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

RIN 3133-AB67

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: Final rule.

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SUMMARY: NCUA is issuing a final rule governing corporate credit

unions. The rule strengthens capital requirements, establishes

parameters to ensure that the risk on corporate credit union balance

sheets is adequately managed, provides for corporate credit unions with

more developed systems and infrastructures to take more planned and

controlled risk, and sets forth special rules for wholesale corporate

credit unions.

EFFECTIVE DATE: January 1, 1998.

ADDRESSES: National Credit Union Administration, 1775 Duke Street,

Alexandria, Virginia 22314-3428.

FOR FURTHER INFORMATION CONTACT: Robert F. Schafer, 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

In April 1995, NCUA issued a proposed regulation to revise most of

Part 704. 60 FR 20438, Apr. 26, 1995. In response to the comments

received and results of risk-profile assessments of corporate credit

unions using simulated modeling techniques, NCUA determined to issue a

revised proposed rule for another round of public comment. 61 FR 28085,

June 4, 1996. The proposed rule provided for a 90-day comment period,

ending on September 3, 1996. On July 16, 1996, NCUA issued a proposed

rule addressing the special circumstances of wholesale corporate credit

unions. 61 FR 38117, July 23, 1996. The comment period to this proposal

also ended on September 3, 1996. The comment period for both proposals

subsequently was extended to October 18, 1996. 61 FR 41750, August 12,

1996. This final rule addresses both proposals.

A total of 289 comments were received on the proposals, 202 from

natural person credit unions, 36 from corporate credit unions, 24 from

state banking trade associations; 10 from state credit union leagues, 5

from state credit union regulatory authorities, 4 from national credit

union trade associations, 4 from credit union organizations and

consultants, 3 from other entities that do business with credit unions,

and 1 from another type of trade association. The commenters

complimented NCUA's efforts to strengthen the regulation and stated

that progress had been made from the previous proposal but that changes

were still necessary.

A general comment was a request to standardize the time frames for

corporate credit unions to take various actions described throughout

the regulation. The proposed regulation required corporate credit

unions to take action in some cases in business days and in others in

calendar days. There also were five different numbers of days for those

actions. To make compliance easier, all dates in the final regulation

have been changed to calendar days, and the number of days for

compliance has been reduced to either 10 days, when only notification

is required, or 30 days, when more substantive action is required.

A common thread in many of the comments was the comparison of

corporate credit unions with natural person credit unions, banks,

savings and loans, and other financial institutions. Another was the

suggestion that NCUA take the same approach with corporate credit

unions as its sister federal financial institution regulatory agencies

take with their respective institutions. While these comparisons are

understandable, NCUA cautions that in many cases, they are not

appropriate.

Corporate credit unions differ from natural person credit unions,

banks, savings institutions, and other financial institutions that

serve consumers. They serve exclusively one class of customer: credit

unions. Corporate credit union balance sheets, cash flows, and

liquidity demands differ significantly from those of other financial

institutions. In general, the volume of large dollar transactions

present unique risks not seen in consumer-oriented institutions. As a

result, while considering comparisons with other institutions and

sister agencies, NCUA has been careful to put those comparisons into

proper perspective and to regulate to the areas of risk.

A number of commenters strongly suggested that NCUA review the

corporate regulation on an annual basis. While NCUA believes that a

periodic review is necessary, it believes that circumstances and need

should determine the frequency. NCUA has identified a number of issues,

some of which are identified in this supplementary information section,

that warrant further study relatively soon after the regulation is

implemented. Accordingly, the Office of Corporate Credit Unions will

present a report of these and other issues within 18 months of

publication of the final rule.

B. 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, the proposed rule added language to the Scope

section stating 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. Although a few commenters questioned the need

for such a contract, the language has been retained in the final rule.

Since the majority of natural person credit unions are federally

insured, NCUA has a strong interest in ensuring that corporate credit

unions which accept their funds remain safe and sound institutions.

Proposed Section 704.1(b), which set forth NCUA's authority to

waive a requirement of Part 704, is retained in this final rule. NCUA

may use this authority to respond to innovation at corporate credit

unions and in the marketplace. NCUA envisions the approval of pilot

programs involving new investments or activities. Such programs would

be approved on a limited basis so that NCUA could assess their impact

on corporate credit unions.

Language has been added to clarify that a state chartered corporate

credit union's request for expanded authority must be approved by the

state supervisory authority before being submitted to NCUA.

Section 704.2--Definitions

The proposed rule added a number of new definitions, revised

others, and deleted some. A few commenters took exception to specific

proposed definitions. Their comments and NCUA's responses are discussed

below.

In response to a comment, the definitions of the following terms

have been changed from the language that was proposed. The definition

of ``adjusted trading'' has been amended to include transactions not

``used to defer

[[Page 12930]]

a loss.'' The definition of collateralized mortgage obligation has been

changed so that the collateral may consist simply of ``mortgages,''

rather than ``whole loan mortgages.'' The word ``may'' has been added

to the definition of ``commitment'' so that the list of items included

in the term is not absolute. Although the definition of ``expected

maturity'' was proposed to be deleted, it has been retained. A

commenter noted that the term is used in the definitions of ``long-term

investment'' and ``short-term investment.'' The definition of ``federal

funds'' has been broadened to include transactions with domestic

branches of foreign banks, various government-sponsored enterprises,

and other non depository entities. The definition of ``securities

lending'' has been expanded to more precisely describe the activity.

The definition of ``wholesale corporate credit union'' has been changed

in light of the addition of Section 701.19 to the regulation.

The proposed definition that elicited the most comments was that

for ``market value of portfolio equity (MVPE).'' The proposed

definition treated membership capital as a liability, rather than as

part of MVPE. A number of commenters urged that it be included in MVPE.

Before addressing that issue, it must be noted that NCUA has determined

to replace the term MVPE in the rule with that of net economic value

(NEV). The calculation itself has not been altered, merely renamed. The

adoption of the term ``net economic value'' in place of ``market value

of portfolio equity'' is preferred because of the potential confusion

that results from the integral terms ``market'' and ``portfolio.'' The

calculation of estimated fair value, for both assets and liabilities,

is not only obtained from market sources. The term ``portfolio'' is

more typically used to describe investment or loan assets in contrast

to an entire balance sheet. While MVPE is a commonly used term in the

profession of asset and liability management, many practitioners and

other financial regulators have recently opted for new terminology. NEV

better connotes the concept of intrinsic or fair value of the whole

balance sheet than does MVPE.

The suggestion that ``capital is capital,'' whatever its form, is

the basis for the argument that corporate credit unions should be

permitted to include secondary capital in the base for all risk-taking

activities. The calculation of NEV serves as the base for credit and

interest rate risk limits as well as other activity restrictions, and

many commenters suggested that corporate credit unions should have as

much risk-taking potential as possible. NCUA disagrees that membership

capital should be included in the definition of NEV.

The function of membership capital is to serve as a secondary

resource for the absorption of risk when reserves and undivided

earnings have been exhausted. The holder of membership capital has the

option to sell the shares back to the corporate credit union three

years after notification of intent to withdraw. This option makes the

membership capital considerably less permanent than ``core'' capital,

since it is not controlled by the corporate credit union and is

potentially short-lived. NCUA regards this form of capital to be

distinctly different and less reliable than internally generated

capital or paid-in capital with far longer or no maturity. Permitting

corporates to place this form of secondary capital directly at risk

substantially, and inappropriately, increases the risk of a crisis in

membership confidence when losses do occur.

NCUA views the balance between core capital and risk-taking as

essential if the corporate credit union network is to maintain and

enhance its ability to withstand financial crises, whether limited to

one institution or systemic in nature. This final rule is designed to

strengthen core capital so that the corporate credit union network can

better withstand financial stress without placing an inappropriate

reliance upon its membership resources. Corporate credit unions should

gradually reduce their reliance on secondary capital as core capital

accumulates over time.

To bolster the accumulation of core capital, the proposed rule

authorized the issuance of paid-in capital, defined as funds obtained

from credit union and non credit union sources, having no maturity, and

being 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. Paid-in capital is included in the

definition of NEV, thus giving corporate credit unions the option of

raising permanent capital from their membership. Only a few commenters

addressed paid-in capital. To make clear that paid-in capital is

subordinate to membership capital, the definition has been modified and

expanded in this final rule. The requirement that the funds have no

maturity has been deleted.

The final rule distinguishes between ``member paid-in capital'' and

``non member paid-in capital.'' The former is held by the corporate

credit union's members, has a minimum 20-year maturity, and may not be

a condition of membership, services, or prices. Member paid-in capital

may be retired prior to the stated maturity only when the corporate

credit union elects to ``call'' the shares. Non member paid-in capital

is sold to the outside marketplace and must be approved by NCUA. Most

of the features of non member paid-in capital remain unspecified in the

regulation so that issuance can be tailored to reflect prevailing

market demands. The marketplace is the most efficient distribution

mechanism for capital, as the market immediately determines the value

and liquidity of an issue based on an issuer's performance and the

perceived risk of the issue.

NCUA believes that paid-in capital should not be issued unless the

corporate credit union can convince the market or its members that it

will use the new capital to create new value. The members, like the

marketplace, need to risk-adjust the expected return on paid-in capital

and expect a fair return. A capital offering that serves to increase

risk without increasing value is in no one's interest.

The proposed separate definitions for ``reserves'' and ``undivided

earnings'' have been unified in the final rule as ``reserves and

undivided earnings.'' The following proposed definitions have been

deleted because the term is no longer used in the regulation or is so

self-evident as not to require a definition: ``business day,''

``commitment,'' ``forward rate agreement,'' ``futures contract,''

``gains trading,'' ``material,'' ``maturity date,'' ``mortgage-backed

security,'' ``option contract,'' ``primary dealer,'' ``private

placement,'' ``reverse repurchase transaction,'' ``secured loan,''

``swap agreement,'' tri-party contract,'' ``United States Government or

its agencies,'' and ``United States Government sponsored corporations

and enterprises.''

A few definitions that were not proposed have been added to the

final rule, generally to accommodate the granting of certain additional

investment authorities. Corporate credit unions may engage in the

forward settlement of transactions beyond regular way settlement, under

certain conditions, and definitions of ``forward settlement'' and

``regular way settlement'' have been provided. Corporate credit unions

with additional authorities have been authorized to engage in dollar

roll transactions and when-issued trading, and definitions of those

activities have been provided.

