Powers and Responsibilities of Federal Home Loan Bank Boards of Directors and Senior Management

FEDERAL HOUSING FINANCE BOARD

12 CFR Part 917

[No. 99-64]

RIN 3069-AA90

Powers and Responsibilities of Federal Home Loan Bank Boards of

Directors and Senior Management

AGENCY: Federal Housing Finance Board.

ACTION: Proposed rule.

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SUMMARY: The Federal Housing Finance Board (Finance Board) is proposing

new regulations to set forth the responsibilities of the boards of

directors and senior management of the Federal Home Loan Banks (Banks)

as a means of ensuring that they fulfill their duties to operate the

Banks in a safe and sound manner and in furtherance of the Banks'

housing finance and community lending mission.

DATES: Comments on this proposed rule must be received in writing on or

before February 2, 2000.

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; Office of

Policy, Research and Analysis; Eric M. Raudenbush, Senior Attorney-

Advisor, (202) 408-2932; Office of General Counsel, Federal Housing

Finance Board, 1777 F Street, NW, Washington, DC 20006.

SUPPLEMENTARY INFORMATION:

I. Background

A. Devolution of Corporate Governance Authorities

Prior to the enactment of the Financial Institutions Reform,

Recovery and Enforcement Act (FIRREA) of 1989, Pub. L. 101-73, 103

Stat. 413 (1989), many decisions regarding the corporate governance of

the Banks were either made or approved by the Bank System regulator

(which, prior to FIRREA, was the former Federal Home Loan Bank Board).

Since the creation of the Finance Board and the reform of the Bank

System under FIRREA, it has been the policy of the Finance Board to

devolve to the Banks authority to act on most matters of corporate

governance without the prior approval of the Finance Board, to the

extent permitted by statute and to the extent such devolution does not

compromise the Finance Board's duty to ensure the safety and soundness

of the Banks. The Finance Board has long recognized the importance of

maintaining its regulatory independence, and that the safety and

soundness regulator of the Banks should not involve itself in the

business affairs of the Banks, nor make governance decisions that more

properly lie with the Banks as corporate entities.\1\ Despite this

regulatory policy, statutory provisions have required that certain

matters pertaining to corporate governance remain within the decision-

making power of the Finance Board.

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\1\ See General Accounting Office, Federal Home Loan Bank

System--Reforms Needed to Promote Its Safety, Soundness, and

Effectiveness (Dec. 1993).

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On November 12, 1999, the President signed into law the Federal

Home Loan Bank System Modernization Act of 1999 \2\ (Modernization

Act), Pub. L. 106-102, Title VI (1999), which, among other things,

removed the remaining corporate governance authorities that previously

had been vested in the Finance Board under the Federal Home Loan Bank

Act (Bank Act). 12 U.S.C. 1422-49. To implement these statutory

changes, the Finance Board has published separately an interim final

rule removing regulations that required Finance Board approval for the

following matters of corporate governance: selection and compensation

of Bank officers and employees; entering into building leases and

purchases; adoption and revision of Bank bylaws; dividend payments;

application forms for Bank advances; Bank approval of conditional

advances; and transfer of advances and advance participations. See 64

FR 71275 (1999).

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\2\ The Modernization Act is Title VI of the larger Gramm-Leach-

Bliley Act. Pub. L. 106-102 (1999).

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Management responsibilities over the Banks have been rightfully

removed from the statutory purview of the Finance Board. However, the

Finance Board continues to be responsible for ensuring that the Banks

operate in a financially safe and sound manner and carry out their

statutory housing finance and community lending mission. See 12 U.S.C.

1422a(a)(3). In that capacity, the Finance Board believes that it is

prudent to set forth explicitly in regulation a state-of-the-art

corporate governance framework for the Banks' boards of directors and

senior management.

The proposed rule includes provisions defining the

responsibilities--and thus the accountability--of the boards of

directors and senior management of the Banks 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, the establishment of independent audit committees, and

adoption of and compliance with a strategic business plan, as further

detailed below.

B. Effect of the Proposed Rule To Reorganize the Finance Board's

Regulations

On September 27, 1999, the Finance Board published a notice of

proposed rulemaking to reorganize its regulations to implement a more

logical and efficient presentation of the regulations governing the

Banks and the Bank System. See 64 FR 52148 (1999). Because it is

anticipated that a final reorganization rule will be in effect before

the substantive regulatory amendments contained in this proposal would

become final, cross-references appearing in the text of this proposed

rule are made to the new section and part numbers that would be in

effect once the final reorganization rule is adopted. Where such

references are to provisions that currently exist under different

section or part numbers, the existing citation has been noted in this

preamble.

C. The Banks as Corporate Entities

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 Bank Act (as

amended by the Modernization 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 Bank 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 Bank Act grants each

Bank all such incidental powers as are consistent with the provisions

of the Bank Act and customary and usual in corporations generally. See

id. at 1432(a). The Finance Board believes that, attendant to the

exercise of customary and usual

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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 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. 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 (which, in this rule, the Finance Board has

referred to as ``associates'') upon statutorily specified collateral.

See id. at 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 has the power to sue and be sued. See id. at

1432(a). In addition, each Bank has adopted bylaws that address such

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.

II. Analysis of Proposed Rule

A. Overview

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 would 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 each Bank. Generally, under proposed part 917, the board

of directors of each Bank would be responsible for: (1) Approving and

periodically reviewing the significant policies of the Bank; (2)

understanding the major risks taken by the Bank, setting acceptable

tolerance levels for these risks and requiring that senior management

takes the steps necessary to identify, measure, monitor and control

these risks; (3) monitoring the Bank's compliance with applicable

statutes, regulation and policy (both of the Finance Board and the

Bank); (4) adopting and maintaining policies to ensure that the Bank

carries out its housing finance and community lending mission; (5)

approving the organizational structure and delegations of authority;

and (6) overseeing senior management's establishment and maintenance of

an adequate and effective system of internal controls and senior

management's monitoring of the effectiveness of the internal control

system.

