Corporate Credit Unions

NATIONAL CREDIT UNION ADMINISTRATION

12 CFR Parts 702, 703, 704, 709, and 747

RIN 3133-AD58

Corporate Credit Unions

AGENCY:

National Credit Union Administration (NCUA).

ACTION:

Final rule.

SUMMARY:

NCUA is issuing final amendments to its rule governing corporate credit unions. The major revisions involve corporate credit union capital, investments, asset-liability management, governance, and credit union service organization (CUSO) activities. The amendments establish a new capital scheme, including risk-based capital requirements; impose new prompt corrective action requirements; place various new limits on corporate investments; impose new asset-liability management controls; amend some corporate governance provisions; and limit a corporate CUSO to categories of services preapproved by NCUA. In addition, this rulemaking contains conforming amendments to rules governing Prompt Corrective Action (for natural person credit unions); Investments and Deposit Activities (for federal credit unions); Administrative Actions, Adjudicative Hearings, Rules of Practice and Procedure, and Investigations; and Involuntary Liquidation of Federal Credit Unions and Adjudication of Creditor Claims Involving Federally Insured Credit Unions. These amendments will strengthen individual corporates and the corporate credit union system as a whole.

DATES:

This rule is effective January 18, 2011, except that the amendments to 12 CFR 702.105(a), 703.14(b), 704.2, 704.3, 704.4, and subpart M of 12 CFR part 747, are effective October 20, 2011.

FOR FURTHER INFORMATION CONTACT:

David Shetler, Deputy Director, Office of Corporate Credit Unions, at telephone (703) 518-6640, National Credit Union Administration, 1775 Duke Street, Alexandria, Virginia 22314; Ross Kendall, Staff Attorney, Office of General Counsel, at the address above or telephone (703) 518-6540; or Paul Peterson, Associate General Counsel, at the address above or telephone (703) 518-6540.

SUPPLEMENTARY INFORMATION:

I. Background

In January 2009, NCUA solicited public comment on whether comprehensive changes to the structure of the corporate credit union (corporate) system were warranted. 74 FR 6004 (Feb. 4, 2009). This corporate Advanced Notice of Proposed Rulemaking (ANPR) sought comment on how best to define and structure the role of corporates in the credit union system, whether to modify the level of required capital for corporates, whether to modify or limit the range of permissible investments for corporates, whether to impose new standards and limits on asset-liability management (ALM) and credit risk, and whether to make modifications in the area of corporate governance. NCUA received some 445 comments in response to the ANPR. NCUA reviewed these public comments closely and considered them carefully.

On November 19, 2009, the NCUA Board issued a Notice of Proposed Rulemaking (NPR) containing extensive, specific proposed revisions to NCUA's rule governing corporate credit unions (corporates) and related rule provisions. 74 FR 65210 (Dec. 9, 2009). The proposed revisions covered corporate capital, prompt corrective action (PCA), investments, ALM, CUSOs, and governance. Briefly summarized, the major provisions in the proposal would have:

• Imposed new minimum capital ratios, new risk based capital calculations, and new elements of capital, all in general accordance with the Basel I capital requirements imposed by the banking regulators on banks.

• Required that retained earnings (RE) constitute a certain portion of corporate capital, and that corporates build retained earnings over time.

• Eliminated the current prohibition on conditioning membership, the receipt of services, or the pricing of services upon the purchase of paid-in capital.

• Added new PCA provisions similar to those currently applicable to banks.

• Prohibited investments in collateralized debt obligations (CDOs) and net interest margin (NIM) securities.

• Toughened the capital requirements for expanded investment authority, and restricted the credit ratings for investments purchased by such corporates to a minimum of “A−.”

• Required that a corporate examine every available Nationally Recognized Statistical Rating Organization (NRSRO) rating for a particular security and only employ the lowest of those ratings, and that at least 90 percent of a corporate's investments be rated by at least two NRSROs.

• Tightened the existing single obligor concentration limit and imposed new sector concentration limits.

• Placed limits on subordinated positions in structured securities.

• Imposed new limits on the maximum difference between the estimated average life of the asset cash flows and the average life of the liability cash.

• Restricted the weighted average life (WAL) of a corporate's cash-flowing assets to two years.

• Limited a corporate's aggregate borrowing to the lesser of 10 times capital or 50 percent of shares and capital; and further restrict secured borrowing to maximum maturities of 30 days and only for liquidity purposes.

• Prohibited a corporate from accepting investments or loans from any one entity that exceed ten percent of the corporate's assets.

• Required that a corporate CUSO only engage in categories of services preapproved by NCUA, including, initially, brokerage and investment advisory services.

• Required that a corporate CUSO agree with the corporate by contract to permit NCUA access to the CUSO's books, records, personnel, equipment, and facilities.

• Required that all corporate board members hold either a CEO, CFO, or COO position at a member credit union or other member entity.

• Generally limited corporate board members to no more than six years of service.

• Required that a majority of a corporate's board members be representatives of natural person credit unions (NPCUs).

• Required that each corporate annually disclose to its members the compensation of each senior executive officer and director.

• Required a merging federally-chartered corporate affirmatively disclose to both NCUA and its members any material, merger-related increase in compensation for any senior executive or director.

• Prohibited parties affiliated with a corporate from receiving 1) indemnification in connection with administrative or civil proceedings instituted by NCUA or a state regulatory authority where the party is ultimately found liable and 2) golden parachute payments.

The preamble to the NPR included an extensive discussion of the crisis in the corporates giving rise to the need for regulatory reform, followed by a discussion of the nature of, and justification for, each proposed revision.

Id.

at 65211-65255.

The public comment period for the NPR closed on March 9, 2010. NCUA received 815 public, written comments letters totaling more than 2,600 pages of comments. In addition, NCUA held several town halls and webinars during the comment period during which NCUA both answered questions about the proposed rulemaking and listened to oral comments about the proposal.

Most commenters liked some portions of the proposed rule and disliked other portions. The most common comment on the overall rulemaking was support for the proposed stronger capital requirements; increased limits on single obligors; concentration limits on certain investment sectors; and prohibitions on certain high risk securities—but also serious reservations about other portions of the proposal, including certain ALM, investment, CUSO, and corporate governance provisions.

Of those commenters who expressed a general opinion on the overall rulemaking, many, including some trade groups and various larger NPCUs (

i.e.,

over $1.2 billion in assets), generally support the rule. Many more commenters, however, generally oppose the proposed rule, among them many small and medium-sized NPCUs ranging up to over $1 billion in assets. Many of the commenters in opposition believed that the various investment and ALM restrictions in the proposed rule would cause major changes in corporate operations; that these changes would threaten the ability of corporates to provide liquidity and other valuable services to NPCUs; and that these changes might force NPCUs to turn to banks (their competitors) for services—considered by the commenters as a more expensive and less reliable alternative to today's corporate system. The comments that pertain to specific, proposed revisions are discussed in more detail in the section-by-section analysis below.

The NCUA Board has now determined to issue final revisions based on the proposal and the comments received. Generally, these revisions will become effective 90 days following the publication in the

Federal Register

, but the effective date for many of the revisions will be delayed beyond 90 days.

The remainder of this preamble contains four sections: A summary of the significant revisions in the final rule, a section-by-section analysis of all the revisions, an analysis of how the final investment, credit risk, and asset liability provisions might affect a corporate's ability to achieve its capital requirements, and a discussion of the regulatory procedures affecting this rulemaking.

II. Summary of Significant, Final Revisions

A. Overview

Ultimately, the primary purposes of this extensive rulemaking were twofold. First, NCUA wanted to design a corporate rule that would prevent the catastrophic losses that occurred in the corporate system beginning in 2007 from ever recurring. Second, NCUA wanted to allow for the survival of some form of a well-run corporate system that could provide necessary services, including payments systems services, to its members, and build and attract sufficient capital.

The Board believes this final rule accomplishes these two purposes.

First, and as discussed in more detail below, the 2007 losses resulted almost entirely from private label residential mortgage backed securities (RMBS), with many of the worst performing of these securities being subordinated RMBS. The final rule prohibits corporates from purchasing either private label RMBS, or subordinated-type securities, going forward. In the most specific sense, then, the rule will make it

impossible

for corporates to repeat what happened in 2007. Of course, the next financial crisis may not be a credit or mortgage crisis, so the final rule includes a series of other investment, credit risk, ALM, liquidity, and capital measures that together should greatly reduce the systemic risk posed by the corporates regardless of the source of the next crisis.

Second, the Board believes that a well-run corporate should be able to operate within the confines of the new rule and construct a business model, and an investment portfolio, that permits it to attract capital and grow retained earnings going forward. Again, this is discussed and demonstrated in some detail in Section IV. of the preamble below.

Affected Sections of NCUA's Rules and Regulations

The final revisions affect part 704,

Corporate Credit Unions,

and several other sections of NCUA's regulations. The following chart lists the affected sections. It also summarizes the applicability dates for each section and, in some cases, the applicability dates for particular paragraphs or individual definitions.

Current rule provision

Amended?

Delayed applicability date?

(

e.g.,

“+12 months” means delayed 12 months following date of publication of final rule in

Federal Register

)

704.1

Scope

No

Not applicable (N/A).

704.2

Definitions

Yes. Removed and replaced twice. Second replacement introduces capital and PCA definitions

First replacement of 704.2. +90 days.

Second replacement of 704.2. +12 months.

Adjusted core capital.

—deduct PCC or NCA at another corporate. +12 months

—deduct certain excess PCC. +72 months to +120 months

—deduct PCC in excess of retained earnings. +120 months

Permanent leverage ratio.

+36 months

704.3

Corporate credit union capital

Yes

Current 704.3 replaced. +12 months.

704.3(a)(3): If RE ratio less than 0.45, must submit REAP. +36 months.

704.3(f)(4): Corporate with unconverted MCAs must notify MCA holders of account status. +14 months.

704.4

Board responsibilities

Yes. The current

Board responsibilities

is redesignated as 704.13. New 704.4

Prompt corrective action

(PCA) added

Current 704.4 replaced with PCA section. +12 months.

704.5

Investments

Yes

+90 days.

704.6

Credit risk management

Yes

+90 days.

704.7

Lending

No

N/A.

704.8

Asset and liability management

Yes

Generally, +90 days.

704.8(k): Prohibition on a corporate receiving more than 15 percent of business from one member or credit union. +30 months.

704.9

Liquidity management

Yes

+90 days.

704.10

Investment action plan

No

N/A.

704.11

Corporate CUSOs

Yes

Generally, +90 days.

704.11(e)(1): Requirement for NCUA approval of corporate CUSO activities. +180 days.

704.11(e)(2): Requirement that corporate divest from CUSO engaged in unapproved activities. +12 months.

704.12

Permissible services

No

N/A.

704.13 [Reserved]

Yes

The current 704.4

Board responsibilities

redesignated as 704.13. +90 days.

704.14

Representation

Yes

Generally, +90 days.

704.14(a)(2): Requirement that only CEO, CFO, or COO may seek election to corporate board. +120 days.

704.14(a)(9): Requirement that at least a majority of each corporate's directors be representatives of NPCUs. +36 months.

704.15

Audit requirements

No

N/A.

704.16

Contract/written agreements

No

N/A.

704.17

State-chartered corporate credit unions

No

N/A.

704.18

Fidelity bond coverage

No

N/A.

704.19

Wholesale corporate credit unions

Yes

Current 704.19 removed, and new 704.19,

Disclosure of executive and director compensation,

added. +90 days.

704.20 None.

Yes

New 704.20,

Golden parachute and indemnification payments,

added. +90 days.

Appendix A

Model forms

Yes

Amended and renamed

Capital Prioritization and Model Forms.

+90 days.

Appdx A, Part I: Corporates may determine that newly contributed capital has priority over existing capital. +90 days.

Appendix B

Expanded Authorities and Requirements

Yes

Generally, +90 days.

Part I(e): Substitute “leverage ratio” for “capital ratio.” +12 months.

Appendix C None.

Yes

New Appendix C,

Risk-Based Capital Cred-it Risk-Weight Categories,

added. +12 months.

702.105

Yes

Conforming amendment (to substitute new capital terms). +12 months.

703.14(b)

Yes

Conforming amendment (to substitute new capital terms). +12 months.

709.5(b)

Yes

Conforming amendment (to substitute new capital terms). +90 days.

Part 747, subpart M

Yes

Add new subpart M on due process for PCA actions. +12 months.

Third Party Evaluation of Proposed Rulemaking

NCUA commissioned an outside consultant, Kamakura, Inc., to provide NCUA with an assessment of the proposed corporate rule. Kamakura issued its final report, entitled

Impact Analysis—Proposed Modification of 12 Code of Federal Regulations Part 704—National Credit Union Administration

(the “Kamakura Report”), on July 12, 2010. Interested parties can download a copy of the Kamakura Report from NCUA's Web site at

http://

www.ncua.gov.

As discussed throughout the following preamble, NCUA carefully considered the Kamakura Report when finalizing the investment and ALM provisions of this rulemaking.

Legacy Assets

The ability of some corporates to comply with the provisions of this final rule depends on managing certain “legacy assets” on their balance sheet. These legacy assets are securities, generally private label RMBS, that continue to carry significant credit risk and market values far below their intrinsic values.

NCUA has been working for some time on a plan to isolate such legacy assets in those corporates where the exposure represents the greatest risk to the insurance fund. In general, these cases represent corporate credit unions where expected future credit losses exceed the corporate's total capital, and recapitalization would not occur without agency assistance. NCUA has, as promised, released its plans for dealing with those corporates' legacy assets. Information about the plans can be obtained from NCUA's Web site at

http://

www.ncua.gov.

Some corporates have lesser positions in RMBS assets where NCUA does not expect the associated credit losses to exceed the corporate's total capital. They may also have other assets with long WALs, positions that are concentrated beyond the prescribed diversification limits, or other portfolios that otherwise inhibit compliance with new rule. NCUA expects these institutions to develop business plans and take action to become compliant with the rule. Generally, NCUA will want these corporates to sell these legacy assets as soon as possible so as to come into compliance with the corporate rule. If the corporate decides an alternative approach to selling the legacy assets is sound and supportable, the corporate will have to submit a draft investment action plan to NCUA for its approval under § 704.10 and other provisions of the corporate rule, such as § 704.8(j)(2)(i). For example, NCUA will consider approval of an action plan that includes retention of these legacy assets while they amortize if the corporate can

document that the expected future credit losses on these assets are significantly less than the losses the corporate would take if the investments were sold at current market prices. Depending on the circumstances of the corporate, an NCUA-approved action plan might permit the corporate to operate temporarily outside the WAL limitations and other applicable investment, credit risk, or ALM limitations in the corporate rule. In addition, NCUA might grant these corporates a waiver of time to build the retained earnings required by this regulation—but only to the extent of documented losses flowing from legacy assets identified in an approved action plan. 12 CFR 704.1(b).

Effect of the Dodd-Frank Act on the Use of Credit Ratings

Just recently, on July 21, 2010, Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA). The DFA, which contains 848 pages divided into 16 separate Titles, has multiple impacts on NCUA, its regulations, and its enforcement authority. The Board is carefully considering the implications of the DFA and the actions NCUA is required to take under the DFA.

Section 939A of the DFA is likely to affect NCUA's regulations, including the corporate credit union regulation. Both NCUA's current and revised corporate rules include references to NRSRO credit ratings. As stated in section 939A, NCUA has one year to review all its regulations and modify them to remove such references and “substitute in such regulations such standard of credit-worthiness as [the Board] shall determine to be appropriate.” Until the Board completes that review and modification, however, corporates will be expected to comply with all the provisions of the corporate rule that make reference to NRSRO ratings.

