the incentive compen-sation of these executives is paid in the form ofequity-based instruments that vest over multipleyears, with the number of instruments ulti-mately received dependent on the performanceof the organization during the deferral period.

The portion of the incentive compensation ofother covered employees that is deferred or paidin the form of equity-based instruments shouldappropriately take into account the level, nature,and duration of the risks that the employees’activities create for the organization and theextent to which those activities may materiallyaffect the overall performance of the organiza-tion and its stock price. Deferral of a substantialportion of an employee’s incentive compensa-tion may not be workable for employees atlower pay scales because of their more limitedfinancial resources. This may require increasedreliance on other measures in the incentive com-pensation arrangements for these employees toachieve balance.

• Banking organizations should carefully con-sider the potential for ‘‘golden parachutes’’and the vesting arrangements for deferred

compensation to affect the risk-taking behav-ior of employees while at the organizations.

Arrangements that provide for an employee(typically a senior executive), upon departurefrom the organization or a change in control ofthe organization, to receive large additional pay-ments or the accelerated payment of deferredamounts without regard to risk or risk outcomescan provide the employee significant incentivesto expose the organization to undue risk. Forexample, an arrangement that provides anemployee with a guaranteed payout upon depar-ture from an organization, regardless of perfor-mance, may neutralize the effect of any balanc-ing features included in the arrangement to helpprevent imprudent risk-taking.

Banking organizations should carefullyreview any such existing or proposed arrange-ments (sometimes called ‘‘golden parachutes’’)and the potential impact of such arrangementson the organization’s safety and soundness. Inappropriate circumstances an organizationshould consider including balancing features—such as risk adjustment or deferral requirementsthat extend past the employee’s departure—inthe arrangements to mitigate the potential forthe arrangements to encourage imprudent risk-taking. In all cases, a banking organizationshould ensure that the structure and terms of anygolden parachute arrangement entered into bythe organization do not encourage imprudentrisk-taking in light of the other features of theemployee’s incentive compensation arrange-ments.

Large complex banking organizations. Provi-sions that require a departing employee to for-feit deferred incentive compensation paymentsmay weaken the effectiveness of the deferralarrangement if the departing employee is able tonegotiate a ‘‘golden handshake’’ arrangementwith the new employer.16 This weakening effectcan be particularly significant for senior execu-tives or other skilled employees at LCBOswhose services are in high demand within themarket.

Golden handshake arrangements present spe-cial issues for LCBOs and supervisors. Forexample, while a banking organization couldadjust its deferral arrangements so that depart-ing employees will continue to receive anyaccrued deferred compensation after departure

15. For example, spreading payouts of incentive compen-sation awards over a standard three-year period may notappropriately reflect the differences in the type and timehorizon of risk associated with the activities of differentgroups of employees, and may not be sufficient by itself tobalance the compensation arrangements of employees whomay expose the organization to substantial longer-term risks.

16. Golden handshakes are arrangements that compensatean employee for some or all of the estimated, non-adjustedvalue of deferred incentive compensation that would havebeen forfeited upon departure from the employee’s previousemployment.



(subject to any clawback or malus17), thesechanges could reduce the employee’s incentiveto remain at the organization and, thus, weakenan organization’s ability to retain qualified tal-ent, which is an important goal of compensa-tion, and create conflicts of interest. Moreover,actions of the hiring organization (which may ormay not be a supervised banking organization)ultimately may defeat these or other risk-balancing aspects of a banking organization’sdeferral arrangements. LCBOs should monitorwhether golden handshake arrangements arematerially weakening the organization’s effortsto constrain the risk-taking incentives ofemployees. The Federal Reserve will continueto work with banking organizations and othersto develop appropriate methods for addressingany effect that such arrangements may have onthe safety and soundness of banking organiza-tions.

• Banking organizations should effectively com-municate to employees the ways in whichincentive compensation awards and paymentswill be reduced as risks increase.

In order for the risk-sensitive provisions ofincentive compensation arrangements to affectemployee risk-taking behavior, the organiza-tion’s employees need to understand that theamount of incentive compensation that they mayreceive will vary based on the risk associatedwith their activities. Accordingly, banking orga-nizations should ensure that employees coveredby an incentive compensation arrangement areinformed about the key ways in which risks aretaken into account in determining the amount ofincentive compensation paid. Where feasible, anorganization’s communications with employeesshould include examples of how incentive com-pensation payments may be adjusted to reflectprojected or actual risk outcomes. An organiza-tion’s communications should be tailored appro-priately to reflect the sophistication of the rel-evant audience(s).

2068.0.2.2 Principle 2: Compatibilitywith Effective Controls andRisk-Management

A banking organization’s risk-management pro-cesses and internal controls should reinforceand support the development and maintenanceof balanced incentive compensation arrange-ments.

In order to increase their own compensation,employees may seek to evade the processesestablished by a banking organization to achievebalanced compensation arrangements. Similarly,an employee covered by an incentive compensa-tion arrangement may seek to influence, in waysdesigned to increase the employee’s pay, therisk measures or other information or judgmentsthat are used to make the employee’s pay sensi-tive to risk.

Such actions may significantly weaken theeffectiveness of an organization’s incentivecompensation arrangements in restricting impru-dent risk-taking. These actions can have a par-ticularly damaging effect on the safety andsoundness of the organization if they result inthe weakening of risk measures, information, orjudgments that the organization uses for otherrisk-management, internal control, or financialpurposes. In such cases, the employee’s actionsmay weaken not only the balance of the organi-zation’s incentive compensation arrangements,but also the risk-management, internal controls,and other functions that are supposed to act as aseparate check on risk-taking. For this reason,traditional risk-management controls alone donot eliminate the need to identify employeeswho may expose the organization to materialrisk, nor do they obviate the need for the incen-tive compensation arrangements for theseemployees to be balanced. Rather, a bankingorganization’s risk-management processes andinternal controls should reinforce and supportthe development and maintenance of balancedincentive compensation arrangements.

• Banking organizations should have appropri-ate controls to ensure that their processes forachieving balanced compensation arrange-ments are followed and to maintain the integ-rity of their risk-management and other func-tions.

To help prevent damage from occurring, abanking organization should have strong con-

17. A malus arrangement permits the employer to preventvesting of all or part of the amount of a deferred remunerationaward. Malus provisions are invoked when risk outcomes areworse than expected or when the information upon which theaward was based turns out to have been incorrect. Loss ofunvested compensation due to the employee voluntarily leav-ing the firm is not an example of malus as the term is used inthis guidance.



trols governing its process for designing, imple-menting, and monitoring incentive compensa-tion arrangements. Banking organizationsshould create and maintain sufficient documen-tation to permit an audit of the effectiveness ofthe organization’s processes for establishing,modifying, and monitoring incentive compensa-tion arrangements. Smaller banking organiza-tions should incorporate reviews of these pro-cesses into their overall framework forcompliance monitoring (including internalaudit).

Large complex banking organizations.LCBOs should have and maintain policies andprocedures that (1) identify and describe therole(s) of the personnel, business units, and con-trol units authorized to be involved in thedesign, implementation, and monitoring ofincentive compensation arrangements; (2) iden-tify the source of significant risk-related inputsinto these processes and establish appropriatecontrols governing the development andapproval of these inputs to help ensure theirintegrity; and (3) identify the individual(s) andcontrol unit(s) whose approval is necessary forthe establishment of new incentive compensa-tion arrangements or modification of existingarrangements.

An LCBO also should conduct regular inter-nal reviews to ensure that its processes forachieving and maintaining balanced incentivecompensation arrangements are consistently fol-lowed. Such reviews should be conducted byaudit, compliance, or other personnel in a man-ner consistent with the organization’s overallframework for compliance monitoring. AnLCBO’s internal audit department also shouldseparately conduct regular audits of the organi-zation’s compliance with its established policiesand controls relating to incentive compensationarrangements. The results should be reported toappropriate levels of management and, whereappropriate, the organization’s board ofdirectors.

• Appropriate personnel, including risk-management personnel, should have inputinto the organization’s processes for design-ing incentive compensation arrangements andassessing their effectiveness in restrainingimprudent risk-taking.

Developing incentive compensation arrange-ments that provide balanced risk-taking incen-tives and monitoring arrangements to ensure

they achieve balance over time requires anunderstanding of the risks (including compli-ance risks) and potential risk outcomes associ-ated with the activities of the relevant employ-ees. Accordingly, banking organizations shouldhave policies and procedures that ensure thatrisk-management personnel have an appropriaterole in the organization’s processes for design-ing incentive compensation arrangements andfor assessing their effectiveness in restrainingimprudent risk-taking.18 Ways that risk manag-ers might assist in achieving balanced compen-sation arrangements include, but are not limitedto

1. reviewing the types of risks associated withthe activities of covered employees;

2. approving the risk measures used in riskadjustments and performance measures, aswell as measures of risk outcomes used indeferred-payout arrangements; and

3. analyzing risk-taking and risk outcomes rela-tive to incentive compensation payments.

Other functions within an organization, suchas its control, human resources, or finance func-tions, also play an important role in helpingensure that incentive compensation arrange-ments are balanced. For example, these func-tions may contribute to the design and review ofperformance measures used in compensationarrangements or may supply data used as part ofthese measures.

• Compensation for employees in risk-management and control functions should besufficient to attract and retain qualified per-sonnel and should avoid conflicts of interest.

The risk-management and control personnelinvolved in the design, oversight, and operationof incentive compensation arrangements shouldhave appropriate skills and experience needed toeffectively fulfill their roles. These skills andexperiences should be sufficient to equip thepersonnel to remain effective in the face ofchallenges by covered employees seeking toincrease their incentive compensation in waysthat are inconsistent with sound risk-management or internal controls. The compen-sation arrangements for employees in risk-management and control functions thus shouldbe sufficient to attract and retain qualified per-

18. Involvement of risk-management personnel in thedesign and monitoring of these arrangements also should helpensure that the organization’s risk-management functions canproperly understand and address the full range of risks facingthe organization.



sonnel with experience and expertise in thesefields that is appropriate in light of the size,activities, and complexity of the organization.

In addition, to help preserve the indepen-dence of their perspectives, the incentive com-pensation received by risk-management andcontrol personnel staff should not be based sub-stantially on the financial performance of thebusiness units that they review. Rather, the per-formance measures used in the incentive com-pensation arrangements for these personnelshould be based primarily on the achievementof the objectives of their functions (e.g., adher-ence to internal controls).

• Banking organizations should monitor theperformance of their incentive compensationarrangements and should revise the arrange-ments as needed if payments do not appropri-ately reflect risk.

Banking organizations should monitor incen-tive compensation awards and payments, riskstaken, and actual risk outcomes to determinewhether incentive compensation payments toemployees are reduced to reflect adverse riskoutcomes or high levels of risk taken. Resultsshould be reported to appropriate levels of man-agement, including the board of directors wherewarranted and consistent with Principle 3 below.The monitoring methods and processes used bya banking organization should be commensuratewith the size and complexity of the organiza-tion, as well as its use of incentive compensa-tion. Thus, for example, a small, noncomplexorganization that uses incentive compensationonly to a limited extent may find that it canappropriately monitor its arrangements throughnormal management processes.

A banking organization should take theresults of such monitoring into account in estab-lishing or modifying incentive compensationarrangements and in overseeing associated con-trols. If, over time, incentive compensation paidby a banking organization does not appropri-ately reflect risk outcomes, the organizationshould review and revise its incentive compen-sation arrangements and related controls toensure that the arrangements, as designed andimplemented, are balanced and do not provideemployees incentives to take imprudent risks.

2068.0.2.3 Principle 3: Strong CorporateGovernance

Banking organizations should have strong andeffective corporate governance to help ensure

sound compensation practices, including activeand effective oversight by the board of directors.

Given the key role of senior executives in man-aging the overall risk-taking activities of anorganization, the board of directors of a bankingorganization should directly approve the incen-tive compensation arrangements for seniorexecutives.19 The board also should approveand document any material exceptions or adjust-ments to the incentive compensation arrange-ments established for senior executives andshould carefully consider and monitor theeffects of any approved exceptions or adjust-ments on the balance of the arrangement, therisk-taking incentives of the senior executive,and the safety and soundness of theorganization.

The board of directors of an organizationalso is ultimately responsible for ensuring thatthe organization’s incentive compensationarrangements for all covered employees areappropriately balanced and do not jeopardizethe safety and soundness of the organization.The involvement of the board of directors inoversight of the organization’s overall incen-tive compensation program should be scaledappropriately to the scope and prevalence ofthe organization’s incentive compensationarrangements.

Large complex banking organizations andorganizations that are significant users of incen-tive compensation. The board of directors of anLCBO or other banking organization that usesincentive compensation to a significant extentshould actively oversee the development andoperation of the organization’s incentive com-pensation policies, systems, and related controlprocesses. The board of directors of such anorganization should review and approve theoverall goals and purposes of the organization’sincentive compensation system. In addition, theboard should provide clear direction to manage-ment to ensure that the goals and policies itestablishes are carried out in a manner that

19. As used in this guidance, the term ‘‘board of directors’’is used to refer to the members of the board of directors whohave primary responsibility for overseeing the incentive com-pensation system. Depending on the manner in which theboard is organized, the term may refer to the entire board ofdirectors, a compensation committee of the board, or anothercommittee of the board that has primary responsibility foroverseeing the incentive compensation system. In the case ofFBOs, the term refers to the relevant oversight body for thefirm’s U.S. operations, consistent with the FBO’s overallcorporate and management structure.



achieves balance and is consistent with safetyand soundness.

The board of directors of such an organiza-tion also should ensure that steps are taken sothat the incentive compensation system—including performance measures and targets—isdesigned and operated in a manner that willachieve balance.

• The board of directors should monitor theperformance, and regularly review the designand function, of incentive compensationarrangements.

To allow for informed reviews, the boardshould receive data and analysis from manage-ment or other sources that are sufficient to allowthe board to assess whether the overall designand performance of the organization’s incentivecompensation arrangements are consistent withthe organization’s safety and soundness. Thesereviews and reports should be appropriatelyscoped to reflect the size and complexity of thebanking organization’s activities and the preva-lence and scope of its incentive compensationarrangements.

The board of directors of a banking organiza-tion should closely monitor incentive compensa-tion payments to senior executives and the sen-sitivity of those payments to risk outcomes. Inaddition, if the compensation arrangement for asenior executive includes a clawback provision,then the review should include sufficient infor-mation to determine if the provision has beentriggered and executed as planned.

The board of directors of a banking organiza-tion should seek to stay abreast of significantemerging changes in compensation plan mecha-nisms and incentives in the marketplace as wellas developments in academic research and regu-latory advice regarding incentive compensationpolicies. However, the board should recognizethat organizations, activities, and practiceswithin the industry are not identical. Incentivecompensation arrangements at one organizationmay not be suitable for use at another organiza-tion because of differences in the risks, controls,structure, and management among organiza-tions. The board of directors of each organiza-tion is responsible for ensuring that the incen-tive compensation arrangements for itsorganization do not encourage employees totake risks that are beyond the organization’sability to manage effectively, regardless of thepractices employed by other organizations.

Large complex banking organizations andorganizations that are significant users of incen-tive compensation. The board of an LCBO orother organization that uses incentive compensa-tion to a significant extent should receive andreview, on an annual or more frequent basis, anassessment by management, with appropriateinput from risk-management personnel, of theeffectiveness of the design and operation of theorganization’s incentive compensation systemin providing risk-taking incentives that are con-sistent with the organization’s safety and sound-ness. These reports should include an evaluationof whether or how incentive compensation prac-tices may increase the potential for imprudentrisk-taking.

The board of such an organization also shouldreceive periodic reports that review incentivecompensation awards and payments relative torisk outcomes on a backward-looking basis todetermine whether the organization’s incentivecompensation arrangements may be promotingimprudent risk-taking. Boards of directors ofthese organizations also should consider periodi-cally obtaining and reviewing simulation analy-sis of compensation on a forward-looking basisbased on a range of performance levels, riskoutcomes, and the amount of risks taken.

• The organization, composition, and resourcesof the board of directors should permit effec-tive oversight of incentive compensation.

The board of directors of a banking organiza-tion should have, or have access to, a level ofexpertise and experience in risk-managementand compensation practices in the financial ser-vices industry that is appropriate for the nature,scope, and complexity of the organization’sactivities. This level of expertise may be presentcollectively among the members of the board,may come from formal training or from experi-ence in addressing these issues, including as adirector, or may be obtained through advicereceived from outside counsel, consultants, orother experts with expertise in incentive com-pensation and risk-management. The board ofdirectors of an organization with less complexand extensive incentive compensation arrange-ments may not find it necessary or appropriateto require special board expertise or to retainand use outside experts in this area.

In selecting and using outside parties, theboard of directors should give due attention topotential conflicts of interest arising from otherdealings of the parties with the organization orfor other reasons. The board also should exer-cise caution to avoid allowing outside parties to



obtain undue levels of influence. While theretention and use of outside parties may behelpful, the board retains ultimate responsibilityfor ensuring that the organization’s incentivecompensation arrangements are consistent withsafety and soundness.

Large complex banking organizations andorganizations that are significant users of incen-tive compensation. If a separate compensationcommittee is not already in place or required byother authorities,20 the board of directors of anLCBO or other banking organization that usesincentive compensation to a significant extentshould consider establishing such acommittee—reporting to the full board—thathas primary responsibility for overseeing theorganization’s incentive compensation systems.A compensation committee should be composedsolely or predominantly of non-executive direc-tors. If the board does not have such a compen-sation committee, the board should take othersteps to ensure that non-executive directors ofthe board are actively involved in the oversightof incentive compensation systems. The com-pensation committee should work closely withany board-level risk and audit committees wherethe substance of their actions overlap.

• A banking organization’s disclosure prac-tices should support safe and sound incentivecompensation arrangements.

If a banking organization’s incentive compen-sation arrangements provide employees incen-tives to take risks that are beyond the toleranceof the organization’s shareholders, these risksare likely to also present a risk to the safety andsoundness of the organization.21 To help pro-mote safety and soundness, a banking organiza-tion should provide an appropriate amount ofinformation concerning its incentive compensa-tion arrangements for executive and non-executive employees and related risk-management, control, and governance processesto shareholders to allow them to monitor and,where appropriate, take actions to restrain thepotential for such arrangements and processesthat encourage employees to take imprudentrisks. Such disclosures should include informa-tion relevant to employees other than seniorexecutives. The scope and level of the informa-

tion disclosed by the organization should betailored to the nature and complexity of theorganization and its incentive compensationarrangements.22

• Large complex banking organizations shouldfollow a systematic approach to developing acompensation system that has balanced incen-tive compensation arrangements.

At banking organizations with large numbersof risk-taking employees engaged in diverseactivities, an ad hoc approach to developingbalanced arrangements is unlikely to be reliable.Thus, an LCBO should use a systematicapproach—supported by robust and formalizedpolicies, procedures, and systems—to ensurethat those arrangements are appropriately bal-anced and consistent with safety and soundness.Such an approach should provide for the organi-zation effectively to:

1. Identify employees who are eligible toreceive incentive compensation and whoseactivities may expose the organization tomaterial risks. These employees shouldincludea. senior executives and others who are

responsible for oversight of the organiza-tion’s firm-wide activities or materialbusiness lines;

b. individual employees, including non-executive employees, whose activitiesmay expose the organization to materialamounts of risk; and

c. groups of employees who are subject tothe same or similar incentive compensa-tion arrangements and who, in the aggre-gate, may expose the organization tomaterial amounts of risk;

2. Identify the types and time horizons of risksto the organization from the activities ofthese employees;

3. Assess the potential for the performancemeasures included in the incentive compen-sation arrangements for these employees toencourage the employees to take imprudentrisks;

4. Include balancing elements, such as risk

20. See New York Stock Exchange Listed CompanyManual Section 303A.05(a); Nasdaq Listing Rule 5605(d);Internal Revenue Code section 162(m) (26 U.S.C. 162(m)).

21. On the other hand, as noted previously, compensationarrangements that are in the interests of the shareholders of abanking organization are not necessarily consistent with safetyand soundness.

22. A banking organization also should comply with theincentive compensation disclosure requirements of the federalsecurities law and other laws as applicable. See, for example,Proxy Disclosure Enhancements, SEC Release Nos. 33-9089,34-61175, 74 F.R. 68334 (Dec. 23, 2009) (to be codified at 17C.F.R. 229 and 249).



adjustments or deferral periods, within theincentive compensation arrangements forthese employees that are reasonably designedto ensure that the arrangement will be bal-anced in light of the size, type, and timehorizon of the inherent risks of the employ-ees’ activities;

5. Communicate to the employees the ways inwhich their incentive compensation awardsor payments will be adjusted to reflect therisks of their activities to the organization;and

6. Monitor incentive compensation awards,payments, risks taken, and risk outcomes forthese employees and modify the relevantarrangements if payments made are notappropriately sensitive to risk and riskoutcomes.

2068.0.3 CONCLUSION ON SOUNDINCENTIVE COMPENSATION

Banking organizations are responsible for ensur-ing that their incentive compensation arrange-ments do not encourage imprudent risk-taking

behavior and are consistent with the safety andsoundness of the organization. The FederalReserve expects banking organizations to takeprompt action to address deficiencies in theirincentive compensation arrangements or relatedrisk-management, control, and governanceprocesses.

The Federal Reserve intends to actively moni-tor the actions taken by banking organizationsin this area and will promote further advances indesigning and implementing balanced incentivecompensation arrangements. Where appropri-ate, the Federal Reserve will take supervisory orenforcement action to ensure that material defi-ciencies that pose a threat to the safety andsoundness of the organization are promptlyaddressed. The Federal Reserve also will updatethis guidance as appropriate to incorporate bestpractices as they develop over time.



Taxes (Consolidated Tax Filing)Section 2070.0


Effective July 2014, this section is revised toinclude a June 13, 2014, interagency Addendumto the 1998 “Interagency Policy Statement onIncome Tax Allocation in a Holding CompanyStructure” (Addendum). The Board of Gover-nors of the Federal Reserve System, FederalDeposit Insurance Corporation, and the Officeof the Comptroller of the Currency (Agencies)announced the issuance of the Addendum toensure that insured depository institutions (IDIs)in a consolidated group maintain an appropri-ate relationship regarding the payment of taxesand treatment of tax refunds. The purpose of theAddendum is to ensure that tax allocation agree-ments expressly acknowledge an agency rela-tionship between a holding company1 and itssubsidiary IDI to protect the IDI’s ownershiprights in tax refunds. State member banks andholding companies should implement the guid-ance as soon as reasonably possible, which theAgency expect would not be later than October31, 2014. This Addendum clarifies and supple-ments but does not replace the 1998 InteragencyPolicy Statement. (Refer to SR-14-6.)

A holding company and its depository institu-tion subsidiaries may generally file a consoli-dated group income tax return. For bank regula-tory purposes, however, each depositoryinstitution is viewed as, and reports as, a sepa-rate legal and accounting entity. Each holdingcompany subsidiary that participates in filing aconsolidated tax return should record its taxexpenses or tax benefits as though it had filed atax return as a separate entity. The amount andtiming of any intercompany payments orrefunds to the subsidiary that result from itsbeing a part of the consolidated return groupshould be no more favorable than if the subsidi-ary was a separate taxpayer. A consolidatedreturn permits the parent’s and other subsidi-aries’ taxable losses to be offset against othersubsidiaries’ taxable income, with the parentmost often providing the principal loss. This canbe illustrated with the following example:

Parent

Only Bank

Non-

bank A

Non-

bank B

Consoli-

dated

Contribution to

consolidated net

taxable income

(loss): $(100) $2,000 $500 $(50) $2,350

Assumed tax

rate 40% 40% 40% 40% 40%

Tax payment/

(benefit) $(40) $ 800 $200 $(20) $ 940

In this example, the parent, as the representa-tive of the consolidated group to the InternalRevenue Service, would collect $800 from thebank subsidiary and $200 from Nonbank Sub-sidiary A, and pay $20 to Nonbank SubsidiaryB. In return, the parent would remit to the taxauthorities $940, resulting in a net cash reten-tion of $40 by the parent.

Bank holding companies employ numerousmethods to determine the amount of estimatedpayments to be received from their subsidiaries.Although the tax-accounting methods to be usedby bank holding companies are not prescribedby the Federal Reserve System, the methodemployed must afford subsidiaries equitabletreatment compared with filing separate returns.In general terms, tax transactions between anysubsidiary and its parent should be conducted asthough the subsidiary was dealing directly withstate or federal taxing authorities.

The tax structure of holding companiesbecomes more complicated when deferred taxesare considered in the intercorporate tax settle-ments.2 Deferred taxes occur when taxableincome, for financial reporting purposes, differsfrom taxable income as reported to the taxingauthorities. This difference is due to timing dif-ferences between financial-statement incomeand tax income for loan-loss provisions andother items, such as foreign tax credits. In addi-tion, differences result from the use of the cashbasis of accounting for tax purposes, as opposedto the accrual basis of accounting used in finan-

1. For the purpose of this guidance, the term, “holding

company” refers to a bank holding company or a savings and

loan holding company.

2. The issue becomes more complex because of GAAP-

based tax expenses versus actual taxes paid under relevant tax

laws (the difference between the two expenses is either a

deferred tax liability or asset on the balance sheet). If the

sharing agreement is based on the tax expense on the state-

ment of income, more funds may be transferred to the paying

agent than are required to settle the actual taxes owed.


cial reporting. The different bases are chosen bymanagement.

An example of deferred income taxes fol-lows, using an estimated tax rate of 40 percent.

Financial

Reporting

Tax

Return

Pre-tax income $200 $150

Currently payable 60 60

Deferred portion 20 —

TOTAL 80 60

Net income $120 $90

The deferred portion represents the tax effect ofdelaying the recognition of income or takingmore of a deduction for tax-return purposes(40% x $50). This is a temporary differencesince over the “life” of the holding company,income and deductions should theoreticallyequalize for both book and tax purposes.

Financial Accounting Standards BoardAccounting Standards Codification 740-10Statement No. 109 (FAS 109), “Accounting forIncome Taxes,” provides guidance on manyaspects of accounting for income taxes, includ-ing the accounting for deferred tax liabilitiesand assets. FAS 109 describes how a bank hold-ing company should record (1) taxes payable orrefundable for the current year and (2) deferredtax liabilities and assets for the future tax conse-quences of events that have been recognized inthe banking organization’s financial statementsor tax returns.

Generally, all bank and other holding compa-nies file annual income tax returns. The holdingcompany pays the entire amount of tax (that is,the amount still due after estimated tax pay-ments) on or before the due date for filing, or itcan elect to pay by the extension deadline if oneis granted. Bank holding companies may receiveextensions from taxing authorities to file theirreturns later. For the federal tax return, a six-month extension may be granted.

Bank holding companies generally pay esti-mated taxes throughout the year. The most com-mon payment dates will be as follows (assum-ing calendar period):

April 15 —first estimate (25%)June 15 —second estimate (25%)September 15 —third estimate (25%)December 15 —fourth estimate (25%)

March 15 —Due date for income taxreturn for U.S. corporationsor foreign corporations withoffices in the United States.Last day for filing for the auto-matic six-month extension.

September 15 —Due date of return if six-monthextensions were granted.

Bank holding companies have engaged inintercorporate income tax settlements that havethe effect of transferring assets and income froma bank subsidiary to the parent company. TheBoard will apply appropriate supervisory rem-edies to situations that are considered inequi-table or improper. These remedies may include,under certain circumstances, the Board’s cease-and-desist powers.

On occasion, bank holding companies haveused deferred tax assets as a vehicle to transfercash or other earning assets of subsidiaries, prin-cipally from the bank, into the parent company.The Board’s opinion is that each deferred taxasset or liability must remain on the books ofthe subsidiary. If deferred tax assets have beentransferred to the parent, regardless of when thetransfer may have occurred, immediate arrange-ments must be made to return the asset to theappropriate subsidiary. Instances of transferringdeferred tax assets to the parent are worthy ofinclusion in the Examiner’s Comments and Mat-ters Requiring Special Board Attention sectionor page of the inspection report.

