Federal Home Loan Bank Financial Management and Mission Achievement
Federal RegisterSep 27, 1999
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FEDERAL HOUSING FINANCE BOARD
12 CFR Parts 917, 925, 930, 940, 954, 955, 958, 965, 966 and 980
[No. 99-45]
RIN 3069-AA84
Federal Home Loan Bank Financial Management and Mission
Achievement
AGENCY: Federal Housing Finance Board.
ACTION: Proposed rule.
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SUMMARY: The Federal Housing Finance Board (Finance Board) is proposing
to adopt new financial management and mission achievement regulations,
and amend certain existing regulations, for the Federal Home Loan Banks
(Banks). The proposal would modernize policies governing the business
activities of the Banks and, for the first time, would establish
regulatory standards for mission achievement by the Banks and a
definition of mission assets. The proposal includes a risk-based
capital requirement, pursuant to which the amount of capital required
to be maintained by a Bank would be based on the credit, market, and
operations risks to which it is exposed. The risk-based capital regime
builds upon the regulatory framework used by other financial
institution and government-sponsored enterprise (GSE) regulators. The
mission achievement requirement in the proposal would: codify the
authority of the Banks to hold mortgage assets, including mortgage-
backed securities; allow mortgage assets meeting certain regulatory
requirements to be counted as mission assets; and eliminate the use of
the Banks' GSE advantages in issuing debt to fund arbitrage
investments. The proposal also sets forth in the regulation the
responsibilities of the boards of
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directors and senior management of the Banks, as a means of ensuring
that they fulfill their duties in operating the Banks in a safe and
sound manner and in furtherance of their mission. The proposal will
enable the Banks to help their members be more effective competitors in
the housing finance and community lending marketplace, which in turn
will assure that benefits accrue to consumers. In a separate
rulemaking, the Finance Board is proposing to reorganize its
regulations in a more logical arrangement and to reflect the revisions
to be made by this proposal.
DATES: Comments on this proposed rule must be received in writing on or
before December 27, 1999.
ADDRESSES: Comments should be mailed to: Elaine L. Baker, Secretary to
the Board, Federal Housing Finance Board, 1777 F Street, NW,
Washington, DC 20006. Comments will be available for public inspection
at this address.
FOR FURTHER INFORMATION CONTACT: James L. Bothwell, Director and Chief
Economist, (202) 408-2821; Scott L. Smith, Deputy Director, (202) 408-
2991; Julie Paller, Senior Financial Analyst, (202) 408-2842; Ellen E.
Hancock, Senior Financial Analyst, (202) 408-2906; Austin Kelly, Senior
Financial Economist, (202) 408-2541; or Syed Ahmad, Senior Financial
Economist, (202) 408-2870; Office of Policy, Research and Analysis,
Federal Housing Finance Board, 1777 F Street, NW, Washington, DC 20006.
SUPPLEMENTARY INFORMATION:
I. Overview of Proposal
The proposed rule would establish new financial management and
mission achievement requirements for the Banks, including: (1) a
capital provision that would incorporate both minimum total capital and
risk-based capital elements; (2) provisions linking the GSE debt
funding advantage to activities that further the mission of the Banks
(as set forth in the new regulatory definition), thus eliminating GSE
debt-funded arbitrage investments and authorizing the Banks to hold
``member mortgage assets''; and (3) provisions defining the
responsibilities--and thus the accountability--of the boards of
directors and senior management of the Banks. The proposal would give
the Banks greater flexibility to manage their business so as to better
serve their members and fulfill their public purpose, while operating
within a risk-based capital framework that ensures the safety and
soundness of the Bank System.
A. Capital Requirements
Under current law, the amount of capital a Bank must hold is
determined not by the risks inherent in its portfolio or business
practices, but by the asset size of, or the dollar amount of advances
outstanding to, its members. Specifically, a member must maintain a
minimum investment in the capital stock of its Bank in an amount equal
to the greater of: (1) 1 percent of the member's mortgage assets; (2)
0.3 percent of the member's total assets; or (3) 5 percent of total
advances outstanding to the member (with a somewhat higher percentage
for any member that is not a ``qualified thrift lender''). See 12
U.S.C. 1426(b)(1), (b)(2), (b)(4); 1430(c), (e)(1), (e)(3); 12 CFR
933.20(a).
The Banks currently operate in accordance with the Finance Board's
Financial Management Policy (FMP), under which risk management is
accomplished principally through a list of specific restrictions and
limitations on the Banks' investment practices and a leverage limit
which prohibits Banks from incurring liabilities in the form of
consolidated obligations (COs) or unsecured senior liabilities in an
amount greater than twenty times their capital stock. See 62 FR 13146
(Mar. 19, 1997); Finance Board Res. No. 96-45 (July 3, 1996), as
amended by Finance Board Res. No. 96-90 (Dec. 6, 1996), Finance Board
Res. No. 97-05 (Jan. 14, 1997), and Finance Board Res. No. 97-86 (Dec.
17, 1997). Though this approach has served the purpose of ensuring the
safety and soundness of the Bank System, it lacks the flexibility that
would enable the Banks to fulfill their mission to the maximum extent.
To ensure that the risks taken by a Bank are adequately supported
by its capital, the proposal would implement, for the first time, a
risk-based capital requirement for the Banks, which builds upon the
risk-based capital regimes of other federal financial institution
regulators. Under the proposed rules, the amount of capital to be held
by each Bank would depend, in part, on the risks--credit risk, market
risk, and operations risk--to which the Bank is exposed. The credit
risk capital requirement would be set according to credit ratings and
the associated historical default and recovery data made available by
nationally-recognized statistical rating organizations (NRSROs). This
approach would improve on the broad credit risk weighting categories
set forth in the Basle Accord in 1988 \1\ by determining the credit
risk capital component based on the risk of an instrument rather than
the type of instrument.
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\1\ The risk-based capital standards of the other federal bank
regulatory agencies are based on the document entitled
``International Convergence of Capital Measurement and Capital
Standards'' (July 1988) (the Basle Accord). The Basle Accord was
agreed to by the Basle Committee on Banking Supervision (BCBS) which
comprises representatives of the central banks and supervisory
authorities of the Group of Ten countries (Belgium, Canada, France,
Germany, Italy, Japan, Netherlands, Sweden, Switzerland, United
Kingdom, United States and Luxembourg). The BCBS meets at the Bank
for International Settlements, Basle, Switzerland. The Basle Accord
defines bank capital and sets credit risk-based capital standards
for on-and off-balance sheet instruments. The Basle Accord has been
amended many times with the most significant amendment entitled
``Amendment to the Capital Accord to Incorporate Market Risks''
(Jan. 1996) (the Amendment). The Amendment sets specific risk-based
capital standards for instruments held in trading portfolios of
commercial banks. For debt instruments, the specific risk is defined
by the Amendment as credit and event risk. In addition, the
Amendment incorporates a measure of the market risk due to interest
rates, foreign exchange rates, equity prices and commodity prices
for all instruments held in trading portfolio (trading book); and
foreign exchange and commodity risks for instruments held in non-
trading portfolio (banking book). The BCBS issued a consultative
paper entitled ``A New Capital Adequacy Framework'' (June 1999) (the
Framework) that introduces a new framework to replace the Basle
Accord.
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A Bank's market risk capital requirement would be equal to the
market value of the Bank's portfolio at risk from changes in interest
rates, foreign exchange rates, and commodity and equity prices during
periods of extreme market stress, as determined in accordance with
internal market risk models to be developed by each Bank. A Bank would
be required to assess its market values at risk regularly through
stringent stress testing of its entire portfolio, including both on-
balance sheet assets and liabilities and off-balance sheet items, as
well as related options. By comparison, large commercial banks are
required to conduct such assessments only for their trading account and
for certain other assets, leaving out much bank business from the value
at risk calculation.
The operations risk capital requirement proposed would be equal to
30 percent of the combined amount of capital required for credit and
market risks. This is consistent with the statutory requirement for
operations risk capital imposed on the Federal National Mortgage
Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation
(Freddie Mac). See 12 U.S.C. 4611(c)(2).
In addition to the risk-based capital requirement, the proposal
would establish a minimum total capital requirement that would require
each Bank to maintain total capital of not less than 3.0 percent of its
total assets, regardless of its risk profile, although
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the Finance Board could require a greater amount in individual
cases.\2\
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\2\ By comparison, the statutory minimum total capital
requirement for the other housing GSEs--Fannie Mae and Freddie Mac--
is 2.5 percent of on-balance sheet assets plus, generally, 0.45
percent of off-balance sheet items. See 12 U.S.C. 4612(a).
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B. Mission Achievement
The principal source of funding for the Banks is the COs that are
issued in the global capital markets and for which the twelve Banks are
jointly and severally liable. Because of the Banks' GSE status, the
costs to the Banks of obtaining such funding are substantially less
than the borrowing costs for comparable debt issued by other entities.
The Banks pass the benefit of this funding advantage to their members
through wholesale loans (called advances) priced lower than the members
could otherwise obtain to provide support for housing finance,
including community lending, in fulfillment of the Banks' mission.
The FMP does not expressly require the Banks to use any particular
percentage of the funds obtained through the issuance of COs to provide
advances to their members. In large part due to the financial burdens
imposed on the Banks as a result of the savings and loan crisis, the
Banks began in 1991 to use a portion of the proceeds from COs to
finance investments which the Finance Board does not consider to be
adequately related to their statutory mission. The level of such non-
mission-related investments rose substantially in the early 1990s, but
has begun to decline appreciably, as a percent of assets, in recent
years, as the membership base of the Bank System and the level of
advances outstanding to members have increased.
To better link the GSE advantages in the capital markets to the
mission performance of the Bank System, the proposed rule would
require, by January 1, 2005, that an amount equal to 100 percent of
each Bank's outstanding COs be held by the Bank in core mission
activities. ``Core mission activities'' would be defined as those
activities that assist and enhance members' and eligible nonmember
borrowers' \3\ financing of housing and community lending. Included in
this definition are advances and also a newly authorized class of
investments to be called ``member mortgage assets.'' The transition
period is intended to allow the Banks sufficient time to restructure
their balance sheets as necessary to bring the level of core mission
activities in line with the amount of outstanding COs.
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\3\ Section 10b of the Federal Home Loan Bank Act, 12 U.S.C.
1430b, provides that certain nonmember mortgagees making targeted
housing loans may apply for access to Bank advances.
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The proposed core mission activity requirement would be subordinate
to the safe and sound financial operation of the Banks, as mandated by
the Federal Home Loan Bank Act (Act). See 12 U.S.C. 1422a(a)(3)(A).
During any specified period in which a Bank's board of directors
determines that the core mission activities requirement would be
inconsistent with the safe and sound operation of the Bank, the Bank
would be permitted to be out of compliance with the core mission
activities requirement.
By establishing the core mission activities requirement at 100
percent of COs outstanding, the proposed rule will both permit and
encourage the Banks to develop new products and business activities
(such as member mortgage assets, discussed below) that: further the
statutory mission of the Banks; build upon the cooperative nature of
the Bank's relationship with its members; meet the core mission
activities definition in the proposed rule; and are supported by
appropriate levels of capital.
C. Responsibilities of Bank Boards of Directors and Senior Management
Because it allows the Banks substantially greater authority to
acquire new assets and manage their risks, and to raise member capital
accordingly, the proposed rule also would articulate certain minimum
responsibilities of the Banks' boards of directors and senior
management with regard to operating the Banks in a safe and sound
manner and ensuring that the Banks achieve their statutory mission.
These responsibilities include matters such as the adoption and annual
review of risk management policies, periodic risk assessments, the
maintenance of effective internal controls, independent audit
committees, and adoption and review of and compliance with mission
achievement policies.
D. Reorganization of Finance Board Regulations
Because of the comprehensive nature of the amendments that would be
made by the proposal, the Finance Board separately is proposing to
reorganize its regulations in order that the revised regulations will
remain internally consistent and will reflect the proposed changes in a
logical manner. Cross-references appearing in the text of the proposed
rule are made to the new section and part numbers that would be in
effect once the reorganization regulation is finalized. Where such
references are to provisions that currently exist under different
section or part numbers, the existing citation has been noted in this
preamble. For ease of reference, this proposed reorganization
regulation is also being published in this edition of the Federal
Register.
E. Public Hearing
The Finance Board will hold a public hearing on this proposal.
Persons interested in participating in the public discussion of the
proposed rule should contact Karen H. Crosby, Director, Office of
Strategic Planning, in writing at the Federal Housing Finance Board,
1777 F St. NW, Washington, DC, 20006, by the close of business October
15, 1999.
II. Statutory and Regulatory Background
A. The Bank System
The twelve Banks are instrumentalities of the United States
organized under the authority of the Act. See 12 U.S.C. 1423, 1432(a).
The Banks are cooperatives; only members of a Bank may own the capital
stock of a Bank and only members or certain eligible nonmember
borrowers (such as state housing finance agencies) may obtain access to
the products provided by a Bank. See 12 U.S.C. 1426, 1430(a), 1430b.
Each Bank is managed by its own board of directors and serves the
public by enhancing the availability of residential mortgage and
community lending credit through its members and eligible nonmembers.
See 12 U.S.C. 1427. Any eligible institution (typically, an insured
depository institution) may become a member of a Bank by satisfying
certain criteria and by purchasing a specified amount of the Bank's
capital stock. See 12 U.S.C. 1424, 1426, 1430(e)(3); 12 CFR part 933.
As GSEs, the Banks are granted certain privileges that enable them to
borrow funds in the capital markets on terms more favorable than could
be obtained by other entities. Typically, the Bank System can borrow
funds at a modest spread over the rates on U.S. Treasury securities of
comparable maturity. The Banks pass along their GSE funding advantage
to their members--and ultimately to consumers--by providing advances
(secured loans) and other financial services at rates that would not
otherwise be available to their members.
Together with the Office of Finance, the twelve Banks comprise the
Bank System, which operates under the supervision of the Finance Board,
an independent agency in the executive branch of the U.S. government.
The primary duty of the Finance Board is to
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ensure that the Banks operate in a financially safe and sound manner;
consistent with that duty the Finance Board is required to supervise
the Banks, ensure that they carry out their housing finance mission,
and ensure that they remain adequately capitalized and able to raise
funds in the capital markets. 12 U.S.C. 1422a(a)(3)(A), (B).
B. The Banks' Housing Finance and Community Lending Mission
Under section 10 of the Act and part 935 of the Finance Board's
regulations, the Banks have broad authority to make advances in support
of housing finance, which includes community lending. See 12 U.S.C.
1430(a), (i), (j); 12 CFR part 935. The Banks also are required to
offer two programs--the Affordable Housing Program (AHP) and the
Community Investment Program (CIP)--to provide subsidized or at-cost
advances, respectively, in support of unmet housing finance or targeted
economic development credit needs. See 12 U.S.C. 1430(i), (j); 12 CFR
parts 960, 970. In addition, section 10(j)(10) of the Act, as
implemented by a recently issued Finance Board regulation, authorizes
the Banks to establish Community Investment Cash Advance (CICA)
Programs for community lending, defined as providing financing for
economic development projects for targeted beneficiaries. See 12 U.S.C.
1430(j)(10); 12 CFR part 970; 63 FR 65536 (Nov. 27, 1998).
C. Investment Authority and Oversight
The Banks' investment authority is set forth primarily in sections
11(h) and 16(a) of the Act, which govern the investment of the Banks'
surplus and reserve funds, respectively. See 12 U.S.C. 1431(h),
1436(a). Under both of these sections, the Banks are authorized to
invest in: obligations of the United States; certain obligations of
Fannie Mae, the Government National Mortgage Association (Ginnie Mae),
or Freddie Mac; and in such securities in which fiduciary and trust
funds may be invested under the law of the state in which the Bank is
located. Section 11(h) also authorizes investments in the securities of
certain small business investment companies (SBIC).
