[Federal Register Volume 62, Number 117 (Wednesday, June 18, 1997)]
[Rules and Regulations]
[Pages 32989-33006]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-15915]
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Rules and Regulations
Federal Register
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Federal Register / Vol. 62, No. 117 / Wednesday, June 18, 1997 /
Rules and Regulations
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NATIONAL CREDIT UNION ADMINISTRATION
12 CFR Part 703
RIN 3133-AB73
Investment and Deposit Activities
AGENCY: National Credit Union Administration (NCUA).
ACTION: Final rule.
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SUMMARY: The final regulation clarifies a number of areas, adds
restrictions on some securities which have been determined to be
inappropriate for credit unions, broadens authority in certain areas,
and requires that a credit union's staff and board of directors meet
certain safety and soundness standards with respect to the potential
risks of the credit union's investment options.
DATES: This rule is effective January 1, 1998. However, early
participation in the pilot program in Sec. 703.140 may begin on or
after July 18, 1997.
ADDRESSES: National Credit Union Administration, 1775 Duke Street,
Alexandria, Virginia 22314-3428.
FOR FURTHER INFORMATION CONTACT: David M. Marquis, Director, Office of
Examination and Insurance, (703) 518-6360, or Daniel Gordon, Senior
Investment Officer, Office of Investment Services, (703) 518-6620, or
at the above address.
SUPPLEMENTARY INFORMATION:
A. Background
In recent years there have been significant advances in modeling
and measuring the risk factors of debt instruments. During this same
period, financial market innovations severed any necessary link between
the cash flows of an instrument and its underlying collateral. Based on
these developments, which deal directly with safety and soundness
issues, NCUA has shifted the focus of Part 703 from emphasis on
specific instruments to the characteristics that affect risk management
of investment activities.
Proposed Rule
On November 16, 1995, the NCUA Board issued a proposed rule to
significantly revise Part 703. 60 FR 61219 (November 29, 1995). The
proposal (i) emphasized credit union board and staff understanding of
the potential risks associated with a credit union's investment
activities and (ii) established new procedures to value and monitor
instruments in the investment portfolio. The comment period was to have
expired on March 28, 1996, but was extended three times. 61 FR 8499
(March 5, 1996); 61 FR 29697 (June 12, 1996); 61 FR 41750 (August 12,
1996). The comment period expired on November 18, 1996.
Comments
Federal credit unions, state-chartered credit unions, corporate
credit unions, trade organizations, securities broker-dealers,
investment advisors, state credit union regulators, law firms, banks,
and individuals delivered a total of 596 comments to NCUA on the
proposed rule. A majority of the commenters supported the general
approach of the proposed rule but suggested specific changes. A sizable
minority of the commenters disagreed with substantial portions of the
proposed rule. NCUA thoroughly evaluated the comments and incorporated
many of the suggested changes into this final rule.
CMO Study
The preamble to the proposed rule noted an NCUA study of
approximately 300 credit unions with investments in collateralized
mortgage obligations (CMOs) and Real Estate Mortgage Investment
Conduits (REMICs) in excess of capital (CMO Study). The CMO Study
revealed that in 39 percent of the credit unions, credit union managers
did not fully understand and appreciate the interest rate risk of CMOs/
REMICs, 24 percent of credit unions were taking unacceptable risks, and
47 percent did not have acceptable asset-liability management policies.
A number of commenters stated that the CMO Study, by itself, did not
justify all of the proposed changes to Part 703.
NCUA notes that while the CMO Study provided important information
regarding the management and understanding of some individual
investments, it was not the primary impetus for the proposed changes.
The safety and soundness concerns raised by the prospect of continuous
innovation in the financial marketplace and increasing interest rate
risk to credit union balance sheets, together with technical
innovations that aid the analysis of risk, motivated NCUA to amend the
rule to place greater emphasis on risk management.
Final Rule
This final rule establishes parameters for risk assessment and
permits credit unions to operate flexibly within those parameters. At
the same time, it minimizes the regulatory burden on those credit
unions that choose to maintain a simple portfolio of investments.
A credit union's balance sheet risk only partially arises from its
investment activities. In fact, on average, investments constitute
approximately one-third of all credit union assets. Comprehensive risk
management should include an ongoing risk evaluation of the entire
balance sheet and appropriate asset-liability management (ALM) policies
and procedures. NCUA has decided not to develop an ALM rule at this
time because of the diversity of approaches that could be appropriate
for credit unions. Instead NCUA will evaluate a credit union's ALM
through the examination process.
An underlying premise of the regulation is that a credit union must
establish its own risk limits and measure, monitor, and control the
risks it decides to undertake. Credit unions that have the capacity for
minimal risk management will necessarily set conservative risk
parameters in order to meet the requirements of the rule. On the other
hand, credit unions that have the capacity to measure, monitor, and
control greater risks may set broader parameters.
Many credit unions will, as part of their standard business
practice, establish policies and procedures which properly go beyond
the minimum requirements of this rule. In fact, one of the primary
conclusions of the six focus groups conducted in the early stages of
development of the rule was that the rule reflected sound business
principles and would impose little additional burden on most credit
unions.
[[Page 32990]]
Format
Although the proposed rule was written in the traditional
regulatory format, this final rule uses plain language drafting
techniques that have been promoted by the Vice President's Regulatory
Reinvention Initiative. The goal of plain language drafting is to
decrease confusion, inadvertent errors, the need to seek clarification
in correspondence and phone calls, and the amount of staff time credit
unions must devote to understanding the regulations. Plain language
drafting emphasizes the use of informative headings (often written as a
question), lists and charts where appropriate, sections and paragraphs,
non-technical language (including the use of ``you''), and sentences in
the active voice. This final rule is written as a series of questions
and answers, asked by a federal credit union and answered by NCUA. The
words ``I'' in a question and ``you'' in an answer refer to a federal
credit union. Occasionally, the regulation refers to ``you'' performing
some action in relation to ``your'' board of directors. This should be
read as a credit union's staff and/or management performing the action
in relation to the credit union's board.
One plain language drafting technique is to move definitions away
from the beginning of a regulation, to avoid bombarding the reader with
terms for which there is no context. In this final rule, a number of
definitions have been moved to the end of the part, and others to where
the term is used.
Although commenters did not have the opportunity to express
opinions on the plain language format prior to its use in this final
rule, NCUA believes that the benefits of using the format justify this
omission. NCUA welcomes comments on the format, however, and
suggestions on how to improve it. NCUA is committed to converting more
of its regulations to the plain language format in order to reduce
regulatory burden and notes that the recently issued proposed rules
governing credit union service organizations, 62 FR 11779 (March 13,
1997), and production of nonpublic records and testimony of NCUA
employees in legal proceedings, 62 FR 19941 (April 24, 1997), and an
upcoming proposed rule governing member business loans use plain
language drafting.
B. Section-by-Section Analysis
Section 703.10 What Does Part 703 Cover?
The proposed rule deleted some sentences in the scope section as
unnecessary, and added the provision that Part 703 does not apply to
corporate credit unions. Investment activities of corporate credit
unions are governed by Part 704. The proposed rule, however, did not
change the format of the section. To improve readability, this final
rule divides the section in two, with Section 703.10 addressing what
Part 703 does cover and Section 703.20 addressing what it does not
cover. The language in Section 703.10 is a slight rewording of the
first two sentences in the scope section of the proposed rule to
provide further clarification, with no change in meaning intended.
Section 703.20 What Does Part 703 Not Cover?
In the scope section of the proposed rule, the clauses addressing
the activities and entities not covered by Part 703 follow one another
as part of one dense paragraph. To improve readability, Section 703.20
of this final rule sets out each activity or entity separately.
As noted above, the proposed rule added the provision that Part 703
does not apply to corporate credit unions. The preamble explained that
the investment activities of corporate credit unions are governed by
Part 704 of NCUA's regulations. There was no objection to this
proposal, and it has been retained in the final rule.
One commenter suggested that the rule should expressly state that
Part 703 does not apply to state-chartered credit unions. NCUA agrees
and has added paragraph (f) to Section 703.20. That paragraph states
that Part 703 does not apply to state-chartered credit unions, except
as provided in Section 741.3(a)(3) of NCUA's regulations. Under Section
741.3(a)(3), a state-chartered credit union must establish a separate
reserve if it invests in instruments not permitted for federal credit
unions by Part 703 or the Federal Credit Union (FCU) Act. In a limited
sense, therefore, Section 703.110, which sets forth activities that are
prohibited for federal credit unions, ``applies'' to state-chartered
credit unions. Paragraph (f) clarifies, however, that the other
requirements of Part 703 do not apply to state-chartered credit unions.
Section 703.30 What Are the Responsibilities of My (a Federal Credit
Union's) Board of Directors?
Section 703.3(a) of the proposed rule expanded on the current
rule's requirements regarding investment policies. Section 703.3(b) of
the proposed rule established a new list of required investment
practices. This final rule divides policies and practices into two
sections; Section 703.30 addresses policies and Section 703.40
addresses practices. In addition, the final rule modifies many of the
specific policies and practices that were proposed. Of the commenters
who addressed this section generally, most agreed with the need to have
investment policies.
Purposes and Objectives of Investment Activities
Proposed Section 703.3(a)(1) required that the board of directors
state in the credit union's policies the purposes and objectives of the
credit union's investment activities. The intent was that the policy
provide a clear statement of the credit union's investment goals. For
example, a credit union's primary goals may be to minimize risk,
provide liquidity, and generate a reasonable rate of return. The
emphasis placed on each goal will vary based on individual credit union
constraints or needs. NCUA received no comments on this provision and
has retained it in Section 703.30(a) of the final rule.
Characteristics of Authorized Investments
Proposed Section 703.3(a)(2) required that a credit union's
investment policy set out the investments that the credit union may
make, by issuer and characteristics. The definitions section of the
proposed rule defined an investment characteristic as a feature of an
investment such as its maturity, index, cap, floor, coupon rate, coupon
formula, call provision, or average life. The preamble stated that a
policy could, for example, authorize investments issued or guaranteed
by the U.S. Treasury, the Federal Home Loan Mortgage Corporation, and
the Federal National Mortgage Association, or could limit investments
to instruments with a maximum maturity of 5 years, or those with a
fixed coupon, or those tied to a particular index. A few commenters
expressed concern that the requirement was too restrictive and would
not allow management sufficient flexibility in making investment
decisions.
NCUA did not intend for boards to specify the parameters of each
approved investment. The intent was for boards to establish guidelines
for investment characteristics. NCUA believes that it is imperative for
a board, which sets the overall ALM strategy for the credit union, to
set investment guidelines and risk parameters that are consistent with
that strategy. Further, for the guidelines to be meaningful, they must
be fairly specific. Therefore, the requirement has been retained in the
final rule, at Section 703.30(b). The language has been modified,
however, to clarify that
[[Page 32991]]
the issuer is another type of characteristic.
The following additional examples may prove helpful in illustrating
the types of policy statements that NCUA might see boards establish: 3-
year bullets (securities that make one principal payment at maturity)
with a fixed coupon; variable rate securities linked to the 3-month
Treasury bill yield or U.S. dollar-denominated LIBOR that, at the time
of purchase, are at least 300 basis points below their cap; and fixed
rate federally insured deposits of one year or less. With respect to
the last, NCUA would not view as necessary that the policy go on to
list specific authorized depository institutions.
As an alternative to the type of limits discussed above, or in
addition to such limits, a board could specify acceptable interest rate
risk for individual investments. For example, a policy could restrict
the credit union to purchasing instruments that are predicted to
experience a price change of less than a certain percentage for an
immediate and sustained parallel shift in the yield curve of a certain
amount. A credit union choosing this approach must be confident it has
the methodology to assess this potential risk.
