Corporate Credit Unions; Involuntary Liquidation of Federal Credit Unions and Adjudication of Creditor Claims Involving Federally Insured Credit Unions in Liquidation; Requirements for Insurance

NATIONAL CREDIT UNION ADMINISTRATION

12 CFR Parts 704, 709, and 741

Corporate Credit Unions; Involuntary Liquidation of Federal

Credit Unions and Adjudication of Creditor Claims Involving Federally

Insured Credit Unions in Liquidation; Requirements for Insurance

AGENCY: National Credit Union Administration (NCUA).

ACTION: Proposed rule.

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SUMMARY: NCUA is issuing proposed revisions to the rules governing

corporate credit unions. As the credit union industry has become more

complex and competitive, the demands on corporate credit unions have

become greater. Corporate credit unions are providing a greater variety

of more sophisticated services. The proposed rule is intended to

strengthen corporate credit union capital and ensure that the risk on

corporate credit union balance sheets is adequately managed and

controlled.

DATES: Comments must be received on or before September 3, 1996.

ADDRESSES: Comments should be directed to Becky Baker, Secretary of the

Board. Mail or hand-deliver comments to: National Credit Union

Administration, 1775 Duke Street, Alexandria, Virginia 22314-3428. Fax

comments to (703) 518-6319. Post comments on NCUA's electronic bulletin

board by dialing (703) 518-6480. Please send comments by one method

only.

FOR FURTHER INFORMATION CONTACT: Robert F. Schafer, Acting Director,

Office of Corporate Credit Unions, at the above address or telephone

(703) 518-6640; or Edward Dupcak, Director, Office of Investment

Services, at the above address or telephone (703) 518-6620.

SUPPLEMENTARY INFORMATION:

A. Background

Part 704 was amended in 1992 to address a broad array of corporate

credit union matters. See 57 FR 22626 (May 28, 1992). The regulation

has been in effect for several years, during a time of great change in

the credit union industry. NCUA has had an opportunity to see how the

regulation has worked and to consider how it could be improved. Section

704.12, governing representation issues, was revised in 1994. See 59 FR

59357 (Nov. 17, 1994). In April 1995, NCUA issued a proposed regulation

to revise most of the sections of Part 704. See 60 FR 20438 (Apr. 26,

1995). Comments were due by June 26, 1995. On May 17, 1995, NCUA

extended the comment period an additional 60 days to August 25, 1995.

See 60 FR 27240 (May 23, 1995). The supplementary information section

noted that NCUA had been working with an outside firm to provide risk-

profile assessments of corporate credit unions, using simulated

modeling techniques, and that the process had proven to be more time-

consuming than envisioned.

In response to the comments received and results of the modeling,

NCUA determined to issue this revised proposed rule for another round

of public comment. In developing this revised proposal, NCUA considered

all of the written comments, the results of further modeling, and the

input provided by corporate credit union representatives in a number of

dialogue meetings conducted by NCUA.

It should be noted that the background section of the initial

proposed rule observed that NCUA supervises all corporate credit unions

but that only those that are federally chartered pay an operating fee

to the agency. Questions were raised as to whether this put federally

chartered corporate credit unions at a competitive disadvantage and

whether all corporate credit unions should pay for NCUA's corporate

credit union supervision program. NCUA asked for comment on whether it

would be appropriate to assess all corporate credit unions an

examination fee or to abolish corporate credit union fees altogether

and require natural person credit unions, since they benefit from the

existence of corporate credit unions, to make up the difference.

[[Page 28086]]

Most of those who commented on this issue favored assessing all

corporate credit unions a fee, rather than having natural person credit

unions pay for corporate credit union supervision. Many noted that not

all natural person credit unions use their corporate credit union. NCUA

has determined not to pursue the issue of funding corporate credit

union supervision expenses in this proposed regulation. However, given

the impact that the proposed rule could have on future supervision

efforts, this issue will be reviewed in the future.

B. Comments

NCUA received over 1300 comments on the proposed regulation, the

bulk of which were from natural person credit unions. Comments were

also received from the national credit union trade associations and

most of the corporate credit unions and state credit union leagues.

Finally, comments were received from other trade associations, state

credit union regulatory authorities, credit union organizations and

consultants, a Member of Congress, other entities that do business with

credit unions, and individuals.

The commenters generally opposed the proposed regulation,

particularly the asset-liability management and capital requirements.

The proposed regulation required that a corporate credit union

identically match all of its shares and deposits, except for 25 percent

of its overnight funds, to corresponding assets. The commenters stated

that the proposal represented an attempt to eliminate risk from the

system, whereas the appropriate role of a corporate credit union was to

manage risk. They stated that the proposal would make it impossible for

corporate credit unions to provide competitive products to their

members and to generate sufficient income to meet the proposed minimum

capital requirements. The proposed regulation required that corporate

credit unions achieve primary capital levels of 4 percent of average

daily assets by January 1, 1998.

The commenters also contended that the proposed rule would

disproportionately affect small natural person credit unions, which

rely more heavily on corporate credit unions for investments and other

services. They argued that because the corporate credit unions would

not be able to earn a spread on their investment activities, costs for

services would increase and yield on investments would decrease. -

C. Dialogue Meetings

After considering the comments and preliminary modeling results,

NCUA determined that some changes to the proposed regulation might be

appropriate. To obtain input on those changes, NCUA hosted a series of

meetings with representatives of corporate credit unions, natural

person credit unions, and national credit union trade associations.

There was a productive exchange of information and views. This proposed

rule incorporates a number of the suggestions received during the

meetings.

D. Modeling

NCUA contracted with a mortgage investment and interest rate risk

advisory firm (the firm) to estimate the market value of portfolio

equity and interest rate sensitivity of the balance sheets of seven

corporate credit unions. The modeling exercise was conducted to provide

NCUA with an independent assessment of the relative market risk in a

broad cross-section of corporate credit unions. The firm believes that

market value of portfolio equity (MVPE) is the best measure of interest

rate risk, as it can be computed quickly, captures interest and

principal cash flows, provides an analysis of embedded option risk, and

is more complete than income simulations. In addition, MVPE models are

not driven by assumptions regarding future behavior or reactions to

interest rate changes. The firm concluded that requiring corporate

credit unions to use MVPE techniques would introduce a necessary risk

analysis and reduction discipline. The firm stated that when properly

implemented, MVPE techniques would significantly reduce the likelihood

of another failure similar to that of Capital Corporate Federal Credit

Union, which failed in early 1995. Interestingly, many of the

commenters to the initial proposed rule recommended that NCUA use MVPE

to measure interest rate risk.

The firm noted that managing market value correctly can reduce the

volatility of earnings and net worth. The effects of good management

decisions stand out when earnings are not significantly affected by

unexpected changes in interest rates. Market value is the best measure

of the firm's value and is usually the best benchmark to judge

management's performance. Also, MVPE, and its volatility, is usually

the best indication of risk to the insurer and regulators.

The firm analyzed the corporate credit unions' base MVPE and the

sensitivity of MVPE for instantaneous and sustained parallel shifts in

interest rates up and down 400 basis points in 100 basis point

increments. It also provided a 12-month net interest income projection

for the same interest rate scenario.

Additional tests included stresses on several market-related

variables to determine their effect on MVPE. These included: (1)

flattening and steepening the reference yield curve with a pivot at the

three-year maturity; (2) increasing market volatilities by 50 percent

from the reference levels; (3) stressing prepayment speed projections

for mortgage-related securities 100 percent faster for the down 300

basis point scenario; (4) stressing prepayment speed projections for

mortgage-related securities 50 percent slower for the up 300 basis

point scenario; and (5) increasing market spreads by 50 basis points

above projected spreads.

Project results concluded that large changes in prepayment

expectations, widening spreads, and increases in volatility levels

would adversely affect corporate credit union MVPEs. Changes in the

shape of the yield curve did not have a significant adverse effect;

this was due, in large part, to the relatively short asset duration of

most corporate credit union balance sheets.

The balance sheets of the corporate credit unions studied were

``long the market,'' that is MVPE increased when interest rates

declined and decreased when interest rates rose. This is a result of

the effective duration of the corporate credit unions' assets being

longer than that of their liabilities. Some corporate credit union

assets were shown to be negatively convex, that is, projected gains to

MVPE were smaller for interest rate declines than losses for equivalent

interest rate increases. This negative convexity is caused by the

presence of embedded options, found most commonly in mortgage-related

securities and structured notes.

The firm determined that many corporate credit unions would need to

upgrade their interest rate risk models to account for the impact of

embedded options. It noted that the establishment of a minimum MVPE

ratio would be a key aspect of any regulation attempting to control

interest rate risk using MVPE techniques. According to the firm, the

minimum should provide a safe margin above the exposures created by a

positive or negative 300 basis point rate shift. This is necessary

because, as the tests indicated, MVPE can also be affected by changes

in the slope of the Treasury curve, prepayment activity that differs

from that expected, changes in market spread levels, and changes in

market volatilities. -

E. Three-Tiered Approach

In developing this revised proposed rule, NCUA acknowledged the

diversity within the corporate credit union network and the breadth of

functions

[[Page 28087]]

that are provided. Accordingly, this proposal provides the flexibility

for additional authorities for those corporate credit unions with a

more developed infrastructure and codifies the requirements to obtain

those authorities. Presently, such authorities are granted by waiver.

The basic regulatory requirements and authorities applicable to all

corporate credit unions are set forth in the main text of Part 704.

Thus, a corporate credit union that does not seek expanded authorities

need read only the main text and Appendix A, which contains model

disclosure forms that a corporate credit union may choose to use for

capital accounts. A ``basic'' corporate credit union need not read

Appendices B and C, which set forth additional authorities available to

corporate credit unions and the requirements to obtain such

authorities. The incorporation of expanded authorities allows for an

element of self-determination that was not a component of the initial

proposal. This approach is intended to remove the ``one-size-fits-all''

constraint and permit flexibility for a corporate credit union to

choose a path consistent with its members' needs. The board of a

corporate credit union may pursue, via a self- assessment, the level at

which it wishes its institution to operate.

F. Effective Date and Transition

Section 704.18 of the initial proposal stated that the rule would

take effect on January 1, 1996. Obviously, that date has passed. Due to

the complexity of this rule, it is difficult to determine when a final

rule will be issued, and thus to predict a reasonable effective date.

Accordingly, rather than stating an effective date in this proposal,

the final rule will announce an effective date that is approximately 1

year from the date the final rule is issued.

The preamble to the initial proposal stated that NCUA was

considering requiring compliance with the investment section 30 days

after issuance of the final rule, which would be prior to the effective

date of the rest of the regulation. This was to deter corporate credit

unions from ``loading up'' on investments that would no longer be

permissible under the new rule. The commenters generally objected to

this provision, and NCUA has determined not to proceed with it. As

noted in proposed Section 704.6(g), a corporate credit union's

authority to hold an investment is governed by the regulation in effect

at the time of purchase.-

As discussed above, if this proposal is made final, each corporate

credit union will have to determine the level at which it wishes to

operate. While a corporate credit union may change its level at a later

date, it will have to make an initial decision regarding what its

status will be when the final rule becomes effective. So that NCUA can

effectively supervise the transition to the new regulation, each

corporate credit union will be asked to inform NCUA, within 90 days of

the final rule's publication, of its decision.

A corporate credit union that plans to operate with expanded

authorities should submit its application for such authorities as soon

as possible to ensure approval and implementation prior to the

effective date. The application must demonstrate that the corporate

credit union either has sufficient staffing and infrastructure to

support the authorities or will make the necessary changes so that it

will have such staffing and infrastructure. The application also must

set forth the expected costs of such changes. Since there is no

guarantee of approval, a corporate credit union normally will not

implement these changes until it receives preliminary approval.

NCUA will work closely with a corporate credit union in evaluating

its application. Once all issues are resolved, NCUA will issue a

preliminary approval. If the issues cannot be resolved, NCUA will

notify the corporate credit union. Once preliminary approval has been

received, the corporate credit union must make the planned changes.

Once NCUA has been notified that the corporate credit union is ready to

begin using the expanded authorities, it will review the corporate

credit union's operations. If they are sufficient to support the

requested authorities, final approval will be granted.

Recognizing that an institution may not be at the required capital

level or within the required MVPE limitations by the effective date of

the regulation, NCUA plans to work with the corporate credit unions to

develop realistic time frames for compliance. NCUA also is aware of the

unique role of wholesale corporate credit unions and will make

accommodations to allow such institutions to comply with the

regulation. -

G. Section-by-Section Analysis

Section 704.1--Scope

Part 704 applies directly to all federally insured corporate credit

unions. It applies to non federally insured corporate credit unions,

via Part 703 of the Rules and Regulations, if such credit unions accept

shares from federally chartered credit unions. To clarify the

application of Part 704, NCUA proposed to amend the Scope section so

that it states both that the regulation applies to all federally

insured corporate credit unions, and that non federally insured

corporate credit unions must agree, by written contract, to adhere to

the regulation and submit to NCUA examination as a condition of

receiving funds from federally insured credit unions. Some commenters

objected to this latter requirement, arguing that it meant that NCUA

was holding non federally insured corporate credit unions to a higher

standard than other investment alternatives available to natural person

credit unions.

These credit unions may be held to a higher standard because they

are differently situated than other natural person credit union

investment alternatives. The failure of a corporate credit union, even

one not federally insured, would affect the credit union system more

dramatically than the failure of a bank or broker-dealer. First, the

public would not necessarily distinguish between a federally and non

federally insured corporate credit union: all would be tarnished.

Second, it is likely that a far greater number of federally insured

natural person credit unions would be affected by the failure of a

corporate credit union than would be affected by the failure of a bank

or broker-dealer. For these reasons, and because of NCUA's

responsibility to protect the National Credit Union Share Insurance

Fund (NCUSIF), NCUA has determined to retain in the revised proposed

rule the requirement that non federally insured corporate credit unions

must agree, by written contract, to adhere to the regulation and submit

to NCUA examination as a condition of receiving funds from federally

insured credit unions.

As in the first proposed rule, Section 704.1(b), which sets forth

NCUA's authority to waive a requirement of Part 704, is retained in

this revised proposal. NCUA again emphasizes that corporate credit

unions are expected to comply with the rule and that waivers will not

be granted as a matter of course.

Section 704.2--Definitions

As noted in the initial proposed rule, Part 704 currently

incorporates by reference Part 703, which governs federal credit union

investments, except where inconsistent with Part 704. To eliminate the

confusion regarding the applicability of certain provisions of Part 703

to corporate credit unions, NCUA determined in the initial proposed

rule to make the investment section in Part 704 stand on its own.

[[Page 28088]]

Among other tasks, this necessitated importing a number of definitions

from Part 703 into Part 704. No commenters objected to this idea, and

it is continued in this revised proposal.

The definitions that have been repeated, either identically or with

minor changes, from current Part 703 are: ``adjusted trading,''

``collateralized mortgage obligation,'' ``federal funds transaction,''

``futures contract,'' ``immediate family member,'' ``market price,''

``maturity date,'' ``real estate mortgage investment conduit,''

``repurchase transaction,'' ``residual interest,'' ``reverse repurchase

transaction,'' ``Section 107(8) institution,'' ``senior management

employee,'' ``settlement date,'' ``short sale,'' ``stripped mortgage-

backed security,'' and ``trade date.''