In addition to those permissive investments, the Banks are required
to have liquidity reserves in an amount equal to deposits from their
members invested in obligations of the United States, deposits in banks
or trust companies, and certain specified short-term advances to their
members. See 12 U.S.C. 1431(g).
Currently, the Finance Board regulates the Banks' investment
practices through its regulations, as well as through the FMP. Section
934.1 of the regulations provides that the Banks may acquire or dispose
of investments only with the prior approval of the Finance Board, or in
conformity with authorizations of the Finance Board or ``stated
[Finance] Board policy.'' 12 CFR 934.1. By resolution, the Finance
Board adopted the FMP, in part, as its ``stated policy'' regarding
permissible Bank investments. The FMP generally provides a framework
within which the Banks may implement their financial management
strategies in a prudent and responsible manner. Specifically, the FMP
identifies the types of investments that the Banks may purchase
pursuant to their statutory investment authority and, therefore, by
implication, prohibits any investments not specifically identified by
the FMP. The FMP also includes a series of guidelines relating to the
funding and hedging practices of the Banks, as well as to the
management of their credit, interest rate and liquidity risks, and
establishes liquidity requirements in addition to those required by
statute, as noted above. See FMP sections III-VII.
The FMP evolved from a series of policies and guidelines initially
adopted by the Finance Board's predecessor agency, the Federal Home
Loan Bank Board (FHLBB), which had adopted guidelines comparable to the
FMP in the 1970s and revised them a number of times thereafter. The
Finance Board adopted the FMP in 1991, consolidating into one document
the previously separate policies on funds management, hedging and
interest rate swaps, and adding new guidelines on management of
unsecured credit and interest rate risks. As discussed in considerably
more detail below, this proposed rule would supersede the FMP as the
Finance Board's means of overseeing the investment practices and
mission achievement of the Banks.
III. Analysis of Proposed Rule
A. Part 917--Responsibilities of Bank Boards of Directors and Senior
Management
1. Overview
Each state generally has laws of incorporation that require, among
other things, a corporation to be managed by a board of directors.
Consistent with this general corporate concept, the Act provides for
the management of each Bank to be vested in the Bank's board of
directors. See 12 U.S.C. 1427(a). The Act states that each Bank is a
corporate body. See id. at 1432(a). In addition to authorizing certain
enumerated corporate and banking powers, see id. at 1431, 1432, the Act
grants each Bank all such incidental powers as are consistent with the
provisions of the Act and customary and usual in corporations
generally. See id. The Finance Board believes that, attendant to the
exercise of customary and usual corporate powers, the Banks' boards of
directors are subject to the same general fiduciary duties of care and
loyalty to which the board of a state-chartered business or banking
corporation would be subject, although this previously has not been set
forth in regulation.
The duties, responsibilities and privileges of a director of a Bank
derive from a source different from that of a director of a state-
chartered business or banking corporation. Each Bank is created in
accordance with Federal law to further public policy, and its statutory
powers and purposes are not subject to change except by the Congress. A
Bank's board of directors has neither the right nor the duty to alter
the purpose of the Bank, whereas an ordinary corporate board of
directors may approve mergers, consolidations and changes in the
corporate charter that could drastically alter the objectives and
nature of the business of the corporation. The directors of a Bank are
responsible for managing that Bank to achieve the statutorily-mandated
objectives of promoting housing finance and community lending and
meeting the Bank's statutory obligations (e.g., paying a portion of the
interest on obligations of the Resolution Funding Corporation
(REFCORP), see id. at 1441b, and making contributions to the AHP, see
id. at 1430(j)), all in a financially safe and sound manner.
All Banks are subject to the supervision of the Finance Board.
Although the directors manage and control their Banks, they may act
only within the parameters established by the Finance Board. The bulk
of the Banks' corporate powers, duties and responsibilities are
described in sections 10, 11, 12 and 16 of the Act. Id. at 1430, 1431,
1432 and 1436. Section 10 of the Act authorizes each Bank to make
secured advances to its members upon collateral sufficient, in its
judgment, to fully secure the advance, and to certain eligible
nonmember borrowers upon statutorily specified collateral. See id.
1430(a), 1430b. The Banks may conduct correspondent services, establish
reserves, make investments and pay dividends, all subject to statutory
limitations. See id. at 1431, 1436. Under section 12(a) of the Act, a
Bank, and hence any director of that Bank, has the power to sue and be
sued. See id. at 1432(a). In addition, each Bank has adopted bylaws
that address such
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matters as: the conduct of meetings of the board of directors;
existence, composition, conduct and administration of committees of the
board of directors; and indemnification.
Proposed part 917 for the first time would set forth in one place
and in regulation the duties and responsibilities of a Bank's board of
directors and of senior management of the Bank. It will make clear the
Finance Board's belief that oversight of management by a strong and
proactive board of directors is critical to the safe and successful
operation of a Bank. Under proposed part 917, the board of directors of
each Bank shall be responsible for: approving and periodically
reviewing the significant policies of the Bank; understanding the major
risks taken by the Bank, setting acceptable tolerance levels for these
risks and ensuring that senior management takes the steps necessary to
identify, measure, monitor and control these risks; monitoring that the
Bank is in compliance with applicable statutes, regulation and policy
(both of the Finance Board and the Bank); ensuring that the Bank
carries out its housing finance and community lending mission;
approving the organizational structure and delegations of authority;
and ensuring that an adequate and effective system of internal controls
is established and maintained and that senior management is monitoring
the effectiveness of the internal control system.
Proposed part 917 provides that senior management of each Bank
shall be responsible for implementing strategies and policies approved
by the Bank's board; developing processes that identify, measure,
monitor and control risks incurred by the Bank; maintaining an
organizational structure that clearly assigns responsibility, authority
and reporting relationships; ensuring that delegated responsibilities
are effectively carried out; setting appropriate internal control
policies; and monitoring the adequacy and effectiveness of the internal
control system.
The proposed requirements for the Banks' boards of directors and
senior management generally are based on widely accepted best corporate
practices. They are intended to augment the responsibilities,
independence and expertise of the boards of directors by requiring them
to oversee both risk management for safety and soundness and
achievement of the public purpose of supporting housing and targeted
economic development. Oversight by both the boards of directors and
senior management is integral to the overall business operation of the
Bank. The first line of defense in ensuring safety and soundness has to
be an effective corporate governance structure within the Banks
themselves. Having an active, informed and engaged board of directors
is the cornerstone of a well-run entity.
In addition, recognition of the importance of mission achievement
must originate with the board of directors and fulfillment of mission
at all levels of the Bank must be promoted and encouraged by the board.
The requirements contained in the proposed rule are intended to ensure
that the boards of directors of the Banks give serious consideration to
these important responsibilities.
2. General Duties of Bank Boards of Directors--Sec. 917.2
Proposed Sec. 917.2 provides that each Bank's board of directors
shall have the general duty to direct the operations of the Bank in
conformity with the requirements of the Finance Board's regulations.
Proposed Sec. 917.2 further provides that each board director shall
carry out his or her duties as director in good faith, in a manner such
director believes to be in the best interests of the Bank, and with
such care, including reasonable inquiry, as an ordinarily prudent
person in a like position would use under similar circumstances.
3. Risk Management--Sec. 917.3
Section 917.3 of the proposed rule sets forth the risk management
responsibilities of Bank boards of directors and senior management.
Proposed Sec. 917.3(a)(1) would require that, within 180 calendar days
of the adoption of the rule in final form, each Bank's board of
directors shall adopt a risk management policy addressing the Bank's
exposure to credit risk, market risk, liquidity risk, business risk and
operations risk in a manner consistent with the substantive risk
management requirements set forth in part 930 of the proposed rule. The
risk limits set forth in the policy shall be consistent with the Bank's
capital position and its ability to measure and manage risk. Under
proposed Sec. 917.3(a)(1), a Bank will be required to submit its
initial risk management policy to the Finance Board for approval;
subsequent versions of the policy or amendments would not be required
to be submitted to, or approved by, the Finance Board. However, Bank
risk management policies will be reviewed by the Finance Board as part
of the ongoing examination process.
Proposed Sec. 917.3(a)(2)(i) would require that the Bank's board of
directors review the Bank's risk management policy on at least an
annual basis. Proposed Sec. 917.3(a)(2)(iii) provides that the board of
directors also would be required to re-adopt the risk management
policy, including interim amendments, not less often than every three
years, as appropriate based on the board's reviews of the policy. In
addition to providing consistency, this requirement is intended to
ensure that, despite the turnover in board personnel that will occur
over a number of years, all or most current members of a Bank's board
of directors will be thoroughly familiar with the Bank's risk
management policy, will have given meaningful consideration to its
provisions and will have expressed an opinion regarding the adequacy of
the policy through the voting process. Proposed Sec. 917.3(a)(2)(iv)
also would make clear that each Bank's board of directors has the
ultimate responsibility to ensure that the Bank is in compliance at all
times with the risk management policy.
Section 917.3(b) of the proposed rule sets forth several specific
requirements for each Bank's risk management policy. Proposed
Sec. 917.3(b)(1) would require that each Bank's risk management policy
describe how the Bank will comply with the risk-based capital standards
set forth in proposed part 930. Proposed Sec. 917.3(b)(2) would require
each Bank's risk management policy to set forth tolerance levels for
the market and credit risk components.
Proposed Sec. 917.3(b)(3) requires each Bank's risk management
policy to set forth standards for the Bank's management of credit,
market, liquidity, business and operations risks. Credit risk is
defined in proposed Sec. 930.1 as the risk that an obligation will not
be paid in full and loss will result. The Banks must assess the
creditworthiness of issuers, obligors, or other counterparties prior to
acquiring investments and, under proposed Sec. 917.3(b)(3)(i), the
Bank's risk management policy would be required to include the
standards and criteria for such an assessment. In addition, the credit
risk portion of each Bank's risk management policy also should identify
the criteria for selecting brokers, dealers and other securities firms
with which the Bank may execute transactions.
Market risk is defined in proposed Sec. 930.1 as the risk of loss
in value of the Bank's portfolio resulting from movements in market
prices. Under proposed Sec. 930.6, each Bank would be required to have
in place a comprehensive market risk management model that allows the
Bank to estimate in a timely manner the value of the portfolio at risk
from changes in market prices under various stress scenarios.
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Proposed Sec. 917.3(b)(3)(ii) would require that each Bank's risk
management policy establish standards for the methods and models used
to measure and monitor market risk, including maximum exposure
thresholds and scenarios for measuring risk exposure.
Liquidity risk is defined in proposed Sec. 917.1 as the risk that a
Bank would be unable to meet its obligations as they come due or meet
the credit needs of its members and eligible nonmember borrowers in a
timely and cost-efficient manner. Operational liquidity addresses day-
to-day or ongoing liquidity needs under normal circumstances.
Operational liquidity needs may be either anticipated or unanticipated.
Contingency liquidity addresses the same liquidity needs, but under
abnormal or unusual circumstances in which a Bank's access to the
capital markets is impeded. This impediment may result from a market
disruption, operational failure, or real or perceived credit problems.
Proposed Sec. 917.3(b)(3)(iii) would require that each Bank's risk
management policy indicate the Bank's sources of liquidity, including
specific types of investments to be held for liquidity purposes, and
the methodology to be used for determining the Bank's operational and
contingency liquidity needs. The proposed new liquidity requirements
are addressed in more detail below in the discussion of proposed
Sec. 930.10.
Operations risk is defined in proposed Sec. 930.1 as the risk of an
unexpected loss to a Bank resulting from human error, fraud,
unenforceability of legal contracts, or deficiencies in internal
controls or information systems. Proposed Sec. 917.3(b)(3)(iv) would
require each Bank's risk management policy to address operations risk
by setting forth standards for an effective internal control system (as
described in more detail below), including periodic testing and
reporting.
Business risk is defined in proposed Sec. 930.1 as the risk of an
adverse impact on a Bank's profitability resulting from external
factors as may occur in both the short and long run. Such factors
include: continued financial services industry consolidation; declining
membership base; concentration of borrowing among members; and
increased inter-Bank competition. Proposed Sec. 917.3(b)(3)(v) would
require that each Bank's risk management policy identify these risks
and include strategies for mitigating such risks, including contingency
plans where appropriate.
In order for each Bank to create and maintain a meaningful risk
management policy, it is important that the boards of directors be
cognizant of the strategic risks facing the Bank. Therefore, proposed
Sec. 917.3(c) would require that senior management of each Bank
perform, at least annually, a written risk assessment that identifies
and evaluates all material risks, including both quantitative and
qualitative aspects, that could adversely affect the achievement of the
Bank's performance objectives and compliance requirements. Proposed
Sec. 917.3(c) also requires that the risk assessment be in written form
and be reviewed by the Bank's board of directors promptly upon its
completion.
4. Internal Control System--Sec. 917.4
While the existing FMP requires that management of each Bank
establish internal control systems, there is no guidance provided on
how to ascertain the sufficiency of the systems. There have been
several instances where internal control weaknesses have been uncovered
through the Finance Board's examination process. As a result, the
Finance Board believes it prudent to provide more specific requirements
for the internal control process that should be in place at each Bank.
In developing requirements for internal control processes for the
Banks, the Finance Board reviewed the available literature on the
appropriate internal control systems for financial institutions.
Included in this review was the BCBS's Framework for Internal Control
Systems published in September 1998 (hereinafter Basle Committee
Report) and the Committee of Sponsoring Organizations of the Treadway
Commission's Internal Control--Integrated Framework Report published in
September 1992 (hereinafter Treadway Commission). The recommendations
contained in these Reports are considered to be state of the art for
defining, implementing, monitoring, and evaluating internal control
systems.
According to the Basle Committee Report, a system of effective
internal controls is a critical component of bank management and a
foundation for safe and sound operation of a banking organization. A
strong system of internal controls can help a bank meet its goals and
objectives, achieve long-term profitability targets, and maintain
reliable financial and managerial reporting. An internal control system
also can help to: (1) Ensure the bank is in compliance with laws,
regulations and the bank's internal policies and procedures; (2)
safeguard assets; and (3) decrease the risk of damage to the bank's
reputation.
The Treadway Commission Report defines internal controls as a
process, effected by the board of directors, management and other
personnel, designed to provide reasonable assurance regarding the
achievement of objectives in the: (1) Effectiveness and efficiency of
operations; (2) reliability of financial reporting; and (3) compliance
with applicable laws and regulations.
Both Reports discuss basic components or principles for
establishing and assessing internal control--management oversight and
the control environment, risk recognition and assessment, control
activities and segregation of duties, information and communication,
and monitoring activities and correcting deficiencies.
The provisions of Sec. 917.4 of the proposed rule were adapted from
the basic components and principles in the Basle Committee and Treadway
Commission Reports. The Finance Board believes that appropriate
internal controls will be critical to successful implementation of this
regulation. The proposed rule would provide the framework for an
effective internal control system, and establish senior management and
board of directors' responsibilities regarding internal controls.
Proposed Sec. 917.4 addresses the requirements for a Bank's
internal control systems. Proposed Sec. 917.4(a)(1) would require each
Bank to establish and maintain an effective internal control system
adequate to ensure: the efficiency and effectiveness of Bank
activities; the safeguarding of assets; the reliability, completeness
and timely reporting of financial and management information and
transparency of such information to the Bank's board of directors and
to the Finance Board; and compliance with applicable laws, regulations,
policies, supervisory determinations and directives of the Bank's board
of directors and senior management.