Interest Rate Risk
Section 703.3(a)(3) of the proposed rule required credit unions to
develop policies on interest rate risk management. One commenter noted
that the rule did not define ``interest rate risk.'' Stated in the
broad context of ALM, interest rate risk is the exposure of a credit
union's current and future earnings and capital arising from adverse
movements in interest rates. Changes in interest rates affect a credit
union's earnings by changing its net interest income and the level of
other interest-sensitive income and operating expenses. Changes in
interest rates also affect the underlying economic value of the credit
union's assets, liabilities, and off-balance sheet items. These changes
occur because the present value of future cash flows, and in many cases
the cash flows themselves, change when interest rates change. The
combined effects of the changes in these present values reflect the
change in the credit union's underlying economic value as well as
provide an indicator of the expected change in the credit union's
future earnings arising from the change in interest rates. While
interest rate risk is inherent in the role of credit unions as
financial intermediaries, a credit union that has a high level of risk
can face diminished earnings, impaired liquidity and capital positions,
and, ultimately, greater risk of insolvency.\1\
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\1\ This discussion of interest rate risk comes from a joint
agency policy statement on interest rate risk issued by the Office
of the Comptroller of the Currency, the Board of Governors of the
Federal Reserve System, and the Federal Deposit Insurance
Corporation in May 1996. See 61 FR 33166, 33167 (June 26, 1996).
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Since this rule is limited to investment activity, it only
addresses interest rate risk in the investment portfolio. Several
commenters observed that a credit union should manage interest rate
risk through its ALM policies and procedures, which additionally take
into account its loan portfolio and liabilities. NCUA recognizes that
interest rate risk can be more fully evaluated this way but, for
reasons discussed in the background section of this preamble, has
decided to limit the rule to investments. A credit union with an ALM
policy that addresses interest rate risk across the balance sheet,
however, need not establish a separate policy addressing interest rate
risk in the investment portfolio.
No commenters objected to the requirement that a credit union
develop a policy on how it will manage interest rate risk in its
investment portfolio, and the requirement has been retained in Section
703.30(c) of the final rule. Based on the comments and further NCUA
discussion, a sentence has been added requiring that a credit union's
interest rate risk management policy establish the amount of risk that
the credit union can take with its investments in relation to its net
capital and earnings.
A credit union's interest rate risk policy must be commensurate
with the scope, size, and complexity of the risks the credit union
assumes. The policy of a credit union with a simple portfolio and
conservative risk parameters might specify that net capital, earnings,
or investment income, may not vary by more than a certain percentage
for a parallel shift in interest rates. The policy of a credit union
with a complex portfolio, however, might also set limits that reflect
changes in the shape of the yield curve, credit spreads, prepayment
patterns, and volatility.
Liquidity Risk
Section 703.3(a)(6) of the proposed rule required credit unions to
develop policies on liquidity risk management. Liquidity risk is the
risk that a credit union will have insufficient liquid assets to meet
immediate cash demands. A liquid asset is one that can be converted
quickly into cash with minimal loss. The intent was that the board
assess the potential for cash demands, document how it arrived at this
assessment, and establish a liquidity policy that will enable it to
meet the demands. Only one commenter opposed the requirement, and it
has been retained in the final rule, in Section 703.30(d).
In assessing the potential for immediate cash demands, credit
unions may use a simple estimate, based upon the history of prior cash
flows. Credit unions also may use a more elaborate approach. Two
commenters suggested that the occasional, temporary use of alternative
balance sheet funding sources (short-term borrowing) is a reasonable
part of liquidity management. NCUA does not disagree but emphasizes
that borrowing should be part of a well thought-out liquidity plan.
Credit Risk
Section 703.3(a)(7) of the proposed rule required credit unions to
develop policies on the management of credit risk, including approved
issuers, or criteria for issuers, and limits on the amounts that may be
invested with each issuer. As noted in the preamble to the proposed
rule, a credit union may rely on credit ratings to manage credit risk.
However, boards should be aware that ratings may fail to timely reflect
a creditor's deteriorating ability to repay its obligations and is only
one source of credit information. A credit union without the ability to
evaluate credit risk may choose to limit its investments to those that
are fully guaranteed or insured. The provision is located at Section
703.30(e) of the final rule.
Concentration Risk
Section 703.3(a)(4) of the proposed rule required credit unions to
set concentration limits in their investment policies. The preamble
stated that the board must develop concentration limits for, among
other things, shares and deposits in corporate credit unions. The
commenters generally supported the requirement to establish
concentration limits, but a number asked whether NCUA would continue
its policy of not taking exception to credit unions placing 100 percent
of their investments in corporate credit unions. Examiners will not
automatically object to 100 percent concentration in a corporate credit
union, but will require all but the smallest credit unions investing
more than the insured amount in a corporate to perform an appropriate
credit analysis. The scope of credit analysis for investments in
corporates and other institutions and issuers is addressed in the
discussion of credit analysis under Section 703.40(e).
[[Page 32992]]
Concentrations can increase a credit union's vulnerability to
unforeseen market, credit, and liquidity risks. Each credit union must
evaluate concentration risk in relation to its financial condition and
its ability to analyze the risks of all investments. The provision is
located at Section 703.30(f) of the final rule.
CMO/REMIC Prepayment Models
Section 703.3(a)(5) of the proposed rule directed credit unions to
identify in their investment policies the specific CMO/REMIC prepayment
models they would use when performing the tests required to purchase or
hold CMOs/REMICs. This was to control the practice of selecting the
prepayment model that would allow a particular CMO/REMIC to pass the
tests. The preamble noted that each credit union had the flexibility to
choose the prepayment models it believed were the best measures of
potential risk, as long as they were reasonable and supportable.
One commenter stated that NCUA should specify which models are
permissible and accept the fact that models are imperfect and will
sometimes give different results.
Since the forecasting of prepayments is an evolving science, NCUA
prefers to leave to each credit union the decision as to which models
it will use. For consistency, it is essential that a credit union use
the same models for testing all CMOs/REMICs.
This final rule moves some material that was in the CMO/REMIC
testing section to the policy section. It clarifies that a credit union
board's first policy decision will be whether the credit union will use
a median prepayment estimate or individual, proprietary estimates. Once
that determination is made, the credit union may use only that method.
If the choice is to use a median estimate, the board then must
determine the source of that estimate, whether it be Bloomberg or
another similar source. If the choice is to use individual estimates,
the board then must determine the sources of those estimates. In
response to a comment, the final rule uses the less confusing term
``prepayment estimate'' rather than ``prepayment model.'' Finally, in
response to a comment, the final rule clarifies that a board must set
policies for prepayment sources for CMO/REMIC testing only where it has
authorized the purchase of CMOs/REMICs. The provision is located at
Section 703.30(g) of the final rule.
Investment Authority
Section 703.3(a)(8) of the proposed rule required a credit union to
state in its investment policy the persons in the credit union to whom
investment authority was delegated, the knowledge and experience
required of such persons, and the extent of their authority. The
provision also stated that this requirement could be met by the board's
approval of position descriptions that address the same criteria. In
addition to this policy requirement, Section 703.3(b)(2)(i) of the
proposed rule required that a credit union follow certain practices
regarding investment authority. It stated that any official or employee
of a credit union who had discretionary investment authority had to
``demonstrate'' an understanding of the risk characteristics of
investments and investment transactions under that authority. It
provided that only a credit union's officials, employees, and members
could be voting members of its investment and/or asset-liability
management committees. Finally, it explicitly affirmed that the
ultimate responsibility for supervising a credit union's investment
activities rested with the board of directors.
There was some confusion regarding the burden that would be imposed
on directors with respect to understanding the risk of authorized
investments. It was never NCUA's intention to require volunteers to
understand all of the factors that affect the risks of each instrument.
This appropriately remains the responsibility of the individuals to
whom investment authority has been delegated. It is the responsibility
of the board, however, to set policy limits, approve procedures,
understand the overall risks associated with the investments, and
receive reports assessing whether the portfolio has remained within
established limits.
The final rule combines proposed Sections 703.3(a)(8) and
703.3(b)(2)(i) into a policy requirement at Section 703.30(h). That
provision requires the investment policy to specify who, of the credit
union's officials and employees, has investment authority and the
extent of that authority. The final rule does not explicitly provide
that the requirement may be met by approving appropriate position
descriptions. NCUA omitted the provision because it was unnecessarily
detailed and might suggest that there was no other way to meet the
requirement. It remains a permissible way to meet the requirement.
Section 703.30(h) also states that individuals given investment
authority must be professionally qualified, by education and/or
experience, to exercise that authority in a prudent manner and to fully
comprehend and assess the risk characteristics of investments and
investment transactions under that authority. Rather than requiring
that persons with investment authority ``demonstrate'' an understanding
of the risk characteristics of the investments under that authority,
the final rule simply requires that they be qualified to exercise that
authority. It is the responsibility of the board to ensure such
qualification.
Section 703.30(h) states that only a credit union's officials and
employees may be voting members of a credit union's ``investment-
related committee.'' Credit unions use a variety of terms for the
committee that is primarily concerned with investments. The proposed
rule used ``investment committee,'' ``asset-liability management
committee,'' or a combination of the two. To avoid inadvertently
excluding a committee with a different name, the final rule uses the
term ``investment-related committee'' throughout.
The final rule also does not include ``member'' in the list of
individuals who can be voting members of that committee. The proposed
rule intended to allow credit union members who serve on such
committees to be able to vote. To lessen confusion, however, the final
rule redefines ``official'' to include a member of a credit union's
investment-related committee.
Finally, Section 703.30(h) does not contain the statement that the
ultimate responsibility for supervising a credit union's investment
activities rests with the board. It is not necessary to make the
statement in the regulation, as Section 113(6) of the FCU Act, 12
U.S.C. 1761b(6), provides that a federal credit union's board of
directors shall have charge of investments.
Broker-Dealers
Section 703.3(a)(9) of the proposed rule required that a credit
union's investment policy list approved broker-dealers and limits on
the amounts and types of transactions for each. The preamble noted that
although the proposal did not require approval of more than one broker-
dealer, reliance on a single individual or firm could be
disadvantageous to the credit union. A credit union might choose to
approve one broker-dealer for the full range of its investment
activities and another for only certain of the investments authorized
by policy. For example, the credit union may permit one broker, with
more limited knowledge, to sell to
[[Page 32993]]
the credit union only Treasury securities with less than 1 year
maturity, while permitting another, with more knowledge and ability, to
sell longer term securities or securities with embedded options issued
by U.S. government agencies, as well as Treasury securities. The
preamble stated that details for these authorizations should be
established by policy.
In response to comments, NCUA has deleted the language regarding
establishing limits on the amounts and types of transactions. In
addition, Section 703.30(i) of the final rule clarifies that the
requirement to list approved broker-dealers applies only if the credit
union uses third parties to purchase or sell investments. A credit
union could purchase an investment without using a third party by, for
example, obtaining a certificate of deposit (CD) directly from a bank
or a Treasury security through the Treasury Direct program. The final
rule defines any such third party as a ``broker-dealer,'' even if that
third party only buys and sells investments that do not meet the formal
definition of ``security,'' such as CDs. Section 703.30(i) also
requires that the credit union maintain the documentation the board
used to approve a broker-dealer as long as the broker-dealer is
approved and until the documentation has been both audited and
examined. That requirement was located at Section 703.3(b)(10) of the
proposed rule.
Safekeeping
Section 703.3(a)(10) of the proposed rule required that a credit
union's investment policy list approved safekeeping entities and limits
on the amounts and types of investments that could be safekept with
each entity. In response to comments, NCUA has deleted the language
regarding amounts and types of investments and the requirement to
maintain documentation used to approve a safekeeper. Section 703.30(j)
of the final rule clarifies that the requirement to list approved
safekeepers applies only if a credit union uses such entities. Also in
response to comments, NCUA wishes to make clear that corporate credit
unions may serve as safekeepers.
``Failed'' Investments
Section 703.4(b)(3) of the proposed rule required that management
notify the board by the next board meeting of any investment that,
because of changing market conditions, falls outside of board policy
after purchase. The proposed rule also created an entire section,
Section 703.7, which established divestiture requirements for a credit
union holding an investment that, because of a credit downgrade or
failure to meet an interest rate shock test, no longer meets regulatory
mandates. Many commenters stated that the proposed requirements,
particularly those regarding ``failed'' investments, preempted the
board's right to establish its own policies in those areas.
NCUA has determined to retain only a few simple requirements for
investments that fail board policy or part 703. They are contained in
Section 703.40(f) of the final rule. Other than these, Section
703.30(k) requires that the board establish its own policies for such
investments.
Trading
Section 703.3(a)(11) of the proposed rule required that a credit
union establish trading policies, if it engages in trading. The
provision listed a number of items that the policies should address. In
1987 NCUA issued Letter to Credit Unions No. 89, which discussed
trading activities. This Letter is still effective. No significant
comments having been received on this provision, it is retained in the
final rule, at Section 703.30(l).