Since the issuance of the initial proposed rule, NCUA has issued a

proposed revision to Part 703. 50 FR 61219 (Nov. 29, 1995). Proposed

Part 703 contains a number of new definitions, some of which have been

included in this revised proposed Part 704. These are: ``business

day,'' ``commercial mortgage related security,'' ``fair value,''

``industry-recognized information provider,'' ``mortgage related

security,'' ``mortgage servicing,'' ``pair-off transaction,''

``prepayment model,'' ``securities lending transaction,'' and ``small

business related security.''

The initial proposed rule also introduced a number of new

definitions, several of which have been included in this revised

proposal. These are: ``embedded option,'' ``forward rate agreement,''

``long-term investment,'' ``market value of portfolio equity,''

``matched'' (``identically matched'' in initial proposal),

``official,'' ``option contract,'' ``penalty for early withdrawal,''

``primary dealer,'' ``short-term investment,'' ``swap agreement,'' and

``wholesale corporate credit union.''

The initial proposal rule deleted a number of definitions because

the terms were not used in the proposed regulation, or because the

meaning was so self-evident as to not require definition. No commenters

objected to this idea and it is continued in this revised proposal. The

definitions that are proposed to be deleted are: ``average life,''

``capital of a broker/dealer,'' ``claims,'' ``corporate reserves,'' non

credit union member,'' ``original maturity,'' ``other reserves,''

``risk-based capital,'' ``secondary capital,'' ``speculative

activities,'' ``term subordinated debt,'' and ``United States

depository institutions.''

Finally, this revised proposal has introduced definitions for the

following terms: ``capital ratio,'' ``correspondent services,''

``credit enhancement,'' ``daily average net assets,'' ``dealer bid

indication,'' ``gains trading,'' ``membership capital,'' ``mortgage-

backed security,'' ``moving daily average net assets,'' ``NCUA,'' ``non

secured investment,'' ``paid-in capital,'' ``private placement,''

``reserves,'' ``reserve ratio,'' ``secured loan,'' ``tri-party

contract,'' and ``weighted average life.'' NCUA believes that the

definitions are self-explanatory, but will clarify any that are

confusing in the preamble to the final rule.

Section 704.3--Corporate Credit Union Capital

Section 704.11 of the current regulation establishes specific

levels of capital that corporate credit unions must maintain, based on

risk-weighted assets. Primary capital, which consists of reserves and

undivided earnings, must be at least 4 percent of risk- weighted

assets, and total capital, which consists of primary capital and

membership capital share deposits, must be at least 8 percent of risk-

weighted assets. In response to public expressions of concern regarding

the relatively low levels of primary capital in corporate credit

unions, Section 704.12 of the initial proposed rule established a new

capital requirement based on the ratio of primary capital to average

daily assets. The goal was for corporate credit unions to reach the

minimum ratio of 4 percent of primary capital to average daily assets

by January 1, 1998. The initial proposed rule also required that all

corporate credit unions maintain a minimum ratio of 10 percent of

capital to risk-weighted assets.

The proposed definition of primary capital included, in addition to

reserves and undivided earnings, certain other reserve accounts and a

new type of member-contributed capital, called a permanent capital

share account (PCSA). Up to 50 percent of primary capital could consist

of PCSAs, the most significant feature of which was that they could be

redeemed only with the written concurrence of NCUA. In general, the

commenters opposed this requirement. Corporate credit union commenters

stated that they would be unable to sell such shares, and natural

person credit unions stated that they would not purchase them.

With respect to the proposed capital requirements, the commenters

stated that if PCSAs were to be retained, all such shares should be

counted toward primary capital. In addition, the commenters objected to

the new membership capital shares, called secondary capital share

accounts, not being included in primary capital. They argued that such

shares were at risk and should be counted. The commenters also argued

that the asset and liability provisions were so stringent that it would

be impossible to meet the 4 percent requirement in the time frame

provided. Many commenters also objected to using two ratios to measure

the adequacy of corporate credit union capital.

NCUA is proposing to move away from the concept of risk-based

capital. Because corporate credit union assets tend to have relatively

low credit risk, most corporate credit unions have high risk-based

capital ratios, even if they have low levels of leverage capital to

protect against interest rate or market risks. This revised proposal

focuses on the capital that is available to protect against those

risks. Comments are specifically requested on whether NCUA should

require the calculation of the capital to risk-weighted assets ratio.

In responding to this issue, commenters should bear in mind that NCUA

would likely require that the ratio be calculated using the same risk

weights and risk categories required by the other federal financial

institution regulators.

Proposed Section 704.3(b) requires that a corporate credit union

without expanded authorities have a capital ratio of 4 percent. Capital

is defined as the sum of a corporate credit union's reserves and

undivided earnings, paid-in capital, and membership capital. Membership

capital accounts are similar to the current membership capital share

deposits, except that they must have at least a three-year notice

provision, rather than a one-year provision. Paid-in capital consists

of funds obtained from credit union and non credit union sources. Paid-

in capital has no maturity and is callable only at the option of the

corporate credit union and only if the corporate credit union meets its

minimum level of required capital after the funds are called.

The capital (or ``leverage'') ratio is calculated by dividing a

corporate credit union's capital by its moving daily average net

assets. Including membership capital in the definition of capital means

that most corporate credit unions are already at 4 percent. NCUA

believes that 4 percent is appropriate, because it is the amount

estimated to meet corporate credit union needs and is comparable to the

levels established by the other financial institution regulators.

The role of membership capital relative to a corporate credit

union's internally generated reserves and undivided earnings has been

cause for extensive debate. NCUA regards

[[Page 28089]]

membership capital as a vital component of the corporate network's

total capital structure. It is used in calculating the minimum leverage

ratio (also included in total capital requirement for expanded

authorities), the limit on loans to members, the limit on loans to

CUSOs, and the limit on fixed assets. However, for purposes of market

and credit risk exposure, this proposal sets the MVPE and concentration

limits as a percentage of the sum of reserves and undivided earnings

and paid-in capital. Indirectly, the member-contributed capital is in

line to absorb losses, but the revised proposal seeks to restrict the

incidence of losses to a corporate credit union's own equity.

The ability of a member to withdraw its capital contribution has

been preserved in this revised proposal. The fact that a member may

cancel its ownership stake, irrespective of any ability on the part of

the corporate credit union to replace it, adds an extraordinary

dimension to the capitalization of corporate credit unions. Some have

argued that a mechanism needs to exist which permits a member to

voluntarily provide a more permanent form of capital to its corporate

credit union. Thus, the revised proposal permits a member to purchase

paid-in capital. This establishes the alternative for a member to make

a perpetual capital investment which the corporate credit union can

use, along with its reserves and undivided earnings, for direct risk-

taking purposes. -

As members of a unique, private, and cooperative financial system,

corporate credit unions will benefit from building appropriate internal

capital reserves and, in turn, diminish the prospect of placing member

funds directly at risk. Over time, the buildup of internal reserves

will increase a corporate credit union's capacity to provide greater

products and services to members while it decreases the risk to members

that they will lose their capital stake due to market or credit risk

exposures or other business losses incurred by their corporate credit

union. -

Proposed Part 703, noted above, limits a natural person credit

union's purchase of capital shares in corporate credit unions to one

percent of the investing credit union's assets. Commenters with

opinions on this issue should direct them at proposed Part 703. -

Since NCUA believes that the stability of the corporate system will

be strengthened if each corporate credit union's reserves and undivided

earnings plus paid-in capital ultimately equals 4 percent of net

assets, proposed Section 704.3(c) establishes mandatory reserve

transfers when the amount is below 4 percent. Although NCUA expects

that a 4 percent capital ratio will be appropriate for most corporate

credit unions without expanded authorities, a higher level may be

necessary in the rare situation when, for example, a corporate credit

union refuses to recognize a loss, or a loss not anticipated by the

regulation occurs. A lower level may be appropriate in the event of a

natural disaster or when, for example, a merger results in the

continuing corporate credit union's reserves falling below 4 percent,

and a workout plan has been approved. To accommodate increasing or

decreasing the capital requirement, proposed Section 704.3(d) provides

that NCUA may require a different minimum capital ratio for an

individual corporate credit union based on its circumstances. Before

imposing a different capital requirement, NCUA will provide notice to

the corporate credit union and allow it to respond. -

In rare circumstances, conditions may exist in a corporate credit

union when additional reserves may be needed but are not available

immediately. In those cases, NCUA may require a corporate credit union

to increase the regularly scheduled reserve transfers with supplemental

transfers which will ultimately raise the reserves to the required

level. As an example, NCUA may require that a corporate credit union

transfer 12 basis points each period, rather than the 10 basis points

required by the regulations. This action may be taken in conjunction

with a reserve transfer, or in lieu of the reserve transfer. -

As noted earlier, NCUA and corporate credit union representatives

have discussed this revised proposal during its development. As the 4

percent capital ratio requirement has been debated, some corporate

credit union representatives have asked about the consequences of going

below 4 percent, because, for example, the corporate credit union has

accepted a large volume of shares. NCUA is committed to corporate

credit unions maintaining capital at the required minimum, but realizes

that there may be situations where a corporate credit union temporarily

drops below that level. To accommodate sudden spikes in share growth,

the capital ratio is calculated by dividing capital by the moving daily

average net assets for the previous 12 months. -

Proposed section 704.3(e) requires management of a corporate credit

union to notify the board of directors, the supervisory committee, and

NCUA within 10 business days when capital falls below the minimum

required. The 10 business days refers to the time period after the

books are closed at month end. It is important to notify the board and

supervisory committee so that they can act promptly, including the

calling of a special meeting, if necessary, to ensure compliance within

the month.

If a corporate credit union is not in compliance by month end,

proposed Section 704.3(f) requires that it submit a plan to restore and

maintain its capital ratio at the minimum required level. For example,

if a corporate credit union closes its books on March 31, and the

capital ratio is 3.9 percent, it must notify the board of directors,

the supervisory committee, and NCUA by April 10. If, on April 30, the

capital ratio is at or above 4 percent, no further action is necessary.

If, however, the ratio is at 3.95 percent, a plan must be submitted to

NCUA by May 15. -

Even if a corporate credit union comes into compliance by the end

of the month, a plan is required if the corporate credit union drops

below the required minimum two more times within 12 months from the

first violation. Violating the required minimum three times in one year

indicates a systemic problem that must be addressed. Failure to develop

an adequate plan, fully supported by projections and estimates,

increases the chances that NCUA will issue a capital directive, a

procedure that is provided for in proposed Section 704.3(g). -

A capital directive may order a corporate credit union to achieve

adequate capitalization by taking one or more of a number of actions,

such as reducing dividends and limiting deposits. Unless a corporate

credit union's capital level is severely under the required minimum, it

is intended that capital directive will be issued only after verbal and

written communication between NCUA and the corporate credit union has

failed to result in an acceptable capital restoration plan or a plan

has not been followed. -

Since a capital directive will be issued only as a last resort,

NCUA expects full and immediate compliance with any such directive.

NCUA will view failure to comply with a capital directive as a serious

issue. -

It should be noted that the proposed regulation provides for

consultation with the state regulator where a state-chartered corporate

credit union is involved. NCUA will support state requirements for

higher capital levels or shorter time frames for compliance. -

Section 704.3(a) requires that a corporate credit union develop

capital

[[Page 28090]]

goals, objectives, and strategies. A corporate credit union should

develop various scenarios to accommodate slow, medium, and rapid asset

growth. It also should consider setting goals higher than regulatory

minimums in order to avoid non compliance due to unexpected growth.

Preplanning for capital growth is needed if a corporate credit union

anticipates applying for expanded authorities.

Section 704.4--Board Responsibilities -

Currently, several different sections of Part 704 set out policy

and operational requirements for corporate credit union boards of

directors. For example, Section 704.3 requires boards to adopt and

review strategic plans and to prepare business plans for certain

material expenditures. Sections 704.4 through 704.7 require corporate

credit unions to develop certain policies and goals in the areas of

asset and liability management, capital, investments, and lending, but

the board is accountable for the ratification of and adherence to such

policies and goals. The initial proposed rule did not substantially

change this approach, maintaining the requirement for board development

of strategic and business plans in Section 704.3 and the requirement

for credit union development of capital goals, objectives, and

strategies in Section 704.6. Section 704.4, however, did combine the

requirements for credit union development of investment and asset and

liability management policies. -

No significant comments were received in this area, but to

emphasize the fact that the board sets the agenda and is ultimately

responsible for the corporate credit union, Section 704.4 of this

revised proposal requires a board to approve comprehensive written

plans and policies. The board should oversee senior management to

ensure that policy limits are consistent with the existing and forecast

levels of capital and that all activities are conducted in a safe and

sound manner and are consistent with the board's overall risk

management philosophy. The board should also understand the role

financial instruments play in the corporate credit union's business

strategies and the mechanisms used to manage risks. The board must

provide for adequate staffing and technological/financial resources to

support the corporate credit union's activities. When a corporate

credit union plans to enter a new market, the board evaluation should

reflect the cost of establishing appropriate controls, procedures, and

attracting professional staff with necessary expertise.

The emphasis upon board responsibilities is not intended to turn

directors into operating managers. A board needs to delegate the

development of goals, policies, and procedures to operating management.

However, the board retains the ultimate responsibility for ensuring

that such delegations are reasonably fulfilled. A board's active

commitment to this can significantly improve its awareness and control

of potential risks.

Section 704.5--Investments

Currently, Section 704.6 requires a corporate credit union to

develop written investment policies and sets out a list of authorized

investments and divestiture requirements. In the initial proposed rule,

the policies provision was moved to Section 704.4, and the remaining

provisions were revised and recodified at Section 704.5. Section 704.5

of the proposed rule also included the relevant provisions of Part 703,

governing natural person federal credit union investments, rather than

simply incorporating them by reference. No comments were received on

this matter, and the split between Parts 703 and 704 has been

maintained in this revised proposal.

Section 704.6 of the initial proposed rule restricted the aggregate

of a corporate credit union's investment in any one institution,

issuer, or trust to 25 percent of primary capital. It instituted

minimum asset size and rating requirements for investments in

depository institutions. It also tightened the standards for CMOs.

A number of commenters stated that the 25 percent of primary

capital limitation was too low, arguing that it would concentrate

corporate credit union investments in the hands of fewer issuers and

create more credit risk in the industry. They also suggested that U.S.

Government and Agency securities should be exempt from the restriction.

NCUA agrees that the 25 percent of primary capital concentration

limit was too low and has also determined that concentration concerns

should properly focus on credit risk. Therefore, new concentration

limits are set forth in proposed Section 704.6, which governs credit

risk management.

The weakness in the current CMO tests became evident during the

bear market of 1994. While the fixed-rate CMO test proved reasonably

adequate in preventing the purchase of many high risk fixed-rate CMOs,

the floating-rate test proved inadequate. Many floating-rate CMOs were

structured to enable them to pass the test even though they contained

significant market risk resulting from option and basis risk.

This revised proposal expands the fixed rate CMO test to include

limits on extension/contraction of weighted average life (WAL) and on

price volatility. These are similar to the second two tests of the

Federal Financial Institutions Examination Council (FFIEC) test for

CMOs. Unlike the current rule, the proposal allows for bonds to extend

from the initial expected WAL provision of five years to seven years.

The price volatility test sets the maximum market value decline at 15

percent of the base case value. This means that the volatility of a CMO

should not exceed the comparable price volatility of approximately a

five year zero coupon bond.