Proposed Sec. 917.4(a)(2) enumerates certain minimum ongoing
internal control activities that the Finance Board considers to be
necessary in order for the internal control objectives described in
proposed Sec. 917.4(a)(1) to be achieved. These activities include: top
level reviews by the Bank's board of directors and senior management;
activity controls, including review of standard performance and
exception reports; physical controls adequate to ensure the
safeguarding of assets; monitoring for compliance with the risk
tolerance limits set forth in the risk management policy that would be
required under proposed Sec. 917.3(a); any required approvals and
authorizations for specific activities; and any required
[[Page 52169]]
verifications and reconciliations for specific activities.
Section 917.4(b) of the proposed rule would charge each Bank's
board of directors with the responsibility of directing the
establishment and maintenance of the internal control system by senior
management, and overseeing senior management's implementation of the
system on a continuing basis. Under proposed Sec. 917.4(b), specific
board actions necessary to fulfill these responsibilities would
include: conducting periodic discussions with senior management
regarding the effectiveness of the internal control system; ensuring
that an effective and comprehensive internal audit of the internal
control system is performed annually; ensuring that the Bank's board of
directors receives reports on internal control deficiencies in a timely
manner and that such deficiencies are addressed promptly; conducting a
timely review of evaluations of the effectiveness of the internal
control system made by auditors and Finance Board examiners; ensuring
that senior management promptly and effectively addresses
recommendations and concerns expressed by auditors and Finance Board
examiners regarding weaknesses in the internal control system;
reporting internal control deficiencies, and the corrective action
taken, to the Finance Board in a timely manner; establishing,
documenting and communicating an clear and effective organizational
structure for the Bank; ensuring that all delegations of board
authority state the extent of the authority and responsibilities
delegated; and establishing reporting requirements.
Section 917.4(c) of the proposed rule would charge each Bank's
senior management with the responsibility to establish, implement and
maintain the internal control system under the direction of the Bank's
board of directors. Under proposed Sec. 917.4(c), specific actions on
the part of senior management that would be necessary to fulfill these
responsibilities include: establishing, implementing and effectively
communicating to Bank personnel policies and procedures that are
adequate to ensure that internal control activities necessary to
maintain an effective internal control system are an integral part of
the daily functions of all Bank personnel; ensuring that all Bank
personnel fully understand and comply with all policies and procedures;
ensuring that there is appropriate segregation of duties among Bank
personnel and that personnel are not assigned conflicting
responsibilities; establishing effective paths of communication
throughout the organization in order to ensure that Bank personnel
receive necessary and appropriate information; developing and
implementing procedures that translate the major business strategies
and policies established by the board of directors into operating
standards; ensuring adherence to the lines of authority and
responsibility established by the Bank's board of directors; overseeing
the implementation and maintenance of management information and other
systems; establishing and implementing an effective system to track
internal control weaknesses and the actions taken to correct them; and
monitoring and reporting to the Bank's board of directors the
effectiveness of the internal control system on an ongoing basis.
5. Audit Committees--Sec. 917.5
Section 917.5 of the proposed rule addresses requirements for the
establishment of an audit committee by each Bank's board of directors.
Current Finance Board requirements for audit committees are contained
in Finance Board Res. No. 92-568.1 (July 22, 1992) and Finance Board
Advisory Bulletin 96-1 (Feb. 29, 1996).
Resolution No. 92-568.1 contains guidelines intended to be the
minimum standards that should be adopted by the Banks for revisions of
the respective audit charters. The guidelines require that: audit
committee charters include a statement of the audit committee's
responsibilities, including a statement of its purpose to assist the
full board of directors in fulfillment of its fiduciary
responsibilities; the audit committee shall consist of at least three
board members and shall include appointed directors and elected
directors; that in determining the membership of the audit committee,
the board of directors should provide for continuity of service; the
audit committee shall meet at least twice annually with the audit
director and the audit committee shall meet in executive session with
both the audit director and the external auditors at least annually;
the audit committee shall oversee the selection, compensation, and
performance evaluation of the audit director; written minutes shall be
prepared for each meeting and a copy of such minutes forwarded to the
Finance Board; and the charters of the audit director and audit
committee shall be reviewed and approved at least annually by the audit
committee and the board of directors, respectively.
Advisory Bulletin 96-1 communicated examination findings regarding
certain Bank practices that may tend to reduce the independence of the
internal audit function, specifically the processes by which Bank audit
director compensation is determined and performance is evaluated. The
Bulletin indicated that examiners would review measures taken by the
audit committee to assure the independence from management of the
internal audit function, and to fulfill its responsibility to select,
set the compensation of, and evaluate the performance of the audit
director, and specified that all Bank audit committees should review
their current practices and revise these as appropriate.
Proposed Sec. 917.5 codifies into regulation the Finance Board's
existing policy on requiring the Banks to have audit committees and
adds requirements addressing their independence and their
responsibilities for oversight of Bank operations. The proposed
requirements for audit committees are based on standard corporate
requirements and best practices. In developing the appropriate
requirements for Bank audit committees, the Finance Board reviewed the
audit committee regulations of other financial institution regulatory
agencies and the Report and Recommendations of the Blue Ribbon
Committee on Improving the Effectiveness of Corporate Audit Committees
(February 8, 1999) (hereinafter Blue Ribbon Committee Report). The
Securities and Exchange Commisssion encouraged the New York Stock
Exchange and the National Association of Securities Dealers to form a
private sector body to investigate perceived problems in financial
reporting. Accordingly, the Blue Ribbon Committee was formed in October
1998 to take an objective look at U.S. corporate financial reporting,
specifically assessing the current mechanisms for oversight and
accountability among corporate audit committees, independent auditors,
and financial and senior management.
Proposed Sec. 917.5(a) would require that each Bank's board of
directors establish an audit committee. Proposed Sec. 917.5(b) would
require that each Bank's audit committee consist of five or more board
directors, each of whom meets the independence criteria discussed
below, and include a balance of representatives of large and small
members and of appointed and elected directors of the Bank. The
requirement in proposed Sec. 917.5(b) that the audit committee comprise
five or more persons differs from the recommendation of the Blue Ribbon
Committee Report that the audit
[[Page 52170]]
committee comprise a minimum of three directors. The Finance Board
believes it is important that the audit committee include
representatives of large and small members and appointed and elected
directors of the Bank in order to prevent dominance by one particular
individual or group of individuals. A minimum of five members is
necessary to ensure that the audit committee will have such diverse
representation.
The terms of audit committee members must be appropriately
staggered to provide for continuity of service, and to avoid a
complete, or substantial, turnover of the membership of the audit
committee in any one year. All members of the audit committee would be
required to have a working familiarity with basic finance and
accounting principles, with at least one member having extensive
accounting or financial management expertise. This requirement is
intended to ensure that audit committee members have the ability to
read and understand the Bank's balance sheet and income statement and
to ask substantive questions of internal and external auditors. The
Finance Board recognizes that, in some cases, a Bank's board of
directors may not include enough members with expertise sufficient for
the demands of service on the audit committee, considering the
representation requirements. Thus, proposed Sec. 917.5(b)(4) would
require that, if such familiarity or expertise is lacking among current
board directors, the board of directors shall, in the case of appointed
directors, notify the Finance Board or, in the case of elected
directors, include in the notice of election required under
Sec. 915.6(a) (existing Sec. 932.6(a)), a statement describing the
skills or expertise needed.
In addition, proposed Sec. 917.5(c) would require that any board
director serving on the audit committee be sufficiently independent of
the Bank and its management so as to maintain the ability to make the
type of objective judgments that are required of audit committee
members. The proposed independence criteria were adapted from the Blue
Ribbon Committee Report, which states that ``common sense dictates that
a director without any financial, family, or other material personal
ties to management is more likely to be able to evaluate objectively
the propriety of management's accounting, internal control and
reporting practices.'' The Finance Board agrees that the independence
of the directors serving on the audit committee is of great importance.
Proposed Sec. 917.5(c) describes several examples, which are not
intended to include all possible examples, of relationships that would
call into question the independence of an audit committee member and
that, therefore, would disqualify any director having such a
relationship with the Bank or its management from serving on the audit
committee. The list is not intended to be exhaustive, because it is
impossible to foresee all potential individual circumstances that might
compromise the independence of a particular director. Thus, the Finance
Board expects that the board of directors will consider all potential
relationships when qualifying a director for service on the audit
committee.
Proposed Sec. 917.5(d) would require that each Bank's audit
committee adopt a formal written charter setting forth the scope of the
audit committee's powers and responsibilities and establishing its
structure, processes and membership requirements. Both the audit
committee itself and the Bank's full board of directors would be
required to review the provisions of the audit committee charter
annually and to adopt the charter, including amendments, not less often
than every three years, as appropriate based on the board's and audit
committee's reviews of the policy. Proposed Sec. 917.5(d)(3) would
require that the audit committee charter contain the following specific
provisions: that the Bank's internal auditor may be removed only with
the approval of the audit committee; that the internal auditor shall
report directly to the audit committee on substantive matters and to
the Bank President on administrative matters; that the audit committee
shall be empowered to employ such outside experts as it deems necessary
to carry out its functions; and that the internal and external auditors
be allowed unrestricted access to the audit committee without any
requirement of management knowledge or approval. The proposed
requirements pertaining to the audit committee charters were adapted
from the recommendations contained in the Blue Ribbon Committee Report
and the current Finance Board requirements on audit committees.
Proposed Sec. 917.5(e) sets forth the duties of each Bank's audit
committee under the new regulatory structure, including the duties to:
ensure that senior management maintains the reliability and integrity
of the accounting policies and financial reporting and disclosure
practices of the Bank; review the basis for the Bank's financial
statements and the external auditor's opinion rendered with respect to
such financial statements and ensure disclosure and transparency
regarding the Bank's true financial performance and governance
practices; oversee the internal audit function; oversee the external
audit function; act as an independent, direct channel of communication
between the Bank's board of directors and the internal and external
auditors; conduct or authorize investigations into any matters within
the audit committee's scope of responsibilities; ensure that senior
management has established and is maintaining an adequate internal
control system; ensure that senior management has established and is
maintaining adequate policies and procedures to ensure that the Bank
can assess, monitor and control compliance with its mission achievement
policy as required in Sec. 917.9(b)(1) of the proposed rule; and report
periodically its findings to the Bank's board of directors.
Proposed Sec. 917.5(e)(8) requires that the audit committee conduct
not only financial audits but also audit the controls in place to
ensure the Bank's compliance with its mission achievement policy. The
audit committee is not required to assess the mission performance of
the Bank. Review of the mission performance assessment of the Bank is
the responsibility of the full board of directors, as more fully
discussed in proposed Sec. 917.9(b)(3) below.
An audit of the controls in place to ensure the Bank's compliance
with its mission achievement policy is considered one type of a
performance audit. In contrast to a financial audit, which is a
financial statement or financial related audit, a performance audit is
an objective and systematic examination of evidence for the purpose of
providing an independent assessment of the performance of an
organization, program, activity or function in order to provide
information to improve public accountability and facilitate decision
making by parties with responsibility to oversee or initiate corrective
action. See U.S. General Accounting Office, Government Auditing
Standards (GAO Yellow Book). Performance audits include economy and
efficiency, program and compliance audits. Economy and efficiency
audits evaluate whether the entity is using its resources economically
and efficiently, and the causes of inefficiencies and uneconomical
practices. Id. at 14. Program audits evaluate the extent to which the
desired results as established by the authorized body are being
achieved, and the effectiveness of organizations, programs, activities
or functions. Id. Compliance audits
[[Page 52171]]
evaluate whether the entity complied with significant laws and
regulations applicable to the organization or program. Id. at 13-14.
The Finance Board requests comments on whether the duties and
responsibilities of the audit committee and the internal auditor should
be broadened in the proposed rule to include economy and efficiency and
program audits, as well as compliance and financial related audits.
Finally, proposed Sec. 917.5(f) would require that each Bank's
audit committee prepare written minutes of each audit committee
meeting.
6. Budget Preparation and Reporting Requirements--Sec. 917.6
Proposed Sec. 917.6 is carried over unchanged from existing
Sec. 934.7 of the Finance Board's regulations.
7. Dividends--Sec. 917.7
Proposed Sec. 917.7 retains in large part the provisions of
existing Sec. 934.17 of the Finance Board's regulations, with certain
proposed amendments as discussed below. The existing dividend
regulation provides that the board of directors of each Bank, with the
approval of the Finance Board, may declare and pay a dividend from net
earnings, including previously retained earnings, on the paid-in value
of capital stock held during the dividend period. See 12 CFR 934.17.
Proposed Sec. 917.7 would devolve the dividend process to the Banks and
allow the payment of dividends without prior Finance Board approval, so
long as such payment will not result in a projected impairment of the
par value of the capital stock of the Bank. Because, under the
regulatory regime proposed in this rulemaking, the earning assets of
the Banks will be either core mission activities or assets that have
not been acquired through debt issued with the benefit of the Banks'
GSE status, the Finance Board's concerns about the proper use of the
Banks' GSE funding advantage will have been addressed, and the need for
prior Finance Board approval will have been obviated.
Each Bank's board of directors would then be responsible for
ensuring that the benefits stemming from membership in the Bank System
would be distributed in an equitable manner to all members of that
cooperatively-owned Bank. Benefits can be distributed in the form of
dividends, but can also be distributed in the form of lower pricing for
advances and other Bank products. Lower product pricing, however, gives
greater assurance that the Bank System's benefits are passed along to
American consumers through increased competition in the housing finance
marketplace. The Finance Board expects the Banks, as cooperatively-
owned institutions, to pass along a greater proportion of the benefits
through lower product pricing (as opposed to higher dividends) than if
the Banks were owned by private, third-party shareholders. The Finance
Board requests comments on the reasonableness of this expectation or
whether it should reconsider the need to have some mechanism to review
or control the Banks' dividend decisions.
The current dividend regulation also provides that the Bank's
dividend period may be quarterly, semiannual or annual periods ending
on March 31, June 30, September 30 or December 31. Proposed Sec. 917.7
would leave the determination of the dividend period to the discretion
of the Banks.
Proposed Sec. 917.7 retains without change the provisions in the
current dividend regulation that dividends shall be computed without
preference and only for the period the stock was outstanding during the
dividend period, and that dividends may be paid in cash or in the form
of stock. As discussed below under ``Capital Stock Redemption
Requirements--Sec. 930.9,'' the Finance Board recently published an
Advance Notice of Proposed Rulemaking (ANPRM) that requested comment on
whether the Banks should be prohibited from paying dividends in the
form of stock. For the reasons discussed under that section, proposed
Sec. 917.7 does not include such a prohibition. Dividend payments by
the Banks also have been subject to a Finance Board Dividend Policy,
see Finance Board Res. No. 90-38 (Mar. 15, 1990), which, in addition to
repeating provisions from the regulation, specifies target dividend
rate formulae and requires the Banks to submit dividend recommendations
and a certification that the recommendation is in compliance with the
Dividend Policy at least 10 days prior to the payment of any dividend.
These requirements from the Dividend Policy have not been included in
proposed Sec. 917.7. Furthermore, the Finance Board anticipates that,
if proposed Sec. 917.7 is adopted as proposed, the Finance Board will
rescind the Dividend Policy.
8. Approval of Bank Bylaws--Sec. 917.8
Proposed Sec. 917.8 is carried over unchanged from existing
Sec. 934.16 of the Finance Board's regulations.