Section 703.40 What General Practices and Procedures Must I Follow in
Conducting Investment Transactions?
As noted earlier, Section 703.3(b) of the proposed rule established
a list of required investment practices. Those practices, many of which
have been modified, are found in Section 703.40 of this final rule.
Classification of Securities
Section 703.3(b)(1) of the proposed rule required that a credit
union classify securities in accordance with generally accepted
accounting principles (GAAP). The applicable principle is Statement of
Financial Accounting Standard (SFAS) 115. The preamble stated that
deposits and shares in depository institutions are not securities and
are not subject to SFAS 115. In response to comments, NCUA notes that
the Financial Accounting Standards Board has stated that jumbo CDs may
meet the definition of security and may be subject to SFAS 115. A
credit union should review the relevant disclosure documents to
determine whether a CD meets the definition of security. The
classification provision has been retained in the final rule, at
Section 703.40(a).
Delegation of Discretionary Investment Authority
Section 703.3(b)(2)(ii) of the proposed rule established a general
prohibition against delegating discretionary control of investment
authority to a person other than an official or employee of the credit
union. However, proposed Section 703.3(b)(2)(iii) permitted a credit
union to delegate such control to an investment adviser who is
registered with the Securities and Exchange Commission (SEC) under the
Investment Advisers Act of 1940. Proposed Section 703.3(b)(2)(iii)
limited the total of a credit union's delegation of discretionary
investment control and investment in mutual funds to 100 percent of
capital.
The commenters strongly opposed the limitation on delegation of
discretionary investment control, particularly the inclusion of
investments in mutual funds in that limitation. Some of the concern
stemmed from confusion over the concept of ``delegation of control.''
Although Section 703.3(b)(2)(ii) stated that control was not considered
delegated if the credit union authorized each purchase and sale,
several commenters thought that a traditional relationship with a
broker-dealer was included in the concept. A credit union has not
delegated discretionary investment control where its broker-dealer
recommends purchases and sales but does not act until it has received
the credit union's approval for the specific transaction. Likewise, if
a credit union is receiving investment advice from an investment
adviser but is still approving each purchase and sale, it has not
delegated discretionary investment control.
For example, if a broker proposed that a credit union purchase a
specific security, and the credit union authorized the purchase, the
credit union has not delegated discretionary control. On the other
hand, if a broker informed a credit union that CMOs/REMICs with 2-year
weighted average lives looked like good investments, and the credit
union responded that the broker should purchase one that ``looks
good,'' the credit union has delegated discretionary control.
NCUA has determined to retain the general prohibition against
delegation of discretionary investment control, except under certain
conditions. Section 703.40(b) establishes the prohibition, and Section
703.40(c) establishes the conditions under which delegation is
permitted. No commenters objected to the proposed requirement that
delegations of discretionary control be limited to investment advisers
registered with the SEC, and it has been retained in paragraph (c)(1).
Paragraph (c)(2) makes explicit what is a part of normal business
practices; that is, analyzing a potential investment adviser's
background.
[[Page 32994]]
Section 703.3(b)(2)(iii) of the proposed rule restricted how an
investment adviser could be compensated, to keep his or her interest
allied with that of the credit union. Several commenters suggested that
the provision be modified to make it clear that there are no
restrictions on compensating a registered investment adviser who does
not have discretionary investment control. NCUA agrees and has made the
change. The provision is located at paragraph (c)(3) of Section 703.40.
Proposed Section 703.3(b)(2)(v) required that investments under the
discretionary control of an investment adviser be classified as either
available-for-sale or trading. One commenter was opposed to this
provision, but NCUA continues to believe it is necessary and has
retained it, at paragraph (c)(4) of Section 703.40. Paragraph (c)(5)
codifies what should be a part of normal business practices, that is
receiving a monthly statement from an adviser.
Finally, as noted above, proposed Section 703.3(b)(2)(iii) limited
the total of a credit union's delegation of discretionary investment
control and investment in mutual funds to 100 percent of capital. In
response to the commenters' concerns, NCUA has determined not to
include investments in mutual funds in the limitation. Also in response
to the comments, NCUA has clarified that the limitation is the
aggregate of a credit union's delegation of discretionary control, that
is, regardless of the number of investment advisers a credit union
uses, it may delegate discretionary control over the portion of its
investment portfolio that represents 100 percent of its capital. This
provision is located at paragraph (c)(6) of Section 703.40. NCUA notes
that whenever a credit union uses any third party, such as investment
adviser, broker-dealer, or safekeeper, to carry out investment
transactions on its behalf, it must ensure that the third party
complies with the restrictions of Part 703 and the FCU Act. This could
be accomplished through written agreement with the third party.
Credit Analysis
Section 703.3(b)(6) of the proposed rule required credit unions to
perform credit analyses of issuing entities unless the investment is
issued or guaranteed by the U.S. government or is covered by share or
deposit insurance. Recognizing that it often is difficult for credit
unions to perform detailed credit analyses, the proposed rule
established a minimum rating of B/C for financial institutions that are
rated. The preamble noted that credit unions should perform credit
analyses for uninsured investments in nonrated financial institutions,
including corporate credit unions.
A number of commenters expressed concern regarding the proposed
requirements, particularly credit analyses of corporate credit unions.
They argued that credit analyses were too burdensome and that credit
unions should be permitted to rely entirely on ratings. Many wondered
how credit analyses of corporate credit unions could be conducted,
while others believed it was not necessary, since corporate credit
unions are examined by NCUA.
NCUA recognizes that a small credit union may be unable to perform
a detailed credit analysis. For a small credit union, investing funds
in corporate credit unions is an appropriate risk management
alternative to investing in securities. NCUA will not take exception to
a small credit union investing all of its surplus funds in a corporate
credit union.
NCUA expects a larger credit union, however, to perform a credit
analysis whenever there is credit risk. The uninsured portion of an
investment in a corporate credit union presents such risk. NCUA
supervises corporate credit unions and is primarily concerned with
their safe and sound operations and adherence to applicable laws,
rules, and regulations. This supervision does not serve as a guarantee
of the investment products a corporate credit union may offer, nor as
assurance against potential loss.
A credit union's membership relationship with its corporate should
assist it in evaluating the corporate's operations and financial
condition. A credit union should review the corporate credit union's
earnings performance, capital level, and investment portfolio. A credit
union also should be aware of the corporate's operating level under
Part 704 and its exposure to a 300 basis point shift in interest rates.
In addition to uninsured investments in corporate credit unions,
investments with credit risk include uninsured CDs, federal funds, bank
notes, municipal securities, and repurchase transactions. As with
investments in corporate credit unions, a credit union must conduct a
credit analysis of these other investments that is commensurate with
the risk of the exposure. The analysis should include a review of
capital, ratings, financial trends, earnings, and loan losses. While
the proposed rule required that this analysis be updated semiannually,
the final rule requires only an annual update. The final rule, located
at Section 703.40(d), also does not establish a minimum financial
institution rating. The commenters noted that the ratings from the
various rating agencies are not consistent and that too many
institutions are unrated.
``Failed'' Investments
As noted above in the discussion of Section 703.30(k), the proposed
rule required board notification of investments that fall outside of
board policy after purchase and also established divestiture
requirements for investments that fail the regulation. In response to
comments, NCUA determined to retain the board notification requirement
for investments failing board policy and to eliminate all of the
requirements for investments failing the regulation except board and
NCUA notification. These requirements are located at Section 703.40(e)
of the final rule. To the extent that Section 703.40(e) conflicts with
Letter to Credit Unions No. 169, governing CMOs/REMICs that fail the
stress test, the Letter is superseded. Credit unions should not
interpret the removal of specific divestiture requirements from the
final rule as NCUA's tacit approval to hold a failed investment
indefinitely. On the contrary, NCUA will continue to review the safety
and soundness of failed investments to determine whether divestiture is
necessary. As always, instruments that were impermissible when
purchased may be subject to immediate divestiture.
Documentation
Proposed Section 703.3(b)(10) required that documentation be
maintained through the examination and audit cycles. The preamble noted
that there had been instances where credit unions failed to maintain
enough documentation for the examiner and auditor to properly analyze
the security or determine the relationship of the investment decisions
to the credit union's policies. There were few comments on this
section, and it has been retained in the final rule, at Section
703.30(f). A credit union must maintain sufficient information to
demonstrate that it has exercised prudent judgment in making investment
decisions.
Section 703.50 What Rules Govern My Dealings With Entities I Use To
Purchase and Sell Investments (``Broker-Dealers'')?
Section 703.3(b)(7) of the proposed rule required that any broker-
dealer used by a credit union be either a federally regulated
depository institution or registered with the Securities and Exchange
Commission
[[Page 32995]]
(SEC). The proposed rule also required that credit unions conduct an
analysis of the financial condition and reputation of the broker-dealer
and sales representative. The comments on this section were mixed, with
some in favor of the proposed requirements and others objecting that
they were too burdensome. NCUA continues to believe that credit unions
should do business only with broker-dealers that meet a certain minimum
standard of conduct and has retained the requirement. This means that
even when purchasing a CD through a broker who only sells CDs, the
broker must be either registered with the SEC or a federally regulated
depository institution.
NCUA also believes that credit unions should exercise due diligence
in determining whether to transact business with a broker-dealer and/or
sales representative. As an additional control, a credit union should
consider prohibiting any official or employee with discretionary
investment authority from maintaining a personal account with the same
sales representative that the credit union uses. If the broker-dealer
acts as a credit union's counterparty in transactions, introducing
credit risk, the credit union must increase its level of due diligence.
Section 703.60 What Rules Govern My Safekeeping of Investments?
Section 703.3(b)(8) of the proposed rule established new
safekeeping requirements for credit unions. It required that a credit
union maintain its securities independently of its broker-dealer and
that it receive a safekeeping receipt for each investment held in
safekeeping. It permitted an investment to be held in street name as
long as the credit union and/or safekeeper maintain documentation
establishing that the credit union is the beneficial owner of the
investment. It required a credit union to review the financial
condition of approved safekeepers at least annually and that purchases
and sales be ``delivery versus payment,'' where payment for an
investment occurs simultaneously with its delivery.
In response to comments, NCUA has eliminated the requirement to
obtain safekeeping receipts, the requirement to review the financial
condition of approved safekeepers, and the language regarding street
name. A credit union may permit investments to be held in the name of a
broker or nominee and should maintain documentation showing that it is
the true owner of the investments. The credit union should be listed as
owner on the individual confirmation statements and monthly safekeeping
statements required by the final rule.
The proposed requirement for investments to be held by a safekeeper
under a written custodial agreement has been retained in the final
rule. In response to comments, however, NCUA wishes to clarify that the
provision does not require that the agreement be between the credit
union and the custodian. The agreement may be between the broker and
the custodian, although in that case, the credit union should obtain a
copy.
Section 703.70 What Must I Do to Monitor My Non-Security Investments
in Banks, Credit Unions, and Other Depository Institutions?
One of the challenges of this rule was establishing criteria to
ensure that credit unions with portfolios of securities know the risks
of those instruments, while permitting credit unions that restrict
their investments to CDs and corporate credit union deposits to do so
without undue burden, even though those instruments can present some
credit and interest rate risk. Sections 703.3 (b)(4) and (b)(5) of the
proposed rule required credit unions to perform certain actions to
value and monitor their securities. The GAAP definition of ``security''
includes marketable instruments such as Treasuries, agencies, mortgage
backed instruments, and as previously discussed, certain jumbo CDs. The
only monitoring provision that addressed investments that were not
securities, such as ordinary CDs and corporate deposits, was at
proposed Section 703.3(b)(4)(ii)(A), which required credit unions to
prepare monthly reports listing the characteristics of each investment
held.
Some commenters expressed concern that the requirements for
securities also applied to ordinary CDs and corporate deposits. This
final rule maintains the proposed rule's distinction between
``securities'' and ``investments,'' but to make it clearer that a
credit union that chooses to invest only in ordinary shares and
deposits need not worry about the requirements for securities, this
final rule establishes a separate section for investments in depository
institutions that do not constitute securities. Further, the regulatory
burden itself has been reduced. Section 703.70 requires a credit union
to list, quarterly rather than monthly, the dollar value of only those
non-security shares or deposits that have embedded options, remaining
maturities greater than 3 years, or coupon formulas related to more
than one index or inversely related to, or multiples of, an index. A
credit union's board should be aware of the potential risk of shares or
deposits with these characteristics.
