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Foreword

Both state chartered banks that are FederalReserve System members (state memberbanks) and bank holding companies may beauthorized to make community developmentequity and debt investments in organizationsand projects designed primarily to benefit thecommunity welfare. Through communitydevelopment corporation (CDC) subsidiaries,limited partnerships or other businessventures, banks and bank holding companiesmay undertake a variety of investmentactivities in urban and rural communities tohelp provide housing and job opportunities forlow- and moderate-income persons, assistsmall and minority businesses, and provideimportant community services.

In promoting community welfare, financialinstitutions may use this authority to purchase,own, rehabilitate, construct, manage, and sellreal property, invest in small business ventures,and support community-based organizationsand their projects. These activities may beapproved by the Federal Reserve System withcertain constraints needed to protect the safetyand soundness of financial institutions andensure that required public benefits result.

This brochure provides guidance to both statemember banks and bank holding companiesabout the formation of CDCs and other usesof equity investments for community develop-ment. It covers the following topics:

■ Federal Reserve policies and guidelinesgoverning bank and bank holding companyCDCs and equity investments

■ Key issues that banks and bank holdingcompanies should address when consider-ing investments for community develop-ment purposes

■ The notice or approval processes for statemember banks and bank holding companies

■ Regulatory treatment of communitydevelopment investments.

For Additional InformationThe Federal Reserve Banks’ CommunityAffairs and Applications processing staffs canprovide additional information and technicalassistance concerning community develop-ment investment options, policy issues, andnotice or application requirements. Any statemember bank or bank holding companyinterested in the formation of a CDC, or inmaking other community developmentinvestments, is encouraged to consult with itsReserve Bank prior to developing a communitydevelopment investment program.

Addresses and telephone numbers of theFederal Reserve Banks appear in the Appendix.

Contents

— Investment Limits .............................. 22

— Liability Limitations–DirectProject Investments ........................... 22

■ Notice and Approval Procedures ........... 22

— Notices for Investments WithoutPrior Approval .................................... 23

— Requests for Approval of OtherInvestments ........................................ 23

Guidelines for Bank HoldingCompanies .................................................. 25

■ The “Community Welfare” Test .............. 25

■ Profits and Dividends .............................. 26

■ Capital Investment .................................. 26

■ Geographic Scope of InvestmentActivity ..................................................... 27

■ Community Involvement ........................ 27

■ Notice and Approval Procedures ........... 28

— Initial Investments by BankHolding Companies ........................... 28

— Additional Investments ..................... 29

Regulatory Treatmentof Investments ........................................... 31

■ General Approach .................................... 31

■ Primary Types of Investments ................ 31

■ CRA and Community DevelopmentInvestments .............................................. 33

Appendix: Federal Reserve Banks ...... 37

Introduction ................................................ 1

Alternative Investment Mechanisms .... 5

■ Subsidiary Community DevelopmentCorporations............................................... 5

■ Consortium CDCs and Equity Pools ........ 7

■ Limited Partnership Investments ............. 8

■ Direct Project Investments......................... 9

Key Considerations for Banksand Holding Companies ......................... 11

■ Community Needs and Market Focus .... 11

■ Geographic Scope of Activities ............... 12

■ Community Resources ............................ 12

■ Commitment of Capital and OtherFinancial Resources ................................. 13

■ Nonprofit vs. For-Profit Approach ......... 13

■ Management and Organization.............. 14

Guidelines for State Member Banks .. 17

■ Public Welfare........................................... 17

■ Geographic Scope of InvestmentActivity ..................................................... 18

■ Profits and Dividends .............................. 18

■ Community Involvement ........................ 18

■ Investments Without Prior Approval ..... 19

— Qualified Entities ............................... 19

— Qualified CommunityDevelopment Activities .................... 20

— Legal and Supervisory Conditions ... 21

Introduction

The Federal Reserve Board believes thatfinancial institutions possess a uniquecombination of financial and managerialresources that make them particularly suitedto help address important housing, community,and economic development needs ofdisadvantaged communities. The Board hasconsistently encouraged financial institutions toexplore the many avenues available to expandtheir community development financingactivities.

Increasingly, financial institutions haveactively pursued a growing number of optionsto help meet important credit needs ineconomically disadvantaged communities. Inaddition to conventional mortgage, homeimprovement, small business and commercialconstruction loans, banks and other holdingcompany subsidiaries originate government-guaranteed loans designed to meet specializedneeds of low- and moderate-income familiesand small and minority businesses. Financialinstitutions also purchase communitydevelopment loans from other lenders, providetechnical and loan packaging assistance tononprofit groups, and participate in a varietyof state and local government financingprograms designed to help meet the housingand business development needs of low-income persons and urban and ruralcommunities. In recent years, an increasingnumber of financial institutions haveestablished lending units which focus oncommunity development finance.

Although these activities are somewhatspecialized, they remain a reflection of thetraditional, primary function of financialinstitutions: market allocation of capital in theform of debt financing. In performing thisfunction, banks and other bank holding

company subsidiaries usually must wait forothers — their customers — to initiate projectsand commit equity capital before theythemselves can make loans.

The absence of equity capital and investorinterest are often important factorscontributing to economic decline or stagnationin certain urban neighborhoods and rural areasin which financial institutions have a presence.Although financial institutions have increasedtheir lending efforts in support of nonprofitdevelopment groups and others who operatein disadvantaged communities, the capacity tolend is often limited by the availability ofprivate investment capital. Moreover, anincreasing number of public sector programsdesigned to provide resources for communitydevelopment now base grant and loandecisions on the commitment of matchingfunds from the private sector. Ultimately,without a minimum level of equity investment,it is difficult for community developers toobtain bank and other public sector financing.

The Federal Reserve Board recognizes thatlimited and focused use of financial institutioncapital in the form of equity and certain debtinvestments for real estate development andother business purposes may be a criticalelement in the community developmentprocess.

Accordingly, since 1971 the Board hasauthorized bank holding companies, underRegulation Y, to make many types of com-munity development equity investments insupport of the public welfare. Moreover, as aresult of an amendment to the Federal ReserveAct and subsequent revisions to Regulation Hthat became effective in January 1995, statemember banks can now make similarcommunity development investments.

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Community DevelopmentInvestmentsWith some limitations, state member banksand bank holding companies can:

■ Create de novo, wholly-owned communitydevelopment corporation (CDC) subsidiar-ies which invest in low- and moderate-in-come housing, commercial and industrialprojects and community services facilities

■ Help capitalize multi-investor or consortiumCDCs along with other financial institutionsand public and private investors

■ Purchase interests in limited partnershipswhich develop, rehabilitate, own and oper-ate low- and moderate-income housingprojects

■ Invest in local, state, or national equity poolsor master limited partnerships which pro-vide capital for low- and moderate-incomehousing

■ Invest in CDCs, joint ventures or limitedpartnerships sponsored by community-based groups for community developmentpurposes

■ Provide venture capital investments forstart-up or expanding small and minority-owned businesses in economically disad-vantaged communities

■ Organize and operate entities that providetechnical and advisory services for housing,community and economic development or-ganizations and their projects.

The practical result is that institutions canexpand the number of roles they play in thecommunity development process. Forexample, rather than waiting for others toinitiate projects, institutions can also buy,rehabilitate and sell properties, or provideimportant front-end equity or special debtinvestments. In effect, the communitydevelopment investment option adds anadditional dimension that allows financialinstitutions to become catalysts for therevitalization of economically distressed areasor play leadership roles in other communitydevelopment activities. Often such action willincrease community confidence and help

attract the interest of other private investors.

Most commonly, this option enables financialinstitutions to fill capital gaps in a manner thathelps make community development projectsfinancially feasible. The capacity to provideadditional equity or special purpose debt for aproject is especially important when aninstitution is focusing on capital- poor areasor working with nonprofit community-baseddevelopment corporations that typically havelittle working capital to support revitalizationprojects and leverage additional financing.

Investments in CDCs or other ventures alsoenable financial institutions to play a direct rolein public-private partnerships for communityrevitalization and job creation. Theseinvestments can help leverage other public andprivate funds, strengthen the capacity ofcommunity-based organizations to undertakekey projects, and provide the capital andexpertise to support other, more traditionalforms of bank financing.

Other Benefits

Use of community development investmentsalso may provide a number of other potentialbenefits to bank holding companies and/ortheir subsidiary financial institutions. Thesebenefits may be direct or indirect and oftenvary depending on a number of factors specificto each bank or bank holding company andthe communities it serves.

Development of New Market Opportunities.The focused use of equity investments incommunity development areas may lead tonew banking opportunities; it can helpgenerate additional deposits and increaseddemand for bank loans or other services inwhat were previously perceived as weakmarkets. Construction or rehabilitation of low-and moderate-income housing, for example,can help create local demand for shopping andother business services. Similarly, economicdevelopment projects that provide jobs forunemployed or underemployed persons canstimulate business activity and could leaddirectly to new or expanded bankingrelationships.

2 Community Development Investments: A Guide for State Member Banks and Bank Holding Companies

Investment Return. When properly conceivedand structured, community developmentequity investments may yield direct capitalgains or after-tax profits for the financialinstitution investor. Although the profitabilityof community development investments willvary with the type of project, the capacity toearn a return on the investment could makeparticipation as an equity investor incommunity projects more attractive than useof funds only as charitable contributions andgrants for essentially the same purposes.

Public Image and Competitive Advantages.In a financial services marketplace that ishighly competitive, community developmentinvestments can sometimes provide a way foran institution to distinguish itself from its bankand nonbank competitors. In addressingimportant community development needs,equity investments can help demonstrate aninstitution’s commitment to the economic well-being of its community and local markets. Suchinvestment activity also may help cementbusiness relationships with decision-makers ingovernment and business and with consumerswho view community support as an importantfactor when they select a financial institution.In both new and existing markets, activeparticipation in community developmenthelps an institution project a positive publicimage which can translate into new businessopportunities.

Enhancing CRA Performance. The strategicuse of CDCs and community developmentinvestments can help strengthen theCommunity Reinvestment Act performance offinancial institutions. For example, byproviding additional equity for communityprojects, a bank or bank holding company CDCmay help those projects qualify for loans frombanks. CDCs may also provide subordinatefinancing to make bank loans feasible. Inaddition, a CDC may provide technical

assistance that will help banks to identifyappropriate projects and package safe andsound community development loans. Itshould be emphasized, however, that theseinvestment activities alone are no substitute forcomprehensive, ongoing bank CRA programs.(For more information on the treatment ofcommunity development investments underCRA, see the section, “Regulatory Treatmentof Investments.”)

The equity investment option has generatedincreased interest among banks and bankholding companies seeking ways to help meetkey community needs. Generally, financialinstitution CDCs or community developmentequity investments have focused on low- andmoderate-income housing and small andminority business development that helpscreate employment opportunities for lower-income persons.

Investments in corporations, limitedpartnerships or other nonbanking entities arenot part of the traditional roles played byfinancial institutions. As exceptions to lawsthat restrict financial institution ownership ofreal estate or limit nonbanking ventures, suchinvestments require special legal andregulatory authority. They also necessitate acautious approach by supervisory agencies toensure that financial institutions are using thisauthority only for legitimate communitydevelopment purposes and in a manner thatdoes not pose undue risk to the participatingbank holding companies or insured financialinstitutions.