2070.0.1 INTERAGENCY POLICYSTATEMENT ON INCOME TAXALLOCATION IN A HOLDINGCOMPANY STRUCTURE

In 1998, the federal bank and savings associa-tion’s regulatory agencies (the agencies) issuedthe following policy statement to provide guid-ance to banking organizations and savings asso-ciations regarding the allocation and payment oftaxes among a holding company and its subsidi-aries. A holding company and its subsidiarieswill often file a consolidated group income taxreturn. However, for bank regulatory purposes,each depository institution of the consolidatedgroup is viewed as, and reports as, a separatelegal and accounting entity. Accordingly, eachdepository institution’s applicable income taxes,reflecting either an expense or benefit, should berecorded as if the institution had filed as a

Taxes (Consolidated Tax Filing) 2070.0


separate tax-paying entity.3 The amount and tim-ing of payments or refunds should be no lessfavorable to a subsidiary than if it was a sepa-rate taxpayer. Any practice that is not consistentwith this policy statement may be viewed as anunsafe and unsound practice prompting eitherinformal or formal corrective action. See SR-98-38.

2070.0.1.1 Tax-Sharing Agreements

A holding company and its subsidiary institu-tions are encouraged to enter into a writtencomprehensive tax-allocation agreement tai-lored to their specific circumstances. The agree-ment should be approved by the respectiveboards of directors. Although each agreementwill be different, tax-allocation agreements usu-ally address certain issues common to consoli-dated groups.

Therefore, such an agreement should—

1. require a subsidiary depository institution tocompute its income taxes (both current anddeferred) on a separate-entity basis;

2. discuss the amount and timing of the institu-tion’s payments for current tax expense,including estimated tax payments;

3. discuss reimbursements to an institutionwhen it has a loss for tax purposes; and

4. prohibit the payment or other transfer ofdeferred taxes by the institution to anothermember of the consolidated group.

2070.0.1.2 Measurement of Current andDeferred Income Taxes

Generally accepted accounting principles,instructions for the preparation of the federallysupervised bank Consolidated Reports of Condi-tion and Income, and other guidance issued bythe agencies require depository institutions toaccount for their current and deferred tax liabil-ity or benefit.

When the depository-institution members of aconsolidated group prepare separate bank regu-latory reports, each subsidiary institution shouldrecord current and deferred taxes as if it files itstax returns on a separate-entity basis, regardlessof the consolidated group’s tax-paying or

-refund status. Certain adjustments for statutorytax considerations that arise in a consolidatedreturn, e.g., application of graduated tax rates,may be made to the separate-entity calculationas long as they are made on a consistent andequitable basis among the holding companyaffiliates.

In addition, when an organization’s consoli-dated income tax obligation arising from thealternative minimum tax (AMT) exceeds itsregular tax on a consolidated basis, the excessshould be consistently and equitably allocatedamong the members of the consolidated group.The allocation method should be based upon theportion of tax preferences, adjustments, andother items generated by each group memberwhich causes the AMT to be applicable at theconsolidated level.

2070.0.1.3 Tax Payments to the ParentCompany

Tax payments from a subsidiary institution tothe parent company should not exceed theamount the institution has properly recorded asits current tax expense on a separate-entity basis.Furthermore, such payments, including esti-mated tax payments, generally should not bemade before the institution would have beenobligated to pay the taxing authority had it filedas a separate entity. Payments made in advancemay be considered extensions of credit from thesubsidiary to the parent and may be subject toaffiliate transaction rules, i.e., sections 23A and23B of the Federal Reserve Act.

A subsidiary institution should not pay itsdeferred tax liabilities or the deferred portion ofits applicable income taxes to the parent. Thedeferred tax account is not a tax liabilityrequired to be paid in the current reportingperiod. As a result, the payment of deferredincome taxes by an institution to its holdingcompany is considered a dividend subject todividend restrictions,4 not the extinguishment ofa liability. Furthermore, such payments mayconstitute an unsafe and unsound banking prac-tice.

3. Throughout the policy statement, the terms “separate

entity” and “separate taxpayer” are used synonymously. When

a depository institution has subsidiaries of its own, the institu-

tion’s applicable income taxes on a separate-entity basis

include the taxes of the subsidiaries of the institution that are

included with the institution in the consolidated group return.

4. These restrictions include the prompt-corrective-action

provisions of section 38(d)(1) of the Federal Deposit Insur-

ance Act (12 U.S.C. 1831o(d)(1)) and its implementing regu-

lations: for insured state nonmember banks, 12 CFR 325,

subpart B; for national banks, 12 CFR section 6.6; for savings

associations, 12 CFR 565; and for state member banks, 12

CFR 208.45.



2070.0.1.4 Tax Refunds from the ParentCompany

An institution incurring a loss for tax purposesshould record a current income tax benefit andreceive a refund from its parent in an amount noless than the amount the institution would havebeen entitled to receive as a separate entity. Therefund should be made to the institution within areasonable period following the date the institu-tion would have filed its own return, regardlessof whether the consolidated group is receiving arefund. If a refund is not made to the institutionwithin this period, the institution’s primary fed-eral regulator may consider the receivable aseither an extension of credit or a dividend fromthe subsidiary to the parent. A parent companymay reimburse an institution more than therefund amount it is due on a separate-entitybasis. Provided the institution will not later berequired to repay this excess amount to theparent, the additional funds received should bereported as a capital contribution.

If the institution, as a separate entity, wouldnot be entitled to a current refund because it hasno carry-back benefits available on a separate-entity basis, its holding company may still beable to utilize the institution’s tax loss to reducethe consolidated group’s current tax liability. Inthis situation, the holding company may reim-burse the institution for the use of the tax loss. Ifthe reimbursement will be made on a timelybasis, the institution should reflect the tax bene-fit of the loss in the current portion of its appli-cable income taxes in the period the loss isincurred. Otherwise, the institution should notrecognize the tax benefit in the current portionof its applicable income taxes in the loss year.Rather, the tax loss represents a loss carry-forward, the benefit of which is recognized as adeferred tax asset, net of any valuation allow-ance.

Regardless of the treatment of an institution’stax loss for regulatory reporting and supervisorypurposes, a parent company that receives a taxrefund from a taxing authority obtains thesefunds as agent for the consolidated group onbehalf of the group members.5 Accordingly, anorganization’s tax-allocation agreement or othercorporate policies should not purport to charac-terize refunds attributable to a subsidiary deposi-tory institution that the parent receives from ataxing authority as the property of the parent.

2070.0.1.5 Income-Tax-ForgivenessTransactions

A parent company may require a subsidiaryinstitution to pay it less than the full amount ofthe current income tax liability that the institu-tion calculated on a separate-entity basis. Pro-vided the parent will not later require the institu-tion to pay the remainder of the current taxliability, the amount of this unremitted liabilityshould be accounted for as having been paidwith a simultaneous capital contribution by theparent to the subsidiary.

In contrast, a parent cannot make a capitalcontribution to a subsidiary institution by “for-giving” some or all of the subsidiary’s deferredtax liability. Transactions in which a parent “for-gives” any portion of a subsidiary institution’sdeferred tax liability should not be reflected inthe institution’s regulatory reports. These trans-actions lack economic substance because eachmember of the consolidated group is jointly andseverally liable for the group’s potential futureobligation to the taxing authorities. Althoughthe subsidiaries have no direct obligation toremit tax payments to the taxing authorities,these authorities can collect some or all of agroup liability from any of the group membersif tax payments are not made when due.

2070.0.1.6 Appendix — 2014 Addendumto 1998 Interagency Policy Statement onIncome Tax Allocation in a HoldingCompany Structure

Since the issuance of the 1998 Interagency Pol-icy Statement, courts have reached varying con-clusions regarding whether tax allocation agree-ments create a debtor-creditor relationshipbetween a holding company and its IDI.6 Somecourts have found that the tax refunds in ques-tion were the property of the holding companyin bankruptcy (rather than property of the sub-sidiary IDI) and held by the holding company as

5. See 26 CFR 1.1502-77(a).

6. Case law on this issue is mixed. Compare Zucker v.

FDIC, as Receiver for BankUnited, 727 F.3d 1100, 1108-09

(11th Cir. Aug. 15, 2013) (“The relationship between the

Holding Company and the Bank is not a debtor-creditor

relationship. When the Holding Company received the tax

refunds it held the funds intact—as if in escrow—for the

benefit of the Bank and thus the remaining members of the

Consolidated Group.”) with F.D.I.C. v. Siegel (In re IndyMac

Bancorp, Inc.), F. App’x , 2014 WL 1568759, *2

(9th Cir. Apr. 21, 2014) (per curiam) (“The TSA does not

create a trust relationship. The absence of language creating a

trust relationship is explicitly an indication of a debtor-

creditor relationship in California”).



the IDI’s debtor.7

On June 13, 2014, an Addendum to the 1998Interagency Policy Statement (Addendum) wasissued by the Board of Governors of the FederalReserve System, Federal Deposit Insurance Cor-poration, and the Office of the Comptroller ofthe Currency (Agencies). It explains that Con-solidated Groups should review their tax alloca-tion agreements to ensure the agreementsachieve the objectives of the Interagency PolicyStatement. This Addendum also clarifies howcertain of the requirements of sections 23A and23B of the Federal Reserve Act (FRA) apply totax allocation agreements between IDIs andtheir affiliates.

In reviewing their tax allocation agreements,Consolidated Groups should ensure the agree-ments: (1) clearly acknowledge that an agencyrelationship exists between the holding com-pany and its subsidiary IDIs with respect to taxrefunds, and (2) do not contain other languageto suggest a contrary intent.8 In addition, allConsolidated Groups should amend their taxallocation agreements to include the followingparagraph or substantially similar language:

The [holding company] is an agent for the[IDI and its subsidiaries] (the “Institution”) withrespect to all matters related to consolidated taxreturns and refund claims, and nothing in thisagreement shall be construed to alter or modifythis agency relationship. If the [holding com-pany] receives a tax refund from a taxingauthority, these funds are obtained as agent forthe Institution. Any tax refund attributable toincome earned, taxes paid, and losses incurredby the Institution is the property of and ownedby the Institution, and shall be held in trust bythe [holding company] for the benefit of theInstitution. The [holding company] shall for-ward promptly the amounts held in trust to theInstitution. Nothing in this agreement isintended to be or should be construed to providethe [holding company] with an ownership inter-est in a tax refund that is attributable to incomeearned, taxes paid, and losses incurred by theInstitution. The [holding company] herebyagrees that this tax sharing agreement does notgive it an ownership interest in a tax refundgenerated by the tax attributes of the Institution.

Going forward, the Agencies generally willdeem tax allocation agreements that contain this

or similar language to acknowledge that anagency relationship exists for purposes of theInteragency Policy Statement, this Addendum,and sections 23A and 23B of the FRA.

All tax allocation agreements are subject tothe requirements of section 23B of the FRA, andtax allocation agreements that do not clearlyacknowledge that an agency relationship existsmay be subject to additional requirements undersection 23A of the FRA.9 In general, section23B requires affiliate transactions to be made onterms and under circumstances that are substan-tially the same, or at least as favorable to theIDI, as comparable transactions involving non-affiliated companies or, in the absence of compa-rable transactions, on terms and circumstancesthat would in good faith be offered to non-affiliated companies.10 Tax allocation agree-ments should require the holding company toforward promptly any payment due the IDIunder the tax allocation agreement and specifythe timing of such payment. Agreements thatallow a holding company to hold and notpromptly transmit tax refunds received from thetaxing authority and owed to an IDI are incon-sistent with the requirements of section 23B andsubject to supervisory action. However, anAgency’s determination of whether such provi-sion, or the tax allocation agreement in total, isconsistent with section 23B will be based on thefacts and circumstances of the particular taxallocation agreement and any associated refund.

State member banks and holding companiesshould implement this 2014 Addendum guid-ance as soon as reasonably possible, which theAgencies expect would not be later than Octo-ber 31, 2014. See 79 Fed. Reg. 35230, June 19,2014, and SR-14-6, July 15, 2014, “Addendumto the Interagency Policy Statement on IncomeTax Allocation in a Holding Company Struc-ture.”

2070.0.2 Qualifying Subchapter SCorporations

The Small Business Job Protection Act of 1996made changes to the Internal Revenue Code (the

7. See e.g., F.D.I.C. v. Siegel (In re IndyMac Bancorp, Inc.),

F. App’x , 2014 WL 1568759 (9th Cir. Apr. 21,

2014) (per curiam).

8. This Addendum clarifies and supplements but does not

replace the Interagency Policy Statement.

9. Section 23A requires, among other things, that loans and

extensions of credit from a bank to its affiliates be properly

collateralized. 12 U.S.C. 371c(c).

10. 12 U.S.C. 371c-1(a). Transactions subject to section 23B

include the payment of money by a bank to an affiliate under

contract, lease, or otherwise and transactions in which the

affiliate acts as agent of the bank. Id. at § 371c-1(a)(2) &

(a)(4).



code). On October 29, 1996, the FFIEC issued abulletin notifying all federally insured banksand thrifts of the impact of these changes. Thriftorganizations may qualify for Subchapter S cor-poration11 status under the code’s revisions andcould generally receive pass-through tax treat-ment for federal income tax purposes if certaincriteria are met.

The bulletin states that no formal applicationis required to be filed with the federal bank andthrift regulatory agencies merely as a result ofan election by a bank, thrift, or parent holdingcompany to become a Subchapter S corporation.However, if an institution takes certain steps tomeet the criteria to qualify for this tax status,particularly the code’s limitations on the num-ber and types of shareholders, applications ornotices to the agencies may be required.

The FFIEC bulletin also states that any distri-butions made by the Subchapter S banking orga-nization to its shareholders, including distribu-tions intended to cover shareholders’ personaltax liabilities for their shares of the income ofthe institution, will continue to be regarded asdividends and subject to any limitations underrelevant banking law. See SR-96-28.

2070.0.3 Inspection Objectives

1. To determine whether the supervisory andaccounting guidance set forth in ASC 740-10(FASB 109), other tax-accounting standards,and the 1998 interagency policy statement onincome tax allocation has been appropriately,equitably, and consistently applied.

2. To verify that the parent’s intercorporate taxpolicy contains a provision requiring the sub-sidiaries to receive an appropriate refundfrom the parent when they incur a loss, andthat such a refund would have been receiv-able from the tax authorities if the subsidiarywas filing a separate return.

3. To ascertain that tax payments and taxrefunds between financial institution subsidi-aries and the parent company have been lim-ited to no more than what the institutionmight have paid to or received from the taxauthorities, if it had filed its tax returns on atimely, separate-entity basis.12

4. To determine that no deferred tax liability,corresponding asset, or the deferred portionof its applicable income taxes has been trans-ferred from a bank subsidiary to the parentcompany.

5. To verify that there has been proper account-ability for tax-forgiveness transactionsbetween the parent company and its financialinstitution subsidiaries.

6. To substantiate that corporate practices areconsistent with corporate policies.

2070.0.4 Inspection Procedures

1. Obtain and discuss with the holdingcompany’s management its intercorporateincome tax policies and tax-sharing agree-ments. Obtain and retain a copy of the inter-corporate tax policies and agreements in theworkpaper files. Review the written intercor-porate tax-settlement policy and ascertainthat it includes the following:a. a description of the method(s) used in

determining the amount of estimated taxespaid by each subsidiary to the parent

b. an indication of when payments are to bemade

c. a statement that deferred taxes are main-tained on the affiliate’s general ledger

d. procedures for handling tax claims andrefunds

Holding companies of depository institutionsshould also have written tax-sharing agreementswith their subsidiaries that specify intercorpo-rate tax-settlement policies. The Board encour-ages these holding companies to develop suchagreements. For tax-sharing agreements, the fol-lowing inspection procedures should be fol-lowed:

a. Determine whether each subsidiary isrequired to compute its income taxes (cur-rent and deferred) on a separate-entitybasis.

b. Ascertain if the amount and timing ofpayments for current tax expense, includ-ing estimated tax payments, are discussed.

c. Determine if reimbursements are dis-cussed when an institution has a loss fortax purposes.

d. Determine if there is a prohibition on thepayment or other transfer of deferredtaxes by an institution to another memberof the consolidated group.

11. Subchapter S corporations are corporations that elect to

pass corporate income tax losses, deductions, and credit

through to their shareholders for federal income tax purposes.

12. The term “separate-entity basis” recognizes that certain

adjustments, in particular tax elections in a consolidated

return, may, in certain periods, result in higher payments by

the depository institution than would have been made if the

depository institution was unaffiliated.



2. Review briefly the parent’s intercompanytransaction report; general ledger income taxaccounts; cash receipts and disbursements;and, if necessary, tax-return workpapers andother pertinent corporate documents.a. Ascertain that the taxes collected by the

parent company from each depositoryinstitution subsidiary do not exceed theamount that would have been paid if aseparate return had been filed.

b. When depository institution subsidiariesare making their tax payments directly tothe taxing authorities, determine whetherother subsidiaries are paying their propor-tionate share.

3. Review the separate regulatory reports fordepository institution members of the hold-ing company that are included in the filing ofa consolidated tax return.a. Verify that each subsidiary institution is

recording current and deferred taxes as ifit was filing its own tax returns on aseparate-entity basis.

b. Ascertain that any adjustments for statu-tory tax considerations, arising from filinga consolidated return, are also made to theseparate-entity calculations consistentlyand equitably among the holding com-pany affiliates.

4. Determine if any excess amounts (tax bene-fits), resulting from the filing of a consoli-dated return, are consistently and equitablyallocated among the members of the consoli-dated group.

5. Review the tax payments that are made fromthe bank and the nonbank subsidiaries to theparent company.a. Determine that payments, including esti-

mated payments that are being requested,do not significantly precede the time thata consolidated or estimated current taxliability would be due and payable by theparent to the tax authorities.

b. Verify with management that the tax pay-ments to the parent company were not inexcess of the amounts recorded by

its depository institution subsidiaries ascurrent tax expense on a separate-entitybasis.

c. Determine that subsidiary institutions arenot paying their deferred tax liabilities onthe deferred portions of their applicableincome taxes to the parent company.

d. Ascertain that the parent company is notderiving tax monies from depository insti-tution subsidiaries that are used for otheroperating needs.

6. When a subsidiary incurs a loss, review thetax system to determine that bank and non-bank subsidiaries are receiving an appropri-ate refund from the parent company, that is,an amount that is no less than what wouldhave been received if the tax return had beenfiled on a separate-entity basis.a. Verify that refunds are received no later

than the date the institutions would havefiled their own returns and that no refundis characterized as the parent company’sproperty.

b. If the parent company does not require asubsidiary to pay its full amount of cur-rent tax liability, and the parent will notlater require the institution to pay theremainder of the current tax liability,ascertain that the amount of the tax liabil-ity is recorded as having been paid andthat the corresponding credit is recordedas a capital contribution from the parentto the subsidiary.

7. Determine that the deferred tax accounts ofeach bank subsidiary are maintained on itsbooks and that they are not transferred to theparent organization.

8. Determine if the Internal Revenue Service orother tax authorities have assessed any addi-tional tax payments on the consolidatedgroup, and whether the holding company hasprovided an additional reserve to cover theassessment.

9. Complete the Other Supervisory Issues pageor section of the Report of Bank HoldingCompany Inspection (FR 1225 or FR 1241).



2070.0.5 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws 1 Regulations 2 Interpretations 3 Orders

Interagency Policy Statementon Income Tax Allocationin a Holding CompanyStructure

2014 Addendum to theInteragency PolicyStatement on IncomeTax Allocation in aHolding Company Structure

4-870 1999 FRB 111

1. 12 U.S.C., unless specifically stated otherwise.

2. 12 C.F.R., unless specifically stated otherwise.

3. Federal Reserve Regulatory Service reference.



Funding(Introduction) Section 2080.0

The purpose of this Section is to discuss thetypes of funding ordinarily found in holdingcompanies and to analyze their respective char-acteristics. It is not intended that this sectioninclude an analysis of the inter-relationships ofthese factors because that will be addressed inthe various subsections of Section 4000 of theManual.The three major types of funding are short-

term debt, long-term debt and equity. The ideal‘‘hypothetical’’ holding company balance sheetwould reflect sufficient equity to fund total bankand nonbank capital needs.The complexity of the debt and/or equity

financing will depend greatly upon the size andfinancial status of the holding company as wellas the access to certain capital markets. Thesmall holding company will be limited in thetype and/or sophistication of financing instru-

ments available for its use, and probably wouldlook to local sources for its debt and equityneeds. This would include sale of equity anddebt instruments to owners of the holding com-pany. The medium-sized holding company hasaccess to public markets through investmentbankers and occasionally may issue its owncorporate notes in the commercial paper market.The large holding company has a wide range ofchoices depending upon its financial conditionand the economic climate at the time of anyoffering. It also has the ability to place debtprivately as an alternate to dealing with publicmarkets. In summary, the type of financingneeded by a holding company will vary with thesize and nature of its banking and nonbankingoperations. The following subsections addressthose issues.


Funding (Bank Holding Company Fundingand Liquidity) Section 2080.05


Effective July 2010, this section was revised toinclude a cross reference to section 4066.0 ofthis manual, which provides the March 17,2010, interagency policy statement on ‘‘Fund-ing and Liquidity Risk Management.’’

A key principle underlying the FederalReserve’s supervision of bank holding compa-nies (BHCs) is that such companies should beoperated in a way that promotes the soundnessof their subsidiary banks. Holding companiesare expected to avoid funding strategies or prac-tices that could undermine public confidence inthe liquidity or stability of their banks. Conse-quently, BHCs should develop and maintainfunding programs that are consistent with theirlending and investment activities and that pro-vide adequate liquidity to the parent companyand its nonbank subsidiaries.

For more information regarding the FederalReserve’s supervisory expectations on liquidityrisk management for BHCs, see section 4066.0,‘‘Consolidated (Funding and Liquidity RiskManagement).’’ This section provides theMarch 17, 2010, interagency policy statementon ‘‘Funding and Liquidity Risk Management.’’(see also SR-10-6 and its attachment.)

2080.05.1 FUNDING AND LIQUIDITY

A principal objective of a parent BHC’s fundingstrategy should be to support capital invest-ments in subsidiaries and long-term assets withcapital and long-term sources of funds. Long-term or permanent financing not only reducesfunding and liquidity risks, but also provides anorganization with investors and lenders thathave a long-run commitment to its viability.Long-term financing may take the form of termloans, long-term debt securities, convertibledebentures, subordinated debt, and equity.

In general, liquidity can be measured by theability of an organization to meet its maturingobligations, convert assets into cash with mini-mal loss, obtain cash from other sources, or rollover or issue new debt obligations. A majordeterminant of a BHC’s liquidity position is thelevel of liquid assets available to support matur-ing liabilities. The use of short-term debt,including commercial paper, to fund long-termassets can result in unsafe and unsound bankingconditions, especially if a BHC does not have

alternative sources of liquidity or other reliablemeans to refinance or redeem its obligations. Inaddition, commercial paper proceeds should notbe used to fund corporate dividends or paycurrent expenses. Funding mismatches canexacerbate an otherwise manageable period offinancial stress or, in the extreme, underminepublic confidence in an organization’s viability.For this reason, BHCs, in managing their fund-ing positions, should control liquidity risk bymaintaining an adequate cushion of liquid assetsto cover short-term liabilities. Holding compa-nies should, at all times, have sufficient liquidityand funding flexibility to handle any runoff,whether anticipated or unforeseen, of commer-cial paper or other short-term obligations—without having an adverse impact on their sub-sidiary banks.

This objective can best be achieved by limit-ing the use of short-term debt to fund assets thatcan be readily converted to cash without undueloss. It should be emphasized, however, that thesimple matching of the maturity of short-termdebt with the stated or nominal maturity ofassets does not, by itself, adequately ensure anorganization’s ability to retire its short-termobligations if the condition of the underlyingassets precludes their timely sale or liquidation.In this regard, it is particularly important thatparent company advances to subsidiaries beconsidered a reliable source of liquidity only tothe extent that they fund assets of high qualitythat can readily be converted to cash. Conse-quently, effective procedures to monitor andensure on an ongoing basis the quality andliquidity of the assets being funded by short-term debt are critical elements of a holdingcompany’s overall funding program.

BHCs should establish and maintain reliablefunding and contingency plans to meet ongoingliquidity needs and to address any unexpectedfunding mismatches that could develop overtime. Such plans could include reduced relianceon short-term purchased funds, greater use oflonger-term financing, appropriate internal limi-tations on parent company funding of long-termassets, and reliable alternate sources of liquidity.It is particularly important that BHCs have reli-able plans or backup facilities to refinance orredeem their short-term debt obligations in theevent assets being funded by these obligationscannot be liquidated in a timely manner whenthe debt must be repaid. In this connection,


holding companies relying on backup lines ofcredit for contingency plan purposes shouldseek to arrange standby facilities that will bereliable during times of financial stress, ratherthan facilities that contain clauses which mayrelieve the lender of the obligation to fund theborrower in the event of a deterioration in theborrower’s financial condition.

In developing and carrying out funding pro-grams, BHCs should avoid overreliance orexcessive dependence on any single short-termor potentially volatile source of funds, such ascommercial paper, or any single maturity range.Prudent internal liquidity policies and practicesshould include specifying limits for, and moni-toring the degree of reliance on, particular matu-rity ranges and types of short-term funding.Special attention should be given to the use ofovernight money since a loss of confidence inthe issuing organization could lead to an imme-diate funding problem. BHCs issuing overnightliabilities should maintain, on an ongoing basis,a cushion of superior quality assets that can beimmediately liquidated or converted to cashwith minimal loss. The absence of such a cush-ion or a clear ability to redeem overnight liabili-ties when they become due should generally beviewed as an unsafe and unsound banking prac-tice.

2080.05.2 ADDITIONALSUPERVISORY CONSIDERATIONS

BHCs and their nonbank affiliates should main-tain sufficient liquidity and capital strength toprovide assurance that outstanding debt obliga-tions issued to finance the activities of theseentities can be serviced and repaid withoutadversely affecting the condition of the affiliatedbank(s). In this regard, BHCs should maintainstrong capital positions to enable them to with-stand potential losses that might be incurred inthe sale of assets to retire holding company debtobligations. It is particularly important that aBHC not allow its liquidity and funding policiesor practices to undermine its ability to act as asource of strength to its affiliated bank(s).

The principles and guidelines outlined aboveconstitute prudent financial practices for BHCsand most businesses in general. Holding com-pany boards of directors should periodicallyassure themselves that funding plans, policies,and practices are prudent in light of their organi-zations’ overall financial condition. Such plansand policies should be consistent with the prin-

ciples outlined above, including the need forappropriate internal limits on the level and typeof short-term debt outstanding and the need forrealistic and reliable contingency plans to meetany unanticipated runoff of short-term liabilitieswithout adversely affecting affiliated banks.

2080.05.3 EXAMINER’SAPPLICATION OF PRINCIPLES INEVALUATING LIQUIDITY AND INFORMULATING CORRECTIVEACTION PROGRAMS

Reserve Bank examiners should be guided bythese principles in evaluating liquidity and informulating corrective action programs forBHCs that are experiencing earnings weak-nesses or asset-quality problems, or that areotherwise subject to unusual liquidity pressures.In particular, BHCs with less than satisfactorysupervisory ratings—composite (C) and thepotential impact (I) of the parent company andnondepository entities—(that is, 3 or worse), orany other holding companies subject to poten-tially serious liquidity or funding pressures,should be asked to prepare a realistic and spe-cific action plan for reducing or redeemingentirely their outstanding short-term obligationswithout directly or indirectly undermining thecondition of their affiliated bank(s).1 Such con-tingency plans should be reviewed and evalu-ated by Reserve Bank supervisory personnelduring or subsequent to on-site inspections. Anydeficiencies in the plan, if not addressed bymanagement, should be brought to the attentionof the organization’s board of directors. If theliquidity or funding position of such a companyappears likely to worsen significantly, or if thecompany’s financial condition worsens to a suf-ficient degree, the company should be expectedto implement, on a timely basis, its plan tocurtail or eliminate its reliance on commercialpaper or other volatile, short-term sources offunds. Any decisions or steps taken by ReserveBanks in this regard should be discussed andcoordinated with Board staff.

