Corporate Credit Unions

NATIONAL CREDIT UNION ADMINISTRATION

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

RIN 3133-AD58

Corporate Credit Unions

AGENCY:

National Credit Union Administration (NCUA).

ACTION:

Proposed rule.

SUMMARY:

NCUA is issuing proposed amendments to its rule governing corporate credit unions contained in part 704. The major revisions involve corporate credit union capital, investments, asset-liability management, governance, and credit union service organization (CUSO) activities. The amendments would establish a new capital scheme, including risk-based capital requirements; impose new prompt corrective action requirements; place various new limits on corporate investments; impose new asset-liability management controls; amend some corporate governance provisions; and limit a corporate CUSO to categories of services preapproved by NCUA. In addition, this proposal contains conforming amendments to part 702, Prompt Corrective Action (for natural person credit unions); part 703, Investments and Deposit Activities (for federal credit unions); part 747, Administrative Actions, Adjudicative Hearings, Rules of Practice and Procedure, and Investigations; and part 709, Involuntary Liquidation of Federal Credit Unions and Adjudication of Creditor Claims Involving Federally Insured Credit Unions. These amendments will strengthen individual corporates and the corporate credit union system as a whole.

DATES:

Comments must be received on or before March 9, 2010.

ADDRESSES:

You may submit comments by any of the following methods (Please send comments by one method only):

•

Federal eRulemaking Portal: http://www.regulations.gov.

Follow the instructions for submitting comments.

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NCUA Web site: http://www.ncua.gov/RegulationsOpinionsLaws/proposed_regs/proposed_regs.html.

Follow the instructions for submitting comments.

•

E-mail:

Address to

regcomments@ncua.gov.

Include “[Your name] Comments on Part 704 Corporate Credit Unions” in the e-mail subject line.

•

Fax:

(703) 518-6319. Use the subject line described above for e-mail.

•

Mail:

Address to Mary Rupp, Secretary of the Board, National Credit Union Administration, 1775 Duke Street, Alexandria, Virginia 22314-3428.

•

Hand Delivery/Courier:

Same as mail address.

Public inspection:

All public comments are available on the agency's Web site at

http://www.ncua.gov/RegulationsOpinionsLaws/comments

as submitted, except as may not be possible for technical reasons. Public comments will not be edited to remove any identifying or contact information. Paper copies of comments may be inspected in NCUA's law library at 1775 Duke Street, Alexandria, Virginia 22314, by appointment, weekdays between 9 a.m. and 3 p.m. To make an appointment, call (703) 518-6540 or send an e-mail to

OGCMail@ncua.gov.

FOR FURTHER INFORMATION CONTACT:

Richard Mayfield, Capital Markets Specialist, Office of Corporate Credit Unions, at the address above or telephone: (703) 518-6642; Ross Kendall, Staff Attorney, Office of General Counsel (OGC), at the address above or telephone (703) 518-6540; Paul Peterson, Director, Applications Section, OGC, at the address above or telephone (703) 518-6540; or Todd Miller, Regional Capital Market Specialist, Region V, at telephone (703) 409-4317.

SUPPLEMENTARY INFORMATION:

The NCUA's primary mission is to ensure the safety and soundness of federally-insured credit unions. NCUA performs this important public function by examining all federal credit unions, participating in the examination and supervision of federally-insured state chartered credit unions in coordination with state regulators, and insuring federally-insured credit union members' accounts. In its statutory role as the administrator of the National Credit Union Share Insurance Fund (NCUSIF), the NCUA insures and supervises approximately 7,740 federally-insured credit unions, representing 98 percent of all credit unions and approximately 89 million members.

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Within the fifty states, approximately 155 state-chartered credit unions are privately insured and are not subject to NCUA regulation or oversight.

Over 95 percent of natural person credit unions (NPCUs) belong to, and receive services from, corporate credit unions (corporates). There are 27

retail

corporates that provide services directly to NPCUs, and there is one

wholesale

corporate, U.S. Central Federal Credit Union (U.S. Central), that provides services to many of the 27 retail corporates.

The corporate system offers a broad range of support to NPCUs. The products and services provided by U.S. Central to retail corporates, and by retail corporates to NPCUs, include: Investment/deposit services, wire transfers, share draft processing and imaging, automated clearinghouse transactions (ACH) processing, automatic teller machine (ATM) processing, bill payment services and security safekeeping. The volume of payment systems-related transactions throughout the system annually runs into the millions and the dollar amounts associated with those transactions are in the billions each month. Corporates also serve as liquidity providers for NPCUs. Natural person credit unions invest excess liquidity in a corporate when the NPCU has lower loan demand and draw down the invested liquidity when loan demand increases. In sum, corporates provide NPCUs with convenient and quality services and expertise, all at a fair price. For many NPCUs, this is a combination that makes the corporate system a valuable resource and, for some smaller NPCUs, an essential resource.

Federally-chartered corporates are governed by federal law and state chartered corporates by state law. In addition, all corporates that are federally-insured, or that accept share deposits from NPCU members that are federally insured, must comply with NCUA's part 704 corporate credit union rule. 12 CFR part 704; § 704.1, and 12 U.S.C. 1766(a). This proposal contains significant changes to part 704 and conforming changes to other parts of NCUA's rules. The changes include new investment limitations, asset-liability management requirements, capital standards, prompt corrective action requirements, corporate governance requirements, and CUSO requirements.

Prior to drafting this proposal, the Board considered all of the existing part 704, but ultimately concluded that the rule provisions addressed in this proposal, and discussed below, were the provisions that needed modification. These modifications are intended not only to avert a repeat of the recent problems encountered in the corporate system but also to anticipate new problems that might occur. For example, while the recent corporate problems were caused in part by spread widening associated with perceptions of credit risk, the proposal requires a corporate conduct a new spread widening test that should demonstrate sensitivity to both credit risk and other potential market risks. Likewise, increased capital requirements and well-defined concentration limits protect not only

against the types of risk that materialized in the past but also different risks that might materialize suddenly in the future.

This preamble is organized in four sections as follows. Section I discusses the historical background leading up to the need for this rulemaking. Section II summarizes affected portions of the current corporate rule and the proposed changes to those portions. Section III contains a more complete analysis of the proposed changes with references to particular sections and paragraph numbers within part 704. Section IV discusses various statutory requirements applicable to the rulemaking process.

Section III, with its analysis of each proposed change to part 704, is particularly important. Included in subsection III.E are illustrations of how the various provisions of this proposal, if they had been applied to the corporate system in the past, would have drastically reduced the recent corporate losses. Section III looks not only to the past, but also the future. Specifically, subsection III.D. includes a discussion of how a hypothetical corporate might structure its balance sheet so as to achieve the proposed new capital requirements while at the same time complying with the various proposed investment and asset-liability limitations. The Board encourages commenters to take a very close look at the discussion in III.D. This discussion will help commenters to understand how the Board envisions the various elements of the proposal, working together, can permit the corporate system to return to a position of providing necessary services to natural person credit unions while ensuring the system operates within appropriate safety and soundness constraints. The Board invites comment on all aspects of Section III, including the viability of the assumptions employed by NCUA.

I. History of Current Issues in the Corporate System

I.A. Corporate System: Prior to 2000

Up until the late 1990s, federally chartered corporates had a defined field of membership (FOM) serving a specific state or geographic region. Most state chartered corporates had national FOMs but primarily serviced the state in which they were incorporated. In 1998, the NCUA Board began to approve national FOMs for federal corporates, in part to provide requested parity with state charters. Within a few years most corporates had a national FOM.

NCUA's intention in allowing national FOMs was to provide NPCUs with the ability to select membership in a corporate that best met the needs of each NPCU in serving its members. The anticipated level of competition was expected to spur consolidation within the industry to build scale and improve efficiencies. In turn, this would build capital through increased earnings. While a few mergers occurred, one of the primary consequences of competition was to reduce margins on services and put pressure on the corporates to seek greater yields on their investments.

I.B. Corporate System: 2000 Through Mid-2007

The investment provisions of NCUA's corporate regulation, located at 12 CFR part 704, have for many years permitted corporates to purchase private label mortgage-backed and mortgage-related securities (collectively referred to as

MBS

). Part 704, however, restricts most corporates (those without expanded investment authority) to investing in only the highest credit quality rated securities by at least one Nationally Recognized Statistical Rating Organization (NRSRO).

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Historically, highly rated securities have experienced minimal defaults and have been very liquid. Under NCUA rules, some corporates were permitted to exercise expanded investment authority and to purchase investment grade securities rated down to BBB because they had higher capital ratios, more highly trained personnel, and more capacity in their systems to monitor and model their portfolios. Even those corporates that had expanded credit risk authority, however, used it sparingly. In addition to being limited to securities with very high NRSRO ratings, corporates were required to perform a comprehensive credit analysis of the underlying collateral supporting the marketable security.

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The term nationally recognized statistical rating organization (NRSRO) is used in federal and state statutes and regulations to confer regulatory benefits or prescribe requirements based on credit ratings issued by credit rating agencies identified by the Securities and Exchange Commission (SEC) as NRSROs. The Credit Rating Agency Reform Act of 2006 requires a credit rating agency seeking to be treated as an NRSRO to apply for, and be granted, registration with the SEC. See final SEC Rule,

Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical Rating Organizations,

at 72 FR 33564 (June 18, 2007).

Either through direct purchase, or indirectly through investments at U.S. Central, the corporate system became heavily invested in privately issued MBS. Between 2003 and mid-2007, the percentage of investments in MBS grew from 24 percent to 37 percent. At purchase, these securities provided the corporates with a modest increase in yield over traditional investments in other asset-backed securities (e.g., securitized credit card and auto receivables). The vast majority of MBS had high credit ratings (AA equivalent or above) and interest rates that reset on a monthly or quarterly basis, which closely matched the corporates' need to fund dividends on member shares.

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These features made MBS highly marketable and thus provided adequate liquidity to the corporates so they, in turn, could provide liquidity to their NPCU members.

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Overnight share dividends repriced daily. Fixed rate share certificates were funded by investing in interest rate swaps. The swaps converted the variable rates paid by the MBS to fixed rates that could be used to pay the certificate dividends.

U.S. Central and Western Corporate Federal Credit Union (WesCorp) had the highest concentrations of MBS in the entire corporate system.

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The advent of national FOMs produced the competition that may, in turn, have helped generate these MBS concentrations. WesCorp was able to attract new NPCU members in part by offering dividend rates higher than other corporates. Consequently, it maintained an aggressive earnings strategy achieved by acquiring higher yielding (i.e., riskier, though still highly rated) MBS with greater amounts of credit risk. In direct response to WesCorp's market share success, other corporates likely pressured U.S. Central, their wholesale corporate, to pay higher, more competitive dividends which those corporates could pass along to their NPCU members. As a result, U.S. Central changed its portfolio strategy and also invested heavily in higher yielding MBS.

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NCUA placed both USC and WesCorp into conservatorship in March 2009, as discussed further below.

NCUA communicated to corporates the need to establish reasonable concentration limits in their board policies. In January 2003, NCUA issued

Corporate Credit Union Guidance Letter 2003-01,

which expressly highlighted the risks associated with credit concentrations and specifically addressed the need for corporates to establish appropriate limitations within their credit risk management policies.

During this timeframe, NCUA was also beginning to focus efforts on identifying and educating NPCUs on emerging risks associated with proper credit risk management of lending, including real estate lending, because of a nation-wide increase in alternative lending arrangements. Over the next few years, NCUA and the federal banking agencies worked cooperatively to provide numerous pieces of industry

guidance on non-traditional mortgage products. NCUA warned of the potential adverse impact these types of loans could have on consumers and credit union balance sheets. Natural person credit unions have responded favorably to the supervision oversight of NCUA; to date, these types of mortgage loans represent less than 4 percent of all first mortgage loans outstanding in the credit union industry.

In April 2007, several months before the distress in the mortgage market surfaced, NCUA issued

Corporate Credit Union Guidance Letter No. 2007-02,

focusing on the various risks associated with MBS. This letter addressed MBS credit risk, liquidity risk, market value risk, and concentration risk, and by mid-2007 corporates had, by-and-large, ceased the purchase of private label MBS. Still, by the summer of 2007 the MBS at the heart of the corporate problem were already on the books of U.S. Central and WesCorp. At that time, all their investments, including MBS, were still rated investment grade, and 98 percent were rated AA or higher. It was not until a year later (June 2008) that these corporates' MBS credit ratings began migrating downward, and even then 96 percent were still investment grade and 92 percent were still rated AA or better.

I.C. Corporate System: Mid-2007 Through Mid-2008

Beginning mid-year 2007, real estate values declined across many markets in the U.S. and greater numbers of mortgages became delinquent leading to a greater number of foreclosures. The higher number of foreclosures further eroded housing prices, resulting in lower recovery of principal and even higher losses when the foreclosed properties were liquidated. This resulted in sharp price declines for MBS and a corresponding shallowing of the market as a flight to quality arose.

Initially, market participants believed the market disturbance was limited to the subprime market and would be short-lived, and the performance of the senior credit positions in MBS, such as those primarily held by corporates, would not be at risk; however, that has proven not to be the case. By the end of 2007 and early into 2008, what started out as problems with sub-prime mortgages spread to Alt-A loans, option ARM loans, and finally to prime mortgage loans.

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Alt-A loans are between subprime and prime. Generally, the borrowers have good credit histories, but pay higher interest because of some other risk factor, such as low documentation or high loan-to-value ratio. Option ARM loans (option adjustable rate mortgages) allow the borrower to choose between different payment options period to period. Prime mortgage loans are considered high quality, with highly rated borrowers and other criteria indicating relatively low risk.

Some MBS were backed by underlying loans that had imprudent underwriting. These alternative mortgage loans were aggressively made to buyers in high-price home markets as a means to address home affordability.

