Capital Requirements for Federal Home Loan Banks

FEDERAL HOUSING FINANCE BOARD

12 CFR Parts 917, 925, 930, 931, 932, 933, 956, and 960

[No. 2000-23]

RIN 3069-AB01

Capital Requirements for Federal Home Loan Banks

AGENCY:

Federal Housing Finance Board.

ACTION:

Proposed rule.

SUMMARY:

The Federal Housing Finance Board (Finance Board) proposes to amend its regulations to implement a new capital structure for the Federal Home Loan Banks (Banks), as is required by the Gramm-Leach-Bliley Act. The proposed rule would establish risk-based, leverage, and operations capital requirements for the Banks. It also addresses the different classes of stock that a Bank may issue, the rights and preferences that may be associated with each class of stock, and the capital plans that each Bank must submit for Finance Board approval.

DATES:

The Finance Board will accept written comments on the proposed rule that are received on or before October 11, 2000.

ADDRESSES:

Send comments to: Elaine L. Baker, Secretary to the Board, at the Federal Housing Finance Board, 1777 F Street, N.W., Washington, D.C. 20006. Comments will be available for 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; Ellen Hancock, Senior Financial Analyst, (202) 408-2906; or Christina Muradian, Senior Financial Analyst, (202) 408-2584; or Julie Paller, Senior Financial Analyst, (202) 408-2842, Office of Policy, Research and Analysis; or Deborah F. Silberman, General Counsel, (202) 408-2570; Neil R. Crowley, Deputy General Counsel, (202) 408-2990; or Thomas E. Joseph, Attorney-Advisor, (202) 408-2512, Office of General Counsel, Federal Housing Finance Board, 1777 F Street, N.W., Washington, D.C. 20006.

SUPPLEMENTARY INFORMATION:

I. Statutory and Regulatory Background

A. The Bank System

The twelve Banks are instrumentalities of the United States organized under the authority of the Federal Home Loan Bank Act (Bank Act). 12 U.S.C. 1423, 1432(a),

as amended.

The Banks are a “government sponsored enterprise” (GSE),

i.e.

, a federally chartered but privately owned institution created by Congress to serve a public purpose. The purpose of the Bank System is to support the financing of housing and community lending.

See

12 U.S.C. 1422a(a)(3)(B)(ii), 1430(i), (j)(10) (1994). As with other GSEs, Congress has granted the Banks certain benefits, including an exemption from registration of their securities under federal securities laws, an exemption from state and local corporate taxation, and an ability to sell debt obligations (at the discretion of the Secretary of the Treasury) to the United States Treasury, that enable them to borrow in the capital markets on favorable terms. Typically, the Banks are able to borrow at a spread that is over the rates on U.S. Treasury securities of comparable maturity but which is less than the rates available to comparably situated private corporate borrowers. The Banks pass along that funding advantage to their members—and ultimately to consumers—by providing advances (secured loans) and other financial services at rates that their members generally could not obtain on their own.

The Banks also are cooperatives, meaning that only their members may own the capital stock and share in the profits of the Banks and only their members, and certain eligible associates (such as state housing finance agencies), may borrow from or use the other products and services provided by the Banks. 12 U.S.C. 1426, 1430(a), 1430b,

as amended.

Each Bank is managed by a board of directors, a majority of whom are elected by its members and the remainder of whom are appointed by the Finance Board. 12 U.S.C. 1427,

as amended.

An institution that is eligible (typically, an insured depository institution) may become a member of a Bank if it satisfies certain statutory criteria and purchases a specified amount of the Bank's capital stock. 12 U.S.C. 1424, 1426 (1994). 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 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) (1994).

B. Federal Home Loan Capital Structure

Since its enactment in 1932, the Bank Act has provided for a “subscription” structure for the capital of the Banks. Under that structure, the amount of capital stock each Bank issued was determined as a percentage of either the total mortgage assets of each member of the Bank or the dollar amount of advances outstanding to each member, whichever was greater. The subscription capital structure was deficient in certain respects, most notably in that the amount of capital each Bank was required to hold bore no relationship to the risks posed by its activities. Moreover, the subscription capital structure caused the Banks to become substantially overcapitalized in relation to the risks they face. The amount of excess capital contributed to an increase in the amount of arbitrage investments made by the Banks,

i.e.

, investments in assets such as money market instruments or mortgage-backed securities that do not advance the housing finance and community lending mission of the Banks. The substantial amount of the non-mission investments held by the Banks collectively, though diminishing in recent years as a percentage of their assets, has been the subject of much criticism from the Administration and the Congress, and was one issue that the Congress intended to address by reforming the capital structure and other aspects of the Bank System. The Congress recognized that if it were to eliminate mandatory membership for federal savings associations, and thus remove the only permanent capital from the Bank System, it also would have to create a new capital structure that would include capital elements with more permanence than one based solely on 6-month redeemable stock.

C. The Gramm-Leach-Bliley Act

On November 12, 1999, the President signed the Gramm-Leach-Bliley Act, Pub. Law No. 106-102, 133 Stat. 1338 (Nov. 12, 1999) (GLB Act), which, among other things, substantially amended the provisions of the Bank Act that relate to the capital structure of the Banks. 12 U.S.C. 1426,

as amended.

As a result of those amendments, the existing subscription capital structure will be replaced over a period of several years by a more modern capital structure, with risk-based and leverage capital requirements that are similar to those applicable to depository institutions and to the other housing GSEs. The GLB Act provides for a transition period to the new capital structure of up to approximately five

years from the date of enactment, during which time the prior capital provisions are to remain in effect. The GLB Act requires the Finance Board to promulgate uniform capital regulations for the Banks no later than November 12, 2000. Under the new structure, each Bank will be required to maintain amounts of total capital and permanent capital that are sufficient to comply with the minimum leverage and risk-based capital requirements, respectively, established by the GLB Act.

The GLB Act requires each Bank to maintain a ratio of total capital to total assets of at least 4 percent. Total capital is defined to include a Bank's permanent capital (defined below), plus the amounts paid-in by members for Class A stock (which is redeemable on 6 months written notice), any general loss allowance (if consistent with generally accepted accounting principles (GAAP) and not established for specific assets), and other amounts from sources determined by the Finance Board as available to absorb losses. Permanent capital is defined as the amounts paid-in by members for the Class B stock (which is redeemable on 5 years written notice), plus the amount of a Bank's retained earnings, as determined in accordance with GAAP. In addition to requiring total capital of 4 percent, the GLB Act requires the Banks to maintain a leverage ratio of 5 percent. In calculating the leverage ratio, the amount paid-in for Class B stock and the amount of retained earnings are multiplied by 1.5, while other capital items are counted at face value. The risk-based capital provision requires each Bank to maintain permanent capital in an amount sufficient to meet the credit and market risks to which the Bank is subject, with the market risk being based on a stress test established by the Finance Board that tests for changes in certain specified market variables.

The GLB Act further requires the capital regulations to address a number of other matters, such as the classes of stock that a Bank may issue, the rights, terms, and preferences that may be established for each class, the issuance, transfer, and redemption of Bank stock, and the liquidation of claims against a withdrawing member. The rules must permit each Bank to issue Class A or Class B stock, or both, with the board of directors of each Bank to determine the rights, terms, and preferences for each class. Both Class A and Class B stock may be issued only to and held only by members of the Bank, and the regulations are to provide the manner in which the stock may be sold, transferred, redeemed, or repurchased. The rules also must address the manner in which a Bank is to liquidate any claims against its members.

The GLB Act separately establishes a number of other capital-related requirements, which pertain to matters such as the termination of an institution's Bank membership, the ability of a Bank to redeem excess stock held by a member (

i.e.

, stock that is in excess of the amount each member is required to hold), restrictions on the ability of a Bank to redeem stock when its capital is impaired, restrictions on readmission to membership after withdrawing, and the ownership of the retained earnings by the Class B stockholders.

Within 270 days after the publication of the final capital rule, the board of directors of each Bank must submit for Finance Board approval a capital plan that the board determines is best-suited for the Bank and its members. Any amendments to the plan also must be approved in advance by the Finance Board. The law does not specify a period of time within which the Finance Board must approve the plans, which allows for the possibility that a Bank may be required to revise its plan before obtaining Finance Board approval. The GLB Act requires the plan to include certain provisions, requires that it be consistent with the regulations adopted by the Finance Board, and that when implemented it must provide the Bank with sufficient capital to meet both the leverage and risk-based capital requirements. Each plan also must include certain provisions specified by the GLB Act. Those provisions relate to the minimum investment required of each member in order for the Bank to meet its regulatory capital requirements, the effective date of the plan and the length of its transition period (which may be up to 3 years from the effective date of the plan), the classes of stock to be offered by the Bank and the rights, terms, and preferences associated with each class, the transferability of the Bank stock, the disposition of Bank stock held by institutions that withdraw from membership, and review of the plan by an independent accountant and a credit ratings agency. Those provisions are only the minimum contents required by the GLB Act; the Finance Board may require that other provisions be included in each plan, and the Banks as well may include other provisions in their plans, provided they are consistent with the Bank Act and the regulations of the Finance Board.

D. Federal Home Loan Bank Stock

Section 6 of the Bank Act, as in effect prior to the GLB Act, authorized the Banks to issue stock, specified the characteristics of the stock, and addressed the manner in which the stock may be issued, transferred, and redeemed. 12 U.S.C. 1426 (1994). Since the establishment of the Bank System in 1932, each of the Banks has been authorized to issue a single class of stock, which could be issued and redeemed only at its statutory par value of $100 per share. An institution becoming a Bank member was required to subscribe for a certain minimum amount of the Bank's stock, for which it was required to pay in full and in cash at the time of its application.

1

1

A member also was allowed to purchase the stock in installments, under which it would pay one-quarter of the full amount at the time of application, and the remainder in three installments over the following 12 months. 12 U.S.C. 1426(c) (1994).

The amount of the initial stock subscription required for membership was the greater of $500, 1.0 percent of the member's mortgage assets, or 0.3 percent of the member's total assets.

2

12 U.S.C. 1426(b), 1430(e) (1994). If a member were to borrow from its Bank, the amount of Bank stock it was required to own could not be less than 5.0 percent of the amount of Bank advances outstanding to the member. Each Bank was required to adjust the minimum stock investment required of each member, as of December 31st of each year, so that each member would own at least the required minimum amount of Bank stock, based on a percentage of either its assets or advances, whichever amount was higher. Each Bank had the discretion to retire any “excess” stock held by a member,

i.e.

, stock in excess of the

minimum required for that member, upon the application of the member.

2

The Bank Act referred to a member's “aggregate unpaid loan principal”, which the Finance Board has defined to include a variety of mortgage assets, such as home mortgage loans, combination loans, and mortgage pass-through securities. 12 U.S.C. 1426(b)(1) (1994); 65 Fed. Reg. 8253 (Feb. 18, 2000), to be codified at 12 CFR 925.1. For purposes of applying the 1.0 percent of mortgage assets test, the Bank Act also established a statutory presumption that each member had at least 30 percent of its assets in mortgage related instruments. 12 U.S.C. 1430(e)(3) (1994). The effect of the presumption was that commercial banks (which typically have a lower percentage of their assets in mortgage related instruments than do savings associations) were required to maintain a minimum investment equal to the greater of 1.0 percent of mortgage assets, 0.3 percent of total assets, or 5.0 percent of outstanding advances. Separately, a member that was not a “qualified thrift lender” (QTL),

i.e.

, an institution with less than 65 percent of its assets in certain mortgage related instruments, was subject to a higher “percentage of advances” requirement, which would vary inversely with its QTL ratio.

Once issued, the stock of a Bank could be transferred only between the member and the Bank or, with the approval of the Finance Board, from one member to another member or to an institution in the process of becoming a member. The Bank Act also required that all stock issued by a Bank share in dividends equally and without preference. The Bank Act also allowed any member, other than a federal savings and loan association, to withdraw from membership by providing six months written notice to the Finance Board. At the end of the six-month notice period, and provided that all indebtedness owed by the withdrawing member to the Bank had been liquidated, a Bank could redeem the stock of the withdrawing member, paying cash to the member equal to the par value of the stock. Any such withdrawing member could not rejoin the Bank system for 10 years, with only limited exceptions.

The Bank stock currently outstanding carries only limited voting rights. The members of each Bank have the right to elect a majority of its directors, typically eight of fourteen directorships, but do not vote on any other matters. The number of votes each member may cast in an election of directors is tied to the amount of Bank stock it is “required to hold” under the subscription capital provisions. Section 7 of the Bank Act provides that the number of votes each member may cast is equal to the number of shares of Bank stock “required [by Section 6 of the Bank Act] to be held by [each] member at the end of the calendar year next preceding the election” of directors. 12 U.S.C. 1427(b) (1994). As noted above, at the end of each year each member was required to hold Bank stock equal to the greater of $500, 1.0 percent of its mortgage assets, 0.3 percent of its total assets, or 5.0 percent of its outstanding advances. For voting purposes, however, Section 7 limits the number of votes that any member may cast at the average number of shares of Bank stock “required to be held” by the members located in the same state at the end of the prior calendar year. Thus, for any members that hold stock in excess of the average for their state, those excess shares are divested of their voting rights.

3

As amended by the GLB Act, all of Section 6 of the Bank Act has been revised and no longer requires a member to hold a particular amount of Bank stock as of the end of the calendar year. Similarly, the Bank Act no longer establishes a required investment for each member. Instead, Section 6 of the Bank Act now authorizes each Bank to determine the amount and nature of any investment each member must maintain in the capital stock of the Bank, and requires each Bank to address the voting rights for each class of stock in its capital structure plan, subject to the approval of the Finance Board.