Reference should also be made to othermanual sections that address funding, cash flow,or liquidity (for example, 2010.1, 2080.0,2080.1, 2080.2, 2080.4, 2080.5, 2080.6, 4010.0,4010.1, 4010.2, 5010.27, and 5010.28).

1. It is important to note that there are securities registra-tion requirements under the Securities Act of 1933 related tothe issuance of commercial paper. A BHC should have proce-dures in place to ensure compliance with all applicable securi-ties and SEC requirements. Refer to manual section 2080.1.

Funding (Bank Holding Company Funding and Liquidity) 2080.05


Funding (Commercial Paper and Other Short-termUninsured Debt Obligations and Securities) Section 2080.1

Commercial paper is a generic term that is gen-erally used to describe short-term unsecuredpromissory notes issued by well-recognized andgenerally financially sound corporations. Thelargest commercial paper issuers are financecompanies and bank holding companies whichuse the proceeds as a source of funds in lieu offixed rate borrowing.Generally accepted limitations on issuances

and uses of commercial paper derive from Sec-tion 3(a)(3) of the Securities Act of 1933 (1933Act). Section 3(a)(3) exempts from the registra-tion requirements of the 1933 Act ‘‘any note . . .which arises out of a current transaction or theproceeds of which have been or are to be usedfor current transactions and which has a matu-rity at the time of issuance not exceeding ninemonths, exclusive of days of grace, or any re-newal thereof the maturity of which is likewiselimited. . . .’’ TheSecurities and Exchange Com-mission (SEC) has rulemaking authority overthe issuance of commercial paper.The five criteria, as set forth in an SEC inter-

pretation (SA Release #33–4412, September 20,1961), that are deemed necessary to qualifysecurities for the commercial paper exemptionare that the commercial paper must:

• Be of prime quality and negotiable;• Be of a type not ordinarily purchased by thegeneral public;

• Be issued to facilitate current operationalbusiness requirements;

• Be eligible for discounting by a Federal Re-serve Bank;

• Have a maturity not exceeding nine months.

2080.1.1 MEETING THE SECCRITERIA

The above criteria are discussed below.

2080.1.1.1 Nine-Month MaturityStandard

Although roll-over of commercial paper pro-ceeds on maturity is common, the SEC hasstated that obligations that are payable on de-mand or have provisions for automatic roll-overdo not satisfy the nine-month maturity standard.However, the SEC staff has issued ‘‘no action’’letters for commercial paper master note agree-ments which allow eligible investors to makedaily purchases and withdrawals (subject to a

minimum amount of $25,000) as long as thenote and each investor’s interest therein, doesnot exceed nine months. Such master noteagreements may permit prepayment by the is-suer, or upon demand of the investor, at anytime.

2080.1.1.2 Prime Quality

Most commercial paper is rated by at least oneof five nationally recognized statistical ratingorganizations. The SEC has not clearly articu-lated the line at which it will regard a specificrating of commercial paper as being ‘‘notprime’’ and, indeed, there is no requirement thata rating be obtained at all in order to qualify.SEC staff has issued a series of ‘‘no-action’’letters to individual bank holding companiesbased on specific facts and circumstances evenwhere it does not appear that a rating was ob-tained. However, where commercial paper isdowngraded to below what is generally re-garded as ‘‘investment quality’’ (ratings of lessthan medium grade—refer to theCommercialBank Examination Manual, section 203.1), or arating is withdrawn, BHCs may not be able toissue commercial paper based on the Section3(a)(3) exemption, in the absence of a markedsignificant improvement in the issuer’s financialcondition.

2080.1.1.3 Current Transactions

There have been considerable interpretativeproblems arising out of the current transactionsconcept. The SEC staff has issued a partiallaundry list of activities which would not bedeemed suitable for investment of commercialpaper proceeds, namely:1. The discharge of existing indebtedness,

unless such indebtedness is itself exempt undersection 3(a)(3) of the 1933 Act;2. The purchase or construction of a plant or

the purchase of durable machinery or equip-ment;3. The funding of commercial real estate de-

velopment or financing;4. The purchase of real estate mortgages or

other securities;5. The financing of mobile homes or home

improvements; or


6. The purchase or establishment of a busi-ness enterprise.The SEC has opined that commercial paper,

which is used as bridge financing by a bankholding company to fund a permanent acquisi-tion within the 270-day maturity period of thepaper, will meet the current transactions crite-rion. The amount of a bank holding company’scommercial paper cannot exceed the aggregateamount of ‘‘current transactions’’ of the bankholding company and its subsidiarieson a con-solidated basis. For this purpose, ‘‘currenttransactions’’ include dividends, interest, taxesand short-term loan repayments. In summary, inmost cases, the ‘‘current transactions’’ require-ment will not be a significant limitation onissuances of commercial paper by bank holdingcompanies.In addition to meeting SEC requirements, a

bank holding company must meet funding andliquidity criteria prescribed by the Board. For adetailed discussion on acceptable use of com-mercial paper in connection with a bank holdingcompany overall funding strategies, see Sec-tions 2080.05 and 2080.6.

2080.1.1.4 Sales to Institutional Investors

Commercial paper is generally marketed only toinstitutional investors (corporations, pensionfunds, insurance companies, etc.) although salesto individuals are not prohibited. It is clear,however, from the legislative history of the Sec-tion 3(a)(3) exemption that commercial paperwas not to be marketed for sale to the generalpublic. Currently, SEC staff will not issue ano-action letter if the minimum denomination ofthe commercial paper to be issued is less than$25,000. One of the underlying premises of theSection 3(a)(3) exemption is that purchasers ofcommercial paper have sufficient financial so-phistication to make informed investment deci-sions without the benefit of the information pro-vided by a registration statement. It is, therefore,generally recognized today that any individualpurchaser of commercial paper should meet the‘‘accredited investor’’ criteria of commercialpaper set forth in SEC Regulation D (17 C.F.R230.501(a)). To qualify as an ‘‘accreditedinvestor’’, an individual can meet one of twotests—a net worth test or an income test. Toqualify under the net worth test, an individual oran individual and his or her spouse must havea net worth at the time of purchase in excess

of $1 million. The alternative test requires$200,000 in income for each of the last twoyears ($300,000 if the spouse’s income is in-cluded) and a reasonable expectation of reach-ing the same income level in the current year.For additional information on marketing of

commercial paper, see the next subsection.

2080.1.2 MARKETING OFCOMMERCIAL PAPER

The sale of bank holding company (or nonbanksubsidiary) commercial paper by an affiliatedbank to depositors or other investors raises anumber of supervisory issues. Of particular con-cern is the possibility that individuals may pur-chase holding company paper with the misun-derstanding that it is an insured deposit orobligation of the subsidiary bank. The probabil-ity of this occurring is increased when a banksubsidiary is actively engaged in the marketingof the paper of its holding company or nonbankaffiliate, or when the holding company or non-bank affiliate has a name similar to the name ofthe commercial bank subsidiary.It is a long-standing policy of the Federal

Reserve (refer to letters SR 90–19 and SR–620)that debt obligations of a bank holding companyor a nonbank affiliate should not be issued,marketed or sold in a way that conveys themisimpression or misunderstanding that suchinstruments are either: 1) federally-insured de-posits, or 2) obligations of, or guaranteed by, aninsured depository institution. The purchase ofsuch holding company obligations by retail de-positors of an affiliated depository institutioncan, in the event of default, result in losses toindividuals who believed that they had acquiredfederally-insured or guaranteed instruments. Inaddition to the problems created for these indi-viduals, such a situation could impair publicconfidence in the affiliated depository institutionand lead to unexpected withdrawals or liquiditypressures.Events surrounding the sale of uninsured debt

obligations of holding companies to retail cus-tomers of affiliated depository institutions havefocused attention on the potential for problemsin this area. In view of these concerns, theFederal Reserve emphasizes that this policy ap-plies to the sale of both long- and short-termdebt obligations of a bank holding company andany nonbank affiliate, as well as to the sale ofuninsured debt securities issued by a state mem-ber bank or its subsidiaries. Debt obligationscovered by this supervisory policy include com-mercial paper and all other short-term and long-

Funding (Commercial Paper and Other Short-term Uninsured Debt Obligations) 2080.1


term debt securities, such as thrift notes andsubordinated debentures.Bank holding companies and nondepository

affiliates that have issued or plan to issue unin-sured obligations or debt securities should notmarket or sell these instruments in any publicarea of an insured depository institution whereretail deposits are accepted, including any lobbyarea of the depository institution. Bank holdingcompanies and any affiliates that are engaged inissuing debt obligations should establish appro-priate policies and controls over the marketingand sale of the instruments. In particular, inter-nal controls should be established to ensure thatthe promotion, sale, and subsequent customerrelationship resulting from the sale of uninsureddebt obligations is separated from the retaildeposit-taking functions of affiliated depositoryinstitutions.State member banks, including their subsidi-

aries, may also be engaged in issuing nonde-posit debt securities (such as subordinated debt),and it is equally important to ensure that suchsecurities are not marketed or sold in a mannerthat could give the purchaser the impression thatthe obligations are federally-insured deposits.Consequently, state member banks and theirsubsidiaries that have issued or plan to issuenondeposit debt securities should not market orsell these instruments in any public area of thebank where retail deposits are accepted, includ-ing any lobby area of the bank. Consistent withlong-standing Federal Reserve policy, debt obli-gations of bank holding companies or their non-bank affiliates, including commercial paper andother short- or long-term debt securities, shouldprominently indicate that: 1) they are not obliga-tions of an insured depository institution; and2) they are not insured by the Federal DepositInsurance Corporation. In cases where purchas-ers do not take physical possession of the obli-gation, the purchasers should be provided with aprinted advice that conveys this information.Employees engaged in the sale of bank holdingcompany debt obligations should be instructedto relate this information verbally to potentialpurchasers. In addition, with respect to the saleof holding company debt obligations, the instru-ments or related documentation should not dis-play the name of the affiliated bank in such away that could create confusion among potentialpurchasers about the identity of the obligor.State member banks involved in the sale ofuninsured nondeposit debt securities of the bankshould establish procedures to ensure that poten-tial purchasers understand that the debt securityis not federally-insured or guaranteed.Federal Reserve examiners are responsible

for monitoring compliance with this supervisorypolicy; and, as part of the examination of statemember banks and bank holding companies, areexpected to continue to review the polices andinternal controls relating to the marketing andsale of debt obligations and securities. Examin-ers should determine whether the marketing andsale of uninsured nondeposit debt obligationsare sufficiently separated and distinguished fromretail banking operations, particularly thedeposit-taking function of the insured deposi-tory affiliate.In determining whether the activities are suf-

ficiently separated, examiners should take intoaccount: 1) whether the sale of uninsured debtobligations of a holding company affiliate oruninsured nondeposit debt securities of a statemember bank is physically separated from thebank’s retail-deposit taking function, includingthe general lobby area1; 2) whether advertise-ments that promote uninsured debt obligationsof the holding company also promote insureddeposits of the affiliated depository institution ina way that could lead to confusion; 3) whethersimilar names or logos between the insured de-pository institution and the issuing nonbankaffiliate are used in a misleading way to promotesecurities of a nonbank affiliate without clearlyidentifying the obligor; 4) whether retaildeposit-taking employees of the insured deposi-tory institution are engaged in the promotion orsale of uninsured debt securities of a nonbankaffiliate; 5) whether information on the sale ofuninsured debt obligations of a nonbank holdingcompany affiliate is available in the retail bank-ing area; and 6) whether retail deposit state-ments for bank customers also promote informa-tion on the sale of uninsured debt obligationsof the bank holding company or a nonbankaffiliate.The Board’s policy is that the manner in

which commercial paper is sold should not leadbank customers or investors to construe com-mercial paper as an insured obligation or aninstrument which may be higher in yield butequal in risk to insured bank deposits. All pur-chasers of commercial paper should clearlyunderstand that such paper is an obligation ofthe parent company or nonbank subsidiary andnot an obligation of the bank and that the quality

1. This policy is not intended to preclude the sale ofholding company affiliate obligations from a bank’s moneymarket desk, provided that the money market function isseparate from any public area where retail deposits are ac-cepted, including any lobby area.



of the investment depends on the risks andoperating characteristics associated with theoverall holding company and its nonbankingactivities.

2080.1.3 THRIFT NOTES ANDSIMILAR DEBT INSTRUMENTS

In the event a bank holding company or non-banking affiliate issues thrift notes or other debtobligations which do not fall within the gener-ally accepted definition of commercial paper,examiners should be guided by the Board’s1978 position on the issuance of small denomi-nation debt obligations by bank holding compa-nies and their nonbanking affiliates. At that time,the Board was considering thrift notes issued bya nonbanking subsidiary of a bank holding com-pany and concluded that such obligations shouldprominently indicate in bold type on their facethat the obligations are not obligations of a bankand are not FDIC insured. The Board also statedthat the obligations should not be sold on thepremises of affiliated banks. Where there is sub-stantial reliance on the sale of thrift notes tofund the operations of a bank holding companyor nonbanking subsidiary, other than an indus-trial bank, a violation of the Glass–Steagall Actmay be involved. Such cases should be dis-cussed with Reserve Bank counsel.

2080.1.4 OTHER SHORT-TERMINDEBTEDNESS

A company’s access to bank credit is almostuniversal, and most small to medium-sized com-panies will reflect this type of debt on theirbalance sheets. An important point to rememberabout bank debt is that maturities of the banknotes are usually short-term while the proceedsof the borrowings are often applied to long-termassets, that is, investment in the bank’s capitaland/or long-term debt accounts. The note maybe subject to renewal on an annual basis, andthe creditor may have the opportunity to call thenote at renewal if the financial condition of thecompany has deteriorated. Rates of interest onshort- term bank notes are usually pegged to thecreditor’s prime rate plus some fraction thereof.The principal is often repaid over a period ofyears as the notes are rolled over despite theirshort-term maturity.

2080.1.5 CURRENT PORTION OFLONG-TERM DEBT

This type of debt has many of the short-termcharacteristics of bank debt, with possibly oneadditional important feature. Such debt is usu-ally tied to a written agreement between creditorand debtor, and encompasses certain minimumstandards of performance to be adhered to bythe company. The examiner must review theagreement to determine that the company isoperating within the parameters of the cove-nants laid out in the agreement. Failure to abideby the covenants can trigger default provisionsof the agreement and escalate the repayment ofthe total loan balance outstanding.


1. To determine the company’s policy andactual practices with respect to the sale of unin-sured debt obligations and securities issued bybank holding companies, nonbank affiliates orState member banks. More often than not, aninformal policy evolves from practice. It thenbecomes important to interview senior officersin charge of this function to determine if theyare adequately aware of the statutory and regula-tory constraints with respect to appropriate us-age of commercial paper.2. To review the company’s funding and

liquidity strategy with a view to determiningwhether it has sufficient liquid assets to supportmaturing liabilities and whether there are anyfunding mismatches. (See Manual sections2080.05, 4010.2.3, 4010.2.7, and 5010.24.1)3. To determine compliance with the Federal

Reserve System’s supervisory policy with re-gard to the marketing of commercial paper, thriftnotes or similar type debt instruments (refer toBoard letter S 2427 dated June 27, 1980, andsupervisory letters SR 90–19 and SR 620).4. To identify potential weaknesses in corpo-

rate policy and practices.


1. Review the bank holding company’s pro-cedures for authorizing the issuance of commer-cial paper and other uninsured debt obligationsand securities of the holding company and/or itsnonbank affiliates.2. Review the board of directors’ resolution

authorizing the issuance of commercial paperand other uninsured debt obligations andsecurities.



3. Determine whether the company hassought a ‘‘no action’’ letter from the SEC. A‘‘no action’’ letter indicates the SEC has re-viewed the company’s issuance of commercialpaper and plans ‘‘no action’’ to require the regis-tration of the commercial paper as ‘‘securities.’’Some companies rely on the opinion of theirown counsel that their paper is not subject toSEC registration requirements. If the companydoes not have a ‘‘no action’’ letter there shouldbe a legal opinion on file from the holdingcompany’s attorney regarding exemption fromregistration under section 5 of the 1933 Act.4. Obtain a copy of the holding company’s

written policy on paper usage to compare withresolution and practice.5. Review to determine the extent to which

the commercial paper and other uninsured debtobligations are supported by back-up lines ofcredit provided by unaffiliated banks. Theselines are established to cover any unexpectedrun-off of paper at maturity. Commitments forlines of credit should be in writing and haveexpiration dates. Commitment fees substantiatethe enforceability of the commitment whereascompensating balances tend to indicate that thelending commitment is less formal. The exam-iner should determine whether material adversechange clauses exist in back-up line of creditagreements which may affect their reliability.Comment if it appears that those provisionsmight be utilized.

Compensating balance arrangementsshould be disclosed. A company may commit toa compensating balance, but if it relies on itsbank subsidiary to provide the funds the bankshould be compensated for utilization of itsfunds.

Reciprocal back-up lines may be estab-lished. This may eliminate the need for fees orcompensating balances and may provide a cer-tain comfort level for company management.6. Obtain a listing of commercial paper and

other uninsured debt obligation holders frommanagement to the extent known. In the case oflarger BHCs, there is a choice between issuingpaper on a local level or placing it nationallythrough the auspices of an investment bankingfirm. In the latter case, there is likely to be norecord of who purchases the paper because thepaper is usually sold on a bearer basis. Holdingcompanies looking for a wider market, nationalrecognition, and higher ratings place their paperthrough an investment banking firm. However,it should be recognized that the market for com-mercial paper placed in this manner is moresophisticated and knowledgeable and thereforemore sensitive to adverse developments than a

local market. The smaller company can be con-tent to sell its paper on a local level through itscorporate headquarters, knowing its customerprofile and limiting the amount to any onepaperholder, thereby limiting its exposure torefinancing problems caused by large scaleredemptions.7. Review for potential weaknesses in corpo-

rate policy and practices. Any amounts in ex-cess of 10 percent in the hands of one paper-holder should be discussed with managementand noted in the report. A large paperholdercould refuse to purchase new paper at maturity(rollover) and place the company in a liquiditysqueeze, requiring sell-off of assets or drawdown of back-up lines.

Rollovers are prohibited under the 1933Act. The instrument must have a definite date ofmaturity with no automatic provision for rein-vestment of proceeds. Companies must abide bythe 270-day provision and if the paperholderelects to reinvest the funds, a new instrumentshould be executed.8. Request a copy of the commercial paper,

thrift note or similar type instrument, and anyprinted advice to the purchasing customer forreview. These documents should be checked forcompliance with the standards set forth underthe captions ‘‘Marketing of Commercial Paper’’and ‘‘Thrift Notes and Similar Debt Instru-ments’’ in this section of the Manual.9. If a bank sells the commercial paper and/or

other uninsured debt obligations of its holdingcompany or nonbanking affiliate, review theprocedures to separate their sale from the retailoperations of the bank.

This segregation should be reviewed aspart of all holding company inspections. Exam-iner judgment must be relied upon, to a largeextent, to determine whether the marketing ac-tivities of commercial bank subsidiaries for thebank holding company’s commercial paper andother uninsured debt obligations are sufficientlyseparated and distinguished from retail bankingoperations, particularly the deposit- taking func-tion. In making this determination, the examinershould consider whether:

a. The sale of uninsured debt obligationsof a holding company affiliate or uninsured non-deposit debt securities of a state member bank isphysically separated from the bank’s retail-deposit taking function, including the generallobby area;

b. Advertisements that promote uninsureddebt obligations of the holding company also



promote insured deposits of the affiliated depos-itory institution in a way that could lead toconfusion;

c. Similar names or logos between the in-sured depository institution and the issuing non-bank affiliate are used in a misleading way topromote securities of a nonbank affiliate withoutclearly identifying the obligor;

d. Retail deposit-taking employees of theinsured depository institution are engaged in thepromotion or sale of uninsured debt securities ofa nonbank affiliate;

e. Information on the sale of uninsureddebt obligations of a nonbank holding companyaffiliate is available in the retail banking area;and

f. Retail deposit statements for bank cus-tomers also promote information on the sale ofuninsured debt obligations of the bank holdingcompany or a nonbank affiliate.

In those cases where the bank holdingcompany or nonbanking affiliates issue thriftnotes or similar type debt instruments, ascertain

that these obligations are not being sold on thepremises of affiliated banks.10. The procedures in Nos. 8 and 9 address

the manner in which bank holding companies(or nonbanking subsidiaries) market their com-mercial paper, thrift notes or similar type debtinstruments; consequently, implementation willnecessitate review of marketing procedures ofall holding companies (or nonbanking subsidi-aries), regardless of the type of charter or theidentity of the primary supervisor of the subsid-iary (affiliate) bank. Exceptions to the policieson the marketing of such paper should be notedon the ‘‘Commercial Paper and Lines of Credit’’pages and discussed on the ‘‘Examiner’sComments’’ page of the inspection report. Themanagements of all bank holding companiesmust be fully informed of the Federal Reserve’spolicy with respect to the marketing of holdingcompany debt obligations, as in SR Letter90–19, and exceptions should be addressed inthe supervisory follow-up process.



Funding(Long-Term Debt) Section 2080.2

Long-term debt represents an alternativefinancing method to short-term debt and equityfunds. Before choosing this type of funding thebank holding company will need to determinehow the advantages and disadvantages of long-term debt apply to its financial position andfunding needs. Interest on long-term debt is anexpense item and therefore is tax deductible.The company issuing debt effectively paysapproximately ‘‘half-price’’ (interest expensenet of tax deduction) on debt while the companyissuing equity pays the full dividend rate with-out a tax benefit. Counterbalancing the tax ad-vantage is the fact that long-term debt must beserviced and retired to prevent default and can-not be used as an offset for losses.The issuance of long-term debt will be rela-

tively advantageous to the holding companywhose price/earnings ratio is low and whosestock is selling significantly below book value.In this instance, the cost to the company ofequity funding rises proportionately to the dropin the price of the stock since less funds areobtained for an equal number of shares, yet thedividend per share remains the same.A major factor influencing a bank holding

company’s decision to issue long-term debt in-stead of equity is the dilution impact of newequity. Straight debt will not dilute ownershipand is typically retired from cash flow, whereasnew equity dilutes earnings per share (more sothan the impact of the debt’s interest expense onearnings).Preferred stock can be retired through a sink-

ing fund and is sometimes convertible to com-mon shares. Convertible stock adds to the dilu-tion effect when the conversion is exercised andprior to conversion, ‘‘fully diluted’’ earnings pershare must be reported that assume full conver-sion. The bank holding company will considerboth stockholder and market reaction to anydilution effects of long-term financing. TheBHC may view debt financing as the best alter-native if it feels that a diluted earnings per sharewould drive down the market price of its stockand contribute to stockholder discontent.Inherent in any financing are intangible costs.

While it is evident that on the surface debtfinancing is cheaper than equity financing, itwould be hard to quantify the effects of poten-tial missed interest payment or default associ-ated with debt instruments. The bank holdingcompany also will be concerned with its addi-tional ‘‘debt capacity’’ if the present issuance ofdebt pushes the debt/equity ratio beyond accept-able limits.

Theoretically, ‘‘straight debt’’ is a direct se-cured or unsecured obligation requiring repay-ment at maturity and generally taking a seniorposition in the claim on assets. Principal issometimes payable in a lump sum, often throughthe use of a sinking fund, while interest is paidat stated periods throughout the life of the note.

2080.2.1 CONVERTIBLESUBORDINATED DEBENTURE

A convertible subordinated debenture is an un-secured debt that is subordinate to other debtand convertible to common stock at a certaindate or price. The essential provision of thisdebt is that it may eventually be retired byequity and inherently has the potential for dilu-tion. With this type of financing, the creditortypically has the right to convert the bond into astated number of shares of common stock atsome future time. Usually the conversion priceis 10 to 15 percent above the market price of thestock. This encourages the bondholder to keepthe bond until the market price meets or sur-passes the conversion price. In many convert-ible debt agreements, the bank holding companyissuing debt will have the option to call the issuewhen the conversion price equals the marketprice.The bank holding company will issue a con-

vertible subordinated debenture when its stockprice is depressed. The convertibility provisionis added as a ‘‘sweetner’’ to the issue and coun-teracts the negative aspect of its subordinatedposition. The subordinated nature of this issuewill help a bank holding company with priordebt which includes covenants that dictateagainst additional senior debt.

2080.2.2 CONVERTIBLE PREFERREDDEBENTURE

This debt instrument is similar to straightconvertible debt except it is convertible intopreferred stock. This alternative is open to thebank holding company which needs to add a‘‘sweetner’’ to this issue in order to marketit, but does not want dilution of ‘‘common’’ownership.


2080.2.3 NEGATIVE COVENANTS

The lender will be concerned with the borrow-er’s debt structure when offering financing. Ifthe borrower’s debt/equity ratio is approachingan unacceptable level, the lender will try toassure that the bank holding company does notoverextend itself. While the lender may demandthe right to approve future equity issues, thelender is likely to be more willing to give suchapproval than to allow more debt because theequity issue adds to the capital base, and thisbase is a possible source of funds for the pay-ment of debt.Closely related to the restriction on further

debt is the position of the lender in the liquida-tion of assets. The holder of a straight debt issuewill usually demand to be senior to other debtholders. This characteristic is particularly suitedto straight debt because straight debt is morevulnerable to default than convertible debt anddoesn’t have other sweetners such as a conver-sion right or a right to participate in distribu-tions of earnings. The examiner will want to de-termine how the covenants affect futuredebt financing and if the effect is positive ornegative.The lender is likely to seek to insure that

neither the structure nor policies of the bankholding company are altered without its ap-proval during the life of the debt. The lender caninsure this through other negative covenantsattached to the debt. Some common covenantsof this type include (1) limitations on capitalexpenditures and on the sale of assets, (2) re-strictions on the BHC’s redemption of its ownstock, (3) restrictions on investments in general,(4) restrictions on dividend payment withoutprior approval, and (5) the imposition of loan tocapital ratios, deposit to capital ratios and assetto capital ratios.


1. To determine the existence of and adher-ence to policies on long-term debt.2. To review the use of long-term funds.3. To determine the existence of debt cove-

nants and compliance by the holding company.


1. Review the parent-only balance sheet andincome statement for debt and interest expensecaptions.2. Review the consolidated balance sheet and

income statement for debt and interest expensecaptions.3. Review any written policies and proce-

dures available as part of an overall capital plan.If no plan or policies exist, the examiner shouldencourage management to develop them, and inlarge BHCs, to put them in writing.4. Determine that the bank holding company

does not finance long-term assets with short-term debt, as this leaves the holding companyvulnerable to rising interest rates and the possi-bility of a credit crunch. On the other hand, itmay be beneficial for the holding company tofinance short-term assets with long-term debt.This is particularly true during periods of risinginterest rates because the bank holding companycan get higher yields on loans financed by lowercost long-term debt, than it can with commercialpaper that has to be turned over at generallyincreasing rates. In any event, the bank holdingcompany will need to insure that it has amplecapacity to finance additional long-term assetswith long-term debt when the opportunity pre-sents itself.5. Review any sinking fund provisions usu-

ally found with straight debt and straight pre-ferred issues if the issue is not going to berefinanced by further debt or by an equity issue.Since payments to the fund will directly draincash reserves, it is imperative that the bankholding company have adequate annual cashflow to service both the interest and add to thesinking fund. The larger the debt, the more thelender will look for a sinking fund feature as ameans of precluding a default when maturityoccurs and refinancing is not available. When asinking fund exists the examiner will need toanalyze the parent’s cash flow statement to seethat payments do not produce an adverse cashdrain.

