Federal Reserve System,

Federal Register: October 26, 2001 (Volume 66, Number 208)Rules and RegulationsPage 54345-54398From the Federal Register Online via GPO Access [wais.access.gpo.gov]

DOCID:fr26oc01-17

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Part II

Federal Reserve System

12 CFR Parts 211 and 265

International Banking Operations; Rules Regarding Delegation of Authority and International Lending Supervision; Final Rule and Proposed Rule

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FEDERAL RESERVE SYSTEM

12 CFR Parts 211 and 265

Regulation K; Docket No. R-0994International Banking Operations; Rules Regarding Delegation of Authority

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Final rule.

SUMMARY: Consistent with section 303 of the Riegle Community Development and Regulatory Improvement Act of 1994 (the Regulatory Improvement Act), the Federal Reserve Act, and the International Banking Act of 1978 (the IBA), the Board has reviewed Regulation K, which governs international banking operations, and is amending subparts A, B, and C. A proposed rule to amend subpart D of Regulation K is being published in this same issue of the Federal Register.

Subpart A of Regulation K governs the foreign investments and activities of all member banks (national banks as well as state member banks), Edge and agreement corporations, and bank holding companies. The amendments streamline foreign branching procedures for U.S. banking organizations, authorize expanded activities in foreign branches of U.S. banks, and implement recent statutory changes authorizing a bank to invest up to 20 percent of capital and surplus in Edge corporations. Changes also have been made to the provisions governing permissible foreign activities of U.S. banking organizations, including securities activities, and investments by U.S. banking organizations under the general consent procedures.

Subpart B of Regulation K (Foreign Banking Organizations) governs the U.S. activities of foreign banking organizations. The amendments include revisions aimed at streamlining the applications procedures applicable to foreign banks seeking to expand operations in the United States, changes to provisions regarding the qualification of foreign banking organizations for exemption from the nonbanking prohibitions of section 4 of the Bank Holding Company Act (the BHC Act), and implementation of provisions of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the Interstate Act) that affect foreign banks.

In addition, there are a number of technical and clarifying amendments to subparts A and B, as well as subpart C, which deals with export trading companies. There are also certain amendments to the Board's Rules Regarding Delegation of Authority.

EFFECTIVE DATE: November 26, 2001.

FOR FURTHER INFORMATION CONTACT: Kathleen M. O'Day, Associate General Counsel (202/452-3786), regarding all subparts: Jon Stoloff, Senior Counsel (202/452-3269), or Alison MacDonald, Counsel (202/452-3236), regarding Subpart A; Ann Misback, Assistant General Counsel (202/452- 3788), Janet Crossen, Senior Counsel (202/452-3281), or Melinda Milenkovich, Counsel (202/452-3274), regarding Subparts B and C; Legal Division; or Michael G. Martinson, Associate Director (202/452-2798), or Betsy Cross, Deputy Associate Director (202/452-2574), regarding all subparts; Division of Banking Supervision and Regulation. For users of Telecommunications Device for the Deaf (TDD) only, please contact 202/ 263-4869.

SUPPLEMENTARY INFORMATION:

Subpart A: International Operations of U.S. Banking Organizations

Statutory Framework

The Board is issuing amendments to Regulation K that will eliminate unnecessary regulatory burden, increase transparency, and streamline the approval process for U.S. banking organizations seeking to expand their operations abroad. The Federal Reserve Act, as amended by the IBA, requires the Board to review its regulations issued under section 25A of the Federal Reserve Act (the Edge Act) at least once every five years and make any changes necessary to ensure that the purposes of the Edge Act are being served in light of prevailing economic conditions and banking practices.\1\ The Board has reviewed the provisions of Subpart A, which govern the operations of Edge corporations, with this statutory mandate in mind.

\1\ The Board last issued final revisions to Subpart A of Regulation K in December 1995, at which time the investment authority for strongly capitalized and well-managed U.S. banking organizations was expanded significantly.

Edge corporations are international banking and financial vehicles through which U.S. banking organizations offer international banking or other foreign financial services and through which they compete with similar foreign-owned institutions in the United States and abroad. The purposes of the Edge Act, which amended the Federal Reserve Act in 1919, include enabling U.S. banking organizations to compete effectively with foreign-owned institutions; providing the means to finance international trade, especially U.S. exports; fostering the participation of regional and smaller U.S. banks in providing international banking and financing services to U.S. business and agriculture; and stimulating competition in the provision of international banking and financing services throughout the United States.

Congress, in enacting this legislation, recognized that U.S. banks needed vehicles that could exercise wider financial powers abroad than were permitted domestically in order to be competitive internationally and to serve the international needs of U.S. firms. At the same time, the Edge Act places limits on U.S. banks' exposure to these broader foreign activities, by limiting the amount that U.S. banks may invest in Edge corporations, establishing a number of statutory safety and soundness constraints, and granting the Board wide discretion in determining what activities should be permissible for such entities. In exercising its authority in this area, the Board is required by the IBA to implement the objectives of the Edge Act consistent with supervisory standards relating to the safety and soundness of U.S. banking organizations.

In December 1997, following a comprehensive review of the regulation, the Board requested public comment on proposed revisions to Regulation K (62 FR 68423) (the '97 Proposal). The Board received 28 comments from outside the Federal Reserve System on the proposed Subpart A revisions. Comments were received from twelve U.S. banks or bank holding companies; one Edge corporation; one bank-owned insurance agency; and thirteen trade associations. The Board also received comments from one state bank supervisory agency.

Subsequent to the Board issuing the '97 Proposal, financial modernization legislation was enacted. The Gramm-Leach-Bliley Act (Pub. L. 106-102, 113 Stat. 1338 (1999) (GLB or the GLB Act) was enacted on November 12, 1999. Many of the activities the Board had proposed to liberalize in the '97 Proposal are covered under the expanded authority available to financial holding companies (FHCs) under GLB. More specifically, under GLB, a bank holding company (BHC) that elects to become an FHC may engage in a broad range of financial activities, including securities underwriting and dealing, insurance sales and underwriting, and merchant banking.

Final action on the '97 Proposal was deferred pending implementation of the expanded authority available under GLB. The Board has issued a number of rules implementing GLB authority, including, for example, those governing

[Page 54347]FHC elections and activities (66 FR 400, Jan. 3, 2001), real estate brokerage activities by FHCs (66 FR 307, Jan. 3, 2001), merchant banking activities (66 FR 8466, Jan. 31, 2001), the capital treatment of nonfinancial equity investments (66 FR 10212, Feb. 14, 2001), transactions between banks and their affiliates (66 FR 24186, May 11, 2001), and financial subsidiaries of state member banks (66 FR 42929, Aug. 16, 2001).

The Board has now reviewed its '97 Proposal in light of the significantly changed landscape in relation to provision of financial services post-GLB, as well as all comments filedon the '97 Proposal. The Board has concluded that a few of the changes proposed in 1997 that would have allowed expansion of activities now authorized under GLB no longer are appropriate, primarily those relating to equity dealing, portfolio investment, and insurance activities. However, consistent with the '97 Proposal, the Board has concluded that a number of provisions relating to foreign activities of U.S. banking organizations should be amended, including changes that would: (1) Expand permissible government bond trading by foreign branches of member banks; (2) streamline procedures for establishment of foreign branches by U.S. banking organizations; (3) expand permissible equity underwriting activities abroad for well-capitalized and well-managed U.S. banking organizations; (4) expand general consent authority for well- capitalized and well-managed U.S. banking organizations; (5) amend the debt/equity swaps authority to reflect changes in circumstances of eligible countries; and (6) implement the statutory provision allowing member banks to invest, with the Board's approval, up to 20 percent of capital and surplus in the stock of Edge and agreement corporations. Additional technical and clarifying amendments were also made. These changes to Regulation K, and the comments received on the '97 Proposal, are discussed below.

The Board also indicated in the '97 Proposal that it had not identified any changes to the permissible U.S. activities of Edge corporations that appeared necessary or appropriate to fulfill the purposes of the Edge Act, but sought comment on whether there was a need for any such changes. One commenter urged the Board to permit Edge corporations to provide incidental services generating insignificant revenues in the United States to U.S. persons affiliated with a foreign person or a foreign organization that is principally engaged in foreign business. The Board does not believe this change is necessary or appropriate or otherwise consistent with the purposes of the Edge Act.

Expansion of Government Bond Trading by Foreign Branches

Section 25 of the Federal Reserve Act permits the Board to authorize foreign branches of member banks to conduct abroad activities that are not permitted domestically. However, the statute states that the Board shall not ``except to such limited extent as the Board may deem necessary with respect to securities issued by any `foreign state' * * * authorize a foreign branch to engage or participate, directly or indirectly, in the business of underwriting, selling, or distributing securities.''

Given the statutory language, the Board, to date, has only permitted foreign branches to underwrite and sell obligations of (i) the national government of the country in which the branch is located, (ii) an agency or instrumentality of the national government where supported by the taxing authority, guarantee, or full faith and credit of the national government, and (iii) a political subdivision of the country. This was determined to be appropriate on the basis that it is often necessary in the ordinary course of banking business for a branch to participate in the selling of the bonds of the host country.

In recent years, U.S. banking organizations have become more active in trading and underwriting foreign government securities. Increasingly, such business, where possible, is being conducted in the foreign branches of U.S. banks. Centralizing trading for all or for certain groups of countries in a single branch can be desirable to facilitate management and funding of this business. For example, a banking organization might wish to centralize government securities trading for all countries in the European Union in one European branch.

For these reasons, the Board proposed that banks be permitted to underwrite and deal through their foreign branches in obligations of governments other than the host government, provided that the obligations are of investment grade and the business is otherwise subject to sound banking practices and prudential regulations. The Board considered the requirement that the obligations must be investment grade would limit cross-border transfer risk to the bank because trading of government securities giving rise to such risk would be required to be conducted either directly through a local branch that is funded locally or through a subsidiary, instead of through the bank. The Board also proposed to retain the existing authority of foreign branches of member banks to underwrite and deal in host government bonds regardless of whether they are investment grade. The Board sought comment on these proposals, as well as on what ratings should be considered to be investment grade for these purposes.