Proposed part 917 also provides generally that senior management of

each Bank would be responsible for: (1) Implementing strategies and

policies approved by the Bank's board; (2) developing processes that

identify, measure, monitor and control risks incurred by the Bank; (3)

maintaining an organizational structure that clearly assigns

responsibility, authority and reporting relationships; (4) ensuring

that delegated responsibilities are effectively carried out; (5)

setting appropriate internal control policies; and (6) 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 require that the boards of directors

oversee both risk management for safety and soundness and achievement

of the public purpose of supporting housing and community lending.

Oversight by both the boards of directors and senior management is

integral to the overall business operation of a Bank. The first line of

defense in ensuring safety and soundness is 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 proposed rule would require that the boards of directors of the

Banks fulfill these important responsibilities.

B. Definitions--Sec. 917.1

Section 917.1 of the proposed rule sets forth definitions of terms

used in part 917. These terms are discussed below as they relate to the

substantive provisions of the proposed rule.

C. General Authorities and Duties of Bank Boards of Directors--

Sec. 917.2

The first sentence of Sec. 917.2(a) of the proposed rule would

implement the first clause of section 7(a) of the Bank Act, 12 U.S.C.

1427(a), which states that the management of each Bank shall be vested

in its board of directors. The Finance Board interprets this statutory

provision as charging each Banks' board of directors with the ultimate

legal responsibility for guiding the activities of the Bank, and not as

a requirement that a Bank's board of directors administer the day-to-

day operations of the Bank. Accordingly, the second sentence of

proposed Sec. 917.2(a) makes clear that a Bank's board of directors may

delegate responsibility for such day-to-day operations to Bank

management, but that, in so doing, may not and can not delegate its

ultimate statutory responsibility for the management of the Bank.

Proposed Sec. 917.2(b) enumerates the duties that would apply to

all official activities of each board director. Specifically, proposed

Sec. 917.2(b)(1) would charge each director with the duty to 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. Proposed

Sec. 917.2(b)(2) would implement section 7(j) of the Bank Act, id. at

1427(j), by requiring that directors administer the affairs of the Bank

fairly and impartially.

Proposed Sec. 917.2(b)(3) would require that each board director be

financially literate (i.e., have a working familiarity with basic

finance and accounting practices), or become financially literate

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within a reasonable time after his or her election or appointment to

the board of directors. This financial literacy may be obtained through

training provided by the Bank if a director does not possess such

financial literacy at the time of his or her election or appointment to

the board. Finally, proposed Sec. 917.2(b)(4) would charge each Bank

director with the general duty to direct the operations of the Bank in

conformity with the requirements of the Bank Act and the Finance

Board's regulations.

In order to ensure that Bank boards of directors are able to

oversee effectively the management of the Banks, proposed

Sec. 917.2(c)(1) would make clear that this section simply codifies the

existing authority all Bank boards of directors, and all committees

thereof, have to retain staff and outside consultants at the expense of

the Bank, as necessary to carry out their official duties and

responsibilities. Proposed Sec. 917.2(c)(2) states that the board of

directors, or any committee thereof, may require any internal Bank

staff providing services to the board or committee on a particular

matter to report directly to the board or committee on that matter.

D. 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, beginning 90 days after

the effective date of this rule in final form, each Bank's board of

directors have in effect at all times a risk management policy

addressing the Bank's exposure to credit risk, market risk, liquidity

risk, business risk and operations risk, as those terms are defined in

proposed Sec. 917.1. 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. While, under proposed Sec. 917.3(a)(1) a Bank need not

submit its risk management policy to the Finance Board, these 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, while proposed Sec. 917.3(a)(2)(ii) would make clear that

each Bank's board shall amend its risk management policy, as

appropriate to meet changing circumstances. 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 would make clear 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 policies and procedures are in place to achieve Bank

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 plan

describe how the Bank will comply with its capital structure plan

required under section 6(b) of the Bank Act (as amended by the

Modernization Act), 12 U.S.C. 1426(b), to be submitted to the Finance

Board within 270 days of the Finance Board's promulgation of

regulations prescribing uniform capital standards for the Banks

pursuant to section 6(a) of the Bank Act (as amended by the

Modernization Act), id. at 1426(a). 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) would require 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. 917.1 as the risk that the market value of an

obligation will decline as a result of deterioration in

creditworthiness. The creditworthiness of an obligation can be affected

by both the creditworthiness of the specific counterparty or the

market's general perception of the creditworthiness of an entire class

of obligations. 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. 917.1 as the risk of loss

in value of the Bank's portfolio resulting from movements in interest

rates, foreign exchange rates and equity and commodity prices. 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. While the Bank System Financial Management

Policy (FMP) currently governs Bank liquidity requirements, it is

anticipated that the Finance Board will promulgate new liquidity

regulations in a future rulemaking.

Operations risk is defined in proposed Sec. 917.1 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 that each Bank's risk management policy address operations risk

by setting forth standards for an effective internal control system (as

described in more detail in the discussion of proposed Sec. 917.4

below), including periodic testing and reporting.

Business risk is defined in proposed Sec. 917.1 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

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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.