3

The Bank Act provides generally that each Bank is to have a board of fourteen directors, eight of whom are elected by the members and six of whom are appointed by the Finance Board. 12 U.S.C. 1427(a) (1994). The elected directorships for each Bank are allocated among the states in each Bank district, based on the amount of stock held by members in the respective states, subject to certain “grandfather” provisions that reserve a specified number of directorships to particular states (based on relative stock ownership in 1960) and certain discretionary authority conferred on the Finance Board to establish a limited number of additional seats in certain Bank districts.

E. The Financial Management and Mission Achievement Proposal

In 1999 the Finance Board proposed to adopt a risk-based capital requirement as part of its “Financial Management and Mission Achievement” (FMMA) rulemaking. 64 FR 52163 (Sept. 27, 1999). The capital provisions of the FMMA would have established a “minimum total capital requirement” and a “minimum total risk-based capital requirement” for each Bank. Under the total risk-based capital requirement a Bank would have been required to maintain “total risk-based capital” in an amount sufficient to meet the sum of its credit risk, market risk, and operations risk capital requirements, each of which would have been established by the proposed rule. The credit risk aspect of the FMMA would have addressed the credit risks to which each Bank is exposed with respect to both its on- and off-balance sheet items, using data from Nationally Recognized Statistical Rating Organizations (NRSRO) to estimate the credit losses likely to be associated with particular classes of items during periods of extreme credit stress. The FMMA would have established the market risk capital requirement based on the market value of a Bank's portfolio at risk from movements in market prices, such as interest rates, foreign exchange rates, commodity prices, or equities prices, that might occur during periods of extreme market stress. The proposal would have allowed for the use of a Bank's internal market risk model, which was to have been approved by the Finance Board. The FMMA would have required each Bank to maintain capital in an amount equal to 30 percent of the sum of its credit risk capital and market risk capital requirements in order to support the operations risks to which the Bank is exposed. The FMMA also would have required the Banks to maintain both a System-wide and individual Bank credit ratings, at levels specified by the proposed rule, and would have required each Bank to maintain “contingency liquidity” in an amount sufficient to enable the Bank to meet its obligations if it were unable to borrow in the capital markets for seven consecutive days. The proposal included provisions limiting the amount of unsecured credit that a Bank could have outstanding to any single counterparty (or to affiliated counterparties) and would have addressed the extent to which the Banks may use hedging instruments. The Finance Board withdrew the FMMA proposal following the enactment of the GLB Act. Board Resolution No. 99-56 (Nov. 15, 1999); 64 FR 66115 (Nov. 24, 1999).

With the enactment of the GLB Act, certain aspects of the proposed FMMA capital rule, such as those pertaining to the types of capital required for the leverage and risk-based capital requirements, no longer would be consistent with Section 6 of the Bank Act, as amended. Other aspects of the capital rules proposed as a part of FMMA, however, remain generally consistent with the amended statute, particularly as it relates to the capital required to be held against credit risk and market risk. The GLB Act requires the Finance Board to adopt a risk-based capital regulation that requires the Banks to maintain sufficient permanent capital to meet the credit risks to which they are subject, but does not otherwise provide how the credit risk is to be measured. Similarly, the GLB Act provides that the market risk element of the risk-based capital requirement must be based on a stress test developed by the Finance Board that “rigorously tests for changes in market variables, including changes in interest rates, rate volatility, and changes in the shape of the yield curve.” The GLB Act does not further specify the provisions of the stress test, other than to require that the Finance Board give “due consideration” to any risk-based capital rules promulgated by the Office of Federal Housing Enterprises Oversight (OFHEO) with respect to Fannie Mae and Freddie Mac. Moreover, the GLB Act does not preclude the Finance Board from incorporating other elements into the risk-based capital rules, such as a requirement to hold some amount of capital to cover the operations risks to which the Banks are subject. In considering the requirements of the GLB

Act for the credit and market risk elements of the capital rules, the Finance Board has determined that in many respects the underlying methodology of the credit and market risk provisions of the capital rules that were proposed as part of the FMMA are consistent with the requirements of the GLB Act. Accordingly, the proposed rule builds on those provisions, as well as on the provisions of the FMMA relating to operating risk.

II. The Proposed Rule

A. Issuance of Bank Stock.

In General.

The GLB Act provides that the capital regulations are to permit each Bank to issue “any one or more” of Class A or Class B stock. Class A stock is to be redeemable at par on six months written notice to the Bank; Class B stock is to be redeemable at par on five years written notice to the Bank. The board of directors of each Bank is to determine the “rights, terms, and preferences” for each class of stock, consistent with Section 6 of the Bank Act, with the regulations of the Finance Board, and with market requirements. The regulations are required to prescribe the manner in which Bank stock may be “sold, transferred, redeemed, or repurchased.” The regulations also are required to restrict the issuance and ownership of Bank stock to the members of the Bank, to prohibit the issuance of other classes of stock, and to provide for the liquidation of claims and the redemption of stock upon an institution's withdrawal from membership in its Bank.

Apart from authorizing the issuance of two classes of Bank stock, the GLB Act eliminated certain key characteristics of the single class of Bank stock that had been established under prior law. For example, the Bank Act no longer mandates a statutory par value for all Bank stock of $100 per share and no longer requires all Bank stock to be issued at par value.

4

As a result, the Bank Act now authorizes a Bank to establish the par value for its Class A and Class B stock (which may differ), and permits the issuance of stock at a price other than par value. The proposed rule includes provisions that implement those changes in the law, as described below.

4

12 U.S.C. 1426(a) (1994). The minimum amount of Bank stock that each member was required to purchase had to be issued at par value. Any subsequent issuance could be at a price in excess of par value, but not less than par value. As a matter of practice, the stock of the Banks has been issued at par value.

Classes of Stock.

In authorizing the new capital structure for the Banks, the GLB Act provides that the regulations promulgated by the Finance Board “shall * * * permit each Federal home loan bank to issue * * * any 1 or more of * * * Class A stock * * * and * * * Class B stock.” 12 U.S.C. 1426(a)(4)(A),

as amended

. The GLB Act also provides that the capital structure plan for each Bank “shall afford each member * * * the option of maintaining its required investment in the bank through the purchase of any combination of classes of stock authorized by the board of directors of the bank and approved by the Finance Board.”

Id.

, 1426(c)(4)(A),

as amended

. Although the GLB Act gives the members the option to decide how to allocate their required investment if a Bank issues both Class A and Class B stock, that option applies only to whatever “classes of stock [are] authorized by the board of directors of the bank” and must be read in light of the other provisions that permit each Bank to issue “any 1 or more” classes of stock. The directive that the regulations must allow a Bank to issue “any 1 or more” class of stock clearly contemplates that a Bank may issue only a single class of stock. Provided that a Bank's board of directors were to determine that a single class structure would be in the best interest of the Bank and its members, such a stock structure would be legally permissible. Accordingly, the proposed rule would permit each Bank to issue either Class A stock or Class B stock, or to issue both Class A and Class B stock. Whatever classes the board of directors of a Bank authorizes, the capital plan must demonstrate that the classes of stock to be issued will result in the Bank having sufficient amounts of permanent capital (

i.e.

, the amounts paid-in for the Class B stock, plus retained earnings) to meet the regulatory risk-based capital requirement and sufficient amounts of total capital (

i.e.

, permanent capital plus the amounts paid-in for Class A stock, certain loss allowances, and other items capable of absorbing losses) to meet the regulatory total capital requirement. For example, if a Bank were to increase its retained earnings to an amount that would provide sufficient permanent capital to comply with the regulatory risk-based capital requirement it may not need to issue any Class B stock. Alternatively, if a Bank were to have only a minimal amount of retained earnings it may need to issue only Class B stock in order to have sufficient permanent capital to meet the regulatory risk-based capital requirement.

The proposed rule would define the essential characteristics of both Class A and Class B stock. As required by the GLB Act, Class A stock would be redeemable in cash at its par value on six-months written notice to the Bank. The Finance Board is proposing to require that the Class A stock have a par value of $100 per share and that it be issued at par value. Because the current capital stock of the Banks has a par value of $100 per share and is issued and redeemed at par, the Finance Board believes that establishing the same characteristics for the Class A stock would facilitate the transition to the new capital structure. The proposed rule also would require each Bank to specify in its capital plan a stated dividend for the Class A stock, which would have a priority over the payment of any dividends paid on Class B stock. The Finance Board anticipates that the stated dividend would be commensurate with the risks of holding an instrument that is putable to the issuer on six months notice. By definition, the Class B stock entails a greater risk to the member because its investment is committed to the Bank for at least five years. The Finance Board believes (and has been so advised by a financial consultant retained by the Banks) that members will demand some form of control over the affairs of the Bank in return for putting their capital at risk for five years. In that event, the members holding Class B stock likely would control the board of directors of the Bank, and thus would be in a position to determine the dividend to be paid on the Class A stock. The Finance Board has included the requirement that the Class A stock pay a stated dividend as a means of ensuring that the Class B stockholders would not be able to reduce or eliminate the dividend for the Class A stock, should they control the board of directors.

Certain of the essential characteristics of Class B stock would differ from those established for the Class A stock. As with the Class A stock (and as required by the GLB Act) the proposed rule would provide that the Class B stock must be redeemable in cash and at par value on five-years written notice to the Bank. The Class B stock would differ from the Class A stock with regard to its par value and its issuance price, which could be different from its par value. Allowing the Banks to set an issuance price above the par value of the Class B stock should result in a greater degree of permanence for the Class B stock that would be more in the nature of common stock. The proposed rule would not require a Bank to issue the Class B stock above par value, but simply would allow a Bank that option. A Bank could issue Class B at par if it wished to do so. The proposed rule also would

provide that a fundamental characteristic of the Class B stock is that it would confer on the member an ownership interest in the retained earnings of the Bank upon acquisition of the stock. The GLB Act provides that the holders of the Class B stock shall own the retained earnings of each Bank, which is consistent with the attributes of permanent equity capital in a corporate setting.

Subclasses of Stock.

The GLB Act requires the capital regulations to provide that a Bank may not issue stock other than as authorized by Section 6 of the Bank Act, and that the stock is to have “such rights, terms, and preferences * * * as the board of directors of that Bank may approve.” Separately, the GLB Act requires the capital plan for each Bank to establish the “terms, rights, and preferences, including minimum investment, dividends, voting, and liquidation preferences for each class of stock issued by the bank.” 12 U.S.C. 1426(a)(4)(A), (c)(4)(B),

as amended.

The Finance Board construes this language as authorizing a Bank to establish rights, terms, and preferences for Class A stock that differ from those established for the Class B stock. The Finance Board also believes that the authority to establish different rights, terms, or preferences for the stock should apply within a particular class of stock as well as between the two different classes. For example, the repeal of the requirement that all stock must be issued at par would allow a Bank to issue two types of Class B stock—one type that was issued at par and another that was issued above par. Although both types of stock would possess the minimum characteristics required for Class B stock,

i.e.,

they would be redeemable on five years written notice to the Bank, they would have been issued on materially different terms. The same rationale would apply if a Bank were to issue one type of Class B stock for which the dividend is to be determined based on the performance of a specific category of Bank assets and other Class B stock for which the dividend would be determined on the general profitability of the Bank. Because the board of directors of a Bank clearly has the authority to establish different rights, terms, and preferences for the Bank stock, the Finance Board believes it would be appropriate to allow a Bank to designate stock of the same class that possesses different rights as separate subclasses of that class.

Issuance of Capital Stock.

The proposed rule would allow each Bank to determine whether to issue either Class A or Class B stock, or both Class A and Class B stock, and whether to issue any subclasses of stock. In accordance with the GLB Act, the proposed rule also would provide that a Bank may issue its capital stock only to its members, and may not issue any other types or classes of capital stock. The proposal would require a Bank to act as its own transfer agent, and to issue its capital stock only in book-entry form, which is consistent with the current practice at each of the Banks, and is intended to ensure that the stock is held only by members. The Finance Board is not aware of any business necessity that would require the Banks to issue stock certificates, especially given the limited universe of potential stockholders, and believes that certificates would only increase the possibility that third parties might acquire the stock. The Finance Board requests comments on whether there are any sound reasons why the Banks should be permitted to issue stock certificates to their members, and if so what safeguards would be appropriate.

In order to allow each Bank to determine the method of distribution that is best suited to its business requirements and to the needs of its members, the Finance Board is not proposing to prescribe the manner in which the Banks must conduct the initial issuance of the Class A and Class B stock. Instead, the proposed rule would require each Bank to determine the manner in which to issue its stock, and would require only that the method of distribution be fair and equitable to all eligible purchasers. The proposal would expressly allow the Banks to conduct the initial issuance through an exchange or conversion, but would not mandate either approach. Whatever method a Bank adopts for the initial stock issuance must be included in the Bank's capital plan, as set forth in § 933.2. Additionally, because a fundamental characteristic of Class B stock is that it confers on the member an ownership interest in the retained earnings of the Bank, the Finance Board is proposing to allow a Bank to distribute its then-existing unrestricted retained earnings as shares of Class B capital stock.

The Finance Board is further proposing to establish concentration limits that would preclude any one member, or group of affiliated members, from controlling the Bank. Thus, the proposed rule would provide that a Bank shall not issue stock to a member or group of affiliated members if it were to result in such member or group of affiliated members owning more than 40 percent of any class or subclass of its outstanding capital stock. Other provisions of the rule would bar a Bank from approving a transfer of stock that would result in a member or group of affiliated members owning more than 40 percent of any class or subclass of its stock. The proposed rule also would allow a Bank to include in its capital plan an ownership cap lower than 40 percent.