This proposal expands the floating rate CMO test to include three

new tests. There is an initial expected WAL limit, an extension/

contraction WAL limit, and a price volatility limit. These tests were

proposed in response to the volatile price history of floating rate

CMOs and the inability of the FFIEC test to adequately capture cap and

basis risk. The view that floating rate securities are immune from

general market risks has been rudely dispelled over the past several

years, and NCUA believes there is a need to subject such securities to

rigorous prepurchase selection tests.

During the dialogue sessions with corporate credit unions, several

participants argued have that a comprehensive MVPE analysis which

captures option and basis risk eliminates the need for a special CMO

test. The fact that total risk is addressed in MVPE, and subsequently

limited as a percentage of reserves and undivided earnings plus paid-in

capital, may make the CMO tests redundant and needlessly restrictive.

Commenters are specifically requested to address this issue.

To control possible ``cherry picking'' involving the testing of

CMOs (selecting a prepayment model that will allow a particular CMO to

pass the tests), this revised proposal requires a corporate credit

union board to approve at least three prepayment models, or a median

estimate, that will be used in the tests. The models must be used for

all subsequent tests.

Section 704.5(c) of this revised proposal establishes consistent,

minimum standards for repurchase and securities lending transactions.

These transactions create room for spread trade opportunities with

minimal MVPE and credit risk. Proposed Section 704.5(c)(4) requires

that collateral securities be legal for corporate credit unions, except

that CMO/REMIC securities that pass the FFIEC HRST are permissible

provided that the term of the transaction does not exceed 95 days. The

95-day limit will permit standard 3-month trades with such collateral.

[[Page 28091]]

Section 704.5(k) of the initial proposed rule carried over the

provision from Part 703 authorizing investment in a mutual fund if the

investments and investment transactions of the fund are legal for the

purchasing credit union. Proposed Section 704.5(d) broadens this

authority by permitting investment in an investment company that is

registered with the Securities and Exchange Commission under the

Investment Company Act of 1940, with the same restriction regarding the

permissibility of the underlying investments and investment

transactions. A mutual fund is the most common type of registered

investment company, but credit unions have been authorized by opinion

letter to invest in other types, such as money market mutual funds and

unit investment trusts. The regulatory language has been changed to

clarify that these other types of registered investment companies are

permissible investments for corporate credit unions. A corporate credit

union can determine if the investments and investment transactions of

an investment company are permissible by reviewing the fund's

prospectus and statement of additional information. Oral or other

written representations regarding the fund's activities are not

sufficient. The language also clarifies that investments such as asset-

backed securities (ABS), which are specifically authorized for

corporate credit unions but are not registered investment companies,

are permissible regardless of the underlying instruments that make up

the security.

Proposed Section 704.5(e) sets forth investment activities that are

prohibited for corporate credit unions that are not operating with

expanded authorities. Several prohibitions are carried over from Part

703. Proposed Section 704.5(e)(1) prohibits a corporate credit union

from purchasing and selling off-balance-sheet financial derivatives.

While derivatives can be important risk management tools, NCUA believes

that they are appropriate only for corporate credit unions that have

sophisticated risk management systems in place. Proposed Section

704.5(e)(3) prohibits a corporate credit union from purchasing

commercial mortgage related securities and small business related

securities because the market for these securities is undeveloped and

the potential timing of cash flows from the securities is not widely

disseminated. -

Section 704.6--Credit Risk Management

Except for the concept of risk-based assets, the current regulation

addresses credit risk only briefly. Section 704.6(a) requires that a

corporate credit union's investment policies address, among other

things, risk diversification and approved investment credit limits and

credit ratings. Section 704.6(b) authorizes the purchase of certain

investments only if they have specific minimum credit ratings.

The initial proposed rule did not significantly change this

approach. Section 704.4 required a corporate credit union to develop

policies regarding acceptable credit risk, to identify the credit risk

associated with an asset prior to purchase, and to monitor such risks

while an asset was held. Section 704.5 established minimum credit

ratings for certain investments and required corporate credit unions to

prepare quarterly evaluations of lines of exposure to foreign banks.

Some commenters took exception to some of the required ratings and to

the mandatory quarterly evaluations. In addition, there was a

suggestion that credit risk be discussed more comprehensively.

This revised proposed rule addresses credit risk in a separate

section and requires that the board of a corporate credit union adopt a

written credit policy that reflects objectives and limits consistent

with its risk management philosophy. Proposed Section 704.6 was

developed in response to concerns that some corporate credit unions

consider that credit risk management only requires the use of credit

ratings. This section requires a corporate credit union to establish a

credit risk management policy, sets concentration limits and minimum

credit ratings for certain investments, and establishes specific

reporting and documentation procedures.

In-depth credit risk management requires considerable human and

financial resources. Many corporate credit unions may not wish to

commit the resources necessary to assume significant credit risk

exposure. Therefore, the proposed rule establishes conservative credit

ratings and concentration requirements. It also permits an expansion of

these basic credit authorities provided that credit risk management

resources increase accordingly. For corporate credit unions that

restrict their credit activities, a minimum due diligence process is

required. However, if a corporate credit union increases its credit

exposure, the requirements will increase accordingly.

Proposed Section 704.6(a) requires that a corporate credit union's

credit risk management policy address how it will ensure that it has

exercised due diligence in analyzing credit risk. The due diligence

requirement will not be met solely by subscribing to a rating agency's

credit research. To the extent that a corporate credit union assumes

material credit risk exposures, the internal analysis must provide the

basis for acceptable credit lines. The analysis should contain a

rationale for the approved risk exposure. A corporate credit union

choosing to accept greater risk exposure must have resident credit

expertise commensurate with the level of risk assumed.

To ensure reduced risks to member credit unions, the proposal

requires a corporate credit union to establish maximum credit limits

based on its reserves, undivided earnings, and paid-in capital. NCUA

believes that establishing limits based upon net assets provides a poor

basis to support risk since the size of a corporate credit union's

balance sheet does not meaningfully correlate to its capacity to absorb

risk.

The proposal also requires that a corporate credit union establish

limits on concentrations of credit risk that may occur, by, for

example, sector (e.g., automobile industry related receivables),

industry (e.g., banks), or region (e.g., geographical concentrations of

loans in private mortgage-backed securities). The policies must address

the fact that diversification by issuer does not mitigate all pertinent

credit risk factors. Absent the appropriate risk considerations, NCUA

is concerned that the corporate credit union system's assets could

become overly concentrated in one type of credit and be prone to a

systemic credit crisis. The remedy is not to avoid credit risk but

rather to analyze and manage it.

The credit risk management section establishes specific

concentration limits for certain types of securities and money market

transactions. These limits are higher than those set forth in the

initial proposal. NCUA was persuaded that the more conservative limits

could have the unintended consequence of forcing corporate credit

unions to purchase securities from issuers with greater credit risk. A

credit instrument which possesses structural components which reduce

the risk of default is preferred to a credit instrument that is based

upon the credit quality of the issuer. Therefore, the concentration

limits make a distinction between securities which have an element of

credit enhancement and non secured direct obligations. The latter have

no collateral or securitization enhancements to absorb losses resulting

from default.

Proposed Section 704.6(c)(1) provides that the aggregate

investments in any single mortgage-backed security (MBS) or asset-

backed security (ABS) or trust are limited to 200 percent of the sum of

[[Page 28092]]

the corporate credit union's reserves and undivided earnings and paid-

in capital. MBS and ABS are instruments with substantial credit

enhanced structures. The underlying instruments provide protection from

a credit risk perspective. The limit on MBS and ABS was set higher than

the limit on unsecured transactions because of the relative lower

credit risk associated with these secured investments. This limit

allows for an appropriate level of activity absent the substantial

credit review process that is requisite for proportionately greater

credit risk exposures.

Repurchase agreements provide opportunities for most corporate

credit unions to obtain spread income while limiting MVPE exposure.

Repurchase agreements and securities lending typically have a high

degree of protection against default. Since these transactions are

fully collateralized and valued on a daily basis, they have minimal

credit risk exposure. The concentration limits set forth in proposed

Section 704.6(c)(2) reflect the objective to maintain credit risk

management requirements commensurate with exposures. It provides that a

corporate credit union's aggregate investments in repurchase and

securities lending agreements with any one counterparty are limited to

400 percent of the sum of reserves and undivided earnings and paid-in

capital. This limit does not apply to investments in a wholesale

corporate credit union. The concentration limit restricts the volume of

repurchase transactions with one counterparty and will require a

corporate credit union to develop an adequate number of relationships

to support the level of current and projected repurchase activity.

Proposed Section 704.6(c)(3) limits non secured transactions to 100

percent of the sum of a corporate credit union's reserves and undivided

earnings and paid-in capital. To the extent that a corporate credit

union cannot conduct an in-depth analysis of credit counterparties,

this limit restrict exposures to an appropriate maximum. It is

understood that preferences for risk taking (i.e., credit versus market

risk) may change over time. The expanded authorities address the

capacity for a corporate credit union to assume greater levels of

credit exposure if and when it chooses. NCUA is concerned about

excessive exposures in non secured credit instruments that are not

supported by the requisite due diligence.

Proposed Section 704.6(d) addresses credit ratings. It cannot be

emphasized too strongly that a high rating is not a substitute for due

diligence. Debt structures and counterparty creditworthiness must still

be evaluated, and the approval of credit lines and limits must contain

rationale which reasonably justifies the willingness of the corporate

credit union to place its capital at risk. The proposed rule requires

that downgraded instruments be reviewed by the corporate credit union.

The corporate credit union must ensure that any decision to hold a

downgraded instrument can be justified. The provision does provide

flexibility to avoid automatic divestiture. The specific conditions for

instruments with rating which fall below the regulatory minimum is

addressed in proposed Section 704.10. Although the initial proposed

rule contained entity ratings, these have not been included in this

revised proposal due to the variability of standards on the part of the

rating agencies.

In establishing a minimum rating for asset-backed securities, NCUA

considered the additional legal and financial structure risks resident

in such securities. The complexity of these factors is typically

greater for lower rated bonds. Taking these other risk factors into

consideration, it was decided that that ABS would be limited to AAA,

despite the fact that the relative credit risk was not necessarily

different from other similarly rated securities.

Proposed Section 704.6(b) exempts from the credit requirements of

Section 704.6 securities issued by the United States government, its

agencies, and enterprises. Although government-sponsored enterprises,

such as Fannie Mae and Freddie Mac, have been exempted, they do possess

some credit risk. A corporate credit union should not fail to consider

that any material credit risk needs to be evaluated commensurate with

the exposure taken. These entities should not be considered exempt from

due diligence.

Section 704.7--Lending

Under Section 704.7 of the current rule, loans to one credit union

member are limited to the corporate credit union's capital or 10

percent of its shares and capital, whichever is greater. The aggregate

amount of loans to non credit union members is limited to 15 percent of

the corporate credit union's capital. The aggregate amount of loans to

credit union non members is limited to 25 percent of the corporate

credit union's shares and capital, with the loans to one credit union

non member being limited to capital or 10 percent of shares and

capital, whichever is greater.

Out of concern that the existing limitation was too permissive and

posed a potential threat to corporate credit unions and the NCUSIF,

Section 704.8 of the initial proposed regulation limited loans to one

member credit union to the corporate credit union's primary capital.

Corporate credit unions were prohibited from lending to members that

were not credit unions, except for loans to CUSOs and overdraft

protection for clearing accounts, and were also prohibited from lending

to non members.

A number of commenters argued that the limitation on loans to one

member credit union was too low. They argued that there should be a

separate limitation for secured and unsecured loans, due to the

differing magnitude of potential risk. NCUA agrees, noting that the

majority of corporate credit union lending to member credit unions is

done on a secured basis. NCUA also notes that a limit based solely on

capital, which includes membership capital, may be unfair to some

corporate credit unions, which may choose not to issue membership

capital. Therefore, Section 704.7(c) of this revised proposal limits

unsecured loans to 50 percent of capital or 75 percent of the sum of

the reserves and undivided earnings and paid-in capital, whichever is

greater, and limits secured loans to 100 percent of capital or 200

percent of the sum of reserves and undivided earnings and paid-in

capital, whichever is greater. NCUA believes that the unsecured limit

represents a balance between safety and soundness concerns and the

mission of corporate credit unions to make loans. The secured lending

limit allows for adequate diversification of the loan portfolio with

limited risk associated with any one borrower.

NCUA emphasizes that the term ``secured loan'' is defined to mean a

loan in which the lender has perfected a security interest in the

collateral. The rules for perfecting a security interest are governed

by state law. For example, if collateral consists of loans, and state

law requires possession of loan documents to perfect a security

interest in a loan, then the corporate credit union must take

possession of the documents. If this is not feasible, then the loan

must be included in the corporate credit union's unsecured loan limit.

To assess the impact of the unsecured vs. secured loan limits, NCUA

seeks comments on restrictions imposed by state law on individual

corporate credit unions' lending activities.

NCUA was convinced by comments that the corporate credit unions

should have the ability to make loans to non credit union members.

Section 704.7(d) of the revised proposal allows corporate

[[Page 28093]]

credit unions to make loans to members other than credit unions as long

as the loans are in compliance with Section 701.21(h) of the NCUA Rules

and Regulations, which governs member business loans. Additionally, the

aggregate of loans to members other than credit unions cannot exceed 15

percent of the corporate credit union's capital plus pledged shares.

NCUA also was convinced that corporate credit unions should have

the authority to make loans to non member credit unions in order to

accommodate credit unions with branches in other states. Proposed

Section 704.7(e) authorizes a corporate credit union to make an

overdraft loan related to correspondent services to a non member credit

union. Although such a loan generally will have a maturity of only one

business day, NCUA will not take exception if, in the regular course of

business, an overdraft loan occasionally has a maturity of two or three

days.

Section 704.8--Asset and Liability Management

Section 704.4 of the current regulation requires a corporate credit

union to develop and implement comprehensive written funds management

policies and to prepare monthly reports showing the degree of mismatch

between the sources and uses of funds. In addition, 704.6 requires a

corporate credit union to develop written investment policies which

address funds management strategies, among other things.

In response to the assumption of significant interest rate risk by

many corporate credit unions, Section 704.4 of the initial proposed

rule required that corporate credit unions identically match almost all

shares and deposits to corresponding assets. In addition, corporate

credit unions were required to calculate the fair value of all

investment securities monthly, limit aggregate losses on available-for-

sale assets to 15 percent of primary capital, limit investment in

instruments with embedded options to capital, and impose early

withdrawal penalties to guarantee protection from replacement risk.

Most respondents to the original proposal pointed out that this

combination was too restrictive to permit both a realistic management

of asset and liability positions and an adequate provision of basic

financial products and services.

To ensure that corporate credit unions were cognizant of potential

interest rate risk exposures before they arose, proposed Section 704.4

required the performance of monthly ``shock test'' calculations to show

the impact on net interest income and MVPE of interest rate changes.

The supplementary information section of the proposed regulation

indicated that NCUA would conduct analytical assessments of the

proposed rule through simulation modeling techniques.

The linchpin of the asset and liability management section of this

revised proposed rule is the use of MVPE. MVPE shocks provide a

critical insight into potential risks to earnings and capital. Most

financial institutions are comfortable viewing risk in terms of

variability of income. MVPE adds the dimension of capital-at-risk to

the assessment of risk exposure. Simulation models that produce

estimates for both net interest income and MVPE provide a more

comprehensive risk assessment.

NCUA is primarily focused upon the preservation of capital. MVPE

simulations provide a long-term, dynamic, and forward-looking

projection of the market risk impact upon capital. Coupled with net

interest income sensitivity analysis, MVPE provides a mechanism to view

earnings on a capital-at-risk basis. In most cases, the management of

MVPE will rely upon the management of asset price volatility.