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The weak credit fundamentals of the underlying mortgages, the inherent risk of the MBS structures, and the declining home market combined to severely affect the performance of MBS holdings of some corporates.

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Very few, if any, of these problem loans that found their way into MBS pools were originated by credit unions.

MBS prices and marketability declined significantly. Even bonds that held AA ratings or higher were unable to be sold at prices close to par, discouraging investors, including corporates, from selling them. Corporates increasingly looked to borrowings to meet liquidity demands. By pledging their MBS assets as security, corporates were able to obtain financing from external lenders.

In hindsight, it would have been preferable for the corporates to have sold their problem MBS in 2007. However, any sale following the MBS market dislocation in the summer of 2007 would have forced unrealized losses to become realized losses at a time when actual credit impairment of the underlying assets was viewed by many as unlikely. Absent a market of willing buyers, private label MBS increasingly could only be sold at a very severe discount (distressed prices)—causing losses even more significant than the accumulated unrealized losses on available-for-sale securities reflected on the financial statements. The conventional market wisdom at the time was that the problems in the MBS markets were temporary and it did not make economic sense to sell securities until market liquidity and counterparty trust improved.

Conditions did not improve and as the MBS markets became more distressed and illiquid, the margin requirements set by lenders for MBS collateral pledged by their corporate credit union borrowers increased. The cost of primary borrowing sources available to corporates became prohibitively expensive as a result. Due to the continued price devaluation of MBS, the ability to borrow by pledging corporate investment portfolios diminished significantly, thereby increasing liquidity pressures. In turn, this reduced leverage diminished the yields paid by the corporates and made them less attractive. NPCUs began to invest part of their excess liquidity elsewhere, further increasing corporate liquidity concerns.

In response to these concerns, NCUA directed corporates to consider a number of steps to ensure adequate sources of liquidity, including: encouraging the establishment of commercial paper and medium-term note programs; encouraging additional liquidity sources (both advised and committed); encouraging an increase in the number of repo transaction counterparties; encouraging membership in a Federal Home Loan Bank (FHLB); requiring independent third party stress test modeling of mortgage-related securities to determine if the securities would continue to cash flow; assisting U.S. Central to gain access to the Federal Reserve Board's discount window; and encouraging education and communication with their members about what was occurring in the financial market and how it was affecting their balance sheets. Corporates have done a good job of communicating these issues with their members and this did assist in preventing significant outflows of funds from the corporate system.

On August 11, 2008, the Wall Street Journal published an article on the unrealized losses on available-for-sale securities in the corporate system. The article generated additional questions and concerns throughout the credit union industry and increased the possibility of a run on corporate shares. A run would have forced some corporates to sell their MBS at severely depressed prices, leading to loss of not only all the member capital in the affected corporates but also most member shares.

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The loss of these shares would have likely caused the failure of many member NPCUs and required numerous recapitalizations of the NCUSIF, with catastrophic effects on the credit union system as a whole.

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The vast majority of shares in corporates are uninsured because the account balances are well above the $250,000 federal insurance limit.

Also in that August 2008 timeframe the media publicized problems with Fannie Mae, Freddie Mac, Bear Stearns, Countrywide, and numerous other financial entities. Liquidity in the global markets froze: liquidity had become not only expensive, but almost impossible to obtain. Unfortunately, these events coincided with seasonal liquidity demands placed by NPCUs on their corporates. Traditionally, NPCUs withdraw funds during August and September, and funds begin to flow back into the corporates in October. The

tightening liquidity environment was of significant concern to NCUA and the corporate system, because corporates must maintain adequate liquidity to ensure the uninterrupted functioning of the payment systems.

The potential loss of member confidence in their corporates, ever-increasing concerns about the credit quality of MBS, and the seasonal liquidity outflows all created the “perfect storm” for the corporate system. NCUA was concerned that some corporates would be unable to meet the liquidity demands of their members in the short-term or be unable to fund payment systems activity. In addition, NCUA had indications of an exodus of NPCU funds from the corporate system due to a lack of confidence. Accordingly, in the fall of 2008 it became critical for NCUA to initiate dramatic action to bolster confidence in the corporates and ensure the continuing flow of liquidity in the credit union system. The NCUA's initial public actions involved liquidity support, while the Board intensified its contingency planning on related issues, including corporate capital and corporate restructuring.

During the last half of calendar year 2008 NCUA took several actions, in tandem with the Central Liquidity Facility (CLF), to increase liquidity throughout the entire credit union system, especially within the corporates. These pro-liquidity actions included:

• Encouraging corporates with large unrealized losses on holdings of MBS to make application to the Federal Reserve Discount Window.

• Converting loans made by corporates to NPCUs to CLF-funded loans using funds borrowed by the CLF from the U.S. Treasury.

• Announcing and implementing the

Temporary Corporate Credit Union Liquidity Guarantee Program

(TCCULGP) on October 16, 2008. The TCCULGP is similar to the FDIC's Temporary Liquidity Guarantee Program announced by the FDIC on October 14, 2008. The TCCULGP provides a 100 percent guarantee on certain new unsecured debt obligations issued by eligible corporates.

• Announcing and implementing the Credit Union System Investment Program (CU SIP) and the Credit Union Homeowners Affordability Relief Program (CU HARP). Both programs allow participating NPCUs to borrow funds from the CLF and invest those funds in CU SIP notes issued by corporates, injecting additional liquidity into the corporates and the entire credit union system. With the launch of CU HARP and CU SIP, NCUA provided about $8 billion of additional funding to corporates to pay down external borrowings.

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The SIP and HARP programs were key in providing liquidity to the corporates and the credit union system at this critical juncture. These two programs, and other CLF lending, would not have been possible without NCUA's advocacy the previous September for lifting the CLF cap.

The unrealized losses in the corporate system grew to nearly $18 billion by year-end 2008. The severity of the MBS price declines and credit downgrades, along with the erosion of subordinated classes within the MBS structures held by corporates, required reconsideration by some corporate credit unions that all such fair value declines were temporary.

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In January, 2009, several corporates reported major realized losses and significant capital depletion, and it became apparent that the NCUA's liquidity assistance efforts by themselves would not be sufficient to stabilize the corporates. The NCUA Board continued its consideration of issues including corporate capital and corporate restructuring and, at its January 28, 2009, meeting, the NCUA Board took the following actions in furtherance of corporate stabilization:

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The term “subordinated” means that the security will absorb credit losses in the underlying pool of loans before other, more senior, securities absorb credit losses. In general, the principal of the subordinated security will be exhausted before the more senior securities absorb any loss.

• Approved issuance of a $1 billion NCUSIF capital note to U.S. Central as a result of pending realized losses on MBS and other asset-backed securities. This action was necessary to preserve confidence in U.S. Central, given its pivotal role in the corporate system, and maintain external sources of funding.

• Approved the

Temporary Corporate Credit Union Share Guarantee Program

(TCCUSGP), which guarantees uninsured shares at participating corporates through September 30, 2011. This program was vital in maintaining NPCU confidence in the corporate system.

• Authorized the engagement of Pacific Investment Management Company, L.L.C. (PIMCO), an independent third party, to conduct a comprehensive analysis of expected non-recoverable credit losses for distressed securities held by corporates. This information served to augment NCUA's previous analysis of potential losses to the NCUSIF and provided an independent assessment of the reliability of information provided by the corporates. The focus on non-recoverable credit losses rather than the higher and more volatile losses due to other market factors was consistent with the need to determine the actual loss exposure of the NCUSIF.

• Announced that losses to the NCUSIF associated with corporates would be several billion dollars, exceeding the NCUSIF's entire retained earnings and impairing each credit union's one percent capitalization deposit.

• Issued an Advance Notice of Public Rulemaking (ANPR) on restructuring the corporate rule. The sixty-day comment period expired in April 2009. NCUA received almost five hundred comment letters, providing suggestions on possible regulatory reforms for corporates and the corporate system.

In March 2009, due to huge operating losses at U.S. Central and WesCorp, lack of sufficient capital, and for other reasons, the NCUA Board was forced to place these two corporates into conservatorship. The action protected retail credit union share deposits and the interests of the NCUSIF and helped clear the way for NCUA to take additional mitigating actions as they might become necessary.

As of May 2009, NCUA estimated that losses to the NCUSIF associated with the troubles in the corporate system exceeded the entire equity in the Fund and impaired approximately 69 percent of the capitalization deposit that all federally insured credit unions maintain with the NCUSIF. These losses necessitated premium and deposit replenishment assessments that would, in total, cost insured credit unions an amount equal to almost one percent of their insured shares. Though the credit union system as a whole had the net worth to absorb these costs and remain well capitalized, the legal structure of the NCUSIF would have required that credit unions take all these insurance expense charges at once, which would result in a contraction of credit union lending and other services. This would come at a particularly difficult time, when it was vital that credit unions be a source of consumer confidence and continue to make credit available to support an economic recovery. In fact, the NCUA Board realized that such a large, sudden impact on credit unions' financial statements could further destabilize consumer confidence.

The Board was committed to seeking the lowest cost option for stabilizing the corporate system, while also minimizing the adverse impact on natural person credit unions and their members so that credit unions could remain a vibrant and healthy sector of the U.S. financial system. In pursuit of these ends, the Board drafted legislation to create a Temporary Corporate Credit Union Stabilization Fund (CCUSF). The

proposed CCUSF would borrow money from the Treasury for up to seven years and use the money to pay expenses associated with the ongoing problems in the corporate credit union system, such as the capital injection into U.S. Central. The primary purpose of this new CCUSF would be to spread over multiple years the costs to insured credit unions associated with the corporate credit union stabilization effort, and to ensure that the payment by insured credit unions of those costs was anti-cyclical, and not pro-cyclical.

The Board sought Congressional support and passage of the CCUSF. On May 20, 2009, Congress enacted and the President signed into law the

Helping Families Save Their Homes Act of 2009

(

Helping Families Act

), Public Law 111-22. Section 204 of the Helping Families Act created the sought-after CCUSF and provided NCUA with other helpful tools, such as increasing the authority of the NCUSIF and CCUSF to borrow from the Treasury and permitting the NCUSIF to assess premiums over as much as 8 years to rebuild the equity ratio should the ratio fall below 1.20 percent.

Immediately following passage of this legislation, the NCUA Board took a series of actions establishing and implementing the CCUSF. On June 18, 2009, the Board obligated the CCUSF to accept assignment from the NCUSIF of the $1 billion capital note extended to U.S. Central executed on January 28, 2009. The Board also determined to legally obligate the CCUSF for any liability arising from the TCCUSGP (share guarantee) and TCCULGP (liquidity guarantee) programs. These steps effectively spread the cost of the corporate stabilization program for insured credit unions over multiple years.

For more than a year, then, going back to the summer of 2008, the NCUA Board has worked a number of avenues to stabilize the corporate system, involving liquidity improvement and protection, capital injections, and spreading the costs to NPCUs of the stabilization program out over multiple years. These actions were critical to the near- and mid-term survival of the corporate system and to minimizing the potential costs to the NCUSIF and to the insured NPCUs obligated to the fund the NCUSIF. For the longer term, however, the Board believes it needs to address the structure of corporates and the corporate system and the investment, capital, and governance standards by which corporates operate. Accordingly, the Board has turned its attention to part 704, NCUA's corporate rule, and to the public comments that the Board solicited in response to its ANPR.

I.D. The Advance Notice of Proposed Rulemaking (ANPR)

In January 2009, NCUA solicited public comment on whether comprehensive changes to the structure of the corporate system were warranted. 74 FR 6004 (Feb. 4, 2009). This corporate credit union ANPR sought comment on how best to define and structure the role of corporates in the credit union system, whether to modify the level of required capital for corporates, whether to modify or limit the range of permissible investments for corporates, whether to impose new standards and limits on asset-liability management and credit risk, and whether to make modifications in the area of corporate governance.

NCUA received some 445 comments in response to the ANPR. More than 370 of these comments came from natural person credit unions (NPCUs). Eighteen corporates, 27 state credit union leagues, four national trade associations, and the National Association of State Credit Union Supervisors also commented.

NCUA reviewed these public comments closely and considered them carefully in drafting this proposed rule. Certain specific comments received in response to the ANPR are discussed in Section C below as they relate to particular proposed amendments.

II. Summary of Current Rule and Proposed Changes

This proposal contains numerous changes to the current corporate rule. Some of these changes are short and straightforward, while others are more lengthy and complex. This Section II briefly summarizes the current part 704 provisions, and the proposed changes. Section III describes each proposed change in more detail.

II.A. Current Part 704 Capital Rules

Currently, corporates have only one mandatory minimum capital requirement: They must maintain total capital—retained earnings, paid-in capital (PIC), and membership capital accounts (MCAs)—in an amount equal to or greater than 4 percent of their moving daily average net assets.

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Failure by a corporate to meet this minimum capital ratio triggers the requirement to file a capital restoration plan with NCUA and may cause NCUA to issue a capital restoration directive and take other administrative action. Although Prompt Corrective Action (PCA) applies to NPCUs and to banking entities, PCA does not currently apply to corporates.

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The current rule also provides that retail corporates with a retained earnings ratio of less than two percent must increase their retained earnings by a certain amount each quarter, but this reserving requirement only applies to a wholesale corporate credit union if its retained earnings ratio falls below one percent.

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12 CFR 704.3(d). Corporates have other capital-related requirements, such as a core capital ratio and a retained earnings ratio, but failure to meet these requirements only triggers future earnings retention requirements and does not trigger a capital restoration plan requirement.