Section 704.3--Corporate Credit Union Capital

The proposal required that a corporate credit union without

expanded authorities have a capital, or leverage,

[[Page 12931]]

ratio of 4 percent. Most of the comments, with the notable exception of

those submitted by banking associations, were supportive of the minimum

leverage ratio of 4 percent. It is important to discuss the

dissimilarities between corporate credit unions and banks to understand

why the level of required capital should be different. Banks primarily

use capital to support exposures to credit risk in the form of

commercial and consumer loans. Corporate credit unions primarily use

capital to support exposures to liquidity and interest rate risk

associated with investment in money market instruments and fixed income

securities.

Corporate credit unions presently provide a contingent liquidity

resource for members at the same time they offer correspondent

financial services. An overwhelming portion of a corporate credit

union's business consists of providing banker's bank services and

issuing shares and share certificates as investment alternatives for

members' excess funds. Corporate credit unions are not, in practice,

primary-lending institutions.

Capital adequacy is the central tenet of the proposed regulation.

The type and amount of risk assumed were fully considered when capital

ratios and corresponding risk limitations were developed. Since

corporate credit union assets are predominantly high-grade investment

securities, not loans, the regulation did not adopt a base leverage

ratio target in excess of 4 percent.

Additionally, the rule has a number of triggers to measure the

adequacy of capital in a corporate credit union. These triggers are

related to market risk exposures as measured by NEV. Risk measures are

required on a regular basis, not only for the contemporary market

environment, but for stressed conditions as well. Similar to the other

federal financial institution regulators, NCUA is requiring the

development of risk management infrastructures which better measure and

control risk.

The scope of these new requirements will vary by institution but

will be commensurate with the amount of risk assumed and the degree of

depth and sophistication employed to control these risks. This approach

will facilitate a more appropriate control of risk and thereby

establish a better early warning detection system when capital adequacy

begins to deteriorate. Thus, the 4 percent minimum capital ratio is

appropriate based upon the type of assets held and the rigorous risk-

assessment requirements of the rule.

Using risk-weighted assets to produce a risk-based capital

calculation has been debated throughout the Part 704 revision process.

Proponents have argued that the calculation captures a meaningful

measure of credit risk exposure which helps members and the public

ascertain credit-risk trends in corporate credit union balance sheets.

Corporate credit unions have high risk-weighted capital-to-asset ratios

relative to other financial institutions, making the ratio a favorable

measure for comparative purposes.

Opponents have argued that the risk-based capital calculation is

too arbitrary in assigning credit risk weights and that the absence of

consideration for interest rate risk makes the numbers misleading. The

most recent proposal for changes to the interagency risk-based capital

standards adjusts some credit risk weights and adds a new calculation

for interest rate risk by adding weights for the duration of each

asset. The calculation appears to be complex and potentially unwieldy

while providing limited regulatory value where corporate credit unions

are concerned.

NCUA advocates meaningful measures for credit and interest rate

risk exposure expressed in relation to capital. Concentration limits,

for example, have been converted from a function of net assets to one

of core capital. While the risk-weighted asset approach is not

utilized, conservative credit risk limitations are explicitly defined

in the regulation and additional credit risk measurement and reporting

requirements have been developed in the new credit risk management

section, Section 704.6.

NCUA does not discourage corporate credit unions that desire to

calculate the risk-weighted capital-to-assets ratio from doing so but

would suggest that they adopt the same standard used by other financial

institutions and understand that the calculation is not a regulatory

requirement.

The proposed regulation provided authority for NCUA to impose a

higher or lower minimum capital requirement on a case-by-case basis,

with prior notice to the corporate credit union. Some commenters

supported this authority, while others expressed concern that the

regulation did not specify all of the circumstances in which it could

be exercised. They suggested that it could be abused by NCUA.

The proposed rule illustrated four situations which might cause

NCUA to require reserve levels other than those specified in the

regulation. The first two were examples of circumstances that could

require a higher level, while the last two were examples that could

warrant a lower one. While NCUA would like to be able to clearly define

every situation in which such actions could be taken, changes in market

conditions and the corporate credit union environment make that

impossible. Leaving the regulation open provides NCUA more flexibility

in addressing unusual or non recurring events, including those which

may result in a reduction in reserve levels.

It should be noted that NCUA already has the authority, under

Section 116(b) of the Federal Credit Union Act, to adjust reserve

requirements for federal corporate credit unions. This regulation will

ensure that such authority is available for state-chartered corporate

credit unions, in the rare event that it is needed.

To address concerns about NCUA abuse, the rule was amended so that

NCUA may take action when significant risk exposure exists only when it

is unsupported by adequate capital or risk management processes.

The proposed regulation also provided authority for NCUA to issue a

capital directive when a corporate credit union fell below its minimum

capital requirement and failed to submit or follow an adequate capital

restoration plan. The directive could 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. Some

commenters objected to this authority, arguing that it would give NCUA

management control over a corporate credit union. NCUA disputes that

directing a corporate credit union to take certain specific actions to

return to a safe and sound level of capital constitutes taking

``control'' of the institution. In addition, the authority in question

is one held by the other federal financial institution regulators and,

as with the authority to impose an individual minimum capital

requirement, would be exercised only rarely. Accordingly, it has been

retained in the final rule.

A number of commenters expressed concern that the NCUA Board would

delegate its capital directive authority to NCUA staff. Several

comments specifically objected to delegating this authority to

examiners. Some commenters requested that the NCUA Board specifically

state in the rule that this and other authorities could never be

delegated to staff.

These comments reflect a lack of understanding of Board practice

regarding administrative actions. While the Board has delegated some

administrative actions to regional and office directors, none of the

authorities

[[Page 12932]]

can be redelegated to other staff members, including examiners.

Additionally, none of the actions delegated are final.

Delegated actions have been limited to preliminary actions, such as

notices of charges and temporary cease and desist orders, which must go

to the Board for final action.

The Board does not intend to delegate its authority to take

administrative actions to examiners and never intended that any action

proposed in Part 704 be delegated to examiners. However, this Board is

unwilling to put into the regulation a restriction that would limit a

future Board from taking an action it believed to be necessary.

Proposed Section 704.3 provided that when taking action in the case

of a state-chartered corporate credit union, NCUA provide notice to the

state supervisory authority. NCUA agrees with comments that notice

should be provided when any action is contemplated, not just one

relating to capital. To simplify the regulation, a general provision

for consultation has been added to Section 704.17, governing state-

chartered corporate credit unions, and individual provisions to that

effect have been deleted. It should be noted that, contrary to the

suggestion of one commenter, consultation does not mean that the state

authority must give its approval before NCUA may act. In order to

protect the share insurance fund, NCUA must have the authority to take

action whenever safety and soundness demands it.

Section 704.4--Board Responsibilities

Proposed Section 704.4 required the board of directors of a

corporate credit union to approve comprehensive written plans and

policies and to oversee senior management to ensure these plans and

policies are carried out. To emphasize the board's ultimate

responsibility for the actions it delegates, the proposed rule stated,

``The board of directors must know and understand the activities,

policies, and procedures of the corporate credit union.'' While this

was not intended to turn directors into operating managers, a large

number of commenters expressed concern about this requirement. To

mitigate this concern, this sentence has been deleted from the final

rule. NCUA is confident that board members will provided appropriate

oversight if they recognize and meet their common law fiduciary

responsibilities.

Some commenters objected to the proposed rule's requirement that a

corporate credit union have in place, for all line support and audit

areas, back-up personnel with adequate cross-training. To lessen the

burden, the final rule allows for back-up resources rather than

personnel, which means that corporate credit unions could temporarily

support their operations with staff from other corporate credit unions

or consulting firms.

Two commenters noted that the proposed requirement that a corporate

credit union follow generally accepted accounting principles (GAAP)

conflicts with the classification of credit union shares as equity.

Since there may be other departures from GAAP in the future, the final

rule requires that corporate credit unions follow GAAP, except where

law or regulation has provided for a departure from GAAP.

Currently, the shares classification is the only departure.

Finally, a number of commenters questioned the proposed rule's

requirement that a corporate credit union retain external consultants

to review the adequacy of resources supporting major risk areas. To

address these concerns, the final rule requires the retention of such

consultants only as appropriate.

Section 704.5--Investments

The proposed rule inadvertently failed to require that a corporate

credit union establish an investment policy. This requirement has been

added to the final rule. The policy must be consistent with the

corporate credit union's other risk management policies and must

address, at a minimum, appropriate criteria for evaluating standard

investments and risk analysis requirements for any new investment type

or transaction considered for a corporate credit union's portfolio and/

or sale to a member.

Certain commenters asked for clarification of the ``risk analysis

requirements.''

This provision addresses the evolutionary nature of instruments in

the financial marketplace. It is expected that new money market and

fixed income securities will be created. Some of these securities may

be legally permissible but may be distinctly different from the

universe of instruments previously available. It is not possible to

anticipate what additional analytical parameters, if any, must be

employed before a product comes to market. Therefore, NCUA believes

that policies must clearly indicate that the potential risks of new

products, not unlike new services, must be carefully evaluated.

Many corporate credit unions engineer new certificate offerings

that are structured to mirror specific investment assets. Such

structured certificates effectively transfer the risk of the asset

through to the holder of the certificate (the member).

Corporate credit unions need to ensure that the risk

characteristics that are inherent, and perhaps unique, in a new

investment type be sufficiently identified and rigorously analyzed

before being purchased for its portfolio or marketed and sold to its

members.

A corporate credit union should not dictate what a member buys, but it

should understand a new product's implications and be able to explain

them to a member.

The proposed rule authorized investments in corporate credit unions

and corporate credit union service organizations (CUSOs). One commenter

asked that investments in wholesale corporate credit unions and CUSOs

be specifically authorized. This is not necessary, as wholesale

corporate credit unions are a subset of corporate credit unions and are

included when the latter term is used.

The proposed rule established an NCUA-modified High Risk Security

Test (HRST) for REMIC/CMO securities. The commenters on the test

generally expressed two views. The first was to urge adoption of the

standard Federal Financial Institutions Examination Council (FFIEC)

parameters for the HRST so that the test would be consistent with those

used by other depository institutions. The second was to drop the use

of the HRST altogether based upon the assertion that proper NEV

calculations would capture the risk of the underlying cash-flows and

their corresponding price sensitivities anyway. These comments were

about evenly divided. One commenter suggested that the proposed NCUA-

modified tests be retained while another expressed that HRST tests

should only be required if a corporate's NEV ratio fell below 1

percent.

