[Federal Register Volume 64, Number 186 (Monday, September 27, 1999)]
[Proposed Rules]
[Pages 52163-52210]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-23416]
-----------------------------------------------------------------------
FEDERAL HOUSING FINANCE BOARD
12 CFR Parts 917, 925, 930, 940, 954, 955, 958, 965, 966 and 980
[No. 99-45]
RIN 3069-AA84
Federal Home Loan Bank Financial Management and Mission
Achievement
AGENCY: Federal Housing Finance Board.
ACTION: Proposed rule.
-----------------------------------------------------------------------
SUMMARY: The Federal Housing Finance Board (Finance Board) is proposing
to adopt new financial management and mission achievement regulations,
and amend certain existing regulations, for the Federal Home Loan Banks
(Banks). The proposal would modernize policies governing the business
activities of the Banks and, for the first time, would establish
regulatory standards for mission achievement by the Banks and a
definition of mission assets. The proposal includes a risk-based
capital requirement, pursuant to which the amount of capital required
to be maintained by a Bank would be based on the credit, market, and
operations risks to which it is exposed. The risk-based capital regime
builds upon the regulatory framework used by other financial
institution and government-sponsored enterprise (GSE) regulators. The
mission achievement requirement in the proposal would: codify the
authority of the Banks to hold mortgage assets, including mortgage-
backed securities; allow mortgage assets meeting certain regulatory
requirements to be counted as mission assets; and eliminate the use of
the Banks' GSE advantages in issuing debt to fund arbitrage
investments. The proposal also sets forth in the regulation the
responsibilities of the boards of
[[Page 52164]]
directors and senior management of the Banks, as a means of ensuring
that they fulfill their duties in operating the Banks in a safe and
sound manner and in furtherance of their mission. The proposal will
enable the Banks to help their members be more effective competitors in
the housing finance and community lending marketplace, which in turn
will assure that benefits accrue to consumers. In a separate
rulemaking, the Finance Board is proposing to reorganize its
regulations in a more logical arrangement and to reflect the revisions
to be made by this proposal.
DATES: Comments on this proposed rule must be received in writing on or
before December 27, 1999.
ADDRESSES: Comments should be mailed to: Elaine L. Baker, Secretary to
the Board, Federal Housing Finance Board, 1777 F Street, NW,
Washington, DC 20006. Comments will be available for public inspection
at this address.
FOR FURTHER INFORMATION CONTACT: James L. Bothwell, Director and Chief
Economist, (202) 408-2821; Scott L. Smith, Deputy Director, (202) 408-
2991; Julie Paller, Senior Financial Analyst, (202) 408-2842; Ellen E.
Hancock, Senior Financial Analyst, (202) 408-2906; Austin Kelly, Senior
Financial Economist, (202) 408-2541; or Syed Ahmad, Senior Financial
Economist, (202) 408-2870; Office of Policy, Research and Analysis,
Federal Housing Finance Board, 1777 F Street, NW, Washington, DC 20006.
SUPPLEMENTARY INFORMATION:
I. Overview of Proposal
The proposed rule would establish new financial management and
mission achievement requirements for the Banks, including: (1) a
capital provision that would incorporate both minimum total capital and
risk-based capital elements; (2) provisions linking the GSE debt
funding advantage to activities that further the mission of the Banks
(as set forth in the new regulatory definition), thus eliminating GSE
debt-funded arbitrage investments and authorizing the Banks to hold
``member mortgage assets''; and (3) provisions defining the
responsibilities--and thus the accountability--of the boards of
directors and senior management of the Banks. The proposal would give
the Banks greater flexibility to manage their business so as to better
serve their members and fulfill their public purpose, while operating
within a risk-based capital framework that ensures the safety and
soundness of the Bank System.
A. Capital Requirements
Under current law, the amount of capital a Bank must hold is
determined not by the risks inherent in its portfolio or business
practices, but by the asset size of, or the dollar amount of advances
outstanding to, its members. Specifically, a member must maintain a
minimum investment in the capital stock of its Bank in an amount equal
to the greater of: (1) 1 percent of the member's mortgage assets; (2)
0.3 percent of the member's total assets; or (3) 5 percent of total
advances outstanding to the member (with a somewhat higher percentage
for any member that is not a ``qualified thrift lender''). See 12
U.S.C. 1426(b)(1), (b)(2), (b)(4); 1430(c), (e)(1), (e)(3); 12 CFR
933.20(a).
The Banks currently operate in accordance with the Finance Board's
Financial Management Policy (FMP), under which risk management is
accomplished principally through a list of specific restrictions and
limitations on the Banks' investment practices and a leverage limit
which prohibits Banks from incurring liabilities in the form of
consolidated obligations (COs) or unsecured senior liabilities in an
amount greater than twenty times their capital stock. See 62 FR 13146
(Mar. 19, 1997); Finance Board Res. No. 96-45 (July 3, 1996), as
amended by Finance Board Res. No. 96-90 (Dec. 6, 1996), Finance Board
Res. No. 97-05 (Jan. 14, 1997), and Finance Board Res. No. 97-86 (Dec.
17, 1997). Though this approach has served the purpose of ensuring the
safety and soundness of the Bank System, it lacks the flexibility that
would enable the Banks to fulfill their mission to the maximum extent.
To ensure that the risks taken by a Bank are adequately supported
by its capital, the proposal would implement, for the first time, a
risk-based capital requirement for the Banks, which builds upon the
risk-based capital regimes of other federal financial institution
regulators. Under the proposed rules, the amount of capital to be held
by each Bank would depend, in part, on the risks--credit risk, market
risk, and operations risk--to which the Bank is exposed. The credit
risk capital requirement would be set according to credit ratings and
the associated historical default and recovery data made available by
nationally-recognized statistical rating organizations (NRSROs). This
approach would improve on the broad credit risk weighting categories
set forth in the Basle Accord in 1988 \1\ by determining the credit
risk capital component based on the risk of an instrument rather than
the type of instrument.
---------------------------------------------------------------------------
\1\ The risk-based capital standards of the other federal bank
regulatory agencies are based on the document entitled
``International Convergence of Capital Measurement and Capital
Standards'' (July 1988) (the Basle Accord). The Basle Accord was
agreed to by the Basle Committee on Banking Supervision (BCBS) which
comprises representatives of the central banks and supervisory
authorities of the Group of Ten countries (Belgium, Canada, France,
Germany, Italy, Japan, Netherlands, Sweden, Switzerland, United
Kingdom, United States and Luxembourg). The BCBS meets at the Bank
for International Settlements, Basle, Switzerland. The Basle Accord
defines bank capital and sets credit risk-based capital standards
for on-and off-balance sheet instruments. The Basle Accord has been
amended many times with the most significant amendment entitled
``Amendment to the Capital Accord to Incorporate Market Risks''
(Jan. 1996) (the Amendment). The Amendment sets specific risk-based
capital standards for instruments held in trading portfolios of
commercial banks. For debt instruments, the specific risk is defined
by the Amendment as credit and event risk. In addition, the
Amendment incorporates a measure of the market risk due to interest
rates, foreign exchange rates, equity prices and commodity prices
for all instruments held in trading portfolio (trading book); and
foreign exchange and commodity risks for instruments held in non-
trading portfolio (banking book). The BCBS issued a consultative
paper entitled ``A New Capital Adequacy Framework'' (June 1999) (the
Framework) that introduces a new framework to replace the Basle
Accord.
---------------------------------------------------------------------------
A Bank's market risk capital requirement would be equal to the
market value of the Bank's portfolio at risk from changes in interest
rates, foreign exchange rates, and commodity and equity prices during
periods of extreme market stress, as determined in accordance with
internal market risk models to be developed by each Bank. A Bank would
be required to assess its market values at risk regularly through
stringent stress testing of its entire portfolio, including both on-
balance sheet assets and liabilities and off-balance sheet items, as
well as related options. By comparison, large commercial banks are
required to conduct such assessments only for their trading account and
for certain other assets, leaving out much bank business from the value
at risk calculation.
The operations risk capital requirement proposed would be equal to
30 percent of the combined amount of capital required for credit and
market risks. This is consistent with the statutory requirement for
operations risk capital imposed on the Federal National Mortgage
Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation
(Freddie Mac). See 12 U.S.C. 4611(c)(2).
In addition to the risk-based capital requirement, the proposal
would establish a minimum total capital requirement that would require
each Bank to maintain total capital of not less than 3.0 percent of its
total assets, regardless of its risk profile, although
[[Page 52165]]
the Finance Board could require a greater amount in individual
cases.\2\
---------------------------------------------------------------------------
\2\ By comparison, the statutory minimum total capital
requirement for the other housing GSEs--Fannie Mae and Freddie Mac--
is 2.5 percent of on-balance sheet assets plus, generally, 0.45
percent of off-balance sheet items. See 12 U.S.C. 4612(a).
---------------------------------------------------------------------------
B. Mission Achievement
The principal source of funding for the Banks is the COs that are
issued in the global capital markets and for which the twelve Banks are
jointly and severally liable. Because of the Banks' GSE status, the
costs to the Banks of obtaining such funding are substantially less
than the borrowing costs for comparable debt issued by other entities.
The Banks pass the benefit of this funding advantage to their members
through wholesale loans (called advances) priced lower than the members
could otherwise obtain to provide support for housing finance,
including community lending, in fulfillment of the Banks' mission.
The FMP does not expressly require the Banks to use any particular
percentage of the funds obtained through the issuance of COs to provide
advances to their members. In large part due to the financial burdens
imposed on the Banks as a result of the savings and loan crisis, the
Banks began in 1991 to use a portion of the proceeds from COs to
finance investments which the Finance Board does not consider to be
adequately related to their statutory mission. The level of such non-
mission-related investments rose substantially in the early 1990s, but
has begun to decline appreciably, as a percent of assets, in recent
years, as the membership base of the Bank System and the level of
advances outstanding to members have increased.
To better link the GSE advantages in the capital markets to the
mission performance of the Bank System, the proposed rule would
require, by January 1, 2005, that an amount equal to 100 percent of
each Bank's outstanding COs be held by the Bank in core mission
activities. ``Core mission activities'' would be defined as those
activities that assist and enhance members' and eligible nonmember
borrowers' \3\ financing of housing and community lending. Included in
this definition are advances and also a newly authorized class of
investments to be called ``member mortgage assets.'' The transition
period is intended to allow the Banks sufficient time to restructure
their balance sheets as necessary to bring the level of core mission
activities in line with the amount of outstanding COs.
---------------------------------------------------------------------------
\3\ Section 10b of the Federal Home Loan Bank Act, 12 U.S.C.
1430b, provides that certain nonmember mortgagees making targeted
housing loans may apply for access to Bank advances.
---------------------------------------------------------------------------
The proposed core mission activity requirement would be subordinate
to the safe and sound financial operation of the Banks, as mandated by
the Federal Home Loan Bank Act (Act). See 12 U.S.C. 1422a(a)(3)(A).
During any specified period in which a Bank's board of directors
determines that the core mission activities requirement would be
inconsistent with the safe and sound operation of the Bank, the Bank
would be permitted to be out of compliance with the core mission
activities requirement.
By establishing the core mission activities requirement at 100
percent of COs outstanding, the proposed rule will both permit and
encourage the Banks to develop new products and business activities
(such as member mortgage assets, discussed below) that: further the
statutory mission of the Banks; build upon the cooperative nature of
the Bank's relationship with its members; meet the core mission
activities definition in the proposed rule; and are supported by
appropriate levels of capital.
C. Responsibilities of Bank Boards of Directors and Senior Management
Because it allows the Banks substantially greater authority to
acquire new assets and manage their risks, and to raise member capital
accordingly, the proposed rule also would articulate certain minimum
responsibilities of the Banks' boards of directors and senior
management with regard to operating the Banks in a safe and sound
manner and ensuring that the Banks achieve their statutory mission.
These responsibilities include matters such as the adoption and annual
review of risk management policies, periodic risk assessments, the
maintenance of effective internal controls, independent audit
committees, and adoption and review of and compliance with mission
achievement policies.
D. Reorganization of Finance Board Regulations
Because of the comprehensive nature of the amendments that would be
made by the proposal, the Finance Board separately is proposing to
reorganize its regulations in order that the revised regulations will
remain internally consistent and will reflect the proposed changes in a
logical manner. Cross-references appearing in the text of the proposed
rule are made to the new section and part numbers that would be in
effect once the reorganization regulation is finalized. Where such
references are to provisions that currently exist under different
section or part numbers, the existing citation has been noted in this
preamble. For ease of reference, this proposed reorganization
regulation is also being published in this edition of the Federal
Register.
E. Public Hearing
The Finance Board will hold a public hearing on this proposal.
Persons interested in participating in the public discussion of the
proposed rule should contact Karen H. Crosby, Director, Office of
Strategic Planning, in writing at the Federal Housing Finance Board,
1777 F St. NW, Washington, DC, 20006, by the close of business October
15, 1999.
II. Statutory and Regulatory Background
A. The Bank System
The twelve Banks are instrumentalities of the United States
organized under the authority of the Act. See 12 U.S.C. 1423, 1432(a).
The Banks are cooperatives; only members of a Bank may own the capital
stock of a Bank and only members or certain eligible nonmember
borrowers (such as state housing finance agencies) may obtain access to
the products provided by a Bank. See 12 U.S.C. 1426, 1430(a), 1430b.
Each Bank is managed by its own board of directors and serves the
public by enhancing the availability of residential mortgage and
community lending credit through its members and eligible nonmembers.
See 12 U.S.C. 1427. Any eligible institution (typically, an insured
depository institution) may become a member of a Bank by satisfying
certain criteria and by purchasing a specified amount of the Bank's
capital stock. See 12 U.S.C. 1424, 1426, 1430(e)(3); 12 CFR part 933.
As GSEs, the Banks are granted certain privileges that enable them to
borrow funds in the capital markets on terms more favorable than could
be obtained by other entities. Typically, the Bank System can borrow
funds at a modest spread over the rates on U.S. Treasury securities of
comparable maturity. The Banks pass along their GSE funding advantage
to their members--and ultimately to consumers--by providing advances
(secured loans) and other financial services at rates that would not
otherwise be available to their members.
Together with the Office of Finance, the twelve Banks comprise the
Bank System, which operates under the supervision of the Finance Board,
an independent agency in the executive branch of the U.S. government.
The primary duty of the Finance Board is to
[[Page 52166]]
ensure that the Banks operate in a financially safe and sound manner;
consistent with that duty the Finance Board is required to supervise
the Banks, ensure that they carry out their housing finance mission,
and ensure that they remain adequately capitalized and able to raise
funds in the capital markets. 12 U.S.C. 1422a(a)(3)(A), (B).
B. The Banks' Housing Finance and Community Lending Mission
Under section 10 of the Act and part 935 of the Finance Board's
regulations, the Banks have broad authority to make advances in support
of housing finance, which includes community lending. See 12 U.S.C.
1430(a), (i), (j); 12 CFR part 935. The Banks also are required to
offer two programs--the Affordable Housing Program (AHP) and the
Community Investment Program (CIP)--to provide subsidized or at-cost
advances, respectively, in support of unmet housing finance or targeted
economic development credit needs. See 12 U.S.C. 1430(i), (j); 12 CFR
parts 960, 970. In addition, section 10(j)(10) of the Act, as
implemented by a recently issued Finance Board regulation, authorizes
the Banks to establish Community Investment Cash Advance (CICA)
Programs for community lending, defined as providing financing for
economic development projects for targeted beneficiaries. See 12 U.S.C.
1430(j)(10); 12 CFR part 970; 63 FR 65536 (Nov. 27, 1998).
C. Investment Authority and Oversight
The Banks' investment authority is set forth primarily in sections
11(h) and 16(a) of the Act, which govern the investment of the Banks'
surplus and reserve funds, respectively. See 12 U.S.C. 1431(h),
1436(a). Under both of these sections, the Banks are authorized to
invest in: obligations of the United States; certain obligations of
Fannie Mae, the Government National Mortgage Association (Ginnie Mae),
or Freddie Mac; and in such securities in which fiduciary and trust
funds may be invested under the law of the state in which the Bank is
located. Section 11(h) also authorizes investments in the securities of
certain small business investment companies (SBIC).
In addition to those permissive investments, the Banks are required
to have liquidity reserves in an amount equal to deposits from their
members invested in obligations of the United States, deposits in banks
or trust companies, and certain specified short-term advances to their
members. See 12 U.S.C. 1431(g).
Currently, the Finance Board regulates the Banks' investment
practices through its regulations, as well as through the FMP. Section
934.1 of the regulations provides that the Banks may acquire or dispose
of investments only with the prior approval of the Finance Board, or in
conformity with authorizations of the Finance Board or ``stated
[Finance] Board policy.'' 12 CFR 934.1. By resolution, the Finance
Board adopted the FMP, in part, as its ``stated policy'' regarding
permissible Bank investments. The FMP generally provides a framework
within which the Banks may implement their financial management
strategies in a prudent and responsible manner. Specifically, the FMP
identifies the types of investments that the Banks may purchase
pursuant to their statutory investment authority and, therefore, by
implication, prohibits any investments not specifically identified by
the FMP. The FMP also includes a series of guidelines relating to the
funding and hedging practices of the Banks, as well as to the
management of their credit, interest rate and liquidity risks, and
establishes liquidity requirements in addition to those required by
statute, as noted above. See FMP sections III-VII.
The FMP evolved from a series of policies and guidelines initially
adopted by the Finance Board's predecessor agency, the Federal Home
Loan Bank Board (FHLBB), which had adopted guidelines comparable to the
FMP in the 1970s and revised them a number of times thereafter. The
Finance Board adopted the FMP in 1991, consolidating into one document
the previously separate policies on funds management, hedging and
interest rate swaps, and adding new guidelines on management of
unsecured credit and interest rate risks. As discussed in considerably
more detail below, this proposed rule would supersede the FMP as the
Finance Board's means of overseeing the investment practices and
mission achievement of the Banks.
III. Analysis of Proposed Rule
A. Part 917--Responsibilities of Bank Boards of Directors and Senior
Management
1. Overview
Each state generally has laws of incorporation that require, among
other things, a corporation to be managed by a board of directors.
Consistent with this general corporate concept, the Act provides for
the management of each Bank to be vested in the Bank's board of
directors. See 12 U.S.C. 1427(a). The Act states that each Bank is a
corporate body. See id. at 1432(a). In addition to authorizing certain
enumerated corporate and banking powers, see id. at 1431, 1432, the Act
grants each Bank all such incidental powers as are consistent with the
provisions of the Act and customary and usual in corporations
generally. See id. The Finance Board believes that, attendant to the
exercise of customary and usual corporate powers, the Banks' boards of
directors are subject to the same general fiduciary duties of care and
loyalty to which the board of a state-chartered business or banking
corporation would be subject, although this previously has not been set
forth in regulation.
The duties, responsibilities and privileges of a director of a Bank
derive from a source different from that of a director of a state-
chartered business or banking corporation. Each Bank is created in
accordance with Federal law to further public policy, and its statutory
powers and purposes are not subject to change except by the Congress. A
Bank's board of directors has neither the right nor the duty to alter
the purpose of the Bank, whereas an ordinary corporate board of
directors may approve mergers, consolidations and changes in the
corporate charter that could drastically alter the objectives and
nature of the business of the corporation. The directors of a Bank are
responsible for managing that Bank to achieve the statutorily-mandated
objectives of promoting housing finance and community lending and
meeting the Bank's statutory obligations (e.g., paying a portion of the
interest on obligations of the Resolution Funding Corporation
(REFCORP), see id. at 1441b, and making contributions to the AHP, see
id. at 1430(j)), all in a financially safe and sound manner.
All Banks are subject to the supervision of the Finance Board.
Although the directors manage and control their Banks, they may act
only within the parameters established by the Finance Board. The bulk
of the Banks' corporate powers, duties and responsibilities are
described in sections 10, 11, 12 and 16 of the Act. Id. at 1430, 1431,
1432 and 1436. Section 10 of the Act authorizes each Bank to make
secured advances to its members upon collateral sufficient, in its
judgment, to fully secure the advance, and to certain eligible
nonmember borrowers upon statutorily specified collateral. See id.
1430(a), 1430b. The Banks may conduct correspondent services, establish
reserves, make investments and pay dividends, all subject to statutory
limitations. See id. at 1431, 1436. Under section 12(a) of the Act, a
Bank, and hence any director of that Bank, has the power to sue and be
sued. See id. at 1432(a). In addition, each Bank has adopted bylaws
that address such
[[Page 52167]]
matters as: the conduct of meetings of the board of directors;
existence, composition, conduct and administration of committees of the
board of directors; and indemnification.
Proposed part 917 for the first time would set forth in one place
and in regulation the duties and responsibilities of a Bank's board of
directors and of senior management of the Bank. It will make clear the
Finance Board's belief that oversight of management by a strong and
proactive board of directors is critical to the safe and successful
operation of a Bank. Under proposed part 917, the board of directors of
each Bank shall be responsible for: approving and periodically
reviewing the significant policies of the Bank; understanding the major
risks taken by the Bank, setting acceptable tolerance levels for these
risks and ensuring that senior management takes the steps necessary to
identify, measure, monitor and control these risks; monitoring that the
Bank is in compliance with applicable statutes, regulation and policy
(both of the Finance Board and the Bank); ensuring that the Bank
carries out its housing finance and community lending mission;
approving the organizational structure and delegations of authority;
and ensuring that an adequate and effective system of internal controls
is established and maintained and that senior management is monitoring
the effectiveness of the internal control system.
Proposed part 917 provides that senior management of each Bank
shall be responsible for implementing strategies and policies approved
by the Bank's board; developing processes that identify, measure,
monitor and control risks incurred by the Bank; maintaining an
organizational structure that clearly assigns responsibility, authority
and reporting relationships; ensuring that delegated responsibilities
are effectively carried out; setting appropriate internal control
policies; and monitoring the adequacy and effectiveness of the internal
control system.
The proposed requirements for the Banks' boards of directors and
senior management generally are based on widely accepted best corporate
practices. They are intended to augment the responsibilities,
independence and expertise of the boards of directors by requiring them
to oversee both risk management for safety and soundness and
achievement of the public purpose of supporting housing and targeted
economic development. Oversight by both the boards of directors and
senior management is integral to the overall business operation of the
Bank. The first line of defense in ensuring safety and soundness has to
be an effective corporate governance structure within the Banks
themselves. Having an active, informed and engaged board of directors
is the cornerstone of a well-run entity.
In addition, recognition of the importance of mission achievement
must originate with the board of directors and fulfillment of mission
at all levels of the Bank must be promoted and encouraged by the board.
The requirements contained in the proposed rule are intended to ensure
that the boards of directors of the Banks give serious consideration to
these important responsibilities.
2. General Duties of Bank Boards of Directors--Sec. 917.2
Proposed Sec. 917.2 provides that each Bank's board of directors
shall have the general duty to direct the operations of the Bank in
conformity with the requirements of the Finance Board's regulations.
Proposed Sec. 917.2 further provides that each board director shall
carry out his or her duties as director in good faith, in a manner such
director believes to be in the best interests of the Bank, and with
such care, including reasonable inquiry, as an ordinarily prudent
person in a like position would use under similar circumstances.
3. Risk Management--Sec. 917.3
Section 917.3 of the proposed rule sets forth the risk management
responsibilities of Bank boards of directors and senior management.
Proposed Sec. 917.3(a)(1) would require that, within 180 calendar days
of the adoption of the rule in final form, each Bank's board of
directors shall adopt a risk management policy addressing the Bank's
exposure to credit risk, market risk, liquidity risk, business risk and
operations risk in a manner consistent with the substantive risk
management requirements set forth in part 930 of the proposed rule. The
risk limits set forth in the policy shall be consistent with the Bank's
capital position and its ability to measure and manage risk. Under
proposed Sec. 917.3(a)(1), a Bank will be required to submit its
initial risk management policy to the Finance Board for approval;
subsequent versions of the policy or amendments would not be required
to be submitted to, or approved by, the Finance Board. However, Bank
risk management policies will be reviewed by the Finance Board as part
of the ongoing examination process.
Proposed Sec. 917.3(a)(2)(i) would require that the Bank's board of
directors review the Bank's risk management policy on at least an
annual basis. Proposed Sec. 917.3(a)(2)(iii) provides that the board of
directors also would be required to re-adopt the risk management
policy, including interim amendments, not less often than every three
years, as appropriate based on the board's reviews of the policy. In
addition to providing consistency, this requirement is intended to
ensure that, despite the turnover in board personnel that will occur
over a number of years, all or most current members of a Bank's board
of directors will be thoroughly familiar with the Bank's risk
management policy, will have given meaningful consideration to its
provisions and will have expressed an opinion regarding the adequacy of
the policy through the voting process. Proposed Sec. 917.3(a)(2)(iv)
also would make clear that each Bank's board of directors has the
ultimate responsibility to ensure that the Bank is in compliance at all
times with the risk management policy.
Section 917.3(b) of the proposed rule sets forth several specific
requirements for each Bank's risk management policy. Proposed
Sec. 917.3(b)(1) would require that each Bank's risk management policy
describe how the Bank will comply with the risk-based capital standards
set forth in proposed part 930. Proposed Sec. 917.3(b)(2) would require
each Bank's risk management policy to set forth tolerance levels for
the market and credit risk components.
Proposed Sec. 917.3(b)(3) requires each Bank's risk management
policy to set forth standards for the Bank's management of credit,
market, liquidity, business and operations risks. Credit risk is
defined in proposed Sec. 930.1 as the risk that an obligation will not
be paid in full and loss will result. The Banks must assess the
creditworthiness of issuers, obligors, or other counterparties prior to
acquiring investments and, under proposed Sec. 917.3(b)(3)(i), the
Bank's risk management policy would be required to include the
standards and criteria for such an assessment. In addition, the credit
risk portion of each Bank's risk management policy also should identify
the criteria for selecting brokers, dealers and other securities firms
with which the Bank may execute transactions.
Market risk is defined in proposed Sec. 930.1 as the risk of loss
in value of the Bank's portfolio resulting from movements in market
prices. Under proposed Sec. 930.6, each Bank would be required to have
in place a comprehensive market risk management model that allows the
Bank to estimate in a timely manner the value of the portfolio at risk
from changes in market prices under various stress scenarios.
[[Page 52168]]
Proposed Sec. 917.3(b)(3)(ii) would require that each Bank's risk
management policy establish standards for the methods and models used
to measure and monitor market risk, including maximum exposure
thresholds and scenarios for measuring risk exposure.
Liquidity risk is defined in proposed Sec. 917.1 as the risk that a
Bank would be unable to meet its obligations as they come due or meet
the credit needs of its members and eligible nonmember borrowers in a
timely and cost-efficient manner. Operational liquidity addresses day-
to-day or ongoing liquidity needs under normal circumstances.
Operational liquidity needs may be either anticipated or unanticipated.
Contingency liquidity addresses the same liquidity needs, but under
abnormal or unusual circumstances in which a Bank's access to the
capital markets is impeded. This impediment may result from a market
disruption, operational failure, or real or perceived credit problems.
Proposed Sec. 917.3(b)(3)(iii) would require that each Bank's risk
management policy indicate the Bank's sources of liquidity, including
specific types of investments to be held for liquidity purposes, and
the methodology to be used for determining the Bank's operational and
contingency liquidity needs. The proposed new liquidity requirements
are addressed in more detail below in the discussion of proposed
Sec. 930.10.
Operations risk is defined in proposed Sec. 930.1 as the risk of an
unexpected loss to a Bank resulting from human error, fraud,
unenforceability of legal contracts, or deficiencies in internal
controls or information systems. Proposed Sec. 917.3(b)(3)(iv) would
require each Bank's risk management policy to address operations risk
by setting forth standards for an effective internal control system (as
described in more detail below), including periodic testing and
reporting.
Business risk is defined in proposed Sec. 930.1 as the risk of an
adverse impact on a Bank's profitability resulting from external
factors as may occur in both the short and long run. Such factors
include: continued financial services industry consolidation; declining
membership base; concentration of borrowing among members; and
increased inter-Bank competition. Proposed Sec. 917.3(b)(3)(v) would
require that each Bank's risk management policy identify these risks
and include strategies for mitigating such risks, including contingency
plans where appropriate.
In order for each Bank to create and maintain a meaningful risk
management policy, it is important that the boards of directors be
cognizant of the strategic risks facing the Bank. Therefore, proposed
Sec. 917.3(c) would require that senior management of each Bank
perform, at least annually, a written risk assessment that identifies
and evaluates all material risks, including both quantitative and
qualitative aspects, that could adversely affect the achievement of the
Bank's performance objectives and compliance requirements. Proposed
Sec. 917.3(c) also requires that the risk assessment be in written form
and be reviewed by the Bank's board of directors promptly upon its
completion.
4. Internal Control System--Sec. 917.4
While the existing FMP requires that management of each Bank
establish internal control systems, there is no guidance provided on
how to ascertain the sufficiency of the systems. There have been
several instances where internal control weaknesses have been uncovered
through the Finance Board's examination process. As a result, the
Finance Board believes it prudent to provide more specific requirements
for the internal control process that should be in place at each Bank.
In developing requirements for internal control processes for the
Banks, the Finance Board reviewed the available literature on the
appropriate internal control systems for financial institutions.
Included in this review was the BCBS's Framework for Internal Control
Systems published in September 1998 (hereinafter Basle Committee
Report) and the Committee of Sponsoring Organizations of the Treadway
Commission's Internal Control--Integrated Framework Report published in
September 1992 (hereinafter Treadway Commission). The recommendations
contained in these Reports are considered to be state of the art for
defining, implementing, monitoring, and evaluating internal control
systems.
According to the Basle Committee Report, a system of effective
internal controls is a critical component of bank management and a
foundation for safe and sound operation of a banking organization. A
strong system of internal controls can help a bank meet its goals and
objectives, achieve long-term profitability targets, and maintain
reliable financial and managerial reporting. An internal control system
also can help to: (1) Ensure the bank is in compliance with laws,
regulations and the bank's internal policies and procedures; (2)
safeguard assets; and (3) decrease the risk of damage to the bank's
reputation.
The Treadway Commission Report defines internal controls as a
process, effected by the board of directors, management and other
personnel, designed to provide reasonable assurance regarding the
achievement of objectives in the: (1) Effectiveness and efficiency of
operations; (2) reliability of financial reporting; and (3) compliance
with applicable laws and regulations.
Both Reports discuss basic components or principles for
establishing and assessing internal control--management oversight and
the control environment, risk recognition and assessment, control
activities and segregation of duties, information and communication,
and monitoring activities and correcting deficiencies.
The provisions of Sec. 917.4 of the proposed rule were adapted from
the basic components and principles in the Basle Committee and Treadway
Commission Reports. The Finance Board believes that appropriate
internal controls will be critical to successful implementation of this
regulation. The proposed rule would provide the framework for an
effective internal control system, and establish senior management and
board of directors' responsibilities regarding internal controls.
Proposed Sec. 917.4 addresses the requirements for a Bank's
internal control systems. Proposed Sec. 917.4(a)(1) would require each
Bank to establish and maintain an effective internal control system
adequate to ensure: the efficiency and effectiveness of Bank
activities; the safeguarding of assets; the reliability, completeness
and timely reporting of financial and management information and
transparency of such information to the Bank's board of directors and
to the Finance Board; and compliance with applicable laws, regulations,
policies, supervisory determinations and directives of the Bank's board
of directors and senior management.
Proposed Sec. 917.4(a)(2) enumerates certain minimum ongoing
internal control activities that the Finance Board considers to be
necessary in order for the internal control objectives described in
proposed Sec. 917.4(a)(1) to be achieved. These activities include: top
level reviews by the Bank's board of directors and senior management;
activity controls, including review of standard performance and
exception reports; physical controls adequate to ensure the
safeguarding of assets; monitoring for compliance with the risk
tolerance limits set forth in the risk management policy that would be
required under proposed Sec. 917.3(a); any required approvals and
authorizations for specific activities; and any required
[[Page 52169]]
verifications and reconciliations for specific activities.
Section 917.4(b) of the proposed rule would charge each Bank's
board of directors with the responsibility of directing the
establishment and maintenance of the internal control system by senior
management, and overseeing senior management's implementation of the
system on a continuing basis. Under proposed Sec. 917.4(b), specific
board actions necessary to fulfill these responsibilities would
include: conducting periodic discussions with senior management
regarding the effectiveness of the internal control system; ensuring
that an effective and comprehensive internal audit of the internal
control system is performed annually; ensuring that the Bank's board of
directors receives reports on internal control deficiencies in a timely
manner and that such deficiencies are addressed promptly; conducting a
timely review of evaluations of the effectiveness of the internal
control system made by auditors and Finance Board examiners; ensuring
that senior management promptly and effectively addresses
recommendations and concerns expressed by auditors and Finance Board
examiners regarding weaknesses in the internal control system;
reporting internal control deficiencies, and the corrective action
taken, to the Finance Board in a timely manner; establishing,
documenting and communicating an clear and effective organizational
structure for the Bank; ensuring that all delegations of board
authority state the extent of the authority and responsibilities
delegated; and establishing reporting requirements.
Section 917.4(c) of the proposed rule would charge each Bank's
senior management with the responsibility to establish, implement and
maintain the internal control system under the direction of the Bank's
board of directors. Under proposed Sec. 917.4(c), specific actions on
the part of senior management that would be necessary to fulfill these
responsibilities include: establishing, implementing and effectively
communicating to Bank personnel policies and procedures that are
adequate to ensure that internal control activities necessary to
maintain an effective internal control system are an integral part of
the daily functions of all Bank personnel; ensuring that all Bank
personnel fully understand and comply with all policies and procedures;
ensuring that there is appropriate segregation of duties among Bank
personnel and that personnel are not assigned conflicting
responsibilities; establishing effective paths of communication
throughout the organization in order to ensure that Bank personnel
receive necessary and appropriate information; developing and
implementing procedures that translate the major business strategies
and policies established by the board of directors into operating
standards; ensuring adherence to the lines of authority and
responsibility established by the Bank's board of directors; overseeing
the implementation and maintenance of management information and other
systems; establishing and implementing an effective system to track
internal control weaknesses and the actions taken to correct them; and
monitoring and reporting to the Bank's board of directors the
effectiveness of the internal control system on an ongoing basis.
5. Audit Committees--Sec. 917.5
Section 917.5 of the proposed rule addresses requirements for the
establishment of an audit committee by each Bank's board of directors.
Current Finance Board requirements for audit committees are contained
in Finance Board Res. No. 92-568.1 (July 22, 1992) and Finance Board
Advisory Bulletin 96-1 (Feb. 29, 1996).