Section 703.80 What Must I Do to Value My Securities?
Proposed Section 703.3(b)(5)(i) required that before purchasing or
selling a security, a credit union obtain a price quotation from a
second broker or from an industry-recognized information provider. The
preamble noted that credit unions have been known to pay or receive
prices that were significantly different from market prices because
their brokers knew they were not verifying prices with other sources.
A number of commenters objected to the requirement to obtain a
second price, arguing that it was burdensome and unrealistic. NCUA
continues to believe that it is imperative for credit unions to ensure
that they know the market prices of the securities they buy and sell,
and has retained the requirement, at Section 703.80(a). Again, to
minimize burden, the rule allows a credit union to obtain a second
price from an industry-recognized information provider. This may be an
electronic service that provides market information (Bloomberg,
Reuters, etc.) or a newspaper of general and regular circulation (Wall
Street Journal, New York Times, etc.). NCUA recognizes that prices from
information providers are indicative only, but they should show whether
a broker's price is reasonable. To further reduce burden, and in
response to comments, an exception has been added for new issues
purchased at par.
The rule does not require that the credit union use the broker with
the best price. NCUA understands that a credit union can receive
ancillary services from a broker that are not reflected in fees, and a
credit union may choose to compensate the broker by occasionally
accepting a poorer price than that available from another broker.
However, credit unions should be aware of the implicit cost of these
services. Therefore, as discussed earlier, Section 703.40(g) requires
that a credit union document the prices it pays or receives for
securities. NCUA understands that prices received from broker-dealers
generally will not be in writing; however, the credit union should
document who was called, the date and time of the call, and the quoted
price or spread to the relevant security. A phone note with the
identified information would meet this requirement.
Proposed Section 703.3(b)(5)(ii) required a monthly review of the
fair value of each security in a credit union's
[[Page 32996]]
portfolio. The preamble noted that this information generally is
provided by broker-dealers or safekeepers. There was virtually no
opposition to this requirement, and it has been retained in the final
rule, at Section 703.90(b).
To ensure some independent verification of a broker's or
safekeeper's prices, proposed Section 703.3(b)(5)(iii) required credit
unions to obtain semi-annual prices on their securities from another
broker or an industry-recognized information provider. In response to
comments, Section 703.80(c) of the final rule simply requires a credit
union's supervisory committee to comply with existing auditing
standards and annually assess the reliability of prices received from a
broker or safekeeper. Credit unions or their auditors should refer to
the practices and procedures discussed in the investments chapter of
the American Institute of Certified Public Accountants guide Audits of
Credit Unions.
Proposed Section 703.3(b)(5) provided, throughout, that where a
credit union could not obtain the price of a particular security, it
could obtain the price of one with substantially similar
characteristics. Rather than repeating this each time a price is
required, Section 703.80(d) of the final rule states it generally.
Section 703.90 What Must I Do to Monitor the Risk of My Securities?
Monthly Report
Proposed Section 703.3(b)(4)(ii) (A) and (B) required a federal
credit union to prepare a monthly report showing the characteristics of
each investment in the portfolio and the change in the fair value or
total return of each security since the date of purchase and for the
last month. In response to comments, NCUA has eliminated the
requirement to list the characteristics of each investment each month.
In addition, since several commenters were confused about the total
return concept, NCUA has deleted all references to total return from
the rule, although credit unions may choose to calculate it in addition
to fair value.
A number of commenters questioned the need to calculate the fair
value of securities classified as hold-to-maturity. NCUA has determined
to retain the requirement for a credit union to report the fair value
and dollar change since the prior month-end of all its securities,
since those changes can affect future earnings. For example, in a
rising interest rate environment, with rate-sensitive members, a credit
union may be compelled to increase its share rates. A credit union with
fixed coupon investments experiences no equivalent increase in interest
income. The resulting decline in earnings occurs regardless of whether
the securities are classified as hold-to-maturity or available-for-
sale. Therefore, it is important for the investment-related committee
and board to know what has happened to the value of all those
securities. The requirement is located at Section 703.90(a) of the
final rule. A credit union that chooses to keep all of its investments
in CDs and corporate credit union shares and deposits is not required
to price its investments and therefore is not subject to the
requirement.
Quarterly Report
Proposed Section 703.3(b)(4)(ii)(C) required a credit union to
calculate, quarterly, the value of securities that NCUA determined
represented greater potential interest rate risk. They were: (1)
Securities that amortize; (2) securities with embedded options; (3)
securities with maturities greater than 3 years; and (4) securities
where contract rates are related to more than one index or are
inversely related to, or multiples of, an index.
In response to comments, NCUA has removed amortizing securities
from the list, located at Section 703.90(b) of the final rule. Most
amortizing securities that represent greater potential interest rate
risk will be included because they contain embedded options. NCUA
includes all securities with embedded options because even put
provisions and interest rate floors can affect the price of a security
independent of actual changes in interest rates. To be consistent with
market terminology, NCUA also has changed the term ``contract rate'' to
``coupon formula.''
A number of commenters urged that the maturity threshold be
extended to 5 years, to be consistent with the definition of risk asset
in Section 700.1(i) of the NCUA Rules and Regulations. NCUA notes that
the proposed requirement and the risk asset regulation have different
purposes and effects. The classification of a security as a risk asset
under Section 700.1(i), results in a credit union having to transfer
additional income to reserves under Section 116 of the FCU Act. In
contrast, the only result of classifying a security as representing
greater potential risk under Part 703 is that a credit union might have
to test its securities to gain important information about the interest
rate risk on its balance sheet. NCUA believes that significant risk
would be missed by failing to include securities with maturities from 3
to 5 years in the category that could trigger testing requirements and
has determined to leave the threshold at 3 years. NCUA has clarified,
however, that maturity means remaining maturity.
Several commenters suggested excluding U.S. Treasury and agency
securities from the group that represents greater potential risk. This
comment reflects a misunderstanding of the risk being evaluated. The
securities at issue are those that represent greater potential interest
rate risk, not credit risk. Although Treasury and agency securities do
not present credit risk, they can have considerable interest rate risk
depending on their characteristics. To some extent, this risk can be
estimated by subjecting these securities to interest rate shock tests.
Shock Test
Under Section 703.3(b)(4)(iii) of the proposed rule, if the total
value of securities determined to represent greater potential risk was
greater than a credit union's capital, the credit union was required to
calculate the potential impact, on the fair value and/or total return
of each security in the portfolio and the portfolio as a whole, of
parallel shifts of plus and minus 300 basis points. The purpose of the
analysis was to determine the impact of potential shifts in interest
rates on the credit union's future capital position.
NCUA recognized this was a naive test and that substantial risks
could be missed by credit unions holding potentially more risky
securities in a total amount less than capital. NCUA believed, however,
that the requirement represented a reasonable compromise between
imperfect risk assessment and the burden that would result if every
credit union had to test every security.
As limited as the testing was, a number of commenters argued that
it would be too burdensome, suggesting that the threshold of 100% of
capital be raised to 150% or 200%. To determine the impact of the
requirement on federal credit unions, NCUA analyzed data from December
1995 call reports. NCUA used assumptions about the characteristics of
Treasury and agency securities that probably caused more of such
securities to be included than would actually be the case. The results
of the analysis are described in the following table:
------------------------------------------------------------------------
Asset size (in millions) A B C
------------------------------------------------------------------------
<$2....................................... 18="" 2,173="" 0.8%="" $2-$10....................................="" 90="" 2,507="" 3.6%="" $10-$50...................................="" 351="" 1,769="" 19.8%="">$50...................................... 462 795 58.1%
-----------------------------
[[Page 32997]]
Total............................... 921 7,244 12.7%
------------------------------------------------------------------------
A--Number of federal credit unions that would be required to complete
the 300 basis point stress test.
B--Total number of federal credit unions in the respective asset
ranges.
C--Percentage of A to B (AB=C).
The analysis shows that, at most, only 921, or 12.7 percent, of all
federal credit unions would be required to subject their portfolios to
the test. The vast majority of these have assets greater than $10
million. NCUA believes that the test would not be a significant burden
to these credit unions and that it is imperative for these credit
unions to monitor their potential interest rate risk. Therefore, it has
retained the test, at Section 703.90(c). Credit unions that are either
unwilling or unable to monitor their risk through the test should
rethink their investment strategy. In response to comments, however,
NCUA has reduced their frequency of the test from monthly to quarterly.
Further, as discussed earlier, to avoid confusion, there is no longer
any reference to total return.
NCUA understands that credit unions with deteriorating securities
in the hold-to-maturity portfolio may have less and less likelihood of
meeting the shock test ``hurdle'' due to the use of fair value versus
amortized cost in the calculation. Since securities classified as hold-
to-maturity are not adjusted to fair value, when their value goes down,
there is no corresponding decrease in net capital. As a result, the
ratio of potentially more risky securities to net capital declines.
This may lead to the anomalous situation of a decreasing requirement to
test, because the threshold is less likely to be triggered when hold-
to-maturity values are declining substantially. However, the purpose of
the test is to show potential problems with the portfolio, and
securities rapidly losing value will already be reported under Section
703.90(a).
Some commenters suggested that a test that applies to securities
but not deposits could induce some credit unions to purchase deposit
instruments that have the same risk characteristics as the securities
that trigger the test. If the test is not triggered, the credit unions
will be ignorant of the interest rate risk of their investments. NCUA
was aware of this trade-off, and chose not to impose the test on credit
unions with minimal investments in securities. However, Section 703.70
requires credit unions to list shares and deposits with the relevant
risk characteristics. This information should make credit union boards
aware of the possibility of interest rate risk. In addition, NCUA
intends to collect the information through the call report.
Section 703.100 What Investments and Investment Activities Are
Permissible for Me?
Contracting for Securities
Current Section 703.4(a) permits a credit union to contract for the
purchase or sale of a security provided that the delivery of the
security is to be made within 30 days from the trade date. This
accommodates the settlement of U.S. government and agency securities.
Section 703.4(b) permits a credit union to enter into a cash forward
agreement to purchase or sell a security provided that the period from
the trade date to the settlement date does not exceed 120 days. This
was designed to accommodate the settlement of mortgage-backed
securities. Section 703.4(a) of the proposed rule deleted these
specific time frames, and the authority to enter into cash forward
agreements, and simply provided for a credit union to contract for the
purchase or sale of a security provided that delivery of the security
was by ``regular-way'' settlement.
The current regulation had created some problems distinguishing
between regular delivery and forward commitments. The proposed
regulation was intended to permit a credit union to contract for the
purchase of a security no matter when it settles, as long as the
settlement date is within the normal time frame that the securities
industry has established for that type of security. Regular-way
settlement varies, depending on the type of security and whether it is
being purchased or sold on the secondary market or is a new issuance.
Securities industry practices for regular-way settlement have
become well-defined for most types of investments that are permissible
for credit unions. The time frames arise from customary practice in the
securities industry among brokers and dealers, guidelines established
by the Public Securities Association, and requirements of the
Securities and Exchange Commission and the Municipal Securities
Rulemaking Board.
Regular-way settlement for the most common types of secondary
market securities purchased or sold by credit unions is either one or
three business days after the trade date. For securities that are just
being issued, the time frame from trade date to settlement date can be
considerably longer, depending on the period between the announcement
of the offering and the issuance of the security. Although several
commenters expressed concern about being bound by regular-way time
frames, NCUA is not convinced that it is necessary to go beyond regular
way. Therefore, it has retained the requirement, at Section 703.100(a).
Indexes
The current rule is silent as to the types of indexes to which
variable rate instruments can be tied. Section 703.4(h) of the proposed
rule limited permissible indexes to those tied to domestic interest
rates only. These include, for example, constant maturity Treasury and
U.S. dollar-denominated LIBOR rates, Prime, and the 11th District Cost
of Funds. The preamble noted that this would prohibit a credit union
from purchasing an investment linked to an equity index, either as a
speculative investment or to match against a product offered to a
member. NCUA continues to believe that it is not appropriate for a
credit union to invest in an instrument that does not correlate to its
cost of funds, and has retained the prohibition, at Section 703.100(b).
The provision also prohibits a credit union from purchasing the new
inflation-indexed Treasury bonds.