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Section 216 of the Federal Credit Union Act establishes a PCA scheme for natural person credit unions. 12 U.S.C. 1790d. Paragraph (m) of § 216 states specifically that the provisions of § 216 are not applicable to corporate credit unions. Since corporate credit unions are different in form, function, and mission than natural person credit unions, the PCA scheme set forth in this proposal differs from that contained in § 216 and its implementing regulation, 12 CFR Part 702. The legal authority for this proposed corporate PCA scheme is found in two different places. Section 120(a) of the Act, states, in pertinent part, that “[A]ny central credit union chartered by the Board shall be subject to such rules, regulations, and orders as the Board deems appropriate * * * .” 12 U.S.C. 1766(a). Section 201(b)(9) of the Act also requires that federally insured credit unions “comply with the requirements of this [share insurance] title and of regulations prescribed by the Board thereto.” 12 U.S.C. 1781(b)(9).

II.B. Proposed Amendments to Part 704 Capital Rules

NCUA intends to change the corporate capital requirements to make them stronger and more consistent with the requirements of the banking regulators. For example, the other regulators employ three different minimum capital ratios, not one ratio like NCUA. The current corporate minimum capital ratio is also calculated differently from any of the three ratios employed by the other regulators.

The proposal replaces the current four percent total capital ratio with a four percent

leverage ratio,

and limits the capital that can be used to calculate the leverage ratio to

core,

or

Tier 1,

capital, which would include only the more permanent forms of corporate capital. The proposal also includes new minimum risk-based capital ratios that are calculated based on risk-weighted assets. Failure to meet these minimum ratios will trigger a capital restoration plan requirement, potential capital restoration directives, and other, new prompt corrective action (PCA) provisions. The new PCA provisions are similar to those currently applicable to banks. The due process associated with the new PCA provisions is set out in a new subpart to part 747 of NCUA's rules.

The proposal also refines the acceptable elements of corporate capital. For example, after an appropriate phase-in period a certain percentage of core

capital must be in the form of retained earnings. The timing and amount of this retained earnings requirement is discussed in detail in Section III below.

The proposal will also toughen the requirements for

Tier 2

capital accounts (i.e., MCAs) that can be used in part to satisfy the new total risk based capital ratio. Specifically, the current minimum three year requirement for MCAs will be lengthened to five years, and the adjustable balance type of MCA accounts will be eliminated.

The proposal also renames the two types of contributed capital accounts (PIC and MCA) to render the names more descriptive of what they actually are. PIC is renamed as perpetual contributed capital (PCC), and MCAs are renamed as nonperpetual capital accounts (NCAs). The proposal further permits corporates to issue PCC and NCAs to both members and nonmembers.

The proposal will eliminate the current prohibition on corporates requiring credit unions to contribute capital to obtain membership or receive services. It will also permit members to transfer corporate capital instruments they hold to third parties and will require corporates to facilitate such transfers.

The proposal also eliminates the special treatment that wholesale corporates receive with regard to retained earnings reserving requirements. All corporates will be subject to the same requirements with regard to retained earnings.

Finally, the proposal permits a corporate, at its option, to give new contributed capital priority over existing contributed capital.

II.C. Current Part 704 Investment Limitations

Among other investment provisions, the current part 704:

• Requires that a corporate maintain an internal investment policy that includes reasonable and supportable concentration limits, including limits by investor type and sector, but does not prescribe standards for determining the reasonableness of those limits.

• Requires that the aggregate of all investments in any single obligor is limited to the greater of 50 percent of capital or $5 million.

• Specifies, for permissible investment types, that the investment must be rated no lower than AA—by at least one Nationally Recognized Statistical Rating Organization (NRSRO) at time of purchase. The required rating may be lower for certain investment types if the corporate has expanded authorities. Additional requirements apply if the rating is subsequently lowered. Certain investment types, such as U.S. government securities and CUSO investments, are exempt from the NRSRO requirement.

• Specifically prohibits certain types of investments, including most derivatives, most stripped MBS (e.g., interest only strips and principal only strips), mortgage servicing rights, and residual interests in asset-backed securities (ABS).

• Does not address investments that are structured to be subordinate, in terms of potential credit losses, to other securities.

II.D. Proposed Amendments to Part 704 Investment Limitations

The proposal will impose specific concentration limits by investment sector. Sectors include residential mortgage-backed securities, commercial mortgage-backed securities, student loan asset-backed securities, automobile loan/lease asset-backed securities, credit card asset-backed securities, other asset-backed securities, corporate debt obligations, municipal securities, registered investment companies, and an

all others

category to account for the development of new investments types. The proposal further restricts the purchase of high-risk structured instruments that concentrate, and thus multiply, market risk exposures, such as investments that return a multiple of a particular market interest rate. These limits would be in addition to current limits on derivatives. The proposal would also limit subordinated positions in all sectors. This limit will reduce a corporate's credit risk by restricting its ability to purchase

mezzanine

residential mortgage-backed securities, as some corporates did, or other subordinated structured securities that are not the most senior security in terms of credit risk.

The proposed changes would prohibit additional investment types that have proven problematic, such as collateralized debt obligations (CDOs) and Net Interest Margin (NIM) securities.

The proposed changes would require that a corporate get multiple ratings from different NRSROs, and only use the lowest of the ratings, and require that ratings be used only to exclude an investment, not as authorization to include one. Credit ratings will not be a substitute for pre-purchase due diligence and ongoing risk monitoring. Downgrades below the minimum rating threshold will continue to trigger investment action plans. These provisions, along with the asset-liability management (ALM) provisions described below, will reduce reliance on NRSRO ratings.

The proposal will eliminate the current Part II expanded investment authority, modify the current Part IV expanded authority on derivatives, and impose increased capital requirements to qualify for Part I and II expanded investment authorities.

II.E. Current Part 704 ALM Provisions

The current part 704 requires that corporates maintain an internal ALM policy. The rule requires that as part of that policy the corporate do Net Economic Value (NEV) modeling to measure interest rate risk, but the rule does not have any other specific requirements relating to the risks of mismatches between asset and liability cash flows. The current part 704 requires that any corporate permitting early withdrawals on share certificates “assess a market-based penalty sufficient to cover the estimated replacement cost of the certificate redeemed.” The current rule does not establish any minimum amount of cash, or cash equivalents, that a corporate must, for liquidity purposes, maintain on hand at all times. The current rule limits a corporate's borrowing to the greater of 10 times capital or 50 percent of shares and capital, but does not place any additional limits on secured borrowings.

II.F. Proposed Amendments to Part 704 ALM Provisions

The proposal would:

• Establish a maximum limit on the weighted average life of a corporate's aggregate assets.

• Establish limits on cash flow mismatches so as not to exceed an acceptable gap between the average life of assets and liabilities.

• Require additional testing for spread widening and net interest income (NII) modeling; including testing standards.

• Further limit a corporate's ability to pay a market-based redemption price to no more than par, thus eliminating the ability to pay a premium on early withdrawals.

• Require a corporate maintain a minimum amount of cash or cash equivalents to ensure sufficient liquidity protection for payment system operations.

• Restrict the use of secured borrowings for purposes other than liquidity needs.

The effects of these new, proposed ALM provisions, as well as the investment provisions discussed in paragraph E. above, are illustrated in more detail in subsection III.D. below.

II.G. Current Part 704 Corporate Governance Provisions

The current part 704 places limitations on board representation, including limits on the number of trade organization representatives. The current rule does not, however, place any experience or knowledge requirements on individual corporate directors. The current rule does not require any disclosure of executive compensation to the members of a corporate, nor does it place any limits on

golden parachute

severance packages for senior executives.

12

The current part 704 does not limit the representation of corporate executives and officials on the boards of other corporates.

12

The Internal Revenue Code, and state law, may require some disclosure for state chartered corporates, but not for federal charters.

II.H. Proposed Amendments to Part 704 Corporate Governance Provisions

The proposed changes, after appropriate phase-in periods, would:

13

13

Some of these proposals are phased-in over time.

• Require that corporate directors currently hold a Chief Executive Officer (CEO), Chief Financial Officer (CFO), or Chief Operating Officer (COO) position, at their credit union or member entity.

• Require that all compensation agreements between a corporate and its senior executives and directors be disclosed to the members of the corporate upon request and at least once annually to the entire membership.

• Provide for disclosure of material increases in compensation related to corporate mergers.

• Prohibit certain golden parachute payments and related indemnification provisions.

• Require that a majority of all corporate boards (including USC) consist of representatives from natural person credit unions.

• Establish term limits on both corporate members and individuals serving as representatives of corporate members.

• Prohibit an individual from serving on the boards of more than one corporate at a time and prohibit an organizational entity from having two or more individual representatives on the board of a single corporate.

II.I. Miscellaneous Proposed Amendments to Part 704

The proposal:

• Removes § 704.19, which provided wholesale corporates with a lower retained earnings requirement than retail corporates.

• Restricts the total amount of investments and loans a corporate may accept from any single member.

• Requires that corporate CUSOs restrict their services to brokerage services, investment advisory services, and other categories of services as preapproved by NCUA.

• Expands the current requirement that corporate CUSOs agree to give NCUA access to books and records to include access to the CUSO's personnel and facilities.

III. Discussion and Analysis of Particular Proposed Amendments

This proposed rule contains amendments to different sections and appendices in part 704. The following table summarizes the current organization of part 704, and where, when, and how the Board intends to amend that organization and substance.

Current part 704 Rule Provision

Amended?

704.1 Scope

No.

704.2 Definitions

Yes. First amendment effective upon publication of final rule. Second amendment effective one year after publication of final rule.

704.3 Corporate credit union capital

Yes. Removed and replaced effective one year after publication of final rule.

704.4 Board responsibilities

Yes. Effective one year after publication of final rule, current

Board responsibilities

moved to 704.13. Effective one year after publication of final rule, new 704.4 (

Prompt corrective action

) added.

704.5 Investments

Yes.

704.6 Credit risk management

Yes.

704.7 Lending

No.

704.8 Asset and liability management

Yes.

704.9 Liquidity management

Yes.

704.10 Investment action plan

No.

704.11 Corporate CUSOs

Yes.

704.12 Permissible services

No.

704.13 [Reserved]

Effective one year after publication of final rule, current 704.4,

Board responsibilities,

moved to 704.13. No change to substance.

704.14 Representation

Yes.

704.15 Audit requirements

No.

704.16 Contract/written agreements

No.

704.17 State-chartered corporate credit unions

No.

704.18 Fidelity bond coverage

No.

704.19 Wholesale corporate credit unions

Yes. Current 704.19 removed. New 704.19,

Disclosure of executive and director compensation,

added.

704.20 None.

Yes. New 704.20,

Golden parachute and indemnification payments,

added.

Appendix A—Model Forms

Yes. Renamed

Capital Prioritization and Model Forms.

Appendix B—Expanded Authorities and Requirements

Yes.

Appendix C—None

Yes. Effective one year after publication of final rule, new Appendix C,

Risk-Based Capital Credit Risk-Weight Categories,

added.

This section of the preamble discusses each of these proposed amendments in detail. This section generally follows the organization of part 704, that is, starting with the proposed capital (§ 704.3) and PCA (§ 704.4) amendments, then investments (§ 704.5) and credit risk (§ 704.6), then asset and liability management (§ 704.8), then corporate

board representation § (704.14), and then the new sections relating to disclosure of executive and director compensation (§ 704.19) and golden parachutes and indemnification (§ 704.20).

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

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

III.A. Amendments to Part 704 Relating to Capital

Current Part 704 Capital Requirements

Adequate capital is essential to the safe and sound operation of a corporate. It ensures that the corporate has a buffer against the losses associated with all the various risks associated with the investments and activities of a corporate.

Currently, part 704 contains only one mandatory, minimum capital requirement: that corporates achieve and maintain a ratio of capital to moving daily average net assets of at least four percent. Part 704 defines capital, generally, to include retained earnings, paid-in capital (PIC), and membership capital accounts (MCAs). The current capital requirements in part 704 differ in certain respects from the capital requirements that banking regulators impose on banks. For example, part 704 does not include any capital calculations based on risk-weighted assets. Part 704 also permits certain membership capital accounts to qualify as corporate capital where those same accounts would not satisfy the bank regulators' definition of capital. Part 704 permits membership capital accounts with terms as short as three years, while banking regulators require such capital to have terms of at least five years. In addition, part 704 permits adjustable balance membership capital accounts; while banking regulators do not recognize any sort of adjustable balance accounts as capital.

Public Comment on the ANPR

The ANPR discussed various approaches that NCUA is considering with respect to capital requirements for corporates and solicited comment on several aspects of this issue. For example, the agency asked whether it should establish a new

leverage ratio

consisting only of more permanent (core) capital and excluding MCAs; increase the required capital ratio to more than four percent; and implement changes that would result in redefining MCAs in line with accepted banking notions of capital. The agency asked whether it should establish new minimum capital ratios based on risk-weighted asset classifications, which could include the use of some form of membership capital. Another question presented for comment and discussion in the ANPR was whether natural person credit unions should maintain contributed capital as a prerequisite to obtaining services from a corporate.

Comments about capital and capital requirements were wide ranging, reflecting the importance and difficulty of this issue. Many commenters believe there is a need for greater capital within the corporate system and for more sensitive measures of the necessary capital.

Ninety-seven commenters addressed the question of whether the agency should establish a new required capital ratio consisting of core capital only and excluding membership capital accounts. Sixty-four favored such a new capital ratio while 33 opposed it. One hundred sixteen commenters discussed whether a corporate should be permitted to provide services only to members who contributed tier 1 capital; 82 favored this restriction while 34 opposed it. Regarding the question of whether the required capital ratio should be increased, the vast majority of commenters—80 of 93—favored increasing the required capital ratio to more than four percent.

Of the 58 commenters who addressed the topic of whether the agency should change the rules regarding the manner in which membership capital can be adjusted, 44 favored and 14 opposed rule changes in this area. On the question of whether the corporates should be subject to risk-based capital standards, the commenters were nearly unanimous, with 173 of 185 comments favoring risk-based capital standards for corporates.