NCUA realizes that the level of MVPE that a corporate credit union

targets is not static. As a corporate credit union assumes a greater

mismatch between liabilities and assets, MVPE variability will rise.

Corporate credit unions will need to make constant adjustments to the

level of MVPE exposure based upon their market biases and preferences.

It is assumed that a corporate credit union uncomfortable with

positioning its balance sheet based upon assumptions about future

market factors will minimize MVPE variability by matching a majority of

assets and liabilities. The management of higher MVPE variability

requires considerable human, financial, and system resources. The

proposed regulation recognizes that some corporate credit unions will

have sufficient infrastructure to permit them to incur more interest

rate risk.

This proposal requires that a corporate credit union maintain a

certain level of MVPE and that it not decline too drastically in

response to interest rate shocks. However, effective risk management

begins and ends with the board of directors. The board should consider

that the regulatory limitations in this rule are outer boundaries. It

is anticipated that boards will set policies within these boundaries,

recognizing that shock tests can only approximate real world events are

based upon a number of subjective inputs. Estimated results frequently

vary from actual results, and corporate credit unions will need to

develop procedures to ensure regulatory and board policy limits are not

exceeded.

The board also is required to establish policy limits on the

maximum decline in net income in both percentage and dollar terms.

While NCUA does not address specific limits for net interest income or

net income in the asset and liability management section, it recognizes

that corporate credit unions must evaluate risk both from a liquidation

and a going concern perspective. The board should receive reports which

reflect the impact on both the net interest margin and the non interest

components of income.

A corporate credit union also must model indexes so that it can

establish a relevant correlation between its cost of funds and the

reference indexes to which asset coupon formulas are linked. The risk

that an index will change independently of the factors which affect

liabilities creates basis risk. The MVPE calculation misses a

significant risk when indexes (market and non market) are not modeled

appropriately. This is particularly important for non market indexes,

such as COFI, where correlations to funding behavior may be weak or

changes may be difficult to project.

Proposed Section 704.8(e) requires a corporate credit union to

evaluate the risk in its balance sheet by measuring the impact of

interest rate changes on its MVPE and MVPE ratio. A corporate credit

union must limit its risk exposure to levels that do not result in an

MVPE ratio below 1 percent or a decline in MVPE of more than 18

percent. Frequency of testing is a function of the MVPE ratio. If MVPE

is 2 percent or above, testing must be done quarterly. If it falls

below 2 percent, monthly testing is required.

The MVPE floor provision of 1 percent is included in the regulation

to reflect, in part, the potential that a forecast of the effect of

interest rates on a corporate credit union's balance sheet will only

approximate actual market effects of interest rates. This floor

(remaining reserves and undivided earnings plus paid-in capital) must

also absorb other risks which could affect the corporate's balance

sheet such as operational, credit, legal, liquidity, settlement and

systemic risk.-

There has been considerable debate on the appropriate level of this

floor. A floor as low as 1 percent provides a reduced cushion to absorb

differences between forecast results and actual market conditions, the

impact of interest rate risk not fully reflected by a 300 basis point

parallel shock, and the other risks identified above. This increases

[[Page 28094]]

the potential that credit unions could lose membership capital during

significant market disruptions. Therefore, a low floor may require NCUA

to act more quickly and forcefully to protect both natural person

credit union membership capital and the NCUSIF.

NCUA seeks specific data from corporate credit unions to support

the claim that a floor other than 1 percent is appropriate. It seeks

similar analytical support for challenges to the 18, 35, and 50 percent

variation limits.

If all liabilities are matched with corresponding assets, investing

all reserves and undivided earnings and paid-in capital in a 6-year

zero coupon bond is about the same as an MVPE variance of 18 percent.

This is a moderate but acceptable risk limit for corporate credit

unions with limited risk management infrastructure. The firm's modeling

results showed that corporate credit unions with matched assets and

liabilities had MVPE variances of less than 5 percent when their

balance sheets were subjected to plus and minus 300 basis point

parallel shocks. Therefore, corporate credit unions that choose to

remain with the base case authorities will have room to manage a

mismatch of assets and liabilities while remaining within prudent

limits.

The assumption of higher MVPE variability is possible through

expanded authorities, but it is expected that a corporate credit union

with that authority will aggressively alter its balance sheet in

response to shifting market trends. Again, the MVPE variability limit

should not be viewed as a static operating level for market exposure.

Managing money via significantly mismatching assets and liabilities

carries a host of attendant risks which must be constantly evaluated. A

corporate credit union cannot run a mismatched portfolio with a ``buy

and hold'' strategy. Instead, it must actively manage its balance sheet

in response to changing market factors.

NCUA believes that the basic shock test set forth in this revised

proposal will reflect most interest rate risk, although it may fail to

capture some of the risk associated with other market conditions. One

of the primary concerns with the MVPE calculations is the estimate of

convexity risk resulting from embedded options. Most of the excessive

MVPE variability experienced within the corporate network in recent

years is the result of an excess of options written (e.g., prepayment

options on amortizing securities and periodic and lifetime caps on

variable rate bonds) versus options purchased (usually none). These

options typically represent the most dynamic component of the MVPE

variability.

Therefore, under the proposed rule, a corporate credit union with

instruments which possess unmatched embedded options in excess of 200

percent of the sum of its reserves and undivided earnings and paid-in

capital must conduct additional tests. NCUA recognizes that this is a

naive hurdle since the book amount of an instrument with an option does

not represent the actual amount of option risk. The development of a

specific measure of option risk was not pursued because of the unwieldy

nature of compliance. This level was chosen as an approximate threshold

when aggregate unmatched option exposure could have a material effect

upon MVPE. A number of tests, in addition to the standard rate shocks,

are required when this hurdle is exceeded. For example, a corporate

credit union must evaluate the effect on MVPE of non parallel shifts in

the yield curve. Simulation tests done in conjunction with this

proposal found that non linear shifts did not have a significant

incremental effect on the test results. However, the pivot point was

selected at the three year note. A corporate credit union would need to

conduct a test which pivots around a point on the curve that reflects

its balance sheet structure.

In addition, adjustments to prepayment speeds are necessary because

the historical evidence indicates that prepayment projections have

varied substantially from actual prepayment behavior. The adjustment to

prepayment speeds in the firm's simulated model exercise yielded

significantly different MVPE results.

The supply and demand factors which can dominate various investment

sectors are reflected in the spread at which such investments trade

relative to Treasuries. If a model maintains a static spread assumption

in all tests it may not reflect a crucial form of market risk. Credit

spreads can be driven by numerous factors, and a corporate credit union

should be prepared to address the impact of such spreads.

A major potential component of option value is the measure of

volatility. A corporate credit union must be able to measure the impact

of how changes in volatility affect MVPE if it has a material exposure

to option risk.

Proposed Section 704.8(f) sets forth procedures for violations of

the regulatory MVPE limits. This proposed rule does not require the use

of particular risk models, allowing corporate credit unions to use

their own. NCUA regards the timely disclosure of violations as

essential for this approach to remain valid. It is crucial that NCUA,

the corporate credit union board, and the supervisory committee, be

informed as soon as possible of any violation that is not corrected

within 5 days. NCUA will work with the corporate credit union to assist

it in returning to compliance.

Proposed Section 704.8(g) sets forth procedures for violations of

board asset and liability policy. Again, NCUA must be informed, but

after notification is provided to the board.

Section 704.9--Liquidity Management

The current rule does not address liquidity explicitly, although

the requirements in Sections 704.4 and 704.6 regarding the development

of funds management policies clearly include a concern for liquidity.

Further, Section 704.8 provides that a corporate credit union may

borrow up to 10 times capital or 50 percent of shares, whichever is

greater. The initial proposed rule also did not contain a separate

section regarding liquidity, but paragraph (j) of the asset and

liability section did require corporate credit unions to develop

contingency funding plans that ranked all sources of liquidity that

were available to service immediate outflows of member funds. Proposed

Section 704.9 authorized a corporate credit union to borrow up to 10

times capital or 50 percent of shares, whichever was less, and stated

that borrowing could only be done for liquidity needs.

No significant comments were received on proposed Section 704.4(j),

but a number of commenters objected to the proposed limitation on

borrowed funds. In addition, many commenters questioned the restriction

on borrowing only for liquidity purposes. In Section 704.9 of this

revised proposal, NCUA has determined to leave the borrowing limit at

the current level, that is 10 times capital or 50 percent of shares,

whichever is greater. Further, the restriction on borrowing only for

liquidity needs has been removed. However, this revised proposal

requires that a corporate credit union take a number of actions to

ensure that it can fulfill one of its primary functions, that of being

a liquidity provider. A corporate credit union must evaluate the

potential liquidity needs of its members in a variety of economic

scenarios, continuously monitor sources of internal and external

liquidity, ensure that it has sufficient investment securities

classified as available-for-sale to meet liquidity needs, and develop a

contingency funding plan.

[[Page 28095]]

Section 704.10--Divestiture

Currently, Section 704.6(d) provides that a corporate credit union

in possession of an investment that does meet regulatory requirements

must either sell the investment within 10 days or request NCUA

permission to hold it. Section 704.5(a) of the initial proposed rule

required divestiture within 10 days of any downgraded asset, and

704.5(h)(4) required the same of any CMO that failed the average life

test or the price sensitivity test.

Many commenters objected to the general divestiture requirement,

stating that it could result in one corporate credit union being

required to sell a security at the same time that it was a legal

investment for another corporate credit union. The commenters also

objected to the absolute nature of both requirements and the fact that

corporate credit unions were given only 10 days to sell the downgraded

or failed securities. They stated that automatic divestiture within a

short time frame could magnify losses if a corporate credit union were

forced to sell in an adverse market.

With respect to instruments that have been downgraded but are still

permissible under the regulations, proposed Section 704.6 now requires

only that a corporate credit union review the investment and be able to

justify any decision to hold. With respect to instruments that have

failed a requirement of Part 704, proposed Section 704.10 requires that

the board and NCUA be informed within 20 business days. If the

investment continues to fail, the corporate credit union must provide

NCUA with a plan within 25 business days that provides the

characteristics and risks of the investment, how it fits into the

corporate credit union's asset and liability management strategy, the

impact of holding or selling, and the likelihood that the investment

will again meet the requirements of Part 704. Although the proposed

rule provides for NCUA to require submission of the plan in less than

25 days, it is anticipated that this would be necessary only if there

were a serious safety and soundness problem.

Section 704.11--Corporate Credit Union Service Organizations (Corporate

CUSOs)

Currently, the authority of corporate credit unions to invest in

credit union service organizations (CUSOs) is contained in Section

704.6 and the authority to lend to CUSOs is contained in Section 704.7.

In addition, rather than setting forth specific CUSO guidelines,

Section 704.6 incorporates by reference much of Section 701.27, which

governs natural person investments in and loans to CUSOs. NCUA

determined, in the initial proposed rule, to address corporate credit

union investments in and loans to CUSOs in one section and to

explicitly include the applicable portions of Section 701.27. This was

done in proposed Section 704.7.

NCUA also proposed to create a new term for corporate CUSOs:

corporate service organizations (CSOs). A CSO was limited to serving

only the corporate credit unions that had invested in or loaned to the

CSO and/or the members of such corporate credit unions. In addition,

CSOs were authorized to provide only a few of the services authorized

for natural person CUSOs. Finally, the proposed rule required that a

CSO be chartered as a corporation under state law.

In response to comments and because ``CUSO'' is a term used and

understood throughout the credit union industry, NCUA has determined to

retain use of the term in the context of corporate credit unions. To

avoid confusion with natural person CUSOs, however, this revised

proposal does adopt the term ``corporate CUSO.'' In addition, for ease

of reference, the definition of corporate CUSO has been included in

Section 704.11, rather than being placed in Section 704.2.

The limitation on the types of entities that could be served by a

CSO was designed to preserve the integrity of field of membership

requirements. The thought was that if a corporate credit union could

provide services to any natural person credit union through a CUSO,

field of membership limitations would be less meaningful. Further, NCUA

did not wish to address the issue of broadening corporate credit union

fields of membership in the proposed regulation. The commenters,

however, argued forcefully that CSOs should be able to provide services

to non members. They suggested that a CSO should be permitted to

develop expertise in a specific service which could benefit all natural

person credit unions. NCUA agrees and the proposed rule allows

corporate CUSOs to serve natural person credit unions that are not

members of affiliated corporate credit unions.

In proposing to limit the services that could be provided by CSOs,

NCUA was attempting to relate those services to the daily activities of

corporate credit unions, that is, serving credit unions rather than

natural persons. However, the commenters argued that CSOs should be

able to participate in ventures related to services for members of

natural person credit unions, such as shared branching and home

banking. NCUA is persuaded that corporate CUSOs can have a broader

purpose. Accordingly, this revised proposed rule requires simply that a

corporate CUSO restrict its services to those related to the daily

activities of credit unions. Section 701.27(d) of the NCUA Regulations

provides guidance in this area.

Section 704.7 of the initial proposed rule limited the aggregate of

all investments in and loans to member and non member CSOs to 15

percent of a corporate credit union's capital. Some commenters

expressed concern that CUSOs involved in secondary mortgage market

activities might need additional funds at certain times. This revised

proposal allows a corporate credit union to loan to CUSOs an additional

15 percent of capital, provided that the loan is secured.

Section 704.7 of the initial proposal also incorporated some of the

limitations and requirements of Section 701.27 (b) and (d). One of

these was the requirement that the credit union ``ensure'' that it will

not be held liable for the obligations of the CUSO. Some commenters

stated that it was impossible to provide absolute assurance on this

score. In response, Section 704.11(b) of this revised proposal requires

a corporate credit union to obtain a written legal opinion that the

corporate CUSO is organized and operated in such a manner that the

corporate credit union will not ``reasonably be held liable'' for the

obligations of the corporate CUSO. The point of this requirement is to

obtain reasonable assurance that a corporate CUSO is operated as a

sufficiently separate entity that a court would not ``pierce the

corporate veil,'' conclude that the CUSO and corporate credit union

were essentially the same organization, and hold the corporate credit

union liable for the obligations of the CUSO. Since there seems to be

some confusion on this issue, clarifying language has been added.

Since initial proposed Sections 704.7(b) and (c) received little

comment, they have been retained in revised proposed Sections 704.11(c)

and (d). Section 704.7(d) of the initial proposed rule required a

corporate credit union to take steps to bring its investments and loans

in line with the new regulation. Since CSOs were significantly more

restricted than were CUSOs, it was possible that many investments in

and loans to CUSOs would not have been authorized. This provision has

not been retained in the revised proposed rule, as

[[Page 28096]]

corporate CUSOs will have much the same authority as existing CUSOs,

and the majority of existing investments and loans will continue to be

authorized. Finally, Section 704.11(e) of the revised proposed rule

clarifies that the sole authority for a corporate credit union to

invest in or loan to a CUSOs is that contained in Part 704.

Section 704.12--Services

-Section 704.9 currently states that corporate credit unions may

provide services involving investments, liquidity management, payment

systems, and correspondent services. NCUA believed that this authority

had, on occasion, been interpreted too broadly and proposed revising

this section to eliminate the specific list of services. The initial

proposal simply stated that corporate credit unions could provide

services to their member credit unions, intending that to mean

traditional loan, deposit, and payment services. The initial proposal

also stated that a corporate credit union could provide services only

to its members and could not provide services to non members through

correspondent credit union arrangements or the service contract

authority of Section 701.26 of the NCUA Rules and Regulations.