Corporate Credit Unions
Proposed Section 703.4(f) addressed credit union investments in
corporate credit union capital shares and deposits. The proposed rule
limited credit union investment in the capital shares of a corporate
credit union to a total of one percent of the investing credit union's
assets, due to the potential risk associated with such investments.
A number of commenters seemed confused by the provision, believing
that NCUA was proposing a limit on all investments in corporate credit
unions. That is not the case. The proposed limit does not apply to
regular shares or deposits in corporate credit unions; it applies only
to capital shares, which can come in two forms:
Membership capital and member paid-in capital. To clarify the scope
of the limitation, the final rule expressly uses those terms. NCUA
intends that a credit union be limited to investing a total of 1
percent of its assets, all in membership capital, all in member paid-in
capital, or divided between them, in each corporate credit union in
which it invests. A few commenters expressed concern that some credit
unions might now have more than 1 percent of assets in capital shares
in one corporate credit union. Any such investment will be
grandfathered.
[[Page 32998]]
A credit union must fully understand the risks associated with
paid-in and membership capital before making such investments. An
investing credit union must be aware that its funds are at risk and
that it may not have access to them for 20 years, in the case of paid-
in capital, and 3 years, in the case of membership capital. Corporate
credit unions are required to fully disclose the conditions of their
capital instruments, and a credit union should review the disclosures
carefully before deciding to invest.
Common Trust Funds, Mutual Funds, and Other Investment Companies
Section 703.4(j) of the current regulation provides that a federal
credit union may invest in a mutual fund, provided that the investments
and investment transactions of the fund are legally permissible for
federal credit unions under the FCU Act and NCUA regulations. Proposed
Section 703.4(d) broadened this authority by permitting investment in
an investment company that was registered with the Securities and
Exchange Commission under the Investment Company Act of 1940.
The proposal retained the requirement that the investments and
investment transactions of the investment company be permissible for
federal credit unions and clarified that this limitation be established
by the company's prospectus and/or statement of additional information,
changeable only by shareholder vote. One method of establishing that a
fund was a permissible investment was for the prospectus to state that
it was ``a legal investment for federal credit unions'' or ``legal
under the FCU Act and NCUA Rules and Regulations.'' The proposed rule
also limited the aggregate of a credit union's investment in investment
companies and delegation of discretionary investment control to an
investment adviser to 100 percent of capital.
In response to comments, NCUA has eliminated the shareholder
approval requirement in Section 703.100(d) of the final rule. NCUA also
has determined that Section 703.100(d) need not explicitly mention the
statement of additional information, since it is generally incorporated
by reference into the prospectus. In addition, NCUA has removed the
limitation on how much a credit union may invest in an investment
company.
NCUA also has deleted the sentence that described how a mutual fund
can establish that it is a permissible investment for federal credit
unions. Some commenters mistakenly concluded that it meant that for a
mutual fund to be legal for federal credit unions, the prospectus was
required to say that the fund complies with the FCU Act and NCUA Rules
and Regulations. The sentence was intended to make it clear that NCUA
was departing from the position taken in Letter to Credit Unions No.
155, which required that a prospectus detail every investment and
transaction authorized for a fund, so that a credit union could
determine whether the fund was a permissible investment. As noted in
the preamble to the proposed rule, NCUA found it difficult to establish
how much detail was necessary to determine that a fund engaged only in
activities that were permissible for credit unions. The proposed
sentence intended to convey that one way of meeting that requirement
was for a prospectus to state that the fund was permissible. Federal
securities laws require that a prospectus accurately represent the
activities of the fund.
To avoid confusion, NCUA has deleted the sentence. The position
remains the same, however. A credit union should review the prospectus
of any mutual fund in which it is considering investing. If the
prospectus lists the authorized investments and investment activities
of the fund in sufficient detail for the credit union to determine that
all of them are permissible, it may invest in the fund. If the
prospectus lists the activities of the fund generally, and none of them
are impermissible for federal credit unions, but also states that the
fund is ``legal under the FCU Act and NCUA Rules and Regulations,'' or
something to that effect, a credit union may invest in the fund.
Regardless of whether a prospectus states that a fund is legal for
federal credit unions, if it is clear that some of the activities are
impermissible, a credit union may not invest in the fund.
A final change to this section was the addition of bank-managed
collective investment funds, also known as common trust funds, as
permissible investments. Such funds are subject to the same rules as
are mutual funds regarding the underlying investments and content of
the prospectus.
CMOs/REMICs
Section 704.4(e) of the proposed rule addressed the high risk
securities test (HRST) for CMOs/REMICs. The most significant change was
the application of the entire test to variable as well as fixed rate
CMOs/REMICs. NCUA had determined that the price sensitivity portion of
the HRST failed to reflect adequately the impact of basis and cap risk.
Although a number of commenters objected to applying the average life
and average life sensitivity tests to variable rate CMOs/REMICs, NCUA
has concluded that the requirement should substantially reduce the risk
exposure for these securities and has retained it at Section
703.100(e).
Municipal Securities
Section 703.4(g) of the proposed rule established minimum credit
ratings for municipal bonds. Credit unions were limited to purchasing
bonds rated in one of the two highest rating categories by at least one
nationally recognized statistical rating organization (NRSRO). In
response to comments, NCUA has expanded the category of permissible
municipal bonds to those rated in one of the four highest rating
categories, that is, those that are investment grade. NCUA also has
added language to explain NRSROs. The provision is located at Section
703.100(f).
Depository Institutions
Section 703.4(c) of the proposed rule permitted a credit union to
sell federal funds to a Section 107(8) institution, and Section
703.4(h) provided that a credit union could purchase yankee dollar
deposits, eurodollar deposits, and banker's acceptances. NCUA received
no comments on these sections and has retained them in Sections 703.100
(g) and (h), respectively, of the final rule. To clarify and
standardize positions it has taken in opinion letters, NCUA also has
added the authority to purchase deposit notes and certain bank notes.
Repurchase Transactions
Section 703.4(b) of the proposed rule simplified the language
authorizing credit union investment in repurchase transactions. NCUA
received no negative comments on the provision and has retained it at
Section 703.100(i) of the final rule. The provision has been clarified
to require daily assessment of the market value of the repurchase
securities and explicitly includes the standard practice of entering
into signed contracts with approved counterparties. Credit unions
should review NCUA Interpretive Ruling and Policy Statement (IRPS) No.
85-2 for a detailed discussion of appropriate controls for repurchase
transactions.
Reverse Repurchase Transactions and Securities Lending
Proposed Section 703.6 established a new section addressing the
pledging of securities through reverse repurchase transactions,
securities lending, and collateralized borrowing. In response to a
comment, the final rule establishes separate sections for reverse
repurchase
[[Page 32999]]
transactions and securities lending, Sections 703.100 (j) and (k),
respectively. The final rule does not explicitly address collateralized
borrowing. The new sections have been clarified to require daily
pricing of any securities received in the transaction. The sections
also include the standard practice of entering into signed contracts
with approved counterparties and borrowers. IRPS 85-2, discussed above,
provides guidance for reverse repurchase transactions and may also be
consulted when lending securities.
Trading
The current regulation does not specifically address trading
practices. Section 703.3(b)(9) of the proposed rule incorporated
trading practices from Letter to Credit Unions No. 89. NCUA received no
comments regarding the proposed trading practices but did receive
several comments urging that when-issued trading and pair-off
transactions be permitted in the trading account. NCUA agrees, and in
addition to describing required trading practices, Section 703.100(l)
of the final rule authorizes when-issued trading and pair-offs. NCUA
notes that IRPS 92-1 states that federal credit unions engaging in
when-issued trading must follow NCUA's regulation on cash forward
agreements. When this rule becomes effective, that statement will no
longer be accurate. Cash forward agreements will be impermissible, and
when-issued trading will be permissible without restriction, except for
being accounted for in accordance with GAAP. In general, when IRPS 92-1
conflicts with this rule, the IRPS is superseded.
Section 703.110 What Investments and Investment Activities Are
Prohibited for Me?
Section 703.5 of the proposed rule added prohibitions against
engaging in when-issued trading and pair-off transactions and
purchasing or selling options, interest rate swaps, stripped mortgage-
backed securities, CMO/REMIC residuals, commercial mortgage related
securities, and small business related securities. It also prohibited
credit unions from purchasing mortgage servicing rights directly. As
noted above, NCUA has determined to permit credit unions to engage in
when-issued trading and pair-offs, when conducted in the trading
account. These activities have been deleted from the prohibitions
section, located at Section 703.110 of the final rule.
Several commenters urged that credit unions be permitted to engage
in financial derivatives. NCUA recognizes that in a dynamic financial
environment it will be desirable for credit unions to consider a
broader range of financial alternatives. The most likely extension will
be into swaps, futures and options, which can be used to reduce
interest rate exposure. NCUA has decided to consider allowing a limited
number of individual credit unions to expand into these areas through
the investment pilot program, described in Section 703.140.
Other than comments regarding financial derivatives, only a few
commenters opposed the proposed prohibitions. NCUA continues to believe
that the listed investments are inappropriate for federal credit
unions, and has prohibited them in the final rule. NCUA notes, however,
that a CMO/REMIC with the characteristics of a stripped mortgage-backed
security is permissible if it meets the CMO/REMIC stress tests in this
regulation. NCUA also notes that the prohibition against small business
related securities does not prohibit credit unions from purchasing
investments in securities issued or guaranteed by the Small Business
Administration. Finally, NCUA notes that the prohibition against
purchasing mortgage servicing rights directly does not affect a credit
union's authority to retain servicing rights of loans that it sells,
whether the loans have been made by the credit union or purchased to
complete a pool for sale or pledge on the secondary market.
Section 703.120 May My Officials or Employees Accept Anything of Value
in Connection With an Investment Transaction?
No commenters objected to Section 703.8 of the proposed rule, which
addressed prohibited fees, and it has been retained at Section 703.120
of the final rule.
Section 703.130 May I Continue To Hold Investments Purchased Before
January 1, 1998, That Will Be Impermissible After That Date?
To assist credit unions in determining what regulations govern
investments purchased prior to January 1, 1998, the effective date of
this final rule, Section 703.9 of the proposed rule set out various
provisions that have governed certain investments since 1991. Minor
corrections have been made to these provisions, and they have been
retained at Section 703.130 of the final rule.
Section 703.140 What Is the Investment Pilot Program and How Can I
Participate in It?
A number of commenters asked for authority to engage in certain
investment activities that NCUA does not believe are appropriate for
all federal credit unions at this time. However, certain activities
that are permissible under the FCU Act but prohibited under this rule,
such as financial derivatives, may be appropriate for some credit
unions. As credit unions and NCUA gain experience with the activities,
NCUA may determine that they are appropriate for all credit unions, are
suitable only for some, or remain inappropriate for all credit unions.
To assist credit unions and NCUA in gaining experience with these
activities, NCUA has developed the investment pilot program.
Under the program, a credit union that wishes to engage in an
otherwise prohibited activity must apply to NCUA for permission to
engage in the activity. Section 703.140 sets out the requirements and
procedures for the application. NCUA will assess the credit union to
determine its ability to safely and soundly engage in the activity.
NCUA will determine the scope of the activity to assess its impact on
the credit union industry as a whole. If NCUA determines that a
particular activity is appropriate for all credit unions, it will
consider amending Part 703.
The pilot program also provides for NCUA to approve a third party's
investment program. In such a case, a credit union would not be
required to obtain individual approval to participate in the program,
although NCUA might limit the number of credit unions to which the
third party may market the program.
NCUA notes that the pilot program is not equivalent to a waiver
process. That is, once there are enough credit unions engaging in an
activity for NCUA to assess it, no more credit unions will be approved
to engage in the activity. An important factor in the number of credit
unions and activities that will be approved for the program is the
availability of NCUA staff resources.
Although commenters did not have the opportunity to express
opinions on the investment pilot program, NCUA notes that without
adding it to the final rule, credit unions would have no ability to
engage in these activities, which may benefit the credit union industry
and NCUA. NCUA believes that the benefits of the program justify adding
it at this late date. NCUA welcomes comments on the program, however,
and suggestions on how to improve it.
Section 703.150 What Additional Definitions Apply to This Part?
NCUA proposed to add a number of new definitions, to clarify
certain already-defined terms by re-definition,
[[Page 33000]]
and to delete several unnecessary definitions. In the final rule, some
of the proposed terms are not used, some new terms have been added,
and, based on comments, some definitions have been modified. In
addition, NCUA has deleted definitions for some terms, believing them
to be of such common usage as to no longer require definitions.