Commenters expressed general support for the Board's proposal. Some commenters suggested that the Board treat any government obligation, investment grade or otherwise, of any country or, alternatively, any country in which a bank has a foreign branch, as eligible to be underwritten and traded in branches located outside of that country. Other commenters argued that safety and soundness is enhanced by having centralized underwriting and dealing of all government securities, since the local branch which has authority to engage in non-investment grade underwriting and dealing may not have the appropriate experience to manage such operations.

The Board continues to believe the investment grade requirement for obligations of governments other than the host government is appropriate for the reason set out in the proposal, namely, limitation of cross-border transfer risk to the bank. Non-investment grade government securities issued by foreign governments other than the host government are more likely to give rise to such risks. For this reason, the Board continues to be of the view that trading of non-investment grade securities should be conducted either directly through a local branch that is funded locally or through a subsidiary, instead of through the bank. Accordingly, in the final rule, the Board has retained the investment grade requirement for obligations of governments other than the host government.

A few commenters recommended that the Board permit foreign branches of U.S. banks to underwrite and deal in investment grade obligations of all political subdivisions, and of agencies and instrumentalities whether or not backed by the national government. After further consideration, the Board has determined that it is appropriate to adopt this suggestion at least in part, so long as all such obligations are investment grade. As at present, obligations of agencies and instrumentalities will be required to be supported by the taxing authority, guarantee, or full faith and credit of the national government.

Commenters also requested that foreign branches be permitted to

[Page 54348]underwrite and deal in all securities guaranteed by a foreign government. The Board notes that the authority granted in section 25 of the Federal Reserve Act in relation to this activity is with respect to securities ``issued by `foreign state','' and declines to adopt this change.

With respect to the Board's request for comment on which ratings should be considered to be investment grade for these purposes, commenters urged the Board to adopt the definition of ``investment grade'' set out in the Office of the Comptroller of the Currency's (OCC) investment securities regulation. 12 CFR 1.2(d). The OCC defines the term to mean a security that is rated in one of the four highest rating categories by two or more ``nationally recognized statistical rating organizations'' (NRSROs) as designated by the Securities and Exchange Commission (SEC), or one such agency if the security has been rated by only one NRSRO. The Board considers this definition to be appropriate for purposes of this activity of foreign branches of U.S. banks; accordingly, that definition is incorporated into the final rule.

A few commenters also urged the Board to adopt a procedure that would permit the addition of agencies to the list of permissible rating agencies beyond those that have been approved by the SEC because of concern that a rating by a NRSRO may not be available for some foreign government securities. The Board is not inclined to adopt such a procedure at this time in view of the number of NRSROs that rate foreign government securities. Board staff should be consulted if any issues arise in relation to application of the ``investment grade'' requirement. If it appears that additional guidance is warranted, the Board will consider the matter further.

Comments also suggested that securities that are not speculative in nature and are deemed by the investor to be the credit equivalent of a security that is rated investment grade should be considered ``investment grade'' under this provision of Regulation K. The Board believes that such an approach would essentially mean that there would be no requirement that the obligations be investment grade and rejects it for this reason. Finally, commenters sought clarification as to whether the limits applicable to government obligations, whether as a percentage of capital or of local deposits, may be calculated on a net basis rather than a gross basis. The limits applicable to government obligations under this section may be calculated on a net basis, provided that the banking organization otherwise has received no objection to its internal models being employed for purposes of compliance with these limits.

Foreign Branching

The Board's responsibilities as home country supervisor under the Minimum Standards for the Supervision of International Banking Groups and their Cross-border Establishments issued by the Basle Committee on Banking Supervision (the Minimum Standards) call for its specific authorization of a U.S. banking organization's outward expansion. Outward expansion for these purposes means the initial establishment of a banking presence in a country by the bank or any affiliate.

Regulation K currently requires the specific consent of the Board for the establishment of branches by a member bank, an Edge or agreement corporation, or a foreign bank subsidiary in its first two foreign countries. The Board proposed to amend Regulation K to require only 30 days' prior notice to the Board before establishment of branches in the first two countries, on the basis that such a requirement also would fulfill the Board's responsibilities under the Minimum Standards. The Board also proposed that 30 days' prior notice would be required, consistent with the Minimum Standards, if the initial banking presence abroad would be in the form of a subsidiary bank; such notice would be required even if the amount to be invested were below the general consent limits.

Under Regulation K at present, no prior Board approval is required for a banking entity to establish additional branches in any foreign country where it already operates one or more branches. However, a banking entity must give the Board prior notice before establishing a branch in a foreign country where it has no branches even though a banking affiliate operates a branch in that country.

The Board proposed to liberalize Regulation K such that if any of the member banks, their Edge or agreement corporation subsidiaries, or a foreign bank subsidiary (whether a subsidiary of the bank or of the bank holding company) already has a branch in a particular foreign country, a banking affiliate would be authorized to branch there without prior notice to the board. After-the-fact notice, however, would still be required.

The Board also proposed that the 45 days' prior notice currently required in order to branch into additional countries where there is no affiliated banking presence (after the organization has branches engaged in banking in two foreign countries) should be reduced to 12 business days. In taking this approach, the foreign branching establishments of the entire banking organization would be taken into account in determining whether the banking entity would be subject to the 30 day or 12 day prior notice procedure. Where a U.S. banking organization as a whole already operates foreign branches of banking entities in two countries, any banking affiliate would be able to open a branch in a country where such organization has no banking presence, pursuant to the 12 days' prior notice procedure.

Finally, currently under Regulation K, nonbanking subsidiaries may branch into any country in which any affiliate has a branch without prior notice, but a 45-day prior notice must be submitted to establish a branch in a country where no affiliate has a presence. The Board proposed permitting nonbanking subsidiaries held pursuant to Regulation K to establish foreign branches without prior review, subject only to an after-the-fact notice requirement.

The Board sought comment on these proposed changes, including in particular whether the proposed modified notice periods would sufficiently accommodate foreign expansion plans. Commenters supported the Board's proposed changes. Accordingly, the Board is adopting the foreign branching provisions as proposed. The Board wishes to clarify that filing Form FR 2058 fulfills the after-the-fact notice requirements of the foreign branching provisions. Additionally, the Board notes that the streamlined procedures for establishment of foreign branches are not limited to well-capitalized, well-managed institutions. However, the Board retains the authority to suspend general consent authority in whole or in part should circumstances warrant.

Permissible Activities of Foreign Subsidiaries of U.S. Banking Organizations

One aspect of bank regulation to which the Federal Reserve subscribes is the fostering of a level competitive playing field for financial intermediaries. Thus, in the United States, the Board has advocated that expansion by banking organizations into nonbanking activities should generally occur through the bank holding company and not the bank. Banks in the United States benefit from the implicit support of the national government and its sovereign credit rating through federal deposit insurance, Federal Reserve discount window access, and final riskless settlement of payment

[Page 54349]system transactions. Extension of this system would make the existing playing field in the United States unlevel for nonbank competitors and create unnecessary distortions in competition.

The same principle applies to U.S. banking organizations abroad. Other nations have chosen to allow their banks to engage in a broad array of financial activities, especially investment banking activities, thereby extending to these activities the implicit support of their governments. In those markets, U.S. banking organizations would be at a disadvantage if unable to offer their customers an equivalent range of key services with the convenience and efficiency of their local bank competitors. In many of these markets, banks are the only significant providers of capital markets services. Independent securities firms are not generally substantial competitors in these markets, both for historical reasons and because they may be unable to compete effectively with banks that have the explicit and implicit support of their governments.

Congress has recognized the existence of conflicting policy objectives and competitive pressures faced by U.S. banking organizations operating abroad and through legislation has struck a balance. In relation to the United States, Congress in enacting GLB demonstrated a strong preference that expanded nonbanking financial activities be conducted in a structure that does not involve the federal bank subsidy. Expanded activities authorized by GLB are required to be conducted either in nonbank subsidiaries of a financial holding company or in a financial subsidiary of a bank, which would be subject to the restrictions on funding by a parent bank set out in sections 23A and 23B of the Federal Reserve Act. In relation to competitive pressures arising from abroad, Congress preserved the Board's authority under the Edge Act to permit Edge corporations, which may be owned by U.S. banks, to engage in a wider range of activities outside the United States than permitted to U.S. banks domestically, where such powers are considered necessary to enable them to compete effectively with similar foreign-owned institutions in the United States and abroad and liberalization otherwise is consistent with safety and soundness considerations. Congress, in enacting the Edge Act, recognized that U.S. banks in some circumstances may need vehicles that could exercise broader financial powers abroad in order to remain competitive internationally and to serve the needs of U.S. firms. Congress granted the Board similar broad discretion to allow bank holding companies to engage in activities outside the United States.

In exercising its statutory authority under the Edge Act, the Board has sought to balance the need for U.S. banking organizations to be competitive abroad with the public interest in assuring the safety and soundness of the banks, protecting the deposit insurance fund, and limiting the extension of the federal safety net. In adopting final revisions to Regulation K, the Board has sought to grant expanded authority only in relation to those activities where: (i) The existing restrictions of Regulation K appear to result in a competitive harm to the ability of an Edge corporation to provide financial services necessary to attract and retain customers; and (ii) requiring the activities to be conducted outside the bank chain of ownership appears to compromise significantly the competitive position of U.S. banking organizations. The Board has concluded that equity underwriting is one such activity, and the expansion of authority proposed in 1997 with regard to this activity has been adopted, as discussed further below. The Board has concluded, however, that liberalization set out in the '97 Proposal in relation to other activities, such as equity dealing, venture capital investments and insurance activities, should not be adopted at this time in light of the passage of GLB. These latter activities appear to be able to be conducted competitively outside the bank chain of ownership under authority granted in GLB.

Two-Tier Capital Test for Edge Corporations

As the Board noted in the '97 Proposal, tying applicable limits to the capital of the parent bank is particularly important for subsidiaries of Edge corporations. Congress has limited a member bank's investment in Edge and agreement corporations to 20 percent of the bank's capital.\2\ However, for various reasons, Edge corporations historically have tended to retain their earnings rather than dividending them to the parent bank. In some cases due to such retained earnings, the capital of a bank's Edge and agreement corporations may be in excess of 20 percent of the parent bank's consolidated capital, even though its investment in the Edge subject to the above-referenced statutory limit is below 20 percent.