Some commenters expressed confusion regarding the prohibition

against correspondent credit union arrangements. The intent was to

prohibit arrangements whereby two corporate credit unions would agree

for one to provide services to the members of another. NCUA has

determined, however, that a corporate credit union may provide services

to the members of another corporate credit union, provided that the

second corporate credit union consents and NCUA has given its prior

written approval. A corporate credit union also may provide

correspondent services to non member, natural person credit union

branch operating in the geographical area that the corporate credit

union serves. --

Section 704.13--Fixed Assets

Currently, Section 704.11 limits a corporate credit union's

investment in fixed assets to 15 percent of capital. The initial

proposed rule changed the limitation to 15 percent of primary capital,

in order to control future large fixed asset investments. Some

commenters argued that the proposed limitation was too restrictive,

while others stated that corporate credit unions should not put a

significant portion of their funds into fixed assets.

NCUA has determined that corporate credit unions may need to make

greater investments in fixed assets, in order to better serve their

member credit unions, and has set the limit in this revised proposed

rule at 15 percent of capital. In addition, the requirements relating

to the submission of waivers from the limitation have been condensed.

As in the initial proposed rule, this revised proposal eliminates the

provision regarding a corporate credit union proceeding with its

investment if it does not receive notification of the action taken on

its request within 45 days. This will ensure that NCUA has adequate

time to review requests to invest more than 15 percent of capital in

fixed assets.

Section 704.14--Representation

As noted earlier, NCUA amended the representation section of Part

704 in 1994. Those changes were made because NCUA was concerned about

both real and apparent conflicts of interest. The initial proposed rule

recodified that section as 704.13, and amended it further by providing

that only representatives of member credit unions were permitted to

vote and stand for election. It also incorporated by reference the

provisions of Section 701.14 of the Rules and Regulations, governing

changes in officials and senior executive officers in credit unions

that are newly chartered or in troubled condition.

Although few comments were received on this section, NCUA has

received assurances that this issue will be addressed by the corporate

credit unions themselves and, thus, has determined not to go forward

with the proposal to allow only representatives of member credit unions

to vote and run for office.

For the reasons stated in the preamble to the initial proposed

rule, this revised proposal again incorporates the provisions of

Section 701.14.

Section 704.15--Audit Requirements

Currently, Section 704.13 only addresses the requirements for

annual audits. The initial proposed rule recodified the provision at

Section 704.14 and added a requirement for an internal auditor function

for corporate credit unions with assets over $100 million. The proposed

rule did not require the hiring of a full-time internal auditor, and

the supplementary information section indicated that, based on the

asset size and complexity of the institution, it would be permissible

to hire a part-time auditor or contract with an outside firm to perform

the function. The proposed rule did list specific responsibilities of

the internal auditor.

Section 704.15 of the revised proposed rule segregates the audit

requirements by external and internal functions. The external audit

function relates to the annual opinion audit. Although the existing

regulation contains the phrase reportable conditions letter, some

commenters were confused about the meaning of the term. Accordingly, it

has been deleted. This revised proposal requires that all

correspondence provided to a corporate credit union by the external

auditor be made available to NCUA.

A number of commenters stated that $100 million was too low a

threshold for an internal auditor function requirement. NCUA agrees and

has set a threshold of $400 million in this proposal. In addition,

rather than listing specific responsibilities for the internal auditor,

the revised proposed rule simply states that the auditor must meet the

guidelines of the Standards and Professional Practices of Internal

Auditing, as established by the Institute of Internal Auditors. This

proposal also requires that the internal auditor report to the chair of

the supervisory committee, who may delegate supervision of the internal

auditor's daily activities to the chief executive officer of the

corporate credit union. The authority to delegate was provided in

response to comments that the supervisory committee normally is not

directly involved in the daily operation of the corporate credit union,

Notwithstanding the statement in the supplementary information

section that the proposed rule did not require the hiring of a full-

time internal auditor, some commenters stated that the corporate credit

union did not have the resources to hire such an auditor. Again, this

is not required. Some corporates have the operational complexity to

warrant a full-time internal auditor on staff. Other corporate credit

unions may choose to hire a part-time internal auditor or contract with

an outside firm to perform the internal auditor function. -

Section 704.16--Contracts/Written Agreements

Neither the initial proposed rule nor this revised proposal made

changes to this provision.

Section 704.17--State-Chartered Corporate Credit Unions

The initial proposed rule added new Section 704.16(b) to put non

federally insured state-chartered corporate credit unions that receive

funds from federally insured credit unions on notice that they were

considered ``institution-affiliated parties'' within Section 206(r) of

the Federal Credit Union Act and

[[Page 28097]]

subject to all of the enforcement provisions of the Act. There was no

significant objection to the proposal and it has been retained in this

revised proposed rule.

Section 704.18--Fidelity Bond Coverage

The currently regulation specifically lists the bond forms that

NCUA has approved for corporate credit unions. NCUA has recently

approved several new forms for credit unions, CUMIS Credit Union Bond

200, CUMIS Credit Union Bond 300, and CUMIS Credit Union Bond 400, all

of which corporate credit unions may use, although some may not be

appropriate for particular institutions. Rather than adding these to

the proposal and then having to amend the regulation as other forms are

approved in the future, this proposal deletes all references to

specific bond forms. Instead of listing them in the regulation, NCUA

will notify corporate credit unions of all approved forms as new forms

are approved.

In current Section 704.17, the deductibles are based on a corporate

credit unions primary capital to risk asset ratio. Since the initial

proposed rule eliminated this ratio, the primary capital ratio was used

in this section. The initial proposal also clarified that the minimum

bond coverage would be based on a corporate credit union's average

daily assets as of the preceding December 31. NCUA received few

comments on this section.

Since the primary capital ratio is being eliminated in this revised

proposed rule proposed Section 704.19 uses the corporate credit union's

reserve ratio. NCUA requests comments on the effect of this change on a

corporate credit union's deductible. In addition, the proposed rule

deletes current Section 704.17(e), which allows a corporate credit

union to request approval for reduced coverage. Under Section 704.1, a

corporate credit union may request a waiver of any provision of Part

704.

Appendix A--Model Forms

Appendix A of the current rule sets forth a summary of risk weights

and risk categories used to calculate a corporate credit union's

capital to risk-weighted assets ratio. Since this revised proposed rule

eliminates the required calculation of that ratio, the summary has been

deleted. Appendix A of this revised proposal contains variations of the

model disclosure forms that were set forth in Appendix C of the initial

proposal.

Appendix B--Expanded Authorities and Requirements; Appendix C--

Guidelines for Evaluating Requests for Expanded Authorities

Appendix B of the current rule sets out off-balance-sheet

conversion factors that are used in calculating the capital to risk-

weighted assets ratio. Since the ratio is not used in this proposal,

the factors have been deleted. Appendix C currently contains a list of

U.S. Government obligations and agencies. Rather than having a fixed

list, which may become outdated as entities are created, dissolved, or

changed, the proposed rule contains definitions of government agencies

and enterprises and places the responsibility for determining an

entity's status on the corporate credit union.

Appendix B of this revised proposal sets forth incrementally

greater authorities for corporate credit unions and the infrastructure

and capital requirements that must be in place to obtain such

authorities. NCUA recognizes that each corporate credit union has

partly evolved in response to unique competitive forces and member

needs. The mission of a corporate credit union and its capacity to

fulfill its respective goals can vary considerably from institution to

institution. Expanded authorities were established to permit the

corporate credit unions that qualify to obtain a reasonable expansion

of market and credit risk limits. This mechanism permits the

flexibility for self-determination and it avoids the consequence of

regulating down to the least developed institutions at the expense of

the most developed.

The expanded authorities are a natural extension of the existing

waiver process whereby a corporate can submit a request to NCUA to

obtain additional powers or an exemption from some provision of the

rules and regulations. None of the incremental powers provided for in

this proposal are beyond the scope of existing waiver authorities.

Codifying these powers in the regulation standardizes the process and

provides an established set of criteria for approval.

Authorities are segregated into four parts to allow for some

measure of selectivity by corporate credit unions that may seek only

limited expansions of their basic operating powers. These parts, and

their respective guidelines for approval, are based upon an increasing

scale of depth and complexity. Greater expansions of authority are

supported by greater capacities to measure and control the

corresponding risks.

Proposed Appendix C sets forth guidelines for evaluating requests

for expanded authorities. The guidelines are based, in part, on a

number of subjective factors. Factors include the areas of board,

management and staff; systems and operations; credit risk management;

liquidity risk management; audit and compliance; and legal.

The proposal requires that a corporate credit union seeking to use

the expanded authorities set forth in Part 1 of Appendix B have a

capital ratio of 5 percent and meet additional infrastructure criteria

set forth in Appendix C. Additional capital is required because of the

greater opportunity to take risk. Strengthened management, staff, and

systems are required in order to safely manage that risk. A corporate

credit union seeking to use the even more expanded authorities set

forth in Part 2 of Appendix B must have a capital ratio of 6 percent

and meet even stronger infrastructure criteria. Again greater risk

requires greater protection against loss and greater ability to manage

the risk.

The proposal requires that a corporate credit union seeking to

invest in foreign obligations, as set forth in Part 3 of Appendix B,

have a capital ratio of 5 percent, meet the infrastructure criteria

required for corporate credit unions seeking the expanded authorities

under Part 1 of Appendix B, and meet additional infrastructure criteria

relating to automation of systems and staff experience with foreign

credit. A corporate credit union seeking to use financial derivatives,

as set forth in Part 4 of Appendix B, also must have a capital ratio of

5 percent and meet the infrastructure required for corporate credit

unions seeking the expanded authorities under Part 1 of Appendix B. In

addition, the corporate credit union must apply to NCUA for the

specific derivatives authority sought and have additional staff and

systems in place to adequately control the risks of such instruments.

Part 709--Involuntary Liquidation and Creditor Claims

Section 709.5(b) of the NCUA Rules and Regulations establishes a

payout priority for claims against credit unions that are in

involuntary liquidation. Currently, the seventh item is membership

capital share deposits of corporate credit unions. Since the proposed

rule uses the term ``membership capital,'' the words ``share deposits''

have been deleted. The proposed rule also provides for an eighth item,

i.e., paid-in capital.

[[Page 28098]]

Part 741--Requirements for Insurance

The initial proposed rule amended Section 741.3 of the NCUA Rules

and Regulations, governing requirements for insured credit unions, to

prohibit federally insured credit unions from transacting business with

corporate credit unions that did not comply with Part 704 and were not

examined by NCUA. There was no significant objection to the proposal

and it has been retained in this revised proposed rule. In the interim,

Section 741.3 has been recodified, so this revised proposed rule

creates new Section 741.219, containing the same language as set forth

in the initial proposal.

H. Regulatory Procedures

Regulatory Flexibility Act

NCUA certifies that the proposed rule, if made final, will not have

a significant economic impact on small credit unions (those under $1

million in assets). The rule applies only to corporate credit unions,

all of which have assets well in excess of $1 million. Accordingly, a

Regulatory Flexibility Analysis is not required.

Paperwork Reduction Act

The collection of information contained in this notice of proposed

rulemaking has been submitted to the Office of Management and Budget

for review in accordance with the Paperwork Reduction Act of 1980 (44

U.S.C. 3504(h)). Comments on the collection of information should be

directed to Ms. Beauchesne, at the National Credit Union

Administration, 1775 Duke Street, Alexandria, Virginia 22314-3428; Fax

No. (703) 518-6433; E-Mail Address: [email protected] within 90 days from

the date of this publication in the Federal Register. Comments should

also be sent to the OMB Desk Officer at the following address: Mr. Milo

Sunderhauf, OMB Reports Management Branch, New Executive Office

Building, Room 10202, Washington DC 20530.

The collection of information requirements in this proposed

regulation are found in 12 CFR [704.2; 704.3(a); 704.4(a); 704.6(a);

704.7(a); 704.8(a); 704.3(e)-(g); 704.5(b)(i)-(v); 704.6(e); 704.8(e)-

(g); 704.10; 704.15(b); and Appendices A and B]. This information is

required by corporate credit union management and staff in making

critical operational decisions on an ongoing basis. Additionally, the

information will be utilized by NCUA during the annual examination and

the ongoing supervision process. The respondents and recordkeepers are

corporate credit unions. Respondents and recordkeepers are not required

to respond to this collection of information unless it displays a

currently valid OMB control number.

Respondents: Corporate credit unions.

Estimated number of respondents and/or recordkeepers: 41.

Estimated average annual burden hours per respondent/recordkeeper:

3,909 hours.

Estimated total annual reporting and recordkeeping burden: 160,293

hours.

Estimated Total Annual Cost: $4,018,630.

Executive Order 12612

Executive Order 12612 requires NCUA to consider the effect of its

actions on state interests. It states that: ``Federal action limiting

the policy-making discretion of the states should be taken only where

constitutional authority for the action is clear and certain, and the

national activity is necessitated by the presence of a problem of

national scope.'' The risk of loss to federally insured credit unions

and the NCUSIF caused by actions of corporate credit unions are

concerns of national scope. The proposed rule would help assure that

proper safeguards are in place to ensure the safety and soundness of

corporate credit unions.

The rule applies to all corporate credit unions that accept funds

from federally insured credit unions. NCUA believes that the protection

of such credit unions, and ultimately the NCUSIF, warrants application

of the proposed rule to non federally insured corporate credit unions.

NCUA, pursuant to Executive Order 12612, has determined that this rule

may have an occasional direct effect on the states, on the relationship

between the national government and the states, or on the distribution

of power and responsibilities among the various levels of government.

However, the potential risk to the NCUSIF without these changes

justifies them.

I. List of Subjects

12 CFR Part 704

Credit unions, Reporting and recordkeeping requirements.

12 CFR Part 709

Claims, Credit unions, Liquidation.

12 CFR Part 741

Bank deposit insurance, Credit unions, Reporting and recordkeeping

requirements.

By the National Credit Union Administration Board on May 22,

1996.

Becky Baker,

Secretary of the Board.

For the reasons set out in the preamble, NCUA proposes to amend 12

CFR parts 704, 709, and 741 as follows:

1. Part 704 is revised to read as follows:

PART 704--CORPORATE CREDIT UNIONS

Sec.

704.1 Scope.

704.2 Definitions.

704.3 Corporate credit union capital.

704.4 Board responsibilities.

704.5 Investments.

704.6 Credit risk management.

704.7 Lending.

704.8 Asset and liability management.

704.9 Liquidity management.

704.10 Divestiture.

704.11 Corporate Credit Union Service Organizations (Corporate

CUSOs).

704.12 Services.

704.13 Fixed assets.

704.14 Representation.

704.15 Audit requirements.

704.16 Contracts/written agreements.

704.17 State-chartered corporate credit unions.

704.18 Fidelity bond coverage.

Appendix A to Part 704--Model Forms

Appendix B to Part 704--Expanded Authorities and Requirements

Appendix C to Part 704--Guidelines for Evaluating Requests for Expanded

Authorities

Authority: 12 U.S.C. 1762, 1766(a), 1781, and 1789.

PART 704--CORPORATE CREDIT UNIONS

Sec. 704.1 Scope.