C. Derivation Table
------------------------------------------------------------------------
Original provision New provision Comment
------------------------------------------------------------------------
703.1........................... 703.10 & 703.20... Modified.
703.2........................... 703.150........... Significantly
Changed.
703.3(a)........................ 703.30(a)......... Modified.
703.3(b)........................ 703.30(h)......... Modified.
703.3(c)........................ 703.30(f)......... Modified.
703.3(d)........................ 703.30(b)......... Significantly
Changed.
703.3(e)........................ 703.30(c)......... Modified.
703.3(f)........................ 703.30(e)......... Modified.
703.3(g)........................ 703.30(i)......... Modified.
703.3(h)........................ 703.30(j)......... Modified.
N/A............................. 703.30 (d), (g), Added.
(k), & (l).
N/A............................. 703.40 (a), (b), Added.
(c), (e), & (f).
N/A............................. 703.70, 703.80, & Added.
703.90.
703.4 (a) & (b)................. 703.100(a)........ Significantly
Changed.
703.4(c)........................ 703.40(d) & Significantly
703.100(c). Changed.
703.4(d)........................ 703.100(i)........ Significantly
Changed.
703.4(e)........................ 703.100(j)........ Modified.
703.4(f)........................ 703.100(g)........ Modified.
703.4 (g), (h), & (i)........... 703.100(h) (1), No Change.
(2), & (3).
703.4(j)........................ 703.100(d)........ Modified.
N/A............................. 703.100 (b), (f), Added.
(h) (4) & (5),
(k), & (l).
703.5(a)........................ N/A............... Removed.
703.5(b)........................ 703.110(a)........ No Change.
703.5 (c) & (d)................. 703.110(b)........ No Change.
703.5(e)........................ 703.100(c)........ Modified.
703.5 (f) & (h)................. 703.110(c)........ Modified.
703.5 (g) & (j)................. 703.100(e)........ Modified.
703.5(i)........................ N/A............... Removed.
703.5(k)........................ 703.110(d)........ No Change.
703.5 (l) & (m)................. 703.120........... Modified.
N/A............................. 703.130 & 703.140. Added.
------------------------------------------------------------------------
D. Regulatory Procedures
Regulatory Flexibility Act
The Regulatory Flexibility Act requires NCUA to prepare an analysis
to describe any significant economic impact any final regulation may
have on a substantial number of small credit unions, defined as those
having less than $1 million in assets. The NCUA Board has determined
and certifies that the final rule will not have a significant economic
impact on a substantial number of small credit unions. Approximately
1,300 federal credit unions, out of 7,200, have assets of $1 million or
less. Of these 1,300, only 95 have investments in treasury or agency
securities, which are the investments that are subject to the majority
of the policy, reporting, and monitoring requirements of the final
rule. Accordingly, the NCUA Board has determined that a regulatory
flexibility analysis is not required.
Paperwork Reduction Act
The information collection requirements of the proposed rule were
submitted to the Office of Management and Budget. Fifteen commenters
addressed NCUA's estimates of the burden of those requirements, with
all but one stating that the estimates were too low. Credit unions
range in asset size from less than $100,000 to over $9 billion,
however, and the estimates were based on averaging the time it would
take both small and large credit unions to comply with the
requirements. Although the estimates may be understated for larger
credit unions, the reverse is true for smaller institutions.
The final rule has been modified from the proposed rule in ways
that reduce the burden estimates. The requirement to prepare a monthly
written report of investments was reduced by eliminating the obligation
to list all characteristics. The frequency of the interest rate shock
test was changed from monthly to quarterly. The requirement to
semiannually verify the pricing of all securities held was changed to
annually and only the amount necessary to satisfy generally accepted
auditing standards. The credit analysis requirement was changed from
semiannually to annually. Finally, the requirement to prepare and
provide to the Regional Director a written divestiture plan was
eliminated.
A revised Paperwork Reduction Act estimate will be sent to the
Office of Management and Budget (OMB). The NCUA Board invites comment
on: (1) Whether the collection of the information is necessary for the
proper performance of the functions of NCUA, including whether the
information will have practical utility; (2) the accuracy of NCUA's
estimate of the burden of collecting the information; (3) ways to
enhance the quality, utility, and clarity of the information to be
collected; and (4) ways to minimize the burden of collecting the
information. Send comments to Attn: Alexander Hunt, OMB Reports
Management Branch, New Executive Office Building, Rm. 10202,
Washington, DC 20530, with copies to Betty May, Acting Paperwork
Reduction Act Coordinator, NCUA, 1775 Duke St., Alexandria, VA 22314-
3428.
Under the Paperwork Reduction Act of 1995, no persons are required
to respond to a collection of information unless it displays a valid
OMB control number. The control number will be displayed in the table
at 12 CFR Part 795.
Executive Order 12612
Executive Order 12612 requires NCUA to consider the effect of its
actions on state interests. The final rule applies directly only to
federal credit unions, with Sec. 704.110 of the final rule applying
indirectly to state-chartered credit unions, through the insurance
provisions at 12 CFR Part 741. NCUA has determined that the final rule
does not constitute a ``significant regulatory action'' for purposes of
the Executive Order.
Small Business Regulatory Enforcement Fairness Act
The Small Business Regulatory Enforcement Fairness Act of 1996
(Public Law 104-121) provides generally for Congressional review of
agency rules. The reporting requirement is triggered in instances where
NCUA issues a final rule as defined by Section 551 of the
Administrative Procedure Act, 5 U.S.C. 551.
OMB has determined that this final revision to Part 703 does not
constitute a ``major'' rule as defined by the statute. A ``major'' rule
is defined as being any final rule that the Administrator of the Office
of Information and Regulatory Affairs of OMB finds has resulted in or
is likely to result in: (1) An annual effect on the economy of $100
million or more; (2) A major increase in costs or prices for consumers,
individual industries, Federal, State, or local government agencies, or
geographic regions; or (3) Significant adverse effects on competition,
employment, investment, productivity, innovation, or on the ability of
United States based
[[Page 33001]]
enterprises to compete with foreign-based enterprises in domestic and
export markets.
List of Subjects in 12 CFR Part 703
Credit unions, Investments, Reporting and recordkeeping
requirements.
By the National Credit Union Administration Board on June 12,
1997.
Becky Baker,
Secretary of the Board.
For the reasons set forth in the preamble, NCUA revises 12 CFR part
703 to read as follows:
PART 703--INVESTMENT AND DEPOSIT ACTIVITIES
Sec.
703.10 What does this part 703 cover?
703.20 What does this part 703 not cover?
703.30 What are the responsibilities of my (a federal credit
union's) board of directors?
703.40 What general practices and procedures must I follow in
conducting investment transactions?
703.50 What rules govern my dealings with entities I use to
purchase and sell investments (``broker-dealers'')?
703.60 What rules govern my safekeeping of investments?
703.70 What must I do to monitor my non-security investments in
banks, credit unions, and other depository institutions?
703.80 What must I do to value my securities?
703.90 What must I do to monitor the risk of my securities?
703.100 What investments and investment activities are permissible
for me?
703.110 What investments and investment activities are prohibited
for me?
703.120 May my officials or employees accept anything of value in
connection with an investment transaction?
703.130 May I continue to hold investments purchased before January
1, 1998, that will be impermissible after that date?
703.140 What is the investment pilot program and how can I
participate in it?
703.150 What additional definitions apply to this part?
Authority: 12 U.S.C. 1757(7), 1757(8), 1757(15).
Sec. 703.10 What does this part 703 cover?
This part 703 interprets several of the provisions of Sections
107(7), 107(8), and 107(15) (B) and (C) of the Federal Credit Union Act
(``Act''), 12 U.S.C. 1757(7), 1757(8), 1757(15) (B) and (C), which list
those securities, deposits, and other obligations in which a federal
credit union (``you'') may invest.
Sec. 703.20 What does this part 703 not cover?
This part 703 does not apply to:
(a) Investment in loans to members and related activities, which is
governed by Secs. 701.21, 701.22, and 701.23 of this chapter;
(b) The purchase of real estate-secured loans pursuant to Section
107(15)(A) of the Act, which is governed by Sec. 701.23 of this
chapter;
(c) Investment in credit union service organizations, which is
governed by Sec. 701.27 of this chapter;
(d) Investment in fixed assets, which is governed by Sec. 701.36 of
this chapter;
(e) Investment by corporate credit unions, which is governed by
part 704 of this chapter; or
(f) Investment activity by state-chartered credit unions, except as
provided in Sec. 741.3(a)(3) of this chapter.
Sec. 703.30 What are the responsibilities of my (a federal credit
union's) board of directors?
Your (a federal credit union's) board of directors must establish a
written investment policy that is consistent with the Act, this part,
and other applicable laws and regulations. The investment policy may be
part of a broader, asset-liability management policy. Your board must
review the policy at least annually. The policy must address the
following items:
(a) The purposes and objectives of your investment activities.
(b) The characteristics of the investments you may make. The
characteristics of an investment are such things as its issuer,
maturity, index, cap, floor, coupon rate, coupon formula, call
provision, average life, and interest rate risk.
(c) How you will manage your interest rate risk, including the
amount of risk you can take with your investments in relation to your
net capital and earnings.
(d) How you will manage your liquidity risk.
(e) How you will manage your credit risk. The policy must list
specific institutions, issuers, and counterparties you may use, or
criteria for their selection, and limits on the amounts you may invest
with each. Counterparty means the party on the other side of a
transaction.
(f) How you will manage your concentration risk, which can result
from single or related issuers, lack of geographic distribution,
holdings of obligations with similar characteristics, such as
maturities and indexes, holdings of bonds having the same trustee, and
holdings of securitized loans having the same originator, packager, or
guarantor.
(g) If you purchase CMOs/REMICs, whether you will use a median
prepayment estimate or individual prepayment estimates for the CMO/
REMIC testing required in Sec. 703.100(e). Once the board makes that
determination, you may use only that method.
(1) If the policy states that you will use a median estimate, it
must identify the industry-recognized information provider that will
supply the estimate.
(2) If the policy states that you will use individual estimates, it
must identify at least two specific sources for those estimates. One
source may be the median estimate from an industry-recognized
information provider.
(h) Who of your officials or employees has investment authority and
the extent of that authority. The individuals given investment
authority must be professionally qualified by education and/or
experience to exercise that authority in a prudent manner and to fully
comprehend and assess the risk characteristics of investments and
investment transactions under that authority. Only your officials and
employees may be voting members of any investment-related committee.
(i) If you use third-party entities to purchase or sell investments
(``broker-dealers''), the specific broker-dealers you may use. You must
maintain the documentation the board used to approve a broker-dealer as
long as the broker-dealer is approved and until the documentation has
been audited in accordance with Sec. 701.12 of this chapter and
examined by NCUA.
(j) If you use a third-party entity to safekeep your investments,
the specific entities you may use.
(k) How you will handle an investment that either is outside board
policy after purchase or fails a requirement of this part.
(l) If you engage in trading activities, how you will conduct those
activities. The policy should address the following:
(1) The persons who have purchase and sale authority;
(2) Trading account size limitations;
(3) Allocation of cash flow to trading accounts;
(4) Stop loss or sale provisions;
(5) Dollar size limitations of specific types, quantity and
maturity to be purchased;
(6) Limits on the length of time an investment may be inventoried
in the trading account; and
(7) Internal controls, including appropriate segregation of duties.
Sec. 703.40 What general practices and procedures must I follow in
conducting investment transactions?
(a) You (a federal credit union) must classify a security as hold-
to-maturity, available-for-sale, or trading, in accordance with
generally accepted
[[Page 33002]]
accounting principles and consistent with your documented intent and
ability regarding the security.
(b) Except as provided in paragraph (c) of this section, you must
retain discretionary control over the purchase and sale of investments.
NCUA does not consider you to have delegated discretionary control when
you are required to authorize a recommended purchase or sale
transaction prior to its execution and you, in practice, review such
recommendations and authorize such transactions.
(c)(1) You may delegate discretionary control over the purchase and
sale of investments, within established parameters, to a person other
than your official or employee, provided that the person is an
investment adviser registered with the Securities and Exchange
Commission under the Investment Advisers Act of 1940 (15 U.S.C. 80b).
