United States: Federal Reserve Rule Regarding Capital Treatment of Trust Preferred Securities

The Federal Reserve Board (the Fed) has adopted a rule that would continue to permit trust preferred securities (which are cumulative)1 to be treated as Tier 1 capital; however, the rule subjects these securities to stricter quantitative limits than under current Fed policy.

Background of Rule

Fed action on the topic of capital treatment of trust preferred securities has been anticipated since late December 2003 when (1) FASB issued Interpretation No. 46R (FIN 46R), Consolidation of Variable Interest Entities,2 which clarified FASB’s view that the proper GAAP accounting treatment for trust preferred securities was for a bank holding company, or BHC, to deconsolidate the trust that issued the trust preferred securities (the issuer trust) and record the principal amount of the subordinated debenture issued to the issuer trust by the BHC as debt on its financial statements (rather than consolidating the issuer trust and recording the trust preferred securities as minority interest) and (2) the Staff of the Securities and Exchange Commission (SEC) made clear its agreement with FASB regarding GAAP accounting treatment for trust preferred securities through informal guidance given to bank holding companies.

Trust preferred securities generally continue to be accounted for as equity for GAAP purposes at the level of the trust that issues them, but the instruments may no longer be treated as minority interest in the equity accounts of a consolidated subsidiary on a BHC’s consolidated balance sheet. Instead, under FIN 46 and FIN 46R, a BHC must reflect on its consolidated balance sheet the deeply subordinated note the BHC issued to the deconsolidated special purpose entities (SPE).

GAAP accounting for a capital instrument does not necessarily change the regulatory capital treatment of that instrument, although GAAP informs the definition of regulatory capital. BHCs are required to follow GAAP for regulatory reporting purposes.3

Trust preferred securities provide financial support to a consolidated BHC because of their deep subordination and the ability of the BHC to defer dividends for up to 20 consecutive quarters. Although trust preferred securities, like other forms of minority interest, are not included in GAAP equity and cannot forestall a BHC’s insolvency, trust preferred securities are available to absorb losses because the issuing trust’s sole asset is a deeply subordinated note of its parent BHC and the ability to defer payments on the junior subordinated notes enables the BHC to use the cash flow anywhere within the consolidated organization. Dividend deferrals on equity issued by the typical operating subsidiary, on the other hand, absorb losses and preserve cash flow only within the subsidiary; the cash generally cannot be used elsewhere in the consolidated organization.

The Fed has decided, as proposed, to retain in the final rule the standard that voting common stock should be the dominant form of a BHC’s Tier 1 capital. The final rule continues to caution that excessive non-voting elements likely will be reallocated to Tier 2 capital.

Pooled issuances generally constitute the issuance of trust preferred securities by a number of BHCs to a pooling entity that issues asset-backed securities representing interests in the BHCs’ pooled trust preferred securities. Such pooling arrangements, which have become increasingly popular and typically involve 30 or more separate BHC issuers, have made the issuance of trust preferred securities possible for even very small BHCs, most of which had not previously enjoyed capital market access for raising Tier 1 capital.

The following is a summary of the most significant aspects of the proposed rule:

Changes in Capital Rules for Trust Preferred Securities


  • Since October 1996, the Fed has permitted a bank holding company to count trust preferred securities, together with cumulative preferred stock issued by the bank holding company, up to 25 percent of the amount of Tier 1 capital without regard to goodwill.
  • Under the final rule, trust preferred securities may be included in the Tier 1 capital of BHCs but subject to tightened quantitative limits for trust preferred securities and a broader range of Tier 1 capital components defined as restricted core capital elements. There will be a 15 percent limit (which excludes mandatory convertible preferred securities) applicable to internationally active BHCs and certain others, and a "new" 25 percent limit (which counts mandatory convertible preferred securities). Specifically, restricted core capital elements are defined to include qualifying cumulative perpetual preferred stock (and related surplus), minority interest related to qualifying cumulative perpetual preferred stock directly issued by a consolidated U.S. depository institution or foreign bank subsidiary (Class B minority interest), minority interest related to qualifying common or qualifying perpetual preferred stock issued by a consolidated subsidiary that is neither a U.S. depository institution nor a foreign bank (Class C minority interest) and qualifying trust preferred securities.
  • The Fed has decided to apply the 15 percent limitation only to internationally active BHCs .4 The Fed will generally expect and strongly encourage opt-in AIRB BHCs to plan for, and come into compliance with, the 15 percent limit on restricted core capital elements as they approach the criteria for internationally active BHCs. The Fed intends to set forth the 15 percent Tier 1 sub-limit for internationally active BHCs, as well as this expectation and encouragement for opt-in AIRB BHCs, in its forthcoming notice of proposed rulemaking.
  • Although BHCs that are not internationally active BHCs are not required to comply with the 15 percent Tier 1 capital sublimit, these BHCs are encouraged to ensure the soundness of their capital bases.5
  • Because of the "netting" of goodwill and the inclusion of additional restricted core capital elements subject to the limit, the proposed 25 percent limit in practice reduces the amount of trust preferred securities that may be included in Tier 1 capital for any bank holding company with goodwill and Class B minority interest and/or Class C minority interest. The restrictive effect of the new 25 percent limit on any particular bank holding company will depend on the bank holding company’s amount of goodwill and other restricted core capital elements that count against the limit.6
  • In general, the new 25 percent limit will have a potentially greater effect on bank holding companies that have been (or intend to be) more acquisitive.