The Federal Reserve Board views CDCs andrelated investment activities as important,flexible tools for banks and bank holdingcompanies. These specialized activitiesgenerally should be used to stimulate andsupplement, rather than replace, the ongoingcommunity development lending programs offinancial institutions.

Introduction 3

Alternative Investment Mechanisms

With appropriate notices (or in some cases,regulatory approvals), state member banks andbank holding companies may engage incommunity development equity investmentsto promote community welfare through anumber of mechanisms. Financial institutionshave used four primary approaches:

■ Creation of a de novo CDC as a subsidiarythat can make investments in a variety ofcommunity development projects and busi-ness ventures

■ Participation in a multi-investor, consortiumCDC or equity pool that, in turn, invests inone or more community developmentprojects and business ventures

■ Investment in limited partnerships formedto invest in one or more community devel-opment projects

■ Direct investment in a single-purpose com-munity development project or businessventure, alone or jointly with others.

Each approach has a number of advantagesand disadvantages, depending on the bank’sor holding company’s size and objectives, aswell as the nature of the local communitydevelopment environment.

Among the factors that will govern the choiceof any particular approach are: the needs ofthe communities to be served; the nature andstructure of project proposals the institutionreceives; the availability of communityresources; the interest of other potentialinvestors; the institution’s interest in engagingin particular investment activities on a long-or short-term basis; and the extent to whichan institution can commit capital andmanagement resources to community develop-ment investment.

Each of the four basic approaches providesample opportunity for state member banks orbank holding companies to support localcommunity development projects with equity

capital, and all may be accommodated underRegulation H or Regulation Y subject to certainconditions. Some institutions, for example,form subsidiary CDCs which invest in limitedpartnerships, directly develop projects, orparticipate in joint ventures. A bank holdingcompany may choose to invest in individualprojects without creating separate CDCs orusing limited partnerships as conduits. Stillothers make separate investments in CDCs andin one or more limited partnerships.

Subsidiary Community DevelopmentCorporationsA CDC is a corporate entity that specializes indevelopment and rehabilitation of real estate,investment in business ventures, and relatedactivities specifically designed to addressthe housing, commercial redevelopment,employment, and community facilities needsof low- and moderate-income persons andareas. Typically, bank or bank holdingcompany CDCs are used to undertake anumber of projects over a long time-frame,usually reinvesting any income in futureprojects.

The CDC concept is an outgrowth of the anti-poverty programs of the 1960s and 1970s whenlocal nonprofit groups organized CDCs asvehicles to help stabilize detriorated ordeclining neighborhoods that lacked internalresources or outside investor interest. TheseCDCs were community-based organizationscharacterized by strong dedication tocommunity revitaliztion and an ability toassemble and focus neighborhood, govern-ment, and private resources to create grass-roots solutions to neighborhood problems.Most importantly, in the absence of privateinvestment, these CDCs developed thecapacity to serve as catalysts for communityrevitalization by taking direct action throughthe purchase and rehabilitation of real estate,

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development expertise. Hiring and trainingstaff to develop expertise in communitydevelopment finance will be especiallyimportant. Community development financein general, and equity investment in particular,are unique activities requiring special expertisein real estate development, government-assisted housing, community and economicdevelopment programs, and communitydevelopment finance techniques. Thisexpertise may not be present in traditionalbanking organizations.

Fourth, establishing a subsidiary CDC enablesa bank or bank holding company to leverageits capital for community developmentpurposes while limiting its exposure to risksassociated with investing in economicallydistressed or declining areas. As a corporateentity, a CDC can leverage its capital with loansand reinvest its income in additional projectswithout requiring additional financialresources from its parent bank or holdingcompany. A CDC’s corporate structure alsohelps shield the parent institution fromexposure to potential liabilities associated withreal estate development or business ventures.

Finally, a CDC subsidiary, especially one at thebank holding company level, can be useful inhelping bank affiliates to design andimplement community development financeprograms, thereby enhancing the image ofaffiliate banks in their respective communities.For example, the CDC may provide technicalassistance, advisory services, equityinvestments, or debt financing for affiliatebanks and their community development loanprograms.

Generally, most large and medium sized banksor bank holding companies that regularlyreceive requests from affiliate banks,government agencies, and community groupsto help finance community developmentprojects, or that wish to engage in communitydevelopment activities on a long-term basis,might find it advantageous to create a wholly-owned CDC subsidiary.

Although smaller institutions have createdwholly-owned CDCs, many may be unable orunwilling to commit sufficient capital for asingle subsidiary that is devoted exclusively

or the creation and support of other businessventures.

The CDC concept attracted congressional andsupervisory agency interest, and was soonadapted to banking. In the early 1970s bankholding companies and national banks wereauthorized by their federal regulators to investin real estate and business ventures forcommunity development purposes. Since then,a number of states have passed laws allowingstate-chartered banks to undertake similaractivities. In 1992, legislation authorized statemember banks to make communitydevelopment investments under certainconditions.

Financial institutions that create wholly-owned, subsidiary CDCs typically do so forseveral reasons. First, a CDC subsidiary canserve as a mechanism to address communitydevelopment needs on an ongoing basis.Deteriorated or declining neighborhoods andcommunities almost always have amultiplicity of needs that require a long-termcommitment of resources to facilitaterevitalization. In that context, a CDC representsan institutional commitment that enables abank or bank holding company to take actionon multiple community development projectsover time.

Second, the CDC approach provides themaximum flexibility for making communitydevelopment investments of all types andresponding to community needs or projectopportunities as they arise. For example, asubsidiary CDC may be authorized to developits own projects, form or invest in joint venturesand limited partnerships, invest in smallbusinesses, and provide gap equity andfinancing for single-purpose communitydevelopment projects developed by others.Although some financial institution CDCsspecialize only in housing or small businessinvestment, others take a comprehensiveapproach to community development.

Third, a subsidiary CDC, like a specializedbank lending unit, can provide anorganizational focal point within theinstitution for community developmentinvestment activities, enabling it to marshallresources and centralize community


to community development. Where a long-term effort is required, many smallerinstitutions have found it advantageous to joinwith others in a multi-bank, or multi-investorCDC.

Consortium CDCs and Equity PoolsA second major option used by financialinstitutions involves participation in CDCs,business corporations, or equity pools formedby a number of financial institutions ornonbank investors. Such CDCs or ventures,commonly called multi-bank or consortiumCDCs, allow financial institutions to poolresources and share investment risks withothers who are also interested in communityrevitalization.

As with a wholly-owned CDC subsidiary, astate member bank or bank holding companymay be authorized to invest in a consortiumCDC that undertakes a variety of communitydevelopment activities which promote publicwelfare. Most consortium CDCs have beenorganized at the local level in cooperativeefforts to address either low- and moderate-income housing or small and minoritybusiness development needs in a single city ormetropolitan area. Some may focus on a singleneighborhood or target area, while othersoperate on a city-wide basis. Still otherconsortium CDCs or equity pools providecommunity development assistance on a state-wide or even national basis.

Other investors in consortium CDCs ofteninclude national banks, state banks (whereauthorized by state law), thrifts, utilities,insurance companies and other localcorporations, businesses, and individuals.Where statutes allow, state and localgovernment redevelopment agencies, or quasi-public development corporations, may also beinvestors in consortium CDCs. Whenever otherinvestors are involved, however, a statemember bank or bank holding companyshould take steps to ensure that it is incompliance with other regulatory require-ments, such as those governing joint ventures,investments in nonbank entities, and otherapplicable laws and regulations.

Generally, the consortium approach may beespecially well suited for financial institutionsthat lack sufficient capital or communitydevelopment expertise to engage in thedevelopment process, address multiplecommunity needs or larger, more complexprojects. By pooling its investment with fundsfrom other investors, an institution can helpassemble equity capital in amounts necessaryto respond to community development needsand opportunities that it might be unable tohandle alone.

An important advantage of a consortium CDCis its ability to tap the expertise and resourcesof its investor organizations to help manageCDC operations. Often, banking companiesand other investor firms can make availableexecutives with a variety of skills andprofessional backgrounds to serve on the CDCboard and investment and loan committees. Inother cases, executives on loan from theinvestor institutions or firms can help manageCDC operations on a day-to-day basis. And, ifnecessary, a consortium CDC can raise thefunds needed to hire full-time managementand staff with expertise in the developmentprocess and community developmentfinancing techniques, without burdening anyone investor.

Moreover, the consortium approach helpsreduce the amount of capital any oneinstitution needs to commit. It also spreads therisk among many investors, thereby limitingpotential losses for each participant.

For some financial institutions, consortiumCDCs may present drawbacks. First, given theCDC’s multiple stockholders or investors,project investment decisions are made on acollective basis and may not always match thepriorities or preferences of a particular institution.

Second, participation in a consortium CDCmay not provide the desired benefits thatmight otherwise be associated with a wholly-owned CDC that carries the name of the bankor bank holding company. Investment returnsmust be shared with other investors, as mustpublic recognition for the support given to theCDC’s activities. It also may be more difficult,depending on how the consortium isstructured, for a bank or bank holding

Alternative Investment Mechanisms 7

Generally, there are two basic types of low-income housing limited partnerships:operating limited partnerships and masterlimited partnerships. Both types can providedirect investment returns to the limitedpartners, allowing them to obtain the benefitswhile limiting many of the liabilities associatedwith direct real estate development.

Operating Partnerships. These partnershipsare generally created to attract investments ina particular housing project, though somepartnerships may own multiple projects. Theyare generally formed by the project developeror owner (usually a private developer or anonprofit development corporation that servesas the general partner) to attract equityinvestments from businesses and corporations.A financial institution may be the sole limitedpartner, or alternatively it may purchase onlyone or a few of many such shares. Thepartnership owns the housing project and thestate member bank or bank holding company,as a limited partner, benefits from any netincome and tax credits generated by the projectin proportion to its ownership interest.

The equity generated by an operatingpartnership reduces significantly the amountof debt needed to finance the project. Hence,the debt service that the rents must support isalso lower, allowing for reduced rents that areaffordable to low- and very low-incomefamilies.

Master Limited Partnerships. Some limitedpartnerships are formed to make investmentsin multiple projects and in many locations.These “master” limited partnerships generallypurchase shares in other operating limitedpartnerships. This helps spread the risk amonginvestors and shield them from liabilities.

Master limited partnerships, especially thosefocusing on low-income housing, are usuallycreated by national or statewide groups —including housing finance agencies andnonprofit or quasi-public corporations —although some are locally based. Low-incomehousing “equity funds” or equity pools areoften organized as master limited partnerships;others may employ the corporate form andoperate as consortium CDCs.

company to benefit from any tax credits andother tax advantages flowing from the CDCand its project investments.

Finally, in the case of bank holding companies,the consortium approach may limit theirability to assist their affiliate banks, oftenlocated in different communities and states,through the CDC. For that reason, some bankholding companies may wish to help capitalizeconsortium CDCs in a number of localcommunities where their affiliate banks havea presence.