E. Internal Control System--Sec. 917.4

While the existing FMP requires that the management of each Bank

establish internal control systems, the FMP provides no guidance on how

to ascertain the sufficiency of the systems. There have been several

instances where internal control weaknesses have been discovered

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 must 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 Basle Committee on Banking

Supervision's (BCBS) 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 Report). 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--i.e., 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 the successful devolution of full

corporate governance authority to the Banks. 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(a)(1) would require each Bank to establish and

maintain an effective internal control system that addresses: (i) The

efficiency and effectiveness of Bank activities; (ii) the safeguarding

of assets; (iii) 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 (iv) 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: (i)

Top level reviews by the Bank's board of directors and senior

management; (ii) activity controls, including review of standard

performance and exception reports; (iii) physical and procedural

controls adequate to safeguard, and prevent the unauthorized use of,

assets; (iv) 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); (v) any required approvals and authorizations

for specific activities; and (vi) any required 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 to ensure that the internal

control system required under proposed Sec. 917.4(a)(1) is established

and maintained, and to oversee senior management's implementation of

the system on an ongoing basis. Under proposed Sec. 917.4(b), a Bank's

board of directors will be considered to have met these general

requirements on internal control system establishment, maintenance and

oversight if it: (1) Conducts periodic discussions with senior

management regarding the effectiveness of the internal control system;

(2) ensures that an effective and comprehensive internal audit of the

internal control system is performed annually; (3) requires internal

control deficiencies to be reported to the Bank's board of directors in

a timely manner and ensures that such deficiencies are addressed

promptly; (4) conducts a timely review of evaluations of the

effectiveness of the internal control system made by auditors and

Finance Board examiners; (5) ensures that senior management promptly

and effectively addresses recommendations and concerns expressed by

auditors and Finance Board examiners regarding weaknesses in the

internal control system; (6) reports internal control deficiencies, and

the corrective action taken, to the Finance Board in a timely manner;

(7) establishes, documents and communicates a clear and effective

organizational structure for the Bank; (8) ensures that all delegations

of board authority state the extent of the authority and

responsibilities delegated; and (9) establishes reporting requirements.

Section 917.4(c) of the proposed rule would require senior

management at each Bank 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: (1) Establishing, implementing and

effectively communicating to Bank personnel policies and procedures

that are adequate to ensure that internal control activities necessary

to maintain

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an effective internal control system are an integral part of the daily

functions of all Bank personnel; (2) ensuring that all Bank personnel

fully understand and comply with all policies and procedures; (3)

ensuring appropriate segregation of duties among Bank personnel and

that personnel are not assigned conflicting responsibilities; (4)

establishing effective paths of communication throughout the

organization in order to ensure that Bank personnel receive necessary

and appropriate information; (5) developing and implementing procedures

that translate the major business strategies and policies established

by the board of directors into operating standards; (6) ensuring

adherence to the lines of authority and responsibility established by

the Bank's board of directors; (7) overseeing the implementation and

maintenance of management information and other systems; (8)

establishing and implementing an effective system to track internal

control weaknesses and the actions taken to correct them; and (9)

monitoring and reporting to the Bank's board of directors the

effectiveness of the internal control system on an ongoing basis.

F. Audit Committees--Sec. 917.5

Section 917.5 of the proposed rule would require that each Bank's

board of directors establish an audit committee. 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: (1) 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; (2) the audit committee shall consist of at least

three board members and shall include appointed directors and elected

directors; (3) that in determining the membership of the audit

committee, the board of directors should provide for continuity of

service; (4) 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; (5) the audit committee shall oversee the selection,

compensation, and performance evaluation of the audit director; (6)

written minutes shall be prepared for each meeting and a copy of such

minutes forwarded to the Finance Board; and (7) 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 would set forth a clear regulatory requirement

that each Bank have an audit committee, and would govern the audit

committees' 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 federal

financial institution regulatory agencies and the Report and

Recommendations of the Blue Ribbon Committee on Improving the

Effectiveness of Corporate Audit Committees (Feb. 8, 1999) (hereinafter

Blue Ribbon Committee Report). The Securities and Exchange Commission

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 Secs. 917.5(b)(1) and

(2) 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 community

financial institutions, as defined in section 2(13) of the Bank Act (as

amended by the Modernization Act) 12 U.S.C. 1422(13), and other members

and of appointed and elected directors of the Bank. The requirement in

proposed Sec. 917.5(b)(1) that the audit committee comprise five or

more persons differs from the recommendation of the Blue Ribbon

Committee Report that the audit 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 interest. A minimum of five members is

necessary to achieve diverse representation on the audit committee.

Proposed Sec. 917.5(b)(3) would require that the terms of audit

committee members 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.

Under proposed Sec. 917.2, all members of a Bank's board of

directors would be required to be financially literate; that is, to be

able to read and understand the Bank's balance sheet and income

statement and to ask substantive questions of internal and external

auditors. In addition to this general requirement, proposed

Sec. 917.5(b)(4) would require that at least one member of each bank's

audit committee have extensive accounting or related financial

management experience. The Finance Board requests comment as to whether

this requirement regarding accounting or financial management

experience should be made to apply specifically to the chair of the

audit committee, or whether it is sufficient to require only that at

least one member of the audit committee possess such experience. The

Finance Board also requests comment on whether the chair of the audit

committee should be required to serve as vice-chair of the full board

of directors in order to ensure that the audit committee chair has

adequate incentive for effective leadership.