Commenters advocating greater capital requirements generally supported a phase-in period before any new requirements become effective. The corporate trade association and many corporates suggested that all corporates should attain a minimum Tier 1 core capital ratio of four percent using 12 month daily average net assets (DANA) by the end of 2010 and higher minimum core capital levels in the future based on Basel.

14

These commenters also said the use of DANA is necessary to account for fluctuations in assets due to the cash flow seasonality of credit unions, although there were different views among the commenters about the appropriate length of DANA, ranging from three months to three years.

14

The definitions of DANA, and moving DANA, are laid out and discussed further on in this preamble.

Some commenters took the opposing view, suggesting that current capital requirements are adequate with proper oversight and risk management. One commenter noted that an increased capital contribution requirement would limit the flexibility of credit unions in dealing with the corporate system. Another commenter indicated that, with an appropriate limitation on the investment authority and range of permissible services offered by a corporate in a consolidated corporate network, current capital rules should be adequate.

Other commenters advocated that NCUA require mandatory capital contributions by natural person credit unions as a condition of receiving services from a corporate. One corporate that supported mandatory capital for services stated that such a requirement would likely drive the regionalization of corporates as natural person credit unions would limit their corporate relationships to one nearby corporate. Some commenters, however, took the opposite view, believing mandatory capital contributions to be too limiting on the ability of credit unions to choose the corporate they want to do business with; these commenters suggested that the corporate simply charge higher service fees for members not contributing capital.

Many of those commenters who discussed the issue of membership capital accounts (MCAs) supported the idea of making MCA conform to the accepted banking standard of

Tier 2

capital, e.g., to require that it be a minimum of five year term or, if of indefinite term, subject to at least five years notice of withdrawal. Many commenters suggested that MCA contributions be tied to asset size and

also that NCUA mandate that corporates implement MCA with uniform characteristics, so that there would be less competition among the corporates for capital from NPCUs. Some commenters also stated that MCA withdrawals should only be permitted if the corporate would be in compliance with applicable capital standards after withdrawal. Some commenters expressed the opposite view, with one suggesting that withdrawal within six months of notice should be sufficient.

Commenters who supported the idea of a risk-based approach to capital indicated that they believed that appropriately designed risk-based capital requirements would encourage corporates to monitor and control their more risky investments and activities. Some of these commenters, however, stated that if NCUA restricts investment or other authorities of corporates through regulatory changes, then capital requirements should be less than that required of other institutions under Basel standards. Another commenter expressed doubt about the effectiveness of a risk-based system, noting that it did not alleviate or prevent the current difficulties being experienced in the banking sector.

Discussion of Proposed Capital Regulations

A corporate's capital levels must be consistent with the risks associated with the activities in which a corporate engages. Linking the amount of a credit union's capital requirement to the overall riskiness of its assets is a more accurate method of ensuring that the credit union can afford to cover losses that may arise from such activities without becoming insolvent. The other federal banking regulators have adopted this risk-based approach to capital in a manner consistent with the international framework for capital standards established by the Basel Committee on Banking Supervision (commonly referred to as the

Basel Supervisors Committee

) in July, 1988 (

Basel I

), and as subsequently expanded upon in 2006 (

Basel II

).

Activities that potentially have higher returns generally have such potential because of their higher risk of loss. Because higher risk/return activities can exhaust a corporate's capital faster than lower risk/return activities, the Board believes corporates engaging in higher risk activities should hold more capital to protect the National Credit Union Share Insurance Fund and to provide appropriate incentives for prudent management. Likewise, institutions that engage in lower risk activities do not need as large a capital cushion and should be permitted to operate with a lower minimum capital requirement, consistent with protection of the insurance fund and the long-term safety of the credit union industry and the individual corporate.

Unfortunately, it is not easy to develop a capital scheme that accounts for all possible risks and that requires only as much capital as is necessary to cover the potential losses associated with such risks. The Board has closely examined the efforts of the other regulators to develop a risk-based capital scheme. Those efforts are based, in large part, on the Basel Accords. A short discussion of those Accords and the related efforts of the banking regulators follows.

Summary of the Basel Accords

A group of eleven industrialized nations, including the U.S., formed the Basel Committee to harmonize banking standards and regulations among the member nations. One of the Committee's tasks was to design standards that would provide a bank with sufficient capital in relation to the risks undertaken by the bank. In July of 1988, the Committee issued the

International Convergence of Capital Measurements and Capital Standards,

known informally as

Basel I.

Basel I created a risk-based capital scheme based on four

pillars.

The first pillar,

constituents of capital,

defined the elements of Tier 1 and Tier 2 capital. The second pillar,

asset risk weighting,

provided for risk-weighting of asset classes into four categories: zero percent, 20 percent, 50 percent, and 100 percent. The third pillar,

target standard ratio,

imposed an eight percent minimum risk-weighted capital ratio, at least half of which (four percent) must be Tier 1. Pillar 4, or

transitional and implementing agreements,

urged banking regulators to support these capital requirements with strong surveillance and enforcement. All of the major U.S. banking regulators subsequently adopted capital requirements based on Basel I.

15

15

References to banking regulators here mean the Federal Reserve (Fed), Office of the Comptroller of the Currency (OCC), Office of Thrift Supervision (OTS), and the Federal Deposit Insurance Corporation (FDIC).

Basel I, however, was subject to significant domestic and international criticism. One criticism was that the risk-weightings only accounted for credit risk. In other words, Basel I did not provide a capital buffer for potential loss from other risks, such as operational risk, market risk, interest rate risk, legal risk, currency risk, and reputational risk.

16

The U.S. banking regulators compensated for the capital requirements associated with these additional risks by imposing a separate capital ratio, the leverage ratio, which was not based on the credit risk-weighted assets but was based on

total

assets. Another criticism of Basel I was that the risk-weightings were too broad and general, and that within a particular asset class individual assets should not all be risk-weighted at, say, 50 percent, but should be classified with more specificity. For example, loans to corporations are of varying credit quality and should not all carry the same risk-weighting. Again, the leverage ratio helps compensate for this lack of granularity in credit-risk weighting. Also, Basel I did not account for new asset classes, such as the securitizations that were first making an appearance during the 1980s.

16

“Operational risk” includes risks such as loss due to fraud and legal/compliance risk. “Market risk” includes losses due to general economic downturns and market fluctuations, but also sometimes includes the other enumerated risks (e.g., reputational and interest rate risk).

Due in part to the criticisms of Basel I, the Basel Committee set to work on another agreement, the

International Convergence of Capital Measurement and Capital Standards: A Revised Framework,

which was finalized in 2006. This

New Accord,

also known as

Basel II,

greatly expands the scope, technicality, and depth of Basel I. Basel II provides for new approaches to credit risk; adapts to the securitization of bank assets; covers market, operational, and interest rate risk; and incorporates market based surveillance (market discipline) and regulation.

Basel II has three pillars. Pillar one,

minimum capital requirements,

created a formula for risk-based capital that translates roughly into Reserves (capital) = (.08)(Risk-Weighted Assets) + (Operational Risk Reserves) + (Market Risk Reserves). Basel II provided alternative ways to calculate credit-risk weights and operational reserves.

17

Pillar two,

the supervisory review process,

required that banking regulators provide significant oversight and enforcement of capital standards. Pillar three,

market discipline,

required

that banks make significant public disclosure of their investments and activities to help control risk through market discipline.

17

The other banking agencies, in their July 2008 proposed rulemaking, listed six different Basel II methods for calculating the reserve requirements associated with credit and operational risk:

Credit-Risk Weighting Methods:

Standardized

Foundation Internal ratings based

Advanced internal ratings based

Operation Risk Reserve Methods:

Standarized

Basic Indicator Approach (BIA)

Advanced Measurement (AMA)

The primary criticism of Basel II is the complexity associated with its more comprehensive, and more complex, risk and risk-weighting scheme.

Status of the Capital Schemes of the Banking Regulators

As noted above, the primary banking regulators have adopted capital schemes based on Basel I, referred to here as the “general risk-based capital rules.” Since the completion of Basel II these regulators have published three important rulemakings related to capital.

• In September 2006, the banking regulators issued a proposed rule with

Advanced

Basel II risk standards and measurements. Generally, the proposal would have permitted banks to adopt their own methodology for calculating credit and operation risks, so long as the methodology complied with the three pillars of Basel II and the banks could justify the methodology to the regulators. In December 2007, the regulators finalized this Advanced Basel II rulemaking.

18

Compliance with this Advanced methodology is mandatory for large banks (i.e., above $250 billion), and optional for all other banks.

18

72 FR 69288 (Dec. 7, 2007).

• In December 2006, the banking regulators published proposed improvements to the general risk-based capital rules, which they labeled as the

Basel IA NPR.

19

This Basel IA NPR stated: “A banking organization would be able to elect to adopt these proposed revisions or remain subject to the Agencies' existing risk-based capital rules, unless it uses the Advanced Capital Adequacy Framework proposed in the notice of proposed rulemaking published in September 2006.” The banking regulators, however, never adopted these proposed improvements.

19

71 FR 77446 (Dec. 26, 2006).

• In July 2008, the banking agencies published a proposed Basel II rulemaking called the

Standardized Framework.

20

The preamble to this NPR noted that the “[a]gencies have decided not to finalize the Basel IA NPR and to propose instead a new risk-based capital framework that would implement the Standardized Framework for credit risk, the Basic Indicator Approach for operational risk, and related disclosure requirements,” and “[m]any commenters felt the Basel II Standardized Framework is more risk sensitive than the Basel IA NPR and would more appropriately address the industry's economic concerns regarding domestic and international competitiveness.” Under this proposed Basel II Standardized Framework banks that are not required to use the Basel II Advanced approach have the option of either continuing with existing (pre-Basel IA) general risk-based capital rules or opting into the new Basel II Standardized Framework. Also, regardless of whether a bank opts to continue under the Basel I rules or the Basel II Standardized Framework rules, the banking regulators indicated that they will continue to require a minimum leverage ratio as well as risk-based capital ratios. As of October 2009, the banking regulators, however, had not adopted a final Basel II Standardized rulemaking.

20

73 FR 43983 (July 29, 2008).

In determining how to amend the existing capital requirements of part 704 to meet the needs of corporates, NPCUs, and the NCUSIF, the Board concluded that the ideal would be a corporate capital scheme that provides sufficient capital protection against risk without undue complexity. The scheme needs to take into account the capital schemes of the banking regulators, so as to give external entities some comfort with the scheme, while including capital elements that account for the unique nature of corporate as member-owned cooperatives serving other member-owned cooperatives. The capital scheme must also account for the fact that corporates have limited means to raise capital because, for example, they cannot issue stock.

The Advanced Basel II approach appears inappropriate for corporates at this time. The Advanced approach is more complex than necessary, and the other regulators do not require it for banks with less than $250 billion in assets. The Standardized Basel II approach also appears inappropriate for corporates because the other regulators have not yet finalized their Standardized methodology and could make significant changes to that methodology. In addition, even when the other regulators do finalize their Basel II Standardized Framework, they will permit banks smaller than $250 billion in size to elect to continue under the Basel I rules. If NCUA adopted a Basel II Standardized Framework, NCUA would need to have both a Basel II and a Basel I rule for corporates to be consistent with the rules of the other regulators—which would add an additional level of complexity to the pending NCUA rulemaking. The Board has determined that, given this fact and the relative size of corporates and their activity base, the NCUA should adopt a corporate capital rule based on the existing general risk-based capital rules of the other regulators, that is, the Basel I rules. The Basel I standards, when combined with investment and ALM requirements that limit noncredit risk and a robust leverage ratio requirement, should ensure corporates have the capital they need to cover noncredit risks and to reserve for weaknesses in the Basel I credit risk methodology. The Board believes use of the existing Basel I format provides the best synthesis of capital requirements and ease of application.

21

21

To understand the length and complexity of the Basel I capital rules alone, the OTS Basel I capital provisions fill up 35 full pages in the Code of Federal Regulations (CFR), and the OTS Prompt Corrective Action provisions fill up another 10 full CFR pages, for a total of 45 pages. These two OTS rulemakings together are twice as long as NCUA's entire corporate rule, Part 704, which fills up about 23 CFR pages. The proposed Basel II Standardized and the final Basel II Advanced rules are even longer.

In crafting the proposed capital rule, NCUA closely examined the capital rules of the federal banking regulators. In particular, NCUA looked to the capital rules of the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OTS), the primary regulators of federally-chartered banks.

22

The NCUA also looked to the capital rules of the Federal Deposit Insurance Corporation (FDIC) for state chartered nonmember banks, since both the NCUA and the FDIC function as federal account insurers.

23

The Board adapted these rules, as much as possible, to the capital needs of corporates, in consonance with the differences between credit unions and banks and with a view toward simplification wherever possible.

22

See 12 CFR part 567 (OTS Capital Rules) and 12 CFR part 3 (OCC Capital Rules). The OTS rules were of particular interest the mutual savings banks regulated by the OTS, like credit unions, are structured as mutual organizations.

23

See 12 CFR part 325 (FDIC capital rules).

The NCUA also looked to the OTS' PCA regulations, and Section 38 of the Federal Deposit Insurance Act (FDIA), in drafting proposed regulations for corporates on the consequences of having inadequate capital.

24

The proposed PCA regulations are discussed later in this preamble.

24

12 CFR 565 (OTS' Prompt Corrective Action rules); and 18 U.S.C. 1831o (FDIA Prompt Corrective Action).

The NCUA believes that corporates operating with adequate capital have more incentive and are better positioned to evaluate the potential risks and rewards inherent in various activities. Thus, a corporate operating with more than minimum amounts of capital may be permitted a wider range of activities

without as much direct regulatory restriction, subject only to supervisory review.