Resolution No. 92-568.1 contains guidelines intended to be the
minimum standards that should be adopted by the Banks for revisions of
the respective audit charters. The guidelines require that: audit
committee charters include a statement of the audit committee's
responsibilities, including a statement of its purpose to assist the
full board of directors in fulfillment of its fiduciary
responsibilities; the audit committee shall consist of at least three
board members and shall include appointed directors and elected
directors; that in determining the membership of the audit committee,
the board of directors should provide for continuity of service; the
audit committee shall meet at least twice annually with the audit
director and the audit committee shall meet in executive session with
both the audit director and the external auditors at least annually;
the audit committee shall oversee the selection, compensation, and
performance evaluation of the audit director; written minutes shall be
prepared for each meeting and a copy of such minutes forwarded to the
Finance Board; and the charters of the audit director and audit
committee shall be reviewed and approved at least annually by the audit
committee and the board of directors, respectively.
Advisory Bulletin 96-1 communicated examination findings regarding
certain Bank practices that may tend to reduce the independence of the
internal audit function, specifically the processes by which Bank audit
director compensation is determined and performance is evaluated. The
Bulletin indicated that examiners would review measures taken by the
audit committee to assure the independence from management of the
internal audit function, and to fulfill its responsibility to select,
set the compensation of, and evaluate the performance of the audit
director, and specified that all Bank audit committees should review
their current practices and revise these as appropriate.
Proposed Sec. 917.5 codifies into regulation the Finance Board's
existing policy on requiring the Banks to have audit committees and
adds requirements addressing their independence and their
responsibilities for oversight of Bank operations. The proposed
requirements for audit committees are based on standard corporate
requirements and best practices. In developing the appropriate
requirements for Bank audit committees, the Finance Board reviewed the
audit committee regulations of other financial institution regulatory
agencies and the Report and Recommendations of the Blue Ribbon
Committee on Improving the Effectiveness of Corporate Audit Committees
(February 8, 1999) (hereinafter Blue Ribbon Committee Report). The
Securities and Exchange Commisssion encouraged the New York Stock
Exchange and the National Association of Securities Dealers to form a
private sector body to investigate perceived problems in financial
reporting. Accordingly, the Blue Ribbon Committee was formed in October
1998 to take an objective look at U.S. corporate financial reporting,
specifically assessing the current mechanisms for oversight and
accountability among corporate audit committees, independent auditors,
and financial and senior management.
Proposed Sec. 917.5(a) would require that each Bank's board of
directors establish an audit committee. Proposed Sec. 917.5(b) would
require that each Bank's audit committee consist of five or more board
directors, each of whom meets the independence criteria discussed
below, and include a balance of representatives of large and small
members and of appointed and elected directors of the Bank. The
requirement in proposed Sec. 917.5(b) that the audit committee comprise
five or more persons differs from the recommendation of the Blue Ribbon
Committee Report that the audit
[[Page 52170]]
committee comprise a minimum of three directors. The Finance Board
believes it is important that the audit committee include
representatives of large and small members and appointed and elected
directors of the Bank in order to prevent dominance by one particular
individual or group of individuals. A minimum of five members is
necessary to ensure that the audit committee will have such diverse
representation.
The terms of audit committee members must be appropriately
staggered to provide for continuity of service, and to avoid a
complete, or substantial, turnover of the membership of the audit
committee in any one year. All members of the audit committee would be
required to have a working familiarity with basic finance and
accounting principles, with at least one member having extensive
accounting or financial management expertise. This requirement is
intended to ensure that audit committee members have the ability to
read and understand the Bank's balance sheet and income statement and
to ask substantive questions of internal and external auditors. The
Finance Board recognizes that, in some cases, a Bank's board of
directors may not include enough members with expertise sufficient for
the demands of service on the audit committee, considering the
representation requirements. Thus, proposed Sec. 917.5(b)(4) would
require that, if such familiarity or expertise is lacking among current
board directors, the board of directors shall, in the case of appointed
directors, notify the Finance Board or, in the case of elected
directors, include in the notice of election required under
Sec. 915.6(a) (existing Sec. 932.6(a)), a statement describing the
skills or expertise needed.
In addition, proposed Sec. 917.5(c) would require that any board
director serving on the audit committee be sufficiently independent of
the Bank and its management so as to maintain the ability to make the
type of objective judgments that are required of audit committee
members. The proposed independence criteria were adapted from the Blue
Ribbon Committee Report, which states that ``common sense dictates that
a director without any financial, family, or other material personal
ties to management is more likely to be able to evaluate objectively
the propriety of management's accounting, internal control and
reporting practices.'' The Finance Board agrees that the independence
of the directors serving on the audit committee is of great importance.
Proposed Sec. 917.5(c) describes several examples, which are not
intended to include all possible examples, of relationships that would
call into question the independence of an audit committee member and
that, therefore, would disqualify any director having such a
relationship with the Bank or its management from serving on the audit
committee. The list is not intended to be exhaustive, because it is
impossible to foresee all potential individual circumstances that might
compromise the independence of a particular director. Thus, the Finance
Board expects that the board of directors will consider all potential
relationships when qualifying a director for service on the audit
committee.
Proposed Sec. 917.5(d) would require that each Bank's audit
committee adopt a formal written charter setting forth the scope of the
audit committee's powers and responsibilities and establishing its
structure, processes and membership requirements. Both the audit
committee itself and the Bank's full board of directors would be
required to review the provisions of the audit committee charter
annually and to adopt the charter, including amendments, not less often
than every three years, as appropriate based on the board's and audit
committee's reviews of the policy. Proposed Sec. 917.5(d)(3) would
require that the audit committee charter contain the following specific
provisions: that the Bank's internal auditor may be removed only with
the approval of the audit committee; that the internal auditor shall
report directly to the audit committee on substantive matters and to
the Bank President on administrative matters; that the audit committee
shall be empowered to employ such outside experts as it deems necessary
to carry out its functions; and that the internal and external auditors
be allowed unrestricted access to the audit committee without any
requirement of management knowledge or approval. The proposed
requirements pertaining to the audit committee charters were adapted
from the recommendations contained in the Blue Ribbon Committee Report
and the current Finance Board requirements on audit committees.
Proposed Sec. 917.5(e) sets forth the duties of each Bank's audit
committee under the new regulatory structure, including the duties to:
ensure that senior management maintains the reliability and integrity
of the accounting policies and financial reporting and disclosure
practices of the Bank; review the basis for the Bank's financial
statements and the external auditor's opinion rendered with respect to
such financial statements and ensure disclosure and transparency
regarding the Bank's true financial performance and governance
practices; oversee the internal audit function; oversee the external
audit function; act as an independent, direct channel of communication
between the Bank's board of directors and the internal and external
auditors; conduct or authorize investigations into any matters within
the audit committee's scope of responsibilities; ensure that senior
management has established and is maintaining an adequate internal
control system; ensure that senior management has established and is
maintaining adequate policies and procedures to ensure that the Bank
can assess, monitor and control compliance with its mission achievement
policy as required in Sec. 917.9(b)(1) of the proposed rule; and report
periodically its findings to the Bank's board of directors.
Proposed Sec. 917.5(e)(8) requires that the audit committee conduct
not only financial audits but also audit the controls in place to
ensure the Bank's compliance with its mission achievement policy. The
audit committee is not required to assess the mission performance of
the Bank. Review of the mission performance assessment of the Bank is
the responsibility of the full board of directors, as more fully
discussed in proposed Sec. 917.9(b)(3) below.
An audit of the controls in place to ensure the Bank's compliance
with its mission achievement policy is considered one type of a
performance audit. In contrast to a financial audit, which is a
financial statement or financial related audit, a performance audit is
an objective and systematic examination of evidence for the purpose of
providing an independent assessment of the performance of an
organization, program, activity or function in order to provide
information to improve public accountability and facilitate decision
making by parties with responsibility to oversee or initiate corrective
action. See U.S. General Accounting Office, Government Auditing
Standards (GAO Yellow Book). Performance audits include economy and
efficiency, program and compliance audits. Economy and efficiency
audits evaluate whether the entity is using its resources economically
and efficiently, and the causes of inefficiencies and uneconomical
practices. Id. at 14. Program audits evaluate the extent to which the
desired results as established by the authorized body are being
achieved, and the effectiveness of organizations, programs, activities
or functions. Id. Compliance audits
[[Page 52171]]
evaluate whether the entity complied with significant laws and
regulations applicable to the organization or program. Id. at 13-14.
The Finance Board requests comments on whether the duties and
responsibilities of the audit committee and the internal auditor should
be broadened in the proposed rule to include economy and efficiency and
program audits, as well as compliance and financial related audits.
Finally, proposed Sec. 917.5(f) would require that each Bank's
audit committee prepare written minutes of each audit committee
meeting.
6. Budget Preparation and Reporting Requirements--Sec. 917.6
Proposed Sec. 917.6 is carried over unchanged from existing
Sec. 934.7 of the Finance Board's regulations.
7. Dividends--Sec. 917.7
Proposed Sec. 917.7 retains in large part the provisions of
existing Sec. 934.17 of the Finance Board's regulations, with certain
proposed amendments as discussed below. The existing dividend
regulation provides that the board of directors of each Bank, with the
approval of the Finance Board, may declare and pay a dividend from net
earnings, including previously retained earnings, on the paid-in value
of capital stock held during the dividend period. See 12 CFR 934.17.
Proposed Sec. 917.7 would devolve the dividend process to the Banks and
allow the payment of dividends without prior Finance Board approval, so
long as such payment will not result in a projected impairment of the
par value of the capital stock of the Bank. Because, under the
regulatory regime proposed in this rulemaking, the earning assets of
the Banks will be either core mission activities or assets that have
not been acquired through debt issued with the benefit of the Banks'
GSE status, the Finance Board's concerns about the proper use of the
Banks' GSE funding advantage will have been addressed, and the need for
prior Finance Board approval will have been obviated.
Each Bank's board of directors would then be responsible for
ensuring that the benefits stemming from membership in the Bank System
would be distributed in an equitable manner to all members of that
cooperatively-owned Bank. Benefits can be distributed in the form of
dividends, but can also be distributed in the form of lower pricing for
advances and other Bank products. Lower product pricing, however, gives
greater assurance that the Bank System's benefits are passed along to
American consumers through increased competition in the housing finance
marketplace. The Finance Board expects the Banks, as cooperatively-
owned institutions, to pass along a greater proportion of the benefits
through lower product pricing (as opposed to higher dividends) than if
the Banks were owned by private, third-party shareholders. The Finance
Board requests comments on the reasonableness of this expectation or
whether it should reconsider the need to have some mechanism to review
or control the Banks' dividend decisions.
The current dividend regulation also provides that the Bank's
dividend period may be quarterly, semiannual or annual periods ending
on March 31, June 30, September 30 or December 31. Proposed Sec. 917.7
would leave the determination of the dividend period to the discretion
of the Banks.
Proposed Sec. 917.7 retains without change the provisions in the
current dividend regulation that dividends shall be computed without
preference and only for the period the stock was outstanding during the
dividend period, and that dividends may be paid in cash or in the form
of stock. As discussed below under ``Capital Stock Redemption
Requirements--Sec. 930.9,'' the Finance Board recently published an
Advance Notice of Proposed Rulemaking (ANPRM) that requested comment on
whether the Banks should be prohibited from paying dividends in the
form of stock. For the reasons discussed under that section, proposed
Sec. 917.7 does not include such a prohibition. Dividend payments by
the Banks also have been subject to a Finance Board Dividend Policy,
see Finance Board Res. No. 90-38 (Mar. 15, 1990), which, in addition to
repeating provisions from the regulation, specifies target dividend
rate formulae and requires the Banks to submit dividend recommendations
and a certification that the recommendation is in compliance with the
Dividend Policy at least 10 days prior to the payment of any dividend.
These requirements from the Dividend Policy have not been included in
proposed Sec. 917.7. Furthermore, the Finance Board anticipates that,
if proposed Sec. 917.7 is adopted as proposed, the Finance Board will
rescind the Dividend Policy.
8. Approval of Bank Bylaws--Sec. 917.8
Proposed Sec. 917.8 is carried over unchanged from existing
Sec. 934.16 of the Finance Board's regulations.
9. Mission Achievement--Sec. 917.9
Proposed Sec. 917.9 sets forth new requirements that each Bank must
meet in developing a mission achievement policy and overseeing the
Bank's mission achievement. The Act establishes the Finance Board's
primary responsibility for ensuring the safety and soundness of the
Bank System and consistent with that duty, ensuring that the Banks
fulfill their public policy mission. See 12 U.S.C. 1422a(a)(3). As with
the risk management function, a Bank's board of directors must take its
mission responsibilities seriously and impress the importance of
mission achievement upon Bank management and staff. The Banks' boards
of directors must be fully engaged so that there is a focus on mission
achievement at all levels of the Bank.
Proposed Sec. 917.9(a)(1) would require that each Bank's board of
directors adopt and submit to the Finance Board for approval a mission
achievement policy within 180 calendar days of the effective date of
the rule in final form. This mission achievement policy would be
required to detail how the Bank will comply with the core mission
activity requirements set forth in proposed part 940 (discussed in more
detail below), including contingent business strategies for meeting the
core mission activity requirements under different assumptions about
future economic and mortgage market conditions. The policy also would
be required to outline a process for developing and implementing new
mission-related products and services. The board should foster an
environment that encourages management to be innovative and committed
in developing products that provide assistance to Bank members in the
financing of housing and community lending.
As with the risk management policy, proposed Sec. 917.9(a)(2)(i)
would require that the Bank's board of directors review the Bank's
mission achievement policy on at least an annual basis. Proposed
Sec. 917.9(a)(2)(iii) would require a Bank's board of directors to re-
adopt a mission achievement policy, including interim amendments, not
less often than every three years, as appropriate based on the board's
reviews of the policy. Again, as with the similar provision in proposed
Sec. 917.3(a)(2), this requirement is intended to ensure that, even
given the turnover in board personnel that will occur over a number of
years, all or most current members of a Bank's board of directors will
be thoroughly familiar with the Bank's mission achievement policy, will
have given meaningful consideration to its provisions and will have
expressed their opinion regarding the adequacy of the policy through
the voting process. Proposed Sec. 917.9(a)(2)(iv) also would make clear
that each Bank's board of directors has the ultimate responsibility to
ensure
[[Page 52172]]
that the Bank is in compliance at all times with the mission
achievement policy.
Under proposed Sec. 917.9(a), each Bank would be required to submit
its initial mission achievement policy to the Finance Board for
approval; subsequent versions of the policy adopted thereafter or
amendments would not be required to be submitted to, or approved by,
the Finance Board. However, as with the risk management policies, Bank
mission achievement policies will be reviewed by the Finance Board as
part of the ongoing examination process.
Proposed Sec. 917.9(b) would require that each Bank's board of
directors: (1) direct the establishment and maintenance, by senior
management, of adequate policies and procedures to ensure that the Bank
can assess, monitor and control compliance with its mission achievement
policy; (2) establish a mechanism to measure and assess the Bank's
performance against its mission achievement goals and objectives; and
(3) require that performance assessments be conducted at least annually
that evaluate the Bank's mission achievement and measure its
performance against the Bank's goals and objectives and that such
performance assessments be reviewed by the Bank's board of directors.
These provisions are intended to ensure that the board of directors
oversees the process of assessing mission achievement, but do not
require that this responsibility reside with the audit committee or the
internal auditor. It is not necessary that the requirements for the
audit committee, which oversees the financial audit of the Bank, be
applied to the oversight of mission performance. Thus, proposed
Sec. 917.9(b) requires that the board of directors oversee mission
performance, but it allows the board to determine how, and by what
mechanism, it will carry out this responsibility. However, as
previously discussed, the audit committee shall be responsible for
ensuring that proper controls exist to ensure that an assessment of
mission achievement is carried out. In any event, the mission
management assessments should follow the requirements for program
audits contained in the GAO Yellow Book.
B. Part 925--Members of the Banks
Existing part 933 of the Finance Board's regulations, ``Members of
the Banks,'' has been proposed to be redesignated as new part 925 in
the Finance Board's proposed rule to reorganize all of the Finance
Board's regulations published separately in this issue of the Federal
Register. Part 925 of the proposed reorganization rule retains in large
part the provisions of existing part 933. Certain proposed amendments,
which consist primarily of cross-references to sections of this
proposed financial management and mission achievement regulation, are
included in this rulemaking and discussed here.
Specifically, Secs. 933.14, 933.22, and 933.24 through 933.28 of
the Finance Board's existing membership regulations have been
redesignated as Secs. 925.14, 925.22, and 925.24 through 925.28 in the
proposed reorganization regulation. Each of these sections contains
provisions regarding the treatment of outstanding advances and Bank
stock in different events: conditional membership approvals of de novo
insured depository institution applicants deemed void (Sec. 925.14);
ownership of excess shares of capital stock (Sec. 925.22);
consolidations of members (Sec. 925.24); consolidations involving
nonmembers (Sec. 925.25); member withdrawals (Sec. 925.26); removal of
members (Sec. 925.27); and automatic termination of members placed in
receivership (Sec. 925.28). In each of these situations, where
applicable, liquidation of outstanding indebtedness owed to the Bank
(mainly advances) in which membership has ceased is proposed to be
handled in accordance with newly designated Sec. 925.29. The redemption
of stock in each circumstance described in these sections is proposed
to be conducted pursuant to new Sec. 930.9 (capital stock redemption
requirements), proposed in this rulemaking.
C. Part 930--Risk Management and Capital Standards
1. Overview
As discussed previously, the Banks' current capital requirements
are determined according to a statutory formula, which uses either the
asset size of a member or the amount of its borrowings from a Bank to
determine the amount of stock the member must purchase from its Bank.
See 12 U.S.C. 1426(b)(1), (b)(2), (b)(4); 1430(c), (e)(1), (e)(3). The
Banks' risk management and investment practices are governed by the
FMP. This proposal would create a modern risk-based capital system for
the Banks. The Banks would be allowed greater flexibility to set their
own risk tolerances, subject to the requirement that they hold
sufficient capital to support the risks they chose to accept. The
proposed rule also would allow for a more efficient and effective use
of the Banks' capital than is currently possible.
The risk-based capital requirement, together with other provisions
of this capital proposal, would replace the FMP, which the Finance
Board currently uses to address the risks inherent in the financial
management practices of the Banks. Given the advent of the Basle
Accord, the practices of the other bank regulatory agencies, and the
Finance Board's proposal for the Banks to become more mission oriented,
the Finance Board has determined that the development of risk-based
capital standards for the Banks should be an integral part of any
comprehensive risk management system for overseeing the Banks. The FMP
is a prescriptive risk control system with a series of detailed
business and operating guidelines. It is based on policies originally
adopted by the FHLBB, the predecessor agency to the Finance Board, and
has been revised a number of times over the years. The FMP is a product
of its history and reflects a now outmoded approach that emphasizes in
considerable detail what is, and what is not, a permissible practice
for the Banks. It is composed of a series of lists, which address
matters such as allowable and prohibited assets, reserve requirements,
funding guidelines, and hedging, credit, and interest rate risk
guidelines. Federal banking regulation now focuses more on the adequacy
of the audit and control systems, as well as risk management systems
and managerial capability. The Finance Board is proposing to adopt a
modern approach to overseeing the Banks, which would require the Banks
to implement a comprehensive risk management system (including
regulatory capital requirements) and would require the Finance Board to
verify the integrity of those internal systems.
The bank regulatory authorities in the United States and in other
industrialized countries have adopted some form of risk-based capital
structure for the financial institutions they oversee. The basis for
all of those risk-based capital systems is the Basle Accord, which was
adopted in July 1988 and which measures credit risk through a system of
risk-weight categories. As a matter of practice, the Basle Accord has
been applied to all banks and thrifts in the United States and has
become the global benchmark for credit risk capital standards.
The Basle Accord is based principally on a standardized system of
risk weights, under which the book value of an on-balance sheet asset
is assigned a particular risk weight based on the relative level of
credit risk associated with that category of asset. The same method is
used with respect to off-
[[Page 52173]]
balance sheet items, which are converted to ``credit equivalent
amounts'' and assigned to the appropriate risk weight category. The
risk weight categories range from zero percent, for items such as cash
and Treasury obligations, to 100 percent, which includes claims on
private obligors. The Basle Accord credit risk capital regime is based
on an 8 percent benchmark, i.e., that an institution must maintain
total capital in an amount equal to 8 percent of the book value of any
asset that is in the 100 percent risk weight category. Assets in lower
risk-weight categories would carry a correspondingly lower capital
requirement, such that an asset in the 50 percent category would
require capital equal to 4 percent of its book value and an asset in
the zero percent risk weight category would require no capital for
credit risk. Because the Basle Accord made no explicit provision for
market risk in the risk weight categorizations, the required capital
percentage serves as protection against both credit and market risk.
The Finance Board, and other commentators, believe that the Basle
Accord has a number of shortcomings. For example, for instruments
within the same risk weight category, the Basle Accord does not
distinguish between those instruments with different credit quality
(i.e., those with different credit ratings), which would, in fact, have
markedly different credit risks. The Basle Accord also does not take
into consideration how differences in the maturities of two instruments
would affect their relative credit risk, nor does it distinguish
between immediate exposure and possible future credit exposures, or
between the credit risks associated with a diversified portfolio
compared to those associated with a concentrated portfolio.
Under the 1996 amendment to the Basle Accord (the Amendment), debt
instruments held in the trading portfolios of large banks are exempt
from the risk-based capital requirements of the Basle Accord. The
Amendment remedies some of the shortcomings of the 1988 Basle Accord
discussed above and offers two alternatives for calculating the credit
risk capital requirements for debt instruments held in the trading
portfolios of large banks. These alternatives are based on publicly
available credit ratings, or credit ratings that are internally
generated by large banks. The first alternative for large banks is to
use internal credit risk models to calculate value at risk due to
credit risk on debt instruments held in trading portfolio. A second
alternative for large banks lacking satisfactory internal models is to
use standardized credit risk capital percentage requirements specified
in the Amendment. These percentage requirements are significantly lower
than the risk-based capital requirements for the non-trading portfolio
(banking book) and are related to the maturities of the investment
grade instruments. The smaller percentage requirements mainly reflect
the fact that holding periods, commonly referred to as default
horizons, for debt instruments held in trading portfolios are generally
shorter than the holding periods for the banking book.
Principally to address some shortcomings of the Basle Accord with
respect to the banking book, the BCBS recently published the Framework,
which proposes a system to better correlate regulatory solvency to the
economic-capital needs of a bank, as well as with the risks and returns
of their lending activities.\4\ The Framework would base risk-based
capital requirements more closely on the underlying credit risks, and
would recognize the improvements in risk measurement and control that
have occurred in recent years. The Framework would allow for the use of
internal credit ratings and credit risk models to better assess a
bank's capital requirement in relation to its risk profile. The BCBS
also issued a separate paper on internal credit risk modeling, and
invited comments on the issue of using a portfolio-based approach to
calculating an overall capital requirement.\5\ Portfolio credit risk
modeling is a long-term project for the BCBS; ultimately, it is
anticipated that sophisticated banking institutions would employ a
comprehensive portfolio risk modeling approach, under which regulatory
capital requirements would be based entirely on internal models. This
proposed regulation addresses many of the concerns raised in the recent
BCBS papers, by closely tying regulatory capital requirements to each
Bank's level of credit risk.
---------------------------------------------------------------------------
\4\ New Basle Committee Proposals Have Positive Bank Credit
Implications, Moody's Credit Perspectives, June 21, 1999, at 1, 18.
\5\ BCBS, Credit Risk Modeling: Current Practices and
Applications (Apr. 1999).
---------------------------------------------------------------------------
As discussed above, the drive to incorporate a measure of general
market risk into the Basle Accord has been spearheaded by the BCBS. The
Basle Accord addressed credit risk but did not include a requirement
for market risk. However, as depository institutions' involvement in
both on- and off-balance sheet instruments containing structured and
exotic features as well as complex options grew, the BCBS became
concerned with the market risk aspect of the risk-based capital
standards. This led to the Amendment which, in addition to credit risk,
addressed market risk from interest rates, foreign exchange rates,
equity prices and commodity prices within the trading book and foreign
exchange and commodity risks in the banking book. The Amendment is
limited in that it essentially applies to large commercial banks;
banking book interest rate risk is still not addressed. However, the
BCBS has published a separate proposal providing guidance for the
management of overall interest rate risk in a banking organization,
including interest rate risk within the banking book.\6\ In the
recently published Framework, the BCBS has proposed to develop a
specific capital requirement for interest rate risk in the banking book
for banks where interest rates risks are significantly above average.
The bank regulatory authorities in the United States and in other
industrialized countries have adopted the Amendment to incorporate
general market risk into the risk-based capital standards.
---------------------------------------------------------------------------
\6\ See BCBS, Principles for the Management of Interest Rate
Risk (Jan. 1997).
---------------------------------------------------------------------------
2. Requirements for Bank System and Individual Bank Credit Ratings--
Sec. 930.2
Proposed Sec. 930.2 addresses credit ratings for Bank System COs
and for the overall capacity of individual Banks to meet their
obligations. Section 930.2(a)(1) would require that the Banks,
collectively, obtain from a NRSRO, and at all times maintain, a current
credit rating on the Banks' COs. Under Sec. 930.1 of the proposed rule,
an NRSRO would be defined to include those credit rating organizations
recognized as NRSROs by the SEC. To date, the SEC regards five credit
rating organizations as NRSROs: Standard & Poor's; Moody's; Fitch IBCA;
Duff & Phelps; and (for certain financial institutions) Thompson
BankWatch, Inc. See 62 FR 68018-24 (Dec. 30, 1997).
The Banks' COs currently are rated by both Moody's and Standard &
Poor's and have received the highest credit rating from both NRSROs,
based upon the conservative management policies and consistent
profitability of the Banks, both as a group and individually, and the
status of the Banks as GSEs. Proposed Sec. 930.2(a)(2) would require
that each Bank operate in such a manner and take any actions necessary
to ensure that the Banks' COs receive and continue to receive the
highest credit rating from any NRSRO by which the COs have been then
rated (e.g., triple-A).
[[Page 52174]]
Regardless of whether any actual downgrade were to occur, a Bank still
would be considered to be in violation of proposed Sec. 930.2(a)(2) if
that Bank were to take any action, or were to create a situation
through a failure to act, that potentially could lead any NRSRO to
downgrade the rating for COs to a level below that NRSRO's highest
investment grade.
In addition to the requirements pertaining to the rating of the
Banks' COs, Sec. 930.2(b) of the proposed rule would require each Bank,
individually, to operate in such a manner and take any actions
necessary to ensure that the Bank has and maintains an individual
issuer credit rating of not lower than the second highest credit rating
from any NRSRO by which the Bank is rated (e.g. double-A), where the
NRSRO states that the rating is a meaningful measure of the Bank's
financial strength and stability apart from the GSE status of the Bank
System. The latter requirement is intended to ensure that the Banks'
boards of directors and senior management focus upon the business
practices necessary to maintain not lower than the second highest
credit rating on an individual basis without regard to the GSE status
of the Bank System.
Proposed Sec. 930.2(c) would require each Bank to obtain an
individual issuer credit rating from an NRSRO within one year of the
effective date of new part 930. In addition, under proposed
Sec. 930.2(b)(3), each Bank would be required to update its individual
issuer credit rating on an annual basis, or more frequently, as
required by the Finance Board. Eleven of the Banks already have
obtained an individual credit rating from at least one NRSRO and all
eleven have received the highest long-term credit rating from the
NRSROs by which they have been rated.
In order to facilitate the Banks' fulfillment of the core mission
activities requirements set forth in part 940 of the proposed rule,
discussed below, the proposed rule would authorize the Banks to make a
wider range of investments, and to offer their members and eligible
nonmember borrowers a wider range of products and services, than is
currently authorized in the absence of specific prior Finance Board
approval. The risk-based capital requirements set forth in proposed
part 930, also discussed below, are intended to require the Banks to
manage effectively the increased risks that could accompany the
broadened investment and programmatic authority that the Banks would
enjoy under the proposed rule. As provided for under proposed
Sec. 930.2, it is of vital importance that the Banks' COs continue to
receive the highest possible credit rating so as to ensure that the
Banks remain able to access to the capital markets at the lowest
possible cost of funds and, consequently, to fund activities that
safely and soundly further the Banks' housing finance and community
lending mission.
At the same time, the Finance Board finds it appropriate to permit
the Banks to maintain individual issuer credit ratings of at least the
second highest credit rating given by any NRSRO from which a rating has
been received, rather than continuing to require the highest credit
rating, as individual Banks are required to maintain under the FMP. In
meetings with Finance Board staff, representatives of both Moody's and
Standard & Poor's indicated that the Bank's COs could continue to
receive the highest credit rating, even if all of the Banks were to
receive only the second highest issuer credit rating on an individual
basis. Both NRSROs confirmed to Finance Board staff that the GSE status
of the Banks plays a key role in the rating of the Banks' COs. While
both NRSROs indicated that any significant changes to the Banks'
management policies and profitability potentially could adversely
affect the credit rating of the COs, both also stated that the proposed
new regulatory structure does not give rise to any serious concern that
the COs will not continue to receive the highest credit rating from
both organizations.
3. Minimum Total Capital Requirement--Sec. 930.3
a. Background. Capital serves as a barrier against insolvency. Its
purpose is to absorb the risks inherent in business endeavors, and to
provide market discipline to limit risk-taking by management. To be
effective, capital must be available to offset losses if economic
conditions are unfavorable.
The capital requirements in the proposed rule represent a change in
philosophy from the FMP. Rather than prohibiting certain types of
investments, and establishing limits on Bank behavior towards risk such
as duration of equity limits, the proposed rule would allow the Banks
wide latitude to engage in mission-related activities, so long as they
hold sufficient capital to cover the risks entailed by such activities.
The rule proposes two capital-based standards for the Banks. The
first standard is a requirement that total outstanding Bank capital
stock must equal at least 3.0 percent of the Bank's total assets. The
second standard is a requirement generally that the Banks must hold the
most permanent forms of capital, referred to as risk-based capital,
against the risks measured in the Bank's portfolio. The risk-based
capital requirement is discussed further below under Sec. 930.4.
b. Minimum total capital requirement. Section 930.3(a) of the
proposed rule provides that each Bank shall have and maintain at all
times total capital in an amount equal to at least 3.0 percent of the
Bank's total assets. Total capital is defined in proposed Sec. 930.1 as
the sum of a Bank's retained earnings and total capital stock
outstanding, less the Bank's unrealized net losses on available-for-
sale securities. The minimum total capital requirement serves to limit
the size of a Bank's balance sheet for a given quantity of capital.
As discussed above in the Overview of Proposal section, the Act
sets forth minimum capital requirements for the Banks. See 12 U.S.C.
1426(b)(1), (b)(2), (b)(4); 1430(c), (e)(1), (e)(3); 12 CFR 933.20(a).
Among these provisions is a requirement that members hold stock equal
to at least 5 percent of their advances. Currently, the FMP limits the
holding of mortgage-backed securities by the Banks to three times
capital. Taken together, these two provisions limit advances plus
mortgage-backed securities to no more than 23 times capital, as
advances can be no more than 20 times capital, and mortgage-backed
securities can be no more than 3 times capital. Thus the ratio of
capital to advances plus mortgage-backed securities must be at least
one twenty-third, or 4.35 percent.\7\
---------------------------------------------------------------------------
\7\ To the extent that a Bank chooses to accumulate retained
earnings, its assets may be limited to something less than 23 times
capital. This is because the capital held to support advances can,
by statute, only be in the form of capital stock, while the capital
held to support mortgage-backed securities (MBS) holdings can be
either capital stock or retained earnings. Retained earnings are a
small percentage of total capital for the Banks.
---------------------------------------------------------------------------
The numerically operative and, therefore, more important constraint
contained in current regulations is a leverage limit, such that the
ratio of COs plus unsecured senior liabilities for a Bank can be no
more than 20 times capital. See FMP section IV.C. Because assets equal
capital plus COs plus unsecured senior liabilities, a Bank's assets
cannot exceed 21 times its capital or, inversely, capital must be at
least 4.76 percent of assets. The Bank System had an average capital-
to-assets ratio of 5.4 percent during 1998.
The proposed 3.0 percent minimum total capital requirement for the
Banks would be more conservative than the 2.5 percent minimum total
capital
[[Page 52175]]
requirement imposed by statute on the on-balance sheet assets of Fannie
Mae and Freddie Mac.\8\ Also, the proposed minimum total capital
requirement of 3.0 percent for the Banks is consistent with the minimum
total capital requirements imposed by other financial institution
regulators for the strongest financial institutions without supervisory
concerns.
---------------------------------------------------------------------------
\8\ A leverage requirement is imposed on Fannie Mae and Freddie
Mac such that their capital must be at least 2.5 percent of their
on-balance sheet assets. 12 U.S.C. 4612(a). Generally, they must
also hold capital equal to at least .45 percent of their off-balance
sheet obligations. Unlike the Banks, Fannie Mae and Freddie Mac have
substantial volumes of guarantees and other off-balance sheet items.
---------------------------------------------------------------------------
Section 930.3(b) of the proposed rule provides that, for reasons of
safety and soundness, the Finance Board may require an individual Bank
to have and maintain a higher minimum capital ratio than 3.0 percent.
4. Minimum Total Risk-Based Capital Requirement--Sec. 930.4
a. General requirement. Section 930.4(a) of the proposed rule
provides that each Bank shall have and maintain at all times total
risk-based capital in an amount at least equal to the sum of its credit
risk capital requirement, its market risk capital requirement, and its
operations risk capital requirement, calculated in accordance with
Secs. 930.5, 930.6 and 930.7, respectively. As discussed above under
the Overview of Proposal section, the proposed rule would implement,
for the first time, a risk-based capital requirement for the Banks
related to the risks inherent in the Banks' portfolios and business
practices. The three separate capital components are discussed further
below under their respective sections.
b. Definition of Total Risk-Based Capital. In order to serve as the
primary barrier against insolvency, risk-based capital must be
permanent in nature, i.e., available to cover losses which may occur
under adverse conditions without being subject to redemption by
members. Proposed Sec. 930.1 contains a definition of total risk-based
capital for a Bank, the elements of which are discussed below.
The first element of total risk-based capital under the definition
in proposed Sec. 930.1 is retained earnings, less unrealized net losses
on available-for-sale securities. Retained earnings clearly are
permanent in nature because they are not subject to withdrawal at the
request of individual member shareholders.