\2\ The Edge Act prohibited member banks from investing more than 10 percent of their capital and surplus in the capital stock of Edge and agreement corporations. In September 1996, congress amended this limit to permit investments in excess of 10 percent of capital and surplus with the specific approval of the Board, provided the amount invested shall not exceed 20 percent of capital and surplus of the bank. See The Economic Growth and Regulatory Paperwork Reduction Act (EGRPRA), Pub. L. 104-208, sec. 2307 (12 U.S.C. 618).

In these circumstances, the Board considered that the capital of an Edge corporation that is in excess of 20 percent of the parent bank's consolidated capital, when retained earnings are counted, generally should be excluded for purposes of determining applicable limits for activities of the Edge and its subsidiaries. Accordingly, the Board proposed that Edge and agreement corporations, as well as foreign bank subsidiaries of member banks (which are treated as Edge corporations for purposes of their limits), would be subject to two limits, one tied to a percentage of the Edge corporation's tier 1 capital and the other tied to a percentage of the parent bank's tier 1 capital. Limits tied to the parent bank's capital would be 20 percent of the limits otherwise applicable to Edge corporations, and the lower limit would be binding. For example, if a limit proposed for a given activity of an Edge corporation is 10 percent of the Edge corporation's capital but the Edge corporation's capital is in excess of 20 percent of the bank's total capital, the binding limit for the Edge corporation would be two percent of the parent bank's tier 1 capital. For those U.S. banks that do not have significant levels of retained earnings at the Edge, the binding limit more than likely would be the separate limit tied to the Edge corporation's capital.

The Board considered that this approach would be consistent with the intent underlying the provisions of the Edge Act limiting the total amount of capital a bank may invest in Edge corporations. This approach effectively would place a cap on the percentage of total bank capital that could be placed at risk through activities or investments not otherwise permitted to the bank directly, regardless of the capital level of the Edge corporation. This approach also would reduce any regulatory incentive to retain earnings at the Edge because any regulatory benefit from such retained earnings, in terms of expanded limits on activities abroad, would be denied.

The Board proposed that all limits applicable to Edge corporations under the '97 Proposal would proceed on this basis. Comment was requested on these proposals and whether any other approach might achieve similar objectives.

One commenter opposed the Board's proposal to impose a two-tier capital test on Edge corporations, arguing that the proposal penalized organizations that achieve strong earnings in a

[Page 54350]subsidiary of a bank rather than a subsidiary of the holding company. It further maintained that the limitation on the amount a bank can invest in an Edge corporation creates a practical limit on the risk to the bank's own capital. Therefore, it argued the Board should look only at the capital of the Edge corporation in setting limits as a percentage of capital. The Board continues to believe this two-tier approach is consistent with the intent underlying provisions of the Edge Act that limit the total amount of capital a bank may invest in Edge corporations. The Board notes that, due to the accumulation of large amounts of retained earnings in Edge corporations, the limitation on the amount a bank can invest in an Edge corporation may not limit the overall risk to the bank's consolidated capital.

Two other commenters argued the Board should look only at the capital of the parent bank in setting limits under the Edge corporation. The Board believes, however, that activity limits for Edge corporations should be tied to the capital of both the Edge corporation and the parent member bank, in order to ensure that Edge corporations are not a source of potential weakness to the U.S. parent bank.

Securities Activities

Current Restrictions on Securities Activities

Foreign subsidiaries of U.S. banking organizations have been permitted broad authority to underwrite and deal in debt securities for over 25 years, subject to the provision that the securities must be included with loans for purposes of compliance with the parent bank's lending limit. No separate dollar limits have been placed on underwriting and dealing in debt securities.

Since 1979, Regulation K also has specifically authorized foreign subsidiaries of both U.S. banks and bank holding companies to underwrite and deal in equity securities outside the United States, subject to certain limitations and restrictions. These activities were determined to be permissible, within the applicable limits, on two bases. First, it became clear that it was necessary for U.S. banking organizations to be able to engage in these activities abroad, if they were to compete successfully with foreign banks in the provision of services to foreign customers. Indeed, for some time, virtually all the major foreign competitors of U.S. banking organizations have been foreign banks that conduct equity securities activities either directly in the bank or in a subsidiary of the bank. Thus, consistent with the purposes underlying the Edge Act and the BHC Act, there is clear statutory authority for U.S. banking organizations to engage in these activities through subsidiaries abroad. Second, in any event, the provisions of the Glass-Steagall Act did not apply extra-territorially to the operations of foreign subsidiaries of U.S. banking organizations.

While equity underwriting and dealing have been permissible activities for U.S. banking organizations' foreign subsidiaries for some time, as noted above, the level of such activity is subject to limits under Regulation K. Restrictions currently applied to equity securities underwriting and dealing activities under Regulation K include the following.

Underwriting limits--Through a foreign subsidiary, an investor \3\ may underwrite equity securities in amounts up to the lesser of $60 million or 25 percent of its tier 1 capital. These limits do not include amounts covered by binding commitments from sub-underwriters or other purchasers. If the underwriting is done in a subsidiary of the member bank, the amount of the uncovered underwriting must be included in computing the bank's single borrower lending limit with respect to the issuer.

\3\ An investor for these purposes means an Edge corporation, agreement corporation, bank holding company, member bank and any foreign bank owned directly by a member bank.

Dealing limits--Through a foreign subsidiary, an investor may hold a dealing position in the equity securities of any one issuer in amounts up to the lesser of $30 million or 10 percent of its tier 1 capital. An investor must include any shares of a company held in an affiliate's dealing account in determining compliance with any percentage limits placed on ownership of that company.

Aggregate limit--There is an aggregate limit on the total amount of equity securities that may be held in investment and dealing accounts, aggregating all shares held by subsidiaries: for a bank holding company, the limit is 25 percent of tier 1 capital; for an Edge corporation,\4\ the limit is 100 percent of the Edge's tier 1 capital.\5\

\4\ Any foreign bank directly owned by a U.S. bank is treated as an Edge corporation for purposes of its limits.

\5\ Investments in companies must be added to any shares of such companies held in the dealing account for purposes of this limit.

Prior review--Banking organizations must submit to a review of their foreign securities operations prior to engaging in foreign equity securities activities to the extent of these limits. They may also seek Board approval for higher underwriting limits, subject to certain conditions.

Revisions of Equity Securities Authority

Equity Underwriting

'97 Proposal

Although, as discussed above, the existing limits on underwriting equity securities in Regulation K are expressed both in terms of percentages of tier 1 capital of the investor and absolute dollar limits, as a practical matter it has been the dollar limits that have constrained the extent to which U.S. banking organizations may engage in these activities through their foreign subsidiaries. In the '97 Proposal, the Board noted the $60 million limit on underwriting equity securities significantly impedes the ability of U.S. banking organizations to compete for this business in foreign markets, where securities underwriting is a service routinely offered by local banks. At the same time, the risks associated with the activity suggest that such a stringent limit is not required for safety and soundness purposes for well-capitalized and well-managed banking organizations. While initial underwriting commitments may involve large sums, in most cases by the time the underwriting goes to market, large portions of the exposure have been passed on to sub-underwriters or presold. Thus, in most cases, the initial underwriting commitment substantially overstates the risk being assumed.

In order to reduce further these constraints, the Board proposed in 1997 to replace the dollar limits for underwriting activity with limits based solely on percentages of the investor's tier 1 capital for well- capitalized and well-managed organizations. The Board considered that, if a banking organization is well-capitalized and well-managed, tying the underwriting limits solely to capital levels would have the benefit of more closely linking the limits to the ability of the company to support the activity. It would also provide U.S. banking organizations with greater flexibility in responding to changing market conditions, because the amount of capital devoted to an activity is, after meeting regulatory constraints, determined by the firm.

Accordingly, the Board proposed to amend Regulation K in relation to those banking organizations that are well-capitalized and well- managed by removing the existing dollar limits applicable to equity underwriting

[Page 54351]activities, and instead providing that such activities would be limited to percentages of the investor's tier 1 capital. For well-capitalized and well-managed organizations, the Board proposed applicable limits to be determined as follows.\6\ In relation to securities activities of subsidiaries of bank holding companies, their limits would be determined by reference to percentages of the tier 1 capital of the holding company. The Board proposed that limits applicable to such activities undertaken by subsidiaries of Edge and agreement corporations, as well as foreign banks that may be direct subsidiaries of member banks, would be determined by reference to the tier 1 capital of the parent bank as well as to the tier 1 capital of the bank subsidiary. More specifically, limits for underwriting exposure to a single company would be established at 15 percent of the bank holding company's tier 1 capital for its subsidiaries and, for subsidiaries of Edge corporations, the lesser of three percent of tier 1 capital of the bank or 15 percent of the tier 1 capital of the Edge.

\6\ The Board proposed that existing dollar limits would be retained for companies that are not well-capitalized and well- managed.

Under the '97 Proposal, these limits on underwriting exposure to a single company would be applied on an aggregate basis. A bank holding company's limit would include all underwriting exposure to one issuer by all of the holding company's direct and indirect subsidiaries, including exposures held through its bank subsidiaries. The bank's and Edge's limits would include all exposures held by their respective subsidiaries. The Board proposed, however, that this expanded underwriting authority would be available to U.S. banking organizations only if each of the bank holding company, bank, and Edge or agreement corporation qualify as well-capitalized and well-managed.\7\

\7\ The Board proposed that what, if any, action should be taken in relation to banking organizations' limits if they ceased to be well-capitalized and well-managed would be addressed on a case-by- case basis through supervisory action.

For organizations that fail to meet the well-capitalized and well- managed criteria, the Board proposed that the existing dollar limits (i.e., $60 million) on commitments by an investor and its affiliates for the shares of an organization would be retained.

The Board proposed that, in order to engage in such activities, all banking organizations would be required to implement internal systems and controls adequate to ensure proper risk management. Controls would have to be in place to assure that underwriting positions do not result in violations of limits on securities held in the trading account or exceed the parent bank's lending limits when the underwriting positions are combined with other credit exposures. Sanctions (such as temporary suspension of underwriting authority) may be imposed for violations of such limits.