Structure of Proposed Capital Regulations

The proposed changes to the capital requirements of part 704 affect three different sections.

Proposed § 704.3 establishes new risk-based and leveraged capital ratios and standards. The credit risk categories that are used in determining a corporate's risk-weighted assets appear in a proposed new Appendix C to part 704.

Proposed amendments to § 704.2 contain revised definitions of terms used in the capital standards. The permissible components of a corporate's capital base, including which items qualify as core capital, which items qualify as supplementary capital, and which items must be deducted in determining the corporate's capital base for purposes of the risk-based and leverage ratio standards are set forth in proposed § 704.2.

Proposed § 704.4, prompt corrective action, outlines the potential consequences of a corporate's failure to meet any of its regulatory capital requirements.

Proposed § 704.3 Corporate Credit Union Capital

Overview

The proposed rule establishes three standards that a corporate must satisfy in order to meet its capital requirement: a leverage ratio of adjusted core capital to moving daily average net assets (DANA), a tier 1 risk-based capital ratio of that same adjusted core capital over moving daily average net risk-based assets (DANRA), and a total risk-based capital standard expressed as a percentage of total capital to moving DANRA.

The two risk-based capital standards address the credit risk inherent in the assets in a corporate's investment portfolio and activities. Of course, there are other risks that are inherent in corporates and their portfolios and activities, such as market risk, interest rate risk, liquidity risk, and the risk of fraud. The leverage ratio requirement is intended to ensure that no matter how free from credit risk a corporate may be, it must maintain a minimum amount of capital measured in terms of its total assets as protection against risks other than credit risk. While there are other, important provisions of the existing corporate rule and the proposal that place limits around these noncredit risks, these risks still exist and are significant.

25

Accordingly, a minimum leverage ratio requirement is essential.

25

For example, the interest rate sensitivity analysis required by § 704.8(d) of the current corporate rule controls for, but does not eliminate, interest rate risk. Likewise, the provisions in this proposed rule that would control the mismatch in the duration of a corporate's assets and liabilities would limit, but not eliminate, the risk of spread widening.

These proposed capital measurements and associated minimums are similar to those described in Basel I and adopted by the federal banking regulators. There are some minor differences, reflecting the mutual organization of corporates and the unique role they play in the credit union system. For example, this proposal employs average asset calculations in the capital ratio denominators, and not the period-end assets employed by the banking regulators. This reflects the corporate's unique role as a liquidity provider, as discussed further below. The proposal also does not include a tangible capital or tangible equity requirement.

26

On the other hand, the proposal does require that corporates build and maintain a certain amount of retained earnings to satisfy their minimum leverage ratio requirement.

26

See, e.g.,

12 CFR 567.2(a)(3).

Elements of Capital

As discussed above, the current part 704 sets forth three different categories of capital: retained earnings, PIC, and MCAs. These elements of capital are divided by moving DANA to obtain the capital ratio. A corporate must maintain a minimum four percent capital ratio.

MCAs are currently defined in part 704 as:

[F]unds contributed by members that: are adjustable balance with a minimum withdrawal notice of 3 years or are term certificates with a minimum term of 3 years; are available to cover losses that exceed retained earnings and paid-in capital; are not insured by the NCUSIF or other share or deposit insurers; and cannot be pledged against borrowings.

12 CFR 704.2. The proposed rule changes the nomenclature for MCAs, renaming them with a more descriptive title:

nonperpetual contributed capital accounts

(NCAs). This proposed retitling summarizes the substantive difference between MCAs and PIC and reflects that fact that the proposal will permit corporates to issue NCAs to both members and nonmembers.

27

The proposal specifically defines NCAs as follows:

27

PIC will also be retitled as

perpetual contributed capital,

as discussed further below.

Nonperpetual capital

means funds contributed by members or nonmembers that: are term certificates with a minimum term of five years or that have an indefinite term (i.e., no maturity) with a minimum withdrawal notice of five years; are available to cover losses that exceed retained earnings and perpetual contributed capital; are not insured by the NCUSIF or other share or deposit insurers; and cannot be pledged against borrowings. In the event the corporate is liquidated, the holders of nonperpetual capital accounts (NCAs) will claim equally. These claims will be subordinate to all other claims (including NCUSIF claims), except that any claims by the holders of perpetual contributed capital (PCC) will be subordinate to the claims of holders of NCAs.

The currently permissible three-year term MCAs, and MCAs that are adjustable balance over a short period of time, are insufficiently permanent to meet the definition of capital as described in the Basel accords and as adopted by the federal banking regulators.

28

To qualify as capital, the proposal requires that hybrid debt instruments such as nonperpetual contributed capital accounts (NCAs) be term instruments of an initial maturity of at least five years or, if structured as indefinite notice (or “no maturity”) accounts, must have a notice period of at least five years.

28

See, e.g.,

12 CFR 3.100(f) (OCC requires minimum five year term).

Accounts that can adjust automatically as permitted under the current rule on a periodic basis are also of insufficient permanency. A member can rapidly manipulate its share balances in a corporate, so NCA adjustments based on share balances have little permanency—and a member can even manipulate its asset size to some extent and so that measure also does not ensure the necessary capital permanency. The proposed redefinition of NCAs to eliminate adjustable balance accounts helps ensure permanency and so ensure that NCAs reflect the basic requirements of true capital. Although the proposal eliminates adjustable balance capital accounts, a corporate may enter into an agreement with a member where the member commits to providing additional capital if the member uses certain services or increases its shares at the corporate above a certain level.

The current part 704 permits a corporate to issue paid-in capital to both members and nonmembers, but the membership capital account, as suggested by its name, is currently available only to members of the corporate. Corporates may, of course, borrow funds from various entities under various terms, and the Board believe that if a corporate issues long-term subordinate debt to nonmembers under terms and conditions identical to

the current membership capital, the corporate should be able to treat such nonmember subordinated debt as capital in the same manner it treats membership capital accounts. Accordingly, the proposal permits both members and nonmembers to invest in nonperpetual contributed capital accounts (NCAs).

Currently, Part 704 Defines

Paid-In Capital

(PIC) as Follows:

Paid-in capital means accounts or other interests of a corporate that: are perpetual, non-cumulative dividend accounts; are available to cover losses that exceed retained earnings; are not insured by the NCUSIF or other share or deposit insurers; and cannot be pledged against borrowings.

12 CFR 704.2. The proposal does not make any change to the definition of PIC except to rename PIC as

perpetual contributed capital

(PCC). To ensure that a corporate can function as a viable entity, it must be clear to creditors, both current and future, that capital in the form of PCC and NCAs protect the creditors against any losses borne by the corporates. Capital instruments, to perform their function as capital, must be depleted when needed to cover corporate losses.

Accordingly, the proposal also adds the following definition of

available to cover losses

in § 704.2 to clarify the meaning of that phrase:

Available to cover losses that exceed retained earnings

means that the funds are available to cover operating losses realized, in accordance with generally accepted accounting principles (GAAP), by the corporate credit union that exceed retained earnings. Likewise,

available to cover losses that exceed retained earnings and perpetual contributed capital

means that the funds are available to cover operating losses realized, in accordance with GAAP, by the corporate credit union that exceed retained earnings and perpetual contributed capital. Any such losses must be distributed

pro rata

at the time the loss is realized first among the holders of perpetual contributed capital accounts (PCC), and when all PCC is exhausted, then

pro rata

among all nonperpetual contributed capital accounts (NCAs), all subject to the optional prioritization in Appendix A of this Part. To the extent that any contributed capital funds are used to cover losses, the corporate credit union must not restore or replenish the affected capital accounts under any circumstances. In addition, contributed capital that is used to cover losses in a fiscal year previous to the year of liquidation has no claim against the liquidation estate.

This language is similar to that used to define the phrase

available to cover losses

as it relates to secondary capital in NCUA's low income credit union rule. 12 CFR 701.34(b)(7).

The proposal defines

core capital

as Generally Accepted Accounting Principles (GAAP) retained earnings, PCC, the retained earnings of any acquired credit union if the acquisition was a mutual combination, and certain minority interests in the equity accounts of CUSOs that are fully consolidated. This definition is the same as the current § 704.2 definition, with the addition of any minority interests in the equity accounts of CUSOs that are fully consolidated with the corporate. So, for example, if a corporate owned 90 percent of the equity in a CUSO, with 10 percent equity owned by third parties, and the corporate consolidated its financials with the CUSO, the corporate could include the remaining 10 percent minority interest in its Tier 1 capital. This treatment is consistent with the treatment afforded such minority interests by the other regulators.

29

29

See, e.g.,

12 CFR 567.5(a)(1)(iii) (OTS definition of Tier 1 capital); 12 CFR part 3, Appendix A, § 2(a)(3) (OCC definition of Tier 1 capital). “[M]inority interests in the equity accounts of consolidated subsidiaries * * * [are] accorded Tier 1 treatment because, as a general rule, [they] represent equity that is freely available to absorb losses in operating subsidiaries.'” Todd Eveson, “Financial and Bank Holding Company Issuance of Trust Preferred Securities,” 6 N.C. Banking Inst. 315, 321 (2002).

Also, the terms

core capital

and

Tier 1 capital

are used synonymously in this proposal.

The proposal further defines

supplementary capital

as including certain portions of its NCAs, GAAP allowance for loan and lease losses, and net unrealized gains on available-for-sale equity securities with readily determinable fair values. During the last five years of an nonperpetual contributed capital account, the amount that may be considered supplementary capital is reduced, on a monthly basis, until the amount reaches zero when the account has only one year of life remaining, all as described in paragraph 704.3(b)(3). This reduction is consistent with the current corporate rule and the capital regulations of the other regulators. A corporate may also include its allowance for loan and lease losses in supplementary capital, up to a maximum of 1.25 percent of risk-weighted assets. This is also consistent with the capital regulations of the other regulators. As noted by the OCC:

The allowance for loan and lease losses is intended to absorb future losses. Although future losses may not be identified specifically at the time a provision is made, a presumption exists that losses are inherent in the loan and lease portfolio. The obvious link between the allowance and inherent losses in the loan and lease portfolio precludes it from qualifying as Tier 1 capital, which encompasses only the purest and most stable forms of capital. Furthermore, it is intended that the loan loss reserves which qualify for inclusion as Tier 2 capital will be general in nature. That is, any portion of the allowance for loan and lease losses which is ascribed to particular assets that have been identified as possessing a reasonable probability of some loss is not to be included as Tier 2 capital * * *. Beyond the clearly identified specific loan loss reserves, it is difficult to distinguish between the portion of the loan loss reserve that is freely available to absorb future losses within the portfolio and the portion that reflects likely losses on existing problem or troubled loans. However, a bank that maintains a relatively large allowance for loan and lease losses usually has a relatively greater incidence of identified asset quality problems in its loan and lease portfolio, and in this situation the entire allowance for loan and lease losses cannot be considered to be a true general reserve for the purposes of risk-based capital. Therefore, a standard percentage limitation, based on total risk-weighted assets, is the most reasonable method of eliminating the bulk of the non-qualifying loan loss reserves from banks' capital calculations. The figure of 1.25 percent of risk-weighted assets was determined on the basis of historical data * * *.

54 FR 4168 (Jan. 27, 1989).

The proposal also provides that a corporate may include 45 percent of its unrealized gains on available-for-sale equity securities in supplementary capital. Unrealized gains are unrealized holding gains, net of unrealized holding losses, calculated as the amount, if any, by which fair value exceeds historical cost. The proposal further provides that NCUA may disallow such inclusion in the calculation of supplementary capital if the NCUA determines that the securities are not prudently valued. Again, this is similar to how the other regulators define supplementary capital.

30

Although it is unlikely that corporates will hold much in the way of equity securities, they might have some equity securities in CUSOs. Because the 45 percent limitation used by the banking regulators includes the effects of possible taxation upon sale, and corporates are not subject to income taxation, the Board invites comment on the proposed 45 percent limitation.

31

30

See, e.g.,

12 CFR 567.5(a) (OTS capital rule).

31

“The Basel Accord also permits institutions to include up to 45 percent of the pretax net unrealized gains on equity securities in supplementary capital. As explained in the Basel Accord, the 55 percent discount is applied to the unrealized gains to reflect the potential volatility of this form of unrealized capital, as well as the tax liability charges that generally would be incurred if the unrealized gain were realized or otherwise taxed currently.” 63 FR 46518 (Sept. 1, 1998) (Discussion of joint FDIC, OTS, and OCC capital rulemaking).

The terms

supplementary capital

and

Tier 2 capital

are used synonymously in this preamble and the proposal.

Nonperpetual contributed capital

is a form of Tier 2 capital.

The use of core capital and supplementary capital, and their incorporation into the proposed minimum capital ratios, is discussed further in the following paragraph-by-paragraph summary of the proposed § 704.3.

Paragraph-by-Paragraph Analysis of § 704.3

Paragraph 704.3(a) Capital Requirements

This proposed paragraph (a) requires a corporate to maintain, at all times, three minimum capital ratios. Paragraph (a)(1) requires all corporates maintain a leverage ratio of 4.0 percent or greater, a Tier 1 risk-based capital ratio of 4.0 percent or greater, and a total risk-based capital ratio of 8.0 percent or greater. Each of these ratios are further defined in § 704.2 as discussed below. Paragraph 704.3(a)(2) continues the existing requirement that a corporate have a capital plan in place to achieve and maintain the necessary capital. Paragraph (a)(3) requires that the corporate prepare and submit a retained earnings accumulation plan if, under certain circumstances described below, the corporate is not making sufficient progress in building the necessary retained earnings to satisfy its future minimum leverage ratio requirements.