The second element of total risk-based capital under the definition
in proposed Sec. 930.1 is any outstanding non-redeemable capital stock
of the Bank. The Finance Board has authority under the Act to allow the
Banks to create additional classes of stock if the Banks wish to
include such other classes of stock as a part of their capital
structure. Any non-redeemable outstanding capital stock that a Bank may
be authorized to issue would be permanent by its non-redeemable nature.
The third element of total risk-based capital under the definition
in proposed Sec. 930.1 is all outstanding capital stock satisfying the
minimum capital stock purchase requirement for membership under
sections 6(b)(1) and 10(e)(3) of the Act (12 U.S.C. 1426(b)(1),
1430(e)(3)) for all mandatory members. Outstanding capital stock of
mandatory members has permanent features, because a mandatory member
may have its stock redeemed only if it changes its charter to a form
that would make the member a voluntary member and withdraws from
membership in the Bank System. Charter conversions generally are not
effected by a member solely for the purpose of withdrawing from Bank
membership and redeeming Bank stock. A charter conversion would have a
serious impact on all aspects of an institution's business operations,
and would require a significant amount of time and cost to complete.
Mandatory members that convert to voluntary status also may be
discouraged from withdrawing from the Bank System because the Act
prohibits withdrawing members from rejoining the Bank System for ten
years. See 12 U.S.C. 1426(h).
The fourth element of total risk-based capital under the definition
in proposed Sec. 930.1 is a percentage of the minimum capital stock
purchase requirement for membership under sections 6(b)(1) and 10(e)(3)
of the Act (12 U.S.C. 1426(b)(1), 1430(e)(3)) for all voluntary
members. Each Bank may designate a percentage, not to exceed 50
percent, of the minimum capital stock of voluntary members as risk-
based capital. The required capital stock of voluntary members is less
permanent than the required capital stock of mandatory members, but is
more permanent than stock which supports member borrowing. Although the
ten-year prohibition on rejoining the Bank System after withdrawing may
discourage voluntary members from withdrawing from the Bank System and
redeeming their capital, they may, if they decide to withdraw, have
their capital stock redeemed at par, provided that the Finance Board
finds no impairment or likely impairment of the Bank's capital. See 12
U.S.C. 1426(e). This capital stock, therefore, has more limited use as
a loss absorber than the other forms of capital stock discussed above.
However, a Bank may need more than its retained earnings and
outstanding minimum capital stock of mandatory members in order to meet
its risk-based capital requirement. Therefore, a percentage not to
exceed 50 percent of minimum required voluntary member stock may serve
as an element of total risk-based capital only if the Bank is willing
to subject its redemption to Finance Board approval.
The fifth and final element of total risk-based capital under the
definition in proposed Sec. 930.1 is a percentage of the remaining
capital stock of mandatory and voluntary members. Each Bank may
designate a percentage, not to exceed 50 percent, of the remaining
capital stock of mandatory and voluntary members as risk-based capital
only if the Bank is willing to subject its redemption to Finance Board
approval. The Act provides that a Bank has discretion, unless
prohibited by the Finance Board, to determine whether to redeem a
mandatory or voluntary member's capital stock that exceeds its
statutory minimum capital stock purchase requirement. See 12 U.S.C.
1426(b)(1). Because a Bank can decline to redeem excess capital stock
of members, such stock can serve as a permanent capital loss absorber.
The proposed definition allows each Bank to designate different
percentages of stock as elements of total risk-based capital under the
fourth and fifth elements of the definition (that is, up to 50 percent
of the membership stock of voluntary members, and up to 50 percent of
all remaining outstanding capital stock of mandatory and voluntary
members). Therefore, some Banks may choose to designate a larger
percentage of the minimum capital stock of voluntary members as risk-
based capital stock, as this stock has a greater degree of permanence.
This would allow a smaller percentage of capital stock which supports
advance borrowing to be designated as an element of total risk-based
capital, so that the use of advances by members would not be
discouraged.
c. Transition provisions. The transition provisions in the proposed
rule ensure that the Banks will continue to operate in a safe and sound
manner, under proven standards, until such time as they have
demonstrated the capacity to operate under the more flexible proposed
regulation. Specifically, each Bank must demonstrate to the Finance
Board that it has risk management policies and internal controls in
place which are sufficient to manage its credit, market, and operations
risk. Each
[[Page 52176]]
Bank must also have an internal market risk model approved by the
Finance Board. Finally, each Bank must have sufficient capital to meet
the capital requirements in the proposed rule. Until these conditions
are met by a Bank, the current rules as contained in the FMP will
apply. See proposed Secs. 930.4(b)(1) and 930.4(b)(2).
5. Credit Risk Capital Requirement--Sec. 930.5
a. Background. Unlike commercial banks and savings associations,
the Banks currently are not subject to statutory or regulatory risk-
based capital requirements. As discussed previously, the Banks' capital
requirements are determined according to a statutory formula, which
uses either the asset size of a member or the amount of its borrowings
from a Bank to determine the amount of stock the member must purchase
from its Bank. The risk-based capital requirement for the Banks
established in this proposal would include as one component a separate
capital requirement to address the credit risk to which a Bank is
exposed. The credit risk component of the capital requirement would
encompass the credit risks associated with both on-balance sheet assets
and off-balance sheet items of each Bank.
The objective of the Finance Board in proposing this credit risk
capital standard for Banks is to provide a regulatory framework that
would: (i) assess capital charges based on the extent of the underlying
credit exposure; (ii) address on-and off-balance sheet exposures
consistently; (iii) allow for changes to the portfolios of the Banks,
as well as in the markets; and (iv) reflect improvements in risk
measurement and control systems, as they develop and become available
for use by the Banks. To the extent the proposed rule achieves these
objectives, it would improve upon the Basle Accord.
b. Finance Board determination of specific credit risk percentage
requirements. Proposed Sec. 930.5(b) provides that for an on-balance
sheet asset, the credit risk capital requirement would be equal to the
book value of the asset multiplied by the ``credit risk percentage
requirement'' to which the asset is assigned. Proposed Sec. 930.5(c)
provides that for off-balance sheet items, the credit risk capital
requirement would be the ``credit equivalent amount'' of the item,
multiplied by the specific credit risk percentage requirement to which
the item is assigned.
Proposed Sec. 930.5(d) provides that the Finance Board shall
determine initially, and update periodically, credit risk percentage
requirements for various categories of credit risk for on-balance sheet
assets and off-balance sheet items, using data from NRSROs and any
other relevant sources to calculate estimates of credit losses
associated with the particular categories. The estimates of credit risk
are required to represent the credit losses that could be expected to
occur on the particular categories of instruments during periods of
extreme credit stress, based on historical data that reflect the
longer-term nature of credit cycles and span multiple credit cycles.
The periodic updates to initial credit risk percentage requirements
will be implemented by the Finance Board as amendments to
Sec. 930.5(d)(3).
The proposal includes, in Table 1 of proposed Sec. 930.5(d)(3), the
percentages to be applied to the book value of on-balance sheet assets,
or the credit equivalent amounts of off-balance sheet items, in
determining a Bank's credit risk capital requirement. Cash and
government securities are assigned to the zero percent category,
meaning that they are deemed not to present any credit risk to the
Bank. The proposal assigns increasing percentages (0.3, 0.6, 1.0, and
1.3) to each of the four levels of investment grade ratings assigned by
an NRSRO (i.e., triple-A, double-A, single-A, triple-B), and treats
credit risk from advances as equivalent to credit risk associated with
the highest category of investment grade credit ratings. The proposal
also includes a credit risk percentage for a Bank's tangible assets,
``Premises, Plant and Equipment,'' to be set at 8.0 percent, which is
consistent with the Basle Accord. Investments that are downgraded below
investment grade after being acquired by a Bank would be assigned
higher credit risk percentages: 12.0 percent for assets with the
highest rating below investment grade; 50.0 percent for assets with the
second highest rating below investment grade; and 100 percent for all
other assets downgraded below investment grade.
In assigning only cash and direct obligations of the U.S.
government to the zero credit risk category, the proposal is more
restrictive than the Basle Accord, which assesses zero credit risk
capital for all Organization for Economic Cooperation and Development
(OECD) government obligations, although proposed revisions to the Basle
Accord would treat all triple-A and double-A rated sovereign
obligations as free of credit risk. The proposal would treat Bank
advances as a triple-A rated credit exposure. The assignment of
advances to a triple-A credit risk category is based on factors such as
the historical credit loss record for Bank advances (no credit losses
have been incurred on the advance portfolio), the conservative lending
and collateral management policies of each Bank (all classes of
collateral are discounted based on risk), the blanket lien arrangements
that some Banks employ with certain members over all of the assets of
that member, the statutory priority lien, which gives the Banks
priority over other secured creditors (so long as those secured
interests are not perfected, see 12 U.S.C. 1430(e)), and a statutory
stock purchase requirement that requires a member to maintain an
investment in the Bank at least equal to 5 percent of its outstanding
advances. See id.
The Finance Board considered treating advances as cash or direct
obligations of the U.S. government and assigning a zero credit risk
capital requirement. However, two credit rating agencies expressed
their opinion that such treatment is not appropriate for advances--
i.e., that advances should not be treated as equivalent to credit risk
free investments. The two rating agencies expressed their preference
for advances being treated as triple-A rated assets. Based on the
historical (over 60 years) experience of zero credit losses for
advances versus rating downgrades leading to eventual credit losses on
triple-A rated corporate securities, an argument can be made that
advances are a better credit than triple-A rated assets. As a result,
advances may be treated as assets that pose credit risk somewhere
between U.S. government securities and triple-A rated corporate
securities. At this time, the Finance Board is proposing to treat
advances as triple-A rated assets and is requesting comments from
interested parties as to whether a satisfactory analytical framework
exists that can be used to determine a more appropriate capital charge
for the credit risk of advances.
Based on data obtained from Moody's, the worst default frequency
over a two-year horizon for triple-A rated corporate debt is 0.0. In
fact, a triple-A rated security has never defaulted at the time it was
still rated triple-A. Given a sufficiently long period of time,
however, even triple-A rated corporate credits will default following
rating downgrades.\9\ In fact, some triple-A rated credits have been
downgraded within a year after receiving the triple-A rating. In
addition, the market credit spreads for triple-A rated securities can
widen without any change in credit
[[Page 52177]]
ratings.\10\ Credit deterioration and spread widening can lead to
losses in market value for triple-A rated securities within a
relatively short time after such securities are assigned a triple-A
rating. Because such risks exist and the holding periods associated
with long-term held-to-maturity securities are relatively long, the
proposal adopts a conservative approach and requires 0.3 percent
capital to be maintained for triple-A rated credit exposures. This
number is a linear interpolation of the estimated credit losses for
U.S. government securities and double-A rated debt. Moreover, this
requirement is consistent with the results from an internal models-
based estimate for credit risk capital for triple-A rated corporate
bonds held in a diversified trading portfolio of a large commercial
bank, which is 0.26 percent.\11\
---------------------------------------------------------------------------
\9\ According to Moody's data from 1970 to 1998, over a 4-year
default horizon, the worst historical probability of default
(default rate) for triple-A rated debt is 1.21 percent.
\10\ This applies equally to triple-A rated securities issued by
GSEs.
\11\ This estimate is based on a 10 business day horizon and a
99th percentile of the value at risk distribution as required under
the Amendment for calculating credit risk capital for debt
instruments held in the trading portfolios of large banks. The
estimate of 0.26 percent reflects a multiplier of 4 which is the
highest multiplier that may be required under the Amendment. In
addition to the possibility of default, this estimate captures
potential deterioration in credit risk and widening of credit
spreads in the market. If the underlying distribution of value at
risk is approximately normal, the multiplier of 4 effectively
extends the 10 day horizon to 160 business days, or approximately 8
months. The holding periods relevant to long-term debt instruments
held in banking portfolios are longer and commercial banks generally
use 1 year for calculating economic capital requirements.
---------------------------------------------------------------------------
Credit risk capital requirements for double-A, single-A, triple-B
and double-B rated credit exposures in the proposal are generally equal
to the worst default rate observed over two-years by Moody's in data
collected from 1970-1998. To preserve consistency between credit
ratings and capital requirements, the proposed requirement for a
single-A rated credit exposure is set equal to the average of the
capital requirements for double-A and triple-B rated instruments.\12\
Also, a conservative zero recovery rate in default has been assumed for
purposes of calculating the credit risk capital requirements. Defaulted
bond price data from Moody's provides support for the zero recovery
rate assumption under extreme credit stress conditions.\13\
---------------------------------------------------------------------------
\12\ This is because over a 2 year horizon, the worst single-A
rated default rate is lower than the corresponding double-A rated
default rate.
\13\ As for triple-A rated instruments, the proposed capital
requirements for double-A, single-A, triple-B and double-B rated
credit exposures are generally consistent with the results from an
internal models-based estimate for credit risk capital for corporate
bonds held in a diversified trading portfolio of a large commercial
bank, which are 0.77, 1.00, 2.40 and 5.24 percent, respectively.
---------------------------------------------------------------------------
Under proposed Sec. 955.3(a)(3), the Banks would not be authorized
to invest in debt instruments rated below investment grade. If an
investment were to be downgraded after acquisition by a Bank to the
second highest rating below investment grade (single-B rating), the
proposal would assign it to the 50 percent credit risk percentage,
which the Finance Board believes to be a conservative level for such an
exposure. Any credit exposures rated at triple-C or below would be
placed in the 100 percent credit risk capital category.
Under proposed Secs. 940.3(e) and 955.2(e), a Bank may make equity
investments in the stock of a SBIC, in government-aided economic
development entities, and in certain entities that are permissible
investments for national banks, that are not rated but are defined in
this proposal as core mission activities of the Banks. The proposal
would assign investments in these types of entities to the 8.0 percent
credit risk percentage category. This requirement is based upon, and is
consistent with, the risk-based capital requirements for investments in
such entities by national banks established by the OCC. For SBICs, the
8 percent requirement is likely conservative given changes to the SBIC
program implemented in 1994. In addition, consistent with the public
purpose of GSEs, the Finance Board wants to encourage the Banks to give
every consideration to investments that will provide targeted
assistance to people in underserved low and moderate-income
communities.
The following table, which is set forth in proposed
Sec. 930.5(d)(3), presents the credit risk percentage capital
requirements for each category of credit exposures described above:
Credit Risk Capital Requirements for Banks
------------------------------------------------------------------------
Percent of
on-balance
Credit risk category sheet
equivalent
value
------------------------------------------------------------------------
Authorized Investments
Cash and U.S. Government Securities........................ 0.0
Advances................................................... 0.3
Highest Investment Grade--triple-A......................... 0.3
Second Highest Investment Grade--double-A.................. 0.6
Third Highest Investment Grade--single-A................... 1.0
Fourth Highest Investment Grade--triple-B.................. 1.3
Premises, Plant, and Equipment............................. 8.0
Core Mission Equity Investments Under Sec. 940.3(e)....... 8.0
Investments Downgraded to Below Investment Grade After
Acquisition by a Bank
Highest Below Investment Grade--double-B................... 12.0
Second Highest Below Investment Grade--single-B............ 50.0
All Other Below Investment Grade--At or Below triple-C..... 100.0
------------------------------------------------------------------------
The Finance Board expects that the above capital requirements may
change as comments on proposed Sec. 930.5(d)(3) are received and
further research is undertaken before a final rule is published. Even
after a final rule is adopted, the Finance Board anticipates that it
will periodically amend the capital requirements reflected in the chart
above as additional data is available and new methodologies become
feasible.
One of the limitations of the Basle Accord was its failure to
consider the term structure of credit risk, such that an overnight
exposure would receive the same capital charge as a 2 or a 10 year
exposure. However, under the Amendment, the term structure of credit
risk can be fully recognized for trading portfolios of large banks with
satisfactory internal models and is partially recognized for others
through a standardized table. In addition, the recently proposed
Framework addresses this limitation in the Basle Accord by according
limited recognition to the term structure of credit risk. The Farm
Credit Administration similarly accords limited recognition to the term
structure of credit risk in their risk-based capital requirements for
the farm credit banks. In proposed Sec. 930.5(d)(3), there is no such
recognition given to the term structure of credit risk. However, the
Finance Board realizes that a significant proportion of the Banks'
assets have maturities within 1 month and, therefore, intends to
undertake further research on incorporating term structure of credit
risk into Sec. 930.5(d)(3). At this time, the Finance Board requests
comments on the treatment of term structure of credit risk.
c. Bank determination of specific credit risk percentage
requirements. Section 930.5(d)(4)(i) of the proposed rule would require
each Bank to determine the credit risk capital requirement for each
asset and item first by determining its type and its credit rating (if
any), then by determining its
[[Page 52178]]
appropriate risk category and applying the applicable credit risk
percentage for that risk category under Table 1. The proposal includes
guidance for the Banks on how to determine the credit rating for a
particular asset or item. If an asset or item is directly rated by an
NRSRO, the Banks must use that rating. If an asset or item is not rated
directly by an NRSRO, but its issuer or guarantor is so rated or the
asset or item is backed by collateral that is so rated, then a Bank may
use the highest rating given to the issuer, guarantor, or collateral,
to the extent that the issuer, guarantor, or collateral supports the
asset or item held by the Bank. If the asset or item is not fully
backed by a rated issuer, guarantor, or collateral, then only the
portion to which such rated support applies may receive the highest
rating noted above; the portion of the asset or item that is not so
supported must be assigned to the category that would be appropriate
for such an asset on a stand alone basis. For example, if up to 25
percent of a triple-B asset is guaranteed by a triple-A-rated entity,
then 25 percent of the value of the asset may be assigned to the
highest investment grade category with a capital requirement of 0.3
percent and the remaining 75 percent of the value of the asset will be
assigned to the fourth highest investment grade category with a capital
requirement of 1.3 percent.
The proposal further provides that the Banks shall disregard
modifiers attached to a particular credit rating. Thus, an asset with
an A+ rating and an asset with an A- rating would both be placed in the
A category for risk-based capital purposes. NRSROs generally assign
rating modifiers such as ``1'', ``2'' and ``3'' or ``+'' and ``-''
along with letter grades. Such modifiers are provided to further
distinguish among credit risks that are assigned identical letter
grades. Consequently, historical samples containing default activity
for each modified letter grade are smaller than what they would be if
modifiers were ignored. The smaller sample size makes it difficult to
calculate credit risk capital requirements corresponding to modified
ratings with some degree of statistical precision and confidence.
Therefore, the Finance Board is proposing to disregard rating
modifiers. This is consistent with the treatment specified for
investment grade credit exposures under the Amendment and the
Framework.
The proposal also provides that where a particular asset or item
has been rated multiple times by the same NRSRO, the Bank must use the
most recent rating from that NRSRO, and that if an asset or item has
received ratings from multiple NRSROs, the Bank must use the lowest of
those ratings. If an asset is not rated by an NRSRO and does not fall
within one of the categories in Table 1, the proposal would require a
Bank to determine its own credit rating for the asset or item or
relevant portion thereof using credit rating standards available from
an NRSRO or other similar standards.
As a general matter, collateral may be used to enhance the
creditworthiness of a particular asset or item, which can result in a
lower credit risk capital requirement for a Bank. The BCBS has
recognized that the Basle Accord did not provide sufficient incentive
for banks to reduce their credit risk by taking an interest in other
collateral, and recently has proposed to extend the scope of collateral
recognition to all financial assets--not just marketable securities.
The Finance Board proposal would allow a Bank to look through to the
collateral supporting a given asset or instrument for risk-based
capital purposes if certain conditions are met. In order to recognize
such collateral for capital purposes, the collateral must be held by
the Bank (which could include being held by a third party custodian or
by the member), must be legally available to absorb losses (i.e., the
Bank must have a legal right to liquidate the collateral), must have a
readily determinable value at which it can be liquidated, and must be
held in conformance with the Bank's collateral management policy. This
would include arrangements under which a third-party custodian holds
collateral from a Bank's counterparty and may not return the collateral
to the counterparty without the express permission of the Bank. In
using collateral to reduce the credit risk capital requirement, a bank
must make appropriate allowance for haircuts or overcollateralization
reflecting the market risk underlying the collateral.
With respect to third-party guarantees, the proposal would
recognize all third-party guarantees provided by any counterparty with
an investment grade rating. This is consistent with that aspect of the
proposal that would limit investments by the Banks to those with an
investment grade rating. See proposed Sec. 955.3(a)(3).
The proposed rule would allow on-balance sheet assets (underlying
assets) that are hedged with credit derivatives to be assigned to the
zero risk category under three scenarios specified in the rule. Even if
the credit risk capital requirement for the underlying asset is
decreased through the use of a credit derivative, the applicable credit
risk capital required for the derivative contract still would apply.
Within an internal credit risk model in which credit risks are
marked-to-market, recognition of offsets, or credit hedges, whether
perfect or imperfect, can be readily accommodated. Large commercial
banks have accomplished this as part of their credit risk, value at
risk models for trading portfolios. Under the proposed rule, some of
the offsets will be recognized. If the offset is perfect (i.e., the two
positions are of identical remaining maturity and relate to exactly the
same instrument) it is straightforward to reduce the credit risk
capital requirement for the underlying asset to zero (i.e., to grant
full capital relief). For example, if a Bank purchases a triple-B rated
corporate bond with a maturity of 5 years and at the same time enters
into a 5-year credit default option contract based on the same bond
(reference asset), the credit risk capital requirement for the
underlying asset will be zero. The net credit risk capital requirement
for the pair will equal the counterparty risk capital for credit
exposure on the derivative contract.
If the underlying asset and the referenced asset of a credit
derivative are identical, but the remaining maturities are different,
the capital relief in the proposed rule would depend on a maturity
comparison between the two. If the same triple-B rated 5-year corporate
bond was hedged with a credit derivative with a remaining maturity of
2-years or longer, there would be no credit risk on the underlying
asset within the Finance Board's proposed default horizon, which is 2
years. Therefore, such a hedge would be fully recognized and the
capital requirement on the underlying asset would be zero. However, if
the derivative maturity were less than 2 years, no capital relief would
be granted under the proposal. In all cases, there will be a
counterparty risk capital requirement for credit exposure on the
derivative contract. This issue will continue to be researched by the
Finance Board during the comment period.
If the remaining maturities of the underlying asset and a credit
derivative are the same, but the underlying asset is different from the
asset referenced in the credit derivative, capital relief for the
underlying asset may or may not be granted. It is proposed that the
capital requirement on the underlying asset be reduced to zero only if
the referenced and the underlying assets have been issued by the same
obligor, the referenced asset ranks pari passu to or more junior than
the underlying asset, and cross-default clauses are in effect.
If the remaining maturities of the two assets are identical but the
underlying
[[Page 52179]]
asset and the referenced asset have been issued by different obligors,
the proposed rule does not provide any capital relief for the
underlying asset. For example, a Bank may invest in a triple-B rated
bond issued by corporate entity X, but hedge the credit risk with a
derivative based on triple-B rated bond issued by corporate entity Y,
and where X and Y belong to the same industry. The Finance Board
recognizes that such a hedge may provide significant credit protection
to the Bank as there may be a high degree of default correlation
between X and Y, and that capital relief for such hedges can be
accommodated under an internal portfolio credit risk model. Thus, the
Finance Board requests comments on whether to allow affected Banks to
petition the Finance Board for capital relief on a case by case basis,
provided the petition is accompanied by adequate data and analysis.
d. Credit risk percentage requirements for off-balance sheet items.
Off-balance sheet items may expose a Bank to credit risks similar to
those associated with on-balance sheet assets. The Finance Board is
proposing to apply the credit risk capital framework consistently to
all on- and off-balance sheet instruments. Under proposed Secs. 930.5
(e) and (f), the Banks are required to convert all off-balance sheet
credit exposures into equivalent on-balance-sheet credit exposures
(credit equivalent amounts) and then apply the ratings-based framework
in Table 1 to estimate the credit risk capital requirement. The Finance
Board would allow the Banks to use Finance Board approved internal
models to convert some or all off-balance sheet credit exposures into
equivalent on-balance-sheet credit exposures. For Banks that lack
appropriate internal models, the Finance Board is proposing to adopt
the Basle Accord treatment for such instruments as used by the other
federal bank regulatory agencies to convert an off-balance sheet credit
exposure into an equivalent on-balance-sheet exposure.
Under the Basle Accord as incorporated by the federal bank
regulatory agencies, off-balance sheet instruments, other than
derivative contracts, that are substitutes for loans (e.g., standby
letters of credit serving as financial guarantees for loans and
securities) have the same credit risk as an on-balance sheet direct
loan. For some off-balance sheet instruments, the full face value, or
notional amount, is not exposed to credit risk. This means that a
dollar of off-balance sheet exposure may be equivalent to less than a
dollar of on-balance sheet exposure. The following table (Table 2 in
proposed Sec. 930.5(e)), which includes the same categories as are used
by the federal bank regulatory agencies and those proposed under the
Framework, presents credit exposure conversion factors that are to be
multiplied by the face amount of an off-balance sheet instrument other
than a derivative contract.
Credit Conversion Factors for Off-Balance Sheet Items Other Than
Derivative Contracts
------------------------------------------------------------------------
Credit
conversion
Instrument factor (in
percent)
------------------------------------------------------------------------
Standby letters of credit.................................. 100
Asset sales with recourse, where credit risk remains with ...........
the Bank..................................................
Sale and repurchase agreements............................. ...........
Forward asset purchases.................................... ...........
Commitments to make advances or other loans with certain ...........
drawdown \1\..............................................
Other commitments with original maturity of over one year.. 50
Other commitments with original maturity of one year or 20
less......................................................
------------------------------------------------------------------------
\1\ I.e., where it is known during the pendency of the commitment that
the advance or loan funds definitely will be drawn in full.
The credit conversion factor would be zero for Other Commitments
that are unconditionally cancelable, or that effectively provide for
automatic cancellation, due to deterioration in a borrower's
creditworthiness, at any time by the Bank without prior notice. The
Finance Board would allow the Banks to use Finance Board approved
internal models to calculate credit conversion factors instead of those
specified in Table 2. These factors were developed by the BCBS and
adopted by other federal bank regulatory agencies. Under the Basle
Accord, a 100 percent conversion factor is assigned to an off-balance
sheet instrument where the instrument is a direct credit substitute and
the credit risk is equivalent to that of an on-balance sheet exposure
to the same counterparty. A 50 percent conversion factor is assigned to
an off-balance sheet instrument where there is a significant credit
risk but mitigating circumstances exist which suggest less than full
credit risk. A 20 percent conversion factor is assigned to an off-
balance sheet instrument where there is a small credit risk but not one
which can be ignored. The Finance Board intends to undertake further
research on the magnitude and appropriateness of the credit conversion
factors set forth in proposed Sec. 930.5(e) and may revise them before
a final rule is published.
e. Credit risk percentage requirements for derivative contracts.
Proposed Sec. 930.5(f) provides that for market driven instruments
(over-the-counter derivative contracts such as swaps, forwards,
options, etc.) subject to counterparty default, the credit risk capital
requirement will be based on both current and potential credit
exposures. In recognizing collateral, the haircuts requirement under
proposed Sec. 930.5(d)(4)(iv) to reflect the market risk embedded in
the collateral would apply. The derivatives contracts may be based on
underlying market interest rates or prices and may include credit-
linked contracts. The credit equivalent amount for a derivative
contract is equal to the sum of: the current credit exposure (sometimes
referred to as the replacement cost) of the contract; and the potential
future credit exposure (sometimes referred to as the potential future
replacement cost) of the contract.
Proposed Sec. 930.5(f)(1) provides that the current credit exposure
is equal to the maximum of the mark-to-market value of the contract and
zero, as contracts with negative mark-to-market values do not create
any current credit exposure for a Bank.
Proposed Sec. 930.5(f)(2) provides that the potential future credit
exposure (PFE) of a contract shall be determined by using an internal
market risk model approved by the Finance Board or, in the case of
Banks that lack appropriate internal models to calculate PFE, using the
Basle Accord's standardized approach set forth in Table 3 of the
proposed rule.\14\ Under this approach, the PFE of a contract,
including a contract with a negative mark-to-market value, is estimated
by multiplying the effective notional principal amount of the contract
by a credit conversion factor for the underlying market risk as
specified in Table 3, as follows:
---------------------------------------------------------------------------
\14\ See BCBS, Basle Capital Accord: Treatment of Potential
Credit Exposure for Off-Balance Sheet Items (Apr. 1995). The BCBS
ran Monte Carlo simulations on numerous contracts before determining
the conversion factors included in Table 3.
[[Page 52180]]
Credit Conversion Factors for Potential Future Credit Exposure Derivative Contracts
[In percent]
----------------------------------------------------------------------------------------------------------------
Underlying market rate or price
---------------------------------------------------------------------------------
Residual maturity Foreign Precious
Interest rate exchange and Equity metals except Other
gold gold commodities
----------------------------------------------------------------------------------------------------------------
One year or less.............. 0 1 6 7 10
Over 1 year to five years..... .5 5 8 7 12
Over five years............... 1.5 7.5 10 8 15
----------------------------------------------------------------------------------------------------------------
Under the proposed rule, forwards, swaps, purchased options and
similar derivative contracts that are not included in the Interest
Rate, Foreign Exchange and Gold, Equity, or Precious Metals except Gold
categories shall be treated as Other Commodities for purposes of Table
3. If a Bank determines not to use an internal model for single
currency interest rate swaps in which payments are made based upon two
floating indices (floating/floating or basis swaps), the PFE for such
swaps shall be zero. If a Bank determines to use Table 3 for credit
derivative contracts, the credit conversion factors applicable to
Interest Rate Contracts under Table 3 shall apply.\15\ If a Bank
determines to use an internal model for a particular type of derivative
contract, the Bank shall use the same model for all other similar types
of contracts. However, the Bank may use an internal model for one type
of derivative contract and Table 3 for another type of derivative
contract. In other words, within each category of market risks, a Bank
would not be allowed to arbitrage between capital requirements based on
Table 3 and internal models.\16\
---------------------------------------------------------------------------
\15\ The BCBS has yet to determine conversion factors for credit
derivatives. Given that fluctuations in investment grade credit
spreads are generally of a smaller magnitude than shifts in the
level of interest rates, it appears that the potential future
changes in the market value of credit-linked contracts should not
generally exceed potential shifts in the market value of interest
rate linked contracts. The Finance Board plans to examine any credit
derivative contracts that the Banks may enter into and require
larger conversion factors for credit derivatives, if necessary.
\16\ A Bank that uses an internal model for simple interest rate
contracts may utilize Table 3 for interest rate contracts with
embedded options, stand-alone interest rate options or other
complex/structured contracts. The reverse may not be allowed as a
Bank that is capable of internally calculating PFE for complex/
structured contracts must use such internal model for simple
contracts.
---------------------------------------------------------------------------
The proposed rule does not contain any specific means to account
for portfolio diversification effects. Consequently, the proposal would
require the same regulatory capital charge for two portfolios that are
of the same credit quality, but where the credit risk of one is
significantly more concentrated than that of the other. However, as
noted by the BCBS, this limitation may be effectively addressed in a
portfolio-based internal credit risk capital framework. Portfolio
credit risk modeling is a long-term project for the BCBS; ultimately,
it is anticipated that sophisticated banking institutions would employ
a comprehensive portfolio risk modeling approach under which regulatory
capital requirements would be based entirely on internal models.
Similarly, the Finance Board will encourage the Banks to develop
internal credit risk models. Building such an internal model should not
be a formidable task for the Banks, given that their portfolios largely
consist of credit exposures that may be rated and almost all the Banks'
counterparties are financial institutions. The remaining unrated
exposures are insignificant and may be dealt with outside a credit risk
model.
Proposed Sec. 930.5(g) sets forth the requirements for calculation
of credit equivalent amounts for multiple derivative contracts subject
to a qualifying bilateral netting contract. The provisions in the
proposal are consistent with the requirements set forth in the risk-
based capital guidelines of the federal bank regulatory agencies.
6. Market Risk Capital Requirement--Sec. 930.6
a. Background. Section 930.6(a) of the proposed rule provides that
a Bank's market risk capital requirement shall equal the market value
of the Bank's portfolio at risk from movements in market prices, i.e.,
interest rates, foreign exchange rates, commodity prices and equity
prices, as could occur during periods of extreme market stress, as
determined using the Bank's internal market risk model approved by the
Finance Board.
Market risk may be defined as the risk that the market value of a
Bank's portfolio will decline as a result of changes in the general
level of interest rates, foreign exchange rates, equity and commodity
prices.
The Banks engage in activities that carry complex on- and off-
balance sheet market risks. For example, CO issuances, for which the
Banks are jointly and severally liable, include: structured notes
having embedded options and exotic features; callable, putable and
index amortizing bonds; bonds that amortize based on a particular
mortgage pool; bonds denominated in foreign currencies; and bonds
linked to equity prices or foreign interest rates. To hedge the market
risk on such complex instruments, the Banks enter into off-balance
sheet derivative contracts that reflect the risks embedded in those
bonds.
The Banks also make advances on a simple fixed or floating rate
basis, as well as callable, putable/convertible and amortizing
advances. The Banks also have invested in agency bonds with callable
and structured features, mortgage and mortgage-backed instruments with
embedded options, and collateralized mortgage obligations.
Given that the Banks undertake transactions that carry market risks
similar to the risks incurred by large banks or securities dealers, the
Finance Board believes that the capital regime for the Banks' market
risks should be similar to the market risk capital requirements
established or recommended by the Basle Committee and other financial
institution regulatory agencies, but broader in scope.
As previously discussed, the drive to institute a risk-based
capital system for general market risk has been spearheaded by the
BCBS. Following the BCBS's lead, the federal bank regulatory agencies
(Office of the Comptroller of the Currency (OCC), Federal Reserve Board
(FRB) and Federal Deposit Insurance Corporation (FDIC)) issued a joint
final rule in September 1996 (12 CFR parts 3, 208, 225 and 325) to
incorporate a measure for market risk, effective as of January 1, 1998
(Joint Rule). Institutions whose trading activity (defined in the Joint
Rule as total assets plus total liabilities in the trading portfolio)
equals 10
[[Page 52181]]
percent or more of their total assets, or whose trading activity equals
$1 billion or more, must use an internal model (with standardized
parameters as set in the Joint Rule) to calculate the capital they must
hold to support their exposure to general market risk. Positions
covered by the rule include: (i) all positions in an institution's
trading account; and (ii) foreign exchange and commodity positions
whether or not in the trading account.
Overall, the Joint Rule implements market risk based capital
requirements that are based on actual risks undertaken by large banks.