9. Mission Achievement--Sec. 917.9
Proposed Sec. 917.9 sets forth new requirements that each Bank must
meet in developing a mission achievement policy and overseeing the
Bank's mission achievement. The Act establishes the Finance Board's
primary responsibility for ensuring the safety and soundness of the
Bank System and consistent with that duty, ensuring that the Banks
fulfill their public policy mission. See 12 U.S.C. 1422a(a)(3). As with
the risk management function, a Bank's board of directors must take its
mission responsibilities seriously and impress the importance of
mission achievement upon Bank management and staff. The Banks' boards
of directors must be fully engaged so that there is a focus on mission
achievement at all levels of the Bank.
Proposed Sec. 917.9(a)(1) would require that each Bank's board of
directors adopt and submit to the Finance Board for approval a mission
achievement policy within 180 calendar days of the effective date of
the rule in final form. This mission achievement policy would be
required to detail how the Bank will comply with the core mission
activity requirements set forth in proposed part 940 (discussed in more
detail below), including contingent business strategies for meeting the
core mission activity requirements under different assumptions about
future economic and mortgage market conditions. The policy also would
be required to outline a process for developing and implementing new
mission-related products and services. The board should foster an
environment that encourages management to be innovative and committed
in developing products that provide assistance to Bank members in the
financing of housing and community lending.
As with the risk management policy, proposed Sec. 917.9(a)(2)(i)
would require that the Bank's board of directors review the Bank's
mission achievement policy on at least an annual basis. Proposed
Sec. 917.9(a)(2)(iii) would require a Bank's board of directors to re-
adopt a mission achievement policy, including interim amendments, not
less often than every three years, as appropriate based on the board's
reviews of the policy. Again, as with the similar provision in proposed
Sec. 917.3(a)(2), this requirement is intended to ensure that, even
given the turnover in board personnel that will occur over a number of
years, all or most current members of a Bank's board of directors will
be thoroughly familiar with the Bank's mission achievement policy, will
have given meaningful consideration to its provisions and will have
expressed their opinion regarding the adequacy of the policy through
the voting process. Proposed Sec. 917.9(a)(2)(iv) also would make clear
that each Bank's board of directors has the ultimate responsibility to
ensure
[[Page 52172]]
that the Bank is in compliance at all times with the mission
achievement policy.
Under proposed Sec. 917.9(a), each Bank would be required to submit
its initial mission achievement policy to the Finance Board for
approval; subsequent versions of the policy adopted thereafter or
amendments would not be required to be submitted to, or approved by,
the Finance Board. However, as with the risk management policies, Bank
mission achievement policies will be reviewed by the Finance Board as
part of the ongoing examination process.
Proposed Sec. 917.9(b) would require that each Bank's board of
directors: (1) direct the establishment and maintenance, by senior
management, of adequate policies and procedures to ensure that the Bank
can assess, monitor and control compliance with its mission achievement
policy; (2) establish a mechanism to measure and assess the Bank's
performance against its mission achievement goals and objectives; and
(3) require that performance assessments be conducted at least annually
that evaluate the Bank's mission achievement and measure its
performance against the Bank's goals and objectives and that such
performance assessments be reviewed by the Bank's board of directors.
These provisions are intended to ensure that the board of directors
oversees the process of assessing mission achievement, but do not
require that this responsibility reside with the audit committee or the
internal auditor. It is not necessary that the requirements for the
audit committee, which oversees the financial audit of the Bank, be
applied to the oversight of mission performance. Thus, proposed
Sec. 917.9(b) requires that the board of directors oversee mission
performance, but it allows the board to determine how, and by what
mechanism, it will carry out this responsibility. However, as
previously discussed, the audit committee shall be responsible for
ensuring that proper controls exist to ensure that an assessment of
mission achievement is carried out. In any event, the mission
management assessments should follow the requirements for program
audits contained in the GAO Yellow Book.
B. Part 925--Members of the Banks
Existing part 933 of the Finance Board's regulations, ``Members of
the Banks,'' has been proposed to be redesignated as new part 925 in
the Finance Board's proposed rule to reorganize all of the Finance
Board's regulations published separately in this issue of the Federal
Register. Part 925 of the proposed reorganization rule retains in large
part the provisions of existing part 933. Certain proposed amendments,
which consist primarily of cross-references to sections of this
proposed financial management and mission achievement regulation, are
included in this rulemaking and discussed here.
Specifically, Secs. 933.14, 933.22, and 933.24 through 933.28 of
the Finance Board's existing membership regulations have been
redesignated as Secs. 925.14, 925.22, and 925.24 through 925.28 in the
proposed reorganization regulation. Each of these sections contains
provisions regarding the treatment of outstanding advances and Bank
stock in different events: conditional membership approvals of de novo
insured depository institution applicants deemed void (Sec. 925.14);
ownership of excess shares of capital stock (Sec. 925.22);
consolidations of members (Sec. 925.24); consolidations involving
nonmembers (Sec. 925.25); member withdrawals (Sec. 925.26); removal of
members (Sec. 925.27); and automatic termination of members placed in
receivership (Sec. 925.28). In each of these situations, where
applicable, liquidation of outstanding indebtedness owed to the Bank
(mainly advances) in which membership has ceased is proposed to be
handled in accordance with newly designated Sec. 925.29. The redemption
of stock in each circumstance described in these sections is proposed
to be conducted pursuant to new Sec. 930.9 (capital stock redemption
requirements), proposed in this rulemaking.
C. Part 930--Risk Management and Capital Standards
1. Overview
As discussed previously, the Banks' current capital requirements
are determined according to a statutory formula, which uses either the
asset size of a member or the amount of its borrowings from a Bank to
determine the amount of stock the member must purchase from its Bank.
See 12 U.S.C. 1426(b)(1), (b)(2), (b)(4); 1430(c), (e)(1), (e)(3). The
Banks' risk management and investment practices are governed by the
FMP. This proposal would create a modern risk-based capital system for
the Banks. The Banks would be allowed greater flexibility to set their
own risk tolerances, subject to the requirement that they hold
sufficient capital to support the risks they chose to accept. The
proposed rule also would allow for a more efficient and effective use
of the Banks' capital than is currently possible.
The risk-based capital requirement, together with other provisions
of this capital proposal, would replace the FMP, which the Finance
Board currently uses to address the risks inherent in the financial
management practices of the Banks. Given the advent of the Basle
Accord, the practices of the other bank regulatory agencies, and the
Finance Board's proposal for the Banks to become more mission oriented,
the Finance Board has determined that the development of risk-based
capital standards for the Banks should be an integral part of any
comprehensive risk management system for overseeing the Banks. The FMP
is a prescriptive risk control system with a series of detailed
business and operating guidelines. It is based on policies originally
adopted by the FHLBB, the predecessor agency to the Finance Board, and
has been revised a number of times over the years. The FMP is a product
of its history and reflects a now outmoded approach that emphasizes in
considerable detail what is, and what is not, a permissible practice
for the Banks. It is composed of a series of lists, which address
matters such as allowable and prohibited assets, reserve requirements,
funding guidelines, and hedging, credit, and interest rate risk
guidelines. Federal banking regulation now focuses more on the adequacy
of the audit and control systems, as well as risk management systems
and managerial capability. The Finance Board is proposing to adopt a
modern approach to overseeing the Banks, which would require the Banks
to implement a comprehensive risk management system (including
regulatory capital requirements) and would require the Finance Board to
verify the integrity of those internal systems.
The bank regulatory authorities in the United States and in other
industrialized countries have adopted some form of risk-based capital
structure for the financial institutions they oversee. The basis for
all of those risk-based capital systems is the Basle Accord, which was
adopted in July 1988 and which measures credit risk through a system of
risk-weight categories. As a matter of practice, the Basle Accord has
been applied to all banks and thrifts in the United States and has
become the global benchmark for credit risk capital standards.
The Basle Accord is based principally on a standardized system of
risk weights, under which the book value of an on-balance sheet asset
is assigned a particular risk weight based on the relative level of
credit risk associated with that category of asset. The same method is
used with respect to off-
[[Page 52173]]
balance sheet items, which are converted to ``credit equivalent
amounts'' and assigned to the appropriate risk weight category. The
risk weight categories range from zero percent, for items such as cash
and Treasury obligations, to 100 percent, which includes claims on
private obligors. The Basle Accord credit risk capital regime is based
on an 8 percent benchmark, i.e., that an institution must maintain
total capital in an amount equal to 8 percent of the book value of any
asset that is in the 100 percent risk weight category. Assets in lower
risk-weight categories would carry a correspondingly lower capital
requirement, such that an asset in the 50 percent category would
require capital equal to 4 percent of its book value and an asset in
the zero percent risk weight category would require no capital for
credit risk. Because the Basle Accord made no explicit provision for
market risk in the risk weight categorizations, the required capital
percentage serves as protection against both credit and market risk.
The Finance Board, and other commentators, believe that the Basle
Accord has a number of shortcomings. For example, for instruments
within the same risk weight category, the Basle Accord does not
distinguish between those instruments with different credit quality
(i.e., those with different credit ratings), which would, in fact, have
markedly different credit risks. The Basle Accord also does not take
into consideration how differences in the maturities of two instruments
would affect their relative credit risk, nor does it distinguish
between immediate exposure and possible future credit exposures, or
between the credit risks associated with a diversified portfolio
compared to those associated with a concentrated portfolio.
Under the 1996 amendment to the Basle Accord (the Amendment), debt
instruments held in the trading portfolios of large banks are exempt
from the risk-based capital requirements of the Basle Accord. The
Amendment remedies some of the shortcomings of the 1988 Basle Accord
discussed above and offers two alternatives for calculating the credit
risk capital requirements for debt instruments held in the trading
portfolios of large banks. These alternatives are based on publicly
available credit ratings, or credit ratings that are internally
generated by large banks. The first alternative for large banks is to
use internal credit risk models to calculate value at risk due to
credit risk on debt instruments held in trading portfolio. A second
alternative for large banks lacking satisfactory internal models is to
use standardized credit risk capital percentage requirements specified
in the Amendment. These percentage requirements are significantly lower
than the risk-based capital requirements for the non-trading portfolio
(banking book) and are related to the maturities of the investment
grade instruments. The smaller percentage requirements mainly reflect
the fact that holding periods, commonly referred to as default
horizons, for debt instruments held in trading portfolios are generally
shorter than the holding periods for the banking book.
Principally to address some shortcomings of the Basle Accord with
respect to the banking book, the BCBS recently published the Framework,
which proposes a system to better correlate regulatory solvency to the
economic-capital needs of a bank, as well as with the risks and returns
of their lending activities.\4\ The Framework would base risk-based
capital requirements more closely on the underlying credit risks, and
would recognize the improvements in risk measurement and control that
have occurred in recent years. The Framework would allow for the use of
internal credit ratings and credit risk models to better assess a
bank's capital requirement in relation to its risk profile. The BCBS
also issued a separate paper on internal credit risk modeling, and
invited comments on the issue of using a portfolio-based approach to
calculating an overall capital requirement.\5\ Portfolio credit risk
modeling is a long-term project for the BCBS; ultimately, it is
anticipated that sophisticated banking institutions would employ a
comprehensive portfolio risk modeling approach, under which regulatory
capital requirements would be based entirely on internal models. This
proposed regulation addresses many of the concerns raised in the recent
BCBS papers, by closely tying regulatory capital requirements to each
Bank's level of credit risk.
---------------------------------------------------------------------------
\4\ New Basle Committee Proposals Have Positive Bank Credit
Implications, Moody's Credit Perspectives, June 21, 1999, at 1, 18.
\5\ BCBS, Credit Risk Modeling: Current Practices and
Applications (Apr. 1999).
---------------------------------------------------------------------------
As discussed above, the drive to incorporate a measure of general
market risk into the Basle Accord has been spearheaded by the BCBS. The
Basle Accord addressed credit risk but did not include a requirement
for market risk. However, as depository institutions' involvement in
both on- and off-balance sheet instruments containing structured and
exotic features as well as complex options grew, the BCBS became
concerned with the market risk aspect of the risk-based capital
standards. This led to the Amendment which, in addition to credit risk,
addressed market risk from interest rates, foreign exchange rates,
equity prices and commodity prices within the trading book and foreign
exchange and commodity risks in the banking book. The Amendment is
limited in that it essentially applies to large commercial banks;
banking book interest rate risk is still not addressed. However, the
BCBS has published a separate proposal providing guidance for the
management of overall interest rate risk in a banking organization,
including interest rate risk within the banking book.\6\ In the
recently published Framework, the BCBS has proposed to develop a
specific capital requirement for interest rate risk in the banking book
for banks where interest rates risks are significantly above average.
The bank regulatory authorities in the United States and in other
industrialized countries have adopted the Amendment to incorporate
general market risk into the risk-based capital standards.
---------------------------------------------------------------------------
\6\ See BCBS, Principles for the Management of Interest Rate
Risk (Jan. 1997).
---------------------------------------------------------------------------
2. Requirements for Bank System and Individual Bank Credit Ratings--
Sec. 930.2
Proposed Sec. 930.2 addresses credit ratings for Bank System COs
and for the overall capacity of individual Banks to meet their
obligations. Section 930.2(a)(1) would require that the Banks,
collectively, obtain from a NRSRO, and at all times maintain, a current
credit rating on the Banks' COs. Under Sec. 930.1 of the proposed rule,
an NRSRO would be defined to include those credit rating organizations
recognized as NRSROs by the SEC. To date, the SEC regards five credit
rating organizations as NRSROs: Standard & Poor's; Moody's; Fitch IBCA;
Duff & Phelps; and (for certain financial institutions) Thompson
BankWatch, Inc. See 62 FR 68018-24 (Dec. 30, 1997).
The Banks' COs currently are rated by both Moody's and Standard &
Poor's and have received the highest credit rating from both NRSROs,
based upon the conservative management policies and consistent
profitability of the Banks, both as a group and individually, and the
status of the Banks as GSEs. Proposed Sec. 930.2(a)(2) would require
that each Bank operate in such a manner and take any actions necessary
to ensure that the Banks' COs receive and continue to receive the
highest credit rating from any NRSRO by which the COs have been then
rated (e.g., triple-A).
[[Page 52174]]
Regardless of whether any actual downgrade were to occur, a Bank still
would be considered to be in violation of proposed Sec. 930.2(a)(2) if
that Bank were to take any action, or were to create a situation
through a failure to act, that potentially could lead any NRSRO to
downgrade the rating for COs to a level below that NRSRO's highest
investment grade.
In addition to the requirements pertaining to the rating of the
Banks' COs, Sec. 930.2(b) of the proposed rule would require each Bank,
individually, to operate in such a manner and take any actions
necessary to ensure that the Bank has and maintains an individual
issuer credit rating of not lower than the second highest credit rating
from any NRSRO by which the Bank is rated (e.g. double-A), where the
NRSRO states that the rating is a meaningful measure of the Bank's
financial strength and stability apart from the GSE status of the Bank
System. The latter requirement is intended to ensure that the Banks'
boards of directors and senior management focus upon the business
practices necessary to maintain not lower than the second highest
credit rating on an individual basis without regard to the GSE status
of the Bank System.
Proposed Sec. 930.2(c) would require each Bank to obtain an
individual issuer credit rating from an NRSRO within one year of the
effective date of new part 930. In addition, under proposed
Sec. 930.2(b)(3), each Bank would be required to update its individual
issuer credit rating on an annual basis, or more frequently, as
required by the Finance Board. Eleven of the Banks already have
obtained an individual credit rating from at least one NRSRO and all
eleven have received the highest long-term credit rating from the
NRSROs by which they have been rated.