Section 704.2 contains a definition of

small business related securities,

and that definition refers to the definition of the same term in Section 3(a)(53) of the Securities Exchange Act of 1934 (SEA). The Dodd Frank Act, however, changed the SEA definition, and the Board determined that it wanted to continue to use the older definition. Accordingly, this final rule revises the § 704.2 definition of

small business related securities

to remove the reference to the SEA definition.

Section 939(e)(2) the DFA, however, eliminates the reference to NRSRO ratings in Section 3(a)(53), and substitutes a reference to “meets standards of credit-worthiness established by the [Securities and Exchange] Commission (SEC).” Again, until such time as either the SEC or NCUA can provide some content to the latter phrase, NCUA believes that the definition of small business related security in § 704.2 should remain unchanged.

B. Capital

Summary of Current Capital Provisions

Currently, corporates have only one mandatory minimum capital requirement: they must maintain total capital (

i.e.,

retained earnings (RE), paid-in capital, and membership capital accounts) in an amount equal to or greater than 4 percent of their moving daily average net assets.

1

Failure by a corporate to meet this minimum capital ratio triggers the requirement to file a capital restoration plan with NCUA and may cause NCUA to issue a capital restoration directive and take other administrative action.

1

Corporates have other capital-related requirements, such as a core capital ratio and a retained earnings ratio, but failure to meet these requirements only triggers future earnings retention requirements and does not trigger a capital restoration plan requirement or other particular supervisory actions.

The current rule allows a corporate to issue Paid in Capital (PIC) to both members and nonmembers, while Membership Capital Accounts (MCAs) may only be issued to members. The current rule also prohibits a corporate from conditioning membership, the receipt of services, or the pricing of services upon the purchase of PIC.

Summary of Proposed Capital Revisions (November 2009)

The proposal contains a capital scheme based on the Basel I capital regimes of the other banking regulators. The proposal renames PIC as Perpetual Contributed Capital (PCC), and makes certain changes to the MCA requirements and labels those MCAs as Nonperpetual Capital Accounts (NCAs). The proposal then seeks to replace the one existing total capital ratio with three minimum capital ratios, including two Risk Based Capital (RBC) ratios. These RBC ratio calculations involve credit risk-weighting the corporate's assets and off balance sheets activities to produce a moving daily average net

risk-weighted

assets (MDANRA).

The three new proposed ratios are described in the following chart:

Ratio

Numerator

2

Denominator

Minimum level (adequate cap.)

(percent)

Minimum level (well cap.)

(percent)

Leverage Ratio

RE + PCC

MDANA

4

5

Tier-One RBC Ratio

RE + PCC

MDANRA

4

6

Total RBC Ratio

RE + PCC + NCAs

MDANRA

8

10

The proposal

also requires that, in the leverage ratio and Tier 1 RBC ratio, the corporate may only count PCC to the extent that it does not exceed the corporate's RE. That results in the corporate needing 200 basis points (BP) of RE to reach a 4 percent leverage ratio and so be adequately capitalized, and 250 BP to be well-capitalized. This RE requirement, and the various other proposed capital measures, are phased-in over a ten-year time period, as discussed below.

2

These numerator formulas are simplifications. The proposal actually contains certain adjustments to each capital calculation, and those proposed adjustments that received comments are discussed below.

Summary of Proposed Phase-In of Capital Provisions

The proposal contains a multi-step, multi-year phase-in of the new capital requirements:

•

Year one.

None of the new capital requirements would apply during the first year following publication of the final rule. During this period the current total capital ratio would remain in effect, as well as the revised capital order, and associated waivers, issued by the NCUA Board on April 29, 2010.

3

3

The Net Economic Value (NEV) limitations that exist in the current rule have not changed under this final rule. 12 CFR 704.8(d). Thus, these NEV limits continue to be in effect and no implementation delay for these NEV limits is warranted.

•

Years two and three.

The two new risk based capital ratios would come into effect on the first anniversary of the publication of the final rule. Corporates

would be required to meet a minimum 4 percent Tier 1 RBC ratio and a minimum 8 percent Total RBC ratio. In addition, corporates would be required to satisfy an interim leverage ratio, defined almost identically to the existing total capital ratio. Because NCUA should have resolved the legacy assets at this point,

and

most corporates will have very low-risk weighted assets, neither of the two RBC ratios will likely dictate the amount of capital corporates need at this point. Instead, actual minimum capital requirement will likely be dictated by the interim leverage ratio, meaning a corporate will need 200 BP in PCC/RE and another 200 BP in NCAs.

•

Years four through six.

At the third anniversary of the publication of the final rule, the 4 percent minimum leverage ratio goes into effect. In addition, any corporate that does not have at least 45 BP of RE on the third anniversary must file a retained earnings action plan (REAP) with the NCUA illustrating how it is going to achieve the upcoming RE requirements at the sixth and tenth anniversaries of the final rule.

•

Years seven through ten.

At the sixth anniversary of the publication of the final rule, a corporate must have at least 100 BP of RE to be considered adequately capitalized.

•

Year eleven and after.

At the tenth anniversary of the publication of the final rule, a corporate must have at least 200 BP of RE to be considered adequately capitalized.

Overview of Significant Capital Revisions in This Final Rule

Most of the public comments on the capital provisions, including comments received from corporate credit unions, were supportive of the new proposed Basel I capital requirements, including the use of risk-based capital measures. Some of these commenters specifically supported the use of Basel I standards over Basel II, stating that Basel I was adequate and less complex.

The Board agrees with these commenters, and has generally adopted, with some modifications, the minimum capital ratios, risk based capital calculations, and new elements of capital, as set forth in the proposed rule. As in the proposed, the final revisions will require that RE constitute a certain portion of capital. For example, to be adequately capitalized, a corporate must have at least 100 BP of RE after six years, and 200 BP of RE after ten years. Other elements of the new capital provisions will also be phased in over time, beginning one year after publication of this final rulemaking. The final revisions eliminate the current prohibition on conditioning membership, services, or the pricing of services upon the purchase of paid-in capital. Details about each final revision are contained in the section-by-section analysis below.

Some commenters, including NPCUs, questioned whether corporates need

any

capital. Other commenters stated that NCUA should not require any contributed capital, and that corporates should be given sufficient time to “earn” their way to adequate capitalization.

The Board is concerned that NCUA's extraordinary actions to stabilize and protect the corporate system over the past few years have been misunderstood by some of these commenters. Because of NCUA's actions, including the Temporary Corporate Credit Union Share Guarantee Program (TCCUSGP) and the Temporary Corporate Credit Union Liquidity Guarantee Program (TCCULGP), many corporates have been able to operate as going concerns with artificially low levels of capital. Measures like the TCCUSGP and TCCULGP are, however, temporary measures. In the future, NCUA will wind down and terminate these measures, and corporates will have to function on their own. Further, corporates and their members cannot expect to ever again receive such extraordinary government support, either explicitly or implicitly, from NCUA or any other government entity.

4

In fact, it is NCUA's intention with the various revisions in this final rule to ensure that the corporates, going forward, never again present the sort of systemic risk to the entire credit union system that requires such extraordinary intervention. And this means that, without building adequate capital going forward, corporates

will not

be able to function.

4

Except, of course, for the standard federal share insurance of up to $250,000, as mandated by the Federal Credit Union Act.

Inadequate levels of capital introduce unacceptable moral hazards. When the owners of an entity have significant amounts of their own capital at stake, they have incentive to ensure that the entity is prudently operated and does not engage in overly risky activity, because the risk of loss is born by the capital owners. However, when the owners have little or no capital at stake, they have the incentive to overlook, or even encourage, risky behavior by the entities' management. We observed some of this risky behavior at certain corporates in the recent past—and this behavior was likely fueled by contributed capital levels that were too low for the risks undertaken, as well as the fact that some member owners of these corporates did not fully understand the nature and extent of their potential capital losses and so were not actively engaged in the oversight of their corporates. NCUA will not permit corporates to operate with low capital levels that encourage risky behavior. Accordingly, NCUA intends with this rulemaking to ensure corporates have adequate capital levels going forward to mitigate such moral hazard.

5

5

The Board also believes that all NPCUs now understand the nature of any capital commitment to a corporate and the need to be involved in the direction and management of their corporates.

In addition to introducing unacceptable moral hazards, low capital levels have negative, direct effects on an entity's ability to function. For example, potential creditors would not likely lend to any corporate that does not have capital sufficient to absorb losses, because the creditors will have legitimate fears that any operating losses in the corporate will keep the creditors from getting repaid. Likewise, potential third-party vendors would not do business with corporates that do not have capital available to absorb operating losses, because these vendors would be afraid that any losses would have negative effects on the corporate's ability to pay the vendors' invoices.

6

6

As indicated above, after the TCCUSGP and the TCCULGP have served their purposes and been terminated NCUA will no longer provide corporates with extraordinary support. NCUA will disabuse the public, the members, any potential creditors of a corporate, and any potential vendors of a corporate, of the idea that NCUA will again intervene to protect insolvent corporates.

In sum, going forward corporates must survive on their own and without continued government assistance—and that means corporates must have their own adequate capital.

In response to the other comments, NCUA is not requiring that any of a corporate's capital be contributed capital. NCUA will not, however, continue its extraordinary support of the corporate system over the time it would take to build sufficient capital just through RE growth alone. For example, to achieve a 4 percent capital ratio just through RE growth could take 20 years or longer. It is inappropriate for the NCUA, which is a government entity, to provide the necessary guarantees and other assistance that would enable a corporate to survive that long with such low levels of capital. And that means that, to survive as a going concern without continued government assistance, a corporate must solicit and achieve sufficient capital in the form of contributed capital. Any corporate that

is unable to obtain the requisite levels of capital in a timely manner may have to be liquidated or merged.

Some commenters questioned the need for any minimum RE requirement. One corporate stated that, from a NCUSIF standpoint, contributed capital acts in the same capacity as RE. This commenter believes that the building of RE is typically a decision made by the organization's Board and so does not believe that the portion of capital that is RE should be designated within the regulation. Another corporate commenter, however, recognized the need for a minimum RE requirement.

As discussed at length in the preamble to the proposed rule, NCUA believes that, eventually, some part of a corporate's capital must consist of RE. This is the only form of corporate capital that, when depleted, does not result in losses that flow downstream to NPCUs. Without some RE, the corporates would be a continued source of instability to the credit union system as a whole.

A few commenters stated that NCUA needed to look at other sources besides credit unions to recapitalize the corporate system, without specifying which sources. The Board is unaware of any other logical sources of capital. Corporates are member-owned cooperatives established to serve their member NPCUs, so logically the primary source of a corporate's contributed capital should be its member-owner NPCUs. Still, corporates have always been free to sell paid-in capital to nonmembers, including non-credit union nonmembers, but to date have been either unwilling or unable to do so. The proposal, and these final revisions, permit corporates to sell all forms of contributed capital, including nonperpetual capital, to nonmembers at the corporate's discretion. To the extent, however, that some commenters might believe that NCUA or the federal government can donate capital to corporates, that is neither legally possible nor a good idea as a policy matter. As stated above, credit unions in general, and corporates in particular, cannot depend on continued government assistance to survive.

Some commenters thought the proposed capital requirements were overly complex. The NCUA Board disagrees. Corporates are complex financial entities and so require some detail and nuance in their regulation. The Board notes that the Basel I standards, and associated regulations, are no more complex than those capital standards imposed on banking entities with similarly complex operations and activities.

A few commenters that generally opposed the new capital standards stated that the NCUA's basic rationale for the proposed changes is that the permanence of capital and a risk-based capital standard would have mitigated the losses at Corporates in the past two years. This is not a correct statement. NCUA has long been considering amendments to improve corporate capital standards, even before the credit crisis of 2007. The new capital standards, as proposed and finalized here, are intended to help protect the corporates, their members, and the NCUSIF from future losses, whether or not those future losses are related to credit risk in the mortgage markets (as in 2007) or are caused by other factors.

A few commenters questioned why NCUA was imposing capital requirements on corporates that were similar to banking capital requirements while at the same time imposing ALM and investment requirements that were different from those imposed on banks. The Board believes that while many corporates engage in activities and take on risks similar to banks, and thus should have a capital regime similar to banks, the risks that corporates pose to NPCUs are

systemic

risks, and thus different than the risks posed by one bank to another bank. It is true that a few very large banks may present systemic risks to the banking system, but the Basel I standards contained in this rulemaking are different than the Basel II advanced standards that very large banks are subject to.

Several NPCU commenters were concerned that the likelihood of ongoing corporate consolidation, combined with factors in the proposal such as the lengthening of the MCA three year requirement to five years and the requisite NCUA approval for any return of PCC, all increased the possibility that an NPCU might find itself stuck with significant capital in a corporate to which that NPCU did not want to belong. Natural person credit unions will have to decide, going forward, what services they want from corporates. As part of that decision, they will have to decide if they are willing to contribute capital to one or more corporates. If they decide to contribute capital, they will have to take into account the possibility that the corporate may then consolidate or merge with another corporate. If that should happen, and the NPCU no longer desires services from the continuing corporate, the NPCU does have several options. First, it may ask the corporate to redeem the capital. If such redemption complies with NCUA's regulations, and NCUA approves the redemption, the corporate may redeem the capital. Second, the member NPCU can attempt to transfer (sell) the capital to another member. And, third, the member NPCU can attempt to transfer the capital to a nonmember.

A few commenters believe the proposed capital phase-in period is appropriate, and one NPCU labeled it as generous. Many commenters, however, believe that the proposal provides too short a time period for the phase-in of the proposed new capital requirements.

The Board believes that the final capital phase-in, which mirrors the proposed phase-in, is both appropriate and feasible. As discussed in the preamble to the proposed rule, the phase-in period balances the need for corporates to (1) quickly achieve sufficient capital, and wean themselves from government assistance, through solicitations of contributed capital and growth of RE, while (2) providing for an adequate opportunity to make that solicitation and achieve that growth.

The proposed rule was issued ten months ago, and corporates have had some time since then to consider the ramifications of the proposal. Further, none of the new capital provisions will be effective until the first anniversary of the publication of this final rulemaking in the

Federal Register.

This one year period gives corporates ample opportunity to analyze the elements of this final rule, perfect their business plans, convince their members of the validity of their business plans, and solicit contributed capital.

7

Corporates that are well-run should be able to make an effective solicitation so as to garner sufficient contributed capital by the first anniversary.

7

Some corporates may not even need additional capital on the first anniversary.

Under the final rule, the first specific RE target (

e.g.

45 BP of accumulated RE) does not go into effect until the third anniversary of publication, and the first specific RE requirement (100 BP) does not go into effect until the sixth anniversary of publication. As discussed in the sections below on the asset liability management provisions of the final rule, the final investment and ALM provisions permit corporate credit unions a bit more leeway in the mismatch of their assets and liability cash flows than in the proposed rule, and the Board believes this should help corporate credit unions generate additional earnings on their assets. As also discussed below, NCUA has modeled various investment portfolios that corporates could purchase under provisions of the final corporate rule, and the Board has concluded that a well-run corporate can, in fact, generate

45 BP of earnings in the first three years and 100 BP of earnings in the first six years as required by the capital phase-in.

Other, more specific comments on capital are discussed in the section-by-section analysis below.