Funding (Long-Term Debt) 2080.2


Funding(Equity) Section 2080.3

The capacity of the holding company to serve asa source of financial strength to its bank subsid-iaries is a major consideration of the FederalReserve Board in supervising a bank holdingcompany. The cornerstone of this financialstrength is capital adequacy.The financial structure of banking organiza-

tions allows for the use of substantial leverage.If capital is large in relation to debt, additionalborrowing is relatively inexpensive. However,because of added risk to lenders, the cost ofborrowing increases as new obligations areassumed. At some point, therefore, equityfinancing becomes less costly and may becomethe only alternative available for needed funds.Basically, a holding company’s financial

structure can be viewed in two ways: the ‘‘singleentity’’ approach, whereby the holding companyis considered an integrated entity and financialstrength is assessed on the basis of its consoli-dated totals, and the ‘‘building block’’ approach,wherein the holding company is seen as a col-lection of individual components. In the latterview, the company’s financial strength is as-sessed primarily in terms of the financial struc-ture of each component.When applying the ‘‘building block’’ ap-

proach, the liability and capital structure of eachsubsidiary is compared to the norm of its par-ticular industry. The use of the ‘‘building block’’approach has some advantages:1. Comparative statistics are usually avail-

able to measure the performance and strength ofthe individual subsidiaries.2. It permits comparison of capitalization

between holding companies engaged in differ-ing activities.3. It identifies the degree of leveraging within

a single subsidiary of a bank holding company.The parent should maintain a favorable bal-

ance of debt and equity so that it will be able toassist its subsidiaries when necessary throughcontributions of its own capital or through addi-tional funds generated from debt or equityfinancing.At times, however, sale of additional stock

may not be a viable alternative for capital for-mation, even when a company can show afavorable debt/equity balance. Reluctance to en-ter into a new stock offering may stem from adesire to avoid further dilution of existing own-ership interest or from an unfavorable marketprice of outstanding stock in relation to bookvalue. In these instances, long-term quasi-capitalfunds may sometimes be obtained through other

sources, such as convertible securities or subor-dinated debt.

2080.3.1 PREFERRED STOCK

Preferred stock is becoming a more acceptablealternative due to certain advantages. Throughcontracted covenants, it is senior to commonstock because it usually has no voting voice inmanagement as does common stock. Preferredstock usually carries a fixed dividend rate that iseither cumulative or noncumulative. Cumula-tive preferred provides that unpaid dividends inprior years must be paid to preferred sharehold-ers before common dividends can be paid. Anoncumulative feature provides that dividendsforegone during lean years are lost permanently.From the viewpoint of the bank holding com-pany, a noncumulative preferred issue is moredesirable, while investors would desire a cumu-lative feature.Perpetual preferred stock does not have a

stated maturity date and it may not be redeemedat the option of the holder. Advantages thatpreferred stock can offer the bank holding com-pany are (1) avoidance of dilution of earningsper common share and (2) absence of votingrights. On the other hand, dividend payments,particularly cumulative dividends, are expen-sive since they are not a tax-deductible expenseas is interest on debt. Cumulative dividends canbe particularly draining on cash when they aredeclared after several years of suspended divi-dends and payment is then made in a lumpsum.Preferred stock is usually retired by refinanc-

ing with debt or through its own conversionfeature. If the bank holding company feels thatit can afford an equity issue in the future but notat present, it can issue a convertible preferreddebenture to postpone the equity issue until alater date. On the other hand, if debt is thedesired method of financing but the present debt/equity ratio is not acceptable, the bank holdingcompany will issue preferred and refinance withdebt at a more opportune time. However, theBoard has expressed concern that in applica-tions to form a BHC, preferred stock not beused as a debt substitute resulting in circumven-tion of its debt guidelines. On applications withpreferred stock which has debt-like characteris-

BHC Supervision Manual June 1996Page 1

tics, such stock may be treated as debt in thefinancial analysis.


1. To determine the existence of and adher-ence to parent company policies on capital ade-quacy within the subsidiaries and for the con-solidated organization.2. To review the use of proceeds of equity

capital financings.

3. To review any debt covenants that pertainto a minimum acceptable capital position.


1. Review any existing BHC policies regard-ing capital adequacy or capital planning.2. Request any plans regarding proposed

capital issues.

Funding (Equity) 2080.3


Funding(Retention of Earnings) Section 2080.4

Earnings retention provides the most immediatesource of capital formation and growth. Earn-ings retained after dividend payout can often besufficient to keep pace with asset growth,thereby preserving the balance or relationshipbetween equity capital and total assets. Oftenreferred to as ‘‘internal funding,’’ earnings reten-tion should be carefully reviewed to assure thatthe BHC’s capital base is keeping pace withasset growth.

Bank earnings retention should be reviewedcarefully due to the dividend requirements oftenimposed on banks by their parent companies.Although a bank’s board of directors mustapprove the declaration and payment of anybank dividend, often the bank’s board is actu-ally ratifying a decision determined at the parentlevel. The need for bank retention of earnings isparticularly pronounced either during periods ofexpansion or periods of declining earnings orlosses.

Parent company management may be underpressure from shareholders or ‘‘the market’’ toincrease dividends or to maintain dividends athistoric levels despite reversals in consolidatedearnings trends. Examiners should be careful topoint out to management that dividend pres-sures often serve to the detriment of the banksubsidiary(ies) which is often asked to supplythe proceeds via a dividend to the parent com-pany. As a regulator of banks (and bank holdingcompanies), the Federal Reserve System is con-cerned with the preservation and maintenanceof a sound banking system and in particular,soundly capitalized banks. Earnings retentioncontributes to capital growth and should beencouraged. For additional information on earn-ings retention and dividends see sections2020.5.1, 4010.1, 4020.1, and 4060.9. See sec-tion 4070.1 of the Commercial Bank Examina-tion Manual.

2080.4.1 PAYMENT OF DIVIDENDSBY BANK SUBSIDIARIES

Bank dividends can be determined to be exces-sive if they exceed the limitations imposed byeither section 5199(b) or 5204 (also referred to

as sections 56 and 60(b)) of the Revised Statutesand accordingly, should be reviewed with regardto those limitations. The Federal Reserve Boardamended Regulation H regarding the paymentof dividends by state member banks on Decem-ber 20, 1990, [12 C.F.R. 208.19(a) and208.19(b)]. The rule was revised, effective Octo-ber 1, 1998, and replaced as renumbered section208.5 (see 12 C.F.R. 208.5), ‘‘Dividends andother distributions.’’ It sets forth the ‘‘Limitationon withdrawal of capital by dividend or other-wise,’’ in subsection 208.5(d). The regulationdiscusses the elements that are taken intoaccount in determining a state member bank’sdividend paying capacity. Two different calcula-tions are performed to measure the amount ofdividends that may be paid, a Net Income Testand an Undivided Profits Test.

2080.4.1.1 Net Income Test

The approval of the Federal Reserve is requiredfor dividends declared by a member bank that inany calendar year exceeds the net income of thecurrent year, combined with retained net incomefor the two preceding years (the ‘‘Net IncomeTest’’).

2080.4.1.2 Undivided Profits Test

A member bank must receive prior approval ofthe Federal Reserve, and of at least two-thirds ofthe shareholders of each class of stock outstand-ing, before paying dividends in amounts greaterthan undivided profits.


Funding (Pension Funding andEmployee Stock Option Plans) Section 2080.5

Holding companies have turned to employeepension plans and, to a lesser degree, stockoption plans as ways to provide added capitalfor holding company operations. While theremay be a number of reasons for implementingsuch programs, one of the by-products is theflow of working capital into the holding com-pany. The program usually involves a pre-taxcontribution by the holding company to an em-ployee benefit plan (e.g., profit sharing plan)and the resulting purchase by such plan of com-mon or preferred shares of the holding compa-ny’s stock. The holding company benefitsthrough the use of the funds for working capital,and the plan provides for retirement benefits foremployees as shareholders in the company.Since ESOPs are administered under the Em-ployees Retirement Income Security Act of1974 (ERISA), the guidelines delineated inSR 85–21 should be followed in determiningwhether possible ERISA violations exist. Refer-ence should also be made to Manual section4010.1.1.

2080.5.1 STOCK OPTION PROGRAMS

Employee stock option programs generate anominal percentage of a holding company’sfinancing needs to reward key employees forservice rendered via the reduced price of thecompany’s stock. While such programs consti-tute one method of available funding for a hold-ing company, they generally may not be ex-pected to add any capital amounts beyondnominal levels.

2080.5.2 EMPLOYEE STOCKOWNERSHIP PLANS (ESOPS)

Employee Stock Ownership Plans (ESOP) arean alternative holding company funding tool.An ESOP is a tax-qualified employee benefitplan which is designed to be invested primarilyin employer stock. The concept of an ESOP isto encourage the establishment of employeebenefit programs which expand the employees’share in company stock ownership. Participa-tion in an ESOP may also significantly enhanceemployee motivation. The essential differencesbetween an ESOP and other qualified stockbonus plans are that an ESOP is permitted, incertain circumstances, to incur liabilities in theacquisition of employer securities, and that anemployer may receive additional tax credits for

amounts contributed to ESOPs. Under limitedcircumstances, lenders to ESOP’s may also re-ceive benefits that result in reduced borrowingcosts to the ESOP. As long as ESOP meets theIRS requirements for a qualified employee plan,it may invest up to 100% of its assets in‘‘qualifying’’ employer securities. It is exemptfrom some of the self-dealing limitations appli-cable to most employee benefit plans, as it isviewed as a means of providing stock owner-ship interests for employees rather than asstrictly a retirement plan. Furthermore, an ESOPmay purchase the stock either from the em-ployer company or from shareholders. There-fore, in addition to use as a tool of corporatefinance, an ESOP may serve as a ready pur-chaser for outstanding stock, without a corre-sponding loss of voting control.ESOPs are in some ways similar to deferred

profit sharing plans. ESOPs are authorized un-der the same section, namely, section 401 of theInternal Revenue Code. Employer contributions(within limits based on a percentage of eligiblepayroll) are allowable deductions from the em-ployer’s pre-tax income. Contributions are heldin trust, and benefits when paid out upon anemployee’s retirement, death, or termination ofservice, must be paid in company stock. Thedistinguishing feature of an ESOP lies in thefact that the direct purpose of the plan is toinvest employer contributions in the stock of thecompany.

2080.5.2.1 Accounting Guidelines forLeveraged ESOP Transactions

Newly issued or existing shares of BHC stockare sometimes sold to the ESOP and paid forwith money borrowed from a third party; thesetypes of ESOPs are commonly referred to as‘‘leveraged ESOPs.’’ The borrowings are gener-ally serviced with contributions by the em-ployer, which are a tax deductible expense. Theborrowing arrangement by the ESOP often in-cludes a guarantee or commitment by the em-ployer (the BHC or the subsidiary bank) tomake future contributions to the ESOP suffi-cient to meet debt service requirements.When this occurs, questions arise involving

the appropriate accounting for the leveragedESOP transaction. The Accounting StandardsExecutive Committee of the American Institute


of CPAs has issued a Statement of Position(SOP) 72–3 which discusses ESOP borrowingsituations. Since the Federal Reserve appliesgenerally accepted accounting principles, banksand bank holding companies should follow SOP76–3. The SOP statement covers cases wherethe employer either guarantees the ESOP loanor commits to make future ESOP contributionssufficient to service the debt. For such cases, theSOP indicates that the employer should credit aliability account for the amount of the ESOPdebt and offset that entry by reducing sharehold-ers’ equity. The liability recorded by the em-ployer should be reduced as the ESOP makespayments on the debt. This liability is recordedbecause the guarantee or commitment is in sub-stance the employer’s debt. When there is noguarantee, the ESOP is treated like any othershareholder.In other words, where there is a leveraged

ESOP which has purchased BHC stock, andthere is a guarantee, commitment, or otherarrangement which is in effect a guarantee rela-tive to the debt service of the ESOP, for analyti-cal purposes the amount of ESOP debt will beconsidered as parent debt and thus parent equitywill be reduced accordingly. This will affectdebt to equity ratios as well as consolidatedcapital ratios, where applicable.

2080.5.2.2 Fiduciary Standards underERISA Pertaining to ESOPs

There are also general fiduciary standards underERISA pertaining to ESOPs which have beendelineated largely through court decisions ratherthan issuance of regulations. Although ex-empted from ERISA’s asset diversification re-quirement, ESOP transactions are still requiredto meet fiduciary standards of prudence, andmust be designed and administered for the ‘‘ex-clusive benefit’’ of plan employees. (ERISA§404(a) and 29 CFR 2550.407d–6). Yet, asstated above, ESOPs may have distinct advan-tages which inure primarily to the sponsoringcompany, its management and large sharehold-ers. Due to these potential or actual conflicts ofinterest, it is important that the sponsoring em-ployer and any other fiduciaries of a plan under-take every effort to assure full consideration ofthe best interests of plan employees.The safeguarding of the statutory ‘‘exclusive’’

interests of plan employees pursuant to ERISAis within the jurisdiction of the IRS and the

Department of Labor. The bank regulatory agen-cies also have some responsibility in their re-view and examination activities where employeebenefit plans such as ESOPs are involved. Inthis connection, a Uniform Interagency ReferralAgreement mandated by statute, has been ineffect since 1980 whereby certain possible vio-lations of the provisions of ERISA are referredto the DOL by the Division of Banking Supervi-sion and Regulation, pursuant to delegated au-thority. SR 81–697 (SA) contains the proce-dures for making referrals to the Department ofLabor. Attached to the SR letter is an exhibit,ERISA Referral Format,which lists the informa-tion necessary when making referrals. Holdingcompany examiners can expedite the ERISAreferral process by including that information intheir reports.

2080.5.3 STATUS OF ESOP’S UNDERTHE BHC ACT

On August 6, 1985, the Board determined (1985FRB 804) that an ESOP that controls more than25 percent of the voting shares of a bank orbank holding company is a bank holding com-pany. The Board determined that the underlyingtrust which held the shares of the bank holdingcompany is a ‘‘business trust’’ as defined in theBHC Act and was thus not excluded from thedefinition of a ‘‘company’’ under the terms ofthe Act.

2080.5.4 INSPECTIONCONSIDERATIONS

Examiners should review unfunded pension lia-bilities of the BHC to determine their potentialimpact on the organization. In addition, examin-ers should review the soundness of any borrow-ings used to fund ESOP purchases of BHCstock. ESOP borrowings from an affiliated bankused to purchase BHC shares may result in anapparent increase in BHC capital which in factturns out to have been funded with subsidiarybank funds, a practice considered suitable forin-depth review by examination staff. Section401 (of the Internal Revenue Code) plan hold-ings of BHC stock need to be evaluated underthe ‘‘content’’ provisions of the BHC Act,change in Bank Control Act, and Regulation Y.When an ESOP is subject to the Change in

Bank Control Act, this fact should be brought tothe attention of a BHC’s management. Section225.41 of Regulation Y specifies transactions—acquisitions—that would require providing the

Funding (Pension Funding and Employee Stock Option Plans) 2080.5


Board with 60 days prior written notice beforeacquiring control of a bank holding company(or a state member bank), unless the transactionis exempt under section 225.42 of the Regula-tion. In addition to the above, a determination

should be made as to whether the ESOP is abank holding company. The examiner may alsorefer to the Financial Accounting StandardsBoard’s Statement No. 87, ‘‘Employers’ Ac-counting for Pensions.’’

Funding (Pension Funding and Employee Stock Option Plans) 2080.5


Funding (Bank Holding Company Fundingfrom Sweep Accounts) Section 2080.6

A key principle underlying the Federal Re-serve’s supervision of bank holding companiesis that such companies should be operated in away that promotes the soundness of their subsid-iary banks. Holding companies are expected toavoid funding strategies or practices that couldundermine public confidence in the liquidity orstability of their banks. Consequently, bankholding companies should develop and maintainfunding programs that are consistent with theirlending and investment activities and that pro-vide adequate liquidity to the parent companyand its nonbank subsidiaries.

2080.6.1 FUNDING BY SWEEPINGDEPOSIT ACCOUNTS

A principal objective of a bank holding compa-ny’s funding strategy should be to maintain anadequate degree of liquidity at the parent com-pany and its subsidiaries. Funding mismatchescan exacerbate an otherwise manageable periodof financial stress and, in the extreme, under-mine public confidence in an organization’sviability. In developing and carrying out fund-ing programs, bank holding companies shouldgive special attention to the use of overnight orextremely short-term liabilities since a loss ofconfidence in the issuing organization couldlead to an immediate funding problem. Accord-ingly, bank holding companies relying on over-night or extremely short-term funding sourcesshould maintain a level of superior quality as-sets, namely, assets that can be immediatelyliquidated or converted to cash with minimalloss, that is at least equal to the amount of thosefunding sources.A potential source of funding mismatch arises

from the use of what has been commonly re-ferred to as deposit sweeps. This practice isbased upon an agreement with a subsidiarybank’s deposit customers (typically corporateaccounts) which permits these customers to re-invest amounts in their deposit accounts above adesignated level in overnight obligations of theparent bank holding company. These obliga-tions include such instruments as commercialpaper, program notes, and master notes.In view of the extremely short-term maturity

of most sweep arrangements, banking organiza-tions should exercise great care when investingthe proceeds. Appropriate uses of the proceedsof deposit sweep arrangements are limited toshort-term bank obligations, short-term U.S.Government securities, or other highly liquid,

readily marketable, investment grade assets thatcan be disposed of with minimal loss of princi-pal.1 Use of such proceeds to finance mis-matched asset positions, such as those involvingleases, loans, or loan participations, can lead toliquidity problems at the parent company andare not considered appropriate. The absence of aclear ability to redeem overnight or extremelyshort-term liabilities when they become dueshould generally be viewed as an unsafe andunsound banking activity.Reserve Bank supervisory and examination

personnel are to ensure that bank holding com-panies and their state member banks are incompliance with this section and related super-visory letters addressing the marketing of unin-sured debt instruments, including master notesand other sweep arrangements (refer to Manualsections 2080.05 and 2080.1). Banking organi-zations not in compliance should take the neces-sary steps to achieve full compliance within areasonable period of time. Reserve Banksshould provide copies of the supervisory letterSR 90–31 to any bank holding company en-gaged in sweep arrangements with their subsidi-ary banks, or to any other organization if neces-sary to facilitate compliance.

1. Some banking organizations have interpreted languagein a 1987 letter signed by the Secretary of the Board ascondoning funding practices that may not be consistent withthe principles set forth in this supervisory letter and priorBoard rulings. The 1987 letter involved a limited set of factsand circumstances that pertained to a particular banking orga-nization; it did not establish or revise Federal Reserve policieson the proper use of the proceeds of short-term fundingsources. In any event, banking organizations should no longerrely on the 1987 letter to justify the manner in which they usethe proceeds of sweep arrangements. Banking organizationsemploying sweep arrangements are expected to ensure thatthese arrangements conform with the policies contained inthis section and in the Manual section 2080.05 on bankholding company funding.


Control and Ownership(General) Section 2090.0


Effective July 2010, this section has beenrevised to include a reference to the Board’sSeptember 21, 2008, ‘‘Policy Statement onEquity Investments in Banks and Bank HoldingCompanies.’’ (See the Board’s September 22,2008, press release and section 2090.4.4.) Thepolicy statement provides additional guidanceon the Board’s position on minority equityinvestments in banks and bank holding compa-nies that generally do not constitute ‘‘control’’for purposes of the Bank Holding Company Act.This policy updates the guidance found in theBoard’s July 1982 ‘‘Policy Statement on Non-voting Equity Investments by Bank HoldingCompanies.’’ (See section 2090.4.)

2090.0.05 DEFINITIONS

The control provisions of the Bank HoldingCompany Act (the act) are found in section2(a)(1) and (2) (see 12 U.S.C. 1841(a)) underthe definition of a bank holding company. Abank holding company is defined as ‘‘any com-pany which has control over any bank or overany company that is or becomes a bank holdingcompany by virtue of the Act.’’

The term ‘‘company’’ means any corporation,partnership, business trust, association, or simi-lar organization, or any other trust.1 Any corpo-ration in which the majority of the shares areowned by the United States or by any state isnot considered a company.

A ‘‘company covered in 1970’’ means a com-pany that became a bank holding company as aresult of the enactment of the Bank HoldingCompany Act Amendments of 1970 and whichwould have been a bank holding company onJune 30, 1968, if those amendments had beenenacted on that date.

2090.0.1 CONCLUSIVEPRESUMPTIONS OF CONTROL

The conclusive presumptions of control areestablished in section 2(a)(2)(A) and (B) of theact when—

1. a company directly or indirectly or actingthrough one or more other persons owns,controls, or has power to vote 25 percent ormore of any class of voting securities of abank or company or

2. a company controls in any manner the elec-tion of a majority of the directors or trusteesof the bank or company.

‘‘Acting through one or more other persons’’could include—

1. acting through the executive officer of a com-pany, or a relative or business associate ofthat officer;

2. financing the purchase of shares of a bank orcompany when—a. the amount of credit approximates the

purchase price,b. there is no definite maturity on the credit

extended,c. the credit is obtained at a favorable rate of

interest, andd. the bank whose shares are held as collat-

eral maintains an excessive balance withthe lending company;

3. by a resolution of a company’s board ofdirectors, guaranteeing an individual againstany loss in relationship to his ownership in abank or company when such ownership rep-resents 25 percent or more of any votingclass;

4. recognizing earnings from another company;or

5. participating in policy formation or dailyoperations of another company.

The ‘‘power to vote’’ includes the right tovote, to direct the voting of shares, or to imme-diately transfer shares to the name of the holderof such rights or the holder’s nominee, pursuantto any proxy, contract, or agreement. However,when stock is held as collateral for a loan underan agreement which enables the lender to trans-fer the stock into the name of the lender or itsnominee without the power to vote, the right tohave the shares transferred does not in itselfconstitute control. To constitute control, thepower to vote must be perfected along with thetransfer of the stock into the name of the lenderor its nominee.

1. Unless the terms of the trust require it to terminatewithin 25 years or not later than 21 years and 10 months afterthe death of individuals living on the effective date of thetrust.


2090.0.2 DIRECT CONTROL

Direct control exists when a company (asdefined in section 2(b) of the act) owns 25 per-cent or more of any one class of voting securi-ties of a bank (as defined in section 2(c) of theact) or company. ‘‘Voting securities’’ includespotential as well as actual voting authority.

2090.0.3 INDIRECT CONTROL

Indirect ownership or control is defined in sec-tion 2(g) of the act in subsections 1 and 2 asfollows:‘‘(1) Shares owned or controlled by any subsid-

iary of a bank holding company shall bedeemed to be indirectly owned or con-trolled by such bank holding company;and

‘‘(2) Shares held or controlled directly or indi-rectly by trustees for the benefit of (A) acompany, (B) the shareholders or mem-bers of a company, or (C) the employees(whether exclusively or not) of a com-pany, shall be deemed to be controlled bysuch company.’’

To assist in the interpretation of the above sub-sections the following explanations areprovided.1. All shares owned by a subsidiary of a bank

holding company are deemed to be con-trolled by the parent’s ownership interest inthe directly owned subsidiary.

2. Shares held in a trust for the benefit of acompany are deemed to be controlled bysuch company regardless of whether thetrustee or company votes the shares. A com-pany is deemed to be the beneficial owner ofshares which it does not vote if all othershareholders’ rights are retained by suchcompany (that is, dividends, or other rights).

3. Shares owned by a trustee for the benefit of acompany’s subsidiary (or the subsidiary’sshareholders, members, or employees) aredeemed to be controlled by both the subsidi-ary and its parent.

4. Shares held in a trust for the benefit ofan individual ‘‘stockholder, member, oremployee’’ are not deemed to be controlledby a company because such shares are heldfor the individual regardless of his or herrelationship with the company. For a com-pany to have control over the shares held forthe benefit of a company’s ‘‘stockholders,

members, or employees,’’ the shares must beheld as a class.

5. If a trust meets the definition of a company, itis possible for such a trust to be a bankholding company. In addition, it is possiblefor a bank through the administration of atrust(s)(which does not meet the definition ofa company) to become a bank holding com-pany (that is, a bank which has control overvarious trusts whose shares aggregate to25 percent or more of a bank or bank holdingcompany could be deemed a bank holdingcompany; a bank which administers a trustthat owns 25 percent or more of a bank orbank holding company (and such trust doesnot meet the definition of a company) couldbe a bank holding company.

In addition to the above determinants involv-ing conclusive presumptions of control, theBoard has determined that whenever the trans-ferability of 25 percent or more of any class ofvoting securities of a company is restricted, inany manner, upon the transfer of 25 percent ormore of any class of voting securities of anothercompany, the holders of the two securitiesaffected by the restriction constitute a companyfor the purposes of the act. This determinationapplies unless one of the issuers of such securi-ties is a subsidiary of the other and is so identi-fied in a Board order or in a registration state-ment or report accepted by the Board under theact.

In any administrative or judicial proceedingsregarding conclusive presumptions of control, acompany would not be considered to control abank or company at any given time unless thatcompany, at the time in question, directly orindirectly owned, controlled, or had power tovote 5 percent or more of any class of votingsecurities of the bank or company.

2090.0.4 REBUTTABLEPRESUMPTIONS OF CONTROL

A rebuttable presumption of control exists whenthe Board determines, after notice and opportu-nity for hearings, that a company directly orindirectly exercises a controlling influence overthe management or policies of a bank or com-pany (section 2(a)(2)(C) of the act). With regardto the above, there is a presumption that anycompany which directly or indirectly owns, con-trols, or has power to vote less than 5 percent ofany class of voting securities of a given bank orcompany does not have control over that bankor company (section 2(a)(3) of the act). This5 percent presumption does not prohibit the

Control and Ownership (General) 2090.0


Board from determining that a company exer-cises a ‘‘controlling influence’’ when such com-pany owns, controls, or has power to vote lessthan 5 percent of any class of voting securitiesof another company or bank. However, in over-coming the presumption, the Board bears theburden of proving that such a controlling influ-ence exists.

2090.0.4.1 Regulation Y Determinants ofControl

The Board has established the following rebut-table presumptions of control in section 225.31of Regulation Y for use in proceedings:

1. Control of voting securities.a. Securities convertible into voting securi-

ties. A company that owns, controls, orholds securities that are immediatelyconvertible, at the option of the holderor owner, into voting securities of a bankor other company controls the votingsecurities.

b. Option or restriction on voting securities.A company that enters into an agreementor understanding under which the rightsof a holder of voting securities of a bankor other company are restricted in anymanner controls the securities. This pre-sumption does not apply where the agree-ment or understanding—(1) is a mutual agreement among share-

holders granting to each other a rightof first refusal with respect to theirshares;

(2) is incident to a bona fide loan transac-tion; or

(3) relates to restrictions on transferabil-ity and continues only for the timenecessary to obtain approval from theappropriate federal supervisoryauthority with respect to acquisitionby the company of the securities.