NCUA is persuaded that the requirement to produce net interest

income and NEV measures, set forth in Section 704.8, should be

sufficient to evaluate the individual risk characteristics of all

financial instruments, including CMOs/REMICs. Because all instruments

will have to be individually modeled for plus and minus 300 basis point

shifts, the HRST is effectively part of the risk measurement process

already.

When appropriately modeling CMO/REMIC cash-flows in conjunction

with the calculation of net interest income and NEV sensitivity, the

HRST is redundant. The test is useful indication, however, of potential

price volatility and liquidity risk. Bonds which pass the

[[Page 12933]]

FFIEC test are regarded to have a substantially greater universe of

potential buyers. Given the liquidity priority of corporate credit

unions, it makes sense to subject bonds to a periodic analysis of

factors which will drive the market's bias towards such securities. By

utilizing the test employed by other depository institutions, corporate

credit unions gain useful insight into the contingent liquidity

potential of individual CMO/REMIC securities.

Several commenters urged that the requirement to run a monthly HRST

be changed to quarterly. NCUA agrees that if the net interest income

and NEV tests are appropriately prepared in accordance with the rule,

the HRST requirement is less significant and that quarterly testing

will be adequate.

Some commenters suggested that the rule allow for the use of fewer

prepayment models where the proposal called for at least three models.

The reason that the rule required three or more models was to avoid the

risk of ``cherry picking'' one favorable prepayment model to cause a

CMO/REMIC to pass whenever possible. With the advent of simulation

modeling requirements for net interest income and NEV, NCUA accepts

that a more sophisticated corporate credit union will have the capacity

to appropriately analyze the risk of a CMO/REMIC security with fewer

than three prepayment models. Thus, the requirement that the board

approve at least three prepayment models for CMOs/REMICs was removed

from the Part I and Part II authorities but retained at the base level.

The proposed rule established identical standards for repurchase

and securities lending transactions. One commenter noted that these are

distinguishable economic and legal transactions and urged that they be

separated in the regulation. NCUA agrees and effected that separation.

The proposed rule required that collateral securities be legal for

corporate credit unions, except that CMO/REMIC securities that passed

the FFIEC HRST were permissible provided that the term of the

transaction did not exceed 95 days. A number of commenters asked that

the 95-day limit be dropped. The whole exception is unnecessary, now,

with the substitution of the FFIEC HRST for the NCUA-modified test.

The proposed rule authorized investment in a registered investment

company, provided that the portfolio of such investment company was

restricted by its investment policy, changeable only if authorized by

shareholder vote, solely to investments that were permissible for the

corporate credit union making the investment. In response to comments,

the shareholder vote restriction has been deleted.

As proposed, the final rule provided a grandfather clause, allowing

corporate credit unions to continue to hold investments that were

permissible when purchased but have become impermissible because of

regulatory changes. One commenter stated that this was inconsistent

with proposed Section 704.10, governing divestiture. That section

requires divestiture of or a written plan to keep an investment that

fails a requirement of Part 704. It should be understood that the

grandfather provision supersedes the divestiture provision.

Section 704.6--Credit Risk Management

Most corporate and natural person credit unions recommended only

minor revisions to the credit risk management section. Some, however,

objected to the requirement of any credit due diligence, given that

minimum credit ratings were limited to the top of the investment-grade

range. Credit ratings obtained from nationally recognized statistical

rating organizations are a significant tool for investors to evaluate

credit risk associated with a specific security, issuer, guarantor, or

provider of credit. They are no substitute for due diligence, however,

and should be regarded as only one part of the credit risk management

process.

Significant exposures to credit risk require extensive and

continuous credit analysis by professionally trained staff. Managing a

large credit exposure requires considerable personnel and financial

resources, which many corporate credit unions do not possess. Expanded

authority provisions allow for a broader spectrum of credit risk, and

increased credit due diligence by corporate credit unions that obtain

such authorities is key. Conversely, the amount of credit analysis

conducted by institutions that operate at the base level and maintain

very limited exposure to credit risk is not expected to be significant.

Credit risk exposure can be limited by restriction of counterparty,

dollar amount, and/or maturity. Those corporate credit unions that

remain at the base level and do not assume significant exposures should

be able to achieve an adequate degree of credit risk management by

employing a combination of these techniques. If a corporate credit

union expands its tolerance for credit risk, it must increase its due

diligence accordingly. That may mean hiring adequately trained staff

and/or increasing the frequency and depth of review.

Several commenters suggested that specific concentration limits on

repurchase agreements be removed from the regulation and left up to a

corporate credit union's board of directors. The regulation allows

corporate credit unions with expanded authorities to develop their own

credit limits for these transactions based upon the additional depth

and scope of their credit risk management. The base level was designed

to accommodate institutions with restricted capacity to handle credit

risk. The concentration limits are commensurate with the very limited

due diligence expected to support low credit risk strategies.

One commenter requested that NCUA clearly state that it supported

corporate credit unions using outside providers for investment and

credit due diligence. The implication is that a CUSO or other third

party provider could become the primary arbiter of the appropriateness

and selection of investment assets. The desire of corporate credit

unions to create cost-effective approaches to risk management is

understandable, but outsourcing risk-management evaluations diminishes

the control, independence, and accountability of risk making decisions.

While discretionary judgments can be outsourced, the board and

management's accountability for investment decisions cannot be

delegated, and the issue of credit risk becomes particularly

complicated. For example, how would a CUSO, serving multiple

institutions, determine how to equitably alert all clients to a

declining credit which requires disposition? The sale of distressed

financial instruments often accelerates market value declines (not

inappropriately) leaving other investors with unsold positions at an

increasing disadvantage. In other words, which client gets out first?

In the event of material credit-related losses, who bears

responsibility for the justification of the exposure and what recourse

would affected clients have with a CUSO?

Aside from accountability issues, NCUA fears that a CUSO serving

numerous corporate credit unions with credit risk research would

significantly increase the potential for a crisis in the credit union

system. The incidence of systemic crises is not uncommon for U.S.

depository institutions. Occurrences are infrequent but typically

severe, such as investments in Penn Square, where numerous corporate

credit unions were simultaneously affected to a significant degree.

[[Page 12934]]

Another commenter urged that NCUA remove the specific reporting and

documentation requirements. NCUA developed this language to convey the

minimum expectations for this important element of credit risk

management. While modifications were made to this section to make it

slightly more generalized, the need for some specificity was too

critical to dismiss altogether.

Several commenters sought clarification on the credit risk

management policy provision addressing concentrations of credit risk.

The examples of concentration characteristics included in the

regulation are ``industry type, sector type, and geographic.''

Commenters were concerned that NCUA would expect that all credit

instruments be evaluated on the basis of a set list of concentration

characteristics regardless of whether all of the characteristics

applied to an individual instrument.

Examples were provided to indicate that there are a number of

relevant concentration risks that can arise in the process of managing

credit risk. Not all concentration types apply to all credit

instruments. For example, a corporate credit union may need to consider

whether a particular industry is disproportionately represented in its

overall portfolio. To capture aggregate exposure, a corporate will need

to summarize such concentration by reviewing across all transaction

types.

Section 704.7--Lending

The proposed rule established limits on secured and unsecured loans

to one member. A secured loan was defined to mean one in which the

corporate credit union had perfected a security interest in the

collateral. In response to comments, the requirement that the security

interest be perfected has been deleted from the final rule. Further,

exclusions have been added for loans secured by shares and marketable

securities and for member reverse repurchase transactions.

The proposed rule required that a loan to a non credit union member

be made in conformance with the member business loan rule. In response

to comments, an exception has been provided for loans fully guaranteed

by a credit union or credit unions. A few commenters suggested that

corporate credit unions be permitted to participate with natural person

credit unions in making loans to natural person members. In the past,

NCUA was concerned that such activity could jeopardize a corporate

credit union's banker's bank exemption from the Federal Reserve Board's

Regulation D reserve requirements.

While NCUA believes that this area should be researched thoroughly,

for several reasons, it will take no action now. First, the research

necessary to analyze the potential impact of such loans would

unnecessarily delay this final rule. In light of the few credit unions

indicating interest, NCUA believes it more beneficial to finalize the

rule and take the issue up at a later date. Second, if corporate credit

unions were to participate in such loans, additional reserves would be

necessary to cover the risk of default by natural persons. The public

should have an opportunity to comment on such reserves before corporate

credit unions are required to comply with them.

The NCUA Board has asked the Office of Corporate Credit Unions to

study the issue and be prepared to make a recommendation when it

provides its interim report to the Board 18 months after publication of

this final rule.

Section 704.8--Asset and Liability Management

The proposed rule required a written asset and liability management

(ALM) policy which addressed, among other things, the modeling of

indexes that serve as references in financial instrument coupon

formulas. Several commenters raised questions about this requirement.

Many adjustable rate securities are available in the marketplace which

have interest rate formulas linked to a number of reference rates,

foreign currencies, and/or commodities. Corporate credit unions tend to

buy variable rate securities which are linked to U.S. money market

rates such as U.S. LIBOR or Fed Funds. Still others have purchased

securities linked to constant maturity Treasuries (CMT), the Prime

rate, or the 11th District Cost of Funds (COFI). It is important for an

institution to evaluate the basis risk in such instruments to ensure

that it has adequately measured the interest rate risk associated with

the respective repricing behavior (vis-a-vis its cost of funds). The

weaker the correlation between an index and the cost of funds, the

greater the need to estimate the future behavior of the index.

The proposed rule required a corporate credit union to evaluate the

risk in its balance sheet by measuring the impact of interest rate

changes on its NEV and NEV ratio. A corporate credit union was required

to limit its risk exposure to levels that did not result in an NEV

ratio below 1 percent or a decline in NEV of more than 18 percent. The

limit for corporate credit unions with Part I expanded authorities was

35 percent and for those with Part II authorities was 50 percent.

Frequency of testing was a function of the NEV ratio. If NEV was 2

percent or above, testing had to be done quarterly. If it fell below 2

percent, monthly testing was required.