C. Prompt Corrective Action (PCA)

Although prompt corrective action (PCA) applies to natural person credit unions (NPCUs) and to banking entities, PCA does not currently apply to corporates. The proposed rule contained a PCA regime similar to what the other banking regulators, and the Federal Deposit Insurance Act, impose on banks.

The final rule adopts the proposed PCA provisions substantially as proposed. Each corporate will be assigned to one of five capital categories: Well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. The potential consequences of failing to meet capital standards include restrictions on activities, restrictions on investments and asset growth, restrictions on the payment of dividends, restrictions on executive compensation, requirements to elect new directors or dismiss management, and possible conservatorship. The final rule does include some due process enhancements beyond those contained in the proposed rule.

D. Corporate Investments, Credit Risk, and Asset-Liability Management (ALM)

Summary of Current Investment, Credit Risk, and ALM Provisions

The current Part 704 generally prohibits certain types of investments, including derivatives, stripped mortgage backed securities (MBS), mortgage servicing rights, and residual interests in asset backed securities (ABS). The rule specifies, for permissible investment types, that investments must be rated no lower than AA- by at least one NRSRO at time of purchase. Corporates that qualify for Part I expanded authority, however, have additional investment authority, including the purchase of investments rated down to A-. Corporates that qualify for Part II expanded authority may purchase investments rated down to BBB(flat). Corporates that qualify for Part III expanded authority may invest in certain foreign obligations; corporates that qualify for Part IV expanded authority may engage in derivatives transactions for certain specified purposes; and corporates with Part V expanded authority may engage in certain loan participations.

The current rule requires that corporates maintain an internal investment policy that includes “reasonable and supportable concentration limits” including limits by “investor type and sector.” The current rule limits the aggregate of all investments in any single obligor to the greater of 50 percent of capital or $5 million, but includes no regulatory sector limits. The rule does not limit investments that are structured to be subordinate, in terms of potential credit losses, to other securities.

Summary of Significant Proposed Investment, Credit Risk, and ALM Provisions

NCUA developed the proposed changes to the investment, credit risk, and ALM provisions based on lessons learned from both the recent experience with corporate investment portfolios and their associated losses and comments received from the ANPR.

NCUA determined that three major risk conditions were the primary contributors to the current losses in the corporate system: (1) Excessive investment sector concentrations, particularly private label RMBS; (2) excessive average-life mismatches between assets and liabilities; and (3) excessive concentrations in subordinated securities, including mezzanine securities. The proposed revisions to the investment and asset-liability provisions of the corporate rule control these risk conditions in the aggregate through the use of limits, many of which are tied to a corporate credit union's capital. The proposal provided a framework that allowed for a level of risk-taking necessary to support the profitability of a corporate but which would also be continuously and adequately protected by the corporate's capital.

The proposed rule established new prohibitions for investments in collateralized debt obligations (CDOs) and net interest margin (NIM) securities.

The proposal also required that a corporate examine the NRSRO rating from every NRSRO that publicly rates a particular investment and only employ the lowest of those ratings and required that at least 90 percent of a corporate's investments be rated by at least two NRSROs. The proposal eliminated Part II expanded authority, thus making “A−” the lowest possible rating for an NRSRO-rated investment purchased by a corporate with expanded investment authority. To qualify for Parts I and II (

i.e.,

the current Parts I and III) expanded investment authority, the proposal required a corporate achieve and maintain higher capital levels, that is, a minimum six percent capital ratio.

The proposal generally reduced the single obligor limits from 50 percent of capital to 25 percent of capital, with slightly higher limits for investments in mutual funds and repurchase agreements. The proposal also imposed specific concentration limits by investment sector. Sectors included residential mortgage backed securities (RMBS), commercial mortgage backed securities (CMBS), student loan asset backed securities (ABS), automobile loan/lease asset backed securities, credit card asset backed securities, other asset backed securities, corporate debt obligations, municipal securities, and money market mutual funds, and an “all others” category to account for the development of new investment types. The proposed sector limits were, generally, (1) the lower of 500 percent of capital/25 percent of assets, or (2) the lower of 1000 percent of capital/50 percent of assets (for the less risky sectors).

The proposal excluded certain assets entirely from both the single obligor concentration limit in § 704.6(b) and the sector concentration limits in § 704.6(c). The excluded assets include fixed assets, loans, investments in CUSOs, investments issued by the United States or its agencies or its government sponsored enterprises, and investments fully guaranteed or insured as to principal and interest by the United States or its agencies. Investments in other federally-insured credit unions, deposits in other depository institutions, and investment repurchase agreements would also be excluded from the sector concentration limits but not the single obligor concentration limit. Investments in CUSOs, while excluded from both the § 704.6 concentration limits, would still be subject to the investment limits in the corporate CUSO rule, § 704.11(b).

The proposal limited subordinated positions in a structured security to the lesser of 100 percent of capital/5 percent of assets in any given sector class and the lesser of 400 percent of capital/20 percent of assets in the aggregate.

The proposal generally limited a corporate's Part III (renumbered from Part IV) derivatives activity to derivatives used for the purposes of reducing the corporate's overall risk.

Summary of Significant Investment, Credit Risk, and ALM Revisions From the Proposed to the Final Rule

Based on comments received and further review, the NCUA Board adopted most of the proposed

provisions but also made some significant changes. The most significant changes in the final rule were the removal of the two ALM provisions designed to limit cash flow mismatches between assets and liabilities. In place of these tests, the final rule substitutes an alternative weighted average life extension test on the corporate's investments along with specific prohibitions on private label RMBS and subordinated securities.

The effect of these changes is to create the following, final set of investment, credit risk, and ALM hurdles through which a corporate must run any contemplated investment purchase:

•

NRSRO ratings screen.

The final rule uses NRSRO ratings as a screening tool. The final NRSRO screen is tougher than the current rule provides. For example, to get by the ratings screen the corporate has to look at all available NRSRO ratings (not just one rating), and the corporate has to take the lowest of all the ratings (

i.e.,

it can't cherry pick ratings). This ratings screen is

exclusionary,

not

inclusionary.

Even if a security gets by the ratings screen, there are still six additional hurdles (listed below) each security must pass before the corporate can buy the security.

•

Prohibition of certain highly complex and leveraged securities.

NCUA is adding to the list of outright prohibited securities in part 704 that are overly complex and/or leveraged. So a corporate cannot buy the security if it is:

○ A Collateralized debt obligation (CDO), or

○ A Net Interest Margin security (NIM), or

○ A Private label RMBS, or

○ A security subordinated to any other securities in the issuance.

•

Single obligor limit.

The final rule tightens the existing limit from 50% of capital to 25% of capital. So if the corporate wanted to buy, say, a highly rated student loan asset backed security (ABS) issued by “Mainstreet Bank,” but the corporate has already reached the 25% of capital limit in investments issued by the same Mainstreet Bank trust, the corporate can't buy that additional ABS within the same trust.

•

Sector concentration limits.

Assuming the corporate still wants to buy that Mainstreet Bank ABS, and it has not reached its single obligor limit with Mainstreet Bank, the corporate must then apply the

sector limits

for these ABS. If the purchase of the Mainstreet Bank ABS would put the corporate over the private label student loan ABS sector limit (generally, the lower of 500% of capital or 25% of assets), the corporate can't buy the ABS.

•

Portfolio WAL not to exceed two years.

If the corporate got the Mainstreet Bank ABS past all those hurdles above, there are still more hurdles to overcome. The corporate cannot buy the ABS if it would put the weighted average life (WAL) of the corporate's loan and investment portfolio over two years in length.

•

Portfolio WAL (assuming prepayment slowdown of 50%) not to exceed 2.25 years.

The corporate must then test the Mainstreet Bank ABS for extension risk. The corporate cannot buy the ABS if it would put the weighted average life of the corporate's loan and investment portfolio, assuming the portfolio prepayment speeds slow by 50%, out over 2.25 years in length.

•

Interest rate risk shock test.

This IRR test is in the current rule, and the final rule does not change this test. Assuming that the Mainstreet Bank ABS is floating rate, and its liabilities reset rates in similar fashion, it would likely not be affected at all by this particular test. But if its liabilities did not reprice similarly to the ABS (

e.g.,

the floating rate ABS was funded by fixed rate liabilities), its addition to the portfolio could not cause the corporate's NEV to decline by more than 15 percent when the portfolio as a whole is shocked by 300 BP.

8

8

Assuming the corporate was operating under Base level investment authority.

These final revisions provide for a simpler rule that still accomplishes NCUA's goal of reducing or eliminating various risks while allowing for sufficient potential for growth in a corporate's RE.

Investment Action Plans for Prohibited Investments

Most of the new investment prohibitions and other credit and ALM requirements go into effect 90 days after publication of the final rule. Some corporates may hold investments that are in violation of one or more of these new prohibitions, and these investments will be subject to the investment action plan provisions of § 704.10. For example, if a corporate holds a subordinated security prohibited by the revised paragraph 704.5(h)(8), and determines not to sell that security, it must, within 30 calendar days of the effective date of the 704.5(h)(8) prohibition prepare and submit to the OCCU Director an investment action plan. 12 CFR 704.10(a). If the plan is not approved by the OCCU Director, the corporate must comply with the “Director's directed course of action.” 12 CFR 704.10(c).

E. Liquidity

Summary of Current Rule

The current rule generally requires a corporate evaluate its liquidity needs and plan for appropriate liquidity. It also provides that a corporate credit union may borrow up to the

greater

of 10 times capital or 50 percent of capital and shares (excluding shares created by the use of member reverse repurchase agreements).

Summary of Significant Revisions

The proposal restricted a corporate's borrowing to the

lower

of 10 times capital or 50 percent of capital and shares (excluding shares created by the use of member reverse repurchase agreements). The proposal also added a sublimit for secured borrowings. The final rule adopts the proposal without changes.

F. Corporate Governance Provisions

Summary of Current Rule

The current Part 704 places limitations on board representation, including limits on the number of trade organization representatives. The current rule does not, however, place any experience or knowledge requirements on individual corporate directors; limit the representation of corporate managers and officials on the boards of other corporates; provide for term limits; require any disclosure of senior executive compensation to the members of a corporate; or place any limits on “golden parachute” severance packages for corporate senior executives.

Summary of Significant Governance Revisions

The final revisions require that all corporate board members hold either a CEO, CFO, or COO position at their member credit union or other member entity. The final rule will, for clarity, add the positions of Manager and Treasurer, as these are often the equivalent of CEO or CFO at smaller credit unions. The revisions also require that a majority of a corporate's board members be representatives of NPCU members. The proposal also included a six year term limit on board service, but this mandatory term limit has been removed from the final rule.

The final revisions require that each corporate annually prepare, and provide to its members, a document that discloses the compensation of certain employees. For corporates with 41 or more employees, the disclosure must include the top five compensated employees. For corporate with 31 to 40 employees, the disclosure must include

the top four compensated employees. For corporates with 30 or fewer employees, the disclosure must include the top three compensated employees.

With respect to any corporate merger, the final revisions require a merging federally-chartered corporate affirmatively disclose to both NCUA and its members any material, merger-related increase in compensation (

i.e.,

an increase of more than 15 percent of annual compensation or $10,000, whichever is greater) for any senior executive or director. A state-chartered corporate must also make the merger-related disclosure, but only to NCUA unless state law requires otherwise.

The final revisions prohibit golden parachutes, that is, payments made to an institution affiliated party (IAP) that are contingent on the termination of that person's employment and received when the corporate making the payment is either troubled, undercapitalized, or insolvent. The revisions also generally prohibit a corporate, regardless of its financial condition, from paying or reimbursing an IAP's legal and other professional expenses incurred in administrative or civil proceedings instituted by NCUA or a state regulatory authority where the IAP is ultimately found liable.

G. Corporate CUSOs

Summary of Current Rule

The current corporate CUSO provisions do not specify the particular services that corporate CUSOs may offer, but does provide that the CUSO must “primarily serve credit unions” and “restrict its services to those related to the normal course of business of credit unions.” The current rule requires the CUSO agree to allow the corporate's auditor, the corporate's board, and also NCUA access to the CUSO's “books, records, and any other pertinent documentation.”

Summary of Significant CUSO Revisions

The final revisions will retain the existing 704.11 requirements, and further require that a corporate CUSO may only engage in categories of services preapproved by NCUA. Brokerage services and investment advisory services will be preapproved in the rule, and NCUA will approve additional categories of services on an

ad hoc

basis. Once approved, however, NCUA may only remove a category of service through a rulemaking. The final rule provides extra time for a CUSO to seek NCUA approval of a service category, and extra time for a corporate to extricate itself from a CUSO that is engaged in activities not preapproved by NCUA.

The final revisions further require a CUSO agree to permit the corporate and NCUA to access the books, records, personnel, equipment, and facilities of the CUSO.

H. Delay of Effective Dates

None of these final revisions will take effect until 90 days following publication of this final rulemaking in the

Federal Register.

This delay in the effective dates will generally provide the corporates, and their NPCU members, some time to analyze and adapt to the final rule and to observe how NCUA is moving forward on resolution of the legacy asset problem.

Some provisions of this final rule, including the capital and PCA provisions, will have delays in their effective dates that are much longer than 90 days. Those delays will be discussed below.

III. Section-by-Section Analysis

This section, which provides a section-by-section analysis of the final revisions, generally follows the organization of part 704, that is, starting with the proposed capital (§ 704.3) and PCA (§ 704.4) amendments, then investments (§ 704.5) and credit risk (§ 704.6), then asset and liability management (§ 704.8), then corporate board representation (§ 704.14), and then the new sections relating to disclosure of executive and director compensation (§ 704.19) and golden parachutes and indemnification (§ 704.20).

Many of the final revisions require new definitions that appear in § 704.2, and the discussion of these definitions generally appears with the discussion of the associated substantive change to the corporate rule. This rulemaking revises Appendices A and B, and adds a new Appendix C. Since Appendix B relates to investment authority, the revisions to that appendix are discussed as part of the discussion of § 704.5. Since Appendices A and C (on model forms and the risk-weighting of assets, respectively) relate to corporate capital, the changes to these appendices are discussed immediately following the discussion of § 704.3. The new subpart L to part 747 provides the due process associated with the new PCA provisions in § 704.4, and so is discussed following the § 704.4 discussion.

The revisions to capital terminology in part 704 also necessitate conforming amendments to parts 702, 703, and 709, as discussed below.

A. Part 702 Prompt Corrective Action

Part 702 sets forth PCA for NPCUs. The proposal contained a conforming amendment to paragraph 702.105(d) changing references to paid-in capital and membership capital to perpetual capital and nonperpetual capital accounts, respectively. The final 702.105(d) is adopted as proposed.

B. Part 703 Investments and Deposit Activities

Part 703 sets forth the permissible investment and deposit activities generally applicable to federal credit unions. The proposal contained a conforming amendment to paragraph 703.14(b) changing references to paid-in capital and membership capital to perpetual capital and nonperpetual capital accounts, respectively. The final 703.14(b) is adopted as proposed.

C. Part 704 Corporate Credit Unions

Section 704.2 Definitions

New and modified definitions in § 704.2 are discussed below in the section where the defined word or phrase appears.

Section 704.3 Capital

Section 704.3 establishes the capital requirements for corporates. The final 704.3 contains six paragraphs (a) through (f). Paragraph (a) covers the basic capital requirements. Paragraph (b) contains the requirements for nonperpetual capital accounts (NCAs) and paragraph (c) contains the requirements for perpetual contributed capital (PCC). Paragraph (d) contains the requirements and procedures for establishing different minimum capital requirements for a particular corporate. Paragraph (e) contains certain other reservations of authority to the NCUA Board. Paragraph (f) explains the treatment of certain former capital accounts under the old corporate rule (

i.e.,

membership capital accounts) that are not converted to the new forms of capital (

i.e.,

either NCAs or PCCs).