Limited Partnership InvestmentsAn increasing number of financial institutionsare being asked to invest in limitedpartnerships that channel equity capital to low-and moderate-income housing and othercommunity development projects. With somelimitations, state member banks and bankholding companies may purchase one or morepartnership shares in a limited partnershiporganized by others.

Limited partnerships may be formed for manybusiness purposes, including development ofcertain commercial or industrial projects,consistent with the Board’s community welfarestandards for state member banks and bankholding companies. Most limited partnershipsin which financial institutions participate,however, have focused on development orrehabilitation of low-income housing.

Although changes in federal tax law reducedtax benefits for individuals investing in realestate, the advent of the federal low-incomehousing tax-credit has made investment inlow-income housing increasingly attractive tobusinesses and corporations. As a result, agrowing number of limited partnerships investexclusively in qualified low-income housingprojects. Most are formed by privatedevelopers who serve as general partners, butmany limited partnerships are created bynonprofit organizations and government-sponsored housing finance corporations asvehicles for attracting private investment tolow-income housing projects.


Alternative Investment Mechanisms

Because limited partnership arrangementsoften involve complex legal, accounting andtax issues, users of the limited partnershipmechanism for community developmentinvestment often must incur significant “duediligence” costs prior to making anyinvestment decision.

Limited partners are essentially passiveinvestors, and risk losing their limited liabilitystatus if they participate in managing ordirecting the partnership’s investment activity.Consequently, the financial strength,experience, and character of the general ormanaging partner is of utmost importance andmust be assessed carefully by any financialinstitution interested in purchasing shares asa limited partner.

Direct Project InvestmentsState Member Banks. State member banksmay not invest in community developmentcorporations or business ventures that wouldexpose them to liability beyond the amount oftheir investments. This would generallyprevent state member banks from taking adirect ownership position in nonbanking realestate or unincorporated businesses orventures, such as by purchasing propertydirectly in the bank’s name, or otherwiseserving as a general partner in a limitedpartnership. As a direct business owner,developer or general partner, the state memberbank could be liable for debts and other

potential expenses beyond the amount of itsinvestment, unless specific, additionalprotections are put in place.

Bank Holding Companies. Under RegulationY, however, bank holding companies may beauthorized to invest directly in individualcommunity development projects or businessventures as opportunities arise, withoututilizing a CDC subsidiary or limitedpartnership as a conduit. Such direct projectinvestments must have significant publicbenefits and satisfy safety and soundness andother regulatory requirements. In undertakingdirect project investments, bank holdingcompanies could serve as the sole owner ordeveloper. More often, bank holdingcompanies using this approach have preferredto enter into a joint venture with the localdeveloper or nonprofit developmentcorporation that initiates and manages theproject.

The direct project investment approach may beuseful in helping a bank holding companyrespond on a timely basis to a specific andimmediate community need or proposal. Aproject investment may be made withoutincurring delays and costs associated withincorporation of a CDC or formation of alimited partnership. On the other hand, thisoption may not be appropriate if the bankholding company intends to participate in anumber of community developmentinvestment activities over time.

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Key Considerations for Banks andBank Holding Companies

When entering into any new line of business,financial institutions usually consider themarkets in which they will operate and analyzealternatives to determine which approach bestmatches the institution’s capacity andobjectives. These assessments are no lessnecessary in the community development area.

In determining which community develop-ment investment strategy and organizationalmechanism will be most suitable, banksand bank holding companies must carefullyassess a number of key issues. Among themare:

■ Nature of the Market and the CommunityNeeds To Be Addressed. What are the keycommunity development needs on whichthe institution’s investment activity will fo-cus? Will it be low- and moderate-incomehousing? Creating jobs for low- and moder-ate-income persons through small and mi-nority business development? Developmentof community facilities? Or a combinationof these?

■ Geographic Scope of Activities. Where willthe investment activity take place? Will theinvestment activity target any particularneighborhoods, communities, or states?

■ Community Resources and InvestmentStrategies. To what extent are other privateand public organizations committed to com-munity development and revitalization inthe target area or community? Are there ef-fective, experienced groups with which theinstitution could work? What other publicand private financial and managerial re-sources are available in the target areas orcommunities? Does the financial institutionplan to develop its own projects, or will itfocus on helping finance projects sponsoredby others? Will the institution be providinggap equity and debt for projects, or does itexpect to provide the bulk of project financ-ing in most cases?

■ Commitment of Capital and Other Finan-cial Resources. What initial capital invest-ment is the institution prepared to commit tocommunity development activities? Will thissum be accompanied by a commitment ofloans or lines of credit? What is the maximumcapital investment the institution expects tomake over time? Is this expected capital in-vestment consistent with the institution’ssafety and soundness?

■ Management Issues. How and by whomwill the community development invest-ment activity be managed? What commit-ment of financial institution resources willit take to provide effective management?

Community Needs and Market FocusThe nature of the community developmentmarketplace to be served is a critical element.Because communities — whether urban orrural — usually have a multiplicity of needs,the institution’s selection of investmentactivities on which to focus is an important firststep in the process.

Typically, financial institutions have used theirbusiness experience and ongoing communityrelationships to help them develop theirinvestment strategies. Community outreachhelps identify critical needs and projects,potential target areas, and capital gaps thatmight be addressed.

In some cases, institutions participate in formalcommunity planning activities from whichcommunity development needs, priorities, andinvestment opportunities emerge. But oftencommunity investment programs are createdwhen an institution finds that it cannotrespond to specific financing requests frombusinesses, government agencies, orcommunity groups using only conventionalloans and banking services.

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Financial institutions have establishedinvestment programs designed to serve avariety of community needs. Some institutionshave focused exclusively on low- andmoderate-income housing. Others providesupport for small and minority businessdevelopment, or neighborhood economicdevelopment projects that will generateneeded long-term employment opportunitiesfor low- and moderate-income persons. Stillothers engage in a range of these activities.

In determining their investment strategies,institutions should have a clear idea both oftheir initial objectives and of the types of futureinvestment activities they may want toundertake. For example, although aninstitution’s immediate interest may be toinvest in one specific, low-income housingproject in a particular neighborhood, it mayalso be aware of other communitydevelopment needs that it would want toaddress in the near future. In such cases, theinstitution might wish to structure its proposalbased on a range of contemplated investmentactivities that would meet regulatorystandards and conditions.

This decision, however, will require carefulassessment of the markets and communitiesto be served to identify key communitydevelopment needs and potential target areas.

Geographic Scope of ActivitiesConsideration also should be given togeographic scope. An institution’s initialinvestments may begin in one neighborhoodor community. But as banks and bank holdingcompanies extend their operations to othercommunities and even to other states, theymay also want to expand the geographic baseof their community development investmentactivity. It often makes sense for an institutionto seek authority to conduct its CDC andinvestment activities over a broadergeographic area than is required for the initialprojects.

Banks consummating mergers acrosscommunity lines, or opening branches in newareas, will likely want to conduct communitydevelopment investment activities in these

new markets. Similarly, a bank holdingcompany moving interstate might want toextend the area in which it makes communitydevelopment investments to assist newaffiliates across state lines.

For a community bank, or a smaller one-bankholding company, a community developmentinvestment program initially targeted for oneneighborhood may become the focal point forrequests for participation in projects located inother neighborhoods and communities in theirtrade area. This often will occur even thoughthe initial CDC or community developmentinvestment activity was narrowly focused.

Since considerable time and effort may berequired to plan, and implement successivesingle projects or narrowly focused communitydevelopment activities, there may be real valuefor an institution to include in its notice orrequest for approval to regulators a range ofqualified community development activitiesover a broader geographical area. Theinstitution can then respond to communityneeds and opportunities in this wider area ona timely basis as they arise.

Community ResourcesAnother key factor is the availability andstructure of community resources, includingthe capacity of existing organizations toundertake effective community developmentand revitalization activities. Where effectiveneighborhood CDCs, local developmentagencies and entrepreneurs with communitydevelopment experience are already in place,financial institution CDCs and investmentactivities may be more appropriatelystructured to help meet capital gaps for projectsinitiated by others. On the other hand, incommunities or neighborhoods that lackeffective, experienced community develop-ment partners, financial institutions mayhave to play a leadership role in developingprojects and in assembling other financial andmanagerial resources.

The extent to which public sector funds arecommitted to, and available for, communityrevitalization also will have a bearing onfinancial institution investment strategies and


decisions. The potential for development ofprojects that help meet the needs of low- andmoderate-income persons or areas is enhancedwhere public funds -- from local, state andfederal government programs -- are availablefor community development. If public sectorcommitment and funding is inconsistent oruncertain, financial institution CDCs may haveto utilize additional equity capital for projects,or rely more on additional private sectorsources of subsidized capital, such asfoundation grants, corporate and individualdonations, and voluntary sweat equitycontributions.

Where effective community partners andresources are present, strategies can focus onleveraging financing by providing supple-mentary equity capital to fill financial gaps inprojects. Where these other resources arelimited, any investment activity will likely bemore capital intensive and require significantlygreater planning and managerial resourcesfrom financial institutions.

Commitment of Capital and OtherFinancial ResourcesThe capital requirements of a CDC orinvestment activity, over both the short andlong term, should be carefully considered. Theamount of capital investment will vary withthe nature of community needs to beaddressed, the availability of other resourcesand partners, the objectives of the financialinstitution, and any limitations imposed byregulatory agencies. Most importantly,capitalization should be appropriate, both interms of equity and debt, to the activities beingundertaken by the financial institution or itsCDC. A bank or bank holding company CDCcan begin with a modest amount of equitycapital which, over time, may grow as newproject opportunities arise.

Bank CDCs or investment programs mayprovide debt financing along with equityinvestments for community developmentprojects. The anticipated maximum amounts,funding options, and structure of such debtfinancing should be assessed when planninga community development investment

program. Examples of debt financing includedirect loans to the CDC (in which the bank orbank holding company also has investedequity), the purchase of debt securities issuedby the CDC or entity, issuance of lines of creditto the CDC, or participation in loans made bythe CDC.

Use of a financial institution’s equity capitalfor community development investment hasboth practical and regulatory limits. Both theFederal Reserve Board (for state memberbanks), and the Comptroller of the Currency(for national banks) employ some form oflimitations on the amount of capital aninstitution can use for community develop-ment investments. Although the FederalReserve provides slightly more flexibility forbank holding companies, the Board doesexpect each holding company to be prudentin funding a CDC or project, in accordance withsafety and soundness considerations.

Nonprofit vs. For-Profit ApproachA CDC or community development invest-ment activity can operate on a for-profit or anonprofit basis, and banks and bank holdingcompanies should carefully consider theiroptions. Both approaches have advantages anddisadvantages.

Nonprofit organizations are eligible to receivegrant money directly from many foundationsand federal and state agencies. Such grants canbe a valuable resource for a CDC or communitydevelopment project. In the case of rental orfor-sale housing, these funds help reduce debtservice costs and allow rents or sale prices tobe set at levels affordable to low-incomepersons.