In addition, proposed Sec. 917.5(c) would require that any 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

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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 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. This 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 and assess the adequacy of and, where appropriate,

amend the provisions of the audit committee charter annually and to

readopt the charter, including amendments, not less often than every

three years, 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: (i) that

the audit committee has the responsibility to select, evaluate and,

where appropriate, replace the internal auditor and that the internal

auditor may be removed only with the approval of the audit committee;

(ii) that the internal auditor shall report directly to the audit

committee on substantive matters and that the internal auditor is

ultimately responsible to the audit committee and the board of

directors; and (iii) that the internal and external auditors be allowed

unrestricted access to the audit committee without any requirement of

management knowledge or approval. Although not expressly stated in

Sec. 917.5, the audit committee would be required, under the general

provisions of proposed Sec. 917.2(c), to have the authority to use the

services of Bank staff and to employ such outside experts as it deems

necessary to carry out its functions. 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:

(1) Direct senior management to maintain the reliability and integrity

of the accounting policies and financial reporting and disclosure

practices of the Bank; (2) review the basis for the Bank's financial

statements and the external auditor's opinion rendered with respect to

such financial statements and ensure that policies are in place to

achieve disclosure and transparency regarding the Bank's true financial

performance and governance practices; (3) oversee the internal audit

function; (4) oversee the external audit function; (5) act as an

independent, direct channel of communication between the Bank's board

of directors and the internal and external auditors; (6) conduct or

authorize investigations into any matters within the audit committee's

scope of responsibilities; (7) ensure that senior management has

established and is maintaining an adequate internal control system; (8)

review the policies and procedures established by senior management to

monitor implementation of the Bank's strategic business plan required

under Sec. 917.9 of the proposed rule; and (9) report periodically its

findings to the Bank's board of directors.

Proposed Sec. 917.5(e)(8) requires that the audit committee oversee

not only financial audits but also oversee an audit of the controls in

place to ensure the Bank's compliance with its strategic business plan.

However, the audit committee is not required to assess the Bank's

actual conformity with its strategic business plan, or the extent to

which the Bank has achieved its statutory mission. Review of the

strategic business plan of the Bank is the responsibility of the full

board of directors, as more fully discussed in proposed

Sec. 917.9(c)(3) below.

Finally, proposed Sec. 917.5(f) would require that each Bank's

audit committee prepare written minutes of each audit committee

meeting.

G. Budget Preparation--Sec. 917.6

Proposed Sec. 917.6 would require that: (a) Each Bank's board of

directors adopt an annual operating expense budget and a capital

expenditures budget; (b) a Bank's board of directors not delegate the

authority to approve the Bank's annual budgets, or any subsequent

amendments thereto, to Bank officers or other Bank employees; (c) each

Bank's annual budgets be prepared based upon an interest rate scenario

as determined by the Bank; and (d) no Bank exceed its total annual

operating expense budget or its total annual capital expenditures

budget without prior approval by the Bank's board of directors of an

amendment to such budget.

These provisions are carried over from existing Sec. 934.7 of the

Finance Board's regulations, which itself was recently amended by an

interim final rule. See 64 FR 71275. As part of the Finance Board's

effort to relinquish all Bank corporate governance responsibilities,

the recent interim final rule deleted old paragraphs (b) through (e) of

Sec. 934.7, which had required that each Bank submit to the Finance

Board certain specified budget information. In addition, the interim

final rule deleted old paragraph (a)(2) of Sec. 934.7, requiring

Finance Board approval for Banks' purchase or long-term lease of

buildings, because, subsequent to the enactment of the Modernization

Act, such approval is no longer a statutory requirement. See

Modernization Act at 606(d). Finally, the interim final rule

redesignated remaining paragraphs (a)(1), (3), (4) and (5) as

paragraphs (a), (b), (c) and (d), respectively.

The Finance Board is proposing to move the provisions of Sec. 934.7

to part 917 because most of the material in part 934 will be deleted

through the reorganization rule, and regulations governing budget

reporting requirements come logically within the realm of board of

directors' and senior management responsibilities.

H. Dividends--Sec. 917.7

Section 917.7 of the proposed rule provides that a Bank's board of

directors may declare and pay a dividend only from previously retained

earnings or current net earnings, as determined by the Bank, and only

if such payment will not result in the impairment of the par value of

the capital stock of the Bank. This language has been moved from

existing Sec. 934.17, which, itself, was recently amended in an interim

final rule intended to immediately implement certain devolutionary

changes required under the Modernization Act. See 64 FR 71275.

Before the enactment of the Modernization Act, section 16(a) of the

Bank Act provided generally that dividends may be paid by the Banks out

of previously retained earnings or current net earnings only with the

approval of the Finance Board. See 12 U.S.C. 1436(a) (1999). Section

934.17 of the Finance Board's regulations formerly implemented this

statutory provision by providing generally that

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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 (1999). In addition,

dividend payments by the Banks were formerly subject to a Finance Board

Dividend Policy, see Finance Board Res. No. 90-38 (Mar. 15, 1990), as

well as Board of Directors Resolutions approving specific Bank dividend

payments, that established specific conditions for approval of such

dividend payments, including that the dividend payment would not result

in a projected impairment of the par value of the capital stock of the

Bank.

The Modernization Act amended section 16(a) of the Bank Act by

removing the requirement for Finance Board approval of Bank dividend

payments. See Modernization Act at section 606(g)(1)(B). Accordingly,

the Finance Board removed most of the specific dividend payment

restrictions formerly set forth in Sec. 934.17 and in the Dividend

Policy. However, for considerations of safety and soundness, the

Finance Board believes that the impairment restriction formerly imposed

under the Dividend Policy should continue to apply. In addition, while

the Modernization Act provided for the repeal of section 6(g) of the

Bank Act (requiring that all Bank stock share in dividends without

preference), section 6(g) remains in effect during a transition period

until the Finance Board has adopted capital regulations and approved

the capital structure plans of the Banks. See Modernization Act at

section 608. Consequently, Sec. 934.17 was amended to contain only the

requirement that dividends be paid on all stock without preference and

the impairment restriction set forth in the former Dividend Policy.