As discussed previously, this new 704.3 capital section will not become effective until October 20, 2011, and some elements of this section, and associated definitions, have applicability dates that are delayed beyond October 20, 2011.

704.3(a) Capital Requirements

The proposed 704.3(a), along with associated definitions in 704.2, established a new leverage ratio, new Tier 1 risk based capital ratio (T1RBC ratio), and a new total risk based capital ratio (Total RBC ratio). The proposal established minimum of 4 percent for

the leverage ratio, 4 percent for the T1RBC ratio, and 8 percent for the Total RBC ratio. The proposal required a corporate develop goals, objectives, and strategies to ensure adequacy of capital. The proposal required that a corporate attempt to build RE to a level of 0.45 percent of its moving daily average net assets (DANA) within 36 months of publication of the final rule, and submit a RE accumulation plan (REAP) to NCUA if it fails to do so.

The final rule generally adopts 704.3(a), and the associated definitions, as proposed. Some commenters, however, sought clarification about certain provisions, as discussed below.

704.3(a)(1)(i) and 704.2 Definitions of Leverage Ratio

A few commenters expressed confusion about the effective date of the new leverage ratio, and whether that date was actually 12 months following publication of the final rule, or 36 months as stated in the preamble. In fact, the permanent leverage ratio will become effective 36 months after publication, but the rule does contain an interim leverage ratio to bridge the gap between the general effective date of the capital provision (

i.e.,

12 months after publication) and the permanent leverage ratio.

The proposal, between 12 months and 36 months following publication of the final rule, requires a minimum 4 percent interim leverage ratio, which was defined as the adjusted total capital divided by moving DANA. The proposed definition of “total capital” included RE, PCC, and NCAs, while the proposed definition of “adjusted total capital” then excluded all NCAs in excess of the amount of PCCs. This result would have limited the use of NCAs to only 200 BP toward the 400 BP necessary to achieve the minimum leverage ratio.

Two corporate commenters suggested that corporates be allowed to use NCAs, without limit to satisfy their interim leverage ratio (that is, until the 36 month point). One stated that the current calculation of interim leverage ratio will result in NCAs not being an effective capital tool. This commenter believes that under the proposal as drafted corporates will immediately solicit PCC following publication of the final rule so as to be in compliance with the interim leverage ratio at the 12 month mark. This commenter suggests, instead, that NCUA redefine the numerator of leverage ratio from “adjusted total capital” to “total capital,” thus allowing for unrestricted use of NCAs in the numerator until at least the third anniversary of publication of the final rule. This commenter states this will give NPCUs additional time to decide whether they want to stay in the corporate system and invest permanently in the corporates through PCCs, and will also improve the corporate's ability to grow RE in the first three years, as NCAs are less expensive than PCCs.

The Board agrees with these commenters. Accordingly, in the final rule the numerator of the interim leverage ratio includes all elements of capital and permits the use of any one element without limitation. Hence, a corporate could use just NCAs, if it desires, to satisfy the 4 percent interim leverage ratio requirement. Thirty six months after publication of the final rule, the proposal defined, and this final rule adopts, the permanent leverage ratio to be defined as adjusted core capital divided by moving DANA. Core capital, in turn, is limited to Tier 1 capital (

i.e.,

RE and PCCs).

Accordingly, NCAs will not count at all toward the permanent leverage ratio when it becomes effective after 36 months.

The final rule also adds clarifying statements at the end of each of the two definitions, that is “[T]his is the interim leverage ratio,” and “[T]his is the permanent leverage ratio,” so that those who read the definitions will understand that these are two distinct definitions.

704.2 Definition of “Core Capital”

The proposal defines core capital as the sum of the corporate credit union's RE, paid-in capital, and the RE of any acquired credit union, or of an integrated set of activities and assets, calculated at the point of acquisition, if the acquisition was a mutual combination. Upon the first anniversary of the publication of the final rule, the new Basel I capital provisions and ratios become effective. On that date, the proposal adjusts the definition of core capital to make a nomenclature change (

i.e.,

replace PIC with PCC) and to add to capital the minority interests in the equity accounts of CUSOs that are fully consolidated with the corporate.

704.2 Definition of “Adjusted Core Capital”

The permanent leverage ratio and the Tier 1 risk based capital ratio use

adjusted

core capital as the numerator. The proposal defined

adjusted core capital

as core capital modified by six different deductions.

The proposed deductions required when adjusting core capital include the amount of the corporate's investments in consolidated CUSOs. Some commenters objected to this deduction, arguing that such a deduction varies from the Basel I standards. The Board agrees that this proposed deduction, as worded in the proposed, did not accurately reflect the Basel I standard. The deduction should be for investments in CUSOs that are

not

consolidated with the corporate, as described in the Basel I Accord:

It has been concluded that the following deductions should be made from the capital base for the purpose of calculating the risk-weighted capital ratio. The deductions will consist of: * * * investments in subsidiaries engaged in banking and financial activities which are not consolidated in national systems. The normal practice will be to consolidate subsidiaries for the purpose of assessing the capital adequacy of banking groups. Where this is not done, deduction is essential to prevent the multiple use of the same capital resources in different parts of the group. The deduction for such investments will be made against the total capital base. The assets representing the investments in subsidiary companies whose capital had been deducted from that of the parent would not be included in total assets for the purposes of computing the ratio.

9

9

International Convergence of Capital Measurement and Capital Standards (July 1988, updated to April 1998), Section I(c), paragraph 24(ii) (emphasis added).

See also

12 CFR part 3, Appendix A, § 2(c)(7)(i) (Office of the Comptroller of the Currency deductions from capital), and 12 CFR part 208, Appendix A, § II.B.(ii) (Federal Reserve Board deductions from capital).

The Board has amended the final definition of

adjusted total capital

to required deduction of investments in unconsolidated CUSOs.

The proposed definition of adjusted core capital also requires that corporates should deduct from their own capital any capital they have contributed to other corporates. Specifically, the proposal stated:

If the corporate credit union, on or after (the first anniversary of the final rule), contributes new capital or renews an existing capital contribution to another corporate credit union, deduct an amount equal to the aggregate of such new or renewed capital * * *.

Some NPCU commenters specifically agreed with this deduction, noting that cross-corporate capitalization can inflate capital levels and exposes NPCU members of the contributor corporate to the problems of another corporate.

One commenter asked for clarification about the meaning of “renew an existing capital contribution.” The only capital placed in another corporate that is exempt from this required deduction is existing PIC that is converted directly to PCC on the first anniversary of the publication of the final rule or unconverted MCAs that are amortizing under the provisions of paragraph 704.3(f). All other PCC, and all NCAs,

must be deducted. The Board has amended the final version of the rule text to clarify that if the corporate credit union contributes any PCC, or maintains any NCAs, at another corporate credit union, it may deduct an amount equal to that PCC or NCA.

Another commenter said NCUA should consider an exception for de minimus member capital contributions between corporates. The Board considered this last comment, but does not believe a de minimus exception is necessary.

One commenter objected to this proposed deduction, stating that it seemed to indicate that NCUA would consider any capital deposits made by NPCUs into corporates to have a 100 percent risk weighting, if and when NPCUs might fall under a risk-weighted capital system, and this would further hinder corporate recapitalization. The Board does not believe that NPCU's should equate capitalization by NPCUs of retail corporates with cross-capitalization of corporates for purposes of PCA.

One commenter stated that the definition of core capital should include NCAs. The Board disagrees. Adding NCAs to the definition of core capital would undermine the permanent nature of core capital and the associated capital protection provided by the minimum leverage ratio.

704.2 Definition of “Supplementary Capital”

The proposed definition of supplementary capital included NCAs, a portion of the corporates allowance for loan and lease losses, and a portion of the unrealized gains on available for sale equity securities with readily determinable fair values. The term, which is synonymous with

Tier 2

capital, is used in the numerator of the total risk based capital ratio. One commenter suggested that all of the unrealized gains on equity securities should count as supplementary capital. The Board disagrees, as this approach would be inconsistent with the Basel I regulations of the other banking regulators.

10

The Board also notes that corporates are not likely to have much in the way of equity securities, as they are generally impermissible investments for corporates.

10

See, e.g.,

12 CFR part 208, Appendix A, § II.A.2.(e) (Federal Reserve supplementary capital elements).

704.2 Definition of “Fair Value”

The final rule also refines the definition of

fair value

to be consistent with Financial Accounting Standard 157.

704.2 Definition and Use of “Moving Monthly Average Net Risk-Weighted Assets”

The proposal defined the denominator of both new risk based capital ratios as “Moving Daily Average Net Risk-Weighted Assets” (MDANRA). Some commenters questioned the burden of daily risk weighting to produce the MDANRA figure. The Board agrees that a daily calculation is not necessary and could be quite burdensome for some corporates. Accordingly, the final rule replaces the denominator of both risk based capital ratios with a new

moving monthly average net risk-weighted assets (MMANRA),

defined to mean the average of the net risk-weighted assets for the month being measured and the previous eleven (11) months. The definition also requires that MMANRA measurements be taken on the last day of each month.

704.2 Definition of  “Retained Earnings”

The final rule amends the definition of retained earnings to create a cross reference to GAAP: “

Retained earnings

means retained earnings as defined under Generally Accepted Accounting Principles (GAAP).”

704.3(a)(3) RE Accumulation Target and REAP

Some commenters incorrectly characterized the proposal as establishing a “requirement” for 45 BP of RE after three years, and questioned the feasibility of reaching that target under the proposed ALM and investment restrictions (discussed elsewhere). In fact, the proposal does not require 45 BP after three years, but, rather, calls for the submission of a RE accumulation plan (REAP) if the 45 BP target is not met.

Many commenters, including both NPCUs and corporates, thought that the multi-step RE phase-in (

i.e.,

target of 45 BP after three years, and a requirement for 100 BP after six years, and then 200 BP after ten) was too difficult for corporates to achieve. Commenters thought this was too difficult because of the current interest rate environment; the fact that most corporate income comes from investments, and not loans; and the limitations imposed by the proposed ALM and investment requirements (discussed elsewhere). One of these commenters stated this RE timetable was likely to encourage aggressive strategies to accumulate RE or cause a corporate “to solicit high cost capital,” and that corporates “must not be unnecessarily forced into a survival mode while rebuilding capital.” Many of these same commenters suggested that these milestones be changed from three, six, and ten years to four, eight, and twelve years, respectively. One of these commenters asked that these milestones be changed to five, seven, and twelve years, respectively. One corporate commenter, however, did state its belief that these RE targets and requirements were achievable.

The Board disagrees with those commenters who believe the proposed time line is not achievable. The proposed timeline, which the Board has adopted in the final, provides the necessary balance between permitting a well-run corporate time to solicit capital and grow retained earnings, while ensuring that there is pressure on the corporate to achieve adequate capital levels.

Of the commenters who specifically thought requiring 100 BP of RE by year six was too aggressive, one asked that NCUA make public its third-party review of this requirement, along with the assumptions used during the review. As discussed above, NCUA has made public the Kamakura report, and has made changes in response to portions of the report. Overall, NCUA believes these changes will make it easier for a corporate to achieve the necessary RE growth, as discussed in more detail below.

One commenter stated that the proposal should require a state chartered corporate submit any REAP to both NCUA and the relevant state regulator, and that NCUA consult with the state regulator on the evaluations of the REAP. The NCUA Board agrees that it should consult with the relevant state regulator in these circumstances, and has amended the final regulation accordingly.

Except as described above, the Board adopts the final paragraph 704.3(a), and associated capital definitions in § 704.2, as proposed.

704.3(b) Requirements for Nonperpetual Capital Accounts (NCAs)

The proposal replaced membership capital accounts (MCAs) with nonperpetual capital accounts (NCAs). NCAs must be either term or notice accounts, with a minimum maturity or notice period of five years. Under the proposal, adjustable balance NCAs were not permitted.

Two commenters stated that five-year notice is more appropriate than three-year notice, since “this three year time period is short in relation to the term of some corporate assets.” These commenters, however, believe that all

contributed capital should be five-year notice and that there is no need for perpetual contributed capital. The Board believes it is important to have some element of perpetual capital in corporates. This is consistent with Basel I and with the fact that, going forward, corporates cannot expect any future extraordinary government intervention.

One NPCU stated that NCUA should continue to permit accounts that adjust with credit union balance sheets. This commenter stated that such adjustable accounts are “necessary for the system and in times of tight liquidity allows credit unions to have flexibility.” The Board disagrees. Capital must have a sense of permanence. Capital accounts that adjust based on measures that can be manipulated by the member lack this permanence.

One commenter asked that, with regard to the new NCAs, the word “original” be placed in front of the phrase “minimum term.” The Board agrees and has made this clarification.

Two commenters recommended that, for “nonmaturity” or “notice” NCAs, the withdrawal notice be changed from five years to three years if the NCAs have been in existence at the corporate for at least two years. The Board believes this change would be confusing to implement, would undermine the stability of NCAs, and would be inconsistent with the Basel standards. Accordingly, the Board is not adopting this recommendation.

A few commenters objected to the proposed change from three years to five and said MCA maturity should stay at three years; and one billion dollar NPCU stated that the proposed extension to five years could cause some credit unions to leave the corporate network. A few NPCUs stated that if NCUA wanted NPCUs to recapitalize corporates, it would shorten the term of MCAs instead of lengthening the term, and one of these NPCUs suggested a term of one to two years. The Board believes that the importance of having solid, perpetual capital, consistent with the international Basel I standards, outweighs these concerns.

Another commenter stated that credit unions will need the flexibility to withdraw or change to another corporate credit union that meets their needs without having to wait three to five years to withdraw a capital deposit. The Board disagrees. Capital by its very nature must be stable and not subject to easy withdrawal. As discussed above, potential creditors and vendors of a corporate will not do business with the corporate absent a strong capital regime that is available to absorb losses ahead of these third parties.

704.3(b)(6), (c)(5) Permitting the Transfer of Contributed Capital Accounts (NCA and PCC) to Third Parties

The proposal would permit members to freely transfer their NCAs (704.3(b)(6)) and PCCs (704.3(c)(5)) to third parties, regardless of membership status.

One NPCU commenter stated that free transferability of capital was good, as it helped enforce market discipline. A few commenters, however, stated that there should be limits on the ability of a member to unilaterally sell or transfer their contributed capital to any other member or a nonmember. These commenters believe that a corporate credit union's board must be empowered to preapprove any proposed transfer of capital funds (other than in a merger or liquidation). One of these commenters would restrict transfers to other entities in the field of membership, and another commenter stated that:

It does not appear that the corporate credit union would have any ability to control the transfer of or the ultimate ownership of its capital shares. This lack of control could lead to the required registration of capital shares as public securities. Such a registration could be required despite the wishes of the corporate and the majority of its members. Registration would dramatically increase the cost and complexity of operating a corporate. In addition, the free transfer of capital shares could allow manipulation including enabling natural person credit unions to cut their capital exposure to a corporate by selling shares rather than by putting them on notice. Alternatively, a prospective member credit union could buy shares rather than contributing capital directly to a corporate. This regulation would hamper the objective of building committed corporate capital.

The Board agrees that there should be additional limits on the transferability of NCAs and PCCs to mitigate the possibility of securities laws violations. PCC and NCAs are generally subject to the securities laws because they meet the general definition of “security.”