The proposed rule also required corporate credit unions with

significant holdings of instruments with embedded options to perform

additional testing beyond the 300 basis point parallel shift of the

yield curve. The base test may not be sufficient to evaluate the

potential risk to the balance sheet, particularly for those portfolios

comprised of complex securities. Changes in the shape of the yield

curve, shifts in the credit and liquidity risk premium reflected in

spread changes, factors affecting prepayment speeds, and changes in

volatility, will all have an impact. While the rule did not establish

the testing frequency or the parameters to be used to evaluate the

impact of these factors, it did require that the tests reflect these

components of risk.

NCUA sought specific data from corporate credit unions to support

the claim that a floor other than 1 percent was appropriate. It sought

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

variation limits.

Most corporate credit union commenters pointed out that the minimum

NEV ratio poses a major restriction on balance sheet growth even if

such growth adds no incremental risk to the balance sheet. Commenters

overwhelmingly supported keeping the minimum ratio at 1 percent of the

fair value of assets, and some suggested removal of a minimum NEV ratio

altogether. The vast majority of comments submitted were without

supporting data. It is intuitive, however, that substantial growth in

corporate credit union assets would exacerbate the risk of penetrating

a floor of 2 percent or higher, since average core capital levels are

presently between 2 percent and 3 percent of assets.

The use of a minimum NEV ratio is intended to establish a floor for

primary capital which prevents a corporate credit union's core leverage

ratio from falling dangerously low. It provides an estimate of the

internal capacity of an institution to handle its risk exposures in the

future and thus alerts the corporate credit union and NCUA to potential

capital shortfalls.

Corporate credit unions have not historically had a growth

inhibitor in the form of minimum capital ratios, and thus, the NEV

ratio introduces a new element for management to control. While the NEV

ratio does not indicate the nature or degree of risk that is

[[Page 12935]]

inherent in a balance sheet, it does indicate the degree of leverage.

Capital is the reserve of funds available to manage all the risks of

the institution, including those which are not part of the risks

associated with changes in interest rates.

Measuring risk is an imprecise business because of the multitude of

assumptions that are required to evaluate potential outcomes. NCUA

believes that an NEV ratio below 1 percent would be imprudent because

little room would remain for errors in measurement or for the potential

confluence of business risks. An NEV ratio of 1 percent will provide a

reasonable early-warning detection mechanism for capital inadequacy.

The present levels of capital would not permit a substantially higher

floor at this time without a risk of forced shrinkage in corporate

credit union balance sheets.

Consistent with the base level thresholds established in the credit

risk management section, an 18 percent NEV volatility limit is adopted

to set a conservative market risk limit for corporate credit unions

that do not possess the financial, system, or personnel resources to

support a significant market-risk earnings strategy. The 18 percent

limit allows corporate credit unions at the base authority level to

entertain a modest mismatch between liabilities and assets (overnight

and/or term) and capital investments inside of seven years.

NEV is an imperfect measure in the sense that it portrays the risk

inherent in the balance sheet as one number. It is a present value of

the asset cash-flows less a present value of the liability cash-flows

plus/minus the time value of any embedded options. NEV does not

indicate when the risk will occur but it does indicate the aggregate

amount of potential risk. Used in conjunction with income simulation (a

short-term view of risk), NEV provides a good method for simultaneously

managing the earnings and net worth of an institution.

It is expected that corporate credit unions will have some degree

of mismatch in the normal course of business because member demands for

amount and maturity on the liability side of the balance sheet do not

perfectly correlate to available market instruments on the asset side.

The NEV calculations will capture the aggregate market risk and permit

corporate credit unions, no matter how their respective mismatches are

structured, to convey risk in a relatively simple and consistent

manner.

An NEV volatility limit of 18 percent was criticized by many

commenters as being too low and ``essentially a matched book.'' Any NEV

variance can be achieved with a total matched book in place since the

duration of the asset purchased with capital (not matched) will

determine the net risk. If capital is invested in short duration

instruments, the NEV volatility will be correspondingly low. If capital

is invested in long duration instruments, the volatility will be

higher. There is no precise level of NEV that equates to a ``matched

book.'' The 18 percent NEV limit is the same as a net risk position

with a price sensitivity equal to that of seven year zero-coupon

Treasury bond. This is not an insignificant amount of market risk. It

is a corporate credit union's choice whether it takes that risk in an

overnight account or whether it spreads it out among various books of

business (overnight, term, capital, etc.). Some institutions may choose

to run matched books and take all the risk with their capital.

Regardless, the maximum decline will be limited to 18 percent of base

case NEV.

One aspect of using NEV which must be noted is the effect of

negative convexity. Two corporate credit unions may have an equivalent

net risk exposure at a given point in time, but the respective

exposures will change very differently with subsequent changes in

market factors, depending on the composition of assets. One may choose

to take the bulk of its mismatch in the overnight account using

optionless money market instruments and invest its capital in a medium-

maturity debenture. The other may incur a mismatch by buying low

duration floating rate securities which possess a considerable amount

of option and basis risk.

In the first example, the sensitivity of NEV is fairly constant and

the risk profile may be altered relatively quickly with the passage of

time (by letting short maturities roll into overnight). In the latter

example, the option and basis risk may not emerge until the interest

rate environment has changed. Because securities with call, prepayment,

and cap options can extend dramatically, it is possible for such a

portfolio to go from a sensitivity of 18 percent to an exposure many

times that amount in a short time as the institution calibrates its

rate shocks to a new plus and minus 3 percent range.

Several corporate commenters suggested that an interim operating

level be considered for moderate capacity corporates, consisting of an

NEV volatility limit of 25 percent, with no additional investment or

credit authorities. They argued that the cost of building a risk

management infrastructure was essentially a barrier to entry for

expanded authorities, and they viewed the higher NEV limit as a

mechanism for funding the incremental costs of getting there. To

compensate for the incrementally greater risk, the commenters suggested

that qualifying corporate credit unions conduct the rate shock tests

monthly, as opposed to quarterly, and that they also conduct the

additional tests, beyond the 300 basis point parallel shift of the

yield curve, regardless of their holdings of instruments with embedded

options.

NCUA agrees that select corporate credit unions are capable of

operating between the base and Part I limits, and has created a ``base-

plus'' level. With NCUA approval, an institution can operate with an

NEV volatility of 25 percent provided that it performs additional tests

and has additional management and infrastructure. NCUA will assess the

institution to verify that the incremental qualifications are resident.

For example, more than one senior manager will be expected to have

strong knowledge of investments and ALM. In addition to risk

measurement, the ability for the institution to withstand the departure

of a key staff member and the ability to achieve adequate separation

between risk takers and risk monitors will be important.

Corporate credit unions qualifying for a 25 percent NEV variance

will be expected to conduct risk modeling with greater vigilance than

those operating with an 18 percent variance, and such institutions must

establish commensurate policies, procedures, and internal controls.

NCUA will expect corporate credit unions that qualify for a 25 percent

NEV limit to demonstrate a greater ability and inclination to

aggressively respond to adverse market developments than base authority

institutions. Operating with an NEV volatility of 25 percent may

increase current earnings, but it also raises the probability of

experiencing future losses.

For corporate credit unions that want to run bigger mismatches, the

Part I expanded authorities doubles the amount of permitted market risk

from the base, allowing an NEV decline of 35 percent. This degree of

mismatch has the aggregate risk sensitivity of a 15 year zero-coupon

Treasury bond. Part II expanded authorities allows an NEV decline of 50

percent, equating to an aggregate risk sensitivity of a 24 year zero-

coupon bond. The following table shows the risk sensitivities of zero-

coupon bonds of various durations.

[[Page 12936]]

Price Sensitivity of Zero-Coupon Treasury Bonds

[Prices as of 01/08/97]

------------------------------------------------------------------------

Price Price

sensitivity sensitivity

Investment (years) +2% shock +3% shock

(percent) (percent)

------------------------------------------------------------------------

7...................................... -13 -18

10...................................... -18 -25

15...................................... -26 -36

24...................................... -38 -51

------------------------------------------------------------------------

Source: Bloomberg; S , TRA(O).

NCUA has allowed sophisticated and well-developed corporate credit

unions to take much greater market risk than that permitted for

institutions with base authorities. If a corporate credit union wishes

to make market timing a substantial portion of its earnings strategy,

the expanded authority levels provide ample room for managing sizable

mismatches between assets and liabilities. But, at the base level, the

rule must have prudent limitations on market risk that reflect the more

limited capacity of many smaller and/or more conservative institutions

which cannot afford or do not desire to commit the financial and

personnel resources to build the appropriate risk-taking infrastructure

that is required to support higher NEV volatility.

The base level is intended to establish a conservative territory

where even the smallest and most thinly developed corporate credit

union can continue to provide standard products and services without

being subject to imprudent risks or burdened with excessive

infrastructure costs. In order for the regulation to encompass the full

spectrum of corporate credit unions, it must provide both a minimum

safety and soundness barrier as well as a mechanism for expanding

opportunities (commensurate with an increasing capacity to manage

risk). The rule is structured to create distinctive operating

classifications in response to the widely diverse corporate credit

union network.

A number of commenters noted that NCUA was adopting specific limits

on interest rate risk where other federal financial institution

regulators have elected to handle it through supervision. NCUA

acknowledges this difference but disagrees with the notion that its

approach is inconsistent or inappropriate.

Corporate credit unions comprise a relatively small private

financial network which serves a finite universe of members. The credit

union system cannot afford the failure of a corporate credit union,

whereas the failure of an individual bank or thrift is less

consequential to the survival of all other banks and thrifts. Because

of these differences, NCUA believes that explicit measures of risk

tolerances are appropriate.

In addition, many corporate credit unions are making a transition

from a traditional strategy where little interest rate risk was taken

(achieved through maturity and rate-reset matching of assets and

liabilities) to a strategy which assumes a variety of intentional

market risk mismatches, including maturity, option, and basis risk.

Explicit risk measures are essential in such an environment.

One corporate credit union commenter, joined by a number of its

member credit unions, claimed that the rule encourages corporate credit

unions to take credit risk as opposed to interest rate risk. This

sentiment is troubling. The proposed rule is intended to promote and

reinforce the discipline of comprehensive risk management, regardless

of the risk type assumed.

If a corporate credit union intends to entertain significant

exposures to market, credit, and/or liquidity risk in order to generate

its spread income, the obligation to professionally control those risks

is substantial. The expanded authority concept is predicated on the

idea that professional risk taking must be supported by a state-of-the-

art risk management infrastructure.