The investment by one Bank in the assets of another Bank, such as Acquired Member Assets, has been increasing in recent years. As these “joint assets” increase, capital issues under the new structure will exist. One such issue would be whether two or more Banks jointly managing assets through a participation agreement could jointly issue stock. Another issue would be whether two or more Banks jointly managing assets could pool their capital stock in order to meet the regulatory capital requirements. The Finance Board specifically requests comments on whether the Banks should be allowed to issue stock jointly or to pool stock to meet regulatory capital requirements for assets that are being jointly managed by two or more Banks.

B.

Voting rights.

Section 7 of the Bank Act addresses, among other things, the manner in which the members of each Bank elect directors and the manner in which the Finance Board allocates directorships among the states in each Bank district. The GLB Act did not expressly amend Section 7 as it relates to those issues, but it did include certain amendments to Section 6 that conflict with those provisions of Section 7. In the proposed rule, the Finance Board has attempted to strike a balance between the conflicting provisions of Sections 6 and 7, respectively, by giving full effect to the more recent amendments to Section 6, while preserving as much as possible the provisions of Section 7. The approach taken in the proposed rule represents one means of reconciling the competing provisions of Section 6 and Section 7. The Finance Board recognizes that there may be other approaches to balancing the requirements of these provisions and specifically requests public comment on how else the provisions might be harmonized, and how the proposed rule may affect the cooperative structure of the Bank System. The Finance Board also would like to know whether there are any other restrictions on voting rights or allocation of directorships that should be incorporated into the rule as mandatory requirements, or whether there are other restrictions or requirements that the Finance Board should encourage the Banks to include as part of their capital plans.

Since 1932, the Banks have been authorized to issue only one class of stock. Ownership of Bank stock has conferred on a member the right to participate in the election of directors. In 1961, Congress amended Section 7 of the Bank Act to provide that the number of votes each member may cast in an election of directors, and the manner in which the elected directorships are to be allocated among the states, would be determined on the basis of the subscription capital provisions of Section 6. Specifically, Section 7 was amended to provide that “each such member may cast * * * a number of votes equal to the number of shares of stock in [the Bank] required by this Act to be held by such member at the end of the calendar year next preceding the election”.

5

At that time, Congress also amended Section 7 to require that the allocation of elected directorships, like the method for determining the number of votes, be determined based on the proportionate amounts of Bank stock “required to be held” by the members in each state as of the end of the preceding calendar year, subject to a “grandfather” provision that reflected the allocation of directorships as of December 31, 1960.

See

12 U.S.C. 1427 (a)-(c) (1994).

5

Act of September 8, 1961, Pub. Law No. 87-211;

see,

12 U.S.C. 1427(b) (1994). Although each share of Bank stock carried one vote, the Bank Act also limited the number of votes any one member could cast to the average number of shares of Bank stock “required to be held” by each member in that state as of the end of the preceding calendar year. That provision had the effect of partially disenfranchising any members that owned Bank stock in excess of the average stockholdings within that state.

The language in Section 7 regarding the amount of Bank stock “required to be held” by the members as of the preceding December 31st refers to the subscription capital provisions of Section 6, as in effect prior to the GLB Act. As described previously, the subscription capital provisions required each member to purchase an amount of Bank stock based on a statutory formula (

i.e.,

the greater of $500, 1.0 percent of mortgage assets, 0.3 percent of total assets, or 5.0 percent of advances) that was to be applied to each member as of December 31st of each year. By incorporating into Section 7 a principal component of Section 6—

i.e.,

the amount of Bank stock “required to be held” by each member as of the end of each year—the Congress in 1961 effectively linked the process of electing Bank directors to the subscription capital structure. In the GLB Act the Congress removed the subscription capital provisions from Section 6, but made no conforming amendments to Section 7. As a result, Section 7 of the Bank Act continues to require that the allocation of directorships and the determination of member votes be based solely on the subscription capital provisions, which will no longer exist when the new capital plans take effect. The Congress has provided no guidance on how, if at all, it intended the references to the subscription capital provisions within Section 7 to be applied in conjunction with the new risk-based capital provisions of Section 6.

The most apparent conflict between Section 7 and Section 6 (as amended) pertains to the number of votes each member may cast in an election of directors. Though Section 7 provides that the number of votes each member may cast shall equal the number of shares of Bank stock that the member is required to own, Section 6 expressly authorizes each Bank to establish voting preferences for its capital stock. As amended, Section 6 would authorize a Bank to assign voting rights exclusively to either its Class A or Class B stock, or to the Class A and Class B stock equally, or to both Class A and Class B but with a disproportionate weighting. The Finance Board believes that it is not possible to reconcile these provisions, as a Bank cannot establish a system of voting preferences (which, by definition, results in disparate voting rights for each class) while at the same time adhering to a requirement that all shares of its stock are to have uniform voting rights (subject only to the cap on members with large stockholdings).

6

In order to give effect to the GLB Act capital amendments that have authorized each Bank to establish voting preferences, the Finance Board is of the opinion that the provisions of Section 7(b) of the Bank Act that establish a “one share, one vote” structure must be considered to have been impliedly repealed by Section 6(c)(4)(B), as amended by the GLB Act.

6

As a technical matter, members with large amounts of Bank stock cannot vote all of their shares of stock due to the cap based on the average holdings within each state. For those shares that can be voted, however, all votes count equally.

In a similar fashion, there are conflicts between provisions of Section 7(b), (c), and (e), regarding the designation of directorships among the states, and Section 6, as amended by the GLB Act. The former provisions are premised on the assumption that the Banks are to be capitalized in accordance with a statutory formula, whereas the latter provisions require the Banks to be capitalized in relation to their risks. As described previously, Section 7 continues to require the Finance Board to designate the elected directorships of each Bank among the states in the approximate ratio of the Bank stock required to be held by the members in each state to the total stock outstanding, as of the end of the calendar year. The Finance Board cannot determine those ratios in the manner required by the literal language of Section 7, however, because under the new capital structure the members will no longer be required to maintain an investment in Bank stock in accordance with the statutory formula and as of December 31st of each year. The Finance Board has considered whether it would be feasible to calculate the Section 7 ratios for the allocation of directorships on the basis of Section 6, as it has been amended, but believes that doing so likely would create a host of uncertainties that are not addressed by the Bank Act and which the Finance Board would be required to resolve.

As amended by the GLB Act, Section 6 does refer to a “minimum investment” that each member must maintain in the stock of the Bank, but it does not specify what that term means, other than indicating that it may be based on a percentage of a member's assets or a percentage of its advances, or any other provision approved by the Finance Board. The Finance Board could define the term, but there likely are several ways in which to do so, none of which would be compelled by statute. However the term is to be defined, it would have to be correlated in some fashion to the risks to which the Bank is exposed,

i.e.,

it should not result in a Bank having too little or too much capital in relation to its risks. Thus, a bare formulaic definition of the term (as formerly included in the subscription capital provisions) likely would not be appropriate because it would have no relation to the risks to which the Banks are exposed.

As one possibility, the Finance Board could define “minimum investment” to mean an amount of Bank stock required to be held as a condition of membership in the Bank. That approach, however, would be complicated by the issuance of the two classes of Bank stock authorized by the GLB Act. The existence of two classes of stock means that for every state within a Bank district each member located in that state would hold a certain percentage of the Bank's Class A stock and a certain percentage of the Bank's Class B stock. Because the GLB Act gives each member the option of determining which class of stock to buy, it is likely that if a Bank issues both Class A and Class B stock there will be some members that purchase only one class of Bank stock and other members that purchase both

classes of stock but in varying combinations. As a result, for each state in a Bank district it is unlikely that the percentage of Class A stock held by the members located in that state will be identical to the percentage of Class B stock held by the members in that state. Indeed, it appears probable that the relative percentages of Class A and Class B stock held by the members in a particular state will differ, and may well differ substantially. Thus, it would be possible, and perhaps probable, that the Class A stock of a Bank may be concentrated in certain states while the Class B stock would be concentrated in other states within the Bank district. In that event, the Finance Board should be able to determine the ratio of Class A stock held by members in a given state, and separately should be able to determine the ratio of Class B stock held by the members in that state. It is not at all clear, however, how the Finance Board could apply those ratios to allocate the elected directorships in the manner required by Section 7, especially if there are material differences among the ratios for the various states in the Bank district. The possibility of having two different ratios would be further complicated by the provisions of the GLB Act that allow a Bank to set a lower minimum investment for the B stock than for the Class A stock. Thus, even if the Finance Board could readily calculate the ratios for the Class A and Class B stock, respectively, for each state, the ratio for the Class B stock most likely would have to be adjusted in some fashion.

As an alternative to viewing the term “minimum investment” as an investment required as a condition of membership, it could be defined in terms of the amount of Bank stock required to support the credit, market, and operations risks created for the Bank as a result of entering into business transactions (such as making advances, acquiring mortgage assets, or issuing letters of credit) with a member. Because all Bank assets entail some degree of risk, a member could be required to purchase Class A and Class B stock in whatever amounts are necessary to provide the total capital and permanent capital required to cover the risks associated with the assets created by its business transaction with the Bank. If the Finance Board were to define “minimum investment” on the basis of the risk placed on the balance sheet, such an approach would result in most members investing in both Class A and Class B stock. The relative amounts of each class of stock held by a member under such an approach would vary with the degree of risk associated with the underlying assets. Thus, one would expect that a member placing somewhat more risky assets on the balance sheet of the Bank would be required to purchase a correspondingly greater amount of Class B stock than a member creating the same amount of a less risky asset. Because the leverage requirement applies independently of risk, however, an equal amount of assets with different risk characteristics should require the same amount of Class A stock for leverage purposes. Thus, defining “minimum investment” in this manner also would be likely to result in the ratio of Class A stock held by the members in a particular state differing from the ratio of Class B stock held by the members in that state, which would present the same difficulties in calculating the individual state ratio described previously. Moreover, it is likely that the term “minimum investment” could not be defined solely on the basis of a member's transactions with the Bank because not all members will at all times be engaged in a business transaction with the Bank. For that reason, it is likely that a definition of “minimum investment” would have to incorporate both membership and risk aspects. If so, the Finance Board then would be faced with using as many as four different stock ratios for each state if it were to determine the allocation of directorships in accordance with the literal language of Section 7.

Apart from those definitional concerns, the Finance Board has a more general concern that requiring the allocation of elected directorships among the states, regardless of how it is done, could impair the ability of the Banks to sell Class B stock in amounts sufficient to comply with their risk-based capital requirements. If that were to occur, the adherence to the state-based allocation formula clearly would frustrate the intent of Congress in establishing a risk-based capital structure for the Banks. In requiring the Banks to have sufficient permanent capital to meet their risk-based capital requirements, the GLB Act has effectively mandated that the Banks, through sale or conversion, issue a significant amount of Class B stock.

7

In tension with this requirement is another provision of the GLB Act, which requires that each Bank's capital plan allow each member the option of determining what combination of classes of authorized Bank stock to purchase. In effect, the GLB Act requires the Banks to issue Class B stock but does not compel the members to purchase the Class B stock. The GLB Act does provide that each Bank is to establish the terms, rights, and preferences for each class of stock that are “consistent with Finance Board regulations and market requirements.” That provision recognizes that if the purchase of Class B stock is to be voluntary, then the Banks must be authorized to establish terms for the Class B stock, such as voting and dividend preferences, that provide economic incentives for the members to purchase the Class B stock.

7

Although a Bank may include its retained earnings as permanent capital, no Bank has sufficient retained earnings to comply with the risk based capital requirements at present or is likely to have sufficient retained earnings in the near future. Since the enactment of FIRREA in 1989, the Banks have maintained only nominal amounts of retained earnings. Moreover, in the six months since the enactment of the GLB Act, some Banks have paid out significant portions of their retained earnings to their members. As of March 31, 2000, the retained earnings of the Bank System were equal to 0.11 percent of the total assets of the Banks, and the amounts at the individual Banks ranged from 0.03 percent to 0.20 percent of total assets.

The paramount intent of Congress in revising the capital structure for the Banks was to ensure that the risks to which each Bank are exposed are supported by permanent capital,

i.e.,

Class B stock and retained earnings. Because Class B stock is the only practical source of permanent capital for the immediate future, the intent of the Congress cannot be implemented unless the Banks are able to sell Class B stock. To the extent that other provisions of the Bank Act might impair the ability of the Banks to do so, the application of those provisions would frustrate the intent of Congress in creating the new risk-based permanent capital structure. The Finance Board believes that requiring the allocation of the elected directorships of each Bank exclusively on a state-based formula would make the Class B stock a less attractive economic option for the members because there would be no assurance that the Class B stock would be distributed in the same proportion that the directorships would be allocated among the states.

Because of the difficulties in using a “minimum investment” as a proxy for the amount of stock “required to be held” as of each December 31st, and the likelihood that a state-based allocation of directorships would make the sale of Class B stock more difficult, the Finance Board has preliminarily determined that it cannot apply the provisions of Section 7 regarding the allocation of directorships without frustrating the intent of Congress to create a workable risk-based permanent capital structure

for the Banks. The Finance Board believes that there is no practical way to give simultaneous effect to one provision of law that would require the preservation of the subscription capital structure for the purpose of allocating directorships and voting rights and another provision of law that would repeal the subscription capital structure in its entirety. The Finance Board is proposing to resolve that conflict by giving precedence to the provisions of Section 6 of the Bank Act, as amended by the GLB Act, over those provisions of Section 7(b), (c), and (e) relating to voting and the allocation of directorships.