This is the only market risk capital framework that has been both
agreed to internationally and implemented in a number of countries.
Under the Joint Rule, large banks in the United States generally have
adopted a simulation-based approach that is capable of capturing market
risks from holding a wide range of simple, exotic and structured
instruments--with or without options and based on mortgages or other
types of transactions.
Financial institutions regulated by the Office of Thrift
Supervision (OTS) (12 CFR 567.5) and the Farm Credit Administration (12
CFR 615.5205, 615.5210) currently are subject to the Basle Accord's
credit risk capital requirements that contain no market risk capital
components (consistent with the small bank regulatory capital
framework). However, the Office of Federal Housing Enterprise Oversight
(OFHEO) recently published a Notice of Proposed Rulemaking including
its regulatory model for calculating risk-based capital for Fannie Mae
and Freddie Mac; that model does account for both interest rate risk
and credit risk. See 12 CFR part 1750. The OFHEO interest rate risk
based capital rule is based on the Federal Housing Enterprise Financial
Safety and Soundness Act of 1992 (1992 Act), which requires that
capital requirements account for market risks. The market risk capital
requirement is determined by a stress test, which examines the effects
of two specified interest rate shocks. See 12 U.S.C. 4611(a)(2).
Currently, the Banks are not subject to any market risk capital
requirements. The FMP requires that the Banks limit their interest rate
risk based on a methodology that uses interest rate shocks similar to
those proposed but never adopted by the three U.S. bank regulatory
agencies (the OCC, the FRB and the FDIC) and the OTS. The FMP requires
the Banks to limit interest rate risk by maintaining the duration of
their equity to within +/-5 years. The FMP also requires the Banks to
maintain the duration of their equity to +/-7 years under an assumed
change in interest rates of +/-200 basis points.
The Finance Board does not believe that the FMP interest rate risk
methodology is sufficiently flexible to continue to capture the market
risks undertaken by the Banks in line with the developments in market
risk measurement and management. Accordingly, this proposed rule sets
forth market risk measures consistent with the value at risk (VAR)
framework for calculation of market risk capital adopted by the BCBS
and other financial institution regulators, an approach that can be
implemented with commercially available models, is practical, and is
sufficiently rigorous.
b. Measurement of market value at risk under Bank internal market
risk model. Section 930.6(b)(1) of the proposed rule requires each Bank
to measure, as the market risk component of its risk-based capital
requirement, the market value at risk using an internal VAR model,
subject to the parameters in the proposed rule. The VAR must be
calculated for interest rate, foreign exchange rate, equity price, and
commodity price risks undertaken by the Bank, including related
options. Currently, the Banks are required by the FMP to hedge risk
associated with foreign exchange rates, equity prices, and commodity
prices with matching derivative contracts. Therefore, the bulk of the
proposed market risk capital requirement will reflect interest rate and
related options risks. Although the Banks will have to consistently
apply the VAR framework to instruments linked to foreign exchange
rates, equity prices, and commodity prices, these other market risks
currently pose a smaller amount of risk, relative to interest rate
risk.
Under proposed Sec. 930.6(b)(1), each Bank must use an internal
market risk model that measures the market value of its portfolio at
risk during periods of extreme market stress arising from all sources
of market risks based on the Bank's holdings of on-balance sheet assets
and liabilities and off-balance sheet items, including risks associated
with related options. Proposed Sec. 930.6(b)(2) provides that the
Bank's internal market risk model may use any generally accepted
measurement technique, such as variance-covariance models, historical
simulations, or Monte Carlo simulations, for estimating the market
value of the Bank's portfolio at risk, provided that any measurement
technique used must cover the Bank's material risks. Proposed
Sec. 930.6(b)(3) provides that the Bank's internal market risk model
must measure the risks arising from the non-linear price
characteristics of options and the sensitivity of the market value of
options to changes in the volatility of the option's underlying rates
or prices. For example, a variance-covariance methodology may be
sufficient for instruments that contain no optionality, while it would
be essential to use a simulation technique for instruments with options
characteristics.
Section 930.6(b)(4) of the proposed rule provides that the Bank's
internal market risk model must use interest rate and market price
scenarios for estimating the market value of the Bank's portfolio at
risk, but must at a minimum include: (i) Monthly estimates of the
market value of the Bank's portfolio at risk so that the probability of
a loss greater than that estimated shall be no more than 1 percent;
(ii) scenarios that reflect changes in rates and market prices
equivalent to those that have been observed over 90-business day
periods of extreme market stress \17\ (for interest rates, the relevant
historical observation period specified in Sec. 930.6(b)(4) is to start
from the end of the previous month and go back to the beginning of 1978
and the VAR measure may incorporate empirical correlations among
interest rates, subject to a Finance Board determination that the
model's system for measuring such correlations is sound); and (iii) the
two interest rate scenarios required to be used by OFHEO to determine
the risk-based capital requirements for Fannie Mae and Freddie Mac,
pursuant to 12 U.S.C. 4611(a)(2).
---------------------------------------------------------------------------
\17\ If the underlying distribution for VAR is approximately
normal, the multiplier of 3 effectively extends the 10 business day
horizon required under the Amendment to 90 business days and applies
to large banks with satisfactory internal models, as determined by
regulators.
---------------------------------------------------------------------------
Proposed Sec. 930.6(b)(5) provides that if a Bank participates in
COs denominated in a currency other than U.S. Dollars or linked to
equity or commodity prices, and these instruments have been hedged for
foreign exchange, equity and commodity risks, the Bank's internal
market risk model must be used to calculate the market value of its
portfolio at risk due to these market risks and using the qualitative
and quantitative requirements specified in the proposed rule, i.e., the
probability of a loss greater than that estimated must not exceed 1
percent and must include scenarios that reflect changes in rates and
market prices that have been observed over 90-business day periods of
extreme market stress. This requirement reflects the conservative
approach adopted by the Finance Board
[[Page 52182]]
with respect to the Banks' safety and soundness and the comprehensive
measurement of all market risks throughout each Bank.
The market valuations for COs may differ from valuations for
matching hedging instruments in the derivative market because of
different assumptions concerning the underlying discount curves,
volatilities and correlations. Prices in the two markets may not be the
same and may fail to move in perfect correlation over time. Therefore,
some measure of market risk remains even if the foreign exchange,
equity or commodity risks are hedged with matching derivative
contracts. The Finance Board believes foreign exchange rates, equity
prices, and commodity prices pose a relatively small amount of market
risk to the Banks at this time. For calculation of value at risk due to
foreign exchange rates, equity and commodity prices, historical
observation data from an appropriate period satisfactory to the Finance
Board must be used. The value at risk measure may incorporate empirical
correlations within foreign exchange rates, equity prices, and
commodity prices, but not among the three risk categories, subject to a
Finance Board determination that the model's system for measuring such
correlations is sound.
Proposed Sec. 930.6(b)(5)(iv) provides that if there is a default
on the part of a counterparty to a derivative contract linked to
foreign exchange rates, equity prices or commodity prices, the Bank
must enter into a replacement contract in a timely manner and as soon
as market conditions permit. Besides strengthening safety and
soundness, this requirement formalizes the long standing practice at
the Banks under which the Banks have not assumed an open (unhedged)
foreign exchange, equity or commodity position and is consistent with
the requirement in proposed Sec. 955.3(b) that the Banks shall not
engage in an open foreign exchange, equity and commodity position.
c. Independent validation of Bank internal market risk model.
Section 930.6(c) of the proposed rule provides that each Bank shall
conduct an independent validation of its internal market risk model
within the Bank or obtain independent validation by an outside party
qualified to make such determinations, on an annual basis, or more
frequently as required by the Finance Board. In order for validations
conducted within the Bank to be considered independent, the validation
must be carried out by personnel not reporting to the business line
responsible for conducting business transactions for the Bank. Such
validation may include periodic comparisons, such as on a quarterly
basis, of model generated mark-to-market values with values obtained
from dealers/markets and periodic comparisons, such as on an annual
basis, of model generated VAR values with values obtained from an
independent third-party source. A Bank may use a representative sample
of its on- and off-balance sheet instruments for this source. An
integral part of this process is the necessity to validate key
assumptions and associated parameters underlying the Bank's market risk
models. For example, a Bank must periodically determine the impact on
VAR of shifts in key parameters such as correlations or regime shifts
in volatility parameters. The results of such validations must be
reviewed by the Bank's board of directors and provided to the Finance
Board.
d. Finance Board approval of Bank internal market risk model.
Section 930.6(d)(1) of the proposed rule provides that each Bank must
obtain approval from the Finance Board of its internal market risk
model, including subsequent material adjustments to the model made by
the Bank, prior to the model's use. A Bank must make any subsequent
adjustments to its model that may be directed by the Finance Board.
e. Basis risk. Banks are exposed to basis risk, which is the risk
that rates or prices of different instruments on the two sides of the
balance sheet (after taking associated off-balance instruments into
account) do not change in perfect correlation over time. The BCBS has
emphasized the importance of basis risk as part of a comprehensive
process for the management of interest rate risk.\18\ In the final
rule, the Finance Board may require the Banks to submit a monthly
report identifying the relevant interest rate or price indices along
with related basis risk exposures. Based on an analysis of such reports
and with the help of other relevant data, an assessment will be made as
to the necessity of developing a basis risk measure to incorporate into
the market risk capital requirement as an amendment to the final
regulation. At this time, the Finance Board is requesting comments on
the treatment of basis risk.
---------------------------------------------------------------------------
\18\ See Principles for the Management of Interest Rate Risk
(Jan. 1997).
---------------------------------------------------------------------------
f. Transition provision. Section 930.6(d)(2) of the proposed rule
would require each Bank to submit its initial internal market risk
model to the Finance Board for approval within one calendar year of the
effective date of the final rule.
7. Operations Risk Capital Requirement--Sec. 930.7
Proposed Sec. 930.7 provides that each Bank's operations risk
capital requirement shall at any time equal 30 percent of the sum of
the Bank's credit risk capital requirement and market risk capital
requirement at such time. Operations risk is defined in proposed
Sec. 930.1 as the risk of an unexpected loss to a Bank resulting from
human error, fraud, unenforceability of legal contracts, or
deficiencies in internal controls or information systems. There is
currently no generally accepted methodology for measuring the magnitude
of operations risk. Therefore, the proposed rule adopts the same
requirement imposed by statute on Fannie Mae and Freddie Mac. See 12
U.S.C. 4611(c)(2).
8. Reporting Requirements--Sec. 930.8
Proposed Sec. 930.8 provides that each Bank shall report to the
Finance Board by the 15th day of each month its minimum total risk-
based capital requirement, by component amounts (credit risk capital,
market risk capital, and operations risk capital), and its actual total
capital amount and risk-based capital calculated as of the last day of
the preceding month, or more frequently as may be required by the
Finance Board.
9. Capital Stock Redemption Requirements--Sec. 930.9
a. General. The Act establishes minimum stock purchase requirements
for members for purposes of membership, see 12 U.S.C. 1426(b)(1),
1430(e)(3), and for purposes of taking advances. Id. at 1430 (c),
(e)(1). For a variety of reasons, such as a member's anticipation of a
seasonal increase in advance borrowing, many members of the Bank System
currently hold stock in a Bank in excess of the statutory minimum
requirements.
Pursuant to proposed Sec. 930.1 (definition of ``total risk-based
capital for a Bank''), a Bank may allocate a percentage not exceeding
50 percent of all outstanding capital stock satisfying the minimum
capital stock purchase requirements for membership under sections
6(b)(1) and 10(e)(3) of the Act of all voluntary members, and a
percentage not exceeding 50 percent of all other outstanding capital
stock, towards meeting the Bank's total risk-based capital requirement.
Proposed Sec. 930.9(a) provides that the capital stock designated
by a Bank to meet the Bank's total risk-based capital
[[Page 52183]]
can only be redeemed by the Bank with the approval of the Finance
Board. This would be true even for institutions withdrawing from
membership in the Bank System pursuant to section 6(e) of the Act. Id.
at 1426(e). Proposed Sec. 930.9(b) provides that a Bank may at any time
redeem any portion of a member's capital stock not included in or
allocated by the Bank to the Bank's total risk-based capital, provided
that the member's minimum capital stock purchase requirement for
membership in the Bank System under sections 6(b)(1) and 10(e)(3) of
the Act, id. at 1426(b)(1), 1430(e)(3), is maintained. The Bank may
subject such redemptions to the six-month notice provision in section
6(e) of the Act, id. at 1426(e), or may shorten or waive the six-month
notice provision.
The Finance Board's current regulations allow a Bank, after
providing 15 calendar days advance written notice to a member, to
conduct mandatory, unilateral redemption of excess stock, provided that
the minimum stock requirements for membership under the Act are
maintained. See 12 CFR 935.15(b)(1). This provision is retained in the
proposed rule as Sec. 930.9(b)(3). Section 935.15(b)(2) of the Finance
Board's current regulations, 12 CFR 935.15(b)(2), provides that a Bank
may not impose on or accept from a member a fee in lieu of the
mandatory redemption of the member's capital stock. This provision also
is being retained in the proposed rule as Sec. 930.9(b)(4).
The redemption scheme in the proposed rule is designed to maintain
a level of permanence in the Bank's capital within the flexible overall
risk-based capital framework of the proposal. In this way, the most
permanent forms of capital are measured and used as a limitation on
risk-taking activity. The permanent capital of each Bank, retained
earnings and the minimum stock requirement of mandatory members, may be
supplemented by less permanent capital only to the extent that each
Bank designates it as risk-based and imposes on its members the risk
that capital impairment will impede its redemption.
b. Advance Notice of Proposed Rulemaking; Interim Final Rule. The
Finance Board recently published an ANPRM requesting comment on whether
each Bank should be required to unilaterally redeem its members' excess
Bank capital stock to help achieve the goal of reducing the excess
capital stock in each Bank and thereby to reduce each Bank's arbitrage
of its GSE status in non-core mission assets. See 64 FR 16792 (Apr. 6,
1999). Each of the Banks today holds investments that would not be core
mission assets under the proposed rule. Banks with relatively high
amounts of such investments also tend to have relatively high levels of
excess capital stock. See id. at 16793-94.
As discussed in the ANPRM, the Finance Board believes that the
Banks' arbitrage activities for the purpose of generating sufficient
earnings to pay adequate dividends on excess capital stock detract from
the mission of the Banks to promote housing finance and community
lending, by encouraging activities not related to the Banks' mission
and thereby detracting from the financial incentive to engage in
mission-related activity. See id. at 16794. A reduction in the amount
of excess capital stock would reduce the amount of capital stock on
which dividends must be paid, thereby reducing the level of arbitrage
activities conducted in order to generate earnings to pay dividends on
such capital stock. See id. Accordingly, the ANPRM requested comment on
whether the Banks should be required to unilaterally redeem members'
excess capital stock as a way to reduce excess capital stock in the
Bank System and thereby reduce arbitrage activities in non-core mission
assets by the Banks. See id. at 16795.
For the reasons discussed above, the Finance Board also adopted an
interim final rule amending Sec. 935.15(b) of its Advances Regulation
to prohibit the Banks from imposing or accepting a fee in lieu of
redeeming a member's excess capital stock. See 64 FR 16788 (Apr. 6,
1999) (to be codified in 12 CFR 935.15(b)(2)).
The Finance Board received 68 comment letters on the ANPRM, mostly
opposing requiring the Banks to unilaterally redeem members' excess
capital stock, for reasons including that it would adversely impact the
Banks' financial management, daily operations, long-term customer
relationships and flexibility in responding to market needs. The
Finance Board received 4 comment letters on the interim final rule,
with two commenters supporting and two commenters opposing the rule.
The concerns about a Bank's arbitrage of its GSE status with non-core
mission assets that the ANPRM and interim final rule attempted to
address through mandatory reduction of excess capital stock, are
addressed in a different fashion under the financial management and
mission achievement provisions of this proposed rule. Accordingly, the
Finance Board does not intend to pursue at this time the proposals
raised for comment in the ANPRM, but is retaining Sec. 935.15(b)(2) of
its Advances Regulation regarding the fee in lieu prohibition (as
proposed Sec. 930.9(b)(4)).
10. Minimum Liquidity Requirements--Sec. 930.10
Liquidity risk is defined in proposed Sec. 917.1 as the risk that a
Bank would be unable to meet its obligations as they come due or meet
the credit needs of its members and eligible nonmember borrowers in a
timely and cost-efficient manner. In general, the liquidity needs of
the Banks may be classified as: (1) operational liquidity; and (2)
contingency liquidity. Operational liquidity addresses day-to-day or
ongoing liquidity needs under normal circumstances, and may be either
anticipated or unanticipated. Contingency liquidity addresses liquidity
needs under abnormal or unusual circumstances in which a Bank's access
to the capital markets is temporarily impeded. Under such unusual
circumstances, a Bank may still need funds to meet all of its
obligations that are due or to meet some of the credit needs of its
members and eligible nonmember borrowers.
Currently, the Banks operate under two general liquidity
requirements. Both are easily met by the Banks. However, neither is
structured to meet the Banks' liquidity needs should their access to
the capital markets be limited for any reason. The first requirement is
statutory and requires the Banks to maintain an amount equal to total
deposits invested in either obligations of the United States, deposits
in banks or trusts, or advances to members that mature in 5 years or
less. See 12 U.S.C. 1421(g). The second liquidity requirement is in the
FMP. It requires each Bank to maintain a daily average liquidity level
each month in an amount not less than 20 percent of the sum of the
Bank's daily average demand and overnight deposits and other overnight
borrowings during the month, plus 10 percent of the sum of the Bank's
daily average term deposits, COs, and other borrowings that mature
within one year. See FMP section III.C.
The proposed rule specifies a contingency liquidity requirement,
but does not specify an operational liquidity requirement. However,
proposed Sec. 917.3(b)(3)(iii) would require that each Bank's risk
management policy indicate the Bank's sources of liquidity, including
specific types of investments to be held for liquidity purposes, and
the methodology to be used for determining the Bank's operational
liquidity needs.
Section 930.10 of the proposed rule provides that the Banks must
meet not only the statutory liquidity
[[Page 52184]]
requirements contained in section 11(g) of the Act, 12 U.S.C. 1431(g),
but also each Bank shall hold contingency liquidity in an amount
sufficient to enable the Bank to cover its liquidity risk, assuming a
period of not less than seven calendar days of inability to borrow in
debt markets. Contingency liquidity may be provided through Banks: (1)
selling liquid assets; (2) pledging government, agency and mortgage-
backed securities as collateral for repurchase agreements; and (3)
borrowing in the federal funds market. Consequently, contingency
liquidity is defined in proposed Sec. 930.1 as: (1) marketable assets
with a maturity of one year or less; (2) self-liquidating assets with a
maturity of seven days or less; and (3) assets that are generally
accepted as collateral in the repurchase agreement market. Proposed
Sec. 930.10 provides that an asset that has been pledged under a
repurchase agreement cannot be used to satisfy the contingency
liquidity requirement, since such an asset will not be available to
provide liquidity should a contingency arise.
The proposed seven-day contingency liquidity requirement would help
to ensure that the Banks maintain sufficient liquidity to meet their
funding needs should their access to the capital markets be temporarily
limited by occurrences such as: (1) a power outage at the Bank System's
Office of Finance (OF); (2) a natural disaster; or (3) a real or
perceived credit problem. This requirement was calculated using daily
data on CO redemptions during 1998. The Finance Board found that the
99th percentile of the 5-business day CO redemption distribution
resulted in liquidity requirements that ranged from about 5 percent to
17 percent of each Bank's total assets.
It is expected that the contingency liquidity requirement and the
Banks' operational liquidity needs can be met within the core mission
activities requirement in proposed Sec. 940.4. The Banks' capital and
deposits are available to fund liquidity assets, and some core mission
assets may also serve as liquidity assets. In addition, the Finance
Board expects that the Banks' liquidity requirements will generally
decline as they restructure their balance sheets to comply with the
core mission activities requirements in proposed Sec. 940.4.
The seven-day requirement may be viewed as conservative when
examined in the context of events which could impair the normal
operations of the OF. The likelihood that there would be no access to
the capital markets for as long as five business days is extremely
remote, given OF contingency plans to be back in operation within the
same business day following a disaster. The OF contingency plans
include back-up power sources and two back-up facilities, plus
procedures to back-up their databases at both their main location as
well as the primary alternative site. A back-up data tape from OF's
main location is sent and stored off-site on a daily basis.
Real or perceived concerns about creditworthiness of the Bank
System could lead to a widening of the spreads to U.S. Treasury
securities at which the Bank System COs are issued. Depending on the
size of the increase in credit spreads, such an event could
substantially impair the Banks' ability to carry out their mission. Two
such episodes affecting other GSEs took place in the 1980s. In both
cases, the interest rate spread narrowed back to normal levels only
after the GSEs received assistance from the federal government.\19\ In
the first instance, the spread to comparable U.S. Treasury securities
for a Farm Credit System issue increased approximately 80 basis points
within a 6 month period during 1985 as the Farm Credit System ran into
financial difficulty and started posting losses. Fannie Mae underwent a
similar episode in which its debt spread widened substantially.
---------------------------------------------------------------------------
\19\ See Federal Reserve Bank of Richmond, Instruments of the
Money Market 153 (1993).
---------------------------------------------------------------------------
The likelihood that such an event could take place with respect to
the Banks is remote and, in any event, would need to be addressed with
resources beyond those dedicated to the contingency liquidity
requirement. The seven-day contingency liquidity requirement provides
policy makers with some time to address the underlying problem.
Further, should a crisis arise affecting liquidity at all financial
institutions, assistance would be needed from the Federal Reserve
System, the U.S. Treasury, or the Congress.
Other regulators also recognize the importance of adequate levels
of liquidity but, for the most part, have not imposed liquidity
requirements with the degree of specificity contained in the proposed
rule. Specifically, depository institution regulators have not
implemented any numeric ratios or other quantitative requirements with
respect to liquidity. However, the importance of liquidity is reflected
in the fact that it is one of the six components of the Uniform
Financial Institutions Rating System (UFIRS) that was adopted by the
Federal Financial Institutions Examination Council (FFIEC) on November
13, 1979 and revised as of January 1, 1997. The UFIRS has been used as
an internal supervisory tool for evaluating the soundness of financial
institutions and for identifying those institutions requiring special
attention or concern. Under 12 CFR 615.5134, each banking institution
regulated by the Farm Credit Administration is required to maintain a
minimum liquidity reserve. This liquidity reserve requirement ensures
that Farm Credit System banks have a pool of liquid investments to fund
their operations for approximately 15 days should their access to the
capital markets become impeded. OFHEO has not published any regulation
concerning liquidity requirements for Fannie Mae and Freddie Mac.
Rating agencies also consider adequate liquidity an important
component in a financial institution's rating. Liquid investments held
by the Banks are stated by Moody's as one of the reasons behind the
triple-A rating for the Banks.\20\
---------------------------------------------------------------------------
\20\ Moody's Investor Service, Global Credit Research, Moody's
Credit Opinions--Financial Institutions, (June 1999).
---------------------------------------------------------------------------
11. Limits on Unsecured Extensions of Credit to One Counterparty or
Affiliated Counterparties; Reporting Requirements For Total Secured and
Unsecured Extensions of Credit to One Counterparty or Affiliated
Counterparties--Sec. 930.11
a. Limits on unsecured extensions of credit. Section 930.11(a) of
the proposed rule establishes maximum capital exposure limits for
unsecured extensions of credit by a Bank to a single counterparty or to
affiliated counterparties. Section 930.11(b) of the proposed rule
establishes reporting requirements for total unsecured extensions of
credit and total secured and unsecured extensions of credit to single
counterparties and affiliated counterparties that exceed certain
thresholds.
Concentrations of unsecured credit by a Bank with a limited number
of counterparties or group of affiliated counterparties raise safety
and soundness concerns. Unlike Bank advances, which must be secured,
unsecured credit extensions are more likely to result in limited
recoveries in the event of default. Thus, significant credit exposures
to a few counterparties increase the probability that a Bank may
experience a catastrophic loss in the event of default by one of the
counterparties. In contrast, holding small credit exposures in a large
number of counterparties, while making a small
[[Page 52185]]
loss more likely, reduces the probability of a catastrophic loss to a
Bank.
Safety and soundness concerns also arise where a Bank's credit
extensions are concentrated in a single counterparty whose debt, in
turn, is concentrated in one or a few lenders. The fact that the
counterparty's debt is concentrated may suggest that other lenders have
declined to lend to such counterparty due to concerns about the
counterparty's ability to repay a loan. The Bank's concentration of
credit in such a counterparty may put the Bank's extensions of credit
more at risk.
In addition, where a Bank's extensions of credit to a single
counterparty are in jeopardy of nonpayment, the Bank may be reluctant
to take appropriate actions to reduce losses, such as declaring a
default, or selling the loans, which could depress their price.
Further, a Bank may even be tempted to lend additional funds to the
counterparty to keep the counterparty in business, if that Bank has a
significant credit exposure to the counterparty.
Affiliated counterparties generally share aspects of common
ownership, control or management. Thus, if one member of a group of
affiliates defaults, the likelihood is high that other members of the
affiliated group also are under financial stress. A Bank's unsecured
extensions of credit to a group of affiliated counterparties thus
should be aggregated in considering the Bank's unsecured credit
exposure to any one counterparty in the affiliated group.
Concentrations of credit by multiple Banks in a few counterparties
also may raise safety and soundness concerns at the Bank System level.
Several Banks in recent years have had unsecured credit exposures to
affiliated counterparties that exceeded 20 percent of each Bank's
capital. These credit exposures were to counterparties ranked at the
second highest investment grade. A few counterparties have spread their
exposure among several Banks. Such credit concentrations may result in
large aggregate credit exposures for the Bank System, raising concerns
regarding the liquidity of such debt in the event of adverse
information regarding a counterparty.
The risk-based capital requirements in the proposed rule do not
take into account the increase in credit risk associated with
concentrations of unsecured credit. Therefore, the Finance Board
believes that it is necessary, for safety and soundness reasons, to
impose separate limits on unsecured extensions of credit by a Bank to
single counterparties and to affiliated counterparties. This is
consistent with the regulatory approaches of other financial
institution regulators. See, e.g., 12 CFR 32 (OCC's loans-to-one-
borrower limit is generally 15 percent of a national bank's capital and
surplus).
Currently, the FMP limits Bank unsecured extensions of credit to a
single counterparty based on the credit rating of the counterparty. See
FMP section VI. Under the FMP, the lower the credit rating of the
counterparty, the lower the maximum permissible credit exposure limit,
because the probability of default increases as the counterparty's
rating decreases. The FMP does not impose limits on unsecured lending
to affiliated counterparties, but does require the Banks to monitor
such lending and impose limits if necessary. As of December 31, 1998,
five Banks had adopted explicit unsecured credit exposure limits to
affiliated counterparties.
Consistent with the general approach of the FMP,
Sec. 930.11(a)(1)(i) of the proposed rule provides that unsecured
extensions of credit by a Bank to a single counterparty that arise from
authorized Bank investments or hedging transactions shall be limited to
the maximum capital exposure percent limit applicable to such
counterparty, as set forth in Table 4 of the proposed rule, multiplied
by the lesser of: (i) the Bank's total capital; or (ii) the
counterparty's Tier 1 capital, or total capital if Tier 1 capital is
not available. The maximum capital exposure percent limits applicable
to specific counterparties in Table 4 range from a high of 15 percent
for counterparties with the highest investment grade rating, to a low
of 1 percent for counterparties with a below investment grade rating.
These limits are consistent with those established internally by large
lenders.
Section 930.11(a)(1)(ii)(D) of the proposed rule provides that
where a counterparty has received different credit ratings for its
transactions with short-term and long-term maturities: (i) the higher
credit rating shall apply for purposes of determining the allowable
maximum capital exposure limit under Table 4 applicable to the total
amount of unsecured credit extended by the Bank to such counterparty;
and (ii) the lower credit rating shall apply for purposes of
determining the allowable maximum capital exposure limit under Table 4
applicable to the amount of unsecured credit extended by the Bank to
such counterparty for the transactions with maturities governed by that
rating. For example, if a counterparty has received a lower rating on
its long-term debt than its short-term debt, the Bank will be more
severely limited in the amount of the counterparty's long-term debt
that it can hold. If the Bank wishes to hold any more of this
counterparty's debt, it will be limited to holding the higher rated
short term debt, up to a total amount of credit exposure governed by
proposed Sec. 930.11(a)(1)(ii)(D)(1).
Section 930.11(a)(1)(ii)(E) of the proposed rule provides that if a
counterparty is placed on a credit watch for a potential downgrade by
an NRSRO, the Bank shall determine its remaining available credit line
for unsecured credit exposures under Table 4 by assuming a rating from
that NRSRO at the next lower grade.
Section 930.11(a)(2) of the proposed rule provides that the total
amount of unsecured extensions of credit by a Bank to all affiliated
counterparties may not exceed: (i) the maximum capital exposure limit
applicable under Table 4 based on the highest credit rating of the
affiliated counterparties; (ii) multiplied by the lesser of: (A) the
Bank's total capital; or (B) the combined Tier 1 capital, or total
capital if Tier 1 capital is not available, of all of the affiliated
counterparties.
b. Reporting requirement for total unsecured credit concentrations.
Currently, there is no centralized mechanism for maintaining and
measuring aggregate unsecured credit concentration exposure data at the
Bank System level. As discussed above, Bank unsecured credit
concentrations raise safety and soundness concerns at the Bank System
level, as well as at the individual Bank level. The FMP does not
establish maximum unsecured credit exposure limits or reporting
requirements for aggregate unsecured credit concentrations at the Bank
System level.
Accordingly, Sec. 930.11(b)(1) of the proposed rule requires each
Bank to report monthly to the Finance Board the amount of the Bank's
total unsecured extensions of credit to any single counterparty or
group of affiliated counterparties that exceeds 5 percent of: (i) the
Bank's total capital; or (ii) the counterparty's Tier 1 capital (or
total capital if Tier 1 capital is not available), or in the case of
affiliated counterparties, the combined Tier 1 capital (or total
capital if Tier 1 capital is not available) of all of the affiliated
counterparties.
The Finance Board will be considering limits on aggregate unsecured
credit concentration exposures at the Bank System level for the final
rule. The Finance Board specifically requests comments on whether such
limits should be imposed and what the size and form of such limits
should be.
[[Page 52186]]
c. Reporting requirement for total secured and unsecured credit
concentrations. Bank concentrations of secured credit, primarily
advances, to a single counterparty or group of affiliated
counterparties also may present safety and soundness concerns for
individual Banks and the Bank System. Other financial institution
regulators impose loans-to-one-borrower limits for secured as well as
unsecured extensions of credit, with exceptions for loans secured by
high-quality collateral. See, e.g., 12 CFR 932. There may be reasons to
exclude concentrations of advances from such limits, given the extent
of their overcollateralization, their statutory superlien protection
and core mission activity status.
Accordingly, Sec. 930.11(b)(2) of the proposed rule requires each
Bank to report monthly to the Finance Board the amount of the Bank's
total secured and unsecured extensions of credit to any single
counterparty or group of affiliated counterparties that exceeds 5
percent of the Bank's total assets. Because secured credit is supported
by collateral, not capital, in the first instance, the Finance Board
believes that exposures as a percent of assets rather than of capital
is a more appropriate measure of the size of the exposure.
The Finance Board will be considering limits on total secured and
unsecured credit concentration exposures applicable to the Banks or the
Bank System for the final rule. The Finance Board specifically requests
comments on whether such limits should be imposed and what the size and
form of such limits should be.
D. Part 940--Core Mission Activities Requirements
1. Bank Investment Practices
By virtue of their GSE status, the Banks enjoy two major advantages
over non-GSE borrowers in the capital markets: (1) the ability to
borrow in the capital markets at rates only slightly above U.S.
Department of the Treasury borrowing rates; and (2) the ability to
issue large amounts of debt, including debt with complex structures.
Given its duty under the Act to ensure that the Banks carry out their
housing finance mission, the Finance Board has been concerned for some
time that the Banks have used substantial amounts of the proceeds of
their GSE borrowings to finance arbitrage investments.
Prior to the thrift crisis of the late 1980s and the enactment of
the Financial Institutions Reform, Recovery, and Enforcement Act of
1989 (FIRREA), Pub. L. 101-73, 103 Stat. 183 (1989), the Banks' assets
were primarily advances to thrift members for the purpose of funding
home mortgage loans. The Banks' balance sheets expanded and contracted
with thrift member demand for advances, and thus, generally reflected
the cyclical nature of the housing and credit markets. During this
period, the Banks maintained relatively small portfolios of investments
in assets other than advances, generally for liquidity purposes. For
the period from 1980 through 1988, advances represented, on average,
about 84 percent of Bank System total assets, while total investments
other than advances represented about 14 percent of Bank System total
assets. Over the same time period, advances averaged 118 percent of
COs, indicating that the Banks funded advances not only with COs, but
also with a portion of deposits and capital. As a result of using all
COs issued to fund advances, the Banks were using their GSE funding
advantage only to enhance the availability of housing finance.
Significant and rapid changes in the structure of the Bank System's
balance sheet and its profitability occurred following the enactment of
FIRREA. Among other things, the results of FIRREA included: (1) the
liquidation of hundreds of failed thrift institutions, and the
concomitant advance prepayments and stock redemptions; (2) the
imposition of new and higher statutory capital requirements for thrifts
that caused many Bank System thrift members to either reduce their
asset size and prepay advances or to stop growing and reduce their
demand for new advances during the early 1990s; (3) the transfer of
$2.5 billion in Bank System retained earnings to the Resolution Funding
Corporation (REFCorp) to help pay for the cost of thrift resolutions
(in addition to the Banks' payment of $700 million in retained earnings
to defease the Financing Corporation bonds as required under the
Competitive Equality Banking Act of 1987); (4) the requirement that the
Bank System make a $300 million annual payment of interest on the
REFCorp bonds; and (5) the requirement that the Bank System make a
payment, beginning in 1990, of the greater of five percent of net
income or $50 million, and increasing by steps to the greater of ten
percent of net income or $100 million in 1995 and thereafter, to fund
the newly-required Affordable Housing Program (AHP). One other
important provision of FIRREA allowed federally-insured commercial
banks with at least ten percent of their assets in residential mortgage
loans to join the Bank System.