A nonprofit CDC cannot return its earnings tothe parent bank or holding company; it mustreinvest them in other development projects.Thus, the selection of this approach serves toemphasize that community benefit, not directfinancial gain, is the primary purpose of thefinancial institution’s community develop-ment activity. By conveying this message, afinancial institution’s nonprofit CDC mayachieve increased community support andcredibility.

Key Considerations for Banks and Bank Holding Companies 13

The nonprofit approach also may have somedrawbacks. Government and foundationgrants are generally scarce and difficult toobtain. A nonprofit CDC controlled by afinancial institution could be perceived as anadvantaged competitor for such funds byexisting community-based nonprofit groups,which rely heavily on government andfoundation grants to support their operationsand projects. They may not welcome creationof a bank-sponsored nonprofit CDC seekinggrants for its projects.

A nonprofit CDC also may have difficultiesattracting investments from those to whom thepotential for a profitable investment return isan important factor. This is especially true inthe case of consortium CDCs or partnerships,which may need to attract capital from avariety of corporate and individual investorsso that larger revitalization projects may beundertaken.

The for-profit approach has several benefits. Itmay be more acceptable to management andboards of directors, because it placescommunity development in a business contextthat conveys seriousness of purpose andorganizational discipline. Plus, the potentialfor investment returns (including, in somecases, tax benefits) may help attractinvestments from others in a community whoshare an interest in community revitalization.Successful for-profit CDCs and ventures helpdemonstrate to other developers andbusinesses that community development workcan be profitable and rewarding.

For some financial institutions, the for-profitapproach to community developmentinvestments may have some disadvantages.For example, community and neighborhoodgroups may perceive a for-profit CDC as morerisk-averse and less willing to pursue difficultprojects in low-income areas, even thoughthese may be most needed.

Also, some community organizations mayprefer to see potential net earnings from anycommunity development project used toreduce project costs, rents or sale prices, ratherthan be passed back to the financial institutionsponsors as profits. A for-profit CDC orinvestment may not be viewed by the

community as one that provides the maximumbenefits to low- and moderate-income persons.

Most banks and bank holding companies withCDC or community development investmentshave chosen the for-profit route. Most havefound that many of the advantages of nonprofitoperations can be obtained by working closelywith existing nonprofit community organi-zations that may serve as joint venture partnersin community development projects. In a fewcases, financial institutions have formed both afor-profit and a nonprofit CDC, with eachfocused on activities for which its particular formis most advantageous.

Management and OrganizationGiven the complexities of the communitydevelopment investment process, it is essentialfor banks and bank holding companies toensure that CDCs and investments receiveeffective management and oversight. The levelof commitment of management resources mayvary considerably, depending on theinvestment mechanism being used and thetypes of investments being made.

The Federal Reserve has found it especiallyimportant that financial institution investorsin CDCs and other similar entities beparticularly attentive to the need to matchmanagement and staff experience andexpertise with the types of activities the CDCor entity will undertake. For example, CDCsthat specialize in the purchase, rehabilitationand resale of affordable housing, shouldemploy, at both the staff and board level,people with appropriate experience in realestate development and real estate financing.Similarly, CDCs that focus on venture capitalinvestments in small and minority businesseswill require staff and/or board members withthe expertise and experience needed toproperly assess the prospects and performanceof small businesses, structure appropriatefinancing packages, and effectively monitor onan ongoing basis the progress of the businessesassisted.

A subsidiary CDC that is participating in anumber of projects on an ongoing basis, mayrequire a full-time chief executive officer andother staff — to conduct community outreach,


Key Considerations for Banks and Bank Holding Companies

would constitute “management” of thepartnership, since this could expose them topotential liabilities as a general partner.

Nonetheless, these investments may beextremely labor intensive during the periodwhen the holding company is consideringpurchase of partnership shares and reviewingpartnership documents. Institutions will needto exercise appropriate review of projects inwhich the partnership plans to invest and ofthe activities of the general or managingpartner, to ensure that their interests areprotected and that any tax benefits promisedthe limited partners are in fact provided.

Overall, managerial resources devoted tocommunity development investments by astate member bank or bank holding companyshould be appropriate to the investmentmechanism being used and the nature andextent of planned community investmentactivities.

review project proposals, manage theinvestment approval process, and monitorinvestments once made. Other CDCs can bemanaged effectively by their boards ofdirectors with support from bank or bankholding company personnel on a part-timebasis, especially when the CDC is used to makeonly occasional project investments as needsor opportunities arise. In such cases, careshould be taken to ensure that board membersand bank staff have the expertise and properexperience to deal effectively with the types ofinvestments being considered.

Most CDCs also make use of an investment orloan committee. It is often comprised of bankor bank holding company officers and otherreal estate development experts who may needto meet only occasionally.

Limited partnership investments require farfewer resources for ongoing management.Indeed, as limited partners, financialinstitutions should not engage in activities that

15

Guidelines for State Member Banks

Although bank holding companies have longbeen authorized to make communitydevelopment investments, until recently,restrictions in the Federal Reserve Actprecluded state member banks from engagingin many community development investmentactivities. State member banks could lend tocommunity development corporations andother entities engaged in similar activities, butthey generally could not make equityinvestments themselves for communitydevelopment purposes if those investmentswere in real estate, business ventures or othernonbanking corporations. This had the effectof restricting the options available when statemember banks were asked to help fill financialgaps in community development projects, orwanted to join with other institutions in theircommunity to form a CDC or other financialintermediary.

The Depository Institutions Disaster Relief Actof 1992, however, amended Section 9 of theFederal Reserve Act (12 U.S.C. 321-338) byadding a new paragraph (12 U.S.C. 338a) toallow state member banks, under certainconditions, to make public welfare investmentsfor community development purposes. Thelaw states that:

State member banks may make invest-ments designed primarily to promote thepublic welfare, including the welfare oflow- and moderate-income communitiesor families (such as by providing hous-ing, services, or jobs), to the extent per-missible under State law, and subject tosuch restrictions and requirements as theBoard of Governors of the Federal ReserveSystem may prescribe by regulation ororder....

In response to these changes to the act, theFederal Reserve Board revised its RegulationH (12 CFR Part 208), which governs the

activities of state member banks, by adding anew section entitled “Community Develop-ment and Public Welfare Investments.” Theseregulatory provisions became effective January9, 1995. They describe those circumstancesunder which state member banks arepermitted to make certain types of communitydevelopment investments without priorapproval and those instances when priorapproval must be sought from the FederalReserve.

Public WelfareCommunity development investmentauthority for state member banks is restrictedto investments that primarily promote thepublic welfare. Although the Federal ReserveAct does not specifically define the term“public welfare,” the Board has adopted aflexible approach consistent with its experiencein approving bank holding companycommunity development investments and thepolicies adopted under Regulation Y.

The Board determined that there are a numberof community development investmentactivities that clearly promote the publicwelfare and are permissible for state memberbanks, if other conditions (see below) are met.Generally, investments that promote the publicwelfare are those that provide housingopportunities for low- and moderate-incomefamilies, and employment opportunities orother services that are targeted toward low-and moderate-income communities orfamilies. For example, state member bankinvestments in entities that support thepurchase, rehabilitation, and sale of singlefamily homes, or the purchase, development,rehabilitation, sale or rental of multi-familyhousing, would meet the public welfarestandard if the majority of the housing unitsserve low- and moderate-income families.

17

Also, investments in corporations or otherentities that invest in, or otherwise helpfinance, small businesses or commercialrevitalization projects, generally would bepresumed to meet the public welfare test ifthose projects or ventures are (1) located in low-and moderate-income communities and (2)provide services and long-term employmentfor low- and moderate-income persons.

Because community development ofteninvolves a variety of special circumstances andprojects with unique attributes based on localneeds and resources, there may be someuncertainty about whether a proposedinvestment would meet the public welfare test.In such cases, state member banks areencouraged to consult with the Applicationsand Community Affairs staff at their ReserveBanks.

Geographic Scope of InvestmentActivityOne of the primary purposes of a bank’sparticipation in community development is tohelp improve economic conditions in low- andmoderate-income areas served by the bank.Consequently, although the Federal Reservedoes not specifically limit the geographic scopeof a state member bank’s communitydevelopment investments, such investmentswill usually be made in response to communitydevelopment needs in the bank’s general tradeor market area. If a state member bank’s tradearea covers more than one state as a result ofbranching, it would not be unusual to see thebank making community developmentinvestments to help meet the needs of low- andmoderate-income areas in those states.

In some cases, state member banks may chooseto invest in statewide (or even national)community development corporations(CDCs), limited partnerships or equity poolsbeing formed by many financial institutionsand perhaps other investors. Usually, a bankwould make this type of investment with theexpectation that future communitydevelopment projects in the bank’s trade areawould be eligible to receive assistance from thestatewide organization.

Profits and DividendsAlthough substantial return on investment isgenerally not the primary purpose of financialinstitution participation in communitydevelopment investment activity, investmentsmay be in for-profit community developmentcorporations, limited partnerships and otherfor-profit entities. Hence, state member banksmay anticipate receiving some returns on theirinvestments.

As in the case of bank holding companycommunity development investments, theFederal Reserve places no limits on either theamounts or the timing of profits that can begenerated from a state member bank’scommunity development investment activity.The state member bank can receive profitdistributions or dividends from a CDC,partnership or other venture at any time, andthere is no requirement that such profits bereinvested in other community developmentactivities.

As a practical matter, however, the nature ofcommunity development investment activitymakes significant returns unlikely in the shortrun and most financial institutions usuallyreinvest profits in the CDC or additionalcommunity development projects. This helpssustain the community development activitiesand limits the need for additional capitalcommitments from investor financialinstitutions.

Community InvolvementThe Federal Reserve does not require statemember banks to engage in any particularforms of community involvement as aprerequisite to making community develop-ment investments. The Board believes,however, that the potential for successfulcommunity development investments isimproved where financial institutions seek andconsider the views of the affected neighbor-hoods or communities before engaging ininvestment activity. Community developmentis a process that almost by definition involvesthe participation of a variety of public andprivate organizations. Efforts to help meet the


housing and employment needs of low- andmoderate-income persons and economicallydistressed communities can rarely occur or betruly successful without effective communityinput and participation in the planning andfinancing processes.

To ensure that CDC and project investmentsare responsive to community needs and helpleverage community resources, state memberbanks are encouraged to establish effectivemechanisms for outreach and consultationwith affected groups in the community orproject area. Depending on the nature andlocation of a project, these groups mightinclude neighborhood developmentorganizations, community advocacy groups,local government officials and agencies, smallbusinesses, merchant’s associations, and otherbusiness organizations. Consultation withaffected parties helps an institution identifyworthwhile projects, establish cooperativeworking relationships with public agencies,development groups, and potential investors,and market completed projects to those mostin need.

The Federal Reserve does not specify anyparticular approach for ensuring communityinvolvement. Some financial institution CDCshave established a community advisorycommittee in the community where projectsare considered. Others have preferred to utilizecommunity outreach mechanisms alreadyestablished by their institution. Communityrepresentation on the board of directors of astate member bank’s CDC is helpful but notrequired.