(a) This part establishes special rules for all federally insured

corporate credit unions. Non federally insured corporate credit unions

must agree, by written contract, to both adhere to the requirements of

this part and submit to examinations, as determined by NCUA, as a

condition of receiving shares or deposits from federally insured credit

unions. This part grants certain additional authorities to federal

corporate credit unions. Except to the extent that they are

inconsistent with this part, other provisions of NCUA's Rules and

Regulations (12 CFR Chapter VII) and the Federal Credit Union Act apply

to federally chartered corporate credit unions and federally insured

state-chartered corporate credit unions to the same extent that they

apply to other federally chartered and federally insured state-

chartered credit unions, respectively.

[[Page 28099]]

(b) The Board has the authority to issue orders which vary from

this part. This authority is provided under Section 120(a) of the

Federal Credit Union Act, 12 U.S.C. 1766(a). Requests by state-

chartered corporate credit unions for waivers to this part must be

approved by the state regulator before being submitted to NCUA.

Sec. 704.2 Definitions.

Adjusted trading means any method or transaction used to defer a

loss whereby a corporate credit union sells a security to a vendor at a

price above its current market price and simultaneously purchases or

commits to purchase from the vendor another security at a price above

its current market price.

Asset-backed security means a security that is primarily serviced

by the cashflows of a discrete pool of receivables or other financial

assets, either fixed or revolving, that by their terms convert into

cash within a finite time period plus any rights or other assets

designed to assure the servicing or timely distribution of proceeds to

the securityholders. This definition excludes those securities referred

to in the financial markets as mortgage-backed securities (MBS), which

includes collateralized mortgage obligations (CMOs) and real estate

mortgage investment conduits (REMICs).

Business day means a day other than a Saturday, Sunday, or federal

holiday.

Capital means the sum of a corporate credit union's reserves and

undivided earnings, paid-in capital, and membership capital.

Capital ratio means the corporate credit union's capital divided by

its moving daily average net assets.

Collateralized Mortgage Obligation (CMO) means a multi-class bond

issue collateralized by whole loan mortgages or mortgage-backed

securities.

Commercial mortgage related security means a mortgage related

security where the mortgages are secured by real estate upon which is

located a commercial structure.

Commitment means any unconditional arrangement that obligates a

corporate credit union to extend credit in the form of loans; to

purchase loans, securities or other assets; or to participate in loans

and leases. Commitments also include overdraft facilities, revolving

credit, home equity, and mortgage lines of credit, and similar

transactions. An obligation is conditional if the corporate credit

union is not automatically obligated to extend funds.

Corporate credit union means an organization that:

(1) Is chartered under Federal or state law as a credit union;

(2) Receives shares from and provides loan services to credit

unions;

(3) Is operated primarily for the purpose of serving other credit

unions;

(4) Is designated by NCUA as a corporate credit union;

(5) Limits natural person members to the minimum required by state

or federal law to charter and operate the credit union; and

(6) Does not condition the eligibility of any credit union to

become a member on that credit union's membership in any other

organization.

Correspondent services means services provided by one financial

institution to another, and includes check clearing, credit and

investment services, and any other banking services.

Credit enhancement means collateral, third-party guarantees, and

other features that are designed to provide structural support and

protection against losses to investors in a particular security.

Daily average net assets means the average of net assets calculated

for each day during the period.

Dealer bid indication means a dealer's approximation of the bid

price of a security.

Embedded option means a characteristic of certain assets and

liabilities which gives the issuer of the instrument the ability to

change the features such as final maturity, rate, principal amount and

average life. Options include, but are not limited to, caps, floors,

and prepayment options.

Fair value of a financial instrument means the amount at which an

instrument could be exchanged in a current arms-length transaction

between willing parties, other than in a forced liquidation sale.

Market prices, if available, are the best evidence of the fair value of

financial instruments. If market prices are not available, the best

estimate of fair value may be based on the quoted market price of a

financial instrument with similar characteristics or on valuation

techniques (for example, the present value of estimated future cash

flows using a discount rate commensurate with the risks involved,

option pricing models, or matrix pricing models).

Federal funds transaction means a short-term or open-ended transfer

of funds between U.S. depository institutions.

Foreign bank means an institution which is organized under the laws

of a country other than the United States, is engaged in the business

of banking, and is recognized as a bank by the banking supervisory

authority of the country in which it is organized.

Forward rate agreement means an over-the-counter contract between

counterparties where one party agrees to pay the other a specified

interest rate payment on a reference notional amount at a specified

date in the future (settlement date). The amount paid or received at

the settlement date of the contract is based on the market value of the

contract. The market value depends upon the notional amount, the

contract rate, and the prevailing market reference rate at the time of

settlement.

Futures contract means a contract for the future delivery of

commodities, including certain money market instruments and government

securities, sold on commodities exchanges.

Gains trading means the purchase of a security as an investment

portfolio asset and the subsequent sale of that same security at a

profit after a short-term holding period.

Immediate family member means a spouse or other family member

living in the same household.

Industry recognized information provider means an organization

which obtains compensation by providing information to investors and

receives no compensation for the purchase or sale of investments.

Long-term investment means, for the purpose of issue ratings, an

investment that has an initial maturity, or expected maturity, greater

than one year.

Market price means the price at which a security can be bought or

sold.

Market value of portfolio equity (MVPE) means the fair value of

assets minus the fair value of liabilities. All fair value calculations

must include the value of embedded options. Membership capital is

treated as a liability for purposes of this calculation. The MVPE ratio

is calculated by dividing MVPE by the fair value of assets.

Matched means, with respect to assets and liabilities, that the

factors which affect cash flows of an asset are replicated in a

corresponding liability.

Material means an amount that exceeds 5 percent of the corporate

credit union's capital.

Maturity date means the date on which a security matures, and shall

not mean the call date or the average life of the security.

Member reverse repurchase transaction means an integrated

transaction in which a corporate credit union purchases a security from

one of its member credit unions under agreement by that member credit

union

[[Page 28100]]

to repurchase the same security at a specified time in the future. The

corporate credit union then sells that same security, on the same day,

to a third party, under agreement to repurchase it on the same date on

which the corporate credit union is obligated to return the security to

its member credit union.

Membership capital means funds contributed by members which are

available to cover losses that exceed reserves and undivided earnings

and paid-in capital. In the event of liquidation of the corporate

credit union, membership capital is payable only after satisfaction of

all liabilities of the liquidation estate, including uninsured share

obligations to shareholders and the National Credit Union Share

Insurance Fund (NCUSIF). The funds have a minimum withdrawal notice of

three years, are not insured by the NCUSIF or other share or deposit

insurers, and cannot be used to pledge against borrowings. Membership

capital may be sold to a member, subject to the corporate credit

union's approval. The funds may be in the form of a term certificate,

or may be in the form of an adjusted balance account. An adjusted

balance account may be adjusted in relation to a measure established

and disclosed by the corporate credit union at the time the account is

opened (e.g., one percent of a member credit union's assets). Upon

written notice of intent to withdraw membership capital, the balance of

the account will be frozen (no annual adjustment) until the conclusion

of the notice period. The terms and conditions of a membership capital

account must be disclosed to the recorded owner of such account at the

time the account is opened and at least annually thereafter. Upon

notification of intent to withdraw, the amount of the account on notice

that can be considered membership capital is reduced by a constant

monthly amortization which ensures the recognition of membership

capital is fully amortized at the end of the notice period. The full

balance of a membership capital account that has been placed on notice,

not just the remaining non amortized portion, is available to absorb

losses in excess of the sum of reserves and undivided earnings and

paid-in capital until the funds are released by the corporate credit

union at the conclusion of the notice period.

Mortgage backed security means a security that represents either an

ownership claim in a pool of mortgages or an obligation that is secured

by such a pool, where the cash flows are passed through to the holders

of the security.

Mortgage related security means a security as defined in Section

3(a)(41) of the Securities Exchange Act of 1934, i.e., a privately-

issued security backed by mortgages secured by real estate upon which

is located a dwelling, mixed residential and commercial structure,

residential manufactured home, or commercial structure. -

Mortgage servicing means performing tasks to protect a mortgage

investment, including collecting the installment accounts, monitoring

and dealing with delinquencies, and overseeing foreclosures and

payoffs.

Moving daily average net assets means the average of daily average

net assets for the month being measured and the previous 11 months.

NCUA means NCUA Board (Board), unless the particular action has

been delegated by the Board.

Net assets means total assets less Central Liquidity Facility (CLF)

stock subscriptions, CLF loans guaranteed by the NCUSIF, U.S. Central

CLF certificates, and member reverse repurchase transactions. For its

own account, a corporate credit union's payables under reverse

repurchase agreements and receivables under repurchase agreements may

be netted out if the Generally Accepted Accounting Principles (GAAP)

conditions for offsetting are met.

Net interest income means the difference between income earned on

interest bearing assets and interest paid on interest bearing

liabilities.

Nonsecured investment means an obligation backed solely by the

creditworthiness of the obligor.

Official means any director or committee member.

Option contract means a right, but not an obligation, to buy or

sell a security at a specified price and settlement date in the future.

Paid-in capital means funds which are obtained from credit union

and non credit union sources and are available to cover losses that

exceed reserves and undivided earnings. Paid-in capital is nonvoting

and subordinate to membership capital and the NCUSIF. The funds have no

maturity and are callable only at the option of the corporate credit

union and only if the corporate credit union meets its minimum level of

required capital after the funds are called. The terms and conditions

of a paid-in capital account held by a member or non member credit

union must be disclosed to the recorded owner of such account at the

time the account is opened and at least annually thereafter.

Pair-off transaction means a security purchase transaction that is

closed out or sold at, or prior to, the settlement or expiration date.

Penalty for early withdrawal of a share, deposit, or liability

means a fee which will, at a minimum, fully compensate a corporate

credit union for the difference between fair value and book value of

the asset that is divested (including any accumulated losses since the

asset was purchased), or the replacement cost of funds, to meet the

demand for early withdrawal.

Prepayment model means an empirical method which produces a

reasonable and supportable forecast of mortgage prepayments in

alternative interest rate scenarios. Models are typically available

from securities broker-dealers and industry-recognized information

providers. These models are used in tests to forecast the weighted

average life, change in weighted average life, and price sensitivity of

CMOs/REMICs and mortgage-backed securities.

Primary dealer means a bank or investment dealer authorized to buy

and sell government securities in direct dealings with the Federal

Reserve Bank of New York in its execution of Fed open market

operations.

Private placement means the sale of an entire issue to a small

group of investors. Except for investments with tax shelter provisions,

private placement to 35 or fewer investors are exempt from Securities

and Exchange Commission registration requirements.

Real Estate Mortgage Investment Conduit (REMIC) means a nontaxable

entity formed for the sole purpose of holding a fixed pool of mortgages

secured by an interest in real property and issuing multiple classes of

interests in the underlying mortgages.

Repurchase transaction means a transaction in which a corporate

credit union agrees to purchase a security from a counterpart and to

resell the same or any identical security to that counterpart at a

later date.

Reserve ratio means the corporate credit union's reserves and

undivided earnings plus paid in capital divided by its moving daily

average net assets.

Reserves mean all regular or statutory reserves, including all

valuation allowances established to meet the full and fair disclosure

requirements of Sec. 702.3 of this chapter.

Residual interest means the remainder cash flows from a CMO or

REMIC transaction after payments due bondholders and trust

administrative expenses have been satisfied.

Reverse repurchase transaction means a transaction whereby a

corporate credit union agrees to sell a security to a purchaser and to

repurchase the same or any identical security from that

[[Page 28101]]

purchaser at a future date and at a specified price.

Section 107(8) institution means an institution described in

Section 107(8) of the Federal Credit Union Act (12 U.S.C. 1757(8)).

Secured loan means a loan collateralized by assets in which the

lender has perfected a security interest under state law.

Securities lending transaction means a transaction in which a

federal credit union agrees to lend a security to a counterparty.

Senior management employee means a chief executive officer, any

assistant chief executive officer (e.g., any assistant president, any

vice president or any assistant treasurer/manager) and the chief

financial officer (controller).

Settlement date means the date originally agreed to by a corporate

credit union and a counterpart for settlement of the purchase or sale

of a security.

Short sale means the sale of a security not owned by the seller.

Short-term investment means, for the purpose of issue ratings, an

investment that has an initial maturity, or expected maturity, of one

year or less.

Small business related security means a security as defined in

Section 3(a)(53) of the Securities and Exchange Act of 1934, i.e., a

security, rated in one of the four highest rating categories by a

nationally recognized statistical rating organization, that represents

ownership of one or more promissory notes or leases of personal

property which evidence the obligation of a small business concern. It

does not mean a security issued or guaranteed by the Small Business

Administration.

Stripped Mortgage-Backed Security means a security that represents

either the principal or interest only portion of the cash flows of an

underlying pool of mortgages.

Swap agreement means a contract to exchange payments that are based

upon a specified dollar amount at specified dates in the future.

Trade association means an association of organizations or persons

formed to promote their common interests. For the purposes of

Sec. 704.14, the term includes entities owned or controlled directly or

indirectly by such an association but does not include credit unions.

Trade date means the date a corporate credit union originally

agrees, whether orally or in writing, to enter into the purchase or

sale of a security.

Tri-party contract means a repurchase agreement between two parties

in which a third party acts as a custodian for the securities involved.

Undivided earnings means all forms of retained earnings, except:

(1) Regular or statutory reserves; and

(2) Valuation allowances established to meet the full and fair

disclosure requirements of Sec. 702.3 of this chapter.

United States Government or its agencies means the United States

Government or instrumentalities of the United States, the debt

obligations of which are fully and explicitly guaranteed as to the

timely payment of principal and interest by the full faith and credit

of the United States Government.

United States Government-sponsored corporations and enterprises

means agencies originally established or chartered to serve public

purposes specified by Congress, the debt obligations of which are not

explicitly guaranteed by the full faith and credit of the United States

Government.

Weighted average life means the weighted average time to principal

repayment of a security based upon the proportional balances of the

cash flows that make up the security.

Wholesale corporate credit union means a corporate credit union

which meets the requirements of Part II of Appendix B of this part and

which primarily serves other corporate credit unions.

Sec. 704.3 Corporate credit union capital.

(a) General. A corporate credit union must develop and ensure

implementation of written short- and long-term capital goals,

objectives, and strategies which provide for the building of capital

consistent with regulatory requirements, the maintenance of sufficient

capital to support the risk exposures that may arise from current and

projected activities, and the periodic review and reassessment of the

capital position of the corporate credit union.

(b) Capital ratio. A corporate credit union will maintain a minimum

capital ratio of 4 percent, except as otherwise provided in this part.

A corporate credit union must calculate its capital ratio at least

monthly.

(c) Reserve transfers. A corporate credit union's monthly reserve

transfers are based upon the level of its reserve ratio. Where the

reserve ratio is greater than or equal to 4 percent, the reserve

transfer is optional. Where the reserve ratio is greater than or equal

to 3 percent but less than 4 percent, the corporate credit union must

transfer .10 percent of its moving daily average net assets. Where the

reserve ratio is less than 3 percent, the corporate credit union must

transfer .15 percent of its moving daily average net assets. Reserve

transfers must be calculated on a monthly basis and funded on at least

a quarterly basis.

(d) Individual capital ratio, reserve transfer requirement. (1)

When significant circumstances or events warrant, NCUA may require a

different minimum capital ratio and/or reserve transfer level for an

individual corporate credit union based on its circumstances. Factors

that might warrant a different minimum capital ratio or reserve

transfer level include, but are not limited to, for example:

(i) An expectation that the corporate credit union has or

anticipates losses resulting in capital inadequacy;

(ii) Significant exposure exists due to credit, liquidity, market,

fiduciary, operational, and similar types of risks;

(iii) A merger has been approved; or

(iv) An emergency exists because of a natural disaster.