11

Securities issued by corporate credit unions are exempt from registration under the Securities Act of 1933 (SA),

12

and since it is unlikely that either members or corporates would engage in activities involving PCC or NCAs that would trigger the application of broker/dealer provisions of the Securities and Exchange Act of 1934 (SEA), the risk of securities law violations is minimal. Still, the anti-fraud provisions of SEA § 10(b) and SEC Rule 10b-5 would apply to any transfer, so that members should not withhold, or misstate, any available financial information about the corporates when making such a transfer and should also ensure that the potential transferees have some sophistication.

13

11

See, e.g.,

15 U.S.C. 77b(a)(1), 15 U.S.C. 77c(a)(10).

12

See

15 U.S.C. 77c(a)(5), and Securities and Exchange Commission (SEC) Release No. 33-6758, Regulation D Revisions, 53 FR 7866, note 10 (March 3, 1988).

13

See

15 U.S.C. 78j(b).

Accordingly, the final rule requires a corporate member wishing to transfer PCC or NCAs to a non-credit union third party must ensure the potential transferee obtains appropriate financial information about the corporate. To ensure the proper flow of information, the rule provides that the member must notify the corporate at least 14 days before consummating the transaction, and the corporate must then provide both the member and the potential transferee all financial information about the corporate available to the members or the public, including any call report data submitted by the corporate to NCUA but not yet posted by NCUA.

The final rule also limits such transfer to nonnatural persons. This serves a consumer protection function and is also consistent with NCUA's rules on the sale of secondary capital at low income credit unions.

704.2 Definition of “Aavailable To Cover Losses That Exceed Retained Earnings”

NCAs must be “available to cover losses that exceed retained earnings and perpetual contributed capital.”

14

The quoted phrase is defined in proposed 704.2, and the definition provided that “[t]o the extent that contributed capital funds are used to cover losses, the corporate credit union must not restore or replenish the affected capital accounts under any circumstances.” Some commenters believe that this is a new requirement. In fact, it is not a new requirement, but simply a clarification of an existing requirement. The proposal also provided that contributed capital that is used to cover losses in a fiscal year previous to the year of liquidation has no claim against the liquidation estate. To avoid the ambiguity associated with different possible fiscal years, the final rule replaces “fiscal year” with “calendar year.” The entire final definitions now read as set forth in the regulatory text of this rule.

15

14

And PCCs must be “available to cover losses that exceed retained earnings.” 12 CFR 704.2.

15

The final revisions to the corporate rule contain two different versions of the definitions section (§ 704.2): A temporary version that goes into effect with the bulk of the revisions 90 days after

publication in the

Federal Register

, and a permanent version that goes into effect one year after publication on the effective date of the capital and PCA provisions. The definition of

Available to cover losses that exceed retained earnings

set forth following amendatory instruction 7 of this rule is the permanent version of the definition. The temporary version following amendatory instruction 6 of this rule refers to PIC and MCAs, not PCC and NCAs.

Except as discussed above, the Board adopts the final paragraph 704.3(b), and associated definitions in § 704.2, as proposed.

704.3(c) Requirements for Perpetual Contributed Capital (PCC)

The proposal renamed paid in capital (PIC) as perpetual contributed capital (PCC). Generally, the proposed terms and conditions for PCC tracked those of the existing PIC, with the following exceptions.

The existing rule permits a corporate to call PIC if the corporate would meet its minimum levels of capital and NEV ratios after redemption; the proposal requires NCUA's prior approval for any such redemption. The proposal permits the free transferability of PCC to certain nonmember third parties, under the same conditions as NCAs may be transferred (as discussed above). The proposal also eliminated the existing prohibition on conditioning membership, services, or prices for services on a member's ownership of PIC (now to be renamed PCC).

704.3(c)(3) Callability of PCC

Many commenters objected to the 704.3(c)(3) proposal that NCUA must preapprove a corporate's determination to call, or redeem, PCC. Some of these commenters believe NCUA preapproval is overreaching and unnecessary in light of other provisions in the proposed regulation. Some of these commenters stated that the corporate should be free to permit redemption of PCC, without NCUA preapproval, so long as the corporate would continue to meet its minimum capital requirements. Two commenters stated that this prohibition might discourage members from contributing PCC. One stated that over time RE will replace much of the PCC, and that should reduce NCUA's concerns with PCC redemption.

PCC will fulfill a central role in corporate capital structures for many years to come. The Board wishes to ensure that, before a corporate lets any PCC go through redemption, the corporate truly does meet its minimum capital and NEV levels, and is likely to maintain those levels into the foreseeable future. Accordingly, the final rule retains the proposed requirement for NCUA preapproval of any PCC redemption.

704.3(c)(6) Conditioning Membership, Services, and Prices of Services on Purchase of PCC

Many commenters recommended that NCUA not eliminate the current prohibition

on a corporate conditioning membership, services, or prices for service on a credit union's ownership of PIC (PCC going forward). One of these commenters stated that granting the corporates the ability to condition payment services or other services on “membership” could force only those NPCUs who have no other alternative to place more capital at risk and out of their control. Another NPCU commenter stated that it learned from the Capital Corporate collapse in the 1990s and has avoided buying capital shares, and does not want to be forced to contribute capital going forward.

Many other commenters, however, including many NPCU commenters, supported the full elimination of this prohibition. Most of these commenters believe this sort of decision on requiring capital contributions is appropriately left to the board and management of the corporate credit union. One commenter stated that lifting this prohibition was necessary to protect against free riders, noting that because of this prohibition the current distribution of losses among members of corporate was unfair.

A few NPCU commenters even thought a corporate should require member capital to receive services. Some of these commenters thought that the requirement should be linked to the amount of the NPCU's deposits at the corporate, and others to an NPCU's asset size, and some stated that larger NPCUs should not be permitted to subscribe to lesser amounts of capital as a percentage of asset size.

In the Board's view, corporates are designed to service NPCUs, and NPCUs own the corporates and the associated risks and rewards of such ownership. If NPCUs believe that corporates provide some valuable or essential service, then NPCUs will need to capitalize the corporates. Accordingly, the Board believes it is appropriate that a corporate be given the option of conditioning its membership, services, or the prices for services, on the purchase of PCC. This authority helps the corporate protect itself from free riders, that is, those NPCUs and other entities that want the benefits of the corporate without taking on any risks. The Board does not believe that NCUA should, by rule, require some minimum amount of capital contribution, but does believe that the corporate's board should have the authority to do so.

Several commenters stated, however, that if this prohibition is eliminated, the regulation should make clear that corporates cannot change their policies so as to threaten

immediate

termination of essential services absent immediate PCC contributions. Many of these commenters suggested that an NPCU that refuses to meet a new demand for contributed capital be given at least 12 months to find another service provider.

The Board appreciates the concern of these commenters. Corporate members should be given adequate time to look for alternatives should they find any particular, proposed conditions on membership, services, or the prices for services too onerous. The Board believes, however, that six months to find an alternative service provider should be appropriate. Accordingly, the final paragraph 704.3(c)(6) provides that a corporate must give a member at least six months written notice of (i) the requirement to purchase PCC, including specific amounts; and (ii) the effects of a failure to purchase the requisite PCC on the pricing of services or on the member's access to membership or services.

One NPCU commenter stated that if corporates are permitted to require capital contributions as a condition of membership or services, the NCUSIF should insure the capital contribution. Another NPCU commenter stated that capital should be “portable,” meaning that if an NPCU wishes to move to another corporate because they may not be satisfied with the services being offered, then the NPCU should be free to shift its existing capital to the new corporate without any conditions or time constraints. Again, these commenters misunderstand the fundamental nature of capital. Capital is a buffer to ensure that creditors and vendors of a corporate will not be first in line to absorb operating losses. If NCUA insured the capital, that would be transferring the risk from the member-owner to the entire universe of insured credit unions, and that is not appropriate. Further, if NCUA permitted capital to be “portable,” it would undermine this primary role of capital as assuring potential creditors and vendors of the corporate of the continued availability of that capital to absorb operating losses.

704.2 Definition of Tier 2 Capital Includes Certain PCC

Paragraphs (5) and (6) of the proposed definition of

adjusted core capital

excludes certain PCC that exceeds certain levels of RE. The purposes of

these exclusions is to force corporates to build up their RE for inclusion in adjusted core capital and inclusion in the corresponding leverage ratio and Tier 1 risk based capital ratios. The effect of these provisions, however, was to also exclude the excess PCC from all capital calculations, including Tier 2 capital ratios.

Some commenters stated that all PCC should continue to count as capital. They ask that some other method be used to encourage RE growth but, if not, then in the alternative that excess PCC should continue to count as at least Tier 2 capital (

i.e.,

and count toward the total RBC ratio). These commenters understood that the proposal intends to push corporates toward building RE growth, but they argue that any existing excess PCC still protects the corporate from losses. Two commenters stated that to the extent PCC does not count as capital it should be returned to the members.

The Board agrees that excess PCC should continue to count as Tier 2 capital. Accordingly, in the final rule the Board amends the definition of Tier 2 capital to include “any perpetual capital deducted from adjusted core capital.”

704.2 Definition of Equity Investments

The proposal uses the term

equity investments

as a deduction for purposes of calculating adjusted core capital, and defines the term in 704.2 to include only investments in real property and equity securities. One commenter pointed out that equity investments can also take the form of investments in partnerships or limited liability companies. Accordingly, the final rule adds those investments to the definition.

Accordingly, and except as described above, the Board adopts the final paragraph 704.3(c), and associated definitions in § 704.2, as proposed.

704.3(d) Individual Minimum Capital Requirements

Proposed paragraph 704.3(d) gave NCUA the authority to require higher minimum capital requirements of individual corporate credit unions. The proposal provided the corporate with notice and an opportunity to respond in writing before imposition of the new capital requirements.

Many commenters opposed this paragraph as giving too much discretionary power to NCUA and NCUA examiners. Some of these commenters mistakenly believe that the proposal delegates this authority to the OCCU Director or some other “individual.” In fact, the proposal provides this authority to the “NCUA,” meaning the “NCUA Board” (unless further delegated by the Board). The Board believes that this provision gives the Board powers it needs to ensure the health of the corporate system and the credit union system as a whole. The Board does agree that some additional due process may be appropriate, as discussed below.

704.3(d)(4) Standards for Determination of New Minimum Capital Requirement

Some commenters objected to the language in proposed 704.3(d)(3) stating that “levels for an individual corporate cannot be determined solely through the application of a rigid mathematical formula or wholly objective criteria. The decision is necessarily based in part on subjective judgment grounded in agency experience.” These commenters thought this language was too subjective, and that it departed from the models of the other banking regulators that NCUA was purporting to follow. In fact, this statement is true. Further, the same language does appear in the regulations of the other banking regulators.

See, e.g.,

12 CFR 3.11 (OCC Regulation). Accordingly, the final rule retains this language.

704.3(d)(4) Procedures for Imposing New Minimum Capital Requirement

The proposal does provide the corporate due process, that is, notice and an opportunity to respond in writing. The proposal generally provides that a corporate will have 30 days to respond to the notice, but that NCUA may shorten this period for good cause, and two commenters stated that the corporate should have at least a minimum time of 15 days to respond. One of these commenters stated that such powers should be exercised only by the NCUA Board, and not be delegable. Another commenter stated that, for state chartered corporates, the regulation should require the NCUA Board obtain the concurrence of the state regulator before exercising this authority.

The Board agrees that additional due process may be warranted in some cases. Accordingly, the final rule includes a new paragraph 704.3(d)(4)(vi) that permits a corporate to request an informal hearing. The corporate must make the request in writing, and NCUA must receive the request no later than 10 days following the initial notice of NCUA's intent to establish a different minimum capital requirement. Upon receipt of the request for hearing, NCUA will conduct an informal hearing and render a decision using the procedures described in paragraphs (d), (e), and (f) of Section 747.3003.

Some of these commenters also objected to the statement that the NCUA decision on this matter represents “final agency action.” However, this statement is true as there is no administrative appeal from NCUA's decision in this matter. Accordingly, the final rule retains this language.

Except as described above, the Board adopts the final 704.3(d) as proposed.

704.3(e) Reservation of Authority

The proposed paragraph 704.3(e) provided for various reservations of authority to NCUA.

Proposed paragraph 704.3(e)(2) gave NCUA the authority to require a corporate to use period end assets, instead of moving DANA, for purposes of calculating capital ratios. One corporate commenter objected to this proposed authority, stating that month-end assets can be more than 10 percent higher than DANA for the month. This commenter suggested NCUA adopt an objective standard for the use of this authority, such as where month-end assets are at least 125 percent of DANA for three consecutive months. Another commenter stated that corporates should be given the option of using average or period end assets, as NPCUs are permitted to do under the PCA regime. The Board disagrees, and refuses to put such limits on its authority to require the use of period-end assets in appropriate cases.

Proposed paragraph 704.3(e)(3) gave NCUA authority to discount a particular asset or capital component of a particular corporate from the computation of capital. Some commenters opposed this as giving too much power to NCUA, the OCCU Director, and NCUA examiners. One commenter stated that no corporate should be treated differently from others just because of the examiner. The provision, however, only empowers the NCUA Board, not the OCCU Director or NCUA examiners (unless the Board delegates its authority).

A few commenters correctly noted that the proposal does not provide for any particular due process before NCUA acts. Another commenter believes that there should be some stated time for the corporate to correct the deficiency that gave rise to the unsatisfactory rating.

The Board agrees that there should be some due process associated with its reservations of authority under paragraph 704.3(e), and the final rule adds a new paragraph 704.3(e)(5) setting forth such due process. Before taking any action under paragraph (e), NCUA will provide the corporate with written

notice of the intended action and the reasons for such action. The corporate will have seven days to provide NCUA with a written response, and NCUA will consider the response before taking the action. Upon the timely request of the corporate credit union, and for good cause, NCUA may extend the seven-day response period.

704.3(f) Former Capital Accounts

Many commenters suggested that three-year MCAs that are not converted to five-year NCAs be permitted to count as capital, and some stated that they should count on a two-year declining basis. These commenters argued that MCAs were available for some loss protection until such time as they were converted or returned and so should count in some way toward the corporate's capital requirements. One commenter asked whether NCUA would permit the corporate to return to its members three-year MCAs that were not converted to five-year NCAs.

The Board agrees that some corporate members may refuse to convert their existing three-year MCAs to the new five-year NCA or to perpetual PCC prior to the effective date of the new capital rules (

i.e.,

the first anniversary of the publication of the final rule in the

Federal Register

). The Board also agrees that the entire balance of these accounts is available to absorb losses until the account is closed, and that these unconverted MCAs should count, at least partially, as Tier 2 capital. Accordingly, the final rule adds a new paragraph 704.3(f) that provides, effective on the first anniversary of publication of the final rule, unconverted MCAs will be treated as follows:

•

For “adjustable balance” MCAs,

the corporate will immediately put those accounts on notice of withdrawal (if they are not already on notice). The corporate will continue to adjust the balances of the MCA account in accordance with the original terms of the account until the entire notice period has run and then return the remaining balance, less any losses, to the member. Until the expiration of the notice period, the entire adjusted balance will be available to cover losses that exceed RE and certain contributed capital. The corporate may count the unconverted MCAs as Tier 2 capital on an amortizing basis, using the amortization method described in proposed 704.3(b)(3).

16

Corporates will also be required, on the first anniversary of the publication of the final rule, to provide members who hold unconverted MCAs a one-time disclosure about the status of their MCA accounts.