8

The Finance Board does not believe that any other provisions of Section 7 are inconsistent with Section 6, as amended. Thus, the other provisions of Section 7, such as those regarding the size of the board of directors (including both elected and appointed directors), the requirements applicable to individual directors, the terms of office, term limits, vacancies, compensation, duties, and indemnification, would not be affected by the application of Section 6, as amended.

8

Puerto Rico presents a unique situation of a prior Finance Board establishment of a directorship, which has been made permanent by statute. In 1962, Congress amended Section 7(e) to authorize the Finance Board to establish an additional elected directorship for the Bank in which the Commonwealth of Puerto Rico was located, which directorship was required to be designated to Puerto Rico. The Finance Board exercised that authority, creating an additional elected directorship for the New York Bank, which it designated as representing the members located in Puerto Rico. Although the designation of that seat to Puerto Rico is inconsistent with the risk-based capital amendments to Section 6, for the same reasons that the other state-based designations are inconsistent with Section 6, the preservation of the additional directorship can be reconciled with Section 6, as amended. Accordingly, the New York Bank would continue to have an additional elected directorship pursuant to Section 7(e), and the proposed rule would allow the Bank to accommodate the representation of members located in Puerto Rico as part of its capital plan. As provided in Section 7(e), if the Finance Board ever were to relocate the Commonwealth of Puerto Rico to another Bank district, the additional elected directorship created by Section 7(e) would cease to exist.

In cases of conflicting statutory provisions, it is an ordinary rule of statutory construction that later-enacted provisions take precedence over older provisions, to the extent that the older provision is inconsistent with the later-enacted provision. See

Tennessee Gas Pipeline Co.

v.

Federal Energy Regulatory Comm'n,

626, F.2d 1020, 1022 (D.C. Cir. 1980);

Estate of Flanigan

v.

Commissioner of Internal Revenue,

743 F.2d 1526, 1532 (11th Cir. 1984). The Finance Board believes, as described above, that the provisions of Section 6 must take precedence over the provisions of Section 7 that relate to the allocation of directorships and voting. The U.S. Supreme Court has made clear, however, that it is also a “cardinal rule” of statutory construction that judicial findings of such implied repeals of statutory provisions are not favored.

Morton

v.

Mancari,

417 U.S. 535, 549 (1974);

Posadas

v.

National City Bank,

296 U.S. 497, 503 (1936). The Court has explained that effect should be given to both provisions wherever possible and that absent a “clear and manifest” intention on the part of Congress to repeal a statutory provision, the only permissible justification for a repeal by implication is when the earlier and later statutes are “irreconcilable.” Morton, 417 U.S. at 550-51; see

Georgia

v.

Pennsylvania RR Co.,

324 U.S. 439, 456-57;

FAIC Securities

v.

United States,

768 F.2d 352, 362 (D.C. Cir. 1985);

United Ass'n of Journeymen and Apprentices

v.

Thornburgh,

768 F. Supp. 375, 379-80 (D.D.C. 1991).

In determining whether an “irreconcilable” conflict exists between statutory provisions, a court will first look to the plain language of the statutes. See

Flanigan,

743 F.2d at 1532 (finding that two provisions of the Internal Revenue Code were, on their face, plainly irreconcilable). Only when the language of two provisions leaves the court in doubt as to whether they represent truly irreconcilable intentions will a court resort to any legislative history that may be pertinent to the issue. See

Demby

v.

Schweiker,

671 F.2d 507, 510 (D.C. Cir. 1981) (wherein the court resorted to the legislative history of the newer act in finding that the provisions in question were not irreconcilable).

An administrative agency charged with the implementation of a particular statute may implement an administrative resolution of two conflicting provisions in that statute through a proper APA notice-and-comment rulemaking.

Citizens to Save Spencer County

v.

Environmental Protection Agency,

600 F.2d 844, 875-78 (D.C. Cir. 1979). In undertaking such a rulemaking, an agency should determine, based on the plain language of the provisions and, if necessary, on the legislative history of the statutes, that the provisions are irreconcilable.

Id.

at 863-68. The agency should then consider the statute as a whole and the purposes of the provisions in question in order to fashion a solution that avoids unnecessary hardship or surprise to affected parties and remains within the general bounds of the statute in question.

Id.

at 870-71. The Finance Board believes that the provisions of Sections 6 and 7 of the Bank Act described above are in conflict and is proposing through this rulemaking to give precedence to the capital provisions of Section 6. The legislative history of the GLB Act does not address the interrelationship between Section 6 and Section 7, though the language of the statute and the legislative history do suggest strongly that the creation of a sound system of permanent capital was of paramount concern to the Congress in amending Section 6. The proposed rule has been structured to give effect to Section 7 to the greatest degree possible, and would not preclude a Bank from establishing a state-based structure if it believed that approach would be consistent with capitalizing the Bank in the manner required by the GLB Act.

The proposed rule would require that the capital plan for each Bank specify the manner in which the members are to elect directors and the other corporate matters, if any, on which the members will be entitled to vote. The capital plan also must describe the voting preferences, if any, to be assigned to any particular class or subclass of stock, and whether the Bank will permit cumulative voting by its members and, if so, the matters on which members may vote cumulatively.

If a Bank were to issue any Class B stock, the proposed rule would require that the Bank assign some voting rights to the Class B stock. The proposed rule would not specify what voting rights should be assigned to the Class B stock, and thus would allow each Bank to determine whether the Class B stock would have exclusive voting power or shared voting power. If a Bank were to issue Class B stock, the proposed rule would allow the Bank, in its discretion, also to assign some voting rights to the Class A stock, and would allow some voting rights to be assigned to the members generally,

i.e.,

without regard to the amount or class of Bank stock that each member owns. Within each class or subclass of stock, however, the proposed rule would require that all shares have equal voting rights, although a Bank could give preferences to one or more classes. Thus, all Class B stock would vote equally, although a Bank could authorize the Class B members to elect a majority of the elected directors by giving Class B a preference over the Class A stock. As suggested to the Finance Board by an independent consultant retained by the Banks to study the GLB Act capital issues, a Bank may find that such preferences are necessary in order to sell the Class B stock because it bears more of the risks than does the Class A stock.

As a means of preventing undue concentration of voting power within a

small number of members, the proposed rule would cap the number of votes any member (including affiliated members) may cast in an election at 20 percent of the votes eligible to be cast in that election. The Finance Board recognizes that in some Bank districts a member with less than 20 percent of the vote may be able to control the Bank and therefore is proposing to allow any Bank to establish a lower percentage as part of its capital plan.

As noted above, in order to ensure that the new capital structure is workable and the Banks are able to sell the Class B stock, the proposed rule would state expressly that the elected directorships for a Bank need not be allocated among the states on the basis of the amount of stock required to be held under the now-repealed subscription capital requirements, and that the number of votes for each member also need not be based on the amount of stock each member was required to hold as of the end of the prior year. Notwithstanding that provision the proposed rule would not preclude a Bank from allocating voting rights among its members on a state-by-state basis, provided such an allocation were approved as part of the Bank's capital plan. A Bank also could adopt any other reasonable method of electing directors, such as authorizing each class of stock to elect a specified number of directors, or allocating the directors among the members based on the asset size of the members. The proposed rule also would require that each Bank include in its capital plan, to the extent feasible, a provision for the representation of small members that own Class B stock, particularly members that are community financial institutions (CFI), as that term is defined by the GLB Act.

Although the proposed rule includes provisions addressing concentration of stock ownership, limits on voting rights, and representation of CFIs on the boards of directors, the Finance Board is especially interested in receiving comments on these issues and whether there may be other ways to address each of them. The approach taken in the proposed rule regarding voting would allow each Bank to determine the manner in which the members are to elect directors, which recognizes that the board of each Bank may be best suited to determining how to balance the interests of its members against the need to raise the capital required by the GLB Act. Notwithstanding the approach embodied in the proposed rule, the Finance Board requests public comments on whether there might be a need to include some limitations in the rule such that it does not have any untoward consequences for the cooperative structure of the Bank System.

On the issue of board composition, the Finance Board would like to receive comments on whether the rule should include a provision requiring certain types of members, such as CFIs, to be represented on the boards of the Banks. As proposed, the rule would require the Banks to ensure that small members, specifically including CFIs, that own Class B stock be represented on the board, to the extent it is feasible to do so. The Finance Board would like to know whether this type of requirement should be made mandatory on the Banks, such that some number of the elected directorships should be assigned permanently to the CFIs within that district. The Finance Board also would like to receive comments on whether the rule should mandate some form of state-based representation on the boards of the Banks. With the removal of barriers to interstate banking, it is less clear what purpose is served by retaining a state-based board of directors, especially when there is no requirement that the members within a particular state hold any Class B stock. The Finance Board requests that any comments advocating a requirement for state-based representation address the details of how that should be accomplished, especially in light of the varying number of states in each Bank district, which range from two to eight, and the cooperative structure of the Bank System. The Finance Board also would like to know whether it would be advantageous to increase the size of the boards of directors to accommodate the representation of small members, which the Finance Board can do in the five Bank districts that include five or more states, and if so, what actions might be appropriate in the other seven Bank districts, for which the Finance Board cannot increase the number of directors on the boards.

One issue on which the Finance Board would like to receive comment is whether the rule should allow a Bank to include advisory directors on its board,

i.e.,

directors who are not elected by the members and who do not vote on board matters, but who may participate in the deliberations of the full board of directors. Advisory directors are neither expressly authorized nor expressly prohibited by the Bank Act, but the Finance Board believes that it could authorize such directors, provided that the management of the Bank (

i.e.,

the ability to vote) remained vested exclusively in the elected and appointed directors. Although an advisory director could not vote on matters before the board of the Bank, the Finance Board believes that there may be some value to the Bank in having such individuals on the board, as they could present the views of members who might not otherwise have a voice at the meetings of the boards of directors. For example, if the members were to elect directors predominantly from certain states or from certain sized institutions, the board could appoint advisory directors from states or classes of members that were not otherwise represented. The proposed rule does not include any provisions regarding advisory directors, but the Finance Board would appreciate comments on whether such directorships, or other advisory panels, might be appropriate to address in the final rule.

The proposed rule would bar any member or affiliated members from owning more than 40 percent of any class of Bank stock and would bar any member or affiliated members from casting more than 20 percent of the eligible votes in any election. Although the proposed rule would allow each Bank to establish lower limits as part of its capital plan, the Finance Board requests comments on whether the percentages used in the proposal are appropriate or whether the Finance Board should adopt some other percentages as a means of preserving the cooperative structure of the Bank System.

With regard to voting rights, the proposed rule would require that the Class B stockholders be assigned some voting rights, but would leave to each individual Bank the responsibility to decide exactly what voting rights the Class B stock shall be assigned. The rule expressly allows a Bank to assign voting rights as well to the Class A stockholders and further allows a Bank to assign voting rights on the basis of membership,

i.e.,

without regard to what class or how much stock a particular member owns. The Finance Board would like to receive comments on whether those matters that are at present left to the discretion of the Banks should be included in the rule as a mandatory requirement,

i.e.,

whether the Banks should be required to assign some portion of the voting rights on a one-member one-vote basis, or should otherwise require that the members generally be allowed to elect some number of directors. Similarly, the Finance Board requests comments on whether some number of directorships or some proportion of the vote should be assigned by regulation to the Class A stockholders.

With regard to all such issues, the Finance Board requests that commenters elaborate on how any alternative voting arrangements recommended by the commenters would work in conjunction with Section 6 and how they would facilitate, or at least not impair, the ability of the Banks to raise the permanent and total capital required by the GLB Act. If the Finance Board ultimately adopts a final rule addressing the voting rights and directorship structure generally as proposed, the final rule also would include conforming amendments to certain provisions of the current election rules, 12 CFR Part 915. Those rules address matters such as the allocation of directorships, the annual capital stock report, the determination of member votes, and the election process. If the final rule authorizes each Bank to determine the manner of electing directors, several of the existing regulations in Part 915 would have to be rescinded or revised, to the extent that they are based on the subscription capital provisions incorporated in Section 7. Assuming that the final rule were to address voting rights and the allocation of directorships in the manner proposed, the Finance Board requests comment on what conforming amendments to the existing elections regulations would be appropriate.

C.

Dividends.

Under the proposed rule, any member, including those withdrawing from the Bank System, that owns Class A or Class B stock, or both, would be entitled to receive dividends declared on its stock for as long as it owned the stock. The Class A stock would be required to pay a stated dividend, and the capital plan would specify the basis on which the stated dividend would be calculated. Any Bank wishing to change the basis on which the stated Class A dividend is calculated would be required to amend its capital plan and submit the amendment to the Finance Board for approval. Payment of the stated dividend on the Class A stock would have priority over the payment of dividends on Class B stock. By providing Class A stockholders a dividend priority, the Finance Board intends to preclude the possible manipulation of the Class A dividend by and for the benefit of Class B shareholders, who are likely to have greater influence on the Bank's dividend policies than Class A stockholders. After a Bank pays its stated Class A dividend, the board of directors of a Bank may augment the stated dividend. This additional payment may be paid, at the discretion of the Bank's board of directors, before, concurrently with, or after payment of dividends on paid-in Class B stock. Along with specifying the basis on which the stated dividend would be calculated, a Bank's board of directors would have to determine, prior to issuance of the stock, whether such dividends are to be cumulative or non-cumulative.