Because the reorganization rule, discussed above, will eliminate

part 934 of the Finance Board's regulations and because the Finance

Board wishes to retain the substance of recently-amended Sec. 934.17 in

its regulations, the agency is proposing to move this material to new

part 917, given that approval of dividend payments is a responsibility

of a Bank's board of directors.

I. Bank Bylaws--Sec. 917.8

Section 917.8 of the proposed rule would require that a Bank's

board of directors have in effect at all times bylaws governing the

manner in which the Bank administers its affairs and that such bylaws

be consistent with applicable laws and regulations as administered by

the Finance Board. The proposed rule merely moves this language from

existing Sec. 934.16, which, as is the case with the section on

dividends discussed above, was recently amended in an interim final

rule intended to immediately implement certain provisions of the

Modernization Act. See 64 FR 71275.

Before the enactment of the Modernization Act, section 12(a) of the

Bank Act provided that the Banks had the power, by their boards of

directors, to prescribe, amend, and repeal bylaws governing the manner

in which their affairs may be administered, subject to the approval of

the Finance Board. See 12 U.S.C. 1432(a). At that time, Sec. 934.16 of

the Finance Board's regulations allowed the Banks to adopt, amend or

repeal their bylaws without Finance Board approval, as long as the

bylaws or amendments were consistent with applicable statutes,

regulations and Finance Board policies. See 12 CFR 934.16.

The Modernization Act amended section 12(a) of the Bank Act by

removing the requirement for Finance Board approval of Bank bylaws,

provided that the bylaws are consistent with applicable laws and

regulations, as administered by the Finance Board. See Modernization

Act at section 606(d)(1)(C). In order to promote sound corporate

governance practice, the Finance Board amended Sec. 934.16 to require

the Banks to have bylaws governing the manner in which the Banks'

affairs are conducted. Because the reorganization rule, discussed

above, will eliminate part 934 of the Finance Board's regulations, the

proposed rule would move the amended language of Sec. 934.16, to part

917, as the enactment of bylaws is a duty of each Bank's board of

directors.

J. Mission of the Banks; Strategic Business Plan--Sec. 917.9

Proposed Sec. 917.9 sets forth requirements that each Bank must

meet in developing a strategic business plan to enumerate the Banks

goals and objectives for achieving the mission of the Bank. The Bank

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, as government-sponsored enterprises

(GSEs), 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 strategic business planning seriously and impress the

importance of implementing the plan and mission achievement upon Bank

management and staff. The Banks' boards of directors must be fully

engaged so that there is an appropriate focus on strategic business

plan implementation and mission achievement at all levels of the Bank.

Proposed Sec. 917.9(a) defines the mission of the Banks as

providing to members and associates (i.e., entities that have been

approved as a nonmember mortgagee pursuant to subpart B of part 950

(currently part 935) of the Finance Board's regulations) financial

products and services, including but not limited to advances (i.e.,

correspondent services and other Bank business activities may be

considered to be mission-related), that assist and enhance such

members' and associates' financing of: (1) Housing, including single-

family and multi-family housing serving consumers at all income levels,

and (2) community lending as defined in Sec. 953.3 (current Sec. 970.3)

of the Finance Board's regulations. This statement of mission and the

related strategic business plan requirements of Sec. 917.9 are intended

to ensure maximum use of the cooperative structure of the Bank System

to provide funds for housing finance and community lending.

Proposed Sec. 917.9(b) would require that, beginning 90 days after

the effective date of the provision, each Bank's board of directors

have in effect at all times a strategic business plan describes how the

business activities of the Bank with achieve the mission of the Bank.

Specifically, the plan would be required to: (1) Enumerate the business

activities that the Bank has determined are consistent with the mission

of the Bank and the reasons that those activities are so designated,

including how such activities assist and enhance members' and

associates' business and further the cooperative nature of the Bank

System; (2) enumerate operating goals and objectives for each major

business activity and all new activities; and (3) describe new business

activities and enhancements to existing activities. In addition,

proposed Sec. 917.9(b)(4) would require that each Bank's strategic

business plan be supported by appropriate and timely research and

analysis of relevant market developments and member and associate

demand for Bank products and services.

The Banks already are required to prepare a ``Housing Finance and

Community Development Mission Achievement Report'' (HFCDMA Report) to

be reviewed by the Finance Board as part of its annual supervisory

examination of each Bank. Although the HFCDMA Report addresses topics

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similar to those that would be addressed in the strategic business

plan, the focus of the Report is primarily retrospective, while the

strategic business plan is intended to be prospective. However, to the

extent that information prepared for the HFCDMA Report, or any other

reports, meets the regulatory requirements for the strategic business

plan, a Bank would be permitted to use this work product to satisfy the

strategic business plan requirements.

As with the risk management policy, proposed Sec. 917.9(c)(1) would

require that the Bank's board of directors review the Bank's strategic

business plan on at least an annual basis, while proposed

Sec. 917.9(c)(2) would require that the board amend the strategic

business plan, as appropriate, based on these reviews. Proposed

Sec. 917.9(c)(3) would require a Bank's board of directors to re-adopt

a strategic business plan, including interim amendments, not less often

than every three years, as appropriate, based on the board's reviews of

the policy. As with the similar provision in proposed

Sec. 917.3(a)(2)(iii), 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 strategic

business plan, 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(c)(4)

also would make clear that each Bank's board of directors has the

responsibility to establish management reporting requirements and

monitor implementation of the strategic business plan and the operating

goals and objectives contained therein.

These provisions would require the board of directors to oversee

the process of assessing the Bank's implementation of its strategic

business plan, but would 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 the

strategic business plan. Thus, proposed Sec. 917.9 requires that the

board of directors oversee Bank implementation of the strategic

business plan, but 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 the

Bank's implementation of its strategic business plan is carried out.

