88-2

June 15, 1988
Dear Mr. ________:
This is in response to your letter of June 1, 1988 concerning the relationship of capital notes to lending limits as specified in Financial Code Section 1221.
As you know, the purpose of a lending limit is to ensure that a bank diversifies its risk based upon its ability to absorb losses through charges to the loss reserve and eventually the capital account. The Department has believed for many years that it is an unsafe and unsound banking practice for a bank to issue capital notes in excess of 50% of its shareholders equity as it would lead to inflated lending limits and ultimately, in some cases, to an excessive loss. In addition, capital notes are not available to absorb charge-offs nor cure capital impairments.
We do recognize that there may be situations where an amount of capital notes in excess of 50% of shareholders equity might be appropriate for a given bank. However, in those situations we insert a condition into the approval that notes exceeding 50% of shareholders equity will not be considered for capital adequacy or lending limit purposes due to safety and soundness considerations.
It appears from reviewing the ________ file that no such condition was placed on the issuance of their notes. Because the increase in lending limits is not significant in this particular case, the Department will make no objection to using the excess amount of capital notes for lending limit purposes.
Very truly yours,

JOHN PAULUS
Deputy Superintendent of Banks