Leverage Ratio

The proposed leverage ratio is defined in the proposal as the adjusted core capital divided by moving DANA. As discussed above, the leverage ratio ensures that the corporate has adequate capital to provide for losses other than credit losses. Paragraph 704.3(a) requires a minimum leverage ratio of 4.0 percent. The capital numerator, and the asset denominator, of the leverage ratio are discussed below.

Leverage Ratio Denominator: Moving DANA

The proposal employs moving DANA as the leverage ratio denominator.

Moving DANA means the average of DANA for the month being measured and the previous eleven (11) months. DANA means the average of net assets calculated for each day during the period (which would be the previous month).

Net assets means total assets less loans guaranteed by the NCUSIF and member reverse repurchase transactions. For its own account, a corporate's payables under reverse repurchase agreements and receivables under repurchase agreements may be netted out if the GAAP conditions for offsetting are met. Also, any amounts deducted from core capital in calculating adjusted core capital are also deducted from net assets.

This is virtually the same denominator employed in the current part 704 for the total capital ratio. The proposal includes a slight modification to make clear that any asset deducted from core capital to obtain adjusted core capital (

i.e.

, the leverage ratio numerator) should likewise be deducted from the denominator.

The proposed leverage ratio differs from that of the banking regulators in that the proposal uses a moving 12-month average of assets where the other regulators use period-end assets. The Board believes that the corporates, in their role as liquidity providers and liquidity managers for natural person credit unions, need some flexibility to handle seasonal variations in total assets—and moving DANA provides that flexibility. Proposed paragraph 704.3(e), however, empowers the NCUA, in appropriate cases, to direct that a particular corporate use period-end assets in its capital ratio calculations rather than moving DANA.

Leverage Ratio Numerator: Adjusted Core Capital

As discussed above, core capital generally means the sum of a corporate's retained earnings, as calculated under GAAP, and perpetual contributed capital.

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To obtain adjusted core capital, the proposal requires the corporate to make several modifications to core capital.

32

For a corporate that acquires another credit union in a mutual combination, core capital also includes the retained earnings of the acquired credit union, or of an integrated set of activities and assets, at the point of acquisition.

First, the corporate must deduct an amount equal to the amount of the corporate's intangible assets that exceed one half percent of the corporate's moving DANA. Generally, intangible assets are difficult to value and highly volatile. In addition, many forms of intangible assets, such as goodwill, decline in value if an entity suffers losses, which is the point in time that the permanency of capital is most important. The other regulators have recognized these problems with intangible assets and so generally require banks to deduct problematic intangibles from both assets and capital when calculating core capital ratios. Corporates, however, do not generally maintain intangibles on their books. The Board, therefore, is proposing that intangibles of a

de minimus

amount (one half of one percent of total assets) may be treated just like other assets in the capital calculation. However, intangibles above this

de minimus

amount must be deducted from both core capital (the numerator of the capital ratios) and assets (the denominator). This treatment of intangibles is similar to the treatment given intangibles by the other regulators.

33

33

See, e.g.

, 12 CFR 567.5(a)(2) (OTS capital rule).

The proposal, however, provides some flexibility on the treatment of intangibles. The NCUA, on its own initiative or upon application from a corporate, may direct that a particular corporate add some or all of these excess intangibles back into the corporate's adjusted core capital and associated assets. In making this determination, the NCUA will consider the volatility and permanency of the particular intangible and the overall financial condition of the particular corporate.

Second, the corporate must deduct investments, both equity and debt, from consolidated CUSOs. To include these investments would overstate the amount of capital available to absorb losses in the consolidated entity. This treatment of these investments is similar to the treatment given these investments by the other regulators.

34

34

See, e.g.

, 12 CFR 567.5(a)(2)(iv) (OTS capital rule).

Third, if the corporate credit union, on or after twelve months following the publication of the final rule, contributes new capital or renews existing capital to another corporate credit union, the corporate must deduct an amount equal to the aggregate of such new or renewed capital. Because the corporate universe is so small, and may get even smaller in the future, the Board is concerned that capital investment between two or more corporates can endanger the stability of the entire corporate system and, ultimately, the stability of the entire credit union system. Accordingly, this proposed deduction from corporate capital discourages capital investment between corporates. For example, without the deduction corporate A might place significant capital in corporate B, which then, in turn, might place significant capital in corporate C. Losses in corporate C might then cause corresponding losses in corporates A and B which, in turn, may have to pass some of those losses to their natural person credit union members. The Board invites comment on this proposed deduction from capital, including whether there should be an exception for

de minimus

member capital contributions between corporates and, if so, how that exception should be

defined. The Board notes that corporates will have some time to adapt to this deduction, since it will not be effective for 12 months and, even then, will not apply to preexisting capital accounts unless the account is renewed in some fashion (

e.g.

, renewal of an NCA instrument upon maturity).

The current part 704 encourages corporates to achieve and maintain retained earnings at 2 percent of assets, but does not actually require them to do so. The Board believes that some regulatory mechanism to force corporates to build retained earnings is necessary. In the long run, contributed capital like PCC is a supplement to retained earnings, but PCC is not an entirely adequate replacement for retained earnings. As demonstrated in the recent corporate crisis, the depletion of the contributed capital at corporates put severe, procyclical stress on their member natural person credit unions. While this situation cannot be entirely avoided in the future, it can be mitigated through retained earnings growth. Accordingly, the proposal requires that, after an appropriate phase-in period, a certain percentage of core capital consist of retained earnings.

The initial adjustment to core capital, effective six years after the date of publication of the final rule, will require that a corporate deduct from core capital any amount of PCC that causes PCC minus retained earnings, all divided by moving daily average net assets (DANA), to exceed two percent. The effect of this provision is to require that, for a corporate to achieve the minimum four percent leverage ratio necessary for adequate capitalization, it must have at least 100 bp of retained earnings at the six year mark. The remaining 300 bp in the ratio numerator may consist of either PCC or retained earnings. Similarly, to have a five percent leverage ratio at the six year mark and thus be well capitalized, a corporate must have 150 bp of retained earnings, and the remaining 350 bp in the ratio numerator may consist of PCC. This adjustment to core capital will, then, force corporates to work toward building their retained earnings.

The Board, however, believes that, ideally, a corporate should continue to increase its retained earnings and reduce its reliance on contributed capital. The second adjustment to core capital, effective ten years after the date of publication of the final rule, will require that a corporate deduct from core capital any amount of PCC that causes PCC to exceed retained earnings. The effect of this provision is to require that, for a corporate to have a four percent leverage ratio at the ten year mark and thus be adequately capitalized, the corporate must have at least 200 bp of retained earnings. The remaining 200 bp in the ratio numerator may consist of PCC. Similarly, to have a five percent leverage ratio at the ten year mark and thus be adequately capitalized, a corporate must have 250 bp of retained earnings, and the remaining 250 bp in the ratio numerator may consist of PCC.

Although the first explicit retained earnings requirement will not become effective for six years, the Board recognizes that corporates must work hard during the entire six year period to build retained earnings. Accordingly, paragraph 704.3(a)(3) provides that, beginning with the first call report submitted by the corporate three years after the date of the final rule:

[A] corporate credit union must calculate and report the ratio of its retained earnings to its moving daily average net assets. If this ratio is less than 0.45 percent, the corporate credit union must, within 30 days, submit a retained earnings accumulation plan to the NCUA for NCUA's approval. The plan must contain a detailed explanation of how the corporate credit union will accumulate earnings sufficient to meet all its future minimum leverage ratio requirements, including specific semiannual milestones for accumulating retained earnings. If the corporate credit union fails to submit a plan acceptable to NCUA, or fails to comply with any element of a plan approved by NCUA, the corporate will immediately be classified as significantly undercapitalized or, if already significantly undercapitalized, as critically undercapitalized. The corporate credit union will be subject to all the associated prompt corrective actions under § 704.4 of this part.

The intent of this retained earnings accumulation plan (REAP) provision is to ensure that corporates strive for, and attain, retained earnings growth rates that are adequate to achieve 100 bp of retained earnings by the end of year six and 200 bp of retained earnings by the end of year ten.

Adequate retained earnings are critical to the health of the corporate system going forward. It is the Board's intent that, if a corporate is subject to a REAP and fails to meet any of the established retained earnings milestones, NCUA will take decisive action under the prompt corrective action authorities of 704.4. Included among those authorities are replacement of the board and senior management, and liquidation, conservatorship or consolidation of the corporate. These actions are discretionary on NCUA's part under 704.4, however, and the NCUA Board requests comment on whether any such actions should be mandatory for a corporate that fails to meet its REAP requirements.

In addition to the REAP provision in paragraph 704.8(a)(3) above, the proposal contains other tools to deal with corporates that are either unable, or unwilling, to build retained earnings at an adequate pace during the phase-in period. For example, proposed § 704.3(d), discussed further below, permits the Board to establish different minimum capital requirements for individual corporates “upon a determination that the corporate credit union's capital is

or may become

inadequate in view of the credit union's circumstances.” Proposed § 704.3(d)(2) (emphasis added). This provision also provides that “higher capital levels may be appropriate when NCUA determines that * * * the credit union has failed to properly plan for, or execute, necessary retained earnings growth.” Proposed § 704.3(d)(2)(ix). NCUA could use this particular tool, and other PCA tools, to address capital inadequacies, if any—even

before

the third anniversary of the final rule and the associated requirement to prepare a REAP.

Tier 1 Risk-Based Capital Ratio

The proposal defines the Tier 1 risk-based capital ratio (T1RBCR) to mean the ratio of adjusted core capital to the moving daily average net risk-weighted assets. NCUA intends this ratio, along with the total risked-based capital ratio (TRBCR), to ensure that the corporate has sufficient capital to handle the credit risk associated with its investments and activities. The combination of the T1RBCR, and the TRBCR ratio discussed below, ensures that at least half of the capital used for purposes of protecting against losses associated with credit risk is the more permanent capital (

i.e.

, core capital). The other portion of capital used to protect against credit risk may be

Tier 2 capital,

also called

supplementary capital,

as discussed below in connection with the TRBCR.

T1RBCR Numerator: Adjusted Core Capital

The capital numerator for the T1RBCR is adjusted core capital, the same as the numerator for the leverage ratio discussed above.

T1RBCR Denominator: Moving Daily Average Net Risk-Weighted Assets (DANRA)

The moving DANRA means the average of daily average net risk-weighted assets for the month being measured and the previous eleven (11) months.

DANRA means the average of net risk-weighted assets calculated for each day during the period (which would be the previous month).

Net risk-weighted assets means risk-weighted assets less CLF stock subscriptions, CLF loans guaranteed by the NCUSIF, U.S. Central CLF certificates, and member reverse repurchase transactions. For its own account, a corporate's payables under reverse repurchase agreements and receivables under repurchase agreements may be netted out if the GAAP conditions for offsetting are met. Also, any amounts deducted from core capital in calculating adjusted core capital are also deducted from net risk-weighted assets. To this point, this is similar to the moving DANA calculation in the denominator of the leverage ratio. However, the moving DANRA calculation required the use of

risk-weighted

assets, which are calculated as provided for in the proposed Appendix C of part 704. This risk-weighting process is described in detail in the section of the preamble devoted to Appendix C.

Total Risked-Based Capital Ratio

The total risk-based capital ratio means the ratio of total capital to moving DANRA.

The denominator, moving DANRA, is the same as the denominator for the T1RBCR, as discussed above. The numerator, “Total capital” means the sum of a corporate's adjusted core capital and its supplementary capital less the corporate's equity investments not otherwise deducted when calculating adjusted core capital.

Supplementary capital, or Tier 2 capital, generally means the sum of all the corporate's NCAs, except that at the beginning of each of the last five years of the life of an NCA instrument the amount that is eligible to be included as supplementary capital is reduced by 20 percent of the original amount of that instrument (net of redemptions). While, as discussed above, the proposal adjusts the definition of NCAs to make these accounts more permanent and bring them in line with the Basel requirements for supplementary capital, the value of these NCAs as a buffer against losses as the NCAs approach their maturity or withdrawal date. The proposed amortization schedule tracks the amortization used by the banking regulators for supplementary capital that takes this hybrid debt instrument form.

Paragraph 704.3(b) Requirements for Nonperpetual Contributed Capital

This proposed paragraph describes the NCA account terms and the various disclosure, transfer, and release requirements. This paragraph is similar to the existing 704.3(b), taking into account the change in NCA terms described above. The proposal also protects against the premature release of NCAs with the addition of the following new paragraph (b)(5):

A corporate credit union may redeem nonperpetual contributed capital prior to maturity or the end of the notice period only with the prior approval of the NCUA.

Paragraph 704.3(c) Requirements for Perpetual Contributed Capital

This paragraph describes the PCC account terms and the various disclosure, transfer, and release requirements. Again, this paragraph is similar to the existing 704.3(c). As with NCA, the proposal protects against the premature release of PCC by permitting a corporate to call PCC only with NCUA's prior approval.

Paragraph 704.3(d) Individual Minimum Capital Requirements

Paragraph 704.3(d) provides that the NCUA may establish increased individual minimum capital requirements for a particular corporate upon a determination that the corporate's capital is or may become inadequate in view of the credit union's circumstances.

The proposal provides several examples where a greater minimum capital requirement may be appropriate, such as where a corporate:

• Is receiving special supervisory attention;

• Has or is expected to have losses resulting in capital inadequacy;

• Has a high degree of exposure to interest rate risk, prepayment risk, credit risk, concentration risk, certain risks arising from nontraditional activities or similar risks, or a high proportion of off-balance sheet risk;

• Has poor liquidity or cash flow;

• Is growing, either internally or through acquisitions, at such a rate that supervisory problems are presented that are not dealt with adequately by other NCUA regulations or other guidance;

• May be adversely affected by the activities or condition of its CUSOs or other persons or credit unions with which it has significant business relationships, including concentrations of credit;

• Has a portfolio reflecting weak credit quality or a significant likelihood of financial loss, or that has loans or securities in nonperforming status or on which borrowers fail to comply with repayment terms;

• Has inadequate underwriting policies, standards, or procedures for its loans and investments;

• Has failed to properly plan for, or execute, necessary retained earnings growth; or

• Has a record of operational losses that exceeds the average of other, similarly situated corporates; has management deficiencies, including failure to adequately monitor and control financial and operating risks, particularly the risks presented by concentrations of credit and nontraditional activities; or has a poor record of supervisory compliance.