Investments Without Prior ApprovalTo provide state member banks with flexibilityto respond to local community developmentneeds on a timely basis, and to reduceregulatory burden, the Board has adoptedprocedures that allow institutions to makecertain community development investmentswithout prior regulatory approval, if theconditions outlined below are met.

Such investments must be in an entity thatundertakes community development activitiesmeeting the public welfare test. These entities

and activities are generally consistent withthose that have been approved by the Boardin the past for bank holding companies, andin most cases, by the Comptroller of theCurrency for national banks.

Qualified Entities

State member bank investments meeting thepublic welfare test can be made without priorapproval only if they are in qualifying entities.A qualified entity is a corporation, limitedpartnership, or other entity that engages solelyin qualified community development activities(see below) and does not expose the bank toliability beyond the amount of the investment.Such an entity can be organized on a for-profitor nonprofit basis.

As specified by Regulation H, qualified entitiesalso include both a particular CDC or limitedpartnership, or a class of CDCs or limitedpartnerships, for which the Board haspreviously approved state member bank orbank holding company public welfareinvestments. For example, if the Board hadapproved a bank holding company publicwelfare investment in a particular CDC orlimited partnership under Regulation Y, a statemember bank could invest in that same CDCor limited partnership without prior Boardapproval.

Moreover, certain classes or types of entitiesare considered qualified entities in which statemember banks can invest without priorapproval. The Board has routinely approvedmany bank holding company investments inCDCs focusing on lower-income housing, orin low-income housing partnerships thatutilize federal low-income housing tax credits(LIHTC). Consequently, any CDC or limitedpartnership that closely fits thosecharacteristics would be part of a class ofqualified entities in which state member bankscan invest without prior approval from theFederal Reserve.

Additionally, a state member bank may investin any specific CDC, limited partnership, orother entity that the Office of the Comptrollerof the Currency has previously approved as aqualified community development investment

Guidelines for State Member Banks 19

for a national bank, under 12 U.S.C. 24(Eleventh). For example, if one or morenational banks have been approved to investin a certain multi-bank CDC under 12 U.S.C.24 (Eleventh), then state member banks couldalso invest in that particular CDC without priorapproval from the Federal Reserve.

Finally, Regulation H also allows state memberbanks to invest, without prior approval, in anyentity that qualifies as a communitydevelopment financial institution (CDFI), asdefined by section 103(5) of the CommunityDevelopment Banking and FinancialInstitutions Act of 1994 (12 U.S.C. 4702(5)).CDFIs are private organizations that focussolely on various types of communitydevelopment financing and are certified by theCDFI Fund.

In any case where a proposed communitydevelopment investment will not be in aqualified entity, the state member bank mustsubmit a request for approval to its FederalReserve Bank.

Qualified Community DevelopmentActivities

A qualified entity (other than one previouslyapproved by the Board and the OCC, or thosequalifying as CDFIs) must engage solely in oneor more public welfare communitydevelopment activities. This ensures the Boardthat the state member bank’s investment meetsthe intent and requirements of the FederalReserve Act, and that bank ownership of realestate or other nonbanking ventures will belimited to community development purposes.It also ensures that the bank’s investment isnot being made for strictly entrepreneurialpurposes that may not be related to meetingthe community development needs of low- andmoderate-income areas or families.

Although there may be a wide variety of otherpublic welfare activities that could beapproved by the Board, the types ofinvestments that do not require prior approval(as long as other conditions are met), includethe following:

Low- and Moderate-Income Housing. TheBoard has found that development,

rehabilitation, ownership, management, saleor rental of housing, (1) where the majority ofthe units are or will be occupied by low- andmoderate-income persons, or (2) that qualifiesfor low-income housing tax credits, areactivities that generally fall within the scopeof permissible public welfare investmentactivities. Typically, these activities areperformed by a for-profit or nonprofitcorporation, or a limited partnership, in whichone or more financial institutions are investors.

Commercial Development and Revita-lization. Efforts to help revitalize commercialareas in low- and moderate-income neighbor-hoods through real estate development or therehabilitation of commercial or othernonresidential properties (including themanagement, sale or rental of such properties),generally will meet the public welfare test if(1) the properties are located in a low- ormoderate-income area, and (2) the goods orservices and employment opportunitiesprovided by businesses occupying theproperties are targeted towards meeting theneeds of low- and moderate-income persons.Commercial development in middle- or upper-income areas, even though it may provideancillary employment opportunities for lower-income persons, is not viewed by the Board asa community development activity in whichstate member banks may invest without firstseeking Federal Reserve approval.

Small Business Development. Investmentsbenefitting small businesses, includingminority-owned businesses, located in low-and moderate-income areas are consideredqualified community development activities.For example, such investments could be in aCDC, limited partnership or other entity thatprovides equity and debt financing for smallbusinesses, develops retail, office, medical,agricultural, manufacturing or service facilitiesused by small businesses, or provides technicalassistance or consulting services to smallbusinesses. Generally, if the firms assisted (1)meet the U.S. Small Business Administration’sdefinitions of small business under either theSmall Business Investment Company programor the Certified Development Companyprogram, and (2) are located in low- andmoderate-income areas, investments in entities


serving or owning such businesses arequalified community developmentinvestments.

Industrial Development, Job Training andOther Community Development Activities.The development, redevelopment, manage-ment, sale or rental of other nonresidentialproperty, such as that used for manufacturing,small business incubators, job training, orother economic development services, alsowould generally meet the public welfare testas a qualified activity if the beneficiaries arelow- and moderate income-persons.

Generally, economic development activities ofany kind, undertaken by an entity located in alow- and moderate-income area, that focus onthe creation of long-term jobs and employmentopportunities targeted towards low- andmoderate-income persons, would be qualifiedactivities.

Counseling and Technical Assistance.Regulation H provides that investments inentities that provide credit counseling,technical assistance, program developmentand related research that facilitates communitydevelopment would be qualified communitydevelopment activities, as long as the activitiesassist low- and moderate-income persons,small businesses or nonprofit corporations inlow- and moderate-income areas. Generally, ifother conditions are met, investments inentities devoted only to providing these typesof services supportive of communitydevelopment may be made without priorapproval.

Legal and Supervisory Conditions

There are several legal and supervisorythresholds that a state member bank mustsatisfy before it can engage in communitydevelopment investment activities, even thosethat involve qualified entities and activities,without seeking prior approval from theFederal Reserve. Some of these requirementsare specified by the law itself, while others areconsistent with supervisory safety andsoundness policies or procedures used by theBoard when considering requests for approvalof other types of bank activities.

First, there are two essential thresholdstandards that must be met: (1) the investmentmust be permissible under state law, and (2)the state member bank must meet certainsupervisory conditions concerning its safetyand soundness and compliance performance,including capitalization and examinationratings. A state member bank that fails tomeet any of these conditions cannot make acommunity development investment withoutprior approval and must submit a request forapproval to its Federal Reserve Bank if itwishes to engage in community developmentinvestment activities.

State Law Requirements. The investmentactivity must be permissible under state lawin the state in which the bank is chartered.Although many states have adopted statutesthat specifically allow state-chartered banksto make certain types of community develop-ment investments, others rely on moregeneral “comparability” statutes whichauthorize state banks to engage in anyactivities legally permissible for nationalbanks. As national banks may, under certainconditions, make community developmentinvestments, it is likely that state bankschartered in states having such comparabilitylaws also may engage in community devel-opment investment activity. A state memberbank in a state with such a comparability lawshould consult with its state banking regu-latory agency, as well as with its FederalReserve Bank, to ensure that proposedcommunity development investments arepermissible.

Supervisory Considerations. A state memberbank must also meet the conditions specifiedin Regulation H before it can engage incommunity development investment activitywithout seeking prior approval. The bankmust:

■ Be at least adequately capitalized under risk-based capital standards

■ Meet supervisory safety and soundnessstandards by achieving a composite super-


visory CAMEL rating of “1” or “2” in thebank’s most recent examination

■ Have an overall consumer compliance rat-ing of at least “satisfactory” as a result of itslatest consumer compliance examination.

In addition, if the bank wishes to engage incommunity development activities withoutseeking prior Federal Reserve approval, it maynot be subject to any written agreement, ceaseand desist order, capital directive, promptcorrective action directive, or memorandum ofunderstanding issued by the Board or a FederalReserve Bank.

Should a state member bank not meet one ormore of these supervisory conditions, it mustsubmit an application to its Federal ReserveBank requesting permission to engage in thecommunity development investment activity,even if that activity clearly meets the publicwelfare test.

Investment Limits

For safety and soundness purposes, there arealso limitations on the amount of capital thata state member bank can devote to communitydevelopment investments. As required byRegulation H, a single community develop-ment investment cannot exceed the sum of twopercent of the state member bank’s capitalstock and surplus, and the aggregate of all of abank’s community development investmentscannot exceed the sum of five percent of capitalstock and surplus.

If a state member bank’s investment in aqualified entity is within these limits, and allother conditions are met, the bank can makeits investment(s) without prior approval. Onthe other hand, if a state member bank wishesto make investments exceeding these limits,it must submit an application to its FederalReserve Bank. In no case, however, may astate member bank’s aggregate communitydevelopment investments exceed 10 percentof capital stock and surplus.

Liability Limitations —Direct Project Investments

Regulation H requires that a state memberbank’s community development investments

be made in a manner that does not expose thebank to liability beyond the amount of theinvestment. Generally, this precludes directinvestments in property, projects orunincorporated business ventures, because asa developer or general partner with directownership of a business venture, the statemember bank would be potentially liable fordebts and civil penalties beyond the amountof the investment.

The most common approach to limitingliability is for a bank to create or invest inentities that provide protection against liability.Typically, these include CDCs or othercorporations, or limited partnerships in whichthe bank is a limited partner. While there maybe ways to limit liability in direct ownershipsituations, the Federal Reserve expects thatcommunity development investments by statemember banks generally will be investmentsin corporations or investments as limitedpartners in limited partnerships.

The Board recognizes, however, that there maybe exceptional cases in which a state memberbank finds it necessary or particularlyadvantageous to make a direct communitydevelopment project or business investment,when other means can be used to limit liability.In any such case, a proposal for a state memberbank investment that forgoes the protectionsof the corporate or limited partnershipstructure, must be submitted to the FederalReserve for prior approval. The bank’s requestfor approval must explain the nature of theinvestment and how limitations on liabilitywill be achieved.

Notice and Approval ProceduresRegulatory procedures for communitydevelopment investments are similar to thoseused for other permissible state member bankactivities. There may be slightly differentprocedures, however, for some communitydevelopment investments, depending onwhether the investments meet the criteriaoutlined above for “Investments without PriorApproval.”


Notices for Investments WithoutPrior Approval

As noted previously, state member bankswishing to make community developmentinvestments in qualified entities may do so (ifother supervisory conditions are met), withoutreceiving prior approval from the FederalReserve. In such cases, however, Regulation Hrequires that the state member bank submit anotice to its Federal Reserve Bank within 30days after making the investment.