Final Rule on Equity Underwriting Limits.

The Board continues to believe that there is a strong competitive need for liberalization of the $60 million Regulation K limit on equity underwriting. Subsidiaries of Edge corporations have been able to gain some underwriting business through obtaining commitments in advance from subunderwriters in order to reduce their own exposure to $60 million, but the limit clearly is a material constraint. Underwriting abroad continues to be a business that is conducted by local banking firms and does not lend itself readily to cross-border activity, thus requiring foreign subsidiaries of U.S. banks to compete with much larger local competitors.

Further, as noted above, the risks associated with equity underwriting activities suggest that stringent limits are not required for safety and soundness purposes for well-capitalized and well-managed banking organizations. Although the percentage limits proposed in the '97 Proposal would significantly increase the amount of underwriting authorized under Regulation K, underwriting is a shorter term activity than, e.g., dealing. Moreover, under Regulation K, positions undertaken in connection with an underwriting and unplaced after 90 days must be moved to the dealing account and counted against the dealing limit. Consequently, the exposure of the banking organization to the activity is minimized.

Commenters strongly supported the Board's proposed liberalization of the equity underwriting limits, and made a few additional suggestions. One commenter recommended that the proposed underwriting limits be doubled. Another expressed concern that the proposed limits might result in some Edge corporations having less underwriting authority than the existing $60 million limit. Some commenters also objected to the disparity between the limits proposed for BHC and bank subsidiaries.

The Board does not believe further expansion of the underwriting limits beyond those proposed is warranted, particularly given that portions of an underwriting that are covered by binding commitments obtained from subunderwriters or other purchasers are not counted in determining compliance with the limits. U.S. banking organizations wishing to engage in underwriting equity securities in amounts larger than those permitted under Regulation K may do so by qualifying for GLB authority. The Board also continues to believe it is appropriate to tie the expanded limits to the investor's capital. If the underwriting limit resulting from an Edge's capital is considered to be too low, it is of course open to the organization to increase its capital and thereby increase its limit.\8\

\8\ Commenters recommended that banking organizations also should be able to net underwriting exposures for purposes of determining compliance with the limits. As a practical matter, Regulation K presently essentially authorizes netting for these purposes given that, where the underwriter is covered by binding commitments from subunderwriters or other purchasers, such commitments are excluded in determining compliance with the limits. Compliance with the limits will continue to proceed on this basis. The Board does not believe a persuasive case has been made for any additional netting authority in relation to equity underwriting at this time.

Commenters also suggested that the existing additional Regulation K underwriting authority, whereby an organization may request the Board's approval to exceed the $60 million underwriting limit so long as the excess amount is deducted from capital and the organization would remain strongly capitalized after such deduction, also should be extended to the expanded limits. The Board does not believe it is appropriate to retain this authority in view of the significant increase in the underwriting limits that would be otherwise authorized under the expanded limits. Moreover, because the limits are determined by reference to capital, banking organizations seeking greater underwriting authority may expand their limits by increasing their capital.

For these reasons, the Board is adopting the expanded underwriting limits for well-capitalized and well-managed banking organizations set out in the '97 Proposal essentially without change. As proposed, the limits would apply to all underwriting exposures held under authority of Regulation K by the relevant entity and all of its subsidiaries (e.g., a BHC's limit would include all underwriting exposures to one issuer by all of the holding company's direct and indirect subsidiaries, including exposures held through its bank subsidiaries, and a

[Page 54352]bank subsidiary's limits would include all exposures held by its subsidiaries).\9\

\9\ Additional comments relevant to the Board's final action on equity underwriting authority also were submitted with regard to the Board's proposed criteria for determining whether banking organizations would be considered to be well-capitalized and well- managed for purposes of the expanded authority, as well as with regard to the two-tiered capital test for Edge corporations for purposes of determining eligibility. Each of these issues is discussed separately.

Equity Dealing

'97 Proposal

The Board also proposed for comment liberalization of dealing activities for well-capitalized and well-managed banking organizations. As with underwriting limits, the proposed expansion of dealing limits would have been based on percentages of capital of the organization and, thus, on the ability of the organization to accommodate risk. The Board also noted its belief that dealing activities presented somewhat greater risk of loss than underwriting, which resulted in somewhat more restrictive limits being proposed for dealing activities relative to underwriting activities.

For well-capitalized and well-managed organizations, the Board proposed to remove the current dollar limits and revise the existing percentage of capital limits as follows. First, in order to provide diversification in the trading account, the Board proposed a limit on holdings of any one stock in the trading account of 10 percent of the tier 1 capital of the bank holding company for its subsidiaries and, for subsidiaries of an Edge corporation, the lesser of two percent of the bank's tier 1 capital or 10 percent of the Edge corporation's tier 1 capital.

Second, the Board proposed an aggregate limit applicable to all holdings of equities in the trading accounts of all direct and indirect subsidiaries authorized pursuant to Subpart A.\10\ Without such an aggregate ceiling, the Board was concerned that a banking organization could have excessive exposure to movements in equity markets. The Board proposed aggregate limits of 50 percent of the bank holding company's tier 1 capital for its subsidiaries and, in the case of an Edge's subsidiaries, the lesser of 10 percent of the tier 1 capital of the bank or 50 percent of the Edge's tier 1 capital.

\10\ As at present, shares held as an investment pursuant to Subpart A also would be included in determining compliance with the applicable aggregate limits.

The Board proposed that the limits on equity dealing would apply to net positions across legal vehicles held, directly or indirectly, by the regulated entity to which the limit applied (that is, the bank holding company, the bank or the Edge corporation). Long equity positions in a single stock could be netted against short positions in the same stock and against derivatives referenced to the same stock.\11\ For purposes of the aggregate limits, all physical and derivative long positions could be netted against physical and derivative short positions. It was further proposed that, for purposes of measuring compliance with these limits, banks would be permitted to use internal models to calculate the value of derivative positions used to offset exposures and net dealing positions in individual stocks, as well as the value of total net equity holdings in the trading account.\12\ The Board considered that the adequacy of such models is subject to review during the exam process, and proposed that no special review would be required for their use in connection with the proposed limits on dealing activities.

\11\ The Board also proposed that a basket of stocks, specifically segregated by the banking organization as an offset to a position in a stock index derivative product, as computed by the bank's internal model, may be netted as a whole against the stock index.

\12\ Currently, the use of internal models in computing net positions in stocks is subject to prior Board review and the limitation that no net long position in a security shall be deemed to have been reduced through netting by more than 75 percent.

For organizations that failed to satisfy the well-capitalized and well-managed criteria, the Board proposed to retain the existing dollar limit on individual shares held in the trading account (i.e., $30 million), which would be calculated in the same manner as at present. As noted, it is generally the dollar limits that currently constrain organizations in their ability to conduct these activities. This is because, at present, only the largest banking organizations are engaged in these activities. The Board noted, however, that in the future a relatively small organization may seek to enter these lines of business and, for it, exposures of $30 or $60 million may be large relative to its capital. The Board therefore also sought comment on whether, in addition to dollar limits, limits based on percentage of capital also should be adopted for organizations that are not well-capitalized and well-managed in order to address the relative exposure of such organizations to these activities.

In addition, for organizations that are not well-capitalized and well-managed, the Board also proposed an aggregate limit on shares held in the trading account, including all dealing positions and investments held pursuant to Regulation K authority, of 25 percent of the holding company's capital for its subsidiaries and, for subsidiaries of Edges and any foreign bank held directly by a member bank, the lesser of 5 percent of the bank's tier 1 capital or 25 percent of the Edge's tier 1 capital. These limits were proposed on the basis that they would be half of those applicable to organizations that were well-capitalized and well-managed.

The Board also sought comment on whether, instead of imposing the limits discussed above in relation to equity underwriting and dealing activities by subsidiaries of well-capitalized and well-managed bank holding companies, it would be appropriate to lift all limits on these activities for such entities except for the limits on individual stocks held in the trading account discussed above (i.e., 10 percent of the holding company's tier 1 capital). The Board considered that, at a minimum, this limit should be imposed on holding companies in order to assure diversification in individual stock holdings. Under this alternative, banking organizations also would be required to implement internal systems and controls adequate to ensure proper risk management and that underwriting positions do not result in violations of limits on investments in any one company.

Developments Since the '97 Proposal

Since the time the Board issued the '97 Proposal for public comment, the statutory and regulatory environment governing the equity dealing activities of U.S. banking organizations, as well as the market demand for such services, have changed significantly. One significant change noted above was the enactment and implementation of GLB. Under GLB, FHCs may engage in unlimited equity dealing activities. While the GLB Act did not make any revisions to the Edge Act, the Board believes that it demonstrates a Congressional intent that significant equity dealing activities should be conducted through FHC powers, absent a competitive need for U.S. banking organizations to engage in such activities through bank subsidiaries.

A second important change since the '97 Proposal has been the dramatic growth in the equity markets over the past few years. The growth in demand in the U.S. market for equity securities since the early 1990s, growing acceptance of equity investments by European investors since the establishment of the Euro, and the global equity market volatility of the past several years have combined with advances in financial engineering to create significant customer demand for

[Page 54353]equity derivative instruments. In particular, the wide variety of sophisticated investment strategies employed by institutional investors and hedge funds, as well as the increasing focus of financial institutions on providing high net worth private banking clients with sophisticated portfolio diversification, hedging, and stock option monetization services, have translated into increasing volumes of equity derivatives at global banking organizations. For example, from December 31, 1996 to December 31, 2000, the notional value of equity derivatives held by U.S. banking organizations has more than tripled to roughly $940 billion. In meeting this demand, institutions generally avoid taking significant net open equity positions and hedge their customer equity derivative transactions either with other equity derivatives or with physical securities.