After the enactment of FIRREA, the Banks needed to generate a level
of income sufficient to cover the decline in earnings associated with
the transfer of over $3 billion in retained earnings to other
government agencies, the statutorily mandated annual fixed REFCorp
obligation of $300 million, contributions to the AHP and the prepayment
of advances as a result of resolutions of insolvent members, while
still providing dividends and benefits, primarily in the form of
advances priced to reflect the Banks' GSE funding advantage, that would
attract and retain member institutions. Reduced spreads on earning
assets and a lower interest rate environment also contributed to the
decline in System net income during the early 1990s. For these reasons,
Bank investments in assets bearing little or no relation to the Banks'
public purpose (primarily money market investments and mortgage backed
securities (MBS)) increased during the years following the enactment of
FIRREA. Of these two investment options, MBS have been appreciably more
profitable per dollar invested.
Therefore, to assist the Banks during this time, the Finance Board
increased the Banks' MBS investment authority from 50 percent to 200
percent of capital when it adopted the FMP in 1991. See Finance Board
Res. No. 91-214 (June 25, 1991). In December 1993, the Finance Board
again raised the Banks' MBS investment authority from 200 percent to
300 percent of capital based on continuing concerns about the Banks'
ability to generate income. See Finance Board Res. No. 93-133 (Dec. 15,
1993). The Finance Board also increased the Bank System's regulatory
leverage limit during this period. See Finance Board Res. No. 93-074
(Sept. 22, 1993).
The Finance Board initially limited MBS investment, as described
above, in part because of concern about the Banks' ability to manage
the interest rate and options risk associated with these assets.
However, now that the Banks have developed more effective techniques
for hedging these risks, and there are policy limits in place
constraining the Banks' interest rate risk exposure, the MBS limit can
be viewed less as a safety and soundness constraint and more as a means
to restrain a non-mission related activity. Although MBS are housing-
related, the extent to which these investments support the Banks'
housing finance mission is debatable. MBS generally are traded in
large, well-established and liquid markets. The Banks' presence in
these markets may not result in increased availability of funds for
housing, or in lower cost of funds. Moreover, and perhaps most
importantly for the Finance Board, the Banks' MBS investments generally
do
[[Page 52187]]
not involve the Banks working with or through Bank System members and
thus do not contribute to the cooperative nature of the Bank System as
advances do.
Another major change in the Bank System following the enactment of
FIRREA was the growth of commercial bank membership. Until 1989, Bank
System membership consisted almost exclusively of thrift institutions.
Bank System membership declined from 1989 to 1990 due to the closing of
failed institutions, but rose rapidly thereafter as commercial banks
joined the Bank System. Total Bank System membership increased from
2,855 at year-end 1990 to 6,884 at year-end 1998. Voluntary members,
primarily commercial banks, represented over 86 percent of total
membership at December 31, 1998. Voluntary members held $143 billion in
advances, representing almost 50 percent of total advances, and held
$13 billion (59 percent) of the capital stock of the Bank System as of
December 31, 1998. Given the large increase in voluntary members since
1989, maintaining dividends and membership benefits to retain voluntary
members has been considered necessary for ensuring a stable Bank
System.
The increase in investments not directly related to the Banks'
public purpose was a rational response to the sharp fall-off in Bank
System advances and net income that occurred during the period
following the enactment of FIRREA. However, Bank System earnings and
advances are now at record levels. Outstanding advances, surpassing the
previous all time high of $167 billion in the second quarter of 1997,
reached $288 billion at year end 1998. Net income has steadily
increased to $1.8 billion in 1998 after dropping to a low of $850
million in 1992.
In addition, although the Banks initially grew investments as a
substitute for advances, Bank investments generally have increased
since 1992 along with advances. Investments grew 73 percent between
1992 and 1998, increasing from $79 billion to $137 billion over the
period. To some extent, this growth was because of lower spreads on
advances due to increased funding competition from other sources. At
the end of 1998, advances represented 66 percent of Bank System total
assets while investments represented 32 percent of Bank System total
assets. Bank System liabilities also increased over this period to fund
the growth in investments and advances. Bank System COs outstanding
increased over 225 percent between 1992 and 1998, growing from $115
billion at year end 1992 to $377 billion at year end 1998, however,
only 76 percent of COs funded advances at year end 1998.
Once the Banks' ability to generate income had demonstrably
improved, the Finance Board initiated steps to address the Bank System-
wide growth of non-mission related investments. A first step was to
recognize that, while the detailed list of restrictions and limits
placed on the Banks' investment authority by the FMP successfully
ensured safety and soundness, it provided little, if any, flexibility
and incentive for the Banks to seek out and develop new assets and
activities that are permissible under the Act and that are consistent
with the mission of the Bank System.
Therefore, to address the lack of flexibility in developing mission
related investments, the Finance Board amended the FMP in 1996 to
permit the Banks, among other things, to engage in new activities
designed in part to add higher yielding and more mission-related assets
to their balance sheets that would also preserve and promote the
cooperative nature of the Bank System. See FMP section II.B.12. These
activities were first approved on a pilot program basis in 1996 and
1997 and have been in operation since then. The Finance Board has
determined, based on the experience of these programs, that certain
mortgage assets, as further discussed below, can be acquired by the
Banks from their members while preserving and promoting the cooperative
nature of the Bank System and providing for greater mission
achievement. It is anticipated that expansion of these activities will
permit the Banks to reduce their holdings of money market investments
and MBS.
In May 1998, the Finance Board held a public hearing on Bank
investment practices in response to concerns about the growth of money
market investments and MBS. In preparation for the hearing, the Finance
Board published a staff paper on the implications of Bank investment
practices for Finance Board investment policy which discussed several
options for limiting money market and MBS investments, including
limiting money market investments to the amount of deposits and capital
held by the Banks. See 63 FR 16505-37 (Apr. 3, 1998).
A second major step taken by the Finance Board to address concerns
about the Bank System-wide growth of non-mission related investments is
the proposed rule, which provides the Banks even greater flexibility,
as well as an incentive, to acquire mission related assets compared to
what now exists in the FMP. Greater flexibility is provided in proposed
Sec. 955.2, as limited by proposed Sec. 955.3 discussed below, which,
among other things, expands the allowable credit rating for authorized
investments from primarily triple-A in the FMP to triple-B. Incentive
to acquire mission related assets is provided in proposed Sec. 940.4,
discussed below, which requires that 100 percent of Bank System COs
must be used to finance mission related activities. The Finance Board
has determined that this requirement is appropriate in view of the
improved financial condition of the Bank System. The process for
implementing this requirement is discussed below.
2. Mission of the Banks--Sec. 940.2
Part 940 of the proposed rule sets forth the core mission
activities (CMA) requirements that would apply to the Banks under the
proposed new regulatory regime. Proposed Sec. 940.2 defines the mission
of the Banks as providing to members and eligible nonmember borrowers,
i.e., entities that have been approved as a nonmember mortgagee
pursuant to subpart B of part 950 of the Finance Board's regulations,
financial products and services, including but not limited to advances,
that assist and enhance such members' and eligible nonmember borrowers'
financing of: (a) housing in the broadest sense including single-family
and multi-family housing serving consumers at all income levels, and
(b) community lending as defined in Sec. 953.3 of the Finance Board's
regulations. This statement of mission and the regulatory provisions
that would implement it are intended to ensure maximum use of the
cooperative structure of the Bank System to provide funds for housing
finance and community lending.
3. Core Mission Activities--Sec. 940.3
Proposed Sec. 940.3 lists those Bank activities that would qualify
as CMA. Under proposed Sec. 940.3(a)(1), all Bank advances and
commitments to make advances with certain drawdown to members or
eligible nonmember borrowers with assets of $500 million or less would
qualify as CMA. There were 6,207 members, representing 89 percent of
all members, with assets of $500 million or less as of March 31, 1999.
Under proposed Sec. 940.3(a)(2), advances and commitments to make
advances with certain drawdown to members or eligible nonmember
borrowers with assets greater than $500 million would qualify as CMA in
an amount up to the total book value of certain assets held by such
member or eligible nonmember borrower. These assets are: (1) housing-
related whole loans; (2) loans and investments that are
[[Page 52188]]
generated by community lending (as that term is used in the Finance
Board's CICA regulation, see 12 CFR 970); and (3) MBS that comprise the
types of loans falling into either of the preceding two asset
categories and that are originated by the member or eligible nonmember
borrower. The term ``housing-related whole loans'' is defined in
proposed Sec. 940.1 to include all whole loans, or participation
interests in whole loans (excluding mortgage backed-securities),
secured by one-to-four family property, multifamily property, or
manufactured housing. The definition mentions loans for the
construction, purchase, improvement, rehabilitation, or refinancing of
housing as a non-exclusive list of loans that would be considered
housing-related under the proposed rule. This broad definition
corresponds with the mission of the Banks, stated in proposed
Sec. 940.2, to finance housing in the broadest sense.
Thus, if a member with over $500 million in assets were to have on
its books such loans and investments in an amount equal to or exceeding
that member's total advances outstanding, the Bank would be able to
count all advances to that member as CMA. On the other hand, if the
member were to have on its books such loans and investments in an
amount less than its total advances outstanding, the Bank would be able
to count as CMA only those advances to that member equal to the amount
of such loans and investments. A review of members with assets greater
than $500 million shows that, as of June 30, 1999, only 54 members had
advances outstanding that exceeded their holdings of residential
mortgage loans (as defined in existing 12 CFR 933.1(bb), but excluding
MBS), a narrower group of assets than allowed under proposed
Sec. 940.3(a)(2). Excess advances over residential mortgage loans were
only $14 billion or 4 percent of total advances outstanding as of June
30, 1999.
The purpose of proposed Sec. 940.3(a)(1) and (2) is to ensure that
those advances that will count as CMA are, at the very least, aligned
with housing and community lending assets held by the member. The
provision allows all advances to members with assets of $500 million or
less to qualify as CMA so that the CMA designation does not result in
any restrictions or limits being imposed on the access of smaller
institutions to advances from the Banks. This provision recognizes that
smaller banks face substantial hurdles in obtaining funds because they
lack access on their own to the capital markets and have been subjected
to a prolonged decline in deposits. This provision also is consistent
with provisions of H.R. 10, passed by the House of Representatives on
July 1, 1999, and S. 900, passed by the U.S. Senate on May 6, 1999,
each of which provides substantially greater latitude to Bank members
with assets equal to or less than $500 million with respect to how they
can use the proceeds of Bank advances.
The methodology proposed for institutions with assets of over $500
million is necessary since it is not possible to track advances to
specific member loans. Limiting the advances that such members may
count as CMA to the amount that can be supported by specific types of
loans and securities, mitigates against including advances that support
large commercial and business loans that do not otherwise qualify as
community lending under the CICA regulation, and securities supported
by such loans, as CMA. It is likely that such loans are not related to
community lending in the community where the large member is located.
The Finance Board requests comments on the practicality of this
provision and suggestions for any alternative methodology.
Under proposed Secs. 940.3(b) and 940.4(c), standby letters of
credit (SLOCs) would count as CMA at a partial value of their face
amount, to be gradually phased out over the transition period.
Following the transition period, SLOCs would qualify as CMA valued at
the fee charged to members for issuance or confirmation of the SLOC
(see discussion below of Sec. 940.4(c)).
Under proposed Sec. 940.3(c), intermediary derivative contracts
(primarily interest rate swaps) valued at the fee charged to members
would qualify as CMA because the fee represents the value of a risk-
management related service provided by the Banks to the members.
Under proposed Sec. 940.3(d), member mortgage assets (MMA) held
pursuant to proposed part 954 (discussed in detail below) would qualify
as CMA.
Three general types of equity investments also would count as CMA
under proposed Sec. 940.3(e). First, equity investments that primarily
benefit low-or moderate-income individuals, or areas, or other areas
targeted for redevelopment by local, state, tribal or Federal
government, would be considered to be CMA if the investment provides or
supports: affordable housing; community services; permanent jobs for
low- or moderate-income individuals; or area revitalization or
stabilization. This type of equity investment is included within the
definition of CMA based on the regulatory definition of equity
investments that are permitted to national banks. See 12 CFR 24.3(a).
Second, investments in the stock of SBICs formed pursuant to 15 U.S.C.
681(d) would qualify as CMA to the extent that the investment is
structured to be matched by an investment in the same SBIC by a member
or eligible nonmember borrower of the Bank making the investment in
SBIC stock. This is also explicitly authorized under section 11(h) of
the Act. See 12 U.S.C. 1431(h). The member matching requirement will
satisfy the statutory requirement that Bank investments in SBICs be for
the purpose of aiding members. Third, equity investments in
governmentally-aided economic development entities structured similarly
to SBICs, and where the investment primarily benefits low- or moderate-
income individuals or areas, would qualify as CMA.
Three other specific investments would be considered CMA under
proposed Secs. 940.3 (f), (g), and (h): the short-term tranche of SBIC
securities guaranteed by the Small Business Administration (SBA);
Section 108 Interim Notes and Participation Certificates guaranteed by
HUD pursuant to section 108 of the Housing and Community Development
Act of 1994 (as amended); and investments and obligations for housing
and community development issued or guaranteed under Title VI of the
Native American Housing Assistance and Self-Determination Act of 1996
(NAHASDA). These investments are all related to housing and community
lending and supported by various government programs at the federal
level. The Finance Board proposes to treat these special equity
investments as CMA because of their potential to move the private
markets to better assist low- and moderate-income communities to become
more prosperous. By treating these investments as CMA, the Board is
intentionally creating a greater incentive for the Banks to make these
investments.
The Finance Board specifically requests comment on whether any
other investment instruments, which are products of federal programs
designed to support housing and community lending programs, should also
be included.
Proposed Sec. 940.3(i) includes as CMA certain assets previously
acquired, or authorized to be acquired, under the FMP. Assets acquired
under section II.B.11 of the FMP, primarily state and local housing
finance agency (HFA) bonds acquired from out-of-district HFAs that may
or may not be eligible
[[Page 52189]]
nonmember borrowers, would be considered to be CMA if acquired before
the effective date of the final rule. Any new investments in state and
local HFA bonds would need to meet the requirements for MMA under
proposed part 954, as discussed below, to continue to qualify as CMA.
This means that only state and local HFA bonds acquired from in-
district eligible nonmember borrowers, or from or through another Bank
that acquired such bonds from eligible nonmember borrowers in its
district, would be considered to be MMA under part 954 of the proposed
rule and, therefore, would qualify as CMA.
Assets authorized by the Finance Board, by resolution or otherwise,
to be acquired or held pursuant to Finance Board approval under section
II.B.12 of the FMP will be considered to be CMA up to the greater of:
(1) the amount permitted under the authorization; or (2) the amount
acquired prior to the effective date of this section. Pilot programs
approved under section II.B.12 may continue to operate under their
authorizing resolutions until the dollar cap prescribed in the
applicable resolution is reached. Any subsequent transactions would
need to meet the requirements for MMA under proposed part 954 in order
to qualify as CMA.
4. CMA Requirement--Sec. 940.4
Proposed Sec. 940.4(a) provides that, following a transition period
that ends on January 1, 2005, each Bank must maintain an annual average
ratio of at least 100 percent of CMA to the book value of the Bank's
total outstanding COs. For purposes of this calculation, on-balance
sheet CMA (i.e., certain advances, MMA, certain equity investments, the
short-term tranche of SBIC securities guaranteed by SBA, Section 108
Interim Notes and Participation Certificates guaranteed by HUD,
investments and obligations for housing and community development
issued or guaranteed under Title VI of NAHASDA, and grandfathered
assets acquired under sections II.B.11 and II.B.12 of the FMP) would be
counted at book value. Off-balance sheet CMA (i.e., SLOCs, intermediary
derivative contracts and commitments to make advances with certain
drawdown) would be counted at an amount prescribed in the off-balance
sheet conversion factor chart contained in proposed Sec. 940.4(c)
discussed below. This ratio would be calculated based on a 12-month
moving average. Proposed Sec. 940.4(b) would require that each Bank
report to the Finance Board its actual CMA ratio as of the last day of
each calendar quarter, based on the preceding 12 months. A Bank would
be free to undertake authorized activities that do not qualify as CMA,
so long as the ratio of its CMA to its total COs outstanding meets the
requirement of proposed Sec. 940.4(b).
While it is unrealistic to expect a return to the pre-FIRREA ratios
of advances to COs for a number of reasons, the Finance Board considers
the 100 percent CMA ratio requirement to be both appropriate public
policy and economically feasible. The primary source of funds for the
Banks is the issuance of COs in the capital markets at rates reflecting
the Banks' GSE funding advantage. Therefore, as a matter of public
policy, the Finance Board believes that 100 percent of the assets
funded with COs should be mission-related. In developing the CMA
requirement, the Finance Board generated simulations that applied a CMA
requirement, i.e., a stated percentage of COs invested in CMA, to each
Bank's average balance sheet for the first six months of 1999. For
these simulations, capital, deposits, and advances were held constant.
Further, the simulations did not incorporate any behavioral responses
on the part of the Banks. Thus, while the results should not be
considered predictions of what will happen as a result of the proposed
rule, they should be considered an indication of the magnitude and
feasibility of the Banks' required balance sheet adjustments. The
simulation results were evaluated based on the aggregate balance sheet
and aggregate earnings for the Bank System as a whole. The CMA
requirement, however, would be imposed separately on each Bank. As the
proposed rule allows Banks to buy and sell CMA among each other, Banks
with CMA ratios below the required CMA ratio would be permitted to
purchase CMA from Banks with CMA ratios above the required CMA ratio.
For this reason simulations at the Bank System level are appropriate.
Based on analysis of empirical data and discussions with Bank
staff, spreads over the CO rate for money market instruments (MMI) were
assumed to be approximately one-seventh that assumed for MBS, and
spreads for MMA, which are discussed in connection with proposed part
954 below, were assumed to be roughly comparable to those for MBS,
based on their similar risk characteristics. The low return on MMI
relative to MMA would allow the Banks to roll-off substantial amounts
of MMI, which could be replaced with relatively smaller amounts of MMA,
while earning the same net income.
A simulation imposing the 100 percent CMA requirement indicates
that the Bank System could continue to pay a dividend comparable to the
annualized dividend for the first half of 1999 and achieve the 100
percent CMA requirement. To do so would require the Banks to reduce MMI
by $43 billion and increase MMA by $65 billion.\21\
---------------------------------------------------------------------------
\21\ MBS holdings would be reduced by $59 billion. Essentially,
the Banks would replace MBS with MMA on a dollar for dollar basis,
and add an additional $6 billion in MMA to compensate for the
reduced income from the reduction in MMI. The $65 billion of MMA to
be acquired would equal about 1.5 percent of residential mortgage
debt outstanding at the end of 1998.
---------------------------------------------------------------------------
Currently, the Banks' ratios of advances to COs, a more
conservative measurement than total CMA to COs, range from 50 percent
to 85 percent. The Finance Board believes it is reasonable and
necessary that there should be a graduated phase-in of the 100 percent
CMA requirement to allow the Banks time to restructure their balance
sheets to include more profitable CMA and to accomplish the transition
in such a manner as to ensure the continued safety and soundness of the
Banks. A simulation of the transition period indicates that by reducing
MMI by $43 billion (a reduction of almost 50 percent from current
levels) so that the level of MMI would equal the sum of deposits and
capital for the Bank System, and increasing MMA by $10 billion,\22\ the
Bank System could continue to pay a dividend comparable to the
annualized dividend for the first half of 1999 while raising the ratio
of CMA to COs from its current level of 75 percent to the 85 percent
transition target for January 1, 2002, as set forth in Sec. 940.4(d) of
the proposed rule discussed below.
---------------------------------------------------------------------------
\22\ MBS holdings would be reduced by $4 billion, which could be
achieved by a run-off of the Banks' existing holdings. The level of
COs is reduced by $37 billion, the difference between the $43
billion decrease in MMI and the $6 billion increase in the net
holding of mortgage assets, so that assets would continue to equal
liabilities plus capital.
---------------------------------------------------------------------------
If the level of advances or deposits were to increase over the
transition period, then the target CMA to CO ratios could be achieved
with smaller increases in MMA than indicated in the above simulations.
In both the transition and the final simulations, capital substantially
exceeds 3 percent of Bank System assets. Therefore, Bank System assets
and earnings could expand substantially beyond the amounts in the
simulation without the need to attract more total capital.\23\
---------------------------------------------------------------------------
\23\ Bank System assets growth may be constrained by risk-based
capital. As both the risk-based capital requirement and the level of
risk-based capital would be determined by decisions made by each
Bank under the proposed rule, the Finance Board has not included the
effects of the proposed risk-based capital requirements in these
simulations.
---------------------------------------------------------------------------
[[Page 52190]]
The Finance Board expects, however, that in order to comply with
the CMA requirement, the Banks will need to adjust the management of
their operational liquidity in some way, perhaps by acquiring assets
that qualify as CMA and also contribute to operational liquidity. The
Banks also may need to adjust their balance sheets by acquiring assets
that qualify as CMA and also meet liquidity requirements to ensure
continued compliance with the contingency liquidity requirements in
proposed Sec. 930.10. For example, certain GNMA securities would
qualify as CMA and could also meet operational and contingency
liquidity needs. The Finance Board requests comment on how the CMA
requirement is likely to impact the ability of the Banks to achieve
their liquidity needs.
In addition, the Finance Board requests comment and empirically-
based analyses regarding the potential impact of the CMA ratio
requirement on the Banks' earnings, dividends and membership benefits
in the form of the pricing of advances, and whether there might be an
effect on voluntary members' decisions to join, remain in, or leave the
Bank System. The Finance Board also requests comment and empirically-
based analyses on whether there will be an impact on the level of
funding for the Bank System's AHP, and if so, whether the Bank System's
contribution to the AHP should be maintained, at a minimum, at 1998
levels, either by voluntary agreement by the Banks or by Finance Board
regulation.
The Finance Board also requests comments on whether all types of
CMA should receive equal weight in calculating a CMA total book value.
Imposing different weights could serve as an incentive for the Banks to
pursue classes of CMA, particularly CMA that might be targeted to
harder-to-serve needs or populations, but in which the Banks might
otherwise hesitate to invest because such classes of CMA may be less
profitable or more risky. However, weighting could undermine the
meaningfulness of a 100 percent CMA target, as the 100 percent target
would no longer represent a true maximum with respect to the allocation
of CO funding to CMA.
5. Conversion of Off-Balance Sheet Items--Sec. 940.4(c)
Proposed Sec. 940.4(c) sets forth conversion factors in Table 1 for
the conversion of off-balance sheet items to on-balance sheet value
equivalents for inclusion in the overall CMA ratio calculation required
under proposed Sec. 940.4(a). Intermediary derivative contracts would
count in the CMA calculation at 100 percent of the value of the fee
charged to members on such transactions. This fee is an objective
measure of value to the members for these instruments given that the
Banks do not need to fund these transactions. Advance commitments with
certain drawdown will count in the CMA calculation at 100 percent of
the value of the contractual commitment, given that a Bank would be
likely to fund the commitment with COs ahead of the commitment date.
During the transition, SLOCs would count at the current year's CMA
ratio requirement (expressed as a percentage) subtracted from 100
percent, then multiplied by the face amount of the SLOC. Thus, for
SLOCs, the conversion factor would be 20 percent or 0.20 in the first
year of the rule's effectiveness (100 percent or 1.00 minus CMA ratio
requirement of 80 percent or 0.80) and would shrink to zero by the end
of the transition period (100 percent minus CMA ratio requirement of
100 percent). The intent of this conversion provision is to ensure that
the financial nature of the transaction, rather than its regulatory
treatment, determines whether a Bank issues an SLOC or an advance. The
conversion factor leaves a Bank indifferent in terms of financial
opportunity as to whether it issues an advance or SLOC, because either
instrument would then have the same impact on the ratio of CMA to COs.
An alternative weighting mechanism could create an incentive for the
Bank to distort the prices of advances and SLOCs such that the nature
of the transaction might no longer guide the choice of instrument. When
the transition period ends, SLOCs would be valued at the fee charged to
members to make this off-balance sheet item consistent with the
treatment of intermediary derivative contracts.
6. Transition Period--Sec. 940.4(d)
Proposed Sec. 940.4(d) sets forth the transition period that would
apply to the CMA ratio requirement. Beginning on January 1, 2001, each
Bank would be required to have a CMA in an amount equal to at least 80
percent of the average book value of the Bank's total outstanding COs.
The CMA ratio requirement would increase by five percentage points on
January 1 of every year until the full 100 percent requirement would
take effect on January 1, 2005.
7. Transfers of CMA to Another Bank--Sec. 940.5
Section 940.5 of the proposed rule makes clear that a CMA of a
Bank, if transferred to another Bank, retains its status as a CMA with
respect to the transferee Bank. This provision allows the Banks to
improve the diversification of the various risks associated with the
CMA by redirecting CMA from one Bank district to another Bank district.
8. Safe Harbor for Anticipated Noncompliance--Sec. 940.6
Under Sec. 940.6(a) of the proposed rule, if a Bank's board of
directors determines that the Bank cannot meet the CMA ratio
requirement for a specified future period without jeopardizing the
safety and soundness of the Bank, the Bank would not be considered to
be out of compliance with the rule for the time period specified. In
order for a Bank to qualify for this safe harbor, the board of
directors' determination would need to be based upon an objective
finding that the Bank: (1) would likely be unable to meet the liquidity
requirement of proposed Sec. 930.10, or any other regulatory
requirement related to safety and soundness of its financial operation;
or (2) would likely be unable to provide a return on equity sufficient
to retain members intending to make use of such Bank's products and
services. The decision-making process of the Bank's board of directors
and the bases for its conclusions, including justification for the time
period that the Bank anticipates being out of compliance, would need to
be fully documented. In addition, the Bank's board of directors would
be required to adopt a plan to achieve compliance with the CMA ratio
requirement at the earliest feasible and prudent date.
The Finance Board believes that proposed Sec. 940.6(a) will provide
regulatory flexibility when business conditions are not amenable to
achieving CMA compliance consistent with the safe and sound operation
of the Bank. However, this safe harbor provision is not intended to
provide regulatory immunity for lack of effort on the part of Bank
management or for reaching such conclusions based on analysis found by
the Finance Board through the examination process to be inadequate as
to substance or documentation.
9. Waivers--Sec. 940.6(b)
Proposed Sec. 940.6(b) would make explicit that, under
circumstances that do not meet the safe harbor requirements of proposed
Sec. 940.6(a), a Bank may request a waiver of the
[[Page 52191]]
requirements in part 940, pursuant to the regulatory waiver provisions
of the Finance Board's regulations that would appear at 12 CFR part 907
(existing part 903).
E. Part 950--Advances
The proposed rule would delete existing Sec. 935.2 of the Finance
Board's Advances regulation, which states the primary credit mission of
the Banks and how the Banks must fulfill such mission. Section 940.2 of
the proposed rule, as discussed above, defines the mission of the
Banks, and no separate or duplicative statements or definitions would
be necessary under the new regulatory structure.
Proposed Sec. 950.1 would amend the definition of ``long-term
advance'' in existing Sec. 935.1 of the Finance Board's Advances
regulation from advances with maturity terms over five years to
advances with maturity terms of greater than one year. The Act provides
that all long-term advances shall only be made for the purpose of
providing funds for residential housing finance. See 12 U.S.C. 1430(a).
This provision is implemented by existing Sec. 935.14, which provides
that prior to approving an application for a long-term advance, a Bank
shall determine that the principal amount of all long-term advances
currently held by the member does not exceed the total value of
residential housing finance assets held by such member. See 12 CFR
935.14(b)(1).
F. Part 954--Member Mortgage Assets
1. Definition of MMA--Sec. 954.2
Part 954 of the proposed rule addresses MMA, that is, generally
mortgages and interests in mortgages that a Bank may acquire from its
members or eligible nonmember borrowers in a transaction that is in
purpose and economic substance functionally equivalent to the business
of making advances in that: (1) it allows the member or eligible
nonmember borrower to use its mortgage assets to access liquidity for
further mortgage lending; and (2) all or a material portion of the
credit risk attached to the mortgage asset is being borne by the member
or eligible nonmember borrower.
Proposed Sec. 954.2 authorizes a Bank to hold MMA acquired from or
through its members or eligible nonmember borrowers, either by
purchasing MMA from the member or eligible nonmember borrower, or
funding the loan through the member or eligible nonmember borrower.
Proposed Sec. 954.2 sets forth a three-part test to be used in
determining which assets qualify as MMA. First, under proposed
Sec. 954.2(a), an asset must fall within one of the following
categories of assets: (1) mortgages, or interests in mortgages,
excluding one-to-four family mortgages where the loan amounts exceed
the conforming loan limits that apply to Fannie Mae and Freddie Mac,
see 12 U.S.C. 1717(b)(2), but including community lending mortgages;
(2) loans, or interests in loans, secured by manufactured housing, even
if the manufactured housing is considered to be personal property in
the state in which the home is located; or (3) state and local HFA
bonds.
Second, under proposed Sec. 954.2(b), a connection of the asset
with the member or eligible nonmember borrower from whom the asset is
acquired must exist, i.e., there must be a member or eligible nonmember
borrower nexus. Specifically, the asset must be either: (1) originated,
if a loan, or issued, if bonds, by or through the member or eligible
nonmember borrower; or (2) held for a valid business purpose by the
member or eligible nonmember borrower prior to acquisition by the Bank.
Assets held for a valid business purpose would not include, for
example, loans that are passed from a nonmember through a member to a
Bank with the intended purpose of extending the benefits of membership
to the nonmember. The valid business purpose requirement is intended to
acknowledge that a member may acquire loans from a nonmember and then
sell them to a Bank.
Third, under proposed Sec. 954.2(c), the member or eligible
nonmember borrower must bear a material portion of the credit risk
attached to the mortgage asset. Through this requirement, MMA
activities would serve to promote and preserve the basic business
relationship between the Banks and their members that has been
established and maintained throughout the history of the Bank System
through advance transactions. The Bank would manage the interest rate
risk while the member would bear all or a material portion of the
credit risk. This requirement emphasizes the cooperative nature of the
Bank System by ensuring that the member or eligible nonmember borrower
shares with the Bank the financial benefits and responsibilities of the
asset. Furthermore, it does so in a rational manner because such shares
are allocated between the Bank and the member or eligible nonmember
borrwer in a way that best employs their respective core competencies
in managing risk.
An asset will be considered to fulfill this requirement if it meets
the ``credit risk-sharing'' test set forth in proposed Sec. 954.2(c).
First, under proposed Sec. 954.2(c)(1), the member or eligible
nonmember borrower must bear the amount of credit risk necessary to
raise the asset or pools of assets to the fourth highest credit rating
category (e.g., triple-B), which is the minimum credit rating for any
asset that may be acquired by a Bank under the safety and soundness
provisions of proposed Sec. 955.3(a)(3). Second, under proposed
Sec. 954.2(c)(2), to the extent that the Bank requires, either at the
time of acquisition or subsequently, that the assets or pools of assets
have a credit rating higher than the fourth highest credit rating
category, the member or eligible nonmember borrower must bear at least
50 percent of any credit risk necessary to raise the assets or pools of
assets from the fourth highest credit rating category to such higher
credit rating category, up to the second highest credit rating category
(e.g., double-A.). Third, under proposed Sec. 954.2(c)(3),
notwithstanding the first two parts of the credit risk-sharing test,
the member or eligible nonmember borrower must bear a material portion
of any credit risk up to the second highest credit rating. This
provision is intended to ensure that the member or eligible nonmember
borrower does bear enough credit risk to share in the financial
consequences of the asset quality no matter what transaction structure
might be devised with a consequence of mitigating the credit risk-
sharing requirement of the first two parts.
Under proposed Sec. 954.2(c)(4), to the extent that the U.S.
government has insured or guaranteed the credit risk of the asset or
pool of assets, the member or eligible nonmember borrower may rely upon
that insurance or guarantee to meet all or part of the above-mentioned
credit risk-sharing requirements. For example, loans that are fully
insured by the Federal Housing Administration (FHA), and GNMA
securities, which are fully guaranteed by the U.S. government, would be
considered to meet the credit risk-sharing requirement. Such loans and
securities, however, also would have to meet the member or eligible
nonmember borrower nexus requirement in proposed Sec. 954.2(b) in order
to qualify as MMA. To the extent that the U.S. government insurance or
guarantee is insufficient or incomplete to cover the member's or
eligible nonmember borrower's credit risk-sharing requirement, that
portion of the requirement not so covered must be borne by the member
or eligible nonmember borrower. This provision allows that the federal
government,
[[Page 52192]]
alone, may substitute for the member or eligible nonmember borrower in
meeting the credit risk-sharing requirement.
The Finance Board specifically requests comment on whether
authorizing the Banks to acquire federally-insured or guaranteed
mortgages or mortgage pools without any such member or eligible
nonmember borrower nexus would enhance the liquidity of the marketplace
for investments that promote housing and targeted economic development
sufficiently to justify any diminution in the cooperative nature of the
Bank System that may result. The Finance Board also seeks comment on
whether loans originated by municipalities, pursuant to section 108 of
the Housing and Community Development Act of 1974 (amended in 1994), or
by tribes pursuant to Title VI of NAHASDA, where the municipalities or
tribes are not eligible nonmember borrowers, should be authorized to be
acquired by the Banks because of the enhancement to the liquidity of
the marketplace for such housing, notwithstanding any diminution in the
cooperative nature of the Bank System that might result.
The MMA tests set forth in proposed part 954 are intended to allow
the Banks and their members and eligible nonmember borrowers the
freedom to employ a variety of transactional structures so long as the
transaction involves a qualifying asset or pool of assets, is acquired
by a Bank pursuant to a transaction with a member or eligible nonmember
borrower, and satisfies the credit risk-sharing requirement. Examples
of two types of purchases that would meet the requirements are: (1) the
Bank originates a loan or pool of loans and gets the needed credit
enhancement from the member (i.e., the member provides a direct credit
substitute); or (2) the member or eligible nonmember borrower sells the
loan to the Bank with recourse.
2. MPF
The purchase by a Bank of one-to-four family mortgages that fall
within the conforming loan limits applicable to the secondary market
GSEs was approved by the Finance Board under section II.B.12 of the FMP
in December 1996. See Finance Board Res. No. 96-111 (Dec. 23, 1996). At
that time, the Finance Board approved a pilot program proposed by the
Federal Home Loan Bank of Chicago (Chicago Bank), known as the Mortgage
Partnership Finance program (MPF), to fund one-to-four family
residential mortgage loans originated by member institutions. The
objective of the pilot program was to unbundle the risks associated
with home mortgage lending and allocate the individual risk components
between the Chicago Bank and its members in a manner that best employs
their respective core competencies. That is, the members would continue
to manage the customer relationship and the credit risk, while the
Chicago Bank would retain the liquidity, interest rate and options
risks-the risks that the Banks have the most expertise in managing.