16

This amortization method reduces the amount that counts towards capital to zero when one year is remaining on the notice period or term. This amortization method also assumes that the adjustment is determined based on a relatively permanent measure, such as the member's assets, and not on some impermanent measure, such as the member shares at the corporate.

•

For three-year term MCAs,

the corporate will return the MCAs at the expiration of the three-year term. Again, until the expiration of three-year term, the entire account balance will be available to cover losses that exceed RE and certain other contributed capital. The corporate may count the unconverted MCAs as Tier 2 capital on an amortizing basis, using the amortization method described in proposed 704.3(b)(3). Corporates will also be required, on the first anniversary of the publication of the final rule, to provide members who hold unconverted MCAs a one-time disclosure about the status of their MCA accounts.

Part 704, Appendix A—Capital Prioritization and Model Forms

The current Appendix A to part 704, entitled

Model Forms,

contains forms that members provide the corporate on an annual basis acknowledging the terms and conditions of the members' PIC and MCA accounts. The proposal renamed Appendix A as

Capital Prioritization and Model Forms.

The proposed Appendix A had two parts. Part I, which is new, provided the corporate's board of directors an option to give entities that contribute new capital to the corporate priority—in terms of availability to absorb losses and payout in liquidation—over existing capital contributions. New capital in this context was defined as any capital contributed more than 60 days following the publication of the final rule. The purpose of this provision is to provide a tool to the corporate for facilitating capital growth. Part II contained amended model disclosure forms that cover MCAs, PIC, NCAs, and PCCs. The forms included variable disclosures depending on whether the corporate exercises the option described in Part I.

NCUA received very few comments on Appendix A, but the final rule does include two minor changes from the proposed.

Consistent with the proposed clarifying amendments to § 709.5, Model Form A in Appendix A of the proposal included disclosure language that depleted capital has no claim against the liquidation estate for claims filed beyond the fiscal year of depletion. For clarity and to reduce the potential ambiguity associated with “fiscal year,” the final rule substitutes “calendar year” for “fiscal year.” The final rule also contains a similar revision to the payout priority paragraphs 709.5(b)(7) (for NCAs) and (b)(9) (for PCC holders).

Also, since the effective date of the final rule will generally be ninety days following the date of publication, the final rule modifies the definition of new contributed capital for purposes of Part I, changing if from capital contributed more than 60 days following publication to capital contributed more than 90 days following publication.

Accordingly, and other than as described above, the final rule adopts Appendix A as proposed.

Part 704, Appendix B relates closely to the investment (§ 704.5), credit risk (§ 704.6) and asset-liability (§ 704.8) provisions of the corporate rule, and is discussed below in connection with those provisions.

Part 704, Appendix C—Risk Weighting of Assets for Risk Based Capital Calculations

The current corporate rule has no risk weighted capital ratios or provisions. The proposal included two new minimum capital ratios defined in terms of risk-weighted assets and activities. Proposed Appendix C contained the detailed instructions for assigning risk weights, including:

• Assets that appear on the corporate's balance sheet will, generally, be risk-weighted at zero percent, 20 percent, 50 percent, or 100 percent, with less risky assets (

e.g.,

treasury bills) given lower percentages, and more risky assets (

e.g.,

loans) given higher percentages.

• Activities that involve risk but that may not appear on a corporate's balance sheet (

e.g.,

an interest rate swap, or a guaranteed line of credit not yet drawn upon) are assigned a conversion factor and then risk weighted as if the underlying assets were, in fact, on the corporate's balance sheet. Recourse obligations (

e.g.,

a recourse obligation on a transferred loan) and direct credit substitutes (

e.g.,

a mortgage backed security that is subordinated to other securities in the same issuance) are generally treated as if the entire amount of the supported asset is on the credit union's balance sheet. Residual interests (

e.g.,

retained, subordinated interests in a loan or loan participation transfer, or a retained credit enhancing interest-only strip) have different, more severe risk weighting calculations.

• A corporate may employ a ratings-based risk weighting option for certain investments, (

i.e.,

a recourse obligation, a direct credit substitute, a residual interest, or an asset- or mortgage-backed security extended in connection with a securitization) that have NRSRO ratings. When there is more than one available NRSRO rating, the corporate must use the lowest rating.

Appendix C, Paragraph I(a) Scope

The final rule amends paragraph I(a)(4) to emphasize that this Appendix does not provide authority for corporates to invest in or purchase any particular type of asset or to engage in any particular type of activity. In other words, a corporate credit must have other identifiable authority for any investment it makes or activity it engages in. So, for example, this Appendix describes risk weightings for subordinated securities, even though the final § 704.5 prohibits corporates from investing in subordinated securities and so a corporate credit union cannot invest in subordinated securities. This risk-weighting provision is retained because it is possible that a corporate could come into possession of a security that is impermissible for direct investment (

e.g.,

through enforcement of a lien on a defaulted loan), or that such securities that are impermissible now might become permissible in the future, and Appendix C will not have to be amended to deal with those situations.

Appendix C, Paragraph II(a) Risk Weighting of On-Balance Sheet Assets

A few commenters sought clarity on the risk weighting for ABS and MBS. Asset backed securities are risk weighted in the “all others” risk weighting category (

i.e.,

100 percent risk weighting) unless rated using the ratings based approach. For private label MBS that are backed by non-qualifying mortgage loans, or a combination of non-qualifying and qualifying mortgage loans, these MBS are also risk-weighted at 100 percent, again unless rated using the ratings based approach. Only MBS backed entirely by qualifying mortgages may use the 50 percent risk weighting permitted by paragraph II(a)(3)(iii).

Appendix C, Paragraph II(b) Risk-Weighting of Off-Balance Sheet Items

Paragraph II(b)(6) Off-Balance Sheet Derivative Contracts; Interest Rate and Foreign Exchange Rate Contracts (Group F).—

One commenter stated that NCUA should consider excluding off-balance sheet items from the risk-based assets calculation. This commenter stated that an alternative may be to allow a corporate to establish a distinct capital pool for off-balance sheet items to prevent any confusion about the items having the same risk as on-balance sheet assets of the corporate. The Board believes the rule as proposed is clear enough on the treatment of on-balance sheet and off-balance sheet items.

One commenter noted that the proposal assigns derivative risk weights for interest rate swaps and foreign currency swaps, but not for other types of derivatives, and corporates may, if authorized by NCUA under the Expanded Authorities, engage in other forms of derivative transactions. The commenter sought clarification of this issue. The Board agrees that clarification is necessary, and so the final rule includes an “all others” catch-all category of derivative risk weighting. As with interest rate swaps and foreign currency swaps, the credit equivalent amount for these other derivatives is generally determined by summing the current credit exposure and the potential future credit exposure. Appendix C, Paragraph II(b)(6)(ii). The current credit exposure is calculated the same way for all derivatives, including other derivatives. Appendix C, Paragraph II(b)(6)(ii)(A). The potential future credit exposure is determined by multiplying the notional principal times a credit conversion factor. Appendix C, Paragraph II(b)(6)(ii)(B). The size of this credit conversion factor depends on the remaining maturity of the derivative. For the catch-all derivatives category, the conversion factors in the final rule are ten percent (remaining maturity of one year or less), 12 percent (remaining maturity of over one year but less than five years), and 15 percent (remaining maturity over five years). This treatment of these other derivatives is similar to that used by the Federal Reserve and the other banking regulators.

See

12 CFR part 208, Appendix A, Paragraph II

I.E.

2.e. (Capital Regulation of the Board of Governors of the Federal Reserve).

After the credit equivalent amount is determined for any derivative, including the catch-all category, a risk weighting is applied to the credit equivalent amount depending on the nature of the counterparty. Appendix C, Paragraph II(b)(6)(iv)(A). The maximum risk weight, however, for the credit equivalent amount of any derivative contract is 50 percent.

One commenter sought clarification on the effects of collateral posted by derivative counterparties on the risk weighting of those derivatives. Appendix C only recognizes certain forms of collateral for the purposes of risk-weighting: cash, treasuries, U.S. Government agency securities, securities issued by the central governments of OECD countries, and securities issued by multilateral lending institutions or regional development banks in which the United States is a member.

17

The portion of the derivative's credit equivalent amount equal to the fair market value of this collateral is generally risk-weighted at 20 percent.

See

Appendix C, Paragraphs II(a)(2)(ii), (vii), (xiii), and (xv).

17

Other forms of collateral, or risk-weighting percentages, may be used for risk-weighting if the derivatives counterparty is a qualified securities firm.

See

Appendix C, Sections II(a)(1)(viii) and II(a)(2)(viii).

Another commenter asked whether derivatives used for hedging the credit risk of other assets in the corporate's portfolio would have a reduced, or zero, risk weighting. The answer is no. Whether or not a derivative is used for hedging is not relevant to its risk weighting for purposes of these Basel I capital ratio calculations.

Appendix C, Paragraph II(c) Risk Weighting of Recourse Obligations, Direct Credit Substitutes, and Certain Other Positions

Paragraph II(c)(3) Ratings Based Approach (RBA)

One commenter asked for clarification on the discretion of corporates to choose between a ratings-based, and non-ratings based, approach to risk weighting for those investments that carry an NRSRO rating and could be risk-weighted using the RBA. The proposed rule language could be interpreted as permitting corporates the freedom to choose their ratings approach if both the general risk weighting and RBA risk weighting might apply, and, perhaps, to apply differing approaches to differing securities on the same call report. To ensure consistency, the Board has added a new paragraph II(c)(3)(iii) to the final rule to require a corporate that uses RBA risk weighting for one or more securities on a particular call report use the RBA approach for all eligible securities on that call report. This requirement is consistent with how the other banking regulators have addressed this issue, at least informally.

See, e.g.,

73 FR 43993 (July 29, 2008) (“Regardless of the method a banking organization chooses [on a call report], it would have to use that approach consistently for all corporate exposures.”). The Board also notes that, currently, RBA is not permissible under Basel I for corporate debt obligations, even short-term debt

obligations.

18

Without the RBA option, corporate debt will generally be risk weighted at 100 percent. The Board has determined a lower risk weight may be appropriate for highly-rated, short term corporate debt (

i.e.,

an original or remaining final maturity of 120 days or less), as proposed by the other banking agencies in their Basel II regulations.

19

18

In the proposal, the RBA is only permitted for a position that is a “recourse obligation, direct credit substitute, residual interest, or asset- or mortgage-backed security * * * .”

19

[Reserved]

Short term rating category

Risk-weight

percentage

Highest Investment Grade

20

Second-Highest Investment Grade

50

Third-Highest Investment Grade

100

Below investment grade

150

No applicable external ratings

100

Accordingly, paragraph II(c)(3)(ii)(A)(

1

) is amended in the final rule to permit corporates the optional use of the RBA for short term corporate debt.

Section 704.4 Prompt Corrective Action (PCA)

The proposed PCA provisions are similar to those currently applicable to banks. Under the proposal, each corporate would be assigned to one of five capital categories: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. The potential consequences of failing to meet capital standards include restrictions on activities, restrictions on investments and asset growth, restrictions on the payment of dividends, restrictions on executive compensation, requirements to elect new directors or dismiss management, and possible conservatorship. The proposed due process for credit unions and their employees associated with the new PCA provisions was set out in a new subpart to part 747 of NCUA's rules.

Many commenters thought generally that the imposition of PCA standards for corporates was a good idea and long overdue. A few commenters stated that the PCA powers given to NCUA under the proposal were appropriate, because as long as the possibility exists for reckless behavior at corporate credit unions, the agency needs the power to intervene. One NPCU commenter said that it at first thought the proposal gave NCUA too much power and was overreaching, but then upon further reflection changed its mind given what has happened and NCUA's central role to oversee the corporate system. One corporate commenter specifically stated that the minimum four percent (leverage and Tier 1 risk based capital ratios) and eight percent (total risk based capital ratio) were appropriate for adequate PCA capitalization.

Many commenters, however, thought that the proposed PCA provisions gave NCUA too much discretionary power and room for arbitrary decisions. Some commenters saw a general need for more clarity and certainty in the due process and appellate rights associated with PCA actions. The Board has addressed these concerns with some changes to the final rule as discussed below.

704.4(a) Purpose

This proposed paragraph set forth the purpose of prompt corrective action. One sentence, related to the coordination with the state authorities for state-chartered corporates on discretionary supervisory activities, was amended and moved in the final rule to paragraph 704.4(f). The amendment is discussed below.

704.4(b) Scope

This proposed paragraph sets forth the scope of the PCA section.

704.4(b)(2) Prohibition on Advertising of PCA Category Without Prior NCUA Approval

The proposal required that no corporate may state in any advertisement or promotional material its PCA category unless NCUA specifically permits such statement or the law requires it. Many NPCU commenters stated that corporates should be required to disclose their capital category as the proposed prohibition denies transparency to the corporate's member/owners and makes it difficult for them to do their due diligence.

The Board is sympathetic to the concerns of the commenters. The members of a corporate need some transparency on the corporate's activities. The members are ultimately responsible for what the corporate does or does not do, and the members usually have both capital and uninsured shares at risk in the corporate. NCUA understands this, and will be taking additional actions in the future, such as improved call reporting requirements, to increase such transparency, at least with regard to the balance sheet. In fact, likely 99 percent of the time, a member will be able to determine a corporate's PCA status from the call report since NCUA will be requiring that a corporate report its capital levels, including its Leverage, T1RBC, and Total RBC ratios, on the call report. If members need additional financial information beyond the call report, they can request the corporate provide them the information voluntarily, or even involuntarily in response to a member petition filed under the member inspection process. 12 CFR 701.3. And, of course, the members have the ultimate power over their corporate board, since the members elect—and can refuse to reelect—board directors who are not responsive to the members.

NCUA wants to clarify one aspect of the members' rights to financial information from their corporates. Exam reports, and other documents prepared by NCUA, or prepared specifically by the corporate at NCUA's request or in response to an NCUA request, belong to NCUA and not to the corporate.

20

The corporate will not be able to release this information to anyone, including the corporate's members, without obtaining NCUA's prior approval.

20

State regulators will likely have similar controls over their interactions with their state chartered corporates.

One commenter agreed with the proposed prohibition on publicizing PCA category, but thought it needed to be clarified since certain PCA terms, such as “adequately capitalized” and “well capitalized,” are common expressions and could be used unintentionally. The Board understands that such phrases might be used unintentionally, but believes it important that corporates strive as much as possible not to discuss their capital adequacy in the public media.

704.4(c) Notice of Capital Category

The proposal set forth the effective date of a PCA capital category, and when the corporate must give notice to NCUA of a change in capital category, and vice versa.

704.4(c)(2)(ii) Notice of Capital Category

This paragraph provides for NCUA notice to the corporate of a change in capital category. One NPCU commenter complained that this provision appears to give NCUA the authority to subjectively reclassify a corporate capital classification based on administrative review, and the commenter objected to this. The Board notes that this provision does not give NCUA substantive authority to change a PCA category. Such authority arises from other provisions, such as 704.3(d)(2) and 704.4(d)(3). These

provisions each have their own associated due process.

704.4(d) Capital Measures and Capital Category Definitions

The proposal set forth the various PCA capital categories and the minimum capital ratios for each category.

704.4(d)(3) Authority of NCUA, After Due Process, To Downgrade a Corporate One PCA Capital Category for an Unsafe or Unsound Condition or Practice

Some commenters opposed the proposed downgrade authority in 704.4(d)(3) as giving too much power to NCUA examiners and the OCCU Director. In fact, under the proposal this authority would reside in the NCUA Board (subject to delegation), not the OCCU Director or examiners.