Finally, although, as noted above, GLB did not expand the authority of banks to acquire equity securities, the Office of the Comptroller of the Currency (OCC) determined last year that several national banks could take positions in equity securities solely to hedge bank permissible, customer-driven equity derivative transactions, as an activity incidental to the business of banking. The OCC imposed no quantitative limit on such equity positions, but rendered the banks' authority to take such positions subject to the following constraints:

  (a) The banks committed that they will use equities solely for hedging and not for speculative purposes;

  (b) The banks will not take anticipatory or maintain residual positions in equities except as necessary to the orderly establishment or unwinding of a hedging position;

  (c) The banks may not acquire equities for hedging purposes that constitute more than 5 percent of a class of stock of any issuer; and

  (d) Banks must obtain OCC supervisory approval prior to engaging in this activity in order to demonstrate that they have an appropriate risk management process in place.

These developments, along with all comments received on the '97 Proposal, have been taken into account by the Board in taking action on the final rule.

Final Rule on Equity Dealing Limits

Equity Securities Acquired To Hedge Equity Derivatives

Existing Regulation K and the '97 Proposal both proceed generally on the basis that acquisition of shares of a company by a subsidiary of a U.S. bank must be authorized by and conform to limits established for dealing in shares of a single issuer and limits applicable to portfolio investments. In other words, both presume that all such acquisitions of equity securities must conform to Regulation K limits because, absent the authority of the Federal Reserve Act and Regulation K, such acquisitions of shares of nonfinancial companies would be impermissible for the bank and its subsidiaries. The OCC's recent determinations, however, render the Regulation K limits largely irrelevant for national banks with respect to their equity derivatives business.

Regulation K, however, also presently authorizes for both subsidiaries of bank holding companies and subsidiaries of member banks abroad ``commercial and other banking activities'', which encompass all activities in which banks are permitted to engage in the United States. 12 CFR 211.5(d)(1). Accordingly, the Board takes this opportunity to clarify that the effect of the determination that banks may take positions in equity securities solely to hedge bank permissible, customer-driven equity derivative transactions as an activity incidental to the business of banking is to render this activity ``commercial or other banking activity'' for purposes of Regulation K. The consequence of this change is that, as an otherwise permissible banking activity, positions taken in equity securities for this purpose may be excluded in determining compliance with the separate Regulation K dealing limits, so long as taking such positions continues to be bank permissible and all constraints placed upon the conduct of this activity in determining its permissibility are observed, namely:

  (a) The equities are used solely for hedging and not for speculative purposes;

  (b) no anticipatory or residual positions in equities will be acquired or maintained, except as necessary to the orderly establishment or unwinding of a hedging position;

  (c) no equities may be acquired for hedging purposes that constitute more than 5 percent of a class of stock of any issuer; and

  (d) the banking organization has obtained approval from its primary federal regulator prior to engaging in such hedging practices in order to demonstrate that they have appropriate risk management processes in place.

The Board is concerned, however, that the first two constraints imposed by the OCC on the conduct of this activity (specifically, requiring the equities to be used solely for hedging and not for speculative purposes, and limiting residual positions to those necessary to the orderly establishment or unwinding of a hedging position) are ambiguous and potentially difficult to apply, particularly in light of the generally integrated nature of equity derivatives business. Indeed, the Board notes that it is usually the case that, even where a bank seeks to fully hedge equity derivatives with physical securities, residual positions will arise. It also is not unusual for traders in this line of business to seek to maximize returns by taking a view on price movements of the underlying security at the same time as putting in place the hedges necessary to cover the unwanted portion of derivative exposures. For this reason, the Board has concluded that, where after full netting and offset of equity securities against derivatives any residual positions in a single issuer remain, the value of all such residual positions as calculated by the organization's internal models must be included in determining the organization's compliance with the dealing limit, as discussed further below.

The Board notes that the effect of this clarification is to place the constraints of the Regulation K dealing limits on those activities involving the acquisition of equity securities that are not bank permissible. Any subsequent regulatory or legislative determination that acquiring equity securities to hedge bank permissible equity derivatives is not a bank permissible activity would have the effect of rendering all such positions subject again to the dealing limits. Equity Dealing Limits

Comments on the '97 Proposal generally supported the Board's proposed expansion of the equity dealing limits for well-capitalized, well-managed organizations.\13\ As noted above, however, in light of the enactment of the GLB Act expanding authority to engage in this activity, the

[Page 54354]Board no longer believes it is appropriate to increase the equity dealing limits under Regulation K. Instead, the Board considers that GLB authority should be the vehicle for any significant increase in equity dealing authority for subsidiaries of bank holding companies and of banks, unless concerns regarding the ability of U.S. banking organizations to compete in the provision of financial services abroad otherwise support additional liberalization under Regulation K. The Board is of the view that no such concerns appear to be raised in relation to dealing activities such as market-making and proprietary trading.

\13\ Some commenters argued that banking organizations should be able to exceed individual and aggregate dealing limits, provided the amount in excess of the limits was deducted from capital and, after deduction, the organization remained well-capitalized. Other commenters were concerned that the proposed limits tied to capital might actually result in a decrease in dealing authority, and recommended higher limits. Another commenter noted that the terms ``shares'' and ``equity'' are both used in the '97 Proposal and recommended using ``shares'' to ensure that convertible debt and participating loans are not included in the limits. In view of its conclusions regarding the absence of justification for any significant expansion of dealing authority under Regulation K, the Board rejects these suggestions. The Board does wish to clarify that convertible debt prior to conversion and participating loans are not encompassed within the dealing limit.

To the contrary, with respect to market-making, a limit of $30-40 million per single issuer appears generally consistent with being able to make a market in a stock, which is necessary to being competitive in foreign securities markets. With respect to proprietary or speculative positions, the Board considers that this is not an area that should be the subject of liberalization under Regulation K. Any banking organization that wishes to take larger speculative positions than Regulation K allows can do so without limit in an FHC subsidiary or a financial subsidiary of the bank.

Accordingly, the Board does not consider that there is sufficient justification at this time for any significant increase in the single issuer dealing limit. However, the Board believes it would be appropriate to make a small incremental increase in the equity dealing limit, raising it from $30 million to $40 million, in recognition of the increased experience of organizations engaged in this activity and the fact that the $30 million limit was adopted 10 years ago. This approach is consistent with the Board's action in the past.

As noted above, all residual positions in equity securities of a single issuer resulting from bank-permissible equity derivatives business must be included in calculating compliance with the $40 million limit. Additionally, while underwriting commitments and shares held for up to 90 days in connection with an underwriting would be excluded from these limits, positions unplaced after 90 days must be moved to the dealing account and counted against the dealing limit.

Otherwise, the Board has determined that the existing dealing authority should remain essentially unchanged.\14\ This would include the existing 25 percent constraint on the availability of derivative hedges as a means of reducing net long positions in physical securities for purposes of compliance with the single issuer limit. More specifically, under existing Regulation K, even if an organization has full netting authority and its net long positions in physical securities of a single company are fully hedged by derivative instruments referenced to the same security, $.25 of each $1 in net long physical securities nevertheless continues to count toward the $30 million single issuer limit. As at present, this additional limit or constraint will only apply to net long positions in physical securities after longs and shorts are netted, and additional derivative hedges may reduce net long positions in physical securities by up to 75 percent. The increase in dealing limit to $40 million will result in an overall cap on net long positions in physical securities of $160 million even where the positions are fully hedged. The Board has determined that, going forward, this additional constraint on dealing activity will only apply to net long positions in physical securities held under Regulation K dealing authority, not to physical securities acquired in connection with bank permissible hedging transactions.

\14\ As discussed further below, however, the Board has adopted the expanded netting authority proposed in 1997 with a few minor changes.

Netting and Otherwise Determining Compliance With Dealing Limits

The Board has determined that it should adopt one additional aspect of the '97 Proposal as it would apply to equity securities activities, namely, allowing netting based on internal models for purposes of determining compliance with the single issuer dealing limit. Comments submitted were overwhelmingly in support of the use of internal models for this purpose.

Thus, consistent with the '97 Proposal, the equity dealing limit will apply to net positions across legal vehicles held, directly or indirectly, by the regulated entity to which the limit is applicable (that is, the bank holding company or the bank subsidiary). Long equity positions in a single stock may be netted against short positions in the same stock and against derivatives referenced to the same stock. Also consistent with the '97 Proposal, a basket of stocks, specifically segregated by the banking organization as an offset to a position in a stock index derivative product, as computed by the bank's internal model, may be netted as a whole against the stock index. For purposes of the aggregate equity limits, all physical and derivative long positions may be netted against physical and derivative short positions. Organizations may use their internal models to calculate the value of derivative positions used to offset exposures and net dealing positions in individual stocks, as well as the value of total net equity holdings in the trading account.

For those banking organizations that wish to rely on netting based on their internal models for purposes of determining compliance with the dealing limits, the valuations generated by those models based upon current market values of the organization's residual positions in a single issuer will count toward the single issuer dealing limit. The Board considers it only appropriate that, if a banking organization uses its internal models for purposes of netting and valuing residual exposures in its equity derivatives line of business, it must use current market values (and not historical cost) for calculating compliance with the dealing limits under Regulation K for all of its equities lines of business. The organization may not ``mix and match'' the use of historical cost and mark-to-market valuations where internal models are used for these purposes.

However, the Board notes that netting based on internal models is not the mandatory method of compliance with the dealing limit. In this regard, Regulation K dealing limits presently encompass only net long positions in physical securities, after netting long and short positions in the same security. As is presently the case, organizations not wishing to determine compliance with the dealing limits by netting and offsetting positions in physical securities against positions in derivatives referenced to the same security may continue to determine compliance with the $40 million dealing limit solely by reference to the historical cost of its net long physical positions.

Commenters requested clarification of one aspect of the '97 Proposal regarding netting, namely, whether positions in a single stock would qualify for netting so long as the hedge for the position is held directly or indirectly by the entity to which the limit applies (i.e., somewhere within the investor chain, but not necessarily in the same legal entity holding the related investment.) The Board confirms that netting of positions on this basis will be permissible. This approach reflects the market or economic risk of positions held by the entity on a consolidated basis.