Section 704.9--Liquidity Management

Relatively few comments were received on this section of the

proposed rule. However, in response to those comments, the rule has

been amended so that a corporate credit union need only monitor its

liquidity sources regularly, rather than continuously, and need not

necessarily test its external lines to ensure that contingent sources

of liquidity remain available. However, a corporate credit union must

be able to demonstrate, whether through testing, written confirmation,

or other means, that such sources remain available.

Section 704.10--Divestiture

Few comments were received on this section of the proposed rule,

and except for changes to time frames to standardize them with others

in the regulation and the addition of the supervisory committee to the

list of entities which must receive a failed investment report, no

changes have been made in the final rule.

Section 704.11--Corporate Credit Union Service Organizations (Corporate

CUSOs)

The proposed rule defined a corporate CUSO as 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. A number of

commenters pointed out that defining an entity that has received a loan

from a corporate credit union as a corporate CUSO would severely

restrict the ability of corporate credit unions to lend to natural

person CUSOs. This was not intended, and that portion of the definition

has been deleted.

Some commenters expressed concern that the restriction of services

to those related to the daily activities of credit unions might unduly

limit the activities of corporate CUSOs, since a legitimate activity

might not occur every day. It was not the intent of the proposed rule

to require that an activity occur every day; however, to allay

concerns, the final rule requires that services be related to the

normal course of business of credit unions.

In response to comments, the rule has been amended to permit

corporate CUSOs to be structured as limited liability companies or

limited partnerships, as well as corporations. NCUA agrees that these

forms are appropriate for corporate CUSOs. Also in response to

comments, the conflict of interest provision has been amended to permit

a corporate credit union to share employees with a corporate CUSO. NCUA

was persuaded that there is a legitimate business purpose for such an

arrangement. However, such arrangements will be scrutinized to ensure

there is no insider self-dealing. Further, the rule still prohibits

corporate credit union directors and committee members from receiving

compensation from a corporate CUSO.

Section 704.12--Services

Few comments were received on this section, and it is unchanged in

the final rule. This section was intended to protect the integrity of

federal corporate credit union fields of membership. However, should

NCUA authorize national fields of membership for federal corporate

credit unions, there may be a determination to eliminate this section

at a future date.

Section 704.13--Fixed Assets

As proposed, the final rule permits a corporate credit union to

invest in fixed assets where the aggregate of all such investments does

not exceed 15 percent of the corporate credit union's capital. In

response to one comment, NCUA wishes to clarify that the 15 percent

refers to book value. As proposed, the final rule provides for a

corporate credit

[[Page 12937]]

union to request a waiver of the limitation from NCUA. The proposed

rule eliminated the current provision that allows a corporate credit

union to proceed with its investment if it does not receive

notification of the action taken on its request within 45 days. Three

commenters objected to NCUA not having a deadline to respond, and the

45 day timeframe has been reinstated.

Section 704.14--Representation

The first proposal to revise Part 704, issued in 1995, amended the

representation section to provide that only representatives of member

credit unions were permitted to vote and stand for election. This

involved changes to a number of paragraphs. When the proposed revision

to Part 704 was reissued in 1996, NCUA determined not to go forward

with the member-only proposal and intended to reverse all of the

changes that had been made in that regard. Inadvertently, some of the

changes were left in place. The final rule corrects this error.

Section 704.15--Audit Requirements

In response to the few comments received on this section, the

language has been clarified and made more consistent with auditing

terminology.

Section 704.16--Contracts/Written Agreements

No changes were made to this provision.

Section 704.17--State-Chartered Corporate Credit Unions

As noted earlier, a paragraph has been added which provides that

NCUA will consult with the state supervisory authority before taking

administrative action against a state-chartered corporate credit union.

Section 704.18--Fidelity Bond Coverage

In response to comments, the calculation of minimum bond has been

clarified and a $5 million cap has been added to each category in the

maximum deductible table.

Section 704.19--Wholesale Corporate Credit Unions

The commenters generally supported this section, and it has been

retained as proposed.

Appendix A--Model Forms

Some changes have been made to Sample Form 2 in the final rule to

accommodate the changes to the definition of paid-in capital.

Appendix B--Expanded Authorities and Requirements

The proposed rule introduced a multi-tier approach to the

regulation of corporate credit unions. Proposed Appendix B set forth

incrementally greater authorities for corporate credit unions and the

infrastructure and capital requirements that were required to be in

place to obtain such authorities. The commenters supported the multi-

tier approach, and it has been retained in the final rule. Based on the

comments received, several additional authorities have been added to

Parts I and II. So that NCUA can effectively supervise the transition

to this final rule, each corporate credit union is asked to inform

NCUA, by April 15, 1997, of its initial decision regarding the level at

which it wishes to operate.

One commenter thought that all investments should be grandfathered

in a case where a corporate has its expanded authorities revoked. This

observation raises an important issue. The final rule will shift the

major focus of risk evaluation from individual financial instruments

towards an aggregate or ``balance sheet'' risk assessment. While

individual securities and transactions might be grandfathered from

automatic divestiture, the revocation of expanded authorities would

likely be precipitated by concerns about the overall risk profile of

that institution. While individual transactions will not necessarily be

singled out, a corporate credit union must be prepared to employ asset

disposition to reduce excessive risk when exposures warrant.

For example, a substantial weakness in internal controls and/or

major capital inadequacy would necessitate a reduction in risk. If

expanded authorities are regarded to be adding risk to an already

unacceptable exposure, then NCUA would have to consider a revocation of

the authorities. This could prompt NCUA to mandate a risk reduction

strategy that requires the institution to adopt asset disposition in

order to achieve an appropriate and timely risk reduction. Once

revocation occurs, any additional expanded-authority activities will

cease and NCUA will evaluate, based on the unique circumstances, what

corrective actions are necessary. Thus, while the rule does not

predetermine the sale of specific expanded-authority transactions,

forbearance from divestiture will not be assured.

Proposed Appendix C set forth guidelines for evaluating requests

for expanded authorities. In response to the comments received, these

guidelines have been removed from the regulation and put into a

handbook format. Consequently, Appendix C has been deleted. The

guidelines will be provided to all corporate credit unions.

Part 709--Involuntary Liquidation and Creditor Claims

No comments were received on this section, and it has been retained

in the final rule.

Part 741--Requirements for Insurance

No comments were received on this section, and it has been retained

in the final rule.

C. 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 reporting requirements in Part 704 have been submitted to and

approved by the Office of Management and Budget under OMB control

number 3133-0129. Under the Paperwork Reduction Act of 1995, no persons

are required to respond to a collection of information unless it

displays a valid OMB control number. The control number will be

displayed in the table at 12 CFR Part 795.

Executive Order 12612

Executive Order 12612 requires NCUA to consider the effect of its

actions on state interests. 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 final rule will 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

[[Page 12938]]

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.

List of Subjects

12 CFR Part 704

Credit unions, Reporting and recordkeeping requirements, Surety

bonds.

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 March 7,

1997.

Becky Baker,

Secretary of the Board.

For the reasons set out in the preamble, NCUA amends 12 CFR chapter

VII 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.

704.19 Wholesale corporate credit unions.

Appendix A to Part 704--Model Forms

Appendix B to Part 704--Expanded Authorities and Requirements

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

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.

(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 and for

expansions of authority under Appendix B of 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 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).

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 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.

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.

Dollar roll means the purchase or sale of a mortgage backed

security to a counterparty with an agreement to resell or repurchase a

substantially identical security at a future date and at a specified

price.

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, calls, caps, and

prepayment options.

Expected maturity means the date on which all remaining principal

amounts of an instrument or bond are anticipated to be paid off on the

basis of projected payment assumptions.

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

[[Page 12939]]

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

unsecured transfer of immediately available funds by one depository

institution to another depository institution or entity.

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 settlement of a transaction means settlement on a date

other than the trade date.

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.

Matched means, with respect to assets and liabilities, that the

factors which affect cash flows of an asset are replicated in a

corresponding liability.

Member paid-in capital means paid-in capital that: Is held by the

corporate credit union's members; and has an initial maturity of at

least 20 years. A corporate credit union may not condition membership,

services, or prices for services on a credit union's ownership of paid-

in capital. When a paid-in capital instrument has a remaining maturity

of 5 years, the amount of the instrument that may be considered paid-in

capital for the purposes of this part is reduced by a constant monthly

amortization which ensures the recognition of paid-in capital is fully

amortized when the instrument has a remaining maturity of 3 years. The

terms and conditions of any member paid-in capital instrument must be

disclosed to the recorded owner of such instrument at the time the

instrument is created and at least annually thereafter.

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 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), but excluding paid-in capital. 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. A member may sell its membership capital to a

credit union in the corporate credit union's field of membership,

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 (e.g., one percent of a member credit union's

assets) established and disclosed by the corporate credit union at the

time the account is opened without regard to any minimum withdrawal

notice period. 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 related security means a security as defined in Section

3(a)(41) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(41)),

i.e., a privately-issued security backed by mortgages secured by real

estate upon which is located a dwelling, mixed residential and

commercial structure, residential manufactured home, or commercial

structure.

Mortgage servicing means performing tasks to protect a mortgage

investment, including collecting the installment 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 economic value (NEV) means the fair value of assets minus the

fair value of liabilities. All fair value calculations must include the

value of forward settlements and embedded options and of off balance

sheet financial derivatives, such as futures, options, interest rate

swaps, and forward rate agreements. Membership capital is treated as a

liability for purposes of this calculation. The NEV ratio is calculated

by dividing NEV by the fair value of assets.

Net interest income means the difference between income earned on

interest bearing assets and interest paid on interest bearing

liabilities.

Non member paid-in capital means paid-in capital that is approved

by NCUA, upon application by the corporate credit union. In determining

whether or not to approve any paid-in capital instrument, NCUA will

consider such features as maturity, capital amortization schedule,

participation, voting, acceleration, redemption, or other rights of the

holder, if any. NCUA will also consider the strategic purpose and

financial impact of the proposed paid-in capital issuance and the

corporate credit union's financial condition and management

capabilities.

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Non secured obligation means an obligation backed solely by the

creditworthiness of the obligor.

Official means any director or committee member.

Paid-in capital means accounts or other interests of a corporate

credit union that: Are available to cover losses that exceed reserves

and undivided earnings; are not insured by the NCUSIF or other share or

deposit insurers; 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. Paid-in capital

includes both member paid-in capital and non member paid-in capital. In

the event of liquidation of the corporate credit union, paid-in capital

is payable only after satisfaction of all liabilities of the

liquidation estate, including uninsured share obligations to

shareholders, the NCUSIF, and membership capital holders. Paid-in

capital shall not exceed reserves and undivided earnings.