(2) In determining whether to transact business with an investment
adviser, you must analyze his or her background and information
available from state or federal securities regulators, including any
enforcement actions against the adviser or associated personnel.
(3) You may not compensate an investment adviser with discretionary
control over the purchase and sale of investments on a per transaction
basis or based on capital gains, capital appreciation, net income,
performance relative to an index, or any other incentive basis.
(4) When you have delegated discretionary control over the purchase
and sale of investments to a person other than your official or
employee, you do not direct the holdings under that person's control.
Therefore, you must classify those holdings as either available-for-
sale or trading.
(5) You must obtain a report from your investment adviser, at least
monthly, that details your investments under his or her control and how
they are performing.
(6) Your aggregate delegation of discretionary control over the
purchase and sale of investments under this paragraph (c) is limited to
100 percent of net capital at the time of delegation.
(d) Except for investments that are issued or fully guaranteed as
to principal and interest by the U.S. government or its agencies,
enterprises, or corporations or fully insured (including accumulated
interest) by the National Credit Union Administration or the Federal
Deposit Insurance Corporation, you must conduct and document a credit
analysis of the issuing entity and/or investment before you purchase
the investment. You must update the analysis at least annually as long
as you hold the investment.
(e) You must notify your board of directors as soon as possible,
but no later than the next regularly scheduled board meeting, of any
investment that either is outside board policy after purchase or has
failed a requirement of this part. You must document the board's action
regarding the investment in the minutes of the board meeting, including
a detailed explanation of any decision not to sell an investment that
has failed a requirement of this part. Within 5 days after the board
meeting, you must notify the appropriate regional director in writing
of an investment that has failed a requirement of this part.
(f) You must maintain documentation regarding an investment
transaction as long as you hold the investment and until the
documentation has been both audited and examined. The documentation
should include, where applicable, bids and prices at purchase and sale
and for periodic updates, relevant disclosure documents or a
description of the security from an industry-recognized information
provider, financial data, and tests and reports required by your
investment policy and this part.
Sec. 703.50 What rules govern my dealings with entities I use to
purchase and sell investments (``broker-dealers'')?
(a) You (a federal credit union) may use a third-party entity to
purchase and sell investments (a ``broker-dealer'') as long as the
broker-dealer either is registered with the Securities and Exchange
Commission under the Securities Exchange Act of 1934 (15 U.S.C. 78a et
seq.) or is a depository institution whose broker-dealer activities are
regulated by a federal regulatory agency.
(b) In determining whether to buy or sell investments through a
broker-dealer, you must analyze and annually update the following
factors:
(1) The background of any sales representative with whom you are
doing business.
(2) Information available from state or federal securities
regulators and securities industry self-regulatory organizations, such
as the National Association of Securities Dealers and the North
American State Administrators Association, about any enforcement
actions against the broker-dealer, its affiliates, or associated
personnel.
(3) If the broker-dealer is acting as your counterparty, the
ability of the broker-dealer and its subsidiaries or affiliates to
fulfill commitments, as evidenced by capital strength, liquidity, and
operating results. You should consider current financial data, annual
reports, reports of nationally recognized statistical rating agencies,
relevant disclosure documents, and other sources of financial
information.
Sec. 703.60 What rules govern my safekeeping of investments?
(a) Your (a federal credit union's) purchased investments and
repurchase collateral must be in your possession, recorded as owned by
you through the Federal Reserve Book-Entry System, or held by a board-
approved safekeeper under a written custodial agreement. A custodial
agreement is a contract in which a third party agrees to exercise
ordinary care in protecting the securities held in safekeeping for its
customers.
(b) You must obtain an individual confirmation statement for each
investment purchased or sold.
(c) You may not allow the selling broker-dealer to safekeep
purchased investments or repurchase collateral, except that where the
broker-dealer is a bank or corporate credit union, you may allow a
separately identifiable department or division of the bank or corporate
credit union to safekeep investments or collateral.
(d) You must obtain and reconcile monthly a statement of purchased
investments and repurchase collateral held in safekeeping.
(e) All purchases and sales of investments must be delivery versus
payment (i.e., payment for an investment must occur simultaneously with
its delivery).
Sec. 703.70 What must I do to monitor my non-security investments in
banks, credit unions, and other depository institutions?
(a) At least quarterly you (a federal credit union) must prepare a
written report listing all of your shares and deposits in banks, credit
unions, and other depository institutions, that have one or more of the
following features:
(1) Embedded options;
(2) Remaining maturities greater than 3 years; or
(3) Coupon formulas that are related to more than one index or are
inversely related to, or multiples of, an index.
(b) The requirement described in paragraph (a) of this section does
not apply to your shares and deposits that are securities.
(c) Where you do not have an investment-related committee, each
member of your board of directors must receive a copy of the report
described in paragraph (a) of this section. Where you have an
investment-related committee, each member of the committee must
[[Page 33003]]
receive a copy of the report, and each member of the board must receive
a summary of the information in the report.
Sec. 703.80 What must I do to value my securities?
(a) Prior to purchasing or selling a security, except for new
issues purchased at par, you (a federal credit union) must obtain,
either:
(1) Price quotations on the security from at least two broker-
dealers; or
(2) A price quotation on the security from an industry-recognized
information provider.
(b) At least monthly, you must determine the fair value of each
security you hold. You may determine fair value by obtaining a price
quotation on the security from an industry-recognized information
provider, a broker-dealer, or a safekeeper.
(c) At least annually, your supervisory committee (itself or
through its external auditor) must independently assess the reliability
of monthly price quotations you receive from a broker-dealer or
safekeeper. Your supervisory committee (or external auditor) must
follow Generally Accepted Auditing Standards, which require either
recomputation or reference to market quotations.
(d) Where you are unable to obtain a price quotation required by
this section for the precise security in question, you may obtain a
quotation for a security with substantially similar characteristics.
Sec. 703.90 What must I do to monitor the risk of my securities?
(a) At least monthly, you (a federal credit union) must prepare a
written report setting forth, for each security you hold, the fair
value and dollar change since the prior month-end, with summary
information for the entire portfolio.
(b) At least quarterly, you must prepare a written report setting
forth the sum of the fair values of all fixed and variable rate
securities you hold that have one or more of the following features:
(1) Embedded options;
(2) Remaining maturities greater than 3 years; or
(3) Coupon formulas that are related to more than one index or are
inversely related to, or multiples of, an index.
(c) Where the amount calculated in paragraph (b) of this section is
greater than your net capital, the report described in that paragraph
must provide a reasonable and supportable estimate of the potential
impact, in percentage and dollar terms, of an immediate and sustained
parallel shift in market interest rates of plus and minus 300 basis
points on:
(1) The fair value of each security in your portfolio;
(2) The fair value of your portfolio as a whole; and
(3) Your net capital.
(d) Where you do not have an investment-related committee, each
member of your board of directors must receive a copy of the reports
described in paragraphs (a) through (c) of this section. Where you have
an investment-related committee, each member of the committee must
receive copies of the reports, and each member of the board must
receive a summary of the information in the reports.
Sec. 703.100 What investments and investment activities are
permissible for me?
(a) You (a federal credit union) may contract for the purchase or
sale of a security as long as the delivery of the security is by
regular-way settlement. Regular-way settlement means delivery of a
security from a seller to a buyer within the time frame that the
securities industry has established for that type of security.
(b) You may invest in a variable rate investment, as long as the
index is tied to domestic interest rates and not, for example, to
foreign currencies, foreign interest rates, or domestic or foreign
commodity prices, equity prices, or inflation rates. For purposes of
this part, the U.S. dollar-denominated London Interbank Offered Rate
(LIBOR) is a domestic interest rate.
(c) You may purchase shares or deposits in a corporate credit
union, except where the NCUA Board has notified you that the corporate
credit union is not operating in compliance with part 704 of this
chapter. Your aggregate purchase of member paid-in capital and
membership capital in one corporate credit union is limited to one
percent of your assets. Member paid-in capital and membership capital
are defined in part 704 of this chapter.
(d) You may invest in a registered investment company or collective
investment fund, as long as the prospectus of the company or fund
restricts the investment portfolio to investments and investment
transactions that are permissible for federal credit unions. For the
purposes of this part, the following definitions apply:
(1) A registered investment company is an investment company that
is registered with the Securities and Exchange Commission under the
Investment Company Act of 1940 (15 U.S.C. 80a). Examples of registered
investment companies are mutual funds and unit investment trusts.
(2) A collective investment fund is a fund maintained by a national
bank under 12 CFR part 9.
(e)(1) You may invest in a fixed or variable rate CMO/REMIC only if
it meets all of the following tests:
(i) Average Life Test. The CMO/REMIC's estimated average life is 10
years or less.
(ii) Average Life Sensitivity Test. The CMO/REMIC's estimated
average life extends by 4 years or less, assuming an immediate and
sustained parallel shift in interest rates of up to and including plus
300 basis points, and shortens by 6 years or less, assuming an
immediate and sustained parallel shift in interest rates of up to and
including minus 300 basis points.
(iii) Price Sensitivity Test. The CMO/REMIC's estimated price
change is 17 percent or less, as a result of an immediate and sustained
parallel shift in interest rates of up to and including plus and minus
300 basis points.
(2) You must retest CMOs/REMICs at least quarterly, more frequently
if market or business conditions dictate.
(3) If you use individual prepayment estimates for testing, you
must obtain estimates from all of the prepayment sources listed in your
investment policy. When you purchase a CMO/REMIC, it must pass the
tests for each estimate. When you retest the CMO/REMIC, it must pass
the tests for a majority of the estimates.
(4) If you use a median prepayment estimate, the median estimate
when you purchase a CMO/REMIC must be based on at least five prepayment
sources. When you retest the CMO/REMIC, the median estimate must be
based on at least two prepayment sources.
(f) You may purchase and hold a municipal security only if a
nationally recognized statistical rating organization (NRSRO) has rated
it in one of the four highest rating categories. A municipal security
is a security as defined in Section 107(7)(K) of the Act. An NRSRO is a
rating organization that the Securities and Exchange Commission has
recognized as an NRSRO.
(g) You may sell federal funds to Section 107(8) institutions and
credit unions, as long as the interest or other consideration received
from the financial institution is at the market rate for federal funds
transactions.
(h) You may invest in the following instruments issued by a Section
107(8) institution or branch:
(1) Yankee dollar deposits;
(2) Eurodollar deposits;
(3) Banker's acceptances;
(4) Deposit notes; and
[[Page 33004]]
(5) Bank notes with original weighted average maturities of less
than five years.
(i) A repurchase transaction is a transaction in which you agree to
purchase a security from a counterparty and to resell the same or an
identical security to that counterparty at a specified future date and
at a specified price. You may enter into a repurchase transaction as
long as:
(1) The repurchase securities are legal investments for federal
credit unions;
(2) You receive a daily assessment of the market value of the
repurchase securities, including accrued interest, and maintain
adequate margin that reflects a risk assessment of the repurchase
securities and the term of the transaction; and
(3) You have entered into signed contracts with all approved
counterparties.
(j) A reverse repurchase transaction is a transaction in which you
agree to sell a security to a counterparty and to repurchase the same
or an identical security from that counterparty at a specified future
date and at a specified price. You may enter into reverse repurchase
and collateralized borrowing transactions as long as:
(1) Any securities you receive are permissible investments for
federal credit unions, you receive a daily assessment of their market
value, including accrued interest, and you maintain adequate margin
that reflects a risk assessment of the securities and the term of the
transaction;
(2) Any cash you receive is subject to the borrowing limit
specified in Section 107(9) of the Act, and any investments you
purchase with that cash are permissible for federal credit unions and
mature no later than the maturity of the transaction; and
(3) You have entered into signed contracts with all approved
counterparties.
(k) You may enter into a securities lending transaction as long as:
(1) You receive written confirmation of the loan;
(2) Any collateral you receive is a legal investment for federal
credit unions, you obtain a perfected first priority interest in the
collateral, you either take physical possession or control of the
collateral or are recorded as owner of the collateral through the
Federal Reserve Book-Entry Securities Transfer System; and you receive
a daily assessment of the market value of the collateral, including
accrued interest, and maintain adequate margin that reflects a risk
assessment of the collateral and the term of the loan;
(3) Any cash you receive is subject to the borrowing limit
specified in Section 107(9) of the Act, and any investments you
purchase with that cash are permissible for federal credit unions and
mature no later than the maturity of the transaction; and
(4) You have executed a written loan and security agreement with
the borrower.