Finally, the '97 Proposal would have allowed netting based on a banking organization's internal models without prior Board approval. The Board continues to believe that prior approval

[Page 54355]should not be required to engage in netting through the use of internal models for this purpose. After further consideration, however, the Board believes prior notice of an organization's intention to use its internal models for this purpose is appropriate so that the Board may object if it considers the models inadequate for any reason. Banking organizations that have previously received approval under Regulation K to engage in netting through the use of their internal models may continue to do so without additional notice to the Board.\15\

\15\ In response to comments, the Board notes that organizations would not be required to create a new model separate from existing internal models used for purposes of market risk assessment in order to engage in netting under Regulation K. Indeed, the Board would expect that organizations would use for this purpose the same internal models otherwise currently employed for purposes of risk management.

Authority To Engage in Equity Underwriting and Dealing Activities

In the '97 Proposal, the Board noted that its approval currently is required to engage in underwriting and dealing in equity securities pursuant to Regulation K and sought comment on whether banking organizations that are well-capitalized and well-managed should be allowed to engage in equity securities activities at the proposed expanded levels without seeking prior Board approval. In response to this request, commenters urged allowing U.S. banking organizations meeting the well-capitalized, well-managed criteria to engage in the expanded activities without Board approval, particularly if the organization already has experience in such activities under Regulation Y or K.

As discussed above, the Board has adopted the '97 Proposal with regard to expanded equity underwriting authority for organizations that are well-capitalized and well-managed, but has only increased the equity dealing authority from $30 to $40 million. The latter increase in authority will be available to all organizations regardless of whether they meet the well-capitalized, well-managed criteria. The Board has concluded that, in view of the significant liberalization in underwriting authority under Regulation K, all organizations that wish to engage in the expanded underwriting activities must first provide 30 days' prior notice to the Board. With regard to the increased dealing authority, all organizations that wish to engage in dealing activities under the $40 million limit also must provide 30 days' prior notice to the Board, unless the organization already has received the Board's consent to engage in dealing activities under the $30 million limit. Organizations presently engaging in dealing activities under the $30 million limit may avail themselves of the additional $10 million in dealing authority without prior notice to the Board.

Venture Capital Activities Through Portfolio Investments

Current Restrictions

Regulation K currently allows U.S. banking organizations to make portfolio investments, that is, limited, noncontrolling investments in foreign commercial and industrial companies. This authority was adopted to enhance the competitiveness of U.S. banking organizations by increasing the range of financial services they may provide abroad. Many foreign financial institutions, including foreign banks, engage in venture capital activities, at times in connection with the provision of other financial services to the company.

'97 Proposal

The Board proposed in the '97 Proposal that existing dollar limits on portfolio investments made by well-capitalized, well-managed bank holding companies under the Board's general consent authority would be replaced by limits tied solely to a percentage of the holding company's tier 1 capital. More specifically, such bank holding companies (and their nonbanking subsidiaries) would be permitted to invest up to 2 percent of the holding company's tier 1 capital in any individual investment and would be subject to an aggregate limit of 25 percent of the holding company's tier 1 capital for all such investments. In determining compliance with the individual limit, shares in such companies held in the trading account by the investor and its affiliates under Regulation K would be included.

For all other investors (i.e., Edge corporations, foreign bank subsidiaries of member banks, and bank holding companies that are adequately capitalized but fail to meet the well-capitalized and well- managed standards), the Board proposed retaining limits of $25 million on investments in any one organization under general consent authority, although larger investments would continue to be eligible for prior notice or specific approval treatment on a case-by-case basis. An aggregate limit on such investments would be imposed. For bank holding company investors, that limit would be 25 percent of tier 1 capital, and for Edge or foreign bank investors, it would be the lesser of 5 percent of the parent bank's tier 1 capital or 25 percent of the Edge's tier 1 capital.

With respect to the limit on voting shares in the target company, the Board proposed that investors would be permitted to make noncontrolling investments in up to 24.9 percent of a company's voting shares. These investments would only be permissible if, as at present, the investor does not control the company in which the investment is made. Accordingly, the Board noted an investor may not: (i) Control a majority of the board of directors or have disproportionate representation on the board; (ii) have a management contract with the company or exercise veto power over its actions; or (iii) use any other means to control the operations of the company.

The Board requested comment on all of the foregoing revisions to the portfolio investment authority. It specifically requested comment on the relative risk of portfolio investments and whether there is a competitive need for foreign subsidiaries of banks also to have expanded authority in relation to such investments.

Final Rule on Portfolio Investment Authority

Comments submitted on this aspect of the Board's '97 Proposal strongly supported the liberalization proposed in relation to limits applicable to portfolio investments made by bank holding companies, as well as in relation to the proposed increase in permissible individual investments up to 24.9 percent of voting shares. Certain of the comments argued that the proposed liberalization for bank holding companies also should be extended to bank subsidiaries, and various clarifications were requested on the interaction between the proposed changes and the existing rule. Clarification of these matters is provided below.

As discussed above, however, the major development in this area since the Board issued the '97 Proposal was enactment of the GLB Act, which authorizes FHCs to make merchant banking investments without regard to dollar limits or geographic restrictions. The Board notes that expanded merchant banking authority under GLB is only available to holding company subsidiaries; such authority may not be exercised in the bank chain.

The Board has therefore reconsidered the '97 Proposal in the light of passage of GLB and has determined not to adopt

[Page 54356]the proposal to increase the general consent limit and the permissible percentage of shares for portfolio investments. The Board considers that the GLB Act established the framework for engaging in merchant banking activities generally, and Regulation K should not establish an alternative framework for expansion of this activity absent a compelling competitive need. The Board does not believe that any such compelling competitive need has been demonstrated. Bank holding companies wishing to engage in merchant banking activities other than under the existing constraints of Regulation K should seek FHC status.

Investment Limits

A number of additional comments were submitted that are also relevant to the operation of existing provisions of Regulation K in relation to portfolio investments. In particular, certain commenters suggested that investors should be permitted to make portfolio investment under Regulation K in excess of the $25 million general consent limit, so long as the amount in excess were deducted from capital. Other commenters suggested that organizations should be permitted to use netting for purposes of calculating compliance with portfolio investment limits. The Board considers that neither of these changes would be appropriate in view of the nature of portfolio investments and the availability of other authority for making such investments.

A few commenters also requested clarification regarding whether the calculation of limits on portfolio investments will continue to be on an historical cost basis. One expressed the concern that an increase in the aggregate portfolio limit would be necessary if these investments would be valued at current market value, not historical cost. The Board considers that limits on portfolio investments should be calculated consistent with their treatment for capital purposes. More specifically, the amount of the investment subject to the Regulation K limit will equal the carrying value of the investment, or the value of the investment on the balance sheet, reduced by any unrealized gains on the investment that are reflected in the carrying value but are excluded from the organizations' tier 1 capital.

Commenters also opposed combining portfolio investments with dealing positions, either for purposes of a single company limit or aggregate limit, noting that these activities have important differences and are managed through separate lines of business. They argued that portfolio investments generally are made with longer time horizons and tend to involve privately held companies, whereas dealing positions generally are taken for short periods of time and involve public companies. The Board considers these points to be well-founded. In view of these comments and the Board's determination not to adopt any significant liberalization either in relation to portfolio investments or dealing authority, the Board believes it is appropriate to amend the single company limits for purposes of portfolio investments and for equity dealing such that the limits will apply to each activity separately. However, the Board notes that all equity shares held in a single company, including those held in connection with dealing activity (but excluding underwriting commitments and shares held for up to 90 days pursuant to an underwriting), must be combined for purposes of determining compliance with the control limitations of: (i) section 4(c)(6) of the BHC Act (with respect to U.S. companies); and (ii) the voting and total equity limits for portfolio investments under Regulation K (with respect to foreign companies).

Additionally, the Board is retaining an overall aggregate equity limit that will apply to all shares held under Regulation K portfolio investment and dealing authority, for the reasons discussed in the section below entitled ``Aggregate Equity Limits for Dealing and Portfolio Investments.''

Finally, commenters recommended that the Board specifically grandfather any investments that might be rendered impermissible by revision to Regulation K, or include a phase-in period for divestiture of such investments. The Board notes that, in view of the fact that it is not diminishing in any way existing authority in relation to these investments, no issues relating to the need for grandfathering arise.

Percentage of Permissible Voting Shares

Commenters expressed support for the `97 Proposal which would have increased the percentage of voting shares permissible for portfolio investments from 19.9 percent to 24.9 percent. A few commenters recommended higher levels of permissible voting shares, as well as increasing the 40 percent nonvoting equity limit, arguing that such increases would better enable U.S. banking organizations to compete with foreign financial institutions.

As noted above, FHCs may now make investments in nonfinancial companies under merchant banking authority without limitation as to the percentage of voting or nonvoting shares held and without restriction geographically. Consequently, the Board believes it is no longer appropriate to alter in any way the existing Regulation K limits on voting and nonvoting shares of portfolio investment companies. U.S. banking organizations wishing to invest in nonfinancial companies outside the United States beyond the existing limits of Regulation K should do so through obtaining FHC status. In these circumstances, the existing Regulation K voting and nonvoting equity limits on qualifying portfolio investments do not appear to affect the ability of U.S. banking organizations to compete abroad.

As noted above, portfolio investments are only permissible within these limits if the investor otherwise also does not control the company in which the investment is made. In this regard, several commenters urged the Board to clarify that restrictive and negative covenants, such as are commonly found in senior debt, also are permissible in connection with portfolio investments on the basis that they would not give the investor control over the company. The Board believes that such covenants may be permissible so long as their purpose is to protect the minority rights of the investor. However, such covenants may not be used as a means to obtain control over a portfolio investment by preventing the company from making normal business decisions. For example, the Board considers that it would be inconsistent with the mandatory noncontrolling nature of portfolio investments for investors to have the right to veto a company's choices for senior management positions. Should questions of this nature arise in connection with a proposed portfolio investment, banking organizations should seek the views of Board staff as to whether the proposed investment would qualify as a portfolio investment.

In this regard, commenters suggested that the Board should adopt for Regulation K a process similar to that adopted in Regulation Y in relation to advisory opinions regarding the scope of financial activities. The Board has adopted this suggestion and will seek to respond to requests for advisory opinions under Regulation K within 45 days of receipt of a complete written request, unless the request raises significant policy issues.