2. Control over company.a. Management agreement. A company that

enters into any agreement or understand-ing with a bank or other company (otherthan an investment advisory agreement),such as a management contract, underwhich the first company or any of itssubsidiaries directs or exercises signifi-cant influence over the general manage-ment or overall operations of the bank orother company controls the bank or othercompany.

b. Shares controlled by company and asso-

ciated individuals. A company that,together with its management officials orprincipal shareholders (including mem-bers of the immediate families of either(as defined in 12 C.F.R. 206.2(k)) owns,controls, or holds with power to vote25 percent or more of the outstandingshares of any class of voting securities ofa bank or other company, if the first com-pany owns, controls, or holds with powerto vote more than 5 percent of the out-standing shares of any class of votingsecurities of the bank or other company.

c. Common management officials. A com-pany that has one or more managementofficials in common with a bank or othercompany controls the bank or other com-pany, if the first company owns, controls,or holds with power to vote more than5 percent of the outstanding shares of anyclass of voting securities of the bank orother company, and no other person con-trols as much as 5 percent of the outstand-ing shares of any class of voting securitiesof the bank or other company.

d. Shares held as fiduciary. The pre-sumptions of control in paragraphs225.31(d)(2)(ii) and (iii) of Regulation Ydo not apply if the securities are held bythe company in a fiduciary capacity with-out sole discretionary authority to exer-cise the voting rights.

2090.0.4.2 Other Presumptions of Control

In addition to the rebuttable presumptions, thereare a number of other circumstances that areindicative of control and may call for furtherinvestigation to uncover facts that support adetermination of control. Such circumstancesinclude the following:1. A company owns at least 10 percent of each

of two banks or at least 5 percent of each ofthree or more banks.

2. A company owns 5 percent or more of abank or bank holding company and has beeninstrumental in the hiring or firing of one ormore persons; establishing policies or placesfor branches; establishing hours of business;deciding on rates, terms, or acceptance ofloans or deposits; following uniform adver-tising practices or using a common telephonesystem; or any other respects directing theactivities of management or establishing the



policies of the bank or company.3. A company lends to a borrower on more

favorable terms than it would have for aborrower of comparable credit standing toenable the borrower to acquire voting sharesof a bank or other company.If the Board proposes to make a determina-

tion based on the above indicators of control,the Board bears the burden of providing evi-dence that such a control situation exists.

2090.0.5 PROCEDURES FORDETERMINING CONTROL

The question of whether a control situationexists may arise from information coming to theBoard’s attention or from a company’s seekingto obtain the Board’s opinion regarding a spe-cific situation. When this question arises, theBoard has instructed each Reserve Bank tomake every effort to resolve the matter with thecompany without resorting to the proceduresoutlined in this section. However, if the ReserveBank is unsuccessful in resolving the matter, itis referred to the Board staff. If the Board stafffeels the matter warrants Board consideration, itwill recommend that the Board make a prelimi-nary determination of control based on the avail-able facts and so inform the company. (Seesection 225.31(a).) Following the preliminarydetermination of control, the company must,within 30 days (or longer as may be permittedby the Board), submit the information requiredby section 225.31(b).

If the company contests the Board’s determi-nation, it is entitled to a formal hearing at itsrequest. (See section 225.31(c).)

Notwithstanding any other provision of theact, a company is not deemed to be a bankholding company by virtue of its control of—1. ‘‘. . . shares [held] in a fiduciary capacity,

except as provided in paragraphs (2) and (3)of subsection (g)’’ (section 2(a)(5)(A) of theact);

2. ‘‘. . . shares acquired by it in connection withits underwriting of securities if such sharesare held only for such period of time as willpermit the sale thereof on a reasonable basis’’(section 2(a)(5)(B) of the act);

3. ‘‘[a] company formed for the sole purpose ofparticipating in a proxy solicitation if thevoting rights of the shares acquired by suchcompany are acquired in the ordinary course

of such a solicitation’’ (section 2(a)(5)(C) ofthe act);

4. ‘‘. . . shares acquired in securing or collect-ing a debt previously contracted in goodfaith, until two years after the date of acquisi-tion’’ (section 2(a)(5)(D) of the act);

(The Board is authorized upon application bya company to extend, from time to time fornot more than one year at a time, the two-yearperiod referred to herein for disposing of anyshares acquired by a company in the regularcourse of securing or collecting a debt previ-ously contracted in good faith, if, in theBoard’s judgment, such an extension wouldnot be detrimental to the public interest, butno such extension shall in the aggregateexceed three years.)

5. ‘‘. . . any State-chartered bank or trust com-pany which(i) is wholly owned by thrift institutions or

savings banks; and(ii) is restricted to accepting—

(I) deposits from thrift institutions orsavings banks;

(II) deposits arising out of the corporatebusiness of thrift insitutions or sav-ings banks that own the bank or trustcompany; or

(III) deposits of public moneys.’’ (section2(a)(5)(E) of the act); and

6. ‘‘. . . a single . . . bank, if such . . . com-pany is a trust company or mutual savingsbank located in the same State as the bankand if . . . (i) such ownership or controlexisted on the date of enactment of the BankHolding Company Act Amendments of 1970and is specifically authorized by applicableState law, and (ii) the trust company ormutual savings bank does not after that dateacquire an interest in any company that,together with any other interest it holds inthat company, will exceed 5 percentum ofany class of the voting shares of that com-pany, except that this limitation shall not beapplicable to investments of the trust com-pany or mutual savings bank, direct and indi-rect, which are otherwise in accordance withthe limitations applicable to national banksunder section 5136 of the Revised Statutes(12 U.S.C. 24)’’ (section 2(a)(5)(F) of theact).


1. To determine whether any change in controlof a bank holding company has resulted in acompany (as defined by section 2(b) of the



act) becoming a bank holding company inviolation of section 3(a)(1) of the act.

2. To ascertain whether an existing bank hold-ing company has acquired either directly orindirectly additional banking assets in viola-tion of section 3(a)(3) of the act.

3. To establish whether a company which haspurchased its own stock is in compliancewith section 225.4(b) of Regulation Y. (Seesection 2090.3.)


1. Review the company’s stock records and thecompany’s investment portfolio.

2. If there are any subsidiaries that are indi-rectly owned or controlled as defined in sec-tion 2(g) of the act, determine if such sharesare held in a trust and, if so, whether the trustagreement contains any provisions that couldpotentially expose the holding company orany of its subsidiaries to financial or otherliabilities.



Regulation Y 225

Direct control votingsecurities

1978 FRB 121

Indirect control as trustee Ltr. 1/14/76 to W.Lloyd, Chicago Fed

Ltr. 10/16/73 to W.Lloyd, Chicago Fed

Acting through others 1970 FRB 3501974 FRB 8651972 FRB 7171974 FRB 1301974 FRB 131

Transfer of shares 1974 FRB 875

Rebuttable presumption ofcontrol

• nonvoting stock• other indicators of control

1972 FRB 487136 Fed. Reg.18945(Sept. 24, 1971)

Procedures for determiningcontrol

S-2173(Sept. 17, 1971)(at 4–191.1)

Patogonia vs. BOG517 F. 2d 803(9th Cir. 1975)

Nonvoting equityinvestments by BHCs

225.143 4-172.1 1982 FRB 413




Equity investments inbanks and BHCs (2008Policy Statement)

225.144

1. 12 U.S.C., unless specifically stated otherwise.2. 12 C.F.R., unless specifically stated otherwise.




Control and Ownership(Qualified Family Partnerships) Section 2090.05


This section has been revised to include a Boardstaff interpretation, pertaining to a qualifiedfamily partnership (QFP), that was issued onMay 10, 2010. The interpretation consideredwhether a proposed assignment of an economicinterest in the partnership interests of a partner-ship that is a QFP under section 2(o)(10) of theBank Holding Company Act would cause thepartnership to lose its status as a QFP.

2090.05.1 QUALIFIED FAMILYPARTNERSHIP EXEMPTION

Under the Bank Holding Company Act (theAct), any ‘‘company’’ (including a partnership)that controls a bank is considered a bank hold-ing company (BHC).1 Section 2(o) of the Act(as amended by section 2610 of the EconomicGrowth and Regulatory Paperwork ReductionAct of 1996),2 however, provides a limitedexemption from the definition of company for a‘‘qualified family partnership’’ (QFP), andaccordingly, a partnership that qualifies as aQFP is not considered a BHC under the Act.3 AQFP, under the Act, is able to own and control aBHC without the partnership becoming subjectto the registration, source of strength, approval,reporting, and other requirements imposed on aBHC.

In order to qualify for the Act’s exemptionfor a QFP, all the partners of the QFP must beindividuals related to each other by blood, mar-riage, or adoption; or trusts for the primarybenefit of those individuals (collectively,‘‘qualified parties’’). In addition, the partner-ship must

• control any bank (its bank investments)through a single registered BHC that remainssubject to all of the provisions of the Act;

• control only one registered BHC;• not engage in any business activity except

indirectly through ownership of other busi-ness entities (that is, the partnership must bean investment vehicle for the family and maynot be an operating company);

• limit its investments to those permitted for aBHC under section 4(c) of the Act; and

• not be obligated on any debt, either directly oras a guarantor.4

Any partnership requesting qualification as aQFP must commit (1) to be subject to FederalReserve Board examination to ensure compli-ance with the conditions for eligibility and (2) tobe treated as a BHC for purposes of enforce-ment actions by the Board. In addition, while aQFP is exempt from the prior-approval require-ments of section 3 of the Act in connection witha bank acquisition, the partnership continues tobe subject to the notice provisions of the Changein Bank Control Act.

As noted above, the primary benefits tobecoming a QFP are (1) exemption from thecapital requirements applicable to BHCs,(2) exemption from the reporting requirementsapplicable to a BHC, and (3) the freedom tomake permissible nonbanking investments with-out prior Board approval. Because the QFP mustuse a single registered BHC to hold all of itsbank investments, there continues to be a BHCsubject to the requirements of the Act in everycase. This structure ensures that the cross-guarantee provisions of the Federal DepositInsurance Act continue to apply to all bankscontrolled by a QFP.

2090.05.2 ASSIGNMENT OFECONOMIC PARTNERSHIPINTEREST THAT IS A QFP

Board staff issued a May 10, 2010, interpreta-tion on whether a proposed assignment of aneconomic interest in the partnership interests ofa partnership that is a QFP under section2(o)(10) of the Act would cause the partnershipto lose its status as a QFP.5 Board staff notedthat the QFP exemption does not distinguishbetween the legal and beneficial ownership ofsuch partnership interest. An assignment of theeconomic interests in a QFP interest, especiallyin the case of a limited partnership interest,would effectively give the assignee a beneficialinterest in the QFP. Where the assignee is not afamily member, Board staff believes that such

1. 12 U.S.C. 184l(a)(1).2. Pub. L. 104-2089, section 2610; 110 Stat. 3009.3. 12 U.S.C. 1841(b).

4. The QFP also must commit to examination by the Boardand to the notice requirements of the Change in Bank ControlAct if it acquires an additional bank.

5. 12 U.S.C. 1841(o)(10).


an assignment would undermine the ‘‘familyrelationship’’ requirement of the Act and wouldexpand the exemption beyond its limited scope.Accordingly, Board staff believes that an assign-ment of the economic interests in the partner-ship interest of a QFP to a non-qualified person

would be inconsistent with the ‘‘relationship’’requirement of the statute. The partnershipwould not be in compliance with the statutoryrequirements of a QFP and would be required toregister as a BHC.

Control and Ownership (Qualified Family Partnerships) 2090.05


Control and Ownership(Change in Control) Section 2090.1

The Change in Bank Control Act of 1978 (theCBC Act), title VI of the Financial InstitutionsRegulatory and Interest Rate Control Act of1978, gives the federal bank supervisory agen-cies the authority to disapprove changes in con-trol of insured depository institutions.1 The Fed-eral Reserve Board is the responsible federalbanking agency for changes in control of bankholding companies and state member banks, andthe Federal Deposit Insurance Corporation andthe Office of the Comptroller of the Currencyare responsible for insured state nonmember andnational banks respectively.

The CBC Act requires any person (that is, anindividual, a partnership, a corporation, a trust,an association, a joint venture, a pool, a soleproprietorship, or an unincorporated organiza-tion) seeking to acquire control of any insureddepository institution or bank holding companyto provide 60 days’ prior written notice to theappropriate federal banking agency. The act spe-cifically exempts transactions that are subject tosection 3 of the Bank Holding Company Act of1956 or section 18 of the Federal Deposit Insur-ance Act because those transactions are coveredby existing regulatory approval procedures. Ac-cordingly, changes in control due to acquisitionsby bank holding companies and changes in con-trol of insured depository institutions resultingfrom mergers, consolidations, or other similartransactions are not covered by the CBC Act.

The CBC Act describes the factors that theFederal Reserve and the other federal bankingagencies are to consider in determining whethera transaction covered by the CBC Act should bedisapproved. These factors include the financialcondition, competence, experience, and integ-rity of the acquiring person (or persons acting inconcert); the effect of the transaction on compe-tition; whether the acquiring persons have pro-vided all required information; and whether theproposed transaction would result in an adverseeffect on the Bank Insurance Fund or the Sav-ings Association Insurance Fund. The FederalReserve Board’s objectives in its administrationof the CBC Act are to enhance and maintainpublic confidence in the banking system by pre-venting identifiable, serious adverse effectsresulting from anticompetitive combinations ofinterests, inadequate financial support, andunsuitable management in the institutions. The

Board will review each notice to acquire controlof a state member bank or bank holding com-pany and will disapprove transactions that arelikely to have serious harmful effects. TheBoard’s intention is to administer the CBC Actin a manner that will minimize delays andgovernment regulation of private-sectortransactions.

If the Board disapproves a change-in-controlfiling, the Board will notify the proposed acquir-ing party in writing within three days after itsdecision. The notice of disapproval will includea statement of the basis for disapproval. TheCBC Act provides that the acquiring party mayrequest a hearing by the Board in the event of adisapproval and provides a procedure for furtherreview by the courts.

Forms for filing notices of proposed transac-tions covered by the CBC Act are availablefrom the Federal Reserve Banks. Persons con-templating an acquisition that would result in achange in control of a BHC or state memberbank should request the appropriate forms andinstructions from the Reserve Bank in whoseDistrict the affected institution is located. Formsand instructions may also be accessed from theFederal Reserve Board’s public web site (www.federalreserve.gov). The primary forms to becompleted are the Interagency Biographical andFinancial Report and the Interagency Notice ofChange in Control. Filers are requested to con-sult with the appropriate Reserve Bank to con-firm what specific information should beincluded in a particular notice. The ReserveBank can provide specialized publication mate-rial that will assist the filers in placing a com-plete announcement of the proposed acquisitionin the appropriate newspaper of general cir-culation. The Board of Governors also will pub-lish the notices in the Federal Register. (SeeSR-03-19.)

When a substantially complete notice isreceived by the Federal Reserve Bank, a letterof acknowledgment will be sent to the acquiringperson indicating the date of receipt. Afterreviewing the submitted information, the Fed-eral Reserve may initiate name checks withcertain other U.S. government agencies (includ-ing law enforcement) on some or all of theindividuals related to the proposal. The informa-tion received from those name checks will beused to further the assessment of the relevantstatutory factors, including the competence,

1. The term insured depository institution includes anydepository institution holding company and any other com-pany that controls an insured depository institution. The CBCAct is found in 12 U.S.C. 1817(j)(1)–(18).


experience, integrity, and financial ability of theindividual filers.

2090.1.1 COMMITMENTS ANDCONDITIONS FOR APPROVAL

Approvals granted by the Federal Reserve underthe CBC Act may be subject to commitments orconditions that require the filer to consult withappropriate Federal Reserve staff before acquir-ing further shares of the subject banking organi-zation. The Board or the Reserve Bank may alsoimpose restrictions on the acquisition of addi-tional shares by any person who already con-trols an institution. The imposition of such com-mitments, conditions, or limitations is intendedto ensure that statutory factors remain consistentwith approval.

2090.1.2 COMPLETION OF THETRANSACTION

The transaction may be completed 61 days afterthe date of receipt stated in the acknowledgmentletter, unless the acquiring person has been noti-fied by the Board that the acquisition has beendisapproved or that the 60-day period has beenextended as provided for in subparagraph (j)(1)of the CBC Act. To avoid undue interferencewith normal business transactions, the Boardmay issue a notice of its intention not to disap-prove a proposal, after consulting with the rel-evant state banking authorities as the CBC Actrequires.

2090.1.3 INFORMATION TO BEINCLUDED IN NOTICES

The CBC Act requires a person proposing toacquire control of a bank holding company orstate member bank to file a notice with theFederal Reserve Board that includes biographi-cal and financial information on the filers;details of the proposed acquisition; informationon any proposed structural, managerial, orfinancial changes that would affect the bankingorganization to be acquired; and other relevantinformation required by the Board.

A current statement of assets and liabilities, abrief income summary, and a statement of anymaterial changes since the effective date of thisfinancial-statement information is required. TheBoard reserves the right to require up to five

years of financial data from any acquiring per-son. For complete details on the informationalrequirements of a change-in-control filing, seethe Board’s public web site at www.federalreserve.gov/generalinfo/applications/afi/.In particular, review the System’s Form FR2081a, Interagency Notice of Change inControl.

2090.1.4 TRANSACTIONSREQUIRING SUBMISSIONOF PRIOR NOTICE

The CBC Act defines control as the power,directly or indirectly, to vote 25 percent or moreof any class of voting securities or to direct themanagement or policies of a bank holding com-pany or insured depository institution. There-fore, unless exempted by the CBC Act, anytransaction that results in the acquiring partyhaving voting control of 25 percent or more ofany class of voting securities or that results inthe power to direct the management or policiesof such an institution would trigger the noticerequirement. However, any person who onMarch 9, 1979, controlled a bank holding com-pany or state member bank shall not be requiredto file a notice to maintain or increase controlpositions in the same institution. In addition, theBoard’s regulation on a rebuttable presumptionof control allows persons who on March 9,1979, fell within a presumption to acquire addi-tional shares of an institution without filingnotice so long as they will not have votingcontrol of 25 percent or more of the institution(Regulation Y, 12 C.F.R. 225.41). In connectionwith transactions that would result in greatervoting control, such persons may file therequired notice or request that the Board makea determination that they already control theinstitution.

Section 225.41 of Regulation Y sets forth thespecific types of transactions that require priornotice under the CBC Act. Prior notice isrequired by any person (acting directly or indi-rectly) that seeks to acquire control of a statemember bank or bank holding company. A per-son may include an individual, a group of indi-viduals acting in concert, or certain entities (forexample, corporations, partnerships, or trusts)that own shares of banking organizations butthat do not qualify as bank holding companies.A person acquires control of a banking organi-zation whenever the person acquires ownership,control, or the power to vote 25 percent or moreof any class of voting securities of theinstitution.

Control and Ownership (Change in Control) 2090.1


2090.1.4.1 Rebuttable Presumption ofControl

Persons who have the power to vote less than25 percent of an institution’s shares may berequired to file notice under the Board’s rebut-table presumption of control, found in section225.41 of Regulation Y. The Board presumesthat an acquisition of voting securities of a statemember bank or bank holding company consti-tutes the acquisition of control under the CBCAct, requiring prior notice to the Board, if,immediately after the transaction, the acquiringperson (or persons acting in concert) will own,control, or hold with power to vote 10 percentor more of any class of voting securities of theinstitution, and if—

1. the institution has registered securities undersection 12 of the Securities Exchange Act of1934 (15 U.S.C. 78l); or

2. no other person will own, control, or hold thepower to vote a greater percentage of thatclass of voting securities immediately afterthe transaction.2

Other transactions resulting in a person’s con-trol of less than 25 percent of a class of votingshares of a bank holding company or statemember bank would not result in control forpurposes of the CBC Act. In addition, custom-ary one-time proxy solicitations and the receiptof pro rata stock dividends are not subject to theCBC Act’s notice requirements.

In some cases, corporations, partnerships, cer-tain trusts, associations, and similar organiza-tions that are not already bank holding compa-nies may be uncertain whether to proceed underthe CBC Act or under the Bank Holding Com-pany Act with respect to a particular acquisition.These organizations should comply with thenotice requirements of the CBC Act if they arenot required to secure prior Board approvalunder the Bank Holding Company Act. How-ever, some transactions (described in sections2(a)(5)(D) and 3(a)(5)(A) and (B) of the BankHolding Company Act), particularly foreclo-sures by institutional lenders, fiduciary acquisi-tions by banks, and increases of majority hold-ings by bank holding companies, do not requirethe Board’s prior approval. They are consideredsubject to section 3 of the Bank Holding Com-

pany Act and, therefore, do not require noticesunder the CBC Act.

2090.1.4.2 Rebuttable Presumption ofConcerted Action

The following persons are presumed to be act-ing in concert3 and must file a CBC Act notice iftheir share of ownership reaches the requiredlevels:

1. a company and any controlling shareholder,partner, trustee, or management official ofthe company, if both the company and theperson own voting shares of the state mem-ber bank or bank holding company

2. an individual and the individual’s immediatefamily

3. companies under common control4. persons that are parties to an agreement, con-

tract, understanding, relationship, or otherarrangement, whether written or otherwise,regarding the acquisition, voting, or transferof control of voting securities of a state mem-ber bank or bank holding company, otherthan through a revocable proxy

5. persons who have made or propose to make ajoint filing under sections 13 and 14 of theSecurities Exchange Act of 1934 (15 U.S.C.78m), and the rules promulgated thereunderby the Securities and Exchange Commission

6. any person and any trust for which the per-son serves as trustee

If there is any doubt whether a proposed transac-tion requires a notice, the acquiring personshould consult the Federal Reserve Bank forguidance. The CBC Act places the burden ofproviding notice on the prospective acquiringperson.

2090.1.5 TRANSACTIONS NOTREQUIRING ANY NOTICE

Section 225.42 of Regulation Y sets forth thetransactions that do not require any notice underthe CBC Act or that require after-the-fact notice.The following transactions do not require anynotice to the Federal Reserve:

2. If two or more persons, not acting in concert, eachpropose to acquire simultaneously equal percentages of 10percent or more of a class of voting securities of the statemember bank or bank holding company, each person must fileprior notice to the Board.

3. Acting in concert includes knowing participation in ajoint activity or parallel action towards a common goal ofacquiring control of a state member bank or bank holdingcompany whether or not pursuant to an express agreement.



1. Existing control relationships. The acquisi-tion of additional shares if the acquirer isdeemed to already have control of the bank-ing organization.

2. An increase in previously authorized acquisi-tions. The acquisition of additional shares ofa class of voting securities of a state memberbank or bank holding company by any per-son (or persons acting in concert) whoacquired and maintained control of the insti-tution after complying with federalrequirements.

3. Any acquisition subject to approval underthe Bank Holding Company Act or the BankMerger Act. Any acquisition of voting securi-ties subject to approval under section 3 of theBHC Act or under the Bank Merger Act(section 18(c) of the Federal Deposit Insur-ance Act).

4. Transactions exempt under the BHC Act.5. A proxy solicitation. Receipt of a revocable

proxy in connection with a proxy solicitationfor the purpose of conducting business at aregular or special meeting of the institution ifthe proxy terminates within a reasonabletime.

6. Stock dividends. Receipt of voting securitiesas a result of a stock dividend (if the propor-tional interest of the recipient remains sub-stantially the same).

7. Acquisition of voting securities of a foreignbanking organization. The acquisition of vot-ing securities of a qualifying foreign bankingorganization.

2090.1.6 TRANSACTIONS NOTREQUIRING PRIOR NOTICE

The transactions that require after-the-factnotice include the acquisition of voting securi-ties (1) through inheritance, (2) as a bona fidegift, or (3) in satisfaction of a debt previouslycontracted in good faith. In these situations, theappropriate Reserve Bank must be notifiedwithin 90 days after the acquisition, and theacquirer must provide any relevant informationrequested by the Reserve Bank.

2090.1.7 UNAUTHORIZED ORUNDISCLOSED CHANGES IN BANKCONTROL

In some instances, a person acquires control of a

banking organization without submitting theprior or after-the-fact notice required by Regula-tion Y. These unauthorized or undisclosedchanges in bank control may not be known tothe person, the state member bank, or the bankholding company but are discovered by ReserveBank examiners during an inspection or exami-nation of the affected institution. In most cases,such a violation of the CBC Act is addressed byhaving the person immediately file a notice withthe Federal Reserve requesting authority toretain the acquired shares.4 The filing shouldinclude an explanation of the circumstances thatresulted in the violation and a description of theactions that have been (or will be) taken by thefilers to ensure no further violations of the stat-ute. Although the burden to file a timely changein bank control notice is on the persons who areacquiring control or causing a change in controlof a banking organization, an acquired bankingorganization or a banking organization undergo-ing a change in control may have better informa-tion regarding current ownership positions,including shareholder lists, than the acquiringindividuals or individuals who propose a changein control. Therefore, it is important that statemember banks and bank holding companies befamiliar with the regulations and policies gov-erning changes in bank control and, when pos-sible, share such information with shareholderswho have significant ownership positions.

2090.1.8 CHANGES ORREPLACEMENT OF ANINSTITUTION’S CHIEF EXECUTIVEOFFICER OR ANY DIRECTOR

Institutions must report promptly any changesor replacement of its chief executive officer orof any director, in accordance with paragraph 12of the CBC Act. Under section 225.42(a)(7) ofRegulation Y, acquisitions of control of foreignbank holding companies are also exempt fromthe prior-notice requirements of the CBC Act,but this exemption does not extend to the reportsand information required under paragraphs 9,10, and 12 of the act. (See section 2090.1.5.)

4. A violation may be addressed through two other means.The affected party may either (1) submit, for the FederalReserve’s approval, a specific plan for the prompt terminationof the control relationship or (2) contest the preliminarydetermination of a control relationship by filing a responsethat sets forth the facts and circumstances in support of theparty’s position that no control exists or, if appropriate, pre-senting such views orally to Federal Reserve staff.



2090.1.9 DISAPPROVAL OFCHANGES IN CONTROL

The CBC Act sets forth various factors to beconsidered in the evaluation of a proposal. TheBoard is required to review the competitiveimpact of the transaction; the financial conditionof the acquiring person; and the competence,experience, and integrity of that person and theproposed management of the institution. Inassessing the financial condition of the acquir-ing person, the Board will weigh any debt-servicing requirements in light of the acquiringperson’s overall financial strength and the insti-tution’s earnings performance, asset condition,capital adequacy, and future prospects, as wellas the likelihood of an acquiring party makingunreasonable demands on the resources of theinstitution.

2090.1.10 ADDITIONAL REPORTINGREQUIREMENTS

Paragraph 12 of the CBC Act requires thatwhenever a change in control of a bank holdingcompany occurs, each insured depository insti-tution is required to report promptly to theappropriate federal banking agency any changesor replacement of its chief executive officer orof any director occurring in the next 12-monthperiod. A statement of the past and currentbusiness and professional affiliations of the newchief executive officer or directors should beincluded in each institution’s report.

Paragraph 9 of the CBC Act indicates thatwhenever any insured depository institutionmakes a loan secured by 25 percent or more ofthe outstanding voting stock of an insureddepository institution (or bank holding com-pany), the president or other chief executiveofficer of the lending bank shall promptly reportsuch fact to the appropriate federal bankingagency of the bank (or bank holding company)whose stock secures the loan. However, noreport need be made when the borrower hasbeen the owner of record of the stock for aperiod of one year or more or when the stock isthat of a newly organized bank before its open-ing. Reports required by this paragraph shallcontain information similar to the informationalrequirements of the Notice of Change inControl.

2090.1.11 STOCK REDEMPTIONS

A stock redemption by a BHC may result in anexisting shareholder (or shareholders) owning

25 percent or more of a class of voting securi-ties, which would require the filing of both achange-in-control and treasury stock notifica-tion. Furthermore, a stock redemption by a BHCmay result in an existing shareholder (or share-holders) owning between 10 percent and 25 per-cent of the outstanding shares and being thelargest shareholder, thereby resulting in a rebut-table presumption of control. For additionalinformation, see section 2090.3 ‘‘Treasury StockRedemptions.’’

2090.1.12 CORRECTIVE ACTION

The Federal Reserve has enforcement jurisdic-tion over those persons who file or should filenotices under the CBC Act. Accordingly, viola-tions of the requirement to file a change in bankcontrol notice may result in the Federal Reservetaking enforcement action against the relevantpersons in appropriate circumstances, includingthose involving willful or negligent misconduct.Violations may result in the persons being sub-ject to a variety of sanctions, including theassessment of a civil money penalty.