MPF transactions are functionally equivalent to, though technically
more sophisticated than, advances transactions authorized under section
10(a) of the Act. The Finance Board considered the two transactions to
be functionally equivalent because, in both cases, the Bank takes an
interest in mortgages originated by its member or eligible nonmember
borrower and, in return, provides that member or eligible nonmember
borrower with liquidity for further mortgage lending. In both cases,
the member or eligible nonmember borrower bears all or a significant
portion of the credit risk: in the case of advances, because the member
or eligible nonmember borrower still owns the mortgage; in the case of
MPF, because the member or eligible nonmember borrower provides a
credit enhancement when selling the mortgage to, or funding the
mortgage through, the Bank. Although, under the MPF program, the Bank
acquires an ownership interest in the mortgage loans--as opposed to a
mere security interest, as it would in the case of an advance
transaction--the Finance Board found this structure to be permissible
because the Banks may invest in mortgages pursuant to their statutory
investment powers.
Based on the experience with the MPF program to date, the Finance
Board has concluded that this line of business could constitute a major
business activity for the Banks that, along with their more traditional
advances business, is consistent with the cooperative structure of the
Banks--i.e., that does not cause the Banks to compete with members and,
in fact, makes members participating in the program more competitive.
As a result, mortgage acquisition activities by the Banks that meet the
requirements of proposed part 954 will no longer be treated as pilot
activities.
The proposed rule will thus encourage the Banks to purchase more
MMA, with the anticipated consequence of increasing competition in the
home mortgage markets and thus lowering home prices for consumers. The
Finance Board requests comment on whether this anticipated benefit to
consumers is a reasonable expectation.
The Finance Board also specifically requests comment on whether all
MBS should be counted in whole or in some limited amount as CMA, and
how counting such MBS could be reconciled with the member or eligible
nonmember borrower nexus and credit risk-sharing requirements of MMA.
Once the Banks have developed more experience in acquiring MMA, the
Finance Board intends to set housing targets for MMA similar to those
that HUD is required by statute to set for Fannie Mae and Freddie Mac.
The Federal Housing Enterprises Financial Safety and Soundness Act of
1992 directed HUD to establish housing goals for the GSEs' mortgage
purchases in three specific areas: (1) housing for low-and moderate-
income families; (2) housing located in central cities, rural areas,
and other underserved areas; and (3) special affordable housing to meet
unaddressed needs of low-income families in low-income areas and very-
low-income families. See 12 U.S.C. 4541 et seq. The purpose of
subjecting the Banks to such targets would be to assure that all GSE-
funded mortgage originators have similar incentives and pressures to
reach underserved markets. This is an element of creating a level
playing field among the housing GSEs.
G. Part 955--Bank investments
1. Authorized Investments--Sec. 955.2
As previously discussed, the Banks' investment authority is derived
from sections 11(g), 11(h) and 16(a) of the Act. 12 U.S.C. 1431(g),
1431(h), 1436(a). Section 934.1 of the Finance Board's current
regulations limits the Banks' investment authority by requiring Finance
Board approval for investments not already authorized by stated policy
or otherwise. See 12 CFR 934.1(a). The Finance Board adopted the FMP as
its stated investment policy pursuant to the regulation. The FMP
restricts Bank investments to those listed in the FMP. Sections 955.2
and 955.3 of the proposed rule would establish the parameters of the
Banks' investment authority under the proposed new regulatory
structure.
Proposed Sec. 955.2 would authorize the Banks to invest in all
instruments in which they are permitted to invest under the Act (with
the exception of Fannie Mae common stock), see 12 U.S.C. 1431(g),
1431(h), 1436(a), subject to the restrictions set forth in proposed
Sec. 955.3. These investments include: (a) obligations of the United
States, see 12 U.S.C. 1431(g), 1431(h) and 1436(a); (b) deposits in
banks or trust companies (as
[[Page 52193]]
defined in proposed Sec. 955.1), see id. at 1431(g); (c) obligations,
participations or other instruments of, or issued by, Fannie Mae or
Ginnie Mae, see id. at 1431(h), 1436(a); (d) mortgages, obligations, or
other securities that are, or ever have been sold by Freddie Mac, see
id. at 1431(h), 1436(a); (e) stock, obligations, or other securities of
any SBIC formed pursuant to 15 U.S.C. 681(d) (to the extent such
investment is made for purposes of aiding Bank members),\24\ see 12
U.S.C. 1431(h); and (f) instruments that the Bank has determined are
permissible investments for fiduciary and trust funds under the laws of
the state in which the Bank is located, see id. at 1431(h), 1436(a).
---------------------------------------------------------------------------
\24\ The Finance Board has determined that the phrase ``for the
purpose of aiding members of the . . . Bank System'' relates not
just to the formation of the SBIC but also to the nature and purpose
of the investment.
---------------------------------------------------------------------------
The Banks' investment authority under the proposed rule essentially
tracks the parameters of that which may be permitted under the Act.
Because several different provisions of the Act address the investment
powers of the Banks, the Finance Board has consolidated and restated
the substance of these investment authorities in proposed Sec. 955.2.
The only investment that is explicitly mentioned in the Act that is not
permitted under proposed Sec. 955.2 is investment in the stock of
Fannie Mae. As discussed in more detail below, proposed
Sec. 955.3(a)(1) would restrict equity investments to those that
qualify as CMA under proposed part 940. Because the Finance Board does
not believe that Fannie Mae stock could under any circumstances qualify
as a CMA, and because Fannie Mae stock is not an authorized investment
under the FMP and is not currently held as an investment by any Bank,
it has simply been omitted from the list of authorized investments in
proposed Sec. 955.2 in order to avoid confusion.
Both sections 11(h) and 16(a) of the Act state that the Banks may
be authorized to invest in ``such securities as fiduciary and trust
funds may be invested in under the laws of the state in which the . . .
Bank is located.'' See id. at 1431(h), 1436(a). In restating this
authority in Sec. 955.2(f) of the proposed rule, the word
``instruments'' has been substituted for the word ``securities'' to
reflect in the rule the Finance Board's construction of the term
``securities'' as it is used in sections 11(h) and 16(a) of the Act to
encompass the broad range of financial investment instruments and not
merely those instruments that are within the technical definition of
``securities'' set forth in the federal securities laws. See 15 U.S.C
77b(1).
2. Prohibited Investments and Prudential Rules--Sec. 955.3
The broad investment authority established under proposed
Sec. 955.2 would be limited by a number of safety and soundness- and
mission-related restrictions set forth in proposed Sec. 955.3. Proposed
Sec. 955.3(a)(1) would prohibit the Banks from making any investment in
instruments that would provide an ownership interest in an entity
(e.g., common or preferred stock, rights, warrants or convertible
bonds), other than those investments that would qualify as CMA under
proposed Sec. 940.3, as discussed more fully above. Thus, under the
proposed rule, the actual equity investment powers of the Banks will be
quite narrow and focused upon core mission activities.
Proposed Sec. 955.3(a)(2) would prohibit the Banks from investing
in instruments issued by foreign entities, except United States
branches and agency offices of foreign commercial banks. Such
instruments conceivably could qualify as permissible investments for
fiduciary and trust funds and, therefore, would be permissible Bank
investment unless specifically prohibited. This is consistent with the
current prohibition in the FMP. See Finance Board Res. No. 97-05 (Jan.
14, 1997).
Proposed Sec. 955.3(a)(3) would prohibit the Banks from investing
in debt instruments that are not rated as investment grade (i.e., one
of the four highest rating categories given by an NRSRO). Despite the
risk management provisions in the proposed rule under which the Banks
are expected to manage whatever risks they might incur as part of their
business operations, the Finance Board is imposing this specific
prohibition on the acquisition of non-investment grade debt as a
further safety and soundness measure. Under proposed Sec. 955.3(a)(3),
the Banks would not be required to divest themselves of debt
instruments that are downgraded to below investment grade after they
already have been acquired by the Bank. Any additional risk that would
arise from such a scenario would be managed through the application of
the higher credit risk capital requirement applicable to the downgraded
instrument. See proposed Sec. 930.4(d)(3).
Finally, proposed Sec. 955.3(a)(4) would prohibit the Banks from
acquiring whole mortgages or other whole loans, or interests in
mortgages or loans, except for: (i) MMA, as defined under part 954 of
the proposed rule; (ii) MBS that would meet the definition of
``securities'' in the Securities Act of 1933, 15 U.S.C. 77b(a)(1); and
(iii) loans held or acquired pursuant to section 12(b) of the Act, 12
U.S.C. 1432(b). As described in detail above, proposed part 954
establishes parameters regarding the types of mortgages and loans, or
interests in mortgages and loans, that the Banks may acquire and the
nature of the transactions through which such assets may be acquired.
Proposed Sec. 955.3(a)(4) is designed to prohibit the holding, purchase
or acquisition of jumbo mortgages and whole mortgages other than MMA,
and otherwise prevent the Banks from circumventing the requirements of
part 954. However, the Banks are not prohibited from holding,
purchasing and acquiring MBS that would meet the definition of that
term under the federal securities laws.
The reference in proposed Sec. 955.3(a)(4)(ii) to the definition of
securities in the Securities Act of 1933 is consistent with the Finance
Board's analysis of the term securities as it is used in the Bank
investment authority provisions of the Act. See discussion above of
proposed Sec. 955.2. As discussed above, for purposes of the Bank's
investment authority generally, the Finance Board has construed the
term ``securities'' as it is used in sections 11(h) and 16(a) of the
Act, 12 U.S.C. 1431(h), 1436(a), to encompass the broad range of
financial investment instruments in a common business sense, and not
merely to mean those instruments that are within the technical
definition of ``securities'' in the federal securities laws. However,
for purposes of proposed Sec. 955.3, the Finance Board has proposed
limitations and restrictions on otherwise-authorized investments, which
it is explicitly authorized to do under sections 11(h) and 16(a) of the
Act. Limiting investments in mortgage-backed securities to those that
would meet a narrower definition of the term ``securities'' than is
contemplated under the investment authority provisions of the Act only
serves to emphasize the differences in the use of the term under the
different statutes and to bolster the Finance Board's construction of
the term under the Act.
Proposed Sec. 955.3(b) would prohibit a Bank from taking a position
in any commodity or foreign currency. Proposed Sec. 955.3(b) also
provides that, in the event that a Bank becomes exposed to currency,
commodity or equity risks through participation in COs that are linked
to a foreign currency or to equity or commodity prices, such risks must
be hedged. The Banks currently do not have expertise in these areas and
the Finance Board can discern no reason for the Banks to have or
develop expertise in managing the risks
[[Page 52194]]
associated with foreign exchange rates or commodities.
Section 955.3(c) of the proposed rule prohibits a Bank from making
investments that are not permitted under the FMP as to such Bank until
the Bank: (1) has received Finance Board approval of its initial
internal market risk model; (2) demonstrates to the Finance Board that
it has sufficient risk-based capital to meet the minimum total risk-
based capital requirement under proposed Sec. 930.4(b) for its then-
current portfolio; and (3) demonstrates to the Finance Board adequate
credit risk assessment and procedures and controls sufficient to show
control over credit, market and operations risks.
As discussed above, one of the reasons that the Finance Board is
proposing to allow the Banks broadened investment authority is because,
under the proposed rule, the Banks will have risk-based capital and
other risk management requirements to counterbalance any increased risk
that might be associated with new investments. Therefore, until a Bank
has sufficient risk-based capital in place to support its current
portfolio, and until the Bank demonstrates to the Finance Board that it
has adequate risk management capabilities, the Finance Board finds it
necessary, as a safety and soundness measure, to continue to require
the Banks to operate within the existing FMP framework.
Although proposed Sec. 955.3 would impose several safety and
soundness-and mission-related restrictions upon the Banks' general
investment authority set forth in proposed Sec. 955.2, the overall
effect of these proposed investment provisions would be to allow the
Banks considerably more freedom in making investment decisions within
the statutory parameters than is currently permitted. Under the FMP,
the Banks are authorized to invest in a list of specific investments
that is narrower than that in which the Banks may invest under the
parameters set by the Act. Under the FMP, Banks wishing to make
investments that may be permissible under the statute, but that are not
specifically enumerated in the FMP, must obtain the permission of the
Finance Board before making the investment.
The approach to Bank investment authorizations reflected in the FMP
allows for little discretion on the part of Banks' senior management
and boards of directors in determining the appropriate investments and
optimal risk/return strategy for their Banks. This approach was
designed to limit the Banks' exposure to risk because the Banks do not
currently operate under a risk-based capital structure, which would
allow the Banks to assume more investment risk, provided that there is
sufficient capital in place to support that risk. Because, under the
proposed rule, the Banks would operate under such a risk-based capital
structure, it would no longer be necessary to impose such stringent
limits on the investment authority for safety and soundness purposes.
Some of the limits on the investment authority reflected in the FMP
also were intended, to some extent, to focus the Banks' investments on
mission-related activities. As more fully described above, under
proposed part 940, each Bank would be required to invest 100 percent of
the proceeds from its share of the COs in CMA. This requirement would
eliminate the need to focus the Banks' investments upon mission
activities through the use of a specific list of authorized investments
and specific limits on certain types of investments. In addition, a
specific list intended to include all authorized investments would not
provide the Banks with the flexibility to adapt to new developments in
the marketplace and would stifle the development of new types of
mission-related activities and investments.
Under the proposed rule, the Banks would be permitted to make any
authorized investment with sources of funds other than those provided
by the COs. Consistent with the Finance Board's ongoing devolution of
management and governance functions to the Banks, the Finance Board
believes that the selection of appropriate investments to be made with
that portion of a Bank's funds that are not obtained through use of the
capital market funding advantage that arises from the Banks' status as
GSEs is an area more appropriate for oversight by the Banks' boards of
directors (subject to safety and soundness constraints imposed by the
proposed rule) than by their regulator. Nonetheless, it is expected
that the Banks' boards of directors would establish appropriate
guidelines for investments when adopting the risk management policy
required under this proposed rule.
3. Use of Hedging Instruments--Sec. 955.4
Section 955.4 of the proposed rule addresses the Banks' use of
hedging instruments. Proposed Sec. 955.4(a) would prohibit the Banks
from making speculative use of hedging instruments. This is not an
activity that is appropriate for the Banks to enter, as it would do
nothing to further the mission of the Banks, while posing risks to the
safety and soundness of the Banks.
Section 955.4(b) of the proposed rule would subject all Bank hedge
transactions to the hedge requirements set forth in Generally Accepted
Accounting Principles (GAAP) and statements promulgated by the
Financial Accounting Standards Board (FASB). Because GAAP prescribes
extensive rules for hedging transactions that are followed by most
market participants, the Finance Board finds it prudent to subject the
Banks to these same requirements, rather than attempting to establish
separate rules over such a complex subject.
Section 955.4(c) of the proposed rule would govern the
documentation that each Bank must have and maintain during the life of
each hedge. Proposed Sec. 955.4(c)(1) would require that each Bank's
hedging strategies be explicitly documented at the time of the
execution of the hedge, and adequate documentation of the hedge must be
maintained for the life of the hedge. Proposed Sec. 955.4(c)(2) would
require that transactions with a single counterparty be governed by a
single master agreement when practicable. Proposed Sec. 955.4(c)(3)
would govern Bank agreements with counterparties for over-the-counter
derivative contracts by requiring each agreement to include: (i) a
requirement that market value determinations and subsequent adjustments
of collateral be made on at least a monthly basis; (ii) a statement
that failure of a counterparty to meet a collateral call will result in
an early termination event; (iii) a description of early termination
pricing and methodology; and (iv) a requirement that the Bank's consent
be obtained prior to the transfer of an agreement or contract by a
counterparty.
All of these requirements are carried over from the FMP. The
requirements are intended to ensure that the Banks monitor and manage
their exposure to counterparties and that the agreements in place with
counterparties provide adequate legal protection to the Banks. Because
the risk-based capital requirements contained in the proposed rule do
not directly alter or replace the need to address these issues, the
Finance Board finds it appropriate to continue to impose these
requirements on Bank hedge transactions.
Under the FMP, the Banks' use of hedging instruments is limited to
a specific list of hedging instruments. The use of the various hedging
instruments by the Banks is permitted provided they assist the Bank in
achieving its interest rate and/or basis risk management objectives.
Like the FMP's Investment Guidelines, the Hedge Transaction Guidelines
of the FMP contain some
[[Page 52195]]
detailed requirements that are no longer necessary. The unsecured
credit concentration limits set forth in proposed Sec. 930.11 and the
credit risk-based capital requirements set forth in proposed Sec. 930.5
would eliminate the need for provisions addressing unsecured credit
exposure and collateralization. In addition, because the Finance Board
is removing the restrictions on certain types of investments, it would
be inconsistent to continue to restrict swaps with characteristics
similar to those investments.
H. Part 958--Off-Balance Sheet Items
Proposed Sec. 958.2(a) authorizes the Banks to enter into the
following types of off-balance sheet transactions: SLOCs; derivative
contracts; forward asset purchases and sales; and commitments to make
advances or other loans. This authorization essentially codifies the
types of off-balance transactions that already have been authorized by
the Finance Board. The Finance Board specifically requests comment on
whether there are additional types of off-balance sheet transactions
that it should consider authorizing.
Proposed Sec. 958.2(b) prohibits the Banks from making speculative
use of derivative contracts. As previously discussed in the general
context of hedging instruments, speculating with derivatives contracts
is not an activity that would be appropriate for the Banks to enter, as
it would do nothing to further the mission of the Banks, while posing
risks to the safety and soundness of the Banks.
I. Part 965--Sources of Funds
Proposed Sec. 965.2 sets forth the types of liabilities authorized
for Bank business operations. The Funding Guidelines section of the FMP
sets forth the parameters for the use of alternative funding sources
and structures by the Banks in funding their activities. The guidelines
differentiate between Bank specific liabilities and COs, which are the
joint and several liabilities of the Banks. See FMP sections IV.B. and
C.
Under the FMP, authorized Bank specific liabilities generally
include: (1) deposits from members, from any institution for which a
Bank is providing correspondent services, from another Bank, and from
other instrumentalities of the United States; (2) federal funds
purchased from any financial institution that participates in the
federal funds market; and (3) repurchase agreements, with the provision
that those requiring the delivery of collateral by a Bank may be only
with Federal Reserve Banks, U.S. Government Sponsored Agencies and
Instrumentalities, primary dealers recognized by the Federal Reserve
Bank of New York, eligible financial institutions,\25\ and states and
municipalities with a Moody's Investment Grade rating of 1 or 2.
---------------------------------------------------------------------------
\25\ Eligible financial institutions include Banks and FDIC-
insured financial institutions, including U.S. subsidiaries of
foreign commercial banks, whose most recently published financial
statements exhibit at least $100 million of Tier I (or tangible)
capital if the institution is a member of the investing Bank or at
least $250 million of tangible capital for all other FDIC-insured
institutions, and which have been rated at least a level III
institution as defined in section VI.C of the FMP.
---------------------------------------------------------------------------
Under the FMP, a Bank is authorized to participate in the proceeds
from COs, so long as entering into such transactions will not cause the
Bank's total COs and unsecured senior liabilities to exceed 20 times
its capital. See id. at IV.C. The FMP authorizes a Bank to participate
in certain types of standard and non-standard debt issues. See id.
Specifically, the FMP requires that Banks participating in non-standard
debt issues must enter into a contemporaneous hedging arrangement that
allows the interest rate and/or basis risk to be passed through to the
hedge counterparty unless the Bank is able to document that the debt
will: (a) be used to fund mirror-image assets in an amount equal to the
debt; or (b) offset or reduce interest rate or basis risk in the Bank's
portfolio, or otherwise assist the Bank in achieving its interest rate
and/or basis risk management objectives. If a Bank participates in debt
denominated in a currency other than U.S. Dollars, it is required to
hedge the currency exchange risk. See id. at IV.C.3.
The FMP also prohibits a Bank from directly placing COs with
another Bank. See id. at IV.C.4.
Proposed Sec. 965.2(a) sets forth each Bank's authority to act as
joint and several obligor with other Banks on COs, as authorized under
proposed part 966. The proposed rule does not draw the distinction
between standard and non-standard debt issues contained in the FMP.
Instead, proposed Sec. 955.3(b) requires that some types of debt issues
previously defined as non-standard be hedged. The types of debt issues
that must be hedged under the proposed rule are those linked to equity
or commodity prices or those denominated in foreign currencies. Other
types of debt issues previously defined as non-standard need not be
hedged, but these debt issues will be included in the market risk
calculation in the proposed rule. The proposed rule does not include
the 20 to 1 leverage limit from Sec. 910.1(b) of the Finance Board's
existing regulations, or the 20 to 1 leverage limit on each Bank
contained in the FMP. Instead, the proposed rule requires each Bank to
have total capital in an amount equal to at least 3 percent of total
assets, and requires each Bank to hold risk-based capital to meet a
risk-based capital requirement. See proposed Secs. 930.3(a) and
930.4(a).
Proposed Sec. 965.2(b) continues the existing prohibition on
directly placing COs with another Bank. It is the opinion of the
Finance Board that such placements do not further the mission of the
Bank System.
COs have been the traditional source for most of the funds required
for Bank operations. The remaining sources of funds have been deposits
and member capital. As discussed above under proposed part 940, once
the rule is fully phased in, 100 percent of COs would be required to be
invested in CMA. The Banks, therefore, still would be able to invest
deposits and member capital in any assets authorized under the proposed
rule. Growing sophistication in the creation of off-balance sheet
instruments could lead to efforts to circumvent the CMA requirement.
For example, it may be possible to create tradeable deposits, which
would be more similar to bonds than to deposits as the term is
traditionally understood. The Banks also could use repurchase
agreements to leverage deposits or capital. COs used to finance MBS may
be replaced with repurchase agreements, using the MBS as collateral. In
this way, the letter of the CMA requirement, but not the substance of
the requirement--a shift in the composition of the balance sheet
towards CMA--might be met. A Bank could hold non-CMA assets, including
MBS, equal to several times its level of deposits plus capital.
Therefore, proposed Sec. 965.2(b) continues each Bank's authority
to accept deposits from members, other Banks and instrumentalities of
the United States, but provides that the deposit transaction may not be
conducted in such a way as to result in the offer or sale of a security
in a public offering as those terms are used in 15 U.S.C. 77b(3). In
addition, recognizing the importance of federal funds and repurchase
agreements for the Banks' liquidity management, proposed Sec. 965.2(c)
allows a Bank to purchase federal funds and enter into repurchase
agreements, but only in order to satisfy the Banks' short-term
liquidity needs.
Proposed Sec. 965.3 would require each Bank to invest an amount
equal to current deposits received from members in: (1) Obligations of
the United States; (2) deposits in banks or trust companies;
[[Page 52196]]
and (3) advances with a maturity of five years or less made to members
in conformity with the advances provisions of the Finance Board
regulations (existing part 935; redesignated part 950).
Section 11(g) of the Act, 12 U.S.C. 1431(g), requires each Bank to
maintain deposit reserves in: (1) obligations of the United States; (2)
deposits in banks or trust companies; (3) advances with a maturity of
five years or less made to members, upon such terms and conditions as
the Finance Board may prescribe; or (4) unsecured advances with a
maturity of not to exceed five years which are made to members whose
creditor liabilities do not exceed five percent of their net assets.
Proposed Sec. 965.3 is intended to implement this statutory requirement
and to clarify the types of advances that count toward the deposit
reserve requirement (the Banks currently are not permitted to make
unsecured advances). The definition of the term ``deposits in banks or
trust companies'' contained in proposed Sec. 965.1 is identical to the
definition of that term set forth in existing Sec. 934.4.
J. Part 966--Consolidated Obligations and Debentures
Existing part 910 of the Finance Board's regulations,
``Consolidated Bonds and Debentures,'' has been proposed to be
redesignated as new part 966 in the proposed reorganization regulation.
Part 966 of this proposed rule retains in large part the provisions of
existing part 910, with certain proposed amendments, which are included
in this rulemaking and discussed here.
Specifically, Secs. 910.0 through 910.6 of the Finance Board's
existing regulations, would be redesignated as Secs. 966.1 through
966.7 and existing Sec. 910.1(b) (which imposes a 20-to-1 COs and
unsecured senior liabilities to capital stock leverage limit on the
Bank System) would be deleted. Proposed Sec. 966.7 has been revised
from existing Sec. 910.6 to: delete references to the leverage limit;
clarify and simplify the provision whereby the Finance Board may
implement changes to the negative pledge requirement \26\ in
Sec. 966.2(b) if the principal and interest on outstanding senior bonds
have been fully defeased; and delete current Sec. 910.6(b)(2), which
purports to impose limitations on the Finance Board's ability to change
the leverage limit provision in current Sec. 910.1(b). In connection
with these proposed amendments, it is the intention of the Finance
Board to preserve the existence of the special asset accounts at the
Banks established when the leverage limit in current part 910 was
raised in 1992 from 12-to-1 to 20-to-1. See Finance Board Res. No. 92-
751 (Dec. 21, 1992). Current Sec. 910.6(b)(2) provides that current
Sec. 910.1(b) may be changed by the Finance Board if the Finance Board
receives either: (i) written evidence from at least one major
nationally recognized securities rating agency that the proposed change
will not result in the lowering of that rating agency's then-current
rating or assessment on senior bonds outstanding or next to be issued;
or (ii) a written opinion from an investment banking firm that the
proposed change would not have a materially adverse effect on the
creditworthiness of senior bonds outstanding or next to be issued. The
Finance Board has consulted with the ratings agencies in developing
this proposed rule. The proposal requires that the Banks maintain the
triple-A rating of Bank System COs.
---------------------------------------------------------------------------
\26\ The ``negative pledge requirement'' is the regulatory
requirement that the Banks maintain certain types of unpledged
assets in an amount equal to the amount of the Banks' senior bonds
(as defined in existing Sec. 910.0(c)) outstanding.
---------------------------------------------------------------------------
K. Part 980--New Business Activities
The proposed changes to the Banks' authorized investment authority
would create opportunities for the Banks to undertake new business
activities that they have not undertaken in the past and, therefore,
could expose the Banks to risks that they have not had to manage in the
past. In order to ensure that entering into new types of business
activities will not create safety and soundness concerns, Sec. 980.2 of
the proposed rule would require each Bank to provide 30 days notice to
the Finance Board of any new business activity that the Bank wishes to
undertake--including investing in new types of instruments--so that the
Finance Board may disapprove or restrict such activities, as necessary,
on a case-by-case basis. Proposed Sec. 980.1 defines a ``new business
activity'' as meaning, with respect to a particular Bank's activities:
(1) an activity that was not previously undertaken by that Bank, or was
undertaken under materially different terms and conditions; (2) an
activity that entails risks not previously and regularly managed by
that Bank or its members; or (3) an activity that introduces operations
not substantially equivalent to operations currently managed by that
Bank. The test of what constitutes a new activity for a particular Bank
is intended to focus attention on worthy new activities. The prior
notice requirement would apply to any Bank desiring to pursue a new
activity, even if another Bank has already undertaken the same
activity.
IV. Regulatory Flexibility Act
The proposed rule applies only to the Banks, which do not come
within the meaning of ``small entities,'' as defined in the Regulatory
Flexibility Act (RFA). See 5 U.S.C. 601(6). Therefore, in accordance
with section 605(b) of the RFA, see id. at 605(b), the Finance Board
hereby certifies that this proposed rule, if promulgated as a final
rule, will not have a significant economic impact on a substantial
number of small entities.
V. Paperwork Reduction Act
This proposed rule does not contain any collections of information
pursuant to the Paperwork Reduction Act of 1995. See 44 U.S.C. 3501 et
seq. Therefore, the Finance Board has not submitted any information to
the Office of Management and Budget for review.
List of Subjects in 12 CFR Parts 917, 925, 930, 940, 950, 954, 955,
958, 965, 966 and 980
Community development, Credit, Housing and Federal home loan banks.
Accordingly, the Finance Board hereby proposes to amend title 12,
chapter IX, Code of Federal Regulations, as follows:
1. New part 917 is added to subchapter C to read as follows:
PART 917--POWERS AND RESPONSIBILITIES OF BANK BOARDS OF DIRECTORS
AND SENIOR MANAGEMENT
Sec.
917.1 Definitions.
917.2 General duties of Bank boards of directors.
917.3 Risk management.
917.4 Internal control system.
917.5 Audit committees.
917.6 Budget preparation and reporting requirements.
917.7 Dividends.
917.8 Approval of Bank bylaws.
917.9 Mission achievement.
Authority: 12 U.S.C. 1422a(a)(3), 1422b(a)(1), 1427, 1432(a),
1436(a), 1440.
Sec. 917.1 Definitions.
As used in this part:
Business risk means the risk of an adverse impact on a Bank's
profitability resulting from external factors as may occur in both the
short and long run.
Contingency liquidity has the meaning set forth in Sec. 930.1 of
this chapter.
Credit risk has the meaning set forth in Sec. 930.1 of this
chapter.
Eligible nonmember borrower has the meaning set forth in Sec. 930.1
of this chapter.
[[Page 52197]]
Immediate family member means a parent, sibling, spouse, child,
dependent, or any relative sharing the same residence.
Liquidity risk means the risk that a Bank is unable to meet its
obligations as they come due or meet the credit needs of its members
and eligible nonmember borrowers in a timely and cost-efficient manner.
Market risk has the meaning set forth in Sec. 930.1 of this
chapter.
Operations risk has the meaning set forth in Sec. 930.1 of this
chapter.
Sec. 917.2 General duties of Bank boards of directors.
The board of directors of each Bank shall have the duty to direct
the operations of the Bank in conformity with the requirements set
forth in this chapter. Each board director shall carry out his or her
duties as director in good faith, in a manner such director believes to
be in the best interests of the Bank, and with such care, including
reasonable inquiry, as an ordinarily prudent person in a like position
would use under similar circumstances.
Sec. 917.3 Risk management.
(a) Adoption of risk management policy. (1) Within 180 calendar
days of the effective date of this section, each Bank's board of
directors shall adopt, and submit to the Finance Board for approval, a
risk management policy that addresses the Bank's exposure to credit
risk, market risk, liquidity risk, business risk and operations risk
and that conforms to the requirements of paragraph (b) of this section
and part 930 of this chapter.
(2) Review and compliance. Each Bank's board of directors shall:
(i) Review the Bank's risk management policy at least annually;
(ii) Have the authority to amend the risk management policy at any
time;
(iii) Re-adopt the Bank's risk management policy, including interim
amendments, not less often than every three years; and
(iv) Ensure Bank compliance at all times with the risk management
policy.
(b) Risk management policy requirements. In addition to meeting any
other requirements set forth in this part, or in part 930 of this
chapter, each Bank's risk management policy shall:
(1) Describe how the Bank will comply with the risk-based capital
standards set forth in part 930 of this chapter;
(2) Set forth the Bank's tolerance levels for the market and credit
risk components; and
(3) Set forth standards for the Bank's management of each risk
component, including but not limited to:
(i) Regarding credit risk arising from all secured and unsecured
transactions, standards and criteria for, and timing of, periodic
assessment of the creditworthiness of issuers, obligors, or other
counterparties including identifying the criteria for selecting
dealers, brokers and other securities firms with which the Bank may
execute transactions; and
(ii) Regarding market risk, standards for the methods and models
used to measure and monitor such risk;
(iii) Regarding day-to-day operational liquidity needs and
contingency liquidity needs for periods during which the Bank's access
to capital markets is impaired:
(A) An enumeration of specific types of investments to be held for
such liquidity purposes; and
(B) The methodology to be used for determining the Bank's
operational and contingency liquidity needs;
(iv) Regarding operations risk, standards for an effective internal
control system, including periodic testing and reporting; and
(v) Regarding business risk, strategies for mitigating such risk,
including contingency plans where appropriate.
(c) Risk assessment. The senior management of each Bank shall
perform, at least annually, a risk assessment that identifies and
evaluates all material risks, including both quantitative and
qualitative aspects, that could adversely affect the achievement of the
Bank's performance objectives and compliance requirements. The risk
assessment shall be in written form and shall be reviewed by the Bank's
board of directors promptly upon its completion.
Sec. 917.4 Internal control system.
(a) Establishment and maintenance. (1) Each Bank shall establish
and maintain an effective internal control system that is adequate to
ensure:
(i) The efficiency and effectiveness of Bank activities;
(ii) The safeguarding of assets;
(iii) The reliability, completeness and timely reporting of
financial and management information and transparency of such
information to the Bank's board of directors and to the Finance Board;
and
(iv) Compliance with applicable laws, regulations, policies,
supervisory determinations and directives of the Bank's board of
directors and senior management.
(2) Ongoing internal control activities necessary to maintain the
internal control system required under paragraph (a)(1) of this section
shall include, but are not limited to:
(i) Top level reviews by the Bank's board of directors and senior
management, including review of financial presentations and performance
reports;
(ii) Activity controls, including review of standard performance
and exception reports by department-level management on an appropriate
periodic basis;
(iii) Physical controls adequate to ensure the safeguarding of
assets;
(iv) Monitoring for compliance with the risk tolerance limits set
forth in the Bank's risk management policy;
(v) Any required approvals and authorizations for specific
activities; and
(vi) Any required verifications and reconciliations for specific
activities.
(b) Internal control responsibilities of Banks' boards of
directors. Each Bank's board of directors shall direct the
establishment and maintenance of the internal control system required
under paragraph (a)(1) of this section, and oversee senior management's
implementation of such a system on an ongoing basis, by:
(1) Conducting periodic discussions with senior management
regarding the effectiveness of the internal control system;
(2) Ensuring that an effective and comprehensive internal audit of
the internal control system is performed annually;
(3) Ensuring that internal control deficiencies are reported to the
Bank's board of directors in a timely manner and are addressed
promptly;
(4) Conducting a timely review of evaluations of the effectiveness
of the internal control system made by internal auditors, external
auditors and Finance Board examiners;
(5) Ensuring that senior management promptly and effectively
addresses recommendations and concerns expressed by internal auditors,
external auditors and Finance Board examiners regarding weaknesses in
the internal control system;
(6) Reporting any internal control deficiencies found, and the
corrective action taken, to the Finance Board in a timely manner;
(7) Establishing, documenting and communicating an organizational
structure that clearly shows lines of authority within the Bank,
provides for effective communication throughout the Bank, and ensures
that there are no gaps in the lines of authority;
(8) Ensuring that all delegations of authority to specific
personnel or committees state the extent of the authority and
responsibilities delegated; and
[[Page 52198]]
(9) Establishing reporting requirements, including specifying the
nature and frequency of reports it receives.