Finally, another commenter sought clarification as to whether the proportionality test for directors should be measured against the investor's voting interest or economic interest, favoring the latter measure. The Board believes that an investor in a portfolio investment should have representation on the board proportionate to its voting

[Page 54357]interest, and not economic interest, in the company. More specifically, in view of the restriction on voting shares held to 19.9 percent, the Board would expect that an investor would have no more than one director for every five seats on the board. In addition, an investor may not have a disproportionate participation on a board's executive committee.

``Incidental'' Activities in the United States

'97 Proposal

In the '97 Proposal, the Board proposed one additional change related to portfolio investments, primarily to provide some relief to U.S. banking organizations with regard to the U.S. activities of their foreign portfolio investments. As a result of limitations in the Federal Reserve Act and the BHC Act, U.S. banking organizations are prohibited from investing in more than 5 percent of the voting shares of foreign companies that engage in impermissible activities in the United States other than those activities that are an incident to their international or foreign business.\16\ The Board previously has taken the view that such permissible incidental activities in the United States are limited to those activities that the Board has determined are permissible for Edge corporations to conduct in the United States.\17\

\16\ In particular, the Federal Reserve Act prohibits investments in companies engaging in ``the general business of buying or selling goods, wares, merchandise or commodities in the United States.'' 12 U.S.C. 615. Section 4(c)(13) investments under the BHC Act are limited only by a requirement that the company do ``no business in the United States except as incident to its international or foreign business.''

\17\ See 12 CFR 211.4(e).

However, as discussed above, companies in which portfolio investments are made generally are engaged in industrial or commercial activities, which are not permissible activities for Edge corporations. Consequently, under Regulation K at present, if a portfolio investment company decides to engage in activities in the United States, the U.S. banking organization is forced to sell its interest in the portfolio investment, even if market considerations are inconsistent with selling the shares at that time. This divestiture would be required despite the fact that the U.S. banking organization, by reason of the mandatory noncontrolling nature of portfolio investments, is unlikely to be in a position to influence the decision to enter the U.S. market. In the '97 Proposal, the Board expressed the concern that, with the increasing globalization of economies around the world, this situation may become more common in the future.

In order to address these changes in circumstances and in view of the minority nature of portfolio investments, the Board proposed that, consistent with the Federal Reserve Act and the BHC Act, investors may retain portfolio investment companies that derive no more than 10 percent of their total revenue from activities in the United States that are not permissible for Edge corporations to conduct in the United States.

In proposing this change, the Board noted the nature of portfolio investments. In particular, most portfolio investments are venture capital investments that are not intended to be permanent holdings of the banking organization and instead are intended to be sold after a period of time. In addition, the preponderance of the value of portfolio investments is derived from their foreign business.

The Board invited comment on this proposed change. It also sought comment on what might be regarded as an appropriate period for divestiture of non-conforming investments, as well as on whether a time limit should be placed on the period for holding these types of investments in view of their supposedly medium-term nature.

Final Action

Commenters strongly endorsed the Board's proposed change in interpretation of U.S. activities considered ``incidental'' to international or foreign activities for this purpose, although some comments recommended that Regulation K should allow portfolio companies to derive a larger percentage of their total revenues (e.g., 20 or 25 percent) from activities in the United States. Some commenters recommended that the Board employ a percentage of total tangible assets test either in lieu of or as an alternative to the revenues test, suggesting that tangible assets are a more stable indicator of the extent of a company's business in the United States and are easier to measure.

The Board adopts the change as set forth in the '97 Proposal. Thus, for purposes of determining whether a portfolio investment may continue to be held or must be divested, portfolio investment companies that derive no more than 10 percent of their total revenue in the United States may be considered to be engaged only in business that is an incident to their international or foreign business and therefore may continue to be held under portfolio investment authority. The Board continues to believe that the 10 percent revenue limit is appropriate to address globalization concerns and is consistent with the provisions of the Federal Reserve Act and the BHC Act. The Board further considers that the revenue test is a better indicator of the level of U.S. activity, rather than the amount of tangible assets in the United States which may be more susceptible to manipulation.

A few commenters requested clarification of the operation of this limit. In response to these requests, the Board notes that revenue derived from activities in the United States in its view would include all revenue derived from activities performed in U.S. offices, but not business that may originate from the United States but is performed offshore. It is, of course, also the case that this revenue test would only be applied to U.S. activities of portfolio investments that are not otherwise permissible for Edge corporations to conduct in the United States.

In response to the Board's request for comment on an appropriate divestiture period for investments that exceed the 10 percent revenue limit, a number of suggestions were made, including allowing U.S. revenues of up to 40 percent for up to five years. Other commenters variously suggested that the Board should adopt existing debts previously contracted (``DPC'') time periods for divestiture; allow some other specified period to divest (e.g., a six month period, with an opportunity for extensions of up to a total of two years); or establish divestiture deadlines on a case-by-case basis. The Board is retaining the current Regulation K requirement of a ``prompt'' divestiture of all nonqualifying portfolio investments, which allows for a case-by-case determination as to the appropriate period of time within which an impermissible investment must be divested.

Aggregate Equity Limits for Dealing and Portfolio Investments

In the '97 Proposal, in view of the significant liberalization in authority proposed for bank holding companies in relation to portfolio investments, an aggregate limit on all portfolio investments was proposed. The Board also proposed an additional aggregate equity limit that would apply to all shares held as portfolio investments and in connection with dealing activities. The proposed aggregate limit for all such investments for banking organizations meeting the well- capitalized and well-managed tests was:

BHC Subsidiaries: 50 percent of tier 1 capital.

[Page 54358]

Bank Subsidiaries: The lesser of 10 percent of tier 1 capital of the bank, or 50 percent of the bank subsidiary's tier 1 capital.

Underwriting commitments and shares acquired pursuant to an underwriting commitment and held for less than 90 days were excluded from the proposed aggregate equity limit.\18\

\18\ The Board also proposed aggregate limits for investors that do not meet the well-capitalized and well-managed standards of half that applicable to well-capitalized and well-managed organizations (i.e., 25 percent of tier 1 capital for bank holding company subsidiaries, and, for bank subsidiaries, the lesser of 5 percent of the parent bank's tier 1 capital or 25 percent of the bank subsidiary's tier 1 capital.

Commenters opposed the aggregation of shares held as portfolio investments with those held in connection with dealing activity in determining compliance with this limit, again arguing that these are two separate lines of business that should not be aggregated. Commenters also opposed the proposed reduction in the combined aggregate limit for Edge corporation investors, from the current 100 percent of tier 1 capital to 50 percent of tier 1 capital, notwithstanding the ability to net dealing positions and the exclusion of underwriting commitments and shares held for up to 90 days pursuant to an underwriting.

In view of the fact that the Board has determined that it will not adopt the liberalization proposed in relation to portfolio investments, it has also decided not to adopt the separate limit on total portfolio investments for any given banking organization. In the absence of expanded authority in this area, no need arises for such a limit.

However, consistent with the provisions of current Regulation K, the Board continues to believe that an aggregate equity limit is necessary with respect to all shares held under Regulation K (whether held under portfolio investment authority or in connection with dealing activity) in companies engaged in activities that would be impermissible for a subsidiary or a joint venture under Regulation K. Accordingly, the Board generally is adopting the aggregate limits on equity securities held under Regulation K previously proposed. Consistent with the '97 Proposal, underwriting commitments and shares held pursuant to an underwriting commitment for up to 90 days would be excluded from the aggregate equity limit.

However, in light of comments received, the Board is not adopting the proposed reduction in the aggregate limit for investors that are subsidiaries of a member bank. Nevertheless, the Board continues to believe it is important to tie the aggregate limit for bank subsidiaries to the capital levels of both the member bank and the bank subsidiary investor. Accordingly, the aggregate equity limit for subsidiaries of banks will be the lesser of 20 percent of the tier 1 capital of the member bank or 100 percent of the tier 1 capital of the bank subsidiary.\19\

\19\ An additional comment recommended that the aggregate equity limit should be expressed as a percentage of assets, rather than as a percentage of tier 1 capital. The Board believes that tying the equity limit to tier 1 capital is a more appropriate restriction on the level of aggregate equity activities under Regulation K and therefore is not adopting this recommendation.

Commenters also requested clarification on whether the aggregate equity limits include: (i) only equity securities held by the investor and its downstream subsidiaries or securities held by all its affiliates; and (ii) only shares held under the authority of Regulation K . The Board notes that, with respect to a particular investor, these limits will include all equity securities held by the investor and its downstream subsidiaries under Regulation K authority, whether arising in connection with portfolio investments or dealing activity.\20\ Thus, the aggregate equity limit will not include investments in joint ventures or subsidiaries under Regulation K, or merchant banking or any other investments made under authority other than Regulation K.

\20\ The Board also notes that application of the dealing limit on shares held in a single issuer will also proceed on this same basis, except that shares held as a portfolio investment will not be included in determining compliance with the single company dealing limit as discussed above.

One commenter recommended that the Board permit aggregate dealing positions to be calculated on a quarterly average and suggested a ``preclearance'' program for additional authority beyond the regulatory limits. The Board considers that determining compliance with these limits on the basis of a quarterly average would be inappropriate and potentially be subject to considerable manipulation. As noted above, should an organization wish to engage in equity securities activities without limit it should do so under FHC status subject to the FHC qualifying criteria. For these reasons, the Board declines to adopt these proposals.

Insurance Activities

Reinsurance Proposal

Section 211.5(d)(16) of Regulation K presently authorizes bank holding companies to own foreign companies that underwrite and reinsure life, annuity, pension-fund related, and other types of insurance, where the associated risks have been previously determined by the Board to be actuarially predictable. Prompted by the Board's consideration in 1997 of a bank holding company's request, the Board requested comment on whether the reinsurance (via a retrocession agreement with an unaffiliated offshore reinsurer) by a foreign subsidiary of U.S. bank holding company of all or a portion of the risk of policies or annuities sold in the United States by U.S. affiliates of the bank holding company or unrelated parties could be considered to fall within this authority. It queried whether the fact that the risk to be reinsured is in the United States could cause the activity to be considered located in the United States, particularly given the potentially significant involvement of the bank holding company's U.S. affiliates.