The notice may be brief, but should, at aminimum, clearly identify:

(1) The amount and type of the bank’s invest-ment (e.g., equity investment in a CDC,purchase of a limited partnership share,purchase of debt securities)

(2) The entity in which the bank has invested(e.g., a wholly owned CDC, multi-investorCDC, limited partnership, venture), includ-ing its name, operating or target area, gen-eral purposes and primary activities, andwhether the entity is one that has also beenapproved by the Comptroller of the Cur-rency for investments by national banks,or is a qualified Community DevelopmentFinancial Institution

(3) The primary beneficiaries of the invest-ment (e.g., low- and moderate-income ar-eas or families, small businesses in low-and moderate-income areas).

The notice should also include a statementcertifying that the bank meets all of theregulatory conditions specified in RegulationH, Section 208.21(b), concerning “Investmentsthat do not require prior Board approval.”

Requests for Approval of OtherInvestments

If the investment or the state member bankdoes not meet all of the requirements for aninvestment that can be made without priorapproval, the bank must request permissionto make the investment. It is also advisable toconsult with the Reserve Bank’s Applicationsstaff and Community Affairs staff prior tofinalizing a request, if the state member bank

is uncertain as to whether the investmentmeets the Board’s public welfare standards.

Contents of the Request for Approval. Theamount of detail will vary among requests, butit is always helpful to include as muchinformation as possible about plannedactivities, as the state member bank bears thefull burden of presenting and documenting itscase for approval. The request should,however, include at least the followinginformation:

■ The amount, type(s) and timing of thebank’s proposed investment(s) (e.g., equityinvestment in a CDC, purchase of a limitedpartnership share, purchase of a CDC’s debtsecurities), and whether the amount iswithin the limits specified in Regulation H,as a percentage of capital stock and surplus

■ The name and description of the entity orventure in which the bank proposes to in-vest (e.g., the specific CDC, limited partner-ship), including its operating or target area,whether it is a for-profit or nonprofit ven-ture, and whether the entity is one for whichnational bank investments have been ap-proved by Office of the Comptroller of theCurrency and/or is a qualified CommunityDevelopment Financial Institution

■ The nature and purposes of the key com-munity development activities (e.g., low-in-come housing rehabilitation, small businessdevelopment) to be undertaken by the entity

■ How, and the extent to which, the proposedcommunity development investment activi-ties will benefit low- and moderate-incomeareas or persons and promote the publicwelfare

■ How the state member bank’s liability willbe limited to the amount of its investment(s).

If the state member bank is proposing to forma subsidiary or is investing in a consortiumCDC or other multi-investor entity, a copy ofthe entity’s proposed or final articles ofincorporation should be included with therequest. For multi-investor CDCs or othercorporations, the state member bank shouldidentify, to the extent possible, expected


nonbank investors in the entity and the nature,if any, of any other business relationshipsbetween the bank and such investors. Forrequests involving limited partnershipinvestments, the state member bank shouldprovide a copy of the partnership’s prospectusand agreement.

Generally, the Federal Reserve Bank will actunder delegated authority, where appropriate,within 30 calendar days of receiving a statemember bank’s completed request for per-

mission to engage in community developmentactivities. If a request is incomplete or requiresclarification, the process may take longer.

Some circumstances may require a FederalReserve Board determination, such as when arequest involves a new public welfare activityor raises policy issues. In such cases the Boardwill generally make a determination within 60calendar days from the date on which acompleted request was received by the ReserveBank.


Guidelines for Bank Holding Companies

The 1970 amendments to the Bank HoldingCompany Act gave the Board new flexibilityto determine what nonbanking activities areproper and permissible for bank holdingcompanies. In the context of this legislativechange and the Board’s interest in encouragingbank holding companies to participate insolutions to community problems, the 1971revisions to Regulation Y explicitly authorizedbank holding companies to engage incommunity development equity investmentactivities.

Regulation Y lists community developmentamong the activities deemed by the Board tobe closely related to banking and thereforepermissible for bank holding companies.Section 225.25 (b)(6) defines the term asfollows:

Community Development. Making equityand debt investments in corporations orprojects designed primarily to promotecommunity welfare, such as the economicrehabilitation and development of low-income areas by providing housing, ser-vices or jobs for residents.

Community Welfare TestA number of Federal Reserve decisions haveaddressed the concept of “communitywelfare,” providing holding companies withflexibility in tailoring their investments to meetthe needs of their disparate communities.Generally, the Board has found thatinvestments in CDC ventures or communitydevelopment projects which primarily benefitlow- and moderate-income persons andeconomically disadvantaged neighborhoodsand communities meet the “communitywelfare” test. Such benefits can include, forexample, new or rehabilitated low- andmoderate-income housing, or the developmentof facilities providing community services tolow- and moderate-income persons.

Bank holding company CDCs and investmentsapproved by the Federal Reserve typically havehad one or more of the following primarypurposes:

■ Development or rehabilitation of rentalhousing for low- and moderate-incomefamilies, including projects utilizing federallow-income housing tax credits

■ Purchase, rehabilitation and sale of afford-able owner-occupied housing for low- andmoderate-income persons

■ Development or expansion of small businessenterprises in economically distressed areas

■ Development of community facilities whichprovide health, educational and other essen-tial services primarily for low- and moder-ate-income persons

■ Provision of technical assistance and advi-sory services to public and private commu-nity development organizations engaged inactivities benefitting low- and moderate-in-come persons and areas, or small businesses.

These and related activities help to createeconomic value and provide direct benefits tolow- and moderate-income persons and areas.

The Federal Reserve has made clear, however,that investments would be presumed not tomeet the community welfare test if they are forcorporations or projects organized to build orrehabilitate high-income housing, orcommercial, office and industrial facilities notdesigned explicitly to create long-term jobopportunities for low- and moderate-incomepersons. This is so even though suchinvestments might provide some indirectbenefits to low- and moderate-income persons.

For example, a bank holding company’s equityinvestment to develop upscale housing in aneconomically distressed community would notmeet the test even though the project ultimatelymight indirectly benefit some low- and

25

moderate-income persons through resultingconstruction jobs or an increase in the local tax-base that would support enhanced communityservices to low-income groups. Similarly, majordowntown real estate development that is notlocated in a low- and moderate-income areaand used primarily for low- and moderate-income persons generally would not meet thetest, although such a project might providesome benefits to a community. Without strongevidence to the contrary, the Board believes thatsuch benefits are too indirect and areinsufficient to merit approval of a communitydevelopment activity under Regulation Y’scommunity welfare standard.

The Federal Reserve has recognized, however,that neighborhoods and communities in bothurban and rural settings vary greatly withrespect to size, population mix, communityneeds, and economic condition. Consequently,the Federal Reserve remains flexible inapplying the standards of Regulation Y forapproval of community developmentactivities. For example, approved communitydevelopment activities have included, in onecase, the creation of a rural test farm for cropexperimentation that could help diversify arural farm economy, and in another case, therehabilitation of a medical services clinic tohelp attract doctors in a small rural community.

Profits and DividendsBank holding company community develop-ment investments may be made on either afor-profit or nonprofit basis.

In the case of for-profit CDCs or ventures, noexplicit limits are set on the profits that maybe generated by a holding companycommunity development investment, butsignificant profits are generally not expected.Moreover, profits or dividends from a CDC orother approved community developmentventure may be provided to the holdingcompany at any time. This flexibility is oftennecessary to attract capital from other nonbankinvestors. Although profits are allowed, theyshould not be the primary purpose of a holdingcompany CDC or project investment.

Most bank holding company CDCs and otherequity investments have been for-profitventures. Although the capacity to obtainimmediate returns on investments may beimportant in principle to holding companiesand participating nonbank investors, inpractice most holding companies choose toreinvest profits in the CDC or additionalprojects that benefit community welfare.

Capital InvestmentIn cases involving a bank holding company’sinitial community development investment,the Federal Reserve takes a flexible approachin its evaluation of capital commitments forbank holding company community develop-ment activities. Although the Federal Reservesets no minimum or maximum levels forcapital investment by bank holding companiesin CDCs or community development projects,it does expect that use of bank holdingcompany equity for such purposes will be(1) appropriate to the nature and scope ofanticipated investment activities, and(2) prudent with respect to the size, financialcondition and capitalization of the holdingcompany.

Bank holding companies’ communitydevelopment investments will varysubstantially in size based on the communityneeds to be addressed and each holdingcompany’s community development objec-tives, financial capacity and geographic scopeof operations. Depending on their objectivesand projects, many bank holding companieshave chosen to capitalize CDC subsidiarieswith small initial investments, adding neededcapital as projects reach the developmentstage. In other cases, such as investments inlimited partnerships that develop or ownlower-income housing, the partnershipagreements often have required phasedpayments of capital by bank holdingcompanies and other investors, over a periodof years. Individual project investments eitherthrough CDCs or directly by the holdingcompany, usually leverage other debtfinancing and may require more or less equity


investment depending on the requirements ofthe project’s total financial package.

In light of the diversity of communitydevelopment activities, the Federal Reserve’sapproach allows for review of proposals on acase-by-case basis. Because communitydevelopment equity investment is notintended to be a major activity of a bankholding company, bank holding companies arenot expected to commit a significantproportion of their capital to CDCs orcommunity development projects. Nor willthe Federal Reserve approve communitydevelopment equity investments in amountsthat might pose undue risk to the safety andsoundness of the bank holding company.

Geographic Scope of InvestmentActivityThe Federal Reserve does not limit thegeographic scope of a bank holding company’scommunity development investments. Bankholding companies typically conduct theirCDC and project investment activities ineconomically disadvantaged neighborhoodsand communities in the market areas servedby their subsidiary banks. As a result, someholding companies choose to conduct theircommunity development investment activitiesin one community or one state, while otherswith interstate operations have establishedCDCs approved to make investments on aninterstate basis.

Some bank holding companies, anticipatingpossible expansion across state lines, obtainapproval to conduct their communitydevelopment equity investment activitiesnationwide so that they can assist newlyacquired subsidiaries wherever they may belocated. So long as the activities in the newlocations meet the community welfare test, areconsistent with the approval previouslygranted by the Federal Reserve, and do notpose safety and soundness concerns, thisapproach generally allows a bank holdingcompany or its CDC to make communitydevelopment investments in new market and

target areas served by subsidiary banks withminimal regulatory consultation and review.

Community InvolvementBank holding companies should seek andconsider the views of the affectedneighborhoods or communities when makingan investment decision. Communitydevelopment is a process that almost bydefinition involves the participation of avariety of public and private organizations.Efforts to help meet the housing andemployment needs of low- and moderate-income persons and economically distressedcommunities can rarely occur or be trulysuccessful without effective community inputand participation in the planning andfinancing processes.

To ensure that CDC and project investmentsare responsive to community needs and helpleverage community resources, bank holdingcompanies are encouraged to establisheffective mechanisms for outreach andconsultation with affected groups in thecommunity or project area. Depending on thenature and location of a project, these groupsmight include neighborhood developmentorganizations, community advocacy groups,local government officials and agencies, smallbusinesses, merchant associations, and otherbusiness organizations. Consultation withaffected parties helps a holding company:identify worthwhile projects; establishcooperative working relationships with publicagencies, development groups, and potentialinvestors; and market completed projects tothose most in need.