In order to facilitate the Banks' fulfillment of the core mission
activities requirements set forth in part 940 of the proposed rule,
discussed below, the proposed rule would authorize the Banks to make a
wider range of investments, and to offer their members and eligible
nonmember borrowers a wider range of products and services, than is
currently authorized in the absence of specific prior Finance Board
approval. The risk-based capital requirements set forth in proposed
part 930, also discussed below, are intended to require the Banks to
manage effectively the increased risks that could accompany the
broadened investment and programmatic authority that the Banks would
enjoy under the proposed rule. As provided for under proposed
Sec. 930.2, it is of vital importance that the Banks' COs continue to
receive the highest possible credit rating so as to ensure that the
Banks remain able to access to the capital markets at the lowest
possible cost of funds and, consequently, to fund activities that
safely and soundly further the Banks' housing finance and community
lending mission.
At the same time, the Finance Board finds it appropriate to permit
the Banks to maintain individual issuer credit ratings of at least the
second highest credit rating given by any NRSRO from which a rating has
been received, rather than continuing to require the highest credit
rating, as individual Banks are required to maintain under the FMP. In
meetings with Finance Board staff, representatives of both Moody's and
Standard & Poor's indicated that the Bank's COs could continue to
receive the highest credit rating, even if all of the Banks were to
receive only the second highest issuer credit rating on an individual
basis. Both NRSROs confirmed to Finance Board staff that the GSE status
of the Banks plays a key role in the rating of the Banks' COs. While
both NRSROs indicated that any significant changes to the Banks'
management policies and profitability potentially could adversely
affect the credit rating of the COs, both also stated that the proposed
new regulatory structure does not give rise to any serious concern that
the COs will not continue to receive the highest credit rating from
both organizations.
3. Minimum Total Capital Requirement--Sec. 930.3
a. Background. Capital serves as a barrier against insolvency. Its
purpose is to absorb the risks inherent in business endeavors, and to
provide market discipline to limit risk-taking by management. To be
effective, capital must be available to offset losses if economic
conditions are unfavorable.
The capital requirements in the proposed rule represent a change in
philosophy from the FMP. Rather than prohibiting certain types of
investments, and establishing limits on Bank behavior towards risk such
as duration of equity limits, the proposed rule would allow the Banks
wide latitude to engage in mission-related activities, so long as they
hold sufficient capital to cover the risks entailed by such activities.
The rule proposes two capital-based standards for the Banks. The
first standard is a requirement that total outstanding Bank capital
stock must equal at least 3.0 percent of the Bank's total assets. The
second standard is a requirement generally that the Banks must hold the
most permanent forms of capital, referred to as risk-based capital,
against the risks measured in the Bank's portfolio. The risk-based
capital requirement is discussed further below under Sec. 930.4.
b. Minimum total capital requirement. Section 930.3(a) of the
proposed rule provides that each Bank shall have and maintain at all
times total capital in an amount equal to at least 3.0 percent of the
Bank's total assets. Total capital is defined in proposed Sec. 930.1 as
the sum of a Bank's retained earnings and total capital stock
outstanding, less the Bank's unrealized net losses on available-for-
sale securities. The minimum total capital requirement serves to limit
the size of a Bank's balance sheet for a given quantity of capital.
As discussed above in the Overview of Proposal section, the Act
sets forth minimum capital requirements for the Banks. See 12 U.S.C.
1426(b)(1), (b)(2), (b)(4); 1430(c), (e)(1), (e)(3); 12 CFR 933.20(a).
Among these provisions is a requirement that members hold stock equal
to at least 5 percent of their advances. Currently, the FMP limits the
holding of mortgage-backed securities by the Banks to three times
capital. Taken together, these two provisions limit advances plus
mortgage-backed securities to no more than 23 times capital, as
advances can be no more than 20 times capital, and mortgage-backed
securities can be no more than 3 times capital. Thus the ratio of
capital to advances plus mortgage-backed securities must be at least
one twenty-third, or 4.35 percent.\7\
---------------------------------------------------------------------------
\7\ To the extent that a Bank chooses to accumulate retained
earnings, its assets may be limited to something less than 23 times
capital. This is because the capital held to support advances can,
by statute, only be in the form of capital stock, while the capital
held to support mortgage-backed securities (MBS) holdings can be
either capital stock or retained earnings. Retained earnings are a
small percentage of total capital for the Banks.
---------------------------------------------------------------------------
The numerically operative and, therefore, more important constraint
contained in current regulations is a leverage limit, such that the
ratio of COs plus unsecured senior liabilities for a Bank can be no
more than 20 times capital. See FMP section IV.C. Because assets equal
capital plus COs plus unsecured senior liabilities, a Bank's assets
cannot exceed 21 times its capital or, inversely, capital must be at
least 4.76 percent of assets. The Bank System had an average capital-
to-assets ratio of 5.4 percent during 1998.
The proposed 3.0 percent minimum total capital requirement for the
Banks would be more conservative than the 2.5 percent minimum total
capital
[[Page 52175]]
requirement imposed by statute on the on-balance sheet assets of Fannie
Mae and Freddie Mac.\8\ Also, the proposed minimum total capital
requirement of 3.0 percent for the Banks is consistent with the minimum
total capital requirements imposed by other financial institution
regulators for the strongest financial institutions without supervisory
concerns.
---------------------------------------------------------------------------
\8\ A leverage requirement is imposed on Fannie Mae and Freddie
Mac such that their capital must be at least 2.5 percent of their
on-balance sheet assets. 12 U.S.C. 4612(a). Generally, they must
also hold capital equal to at least .45 percent of their off-balance
sheet obligations. Unlike the Banks, Fannie Mae and Freddie Mac have
substantial volumes of guarantees and other off-balance sheet items.
---------------------------------------------------------------------------
Section 930.3(b) of the proposed rule provides that, for reasons of
safety and soundness, the Finance Board may require an individual Bank
to have and maintain a higher minimum capital ratio than 3.0 percent.
4. Minimum Total Risk-Based Capital Requirement--Sec. 930.4
a. General requirement. Section 930.4(a) of the proposed rule
provides that each Bank shall have and maintain at all times total
risk-based capital in an amount at least equal to the sum of its credit
risk capital requirement, its market risk capital requirement, and its
operations risk capital requirement, calculated in accordance with
Secs. 930.5, 930.6 and 930.7, respectively. As discussed above under
the Overview of Proposal section, the proposed rule would implement,
for the first time, a risk-based capital requirement for the Banks
related to the risks inherent in the Banks' portfolios and business
practices. The three separate capital components are discussed further
below under their respective sections.
b. Definition of Total Risk-Based Capital. In order to serve as the
primary barrier against insolvency, risk-based capital must be
permanent in nature, i.e., available to cover losses which may occur
under adverse conditions without being subject to redemption by
members. Proposed Sec. 930.1 contains a definition of total risk-based
capital for a Bank, the elements of which are discussed below.
The first element of total risk-based capital under the definition
in proposed Sec. 930.1 is retained earnings, less unrealized net losses
on available-for-sale securities. Retained earnings clearly are
permanent in nature because they are not subject to withdrawal at the
request of individual member shareholders.
The second element of total risk-based capital under the definition
in proposed Sec. 930.1 is any outstanding non-redeemable capital stock
of the Bank. The Finance Board has authority under the Act to allow the
Banks to create additional classes of stock if the Banks wish to
include such other classes of stock as a part of their capital
structure. Any non-redeemable outstanding capital stock that a Bank may
be authorized to issue would be permanent by its non-redeemable nature.
The third element of total risk-based capital under the definition
in proposed Sec. 930.1 is all outstanding capital stock satisfying the
minimum capital stock purchase requirement for membership under
sections 6(b)(1) and 10(e)(3) of the Act (12 U.S.C. 1426(b)(1),
1430(e)(3)) for all mandatory members. Outstanding capital stock of
mandatory members has permanent features, because a mandatory member
may have its stock redeemed only if it changes its charter to a form
that would make the member a voluntary member and withdraws from
membership in the Bank System. Charter conversions generally are not
effected by a member solely for the purpose of withdrawing from Bank
membership and redeeming Bank stock. A charter conversion would have a
serious impact on all aspects of an institution's business operations,
and would require a significant amount of time and cost to complete.
Mandatory members that convert to voluntary status also may be
discouraged from withdrawing from the Bank System because the Act
prohibits withdrawing members from rejoining the Bank System for ten
years. See 12 U.S.C. 1426(h).
The fourth element of total risk-based capital under the definition
in proposed Sec. 930.1 is a percentage of the minimum capital stock
purchase requirement for membership under sections 6(b)(1) and 10(e)(3)
of the Act (12 U.S.C. 1426(b)(1), 1430(e)(3)) for all voluntary
members. Each Bank may designate a percentage, not to exceed 50
percent, of the minimum capital stock of voluntary members as risk-
based capital. The required capital stock of voluntary members is less
permanent than the required capital stock of mandatory members, but is
more permanent than stock which supports member borrowing. Although the
ten-year prohibition on rejoining the Bank System after withdrawing may
discourage voluntary members from withdrawing from the Bank System and
redeeming their capital, they may, if they decide to withdraw, have
their capital stock redeemed at par, provided that the Finance Board
finds no impairment or likely impairment of the Bank's capital. See 12
U.S.C. 1426(e). This capital stock, therefore, has more limited use as
a loss absorber than the other forms of capital stock discussed above.
However, a Bank may need more than its retained earnings and
outstanding minimum capital stock of mandatory members in order to meet
its risk-based capital requirement. Therefore, a percentage not to
exceed 50 percent of minimum required voluntary member stock may serve
as an element of total risk-based capital only if the Bank is willing
to subject its redemption to Finance Board approval.
The fifth and final element of total risk-based capital under the
definition in proposed Sec. 930.1 is a percentage of the remaining
capital stock of mandatory and voluntary members. Each Bank may
designate a percentage, not to exceed 50 percent, of the remaining
capital stock of mandatory and voluntary members as risk-based capital
only if the Bank is willing to subject its redemption to Finance Board
approval. The Act provides that a Bank has discretion, unless
prohibited by the Finance Board, to determine whether to redeem a
mandatory or voluntary member's capital stock that exceeds its
statutory minimum capital stock purchase requirement. See 12 U.S.C.
1426(b)(1). Because a Bank can decline to redeem excess capital stock
of members, such stock can serve as a permanent capital loss absorber.
The proposed definition allows each Bank to designate different
percentages of stock as elements of total risk-based capital under the
fourth and fifth elements of the definition (that is, up to 50 percent
of the membership stock of voluntary members, and up to 50 percent of
all remaining outstanding capital stock of mandatory and voluntary
members). Therefore, some Banks may choose to designate a larger
percentage of the minimum capital stock of voluntary members as risk-
based capital stock, as this stock has a greater degree of permanence.
This would allow a smaller percentage of capital stock which supports
advance borrowing to be designated as an element of total risk-based
capital, so that the use of advances by members would not be
discouraged.
c. Transition provisions. The transition provisions in the proposed
rule ensure that the Banks will continue to operate in a safe and sound
manner, under proven standards, until such time as they have
demonstrated the capacity to operate under the more flexible proposed
regulation. Specifically, each Bank must demonstrate to the Finance
Board that it has risk management policies and internal controls in
place which are sufficient to manage its credit, market, and operations
risk. Each
[[Page 52176]]
Bank must also have an internal market risk model approved by the
Finance Board. Finally, each Bank must have sufficient capital to meet
the capital requirements in the proposed rule. Until these conditions
are met by a Bank, the current rules as contained in the FMP will
apply. See proposed Secs. 930.4(b)(1) and 930.4(b)(2).
5. Credit Risk Capital Requirement--Sec. 930.5
a. Background. Unlike commercial banks and savings associations,
the Banks currently are not subject to statutory or regulatory risk-
based capital requirements. As discussed previously, the Banks' capital
requirements are determined according to a statutory formula, which
uses either the asset size of a member or the amount of its borrowings
from a Bank to determine the amount of stock the member must purchase
from its Bank. The risk-based capital requirement for the Banks
established in this proposal would include as one component a separate
capital requirement to address the credit risk to which a Bank is
exposed. The credit risk component of the capital requirement would
encompass the credit risks associated with both on-balance sheet assets
and off-balance sheet items of each Bank.
The objective of the Finance Board in proposing this credit risk
capital standard for Banks is to provide a regulatory framework that
would: (i) assess capital charges based on the extent of the underlying
credit exposure; (ii) address on-and off-balance sheet exposures
consistently; (iii) allow for changes to the portfolios of the Banks,
as well as in the markets; and (iv) reflect improvements in risk
measurement and control systems, as they develop and become available
for use by the Banks. To the extent the proposed rule achieves these
objectives, it would improve upon the Basle Accord.
b. Finance Board determination of specific credit risk percentage
requirements. Proposed Sec. 930.5(b) provides that for an on-balance
sheet asset, the credit risk capital requirement would be equal to the
book value of the asset multiplied by the ``credit risk percentage
requirement'' to which the asset is assigned. Proposed Sec. 930.5(c)
provides that for off-balance sheet items, the credit risk capital
requirement would be the ``credit equivalent amount'' of the item,
multiplied by the specific credit risk percentage requirement to which
the item is assigned.
Proposed Sec. 930.5(d) provides that the Finance Board shall
determine initially, and update periodically, credit risk percentage
requirements for various categories of credit risk for on-balance sheet
assets and off-balance sheet items, using data from NRSROs and any
other relevant sources to calculate estimates of credit losses
associated with the particular categories. The estimates of credit risk
are required to represent the credit losses that could be expected to
occur on the particular categories of instruments during periods of
extreme credit stress, based on historical data that reflect the
longer-term nature of credit cycles and span multiple credit cycles.
The periodic updates to initial credit risk percentage requirements
will be implemented by the Finance Board as amendments to
Sec. 930.5(d)(3).
The proposal includes, in Table 1 of proposed Sec. 930.5(d)(3), the
percentages to be applied to the book value of on-balance sheet assets,
or the credit equivalent amounts of off-balance sheet items, in
determining a Bank's credit risk capital requirement. Cash and
government securities are assigned to the zero percent category,
meaning that they are deemed not to present any credit risk to the
Bank. The proposal assigns increasing percentages (0.3, 0.6, 1.0, and
1.3) to each of the four levels of investment grade ratings assigned by
an NRSRO (i.e., triple-A, double-A, single-A, triple-B), and treats
credit risk from advances as equivalent to credit risk associated with
the highest category of investment grade credit ratings. The proposal
also includes a credit risk percentage for a Bank's tangible assets,
``Premises, Plant and Equipment,'' to be set at 8.0 percent, which is
consistent with the Basle Accord. Investments that are downgraded below
investment grade after being acquired by a Bank would be assigned
higher credit risk percentages: 12.0 percent for assets with the
highest rating below investment grade; 50.0 percent for assets with the
second highest rating below investment grade; and 100 percent for all
other assets downgraded below investment grade.
In assigning only cash and direct obligations of the U.S.
government to the zero credit risk category, the proposal is more
restrictive than the Basle Accord, which assesses zero credit risk
capital for all Organization for Economic Cooperation and Development
(OECD) government obligations, although proposed revisions to the Basle
Accord would treat all triple-A and double-A rated sovereign
obligations as free of credit risk. The proposal would treat Bank
advances as a triple-A rated credit exposure. The assignment of
advances to a triple-A credit risk category is based on factors such as
the historical credit loss record for Bank advances (no credit losses
have been incurred on the advance portfolio), the conservative lending
and collateral management policies of each Bank (all classes of
collateral are discounted based on risk), the blanket lien arrangements
that some Banks employ with certain members over all of the assets of
that member, the statutory priority lien, which gives the Banks
priority over other secured creditors (so long as those secured
interests are not perfected, see 12 U.S.C. 1430(e)), and a statutory
stock purchase requirement that requires a member to maintain an
investment in the Bank at least equal to 5 percent of its outstanding
advances. See id.