Pair-off transaction means a security purchase transaction that is

closed out or sold at, or prior to, the settlement or expiration date.

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.

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.

Regular way settlement means delivery of a security from a seller

to a buyer within the specified number of days established for that

type of security.

Repurchase transaction means a transaction in which a corporate

credit union agrees to purchase a security from a counterparty and to

resell the same or any identical security to that counterparty 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 and undivided earnings means all forms of retained

earnings, including regular or statutory reserves and 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.

Section 107(8) institution means an institution described in

Section 107(8) of the Federal Credit Union Act (12 U.S.C. 1757(8)).

Securities lending means lending a security to a counterparty,

either directly or through an agent, and accepting collateral in

return.

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 counterparty 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 Exchange Act of 1934 (15 U.S.C.

78c(a)(53)), 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.

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.

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.

When-issued trading means the buying and selling of securities in

the period between the announcement of an offering and the issuance and

payment date of the securities.

Wholesale corporate credit union means a corporate credit union

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, unsupported by adequate capital

or risk management processes, 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

[[Page 12941]]

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.

(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 30 calendar 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 30 calendar 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, 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 of this part,

as applicable, operating management of the corporate credit union must

notify its board of directors, supervisory committee, and NCUA within

10 calendar 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 within

30 calendar days of the occurrence. NCUA will respond to the corporate

credit union regarding the adequacy of the plan within 45 calendar days

of its receipt.

(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.

(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 30

calendar 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

good cause, including the following conditions, the response time may

be shortened or lengthened:

(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 30 calendar 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

[[Page 12942]]

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.

(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:

(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 or resources

with adequate cross-training are in place;

(3) GAAP is followed, except where law or regulation has provided

for a departure from GAAP;

(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 retention of external consultants, as

appropriate, to review the adequacy of technical, human, and financial

resources dedicated to support major risk areas.

Sec. 704.5 Investments.

(a) Policies. A corporate credit union must operate according to an

investment policy that is consistent with its other risk management

policies, including, but not limited to, those related to credit risk

management, asset and liability management, and liquidity management.

The policy must address, at a minimum:

(1) Appropriate tests and criteria, if any, for evaluating standard

investments and investment transactions prior to purchase; and

(2) Risk analysis requirements for any new investment type or

transaction, not previously owned or marketed by the corporate credit

union, considered for purchase by the corporate credit union and/or for

sale to members.

(b) General. All investments must be U.S. dollar-denominated and

subject to the credit policy restrictions set forth in Sec. 704.6.

(c) Authorized activities. 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, Section 107(8) institutions, and 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 that meet the Federal Financial Institutions

Examination Council High Risk Security Test (HRST) requirements.

(i) The HRST must be prepared quarterly on all CMOs/REMICs,

documented and reviewed by an appropriate committee, and retained while

the instrument is held in portfolio and until completion of the next

audit and NCUA examination.

(ii) 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.

(iii) 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 HRST.

(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.

(d) Repurchase agreements. A corporate credit union may enter into

a repurchase agreement provided that:

(1) The corporate credit union, or its agent, nominee, or designee,

receives written confirmation of the transaction and either takes

physical possession or control of the repurchase securities or is

recorded as owner of the repurchase securities through the Federal

Reserve Book-Entry Securities Transfer System;

(2) The repurchase securities are legal investments for that

corporate credit union;

(3) In the event of default, the corporate credit union sells the

repurchase securities in a timely manner, subject to a bankruptcy stay,

to satisfy the commitment of any net principal and interest owed to it

by the counterparty;

(4) The corporate credit union receives daily assessment of the

market value of the repurchase securities, including a market quote or

dealer bid indication and any accrued interest, and maintains adequate

margin that reflects a risk assessment of the repurchase securities and

the term of the transaction;

(5) The corporate credit union has entered into signed contracts

with all approved counterparties. 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 the repurchase securities are 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

[[Page 12943]]

the disposition of the repurchase securities.

(e) Securities Lending. A corporate credit union may enter into a

securities lending transaction provided that:

(1) The corporate credit union, or its agent, nominee, or designee,

receives written confirmation of the loan, obtains a perfected first

priority security interest in the collateral, and either takes physical

possession or control of the collateral or is recorded as owner of the

collateral through the Federal Reserve Book-Entry Securities Transfer

System;

(2) The collateral is a legal investment for that corporate credit

union;

(3) The corporate credit union, directly or through its agent,

receives daily assessment of the market value of collateral, including

a market quote or dealer bid indication and any accrued interest, and

maintains adequate margin that reflects a risk assessment of the

collateral and terms of the loan; and

(4) The corporate credit union, directly or through its agent, has

executed a written loan and security agreement with the borrower,

approved any form of agreement attached thereto, and obtained the right

to approve any material modification to such agreement.

(f) Investment companies. 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 investment company is restricted by

its investment policy solely to investments and investment transactions

that are permissible for that corporate credit union.

(g) Forward settlement of transactions later than regular way. A

corporate credit union may enter into an agreement to purchase or sell

an instrument, with settlement later than regular way, provided that:

(1) Delivery and acceptance are mandatory;

(2) The transaction is clearly disclosed in the appropriate risk

reporting required under Sec. 704.8(b);

(3) If the corporate credit union is the purchaser, it has adequate

cash flow projections evidencing its ability to purchase the

instrument;

(4) If the corporate credit union is the seller, it owns the

instrument on the trade date; and

(5) The transaction is settled on a cash basis at the settlement

date.

(h) Prohibitions. A corporate credit union is prohibited from:

(1) Purchasing or selling off balance sheet financial derivatives,

such as futures, options, interest rate swaps, or forward rate

agreements;

(2) Engaging in pair-off transactions, when-issued trading,

adjusted 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.

(i) Conflicts of interest. 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 credit union.

(j) Grandfathering. 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 Secs. 704.8 and 704.9.

Sec. 704.6 Credit risk management.

(a) Policies. A corporate credit union must operate according to a

credit risk management policy that is commensurate with the investment

and lending risks and activities it undertakes. The policy must

address, 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

counterparty, 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 counterparties 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., industry type, sector

type, and geographic).

(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 counterparty 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 (NRSRO).

(2) The rating(s) must be monitored for as long as the corporate

owns an instrument.

(3) At the time of purchase, asset-backed securities must be rated

no lower than AAA (or equivalent), other long-term investments must be

rated no lower than AA (or equivalent), and short-term investments must

be rated no lower than A-1 (or equivalent).

(4) Any rated instrument that is downgraded by the NRSRO used to

meet the requirements of this part at the time of purchase must be

reviewed by the board or an appropriate committee within 30 calendar

days of the downgrade. Instruments that fall below the minimum rating

requirements of this part are subject to the requirements of

Sec. 704.10.

(e) Reporting and documentation. (1) A written evaluation of each

credit line must be prepared at least annually and formally approved by

the board or an appropriate committee. At least monthly, the board or

an appropriate committee must receive a watch list of existing and/or

potential credit problems and summary credit exposure reports, which

demonstrate compliance with the corporate credit union's risk

management policies.

(2) At a minimum, the corporate credit union must maintain:

[[Page 12944]]

(i) A justification for each approved credit line;

(ii) Disclosure documents, if any, for all instruments held in

portfolio. Documents for an instrument that has been sold must be

retained until completion of the next NCUA examination; and

(iii) The latest available financial reports, industry analyses,

internal and external analyst evaluations, and rating agency

information sufficient to support 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. (1) The maximum aggregate amount

in unsecured 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.

(2) The maximum aggregate amount in secured loans and irrevocable

lines of credit to any one member credit union, excluding those secured

by shares or marketable securities and member reverse repurchase

transactions, shall not exceed 100 percent of capital or 200 percent of

the sum of reserves and undivided earnings and paid-in capital,

whichever is greater.

(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, unless such loan or line

of credit is fully guaranteed by a credit union. 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, other than through

a loan participation with another 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 net economic value

(NEV), compared to current NEV;

(4) The minimum allowable NEV ratio;

(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 (d) of this section;

and

(7) 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 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 (12 CFR chapter VII), 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) 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 and minus 100, 200, and 300

basis points on its NEV, NEV ratio, and net interest income. If the

base case NEV ratio falls below 2 percent at the last testing date,

these tests must be calculated at least monthly until the base case NEV

ratio again exceeds 2 percent;

(ii) Limit its risk exposure to levels that do not result in an NEV

ratio below 1 percent; and

(iii) Limit its risk exposures to levels that do not result in a

decline in NEV of more than 18 percent, except as provided in paragraph

(e) of this section.

(2) 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 periodically, as

appropriate, 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.

(e) Base-plus. (1) In performing the rate stress tests set forth in

paragraph (d)(1)(i) of this section, the NEV of a corporate credit

union which has met the requirements of this paragraph (e) may decline

as much as 25 percent.

(2) The corporate credit union must meet additional management and

infrastructure requirements and receive NCUA's written approval. The

additional requirements are set forth in the NCUA publication

Guidelines for Submission of Requests for Expanded Authority. The

procedures for processing base-plus authority are the same as those set

forth in Appendix B

[[Page 12945]]

of this part for requesting expanded authorities.

(3) The corporate credit union must evaluate monthly the changes in

NEV, NEV ratio, and net interest income for the tests set forth in

paragraph (d)(1)(i) of this section.

(4) Regardless of the amount of instruments which possess unmatched

embedded options, the corporate credit union must conduct periodically,

as appropriate, the tests set forth in paragraph (d)(2) of this

section.

(f) Regulatory violations. If a corporate credit union's base case

NEV or NEV ratio or the NEV or NEV ratio resulting from the tests

indicated in paragraph (d)(1)(i) of this section decline below the

limits established by this part and are not brought into compliance

within 10 calendar days, operating management of the corporate credit

union must immediately report the information to the board of

directors, supervisory committee, and NCUA. If any of these measures

remain below the limits established by this part within 30 calendar

days of the violation, 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 NEV or NEV

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.