(c) Internal control responsibilities of Banks' senior management.
Each Bank's senior management shall be responsible for carrying out the
directives of the Bank's board of directors, including the
establishment, implementation and maintenance of the internal control
system required under paragraph (a)(1) of this section, by:
(1) Establishing, implementing and effectively communicating to
Bank personnel policies and procedures that are adequate to ensure that
internal control activities necessary to maintain an effective internal
control system, including the activities enumerated in paragraph (a)(2)
of this section, are an integral part of the daily functions of all
Bank personnel;
(2) Ensuring that all Bank personnel fully understand and comply
with all policies and procedures;
(3) Ensuring that there is appropriate segregation of duties among
Bank personnel and that personnel are not assigned conflicting
responsibilities;
(4) Establishing effective paths of communication upward, downward
and across the organization in order to ensure that Bank personnel
receive necessary and appropriate information, including:
(i) Information relating to the operational policies and procedures
of the Bank;
(ii) Information relating to the actual operational performance of
the Bank;
(iii) Adequate and comprehensive internal financial, operational
and compliance data; and
(iv) External market information about events and conditions that
are relevant to decision making;
(5) Developing and implementing procedures that translate the major
business strategies and policies established by the Bank's board of
directors into operating standards;
(6) Ensuring adherence to the lines of authority and responsibility
established by the Bank's board of directors;
(7) Overseeing the implementation and maintenance of management
information and other systems;
(8) Establishing and implementing an effective system to track
internal control weaknesses and the actions taken to correct them; and
(9) Monitoring and reporting to the Bank's board of directors the
effectiveness of the internal control system on an ongoing basis.
Sec. 917.5 Audit committees.
(a) Establishment. The board of directors of each Bank shall
establish an audit committee, consistent with the requirements set
forth in this section.
(b) Composition. (1) The audit committee shall comprise five or
more persons drawn from the Bank's board of directors, each of whom
shall meet the criteria of independence set forth in paragraph (c) of
this section.
(2) The audit committee shall include representatives of large and
small members and appointive and elective directors of the Bank.
(3) The terms of audit committee members shall be appropriately
staggered so as to provide for continuity of service.
(4) All members of the audit committee shall have a working
familiarity with basic finance and accounting practices, and at least
one member of the audit committee shall have extensive accounting or
financial management expertise. If the board of directors determines
that there are not a sufficient number of board directors possessing
the necessary skills and expertise to qualify for service on the audit
committee (considering the representation requirements of paragraph
(b)(2) of this section), the board of directors shall:
(i) In the case of audit committee representation of appointive
directors, provide written notification to the Finance Board for
consideration when appointing directors; and
(ii) In the case of audit committee representation of elective
directors, include in the Election Announcement required under
Sec. 915.6(a) of this chapter, a statement describing the skills or
expertise needed.
(c) Independence. Any member of the Bank's board of directors shall
be considered to be sufficiently independent to serve as a member of
the audit committee if that director does not have a disqualifying
relationship with the Bank or its management that would interfere with
the exercise of that director's independent judgment. Such
disqualifying relationships shall include, but shall not be limited to:
(1) Being employed by the Bank in the current year or any of the
past five years;
(2) Accepting any compensation from the Bank other than
compensation for service as a board director;
(3) Serving or having served in any of the past five years as a
consultant, advisor, promoter, underwriter, or legal counsel of or to
the Bank; or
(4) Being an immediate family member of an individual who is, or
has been in any of the past five years, employed by the Bank.
(d) Charter. (1) The audit committee of each Bank shall adopt, and
the Bank's board of directors shall approve, a formal written charter
that specifies the scope of the audit committee's powers and
responsibilities, as well as the audit committee's structure, processes
and membership requirements.
(2) The audit committee and the board of directors of each Bank
shall:
(i) Review the Bank's audit committee charter on an annual basis;
and
(ii) Have the authority to adopt and approve, respectively,
amendments to the audit committee charter at any time; and
(iii) Re-adopt and re-approve, respectively, the Bank's audit
committee charter not less often than every three years.
(3) Each Bank's audit committee charter shall:
(i) Provide that the internal auditor may be removed only with the
approval of the audit committee;
(ii) Provide that the internal auditor shall report directly to the
audit committee on substantive matters and to the Bank President on
administrative matters;
(iii) Empower the audit committee to retain outside counsel,
independent accountants, or other outside consultants; and
(iv) Provide that both the internal auditor and the external
auditor shall have unrestricted access to the audit committee without
the need for any prior management knowledge or approval.
(e) Duties. Each Bank's audit committee shall have the duty to:
(1) Ensure that senior management maintains the reliability and
integrity of the accounting policies and financial reporting and
disclosure practices of the Bank;
(2) Review the basis for the Bank's financial statements and the
external auditor's opinion rendered with respect to such financial
statements (including the nature and extent of any significant changes
in accounting principles or the application therein) and ensure
disclosure and transparency regarding the Bank's true financial
performance and governance practices;
(3) Oversee the internal audit function by:
(i) Reviewing the scope of audit services required, significant
accounting policies, significant risks and exposures, audit activities
and audit findings;
(ii) Assessing the performance, and determining the compensation,
of the internal auditor; and
(iii) Reviewing and approving the internal auditor's work plan;
(4) Oversee the external audit function by:
(i) Approving the external auditor's annual engagement letter;
[[Page 52199]]
(ii) Reviewing the performance of the external auditor; and
(iii) Making recommendations to the Bank's board of directors
regarding the appointment, renewal, or termination of the external
auditor;
(5) Provide an independent, direct channel of communication between
the Bank's board of directors and the internal and external auditors;
(6) Conduct or authorize investigations into any matters within the
audit committee's scope of responsibilities;
(7) Ensure that senior management has established and is
maintaining an adequate internal control system within the Bank by:
(i) Reviewing the adequacy of the Bank's internal control system
and the resolution of identified material weaknesses and reportable
conditions in the internal control system, including the prevention or
detection of management override or compromise of the internal control
system; and
(ii) Reviewing the programs and policies of the Bank designed to
ensure compliance with applicable laws, regulations and policies and
monitoring the results of these compliance efforts;
(8) Ensure that senior management has established and is
maintaining adequate policies and procedures to ensure that the Bank
can assess, monitor and control compliance with its mission achievement
policy; and
(9) Report periodically its findings to the Bank's board of
directors.
(f) Meetings. The audit committee shall prepare written minutes of
each audit committee meeting.
Sec. 917.6 Budget preparation and reporting requirements.
(a) Adoption of annual Bank budgets. (1) Each Bank's board of
directors shall be responsible for the adoption of an annual operating
expense budget and a capital expenditures budget for the Bank, and any
subsequent amendments thereto, consistent with the requirements of the
Act, this section, other regulations and policies of the Finance Board,
and with the Bank's responsibility to protect both its members and the
public interest by keeping its costs to an efficient and effective
minimum.
(2) Pursuant to the requirement of section 12(a) of the Act (12
U.S.C. 1432(a)), a Bank must obtain prior approval of the Finance Board
before purchasing or erecting, or leasing for a term of more than 10
years, a building to house the Bank.
(3) A Bank's board of directors may not delegate the authority to
approve the Bank's annual budgets, or any subsequent amendments
thereto, to Bank officers or other Bank employees.
(4) A Bank's annual budgets shall be prepared based upon an
interest rate scenario as determined by the Bank.
(5) A Bank may not exceed its total annual operating expense budget
or its total annual capital expenditures budget without prior approval
by the Bank's board of directors of an amendment to such budget.
(b) Budget reports. Each Bank shall submit to the Finance Board, by
January 31 of each year, in a format and as further prescribed by the
Finance Board, such Bank budgets and other financial information as the
Finance Board shall require, including the following:
(1) Balance sheet projections;
(2) Income statement projections, including operating expense
budget data and staffing levels;
(3) Capital expenditures budget data;
(4) Management discussion of expected financial performance;
(5) Strategic or business plan;
(6) Interest rate assumptions; and
(7) A copy of the Bank's board of directors resolution adopting the
Bank's annual operating expense budget and capital expenditures budget.
(c) Report on amendments to total annual budgets. A Bank shall
submit promptly to the Finance Board a copy of the Bank's board of
directors resolution adopting any amendment increasing a Bank's total
annual operating expense budget or total annual capital expenditures
budget above originally-approved budget limits.
(d) Mid-year reforecasting report. Each Bank shall submit to the
Finance Board, by July 31 of each year, in a format and as further
prescribed by the Finance Board, a report containing a balance sheet
and income statement setting forth reforecasted projections for the
year relative to the budget projections for that year as originally
approved or amended, including a management discussion explaining any
significant changes in the reforecasted projections from the budget
projections as originally approved or amended.
(e) Annual actual performance results report. Each Bank shall
submit to the Finance Board, by January 31 of each year, in a format
and as further prescribed by the Finance Board, a report containing a
balance sheet and income statement setting forth the actual performance
results for the prior year relative to the budget projections for that
year as originally approved or amended, including a management
discussion explaining any significant changes in the actual performance
results from the budget projections as originally approved or amended.
Sec. 917.7 Dividends.
The board of directors of each Bank may, without the Finance
Board's prior approval, declare and pay a dividend from net earnings,
including previously retained earnings, on the paid-in value of capital
stock held during the dividend period, as determined by the Bank, so
long as such payment will not result in a projected impairment of the
par value of the capital stock of the Bank. Dividends on such stock
shall be computed without preference and only for the period such stock
was outstanding during the dividend period. Dividends may be paid in
cash or in the form of stock.
Sec. 917.8 Approval of Bank bylaws.
The board of directors of a Bank may prescribe, amend, or repeal
bylaws governing the manner in which the Bank administers its affairs
without the Finance Board's prior approval, provided that the bylaws or
amendments are consistent with applicable statutes, regulations and
Finance Board policies.
Sec. 917.9 Mission achievement.
(a) Mission achievement policy. (1) Adoption. Within 180 calendar
days of the effective date of this section, each Bank's board of
directors shall adopt, and submit to the Finance Board for approval, a
mission achievement policy that:
(i) Details how the Bank will comply with the core mission activity
requirements set forth in part 940 of this chapter, including
contingent business strategies for meeting such requirements under
different assumptions about future economic and mortgage market
conditions; and
(ii) Outlines a process for developing and implementing new
mission-related products and services.
(2) Review and compliance. Each Bank's board of directors shall:
(i) Review the Bank's mission achievement policy at least annually;
(ii) Have the authority to amend the mission achievement policy at
any time;
(iii) Re-adopt the Bank's mission achievement policy, including
interim amendments, not less often than every three years; and
(iv) Ensure Bank compliance at all times with the mission
achievement policy.
(b) Mission achievement oversight. Each Bank's board of directors
shall:
(1) Direct the establishment and maintenance, by senior management,
of adequate policies and procedures to ensure that the Bank can assess,
monitor and control compliance with its mission achievement policy;
[[Page 52200]]
(2) Establish a mechanism to measure and assess the Bank's
performance against its mission achievement goals and objectives;
(3) Require that performance assessments be conducted at least
annually that evaluate the Bank's mission achievement and measure its
performance against the Bank's goals and objectives, which performance
assessments shall be reviewed by the Bank's board of directors.
PART 925--MEMBERS OF THE BANKS
2. The authority citation for part 925 continues to read as
follows:
Authority: 12 U.S.C. 1422, 1422a, 1422b, 1423, 1424, 1426, 1430,
1442.
3. Amend Sec. 925.14 by revising paragraph (a)(4)(iv) to read as
follows:
Sec. 925.14 De novo insured depository institution applicants.
* * * * *
(a) * * *
(4) * * *
(iv) Treatment of outstanding advances and Bank stock. If the
applicant's conditional membership approval is deemed null and void
pursuant to paragraph (a)(4)(ii) of this section:
(A) The liquidation of any outstanding indebtedness owed by the
applicant to the Bank shall be carried out in accordance with
Sec. 925.29; and
(B) The redemption of stock of such Bank shall be carried out in
accordance with Sec. 930.9.
* * * * *
4. Amend Sec. 925.22 by removing paragraph (b)(2) and redesignating
paragraph (b)(1) as paragraph (b).
5. Amend Sec. 925.24 by revising paragraph (b)(2) to read as
follows:
Sec. 925.24 Consolidation of members.
* * * * *
(b) * * *
(2) Treatment of outstanding advances and Bank stock. (i) The
liquidation of any outstanding indebtedness owed to the disappearing
institution's Bank shall be carried out in accordance with Sec. 925.29.
(ii) The redemption of stock of the disappearing institution's Bank
shall be carried out in accordance with Sec. 930.9 of this chapter.
* * * * *
6. Amend Sec. 925.25 by revising paragraph (d)(3) to read as
follows:
Sec. 925.25 Consolidations involving nonmembers.
* * * * *
(d) * * *
(3) Upon failure to apply for or be approved for membership. If the
consolidated institution does not apply for membership, or if its
application for membership is denied, then:
(i) The liquidation of any outstanding indebtedness owed to the
disappearing institution's Bank shall be carried out in accordance with
Sec. 925.29; and
(ii) The redemption of stock of the disappearing institution's Bank
shall be carried out in accordance with Sec. 930.9 of this chapter, and
the consolidated institution shall have the limited rights associated
with such stock in accordance with paragraph (e) of this section.
* * * * *
7. Amend Sec. 925.26 by revising paragraphs (a), (b) and (c) to
read as follows:
Sec. 925.26 Procedure for withdrawal.
(a) Notice of withdrawal. Any member that is eligible under
applicable law to withdraw from Bank membership may do so after
providing its Bank with written notice of the member's intention to
withdraw from membership in accordance with the requirements of
Sec. 930.9 of this chapter.
(b) Cancellation of notice of withdrawal. A member may cancel its
notice of withdrawal by providing its Bank written notice of
cancellation any time before the effective date of the withdrawal.
(c) Treatment of outstanding advances and Bank stock. (1) The
liquidation of any outstanding indebtedness owed to the Bank in which
membership has been terminated shall be carried out in accordance with
Sec. 925.29.
(2) The redemption of stock of the Bank in which membership has
been terminated shall be carried out in accordance with Sec. 930.9 of
this chapter.
* * * * *
8. Amend Sec. 925.27 by revising paragraph (e) to read as follows:
Sec. 925.27 Procedure for removal.
* * * * *
(e) Treatment of outstanding advances and Bank stock. (1) The
liquidation of any outstanding indebtedness owed to the Bank in which
membership has been terminated shall be carried out in accordance with
Sec. 925.29.
(2) The redemption of stock of the Bank in which membership has
been terminated shall be carried out in accordance with Sec. 930.9 of
this chapter.
* * * * *
9. Amend Sec. 925.28 by revising paragraph (b) to read as follows:
Sec. 925.28 Automatic termination of membership for institutions
placed in receivership.
* * * * *
(b) Treatment of outstanding advances and Bank stock. (1) The
liquidation of any outstanding indebtedness owed to the Bank in which
membership has been terminated shall be carried out in accordance with
Sec. 925.29.
(2) The redemption of stock of the Bank in which membership has
been terminated shall be carried out in accordance with Sec. 930.9 of
this chapter.
* * * * *
Subpart G--Orderly Liquidation of Advances
10. Revise the heading of subpart G to read as set forth above.
11. Amend Sec. 925.29 by:
a. Revising the heading;
b. Removing paragraphs (b) and (c);
c. Redesignating paragraphs (a)(1) and (a)(2) as paragraphs (a) and
(b), respectively; and
d. Revising newly designated paragraph (b).
The revisions read as follows:
Sec. 925.29 Orderly liquidation of advances.
(b) The indebtedness of the institution that has ceased to be a
member of a Bank owed to such Bank shall be liquidated in an orderly
manner as determined by the Bank in accordance with Sec. 950.19 of this
chapter.
* * * * *
12. New part 930 is added to subchapter E to read as follows:
PART 930--RISK MANAGEMENT AND CAPITAL STANDARDS
Sec.
930.1 Definitions.
930.2 Bank System and individual Bank credit ratings.
930.3 Minimum total capital requirement.
930.4 Minimum total risk-based capital requirement.
930.5 Credit risk capital requirement.
930.6 Market risk capital requirement.
930.7 Operations risk capital requirement.
930.8 Reporting requirements.
930.9 Capital stock redemption requirements.
930.10 Minimum liquidity requirements.
930.11 Limits on unsecured extensions of credit to one counterparty
or affiliated counterparties; reporting requirements for total
extensions of credit to one counterparty or affiliated
counterparties.
Authority: 12 U.S.C. 1422a(a)(3), 1422b(a), 1426, 1429, 1430,
1430b, 1431, 1436, 1440.
Sec. 930.1 Definitions.
As used in this part:
Affiliated counterparty means a counterparty that is an affiliate
of
[[Page 52201]]
another counterparty, as the term ``affiliate'' is defined in 12 U.S.C.
371c(b) (as amended).
Certain drawdown means, in relation to commitments to make advances
or other loans, that it is known during the pendency of the commitment
that the advance or loan funds definitely will be drawn in full.
Contingency liquidity means:
(1) Marketable assets with a maturity of one year or less;
(2) Self-liquidating assets with a maturity of seven days or less;
and
(3) Assets that are generally accepted as collateral in the
repurchase agreement market.
Credit derivative contract means a derivative contract that
transfers credit risk.
Credit risk means the risk that an obligation will not be paid in
full and loss will result.
Derivative contract means generally a financial contract whose
value is derived from the values of one or more underlying assets,
reference rates, or indexes of asset values, or credit-related events.
Derivative contracts include interest rate, foreign exchange rate,
equity, precious metals, commodity, and credit contracts, and any other
instruments that pose similar risks.
Eligible nonmember borrower means an entity that has been approved
as a nonmember mortgagee pursuant to subpart B of part 950 of this
chapter.
Exchange rate contracts include cross-currency interest rate swaps,
forward foreign exchange rate contracts, currency options purchased,
and any similar instruments that gives rise to similar risks.
Financial Management Policy means the Financial Management Policy
For The Federal Home Loan Bank System approved by the Finance Board
pursuant to Finance Board Resolution No. 96-45 (July 3, 1996), as
amended by Finance Board Resolution No. 96-90 (Dec. 6, 1996), Finance
Board Resolution No. 97-05 (Jan. 14, 1997), and Finance Board Res. No.
97-86 (Dec. 17, 1997).
GSE, or Government Sponsored Enterprise, means a United States
Government-sponsored agency originally established or chartered to
serve public purposes specified by the United States Congress, but
whose obligations are not obligations of the United States and are not
guaranteed by the United States.
Interest rate contracts include: Single currency interest rate
swaps; basis swaps; forward rate agreements; interest rate options; and
any similar instrument that gives rise to similar risks, including
when-issued securities.
Investment grade means:
(1) A credit quality rating in one of the four highest credit
rating categories by an NRSRO and not below the fourth highest rating
category by any NRSRO; or
(2) If there is no credit quality rating by an NRSRO, a
determination by a Bank that the issuer, asset or instrument is the
credit equivalent of investment grade using credit rating standards
available from an NRSRO or other similar standards.
Issuer credit rating means an opinion issued by an NRSRO of an
institution's overall capacity to meet its obligations (i.e., the
institution's creditworthiness).
Market risk means the risk that the market value of a Bank's
portfolio will decline as a result of changes in the general level of
interest rates, foreign exchange rates, equity and commodity prices.
Marketable means, with respect to an asset, that the asset can be
sold with reasonable promptness at a price that corresponds reasonably
to its fair value.
Market value at risk is calculated as the maximum loss in the
market value of a portfolio under various stress scenarios.
NRSRO means a credit rating organization regarded as a Nationally
Recognized Statistical Rating Organization by the Securities and
Exchange Commission.
OFHEO means the Office of Federal Housing Enterprise Oversight.
Operations risk means the risk of an unexpected loss to a Bank
resulting from human error, fraud, unenforceability of legal contracts,
or deficiencies in internal controls or information systems.
Repurchase agreement means an agreement between a seller and a
buyer whereby the seller agrees to repurchase a security at an agreed
upon price, with or without a stated time for repurchase.
Retained earnings means the retained earnings required to be
reported by a Bank to the Finance Board for regulatory purposes.
Total assets means the total assets required to be reported by a
Bank to the Finance Board for regulatory purposes.
Total capital means the sum of a Bank's retained earnings and total
capital stock outstanding, less the Bank's unrealized net losses on
available-for-sale securities.
Total capital stock outstanding means all forms and types of
outstanding capital stock required to be reported by a Bank to the
Finance Board for regulatory purposes.
Total risk-based capital for a Bank means the sum of:
(1) Such Bank's retained earnings, less unrealized net losses on
available-for-sale securities;
(2) Any outstanding non-redeemable capital stock of such Bank;
(3) All outstanding capital stock satisfying the minimum capital
stock purchase requirements for membership under sections 6(b)(1) and
10(e)(3) of the Act (12 U.S.C. sections 1426(b)(1), 1430(e)(3)) for all
institutions required by law to be members of such Bank (mandatory
members);
(4) A percentage not exceeding 50 percent, as determined by such
Bank's board of directors, of all outstanding capital stock satisfying
the minimum capital stock purchase requirements for membership under
sections 6(b)(1) and 10(e)(3) of the Act (12 U.S.C. sections
1426(b)(1), 1430(e)(3)) for all Bank members not required by law to be
members of the Bank (voluntary members); and
(5) A percentage (which is not required to be identical to any
percentage determined for purposes of paragraph (4) of this definition
not exceeding 50 percent, as determined by such Bank's board of
directors, of all remaining outstanding capital stock.
Unrealized net losses on available-for-sale securities means the
unrealized net losses on available-for-sale securities required to be
reported by a Bank to the Finance Board for regulatory purposes.
Walkaway clause means a provision in a bilateral netting contract
that permits a nondefaulting counterparty to make a lower payment than
it would make otherwise under the bilateral netting contract, or no
payment at all, to a defaulter or the estate of a defaulter, even if
the defaulter or the estate of the defaulter is a net creditor under
the bilateral netting contract.
Sec. 930.2 Bank System and individual Bank credit ratings.
(a) Bank System credit rating. (1) The Banks, collectively, shall
obtain from an NRSRO, and at all times maintain, a current credit
rating on the Banks' consolidated obligations.
(2) Each Bank shall operate in such a manner and take any actions
necessary to ensure that the Banks' consolidated obligations receive
and continue to receive the highest credit rating from any NRSRO by
which the consolidated obligations have been then rated.
(b) Individual Bank credit rating. Each Bank shall operate in such
a manner and take any actions necessary to ensure that the Bank has and
maintains an individual issuer credit rating of at least the second
highest credit rating from any NRSRO providing a rating, where such
rating is:
[[Page 52202]]
(1) A meaningful measure of the individual Bank's financial
strength and stability, apart from the GSE status of the Bank System;
(2) Obtained from an NRSRO that states in writing to the Bank that
its rating conforms with paragraph (b)(1) of this section; and
(3) Updated at least annually, or more frequently as required by
the Finance Board to reflect any material changes in the condition of
the Bank.
(c) Transition provision. Each Bank shall obtain the credit rating
from an NRSRO required under paragraph (b) of this section within one
calendar year of the effective date of this part.
Sec. 930.3 Minimum total capital requirement.
(a) Minimum total capital ratio. Each Bank shall have and maintain
at all times total capital in an amount equal to at least 3.0 percent
of the Bank's total assets.
(b) Safety and soundness exception. For reasons of safety and
soundness, the Finance Board may require an individual Bank to have and
maintain a higher minimum capital ratio than the ratio set forth in
paragraph (a) of this section.
Sec. 930.4 Minimum total risk-based capital requirement.
(a) General. Each Bank shall have and maintain at all times total
risk-based capital in an amount at least equal to the sum of its credit
risk capital requirement, its market risk capital requirement, and its
operations risk capital requirement, calculated in accordance with
Secs. 930.5, 930.6 and 930.7, respectively.
(b) Transition provisions. (1) Each Bank shall be required to meet
its minimum total risk-based capital requirement under paragraph (a) of
this section within 90 calendar days after the Finance Board's approval
of the Bank's internal market risk model.
(2) No Bank shall be governed by the capital requirements of this
part, and each Bank shall continue to be governed by the Financial
Management Policy, until:
(i) The Bank has received Finance Board approval of the Bank's
internal market risk model and the Bank's risk management policy;
(ii) The Bank demonstrates to the Finance Board that it has
sufficient risk-based capital to meet the minimum total risk-based
capital requirement under paragraph (a) of this section for its then-
current portfolio; and
(iii) The Bank demonstrates to the Finance Board, in its risk
management policy or otherwise, risk assessment procedures and controls
sufficient to manage the Bank's credit, market and operations risks.
Sec. 930.5 Credit risk capital requirement.
(a) General requirement. A Bank's credit risk capital requirement
equals the sum of the Bank's credit risk capital requirements for all
on-balance sheet assets and off-balance sheet items.
(b) Credit risk capital requirements for on-balance sheet assets. A
Bank's credit risk capital requirement for a specific on-balance sheet
asset shall be equal to the book value of the asset multiplied by the
specific credit risk percentage requirement assigned to that category
of credit risk pursuant to paragraph (d) of this section.
(c) Credit risk capital requirement for off-balance sheet items. A
Bank's credit risk capital requirement for a specific off-balance sheet
item shall be equal to the credit equivalent amount of such item, as
determined pursuant to paragraphs (e), (f), or (g) of this section, as
applicable, multiplied by the specific credit risk percentage
requirement assigned to that category of credit risk pursuant to
paragraph (d) of this section.
(d) Determination of specific credit risk percentage requirements--
(1) Finance Board determination of specific credit risk percentage
requirements. The Finance Board shall determine, and update
periodically, specific credit risk percentage requirements for
particular credit risk categories applicable to on-balance sheet assets
and off-balance sheet items, based on the type of asset or item and its
credit rating, if any, as set forth in paragraph (d)(3) of this
section.
(2) Finance Board underlying methodology. (i) In determining the
specific credit risk percentage requirements, the Finance Board shall
use data made available by NRSROs and other relevant sources to derive
estimates of credit risk (or, ``credit losses'') corresponding to
particular categories of credit risks.
(ii) The estimates of credit risk shall represent credit losses as
could occur during periods of extreme credit stress. Historical data
used in deriving estimates of credit losses shall reflect the longer-
term nature of credit cycles and span multiple credit cycles. Estimates
of credit losses shall be equal to the product of extreme values of the
distributions of both the default frequency and the recovery rate in
default for each credit risk category.
(3) Specific credit risk capital requirements by credit risk
category. The specific credit risk percentage requirements applicable
to a Bank's on-balance sheet assets and off-balance sheet items are as
provided in the following Table 1:
Table 1.--Credit Risk Capital Requirements by Credit Risk Category
------------------------------------------------------------------------
Percent of
on-balance
Credit risk category sheet
equivalent
value
------------------------------------------------------------------------
(i) Authorized Investments
(A) Cash; Government Securities............................ 0.0
(B) Advances............................................... 0.3
(C) Highest Investment Grade............................... 0.3
(D) Second Highest Investment Grade........................ 0.6
(E) Third Highest Investment Grade......................... 1.0
(F) Fourth Highest Investment Grade........................ 1.3
(G) Premises, Plant, and Equipment......................... 8.0
(H) Core Mission Equity Investments Under Sec. 940.3(e)... 8.0
(ii) Investments Downgraded to Below Investment Grade After
Acquisition By Bank
(A) Highest Below Investment Grade......................... 12.0
(B) Second Highest Below Investment Grade.................. 50.0
(C) All Other Below Investment Grade....................... 100.0
------------------------------------------------------------------------
(4) Bank determination of specific credit risk percentage
requirements. (i) General requirement. Each Bank shall determine the
credit risk capital requirement for each on-balance sheet asset and
off-balance sheet item by determining the type of asset or item and its
credit rating, if any (as provided in paragraph (d)(4)(ii) of this
section) determining the applicable credit risk category for such asset
or item as set forth in Table 1 of paragraph (d)(3) of this section,
and applying the applicable credit risk percentage requirement for such
credit risk category contained in Table 1.
(ii) Bank determination of credit rating. (A) For assets or items
that are rated directly by an NRSRO, the credit rating that shall apply
for purposes of determining the applicable credit risk category under
Table 1 shall be the credit rating of the asset or item, respectively.
(B) For an asset or item, or relevant portion of an asset or item,
that is not rated directly by an NRSRO, but for which an NRSRO rating
has been assigned to any of the corresponding obligor counterparty,
third party guarantor or underlying collateral, the credit rating that
shall apply to the asset or item or portion of the asset or item
corresponding to a particular rating, for purposes of determining the
applicable
[[Page 52203]]
credit risk category under Table 1, shall be the highest of the credit
ratings corresponding to such asset or item or portion or such asset or
item.
(C) Where a credit rating has a modifier, e.g., A+ or A-, the
credit rating is deemed to be the credit rating without the modifier,
e.g., A+ or A-= A.
(D) In determining the applicable credit risk category under Table
1 for a specific asset or item that has received more than one credit
rating from a given NRSRO, the most recent credit rating shall be used.
(E) If a specific asset or item has received credit ratings from
more than one NRSRO, the lowest credit rating shall be used in
determining the applicable credit risk category for such asset or item
under Table 1.
(F) If an asset or item, or relevant portion of an asset or item,
does not meet the requirements of paragraphs (d)(4)(ii)(A) or (B) of
this section, and does not fall within the credit risk categories of
Cash, Government Securities, Advances, Premises, Plant, Equipment, or
Core Mission Equity Investments, for purposes of determining the
applicable credit risk category under Table 1, the Bank shall determine
its own credit rating for the asset or item or relevant portion of the
asset or item using credit rating standards available from an NRSRO or
other similar standards.
(iii) Recognition of collateral. Assets or items shall be deemed to
be backed by collateral for purposes of this paragraph (d)(4)(iii) if
the collateral is:
(A) Actually held by the Bank or an independent, third-party
custodian, or by the Bank's member or eligible nonmember borrower if
permitted under the Bank's collateral agreement with such party;
(B) Legally available to absorb losses;
(C) Has a readily determinable value at which it can be liquidated
by the Bank; and
(D) Is held in accordance with the provisions of the Bank's
collateral management policy.
(iv) Collateral haircut. In recognizing collateral, appropriate
allowance for haircuts (over collateralization) reflecting the market
risk underlying the collateral must be made.
(5) Specific credit risk capital requirements for on-balance sheet
assets hedged with credit derivatives.
(i) If a credit derivative is used to lower (hedge) the credit risk
on an asset, the credit derivative and such underlying asset are of
identical remaining maturity, and the asset being referenced in the
credit derivative (reference asset) is identical to the underlying
asset, the credit risk capital requirement for the underlying asset
shall be zero.
(ii) If the underlying asset and the reference asset are identical,
but their remaining maturities are different, the credit risk capital
requirement for the underlying asset shall be zero, provided the
remaining maturity of the credit derivative is two years or more.
(iii) If the remaining maturities of the underlying asset and the
credit derivative are identical, but the underlying asset is different
from the asset referenced in the credit derivative, the credit risk
capital requirement for the underlying asset shall be zero, provided
that the reference asset and the underlying asset have been issued by
the same obligor, the reference asset ranks pari passu to or more
junior than the underlying asset, and cross-default clauses apply.
(iv) If the credit risk capital requirement for the underlying
asset is decreased in recognition of a credit derivative, the credit
risk capital requirement for the derivative contract pursuant to
paragraphs (f) and (g) of this section shall still apply.
(e) Calculation of credit equivalent amount for off-balance sheet
items other than derivative contracts. The credit equivalent amount for
an off-balance sheet item other than a derivative contract shall be
determined by a Finance Board approved model or equal to the face
amount of the instrument multiplied by the credit conversion factor
assigned to such risk category of instruments provided in the following
Table 2:
Table 2.--Credit Conversion Factors for Off-Balance Sheet Items Other
Than Derivative Contracts
------------------------------------------------------------------------
Credit
conversion
Instrument factor (in
percent)
------------------------------------------------------------------------
(1) Standby letters of credit.............................. 100
(2) Asset sales with recourse where the credit risk remains 100
with the Bank.............................................
(3) Sale and repurchase agreements......................... 100
(4) Forward asset purchases................................ 100
(5) Commitments to make advances, or other loans, with 100
certain drawdown..........................................
(6) Other commitments with original maturity of over one \1\50
year......................................................
(7) Other commitments with original maturity of one year or \1\20
less......................................................
------------------------------------------------------------------------
\1\ The credit conversion factor would be zero for other commitments
that are unconditionally cancelable, or that effectively provide for
automatic cancellation, due to the deterioration in a borrower's
creditworthiness, at any time by the Bank without prior notice.
(f) Calculation of credit equivalent amount for single derivative
contracts. The credit equivalent amount for a derivative contract that
is not subject to a qualifying bilateral netting contract (single
derivative contract) shall be the sum of the current credit exposure
(replacement cost) and the potential future credit exposure of the
derivative contract.
(1) Current credit exposure. If the mark-to-market value of the
contract is positive, the current credit exposure shall equal that
mark-to-market value. If the mark-to-market value of the contract is
zero or negative, the current credit exposure shall be zero.
(2) Potential future credit exposure. (i) The potential future
credit exposure for a single derivative contract, including a
derivative contract with a negative mark-to-market value, shall be
calculated using an internal model approved by the Finance Board or, in
the alternative, by multiplying the effective notional principal of the
derivative contract by one of the assigned credit conversion factors
for the appropriate category as provided in the following Table 3:
Table 3.--Credit Conversion Factors for Potential Future Credit Exposure Derivative Contracts \1\
(In percent)
----------------------------------------------------------------------------------------------------------------
Foreign Precious
Residual maturity \2\ Interest rate exchange and Equity metals except Other
gold gold commodities
----------------------------------------------------------------------------------------------------------------
(A) One year or less.......... 0 1 6 7 10
[[Page 52204]]
(B) Over 1 year to five years. .5 5 8 7 12
(C) Over five years........... 1.5 7.5 10 8 15
----------------------------------------------------------------------------------------------------------------
\1\ For derivative contracts with multiple exchanges of principal, the conversion factors are multiplied by the
number of remaining payments in the derivative contract.
\2\ For derivative contracts that automatically reset to zero value following a payment, the residual maturity
equals the time until the next payment. However, interest rate contracts with remaining maturities of greater
than one year shall be subject to a minimum conversion factor of 0.5 percent.