The Finance Board considered treating advances as cash or direct
obligations of the U.S. government and assigning a zero credit risk
capital requirement. However, two credit rating agencies expressed
their opinion that such treatment is not appropriate for advances--
i.e., that advances should not be treated as equivalent to credit risk
free investments. The two rating agencies expressed their preference
for advances being treated as triple-A rated assets. Based on the
historical (over 60 years) experience of zero credit losses for
advances versus rating downgrades leading to eventual credit losses on
triple-A rated corporate securities, an argument can be made that
advances are a better credit than triple-A rated assets. As a result,
advances may be treated as assets that pose credit risk somewhere
between U.S. government securities and triple-A rated corporate
securities. At this time, the Finance Board is proposing to treat
advances as triple-A rated assets and is requesting comments from
interested parties as to whether a satisfactory analytical framework
exists that can be used to determine a more appropriate capital charge
for the credit risk of advances.
Based on data obtained from Moody's, the worst default frequency
over a two-year horizon for triple-A rated corporate debt is 0.0. In
fact, a triple-A rated security has never defaulted at the time it was
still rated triple-A. Given a sufficiently long period of time,
however, even triple-A rated corporate credits will default following
rating downgrades.\9\ In fact, some triple-A rated credits have been
downgraded within a year after receiving the triple-A rating. In
addition, the market credit spreads for triple-A rated securities can
widen without any change in credit
[[Page 52177]]
ratings.\10\ Credit deterioration and spread widening can lead to
losses in market value for triple-A rated securities within a
relatively short time after such securities are assigned a triple-A
rating. Because such risks exist and the holding periods associated
with long-term held-to-maturity securities are relatively long, the
proposal adopts a conservative approach and requires 0.3 percent
capital to be maintained for triple-A rated credit exposures. This
number is a linear interpolation of the estimated credit losses for
U.S. government securities and double-A rated debt. Moreover, this
requirement is consistent with the results from an internal models-
based estimate for credit risk capital for triple-A rated corporate
bonds held in a diversified trading portfolio of a large commercial
bank, which is 0.26 percent.\11\
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\9\ According to Moody's data from 1970 to 1998, over a 4-year
default horizon, the worst historical probability of default
(default rate) for triple-A rated debt is 1.21 percent.
\10\ This applies equally to triple-A rated securities issued by
GSEs.
\11\ This estimate is based on a 10 business day horizon and a
99th percentile of the value at risk distribution as required under
the Amendment for calculating credit risk capital for debt
instruments held in the trading portfolios of large banks. The
estimate of 0.26 percent reflects a multiplier of 4 which is the
highest multiplier that may be required under the Amendment. In
addition to the possibility of default, this estimate captures
potential deterioration in credit risk and widening of credit
spreads in the market. If the underlying distribution of value at
risk is approximately normal, the multiplier of 4 effectively
extends the 10 day horizon to 160 business days, or approximately 8
months. The holding periods relevant to long-term debt instruments
held in banking portfolios are longer and commercial banks generally
use 1 year for calculating economic capital requirements.
---------------------------------------------------------------------------
Credit risk capital requirements for double-A, single-A, triple-B
and double-B rated credit exposures in the proposal are generally equal
to the worst default rate observed over two-years by Moody's in data
collected from 1970-1998. To preserve consistency between credit
ratings and capital requirements, the proposed requirement for a
single-A rated credit exposure is set equal to the average of the
capital requirements for double-A and triple-B rated instruments.\12\
Also, a conservative zero recovery rate in default has been assumed for
purposes of calculating the credit risk capital requirements. Defaulted
bond price data from Moody's provides support for the zero recovery
rate assumption under extreme credit stress conditions.\13\
---------------------------------------------------------------------------
\12\ This is because over a 2 year horizon, the worst single-A
rated default rate is lower than the corresponding double-A rated
default rate.
\13\ As for triple-A rated instruments, the proposed capital
requirements for double-A, single-A, triple-B and double-B rated
credit exposures are generally consistent with the results from an
internal models-based estimate for credit risk capital for corporate
bonds held in a diversified trading portfolio of a large commercial
bank, which are 0.77, 1.00, 2.40 and 5.24 percent, respectively.
---------------------------------------------------------------------------
Under proposed Sec. 955.3(a)(3), the Banks would not be authorized
to invest in debt instruments rated below investment grade. If an
investment were to be downgraded after acquisition by a Bank to the
second highest rating below investment grade (single-B rating), the
proposal would assign it to the 50 percent credit risk percentage,
which the Finance Board believes to be a conservative level for such an
exposure. Any credit exposures rated at triple-C or below would be
placed in the 100 percent credit risk capital category.
Under proposed Secs. 940.3(e) and 955.2(e), a Bank may make equity
investments in the stock of a SBIC, in government-aided economic
development entities, and in certain entities that are permissible
investments for national banks, that are not rated but are defined in
this proposal as core mission activities of the Banks. The proposal
would assign investments in these types of entities to the 8.0 percent
credit risk percentage category. This requirement is based upon, and is
consistent with, the risk-based capital requirements for investments in
such entities by national banks established by the OCC. For SBICs, the
8 percent requirement is likely conservative given changes to the SBIC
program implemented in 1994. In addition, consistent with the public
purpose of GSEs, the Finance Board wants to encourage the Banks to give
every consideration to investments that will provide targeted
assistance to people in underserved low and moderate-income
communities.
The following table, which is set forth in proposed
Sec. 930.5(d)(3), presents the credit risk percentage capital
requirements for each category of credit exposures described above:
Credit Risk Capital Requirements for Banks
------------------------------------------------------------------------
Percent of
on-balance
Credit risk category sheet
equivalent
value
------------------------------------------------------------------------
Authorized Investments
Cash and U.S. Government Securities........................ 0.0
Advances................................................... 0.3
Highest Investment Grade--triple-A......................... 0.3
Second Highest Investment Grade--double-A.................. 0.6
Third Highest Investment Grade--single-A................... 1.0
Fourth Highest Investment Grade--triple-B.................. 1.3
Premises, Plant, and Equipment............................. 8.0
Core Mission Equity Investments Under Sec. 940.3(e)....... 8.0
Investments Downgraded to Below Investment Grade After
Acquisition by a Bank
Highest Below Investment Grade--double-B................... 12.0
Second Highest Below Investment Grade--single-B............ 50.0
All Other Below Investment Grade--At or Below triple-C..... 100.0
------------------------------------------------------------------------
The Finance Board expects that the above capital requirements may
change as comments on proposed Sec. 930.5(d)(3) are received and
further research is undertaken before a final rule is published. Even
after a final rule is adopted, the Finance Board anticipates that it
will periodically amend the capital requirements reflected in the chart
above as additional data is available and new methodologies become
feasible.
One of the limitations of the Basle Accord was its failure to
consider the term structure of credit risk, such that an overnight
exposure would receive the same capital charge as a 2 or a 10 year
exposure. However, under the Amendment, the term structure of credit
risk can be fully recognized for trading portfolios of large banks with
satisfactory internal models and is partially recognized for others
through a standardized table. In addition, the recently proposed
Framework addresses this limitation in the Basle Accord by according
limited recognition to the term structure of credit risk. The Farm
Credit Administration similarly accords limited recognition to the term
structure of credit risk in their risk-based capital requirements for
the farm credit banks. In proposed Sec. 930.5(d)(3), there is no such
recognition given to the term structure of credit risk. However, the
Finance Board realizes that a significant proportion of the Banks'
assets have maturities within 1 month and, therefore, intends to
undertake further research on incorporating term structure of credit
risk into Sec. 930.5(d)(3). At this time, the Finance Board requests
comments on the treatment of term structure of credit risk.
c. Bank determination of specific credit risk percentage
requirements. Section 930.5(d)(4)(i) of the proposed rule would require
each Bank to determine the credit risk capital requirement for each
asset and item first by determining its type and its credit rating (if
any), then by determining its
[[Page 52178]]
appropriate risk category and applying the applicable credit risk
percentage for that risk category under Table 1. The proposal includes
guidance for the Banks on how to determine the credit rating for a
particular asset or item. If an asset or item is directly rated by an
NRSRO, the Banks must use that rating. If an asset or item is not rated
directly by an NRSRO, but its issuer or guarantor is so rated or the
asset or item is backed by collateral that is so rated, then a Bank may
use the highest rating given to the issuer, guarantor, or collateral,
to the extent that the issuer, guarantor, or collateral supports the
asset or item held by the Bank. If the asset or item is not fully
backed by a rated issuer, guarantor, or collateral, then only the
portion to which such rated support applies may receive the highest
rating noted above; the portion of the asset or item that is not so
supported must be assigned to the category that would be appropriate
for such an asset on a stand alone basis. For example, if up to 25
percent of a triple-B asset is guaranteed by a triple-A-rated entity,
then 25 percent of the value of the asset may be assigned to the
highest investment grade category with a capital requirement of 0.3
percent and the remaining 75 percent of the value of the asset will be
assigned to the fourth highest investment grade category with a capital
requirement of 1.3 percent.
The proposal further provides that the Banks shall disregard
modifiers attached to a particular credit rating. Thus, an asset with
an A+ rating and an asset with an A- rating would both be placed in the
A category for risk-based capital purposes. NRSROs generally assign
rating modifiers such as ``1'', ``2'' and ``3'' or ``+'' and ``-''
along with letter grades. Such modifiers are provided to further
distinguish among credit risks that are assigned identical letter
grades. Consequently, historical samples containing default activity
for each modified letter grade are smaller than what they would be if
modifiers were ignored. The smaller sample size makes it difficult to
calculate credit risk capital requirements corresponding to modified
ratings with some degree of statistical precision and confidence.
Therefore, the Finance Board is proposing to disregard rating
modifiers. This is consistent with the treatment specified for
investment grade credit exposures under the Amendment and the
Framework.
The proposal also provides that where a particular asset or item
has been rated multiple times by the same NRSRO, the Bank must use the
most recent rating from that NRSRO, and that if an asset or item has
received ratings from multiple NRSROs, the Bank must use the lowest of
those ratings. If an asset is not rated by an NRSRO and does not fall
within one of the categories in Table 1, the proposal would require a
Bank to determine its own credit rating for the asset or item or
relevant portion thereof using credit rating standards available from
an NRSRO or other similar standards.
As a general matter, collateral may be used to enhance the
creditworthiness of a particular asset or item, which can result in a
lower credit risk capital requirement for a Bank. The BCBS has
recognized that the Basle Accord did not provide sufficient incentive
for banks to reduce their credit risk by taking an interest in other
collateral, and recently has proposed to extend the scope of collateral
recognition to all financial assets--not just marketable securities.
The Finance Board proposal would allow a Bank to look through to the
collateral supporting a given asset or instrument for risk-based
capital purposes if certain conditions are met. In order to recognize
such collateral for capital purposes, the collateral must be held by
the Bank (which could include being held by a third party custodian or
by the member), must be legally available to absorb losses (i.e., the
Bank must have a legal right to liquidate the collateral), must have a
readily determinable value at which it can be liquidated, and must be
held in conformance with the Bank's collateral management policy. This
would include arrangements under which a third-party custodian holds
collateral from a Bank's counterparty and may not return the collateral
to the counterparty without the express permission of the Bank. In
using collateral to reduce the credit risk capital requirement, a bank
must make appropriate allowance for haircuts or overcollateralization
reflecting the market risk underlying the collateral.
With respect to third-party guarantees, the proposal would
recognize all third-party guarantees provided by any counterparty with
an investment grade rating. This is consistent with that aspect of the
proposal that would limit investments by the Banks to those with an
investment grade rating. See proposed Sec. 955.3(a)(3).
The proposed rule would allow on-balance sheet assets (underlying
assets) that are hedged with credit derivatives to be assigned to the
zero risk category under three scenarios specified in the rule. Even if
the credit risk capital requirement for the underlying asset is
decreased through the use of a credit derivative, the applicable credit
risk capital required for the derivative contract still would apply.
Within an internal credit risk model in which credit risks are
marked-to-market, recognition of offsets, or credit hedges, whether
perfect or imperfect, can be readily accommodated. Large commercial
banks have accomplished this as part of their credit risk, value at
risk models for trading portfolios. Under the proposed rule, some of
the offsets will be recognized. If the offset is perfect (i.e., the two
positions are of identical remaining maturity and relate to exactly the
same instrument) it is straightforward to reduce the credit risk
capital requirement for the underlying asset to zero (i.e., to grant
full capital relief). For example, if a Bank purchases a triple-B rated
corporate bond with a maturity of 5 years and at the same time enters
into a 5-year credit default option contract based on the same bond
(reference asset), the credit risk capital requirement for the
underlying asset will be zero. The net credit risk capital requirement
for the pair will equal the counterparty risk capital for credit
exposure on the derivative contract.
If the underlying asset and the referenced asset of a credit
derivative are identical, but the remaining maturities are different,
the capital relief in the proposed rule would depend on a maturity
comparison between the two. If the same triple-B rated 5-year corporate
bond was hedged with a credit derivative with a remaining maturity of
2-years or longer, there would be no credit risk on the underlying
asset within the Finance Board's proposed default horizon, which is 2
years. Therefore, such a hedge would be fully recognized and the
capital requirement on the underlying asset would be zero. However, if
the derivative maturity were less than 2 years, no capital relief would
be granted under the proposal. In all cases, there will be a
counterparty risk capital requirement for credit exposure on the
derivative contract. This issue will continue to be researched by the
Finance Board during the comment period.
If the remaining maturities of the underlying asset and a credit
derivative are the same, but the underlying asset is different from the
asset referenced in the credit derivative, capital relief for the
underlying asset may or may not be granted. It is proposed that the
capital requirement on the underlying asset be reduced to zero only if
the referenced and the underlying assets have been issued by the same
obligor, the referenced asset ranks pari passu to or more junior than
the underlying asset, and cross-default clauses are in effect.
If the remaining maturities of the two assets are identical but the
underlying
[[Page 52179]]
asset and the referenced asset have been issued by different obligors,
the proposed rule does not provide any capital relief for the
underlying asset. For example, a Bank may invest in a triple-B rated
bond issued by corporate entity X, but hedge the credit risk with a
derivative based on triple-B rated bond issued by corporate entity Y,
and where X and Y belong to the same industry. The Finance Board
recognizes that such a hedge may provide significant credit protection
to the Bank as there may be a high degree of default correlation
between X and Y, and that capital relief for such hedges can be
accommodated under an internal portfolio credit risk model. Thus, the
Finance Board requests comments on whether to allow affected Banks to
petition the Finance Board for capital relief on a case by case basis,
provided the petition is accompanied by adequate data and analysis.
d. Credit risk percentage requirements for off-balance sheet items.
Off-balance sheet items may expose a Bank to credit risks similar to
those associated with on-balance sheet assets. The Finance Board is
proposing to apply the credit risk capital framework consistently to
all on- and off-balance sheet instruments. Under proposed Secs. 930.5
(e) and (f), the Banks are required to convert all off-balance sheet
credit exposures into equivalent on-balance-sheet credit exposures
(credit equivalent amounts) and then apply the ratings-based framework
in Table 1 to estimate the credit risk capital requirement. The Finance
Board would allow the Banks to use Finance Board approved internal
models to convert some or all off-balance sheet credit exposures into
equivalent on-balance-sheet credit exposures. For Banks that lack
appropriate internal models, the Finance Board is proposing to adopt
the Basle Accord treatment for such instruments as used by the other
federal bank regulatory agencies to convert an off-balance sheet credit
exposure into an equivalent on-balance-sheet exposure.