(2) When NCUA determines that a different minimum capital ratio or

reserve transfer level is necessary or appropriate for a particular

corporate credit union, NCUA will notify the corporate credit union in

writing of the proposed ratio or level and, if applicable, the date by

which the ratio should be reached. NCUA also will provide an

explanation of why the proposed ratio or level is considered necessary

or appropriate for the corporate credit union. In the case of a state-

chartered corporate credit union, NCUA also will provide notification

and explanation to the state supervisory authority.

(3)(i) The corporate credit union may respond to any or all of the

items in the notice. The response must be in writing and delivered to

NCUA within 10 business days after the date on which the corporate

credit union received the notice. NCUA may shorten the time period

when, in its opinion, the condition of the corporate credit union so

requires, provided that the corporate credit union is informed promptly

of the new time period, or with the consent of the corporate credit

union. In its discretion, NCUA may extend the time period for good

cause.

(ii) Failure to respond within 10 business days or such other time

period as may be specified by NCUA shall constitute a waiver of any

objections to any item in the notice. Failure to address any item in a

response shall constitute a waiver of any objection to that item.

(iii) After the close of the corporate credit union's response

period, NCUA will decide, based on a review of the corporate credit

union's response and other information concerning the corporate credit

union, and, in the case of a state-chartered corporate credit

[[Page 28102]]

union, in consultation with the state supervisory authority, whether a

different minimum capital ratio or reserve transfer level should be

established for the corporate credit union and, if so, the ratio or

level and the date the requirement will become effective. The corporate

credit union will be notified of the decision in writing. The notice

will include an explanation of the decision, except for a decision not

to establish a different minimum capital ratio or reserve transfer

level for the corporate credit union.

(e) Failure to maintain minimum capital ratio requirement. When a

corporate credit union's capital ratio falls below the minimum required

by paragraphs (b) or (d) of this section, or Appendix B, as applicable,

operating management of the corporate credit union must notify its

board of directors, supervisory committee, and NCUA within 10 business

days.

(f) Capital restoration plan. (1) A corporate credit union must

submit a plan to restore and maintain its capital ratio at the minimum

requirement when either of the following conditions exist:

(i) The capital ratio falls below the minimum requirement and is

not restored to the minimum requirement by the next month end; or

(ii) Regardless of whether the capital ratio is restored by the

next month end, the capital ratio falls below the minimum requirement

for three months in any 12-month period.

(2) The capital restoration plan must, at a minimum, include the

following:

(i) Reasons why the capital ratio fell below the minimum

requirement;

(ii) Descriptions of steps to be taken to restore the capital ratio

to the minimum requirement within specific time frames;

(iii) Actions to be taken to maintain the capital ratio at the

minimum required level and increase it thereafter;

(iv) Balance sheet and income projections, including assumptions,

for the current calendar year and one additional calendar year; and

(v) Certification from the board of directors that it will follow

the proposed plan if approved by NCUA.

(3) The capital restoration plan must be submitted to NCUA, and in

the case of a state-chartered corporate credit union, to the state

supervisory authority, within 30 business days of the occurrence.

(g) Capital directive. (1) If a corporate credit union fails to

submit a capital restoration plan; or the plan submitted is not deemed

adequate to either restore capital or restore capital within a

reasonable time; or the credit union fails to implement its approved

capital restoration plan, NCUA may issue a capital directive.

(2) A capital directive may order a corporate credit union to:

(i) Achieve adequate capitalization within a specified time frame

by taking any action deemed necessary, including but not limited to the

following:

(A) Increase the amount of capital to specific levels;

(B) Reduce dividends;

(C) Limit receipt of deposits to those made to existing accounts;

(D) Cease or limit issuance of new accounts or any or all classes

of accounts;

(E) Cease or limit lending or making a particular type or category

of loans;

(F) Cease or limit the purchase of specified investments;

(G) Limit operational expenditures to specified levels;

(H) Increase and maintain liquid assets at specified levels; and

(I) Restrict or suspend expanded authorities issued under Appendix

B of this part.

(ii) Adhere to a previously submitted plan to achieve adequate

capitalization.

(iii) Submit and adhere to a capital plan acceptable to NCUA

describing the means and a time schedule by which the corporate credit

union shall achieve adequate capitalization.

(iv) Meet with NCUA.

(v) Take a combination of these actions.

(3) Prior to issuing a capital directive, NCUA will notify a

corporate credit union in writing of its intention to issue a capital

directive. In the case of a state-chartered corporate credit union,

NCUA also will provide notice to the state supervisory authority.

(i) The notice will state:

(A) The reasons for the issuance of the directive; and

(B) The proposed content of the directive.

(ii) A corporate credit union must respond in writing within 10

business days of receipt of the notice stating that it either concurs

or disagrees with the notice. If it disagrees with the notice, it must

state the reasons why the directive should not be issued and/or propose

alternative contents for the directive. The response should include all

matters that the corporate credit union wishes to be considered. For

its comments to be considered, the state supervisory authority must

respond in writing within the same 10 business days. For good cause,

the response time may be shortened or lengthened, including the

following conditions:

(A) When the condition of the corporate requires, and the corporate

credit union is notified of the shortened response period in the

notice;

(B) With the consent of the corporate credit union; or

(C) When the corporate credit union already has advised NCUA that

it cannot or will not achieve adequate capitalization.

(iii) Failure to respond within 10 business days, or another time

period specified in the notice, shall constitute a waiver of any

objections to the proposed directive.-

(4) After the closing date of the corporate credit union's response

period, or the receipt of the response, if earlier, NCUA shall consider

the response and may seek additional information or clarification.

Based on the information provided during the response period, NCUA will

determine whether or not to issue a capital directive and, if issued,

the form it should take.

(5) Upon issuance, a capital directive and a statement of the

reasons for its issuance will be delivered to the corporate credit

union. A directive is effective immediately upon receipt by the

corporate credit union, or upon such later date as may be specified

therein, and shall remain effective and enforceable until it is stayed,

modified, or terminated by NCUA.

(6) A capital directive may be issued in addition to, or in lieu

of, any other action authorized by law in response to a corporate

credit union's failure to achieve or maintain the applicable minimum

capital ratios.

(7) Upon a change in circumstances, a corporate credit union may

request reconsideration of the terms of the directive. Requests that

are not based on a significant change in circumstances or are

repetitive or frivolous will not be considered. Pending a decision on

reconsideration, the directive shall continue in full force and effect.

Sec. 704.4 Board responsibilities.

(a) General. A corporate credit union's board of directors must

approve comprehensive written strategic plans and operating policies,

review them annually, and provide them upon request to the auditors,

supervisory committee, and NCUA. The board of directors must know and

understand the activities, policies, and procedures of the corporate

credit union.

(b) Operating policies. A corporate credit union's operating

policies must be commensurate with the scope and complexity of the

corporate credit union.

(c) Procedures. The board of directors of a corporate credit union

must ensure that:

[[Page 28103]]

(1) Senior managers have an in-depth, working knowledge of their

direct areas of responsibility and are capable of identifying, hiring,

and retaining qualified staff;

(2) Qualified personnel are employed or under contract for all line

support and audit areas, and designated back-up personnel with adequate

cross-training are in place;

(3) GAAP is followed;

(4) Accurate balance sheets, income statements, and internal risk

assessments (e.g., risk management measures of liquidity, market, and

credit risk associated with current activities) are produced timely in

accordance with Secs. 704.6, 704.8, and 704.9;

(5) Systems are audited periodically in accordance with industry-

established standards;

(6) Financial performance is evaluated to ensure that the

objectives of the corporate credit union and the responsibilities of

management are met; and

(7) Planning addresses the necessary retention of external

consultants to review the adequacy of technical, human, and financial

resources dedicated to support major risk areas.

Sec. 704.5 Investments.

(a) All investments must be U.S. dollar-denominated and subject to

the credit policy restrictions set forth in Sec. 704.6.

(b) A corporate credit union may invest in:

(1) Securities, deposits, and obligations set forth in Sections

107(7), 107(8), and 107(15) of the Federal Credit Union Act, 12 U.S.C.

1757(7), 1757(8), and 1757(15), except as provided in this section;

(2) Deposits in, the sale of federal funds to, and debt obligations

of corporate credit unions and Section 107(8) institutions and deposits

in state banks, trust companies, and mutual savings banks not domiciled

in the state in which the corporate credit union does business;

(3) Corporate CUSOs, as defined in and subject to the limitations

of Sec. 704.11;

(4) Marketable debt obligations of corporations chartered in the

United States. This authority does not apply to debt obligations that

are convertible into the stock of the corporation;

(5) Asset-backed securities; and

(6) CMOs/REMICs, subject to these additional limitations:

(i) Fixed rate CMOs/REMICs must meet the following NCUA-modified

Federal Financial Institutions Examination Council (FFIEC) High Risk

Security Test requirements:

(A) The weighted average life may not exceed 5 years at the time of

purchase;

(B) The weighted average life may not extend by more than 2 years,

nor contract by more than 3 years for an instantaneous, permanent, and

parallel shift in market rates of plus or minus 300 basis points;

(C) The extended weighted average life may not, in any case, exceed

7 years; and

(D) The investment's price may not decline by more than 15 percent

for an instantaneous, permanent, and parallel shift in market rates of

plus or minus 300 basis points;

(ii) Floating rate CMOs/REMICs must meet the following NCUA-

modified FFIEC High Risk Security Test requirements:

(A) The weighted average life of the security may not exceed 7

years at the time of purchase;

(B) The weighted average life may not extend by more than 2 years,

nor contract by more than 3 years for an instantaneous, permanent, and

parallel shift in market rates of plus or minus 300 basis points;

(C) The extended weighted average life may not, in any case, exceed

9 years; and

(D) The investment's price may not decline by more than 10 percent

for an instantaneous, permanent, and parallel shift in market rates of

plus or minus 300 basis points;

(iii) The NCUA-modified FFIEC High Risk Security Tests must be

prepared monthly on all CMO/REMICs, documented and reviewed by an

appropriate committee, and retained until after completion of the next

audit and examination;

(iv) A corporate credit union's board of directors must approve at

least three prepayment models for CMOs/REMICs unless a median estimate

from an industry-recognized information provider is used. These

approved models must be used consistently for all subsequent compliance

tests. Any changes in approved models should be infrequent and

documented with a reasonable and supportable justification; and

(v) A corporate credit union must obtain prepayment estimates,

based upon an instantaneous, permanent, parallel shift in market rates

of plus or minus 100, 200, and 300 basis points, to conduct the tests

set forth in paragraph (b)(6) of this section.

(A) If a median prepayment estimate is used, it must be obtained

from an industry-recognized information provider. At purchase, the

median estimate must be based on at least 5 prepayment models. At

retesting, the median estimate must be based on at least 2 prepayment

models.

(B) If individual prepayment models are used, estimates must be

obtained from all of the models identified in the corporate credit

union's investment policy. One of the individual prepayment models may

be the median prepayment estimate from an industry-recognized

information provider. All of the models identified in the investment

policy must be used when purchasing and retesting a CMO/REMIC. At

purchase, a CMO/REMIC must pass the tests for each prepayment model

used. At retesting, the CMO/REMIC must pass the tests for a majority of

the prepayment models used at the time of purchase.

(c) A corporate credit union may enter into a repurchase agreement

or securities lending transaction provided that:

(1) The corporate credit union takes physical possession of the

security, receives written confirmation of the purchase and a

safekeeping receipt from a third party under a written custodial

contract, or is recorded as owner of the security through the Federal

Reserve Book-Entry Securities Transfer System;

(2) Collateral securities are legal investments for corporate

credit unions, except that a corporate credit union may receive, as

permissible collateral, CMO/REMIC securities that pass the FFIEC High

Risk Security Test if the term of the repurchase transaction does not

exceed 95 days from the date of settlement;

(3) In the event of default, the corporate credit union sells the

collateral in a timely manner, subject to a bankruptcy stay, to satisfy

the commitment of any net principal and interest owed to it by the

counterpart;

(4) The corporate credit union receives daily assessment of the

market value of collateral securities, including a market quote or

dealer bid indication and any accrued interest, and maintains adequate

margin that reflects a risk assessment of the collateral securities and

the term of the transaction;

(5) The corporate credit union has entered into signed contracts

with all approved counterparts. Such contracts must address any

supplemental terms and conditions necessary to meet the specific

requirements of this part. Third party arrangements must be supported

by tri-party contracts in which collateral is priced and reported daily

and the tri-party agent ensures compliance; and

(6) The corporate credit union has sufficient market relationships

established in advance to timely execute the disposition of collateral

securities.

[[Page 28104]]

(d) A corporate credit union may invest in an investment company

registered with the Securities and Exchange Commission under the

Investment Company Act of 1940 (15 U.S.C. 80a), provided that the

portfolio of such management company is restricted by its investment

policy, changeable only if authorized by shareholder vote, solely to

investments and investment transactions that are permissible for that

corporate credit union.

(e) A corporate credit union is prohibited from:

(1) Purchasing or selling financial derivatives such as futures,

options, interest rate swap contracts, or forward rate agreement;

(2) Engaging in pair-off transactions, when issued trading,

adjusted trading, gains trading, or short sales; and

(3) Purchasing stripped mortgage-backed securities, residual

interests in CMO/REMICs, mortgage servicing rights, commercial mortgage

related securities or small business related securities.

(f) A corporate credit union's officials, employees, and immediate

family members of such individuals, may not receive pecuniary

consideration in connection with the making of an investment or deposit

by the corporate credit union. Employee compensation is exempt from

this prohibition. All transactions not specifically prohibited by this

paragraph must be conducted at arm's length and in the interest of the

corporate.

(g) A corporate credit union's authority to hold an investment is

governed by the regulation in effect at the time of purchase. However,

all grandfathered investments are subject to the requirements of

Sec. 704.8 and Sec. 704.9.

Sec. 704.6 Credit risk management.

(a) Policies. A corporate credit union must operate according to a

credit risk management policy, which addresses, at a minimum:

(1) The approval process associated with credit limits;

(2) Due diligence analysis requirements;

(3) Maximum credit limits with each obligor and transaction

counterpart, set as a percentage of the sum of reserves and undivided

earnings and paid-in capital. In addition to addressing loans,

deposits, and securities, limits with transaction counterparts must

address aggregate exposures of all transactions, including, but not

necessarily limited to, repurchase agreements, securities lending, and

forward settlement of purchases or sales of investments; and

(4) Concentrations of credit risk (e.g., sector, industry, and

regional concentrations);

(b) Exemption. The requirements of this section do not apply to

instruments that are issued or fully guaranteed as to principal and

interest by the U.S. government or its agencies or enterprises or are

fully insured (including accumulated interest) by the National Credit

Union Administration or Federal Deposit Insurance Corporation.

(c) Concentration limits. (1) Aggregate investments in mortgage-

backed and asset-backed securities are limited to 200 percent of the

sum of reserves and undivided earnings and paid-in capital for any

single security or trust.

(2) Except for investments in a wholesale corporate credit union,

aggregate investments in repurchase and securities lending agreements

with any one counterpart are limited to 400 percent of the sum of

reserves and undivided earnings and paid-in capital.

(3) Except for investments in a wholesale corporate credit union,

the aggregate of all investments in non secured obligations of any

single domestic issuer is limited to 100 percent of the sum of reserves

and undivided earnings and paid-in capital.