Under the proposed rule, the Bank's board of directors could authorize the payment of a dividend to Class B stockholders and would determine the amount of the dividend to be paid. The board of directors would also be able to establish different dividend rates or preferences for different subclasses of Class B stock. A dividend established for a different subclass could, for example, track the performance of specific Bank assets, such as Acquired Member Assets or advances. Any dividend that tracks the performance of a Bank asset, however, must be proportionately appropriate for the level of risk and profitability associated with the underlying asset. For example, the lower the risk and profitability of an asset, the lower the dividend payment should be.

The payment of any Class B dividends would only be permitted after the payment of the stated Class A dividend. Any dividends to Class B stockholders must be payable from GAAP net earnings of the Bank plus the GAAP retained earnings of the Bank (after the payment of Class A dividends). GAAP net earnings are the net earnings of the Bank after the payment of the Resolution Funding Corporation (RefCorp) and Affordable Housing Program obligations. Any dividends on Class B stock would be non-cumulative. Cumulative dividends on Class B stock would not be necessary because the board of directors would set the dividend rate anew each year and could, therefore, effectively treat dividends as cumulative, but only if there were sufficient earnings to do so.

D.

Preferences on Liquidation, Merger, or Consolidation.

Under the proposed rule, in the event of a liquidation, merger, or other consolidation of a Bank, Class A stockholders would be entitled to receive the par value of their stock, plus any accumulated dividends. Class A stockholders would be paid before the Bank (or its successor) could redeem any Class B stock or pay dividends on the outstanding Class B stock that had been issued by the Bank that had been liquidated, merged, or consolidated. The preference given to Class A stockholders in such cases is consistent with the priority given to the payment of the stated dividend to Class A stockholders and with the role of Class B stock as bearing the greater risk.

E.

Transfer of Capital Stock.

As required by the GLB Act, the proposed rule would allow a member to transfer capital stock only to another member of the Bank or to an institution that is in the process of becoming a member. The Finance Board considers the transfer of stock to an institution in the process of becoming a member as an opportunity to minimize the likelihood of a Bank becoming overcapitalized. Any such transfer of stock would be at a price agreed to by the parties, and could be below, at, or above the par value of the stock.

Additionally, the proposed rule would prohibit a Bank from allowing the transfer of Bank stock to a member or group of affiliated members if, after the transfer, the member or group of affiliated members would own more than 40 percent of any class or subclass of capital stock. The proposed rule also would allow a Bank, through its capital plan, to establish an ownership cap lower than 40 percent. The ownership cap is intended to preclude the possibility that a single member or group of affiliated members could control a Bank. If a merger, acquisition, or other consolidation of two or more members of a Bank were to result in the surviving member holding more than 40 percent of any class of stock, or any lower cap set by the Bank, the Bank and member(s) would be required to agree to a plan for the member to divest any stock in excess of the ownership cap in an orderly manner. The Finance Board requests comments on how else the concentration limits might be applied in the case of a merger of members, as well as on how to apply such limits if a member were to exceed the limits as a result of actions taken by a third party, such as the withdrawal of a large member that causes the percentages of all other members to increase.

F.

Membership Investment in Capital Stock.

The GLB Act requires each member to maintain an investment in its Bank. Under the proposed rule, a Bank may require an institution to invest in Class A stock as a condition to becoming and remaining a member of the Bank, or a Bank may establish a membership fee to be assessed in lieu of mandatory stock investment. As noted below, after a Bank reaches its operating capital ratios it could no longer continue to require any additional membership investments, though it would be able to continue to assess annual membership fees. If a Bank were to require a membership investment in Class A stock, the Bank also must provide the member the option of

investing in a lesser proportional amount of Class B stock, which amount would be as determined by the Bank. For example, a lesser proportional amount of Class B stock could be calculated by multiplying the amount of Class A stock otherwise required for membership by a Bank-determined percentage.

If a Bank were at or above its operating total capital ratio and its operating risk-based capital ratio, the proposed rule would provide that the Bank could not require a member to purchase capital stock, but it still could require a member to pay an annual membership fee in lieu of the mandatory stock purchase. Because the amounts paid as membership fees do not constitute total capital or permanent capital under the GLB Act, the proposed rule would not preclude a Bank from assessing an annual membership fee after it has reached or exceeded its operating capital ratios. Both of these provisions have been included in the proposed rule in an effort to avoid a Bank becoming over-capitalized. The Finance Board believes that allowing a Bank to accumulate excessive amounts of capital,

i.e.

, amounts of capital beyond what is required to support the risks inherent in the business of the Bank, plus the marginal amount of additional capital carried as a result of the Bank's operating total capital and risk-based capital ratios, would lead to increased arbitrage investments, which the Congress clearly intended to address as part of the GLB Act capital restructuring. The Finance Board would allow the Banks to operate at higher capital ratios than are required by the GLB Act and this regulation,

i.e.,

higher percentages of total and permanent capital, which the Finance Board does not believe would lead to increased arbitrage investments. Also, by providing the Bank with various options to offer its members, the Finance Board believes members would have the flexibility necessary to accommodate the membership investment requirement that is required by the GLB Act.

G.

Activity-Based Stock Purchase Requirement.

The proposed rule provides that a Bank may require a member to purchase either or both Class A or Class B stock as a condition to entering into a specific business transaction with the Bank. Such an activity-based stock purchase requirement would not be inconsistent with other provisions of the GLB Act, which provide generally that a member shall have the option of purchasing either Class A or Class B stock. Any business transaction between a Bank and a member, such as an advance, is a voluntary transaction initiated by the member that results in an asset being placed on the books of the Bank. Under the risk-based capital provisions of the GLB Act and the proposed rule, every on-balance sheet asset and off-balance sheet item of a Bank must be supported by some amount of permanent capital to cover the credit, market, and operations risks associated with the asset or item. Ultimately, whatever amount of permanent capital is required by each Bank to meet its regulatory risk-based capital ratio and its operating risk-based capital ratio must be provided by the members; if a Bank lacks sufficient capital to engage in a particular transaction, it cannot enter into the transaction. If the provision of the GLB Act allowing each member the option of purchasing either Class A or Class B stock were read to allow each member to decline to purchase any Class B stock, the Banks would be unable to engage in any transactions with their members beyond the amount that could be supported by their retained earnings, the only other source of permanent capital. There is nothing in the GLB Act or its legislative history that suggests that the provision allowing members the option of purchasing Class A or Class B stock was intended to override the other provisions of the GLB Act that require every asset and off-balance sheet item to be supported, at least in part, by some amount of permanent capital. As noted above, the provisions of this proposed rule regarding each member to maintain some investment in the Bank preserves for the members the option of maintaining that investment in either Class A or Class B stock. To ensure that the Banks have sufficient permanent and total capital to cover the risks of their business, the proposed rule would authorize a Bank to require a member, as a condition to doing business with the Bank, to purchase whatever amount of Class A and Class B stock is necessary for the Bank to comply with the regulatory capital requirements (and operating capital ratios) that would be associated with the Bank asset (or off-balance sheet item) to be generated by the transaction with the member. If a member would prefer not to purchase any Class B stock, it would not be required to do so, but the Bank would not be required to make an advance or enter into any other transaction with a member that declined to provide the capital needed for the business it wished to conduct with the Bank.

The activity-based stock purchase requirement also should provide the Banks with some additional flexibility in managing their capital accounts, such that the levels of capital correspond more closely to the risks generated by the business of the Bank. The proposed rule would impose certain limitations on activity-based stock purchases. First, the amount of Class B stock that a member may be required to purchase in order to engage in a certain transaction must be based on the risk characteristics of the asset being acquired by the Bank. Second, a Bank could not require a member entering into a transaction to purchase Class B stock if the amount of the purchase would cause the Bank to exceed its operating total capital ratio and operating risk-based capital ratio, as established in the Bank's capital plan. Although a Bank could not impose an activity-based stock purchase requirement if doing so would cause it to exceed its operating capital ratios, the proposed rule would allow a Bank to enter into a written agreement with a member under which the member would commit to purchase a specific number of shares of Class A or Class B stock at a specified price, but with the purchase to be completed and all payments made at a future date to be determined by the Bank. Any such arrangement would have to be included in the Bank's approved capital plan. Under such an arrangement, if a Bank were to fall below its operating capital ratios it could require the members to honor their commitment to provide the capital that otherwise would have been required at the time they entered into the commitments. These provisions are intended to prevent the Banks from building excessive amounts of capital, which the Finance Board believes would lead to arbitrage investments.

Additionally, the proposed rule would bar a Bank from prohibiting a member that had purchased capital stock in compliance with an activity-based purchase requirement from selling the stock to another member. The members would remain subject to the other provisions of the rule, under which no member may redeem any capital stock if doing so would cause the Bank to fail to comply with any regulatory capital requirement.

H.

Concentration limits.

Under the proposed rule, no member, or group of affiliated members, of a Bank would be permitted to own more than 40 percent of any class or subclass of the outstanding capital stock of the Bank. A Bank would be able, through its capital plan, to establish an ownership cap lower than 40 percent. If at a given time, a member, or group of affiliated members, of a Bank were to acquire stock such that they owned more than 40 percent of any class or subclass of

stock (or any lower amount as established by the Bank) the Bank and member (including any affiliated members) would be required to agree to a plan under which the member would divest sufficient shares of such stock as necessary to comply with the limit. The Finance Board requests comment on the need to include concentration limits in the rule and what percentage limits might be most appropriate to ensure that the Bank cannot be dominated by a small number of members.

I.

Redemption and Purchase of Capital Stock.

As required by the GLB Act, a member may redeem its Class A stock with six-months written notice to the Bank. Class B stock may be redeemed with five-years written notice to the Bank. At the end of the notice periods, a member would be entitled to receive the par value of the stock in cash. The proposed rule would bar a member from having pending at any one time more than one notice of redemption for any class of Bank stock. For example, a member may have pending a notice to redeem 50 shares of Class A stock, as well as a notice to redeem 50 shares of Class B stock. A member, however, could not have two separate notices to redeem only Class B (or only Class A) stock. A Bank would be permitted to impose a fee, as specified in its capital plan, on a member that cancels a pending notice of redemption. The imposition of a fee would be at the discretion of a Bank, as specified in its capital plan. The Finance Board is proposing the option of establishing a fee in order to minimize a Bank's cost associated with canceling a notice of redemption.

J.

Capital Impairment.

Under the proposed rule, the Bank would not be permitted to redeem or purchase any capital stock without prior written approval from the Finance Board if the Bank were not in compliance with any of its regulatory capital requirements. The Bank would also not be permitted to redeem or purchase any capital stock without prior written approval from the Finance Board if such a redemption or purchase of stock would cause the Bank to fail to comply with any of its regulatory capital requirements. These provisions reflect the requirement of the GLB Act that the Bank shall maintain both total and permanent capital that is sufficient to meet its regulatory capital requirements.

K.

Part 932—Federal Home Loan Bank Capital Requirements.

Overview.

As discussed previously, the Banks' current capital requirements have been determined according to a statutory formula, which has used either the assets held by a member or the amount of the member's borrowings from a Bank to determine the amount of Bank stock that the member must hold. 12 U.S.C. 1426(b)(1), (b)(2), and (b)(4); 1430(c), (e)(1), and (e)(3) (1994). The capital provisions of the GLB Act replace this approach with a modern risk-based capital system for the Banks and mandate a capital structure that is more in line with the risk-based capital standards developed under the Basle Accord and with the practices of other bank regulatory agencies.

9

Under the GLB Act amendments, 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 choose to accept. The Finance Board is proposing to implement the capital provisions of the GLB Act by adopting a modern approach to overseeing the Banks, which would require the Banks to implement regulatory capital requirements as part of a comprehensive risk management system. In developing the proposed regulations, the Finance Board has reviewed the Basle Accord, the regulations of other banking regulators, the OFHEO proposed capital regulations,

10

and other papers drafted by the BCBS and other bodies.

9

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.

10

On April 13, 1999, OFHEO published a notice of proposed rule-making with respect to the required risk-based capital standards.

See

64 FR 18083 (Apr. 13, 1999). The original deadline for comments on this proposal was August 11, 1999, but that deadline was extended. The comment period ultimately closed on March 10, 2000.

See

64 FR 56274 (Oct. 19, 1999). On March 13, 2000, OFHEO solicited reply comments in response to the comments received on the proposed rule.

See

65 FR 13251 (Mar. 13, 2000). The deadline for these reply comments was April 14, 2000.

The capital requirements of proposed Part 932 also would replace the risk management provisions of the Finance Board's Financial Management Policy (FMP) under which the Banks currently operate. The FMP imposes specific restrictions and limitations on the Banks' investment practices and includes a leverage limit to regulate the risk management practices of the Banks. 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), Finance Board Res. No. 97-86 (Dec. 17, 1997) and 65 FR 36305 (June 7, 2000). Although the FMP has served the purpose of ensuring the safety and soundness of the Bank System, it lacks sufficient flexibility to enable the Banks to fulfill their mission to the maximum extent possible.

The Basle Accord forms the basis for risk-based capital standards for banks in the world's industrialized countries. Its approach principally involves 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-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 U.S. 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.

, 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.

The Finance Board, and other commentators, believe that the Basle Accord has a number of shortcomings. For example, the risk weight categories are so broad that instruments with markedly different credit risks may be subject to the same risk weighting. The Basle Accord also does not take into consideration how differences in the maturities between two instruments within the same category 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.

The January 1996 amendment to the Basle Accord (the Amendment) remedies some of these shortcomings, especially with respect to debt instruments held in the trading portfolios of large banks.