Under the Basle Accord as incorporated by the federal bank
regulatory agencies, off-balance sheet instruments, other than
derivative contracts, that are substitutes for loans (e.g., standby
letters of credit serving as financial guarantees for loans and
securities) have the same credit risk as an on-balance sheet direct
loan. For some off-balance sheet instruments, the full face value, or
notional amount, is not exposed to credit risk. This means that a
dollar of off-balance sheet exposure may be equivalent to less than a
dollar of on-balance sheet exposure. The following table (Table 2 in
proposed Sec. 930.5(e)), which includes the same categories as are used
by the federal bank regulatory agencies and those proposed under the
Framework, presents credit exposure conversion factors that are to be
multiplied by the face amount of an off-balance sheet instrument other
than a derivative contract.
Credit Conversion Factors for Off-Balance Sheet Items Other Than
Derivative Contracts
------------------------------------------------------------------------
Credit
conversion
Instrument factor (in
percent)
------------------------------------------------------------------------
Standby letters of credit.................................. 100
Asset sales with recourse, where credit risk remains with ...........
the Bank..................................................
Sale and repurchase agreements............................. ...........
Forward asset purchases.................................... ...........
Commitments to make advances or other loans with certain ...........
drawdown \1\..............................................
Other commitments with original maturity of over one year.. 50
Other commitments with original maturity of one year or 20
less......................................................
------------------------------------------------------------------------
\1\ I.e., where it is known during the pendency of the commitment that
the advance or loan funds definitely will be drawn in full.
The credit conversion factor would be zero for Other Commitments
that are unconditionally cancelable, or that effectively provide for
automatic cancellation, due to deterioration in a borrower's
creditworthiness, at any time by the Bank without prior notice. The
Finance Board would allow the Banks to use Finance Board approved
internal models to calculate credit conversion factors instead of those
specified in Table 2. These factors were developed by the BCBS and
adopted by other federal bank regulatory agencies. Under the Basle
Accord, a 100 percent conversion factor is assigned to an off-balance
sheet instrument where the instrument is a direct credit substitute and
the credit risk is equivalent to that of an on-balance sheet exposure
to the same counterparty. A 50 percent conversion factor is assigned to
an off-balance sheet instrument where there is a significant credit
risk but mitigating circumstances exist which suggest less than full
credit risk. A 20 percent conversion factor is assigned to an off-
balance sheet instrument where there is a small credit risk but not one
which can be ignored. The Finance Board intends to undertake further
research on the magnitude and appropriateness of the credit conversion
factors set forth in proposed Sec. 930.5(e) and may revise them before
a final rule is published.
e. Credit risk percentage requirements for derivative contracts.
Proposed Sec. 930.5(f) provides that for market driven instruments
(over-the-counter derivative contracts such as swaps, forwards,
options, etc.) subject to counterparty default, the credit risk capital
requirement will be based on both current and potential credit
exposures. In recognizing collateral, the haircuts requirement under
proposed Sec. 930.5(d)(4)(iv) to reflect the market risk embedded in
the collateral would apply. The derivatives contracts may be based on
underlying market interest rates or prices and may include credit-
linked contracts. The credit equivalent amount for a derivative
contract is equal to the sum of: the current credit exposure (sometimes
referred to as the replacement cost) of the contract; and the potential
future credit exposure (sometimes referred to as the potential future
replacement cost) of the contract.
Proposed Sec. 930.5(f)(1) provides that the current credit exposure
is equal to the maximum of the mark-to-market value of the contract and
zero, as contracts with negative mark-to-market values do not create
any current credit exposure for a Bank.
Proposed Sec. 930.5(f)(2) provides that the potential future credit
exposure (PFE) of a contract shall be determined by using an internal
market risk model approved by the Finance Board or, in the case of
Banks that lack appropriate internal models to calculate PFE, using the
Basle Accord's standardized approach set forth in Table 3 of the
proposed rule.\14\ Under this approach, the PFE of a contract,
including a contract with a negative mark-to-market value, is estimated
by multiplying the effective notional principal amount of the contract
by a credit conversion factor for the underlying market risk as
specified in Table 3, as follows:
---------------------------------------------------------------------------
\14\ See BCBS, Basle Capital Accord: Treatment of Potential
Credit Exposure for Off-Balance Sheet Items (Apr. 1995). The BCBS
ran Monte Carlo simulations on numerous contracts before determining
the conversion factors included in Table 3.
[[Page 52180]]
Credit Conversion Factors for Potential Future Credit Exposure Derivative Contracts
[In percent]
----------------------------------------------------------------------------------------------------------------
Underlying market rate or price
---------------------------------------------------------------------------------
Residual maturity Foreign Precious
Interest rate exchange and Equity metals except Other
gold gold commodities
----------------------------------------------------------------------------------------------------------------
One year or less.............. 0 1 6 7 10
Over 1 year to five years..... .5 5 8 7 12
Over five years............... 1.5 7.5 10 8 15
----------------------------------------------------------------------------------------------------------------
Under the proposed rule, forwards, swaps, purchased options and
similar derivative contracts that are not included in the Interest
Rate, Foreign Exchange and Gold, Equity, or Precious Metals except Gold
categories shall be treated as Other Commodities for purposes of Table
3. If a Bank determines not to use an internal model for single
currency interest rate swaps in which payments are made based upon two
floating indices (floating/floating or basis swaps), the PFE for such
swaps shall be zero. If a Bank determines to use Table 3 for credit
derivative contracts, the credit conversion factors applicable to
Interest Rate Contracts under Table 3 shall apply.\15\ If a Bank
determines to use an internal model for a particular type of derivative
contract, the Bank shall use the same model for all other similar types
of contracts. However, the Bank may use an internal model for one type
of derivative contract and Table 3 for another type of derivative
contract. In other words, within each category of market risks, a Bank
would not be allowed to arbitrage between capital requirements based on
Table 3 and internal models.\16\
---------------------------------------------------------------------------
\15\ The BCBS has yet to determine conversion factors for credit
derivatives. Given that fluctuations in investment grade credit
spreads are generally of a smaller magnitude than shifts in the
level of interest rates, it appears that the potential future
changes in the market value of credit-linked contracts should not
generally exceed potential shifts in the market value of interest
rate linked contracts. The Finance Board plans to examine any credit
derivative contracts that the Banks may enter into and require
larger conversion factors for credit derivatives, if necessary.
\16\ A Bank that uses an internal model for simple interest rate
contracts may utilize Table 3 for interest rate contracts with
embedded options, stand-alone interest rate options or other
complex/structured contracts. The reverse may not be allowed as a
Bank that is capable of internally calculating PFE for complex/
structured contracts must use such internal model for simple
contracts.
---------------------------------------------------------------------------
The proposed rule does not contain any specific means to account
for portfolio diversification effects. Consequently, the proposal would
require the same regulatory capital charge for two portfolios that are
of the same credit quality, but where the credit risk of one is
significantly more concentrated than that of the other. However, as
noted by the BCBS, this limitation may be effectively addressed in a
portfolio-based internal credit risk capital framework. Portfolio
credit risk modeling is a long-term project for the BCBS; ultimately,
it is anticipated that sophisticated banking institutions would employ
a comprehensive portfolio risk modeling approach under which regulatory
capital requirements would be based entirely on internal models.
Similarly, the Finance Board will encourage the Banks to develop
internal credit risk models. Building such an internal model should not
be a formidable task for the Banks, given that their portfolios largely
consist of credit exposures that may be rated and almost all the Banks'
counterparties are financial institutions. The remaining unrated
exposures are insignificant and may be dealt with outside a credit risk
model.
Proposed Sec. 930.5(g) sets forth the requirements for calculation
of credit equivalent amounts for multiple derivative contracts subject
to a qualifying bilateral netting contract. The provisions in the
proposal are consistent with the requirements set forth in the risk-
based capital guidelines of the federal bank regulatory agencies.
6. Market Risk Capital Requirement--Sec. 930.6
a. Background. Section 930.6(a) of the proposed rule provides that
a Bank's market risk capital requirement shall equal the market value
of the Bank's portfolio at risk from movements in market prices, i.e.,
interest rates, foreign exchange rates, commodity prices and equity
prices, as could occur during periods of extreme market stress, as
determined using the Bank's internal market risk model approved by the
Finance Board.
Market risk may be defined as the risk that the market value of a
Bank's portfolio will decline as a result of changes in the general
level of interest rates, foreign exchange rates, equity and commodity
prices.
The Banks engage in activities that carry complex on- and off-
balance sheet market risks. For example, CO issuances, for which the
Banks are jointly and severally liable, include: structured notes
having embedded options and exotic features; callable, putable and
index amortizing bonds; bonds that amortize based on a particular
mortgage pool; bonds denominated in foreign currencies; and bonds
linked to equity prices or foreign interest rates. To hedge the market
risk on such complex instruments, the Banks enter into off-balance
sheet derivative contracts that reflect the risks embedded in those
bonds.
The Banks also make advances on a simple fixed or floating rate
basis, as well as callable, putable/convertible and amortizing
advances. The Banks also have invested in agency bonds with callable
and structured features, mortgage and mortgage-backed instruments with
embedded options, and collateralized mortgage obligations.
Given that the Banks undertake transactions that carry market risks
similar to the risks incurred by large banks or securities dealers, the
Finance Board believes that the capital regime for the Banks' market
risks should be similar to the market risk capital requirements
established or recommended by the Basle Committee and other financial
institution regulatory agencies, but broader in scope.
As previously discussed, the drive to institute a risk-based
capital system for general market risk has been spearheaded by the
BCBS. Following the BCBS's lead, the federal bank regulatory agencies
(Office of the Comptroller of the Currency (OCC), Federal Reserve Board
(FRB) and Federal Deposit Insurance Corporation (FDIC)) issued a joint
final rule in September 1996 (12 CFR parts 3, 208, 225 and 325) to
incorporate a measure for market risk, effective as of January 1, 1998
(Joint Rule). Institutions whose trading activity (defined in the Joint
Rule as total assets plus total liabilities in the trading portfolio)
equals 10
[[Page 52181]]
percent or more of their total assets, or whose trading activity equals
$1 billion or more, must use an internal model (with standardized
parameters as set in the Joint Rule) to calculate the capital they must
hold to support their exposure to general market risk. Positions
covered by the rule include: (i) all positions in an institution's
trading account; and (ii) foreign exchange and commodity positions
whether or not in the trading account.
Overall, the Joint Rule implements market risk based capital
requirements that are based on actual risks undertaken by large banks.
This is the only market risk capital framework that has been both
agreed to internationally and implemented in a number of countries.
Under the Joint Rule, large banks in the United States generally have
adopted a simulation-based approach that is capable of capturing market
risks from holding a wide range of simple, exotic and structured
instruments--with or without options and based on mortgages or other
types of transactions.
Financial institutions regulated by the Office of Thrift
Supervision (OTS) (12 CFR 567.5) and the Farm Credit Administration (12
CFR 615.5205, 615.5210) currently are subject to the Basle Accord's
credit risk capital requirements that contain no market risk capital
components (consistent with the small bank regulatory capital
framework). However, the Office of Federal Housing Enterprise Oversight
(OFHEO) recently published a Notice of Proposed Rulemaking including
its regulatory model for calculating risk-based capital for Fannie Mae
and Freddie Mac; that model does account for both interest rate risk
and credit risk. See 12 CFR part 1750. The OFHEO interest rate risk
based capital rule is based on the Federal Housing Enterprise Financial
Safety and Soundness Act of 1992 (1992 Act), which requires that
capital requirements account for market risks. The market risk capital
requirement is determined by a stress test, which examines the effects
of two specified interest rate shocks. See 12 U.S.C. 4611(a)(2).
Currently, the Banks are not subject to any market risk capital
requirements. The FMP requires that the Banks limit their interest rate
risk based on a methodology that uses interest rate shocks similar to
those proposed but never adopted by the three U.S. bank regulatory
agencies (the OCC, the FRB and the FDIC) and the OTS. The FMP requires
the Banks to limit interest rate risk by maintaining the duration of
their equity to within +/-5 years. The FMP also requires the Banks to
maintain the duration of their equity to +/-7 years under an assumed
change in interest rates of +/-200 basis points.
The Finance Board does not believe that the FMP interest rate risk
methodology is sufficiently flexible to continue to capture the market
risks undertaken by the Banks in line with the developments in market
risk measurement and management. Accordingly, this proposed rule sets
forth market risk measures consistent with the value at risk (VAR)
framework for calculation of market risk capital adopted by the BCBS
and other financial institution regulators, an approach that can be
implemented with commercially available models, is practical, and is
sufficiently rigorous.
b. Measurement of market value at risk under Bank internal market
risk model. Section 930.6(b)(1) of the proposed rule requires each Bank
to measure, as the market risk component of its risk-based capital
requirement, the market value at risk using an internal VAR model,
subject to the parameters in the proposed rule. The VAR must be
calculated for interest rate, foreign exchange rate, equity price, and
commodity price risks undertaken by the Bank, including related
options. Currently, the Banks are required by the FMP to hedge risk
associated with foreign exchange rates, equity prices, and commodity
prices with matching derivative contracts. Therefore, the bulk of the
proposed market risk capital requirement will reflect interest rate and
related options risks. Although the Banks will have to consistently
apply the VAR framework to instruments linked to foreign exchange
rates, equity prices, and commodity prices, these other market risks
currently pose a smaller amount of risk, relative to interest rate
risk.
Under proposed Sec. 930.6(b)(1), each Bank must use an internal
market risk model that measures the market value of its portfolio at
risk during periods of extreme market stress arising from all sources
of market risks based on the Bank's holdings of on-balance sheet assets
and liabilities and off-balance sheet items, including risks associated
with related options. Proposed Sec. 930.6(b)(2) provides that the
Bank's internal market risk model may use any generally accepted
measurement technique, such as variance-covariance models, historical
simulations, or Monte Carlo simulations, for estimating the market
value of the Bank's portfolio at risk, provided that any measurement
technique used must cover the Bank's material risks. Proposed
Sec. 930.6(b)(3) provides that the Bank's internal market risk model
must measure the risks arising from the non-linear price
characteristics of options and the sensitivity of the market value of
options to changes in the volatility of the option's underlying rates
or prices. For example, a variance-covariance methodology may be
sufficient for instruments that contain no optionality, while it would
be essential to use a simulation technique for instruments with options
characteristics.
Section 930.6(b)(4) of the proposed rule provides that the Bank's
internal market risk model must use interest rate and market price
scenarios for estimating the market value of the Bank's portfolio at
risk, but must at a minimum include: (i) Monthly estimates of the
market value of the Bank's portfolio at risk so that the probability of
a loss greater than that estimated shall be no more than 1 percent;
(ii) scenarios that reflect changes in rates and market prices
equivalent to those that have been observed over 90-business day
periods of extreme market stress \17\ (for interest rates, the relevant
historical observation period specified in Sec. 930.6(b)(4) is to start
from the end of the previous month and go back to the beginning of 1978
and the VAR measure may incorporate empirical correlations among
interest rates, subject to a Finance Board determination that the
model's system for measuring such correlations is sound); and (iii) the
two interest rate scenarios required to be used by OFHEO to determine
the risk-based capital requirements for Fannie Mae and Freddie Mac,
pursuant to 12 U.S.C. 4611(a)(2).
---------------------------------------------------------------------------
\17\ If the underlying distribution for VAR is approximately
normal, the multiplier of 3 effectively extends the 10 business day
horizon required under the Amendment to 90 business days and applies
to large banks with satisfactory internal models, as determined by
regulators.