Violations of the CBC Act are addressedthrough the same type of investigative andenforcement authority and formal correctiveactions that are used in other administrativeremedies (12 U.S.C. 1818(b)–(n)). The CBCAct also authorizes the assessment of civilmoney penalties for any violation of the CBCAct (12 U.S.C. 1817(j)(16)) and allows theBoard to seek divestiture of a BHC or bankfrom any person or company who violates theCBC Act (12 U.S.C. 1817(j)(15)).


1. To determine that the BHC has compliedwith the prior-notification requirements ofthe CBC Act and that changes in ownershipbetween 10 percent and 25 percent have beenreviewed for rebuttable presumptionconsiderations.

2. To determine that the BHC has compliedwith the reporting requirements of paragraph12 of the CBC Act regarding changes in itsboard of directors or its chief executive offi-cer that occur within 12 months of a changein control.

3. To determine that the BHC has compliedwith the reporting requirements of paragraph



9 of the CBC Act regarding loans madedirectly by the BHC secured by 25 percent ormore of the outstanding voting stock of aninsured depository institution (or bank hold-ing company).


1. Review the BHC’s stock certificate registeror log to determine if any person (or group ofpersons acting in concert) has acquired10 percent or more of any class of votingsecurities.

2. Review changes in control of between10 percent and 25 percent of any class ofvoting securities to determine if the control-ling party is the single largest shareholder.

3. When inspecting a BHC that was the subjectof a change in control and when a priornotification was filed, review the notificationto determine that information submitted on

the management of the BHC is still valid.When changes in directors or the chiefexecutive officer occurred within 12 monthsof the change in control, determine if theBHC has reported such changes in compli-ance with paragraph 12 of the CBC Act.

4. When inspecting a BHC that has redeemedany of its own shares subsequent to March 9,1979, thereby lowering the number of sharesoutstanding, determine whether the holdingsof any individual shareholder have increasedproportionally to greater than 10 percent,which might trigger the rebuttable presump-tion of control and may require prior notifica-tion of a change in control.

5. Review any loans made directly by the BHCthat are secured by 25 percent or more of theoutstanding shares of a bank (or bank hold-ing company) and determine if the BHC hascomplied with the reporting requirements ofparagraph 9 of the CBC Act.



Control and Ownership(BHC Formations) Section 2090.2


Effective July 2015, this revised section incorpo-rates the Board’s May 15, 2015 (effective date)amendment of the Small Bank Holding Com-pany Policy Statement to expand the applicabil-ity of its policy statement to include certainsavings and loan holding companies.

The policy statement facilitates the transfer ofownership of small community banks and sav-ings associations by allowing their holding com-panies to operate with higher levels of debt thanwould normally be permitted. While holdingcompanies that qualify for the policy statementare excluded from consolidated capital require-ments, their depository institution subsidiariescontinue to be subject to minimum capitalrequirements.

The rule amendment raised the asset thresh-old of the policy statement from $500 million to$1 billion in total consolidated assets. All firmsmust meet certain qualitative requirements,including those pertaining to nonbanking activi-ties, off-balance sheet activities, and publiclyregistered debt and equity. See 80 Fed. Reg.20153–20158 (April 15, 2015).

2090.2.1 FORMATION OF A BANKHOLDING COMPANY AND CHANGESIN OWNERSHIP

The formation of a bank holding company andcertain changes in the ownership of banksowned by a bank holding company come underthe provisions of section 3 of the BHC Act.Section 3(a)(1) prohibits the formation of a bankholding company without prior Board approval.A company may receive approval pursuant tosection 3(a)(1) to become either a one-bankholding company or a multibank holdingcompany.

A primary reason for the formation of a one-bank holding company is to obtain income taxbenefits.1 These benefits include offsettingoperating/capital losses of one corporationagainst the profits/capital gains of another.

Once a company becomes a bank holding

company, either by the formation of a one-bankor multibank holding company, section 3(a)(3)of the act prohibits the direct or indirect acquisi-tion of over 5 percent of any additional bank’sor bank holding company’s shares without priorBoard approval. In addition to the above, sec-tion 3(a)(3) serves to prevent an existing bankholding company from increasing, without priorBoard approval, its ownership in an existingsubsidiary bank unless the BHC already owns50 percent of the shares of the bank (section3(a)(5)(B)). A bank holding company whichowns more than 50 percent of a bank’s sharesmay buy and sell those shares freely withoutBoard approval, provided the ownershipremains above 50 percent. If a bank holdingcompany owns less than 50 percent of a bank’sshares, prior Board approval is required beforeeach additional acquisition of shares until thebank holding company’s ownership of the bankreaches more than 50 percent.

2090.2.2 HISTORY OF THE POLICYSTATEMENT ON THE FORMATIONOF SMALL BANK HOLDINGCOMPANIES

The Board issued the policy statement in 1980to facilitate the transfer of ownership of smallcommunity-based banks in a manner consistentwith bank safety and soundness. The Board hasgenerally discouraged the use of debt by bankholding companies to finance the acquisition ofbanks or other companies because high levels ofdebt can impair the ability of the holding com-pany to serve as a source of strength to itssubsidiary banks. The Board has recognized,however, that small bank holding companieshave less access to equity financing than largerbank holding companies and that the transfer ofownership of small banks often requires the useof acquisition debt. Accordingly, the Boardadopted the policy statement to permit the for-mation and expansion of small bank holdingcompanies with debt levels that are higher thantypically permitted for larger bank holding com-panies. The policy statement contains severalconditions and restrictions designed to ensurethat small bank holding companies that operatewith the higher levels of debt permitted by thepolicy statement do not present an undue risk tothe safety and soundness of their subsidiary

1. A domestic corporation may be entitled to a specialdeduction from gross income for dividends received from ataxable domestic corporation. There is (1) a 70 percent deduc-tion for dividends received from a corporation that is less than20 percent owned; and (2) an 80 percent deduction for divi-dends received from a corporation that is 20 to less than80 percent owned, subject to certain limits.


banks. Previously, the policy statement appliedonly to bank holding companies with pro formaconsolidated assets of less than $500 millionthat met the following qualitative requirements:(1) were not engaged in significant nonbankingactivities either directly or through a nonbanksubsidiary; (2) did not conduct significant off-balance sheet activities (including securitizationand asset management or administration) eitherdirectly or through a nonbank subsidiary; and(3) did not have a material amount of debt orequity securities outstanding (other than trustpreferred securities) that are registered with theSecurities and Exchange Commission. TheBoard last raised the asset threshold in 2006when it increased it from $150 million to$500 million.

2090.2.3 SMALL BANK HOLDINGCOMPANY AND SAVINGS ANDLOAN HOLDING COMPANY POLICYSTATEMENT

In acting on applications filed under the BHCAct, the Board has adopted and continues tofollow the principle that bank holding compa-nies should serve as a source of strength fortheir subsidiary banks. When bank holding com-panies incur debt and rely on the earnings oftheir subsidiary banks as the means of repayingsuch debt, a question arises as to the probableeffect on the financial condition of the holdingcompany and its subsidiary bank or banks.

The Board believes that a high level of debt atthe parent holding company level impairs theability of a bank holding company to providefinancial assistance to its subsidiary bank(s),and, in some cases, the servicing requirementson such debt may be a significant drain on theresources of the bank(s). For these reasons, theBoard has not favored the use of acquisitiondebt in the formation of bank holding compa-nies or in the acquisition of additional banks.Nevertheless, the Board has recognized that thetransfer of ownership of small banks oftenrequires the use of acquisition debt. The Boardtherefore has permitted the formation andexpansion of small bank holding companieswith debt levels higher than would be permittedfor larger bank holding companies. Approval ofthese applications has been given on the condi-tion that the small bank holding companies dem-onstrate the ability to service the acquisition

debt without straining the capital of their subsid-iary banks and, further, that such companiesrestore their ability to serve as a source ofstrength for their subsidiary banks within a rela-tively short period of time.

In the interest of continuing its policy offacilitating the transfer of ownership in bankswithout compromising bank safety and sound-ness, the Board has, as described below, adoptedthe following procedures and standards for theformation and expansion of small bank holdingcompanies subject to this policy statement.

2090.2.3.1 Applicability of PolicyStatement

The policy statement applies only to BHCs withpro forma consolidated assets of less than $1billion that (1) are not engaged in significantnonbanking activities either directly or througha nonbank subsidiary; (2) do not conduct signifi-cant off-balance-sheet activities (including secu-ritization and asset management or administra-tion) either directly or through a nonbanksubsidiary; and (3) do not have a materialamount of debt or equity securities outstanding(other than trust preferred securities) that areregistered with the Securities and ExchangeCommission. The Board may in its discretionexclude any BHC, regardless of asset size, fromthe policy statement if such action is warrantedfor supervisory purposes. With the exception ofsection 4 (Additional Application Requirementsfor Expedited/Waived Processing), the policystatement applies to savings and loan holdingcompanies as if they were bank holding compa-nies. While this policy statement primarilyapplies to the formation of small BHCs, it alsoapplies to existing BHCs that wish to acquire anadditional bank or company and to transactionsinvolving changes in control, stock redemp-tions, or other shareholder transactions.2 Thecriteria are described below.

2090.2.3.2 Ongoing Requirements

The following guidelines must be followed onan ongoing basis for all organizations operatingunder this policy statement.

2. The appropriate Reserve Bank should be contacted todetermine the manner in which a specific situation mayqualify for treatment under this policy statement.

Control and Ownership (BHC Formations) 2090.2


2090.2.3.2.1 Reduction in ParentCompany Leverage

Small BHCs are to reduce their parent companydebt consistent with the requirement that alldebt be retired within 25 years of being incurred.The Board expects that these BHCs reach adebt-to-equity ratio of .30 to 1 or less within 12years after incurrence of the debt.3 The bankholding company must also comply with debt-servicing and other requirements imposed by itscreditors.

Subordinated debt associated with trust pre-ferred securities generally would be treated asdebt for purposes of paragraphs 2.C. (dividendrestrictions), 3.A. (minimum down payment),4.A.i (expedited treatment of certain filings),and 4.B.i (stock redemption filing requirements)of the policy statement. A BHC, however, mayexclude from debt an amount of subordinateddebt associated with trust preferred securitiesthat is up to 25 percent of the bank holdingcompany’s equity (as defined below) less good-will on the parent company’s balance sheet, indetermining compliance with the requirementsof such paragraphs of the policy statement. Inaddition, a BHC subject to the policy statementthat has not issued subordinated debt associatedwith a new issuance of trust preferred securitiesafter December 31, 2005, may exclude fromdebt any subordinated debt associated with trustpreferred securities until December 31, 2010.BHCs subject to this policy statement may alsoexclude from debt until December 31, 2010, anysubordinated debt associated with refinancedissuances of trust preferred securities originallyissued on or prior to December 31, 2005, pro-vided that the refinancing does not increase theBHC’s outstanding amount of subordinateddebt. Subordinated debt associated with trustpreferred securities will not be included as debtin determining compliance with any otherrequirements of this policy statement.

In addition, notwithstanding any other provi-sion of the policy statement and for purposes ofcompliance with paragraphs 2.C., 3.A., 4.A.i.,and 4.B.i. of the policy statement, both a BHCthat is organized in mutual form and a BHC thathas made a valid election to be taxed underSubchapter S of Chapter 1 of the U.S. InternalRevenue Code may exclude from debt subordi-nated debentures issued to the United States

Department of the Treasury under (1) theTroubled Asset Relief Program established bythe Emergency Economic Stabilization Act of2008. (See 74 Fed. Reg. 26077 (June 1, 2009),Division A of Public Law 110-343, 122 Stat.3765 (2008)), and (2) the Small Business Lend-ing Fund established by the Small Business JobsAct of 2010, title IV of Public Law 111-240,124 Stat. 2504 (2010).

The term equity as used in the ratio of debt toequity, means the total stockholders’ equity ofthe BHC, as defined in accordance with gener-ally accepted accounting principles. In deter-mining the total amount of stockholders’ equity,the BHC should account for its investments inthe common stock of subsidiaries by the equitymethod of accounting.

Ordinarily, the Board does not view redeem-able preferred stock as a substitute for commonstock in a small BHC. Nevertheless, to a limiteddegree and under certain circumstances, theBoard will consider redeemable preferred stockas equity in the capital accounts of the holdingcompany if the following conditions are met:(1) the preferred stock is redeemable only at theoption of the issuer and (2) the debt-to-equityratio of the holding company would be at orremain below .30:1 following the redemption orretirement of any preferred stock. Preferredstock that is convertible into common stock ofthe holding company may be treated as equity.

2090.2.3.2.2 Capital Adequacy

Each insured depository subsidiary of a smallBHC is expected to be well capitalized. Anyinstitution that is not well capitalized is expectedto become well capitalized within a brief periodof time.

2090.2.3.2.3 Dividend Restrictions

A small bank holding company whose debt toequity ratio is greater than 1.0:1 is not expectedto pay corporate dividends until such time as itreduces its debt to equity ratio to 1.0:1 or lessand other wise meets the criteria set forth insections 225.14(c)(1)(ii), 225.14(c)(2), and225.14(c)(7) of Regulation Y.4

3. The term debt as used in the ratio of debt to equity,means any borrowed funds (exclusive of short-term borrow-ings that arise out of current transactions, the proceeds ofwhich are used for current transactions) and any securitiesissued by, or obligations of, the holding company that are thefunctional equivalent of borrowed funds.

4. Dividends may be paid by small bank holding compa-nies with debt to equity at or below 1.0:1 and otherwisemeeting the requirements of sections 225.14(c)(1)(ii),



Small bank holding companies formed beforeMay 15, 2015 (the effective date of the policystatement), may switch to a plan that adheres tothe intent of the policy statement provided theycomply with the requirements set forth above.

2090.2.3.3 Core Requirements for AllApplicants

In assessing applications or notices by organiza-tions subject to the policy statement, the Boardwill continue to take into account a full range offinancial and other information about the appli-cant, and its current and proposed subsidiaries,including the recent trend and stability of earn-ings, past and prospective growth, asset quality,the ability to meet debt servicing requirementswithout placing an undue strain on the resourcesof the bank(s), and the record and competencyof management. In addition, the Board willrequire applicants to meet the following require-ments:

2090.2.3.3.1 Minimum Down Payment

The amount of acquisition debt should notexceed 75 percent of the purchase price of thebank(s) or company to be acquired. When theowner(s) of the holding company incurs debt tofinance the purchase of the bank(s) or company,such debt will be considered acquisition debteven though it does not represent an obligationof the BHC, unless the owner(s) can demon-strate that such debt can be serviced withoutreliance on the resources of the bank(s) or BHC.

2090.2.3.3.2 Ability to Reduce ParentCompany Leverage

The BHC must clearly be able to reduce itsdebt-to-equity ratio and comply with its loanagreement(s) as stated within the ongoingrequirements for reduction in parent companyleverage, discussed previously.5 Failure to meet

the criteria would normally result in denial of anapplication.

2090.2.3.4 Additional ApplicationRequirements for Expedited/WaivedProcessing

2090.2.3.4.1 Expedited Notices underSections 225.14 and 225.23 ofRegulation Y

A small BHC proposal will be eligible for theexpedited processing procedures set forth in sec-tions 225.14 and 225.23 of Regulation Y if(1) the BHC is in compliance with the ongoingrequirements of this policy statement, (2) theBHC meets the previously discussed corerequirements for all applicants noted above, and(3) the following requirements are met:

1. The parent BHC has a pro forma debt-to-equity ratio of 1.0:1 or less.

2. The BHC meets all the criteria for expeditedaction of sections 225.14 and 225.23 ofRegulation Y.

2090.2.3.4.2 Waiver of Stock-RedemptionFiling

A small BHC will be eligible for the stock-redemption filing exemption for well-capitalizedBHCs that is found in section 225.4(b)(6) if thefollowing requirements are met:

1. The parent BHC has a pro forma debt-to-equity ratio of 1.0:1 or less.

2. The BHC is in compliance with the ongoingrequirements of this policy statement andmeets the requirements of sections225.14(c)(1)(ii), 225.14(c)(2), and225.14(c)(7) of Regulation Y.


1. To determine compliance with all commit-ments made in the application/notificationprocess.

2. To determine if the BHC or SLHC is incompliance with the Small Bank HoldingCompany and Savings and Loan HoldingCompany Policy Statement (Regulation Y,appendix C), including whether the BHC’sdebt is being reduced within the required orexpected time periods.

225.14(c)(2), and 225.14(c)(7) if the dividends are reasonablein amount, do not adversely affect the ability of the bankholding company to service its debt in an orderly manner, anddo not adversely affect the ability of the subsidiary banks tobe well-capitalized. It is expected that dividends will beeliminated if the holding company is (1) not reducing its debtconsistent with the requirement that the debt to equity rationbe reduced to .30:1 within 12 years of consummation of theproposal or (2) not meeting the requirements of its loanagreement(s).

5. See section 2090.2.3.2.1.




1. Review all commitments made by the com-pany and its shareholders to determine com-pliance therewith.

2. Determine if the BHC or SLHC is in compli-ance with the Small Bank Holding Companyand Savings and Loan Holding CompanyPolicy Statement (Regulation Y, appendix C)by—a. verifying that the board of directors and

senior management have established andregularly maintain a plan to• retire the BHC’s or the SLHC’s debt

within 25 years of incurring the debtand

• reach a debt-to-equity ratio of .30:1 or

less within 12 years of incurring thedebt.

3. Ascertain if the BHC uses a regular periodicmonitoring process to ensure the full retire-ment of the holding company’s debt withinthe above-stated required or expectedperiods.

4. Determine whether the BHC is well capital-ized or, if not, whether it will be well capital-ized within a brief period of time.

5. Determine if the payment of corporatedividends has been restricted until the BHC’sdebt-to-equity ratio is 1.0:1 or less and untilthe BHC otherwise meets the criteriaset forth in sections 225.14(c)(1)(ii),225.14(c)(2), and 225.14(c)(7) of Regula-tion Y.



Capital adequacy guidelines ofBHCs, SLHCs, and state memberbanks (Regulation Q)

217 3–2100

Small BHC and SLHC PolicyStatement Regulation Y,appendix C

225 4–868

Expedited action forcertain acquisitionsby well-run BHCs

225.14 4−024.1

Expedited action fornonbanking proposalsby well-run BHCs

225.23 4−037.1

Savings and loan holdingcompanies (Regulation LL) —Small BHC Policy Statement

238.9 4−750.8

1. 12 U.S.C., unless specifically stated otherwise.2. 12 C.F.R., unless specifically stated otherwise.3. Federal Reserve Regulatory Service reference.



Control and Ownership(Treasury Stock Redemptions) Section 2090.3

‘‘Bootstrapping’’ is the term generally used todescribe a treasury stock transaction in which acompany incurs debt to purchase or redeem itsown outstanding shares. Bootstrapping is oftenused to facilitate a change in control whereby ashareholder or shareholder group need only buyfew or no shares in order to gain control. Therepurchase or redemption is often made inaccordance with a written agreement madebetween a former controlling shareholder(s) andthe new controlling shareholder(s).Section 225.4(b) of Regulation Y requires a

bank holding company to file prior writtennotice with the Board before a purchase orredemption of any of its own equity securities ifthe gross consideration for the purchase orredemption, when aggregated with the net con-sideration paid by the company for all suchpurchases or redemptions during the preceding12 months, is equal to 10 percent or more of thecompany’s consolidated net worth. (Net consid-eration is the gross consideration paid by thecompany for all of its equity securities pur-chased or redeemed during the period minus thegross consideration received for all of its equitysecurities sold during the period other than as apart of a new issue.)Each notice shall furnish the following

information:

• The purpose of the transaction, a descriptionof the securities to be purchased or redeemed,the total number of each class outstanding, thegross consideration to be paid, and the termsof any debt incurred in connection with thetransaction.

• A description of all equity securities redeemedwithin the preceding 12 months, the netconsideration paid, and the terms of anydebt incurred in connection with thosetransactions.

• A current and pro forma consolidated balancesheet if the bank holding company has totalassets of over $150 million, or a current andpro forma parent-company-only balance sheetif the bank holding company has total assetsof $150 million or less.

2090.3.1 CHANGE IN CONTROL ACTCONSIDERATIONS

As indicated earlier, treasury stock redemptionsare often intended to facilitate a change in con-trol of a bank holding company. By redeemingthe shares held by an existing shareholder(s),

the remaining shareholder(s) increases his pro-portionate ownership. If a ‘‘person’s’’ shareownership should rise above 25 percent or moreof the remaining outstanding shares (subsequentto March 9, 1979), that person would then‘‘control’’ the BHC. Under these circumstances,a change in control notification would have tobe filed. If the treasury stock redemption is foran amount sufficient to trigger the requirementfor a prior notification of redemption, then dualnotifications are called for (change in controland redemption of treasury shares).Similarly, prior notification is also required if

a treasury stock redemption should result in ashareholder’s holdings rising to between 10 per-cent and 25 percent of the remaining outstand-ing shares, and if (a) that shareholder is thefirm’s largest single shareholder immediatelyafter the acquisition; or (b) the institution isregistered under section 12 of the SecuritiesExchange Act of 1934 (i.e., corporations havingassets exceeding $1 million, more than 500shareholders, and securities that are publiclytraded). For additional information on change incontrol notification requirements, see section2090.1.Additional notices under the CIBC Act do not

have to be filed if regulatory clearance hadalready been received to acquire 10 percent ormore of the voting shares of a bank holdingcompany, and subsequent treasury stock re-demptions resulted in ownership of between 10and 25 percent of the shares of the bank holdingcompany. Refer to section 225.41(a)(2) of Reg-ulation Y.1


1. To determine that a BHC that hasredeemed shares of its own stock has compliedwith section 225.4(b) of Regulation Y.2. To determine that any new controlling

shareholder of a BHC that has redeemed sharesof its own stock has complied with section225.41(a) of Regulation Y.3. To determine if a treasury stock transac-

tion has taken place for the purpose of depletingthe original 25 percent equity investment in thepurchase price.

1. Revised by the Board, effective November 9, 1990.



1. Review the BHC’s reconcilement of stock-holders’ equity to determine if shares have beenredeemed.2. If shares have been redeemed, review for

compliance with treasury stock redemptionapproval and reporting requirements.3. Determine whether the BHC is using,

repeatedly, the less than 10 percent ownershipexemption to avoid notice requirements, thusundermining the capital position of the bankingorganization, resulting in an unsafe and unsoundpractice.4. Determine if the less than 10 percent own-

ership exemption is being used by the bankholding company when it does not satisfy therequirements of the Board’s capital guidelinesfor redemptions.

The exemption should not be used by abank holding company that does not meet theBoard’s capital guidelines for redemptions.Redemptions of permanent equity or other capi-tal instruments before stated maturity couldhave a significant impact on an organization’soverall capital structure. Use of the exemptioncould significantly reduce its capital. Conse-

quently, an organization considering such a stepshould consult with the Federal Reserve beforeredeeming any equity (prior to maturity) if suchredemption could have a material effect on thelevel or composition of the organization’s capi-tal base.

The exemption should not be used by asmall one-bank holding company if it wouldincrease its debt-to-equity ratios significantlyabove those relied on by the Board in approvingits application to become a bank holdingcompany.5. If shares have been redeemed, determine if

any shareholder’s holdings have risen to 25 per-cent or more of the outstanding shares.6. If shares have been redeemed, determine if

any shareholder’s holdings have risen tobetween 10 percent and 25 percent of the out-standing shares. Furthermore, determinewhether the shareholder is then the largestshareholder or the institution has registeredsecurities under section 12 of the SecuritiesExchange Act of 1934.7. If a stock redemption occurred recently in

a bank holding company, determine if the share-holders have maintained a 25 percent equityinvestment.

Control and Ownership (Treasury Stock Redemptions) 2090.3


Control and Ownership (Policy Statements on EquityInvestments in Banks and Bank Holding Companies) Section 2090.4


Effective January 2009, this section has beenrevised to incorporate the Board’s September21, 2008, ‘‘Policy Statement on Equity Invest-ments in Banks and Bank Holding Companies.’’(See the Board’s September 22, 2008, PressRelease and section 2090.4.4.) The policy state-ment provides additional guidance on theBoard’s position on minority equity investmentsin banks and bank holding companies that gen-erally do not constitute ‘‘control’’ for purposesof the Bank Holding Company Act. This policyupdates the guidance found in the Board’s July1982 ‘‘Policy Statement on Nonvoting EquityInvestments by Bank Holding Companies.’’

2090.4.1 OVERVIEW AND GUIDINGPRINCIPLES

For many years, bank holding companies,nonbank financial companies, private equityfunds, and other firms made minority equityinvestments in banks and bank holding compa-nies. These investments often raised questionsabout the extent to which the investment wouldcause the investor to become subject tosupervision, regulation, and the other require-ments applicable to bank holding companiesunder the Bank Holding Company Act (BHC Actor the Act) and the Board’s Regulation Y. Ingeneral, the BHC Act applies to any companythat controls a bank or bank holding company(banking organization). The BHC Act providesthat a company has control over a bankingorganization if (1) the company directly orindirectly or acting through one or more otherpersons owns, controls, or has power to vote25 percent or more of any class of votingsecurities of the banking organization; (2) thecompany controls, in any manner, the election ofa majority of the directors or trustees of thebanking organization; or (3) the Board deter-mines, after notice and opportunity for hearing,that the company directly or indirectly exercisesa controlling influence over the management orpolicies of the banking organization.1 Minorityequity investments in banking organizations aredesigned not to trigger either of the first twoprongs of the definition of control. Theseinvestments often raised questions, however,regarding whether the investor would be able to

exercise a controlling influence over themanagement or policies of a bankingorganization.2

The text and legislative history of the controldefinition in the BHC Act make manifest thatpossession by an investor of a modicum ofinfluence over a banking organization would notamount to a controlling influence. At the sametime, the definition does not require that aninvestor have absolute control over the manage-ment and policies of a banking organization.Instead, the Act requires that an investor be ableto exercise an amount of influence over a bank-ing organization’s management or policies thatis significant but less than absolute control infact of the banking organization. Notably, theprimary definition of control in the Act is basedon ownership of 25 percent or more of thevoting shares of a banking organization—anamount that does not provide an investor inmost cases with complete control over decisionsbut would allow the investor to play a signifi-cant role in the decision-making process.

In assessing whether an investor has the abil-ity to exercise a controlling influence over abanking organization, the Board has been espe-cially mindful of two key purposes of the BHCAct. First, the BHC Act was intended to ensurethat companies that acquire control of bankingorganizations have the financial and manage-rial strength, integrity, and competence toexercise that control in a safe and sound man-ner. The BHC Act is premised on the principlethat a company that controls a bankingorganization may reap the benefits of its suc-cessful management of the banking organiza-tion but also must be prepared to provide addi-tional financial and managerial resources to thebanking organization to support the company’sexercise of control. In this way, the Act ties thepotential upside benefits of having a control-ling influence over the management and poli-cies of a banking organization to responsibilityfor the potential downside results of exercisingthat controlling influence. By tying control andresponsibility together, the Act ensures that

1. 12 U.S.C. 1841(a)(2).

2. Contemporaneous minority investments in the samebanking organization by multiple different investors also oftenraise questions about whether the multiple investors are agroup acting in concert for purposes of the Change in BankControl Act or are a single association for purposes of theBHC Act. These questions are beyond the scope of the 2008Policy Statement.

BHC Supervision Manual January 2009Page 1

companies have positive incentives to run a suc-cessful banking organization but also bear thecosts of their significant involvement in thebanking organization’s decision-makingprocess, thus protecting taxpayers fromimprudent risk taking by companies that controlbanking organizations. Minority investors inbanking organizations typically seek to limittheir potential downside financial exposure inthe event of the failure of the banking organiza-tion. Concomitantly, the BHC Act requires thatminority investors seeking this protection limittheir influence over the management and poli-cies of the banking organization.