  • Trust preferred securities that do not qualify as Tier 1 capital because of the existing 25 percent limit may qualify as Tier 2 capital.
  • Under the final rule, trust preferred securities which do not qualify as Tier 1 capital because of the new 25 percent limit may be included in Tier 2 capital up to 50 percent of the amount of Tier 1 capital. However, in addition to trust preferred securities not included in Tier 1 capital, this same Tier 2 capital sublimit also applies to subordinated debt, limited term preferred stock and Class C minority interests not included in Tier 1 capital.


  • During the last five years prior to maturity of the subordinated debenture related to the trust preferred securities (i.e., years 26 to 30 for a typical 30 year debenture), trust preferred securities may not be included in Tier 1 capital.
  • During this period, such trust preferred securities may be treated as Tier 2 capital, subject to the Tier 2 capital sublimits.
  • In addition, during this five-year period, such trust preferred securities would be amortized out of Tier 2 capital by one-fifth of the original amount each year and excluded completely in the last year of the life of the subordinated debenture.


  • Junior subordinated debt underlying trust preferred securities generally must meet the criteria for qualifying Tier 2 subordinated debt. For bank holding companies and state member banks the subordinated debt:

  1. must be subordinated in right of payment to the claims of the issuer’s general creditors and, for banks, to the claims of depositors
  2. must be secured
  3. must state clearly on its face that it is not a deposit and is not insured by a federal agency
  4. must have a minimum average maturity of five years
  5. must not contain provisions that permit debtholders to accelerate payment or principal prior to maturity except in the event of bankruptcy of or the appointment of a receiver for the issuing organization
  6. must not contain or be covered by any covenants, terms, or restrictions that are inconsistent with safe and sound banking practice
  7. must not be credit sensitive

  • Junior subordinated debt may be pari passu with obligations to trade creditors and with junior subordinated debt underlying another issue of trust preferred securities, junior subordinated debt may be senior to, or pari passu, with deeply subordinated capital instruments that the Fed may in the future authorize for inclusion in Tier 1 capital.
  • Junior subordinated debt also may accelerate in the event that a major bank subsidiary of the BHC goes into receivership. Junior subordinated debt also may accelerate if the trust issuing the trust preferred securities goes into bankruptcy or is dissolved unless the junior subordinated notes have been redeemed or distributed to the trust preferred securities investors or the obligation is assumed by a successor to the BHC.


  • The Fed has decided to continue prohibiting step-up provisions in Tier 1 capital instruments and Tier 2 subordinated debt. Because such features provide the issuer with the incentive to redeem an instrument, step-ups change the economic nature of instruments from long-term to short-term since the market expects that BHCs will almost always redeem such instruments on the step-up date to preserve market access for future capital raising initiatives. Basically, investors view a step-up provision as an informal commitment by a BHC issuer to call such securities at the time of the step-up, which tenor is inconsistent with the Fed’s view that regulatory capital should provide long-term, stable support to a BHC.


  • The Fed will no longer require that qualifying trust preferred securities include call provisions (partly to accommodate institutional investors who do not want such call options because they are not required in perpetual preferred stock). The Fed call options provide flexibility and are beneficial from both a financial and supervisory perspective because in a declining interest rate environment BHCs would redeem their trust preferred securities and replace them with new issuances at lower rates.


  • Provisions that prohibit interest deferral on junior subordinated debt if a default event has occurred are permissible only if the event of default is one that is authorized to trigger the acceleration of principal and interest under the final rule. Thus, an indenture provision that prohibits deferral upon a default that arises from failure to follow the proper deferral process or upon any other event of default that the final rule does not allow to trigger acceleration is unacceptable.
  • Perpetual preferred stock may provide voting rights to investors upon the non-payment of dividends, or for junior subordinated debt and trust preferred securities to provide voting rights to investors upon the deferral of interest and dividends, respectively. The clauses conferring voting rights may contain only customary provisions, such as the ability to elect one or two directors to the board of the BHC issuer, and may not be so adverse as to create a substantial disincentive for the banking organization to defer interest and dividends when necessary or prudent.

GAAP Accounting Treatment for Trust Preferred Securities

  • For bank holding companies with outstanding issuances of trust preferred securities, this will require deconsolidation of issuer trusts and recording the subordinated debentures issued to issuer trusts as debt.