One commenter who opposed this provision stated that probably within the past five years every corporate would have been downgraded because it had at least one Corporate Risk Information System (CRIS) rating of three or lower.

21

Another NPCU commenter expressed concern that NCUA might use this power to downgrade a corporate to force an involuntary merger, resulting in a transfer of the NPCU member, and his capital accounts, to another corporate which the NPCU may not want to support. Two commenters stated that the rule needed to provide a corporate with the opportunity, and time, to correct the deficiencies leading to the adverse CRIS rating before a PCA downgrade. Two of these commenters noted that during the exam process corporates are given a time frame to correct deficiencies.

21

The proposal, however, does not require NCUA enforce a PCA downgrade because of a low CRIS rating—it only empowers the NCUA Board to take such action.

The Board believes the discretionary authority vested in it by proposed 704.4(d)(3) to downgrade a corporate is appropriate. The Board notes that it would not normally authorize a downgrade of a corporate based solely on a negative CRIS rating until the corporate had had a reasonable opportunity to correct the deficiencies underlying the CRIS rating.

The Board also notes that it is highly likely that there will be some corporate combinations in the coming years. While most of these mergers would be voluntary, some might be involuntary. NPCUs should take this fact into account when deciding which corporate they will use for services and how much capital they are willing to contribute to that corporate.

704.4(d)(4) Modification of Minimum PCA Percentages

Proposed 704.4(d)(4) permits the NCUA, for good cause, to modify any of the minimum PCA percentages for a particular corporate as provided for in 704.3(d). A few commenters objected to this provision because they thought this proposal transfers power from the NCUA Board to the OCCU Director. Again, this authority is simply a cross reference to the authority in 704.3(d). There is no delegation to the OCCU Director, and 704.3(d) provides the affected corporate with due process.

704.4(e) Capital Restoration Plans

The proposal described when a corporate must file a plan with the NCUA, the contents of the plan, the consequences for failure to file a plan, and NCUA's processing and approval of the plan.

704.4(e)(5) Disapproval of Capital Plan

Proposed 704.4(e)(5) provides that if an undercapitalized corporate does not submit a capital restoration plan acceptable to NCUA the corporate will be downgraded to significantly undercapitalized.

Two commenters protested that this allows the Director of the OCCU to treat a corporate that is undercapitalized the same as if it was significantly undercapitalized, and allows the Director to do so for an undue length of time. The Board disagrees. The PCA provisions encourage a corporate to file a timely and realistic capital restoration plan. If a corporate fails to do that, the Board must have the authority to take appropriate action to protect the corporate, its members, and the NCUSIF. In addition, the proposal makes no delegation to the OCCU Director.

704.4(f) Mandatory and Discretionary Supervisory Actions

This proposed paragraph sets forth various mandatory and discretionary PCA actions depending on a corporate's PCA category. One commenter thought that the PCA supervisory actions that come into play depending on the corporate's PCA capital categories, and which are variously labeled within the proposal as

mandatory

or

discretionary

at the given capital category, should never be

mandatory.

Instead, they should all be

discretionary

with NCUA. The Board disagrees. The Board wants corporates to know, with certainty, that certain PCA effects will happen if a corporate falls into a particular PCA category.

A few commenters asked that, for discretionary PCA actions against state chartered corporates, if NCUA determines such an action is appropriate, NCUA give the appropriate state supervisory authority (SSA) an opportunity to take the action separately from, or jointly with, NCUA. As pointed out by the commenters, this approach is consistent with NCUA's PCA rules for NPCUs located in paragraph 702.205(c) of part 702. Accordingly, the final rule amends paragraph 704.4(f)(2) to permit the appropriate SSA an opportunity to take discretionary PCA actions independently from, or jointly with, NCUA.

704.4(g) Directives to Take Prompt Corrective Action

The proposed paragraph requires advance notice of pending directives to significantly and critically undercapitalized corporates. There were no significant comments on this paragraph.

704.4(h) Procedures for Reclassifying a Corporate Credit Union Based on Criteria Other Than Capital

The proposed paragraph requires advance notice of intent to reclassify and makes reference to the associated due process provision. There were no significant comments on this paragraph.

704.4(i) Order to Dismiss a Director or Senior Executive Officer

The proposed paragraph provides that affected individuals are entitled to a copy of the order or directive provided to the corporate, along with notice of the right to seek reinstatement. The paragraph also makes reference to the associated due process. There were no significant comments on this paragraph.

704.4(j) Enforcement of Directives

The proposal cross references § 747.3005 as the source of the process for enforcing PCA directives. There were no comments on this paragraph.

704.4(k) Remedial Actions Towards Undercapitalized, Significantly Undercapitalized, and Critically Undercapitalized Corporate Credit Unions

The proposal prescribes certain remedial actions for corporates in these PCA categories.

704.4(k)(1) Prohibition on Undercapitalized Credit Union Paying Dividends on Capital Accounts

Proposed 704.4(k)(1) prohibited a corporate credit union from making any capital distribution, including payment of dividends on perpetual and nonperpetual capital accounts, if, after

making the distribution, the credit union would be undercapitalized.

A few commenters supported this prohibition. Many commenters, however, were opposed to this prohibition, generally saying that this undermined the attractiveness of capital accounts and would discourage recapitalization of the corporate credit union system, and that the decision on payment of dividends should be left to the corporate's board of directors. One commenter stated that this prohibition could perpetuate the undercapitalized condition. Several of these commenters stated that this prohibition should be limited to significantly or critically undercapitalized corporates. Several others said that this prohibition should be tied to some sort of minimum RE ratio, not the fact that the corporate may be undercapitalized.

The Board disagrees with the commenters that oppose the prohibition. When a corporate is undercapitalized, the payment of dividends on existing capital depletes the corporate's RE and worsens the corporate's capital position, increasing the odds of the corporate's failure. The Board disagrees with those commenters that believe that a corporate must be

significantly undercapitalized

before it is in true capital trouble. The

undercapitalized

PCA category indicates serious capital problems that the corporate must address, and anything that undermines capital retention and growth in the

undercapitalized

PCA category must be controlled. The Board notes that this prohibition on the payment of dividends at undercapitalized corporates is also consistent with the Basel capital regulations of the other banking regulators.

The Board does believe that the NCUA's authority to waive the prohibition as stated in the proposal is unnecessary (due to 704.1(b)), and perhaps even harmful, as this internal waiver language suggests that the NCUA might grant such dividend waivers as a matter of routine. Accordingly, the final rule eliminates the NCUA waiver authority from the text of 704.4(k)(1).

704.4(k)(2)(v) Discretionary Safeguards

This proposed paragraph stated that NCUA may, with respect to any undercapitalized corporate credit union, take one or more of the actions described in paragraph (k)(3)(ii) (

e.g.,

for significantly undercapitalized corporates) if the NCUA determined those actions are necessary to carry out the purpose of the PCA section.

Many commenters thought this proposed paragraph went too far. Several of these commenters mischaracterized this authority as residing with the OCCU Director when, in fact, under the proposal this authority would reside in the NCUA Board (subject to delegation). Some commenters stated that under this provision, the NCUA could fire any employee and or remove any board at any existing corporate today, and will be able to do so for years to come as long as the corporates remain undercapitalized. One commenter called this provision outrageous, and two others questioned its constitutionality. Another commenter said these powers should be reserved only for corporates categorized as either significantly or critically undercapitalized.

The Board agrees with this last commenter, and has eliminated this proposed paragraph from the final rule.

704.4(k)(6)(ii)(C) Restricting the Activities of Critically Undercapitalized Corporates

Proposed paragraph 704.4(k)(6)(ii)(C) prohibits a critically undercapitalized corporate from amending its charter or bylaws without the prior approval of the NCUA, except as necessary to carry out any other requirement of law, regulation, or order.

A few commenters stated that this usurped the authority of state regulators over state charters. The Board disagrees. A corporate that is critically undercapitalized represents a significant risk to the NCUSIF. Accordingly, the NCUA must have control over any significant activities that corporate might undertake, including, but not limited to, charter changes that affect the control or governance of the corporate.

Proposed paragraph 704.4(k)(6)(ii)(F) prohibited a corporate from paying interest on new or renewed liabilities at a rate that would increase the corporate credit union's weighted average cost of funds to a level significantly exceeding the prevailing rates of interest on insured deposits in the corporate credit union's normal market areas. One commenter stated that corporates under PCA should not be restricted to dividend rates in the region the institution is located since some corporates have national fields of membership.

The Board notes that most corporates, even with national FOMs, have a concentration of members within a particular area of the country. In the case of a corporate which has no such identifiable concentration, the market area of the corporate would be the entire nation. Accordingly, the Board sees no need to amend the paragraph as proposed.

704.8(j)(2)(ii) Proposed PCA Downgrade for Failure To Correct NEV Test Failures

The proposed paragraph 704.8(j)(2) in the asset liability section, would require PCA category downgrades for failure to correct NEV test failures. One commenter recommended that PCA compliance and regulatory remedies be eliminated for the NEV type testing, stating that there was no precedent for the application of PCA beyond the three “routine capital measures.” The Board strongly disagrees. Corporates must comply with the corporate rule's NEV requirements. And, if a corporate fails to comply, NCUA must have the supervisory tools to deal with such noncompliance. The PCA downgrade provisions in 704.8(j)(2)(ii) provide the NCUA with the necessary tools.

One commenter suggested that there should be a phase-in period for the new PCA requirements, but this commenter did not indicate whether the desired phase-in was over and above the 12 months currently envisioned under the proposal. The final rule retains the one-year phase-in of the PCA provisions as proposed.

Except as discussed above, the Board adopts the final § 704.4 as proposed.

The proposal also included a new subpart M to Part 747, setting forth the procedures and due process available in connection with the PCA provisions of § 704.4. The proposal adopts subpart M as proposed.

704.5 Investments

704.5(a) Through 704.5(g)

The proposal did not contain any amendments to these seven paragraphs, and they remain as in the current rule.

704.5(h) Prohibitions

The proposed paragraph 704.5(h) added prohibitions on corporate credit unions investing in collateralized debt obligations (CDOs) and net interest margin securities (NIMs).

Many commenters supported the prohibition on CDOs and NIMs, and the final rule retains these prohibitions. Many commenters also stated a desire for additional restrictions on corporate investments. These additional restrictions ranged from limiting corporate credit unions to investing only in government securities to additional prohibitions on securities, including residential mortgage-backed securities (RMBS) and subordinated securities that caused the credit union industry so much of a loss. NCUA hired

Kamakura Corporation (Kamakura) to assist in analyzing the proposed rule, and Kamakura also recommended prohibiting investments in subordinated securities and placing further limits on private label RMBS.

22

22

Kamakura Report, p. 10.

The Board agrees with these commenters and, accordingly, has added a new paragraph (h)(7) to the final rule to prohibit corporates from investing in private label RMBS. Private label RMBS are not guaranteed by the United States Government, its agencies, or its sponsored enterprises. The RMBS' underlying assets, residential mortgage loans, are also more sensitive to macro-economic factors than other investments available to corporate credit unions. In fact, of the current combined losses at Western Corporate Federal Credit Union (WesCorp) and U.S. Central Federal Credit Union (U.S. Central), over 95 percent were related to private label RMBS. NPCUs also invest directly in residential mortgages, and by prohibiting corporates from purchasing private label RMBS, the pro-cyclical nature of corporate and NPCU balance sheets is also diminished. Given the lack of a guarantee, the sensitivity of mortgages to macro-economic factors, the concentration of mortgages on the balance sheets of natural person credit unions, and the recent history of corporate investments, the NCUA Board believes a prohibition on private label RMBS is warranted.

704.2 Definition of Private Label Security

The final rule defines

private label security

as “a security that is not issued or guaranteed by the U.S. government, its agencies, or its government-sponsored enterprises (GSEs).”

704.2 Definition of Residential Mortgage-Backed Security

One commenter noted that while the proposed rule defined the terms “residential property” and “residential mortgage backed security,” the proposed definition of RMBS did not include the use of the phrase “residential property.” The Board agrees that, for precision, the RMBS definition should refer to “residential property,” and the final rule now defines RMBS as “a mortgage-backed security collateralized primarily by mortgage loans on residential properties.” Also, as a point of clarification, this 704.2 definition of RMBS includes not only securities primarily backed by first lien residential mortgages, but also securities primarily backed by other-than-first-lien residential mortgages, such as home equity loans.

704.5(h)(8) Prohibiting Subordinated Securities

The Board has also added a new paragraph 704.5(h)(8) to the final rule prohibiting investment in subordinated securities. Subordinated securities present greater credit risk, liquidity risk, and price volatility than more senior securities. Losses on subordinated securities may at times reach 100 percent of principal, even when a more senior security in the same issuance may only lose pennies on the dollar. In fact, over 48 percent of the current combined losses incurred by WesCorp and U.S. Central are attributable to subordinated securities, mostly subordinated RMBS.

704.2 Definition of Subordinated Security

The proposal defined

subordinated security

in § 704.2 as “[a] security that has a junior claim on the underlying collateral or assets to other securities in the same issuance. If a security is junior only to money market fund eligible securities in the same issuance, the former security is not subordinated for purposes of this definition.” The final rule retains this definition, but adds the words “at the time of purchase” because a subordinated security can lose its subordination as the more senior tranches are paid down. The final rule also moves the existing prohibition on purchasing stripped MBS from paragraph (h)(7) to (h)(9).

The relationship between the other investment, credit risk, and ALM prohibitions, and these two 704.5(h) prohibitions on private label RMBS and subordinated securities, is discussed in more detail below.

Accordingly, and except as described above, the Board adopts the final § 704.5, and associated definitions, as proposed.

704.6 Credit Risk Management

The proposed § 704.6 included tighter single obligor limits and new sector concentration limits. The proposal also required that all corporate investments, other than in another corporate or CUSO, have a minimum credit rating from all publicly available NRSROs of no lower than AA− for long-term ratings and A-1 for short-term ratings. Additionally, 90 percent of corporate investments must have at least two NRSRO ratings.

Several commenters thought the proposed tightening of the existing single obligor limits, and establishing of new sector limits, was a positive change, and some asked for even tighter restrictions. On the other hand, several commenters thought the proposed limits were too tight and may increase risk and limit the corporates' ability to manage their businesses and balance sheets efficiently. The Board agrees that some of the proposed limits should be tightened and others relaxed, as discussed below.

704.6(a) Policies

The proposal did not contain any amendments to this paragraph.

704.6(b) Exemptions

The proposed paragraph 704.6(b) exempted certain assets from both the sector concentration limits and the single obligor concentration limit, including fixed assets, loans, investments in CUSOs, investments issued by the United States or its agencies or its government sponsored enterprises, and investments fully guaranteed or insured as to principal and interest by the United States or its agencies.

Several commenters believed settlement funds should also be exempt. These commenters were concerned that the tight single obligor limit would force corporates to find many additional settlement counterparties given the proposed tighter limit of 25 percent of capital per obligor. The commenters were particularly concerned about seasonal patterns that cause settlement activity to fluctuate throughout the year and could potentially cause violations of the single obligor limits.

The Board agrees with these concerns, and has added settlement funds in federally insured depository institutions to the list of exempt investments in the final 704.6(b). The Board has also added a definition of settlement funds to the final § 704.2 to read as set forth in the regulatory text of this rule.