11

The Amendment offers large banks the

alternative either to use internal credit risk models to calculate value at risk due to credit risk on debt instruments held in its trading portfolio, or, if the bank lacks satisfactory internal models, to use standardized credit risk capital percentage requirements specified in the Amendment.

11

The Amendment, entitled “Amendment to the Capital Accord to Incorporate Market Risks,” 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).

In order to address some shortcomings of the Basle Accord with respect to the non-trading portfolio,

i.e.

, the banking book, the BCBS published in June 1999 a consultative paper entitled “A New Capital Adequacy Framework” (the Framework), which proposed a system to better correlate regulatory solvency with the economic-capital needs of a bank and with the risks and returns of a bank's lending activities.

12

The Framework would calibrate a bank's risk-based capital requirements more closely with its underlying credit risks, and would recognize the improvements in risk measurement and control that have occurred in recent years. The Framework would also 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.

12

New Basle Committee Proposals Have Positive Bank Credit Implications,

Moody's Credit Perspectives, June 21, 1999, at 1, 18.

General Capital Requirements.

Section 6(a)(1) of the Bank Act, 12 U.S.C. 1426(a),

as amended

, requires that each Bank maintain a minimum ratio of total capital to total assets and that each Bank maintain permanent capital in an amount that is sufficient, as determined in accordance with the regulations of the Finance Board, to cover the credit risk and market risk to which a Bank is subject. 12 U.S.C. 1426(a)(1), (3),

as amended.

The GLB Act defines “permanent capital” as the amounts paid for a Bank's Class B stock, plus the Bank's retained earnings (as determined in accordance with GAAP). 12 U.S.C. 1426(a)(5)(A),

as amended.

The term “total capital” includes permanent capital, the amounts paid for Class A stock, any general allowance for losses that are not held against specific assets (determined in accordance with GAAP and Finance Board regulations), and any other amounts available to absorb losses that the Finance Board determines by regulation to be appropriate to be included in total capital. 12 U.S.C. 1426(a)(5)(B),

as amended.

The definitions for “permanent capital” and “total capital” proposed in § 930.1 conform with the statutory definitions. Proposed § 930.1 also defines the term “general allowance for losses” to require that such allowances be consistent with GAAP and not include any amounts held against specific assets of the Bank. The restrictions would be the same as the statutory restrictions placed on loan loss reserves.

Capital requirement transition provisions.

The proposed rule would require that by a date not later than three years from the effective date of the its capital plan, each Bank shall have sufficient total capital to meet the total capital requirement in proposed § 932.2 and sufficient permanent capital to meet the risk-based capital requirement in proposed § 932.3. Before the new total capital and risk-based capital requirements could be implemented, however, each Bank must first obtain Finance Board approval for its internal risk model or its cash flow model, which would be used to calculate the market risk component of its risk-based capital requirement, and for the risk assessment procedures and controls that would be used to manage the Bank's credit, market, and operations risks.

The capital rule would not supercede the risk management provisions of the FMP until after the Finance Board has approved the models and procedures, discussed above, for each Bank and the Bank has met its regulatory capital requirements. Thus, each Bank would continue to be governed by the Hedging Transaction Guidelines and the Interest Rate Risk guidelines of the FMP until those conditions are met.

See

FMP Sections V and VII. The provisions of the FMP that limit the purchase of mortgage-backed securities (MBS), collateralized mortgage obligations (CMOs), real estate mortgage investment conduits (REMICs), and eligible asset-backed securities to 300 percent of capital, Section II.C.2, also would remain in effect until the Bank had met the proposed regulatory capital requirements.

The proposed rule also would mandate that the minimum stock purchase and stock retention requirements of the Bank Act in effect immediately prior to the GLB amendments would remain in effect until the Bank has issued capital stock in accordance with its approved capital plan. (See discussion of proposed Part 933.) This provision is consistent with the GLB Act requirement that the pre-GLB Act stock purchase and stock retention requirements shall continue in effect until the capital plan of a Bank has been approved and implemented. 12 U.S.C. 1426(a)(6),

as amended.

Under the proposed rule, the new capital structure for each Bank would take effect (subject to any transition provision) once a Bank has issued its Class A or Class B capital stock. Any other Finance Board regulations that may affect stock purchase or retention would also apply.

13

13

The Finance Board recently approved a final rule that, among other things, established an asset-based leverage limit under which the aggregate amount of assets of any Bank shall not exceed 21 times the total of paid-in capital stock, retained earnings and reserves (or a capital to assets ratio of at least 4.76 percent). The rule also extended and made permanent the additional leverage authority originally permitted to the Banks for Year 2000 liquidity,

i.e.,

a Bank may have asset-based leverage of up to 25 to 1 (or a capital to assets ratio of at least 4.0 percent) if that Bank's ratio of non-mortgage assets does not exceed 11 percent of the Bank's total assets minus deposits and capital.

See

65 FR 36290, 36299 (June 7, 2000). Non-mortgage assets equal total assets after deduction of core mission activity assets, as defined in proposed § 940.3, and assets described in sections II.B.8 though II.B.11 of the FMP.

See

65 FR 25676, 25688 (May 3, 2000). This 25 to 1 limit is in line with the requirements of the GLB Act.

Total capital requirement.

The GLB Act requires each Bank to maintain a ratio of total capital to total assets of no less than four percent. 12 U.S.C. 1426(a)(2),

as amended.

The statute also requires each Bank to maintain a leverage ratio of total capital to total assets of five percent, where in calculating this ratio, the amounts paid in for the class B stock and the amounts of retained earnings are multiplied by 1.5 and all other items of total capital are included at face value.

Id.

Section 932.2 of the proposed rule would implement these statutory provisions.

Risk-based capital requirement.

The GLB Act requires each Bank to maintain permanent capital in an amount that is sufficient, as determined in accordance with the regulations of the Finance Board, to cover the credit risk and market risk to which a Bank is subject. 12 U.S.C. 1426(a)(1), (3),

as amended.

Section 932.3 of the proposed rule would require each Bank to maintain sufficient permanent capital to meet the combined credit, market, and operations risks to which it is subject, as determined under proposed § 932.4, § 932.5, and § 932.6, respectively.

Although the GLB Act does not address operations risk, the Finance Board is proposing to adopt an operations risk component to the risk-based capital requirements in order to assure that the Banks “operate in a financially safe and sound manner” and “remain adequately capitalized.” 12 U.S.C. 1422a(a)(3)(A), (B),

as amended

. The Finance Board believes that the risk of loss from business operations exists with regard to the Banks and that it is necessary to require the Banks to maintain capital against that risk. Under the new credit and market risk capital provisions in the GLB Act, the amount

of capital held by the Banks will be closely aligned to the expected losses associated with those risks, and is not meant to cover the unexpected losses that may result from human error, fraud, unenforceability of legal contracts, or deficiencies in internal controls or information systems or other operations risks. Without an operations risk requirement, the proposed rule would be deficient and the Banks could be exposed to losses arising from these operational failures. Thus, the Finance Board considers the operations risk requirement necessary to ensuring the continued safe and sound operation of the Bank system.

Credit Risk Capital Requirement.

The GLB Act mandates that each Bank maintain sufficient permanent capital, as determined in accordance with Finance Board regulations, to meet the credit risk to which the Bank is subject. 12 U.S.C. § 6(a)(3)(A)(i),

as amended.

The GLB Act, however, does not specify the elements that make up credit risk or the charges that must be applied to cover such risk, leaving to the Finance Board the responsibility to define the elements of credit risk.

Proposed § 932.4 would implement the credit risk requirements of the GLB Act. In developing these requirements, the Finance Board has reviewed the Basle Accord, the regulations of other banking regulators, OFHEO's proposed capital regulations, and other information prepared by the BCBS and other relevant bodies. As already discussed, the Finance Board has revised the credit risk provisions contained in the proposed FMMA both to meet the GLB requirements and to further enhance the accuracy of the provisions.

The credit risk component of the risk-based capital requirement proposed by the Finance Board would encompass the credit risks associated with both on-balance sheet assets and off-balance sheet items of each Bank. The objective of this credit risk capital standard 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) be responsive to 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.

Finance Board determination of specific credit risk percentage requirements.

The credit risk capital requirement would be equal to the sum of a Bank's credit risk capital charges for all on-balance sheet assets and off-balance sheet items. For an on-balance sheet asset, the credit risk capital charge would equal the book value of the asset multiplied by the “credit risk percentage requirement” assigned to the asset. For off-balance sheet items, the credit risk capital charge would be the “credit equivalent amount” of the item, multiplied by the credit risk percentage requirement assigned to the item.

The proposed rule would include credit risk percentage requirements for various categories of on-balance sheet assets and the credit equivalent amount of off-balance sheet items based on the type of asset or item, its credit rating and, if appropriate, its remaining maturity. The Finance Board has used data from NRSROs and other relevant sources to calculate estimates of credit losses associated with the particular categories. The estimates of credit risk percentage requirements represent the expected credit losses for the particular categories of instruments during periods of credit stress, based on historical data that reflect the longer-term nature of credit cycles, and span multiple credit cycles. The credit losses are estimated after identifying time periods with the highest losses stemming from downgrades and defaults. The loss in market value from a downgrade is estimated for each maturity category of the investment using credit spreads from 1992 to the present that were available to the Finance Board. For defaults, assumptions for loss severity are based on exposure type and maturity as indicated by available data. Periodic updates to the initial credit risk percentage requirements will be implemented by the Finance Board as amendments to the credit risk capital requirement.

In the proposed FMMA, the credit risk percentage requirements did not consider the term structure of credit risk. This limitation mirrored the initial failure of the Basle Accord to consider the term structure of credit risk, such that an overnight exposure on a particular instrument would receive the same capital charge as a two- or a ten-year exposure on another instrument from the same issuer. Recently, however, the BCBS as well as other financial regulators have begun to address this failure. 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 problem 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 its risk-based capital requirements for the farm credit banks. In the proposed rule, the Finance Board would give recognition to the term structure of credit risk.

While consideration of term structure is not necessary for all credit risk categories, the Finance Board incorporated term structure in the percentage requirements for advances and “rated assets or items other than advances or residential mortgage assets.” The Finance Board also has incorporated specific credit risk percentage requirements for residential mortgage assets, which include MBS, by investment grade. As a result, four tables are included in proposed § 932.4(d)(2)(i): Table 1.1—Requirement for Advances; Table 1.2—Requirement for Residential Mortgage Assets; Table 1.3—Requirement for Rated Assets or Items Other Than Advances or Residential Mortgage Assets; and Table 1.4—Requirement for Unrated Assets. These tables set forth 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. The Finance Board seeks comment on its proposed recognition of asset maturity in its calculation of credit risk percentage requirement for certain types of assets or items. The Finance Board also generally requests comment on any aspect of the tables included in the proposed rule.

Table 1.1.

The proposed FMMA assigned advances to a triple-A credit risk category 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), and a statutory stock purchase requirement that required a member to maintain an investment in the Bank at least equal to 5 percent of its outstanding advances. 12 U.S.C. 1430(e) (1994).

In developing the FMMA, the Finance Board considered treating advances in the same manner as cash or as securities that are backed by the full faith and credit of the U.S. government, both of which are assigned zero credit risk. Two credit rating agencies, however, have

expressed their opinion to the Finance Board that such treatment would not be appropriate for advances,

i.e.,

that advances should not be treated as equivalent to assets that have no credit risk. The two rating agencies recommended that advances be treated as triple-A rated assets. They noted, in particular, that legislative authority for the Banks to accept new types of collateral from certain members as one reason why advances should not be rated higher than triple-A. Based on the historical experience of zero credit losses for advances over the past 60 years, however, compared to the experience with triple-A rated corporate securities, some of which have had rating downgrades that have lead to eventual credit losses, it would appear that advances are a better credit than are triple-A rated corporate securities. Accordingly, the proposed rule would treat advances as having somewhat greater credit risk than securities that are backed by the full faith and credit of the U.S. government, but somewhat less than triple-A rated corporate securities. The proposed rule, in Table 1.1, provides unique credit risk percentage requirements for advances by their maturity.

The determination of credit risk percentage requirements or credit losses for advances under stress conditions would require estimates of the default rate and the loss severity rate under such stress conditions. Because the Banks have incurred no credit losses on their advances, the Finance Board has assumed, for purposes of establishing a default rate for advances, that advances would exhibit the same default patterns as the highest investment grade corporate bonds in Moody's Default Risk Service database, and that advances would have a recovery rate of 90 percent (

i.e.,

a loss severity rate of 10 percent). A recovery rate of 90 percent is consistent with the conservative lending and collateral management policies and the historical credit loss record of the Banks with respect to advances. Thus, the credit risk percentage requirements in Table 1.1 for advances are based on the maximum default rates for the highest investment grade exposures from Moody's Default Risk Service database and a recovery of 90 percent.

14

The Finance Board seeks comment on the methodology used for setting the credit risk percentage requirements for advances and whether a more satisfactory analytical framework exists that could be used to determine more appropriate credit risk percentage requirements for advances.

14

The credit risk percentage requirement for advances with maturities above 10 years has been capped at the maximum credit risk percentage requirement for the highest investment grade residential mortgage exposures as historical loss rates for advances have been below the loss rates for residential mortgages.

Table 1.2 and Table 1.3.

Table 1.2 includes the credit risk percentage requirements for residential mortgage assets, which category includes both mortgages and MBS, while Table 1.3 sets forth credit risk percentage requirements for rated assets or items other than advances or residential mortgage assets. The credit risk percentage requirements in Table 1.3 were developed for instruments without embedded options. As explained in more detail following the discussion of Table 1.3, residential mortgage assets have prepayment options, and, therefore, require a separate set of credit risk percentage requirements.