(ii) If a Bank determines to use an internal model for a particular
type of derivative contract, the Bank shall use the same model for all
other similar types of contracts. However, the Bank may use an internal
model for one type of derivative contract and Table 3 for another type
of derivative contract.
(iii) Forwards, swaps, purchased options and similar derivative
contracts not included in the Interest Rate, Foreign Exchange and Gold,
Equity, or Precious Metals Except Gold categories shall be treated as
Other Commodities contracts for purposes of Table 3.
(iv) If a Bank determines to use Table 3 for credit derivatives
contracts, the credit conversion factors applicable to Interest Rate
contracts under Table 3 shall apply to such credit derivative
contracts.
(v) If a Bank determines not to use an internal model for single
currency interest rate swaps in which payments are made based upon two
floating indices (floating/floating or basis swaps), the potential
future credit exposure for such swaps shall be zero.
(g) Calculation of credit equivalent amount for multiple derivative
contracts subject to a qualifying bilateral netting contract.--(1)
Netting calculation. The credit equivalent amount for multiple
derivative contracts executed with a single counterparty and subject to
a qualifying bilateral netting contract described in paragraph (g)(2)
of this section, shall be calculated by adding the net current credit
exposure and the adjusted sum of the potential future credit exposure
for all derivative contracts subject to the qualifying bilateral
netting contract.
(i) Net current credit exposure. The net current credit exposure
shall be the net sum of all positive and negative mark-to-market values
of the individual derivative contracts subject to a qualifying
bilateral netting contract. If the net sum of the mark-to-market value
is positive, then the net current credit exposure shall equal that net
sum of the mark-to-market value. If the net sum of the mark-to-market
value is zero or negative, then the net current credit exposure shall
be zero.
(ii) Adjusted sum of the potential future credit exposure. (A) The
adjusted sum of the potential future credit exposure (Anet)
shall be calculated as follows:
Anet = 0.4 x Agross + (0.6 x NGR x
Agross).
(B) Agross is the gross potential future credit
exposure, i.e., the sum of the potential future credit exposure for
each individual derivative contract subject to the qualifying bilateral
netting contract. NGR is the net to gross ratio, i.e., the ratio of the
net current credit exposure to the gross current credit exposure. The
gross current credit exposure equals the sum of the positive current
credit exposures of all individual derivative contracts subject to the
qualifying bilateral netting contract.
(2) Qualifying bilateral netting contract. A bilateral netting
contract shall be considered a qualifying bilateral netting contract if
the following conditions are met:
(i) The netting contract is in writing;
(ii) The netting contract is not subject to a ``walkaway'' clause;
(iii) The netting contract provides that the Bank would have a
single legal claim or obligation either to receive or to pay only the
net amount of the sum of the positive and negative mark-to-market
values on the individual derivative contracts covered by the netting
contract in the event that a counterparty, or a counterparty to whom
the netting contract has been assigned, fails to perform due to
default, insolvency, bankruptcy, or other similar circumstance;
(iv) The Bank obtains a written and reasoned legal opinion that
represents, with a high degree of certainty, that in the event of a
legal challenge, including one resulting from default, insolvency,
bankruptcy, or similar circumstances, the relevant court and
administrative authorities would find the Bank's exposure to be the net
amount under:
(A) The law of the jurisdiction by which the counterparty is
chartered or the equivalent location in the case of noncorporate
entities, and if a branch of the counterparty is involved, then also
under the law of the jurisdiction in which the branch is located;
(B) The law of the jurisdiction that governs the individual
derivative contracts covered by the netting contract; and
(C) The law of the jurisdiction that governs the netting contract;
(v) The Bank establishes and maintains procedures to monitor
possible changes in relevant law and to ensure that the netting
contract continues to satisfy the requirements of this section; and
(vi) The Bank maintains in its files documentation adequate to
support the netting of a derivative contract.
(h) Exceptions. The following derivative contracts are not included
in the credit risk capital requirement:
(1) An exchange rate contract with an original maturity of 14
calendar days or less (gold contracts do not qualify for this
exception); and
(2) A derivative contract that is traded on an exchange requiring
the daily payment of any variations in the market value of the
contract.
Sec. 930.6 Market risk capital requirement.
(a) General requirement. A Bank's market risk capital requirement
shall equal the market value of the Bank's portfolio at risk from
movements in interest rates, foreign exchange rates, commodity prices
and equity prices as could occur during periods of extreme market
stress, as determined using the Bank's internal market risk model
approved by the Finance Board.
(b) Measurement of market value at risk under Bank internal market
risk model. (1) Each Bank shall use an internal market risk model that
measures the market value at risk, from all sources of the Bank's
market risks, of its holdings of on-balance sheet assets
[[Page 52205]]
and liabilities and of off-balance sheet items, including related
options.
(2) The Bank's internal market risk model may use any generally
accepted measurement technique, such as variance-covariance models,
historical simulations, or Monte Carlo simulations, for estimating the
market value of the Bank's portfolio at risk, provided that any
measurement technique used must cover the Bank's material risks.
(3) The value at risk measures shall include the risks arising from
the non-linear price characteristics of options and the sensitivity of
the market value of options to changes in the volatility of the
option's underlying rates or prices.
(4) The Bank's internal market risk model shall use interest rate
and market price scenarios for estimating the market value of the
Bank's portfolio at risk, but must at a minimum include the following:
(i) Monthly estimates of the market value of the Bank's portfolio
at risk so that the probability of a loss greater than that estimated
shall be no more than 1 percent;
(ii) Scenarios that reflect changes in rates and market prices
equivalent to those that have been observed over 90-business day
periods of extreme market stress. For interest rates, the relevant
historical observation period is to start from the end of the previous
month and go back to the beginning of 1978;
(iii) The value at risk measure may incorporate empirical
correlations among interest rates, subject to a Finance Board
determination that the model's system for measuring such correlations
is sound; and
(iv) The two interest rate scenarios required to be used by OFHEO
to determine the risk-based capital requirements for the Federal
National Mortgage Association and the Federal Home Loan Mortgage
Corporation, pursuant to 12 U.S.C. 4611(a)(2).
(5) If the Bank participates in consolidated obligations
denominated in a currency other than U.S. Dollars or linked to equity
or commodity prices, and these instruments have been hedged for foreign
exchange, equity and commodity risks:
(i) The Bank's internal market risk model must calculate the market
value of its portfolio at risk due to these market risks and using the
qualitative and quantitative requirements specified in this section,
i.e., the probability of a loss greater than that estimated must not
exceed 1 percent and must include scenarios that reflect changes in
rates and market prices that have been observed over 90-business day
periods of extreme market stress.
(ii) The historical data from an appropriate period and
satisfactory to the Finance Board must be used.
(iii) The value at risk measure may incorporate empirical
correlations within foreign exchange rates, equity prices, and
commodity prices, but not among the three risk categories, subject to a
Finance Board determination that the model's system for measuring such
correlations is sound.
(iv) If there is a default on the part of a counterparty to a
derivative (hedging) contract linked to foreign exchange rates, equity
prices or commodity prices, the Bank must enter into a replacement
contract in a timely manner and as soon as market conditions permit.
(c) Independent validation of Bank internal market risk model. (1)
Each Bank shall conduct an independent validation of its internal
market risk model within the Bank that is carried out by personnel not
reporting to the business line responsible for conducting business
transactions for the Bank, or obtain independent validation by an
outside party qualified to make such determinations, on an annual
basis, or more frequently as required by the Finance Board.
(2) The results of such independent validations shall be reviewed
by the Bank's board of directors and provided promptly to the Finance
Board.
(d) Finance Board approval of Bank internal market risk model. (1)
General. Each Bank shall obtain approval from the Finance Board of its
internal market risk model, including subsequent material adjustments
to the model made by the Bank prior to its use. A Bank shall make any
subsequent adjustments to its model that may be directed by the Finance
Board.
(2) Transition provision. Each Bank shall submit its initial
internal market risk model required to be adopted under paragraph
(d)(1) of this section to the Finance Board for approval within one
calendar year of the effective date of this section.
Sec. 930.7 Operations risk capital requirement.
A Bank's operations risk capital requirement shall at any time
equal 30 percent of the sum of the Bank's credit risk capital
requirement and market risk capital requirement at such time.
Sec. 930.8 Reporting requirements.
Each Bank shall report to the Finance Board by the 15th day of each
month its minimum total risk-based capital requirement by component
amounts (credit risk capital, market risk capital, and operations risk
capital), and its actual total capital amount and risk-based capital
amounts calculated as of the last day of the preceding month, or more
frequently as may be required by the Finance Board.
Sec. 930.9 Capital stock redemption requirements.
(a) Redemption with Finance Board approval. A Bank may redeem that
portion of a member's capital stock allocated by the Bank to the Bank's
total risk-based capital pursuant to Sec. 930.1 only if the Finance
Board has approved such redemption.
(b) Redemption without Finance Board approval. (1) A Bank may at
any time redeem any portion of a member's capital stock not included in
or allocated by the Bank to the Bank's total risk-based capital
pursuant to Sec. 930.1, provided that the member's minimum capital
stock purchase requirement under sections 6(b)(1) and 10(e)(3) of the
Act (12 U.S.C. 1426(b)(1), 1430(e)(3)) is maintained.
(2) A Bank may subject redemptions under paragraph (b)(1) of this
section to the six-month notice provision in section 6(e) of the Act
(12 U.S.C. 1426(e)), or may shorten or waive such six-month notice
provision.
(3) A Bank, after providing 15 calendar days advance written notice
to a member, may require redemptions under paragraph (b)(1) of this
section, provided the minimum capital stock requirement under sections
6(b)(1) and 10(e)(3) of the Act (12 U.S.C. sections 1426(b)(1),
1430(e)(3)) is maintained. The Bank's implementation of such unilateral
redemption policy shall be consistent with the requirement of section
7(j) of the Act (12 U.S.C. 1427(j)) that the affairs of the Bank shall
be administered fairly and impartially and without discrimination in
favor of or against any member borrower.
(4) A Bank may not impose on or accept from a member a fee in lieu
of redeeming the member's capital stock under paragraph (b)(3) of this
section.
Sec. 930.10 Minimum liquidity requirements.
In addition to meeting the deposit liquidity requirements contained
in Sec. 965.3 of this chapter, each Bank shall hold contingency
liquidity in an amount sufficient to enable the Bank to meet its
liquidity needs, which shall, at a minimum, cover seven calendar days
of inability to access the consolidated obligation debt markets. An
asset that has been pledged under a repurchase agreement cannot be used
to satisfy minimum liquidity requirements.
[[Page 52206]]
Sec. 930.11 Limits on unsecured extensions of credit to one
counterparty or affiliated counterparties; reporting requirements for
total extensions of credit to one counterparty or affiliated
counterparties.
(a) Maximum capital exposure limits--(1) Unsecured extensions of
credit to a single counterparty--(i) General requirement. Unsecured
extensions of credit by a Bank to a single counterparty that arise from
authorized Bank on- and off-balance sheet transactions shall be limited
to the maximum capital exposure limit applicable to such counterparty,
as set forth in Table 4 of this paragraph (a), multiplied by the lesser
of:
(A) The Bank's total capital; or
(B) The counterparty's Tier 1 capital, or total capital if Tier 1
capital is not available.
(ii) Bank determination of credit ratings and applicable maximum
exposure limits. (A) The applicable maximum capital exposure limits for
specific counterparties are specific maximum percentage limits assigned
to such counterparties based on the credit rating of the counterparty,
as provided in the following Table 4:
Table 4.--Maximum Limits on Unsecured Extensions of Credit to a Single
Counterparty by Counterparty Credit Rating Category
------------------------------------------------------------------------
Maximum
capital
Credit rating of counterparty category exposure
limit (in
percent)
------------------------------------------------------------------------
(1) Highest Investment Grade.............................. 15
(2) Second Highest Investment Grade....................... 12
(3) Third Highest Investment Grade........................ 6
(4) Fourth Highest Investment Grade....................... 1.5
(5) Below Investment Grade or Other....................... 1
------------------------------------------------------------------------
(B) In determining the applicable credit rating category under
Table 4 for a specific counterparty that has received more than one
rating from a given NRSRO, the most recent credit rating shall be used.
(C) If a specific counterparty has received credit ratings from
more than one NRSRO, the lowest credit rating shall be used in
determining the applicable credit rating category for such counterparty
under Table 4.
(D) In the event a counterparty has received different credit
ratings for its transactions with short-term and long-term maturities:
(1) The higher credit rating shall apply for purposes of
determining the allowable maximum capital exposure limit under Table 4
applicable to the total amount of unsecured credit extended by the Bank
to such counterparty;
(2) The lower credit rating shall apply for purposes of determining
the allowable maximum capital exposure limit under Table 4 applicable
to the amount of unsecured credit extended by the Bank to such
counterparty for the transactions with maturities governed by that
rating.
(E) If a counterparty is placed on a credit watch for a potential
downgrade by an NRSRO, the Bank shall determine its remaining available
credit line for unsecured credit concentration exposures under Table 4
by assuming a credit rating from that NRSRO at the next lower grade.
(2) Unsecured extensions of credit to affiliated counterparties.
The total amount of unsecured extensions of credit by a Bank to all
affiliated counterparties may not exceed:
(i) The maximum capital exposure limit applicable under Table 4
based on the highest credit rating of the affiliated counterparties;
(ii) Multiplied by the lesser of:
(A) The Bank's total capital; or
(B) The combined Tier 1 capital, or total capital if Tier 1 capital
is not available, of all of the affiliated counterparties.
(b) Reporting requirements--(1) Total unsecured extensions of
credit. Each Bank shall report monthly to the Finance Board the amount
of the Bank's total unsecured extensions of credit to any single
counterparty or group of affiliated counterparties that exceeds 5
percent of:
(i) The Bank's total capital; or
(ii) The counterparty's, or affiliated counterparties' combined,
Tier 1 capital, or total capital if Tier 1 capital is not available.
(2) Total secured and unsecured extensions of credit. Each Bank
shall report monthly to the Finance Board the amount of the Bank's
total secured and unsecured extensions of credit to any single
counterparty or group of affiliated counterparties that exceeds 5
percent of the Bank's total assets.
13. New part 940 is added to subchapter F to read as follows:
PART 940--CORE MISSION ACTIVITIES REQUIREMENTS
Sec.
940.1 Definitions.
940.2 Mission of the Banks.
940.3 Core mission activities.
940.4 Core mission activities requirements.
940.5 Transfers of core mission activities to another Bank.
940.6 Safe harbor for anticipated noncompliance.
Authority: 12 U.S.C. 1422a(a)(3), 1422b(a), 1430, 1430b, 1431.
Sec. 940.1 Definitions.
As used in this part:
Certain drawdown has the meaning set forth in Sec. 930.1 of this
chapter.
Community lending has the meaning set forth in Sec. 952.3 of this
chapter.
Eligible nonmember borrower has the meaning set forth in Sec. 930.1
of this chapter.
Financial Management Policy has the meaning set forth in Sec. 930.1
of this chapter.
Housing-related whole loans means all whole loans, or participation
interests in whole loans (excluding mortgage-backed securities),
secured by one-to-four family property, multifamily property, or
manufactured housing, including loans for the construction, purchase,
improvement, rehabilitation, or refinancing of housing.
Member mortgage assets means those mortgage-related assets that may
be acquired by a Bank under part 954 of this chapter.
Sec. 940.2 Mission of the Banks.
The mission of the Banks is to provide to members and eligible
nonmember borrowers financial products and services, including but not
limited to advances, that assist and enhance such members' and eligible
nonmember borrowers' financing of:
(a) Housing in the broadest sense, including single-family and
multi-family housing serving consumers at all income levels; and
(b) Community lending.
Sec. 940.3 Core mission activities.
The following Bank activities qualify as core mission activities:
(a) Advances and advance commitments. (1) Advances, and commitments
to make advances with certain drawdown, to members or eligible
nonmember borrowers with assets of $500 million or less; and
(2) Advances, and commitments to make advances with certain
drawdown, to members or eligible nonmember borrowers with assets
greater than $500 million, up to the total book value of the following
assets held by such member or eligible nonmember borrower:
(i) Housing-related whole loans;
(ii) Loans and investments that are generated by community lending;
and
(iii) Mortgage-backed securities that comprise the types of loans
described in paragraphs (a)(2) (i) and (ii) of this section originated
by the member or eligible nonmember borrower;
[[Page 52207]]
(b) Standby letters of credit;
(c) Intermediary derivative contracts;
(d) Member mortgage assets;
(e) Certain equity investments. Equity investments:
(1) That primarily benefit low- or moderate-income individuals or
areas, or other areas targeted for redevelopment by local, state,
tribal or Federal government (including Federal enterprise communities
and Federal empowerment zones) by providing or supporting one or more
of the following activities:
(i) Affordable housing, community services, or permanent jobs for
low- or moderate-income individuals; or
(ii) Area revitalization or stabilization;
(2) In small business investment companies formed pursuant to 15
U.S.C. 681(d) (SBICs), but only to the extent that the equity
investment is structured to be matched by an equity investment in the
same activity by a member or eligible nonmember borrower of the Bank
making the equity investment; or
(3) In governmentally-aided economic development entities
comparable to SBICs where the investment primarily benefits low- or
moderate-income individuals or areas;
(f) The short-term tranche of SBIC securities guaranteed by the
Small Business Administration, which guarantee is backed by the full
faith and credit of the United States;
(g) Section 108 Interim Notes and Participation Certificates
guaranteed by the Department of Housing and Urban Development pursuant
to section 108 of the Housing and Community Development Act of 1974 (as
amended);
(h) Investments and obligations for housing and community
development issued or guaranteed under Title VI of the Native American
Housing Assistance and Self-Determination Act of 1996; and
(i) Certain assets acquired under the Financial Management Policy.
Assets acquired pursuant to:
(1) Section II.B.11 of the Financial Management Policy prior to the
effective date of this section; or
(2) Section II.B.12 of the Financial Management Policy, up to the
greater of:
(i) The amount authorized by resolution of the Finance Board; or
(ii) The amount acquired prior to the effective date of this
section.
Sec. 940.4 Core mission activities requirements.
(a) Core mission activities ratio. Subject to the transition period
set forth in paragraph (d) of this section, and pursuant to the Bank's
mission achievement policy required to be adopted under Sec. 917.9(a)
of this section, each Bank shall have and maintain total core mission
activities, as defined in Sec. 940.3, (i.e., an average book value of
core mission on-balance sheet assets and off-balance sheet items
converted to an on-balance sheet asset value equivalent as prescribed
in paragraph (c) of this section) equal to a minimum of 100 percent of
the average book value of the Bank's total outstanding consolidated
obligations. The Bank's core mission activities ratio shall be
calculated based on a moving 12-month average.
(b) Reporting requirement. Each Bank shall report to the Finance
Board as of the last day of each calendar quarter its actual core
mission activities ratio for the previous 12 months.
(c) On-balance sheet asset value equivalents for off-balance sheet
items. The on-balance sheet asset value equivalent for each core
mission off-balance sheet item is the measure of value of the item
multiplied by its percent conversion factor as provided in the
following Table 1:
Table 1.--Conversion Factors for Core Mission Off-Balance Sheet Items
------------------------------------------------------------------------
Core mission off-balance sheet Conversion factor (in
item Measure of value percent)
------------------------------------------------------------------------
(1) Standby Letters of Credit Face amount...... 100 minus that year's
(during transition period). core mission
activities
requirement (in
percent)
(2) Standby Letters of Credit Fee Charged to 100
(after transition period). Members.
(3) Intermediary Derivative Fee Charged to 100
Contracts. Members.
(4) Commitments to Make Contractual...... 100
Advances with Certain
Drawdown.
------------------------------------------------------------------------
(d) Transition provision. (1) Pursuant to paragraph (b)(1) of this
section, by January 1, 2001, each Bank shall have a minimum core
mission activities ratio of 80 percent.
(2) Thereafter, each Bank's required minimum core mission
activities ratio shall increase annually, on January 1 of each year, by
5 percentage points, up to a required minimum core mission activities
ratio of 100 percent.
Sec. 940.5 Transfers of core mission activities to another Bank.
A core mission activity of a Bank, if transferred to another Bank,
retains its status as a core mission activity with respect to the
transferee Bank.
Sec. 940.6 Safe harbor for anticipated noncompliance.
(a) Safe harbor requirements. If, after conducting the annual risk
management policy review and risk assessment required under Sec. 917.3
of this chapter and the annual mission achievement policy review
required under Sec. 917.9 of this chapter, a Bank's board of directors
determines that, for a certain time period, it will not be consistent
with continued safe and sound operation for the Bank to meet the core
mission activities requirements of Sec. 940.4(a), the Bank shall not be
deemed to be out of compliance with Sec. 940.4(a) for the time period
specified by the Bank's board of directors, provided that:
(1) The determination by the Bank's board of directors that
compliance will not be consistent with continued safe and sound
operation is based upon a finding that, if the Bank were to comply with
the core mission activities requirements during such time period, the
Bank:
(i) Would likely be unable to meet the liquidity requirement of
Sec. 930.10 of this chapter, or any other regulatory requirement
related to the safety and soundness of its financial operation; or
(ii) Would likely be unable to provide a return on equity
sufficient to retain members intending to make use of such Bank's
products and services;
(2) The Bank fully documents the process of review, consideration
and decision-making leading to such determination, including the
reasons for the establishment of a specific time period as the minimum
period of anticipated noncompliance; and
(3) The Bank's board of directors adopts a plan to achieve
compliance with the core mission activities requirement at the earliest
feasible and prudent date.
(b) Waivers. Under other circumstances, a Bank may request a waiver
of the requirements in this part 940, pursuant to part 907 of this
chapter (12 CFR part 907).
[[Page 52208]]
PART 950--ADVANCES
14. The authority citation for part 950 continues to read as
follows:
Authority: 12 U.S.C. 1422a(a)(3), 1422b(a)(1), 1426, 1429, 1430,
1430b and 1431.
15. Amend Sec. 950.1 by revising the definition of ``long-term
advance'' to read as follows:
Sec. 950.1 Definitions.
* * * * *
Long-term advance means an advance with an original term to
maturity greater than one year.
* * * * *
16. Remove Sec. 950.2.
17. Amend Sec. 950.15 by:
a. Removing paragraphs (b)(1) and (b)(2); and
b. Redesignating paragraphs (a)(1) and (a)(2) as paragraphs (a) and
(b), respectively.
18. New parts 954, 955 and 958 are added to subchapter G to read as
follows:
PART 954--MEMBER MORTGAGE ASSETS
Sec.
954.1 Definitions.
954.2 Authorization to hold member mortgage assets.
Authority: 12 U.S.C. 1422a(a)(3), 1422b(a), 1430, 1430b, 1431.
Sec. 954.1 Definitions.
As used in this section:
Eligible nonmember borrower has the meaning set forth in Sec. 940.1
of this chapter.
Residential real property has the meaning set forth in Sec. 950.1
of this chapter.
Sec. 954.2 Authorization to hold member mortgage assets.
Each Bank may hold assets or pools of assets acquired from or
through its members or eligible nonmember borrowers, by means of either
a purchase or a funding transaction involving the Bank and such member
or eligible nonmember borrower, that meet each of the following
requirements:
(a) The assets or pools of assets are either:
(1) Mortgages, or interests in mortgages, excluding one-to-four
family mortgages where the loan amounts exceed the limits established
pursuant to 12 U.S.C. 1717(b)(2);
(2) Loans, or interests in loans, secured by manufactured housing,
regardless of whether such housing qualifies as residential real
property; or
(3) State and local housing finance agency bonds; and
(b) The assets or pools of assets are either:
(1) Originated or issued by or through the member or eligible
nonmember borrower; or
(2) Held for a valid business purpose by the member or eligible
nonmember borrower prior to acquisition by the Bank; and
(c) The transactions through which the Bank acquires the assets or
pools of assets are structured such that:
(1) The member or eligible nonmember borrower bears the amount of
credit risk necessary to raise the assets or pools of assets to the
fourth highest credit rating category;
(2) To the extent that the Bank requires, either at the time of
acquisition or subsequently, that the assets or pools of assets have a
higher credit rating, the member or eligible nonmember borrower bears
at least 50 percent of any credit risk necessary to raise the assets or
pools of assets from the fourth highest credit rating category to such
higher credit rating category, up to the second highest credit rating
category;
(3) If the credit risk-sharing requirements of paragraphs (c)(1) or
(c)(2) of this section do not result in the member or eligible
nonmember borrower bearing a material portion of the credit risk, the
member or eligible nonmember borrower bears a material portion of the
credit risk, up to the second highest credit rating; and
(4) To the extent that the U.S. government has insured or
guaranteed the credit risk of the asset or pool of assets, the member
or eligible nonmember borrower may rely upon that insurance or
guarantee to meet all or part of the risk-bearing requirements of
paragraphs (c)(1) and (c)(2) of this section; however, to the extent
that the U. S. government insurance or guarantee is insufficient or
incomplete, the portion of the risk-bearing requirements not met by the
government insurance or guarantee must be borne by the member or
eligible nonmember borrower.
PART 955--FEDERAL HOME LOAN BANK INVESTMENTS
Sec.
955.1 Definitions.
955.2 Authorized investments.
955.3 Prohibited investments and prudential rules.
955.4 Use of hedging instruments.
Authority: 12 U.S.C. 1422a(a)(3), 1422b(a), 1431, 1436.
Sec. 955.1 Definitions.
As used in this part:
Deposits in banks or trust companies has the meaning set forth in
Sec. 965.1 of this chapter.
Financial Management Policy has the meaning set forth in Sec. 930.1
of this chapter.
GAAP means Generally Accepted Accounting Principles.
Investment grade has the meaning set forth in Sec. 930.1 of this
chapter.
Member mortgage assets means those mortgage-related assets that may
be acquired by a Bank under part 954 of this chapter.
Sec. 955.2 Authorized investments.
Except as provided in Sec. 955.3, and subject to the applicable
limitations set forth in this part and in part 954, each Bank may
invest in:
(a) Obligations of the United States;
(b) Deposits in banks or trust companies;
(c) Obligations, participations or other instruments of, or issued
by, the Federal National Mortgage Association or the Government
National Mortgage Association;
(d) Mortgages, obligations, or other securities that are, or ever
have been, sold by the Federal Home Loan Mortgage Corporation pursuant
to 12 U.S.C. 1454 or 1455;
(e) Stock, obligations, or other securities of any small business
investment company formed pursuant to 15 U.S.C. 681(d), to the extent
such investment is made for purposes of aiding members of such Bank;
and
(f) Instruments that the Bank has determined are permissible
investments for fiduciary or trust funds under the laws of the state in
which the Bank is located.
Sec. 955.3 Prohibited investments and prudential rules.
(a) Prohibited investments. A Bank may not invest in:
(1) Instruments that provide an ownership interest in an entity and
that do not qualify as a core mission activity under Sec. 940.3 of this
chapter;
(2) Instruments issued by non-United States entities, except United
States branches and agency offices of foreign commercial banks;
(3) Debt instruments that are not rated as investment grade, except
for debt instruments that were downgraded to a below investment grade
rating after purchase by the Bank; or
(4) Whole mortgages or other whole loans, or interests in mortgages
or loans, except:
(i) Member mortgage assets;
(ii) Mortgage-backed securities that meet the definition of the
term ``securities'' under 15 U.S.C. 77b(a)(1); and
(iii) Loans held or acquired pursuant to section 12(b) of the Act
(12 U.S.C. 1432(b)).
[[Page 52209]]
(b) Foreign currency or commodity positions prohibited. A Bank may
not take a position in any commodity or foreign currency. If a Bank
participates in consolidated obligations denominated in a currency
other than U.S. Dollars or linked to equity or commodity prices, the
currency, commodity and equity risks must be hedged.
(c) Transition provision. A Bank may not make any investments that
were not permitted under the Finance Board's Financial Management
Policy in effect prior to the effective date as to such Bank of this
part 955 until:
(1) The Bank has received Finance Board approval of the Bank's
initial internal market risk model;
(2) The Bank demonstrates to the Finance Board that it has
sufficient risk-based capital to meet the minimum total risk-based
capital requirement under Sec. 930.4(b) of this chapter for its then-
current portfolio; and
(3) The Bank demonstrates to the Finance Board adequate credit risk
assessment and procedures and controls sufficient to show control over
credit, market and operations risks.
Sec. 955.4 Use of hedging instruments.
(a) Speculative use prohibited. A Bank shall not make speculative
use of hedging instruments.
(b) Applicability of GAAP. All transactions entered into by a Bank
for hedging purposes shall meet the requirements for a hedge under
GAAP.
(c) Documentation requirements. (1) A Bank's hedging strategies
must be explicitly stated at the time of execution of the hedge, and
adequate documentation of the hedge must be maintained during the life
of the hedge.
(2) Transactions with a single counterparty shall be governed by a
single master agreement when practicable.
(3) A Bank's agreement with the counterparty for over-the-counter
derivative contracts shall include:
(i) A requirement that market value determinations and subsequent
adjustments of collateral be made at least on a monthly basis;
(ii) A statement that failure of a counterparty to meet a
collateral call will result in an early termination event;
(iii) A description of early termination pricing and methodology,
with the methodology reflecting a reasonable estimate of the market
value of the over-the-counter derivative contract at termination
(Standard International Swaps and Derivatives Association, Inc.
language relative to early termination pricing and methodology may be
used to satisfy this requirement); and
(iv) A requirement that the Bank's consent be obtained prior to the
transfer of an agreement or contract by a counterparty.
PART 958--OFF-BALANCE SHEET ITEMS
Sec.
958.1 Definitions.
958.2 Authorized off-balance sheet items.
Authority: 12 U.S.C. 1422a(a)(3), 1422b(a), 1429, 1430, 1430b,
1431.
Sec. 958.1 Definitions.
As used in this part:
Derivative contracts has the meaning set forth in Sec. 930.1 of
this chapter.
Repurchase agreement has the meaning set forth in Sec. 930.1 of
this chapter.
Sec. 958.2 Authorized off-balance sheet items.
(a) Authorization. A Bank may enter into the following types of
off-balance sheet transactions:
(1) Standby letters of credit, pursuant to the requirements of 12
CFR part 959;
(2) Derivative contracts;
(3) Forward asset purchases and sales; and
(4) Commitments to make advances or other loans.
(b) Speculative use prohibited. A Bank shall not make speculative
use of derivative contracts.
19. New part 965 is added to subchapter H to read as follows:
PART 965--SOURCES OF FUNDS
Sec.
965.1 Definitions.
965.2 Authorized liabilities.
965.3 Liquidity reserves for deposits.
Authority: 12 U.S.C. 1422a(a)(3), 1422b(a), 1431.
Sec. 965.1 Definitions.
As used in this part:
Deposits in banks or trust companies means:
(1) A deposit in another Bank;
(2) A demand account in a Federal Reserve Bank;
(3) A deposit in, or a sale of federal funds to:
(i) An insured depository institution, as defined in section
2(12)(A) of the Act (12 U.S.C. 1422(12)(A)), that is designated by a
Bank's board of directors;
(ii) A trust company that is a member of the Federal Reserve System
or insured by the Federal Deposit Insurance Corporation, and is
designated by a Bank's board of directors; or
(iii) A U.S. branch or agency of a foreign bank, as defined in the
International Banking Act of 1978, as amended (12 U.S.C. 3101 et seq.),
that is subject to the supervision of the Board of Governors of the
Federal Reserve System, and is designated by a Bank's board of
directors.
Repurchase agreement has the meaning set forth in Sec. 930.1 of
this chapter.
Sec. 965.2 Authorized liabilities.
(a) As a source of funds for business operations, each Bank is
authorized to incur liabilities by:
(1) Acting as joint and several obligor with other Banks on
consolidated obligations, as authorized under part 966 of this chapter;
(2) Accepting time or demand deposits from members, other Banks and
instrumentalities of the United States, so long as the deposit
transaction is not conducted in such a way as to result in the offer or
sale of a security in a public offering as those terms are used in 15
U.S.C. 77b(3); or
(3) Solely in order to satisfy the Bank's short-term liquidity
needs:
(i) Purchasing federal funds; and
(ii) Entering into repurchase agreements.
(b) Consolidated obligations shall not be directly placed with any
Bank.
Sec. 965.3 Liquidity reserves for deposits.
Each Bank shall at all times have at least an amount equal to the
current deposits received from its members invested in:
(a) Obligations of the United States;
(b) Deposits in banks or trust companies; or
(c) Advances with a maturity of not to exceed five years that are
made to members in conformity with part 950 of this chapter.
PART 966--CONSOLIDATED OBLIGATIONS
20. The authority citation for part 966 continues to read as
follows:
Authority: 12 U.S.C. 1422b, 1431.
21. Amend Sec. 966.2 by:
a. Removing paragraph (b);
b. Redesignating paragraph (c) as paragraph (b); and
c. Revising the reference to ``paragraphs (c)(1) through (6)'' in
the last sentence of Sec. 966.2 to read ``paragraphs (b)(1) through
(6).''
22. Amend Sec. 966.7 by revising paragraph (b) to read as follows:
Sec. 966.7 Reservation of right to revoke or amend; limitations
thereon.
* * * * *
(b) Limitation on amendment of negative pledge requirement. No
[[Page 52210]]
revocation or relaxation of any of the restrictions or requirements
contained in or imposed by Sec. 966.2(b) shall be effected except if
there are no senior bonds then outstanding or the principal of and
interest to date of maturity or to such date designated for redemption
and any redemption premium on all senior bonds the holders of which
have not consented to such revocation or relaxation has been fully
defeased.
23. New part 980 is added to subchapter J to read as follows:
PART 980--NEW BUSINESS ACTIVITIES
Sec.
980.1 Definitions.
980.2 Prior notice to Finance Board.
Authority: 12 U.S.C. 1422a(a)(3), 1422b(a), 1431(a), 1432(a).
Sec. 980.1 Definitions.
As used in this part:
New business activity means, with respect to a particular Bank's
activities:
(1) An activity that was not previously undertaken by that Bank, or
was undertaken under materially different terms and conditions;
(2) An activity that entails risks not previously and regularly
managed by that Bank or its members; or
(3) An activity that introduces operations not substantially
equivalent to operations currently managed by that Bank.
Sec. 980.2 Prior notice to Finance Board.
A Bank may undertake a new business activity after providing 30
days notice of such new business activity to the Finance Board, unless
otherwise directed by the Finance Board.
Dated: September 1, 1999.
By the Board of Directors of the Federal Housing Finance Board.
Bruce A. Morrison,
Chairman.
[FR Doc. 99-23416 Filed 9-24-99; 8:45 am]
BILLING CODE 6725-01-P