---------------------------------------------------------------------------
Proposed Sec. 930.6(b)(5) provides that if a Bank participates in
COs denominated in a currency other than U.S. Dollars or linked to
equity or commodity prices, and these instruments have been hedged for
foreign exchange, equity and commodity risks, the Bank's internal
market risk model must be used to calculate the market value of its
portfolio at risk due to these market risks and using the qualitative
and quantitative requirements specified in the proposed rule, i.e., the
probability of a loss greater than that estimated must not exceed 1
percent and must include scenarios that reflect changes in rates and
market prices that have been observed over 90-business day periods of
extreme market stress. This requirement reflects the conservative
approach adopted by the Finance Board
[[Page 52182]]
with respect to the Banks' safety and soundness and the comprehensive
measurement of all market risks throughout each Bank.
The market valuations for COs may differ from valuations for
matching hedging instruments in the derivative market because of
different assumptions concerning the underlying discount curves,
volatilities and correlations. Prices in the two markets may not be the
same and may fail to move in perfect correlation over time. Therefore,
some measure of market risk remains even if the foreign exchange,
equity or commodity risks are hedged with matching derivative
contracts. The Finance Board believes foreign exchange rates, equity
prices, and commodity prices pose a relatively small amount of market
risk to the Banks at this time. For calculation of value at risk due to
foreign exchange rates, equity and commodity prices, historical
observation data from an appropriate period satisfactory to the Finance
Board must be used. The value at risk measure may incorporate empirical
correlations within foreign exchange rates, equity prices, and
commodity prices, but not among the three risk categories, subject to a
Finance Board determination that the model's system for measuring such
correlations is sound.
Proposed Sec. 930.6(b)(5)(iv) provides that if there is a default
on the part of a counterparty to a derivative contract linked to
foreign exchange rates, equity prices or commodity prices, the Bank
must enter into a replacement contract in a timely manner and as soon
as market conditions permit. Besides strengthening safety and
soundness, this requirement formalizes the long standing practice at
the Banks under which the Banks have not assumed an open (unhedged)
foreign exchange, equity or commodity position and is consistent with
the requirement in proposed Sec. 955.3(b) that the Banks shall not
engage in an open foreign exchange, equity and commodity position.
c. Independent validation of Bank internal market risk model.
Section 930.6(c) of the proposed rule provides that each Bank shall
conduct an independent validation of its internal market risk model
within the Bank or obtain independent validation by an outside party
qualified to make such determinations, on an annual basis, or more
frequently as required by the Finance Board. In order for validations
conducted within the Bank to be considered independent, the validation
must be carried out by personnel not reporting to the business line
responsible for conducting business transactions for the Bank. Such
validation may include periodic comparisons, such as on a quarterly
basis, of model generated mark-to-market values with values obtained
from dealers/markets and periodic comparisons, such as on an annual
basis, of model generated VAR values with values obtained from an
independent third-party source. A Bank may use a representative sample
of its on- and off-balance sheet instruments for this source. An
integral part of this process is the necessity to validate key
assumptions and associated parameters underlying the Bank's market risk
models. For example, a Bank must periodically determine the impact on
VAR of shifts in key parameters such as correlations or regime shifts
in volatility parameters. The results of such validations must be
reviewed by the Bank's board of directors and provided to the Finance
Board.
d. Finance Board approval of Bank internal market risk model.
Section 930.6(d)(1) of the proposed rule provides that each Bank must
obtain approval from the Finance Board of its internal market risk
model, including subsequent material adjustments to the model made by
the Bank, prior to the model's use. A Bank must make any subsequent
adjustments to its model that may be directed by the Finance Board.
e. Basis risk. Banks are exposed to basis risk, which is the risk
that rates or prices of different instruments on the two sides of the
balance sheet (after taking associated off-balance instruments into
account) do not change in perfect correlation over time. The BCBS has
emphasized the importance of basis risk as part of a comprehensive
process for the management of interest rate risk.\18\ In the final
rule, the Finance Board may require the Banks to submit a monthly
report identifying the relevant interest rate or price indices along
with related basis risk exposures. Based on an analysis of such reports
and with the help of other relevant data, an assessment will be made as
to the necessity of developing a basis risk measure to incorporate into
the market risk capital requirement as an amendment to the final
regulation. At this time, the Finance Board is requesting comments on
the treatment of basis risk.
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\18\ See Principles for the Management of Interest Rate Risk
(Jan. 1997).
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f. Transition provision. Section 930.6(d)(2) of the proposed rule
would require each Bank to submit its initial internal market risk
model to the Finance Board for approval within one calendar year of the
effective date of the final rule.
7. Operations Risk Capital Requirement--Sec. 930.7
Proposed Sec. 930.7 provides that each Bank's operations risk
capital requirement shall at any time equal 30 percent of the sum of
the Bank's credit risk capital requirement and market risk capital
requirement at such time. Operations risk is defined in proposed
Sec. 930.1 as the risk of an unexpected loss to a Bank resulting from
human error, fraud, unenforceability of legal contracts, or
deficiencies in internal controls or information systems. There is
currently no generally accepted methodology for measuring the magnitude
of operations risk. Therefore, the proposed rule adopts the same
requirement imposed by statute on Fannie Mae and Freddie Mac. See 12
U.S.C. 4611(c)(2).
8. Reporting Requirements--Sec. 930.8
Proposed Sec. 930.8 provides that each Bank shall report to the
Finance Board by the 15th day of each month its minimum total risk-
based capital requirement, by component amounts (credit risk capital,
market risk capital, and operations risk capital), and its actual total
capital amount and risk-based capital calculated as of the last day of
the preceding month, or more frequently as may be required by the
Finance Board.
9. Capital Stock Redemption Requirements--Sec. 930.9
a. General. The Act establishes minimum stock purchase requirements
for members for purposes of membership, see 12 U.S.C. 1426(b)(1),
1430(e)(3), and for purposes of taking advances. Id. at 1430 (c),
(e)(1). For a variety of reasons, such as a member's anticipation of a
seasonal increase in advance borrowing, many members of the Bank System
currently hold stock in a Bank in excess of the statutory minimum
requirements.
Pursuant to proposed Sec. 930.1 (definition of ``total risk-based
capital for a Bank''), a Bank may allocate a percentage not exceeding
50 percent of all outstanding capital stock satisfying the minimum
capital stock purchase requirements for membership under sections
6(b)(1) and 10(e)(3) of the Act of all voluntary members, and a
percentage not exceeding 50 percent of all other outstanding capital
stock, towards meeting the Bank's total risk-based capital requirement.
Proposed Sec. 930.9(a) provides that the capital stock designated
by a Bank to meet the Bank's total risk-based capital
[[Page 52183]]
can only be redeemed by the Bank with the approval of the Finance
Board. This would be true even for institutions withdrawing from
membership in the Bank System pursuant to section 6(e) of the Act. Id.
at 1426(e). Proposed Sec. 930.9(b) provides that a Bank may at any time
redeem any portion of a member's capital stock not included in or
allocated by the Bank to the Bank's total risk-based capital, provided
that the member's minimum capital stock purchase requirement for
membership in the Bank System under sections 6(b)(1) and 10(e)(3) of
the Act, id. at 1426(b)(1), 1430(e)(3), is maintained. The Bank may
subject such redemptions to the six-month notice provision in section
6(e) of the Act, id. at 1426(e), or may shorten or waive the six-month
notice provision.
The Finance Board's current regulations allow a Bank, after
providing 15 calendar days advance written notice to a member, to
conduct mandatory, unilateral redemption of excess stock, provided that
the minimum stock requirements for membership under the Act are
maintained. See 12 CFR 935.15(b)(1). This provision is retained in the
proposed rule as Sec. 930.9(b)(3). Section 935.15(b)(2) of the Finance
Board's current regulations, 12 CFR 935.15(b)(2), provides that a Bank
may not impose on or accept from a member a fee in lieu of the
mandatory redemption of the member's capital stock. This provision also
is being retained in the proposed rule as Sec. 930.9(b)(4).
The redemption scheme in the proposed rule is designed to maintain
a level of permanence in the Bank's capital within the flexible overall
risk-based capital framework of the proposal. In this way, the most
permanent forms of capital are measured and used as a limitation on
risk-taking activity. The permanent capital of each Bank, retained
earnings and the minimum stock requirement of mandatory members, may be
supplemented by less permanent capital only to the extent that each
Bank designates it as risk-based and imposes on its members the risk
that capital impairment will impede its redemption.
b. Advance Notice of Proposed Rulemaking; Interim Final Rule. The
Finance Board recently published an ANPRM requesting comment on whether
each Bank should be required to unilaterally redeem its members' excess
Bank capital stock to help achieve the goal of reducing the excess
capital stock in each Bank and thereby to reduce each Bank's arbitrage
of its GSE status in non-core mission assets. See 64 FR 16792 (Apr. 6,
1999). Each of the Banks today holds investments that would not be core
mission assets under the proposed rule. Banks with relatively high
amounts of such investments also tend to have relatively high levels of
excess capital stock. See id. at 16793-94.
As discussed in the ANPRM, the Finance Board believes that the
Banks' arbitrage activities for the purpose of generating sufficient
earnings to pay adequate dividends on excess capital stock detract from
the mission of the Banks to promote housing finance and community
lending, by encouraging activities not related to the Banks' mission
and thereby detracting from the financial incentive to engage in
mission-related activity. See id. at 16794. A reduction in the amount
of excess capital stock would reduce the amount of capital stock on
which dividends must be paid, thereby reducing the level of arbitrage
activities conducted in order to generate earnings to pay dividends on
such capital stock. See id. Accordingly, the ANPRM requested comment on
whether the Banks should be required to unilaterally redeem members'
excess capital stock as a way to reduce excess capital stock in the
Bank System and thereby reduce arbitrage activities in non-core mission
assets by the Banks. See id. at 16795.
For the reasons discussed above, the Finance Board also adopted an
interim final rule amending Sec. 935.15(b) of its Advances Regulation
to prohibit the Banks from imposing or accepting a fee in lieu of
redeeming a member's excess capital stock. See 64 FR 16788 (Apr. 6,
1999) (to be codified in 12 CFR 935.15(b)(2)).
The Finance Board received 68 comment letters on the ANPRM, mostly
opposing requiring the Banks to unilaterally redeem members' excess
capital stock, for reasons including that it would adversely impact the
Banks' financial management, daily operations, long-term customer
relationships and flexibility in responding to market needs. The
Finance Board received 4 comment letters on the interim final rule,
with two commenters supporting and two commenters opposing the rule.
The concerns about a Bank's arbitrage of its GSE status with non-core
mission assets that the ANPRM and interim final rule attempted to
address through mandatory reduction of excess capital stock, are
addressed in a different fashion under the financial management and
mission achievement provisions of this proposed rule. Accordingly, the
Finance Board does not intend to pursue at this time the proposals
raised for comment in the ANPRM, but is retaining Sec. 935.15(b)(2) of
its Advances Regulation regarding the fee in lieu prohibition (as
proposed Sec. 930.9(b)(4)).
10. Minimum Liquidity Requirements--Sec. 930.10
Liquidity risk is defined in proposed Sec. 917.1 as the risk that a
Bank would be unable to meet its obligations as they come due or meet
the credit needs of its members and eligible nonmember borrowers in a
timely and cost-efficient manner. In general, the liquidity needs of
the Banks may be classified as: (1) operational liquidity; and (2)
contingency liquidity. Operational liquidity addresses day-to-day or
ongoing liquidity needs under normal circumstances, and may be either
anticipated or unanticipated. Contingency liquidity addresses liquidity
needs under abnormal or unusual circumstances in which a Bank's access
to the capital markets is temporarily impeded. Under such unusual
circumstances, a Bank may still need funds to meet all of its
obligations that are due or to meet some of the credit needs of its
members and eligible nonmember borrowers.
Currently, the Banks operate under two general liquidity
requirements. Both are easily met by the Banks. However, neither is
structured to meet the Banks' liquidity needs should their access to
the capital markets be limited for any reason. The first requirement is
statutory and requires the Banks to maintain an amount equal to total
deposits invested in either obligations of the United States, deposits
in banks or trusts, or advances to members that mature in 5 years or
less. See 12 U.S.C. 1421(g). The second liquidity requirement is in the
FMP. It requires each Bank to maintain a daily average liquidity level
each month in an amount not less than 20 percent of the sum of the
Bank's daily average demand and overnight deposits and other overnight
borrowings during the month, plus 10 percent of the sum of the Bank's
daily average term deposits, COs, and other borrowings that mature
within one year. See FMP section III.C.
The proposed rule specifies a contingency liquidity requirement,
but does not specify an operational liquidity requirement. However,
proposed Sec. 917.3(b)(3)(iii) would require that each Bank's risk
management policy indicate the Bank's sources of liquidity, including
specific types of investments to be held for liquidity purposes, and
the methodology to be used for determining the Bank's operational
liquidity needs.
Section 930.10 of the proposed rule provides that the Banks must
meet not only the statutory liquidity
[[Page 52184]]
requirements contained in section 11(g) of the Act, 12 U.S.C. 1431(g),
but also each Bank shall hold contingency liquidity in an amount
sufficient to enable the Bank to cover its liquidity risk, assuming a
period of not less than seven calendar days of inability to borrow in
debt markets. Contingency liquidity may be provided through Banks: (1)
selling liquid assets; (2) pledging government, agency and mortgage-
backed securities as collateral for repurchase agreements; and (3)
borrowing in the federal funds market. Consequently, contingency
liquidity is defined in proposed Sec. 930.1 as: (1) marketable assets
with a maturity of one year or less; (2) self-liquidating assets with a
maturity of seven days or less; and (3) assets that are generally
accepted as collateral in the repurchase agreement market. Proposed
Sec. 930.10 provides that an asset that has been pledged under a
repurchase agreement cannot be used to satisfy the contingency
liquidity requirement, since such an asset will not be available to
provide liquidity should a contingency arise.
The proposed seven-day contingency liquidity requirement would help
to ensure that the Banks maintain sufficient liquidity to meet their
funding needs should their access to the capital markets be temporarily
limited by occurrences such as: (1) a power outage at the Bank System's
Office of Finance (OF); (2) a natural disaster; or (3) a real or
perceived credit problem. This requirement was calculated using daily
data on CO redemptions during 1998. The Finance Board found that the
99th percentile of the 5-business day CO redemption distribution
resulted in liquidity requirements that ranged from about 5 percent to
17 percent of each Bank's total assets.
It is expected that the contingency liquidity requirement and the
Banks' operational liquidity needs can be met within the core mission
activities requirement in proposed Sec. 940.4. The Banks' capital and
deposits are available to fund liquidity assets, and some core mission
assets may also serve as liquidity assets. In addition, the Finance
Board expects that the Banks' liquidity requirements will generally
decline as they restructure their balance sheets to comply with the
core mission activities requirements in proposed Sec. 940.4.
The seven-day requirement may be viewed as conservative when
examined in the context of events which could impair the normal
operations of the OF. The likelihood that there would be no access to
the capital markets for as long as five business days is extremely
remote, given OF contingency plans to be back in operation within the
same business day following a disaster. The OF contingency plans
include back-up power sources and two back-up facilities, plus
procedures to back-up their databases at both their main location as
well as the primary alternative site. A back-up data tape from OF's
main location is sent and stored off-site on a daily basis.
Real or perceived concerns about creditworthiness of the Bank
System could lead to a widening of the spreads to U.S. Treasury
securities at which the Bank System COs are issued. Depending on the
size of the increase in credit spreads, such an event could
substantially impair the Banks' ability to carry out their mission. Two
such episodes affecting other GSEs took place in the 1980s. In both
cases, the interest rate spread narrowed back to normal levels only
after the GSEs received assistance from the federal government.\19\ In
the first instance, the spread to comparable U.S. Treasury securities
for a Farm Credit System issue increased approximately 80 basis points
within a 6 month period during 1985 as the Farm Credi
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