(l)(1) You may trade securities, including engaging in when-issued
trading and pair-off transactions, as long as you can show that you
have sufficient resources, knowledge, systems, and procedures to handle
the risks.
(2) You must record any security you purchase or sell for trading
purposes at fair value on the trade date. The trade date is the date
you commit, orally or in writing, to purchase or sell a security.
(3) At least monthly, you must give your board of directors or
investment-related committee a written report listing all purchase and
sale transactions of trading securities and the resulting gain or loss
on an individual basis.
Sec. 703.110 What investments and investment activities are prohibited
for me?
(a) You (a federal credit union) may not purchase or sell financial
derivatives, such as futures, options, interest rate swaps, or forward
rate agreements, except as permitted under Sec. 701.21(i) of this
chapter.
(b) You may not engage in adjusted trading or short sales.
(c) You may not purchase stripped mortgage backed securities,
residual interests in CMOs/REMICs, mortgage servicing rights,
commercial mortgage related securities, or small business related
securities.
(d) You may not purchase a zero coupon investment with a maturity
date that is more than 10 years from the settlement date.
Sec. 703.120 May my officials or employees accept anything of value in
connection with an investment transaction?
(a) Your (a federal credit union's) officials and senior management
employees, and their immediate family members, may not receive anything
of value in connection with your investment transactions. This
prohibition also applies to any other employee, such as an investment
officer, if the employee is directly involved in investments, unless
your board of directors determines that the employee's involvement does
not present a conflict of interest. This prohibition does not include
compensation for employees.
(b) Your officials and employees must conduct all transactions with
business associates or family members that are not specifically
prohibited by paragraph (a) of this section at arm's length and in your
best interest.
(c) Senior management employee means your chief executive officer
(typically this individual holds the title of President or Treasurer/
Manager), any assistant chief executive officers (e.g., Assistant
President, Vice President, or Assistant Treasurer/Manager) and the
chief financial officer (Comptroller).
(d) Immediate family member means a spouse or other family member
living in the same household.
Sec. 703.130 May I continue to hold investments purchased before
January 1, 1998, that will be impermissible after that date?
(a) Subject to safety and soundness considerations, your (a federal
credit union's) authority to hold an investment is governed by the
regulations in effect when you purchased the investment. Paragraphs (b)
through (d) of this section describe past regulations governing certain
investments.
(b) Subject to safety and soundness considerations, you may hold a
CMO/REMIC purchased:
(1) Before December 2, 1991;
(2) On or after December 2, 1991, but before July 30, 1993, if its
average life does not extend or shorten by more than 6 years if
interest rates rise or fall 300 basis points;
(3) On or after December 2, 1991, but before January 1, 1998, if
for the sole purpose of reducing interest rate risk and:
(i) You have a monitoring and reporting system in place that
provides the documentation necessary to evaluate the expected and
actual performance of the investment under different interest rate
scenarios;
(ii) You use the monitoring and reporting system to conduct and
document an analysis that shows, before purchase, that the proposed
investment will reduce your interest rate risk;
(iii) After purchase, you evaluate the investment at least
quarterly to determine whether or not it actually has reduced your
interest rate risk; and
(iv) You classify the investment as either trading or available-
for-sale.
(c) Subject to safety and soundness considerations, and
notwithstanding paragraph (b) of this section, you may hold a variable-
rate CMO/REMIC purchased:
(1) On or after December 2, 1991, but before July 30, 1993, if:
(i) The interest rate is reset at least annually;
(ii) The maximum allowable interest rate on the instrument is at
least 300
[[Page 33005]]
basis points above the interest rate of the instrument at the time of
purchase; and
(iii) The interest rate of the instrument varies directly (not
inversely) with the index upon which it is based and is not reset as a
multiple of the change in the related index; or
(2) On or after July 30, 1993, but before January 1, 1998, if:
(i) The interest rate of the instrument is reset at least annually;
(ii) The interest rate of the instrument, at the time of purchase
or at a subsequent testing date, is below the contractual cap of the
instrument;
(iii) The index upon which the interest rate is based is a
conventional widely-used market interest rate such as the London
Interbank Offered Rate (LIBOR);
(iv) The interest rate of the instrument varies directly (not
inversely) with the index upon which it is based and is not reset as a
multiple of the change in the related index; and
(v) The estimated change in the instrument's price is 17 percent or
less, due to an immediate and sustained parallel shift in the yield
curve of plus or minus 300 basis points.
(d) Subject to safety and soundness considerations, you may hold a
CMO/REMIC residual, SMBS, or zero coupon security with a maturity
greater than 10 years, if you purchased the investment:
(1) Before December 2, 1991; or
(2) On or after December 2, 1991, but before January 1, 1998, if
for the purpose of reducing interest rate risk and you meet the
requirements of paragraph (b)(3) of this section.
(e) All grandfathered investments are subject to the valuation and
monitoring requirements of Secs. 703.70, 703.80, and 703.90.
Sec. 703.140 What is the investment pilot program and how can I
participate in it?
(a) Under the investment pilot program, NCUA will permit a limited
number of federal credit unions to engage in investment activities
prohibited by this part but permitted by statute.
(b) Except as provided in paragraph (c) of this section, before you
(a federal credit union) may engage in additional activities, you must
obtain written approval from
NCUA. To begin the approval process, you must submit a request to
your regional director that addresses the following items:
(1) Board policies approving the activities and establishing limits
on them.
(2) A complete description of the activities, with specific
examples of how you will conduct them and how they will benefit you.
(3) A demonstration of how the activities will affect your
financial performance, risk profile, and asset-liability management
strategies.
(4) Examples of reports you will generate to monitor the
activities.
(5) A projection of the associated costs of the activities,
including personnel, computer, audit, etc.
(6) A description of the internal systems to measure, monitor, and
report the activities, and the qualifications of the staff and/or
official(s) responsible for implementing and overseeing the activities.
(7) The internal control procedures you will implement, including
audit requirements.
(c) You need not obtain individual written approval to engage in
investment activities prohibited by this part but permitted by statute
where the activities are part of a third-party investment program that
NCUA has approved under this paragraph (c). A third party seeking
approval of such a program must submit a request to the Director of the
Office of Examination and Insurance that addresses the following items:
(1) A complete description of the activities, with specific
examples of how a credit union will conduct them and how they will
benefit a credit union.
(2) A description of any risks to a credit union from participating
in the program.
Sec. 703.150 What additional definitions apply to this part?
The following definitions apply to this part:
Adjusted trading means selling a security to a counterparty at a
price above its current fair value and simultaneously purchasing or
committing to purchase from the counterparty another security at a
price above its current fair value.
Average life means the weighted average time to principal repayment
with the amount of the principal paydowns (both scheduled and
unscheduled) as the weights.
Bank note means a direct, unconditional, and unsecured general
obligation of a bank that ranks equally with all other senior unsecured
indebtedness of the bank, except deposit liabilities and other
obligations that are subject to any priorities or preferences.
Banker's acceptance means a time draft that is drawn on and
accepted by a bank and that represents an irrevocable obligation of the
bank.
Commercial mortgage related security means a mortgage related
security where the mortgages are secured by real estate upon which is
located a commercial structure.
Deposit note means an obligation of a bank that is similar to a
certificate of deposit but is rated.
Embedded option means a characteristic of an investment that gives
the issuer or holder the right to alter the level and timing of the
cash flows of the investment. Embedded options include call and put
provisions and interest rate caps and floors. Since a prepayment option
in a mortgage is a type of call provision, a mortgage-backed security
composed of mortgages that may be prepaid is an example of an
investment with an embedded option.
Eurodollar deposit means a U.S. dollar-denominated deposit in a
foreign branch of a United States depository institution.
Fair value means the price at which a security can be bought or
sold in a current, arms length transaction between willing parties,
other than in a forced or liquidation sale.
Industry-recognized information provider means an organization that
obtains compensation by providing information to investors and receives
no compensation for the purchase or sale of investments.
Investment means any security, obligation, account, deposit, or
other item authorized for purchase by a federal credit union under
Sections 107(7), 107(8), or 107(15) (B) or (C) of the Federal Credit
Union Act, or this part, other than loans to members.
Maturity means the date the last principal amount of a security is
scheduled to come due and does not mean the call date or the average
life of the security.
Mortgage related security means a security as defined in Section
3(a)(41) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(41)),
i.e., a privately-issued security backed by mortgages secured by real
estate upon which is located a dwelling, mixed residential and
commercial structure, residential manufactured home, or commercial
structure.
Mortgage servicing means performing tasks to protect a mortgage
investment, including collecting the installment payments, managing the
escrow accounts, monitoring and dealing with delinquencies, and
overseeing foreclosures and payoffs.
Net capital means the total of all undivided earnings, regular
reserves, other reserves (excluding the allowance for loan losses), net
income, accumulated unrealized gains (losses)
[[Page 33006]]
on available-for-sale securities, and secondary capital as defined in
Sec. 701.34 of this chapter.
Official means any member of a federal credit union's board of
directors, credit committee, supervisory committee, or investment-
related committee.
Pair-off transaction means a security purchase transaction that is
closed or sold at, or prior to, the settlement date. In a pair-off, an
investor commits to purchase a security, but then pairs-off the
purchase with a sale of the same security prior to or on the settlement
date.
Prepayment estimate means a reasonable and supportable forecast of
mortgage prepayments in alternative interest rate scenarios. Broker-
dealers and industry-recognized information providers are sources for
these estimates. Estimates are used in tests to forecast the weighted
average life, change in weighted average life, and price sensitivity of
CMOs/REMICs and mortgage-backed securities.
Residual interest means the remainder cash flows from a CMO/REMIC,
or other mortgage-backed security transaction, after payments due
bondholders and trust administrative expenses have been satisfied.
Section 107(8) institution means an institution in which Section
107(8) of the Act authorizes you to make deposits, i.e., an institution
that is insured by the Federal Deposit Insurance Corporation or is a
state bank, trust company or mutual savings bank operating in
accordance with the laws of a state in which you maintain a facility. A
facility is your home office or any suboffice, including, but not
necessarily limited to, a credit union service center, wire service,
telephonic station, or mechanical teller station.
Security means a share, participation, or other interest in
property or in an enterprise of the issuer or an obligation of the
issuer that: (1) Either is represented by an instrument issued in
bearer or registered form or, if not represented by an instrument, is
registered in books maintained to record transfers by or on behalf of
the issuer;
(2) Is of a type commonly dealt in on securities exchanges or
markets or, when represented by an instrument, is commonly recognized
in any area in which it is issued or dealt in as a medium for
investment; and
(3) Either is one of a class or series or by its terms is divisible
into a class or series of shares, participations, interests, or
obligations.
Settlement date means the date to which a purchaser and seller
originally agree for settlement of the purchase or sale of a security.
Short sale means the sale of a security not owned by the seller.
Small business related security means a security as defined in
Section 3(a)(53) of the Securities Exchange Act of 1934 (15 U.S.C.
78c(a)(53)), i.e., a security that represents ownership of one or more
promissory notes or leases of personal property which evidence the
obligation of a small business concern. It does not mean a security
issued or guaranteed by the Small Business Administration.
Stripped mortgage-backed security (SMBS) means a security that
represents either the principal-only or the interest-only portion of
the cash flows of an underlying pool of mortgages or mortgage-backed
securities. Some mortgage-backed securities represent essentially
principal-only cash flows with nominal interest cash flows or
essentially interest-only cash flows with nominal principal cash flows.
These securities are considered SMBSs for the purposes of this part.
When-issued trading of securities means the buying and selling of
securities in the period between the announcement of an offering and
the issuance and payment date of the securities.
Yankee dollar deposit means a deposit in a United States branch of
a foreign bank licensed to do business in the state in which it is
located, or a deposit in a state-chartered, foreign controlled bank.
You means a federal credit union.
Zero coupon investment means an investment that makes no periodic
interest payments but instead is sold at a discount from its face
value. The holder of a zero coupon investment realizes the rate of
return through the gradual appreciation of the investment, which is
redeemed at face value on a specified maturity date.
[FR Doc. 97-15915 Filed 6-17-97; 8:45 am]
BILLNG CODE 7535-01-P