The proposed credit risk percentage requirements in Table 1.3 for credit exposures of rated assets or items other than advances and residential mortgages are calculated by examining data from Moody's which includes the rating and default history for rated assets over the time period 1970-1999. In calculating the values in Table 1.3, the worst time period for credit losses is found for each rating category, where credit losses are estimated as the sum of defaults, assuming a 100 percent loss severity, and losses in market value from rating downgrades during a specified period or credit risk horizon.

15

See

“Historical Default Rates of Corporate Bond Issuers, 1920-1998,” Moody's Investor Service, January 1999.

15

Based on Moody's data from 1977-98, historical defaulted-bond prices display a great deal of volatility and are zero at two standard deviations below the mean. Unless more data is examined and a positive recovery rate under credit stress conditions can be established with confidence, the Finance Board would adopt a recovery rate of zero for estimation of credit losses that are to be used for credit risk capital requirements.

A maximum of a two year credit risk horizon has been used for calculating the default and downgrade probabilities, because this is the expected period of time, based on experience, needed to resolve asset-quality problems at troubled commercial banks. Furthermore, both the default and downgrade probabilities increase as the horizon is increased from six months to two years. For credit exposures longer than two years, the default and downgrade probabilities remain constant at the two year maximum horizon. The loss in market value from a downgrade is estimated from calculations of market values of corporate bonds at initial credit ratings and market values subsequent to the downgrade. These losses tend to increase with the maturity of the asset.

The probability of a rating downgrade (of one or more categories), and the probability of default, are taken from the worst historical period as defined above. These probabilities, and available credit spread data, are used to estimate the possible loss in value from defaults and downgrades in future stressful environments. Assets with longer maturities will generally have higher credit risk percentage requirements to reflect higher credit risk associated with longer maturities. Even though the default and downgrade probabilities are constant for maturities above two years, the downgrades will have a greater impact on the market value of longer lived assets.

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, no triple-A rated security has ever defaulted while it was rated triple-A. Given a sufficiently long period of time, however, even triple-A rated corporate credits may default following rating downgrades.

16

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 ratings.

17

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 capital to be maintained for triple-A rated credit exposures.

16

According to Moody's data from 1970 to 1998, over a 4-year default horizon, the worst historical probability of default for assets initially rated triple-A is 1.21 percent.

17

This applies equally to triple-A rated securities issued by GSEs.

For Bank assets that are downgraded to below investment grade after being acquired by the Bank, the proposed rule would assign increasingly higher credit risk percentage requirements. The percentage requirements would range from 5.0 percent to 20.0 percent for assets or items that are downgraded to the highest rating below investment grade. For assets or items that are downgraded to the second highest rating below investment grade, the percentages would range from 22.0 percent to 37.0 percent. The proposed rule would assign a percentage requirement of 100 percent for all other assets or items that

are downgraded below investment grade. Table 1.3 includes U.S. government securities that are backed by the full faith and credit of the U.S. government. These securities, which would include Government National Mortgage Association (GNMA) MBS, are assigned to the zero percentage category regardless of their maturity, because they are deemed not to present any credit risk to the Bank.

Credit risk capital requirements in Table 1.3 were developed for instruments without embedded prepayment options.

18

Instruments with prepayment options, such as residential mortgage assets, would require a separate set of capital charges. Therefore, credit risk percentage requirements for residential mortgage related exposures are presented in Table 1.2.

19

Due to prepayment features, the expected or weighted average maturity for 30-year, fixed-rate mortgages is significantly less than 30 years. Therefore, the credit risk percentage requirements in Table 1.3 would be too high for residential mortgage exposures. In addition, the pattern or timing of defaults between corporate bonds and residential mortgages significantly differ. The default rates for corporate bonds generally increase with the time horizon, whereas, mortgage defaults tend to be concentrated between years three and eight.

See

“Moody's Approach to Rating Residential Mortgage Pass-Through Securities,” Moody's Investor Service, November 1996 (hereinafter Moody's). Based on Moody's analysis of the lifetime default curve for 30-year residential mortgages, the default rate becomes very small after 14 years and is zero after 22 years. Due to the build up of borrower equity in residential assets, the loss severity rates generally decline after the first few years of a residential mortgage's life. The Fitch IBCA Residential Mortgage-Backed Securities model utilizes a 14 year credit loss horizon.

See

“Fitch IBCA Residential Mortgage-Backed Securities Criteria” Fitch IBCA, December 1998 (hereinafter Fitch IBCA). Somewhat similar default and loss patterns are found in Duff & Phelps model.

See

“The Rating of Residential Mortgage-Backed Securities” Duff & Phelps Credit Rating Co.

18

The proposed credit risk percentage requirements in Table 1.3 are based on the credit risk from typical bonds that carry normal coupons. Zero or low coupon exposures would require credit risk percentage requirements higher than those being proposed. The Banks' holdings of such exposures and other complex credit-related instruments would be monitored and assigned appropriate credit risk percentage requirements on a case-by-case basis.

19

Conceptually, the data in Table 1.2 should be based on historical mortgage default data. Because sufficient data on historical mortgage default rates was not available, however, the percentages in the table are derived from corporate bond default rates and mortgage loss recovery rates, adjusted to approximate mortgage default rates. The Finance Board believes that the use of corporate bond data is less than ideal and intends to seek better sources of historical mortgage default data for purposes of the final rule. The Finance Board requests comment on any other methods of obtaining accurate data on historical mortgage loan defaults.

As required by the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (1992 Housing Enterprises Act), OFHEO has identified a “benchmark loss experience” for fixed rate mortgages (defined as conventional, 30-year, fixed-rate loans secured by first liens) on single-family properties (defined as single unit, owner occupied, detached properties) that were originated from 1979 to 1993 by the secondary market housing enterprises. OFHEO proposed to base its benchmark credit loss estimates on a 10 year credit loss horizon

See

61 FR 29616. (June 11, 1996).

In the proposed rule, residential mortgage assets, including MBS, held by Banks that are not rated directly for credit quality by rating agencies (NRSROs) must be rated for credit quality internally by Banks based on NRSRO criteria for rated MBS. The determination of credit risk percentage requirements or credit losses for residential mortgages under stress conditions would require estimates of the lifetime default rate corresponding to each rating category and the loss severity rate under stress conditions. In grading the relative credit risk of MBS, rating agencies employ the same symbol system as used for corporate bonds and counterparty obligations. As stated by Moody's, “The overall expected loss for a security of any rating should be the same, whether applied to an unsecured corporate instrument, a senior class of an MBS transaction (where losses would be of small magnitude), or a subordinate tranche.” Moody's at 2. To determine the appropriate thresholds on the distribution of mortgage default rates to be associated with each rating level, Fitch IBCA calibrated the lifetime mortgage default rate curve to the default rate curves for corporate bonds. Fitch IBCA at 4. This means that the corporate bond default rate data could provide a means of determining default rates comparable to mortgage default rates at each credit rating level. Based on the above analysis and conversations with rating agencies, it appears that a credit loss horizon of 15 years would be sufficient to capture the credit risk from residential mortgages. Therefore, the maximum default rate for a 15 year horizon from Moody's Default Risk Service is utilized for calculation of credit risk percentage requirements for residential mortgage assets with prepayment features.

The loss severity rates for residential mortgages can be significantly different from the loss severity rates for corporate exposures. Private label mortgage issues rated single-B have had loss severity rates of 100 percent even though the private label market has yet to cope with a period of serious stress or a prolonged recession. In addition, the actual loss rates for some of the single-B rated issues have been 100 percent. Conversations with credit rating agencies indicate that the loss severity rates for mortgages are associated with credit ratings. Mortgage issues rated triple-A would be expected to have relatively small losses even under a severe recession, and loss severity rates increase with a decline in credit rating. Thus, a loss severity rate of 100 percent is assumed for residential mortgage assets rated single-B or below. Loss severity rates for investment grade mortgage assets are derived by calibrating them to the pattern of loss rates for long corporate bonds.

Credit risk percentage requirements in Table 1.2 for residential mortgage assets are based on 15-year maximum default rate from Moody's Default Risk Service database and the rating specific loss severity rate. Unless separate credit risk percentage requirements are determined by the Finance Board for other classes of mortgages, such as multifamily and commercial properties, the percentages in Table 1.3 would apply to such rated credit exposures. The Finance Board seeks comment on the methodology used for setting credit risk percentage requirements, as well as alternative approaches for setting such percentages, that are linked to specific credit ratings from NRSROs.

Table 1.4.

To the extent possible, credit risk percentage requirements are derived from actual loss experience during periods of financial stress. For several asset categories, however, there is no relevant loss experience from which to calculate the credit risk percentage. The credit risk percentage requirements for certain unrated assets are set forth in Table 1.4, and are the same as previously proposed in the FMMA. Cash would be assigned to the zero percent category, as it is deemed not to present any credit risk to the Bank. All of a Bank's tangible assets, “Premises, Plant and Equipment,” as well as any unrated targeted debt or equity investments made by the Banks

pursuant to proposed § 940.3(a)(5),

20

would be assigned an 8.0 percent requirement. The targeted investments included in this category would be certain non-securitized debt or equity investments that advance certain specific public welfare goals. The 8 percent credit risk percentage requirement for these categories is consistent with the Basle Accord (with regard to tangible assets) and with the capital requirements applicable to national banks (with regard to public welfare investments).

20

See 65 FR 25676, 25688 (May 3, 2000).

Bank determination of specific credit risk percentage requirements.

The proposed rule would require each Bank to determine the credit risk capital requirement for each asset and item, first by identifying its type, its credit rating, and, its remaining maturity (as appropriate), then by identifying its appropriate risk category and applying the applicable credit risk percentage for that risk category under Tables 1.1 through 1.4. The proposal includes guidance for the Banks on how to determine the credit rating for a particular asset or item.

The proposed rule would require the Banks to apply certain criteria when determining the credit rating to be used in finding the applicable credit risk percentage requirement from Tables 1.2 and 1.3. 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 rated or the asset or item is backed by collateral that is 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, and the portion of the asset or item that is not 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 with a maturity of less than one year 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 maturity equal to or less than one year, which would carry a credit risk percentage requirement from Table 1.3 of 0.15 percent, and the remaining 75 percent of the value of the asset will be assigned to the fourth highest investment grade category with a maturity equal to or less than one year, which would carry a credit risk percentage requirement of 1.30 percent.

The proposal further provides that the Banks must 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, or third highest investment grade, for credit risk-based capital charge 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 more difficult to calculate credit risk percentage 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 Tables 1.1 or 1.4 (which do not need to be rated), 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 percentage requirement for the particular asset or item. 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 collateral other than marketable securities, 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 credit risk 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 and have a superior priority to all other parties with competing claims to the asset), must have a readily determinable value at which it can be liquidated, and must be held in conformance with the Bank's member product policy.

See

12 CFR § 917.4. 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 percentage requirement, a bank must make appropriate allowance for discounts, such as haircuts or overcollateralization, to reflect the price risk underlying the collateral.

Credit equivalent amounts 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. The proposed rule would require the Banks to convert all off-balance sheet credit exposures into equivalent on-balance-sheet credit exposures or credit equivalent amounts, determine the type of the item, and then apply the appropriate credit risk percentage requirement from the tables to estimate the instrument's credit risk capital charge. 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 on-balance-sheet credit equivalents. 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. Table 2 in proposed § 932.4(e)(1), 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 used to calculate the credit equivalent amount of an off-balance sheet instrument other than a derivative contract. The conversion factors are given in percentage form so that a conversion factor of 50 results in the face value of the off-balance sheet instrument being multiplied by 0.50 to calculate the credit equivalent amount.

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 it is not one that can be ignored. The proposed rule would assign a credit conversion factor of zero percent for other commitments that are unconditionally cancelable by the Bank without prior notice, or that effectively provide for automatic cancellation, due to deterioration in a borrower's creditworthiness. The proposed rule also would allow the Banks to use Finance Board approved internal models to calculate credit conversion factors instead of those specified in Table 2.

Under the proposed FMMA, a standby letter of credit (SLOC) would have been assigned a 100 percent conversion. Because a SLOC issued by a Bank is rarely drawn down, and if drawn down it converts to an advance, the Finance Board believes that it would be more appropriate to assign a Bank SLOC a 50-percent conversion factor, and has done so in the proposed rule. The Finance Board intends to undertake further research on the magnitude and appropriateness of the credit conversion factors set forth in proposed Table 2 and may make revisions in the final rule based on this research. The Finance Board requests comment on the credit conversion factors generally, and what issues might be appropriate to address as part of the anticipated research on this issue.

Credit equivalent amounts for derivative contracts.

The proposed rule provides that for market driven instruments such as over-the-counter derivative contracts,

i.e.,

swaps, forwards, and options, subject to counterparty default, the credit risk percentage requirement will be based on both current and potential future credit exposures (PFEs). 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 PFE (sometimes referred to as the potential future replacement cost) of the contract.

The proposed rule provides that the current credit exposure is equal to the maximum of the mark-to-market value of the contract, if that value is positive. A current credit exposure of zero is applied for contracts with a zero or negative mark-to-market value because such contracts do not create any current credit exposure for a Bank.

The proposed rule provides that the 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.

21

Under this approach, the PFE of a contract, including a contract with a negative mark-to-market value, is estimated by multiplying the notional amount of the contract by a credit conversion factor for the underlying market risk, as specified in proposed Table 3 of proposed § 932.4(f)(3)(i). The credit conversion factors are given in percentage terms such that a conversion factor of 7 would require the notional amount of a derivative contract to be multiplied by 0.07 to calculate the PFE for the contract.