Several insurance trade associations opposed any expansion of authority in this area. They argued that the reinsurance activity necessarily would be domestic because of its complete dependence on U.S. insurance sales. In addition, they suggested the reinsurance activity would expose U.S. banks to unnecessary risk and conflicts of interests, be contrary to Board precedent, transfer regulatory scrutiny of domestically-originated risks from the state regulators to less rigorous and untested international regimes, and set the stage for U.S. banking organizations to underwrite and reinsure all types of insurance through foreign subsidiaries. Ultimately, they argued, any liberalization in this area should come from Congress, not the Board.

Several U.S. banking trade associations and banking organizations expressed support for expanded authority as described in the '97 Proposal. They emphasized that the proposal would only modestly extend an activity (i.e., underwriting and reinsuring life insurance abroad) long regarded as permissible by the Board. In addition, they maintained that the permissible U.S. insurance sales would be only an incidental, and not a primary, feature of an activity--reinsurance--having an essentially foreign character. They noted that many activities in which U.S. banking organizations are permitted to engage abroad are related to their U.S. activities (e.g., securities activities) and asserted that the relation in this instance between the reinsurance activity and the U.S. insurance sales similarly should not result in rejection of the proposed activity. These commenters also argued that the proposal would further the Edge Act's stated purpose of enhancing U.S.

[Page 54359]banking organizations' competitiveness abroad.

As noted above, the GLB Act was enacted subsequent to the issuance of the Board's reinsurance proposal. The GLB Act allows FHCs to conduct insurance activities on a worldwide basis and demonstrates a Congressional preference for conducting such activities through subsidiaries of FHCs. The Board does not believe, and the comments on the Board's proposal have not shown, that competitive concerns require U.S. banking organizations to proceed under Regulation K in the conduct of this activity rather than GLB authority. Accordingly, the Board declines to adopt the reinsurance proposal. As at present, however, a banking organization may seek the Board's specific consent to engage in insurance activities more expansive than those expressly authorized under the regulation.

Other Comments

Supporters of the Board's reinsurance proposal urged the Board to liberalize Regulation K's insurance provisions further in several respects. First, they recommended that the Board eliminate the requirement that U.S. banks obtain Board approval before engaging in insurance activity through foreign subsidiaries, asserting that banking organizations should be given maximum flexibility to determine how to structure these activities. One commenter suggested that the Board replace the proposed prior approval requirement with a 30-day prior notice requirement. On balance, the Board believes it is appropriate to continue to require prior Board approval for such activities. Further, absent demonstration of a compelling need for competitive reasons, the Board expects insurance underwriting (other than credit life insurance and credit accident and health insurance) to be conducted through subsidiaries of the holding company, or otherwise under the expanded authority provided in GLB.

The commenters also argued that U.S. banking organizations should not be required to deconsolidate and deduct investments in foreign insurance companies from the holding company's capital for capital adequacy purposes, arguing that such a requirement is inappropriate and disproportionate to the risks involved. The Board disagrees and declines to eliminate this requirement. The consolidation of insurance activities may result in overstated capital ratios because the risk- based capital adequacy framework does not take into account traditional insurance risks. Although FHCs currently may consolidate their insurance companies for purposes of their capital ratios, for supervisory purposes their capital ratios also are analyzed after deconsolidation and deduction of such companies. Retaining the deconsolidation and deduction requirement in Regulation K also would be consistent with proposed revisions to the Basel Capital Accord.

In addition, the commenters urged the Board to expand the types of insurance foreign subsidiaries of bank holding companies may underwrite and reinsure, to encompass all credit-related insurance (including insurance incidental to leasing activities or mortgage transactions, and motor vehicle comprehensive insurance in connection with car loans). In the Board's view, in light of passage of GLB, there should be no general expansion of permissible types of insurance underwriting under Regulation K. As at present, however, application may be made on a case-by-case basis for the Board's approval to engage in additional types of insurance activities usual in connection with the business of banking abroad.

Debt/Equity Swaps

Regulation K currently permits banking organizations to swap certain developing country debt for equity interests in companies of any type. Established in 1987 to assist banking organizations in managing large amounts of nonperforming, illiquid sovereign debt, these foreign investment provisions are more liberal than Regulation K's other investment provisions. Under certain conditions set out in Regulation K, investors may invest under general consent authority up to one percent of their tier 1 capital in up to 40 percent of the shares, including voting shares, of private sector companies in eligible countries. Such an investment must be held through the bank holding company, unless the Board specifically permits it to be held through the bank or a bank subsidiary. Eligible countries are defined as those that have rescheduled their debt since 1980, or any country the Board deems to be eligible.

Since the debt/equity swap provisions were introduced, a well developed secondary market in developing country debt has emerged. The vast bulk of developing country problem debt has been repackaged in the form of long-term Brady bonds, mostly denominated in U.S. dollars and fully collateralized as to principal by U.S. government bonds. Many banking organizations actively trade these instruments in the secondary market.

Due to the development of the secondary markets for emerging market debt, U.S. banks now have the same options with regard to many of these assets as they have with other bank assets--namely, they can hold the asset with a view toward collecting at maturity or sell the asset for cash to invest in other bank eligible assets. Indeed, the sovereign debt of most of the historically ``eligible countries'' is no longer illiquid, and those eligible countries that account for the vast share of rescheduled debt have largely regularized their relations with commercial banks.

In light of these changed circumstances and to redirect this special authority to the asset quality problem it was originally intended to help resolve, in the '97 Proposal the Board proposed to redefine the term ``eligible country.'' Under the proposed definition, only countries with currently impaired sovereign debt (i.e., debt for which an allocated transfer risk reserve would be required under the International Lending Supervision Act and for which there is no liquid market) would be eligible for investments through debt/equity swaps under Regulation K. Existing holdings of such investments would be grandfathered, subject to the existing divestiture periods applicable to such investments (i.e., generally, 10 years from the date of acquisition).

The Board solicited comment on these proposed changes. It also sought comment on whether, alternatively, the debt/equity swap authority should be eliminated as obsolete.

Several commenters supported the proposed changes. Only one comment opposed the change to the definition of an ``eligible country''. Another commenter urged the Board to extend the general consent authority for debt/equity swaps to such investments made by banks and bank subsidiaries. The Board continues to believe the additional authority granted under the debt/equity swap provisions should be limited to countries with currently impaired debt, in light of the developments described above and, accordingly, adopts the proposed change to the definition of an ``eligible country.'' The Board also considers that general consent authority for engaging in debt/equity swaps under the bank continues to be inappropriate. As at present, a bank or bank subsidiary may seek authority from the Board to hold such an investment on a case-by-case basis.

[Page 54360]Streamlining Application Procedures

General Consent Limits

The Board noted in the '97 Proposal that, although existing Regulation K procedures have proved effective in maintaining the safety and soundness of U.S. banks' international operations, they have become increasingly complex over the years. For example, under prior notice procedures, the Board has reviewed all foreign investments made by banking organizations above a de minimis level as a principal mechanism for overseeing the safety and soundness of the investing organization. In view of the shift in emphasis to supervision based upon risk management capabilities, the Board believes that prior review of relatively small investments is no longer useful as a fundamental supervisory tool, especially where the investor is well-capitalized and well-managed. Accordingly, the Board proposed that only significant investments, as determined solely on the basis of the investor's capital, would be subject to prior review by the Board, provided that the investors are well-capitalized and well-managed.\21\ The proposed changes to the general consent procedures attempt to balance safety and soundness considerations with the objective of enhancing the ability of U.S. banking organizations to compete with foreign banks overseas.

\21\ The proposed definitions of well-managed and well- capitalized for these purposes are discussed infra under the heading ``Well-capitalized/Well-managed Standards.''

Limits on Investments in One Company

Historically, all general consent investments under Regulation K were subject to absolute dollar limits. Currently, the general consent limit for most investments is $25 million. However, as a result of amendments to Regulation K implemented in December 1995, certain investments by strongly capitalized and well-managed banks are subject to Board review only to the extent they exceed a percentage of the investor's capital.

In the '97 Proposal, the Board proposed expanding upon this approach by eliminating the absolute dollar limits on foreign investments permissible under general consent authority for well- capitalized and well-managed investors (with the exception of those applicable to portfolio investments made under the bank). Under the proposal, general consent limits for all investors (bank holding companies, banks, and Edge corporations) would be based solely on a percentage of their tier 1 capital.\22\

\22\ Under the proposal, if the Edge corporation were making the investment, then the Edge corporation, the member bank, and the bank holding company would be required to meet the well-capitalized and well-managed tests. If the member bank were making the investment, then the bank and the bank holding company would be required to meet the tests.

The limits on individual investments made under general consent authority would vary according to the investor (bank holding company, bank, or Edge corporation) and the type of entity in which the investment is made. For well-capitalized and well-managed investors, the Board proposed the following percentage limits.

General consent limits on investment in a subsidiary

Bank holding company: 10 percent of tier 1 capital of the bank holding company.

Bank: 2 percent of tier 1 capital of the bank.

Bank subsidiaries: the lesser of 2 percent of tier 1 capital of the bank or 10 percent of tier 1 capital of the bank subsidiary.

General consent limits on investment in a joint venture

Bank holding company: 5 percent of tier 1 capital of the bank holding company.

Bank: 1 percent of tier 1 capital of the bank.

Bank subsidiaries: the lesser of 1 percent of tier 1 capital of the bank or 5 percent of tier 1 capital of the bank subsidiary.

These limits were proposed on the basis that they reflected the risk involved in the type of investment. A higher percentage of capital would be permitted in the case of an investment in a subsidiary as opposed to an investment in a joint venture because the latter is considered to carry a greater risk of loss. Thus, with joint ventures, investors acquire less than full control, and the record on such investments has shown that they experience a higher rate of loss. As a result, most U.S. banks do not now make sizeable joint venture investments. In light of these considerations, the Board believed that lower general consent limits may be appropriate for joint venture investments.

For investors that fail to meet the well-capitalized or well- managed standards, the Board proposed the following limits. Individual investments under general consent authority would be limited to the lesser of $25 million or 5 percent of tier 1 capital in the case of an investor that is a bank holding company, and the lesser of $25 million or 1 percent of t