III. Regulatory Flexibility Act

The proposed rule applies only to the Banks, which do not come

within the meaning of ``small entities,'' as defined in the Regulatory

Flexibility Act (RFA). See 5 U.S.C. 601(6). Therefore, in accordance

with section 605(b) of the RFA, see id. at 605(b), the Finance Board

hereby certifies that this proposed rule, if promulgated as a final

rule, will not have a significant economic impact on a substantial

number of small entities.

List of Subjects in 12 CFR Parts 917

Community development, Credit, Housing and Federal home loan banks.

Accordingly, the Finance Board hereby proposes to amend title 12,

chapter IX, Code of Federal Regulations, by adding a new part 917 to

read as follows:

PART 917--POWERS AND RESPONSIBILITIES OF BANK BOARDS OF DIRECTORS

AND SENIOR MANAGEMENT

Sec.

917.1 Definitions.

917.2 General authorities and duties of Bank boards of directors.

917.3 Risk management.

917.4 Internal control system.

917.5 Audit committees.

917.6 Budget preparation and reporting requirements.

917.7 Dividends.

917.8 Bank bylaws.

917.9 Mission of the Banks; Strategic business plan.

Authority: 12 U.S.C. 1422a(a)(3), 1422b(a)(1), 1427, 1432(a),

1436(a), 1440.

Sec. 917.1 Definitions.

As used in this part:

Associate means an entity that has been approved as a nonmember

mortgagee pursuant to subpart B of part 950 of this chapter.

Business risk means 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.

Capital structure plan means the plan establishing and implementing

a capital structure that each Bank is required to submit to the Finance

Board under 12 U.S.C. 1426(b).

Community financial institution has the meaning set forth in 12

U.S.C. 1422(13).

Community lending has the meaning set forth in Sec. 952.3 of this

chapter.

Contingency liquidity means:

(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.

Credit risk means the risk that the market value of an obligation

will decline as a result of deterioration in creditworthiness.

Immediate family member means a parent, sibling, spouse, child,

dependent, or any relative sharing the same residence.

Internal auditor means the individual responsible for the internal

audit function at the Bank.

Liquidity risk means the risk that a Bank is 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.

Market risk means the risk that the market value of a Bank's

portfolio will decline as a result of changes in interest rates,

foreign exchange rates, equity and commodity prices.

Operations risk means 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.

Sec. 917.2 General authorities and duties of Bank boards of directors.

(a) Management of the Bank. The management of each Bank shall be

vested in its board of directors. While Bank boards of directors may

delegate the execution of operational functions to Bank personnel, the

ultimate responsibility of each Bank's board of directors for that

Bank's management is non-delegable.

(b) Duties of Bank directors. Each Bank director shall have the

duty to:

(1) 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;

(2) Administer the affairs of the Bank fairly and impartially and

without discrimination in favor of or against any member;

(3) Be financially literate, or become financially literate within

a reasonable time after appointment or election; and

(4) Direct the operations of the Bank in conformity with the

requirements set forth in the Act and this chapter.

(c) Authority regarding staff and outside consultants. (1) In

carrying out its duties and responsibilities under the Act and this

chapter, each Bank's board of directors and all committees thereof

shall have authority to retain staff and

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outside counsel, independent accountants, or other outside consultants

at the expense of the Bank.

(2) Bank staff providing services to the board of directors or any

committee of the board under paragraph (c)(1) of this section may be

required by the board of directors or such committee to report directly

to the board or such committee, as appropriate.

Sec. 917.3 Risk management.

(a) Adoption of risk management policy. (1) Beginning 90 days after

the effective date of this section, each Bank's board of directors

shall have in effect at all times a risk management policy that

addresses the Bank's exposure to credit risk, market risk, liquidity

risk, business risk and operations risk and that conforms to the

requirements of paragraph (b) of this section and to all applicable

Finance Board regulations and policies.

(2) Review and compliance. Each Bank's board of directors shall:

(i) Review the Bank's risk management policy at least annually;

(ii) Amend the risk management policy as appropriate;

(iii) Re-adopt the Bank's risk management policy, including interim

amendments, not less often than every three years; and

(iv) Ensure that policies and procedures are in place to achieve

Bank compliance at all times with the risk management policy.

(b) Risk management policy requirements. In addition to meeting any

other requirements set forth in this chapter, each Bank's risk

management policy shall:

(1) Describe how the Bank will comply with its capital structure

plan, after such plan is approved by the Finance Board;

(2) Set forth the Bank's tolerance levels for the market and credit

risk components; and

(3) Set forth standards for the Bank's management of each risk

component, including but not limited to:

(i) Regarding credit risk arising from all secured and unsecured

transactions, standards and criteria for, and timing of, periodic

assessment of the creditworthiness of issuers, obligors, or other

counterparties including identifying the criteria for selecting

dealers, brokers and other securities firms with which the Bank may

execute transactions; and

(ii) Regarding market risk, standards for the methods and models

used to measure and monitor such risk;

(iii) Regarding day-to-day operational liquidity needs and

contingency liquidity needs for periods during which the Bank's access

to capital markets is impaired:

(A) An enumeration of specific types of investments to be held for

such liquidity purposes; and

(B) The methodology to be used for determining the Bank's

operational and contingency liquidity needs;

(iv) Regarding operations risk, standards for an effective internal

control system, including periodic testing and reporting; and

(v) Regarding business risk, strategies for mitigating such risk,

including contingency plans where appropriate.

(c) Risk assessment. The senior management of each Bank shall

perform, at least annually, a 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. The risk

assessment shall be in written form and shall be reviewed by the Bank's

board of directors promptly upon its completion.

Sec. 917.4 Internal control system.