Second, the BHC Act was intended to limitthe mixing of banking and commerce. In par-ticular, the Act effectively prevents commercialfirms and companies with commercial interestsfrom also exercising a controlling influence overa banking organization. Many minority inves-tors in banking organizations own commercialinvestments that conflict with this limitation.

2090.4.2 BOARD’S 1982 POLICYSTATEMENT ON NONVOTINGEQUITY INVESTMENTS BY BANKHOLDING COMPANIES

On July 8, 1982, the Board issued a PolicyStatement on Nonvoting Equity Investments byBank Holding Companies (the 1982 PolicyStatement) to provide guidance on the Board’sinterpretation of the ‘‘controlling influence’’prong of the control definition in the BHC Act.3That statement for the first time outlined thepolicies that the Board would consider inreviewing whether a minority investment in abanking organization would result in the exer-cise by the investor of a controlling influenceover the management or policies of the bankingorganization. The 1982 Policy Statementfocused on issues of particular concern in the1980s in the context of investments by bankholding companies in out-of-state banking orga-nizations. For example, the 1982 Policy State-ment primarily addressed investments thatincluded a long-term merger or stock purchaseagreement between the investor and the bankingorganization that would be triggered on achange in the interstate banking laws, andso-called ‘‘lock-up’’ arrangements designed to

prevent another company from acquiring thebanking organization without the permission ofthe investor.

The 1982 Policy Statement sets out theBoard’s concerns with these investments, theconsiderations the Board will take into accountin determining whether the investments are con-sistent with the Act, and the general scope ofarrangements to be avoided by bank holdingcompanies. The Board recognized that the com-plexity of legitimate business arrangements pre-cludes rigid rules designed to cover all situa-tions and that decisions regarding the existenceor absence of control in any particular case musttake into account the effect of the combinationof provisions and covenants in the agreement asa whole and the particular facts and circum-stances of each case.

2090.4.2.1 Statutory and RegulatoryProvisions

Under section 3(a) of the Act, a bank holdingcompany may not acquire direct or indirectownership or control of more than 5 percent ofthe voting shares of a bank without the Board’sprior approval (12 U.S.C. 1842(a)(3)). In addi-tion, this section of the Act provides that a bankholding company may not, without the Board’sprior approval, acquire control of a bank: that is,in the words of the statute, ‘‘for any action to betaken that causes a bank to become a subsidiaryof a bank holding company’’ (12 U.S.C.1842(a)(2)). Under the Act, a bank is a subsidi-ary of a bank holding company if

1. The company directly or indirectly owns,controls, or holds with power to vote 25 per-cent or more of the voting shares of the bank;

2. The company controls in any manner theelection of a majority of the board of direc-tors of the bank; or

3. The Board determines, after notice andopportunity for hearing that the company hasthe power, directly or indirectly, to exercise acontrolling influence over the managementor policies of the bank (12 U.S.C. 1841(d)).

2090.4.2.2 Review of Agreements

Prior to the permissibility of interstate banking,bank holding companies sought to make sub-stantial equity investments in other bank hold-ing companies across state lines, but withoutobtaining more than 5 percent of the votingshares or control of the acquiree. These invest-

3. See 1982 FRB 413, 12 C.F.R. 225.143, or the F.R.R.S at4-172.1.

Control and Ownership (Policy Statements on Equity Investments in Banks and Bank Holding Companies) 2090.4


ments involved a combination of the followingarrangements:

1. Options on, warrants for, or rights to convertnonvoting shares into substantial blocks ofvoting securities of the acquiree bank hold-ing company or its subsidiary bank(s);

2. Merger or asset acquisition agreements withthe out-of-state bank or bank holding com-pany that are to be consummated in the eventinterstate banking is permitted;

3. Provisions that limit or restrict major poli-cies, operations, or decisions of the acquiree;and

4. Provisions that make acquisitions of theacquiree or its subsidiary bank(s) by a thirdparty either impossible or economicallyimpracticable.

The various warrants, options, and rightswere not exercisable by the investing bank hold-ing company until interstate banking was per-mitted. They were transferred by the investoreither immediately or after the passage of aperiod of time or upon the occurrence of certainevents.

After a careful review of a number of thesearrangements, the Board concluded that invest-ments in nonvoting stock, absent other arrange-ments, could be consistent with the Act. Someof the agreements reviewed appeared consistentwith the Act because they were limited toinvestments of relatively moderate size in non-voting equity that may become voting equity. . .

However, other agreements reviewed by theBoard raised substantial problems of consis-tency with the control provisions of the Actbecause the investors. . . sought to assure thesoundness of their investments, prevent take-overs by others, and allow for sale of theiroptions, warrants, or rights to a person of theinvestor’s choice in the event a third partyobtains control of the acquiree or the investorotherwise becomes dissatisfied with its invest-ment. Since the Act precludes the investors fromprotecting their investments through ownershipor use of voting shares or other exercise ofcontrol, the investors substituted contractualagreements for rights normally achieved throughvoting shares.

For example, various covenants in certain ofthe agreements sought to assure the continuingsoundness of the investment by substantiallylimiting the discretion of the acquiree’s manage-ment over major policies and decisions, includ-ing restrictions on entering into new bankingactivities without the investor’s approval andrequirements for extensive consultations with

the investor on financial matters. By their terms,these covenants suggested control by the invest-ing company over the management and policiesof the acquiree.

Similarly, certain of the agreements deprivedthe acquiree bank holding company, by cov-enant or because of an option, of the right tosell, transfer, or encumber a majority or all ofthe voting shares of its subsidiary bank(s) withthe aim of maintaining the integrity of theinvestment and preventing takeovers by others.These long-term restrictions on voting shareswere within the presumption in the Board’sRegulation Y that attributes control of shares toany company that enters into any agreementplacing long-term restrictions on the rights of aholder of voting securities (12 C.F.R.225.31(d)(2).

Finally, investors wished to reserve the rightto sell their options, warrants or rights to aperson of their choice to prevent being lockedinto what may become an unwanted investment.The Board took the position that the ability tocontrol the ultimate disposition of voting sharesto a person of the investor’s choice and tosecure the economic benefits therefrom indi-cates control of the shares under the Act.4 TheBoard concluded that the ability to transferrights to large blocks of voting shares, even ifnonvoting in the hands of the investing com-pany, could result in such a substantial positionof leverage over the management of the acquireeas to involve a structure that would inevitablyresult in control prohibited by the Act.

2090.4.2.3 Provisions that Avoid Control

In 1982, the context of any particular agree-ment, provisions of the type described abovewere acceptable if combined with other provi-sions that serve to preclude control. The Boardbelieved that such agreements would not beconsistent with the Act unless provisions areincluded that will preserve management’s dis-cretion over the policies and decisions of theacquiree and avoid control of voting shares.

As a first step towards avoiding control, man-agement had to be free to conduct banking andpermissible nonbanking activities. Another stepto avoid control included the right of theacquiree to ‘‘call’’ the equity investment and

4. See Board letter dated March 18, 1982, to C.A. Caven-des, Sociedad Financiera.



options or warrants to assure that covenants thatmay become inhibiting can be avoided by theacquiree. This right made such investments oragreements more like a loan in which the bor-rower has a right to escape covenants and avoidthe lender’s influence by prepaying the loan.

A measure to avoid problems of control aris-ing through the investor’s control over the ulti-mate disposition of rights to substantial amountsof voting shares of the acquiree might haveincluded a provision granting the acquiree aright of first refusal before warrants, options, orother rights may be sold and requiring a publicand dispersed distribution of those rights if theright of first refusal is not exercised.

The Board concluded that agreements thatinvolve rights to less than 25 percent of thevoting shares, with a requirement for a dis-persed public distribution in the event of sale,have a much greater prospect of achieving con-sistency with the Act than agreement involvinga greater percentage. This guideline was drawnby analogy from the provision in the Act thatownership of 25 percent or more of the votingsecurities of a bank constitutes control of thebank.

One effect of the guideline was to hold downthe size of the nonvoting equity investment bythe investing company relative to the acquiree’stotal equity, thus avoiding the potential for con-trol because the investor holds a very largeproportion of the acquiree’s total equity. Obser-vance of the 25 percent guideline also madeprovisions in agreements providing for a rightof first refusal or a public and widely dispersedoffering of rights to the acquiree’s shares morepractical and realistic.

Finally, acquirers were to avoid certainarrangements regardless of other provisions inthe agreement that were designed to avoid con-trol. These are

1. Agreements that enabled the investing bankholding company (or its designee) to directin any manner the voting of more than 5 per-cent of the voting shares of the acquiree;

2. Agreements whereby the investing companyhad the right to direct the acquiree’s use ofthe proceeds of an equity investment by theinvesting company to effect certain actions,such as the purchase and redemption of theacquiree’s voting shares; and

3. The acquisition of more than 5 percent of thevoting shares of the acquiree that ‘‘simulta-neously’’ with their acquisition by the invest-

ing company become nonvoting shares,remain nonvoting shares while held by theinvestor, and revert to voting shares whentransferred to a third party.

2090.4.2.4 Review by the Board

The 1982 Policy Statement did not constitutethe exclusive scope of the Board’s concerns, norwere the considerations with respect to controloutlined in this statement an exhaustive catalogof permissible or impermissible arrangements.The Board instructed its staff to review agree-ments of the kind discussed in this statementand to bring to the Board’s attention those thatraise problems of consistency with the Act.

2090.4.3 ACTIVITIES OF BANKINGORGANIZATIONS AND BOARDDETERMINATIONS SUBSEQUENT TOTHE 1982 POLICY STATEMENT

Many aspects of the 1982 Policy Statement havebroader applicability and have served as thefoundation for the Board’s review more gener-ally of whether a minority investment in a bank-ing organization would give the investor a con-trolling influence over the management orpolicies of the banking organization. In thisregard, the 1982 Policy Statement identified anumber of structural measures that the Boardbelieved would limit the ability of an investor toexercise a controlling influence over a bankingorganization. These included restricting the useof covenants that constrain the discretion ofbanking organization management, limiting theamount of voting and nonvoting shares of thebanking organization acquired by the investor,and limiting the ability of the investor to trans-fer large blocks of voting shares.

The Board made clear in the 1982 PolicyStatement that the complexity of legitimatebusiness arrangements precluded establishingrigid rules designed to cover all situations andthat decisions regarding the presence or absenceof control must take into account the specificfacts and circumstances of each case. Accord-ingly, since the 1982 Policy Statement, theBoard has determined whether an equity inves-tor in a banking organization has a controllinginfluence over the management or policies ofthe banking organization by considering care-fully all the facts and circumstances surroundingthe investor’s investment in, and relationshipwith, the banking organization. Large minorityinvestors in a banking organization typically



have avoided acquiring a controlling influenceover the banking organization by providing theBoard with a set of passivity commitments andby avoiding certain control-enhancing mecha-nisms. Specifically, minority investors haveavoided acquiring control over a banking orga-nization by, among other things

• restricting the size of their voting and totalequity investment in the banking organization;

• avoiding covenants that would enable theinvestor to restrict the ability of the bankingorganization’s management to determine themajor policies and operations of the bankingorganization;

• not attempting to influence the banking orga-nization’s process for making decisions aboutmajor policies and operations;

• limiting director and officer interlocks withthe banking organization; and

• limiting business relationships between theinvestor and the banking organization.

2090.4.4 BOARD’S 2008 POLICYSTATEMENT ON EQUITYINVESTMENTS IN BANKS ANDBANK HOLDING COMPANIES

Since issuing the 1982 Policy Statement, theBoard has reviewed a significant number ofnoncontrolling investments in banking organiza-tions. The Board believed that it would be use-ful and appropriate to update its guidance in thisarea and therefore issued its Policy Statementon Equity Investments in Banks and Bank Hold-ing Companies (the 2008 Policy Statement) onSeptember 21, 2008. (See the Board’s Septem-ber 22, 2008, Press Release.)

2090.4.4.1 Specific Approaches to AvoidControl

The 2008 Policy Statement discusses theBoard’s views on specific approaches to avoidcontrol.5

2090.4.4.1.1 Director Representation

The Board generally has not permitted acompany that acquires between 10 and 24.9 per-cent of the voting stock of a banking organization(a minority investor) to have representation on

the board of directors of the banking organiza-tion. The principal exception to this guideline hasbeen in situations in which the investor owns lessthan 15 percent of the voting stock of the bankingorganization and another person (or group ofpersons acting together) owns a larger block ofvoting stock of the banking organization.

The Board has reexamined its precedent inthis area and, based on its experience withminority investors and director representation,believes that a minority investor generallyshould be able to have a single representative onthe board of directors of a banking organizationwithout acquiring a controlling influence overthe management or policies of the banking orga-nization. Typically, boards of directors of bank-ing organizations have 9 or 10 members.Although having a representative on the boardof the banking organization enhances the influ-ence of a minority investor, the Board’s experi-ence has shown that, in the absence of otherindicia of control, it would be difficult for aminority investor with a single board seat tohave a controlling influence over the manage-ment or policies of the banking organization.6

Moreover, a minority investor that has up totwo representatives on the board of directors ofthe banking organization is unlikely, absent otherindicia of control, to be able to exercise acontrolling influence over the banking organiza-tion when the investor’s aggregate directorrepresentation is proportionate to its total interestin the banking organization7 but does not exceed25 percent of the voting members of the board,8

5. See the 2008 Policy Statement at 12 C.F.R. 225.144,beginning at paragraph (c).

6. In addition to formal representation on the board ofdirectors of a banking organization, minority investors alsofrequently seek to have a representative attend meetings of theboard of directors of the banking organization in the capacityof a nonvoting observer. Attendance by a representative of aminority investor as an observer at meetings of the board ofdirectors of a banking organization allows the investor accessto information and a mechanism for providing advice to thebanking organization but has not in previous situationsallowed the investor to exercise a controlling influence overthe management or policies of the banking organization aslong as the observer does not have any right to vote atmeetings of the board.

7. An investor’s total interest is equal to the greater of theinvestor’s voting interest or total equity interest in the bankingorganization.

8. For example, an investor with a 10 percent voting inter-est and a 20 percent total equity interest generally could havetwo representatives on the board of directors of the bankingorganization if the investor’s director representation does notexceed 20 percent of the board seats. On the other hand, aninvestor with a 15 percent voting interest and a 33 percenttotal equity interest generally could have two representativeson the board of directors of the banking organization if theinvestor’s director representation does not exceed 25 percent



and another shareholder of the bankingorganization is a bank holding company thatcontrols the banking organization under the BHCAct.9 The presence of another larger, controllingshareholder of the banking organization that hasbeen approved by the Board, is subject tosupervision and regulation by the Board, and isobligated to serve as a source of strength for thebanking organization should serve as a powerfulcountervailing force to whatever influence theminority investor may have as a result ofits investment and proportional directorrepresentation.

The Board continues to believe that a repre-sentative of a minority investor that serves onthe board of directors of the banking organiza-tion should not serve as the chairman of theboard of the banking organization or as thechairman of a committee of the board of thebanking organization. The Board generallybelieves, however, that representatives of a non-controlling minority investor may serve asmembers of committees of the board of thebanking organization when those representa-tives do not occupy more than 25 percent of theseats on any committee and do not have theauthority or practical ability unilaterally to make(or block the making of) policy or other deci-sions that bind the board or management of thebanking organization.

2090.4.4.1.2 Total Equity

The three-prong control test in the BHC Actmakes no explicit reference to nonvoting equityinvestments. Nevertheless, the Board has longsubscribed to the view that the overall size of anequity investment, including both voting andnonvoting equity, is an important indicator ofthe degree of influence an investor may have.Accordingly, the Board traditionally has takenaccount of the presence and size of nonvotingequity investments in its controlling influenceanalysis. For example, in the 1982 Policy State-ment, the Board set forth a guideline that non-

voting equity investments that exceed 25 per-cent of the total equity of a banking organizationgenerally raise control issues under the BHCAct.10 The Board has recognized in a few lim-ited circumstances, however, that ownership bya minority investor of 25 percent or more of abanking organization’s total equity may not con-fer a controlling influence, usually in situationswhen another controlling investor is present orother extenuating circumstances indicate thatthe exercise of a controlling influence by theminority investor is unlikely.

The Board continues to believe that an inves-tor that makes a very large equity investment ina banking organization is likely to have acontrolling influence over the bankingorganization’s management or policies. Inves-tors with large equity investments have apowerful incentive to wield influence over thebanking organization in which they haveinvested. They have a substantial amount ofmoney at stake in the enterprise, are among thefirst to absorb losses if the banking organiza-tion has financial difficulties, and participate inthe profits of the banking organization goingforward. Moreover, a banking organization islikely to pay heed to its large shareholders tohelp ensure it has the ability to raise equitycapital in the future and to prevent the nega-tive market signal that would be created by thesale of a large block of equity by an unhappyexisting shareholder.

On the other hand, the Board recognizes thatnonvoting equity does not provide the holderwith voting rights that empower the holder toparticipate directly in the selection of bankingorganization management or otherwise in thebanking organization’s decision-makingprocess. Moreover, as noted above, the BHCAct defines control in terms of ownership of25 percent or more of a class of voting securi-ties but does not impose an express limit onownership of nonvoting shares. The Boardcontinues to believe that, in most circumstances,an investor that owns 25 percent or more of thetotal equity of a banking organization ownsenough of the capital resources of a bankingorganization to have a controlling influence overthe management or policies of the bankingorganization. The Board continues to recognize,however, that the ability of an investor toexercise a controlling influence through nonvot-ing equity instruments depends significantly onthe nature and extent of the investor’s overallinvestment in the banking organization and onthe capital structure of the banking organization.

(rather than 33 percent) of the board seats.9. In determining what amount of director representation is

proportional to an investor’s voting interest in a bankingorganization, the investor should round to the nearest wholenumber. For example, the Board would consider a minorityinvestor that owns 15 percent of the voting stock of a bankingorganization to have proportionate director representation if ithad two representatives on a board of directors with 10 ormore members (but not on a board of directors with 9 or fewermembers).

10. 12 C.F.R. 225.143(d)(4) and (d)(5).



In particular, the Board would not expect thata minority investor would have a controllinginfluence over a banking organization if theinvestor owns a combination of voting sharesand nonvoting shares that, when aggregated,represents less than one-third of the total equityof the organization (and less than one-third ofany class of voting securities, assuming conver-sion of all convertible nonvoting shares held bythe investor) and does not allow the investor toown, hold, or vote 15 percent or more of anyclass of voting securities of the organization. Inthese situations, the limitation on voting rightsreduces the potential that the investor may exer-cise influence that is controlling.

In previous cases, investors that haveacquired nonvoting shares often have sought theright to convert those shares to voting sharesunder various circumstances. The Board contin-ues to believe that nonvoting shares that may beconverted into voting shares at the election ofthe holder of the shares, or that mandatorilyconvert after the passage of time, should beconsidered voting shares at all times for pur-poses of the BHC Act. However, in previouscases, the Board has recognized that nonvotingshares that are convertible into voting sharescarry less influence when the nonvoting sharesmay not be converted into voting shares in thehands of the investor and may only be trans-ferred by the investor: (1) to an affiliate of theinvestor or to the banking organization; (2) in awidespread public distribution; (3) in transfersin which no transferee (or group of associatedtransferees) would receive 2 percent or more ofany class of voting securities of the bankingorganization; or (4) to a transferee that wouldcontrol more than 50 percent of the voting secu-rities of the banking organization without anytransfer from the investor. Ownership of thisform of nonvoting, convertible shares, withinthe limits discussed above, allows investors toprovide capital to a banking organization in away that is useful to the organization, minimizesthe opportunity for the investor to exercise acontrolling influence over the organization, andallows the investor to exit the investment with-out conveying control to another party outsidethe parameters of the BHC Act.

2090.4.4.1.3 Consultations withManagement

In many previous cases, minority investors haveagreed not to attempt to influence the opera-tions, management, or strategies of the bankingorganization in which they have invested; not to

threaten to sell their shares in the banking orga-nization as a method for influencing decisionsof banking organization management; and not tosolicit proxies on any matter from the othershareholders of the banking organization. Thesecommitments were designed to limit the exer-cise by a minority investor of a controllinginfluence over the management or policies of abanking organization.

The Board believes that it would be useful toprovide additional guidance on the extent ofcommunications between a minority investorand a banking organization’s management thatwould be consistent with a noncontrol determi-nation. The Board believes that a noncontrollingminority investor, like any other shareholder,generally may communicate with banking orga-nization management about, and advocate withbanking organization management for changesin, any of the banking organization’s policiesand operations. For example, an investor may,directly or through a representative on a bank-ing organization’s board of directors, advocatefor changes in the banking organization’s divi-dend policy; discuss strategies for raising addi-tional debt or equity financing; argue that thebanking organization should enter into or avoida new business line or divest a material subsidi-ary; or attempt to convince banking organiza-tion management to merge the banking organi-zation with another firm or sell the bankingorganization to a potential acquirer. These com-munications also generally may include advo-cacy by minority investors for changes in thebanking organization’s management and recom-mendations for new or alternative manage-ment.11 Although these types of discussions rep-resent attempts by an investor to influence themanagement or policies of the banking organi-zation, discussions alone are not the type ofcontrolling influence targeted by the BHC Act.

To avoid the exercise of a controlling influ-ence, in all cases, the decision whether or not toadopt a particular position or take a particularaction must remain with the banking organiza-tion’s shareholders as a group, its board of direc-tors, or its management, as appropriate. The roleof the minority investor in these decisions mustbe limited to voting its shares in its discretion ata meeting of the shareholders of the banking

11. As discussed later in the 2008 Policy Statement, aminority investor may not have a contractual right to deter-mine (or a veto right over) any of the major policies andoperations of the bank or the composition of the bank’smanagement team.



organization (directly or by proxy, including inconnection with a proxy solicitation launchedby another shareholder), and by exercising vot-ing privileges as a member of the board ofdirectors of the banking organization (to theextent permitted as discussed above). Impor-tantly, communications by minority investorsshould not be accompanied by explicit orimplicit threats to dispose of shares in the bank-ing organization or to sponsor a proxy solicita-tion as a condition of action or non-action by thebanking organization or its management.

2090.4.4.1.4 Other Indicia of Control

2090.4.4.1.4.1 Business Relationships

The Board traditionally has prohibited a non-controlling minority investor in a banking orga-nization from having any material businesstransactions or relationships with the bankingorganization. The Board historically has takenthe view that a major supplier, customer, orlender to a banking organization can exerciseconsiderable influence over the banking organi-zation’s management and policies—especiallywhen coupled with a sizeable voting stockinvestment—by threatening to terminate orchange the terms of the business relationship.

The Board has recognized over the years,however, that not all business relationships—even when accompanied by a materialinvestment—provide the investor a controllinginfluence over the management or policies ofthe banking organization. Accordingly, theBoard has frequently allowed business relation-ships that were quantitatively limited and quali-tatively nonmaterial, particularly in situationswhere an investor’s voting securities percentagein the banking organization was closer to 10 per-cent than 25 percent. The Board continues tobelieve that business relationships shouldremain limited and will continue to review busi-ness relationships on a case-by-case basis withinthe context of the other elements of the invest-ment structure. In that review, the Board willpay particular attention to the size of the pro-posed business relationships and to whether theproposed business relationships would be onmarket terms, non-exclusive, and terminablewithout penalty by the banking organization.

2090.4.4.1.4.2 Covenants

Because the BHC Act explicitly defines control(and many of its other thresholds) in terms thatinclude a percentage of voting securities, com-panies often have structured their investments inbanking organizations in the form of nonvotingsecurities and have attempted to substitute con-tractual agreements for the rights that normallyare obtained through voting securities. TheBoard has taken and continues to hold the viewthat covenants that substantially limit the discre-tion of a banking organization’s managementover major policies and decisions suggest theexercise of a controlling influence.12 In particu-lar, the Board has been concerned about cov-enants or contractual terms that place restric-tions on, or otherwise inhibit, the bankingorganization’s ability to make decisions aboutthe following actions: (1) hiring, firing, andcompensating executive officers; (2) engagingin new business lines or making substantialchanges to its operations; (3) raising additionaldebt or equity capital; (4) merging or consolidat-ing; (5) selling, leasing, transferring, or dispos-ing of material subsidiaries or major assets; or(6) acquiring significant assets or control ofanother firm.13

On the other hand, the Board generally hasnot viewed as problematic for control purposesthose covenants that give an investor rights per-missible for a holder of nonvoting securities asdescribed in section 2(q)(2) of Regulation Y.14

These would include covenants that prohibit thebanking organization from issuing senior securi-ties or borrowing on a senior basis, modifyingthe terms of the investor’s security, or liquidat-ing the banking organization. Noncontrollingcovenants also could include covenants that pro-vide the investor with limited financial informa-tion rights and limited consultation rights.

12. See 12 C.F.R. 225.143(d)(2).13. For an investment to be eligible for inclusion in a

banking organization’s regulatory capital, it must not containor be covered by any covenants, terms, or restrictions thatare inconsistent with safe and sound banking practices, see12 C.F.R. 208, Appendix A, II and 12 C.F.R. 225, AppendixA, II.(i). As described in 12 C.F.R. 250.166(b)(3), such provi-sions include terms that could adversely affect the bankingorganization’s liquidity or unduly restrict management’s flex-ibility to run the organization, particularly in times of finan-cial difficulty, or that could limit the regulator’s ability toresolve problem bank situations.

14. 12 C.F.R. 225.2(q)(2).



2090.4.4.2 Conclusion of the 2008 PolicyStatement

As noted above, whether a minority investor ina banking organization has a controlling influ-ence over the management or policies of thebanking organization depends on all the factsand circumstances surrounding the investor’sinvestment in, and relationship with, the bank-ing organization. This policy statement setsforth some of the most significant factors andprinciples the Board will consider in determin-ing whether investments in a banking organiza-tion are noncontrolling for purposes of the BHCAct.

Importantly, controlling-influence determina-tions depend not just on the contractual rights

and obligations of the investor and the bankingorganization; they also depend on the amount ofinfluence the investor, in fact, exercises over thebanking organization. Accordingly, the Boardhas and will continue to monitor carefullyminority investments in banking organizationsto ensure that investors do not, in fact, exercisea controlling influence over the management orpolicies of the banking organizations in whichthey invest. The Board also continues to evalu-ate its policies in this area and will modify themas appropriate going forward to ensure thatminority investments in banking organizationsremain consistent with the BHC Act.





Required Federal Reserveapproval if a BHC acquiresmore than 5 percent (director indirect control) of vot-ing shares of a bank

1842(a)(3)

Federal Reserve approvalof a BHC acquiring controlof a bank

1842(a)(2)

BHCs and direct or indirectcontrolling influence over abank

1841(d)

Acquiring a bank outsideof the home state of theinvesting bank holdingcompany

1842(d)(1)

Long-term restrictions onthe rights of a holder ofvoting securities

225.31(d)(2)

Specific approaches thatavoid control

225.144(c)

Nonvoting equity invest-ments as a percent of totalequity and control issues

225.143(d)(4)and (d)(5)

Covenants and controllinginfluence issues

225.143(d)(2)

Covenants and rights per-missible for a holder ofnonvoting securities.