21

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.

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 must be treated as Other Commodities for purposes of applying proposed Table 3. If a Bank determines to use proposed Table 3 for credit derivative contracts, the credit conversion factors applicable to Interest Rate Contracts under proposed Table 3 would apply.

22

Within each category of market risks, a Bank would not be allowed to arbitrage between capital requirements based on proposed Table 3 and internal models.

23

If a Bank were to use an internal model for a particular type of derivative contract, the Bank would be required to use the same model for all other similar types of contracts. The Bank, however, could use an internal model for one type of derivative contract and proposed Table 3 for another type of derivative contract. Adjustments to the credit conversion factors provided in Table 3 are specified in the proposed rule for contracts with multiple payment dates or that automatically reset to zero following a payment.

22

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.

23

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 would 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 include 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, even where the credit risk of one is significantly more concentrated than that of the other. As noted by the BCBS, however, this limitation may be effectively addressed in a portfolio-based internal credit risk model 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 their counterparties are financial institutions. The remaining unrated exposures are insignificant and may be dealt with outside a credit risk model. The Finance Board requests comment on whether the rule should take into account the diversification of a Bank's portfolio, and if so, how that should be done.

The proposed rule sets forth specific requirements for calculation of credit equivalent amounts for multiple derivative contracts subject to a

qualifying bilateral netting contract, as defined in the proposed rule. The provisions in the proposal are consistent with the requirements set forth in the risk-based capital guidelines of the federal bank regulatory agencies.

Zero credit risk charge for assets and items.

The proposed rule would allow on-balance sheet assets that are hedged with credit derivatives to be assigned a zero credit risk capital charge under three specified scenarios. Even if the credit risk capital requirement for the on-balance sheet asset were decreased through the use of a credit derivative, the applicable credit risk capital required for the derivative contract still would be applied.

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 and value at risk models for trading portfolios. Under the proposed rule, only some of the offsets would 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 charge for the on-balance sheet asset to zero. For example, if a Bank purchases a triple-B rated corporate bond with a maturity of five years and at the same time enters into a five-year credit default option contract based on the same bond, the credit risk capital charge for the underlying asset will be zero. The net credit risk capital charge for the pair will equal the credit risk capital charge for the credit exposure on the derivative contract.

If the on-balance sheet asset and the asset referenced in a credit derivative are identical, but the remaining maturities for the asset and the credit derivative are different, the capital relief in the proposed rule would depend on a maturity comparison between the two. For example, if the same triple-B rated five-year corporate bond was hedged with a credit derivative referenced to the same five-year corporate bond with a remaining maturity of two years or longer, there would be no credit risk associated with the underlying asset given the Finance Board's proposed default horizon of two years. Therefore, such a hedge would be fully recognized and the credit risk capital charge on the underlying asset would be zero. If the credit derivative maturity were less than two years, however, no capital relief would be granted because the credit derivative would not off-set the exposure associated with the asset for the complete term of the proposed default horizon. In all cases, there will be a credit risk capital charge for the credit exposure on the derivative contract.

If the remaining maturities of the on-balance sheet asset and a credit derivative are the same, but the on-balance sheet asset is different from the asset referenced in the credit derivative, capital relief for the on-balance asset may or may not be granted. It is proposed that the credit risk capital charge for the on-balance sheet asset be reduced to zero only if the asset referenced in the credit derivative and the on-balance sheet asset have been issued by the same obligor, the asset referenced in the credit derivative ranks pari passu or more junior to the on-balance sheet asset, and cross-default clauses are in effect.

Where the on-balance sheet asset and the asset referenced in the credit derivative 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. The Finance Board also more generally requests comment on how it should account for credit derivatives in calculating credit risk capital charges.

The proposed rule also would allow foreign exchange rate contracts with an original maturity of 14 calendar days or less to be assigned a zero credit risk capital charge. Gold contracts would not be considered exchange rate contracts. Derivative contracts that are traded on regulated exchanges that require daily collection of variation margin for the contract also would be assigned a zero credit risk capital charge.

The credit risk capital charge calculations required by the proposed rule, unless otherwise directed by the Finance Board, must be performed based on a Bank's on-balance sheet assets and off-balance sheet items as of the close of business on the last business day of the month for which the credit risk capital requirement is being calculated. Where applicable, calculations of credit risk capital charges must use the most current NRSRO credit risk ratings available as of the last business day of the month for which the credit risk capital requirement is being calculated.

Market Risk Capital Requirement.

The GLB Act requires each Bank to maintain sufficient permanent capital, as determined in accordance with Finance Board regulations, to cover the market risk to which the Bank is subject. 12 U.S.C. 1426(a)(3)(A)(ii),

as amended

. It further specifies that each Bank's market risk be determined:

based on a stress test established by the Finance Board that rigorously tests for changes in market variables, including changes in interest rates, rate volatility, and changes in the shape of the yield curve.

Id.

Beyond requiring that the stress test include the effects of changes in the interest rates, rate volatility and changes in the shape of the yield curve, neither the elements of market risk nor specific elements of the stress test are further defined in the statute, leaving the Finance Board with a degree of discretion to determine the terms and elements of the market risk stress test.

The GLB Act also directs the Finance Board, in developing the market risk stress test, to “take due consideration” of any risk-based capital test established by OFHEO for Fannie Mae and Freddie Mac, with such modifications as are appropriate to reflect differences in operations between the Banks and Fannie Mae and Freddie Mac. 12 U.S.C. 1426(a)(3)(B),

as amended

. This provision requires the Finance Board to take “due consideration” of the OFHEO capital rule only as it may relate to market risk. It does not require consideration of other aspects of the OFHEO rule, such as those relating to credit risk, nor does it mandate deference to OFHEO in any respect. The Finance Board has included the proposed OFHEO market risk test among the factors it has considered in developing the proposed market risk provisions of its capital rules. The Finance Board has modeled a hypothetical $100 billion asset Bank with a portfolio composition similar to the portfolio composition of Freddie Mac and Fannie Mae. The results of this simulation show that the Finance Board's risk-based capital requirement is consistent with what OFHEO has proposed to require for Freddie Mac and Fannie Mae. Given this consideration, the Finance Board believes that it has complied with its legal obligations under the GLB Act. Further, although

OFHEO has not yet adopted a risk-based capital test, the Finance Board intends to consider the substance of the final rule once it is adopted by OFHEO.

Market risk may be defined as the risk that the market value, or estimated fair value if market value is not available, of a Bank's portfolio will decline as a result of changes in interest rates, foreign exchange rates, equity prices and commodity prices. The Banks engage in activities that carry complex on-and off-balance sheet market risks. For example, outstanding consolidated obligations (COs), for which the Banks are jointly and severally liable, include bonds having embedded options, callable and index amortizing bonds, bonds denominated in foreign currencies, and bonds linked to equity prices. To hedge the market risk on such instruments, the Banks typically enter into off-balance sheet derivative contracts that convert the bonds to simple fixed-rate or floating rate bonds or convert the exposure to U.S. dollars. 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 needed to address market risks should be similar to the market risk capital requirements established or recommended by the BCBS and other financial institution regulatory agencies, but broader in scope. The Finance Board further believes that the general approach to market risk developed by the BCBS, as modified in this proposed rule, is consistent with the statutory requirements of the GLB Act.

As previously discussed, the BCBS has led the drive to institute a risk-based capital system for general market risk. 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 to incorporate a measure for market risk, effective as of January 1, 1998 (Joint Rule). 61 FR 47358 (Sept. 6, 1996). Institutions whose trading activity (defined in the Joint Rule as total assets plus total liabilities in the trading portfolio) equals 10 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, including mortgages or other similar types of instruments.

Financial institutions regulated by the Office of Thrift Supervision (OTS) and by the Farm Credit Administration (FCA) currently are subject to credit risk capital requirements that contain no market risk capital components (consistent with the small bank regulatory capital framework).

See

12 CFR 567.5 (OTS), 615.5205, 615.5210 (FCA). OFHEO, however, has published a Notice of Proposed Rulemaking including its regulatory model for calculating risk-based capital for Fannie Mae and Freddie Mac, which model does account for both interest rate risk and credit risk.

See

64 FR 18083 (Apr. 3, 1999). The OFHEO interest rate risk based capital rule is mandated by the 1992 Housing Enterprises Act, which requires that capital requirements account for market risks. Under the proposed OFHEO test, the market risk capital requirement would be determined by a stress test, which examines the effects of two specified interest rate shocks.

See

12 U.S.C. 4611(a)(2). The 1992 Housing Enterprises Act establishes parameters that OFHEO must meet in developing the model used to implement its stress test such that many aspects of OFHEO's stress test are dictated by legislation. This legislative approach is in contrast to the greater flexibility afforded the Finance Board in developing its stress test under the GLB Act. While the 1992 Housing Enterprises Act reflected the state of the art in risk measurement at the time it was drafted, the Finance Board's proposed regulation seeks to incorporate improvements in risk measurement that have been made since then. Furthermore, the statutory constraints imposed on OFHEO have rendered it difficult for OFHEO to develop and implement its capital requirements in a timely manner. The Finance Board believes that its proposed approach would reach the same goal as OFHEO's proposal—that of providing sound capital requirements based on the economic risks undertaken by the regulated entities—albeit with inevitable differences in the underlying methodology. Nonetheless, the Finance Board also notes that its proposed market risk rule would provide Banks with the opportunity to develop a cash flow model, similar to that proposed by OFHEO, as long as the cash flow model is consistent with the requirements of the GLB Act and the Finance Board's proposed requirements governing internal market risk models, and is approved by the Finance Board.

Currently, the FMP limits the Banks' interest rate risk based on a methodology that uses interest rate shocks similar to those proposed but never adopted by the four federal bank regulatory agencies (the OCC, the FRB, the FDIC, and the OTS). Specifically, the FMP requires the Banks to maintain the duration of their equity to within ±5 years and to maintain the duration of their equity to ±7 years under an assumed change in interest rates of ±200 basis points.

See

FMP Section VII.

In the view of the Finance Board, the methodology underlying the FMP is not sufficiently flexible to capture the Banks' market risks as they currently exist, or as they are likely to evolve given the recent proposal to expand their investment authority.

See

65 FR 25676 (May 3, 2000). Additionally, the risk management approach of the FMP is not consistent with a risk-based capital structure, nor would it allow the Finance Board to establish a market risk capital requirement based on a stress test that “rigorously tests for changes in market variables” and captures the risks to which a Bank is subject, as required by the GLB Act. Accordingly, the proposed rule sets forth an approach to measuring market risk that is based on the value at risk (VAR) framework adopted by the BCBS and other financial institution regulators. This approach can be implemented with commercially available models, is practical, and is sufficiently rigorous to comply with the requirements of the GLB Act. In particular, the proposed rule would require each Bank's internal market risk model to capture the effects of various shifts in the interest rate yield curve beyond parallel shocks, and to account for other financial and market shocks that could be experienced by the Banks given historic experience.

Components of the market risk capital requirement.

The proposed market risk capital requirement is the sum of two separate components. One component is the amount by which the current market value of a Bank's total capital is less than 95 percent of the book value of the Bank's total capital. The current market value of a Bank's total capital would be estimated by using the Bank's internal risk model to calculate the market value of the Bank's on-balance sheet assets, liabilities and off-balance sheet items. In essence, these values would be the base line values for the Bank's portfolio prior to running any stress tests required by the proposed rule. The “book value” of total capital would equal the Bank's total capital where all on-balance assets, liabilities and off-balance sheet items are accounted for under GAAP. The second component of the proposed market risk requirement would be the market value of the Bank's portfolio at risk, as estimated by the Bank's approved internal risk model. This value would equal the maximum loss in the market value of a Bank's portfolio under various stress scenarios, where the Bank's portfolio would be comprised of all its on-balance sheet assets and liabilities, and all off-balance sheet items.

The 95 percent test.

The Finance Board believes that significant impairment in a Bank's market value of capital, to the extent that it is not reflected in the book value of capital, must be taken into account in developing an adequate market risk capital requirement. To address this issue, the Finance Board proposes to increase the market risk capital requirement by the amount, if any, that a Bank's market value of total capital is less than 95 percent of its book value of its total capital. Thus, given the proposed test, if the current value of a Bank's total capital were significantly diminished by adverse market changes, a Bank's ability to take on risk would be restrained even if the impact of such adverse market events were not reflected in the book value of a Bank's total capital.

Generally, the proposed rule requires a Bank to measure and report its capital adequacy based upon the book value of total or permanent capital, calculated in accordance with GAAP. Because the Banks have large portfolios of long-term on- and off-balance sheet positions that are held-to-maturity, however, a Bank's financial strength, expressed by its market value, can decline significantly without that decline being reflected in the Bank's book value of capital.

24

This is because under GAAP, held-to-maturity positions would generally be valued at historic cost. Without the proposed 95 percent market value test, a Bank could incur a significant loss in financial strength due to adverse market changes, but not alter its market risk profile in response to that loss. The Finance Board is proposing this 95 percent test as a safeguard measure and believes that it will have little effect on Bank operations because most Banks have a market value of capital above 95 percent of book value. The charge associated with the 95 percent test would only limit a Bank's risk taking activities if its market value of capital were to fall below the 95 percent benchmark, and the Bank had otherwise fully leveraged its permanent capital.

24

The held-to-maturity items in a Bank's portfolio would typi

This text is long and has been trimmed here. Open the source document for the complete record.