Capital Treatment of Trust Preferred Securities Changes
The Federal Reserve Board has amended its capital guidelines to allow bank holding companies (BHCs) to continue including trust preferred securities—commonly known as TRUPS—in their core,1 or tier 1, capital although in lesser amounts than previously permitted. By 2009, most BHCs will have to limit restricted core capital elements,2 which include TRUPS, to 25 percent of the sum of their core capital, and very large or internationally active BHCs will have to limit restricted elements to 15 percent of core capital.
TRUPS spelled out
TRUPS are created when a special purpose entity, which is controlled by a bank holding company, issues preferred stock. Then the controlling BHC issues debt, which the special purpose entity purchases. Interest payments on that debt provide cash flows for paying preferred stock dividends.
TRUPS’ appeal to BHCs is twofold. First, for tax purposes TRUPS are debt, so BHCs can deduct the interest they pay on TRUPS from their income. Second, for regulatory purposes TRUPS are treated as equity and therefore count toward institutions’ required capital. In addition, BHCs can issue TRUPS as part of a larger pool 3 of preferred securities, which provides smaller, community BHCs an affordable means of raising capital.
Securities retain their advantage
Not long ago, BHCs with TRUPS were concerned that bank regulators would make the capital treatment of TRUPS less favorable. But the Fed’s March 2005 issuance of its new risk-based capital standards eased those concerns. These new standards conform to recent changes to the 1998 amendments to the Basel banking accords yet allow continued access to capital markets by community BHCs.
1Core capital elements are common stockholders’ equity, qualifying noncumulative perpetual preferred stock (including related surplus), qualifying cumulative perpetual preferred stock (including related surplus), and minority interest in the equity accounts of consolidated subsidiaries.
2Restricted core capital elements are 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, qualifying TRUPS, or 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.
3Pooling TRUPS issuance allows banks to issue TRUPS at the same time and with the same features. A pooling company purchases all of the preferred securities and then securitizes the cash flows from the TRUPS for sale on the market. The primary benefit of pooling is the ability to spread the fixed cost of issuance, which makes it cost effective for institutions with smaller capital needs to issue TRUPS, giving smaller companies better access to capital markets. If a company that participates in pooled TRUPS issuances purchases the securitized cash flow from the issuance, that company cannot include the TRUPS in its capital.
This article was written by Lynn Woosley in the Atlanta Fed’s Supervision and Regulation department.