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| ## Comptroller of the Currency                                        |
|                                                                       |
| > Administrator of National Banks                                     |
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Washington, DC 20219

**Interpretive Letter #990**

October 17, 2003 **April 2004**

**12 CFR 3**

Dear **\[ \]**:

This letter responds to your letter dated May 20, 2003, concerning the
capital treatment for merchant processing intangibles (MPIs). **\[ \]**
(the Bank) requested that MPIs be included in qualifying intangible
assets subject to the same limitations as purchased credit card
relationships (PCCRs) for purposes of calculating Tier 1 capital. The
OCC has concluded that the current capital treatment of MPIs is
appropriate and that the Bank should continue to deduct MPIs from Tier 1
capital and from assets in calculating regulatory capital.

## Background

Generally, goodwill and other intangible assets are deducted from Tier 1
capital.[^1] Mortgage servicing assets (MSAs), nonmortgage servicing
assets (NMSAs), and PCCRs, however, are qualifying intangible assets
and, subject to certain limits, need not be deducted from Tier 1
capital. Currently, the limit for all qualifying intangible assets is
100% of Tier 1 capital and NMSAs and PCCRs are subject to a further
sublimit of 25% of Tier 1 capital.[^2] Qualifying intangible assets are
also subject to valuation at least quarterly at the lesser of 90% of the
fair value of each intangible asset or 100% of the remaining unamortized
book value.[^3]

When the OCC amended its capital regulations in 1993, it eliminated a
three-part test for determining qualifying intangibles from the
regulatory language. The OCC indicated, however, that it would continue
to use these criteria as guidance in deciding whether to expand the list
of qualifying intangible assets. The three-part test required that:

1)  The intangible asset must be able to be separated and sold apart
    from the bank or from the bulk assets of the bank;

2)  The market value of the intangible asset must be established on an
    annual basis through an identifiable stream of cash flows, and there
    must be a high degree of certainty that the asset will hold this
    market value notwithstanding the future prospects of the bank; and

3)  The bank must demonstrate that a market exists which will provide
    liquidity for the intangible asset.

The *Comptroller's Handbook* defines the business of merchant processing
as, "The settlement of electronic payment transactions for merchants. It
is a separate and distinct business line from credit card issuing.
Merchant processing activity, which is off-balance-sheet, involves
gathering sales information from the merchant, collecting funds from the
issuing bank, and paying the merchant."[^4] Your letter indicates that a
merchant processing intangible arises when a buyer pays a premium for a
merchant processing business or a merchant contract portfolio. The
premium is based on the expected future cash flows generated by the
underlying merchant contracts.

In the fall of 2000, the OCC reviewed the appropriate capital treatment
for MPIs and determined that MPIs should continue to be deducted from
Tier 1 capital. As part of that review, the OCC concluded that MPIs did
not meet the requirements of the three-part test described above. Among
other factors, a sufficiently liquid market for these assets did not
exist.

## Discussion

The Bank has proposed that, for risk-based capital purposes, MPIs should
be treated in the same manner as PCCRs for the following reasons:

-   The merchant processing industry has matured in recent years and the
    marketability and salability of MPIs are equivalent to that of
    PCCRs.

-   MPIs are valued according to GAAP based on projected cash flows
    similar to PCCRs.

-   The Federal Reserve Board's regulations with respect to MPIs are
    unclear.

-   Deducting MPIs from Tier 1 capital puts banks at a competitive
    disadvantage with respect to non-bank competitors.

To support the proposal, the Bank provided information documenting sales
of businesses and portfolios and discussed the method used to value
MPIs. In revisiting the capital treatment for MPIs, the OCC considered
the requirements of the three-part test for separability and valuation
and sought to determine whether the market for MPIs has become
sufficiently liquid that it meets the liquidity requirement for
qualifying intangibles.

**Separability** -- Are MPIs able to be sold separately from a bank? The
Bank suggests that the number of sales of both businesses and portfolios
demonstrates that MPIs are a separately saleable asset. The Bank's data
for sales of merchant processing portfolios and businesses for 1994
through early-2003 identified numerous transactions. The Bank also
indicates that portfolios where the merchant processing is done under
the original bank's name have a higher value.

While the number of transactions suggests that merchant processing
assets can be sold separately from a bank, the OCC notes that many
portfolios are sold on a "flow" basis; i.e., the seller agrees to
generate and sell new accounts to the buyer. The OCC believes that these
continuing relationships with the seller suggest that the "separability"
provision of the three-part test may not be fully met.

**Valuation** -- Can the market value of MPIs be established through an
identifiable stream of cash flows and is there a high degree of
certainty that MPIs will hold this market value independently of a bank?
The Bank argues that the valuation issues for PCCRs and MPIs are similar
and predictable and, in both cases, are based on credit card activity.
As evidence of stable valuation, the Bank notes that estimated earnings
per share for publicly-traded merchant processors closely track actual
earnings per share and that the earnings behavior of "pure play" credit
card companies is actually less predictable and more volatile. As
further support for stable valuation, the Bank observes that current
prices for merchant processing assets range from 2.5-3.5 times net
revenue.

Pricing of merchant processing is a fairly standard process based on
projected net cash flows, but the OCC's analysis indicates that pricing
can vary widely as a multiple of net revenue. Prices vary depending on
the types and number of merchants in a portfolio, charge back and loss
rates, and attrition rates. Growing portfolios also command a higher
price than static portfolios. The OCC is also concerned about the
variability of the key underlying assumptions on which the valuation of
MPIs is based. There appear to be significant annual revisions in
attrition and revenue assumptions.

**Marketability/Liquidity** -- Does a liquid market exist for MPIs? In
2000, the market for merchant processing portfolios was comprised of 4
to 8 buyers of large portfolios and businesses and about 20 buyers of
smaller portfolios. On average, there were 4 to 6 large transactions of
over \$500 million in annual volume per year and at least 12 smaller
deals a year. Based on the information the Bank has provided, the market
today for MPIs appears to be more active than in 2000. The number of
buyers of merchant processing businesses and portfolios increased in
2001 and again in 2002.

While the market is more active, the OCC believes that the saleability
of merchant processing portfolios and businesses varies widely depending
on the degree of concentration of national merchants or types of
merchants, the existence of proprietary processing systems, and other
unique characteristics. Based on these considerations, the OCC believes
the market for MPIs does not meet the liquidity requirement of the
three-part test.

######### Conclusion

For the reasons cited above, the OCC has determined that the list of
qualifying intangible assets should not be expanded. Consequently, MPIs
should not be considered as qualifying intangibles in the calculation of
Tier 1 capital. This conclusion is based in part on the failure of MPIs
to meet the three-part test for separability, valuation, and
marketability. We have consulted with staffs of the other U.S. banking
agencies and they are in agreement with this policy.

If you have questions or need additional information, please contact
Nancy Hunt at (202) 874-5070.

Sincerely,

/s/

Tommy Snow

Director, Capital Policy

[^1]: 12 C.F.R. Part 3, Appendix A Section 2(c)(1)(i) and (ii).

[^2]: 12 C.F.R. Part 3, Appendix A Section 2(c)(2)(i).

[^3]: 12 C.F.R. Part 3, Appendix A Section 2(c)(2)(ii). 

[^4]: *Merchant Processing, Comptroller's Handbook*, December 2001, p.
    1.