225.2(q)(2)

Nonvoting Equity Invest-ments by BHCs (1982 Pol-icy Statement)

225.143 4-172.1

Equity investments inbanks and BHCs (2008Policy Statement)

225.144





Control and Ownership—General (Acquisitions ofBank Shares Through Fiduciary Accounts) Section 2090.5

Pursuant to Section 3 of the Bank Holding Com-pany Act, a bank holding company, directly orthrough its subsidiary banks, may not acquiremore than 5 percent of the shares of an addi-tional bank without the Board’s prior approval.However, it is recognized that banks acting astrustee may acquire such shares without priornotice. Therefore, the Act requires a bank orbanks which are subsidiaries of bank holdingcompanies and acquire in excess of the 5 per-cent threshold limit, to file an application withthe Board within 90 days after the shares ex-ceeding the limit are acquired. The limit gener-ally appliesonly to other bank shares over whichthe acquiring fiduciary exercises sole discretion-ary voting authority. Nevertheless, the Boardhas waived this application requirement undermost circumstances in Section 225.12 of Regu-lation Y, unless—1. the acquiring bank or other company has

sole discretionary authority to vote the securitiesand retains the authority for more than twoyears; or2. the acquisition is for the benefit of the

acquiring bank or other company, or its share-holders, employees, or subsidiaries.In determining whether the threshold limits

have been reached, shares acquired prior to Jan-uary 1, 1971 can ordinarily be excluded. On theother hand, shares of another bank held underthe following circumstances should, in certaininstances, be included in the 5 percent thresh-

old, even though sole discretionary votingauthority is not held:1. Shares held by a trust which is a

‘‘company’’, as defined in Section 2(b) of theBank Holding Company Act; and,2. Shares held as trustee for the benefit of the

acquiring bank or bank holding company, or itsshareholders, employees or subsidiaries.A bank holding company should have proce-

dures for monitoring holdings of the stock ofother banks and bank holding companies forcompliance with the foregoing application re-quirements of the Act, for compliance withreporting requirements on form Y–6, and forcompliance with certain similar reporting re-quirements under the federal securities laws. Ageneral 5 percent threshold applies in all threesituations, although differing requirements andexemptions apply.Examiners specifically trained in trust exami-

nations may need to conduct this portion of aninspection and, in appropriate circumstances,the examiner may need to consult with FederalReserve Bank legal counsel. Trust examinersroutinely review such matters in connectionwith individual trust examinations. The inspec-tion objectives will be to determine whether theholdings of shares of other banks or bank hold-ing companies, in a fiduciary capacity, are ap-propriately monitored to comply with section3(a) of the Bank Holding Company Act withother reporting requirements for such holdings.


Control and Ownership(Control Determinants) Section 2090.6


Effective January 2010, this section was revisedto delete a discussion of, and references to,section 2(g)(3) of the BHC Act. Section 2(g)(3)was repealed by section 2610 of the EconomicGrowth and Regulatory Paperwork ReductionAct of 1996 (Public Law No. 104-208).

2090.6.05 CONTROL DETERMINANTS

The spin-off or sale of property by a bank hold-ing company may not sever the bank holdingcompany’s control relationship over such prop-erty for purposes of the Bank Holding CompanyAct. The factors which are normally consideredin determining whether control has ceasedinclude the presumptions of control listed insection 225.31(a) of Regulation Y and in sec-tions 2(a)(2) and 2(g) of the Act, and certainownership and voting rights.

Most of the irrebuttable and rebuttable pre-sumptions of control were written to establishinitially a control relationship between twocompanies. All of the presumptions of controlmust be considered before presuming that adivestiture is effective. Irrebuttable control rela-tionships are established, or continue to be rec-ognized, when any of the conditions listed insection 225.2(e) of Regulation Y or sections2(a)(2)(A), 2(a)(2)(B), 2(g)(1), or 2(g)(2) of theAct exist. Thus, a company is assumed to haveirrebuttable control over a bank or another com-pany without a Board determination if:

1. The company directly or indirectly, or actingthrough one or more other persons, owns,controls, or has power to vote 25 percent ormore of the voting securities of the bank orcompany;

2. The company controls in any manner theelection of a majority of the directors, trust-ees, or general partners (individuals exerciz-ing similar functions) of the bank or othercompany;

3. The Board determines, after notice andopportunity for hearing, that the companydirectly or indirectly exercises a controllinginfluence over the management or policies ofthe bank or company.

Rebuttable presumptions of control are listedin section 225.31(d) of Regulation Y and insections 2(a)(2)(C) of the Act. These sections

describe situations which are not as clearlydefined as the irrebuttable presumptions. Forexample, a company which enters into a man-agement contract that gives the company signifi-cant control over the operations or managementof a bank or other company may be deemed toexercise a controlling influence over that bankor other company. Section 225.31(c) of Regula-tion Y and section 2(a)(2)(C) of the Act requirea Board determination to establish that a com-pany directly or indirectly exercises a control-ling influence over the management or policiesof a bank or other company.


1. To determine whether or not a significantvoting or ownership interest exists.

2. To determine whether any rebuttable pre-sumptions of control raise any control issues(see section 225.31(d) of Regulation Y).

3. To determine whether section 2(g)(2) of theAct or any of the other irrebuttable presump-tions of control listed in section 225.2(e) ofRegulation Y raise any control issues.


The examiner should review the stock recordsof the transferor, the transferee, and the trans-ferred entity, if possible. Management contracts,trust agreements, and any pertinent agreementsamong these parties also should be reviewed forany evidence of a control relationship. Whenfollowing these procedures for a bank holdingcompany which has divested or will divest ofproperty, the examiner should be aware that thecriteria for establishing a continuing controlrelationship are more stringent than those forestablishing an initial control relationship. Thus,the examiner should review all ownership andvoting rights rather than just those above 5 or25 percent.

The examiner should review the records ofthe bank holding company, its parents, and itssubsidiaries as well as the records of any com-pany being divested and the company (and itsparent and subsidiaries) acquiring divested prop-erty for evidence of a continuing control rela-tionship. If the transferee is an individual or ifthe records of the transferee are not available,


the examiner should inquire whether any of thespecific control relationships exist. Specifically,the examiner should determine whether thetransferee, its parent, or its subsidiaries, are

indebted to or have common personnel (officers,directors, trustees, beneficiaries, policy makingemployees, consultants, etc.) with the transferor,its parent, or its subsidiaries.



Presumptions of control Sections 2(g)(1)and 2(g)(2) ofthe act

225.31(a)225.139

Statement of policyconcerning divestitures

225.138

Rebuttable presumptionsof control

225.31(d)

Requirements placed ontransferee and transferorto ensure a completeseparation

Alfred I.duPontTestamentaryTrust;September 21,1977

Control is not terminatedif a rebuttable presump-tion of control isapplicable

Alfred I.duPontTestamentaryTrust;October 3, 1977

Explanation of ‘‘transf-eror,’’ ‘‘transferee,’’‘‘shares,’’ and procedures

225.139(c)(1) 1978 FRB 211

‘‘Transferee’’ includesindividuals

225.139(footnote 4)

Summit HomeInsuranceCompany, Min-neapolis,Minnesota;August 30,1978

The MoodyFoundation,Galveston,Texas;January 16,1968

Control and Ownership (Control Determinants) 2090.6



Presumption of controlthrough common direc-tors, officers, etc.

225.139 GATXCorporation,Chicago,Illinois;February 21,1978

Reduction of ownershipto less than 5 percent ofa subsidiary is an effec-tive divestiture

FinancialSecuritiesCorporation,Lake City,Tennessee;August 29,1972

Individual may be atransferee; an insignifi-cant debt relationshipmay exist

225.139 MercantileNationalCorporation,Dallas,Texas; June 2,1975

Control terminatedalthough shareswere pledged ascollateral on a noterepresenting part ofpurchase price

EquimarkCorporation,Pittsburgh,Pennsylvania;February 4,1977

Application to retaincontrol pursuant torebuttable presumption;approved, but companynot authorized to acquireadditional shares

First Bancorp,Inc.,Dallas, Texas;February 22,1977

Application to divestcontrol pursuant torebuttable presumption;approved

CommancheLand andCattleCompany,Commanche,Texas;January 15,1980

Indebtedness of trans-feree to transferor

225.139(c)(4) 1980 FRB 237




Board staff letter on adetermination of controlafter a spin-offtransaction

ImperialBancorp;August 19,1998





Control and Ownership(Nonbank Banks) Section 2090.7


This section has been revised to include a March21, 2006, Board staff legal opinion that con-firms that a direct conversion from a state-chartered bank to a national bank would not, byitself, cause a parent company to lose its grand-father rights maintained under section 4(f) ofthe BHC Act. The BHC Act prevents a grand-fathered nonbank BHC from acquiring controlof an additional bank or thrift as a limited-purpose trust company, which would not be abank for the purposes of the BHC Act.

2090.7.1 CEBA AND FIRREAPROVISIONS FOR NONBANK BANKS

The Competitive Equality Banking Act (CEBA),effective August 10, 1987, amended section 2(c)of the BHC Act by expanding the definition ofbank to include all FDIC-insured depositoryinstitutions. The definition also includes anyother institution that (1) accepts demand depos-its or other deposits that the depositor may makepayable to third parties (demand deposits) and(2) is engaged in the business of making com-mercial loans. The new definition covers institu-tions that were not previously covered by theBHC Act (nonbank banks). Thrift institutionsthat remain primarily residential mortgage lend-ers continue to be excepted from the definitionof bank.

CEBA amended section 4 of the BHC Act byadding a grandfather provision that permits anonbanking company that on March 5, 1987,controlled an institution that became a bankunder CEBA to retain the institution and not betreated as a bank holding company. A grandfath-ered company will lose its exemption, however,if it violates any of several prohibitions govern-ing its activities. Among these prohibitions, agrandfathered company may not acquire controlof an additional bank or a thrift institution oracquire more than 5 percent of the assets orshares of an additional bank or thrift.1 In addi-

tion, no bank subsidiary of the grandfatheredcompany may commence to accept demanddeposits and engage in the business of makingcommercial loans. A bank subsidiary of thegrandfathered company may also not permit anoverdraft2 (including an interday overdraft) orincur an overdraft on behalf of an affiliate3 at aFederal Reserve Bank.4

If a grandfathered company no longer quali-fies for an exemption, the company must divestcontrol of all the banks it controls within180 days after the date that the companyreceives notice from the Board that it no longerqualifies for the exemption. The exemption maybe reinstated if, before the end of the 180-daynotice period, the company (1) corrects the con-dition or ceases the activity that caused itsexemption to end or submits a plan to the Boardfor approval to correct the condition or cease theactivity within one year and (2) implementsprocedures reasonably adapted to avoid a recur-rence of the condition or activity.

The Board may examine and require reportsof grandfathered companies and of the nonbankbanks they control but only to monitor orenforce compliance with the grandfather restric-tions. The Board also may use civil enforcementpowers, including cease-and-desist orders, toenforce compliance.

Grandfathered companies, their affiliates, andtheir nonbank banks are also subject to the

1. An exception to this prohibition is made for casesinvolving the acquisition of a failing thrift provided that(1) the thrift is acquired in an emergency acquisition and iseither located in a state where the grandfathered companyalready controls a bank or has total assets of $500 million ormore at the time of the acquisition or (2) the thrift is acquiredfrom the RTC, FDIC, or director of the OTS in an acquisitionin which federal or state authorities find the institution to be indanger of default.

2. Section 225.52 of Regulation Y further defines therestrictions on overdrafts.

3. Section 225.52(b)(2)(ii) of Regulation Y provides that anonbank bank (or an industrial bank) incurs an overdraft onbehalf of an affiliate when (1) the nonbank bank holds anaccount at a Federal Reserve bank for an affiliate from whichthird-party payments can be made and (2) the posting of anaffiliate’s transactions to the nonbank bank’s or industrialbank’s account creates an overdraft or increases the amount ofan existing overdraft in the account.

4. The overdraft prohibition does not apply if the overdraft(1) results from an inadvertent computer or accounting errorthat is beyond the control of both the bank and the affiliate;(2) is permitted or incurred on behalf of an affiliate that ismonitored by, reports to, and is recognized as a primary dealerby the Federal Reserve Bank of New York and is fullysecured, as required by the Board, by direct U.S. obligations,obligations fully guaranteed as to principal and interest by theUnited States, or securities or obligations eligible for settle-ment by the Federal Reserve book-entry system; or (3) ispermitted or incurred by or on behalf of an affiliate in connec-tion with an activity that is financial in nature or incidental toa financial activity and does not cause the bank to violate anyprovision of sections 23A or 23B of the Federal Reserve Actdirectly or indirectly or by virtue of section 18(j) of theFederal Deposit Insurance Act.


anti-tying restrictions of the BHC Act and to theinsider-lending restrictions of section 22(h) ofthe FRA and in Regulation O. Thus, for exam-ple, a nonbank bank may not condition a grantof credit on the purchase of a product or servicefrom its grandfathered holding company, or viceversa, and it may not extend credit to insiders ofthe nonbank bank or its grandfathered holdingcompany on preferential terms.

A bank holding company that controls a non-bank bank may retain it as long as the nonbankbank does not (1) engage in an activity5 thatwould have caused it to be a bank before theeffective date of CEBA or (2) increase the num-ber of locations from which it does businessafter March 5, 1987. These limitations do notapply if (1) the nonbank bank is viewed as anadditional bank subsidiary of the bank holdingcompany and (2) the BHC’s acquisition of thenonbank bank would be permissible under theinterstate banking provisions of the BHC Act.

2090.7.2 RETAINING GRANDFATHERRIGHTS UNDER SECTION 4(F) OFTHE BHC ACT

A state nonmember bank (Bank A) that becamea ‘‘bank’’ for purposes of the BHC Act as aresult of CEBA requested a determination thatits conversion to a national bank and mergerwith a limited-purpose trust company would notcause its parent company to lose certain grand-father rights that it maintains under section 4(f)of the BHC Act. (See 12 U.S.C. 1843(f).)

The parent company could retain ownershipof Bank A and not be treated as a bank holdingcompany, but only if it and Bank A abided bythe conditions set forth in section 4(f) of theBHC Act. One of these conditions generallyprohibits the parent company from acquiringcontrol of more than 5 percent of the shares orassets of an additional bank or savings associa-tion. (See 12 U.S.C. 1843(f)(2)(A)(i) and (ii).)

The parent company wished to convert BankA into a national bank. The conversion wouldbe effected directly, and the parent company

would not establish, or acquire any shares of, aseparate bank or savings association as part ofthe conversion process. Simultaneously with theconversion process, however, the parent com-pany would establish a new, limited-purposenational bank trust company (trust company). Itwas represented that the trust company wouldcomply with the limitations and restrictions in,and would qualify for, the trust company excep-tion from the definition of bank under section2(c)(2)(D) of the BHC Act. (See 12 U.S.C.1841.) The parent company would then causethe trust company to merge into Bank A, withBank A being the entity that survives themerger. Bank A would then change its name(new bank) and the location of its headquarters.

Under the proposed transaction, the parentcompany would remain the sole shareholder ofnew bank. It was represented that, prior to itsmerger with Bank A, the trust company wouldnot be an operating company and would have noassets or liabilities. It was also represented thatthe proposal would not result in any change inownership or control of Bank A.

The Board’s legal staff concluded that thedirect conversion of Bank A from a state-chartered bank to a national bank would not, byitself, cause the parent company to lose itsgrandfather rights under section 4(f) of the BHCAct.6 Also, the BHC Act would not prevent theparent company from chartering the trust com-pany. Although the BHC Act prevents a grand-fathered nonbank bank from acquiring controlof an additional bank or thrift (12 U.S.C.1843(f)(2)(A)), the trust company as a limited-purpose trust company would not be a bank forthe purposes of the BHC Act.

The Board’s Legal Division staff stated that itwould not recommend that the Board determinethat the transactions described in the requestwould cause the parent company to lose itsgrandfather rights under section 4(f) of the BHCAct. New bank is required to comply with theconditions applicable to a nonbank bank and agrandfathered holding company, respectively,under the BHC Act. (See the Board staff legalopinion dated March 21, 2006.)

5. Previously, a nonbank bank could accept demand depos-its or engage in the business of making commercial loans, butcould not engage in both activities.

6. See letter from the general counsel of the Board, datedOctober 12, 2004.

Control and Ownership (Nonbank Banks) 2090.7




Limitations on nonbankbanks

1843(f) 225.52

1. 12 U.S.C., unless specifically stated otherwise.2. 12 C.F.R., unless specifically stated otherwise.3. Federal Reserve Regulatory Service reference.

Control and Ownership (Nonbank Banks) 2090.7


Control and Ownership (Liability of CommonlyControlled Depository Institutions) Section 2090.8

The Financial Institutions Reform, Recoveryand Enforcement Act of 1989 (FIRREA),effective August 9, 1990, provided [12 U.S.C.1815 (e)] that any insured depository institutionwill be liable for any actual or reasonablyanticipated loss incurred or to be incurred by theFDIC in connection with:1. The default of a commonly controlled1

depository institution; or2. Any assistance provided by the FDIC to

any commonly controlled insured depositoryinstitution.

2090.8.1 FIVE YEAR PROTECTIONFROM LIABILITY (5-YEARTRANSITION RULE)

Sister banks, for five years from the enactmentof the law, are protected against losses due tothe default of a thrift acquired before enactment.The law also grants a five- year protection tothrifts for loss due to the default of a bankacquired before the law’s enactment.

2090.8.2 CROSS-GUARANTEEPROVISIONS

FIRREA contains cross-guarantee provisions.These provisions enable the FDIC to obtainreimbursement from insured depository institu-tions, in the event that the FDIC incurs a lossdue to any assistance provided to, or a defaultof, a commonly controlled bank or thrift.The FDIC will provide written notice when

an insured depository institution is being heldliable for losses sustained by the FDIC in con-nection with assistance to a commonly con-trolled bank or thrift. Upon receipt of the writtennotice from the FDIC, the insured depositoryinstitution is required to pay the amount speci-fied. An insured depository institution is notliable for losses incurred by the FDIC, in con-nection with a commonly controlled institution,if the written notice is not received within twoyears from the date of the FDIC’s loss.

The liability the insured depository institutionhas to the FDIC is senior to shareholders’ claimsand any obligation or liability owed to anyaffiliate of the depository institution.2 Claims ofthe FDIC against the depository institution aresubordinate to any deposit liabilities, securedobligations and obligations that are subordi-nated to depositors (i.e. subordinated debt).The FDIC may grant an insured depository

institution a waiver of the cross-guarantee provi-sions, if it determines that such an exemption isin the best interests of the either the Bank orSavings Association Insurance Funds. Limitedpartnerships and affiliates of limited partner-ships (other than an insured depository institu-tion, which is a majority owned subsidiary ofsuch partnership) may also be exempted fromthe provisions, if the limited partnership or itsaffiliate has filed a registration statement withthe Securities and Exchange Commission, on orbefore April 10, 1989. The registration state-ment must indicate that as of the date of thefiling, the partnership intended to acquire one ormore insured depository institutions. If an in-sured depository institution is granted an ex-emption from the cross-guarantee provisions,then the institution and all of its insured de-pository institution affiliates must comply withthe restrictions of sections 23A and 23B ofthe Federal Reserve Act without regard to sec-tion 23A(d)(1) which provides for certainexemptions.

2090.8.3 EXCLUSION FORINSTITUTIONS ACQUIRED IN DEBTCOLLECTIONS

FIRREA provides an exclusion from the cross-guarantee provisions for an institution acquiredin securing or collecting a debt previously con-tracted in good faith. However, during the entireexclusion period, the controlling bank and all ofits insured depository institution affiliates mustcomply with sections 23A and 23B of the Fed-eral Reserve Act (FRA),3 for transactions withthe insured depository institution involvingacquisitions as a result of debts previously con-tracted in good faith.

1. Depository institutions are commonly controlled if:a. Such institutions are controlled by the same deposi-

tory institution holding company (including any company,such as nonbank banks, that are required to file reports under[12 U.S.C. 1843(f)(6)]; or

b. One depository institution is controlled by anotherdepository institution.

2. Does not apply to any obligation to affiliates secured asof May 1, 1989.3. Without regard to section 23A(d)(1) of the FRA.


Control and Ownership(Shareholder Protection Arrangements) Section 2093.0

The Federal Reserve has observed an increasein interest by some holding companies to estab-lish arrangements that are designed to benefitcertain shareholders, enhance short-term inves-tor returns, and/or provide a distinct disincen-tive for investors to acquire or increase owner-ship in a holding company’s common stock andother capital instruments. In some instances,supervisory staff has found that these share-holder protection arrangements would havenegative implications on a holding company’scapital or financial position, limit a holdingcompany’s financial flexibility and capital-raising capacity, or otherwise impair a holdingcompany’s ability to raise additional capital.These arrangements impede the ability of aholding company to serve as a source of strengthto its insured depository subsidiaries1 and wereconsidered unsafe and unsound.

In December 2015, the Federal Reserveissued the following guidance to explain super-visory concerns related to arrangements struc-tured by bank and savings and loan holdingcompanies (collectively, “holding companies”)to protect the financial investments made byshareholders (collectively, “shareholder protec-tion arrangements”). In particular, such arrange-ments raise concerns because they could havenegative implications on a holding company’scapital or financial position, or limit the holdingcompany’s ability to raise capital in the future.2

A holding company, regardless of its asset size,should be aware that the Federal Reserve mayobject to a shareholder protection arrangementbased on the facts and circumstances and thefeatures of the particular arrangement. There-fore, a holding company that is engaged incapital raising efforts or is considering theimplementation or modification of a shareholderprotection arrangement should review this guid-ance to help ensure that supervisory concernsare addressed. (Refer to SR-15-15)

2093.0.1 SHAREHOLDERPROTECTION ARRANGEMENTS—SUPERVISORY ISSUES

Examples of shareholder protection arrange-ments that have raised supervisory issuesinclude, but are not limited to, provisionswhereby:

• The holding company agrees to provide aninvestor with cash payments reflecting thedifference between the price paid by theinvestor and a lower price per share paid byinvestors in subsequent transactions;3

• The holding company agrees to provide aninvestor with additional shares of stock forminimal or no additional cost in the event thatthe holding company issues shares at a pricebelow the price paid by the investor;

• Existing shareholders of the holding companyare able to acquire additional shares at signifi-cant discounts to market value in a new offer-ing if any shareholder crosses a specific own-ership threshold;4

• Investors with less-than-majority control aregranted the contractual right to restrict orprevent the holding company from issuingadditional shares; or

• The holding company’s board of directors has

1. Pursuant to section 616(d) of the Dodd-Frank Wall

Street Reform and Consumer Protection Act and the Board’s

Regulations Y and LL, a holding company is required to serve

as a source of financial strength for its insured depository

subsidiaries and should not conduct its operations in an unsafe

or unsound manner. Specifically, a holding company should

stand ready to use available resources to provide adequate

capital funds to its subsidiary banks and thrifts during periods

of financial stress or adversity. See 12 U.S.C. 1831o-1; 12

C.F.R. 225.4(a); and 12 C.F.R. 238.8(a).

2. As discussed further below, these arrangements may

come in many different forms, including all or portions of

agreements between shareholders (or other relevant parties),

company plans, organizing documents, and other contractual

provisions that provide shareholder protections.

3. Provisions of this type and the next example are often

referred to as “down-round” provisions. Down-round provi-

sions can take many forms, but all are designed to protect

existing shareholders in the event a holding company’s stock

price declines in a subsequent effort to raise capital or sell the

holding company.

4. Provisions of this type are often referred to as “poison

pills” and were originally developed as defenses against con-

tested acquisitions. There are multiple common forms, but

these provisions generally operate by increasing the owner-

ship interest of shareholders other than a buyer of a significant

block of shares, thereby diluting the buyer and preventing the

takeover bid.

Poison pill structures have also been applied in the context

of tax benefit preservation plans (TBPPs), which, in general

terms, are designed to preserve net operating losses within the

requirements of section 382 of the Internal Revenue Code.

Under section 382, the use of deferred tax assets can be

restricted by an “ownership change.” Thus, TBPPs and poison

pills use similar mechanisms to restrict changes in ownership,

despite different underlying purposes. TBPPs may also take

forms different from traditional poison pills.

As an example, a TBPP or poison pill may provide all

shareholders, other than the shareholder crossing the relevant

threshold, the right to acquire shares of the holding company

at a substantial discount, reducing the incentive of sharehold-

ers to acquire more shares at or above the threshold. These

rights may or may not terminate within a set amount of time.


the authority to nullify share purchases undercertain circumstances, require the holdingcompany to repurchase the shares of the com-pany from a new owner of the shares, or takeother actions that would significantly inhibitsecondary market transactions in the shares ofthe holding company.5

Arrangements of these types (in whateverform) have the potential to impose additionalfinancial obligations on a holding company orrestrict in some way the primary or secondarymarket for the holding company’s shares. Often,these arrangements serve to protect the value ofthe initial investment made by a particular sub-set of shareholders rather than the viability ofthe issuing holding company, or, in other ways,provide current shareholders with an advantageover future, similarly situated, investors.6

2093.0.2 SUPERVISORY OVERSIGHT

If supervisory or applications staff determinethat a particular shareholder protection arrange-ment impairs the ability of a holding companyto raise or maintain capital, particularly during aperiod of stress on the firm, or that provisions ofthe arrangement are in violation of applicablesupervisory enforcement actions, FederalReserve staff should consult with appropriateFederal Reserve Board supervisory staff todetermine the appropriate action. This can occurwhen:

• Federal Reserve staff become aware of a pro-posed shareholder protection arrangement(for example, as part of an effort to raisecapital or a proposal to expand): FederalReserve staff should incorporate a review ofsuch arrangements during consideration ofthe specific proposal, whether or not there is aformal application or other approval require-ment.

• Federal Reserve staff become aware of anexisting shareholder protection arrangementduring the course of a supervisory activity(for example, in discussions with the holding

company’s management): Federal Reservestaff should incorporate a review of sucharrangements in the examination scope orsupervisory plan for the holding companyand, on limited occasions, in connection withan application filing.7

The Federal Reserve may direct a holdingcompany’s board of directors to modify orremove a shareholder protection arrangementthat gives rise to safety-and-soundness con-cerns. The corrective actions, if any, will varydepending on the facts and circumstances of theholding company, as well as applicable state andfederal laws and regulations, corporate charterand by-laws, and other considerations.8 TheReserve Bank’s communications with the hold-ing company should comply with applicablesupervisory guidance, including SR-13-13/CA-13-10, “Supervisory Considerations for theCommunication of Supervisory Findings.” If aholding company has questions regarding theremoval or modification of a shareholder protec-tion arrangement, the holding company shouldconsult with the appropriate Federal ReserveBank.

5. These arrangements could include complete prohibitions

on share transfers, as well as certain forms of buy-sell agree-

ments, rights of first refusal, or similar arrangements that

sufficiently restrict the transfer of shares as to effectively

prohibit most, if not all, transfers.

6. In general, the right to participate in subsequent offer-

ings to prevent dilution of ownership, when fully paid for, has

not raised concerns.

7. This guidance is focused on supervisory actions going

forward and is not intended to require active confirmation by

a holding company or Federal Reserve staff on a routine basis

that a shareholder protection issue does not exist. To facilitate

the identification of shareholder protection arrangements that

raise supervisory concern, the management and other repre-

sentatives of holding companies are encouraged to bring all

such existing or proposed arrangements to the attention of

relevant supervisory and applications staff when appropriate.

8. Holding companies subject to the Board’s Regulation Q

(12 C.F.R. 217) are subject to additional regulatory require-

ments that should be considered in connection with share-

holder protection arrangements. In particular, common equity

tier 1 capital instruments and additional tier 1 capital instru-

ments are required to satisfy eligibility criteria that effectively

disqualify instruments with certain features used in some

shareholder protection arrangements, such as features that

limit or discourage future capital issuances, compensate exist-

ing investors if new instruments are issued at a lower price,

create incentives to redeem, or interfere with the full discre-

tion of the issuer to cancel dividend payments except under

limited circumstances. See 12 C.F.R. 217.20. Further, the

Board may require a holding company to exclude capital

instruments from regulatory capital if such instruments have

characteristics or terms that diminish the instrument’s ability

to absorb losses, or otherwise present safety-and-soundness

concerns. See 12 C.F.R. 217.1(d)(2).

Control and Ownership (Shareholder Protection Arrangements) 2093.0


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