When the NCUA determines that a different minimum capital requirement is necessary or appropriate for a particular corporate, including minimum capital relating to classification as significant or critically undercapitalization, the NCUA will notify the corporate in writing of its proposed minimum capital requirements; the schedule for compliance with the new requirement; and the specific causes for determining that the higher individual minimum capital requirement is necessary or appropriate for the corporate. The NCUA will forward the notifying letter to the appropriate state supervisor if a state-chartered corporate would be subject to an individual minimum capital requirement.

The responses of the corporate and appropriate state supervisor must be in writing and must be delivered to the NCUA within 30 days after the date on which the notification was received. The NCUA may extend or shorten the time period for good cause.

The corporate's response must include any information that the credit union wants the NCUA to consider in deciding whether to establish or to amend an individual minimum capital requirement for the corporate, what the individual capital requirement should be, and, if applicable, what compliance schedule is appropriate for achieving the required capital level.

After expiration of the response period, the NCUA will decide whether or not the proposed individual minimum capital requirement should be established for the corporate, or whether that proposed requirement should be adopted in modified form, based on a review of the corporate's response and other relevant information. Failure to provide an adequate response will constitute a legal basis for prompt corrective action under § 704.4.

Paragraph 704.3(e) Reservation of Authority

Financial organizations are constantly developing innovative transactions that may not fit well into the various risk-weight categories in Appendix C to part 704. New investment activities may nominally fit into a particular risk-weight category or credit conversion factor, but impose risks on the holder at levels that are not commensurate with the nominal risk-weight or credit conversion factor for the asset, exposure or instrument. Accordingly, the proposal clarifies NCUA's authority over corporates, on a case-by-case basis, to determine the appropriate risk-weight for assets and credit equivalent amounts and the appropriate credit conversion factor for off-balance sheet items in these circumstances. Specifically, the NCUA may:

• Disregard any transaction entered into by a corporate primarily for the purpose of reducing the minimum required amount of regulatory capital or otherwise evading the requirements of this section;

• Require a corporate to compute its capital ratios on the basis of period-end, rather than average, assets when it is appropriate to carry out the purposes of part 704;

• Notwithstanding the definitions of core and supplementary capital in the corporate rule, find that a particular asset or core or supplementary capital component has characteristics or terms that diminish its contribution to a corporate's ability to absorb losses and require the discounting or deduction of such asset or component from the computation of core, supplementary, or total capital;

• Notwithstanding Appendix C of this section, look to the substance of a transaction, find that the assigned risk-weight for any asset, or credit equivalent amount or credit conversion factor for any off-balance sheet item does not appropriately reflect the risks imposed on the corporate, and may require the corporate to apply another risk-weight, credit equivalent amount, or credit conversion factor that the NCUA deems appropriate; and

• If Appendix C does not specifically assign a risk-weight, credit equivalent amount, or credit conversion factor to a particular asset or activity of the corporate, assign any risk-weight, credit equivalent amount, or credit conversion factor that it deems appropriate.

Exercise of this authority by NCUA may result in a higher or lower risk-weight for an asset or credit equivalent amount or a higher or lower credit conversion factor for an off-balance sheet item. This reservation of authority explicitly recognizes NCUA's retention of sufficient discretion to ensure that corporates, as they become involved with new types of financial assets and activities, will be treated appropriately under the regulatory capital standards.

Applicable State Regulator

Several paragraphs of this proposed § 704.3 on capital, and the proposed § 704.4 on prompt corrective action, refer to the

applicable state regulator

in connection with potential actions involving state chartered corporates. The proposal amends § 704.2 to define

applicable state regulator

as the prudential state regulator of a state chartered corporate.

Appendix A to Part 704—Capital Prioritization and Model Forms

The current Appendix A to part 704, entitled

Model Forms,

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

Capital Prioritization and Model Forms.

The new Appendix A has two parts. Part II contains amended model disclosure forms. Part I is new, and reads as follows:

Part I—Optional Capital Prioritization

Notwithstanding any other provision in this chapter, a corporate credit union, at its option, may determine that capital contributed to the corporate on or after [DATE 60 DAYS AFTER DATE OF PUBLICATION OF FINAL RULE IN

FEDERAL REGISTER

] will have priority, for purposes of availability to absorb losses and payout in liquidation, over capital contributed to the corporate before that date. The board of directors at a corporate credit union that desires to make this determination must:

(a) On or before [DATE 60 DAYS AFTER DATE OF PUBLICATION OF FINAL RULE IN

FEDERAL REGISTER

], adopt a resolution implementing its determination.

(b) Inform the credit union's members and NCUA, in writing and as soon as practicable after adoption of the resolution, of the contents of the board resolution.

(c) Ensure the credit union uses the appropriate initial and periodic Model Form disclosures in Part II below.

This option, if implemented by a corporate's board of directors, will give those entities that contribute new capital to the corporate starting 60 days after the publication of the final rule priority—in terms of availability to absorb losses and payout in liquidation—over those capital contributions made before that date. The purpose of this provision is to provide a tool for facilitating capital growth. The proposal amends the forms so that they are consistent with the proposed definitions of PCC and NCAs. These form changes include changing the notice and term of NCAs from three years to five years, eliminating references to adjustable balance NCAs, and describing in more detail the meanings of the phrase “available to cover losses.” Because this new option will be available to corporates before the other new capital provisions go into effect, including the nomenclature changes (that is, from PIC to PCC, and from MCAs to NCCs), the proposal expands the number of model forms in Part II from the two current forms to eight forms.

The current paragraph (6) in the model forms reads as follows:

Where the corporate credit union is liquidated, membership capital accounts are payable only after satisfaction of all liabilities of the liquidation estate including uninsured obligations to shareholders and the NCUSIF.

It is possible, for example, that a solvent corporate could be voluntarily liquidated and that there could be some funds remaining after payment to creditors, uninsured shareholders, and the NCUSIF. It is also possible (although unlikely) that the value of the assets of an insolvent, involuntarily liquidated corporate credit union could increase between the date of liquidation and the date the assets are sold, and there could then be some funds in the liquidation estate remaining after payment to the creditors, uninsured shareholders, and the NCUSIF. In both of these cases, the NCA holders, and possibly the PCC holders, would receive a distribution

35

—but this is only true to the extent that the NCAs and PCCs were not used in a previous fiscal year to cover losses. Once used to cover losses, the NCAs and PCC are gone to the extent so used, and all possible claims related to those accounts, including liquidation-based claims, are extinguished. Accordingly, the proposal adds the following clarifying language to the end of each paragraph (6):

35

This possibility is recognized in NCUA's involuntary liquidation rule. 12 CFR 709.5(b)(7) and (9).

However, [NCAs or PCCs] that are used to cover losses in a fiscal year previous to the year of liquidation has no claim against the liquidation estate.

The proposal also adds a conforming amendment to NCUA's involuntary liquidation rule, 12 CFR 709.10, to reflect the option to give new contributed capital payout priority.

Appendix C to Part 704—Risk-Based Capital Ratios and Asset Risk-Weightings

A corporate's risk-based capital requirement is calculated based on the credit risk presented by both its on-balance sheet assets and off-balance sheet commitments and obligations. With certain limited exceptions, the asset base of a corporate is determined on a consolidated basis,

i.e.,

including its consolidated CUSOs. Assets are assigned a credit-risk weighting based upon their relative risk. Risk-weights are generally tied to the nature of the underlying obligor.

The risk-weightings range from zero percent for assets backed by the full faith and credit of the United States or that pose no credit risk to the corporate to 100 percent as the standard risk-weighting.

Off-balance sheet commitments are converted to a “credit equivalent” amount by using a conversion factor intended to estimate the likelihood that the contingent obligation will result in an actual obligation of the corporate and the potential size of loss such items may result in. That amount is then risk-weighted according to the risk associated with the underlying obligor, just as an on-balance sheet asset would be. The amount of risk-weighted assets will then be multiplied by a credit risk capital requirement to determine the minimum amount of capital required for that corporate.

The rule also sets forth the items that count as capital and that may be used to satisfy the risk-based capital requirement. “Core capital,” or “tier 1 capital,” includes items of a more permanent nature, such as PCC and GAAP retained earnings. Certain other items provide a somewhat lesser degree of protection, often because of their nonpermanent nature or their imposition of fixed obligations. These items are considered “supplementary capital,” or “tier 2 capital,” and include NCAs. Together, the sum of core and supplementary capital equal a corporate's “total capital.”

Although both core and supplementary capital may be used in meeting the risk-based capital requirement, the amount of supplementary capital that may be counted toward that requirement is limited to the amount of the credit union's core capital through the use of the T1RBC ratio. Additional limits are placed upon certain types of supplementary capital. These limits may restrict the extent to which these forms of supplementary capital may be used to satisfy the corporate's capital requirement. Items that are deducted from a corporate's asset base in determining its assets are also deducted from its capital.

On-Balance Sheet Assets

The proposed amendments sets forth a system of risk-weighted assets similar to that used by the other federal banking regulators. Assets, in general, will be assigned to risk categories based on the degree of credit risk associated with the obligor or nature of the obligation. The categories include risk-weights of 0, 20, 50, and 100 percent.

The 100 percent category is the standard risk category. Assets not specifically included in another category fall within this category. Items that are less risky than a “standard risk asset” because of the traditional financial strength of the obligor, the default history of the asset type, or the guarantee or security backing the asset are assigned to a lower risk category. This reflects the Board's determination, mirroring in many ways the implicit determinations made by the market, that such assets present lower risks.

Risk-weighted assets are determined by taking the book value of each asset and multiplying it by the risk-weight assigned to it. Ownership interests in investment companies such as mutual funds are assigned risk-weights based upon the composition of the investment company's underlying portfolio of assets. The resulting values are added together to arrive at total risk assets. The amount of total risk assets is the amount against which the minimum capital requirement is applied.

Summary of Risk-Weights for On-Balance Sheet Assets

Zero percent weighting (Category 1). This category, presenting, in the Board's estimation, a nearly non-existent level of credit risk, includes:

• Cash;

• Securities issued by and other direct claims on the U.S. Government or its agencies or the central government of an Organization for Economic Cooperation and Development (OECD) country;

• Notes and obligations issued by or guaranteed by the Federal Deposit Insurance Corporation or the National Credit Union Share Insurance Fund and backed by the full faith and credit of the United States Government;

• Deposit reserves at, claims on, and balances due from Federal Reserve Banks; the book value of paid-in Federal Reserve Bank stock;

• Assets directly and unconditionally guaranteed by the United States Government or its agencies, or the central government of an OECD country; and

• Certain claims on a qualifying securities firm that are collateralized by cash on deposit in the corporate or by securities issued or guaranteed by the United States Government or its agencies, or the central government of an OECD country.

Twenty percent weighting (Category 2). This category contains items viewed as presenting a significantly lower level of risk than standard risk assets. It includes:

• Cash items in the process of collection;

• Assets conditionally guaranteed by the United States Government or its agencies, or the central government of an OECD country, or collateralized by securities issued or guaranteed by the United States government or its agencies, or the central government of an OECD country;

• Certain securities issued by the U.S. Government or its agencies which are not backed by the full faith and credit of the United States Government;

• Certain securities issued by United States Government-sponsored agencies;

• Assets guaranteed by United States Government-sponsored agencies;

• Assets collateralized by the current market value of securities issued or guaranteed by United States Government-sponsored agencies;

• Claims guaranteed by a qualifying securities firm, subject to certain conditions;

• Claims representing general obligations of any public-sector entity in an OECD country, and that portion of any claims guaranteed by any such public-sector entity;

• Balances due from and all claims on domestic depository institutions.

• The book value of paid-in Federal Home Loan Bank stock;

• Deposit reserves at, claims on, and balances due from the Federal Home Loan Banks;

• Assets collateralized by cash held in a segregated deposit account by the reporting corporate;

• Claims on, or guaranteed by, official multilateral lending institutions or regional development institutions in which the United States Government is a shareholder or contributing member;

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These institutions include, but are not limited to, the International Bank for Reconstruction and Development (World Bank), the Inter-American Development Bank, the Asian Development Bank, the African Development Bank, the European Investments Bank, the International Monetary Fund and the Bank for International Settlements.

• Assets collateralized by the current market value of securities issued by

official multilateral lending institutions or regional development institutions in which the United States Government is a shareholder or contributing member;

• All claims on depository institutions incorporated in an OECD country, and all assets backed by the full faith and credit of depository institutions incorporated in an OECD country;

• Claims on, or guaranteed by depository institutions other than the central bank, incorporated in a non-OECD country, with a remaining maturity of one year or less; and

• Local currency claims conditionally guaranteed by central governments of non-OECD countries, to the extent the corporate has local currency liabilities in that country.

Fifty percent risk-weighting (Category 3). This category contains assets considered to present a moderate level of credit risk as compared to standard risk assets. It includes:

• Revenue bonds issued by any public-sector entity in an OECD country for which the underlying obligor is a public-sector entity, but which are repayable solely from the revenues generated from the project financed through the issuance of the obligations;

• Qualifying mortgage loans and qualifying multifamily mortgage loans;

• Certain privately-issued mortgage-backed securities; and

• Qualifying residential construction loans.