(4) For purposes of measurement, each new credit transaction must

be evaluated in terms of the corporate credit union's sum of reserves

and undivided earnings and paid-in capital at the time of the

transaction. A subsequent reduction in the sum of reserves and

undivided earnings and paid-in capital will require a suspension of

additional transactions until maturities, sales or terminations bring

existing exposures within the requirements of this part.-

(d) Credit ratings. (1) All debt instruments must have a credit

rating from at least one nationally recognized statistical rating

organization.

(2) The rating(s) must be monitored for as long as the corporate

owns an instrument.

(3) Any rated instrument that is downgraded by the nationally

recognized statistical rating organization(s) used to meet the

requirements of this part at the time of purchase must be reviewed by

an appropriate committee within 20 business days of the downgrade.

Instruments that fall below the minimum rating requirements of this

part are subject to the divestiture requirements of 704.10.

(4) Investments in asset-backed securities must be rated no lower

than AAA (or equivalent). All other investments must be rated no lower

than A-1 (or equivalent) for short-term investments and AA (or

equivalent) for long-term investments at the time of purchase and at

any subsequent time by the nationally recognized statistical rating

organization(s) used to meet the requirements of this part at the time

of purchase.

(e) Reporting and documentation.

(1) A written evaluation of each credit line must be prepared at

least annually and formally approved by an appropriate committee of the

board. A watch list of existing and/or potential credit problems must

be prepared at least monthly and provided to an appropriate committee

of the board. Summary credit exposure reports, which demonstrate

compliance with the corporate's risk management policies, must be

continuously maintained, reviewed by appropriate staff, and provided

monthly to the board.

(2) At a minimum, the corporate must maintain:

(i) A justification for each approved credit line;

(ii) Prospectuses for all publicly traded securities and offering

memoranda for private placements and securities that are exempt from

the registration requirements of the Securities Act of 1933 or the

margin requirements of the Securities Exchange Act of 1934; and

(iii) The latest available financial reports, industry analyses,

internal and external analyst evaluations, and rating agency

information for each approved credit line.

Sec. 704.7 Lending.

(a) Policies. A corporate credit union must operate according to a

lending policy which addresses, at a minimum:

(1) Loan types and limits;

(2) Required documentation and collateral; and

(3) Analysis and monitoring standards.

(b) General. Each loan or line of credit limit will be determined

after analyzing the financial and operational soundness of the borrower

and the ability of the borrower to repay the loan.

(c) Loans to member credit unions. The maximum aggregate amount in

loans and irrevocable lines of credit to any one member credit union,

excluding pass-through and guaranteed loans from the CLF and the

NCUSIF, shall not exceed 50 percent of capital or 75 percent of the sum

of reserves and undivided earnings and paid-in capital, whichever is

greater, for unsecured loans and irrevocable lines of credit, or 100

percent of capital or 200 percent of the sum of reserves and undivided

earnings and paid-in capital, whichever

[[Page 28105]]

is greater, for secured loans and irrevocable lines of credit.

(d) Loans to members that are not credit unions. Any loan or

irrevocable line of credit made to a member, other than a credit union

or a corporate CUSO, must be made in compliance with Sec. 701.21(h) of

this chapter, governing member business loans. The aggregate amount of

loans and irrevocable lines of credit to members other than credit

unions and corporate CUSOs shall not exceed 15 percent of the corporate

credit union's capital plus pledged shares.

(e) Loans to non member credit unions. A loan to a credit union

that is not a member of the corporate credit union is only permissible

if the loan is for an overdraft related to the providing of

correspondent services pursuant to Sec. 704.12. Generally, such a loan

will have a maturity of only one business day.

(f) Loans to corporate CUSOs. A corporate credit union may make

loans and issue lines of credit to corporate CUSOs, subject to the

limitations of Sec. 704.11.

(g) Participation loans with other corporate credit unions. A

corporate credit union is permitted to participate in a loan with

another corporate credit union and must retain an interest of at least

5 percent of the face amount of the loan. The participation agreement

may be executed at any time prior to, during, or after disbursement. A

participating corporate credit union must exercise the same due

diligence as if it were the originating corporate credit union.

(h) Prepayment penalties. If provided for in the loan contract, a

corporate credit union is authorized to assess prepayment penalties on

loans.

Sec. 704.8 Asset and liability management.

(a) Policies. A corporate credit union must operate according to a

written asset and liability management policy which addresses, at a

minimum:

(1) The purpose and objectives of the corporate credit union's

asset and liability activities;

(2) The tests that will be used to evaluate instruments prior to

purchase;

(3) The maximum allowable percentage decline in market value of

portfolio equity (MVPE), over specified periods of time, compared to

current MVPE;

(4) The minimum allowable MVPE ratio under any condition;

(5) The maximum decline in net income (before reserve transfers),

in percentage and dollar terms, compared to current net income;

(6) Policy limits and specific test parameters for the interest

rate risk simulation tests set forth in paragraph (e) of this section;

(7) Concentration limits that reflect the default, liquidity, and

market risks of investments;

(8) Policy limits which address transaction types and amounts for

all off-balance sheet risk (e.g., lines of credit or other contracts);

and

(9) The modeling of indexes that serve as references in financial

instrument coupon formulas.

(b) Asset and liability management committee (ALCO). A corporate

credit union's ALCO must have at least one member who is also a member

of the board of directors. The ALCO must review the asset and liability

management reports on at least a monthly basis. These reports must

address compliance with Federal Credit Union Act, NCUA Rules and

Regulations, and all related risk management policies.

(c) Penalty for early withdrawals. A corporate credit union that

permits early certificate/share withdrawals must assess market-based

penalties sufficient to cover the estimated replacement cost of the

certificate/share redeemed.

(d) Risk analysis. A corporate credit union must adopt appropriate

tests and criteria for evaluating each investment prior to its

purchase. Risk analysis of the instrument type and industry sector must

be conducted for any new product that is considered for purchase by the

corporate credit union and/or for sale to members.

(e) Interest rate sensitivity analysis. (1) A corporate credit

union must:

(i) Evaluate the risk in its balance sheet by measuring, at least

quarterly, the impact of an instantaneous, permanent, and parallel

shock in the Treasury yield curve of plus or minus 100, 200, and 300

basis points on its MVPE and MVPE ratio. If the base case MVPE ratio

falls below 2 percent at the last testing date, these tests must be

calculated no less frequently than monthly until the base case MVPE

ratio again exceeds 2 percent; and

(ii) Limit its risk exposure to levels that do not result in a MVPE

ratio below 1 percent at any time either from a calculation of a base

case MVPE ratio or as a result of the tests indicated in paragraph

(e)(1)(i) of this section.

(2) A corporate credit union must limit its risk exposures to

levels that do not result in a decline in MVPE of more than 18 percent

at any time.

(3) A corporate credit union that owns an aggregate amount of

instruments which possess unmatched embedded options in a book value

amount which exceeds 200 percent of the sum of its reserves and

undivided earnings and paid-in capital must conduct additional tests

that address market factors which potentially can impact the value of

the instruments and that reflect the policy limits addressed in

paragraph (a) of this section. These factors should include, but not be

limited to, the following:

(i) Changes in the shape of the Treasury yield curve;

(ii) Adjustments to prepayment projections used for amortizing

securities to consider the impact of significantly faster/slower

prepayment speeds;

(iii) Adjustments to the market spread assumptions for non Treasury

instruments to consider the impact of widening spreads; and

(iv) Adjustments to volatility assumptions to consider the impact

that changing volatilities have on embedded option values.

(f) Regulatory violations. If a corporate credit union's base case

MVPE or MVPE ratio or the MVPE or MVPE ratio resulting from the tests

indicated in paragraph (e)(1)(i) of this section decline below the

limits established by this part and are not brought into compliance

within 5 business days, operating management of the corporate credit

union must report the information to the board of directors,

supervisory committee, and NCUA on the sixth business day. If any of

these measures remain below the limits established by this part by the

25th business day, the corporate credit union must submit a detailed,

written action plan to NCUA that sets forth the time needed and means

by which it intends to correct the violation. If NCUA determines that

the plan is unacceptable, the corporate credit union must immediately

restructure the balance sheet to bring the exposures back within

compliance or adhere to an alternative course of action determined by

NCUA.

(g) Policy violations. If a corporate credit union's MVPE or MVPE

ratio for any required test(s) exceed the limits established by the

board, it must determine how it will bring the exposures within policy

limits. The disclosure to the board of the limit violation must occur

no later than its next regularly scheduled board meeting. A specific

written disclosure detailing the limit violation(s) and the intended

course of action must be sent to NCUA within 25 business days after

disclosure to the board.

Sec. 704.9 Liquidity management.

(a) General. In the management of liquidity, a corporate credit

union must: -

(1) Evaluate the potential liquidity needs of its membership in a

variety of economic scenarios; -

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(2) Continuously monitor sources of internal and external

liquidity; -

(3) Demonstrate that the accounting classification of investment

securities is consistent with its ability to meet potential liquidity

demands; and

(4) Develop a contingency funding plan that addresses alternative

funding strategies in successively deteriorating liquidity scenarios.

The plan must:

(i) List all sources of liquidity, by category and amount, that are

available to service an immediate outflow of funds in various liquidity

scenarios.

(ii) Analyze the impact that potential changes in fair value will

have on the disposition of assets in a variety of interest rate

scenarios; and

(iii) Be reviewed by an appropriate committee of the board no less

frequently than annually or as market or business conditions dictate.

(b) Borrowing. A corporate credit union may borrow up to 10 times

capital or 50 percent of shares (excluding shares created by the use of

member reverse repurchase agreements) and capital, whichever is

greater. CLF borrowings and borrowed funds created by the use of member

reverse repurchase agreements are excluded from this limit. The

corporate credit union must demonstrate, through periodic usage of

external lines, that all contingent sources of liquidity remain

available.

Sec. 704.10 Divestiture.

(a) Any corporate credit union in possession of an investment that

fails to meet a requirement of this part must, within 20 business days

of the failure, report the failed investment to its board of directors

and NCUA. If the corporate credit union does not sell the failed

investment, and the investment continues to fail to meet a requirement

of this part, the corporate credit union must, by the 25th business day

after the failure, provide to NCUA a written action plan that

addresses:

(1) The investment's characteristics and risks;

(2) The process to obtain and adequately evaluate the investment's

market pricing, cash flows, and risk;

(3) How the investment fits into the credit union's asset and

liability management strategy;--

(4) The impact that either holding or selling the investment will

have on the corporate credit union's earnings, liquidity, and capital

in different interest rate environments; and

(5) The likelihood that the investment may again pass the

requirements of this part.

(b) NCUA may require, for safety and soundness reasons, a shorter

time period for plan development than that set forth in paragraph (a)

of this section.

(c) If the plan described in paragraph (a) of this section is not

approved by NCUA, the credit union must adhere to NCUA's directed

course of action.

Sec. 704.11 Corporate Credit Union Service Organizations (Corporate

CUSOs).

(a) A corporate CUSO is an entity that:

(1) Has received a loan from and/or is at least partly owned by a

corporate credit union;

(2) Primarily serves credit unions;

(3) Restricts its services to those related to the daily activities

of credit unions; and

(4) Is chartered as a corporation under state law.

(b) The aggregate of all investments in and loans to member and non

member corporate CUSOs shall not exceed 15 percent of a corporate

credit union's capital. However, a corporate credit union may loan to

member and non member corporate CUSOs an additional 15 percent of

capital if it is a secured loan. A corporate credit union may not use

this authority to acquire control, directly or indirectly, of another

financial institution, or to invest in shares, stocks, or obligations

of another financial institution, insurance company, trade association,

liquidity facility, or similar organization. A corporate CUSO must be

operated as an entity separate from any credit union. A corporate

credit union investing in or lending to a corporate CUSO must obtain a

written legal opinion that the corporate CUSO is organized and operated

in such a manner that the corporate credit union will not reasonably be

held liable for the obligations of the corporate CUSO. This opinion

must address factors that have led courts to ``pierce the corporate

veil,'' such as inadequate capitalization, lack of separate corporate

identity, common boards of directors and employees, control of one

entity over another, and lack of separate books and records.

(c) An official or senior management employee of a corporate credit

union which has invested in or loaned to a corporate CUSO, and

immediate family members of such an individual, may not receive, either

directly or indirectly, any salary, commission, investment income, or

other income, compensation, or consideration from the corporate CUSO.

This prohibition extends to any other corporate credit union employee

if such employee deals directly with the corporate CUSO.

(d) Prior to making an investment in or loan to a corporate CUSO, a

corporate credit union must obtain a written agreement that the

corporate CUSO will:

(1) Follow GAAP;

(2) Provide financial statements to the corporate credit union at

least quarterly;

(3) Obtain an annual CPA audit and provide a copy to the corporate

credit union; and

(4) Allow the auditor, board of directors, and NCUA complete access

to its books, records, and any other pertinent documentation.

(e) Corporate credit union authority to invest in or loan to a CUSO

is limited to that provided in this section. A corporate credit union

is not authorized to invest in or loan to a CUSO under Sec. 701.27 of

this chapter.

Sec. 704.12 Services.

Except for correspondent services to a non member, natural person

credit union branch office operating in the geographic area defined in

the corporate credit union's charter, a corporate credit union may

provide services only to its members, subject to the limitations of

this part. A corporate credit union may not provide services to non

members through agreements with other corporate credit unions or

pursuant to Sec. 701.26 of this chapter, except with the written

permission of NCUA.

Sec. 704.13 Fixed assets.

(a) A corporate credit union's ownership in fixed assets shall be

limited as described in Sec. 701.36 of this chapter, except that in

lieu of Sec. 701.36(c) (1) through (4), paragraph (b) of this section

applies.

(b) A corporate credit union may invest in fixed assets where the

aggregate of all such investments does not exceed 15 percent of the

corporate credit union's capital. A corporate credit union desiring to

exceed the limitation shall submit a written request to NCUA, which

will provide a written decision.

Sec. 704.14 Representation.

(a) Board representation. The board shall be determined as

stipulated in the standard corporate federal credit union bylaws

governing election procedures, provided that:

(1) At least a majority of directors, including the chair of the

board, must serve on the board as representatives of member credit

unions;

(2) The chair of the board may not serve simultaneously as an

officer, director, or employee of a credit union trade association;

(3) A majority of directors may not serve simultaneously as

officers, directors, or employees of the same credit union trade

association or its affiliates (not including chapters or other subunits

of a state trade association); and

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(4) For purposes of meeting the requirements of paragraphs (a)(1)

and (a)(2) of this section, an individual may not serve as a director

or chair of the board if that individual holds a subordinate employment

relationship to another employee who serves as an officer, director, or

employee of a credit union trade association.

(5) In the case of a corporate credit union whose membership is

composed of more than 25 percent non credit unions, the majority of

directors serving as representatives of member credit unions, including

the chair, must be elected only by member credit unions.

(b) Representatives of member credit unions. (1) A member credit

union may appoint one of its members or officials as a representative

to the corporate credit union. The representative shall be empowered to

attend membership meetings, to vote, and to stand for election on

behalf of the member. No individual may serve as the representative of

more than one member credit union in the same corporate credit union.--

(2) Any vacancy on the board of a corporate credit union caused by

a representative being unable to complete his or her term shall be

filled by the board of the corporate credit union according to its

bylaws governing the filling of board vacancies.

(c) Recusal provision. (1) No director, committee member, officer,

or employee of a corporate credit

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