Corporates must take care to properly classify settlement funds and not include non-settlement short-term investments in this category. Generally, the characteristics of settlement funds are: (1) Funds are used for immediate-value transactions (transactions that must be paid for immediately to be processed or have a particular value at the time of processing); (2) Funds are used to settle transactions from institutions such as clearing houses, banks, payment processors, and other credit unions; and (3) Funds are used for same-day settlement accounts, or in the case of automated clearing house transactions within a few days. The amount of money a corporate classifies as “settlement funds” at a third party for purposes of exclusion from the 704.6

single obligor limit should also be no more than the third party requires under the terms of its settlement policies.

The proposed 704.6(b) had a complete exemption for agency MBS, but the Board has instead determined not to exempt such MBS. Rather, the Board intends to permit investment in MBS, including agency MBS, subject to concentration limits described below. Accordingly, the final rule amends the 704.6(b) exemption for “investments that are issued or fully guaranteed as to principal and interest by the U.S. government or its agencies or its sponsored enterprises” by adding the words “other than mortgage backed-securities” at the end. Also, the reference to subordinated securities is eliminated from the final rule since such securities will be prohibited.

704.6(c) Issuer Concentration Limits

The proposed 704.6(c) tightens the single obligor limits to 25 percent of capital, subject to certain enumerated exceptions.

In addition to the enumerated exceptions, many commenters felt short-term investments, such as federal funds, should have either a relaxed single obligor limit, or be exempt from the single obligor limit, due to the lower risk associated with these transactions. The Board agrees. Investments of shorter maturity present less credit risk, all else being equal. Still, it is not appropriate to exempt these short term investments from some limit, as these obligations (including federal funds) do have some credit risk. Accordingly, the Board adds a new paragraph (c)(2)(i) to the final rule limiting investments in one obligor to 50 percent of capital where the remaining maturity of all obligations with that obligor are less than 30 days.

In general, the obligor in a securitization situation will be the Qualified Special Purpose Entity (QSPE) trust that issues the securities. Some commenters were concerned that there were very few potential obligors in the credit card ABS sector, particularly given the prevalence of “master” QSPE trusts, and so the single obligor limitation could keep corporates from making any significant investments in the credit card ABS sector. Accordingly, the final rule adds a new paragraph 704.6(c)(2)(ii) to the final rule relaxing the single obligor limitation for credit card master trusts to 50 percent of capital. The Board observes that credit card ABS, both as a sector and as individual securities, have withstood both systemic and issuer shocks since these ABS were first issued. Given the sector's relative safety and the limited number of potential counterparties, NCUA believes a 50 percent obligor limitation for these master trusts is appropriate.

704.2 Definition of Obligor

The final rule amends this definition to clarify that, for purposes of securities issued out of a trust, such as a Qualified Special Purpose Entity (QSPE) trust, the trust itself is the obligor.

704.6(d) Sector Concentration Limits

NCUA proposed, as part of its sector concentration limits, that private label RMBS be limited to the lower of 500 percent of capital or 50 percent of assets. Some commenters, and Kamakura, were concerned that these limits were not tight enough. Kamakura recommended tighter limits for both commercial mortgage-backed securities (CMBS) and private label RMBS and a combined limit for the MBS sectors due to the higher correlation of mortgages to macro-economic factors.

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Kamakura recommended a sector limit of 15 percent of the portfolio each for both CMBS and private label RMBS, and a combined sector limit of 25 percent of the portfolio. As discussed earlier, the final rule prohibits private label residential MBS. The Board also agrees a tighter limit for the CMBS sector is appropriate. Additionally, the Board believes an overall restriction on the amount of MBS, including agency MBS, is appropriate due to the additive nature of the corporates' concentration exposure when considered along with NPCU mortgage exposure.

23

Kamakura Report, p. 10.

Accordingly, the Board amended the final paragraph (d)(1)(i) to limit all MBS, inclusive of commercial mortgage-backed securities, to the lower of 1000 percent of capital or 50 percent of assets. Additionally, the final rule revises paragraph (d)(1)(ii) to tighten the limit on CMBS to the lower of 300 percent of capital or 15 percent of assets.

Paragraphs (d)(1) and (d)(2) establish sector concentration limits for specified investment types, and paragraph (d)(3) establishes a general, aggregate limit of 100 percent of capital or 5 percent of assets for any other investment type not described in (d)(1) or (d)(2). Some commenters were concerned that investments in federal funds might be included in the (d)(3) limit since fed funds were not specifically enumerated in the other sectors and were not generally exempt under 704.6(b). The Board recognizes that corporate credit unions need flexibility to engage in short-term investments and agrees that federal funds transactions with federally insured depository institutions should be explicitly excluded from the sector concentration limits in a manner similar to deposits in those institutions. Accordingly, the final rule amends paragraph (d)(4) to explicitly exclude federal funds investments in other federally insured depository institutions from sector concentration limits.

704.6(e) Corporate Debt Obligation Subsector Limits

The proposed paragraph 704.6(e) set out concentration limits for subordinated securities. Since the final 704.5(h) outright prohibits subordinated securities, the proposed text is no longer necessary and has been deleted from the final rule and replaced with a different provision, as discussed below.

The proposed 704.6(d)(1)(viii) limited corporate debt obligations to the lower of 1000 percent of capital or 50 percent of assets. Some commenters, including some trade associations, thought these limits were not restrictive enough. Some of these commenters recommended that NCUA further restrict concentrations in corporate debt by industry. The NCUA Board agrees. The final rule replaces the proposed 704.6(e) with a new 704.6(e) establishing subsector limits for corporate debt obligations. The final rule limits corporate debt to the lower of 200 percent of capital or 10 percent of assets for each of the 20 North American Industry Classification System (NAICS) industry sectors. The 20 NAICS sectors are listed in the following table:

Code

Industry classification

Code

Industry classification

11

Agriculture, Forestry, Fishing and Hunting

53

Real Estate and Rental and Leasing.

21

Mining, Quarrying, and Oil and Gas Extraction

54

Professional, Scientific, and Technical Services.

22

Utilities

55

Management of Companies and Enterprises.

23

Construction

56

Administrative and Support and Waste Management and Remediation Services.

31-33

Manufacturing

61

Educational Services.

42

Wholesale Trade

62

Health Care and Social Assistance.

44-45

Retail Trade

71

Arts, Entertainment, and Recreation.

48-49

Transportation and Warehousing

72

Accommodation and Food Services.

51

Information

81

Other Services (except Public Administration).

52

Finance and Insurance

92

Public Administration.

These subsector limits will ensure more diversification in corporate debt obligations and reduce correlation risk due to excessive concentrations in any single subsector, particularly the finance subsector.

704.6(f) Credit Ratings

As discussed above, the proposed paragraph 704.6(f) required that corporates consult all publicly available NRSRO ratings and use those ratings to screen potential investments.

Several commenters and Kamakura expressed concerns regarding reliance on credit ratings provided by NRSROs. Kamakura recommended corporates not look to NRSRO ratings and instead implement a macro economic analysis approach to evaluating credit risk and conduct their own internal analysis on the probability of default of any given securities.

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The current 704.6(a), which NCUA did not amend in this rulemaking, requires that a corporate adopt a credit risk policy and evaluate the credit risk of individual securities. Still, the Board disagrees with the idea that NRSRO ratings have no value and that they should be entirely ignored when conducting credit analysis on a particular security. NRSRO ratings are useful tools when used, as in the proposed 704.6(f), only to

exclude,

not

include,

securities as potential corporate investments. Corporates must do additional credit analysis on each security that passes the initial NRSRO ratings screen, and each security that passes the NRSRO screen must comply with each and every one of the other investment, credit risk, and ALM provisions of this final rule.

24

Kamakura report, pp. 8-10.

704.6(g) Reporting and Documentation

The proposal did not contain any amendments to this paragraph. Accordingly, and except as described above, the Board adopts the final § 704.6 as proposed.

704.8 Asset and Liability Management (ALM)

The proposed § 704.8 contained several new ALM provisions, including a modification to the provision on early withdrawal penalties, two cash flow mismatches limits, a new 2-year limit on the WAL of a corporate's assets, and a requirement to measure net interest income. Some commenters were in favor of the revisions in the proposed rule. Many commenters, however, objected to different provisions within the proposed rule, generally complaining about the complexity and efficacy of the multi-level testing in proposed paragraphs 704.8(e), (f), and (g). As discussed below, the Board has made several changes from the proposed § 704.8 to the final.

704.8(a) Policies

Proposed paragraph 704.8(a)(6) contained a conforming change to reference the two proposed cash flow mismatch sensitivity tests. Because, as discussed below, these tests are not adopted in the final rule, the conforming amendment has been removed from paragraph (a)(6).

704.8(b) Asset and Liability Management Committee (ALCO)

The proposal did not contain any amendments to this paragraph.

704.8(c) Penalty for Early Withdrawals

The proposal limited a corporate's ability to pay a market-based redemption price to no more than its book value, thus eliminating the corporate's ability to pay a premium on early withdrawals. Hundreds of commenters objected to this prohibition, arguing that the proposed prohibition on premiums would make corporates less competitive with their certificates, and thus reduce corporate liquidity on the front-end. The NCUA Board agrees now that prohibiting a premium is not likely to protect the corporate's liquidity, and could interfere with the corporate's competiveness, and so the Board determined not to adopt the final 704.8(c) as proposed. Instead, paragraph 704.8(c) will remain as in the current rule. Some comments also indicated that all corporates are not applying the current rule correctly. For example, the Board noted a corporate may base its market-based penalty on the asset values the certificate is matched against, and so the redemption value would decline as the value of the underlying assets decline. This methodology violates the current regulation's requirement that penalties be based on the cost of replacing the lost funds.

The following example illustrates the application of the rule in a premium situation.

Assume a corporate is offering 2-year certificates at a 2-percent coupon, and 1-year certificates at a 1.5-percent coupon, and that the corporate then issues a 2-year certificate to “NPCU A.” One year later, assume NPCU A wishes to redeem the certificate and that interest rates have dropped, so that the corporate is now issuing 1-year certificates at 1 percent. That would make the replacement cost of the original certificate approximately 100 basis points (BP) (assuming the corporate can immediately issue a new certificate), but the dividend rate on the original certificate is more than that, at 200 BP. So the net savings for the corporate because of the early redemption is 100 BP. NCUA would then expect the corporate, at a minimum, to redeem this certificate at a premium of nearly 100 BP, but subtract some penalty spread to account for the uncertainty, and expense, in actually issuing a replacement certificate. Using this methodology and a penalty spread of, say, 25 BP, the 2-year certificate will be redeemed at an approximate price of 100.75. The market-based penalty, then, would technically be 25 BP, which reduced the 100 BP premium to 75 BP.

704.8(d) Interest Rate Sensitivity Analysis

The proposal did not contain any specific amendments to this paragraph. However, the final rule clarifies that for interest rate risk (IRR) tests conducted “at least quarterly,” at least one of the tests must be conducted on the last day of the calendar quarter. Traditionally, the last day of the quarter has been used by the corporates, and this clarification ensures consistency in measurement periods. Additionally, if “at least monthly” testing is required because NEV ratio falls below three percent, the last day of the month must also be one of the testing dates.

(Proposed) 704.8(e) Cash Flow Mismatch Sensitivity Analysis

See discussion in next paragraph.

(Proposed) 704.8(f) Cash Flow Mismatch Sensitivity Analysis With 50 Percent Slowdown in Prepayment Speeds

The proposal established new limits on cash flow mismatch sensitivity tests. Although the proposed tests were structured in terms of the effect on NEV of an immediate 300 basis point increase in the yield demanded by investors, the effect of the proposal was to ensure that the gap between the average life of a corporate's assets and its liabilities would remain within a few months and so not present extensive liquidity and market risk to the corporate.

Many commenters thought the two proposed cash flow mismatch sensitivity tests were too restrictive. Other commenters thought these tests were too complicated. Some commenters did not understand the tests were measuring the risk associated with cash flow mismatches, and these commenters discussed spread widening based on historical averages for such widening. Kamakura recommended eliminating the paragraph (e) and (f) stress tests, stating that these tests pose a potential burden on corporate credit unions, greatly reduce the number of securities available for investment, and do not appear to identify securities with differences in credit performance meaningfully related to the performance of securities throughout the credit crisis.

The Board generally concurs with these commenters and Kamakura, and the two proposed cash flow mismatch tests have been removed from the final rule. The elimination of the these two tests will allow corporates to have a larger mismatch between asset and liability cash flows, which increases earnings potential but also increases credit and liquidity risk. To mitigate this increased risk, the NCUA Board has retained the proposed 2-year WAL on assets and added an asset WAL extension test as discussed below.

(Proposed) 704.8(g), (Final) 704.8(e) Net interest income modeling

In addition to this NEV testing, the proposal required every corporate conduct net interest income (NII) modeling. The Board did not receive any significant comments on this provision, other than ones stating that corporates already did this modeling as a matter of policy. The final rule amends the timing of the modeling to read “be performed at least quarterly, including once on the last day of the calendar quarter.” As discussed above, this change ensures consistency in the modeling results. This paragraph is also renumbered as paragraph 704.8(e) in the final.

(Proposed) 704.8(h) (Final) 704.8(f) Weighted Average Asset Life

The proposal prohibited the weighted average life (WAL) of a corporate's loans and investment portfolio, excluding derivatives and equity investments (

e.g.,

investments with indefinite maturities such as PIC and CUSO investments), from exceeding two years.

The primary purpose of this restriction in the proposal was to ensure that a corporate did not artificially inflate the WAL of its liabilities so as to get around the asset—liability cash flow mismatch limits. Many commenters objected to the 2-year asset WAL restriction.

Some of these commenters were concerned that the 2-year WAL restriction would prevent corporates from providing long term liquidity loans to NPCUs. Loans over two years in maturity are not generally liquidity loans—they are loans used for term balance sheet funding to match off against longer-term loans or to fund portfolio growth. Since a corporate's primary role in lending is as a liquidity provider of short-term loans, NPCUs cannot rely on corporates to provide term lending in significant amounts. NPCUs have other viable options for longer-term funding such as the Federal Home Loan Bank system, which provides both fixed rate and variable rate lending.

With the elimination of the cash flow mismatch tests in proposed paragraphs 704.8(e) and 704.8(f), the NCUA Board believes it is very important to retain the proposed 2-year WAL restriction on the investment portfolio. This 2-year limit forces corporates to accommodate to the fact that corporates are, first and foremost, providers of payment systems, which, in turn, requires some matching of the investment portfolio to the short term payment liabilities to ensure liquidity for the payments system. Providing liquidity to NPCUs, particularly long-term liquidity, is of secondary importance to this payment systems function.

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Still, the 2-year WAL restriction is a

portfolio-wide

restriction, and the WAL restriction will allow corporates to make limited amounts of term loans exceeding two years in maturity if those loans are matched by other corporate assets of less than two year maturities.

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Providing investments on a principal basis will be even less of a priority in the corporate business model going forward.

Some of the commenters thought the 2-year asset WAL would prevent a corporate from being able to earn sufficient spread to build retained earnings in a timely manner. As discussed in more detail below in connection with some hypothetical corporate portfolios, the Board does not believe this is true. In fact, as suggested in the Kamakura report, the proposed cash flow mismatch tests were in most cases the determining factor in limiting a corporate's ability to populate its investment portfolio with ABS and MBS that generated higher yields for the corporate. Under the proposed 704.8(e) cash flow mismatch test, and assuming a 4 percent NEV, a corporate's asset WAL could not exceed its liability WAL by more than about 3 months without violating proposed 704.8(e). That meant that if the WAL of the corporate's liabilities was about 8 months—which is about the current average for corp

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