The Federal Reserve does not specify anyparticular approach for ensuring communityinvolvement. Many bank holding companyCDCs have established community advisorycommittees in each community where projectsare considered. Others utilize communityoutreach vehicles already established by theirsubsidiary banks. Community representationon the board of directors of a bank holdingcompany’s CDC is helpful but not required.

Guidelines for Bank Holding Companies 27

Notice and Approval ProceduresInitial Investments by Bank Holding

Companies

For an initial investment by a bank holdingcompany, an appropriate Regulation Y noticewith an accompanying narrative proposalmust be submitted to the Reserve Bank beforea bank holding company can make theinvestment. Proposals filed by bank holdingcompanies to engage in community develop-ment activities under Regulation Y generallyare processed by the Federal Reserve Banksunder delegated authority, unless issues areraised that warrant the review and decision ofthe Federal Reserve Board.

As a first step, any bank holding companyconsidering making an initial communitydevelopment investment is strongly encouragedto discuss its proposed investment with both theFederal Reserve Bank’s Applications staff andCommunity Affairs staff prior to developing andsubmitting a proposal. The Reserve Bank’s staffcan provide feedback on the holding company’sconcept or proposal, highlight issues and respondto questions. This consultative process facilitatesdevelopment of the proposal and helps a bankholding company avoid technical problems andissues that could delay consideration.

The narrative description of the bank holdingcompany’s proposal should include infor-mation on how the proposed investmentactivities meet the requirements of Section4(c)(8) of the Bank Holding Company Act andthe Federal Reserve’s Regulation Y. Theproposal should demonstrate how theproposed investment is primarily designed tobenefit community welfare, focusing on howbenefits will be provided to low- andmoderate-income persons and areas.

Federal Reserve Bank’s Applications staff willreview the notice to form or invest in a CDC orother community development activity todetermine whether it meets all statutory andregulatory requirements, including thecommunity welfare test under Regulation Y.A review is also conducted for safety andsoundness considerations.

Unless issues are raised or public comment isreceived, the decision to authorize CDC or

project investments usually will be made bythe Reserve Bank within 30 days after receiptof a proposal from the holding company. Undersome circumstances, an investment proposalmay raise policy issues requiring review by theFederal Reserve Board. In such cases the Boardwill generally make a determination within 60calendar days after submission of a completenotice.

Contents of the Proposal. A holdingcompany’s initial proposal to engage incommunity development activities, mustinclude sufficient descriptive material to givethe Reserve Bank a complete picture of thecompany’s community developmentinvestment plans. The amount of detail willvary among proposals, but it is always helpfulto include as much information as possibleabout planned activities, since the applicantbears the full burden of presenting anddocumenting its case for approval.

In developing its draft community develop-ment investment proposal and in preparing forits initial contact with Reserve Bank staff, thebank holding company should assemble thefollowing information:

■ A complete description of the proposedcommunity development investment activi-ties in which the holding company wouldengage; this should include information onthe (1) type of entity in which investmentswill be made (e.g., CDC subsidiary, consor-tium CDC, limited partnership, project in-vestment), (2) the primary purposes and ob-jectives of the entity/investment (e.g.,housing for low- and moderate-income per-sons, small business development), (3) thegeographic scope of community develop-ment activities, and (4) whether the invest-ment activities will be conducted on a for-profit or nonprofit basis

■ A discussion of how the proposed commu-nity development activities will benefit low-and moderate-income persons and promotecommunity welfare

■ A description of the amount(s) and timingof the holding company’s community devel-opment equity and debt investments; thisshould cover initial and anticipated futureequity investments by the holding company,


as well as any related loans or lines of creditit would provide

■ A description of the initial project(s) to beundertaken, and other future projects, ifavailable

■ Identification of any other parties that willbe supporting the projects and the natureand extent of their financial or managerialparticipation.

If the holding company is forming a subsidiaryCDC or is investing in a consortium CDC orother multi-investor corporation, a copy of theCDC’s articles of incorporation should beincluded with the notice. For proposedinvestments in multi-investor CDCs or othercorporations, the bank holding companyshould identify, to the extent possible, expectednonbank investors in the entity and the nature,if any, of any other business relationshipsbetween the bank holding company or itssubsidiaries and such investors. In the case ofa notice for a limited partnership investment,the holding company should provide a copyof the partnership’s prospectus and agreement.

Additional Investments

In December 1994, the Federal Reserve Boardissued a revised interpretation on the scope ofpermissible community development activitiesfor those bank holding companies which hadalready received approval to make communitydevelopment investments. The interpretation(12 CFR 225.127), which became effective inJanuary 1995, incorporated previous FederalReserve decisions concerning permissibleinvestments and also authorized bank holdingcompanies to conduct community develop-ment investment activities similar to thoseauthorized for state member banks.

Bank holding companies previously approvedto engage in one or more communitydevelopment investment activities undersection 4(c)(8) of the Bank Holding CompanyAct and Section 225.25(b)(6) of Regulation Ymay make additional community develop-ment investments, as identified in the revisedinterpretation, 225.127, up to a total of fivepercent of the holding company’s consolidatedcapital stock and surplus, without seeking

additional Federal Reserve approval orproviding a notice. This five percent limit foradditional investments without noticeincludes, on a consolidated basis, all com-munity development investments by theholding company, its nonbank subsidiaries,and its subsidiary banks.

Additional investments (by a previouslyapproved bank holding company) may bemade directly, or through a corporation orlimited partnership, without prior approval,for the following purposes:

■ Develop, rehabilitate, manage, sell and rentresidential property if a majority of the unitswill be occupied by low- and moderate-in-come persons, including projects utilizingfederal low-income housing tax credits

■ Develop, rehabilitate, manage, sell and rentnonresidential real property located in low-and moderate-income areas and used pri-marily by low- and moderate-income per-sons

■ Finance development or expansion of smallbusiness enterprises in low- and moderate-income areas to stimulate economic devel-opment

■ Develop job training and placement facili-ties, or community facilities which provideservices primarily for low- and moderate-income persons

■ Invest in an entity located in a low- or mod-erate-income area if that entity creates long-term employment opportunities, a majorityof which will be held by low- and moder-ate-income persons

■ Provide technical assistance and advisoryservices to low- and moderate-income per-sons and areas, small businesses, or non-profit corporations to help achieve commu-nity development

■ Invest in a certified Community Develop-ment Financial Institution as determined bythe Community Development Financial In-stitutions Fund

■ Invest in a corporation or project previouslyapproved by the Comptroller of the Cur-rency for investment by national banks

Guidelines for Bank Holding Companies 29

■ Invest in a corporation or project previouslyapproved by the Federal Reserve Board forinvestment by state member banks.

For example, if a holding company hadpreviously been authorized under RegulationY to invest in a low-income housing limitedpartnership, it could later make other types ofcommunity development investments that arelisted in the Board’s revised Regulation Yinterpretation (under 225.127) withoutapproval from the Federal Reserve, so long asthe aggregate total amount of all of itscommunity development investmentsremained under five percent of the holding

company’s consolidated capital and surplus.Such additional investments, in this example,would not have to be in other low-incomehousing partnerships or related activities, butcould also include CDCs or other venturesengaged in qualified community developmentactivities unrelated to the purposes of theholding company’s initial investment. Ingeneral, once a holding company has beenapproved to make any type of communitydevelopment investment pursuant toRegulation Y, it can then make the other typesof investments identified in the Board’s revisedinterpretation without prior approval, if theaggregate investment limit is honored.


of the bank. Such an investment typically isnot criticized by examiners solely because itsyield might be less than that of more traditionalinvestments. Instead, the historical andprospective performance of the investment ismeasured against the explicit terms of the debtor equity instrument, as well as theexpectations of the bank at the time theinvestment is made. One factor underlyingsuch expectations is generally the expectedyield on comparable investments. Where aparticular community development invest-ment has performed poorly, or has weakprospects, it will be evaluated in that light and,like other similarly situated bank assets, maybe subject to criticism by examiners.

Primary Types of InvestmentsCommunity development investments varyconsiderably and the Federal Reserve does nottreat all such investments alike. Consequently,as with other types of bank loans andinvestments, each community developmentinvestment is considered and evaluated basedon its particular attributes and merits, and thestrength and value of the entity for whichequity or loans are being provided.

The following is an overview of severalcommon types of community developmentinvestments that financial institutions havemade and a general discussion of theregulatory reporting and evaluation processesfor each.

Equity Investment in a CDC

State member banks may invest in communitydevelopment corporations (or CommunityDevelopment Financial Institutions or othersimilar entities). Usually this entails thepurchase of stock in the CDC (if it is a for-profitentity), which is either wholly-owned by thebank or is a multi-investor CDC.

Regulatory Treatment of Investments

General ApproachFor regulatory and reporting purposes, theFederal Reserve treats communitydevelopment investments the same way asother types of similar investments. Eachcommunity development investment is booked,reported and evaluated according to its type, riskand duration.

Reporting. Under normal circumstances, statemember banks do not report communitydevelopment investments under the “otherassets” category. As with other investments,community development investments shouldbe reported in the Reports of Condition andIncome (Call Report) in accordance with thereport’s instructions, which are consistent withgenerally accepted accounting principles(GAAP).

Under the Call Report instructions, equityinvestments are generally accounted for on aconsolidated basis, using the equity method,at cost, or at fair value, as appropriate. Debtsecurities are generally accounted for at fairvalue or at amortized cost, as appropriate, andloans are generally accounted for at amortizedcost. Additional guidance is set forth in the CallReport Instructions and in relevant statementsand interpretations under GAAP.

For example, an equity investment in a wholly-owned subsidiary CDC would be reported ona consolidated basis and treated the same waythat capital contributions to other wholly-owned bank subsidiaries are treated. Similarly,a loan to a bank-owned CDC, multi-bank CDC,or a loan to a project being developed by suchCDCs, is reported the same way as is a loan toany other business venture or entity.

Examinations. Generally, the supervisoryevaluation of a community developmentinvestment is based on its performance, andthe impact of that performance, in turn, on theoperating performance and financial condition

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Wholly-owned CDCs. A wholly-owned CDCis a type of bank subsidiary that is devotedexclusively to community developmentinvestment and lending. Such subsidiaries areincorporated and issue shares of stock whichare purchased en toto by the state member bank.For regulatory accounting and reportingpurposes, the operations of the CDC are nottreated any differently than are the operationsof other wholly-owned bank subsidiaries.Equity investments in (as well as loans to) suchCDCs by the state member bank are accountedfor and reported on a consolidated basis, as areinvestments and loans made by the CDC forcommunity development projects.

Consortium or Multi-investor CDCs. A statemember bank may wish to make an investmentin a consortium, multi-bank or multi-investorCDC, as one of many investors. Because asingle bank would not generally have acontrolling interest in a multi-investor CDC,these CDCs are sometimes referred to asnonbank CDCs, (i.e., they are nonbank CDCsin which one or more banks may be investors).Nonbank CDCs may include existingcommunity-based CDCs, CommunityDevelopment Financial Institutions, or othertypes of community developmentorganizations.

