WASHINGTON -- Rising interest rates have put two regulations on a collision course.

Financial Accounting Standard 115 requires banks to put a current market value on assets that will not be held to maturity. Climbing interest rates are eroding the value of banks' bond portfolios, and FAS 115 is forcing banks to recognize these losses.

The markdowns must be subtracted from Tier 1 capital.

That brings into play "prompt corrective action," which imposes increasingly severe sanctions on a bank as its capital declines.

Graded on Strength

Under PCA, regulators slot every bank into one of five categories, from well-capitalized to Significantly undercapitalized. Which category a bank lands in determines its operating freedom as well as how much it is charged for deposit insurance.

Since its creation in 1991, PCA has been relatively benign; about 98% of the industry is in the best capital category. But as FAS 115 wipes out capital and shifts banks to lower PCA categories, the regulation is becoming painful.

The Independent Bankers Association of America has launched a campaign to keep FAS 115 from affecting Tier 1 capital. And the association has attracted a key ally -- Federal Reserve Board Chairman Alan Greenspan.

Mr. Greenspan, in a May 2 letter to IBAA chairman James R. Lauffer, sympathized: "As you know, the board strongly opposed adoption of statement 115 by the FASB."

Effect of Rate Rise

Mr. Greenspan said the Fed has studied the effect a 200-basis-point rise in rates would have and found that three dozen community banks that were well or adequately capitalized at the end of 1993 would become undercapitalized.

"In addition, a couple hundred would drop from well to adequately capitalized," Mr. Greenspan wrote. "We are concerned about such short-run effects."

So is Mr. Lauffer. In addition to his post at the IBAA, he is chairman, president, and chief executive of First National Bank of Herminie, a $48 million-asset bank in Irwin, Pa., outside Pittsburgh.

The bank's securities available for sale lost $670,000 from the end of February to the end of March, Mr. Lauffer told Mr. Greenspan in an April 7 letter.

'Losing Value Rapidly'

"Bank investment securities classified as available for sale are losing value rapidly," Mr. Lauffer wrote. "A regulatory requirement to take available-for-sale losses against Tier 1 capital could cause an unacceptable number of otherwise healthy banks to be taken over by the regulators."

Prompt corrective action requires regulators to seize an institution once its capital falls below 2%.

The regulatory agencies have a proposal out for public comment now to incorporate unrealized gains and losses on securities available for sale into Tier 1 capital.

Comments are due May 18. At a minimum, the IBAA wants unrealized gains and losses to be incorporated in risk-based capital in general, rather than the more narrow measure of Tier 1. But the trade group is going further, lobbying to change the law that requires regulatory accounting to be as tough as financial accounting.

"We're working with the regulatory agencies to see if they could support a legislative change in this area," IBAA executive vice president Kenneth A. Guenther said Thursday.

Mr. Greenspan said no final decision has been made, but it appears the regulators have little leeway. FAS 115, which became effective Jan. 1, requires the unrealized gains or losses on securities not held to maturity to be included in bank equity.

If regulators do adopt the change, Mr. Greenspan said he expects banks will shorten the duration of their securities portfolios or arrange interest rate hedges to curb the volatility of equity capital.

"We are still investigating banks' ability to arrange such hedges while at the same time limiting volatility of reported income," he wrote.

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