Actions During Transition Period

  • The Fed has decided to extend the transition period from the end of the first quarter of 2007 to the end of the first quarter of 2009 to give BHCs more time to conform their capital structures to the revised quantitative limits. The result of this extension is that the revised quantitative limits will become applicable to BHCs ’ restricted core capital elements for reports and capital computations beginning on March 31, 2009, the reporting date for the first quarter of 2009.


1. Trust preferred securities are undated cumulative preferred securities issued out of an SPE, usually in the form of a trust, in which a BHC owns all of the common securities. The SPE’s sole asset is a deeply subordinated note issued by the BHC. The subordinated note, which is senior only to a BHC’s common and preferred stock, has terms that generally mirror those of the trust preferred securities, except that the junior subordinated note has a fixed maturity of at least 30 years. Trust preferred securities allow dividends to be deferred for at least a twenty-consecutive-quarter period without creating an event of default or acceleration. After the deferral of dividends for this twenty-quarter period, if the BHC fails to pay the cumulative dividend amount owed to investors, an event of default and acceleration occurs, giving investors the right to take hold of the subordinated note issued by the BHC. At the same time, the BHC’s obligation to pay principal and interest on the underlying junior subordinated note accelerates and the note becomes immediately due and payable. For tax purposes the dividends paid on trust preferred securities, unlike those paid on directly issued preferred stock, are a tax deductible interest expense because the Internal Revenue Service ignores the trust and focuses on the interest payments on the underlying subordinated note. Because trust preferred securities are cumulative, they have been limited since their inclusion in Tier 1 capital in 1996, together with a BHC’s directly issued cumulative perpetual preferred stock, to no more than 25 percent of a BHC’s core capital elements.

2. FASB originally issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, in January 2003 to respond to Enron’s abuse of special purpose entities (the now infamous "raptor partnerships"). However, the majority of the big accounting firms concluded FIN 46 was applicable to a broad array of special purpose entities, including Delaware statutory trusts used by bank holding companies to issue trust secured securities. FASB issued FIN 46R to clarify many of the questions and issues raised by FIN 46.

3. Thus, BHCs should, for both accounting and regulatory reporting purposes, determine the appropriate application of GAAP (including FIN 46 and FIN 46R) to their trusts issuing trust preferred securities. Accordingly, there should be no substantive difference in the treatment of trust preferred securities issued by such trusts, or the underlying junior subordinated debt, for purposes of regulatory reporting and GAAP accounting.

4. For this purpose, an internationally active BHC is a BHC that (1) as of its most recent year-end FR Y-9C reports has total consolidated assets equal to $ 250 billion or more or (2) on a consolidated basis, reports total on-balance sheet foreign exposure of $ 10 billion or more on its filings of the most recent year-end FFIEC 009 Country Exposure Report. This definition closely proxies the definition proposed for mandatory advanced AIRB banking organizations in the Advance Notice of Proposed Rulemaking.

5. The Fed has also decided to exempt qualifying mandatory convertible preferred securities—consisting of the joint issuance by a BHC to investors of trust preferred securities and a forward purchase contract, which the investors fully collateralize with the securities, that obligates the investors to purchase a fixed amount of the BHC’s common stock, generally in three years—from the 15 percent Tier 1 capital sub-limit applicable to internationally active BHCs. Accordingly, under the final rule, the aggregate amount of restricted core capital elements (excluding mandatory convertible preferred securities) that an internationally active BHC may include in Tier 1 capital must not exceed the 15 percent limit applicable to such BHCs, whereas the aggregate amount of restricted core capital elements (including mandatory convertible preferred securities) that an internationally active BHC may include in Tier 1 capital must not exceed the 25 percent limit applicable to all BHCs. Typically, prior to exercise of the purchase contract in three years, the trust preferred securities are remarketed by the initial investors to new investors and the cash proceeds are used to satisfy the initial investors’ obligation to buy the BHC’s common stock. The common stock replaces the initial trust preferred securities as a component of the BHC’s Tier 1 capital, and the remarketed trust preferred securities are excluded from the BHC’s regulatory capital.

6. The Fed believes that the Tier 1 capital sub-limits for restricted core capital elements should be keyed more closely than at present to BHCs ’ tangible equity—that is, core capital elements less goodwill—and has decided to require the deduction of goodwill as proposed. Goodwill generally provides value for a banking organization on a going concern basis, but this value declines as the organization deteriorates and has little if any value in the event of insolvency or bankruptcy. Although goodwill is also deducted from the sum of a BHC’s core capital elements in computing its Tier 1 capital, the Fed does not believe that deducting it from the sum of core capital elements for purposes of computing the Tier 1 sub-limit for restricted core capital elements constitutes a double deduction of goodwill. The Fed, however, agrees it would be appropriate to modify the goodwill deduction by netting from the amount of goodwill deducted any associated deferred tax liability. Accordingly, the final rule limits restricted core capital elements to a percentage of the sum of core capital elements, net of goodwill less any associated deferred tax liability.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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