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;

(2) Regularly 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 the board or an appropriate committee 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 that sufficient 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 30 calendar days

of the failure, report the failed investment to its board of directors,

supervisory committee, 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,

within 30 calendar days of 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) Is at least partly owned by a corporate credit union;

(2) Primarily serves credit unions;

(3) Restricts its services to those related to the normal course of

business of credit unions; and

(4) Is structured as a corporation, limited liability company, or

limited partnership 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 collateralized by assets in which the corporate credit union

has perfected a security interest under state law. 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 of a corporate credit union which has invested in

or loaned to a corporate CUSO may not receive, either directly or

indirectly, any salary, commission, investment income, or other income,

compensation, or consideration from the corporate CUSO. This

prohibition also extends to immediate family members of officials.

(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 opinion 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.

[[Page 12946]]

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) of this chapter, 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. Requests

shall be supplemented by such statements and reports as NCUA may

require. If the corporate credit union does not receive notification of

the action taken on its request within 45 calendar days of the date all

required information has been received, it may proceed with its

proposed investment in fixed assets.

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);

(4) For purposes of meeting the requirements of paragraphs (a)(2)

and (a)(3) 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; and

(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 organizational members. (1) An

organizational member of a corporate credit union is a member that is

not a natural person. An organizational member 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 organizational member

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 union shall in any manner, directly

or indirectly, participate in the deliberation upon or the

determination of any question affecting his or her pecuniary interest

or the pecuniary interest of any entity (other than the corporate

credit union) in which he or she is interested, except if the matter

involves general policy applicable to all members, such as setting

dividend or loan rates or fees for services.

(2) An individual is ``interested'' in an entity if he or she:

(i) Serves as a director, officer, or employee of the entity;

(ii) Has a business, ownership, or deposit relationship with the

entity; or

(iii) Has a business, financial, or familial relationship with an

individual whom he or she knows has a pecuniary interest in the entity.

(3) In the event of the disqualification of any directors, by

operation of paragraph (c)(1) of this section, the remaining qualified

directors present at the meeting, if constituting a quorum with the

disqualified directors, may exercise, by majority vote, all the powers

of the board with respect to the matter under consideration. Where all

of the directors are disqualified, the matter must be decided by the

members of the corporate credit union.

(4) In the event of the disqualification of any committee member by

operation of paragraph (c)(1) of this section, the remaining qualified

committee members, if constituting a quorum with the disqualified

committee members, may exercise, by majority vote, all the powers of

the committee with respect to the matter under consideration. Where all

of the committee members are disqualified, the matter shall be decided

by the board of directors.

(d) Administration. (1) A corporate credit union shall be under the

direction and control of its board of directors. While the board may

delegate the performance of administrative duties, the board is not

relieved of its responsibility for their performance. The board may

employ a chief executive officer who shall have such authority and such

powers as delegated by the board to conduct business from day to day.

Such chief executive officer must answer solely to the board of the

corporate credit union, and may not be an employee of a credit union

trade association.

(2) The provisions of Sec. 701.14 of this chapter apply to

corporate credit unions, except that where ``Regional Director'' is

used, read ``NCUA Board.''

Sec. 704.15 Audit requirements.

(a) External audit. The corporate credit union supervisory

committee shall cause an annual opinion audit of the financial

statements to be made. The audit must be performed in accordance with

generally accepted auditing standards and the audited financial

statements must be prepared consistent with GAAP, except where law or

regulation has provided for a departure from GAAP. The supervisory

committee shall submit the audit report to the board of directors. A

copy of the audit report, and copies of all communications that are

provided to the corporate credit union by the external auditor, shall

be submitted to NCUA within 30 calendar days after receipt by the board

of directors. If requested by NCUA, the external auditor's workpapers

shall be made available, at the auditor's office or elsewhere, for

NCUA's review. The corporate credit union shall submit a summary of the

audit report to the membership at the next annual meeting.

(b) Internal audit. A corporate credit union with average daily

assets in excess of $400 million for the preceding calendar year, or as

ordered by NCUA, must employ or contract, on a full- or part-time

basis, the services of an internal auditor. The internal auditor's

responsibilities will, at a minimum, comply with the Standards and

Professional Practices of Internal Auditing, as established by the

Institute

[[Page 12947]]

of Internal Auditors. The internal auditor will report directly to the

chair of the corporate credit union's supervisory committee, who may

delegate supervision of the internal auditor's daily activities to the

chief executive officer of the corporate credit union. The internal

auditor's reports, findings, and recommendations will be in writing and

presented to the supervisory committee no less than quarterly, and will

be provided upon request to the external auditor and NCUA.

Sec. 704.16 Contracts/written agreements.

Services, facilities, personnel, or equipment shared with any party

shall be supported by a written contract, with the duties and

responsibilities of each party specified and the allocation of service

fee/expenses fully supported and documented.

Sec. 704.17 State-chartered corporate credit unions.

(a) This part does not expand the powers and authorities of any

state-chartered corporate credit union, beyond those powers and

authorities provided under the laws of the state in which it was

chartered.

(b) A state-chartered corporate credit union that is not insured by

the NCUSIF, but that receives funds from federally insured credit

unions, is considered an ``institution-affiliated party'' within the

meaning of Section 206(r) of the Federal Credit Union Act, 12 U.S.C.

1786(r).

(c) NCUA will notify, consult with, and provide explanation to the

appropriate state supervisory authority before taking administrative

action against a state-chartered corporate credit union.

Sec. 704.18 Fidelity bond coverage.

(a) Scope. This section provides the fidelity bond requirements for

employees and officials in corporate credit unions.

(b) Review of coverage. The board of directors of each corporate

credit union shall, at least annually, carefully review the bond

coverage in force to determine its adequacy in relation to risk

exposure and to the minimum requirements in this section.

(c) Minimum coverage; approved forms. Every corporate credit union

will maintain bond coverage with a company holding a certificate of

authority from the Secretary of the Treasury. All bond forms, and any

riders and endorsements which limit the coverage provided by approved

bond forms, must receive the prior written approval of NCUA. Fidelity

bonds must provide coverage for the fraud and dishonesty of all

employees, directors, officers, and supervisory and credit committee

members. Notwithstanding the foregoing, all bonds must include a

provision, in a form approved by NCUA, requiring written notification

by surety to NCUA:

(1) When the bond of a credit union is terminated in its entirety;

(2) When bond coverage is terminated, by issuance of a written

notice, on an employee, director, officer, supervisory or credit

committee member; or

(3) When a deductible is increased above permissible limits. Said

notification shall be sent to NCUA and shall include a brief statement

of cause for termination or increase.

(d) Minimum coverage amounts. (1) The minimum amount of bond

coverage will be computed based on the corporate credit union's daily

average net assets for the preceding calendar year. The following table

lists the minimum requirements:

------------------------------------------------------------------------

Minimum

Daily average net assets bond

(million)

------------------------------------------------------------------------

Less than $50 million...................................... $1.0

$50-$99 million............................................ 2.0

$100-$499 million.......................................... 4.0

$500-$999 million.......................................... 6.0

$1.0-$1.999 billion........................................ 8.0

$2.0-$4.999 billion........................................ 10.0

$5.0-$9.999 billion........................................ 15.0

$10.0-$24.999 billion...................................... 20.0

$25.0 billion plus......................................... 25.0

------------------------------------------------------------------------

(2) It is the duty of the board of directors of each corporate

credit union to provide adequate protection to meet its unique

circumstances by obtaining, when necessary, bond coverage in excess of

the minimums in the table in paragraph (d)(1) of this section.

(e) Deductibles. (1) The maximum amount of deductibles allowed are

based on the corporate credit union's reserve ratio. The following

table sets out the maximum deductibles, except that in each category

the maximum deductible shall be $5 million:

------------------------------------------------------------------------

Reserve ratio Maximum deductible

------------------------------------------------------------------------

Less than 1.0 percent......................... 7.5 percent of the sum

of reserves and

undivided earnings and

paid-in capital.

1.0-1.74 percent.............................. 10.0 percent of the sum

of reserves and

undivided earnings and

paid-in capital

1.75-2.24 percent............................. 12.0 percent of the sum

of reserves and

undivided earnings and

paid-in capital.

Greater than 2.25 percent..................... 15.0 percent of the sum

of reserves and

undivided earnings and

paid-in capital.

------------------------------------------------------------------------

(2) A deductible may be applied separately to one or more insuring

clauses in a blanket bond. Deductibles in excess of those showing in

this section must have the written approval of NCUA at least 30

calendar days prior to the effective date of the deductibles.

(f) Additional coverage. NCUA may require additional coverage for

any corporate credit union when, in the opinion of NCUA, current

coverage is insufficient. The board of directors of the corporate

credit union must obtain additional coverage within 30 calendar days

after the date of written notice from NCUA.

Sec. 704.19 Wholesale corporate credit unions.

(a) General. Wholesale corporate credit unions are subject to the

preceding requirements of this part, except as set forth in this

section.

(b) Capital. (1) A wholesale corporate credit union will maintain a

minimum capital ratio of 5 percent.

(2) A wholesale corporate credit union shall make reserve transfers

at the lower of .10 percent of its moving daily average net assets or

the amount that would be required under Sec. 704.3(c).

(i) Required transfers are to be made from earnings in either the

prior calendar month or prior twelve-month period. Transfers made

during the prior twelve-month period must be greater than or equal to

the aggregate amount of required reserve transfers for each of the

months in that twelve-month period.

(ii) NCUA and, in the case of state-chartered wholesale corporate

credit unions, the state supervisory authority, must be notified within

30 calendar days of the close of any calendar month in which a

wholesale corporate credit union's required reserve transfer exceeds

earnings for that month. The notice must include the dollar amounts of

the required reserve transfer and earnings for that month and for the

prior twelve-month period. The notice must also provide an explanation

of why the current month's required reserve

[[Page 12948]]

transfer exceeded earnings for that month.

(c) Asset and liability management. (1) In conducting the interest

rate sensitivity analysis set forth in Sec. 704.8(d)(1)(i), a wholesale

corporate credit union must limit its risk exposure to levels that do

not result, at any time, in an NEV ratio below .75 percent or a decline

in NEV of more than 35 percent.

(2) A wholesale corporate credit union must obtain, at its expense,

an annual third-party review of its asset and liability management

modeling system.

Appendix A to Part 704--Model Forms

This appendix contains sample forms intended for use by

corporate credit unions to aid in compliance with the membership

capital account and paid-in capital disclosure requirements of

Sec. 704.2. Corporate credit unions that use this form will be in

compliance with those requirements.

Sample Form 1

Terms and Conditions of Membership Capital Account

(1) A membership capital account is not subject to share

insurance coverage by the NCUSIF or other deposit insurer.