As with wholly-owned CDCs, investments inconsortium CDCs involve the purchase ofstock which may have certain value forregulatory and reporting purposes, thoughliquidity may be limited. Equity investmentsin consortium CDCs are generally regarded aslong-term investments and may be valued atthe initial investment amount, unlesssignificant material gains or losses by the CDCclearly indicate a change in value. If a statemember bank owns less than 20 percent of theCDC or entity, the straight cost method tovaluation may be used, but ownershippositions of 20 percent or more in the entitymust be valued using the equity method.

Investments by a state member bankrepresenting more than 50 percent of theownership of a CDC would be considered acontrolling interest and would have to bereported by the bank on a consolidated basis.

Nonprofit CDCs. Nonprofit CDCs may becapitalized in the same general way as for-profit ventures, with initial equity, issuance ofdebt securities to investors, loans to the CDC,etc. The “equity” of a nonprofit communitydevelopment corporation, however, usuallycomes in the form of initial “contributions”made to the CDC by its members (investors).For most nonprofit CDCs organized undersection 501(c)(3) of the Internal Revenue Code,such contributions do not purchase orrepresent an ownership position in the CDC,and contributors cannot derive a direct benefitor financial gain from any distribution of theorganization’s funds. These bank contributions(investments) in nonprofit CDCs cannot besold or redeemed by the bank, nor can thenonprofit CDC pay dividends to its membercontributors, should the CDC accumulateincome over expenses. Consequently, an equityinvestment (i.e., contribution) in a nonprofitCDC by a state member bank is not consideredan asset of the bank.

Loans to a nonprofit CDC, or debt securitiesissued by the nonprofit CDC and purchasedby the bank, are reported and evaluated in thesame manner as are loans or debt securities forany other business, venture or entity.

Equity Investment in a Limited Partnership

State member banks may purchase shares inmaster limited partnerships or operatinglimited partnerships that undertake qualifiedcommunity development activities. Usuallysuch partnerships develop, own and rent low-income housing and qualify limited partnersfor the benefits of the federal low-incomehousing tax credit. In larger low-incomehousing equity pools organized as limitedpartnerships, a bank is one of many investorsand purchases only a few of the availableshares. There are some cases, however,especially those involving joint ventures by abank and a nonprofit community-based CDC,where one institution has become a 99 percentlimited partner. Generally, limited partnershipshares purchased by a state member bank willbe valued at their face amounts, with a risk-weighting of 100 percent.


Also, in general, limited partnership shares areaccounted for as equity interests; however, asnoted above, the accounting treatment andreporting of such investments must conformto the instructions for Call Reports.

Purchase of Debt Securities Issuedby a CDC

Debt securities issued by a for-profit ornonprofit CDC and purchased by a state memberbank are evaluated in the same manner as othersimilarly situated debt securities purchased andheld by the bank. Generally, these are consideredlong-term investments which are not made forimmediate resale or trading purposes. Usually,these CDC debt securities will be unrated,though many are secured by mortgages on theCDC’s projects.

Loans to a CDC

Loans made by a state member bank to awholly-owned or multi-investor CDC aregenerally evaluated in the same way as areloans to other businesses or ventures. TheCDC’s earnings, capital, management andother risk factors related to the CDC’s capacityto repay the loan are assessed. Since bank loansto a CDC are usually used by the CDC forrelending to community development projects,the bank’s loans may not always carryconventional terms and conditions. Where a CDCintends to relend at favorable rates or terms, thebank will often offer similar rates or terms to theCDC. Performance of the bank’s loans to a CDCis generally a function of the performance of theCDC’s project loans and investments.

CRA and Community DevelopmentInvestmentsCommunity development investments canplay a number of roles in helping financialinstitutions achieve and demonstrate perfor-mance under the Community ReinvestmentAct (CRA). Under the CRA regulations, asrevised and adopted by the supervisoryagencies in April 1995, bank or bank holdingcompany community development invest-

ments can serve to enhance the CRAperformance of a financial institution undereach of the performance tests that will be usedby the supervisory agencies for larger retailbanks, smaller institutions and wholesale orspecial purpose banks. The impact of anycommunity development investment on aninstitution’s CRA performance, however, willdepend on the amount(s) and type(s) ofinvestment(s) made, and the subsequentactivities of the CDC(s) or other entities inwhich the bank invests. These will beconsidered in the context of the bank’s overallrecord of performance using the appropriateCRA assessment criteria.

The CRA performance of any size or type ofbank can benefit from an investment in a CDCor other community development entity.Because the primary beneficiaries ofcommunity development investments are low-and moderate-income areas or persons, and/or small businesses and small farms, theactivities of a bank-owned or supported CDC,or other similar entity, could help a bank to:

■ Increase the number of housing and smallbusiness loans made in low- and moderateareas or to low- and moderate-income persons

■ Enhance the geographic distribution ofhousing, small business or small farm loanswithin a CRA assessment area

■ Develop innovative loan products, alone orin conjunction with public sector programs,that facilitate credit extensions to low- andmoderate-income persons, small businessesand small farms

■ Increase the number and types of commu-nity development loans made

■ Provide community development invest-ments and community development services.

Larger Retail Banks

Community development investments mayenhance a larger retail bank’s CRAperformance in a number of ways. A bank’sinvestment(s) in a wholly-owned CDC can

Regulatory Treatment of Investments 33

make a positive impact under the investmenttest, while the loans made, and communitydevelopment services provided by such a CDCcan help, in varying degrees, to demonstrateCRA performance under the lending andservice tests respectively.

For example, a wholly-owned CDC or otherwholly-owned entity undertaking communitydevelopment activities, may contribute to thebank’s CRA performance directly, because theloans and investments made by the CDC orentity, as a bank subsidiary, may be assessedon a consolidated basis with those of the bank.Thus small business loans, special purposemortgage loans, or other communitydevelopment loans and equity investmentsmade by the CDC can be assessed as part ofthe bank’s CRA performance, as though theywere made by the bank itself.

Similarly, investments in consortium CDCsthat provide community development loanswithin a bank’s assessment area also cancontribute to a bank’s CRA performance,where consortium participants agree toallocate loans among the CDC’s investors. Tothe extent that these types of loans are onesthe bank might not have made on its own,without the added equity, subordinatedfinancing, or staff expertise provided by a CDC,a wholly-owned or consortium CDC can helpincrease the bank’s capacity to serve low- andmoderate-income markets.

Moreover, equity investments by a larger retailbank in low-income housing limitedpartnerships would be reflected as qualifiedinvestments under the CRA regulation’sinvestment test. A bank’s loans to projectssupported by the partnership’s equityinvestments could be counted under thelending test.

Small Bank CRA Performance

Although smaller institutions are assesseddifferently under CRA than are larger banks,community development investments also canplay significant roles in enhancing small bankCRA performance. As with larger banks,smaller banks can employ communitydevelopment investments to create wholly-

owned CDCs, consortium CDCs, or they caninvest in low-income housing limitedpartnerships and other qualified communitydevelopment entities. In turn, these investmentactivities can help smaller institutions makeloans or investments that respond directly tothe small bank assessment standards that areoutlined in the CRA regulation.

For example, the loans and investments madeby a CDC in which a smaller bank participates,may be considered as lending-related activitiesin assessing the reasonableness of the bank’sloan-to-deposit ratio. The loans of a CDCowned by smaller bank can be considered inassessing whether the majority of the bank’sloans are in its assessment area. By providingadditional equity, subordinate financing orspecial loan products and services, a CDC canhelp a smaller bank make additional loans tolow- and moderate-income persons, improvethe bank’s geographic distribution of loans,and respond effectively to complaints aboutthe bank’s CRA performance.

Wholesale or Limited Purpose Banks

Under the revised regulations, the CRAperformance of a wholesale or limited purposebank is evaluated solely on the basis of acommunity development test which measuresthe bank’s community development perfor-mance. Standards include the level ofcommunity development loans, services andinvestments, the use of innovative or complexcommunity development loans and invest-ments, and the overall responsiveness of thebank to community credit and communitydevelopment needs in its assessment area(s).At the bank’s option, the activities of the bank’saffiliates, consortia and other third parties canbe considered as part of the bank’s CRAperformance.

Consequently, community developmentinvestments used to create and fund theoperations of wholly-owned CDCs, consor-tium CDCs, low-income housing limitedpartnerships and other entities, can be primaryvehicles for helping demonstrate CRAperformance. Moreover, CDCs owned orsupported by the bank can make loans andinvestments that are considered in assessing


Regulatory Treatment of Investments

projects on a safe and sound basis. The bank isthus able to make additional loans in its CRAassessment area that might not otherwise havebeen feasible.

Similarly, the investments and loans of aconsortium CDC in which a bank holdingcompany has invested can, under certaincircumstances, be allocated to one or morebanks owned by the bank holding companyfor CRA evaluation purposes, as long therequirements of the CRA regulation are met.

Overall, bank and bank holding companycommunity development investments cancontribute significantly to a bank’s CRAperformance under the standards of the revisedCRA regulations.

the bank’s CRA performance. Virtually everytype of community development investmentactivity allowed under Regulation H orRegulation Y can become part of the CRArecord of a wholesale or limited purpose bank.

Bank Holding Companies

Although bank holding companies are notevaluated under CRA, their communitydevelopment investment activities can helpsupport the CRA record of performance of theirsubsidiary banks, including larger retailinstitutions, smaller banks and wholesale orlimited purpose banks. For example, bankholding company CDCs can provide gapequity or subordinate financing that helps abank make loans for community development

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Federal Reserve Banks

State member banks and bank holdingcompanies interested in making communitydevelopment investments should consult withboth the Community Affairs Officer and theOfficer in charge of the applications processingfunction in the Supervision and Regulationdepartment of the appropriate Federal ReserveBank. They may be reached at the followingaddresses.

Federal Reserve Bank of Boston600 Atlantic AvenueBoston, Massachusetts 02106(617) 973-3000

Federal Reserve Bank of New York33 Liberty StreetNew York, New York 10045(212) 720-5000

Federal Reserve Bank of PhiladelphiaTen Independence MallPhiladelphia, Pennsylvania 19106(215) 574-6000

Federal Reserve Bank of ClevelandP.O. Box 6387Cleveland, Ohio 44101(216) 579-2000

Federal Reserve Bank of RichmondP.O. Box 27622Richmond, Virginia 23261(804) 697-8000

Appendix

Federal Reserve Bank of Atlanta104 Marietta Street, N.W.Atlanta, Georgia 30303-2713(404) 521-8500

Federal Reserve Bank of ChicagoP.O. Box 834Chicago, Illinois 60690-0834(312) 322-5322

Federal Reserve Bank of St. LouisP.O. Box 442St. Louis, Missouri 63166(314) 444-8444

Federal Reserve Bank of Minneapolis250 Marquette AvenueP.O. Box 291Minneapolis, Minnesota 55480-0291(612) 340-2345

Federal Reserve Bank of Kansas City925 Grand AvenueKansas City, Missouri 64198(816) 881-2000

Federal Reserve Bank of DallasP.O. Box 655906Dallas, Texas 75265-5906(214) 922-6000

Federal Reserve Bank of San Francisco101 Market StreetSan Francisco, California 94105(415) 974-2000

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