(a) Establishment and maintenance. (1) Each Bank shall establish

and maintain an effective internal control system that addresses:

(i) The efficiency and effectiveness of Bank activities;

(ii) The safeguarding of Bank assets;

(iii) 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

(iv) Compliance with applicable laws, regulations, policies,

supervisory determinations and directives of the Bank's board of

directors and senior management.

(2) Ongoing internal control activities necessary to maintain the

internal control system required under paragraph (a)(1) of this section

shall include, but are not limited to:

(i) Top level reviews by the Bank's board of directors and senior

management, including review of financial presentations and performance

reports;

(ii) Activity controls, including review of standard performance

and exception reports by department-level management on an appropriate

periodic basis;

(iii) Physical and procedural controls to safeguard, and prevent

the unauthorized use of, assets;

(iv) Monitoring for compliance with the risk tolerance limits set

forth in the Bank's risk management policy;

(v) Any required approvals and authorizations for specific

activities; and

(vi) Any required verifications and reconciliations for specific

activities.

(b) Internal control responsibilities of Banks' boards of

directors. Each Bank's board of directors shall ensure that the

internal control system required under paragraph (a)(1) of this section

is established and maintained, and shall oversee senior management's

implementation of such a system on an ongoing basis, by:

(1) Conducting periodic discussions with senior management

regarding the effectiveness of the internal control system;

(2) Ensuring that an effective and comprehensive internal audit of

the internal control system is performed annually;

(3) Requiring that internal control deficiencies be reported to the

Bank's board of directors in a timely manner and that such deficiencies

are addressed promptly;

(4) Conducting a timely review of evaluations of the effectiveness

of the internal control system made by internal auditors, external

auditors and Finance Board examiners;

(5) Directing senior management to address promptly and effectively

recommendations and concerns expressed by internal auditors, external

auditors and Finance Board examiners regarding weaknesses in the

internal control system;

(6) Reporting any internal control deficiencies found, and the

corrective action taken, to the Finance Board in a timely manner;

(7) Establishing, documenting and communicating an organizational

structure that clearly shows lines of authority within the Bank,

provides for effective communication throughout the Bank, and ensures

that there are no gaps in the lines of authority;

(8) Reviewing all delegations of authority to specific personnel or

committees and requiring that such delegations state the extent of the

authority and responsibilities delegated; and

(9) Establishing reporting requirements, including specifying the

nature and frequency of reports it receives.

(c) Internal control responsibilities of Banks' senior management.

Each Bank's senior management shall be responsible for carrying out the

directives of the Bank's board of directors, including the

establishment, implementation and maintenance of the internal control

system required under paragraph (a)(1) of this section, by:

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(1) 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, including the activities enumerated in paragraph (a)(2)

of this section, are an integral part of the daily functions of all

Bank personnel;

(2) Ensuring that all Bank personnel fully understand and comply

with all policies, procedures and legal requirements;

(3) Ensuring that there is appropriate segregation of duties among

Bank personnel and that personnel are not assigned conflicting

responsibilities;

(4) Establishing effective paths of communication upward, downward

and across the organization in order to ensure that Bank personnel

receive necessary and appropriate information, including:

(i) Information relating to the operational policies and procedures

of the Bank;

(ii) Information relating to the actual operational performance of

the Bank;

(iii) Adequate and comprehensive internal financial, operational

and compliance data; and

(iv) External market information about events and conditions that

are relevant to decision making;

(5) Developing and implementing procedures that translate the major

business strategies and policies established by the Bank's board of

directors into operating standards;

(6) Ensuring adherence to the lines of authority and responsibility

established by the Bank's board of directors;

(7) Overseeing the implementation and maintenance of management

information and other systems;

(8) Establishing and implementing an effective system to track

internal control weaknesses and the actions taken to correct them; and

(9) Monitoring and reporting to the Bank's board of directors the

effectiveness of the internal control system on an ongoing basis.

Sec. 917.5 Audit committees.

(a) Establishment. The board of directors of each Bank shall

establish an audit committee, consistent with the requirements set

forth in this section.

(b) Composition. (1) The audit committee shall comprise five or

more persons drawn from the Bank's board of directors, each of whom

shall meet the criteria of independence set forth in paragraph (c) of

this section.

(2) The audit committee shall include a balance of representatives

of:

(i) Community financial institutions and other members; and

(ii) Appointive and elective directors of the Bank.

(3) The terms of audit committee members shall be appropriately

staggered so as to provide for continuity of service.

(4) At least one member of the audit committee shall have extensive

accounting or related financial management experience.

(c) Independence. Any member of the Bank's board of directors shall

be considered to be sufficiently independent to serve as a member of

the audit committee if that director does not have a disqualifying

relationship with the Bank or its management that would interfere with

the exercise of that director's independent judgment. Such

disqualifying relationships include, but are not limited to:

(1) Being employed by the Bank in the current year or any of the

past five years;

(2) Accepting any compensation from the Bank other than

compensation for service as a board director;

(3) Serving or having served in any of the past five years as a

consultant, advisor, promoter, underwriter, or legal counsel of or to

the Bank; or

(4) Being an immediate family member of an individual who is, or

has been in any of the past five years, employed by the Bank.

(d) Charter. (1) The audit committee of each Bank shall adopt, and

the Bank's board of directors shall approve, a formal written charter

that specifies the scope of the audit committee's powers and

responsibilities, as well as the audit committee's structure, processes

and membership requirements.

(2) The audit committee and the board of directors of each Bank

shall:

(i) Review, assess the adequacy of and, where appropriate, amend

the Bank's audit committee charter on an annual basis;

(ii) Amend the audit committee charter as appropriate; and

(iii) Re-adopt and re-approve, respectively, the Bank's audit

committee charter not less often than every three years.