(2) A member credit union may withdraw membership capital with

three years' notice.

(3) Membership capital cannot be used to pledge borrowings.

(4) Membership capital is available to cover losses that exceed

reserves and undivided earnings and paid-in capital.

(5) Where the corporate credit union is liquidated, membership

capital accounts are payable only after satisfaction of all

liabilities of the liquidation estate including uninsured

obligations to shareholders and the NCUSIF.

If the form is used when an account is opened, it must also contain

the following statement:

I have read the above terms and conditions and I understand

them. I further agree to maintain in the credit union's files the

annual notice of terms and conditions of the membership capital

account.

The form must be signed by either all of the directors of the member

credit union or, if authorized by board resolution, the chair and

secretary of the board of the credit union.

If the form is used for the annual notice requirement, it must

be signed by the chair of the corporate credit union. The chair must

then sign a statement which certifies that the form has been sent to

member credit unions with membership capital accounts. The

certification must be maintained in the corporate credit union's

files and be available for examiner review.

Sample Form 2

Terms and Conditions of Paid-In Capital

(1) Paid-in capital is not subject to share insurance coverage

by the NCUSIF or other deposit insurer.

(2) The funds 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.

(3) Paid-in capital is available to cover losses that exceed

reserves and undivided earnings.

(4) Paid-in capital is subordinate to membership capital and the

NCUSIF.

If the form is used when a paid-in capital instrument is

created, it must also contain the following statement:

I have read the above terms and conditions and I understand

them. I further agree to maintain in the credit union's files the

annual notice of terms and conditions of the paid-in capital

instrument.

The form must be signed by either all of the directors of the credit

union or, if authorized by board resolution, the chair and secretary

of the board of the credit union.

If the form is used for the annual notice requirement, it must

be signed by the chair of the corporate credit union. The chair must

then sign a statement which certifies that the form has been sent to

credit unions with paid-in capital accounts. The certification must

be maintained in the corporate credit union's files and be available

for examiner review.

Appendix B to Part 704-- Expanded Authorities and Requirements

A corporate credit union may obtain expanded authorities if it

meets all of the requirements of this part 704, fulfills additional

capital, management, infrastructure, and asset and liability

requirements, and receives NCUA's written approval. The additional

requirements and authorities are set forth in this Appendix and in

the NCUA publication Guidelines for Submission of Requests for

Expanded Authority. A corporate credit union which seeks expanded

authorities must submit to NCUA a self-assessment plan which

analyzes and supports its request. A corporate credit union may

adopt expanded authorities when NCUA has provided final approval. If

NCUA denies a request for expanded authorities, it will advise the

corporate of the reasons for the denial and what it must do to

resubmit its request. NCUA may revoke these expanded authorities at

any time if an analysis indicates a significant deficiency. NCUA

will notify the corporate credit union in writing of the identified

deficiency. A corporate credit union may request, in writing,

reinstatement of the revoked authorities by providing a self-

assessment plan which details how it has corrected these

deficiencies.

(a) In order to participate in the authorities set forth in

paragraphs (b) through (d) of this Part I, a corporate credit union

must:

(1) Have a minimum capital ratio of 5 percent;

(2) Evaluate monthly the changes in NEV, NEV ratio, and net

interest income for the tests set forth in Sec. 704.8(d)(1)(i); and

(3) Regardless of the amount of instruments which possess

unmatched embedded options, conduct periodically, as appropriate,

the tests set forth in Sec. 704.8(d)(2).

(b) A corporate credit union which has met the requirements of

paragraph (a) of this Part I is not bound by the concentration

limits on investments set forth at Sec. 704.6(c)(1) and (2).

Instead, the corporate credit union must establish limits on such

investments as a percentage of the sum of reserves and undivided

earnings and paid-in capital that take into account the relative

amount of credit risk exposure based upon, but not limited to, the

legal and financial structure of the transaction, the collateral,

all other types of credit enhancement, and the term of the

transaction.

(c) A corporate credit union which has met the requirements of

paragraph (a) of this Part I may:

(1) Except for investments in a wholesale corporate credit

union, invest in non secured obligations of any single domestic

issuer up to 150 percent of the sum of reserves and undivided

earnings and paid-in capital;

(2) Purchase long-term investments rated no lower than AA-(or

equivalent);

(3) Purchase asset-backed securities rated no lower than AA (or

equivalent);

(4) Engage in short sales of permissible investments to reduce

interest rate risk;

(5) Purchase principal only (PO) stripped mortgage-backed

securities to reduce interest rate risk;

(6) Purchase CMOs/REMICs using fewer prepayment models than

required in Sec. 704.5(c)(6);

(7) Enter into a repurchase transaction where the collateral

securities are rated no lower than A (or equivalent);

(8) Enter into a dollar roll transaction; and

(9) Engage in when-issued trading, when accounted for on a trade

date basis.

(d) In performing the rate stress tests set forth in

Sec. 704.8(d)(1)(i), the NEV of a corporate credit union which has

met the requirements of paragraph (a) of this Part I may decline as

much as 35 percent.

(e) The maximum aggregate amount in unsecured 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 100 percent of the corporate credit union's

capital. The board of directors will establish the limit, as a

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

for secured loans and irrevocable lines of credit.

Part II

(a) In order to participate in the authorities set forth in

paragraphs (b)-(d) of this Part II, a corporate credit union must:

(1) Have a minimum capital ratio of 6 percent; and

(2) Evaluate monthly the changes in NEV, NEV ratio, and net

interest income for the tests set forth in Sec. 704.8(d)(1)(i); and

(3) Regardless of the amount of instruments which possess

unmatched embedded options, conduct periodically, as appropriate,

the tests set forth in Sec. 704.8(d)(2).

(b) A corporate credit union which has met the requirements of

paragraph (a) of this Part II is not bound by the concentration

limits on investments set forth at Sec. 704.6(c) (1) and (2).

Instead, the corporate credit union must establish limits on such

investments as a percentage of the sum of reserves and undivided

earnings and paid-in capital, that take into account the relative

amount of credit risk exposure based upon, but not

[[Page 12949]]

limited to, the legal and financial structure of the transaction,

the collateral, all other types of credit enhancement, and the term

of the transaction.

(c) A corporate credit union which has met the requirements of

paragraph (a) of this Part II may:

(1) Except for investments in a wholesale corporate credit

union, invest in nonsecured obligations of any single domestic

issuer up to 250 percent of the sum of reserves and undivided

earnings and paid-in capital;

(2) Purchase long-term investments rated no lower than A- (or

equivalent);

(3) Purchase asset-backed securities rated no lower than AA (or

equivalent);

(4) Engage in short sales of permissible investments to reduce

interest rate risk;

(5) Purchase principal only (PO) stripped mortgage-backed

securities to reduce interest rate risk;

(6) Purchase CMOs/REMICs using fewer prepayment models than

required in Sec. 704.5(c)(6);

(7) Enter into a dollar roll transaction; and

(8) Engage in when-issued trading, when accounted for on a trade

date basis.

(d) In performing the rate stress tests set forth in

Sec. 704.8(d)(1)(i), the NEV of a corporate credit union which has

met the requirements of paragraph (a) of this Part II may decline as

much as 50 percent.

(e) The maximum aggregate amount in secured and unsecured 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 be established by the board of directors as a

percentage of the corporate credit union's capital plus pledged

shares.

Part III

(a) A corporate credit union which has met the requirements of

paragraph (a) of either Part I or Part II of this Appendix may

invest in:

(1) Debt obligations of a foreign country; and

(2) Deposits in, the sale of federal funds to, and debt

obligations of foreign banks or obligations guaranteed by these

banks.

(b) All foreign investments are subject to the following

requirements:

(i) Short-term investments must be rated no lower than A-1 (or

equivalent);

(ii) Long-term investments must be rated no lower than AA (or

equivalent);

(iii) A sovereign issuer, and/or the country in which a bank

issuer/guarantor is organized, must be rated no lower than AA (or

equivalent) for political and economic stability;

(iv) A bank issuer/guarantor must be rated no lower than AA;

(v) For each approved foreign bank line, the corporate credit

union must identify the specific banking centers and branches to

which it will lend funds;

(vi) Non secured obligations of any single foreign issuer may

not exceed 150 percent of the sum of reserves and undivided earnings

and paid-in capital; and

(vii) Non secured obligations in any single foreign country may

not exceed 500 percent of the sum of reserves and undivided earnings

and paid-in capital.

Part IV

A corporate credit union which has met the requirements of

paragraph (a) of either Part I or Part II of this Appendix may

engage in derivatives transactions which are directly related to its

financial activities and which have been specifically approved by

NCUA. A corporate credit union may use such derivatives authority

only for the purposes of creating structured instruments and hedging

its own balance sheet and the balance sheets of its members.

PART 709--INVOLUNTARY LIQUIDATION OF FEDERAL CREDIT UNIONS AND

ADJUDICATION OF CREDITOR CLAIMS INVOLVING FEDERALLY INSURED CREDIT

UNIONS IN LIQUIDATION

2. The authority citation for part 709 continues to read as

follows:

Authority: 12 U.S.C. 1766; Pub. L. 101-73, 103 Stat. 183, 530

(1989) (12 U.S.C. 1787 et seq.).

3. Section 709.5 is amended by revising paragraphs (b)(7) and

(b)(8) and adding paragraph (b)(9) to read as follows:

Sec. 709.5 Payout priorities in involuntary liquidation.

* * * * *

(b) * * *

(7) In a case involving liquidation of a corporate credit union,

membership capital;

(8) In a case involving liquidation of a low-income designated

credit union, any outstanding secondary capital accounts issued

pursuant to the authority of Secs. 701.34 or 741.204(c) of this

chapter; and

(9) In a case involving liquidation of a corporate credit union,

paid-in capital.

* * * * *

PART 741--REQUIREMENTS FOR INSURANCE

4. The authority citation for part 741 continues to read as

follows:

Authority: 12 U.S.C. 1757, 1766, and 1781-1790. Section 741.4 is

also authorized by 31 U.S.C. 3717.

5. Section 741.219 is added to read as follows:

Sec. 741.219 Investment requirements.

Any credit union which is insured pursuant to Title II of the Act

must adhere to the requirements stated in part 703 of this chapter

concerning transacting business with corporate credit unions.

[FR Doc. 97-6417 Filed 3-18-97; 8:45 am]

BILLING CODE 7535-01-P