(3) Each Bank's audit committee charter shall:

(i) Provide that the audit committee has the responsibility to

select, evaluate and, where appropriate, replace the internal auditor

and that the internal auditor may be removed only with the approval of

the audit committee;

(ii) Provide that the internal auditor shall report directly to the

audit committee on substantive matters and that the internal auditor is

ultimately accountable to the audit committee and board of directors;

and

(iii) Provide that both the internal auditor and the external

auditor shall have unrestricted access to the audit committee without

the need for any prior management knowledge or approval.

(e) Duties. Each Bank's audit committee shall have the duty to:

(1) Direct senior management to maintain the reliability and

integrity of the accounting policies and financial reporting and

disclosure practices of the Bank;

(2) Review the basis for the Bank's financial statements and the

external auditor's opinion rendered with respect to such financial

statements (including the nature and extent of any significant changes

in accounting principles or the application therein) and ensure that

policies are in place to achieve disclosure and transparency regarding

the Bank's true financial performance and governance practices;

(3) Oversee the internal audit function by:

(i) Reviewing the scope of audit services required, significant

accounting policies, significant risks and exposures, audit activities

and audit findings;

(ii) Assessing the performance and determining the compensation of

the internal auditor; and

(iii) Reviewing and approving the internal auditor's work plan;

(4) Oversee the external audit function by:

(i) Approving the external auditor's annual engagement letter;

(ii) Reviewing the performance of the external auditor; and

(iii) Making recommendations to the Bank's board of directors

regarding the appointment, renewal, or termination of the external

auditor;

(5) Provide an independent, direct channel of communication between

the Bank's board of directors and the internal and external auditors;

(6) Conduct or authorize investigations into any matters within the

audit committee's scope of responsibilities;

(7) Ensure that senior management has established and is

maintaining an adequate internal control system within the Bank by:

(i) Reviewing the Bank's internal control system and the resolution

of identified material weaknesses and reportable conditions in the

internal control system, including the prevention or detection of

management override or compromise of the internal control system; and

(ii) Reviewing the programs and policies of the Bank designed to

ensure compliance with applicable laws, regulations and policies and

monitoring the results of these compliance efforts;

[[Page 91]]

(8) Reviewing the policies and procedures established by senior

management to assess and monitor implementation of with the Bank's

strategic business plan and the operating goals and objectives

contained therein; and (9) Report periodically its findings to the

Bank's board of directors.

(f) Meetings. The audit committee shall prepare written minutes of

each audit committee meeting.

Sec. 917.6 Budget preparation and reporting requirements.

(a) Adoption of budgets. Each Bank's board of directors shall be

responsible for the adoption of an annual operating expense budget and

a capital expenditures budget for the Bank, and any subsequent

amendments thereto, consistent with the requirements of the Act, this

section, other regulations and policies of the Finance Board, and with

the Bank's responsibility to protect both its members and the public

interest by keeping its costs to an efficient and effective minimum.

(b) No delegation of budget authority. A Bank's board of directors

may not delegate the authority to approve the Bank's annual budgets, or

any subsequent amendments thereto, to Bank officers or other Bank

employees.

(c) Interest rate scenario. A Bank's annual budgets shall be

prepared based upon an interest rate scenario as determined by the

Bank.

(d) Board approval for deviations. A Bank may not exceed its total

annual operating expense budget or its total annual capital

expenditures budget without prior approval by the Bank's board of

directors of an amendment to such budget.

Sec. 917.7 Dividends.

A Bank's board of directors may declare and pay a dividend only

from previously retained earnings or current net earnings and only if

such payment will not result in a projected impairment of the par value

of the capital stock of the Bank. Dividends on such capital stock shall

be computed without preference.

Sec. 917.8 Bank bylaws.

A Bank's board of directors shall have in effect at all times

bylaws governing the manner in which the Bank administers its affairs

and such bylaws shall be consistent with applicable laws and

regulations as administered by the Finance Board.

Sec. 917.9 Mission of the Banks; Strategic business plan.

(a) Mission of the Banks. The mission of the Banks is to provide to

its members and associates financial products and services, including

but not limited to advances, that assist and enhance such members' and

associates' financing of:

(1) Housing, including single-family and multi-family housing

serving consumers at all income levels; and

(2) Community lending.

(b) Adoption of strategic business plan. Beginning 90 days after

the effective date of this section, each Bank's board of directors

shall have in effect at all times a strategic business plan that

describes how the business activities of the Bank will achieve the

mission of the Bank as set forth in paragraph (a) of this section.

Specifically, each Bank's strategic business plan shall:

(1) Enumerate those business activities of the Bank that the board

of directors has determined are consistent with the mission of the

Banks as set forth in paragraph (a) of this section and the reasons

that those activities are so designated, including how such activities

assist and enhance members' and associates' business and further the

cooperative nature of the Bank System;

(2) Enumerate operating goals and objectives for each major

business activity and for all new business activities and the

strategies for meeting such goals and objectives;

(3) Describe any proposed new business activities or enhancements

of existing activities; and

(4) Be supported by appropriate and timely research and analysis of

relevant market developments and member and associate demand for Bank

products and services.

(c) Review and monitoring. Each Bank's board of directors shall:

(1) Review the Bank's strategic business plan at least annually;

(2) Amend the strategic business plan as appropriate;

(3) Re-adopt the Bank's strategic business plan, including interim

amendments, not less often than every three years; and

(4) Establish management reporting requirements and monitor

implementation of the strategic business plan and the operating goals

and objectives contained therein.

Dated: December 14, 1999.

By the Board of Directors of the Federal Housing Finance Board.

Bruce A. Morrison,

Chairman.

[FR Doc. 99-34037 Filed 12-30-99; 8:45 am]

BILLING CODE 6725-01-P