One hundred percent risk-weighting (Category 4). All assets not classified elsewhere or deducted from calculations of capital pursuant to §§ 704.2 and 704.3 are assigned to this category, which comprises standard risk assets. This category includes:

• Consumer loans;

• Commercial loans;

• Home equity loans;

• Non-qualifying mortgage loans;

• Non-qualifying multifamily mortgage loans;

• Residential construction loans;

• Land loans;

• Nonresidential construction loans;

• Obligations issued by any state or any political subdivision thereof for the benefit of a private party or enterprise where that party or enterprise, rather than the issuing state or political subdivision, is responsible for the timely payment of principal and interest on the obligations;

• Debt securities not specifically risk-weighted in another category;

• Investments in fixed assets and premises;

• Servicing assets;

• Interest-only strips receivable, other than credit-enhancing interest-only strips;

• Equity investments;

• The prorated assets of subsidiaries (except for the assets of consolidated CUSOs) to the extent such assets are included in adjusted total assets;

• All repossessed assets or assets that are more than 90 days past due; and

• Intangible assets not specifically weighted in some other category.

The term “prorated assets” means the total assets (as determined in the most recently available GAAP report) of a consolidated CUSO multiplied by the corporate credit union's percentage of ownership of that consolidated CUSO.

Corporates may take indirect ownership of assets, such as through a mutual fund. The proposal provides that investments representing an indirect holding of a pool of assets are assigned to risk-weight categories based upon the risk-weight that would be assigned to each category of assets in the pool, and described various methods for achieving that result. In no case, however, will any such investment be assigned a total risk-weight of less than 20 percent.

The proposal also recognizes that certain transactions or activities, such as derivatives transactions, may appear on corporate's balance sheet but are not specifically described in the Section II(a) on-balance sheet risk-weight categories. These items will be assigned risk-weights as described in Section II(b) or II(c) below, generally relating to off-balance sheet items.

Off-Balance Sheet Items

The Board is also proposing to incorporate off-balance sheet items in its calculation of risk-weighted assets, using a method similar to that used by the federal banking regulators.

Under the proposal, off-balance sheet items are incorporated into risk-weighted assets by first determining the on-balance sheet credit equivalent amounts for the items and then assigning the credit equivalent amounts to the appropriate risk category according to the obligor, or if relevant, the guarantor or the nature of the collateral.

For many types of off-balance sheet transactions, the risk-weight is determined by a two-step process. First, the notional principal, or face value, amount of the off-balance sheet item is multiplied by a credit conversion factor to arrive at a balance sheet “credit-equivalent amount.” The conversion factor is based upon the relative likelihood that a credit obligation will result from the commitment. The credit-equivalent amount is then assigned to the appropriate risk category depending upon the obligor (e.g., to the 20 percent risk category if guaranteeing an obligation of a depository institution). For certain off-balance sheet contracts, however, including interest and exchange rate contracts, credit equivalent amounts are determined by summing two amounts: the current exposure and the estimated potential future exposure.

Summary of Conversion Factors for Off-Balance Sheet Items

Conversion factors—Group A—100 Percent.

Direct credit substitutes are assigned to Group A. Direct credit substitutes are any irrevocable obligations in which a corporate has essentially the same credit risk as if it had made a direct loan to the obligor or account party. Direct credit substitutes include guarantees (or guarantee-type instruments) backing financial claims, such as outstanding securities, loans, and other financial obligations including those on behalf of CUSOs. Direct credit substitutes also include standby letters of credit, equivalent obligations, and forward agreements that are legally binding agreements (contractual obligations) to purchase assets with certain drawdowns at specified future dates.

Asset sales with recourse, if not already included on the balance sheet, are treated in the same way as direct credit substitutes. Such sales will be treated as if they did not occur. Capital will be required against the full amount sold for assets sold with recourse. Retention of the subordinated portion of a senior/subordinated loan participation or package of loans will be treated in the same manner as an asset sale with recourse. The minimum amount of capital required against loans sold to an institution with full recourse is determined by the type of obligor.

Group B—50 percent.

This group includes transaction-related contingencies and unused commitments not falling within Group E. Transaction-related contingencies include performance bonds, performance standby letters of credit, warranties, and standby letters of credit related to particular transactions. These instruments are different from financial guarantee-type standby letters of credit in that they concern performance of nonfinancial or commercial contracts or undertakings. These instruments generally involve guaranteeing the account party's obligation to deliver a service or product in the conduct of its day-to-day business.

A commitment is defined as any arrangement between an institution and its customer that legally obligates the institution to extend credit to the customer in the form of loans or leases.

It also includes such undertakings as overdraft transactions. Normally, a commitment involves a written contract or agreement, a commitment fee, or some other form of consideration.

Commitments are included in risk-weighted assets regardless of whether they contain “material adverse change” clauses or other similar provisions. Commitments with material adverse change clauses are included in this category (rather than in a category carrying a smaller conversion factor) because they represent obligations that may involve risk if an institution funds the commitment before the customer's condition deteriorates, or before the deterioration is recognized. Moreover, while the Board does not wish to discourage the use of material adverse change clauses, some court decisions suggest that the presence of a material adverse change clause cannot necessarily be relied on to relieve an institution of its obligations pursuant to a commitment.

Only the unused portion of a commitment is treated as an off-balance sheet item. Amounts that are already drawn and outstanding under a commitment appear on the balance sheet; such amounts, therefore, will not be included as commitments for purposes of computing the risk-asset ratio.

Group C—20 percent.

Group C includes short-term, self-liquidating, trade-related contingencies that arise from the movement of goods, including commercial letters of credit and other documentary letters of credit collateralized by the underlying shipments.

Group D—10 percent.

Group D includes unused portions of eligible Asset-backed Commercial Paper (ABCP) liquidity facilities with an original maturity of one year or less. The ABCP risk-weighting treatment is similar to the risk-weighting employed by the other regulators. The proposal adds key terms related to the ABCP risk-weighting to the definitions section. 12 CFR 704.2.

Group E—Zero Percent.

Group E includes unused commitments that are less than one year in maturity or that the corporate can, at its option, unconditionally (without cause) cancel. Facilities that, at the institution's option, are unconditionally cancelable at any time are not considered to be commitments, provided that the institution makes a separate credit decision before each drawdown under the facility. Unused retail credit card lines are deemed to fall under this group if the corporate has the unconditional option to cancel the card at any time.

Group F—Off balance sheet contracts; interest rate and foreign exchange contracts.

Credit equivalent amounts for these contracts, including interest-rate swaps, futures, over-the-counter options, interest-rate options purchased (caps, floors and collars), foreign exchange rate contracts, and forward rate agreements are determined by summing two amounts: the current exposure and the estimated potential future exposure.

The current exposure (sometimes referred to as replacement cost) of a contract is derived from its market value. In most instances the initial market value of a contract is zero.

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A corporate should mark all of its rate contracts to market to reflect the current value of the transaction in light of changes in the market price of the contracts or in the underlying interest or exchange rates. Unless the market value of a contract is zero, one party will always have a positive mark-to-market value for the contract, while the other party (counterparty) will have a negative mark-to-market value.

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An options contract has a positive value at inception, which reflects the premium paid by the purchaser. The value of the option may be reduced due to market movements but it cannot become negative. Therefore, unless an option has zero value, the purchaser of the option contract will always have some credit exposure, which may be greater than or less than the original purchase price, and the seller of the option contract will never have credit exposure.

An institution holding a contract with a positive mark-to-market value is “in-the-money,” that is, it would have the right to receive payment from the counterparty if the contract were terminated. Thus, an institution that is in-the-money on a contract is exposed to counterparty credit risk, since the counterparty could fail to make the expected payment. The potential loss is equal to the cost of replacing the terminated contract with a new contract that would generate the same expected cash flows under the existing market conditions. Therefore, the in-the-money institution's current exposure on the contract is equal to the market value of the contract.

An institution holding a contract with a negative mark-to-market value, on the other hand, is “out-of-the-money” on that contract, that is, if the contract were terminated, the institution would have an obligation to pay the counterparty. The institution with the negative mark-to-market value has no counterparty credit exposure because it is not entitled to any payment from the counterparty in the case of counterparty default. Consequently, a contract with a negative market value is assigned a current exposure of zero. A current exposure of zero is also assigned to a contract with a market value of zero, since neither party would suffer a loss in the event of contract termination. In summary, the current exposure of a rate contract equals either the positive market value of the contract or zero.

The second part of the credit equivalent amount for rate contracts, the estimated potential future exposure (often referred to as the add-on), is an amount that represents the potential future credit exposure of a contract over its remaining life. This exposure is calculated by multiplying the notional principal amount of the underlying contract by a credit conversion factor that is determined by the remaining maturity of the contract and the type of contract.

The potential future credit exposure is calculated for all contracts, regardless of whether the mark-to-market value is zero, positive, or negative. For interest rate contracts with a remaining maturity of one year or less, the credit conversion factor is 0 percent and for those over one year, the factor is .5 percent. For exchange rate contracts with a maturity of one year of less, the factor is 1 percent and for those over one year the factor is 5 percent. Because exchange rate contracts involve an exchange of principal upon maturity and are generally more volatile, they carry a higher conversion factor. No potential future credit exposure is calculated for single-currency interest-rate swaps in which payments are made based on two floating indices (basis swaps).

The potential future exposure is then added to the current exposure to arrive at a credit equivalent amount.

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Each credit equivalent amount is then assigned to the appropriate risk category, according to the counterparty or, if relevant, the guarantor or the nature of the collateral. The maximum risk-weight applied to such rate contracts is 50 percent.

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This method of determining credit equivalent amounts for rate contracts is known as the

current exposure method,

which is used by most banks under $250 billion in assets.

Netting and Risk-Based Capital Treatment of Off-Balance Sheet Contracts

Netting arrangements are a means of improving efficiency and reducing counterparty credit exposure. Often referred to as master netting contracts, these arrangements typically provide for both payment and close-out netting.

Payment netting provisions permit an institution to make payments to a counterparty on a net basis by offsetting payments it is obligated to make with

payments it is entitled to receive and, thus, to reduce its costs arising out of payment settlements. Close-out netting provisions permit the netting of credit exposures if a counterparty defaults or upon the occurrence of another event such as insolvency or bankruptcy. If such an event occurs, all outstanding contracts subject to the close-out provisions are terminated and accelerated, and their market values are determined. The positive and negative market values are then netted, or set off, against each other to arrive at a single net exposure to be paid by one party to the other upon final resolution of the default or other event.

The potential for close-out netting provisions to reduce counterparty credit risk, by limiting an institution's obligation to the net credit exposure, depends upon the legal enforceability of the netting contract, particularly in insolvency or bankruptcy.

Accordingly, the proposal permits a corporate, in determining its current credit exposure for multiple off-balance sheet rate contracts executed with a single counterparty, to net off-balance sheet rate contracts subject to a bilateral netting contract by offsetting positive and negative mark-to-market values, provided that the netting contract meets certain requirements, including that the bilateral netting contract creates a single, enforceable legal obligation for all individual off-balance sheet rate contracts covered by the contract.

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A bilateral netting contract that contains a walkaway clause is not eligible for netting for purposes of calculating the current credit exposure amount. A walkaway clause is a provision in a netting contract that permits the non-defaulting counterparty to make only limited payments, or no payments at all, to the estate of the defaulter even if the defaulter is a net creditor under the contract.

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The Basel Supervisors' Committee issued a consultative paper on April 30, 1993, proposing an expanded recognition of netting arrangements in the regulations based on Basel I. The paper is entitled “The Prudential Supervision of Netting, Market Risks and Interest Rate Risk.” The section applicable to netting is subtitled “The Supervisory Recognition of Netting for Capital Adequacy Purposes.” Specifically, the Basel proposal states that netting for risk-based capital purposes is permissible if (1) In the event of a counterparty's failure to perform due to default, bankruptcy or liquidation, the corporate's claim (or obligation) would be to receive (or pay) only the net value of the sum of unrealized gains and losses on included transactions; (2) the banking entity has obtained written and reasoned legal opinions stating that in the event of legal challenge, the netting would be upheld in all relevant jurisdictions; and (3) the entity has documentation and procedures in place to ensure that the netting arrangements are kept under review in light of changes in relevant law. These criteria are contained in the proposed rule.

Certain off-balance sheet rate contracts are not subject to the above calculation, and therefore, are not part of the denominator of a corporate's risk-based capital ratio. These include a foreign exchange rate contract with an original maturity of 14 calendar days or less; any interest rate or foreign exchange rate contract that is traded on an exchange requiring the daily payment of any variations in the market value of the contract; and certain asset-backed commercial paper programs.

Recourse Obligations, Direct Credit Substitutes, and Certain Other Positions

The proposed rule provides additional risk-weighting provisions for recourse obligations, direct credit substitutes, and certain other positions. These terms generally relate to asset securitization and associated securities. A discussion of asset securitization follows.

Asset securitization is the process by which loans or other credit exposures are pooled and reconstituted into securities, with one or more classes or positions, that may then be sold. Securitization provides an efficient mechanism for depository institutions to buy and sell loan assets or credit exposures and thereby to increase the organization's liquidity.

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For purposes of this discussion, references to “securitization” also include structured finance transactions or programs and synthetic transactions that generally create stratified credit risk positions, which may or may not be in the form of a security, whose performance is dependent upon a pool of loans or other credit exposures. Synthetic transactions bundle credit risks associated with on-balance sheet assets and off-balance sheet items and resell them into the market. For examples of synthetic securitization structures,

see

Banking Bulletin 99-43, November 15, 1999 (OCC).

Securitizations typically carve up the risk of credit losses from the underlying assets and distribute it to different parties. The “first dollar,” or most subordinate, loss position is first to absorb credit losses; the most “senior” investor position is last to absorb losses; and there may be one or more loss positions in between (“second dollar” loss positions). Each loss position functions as a credit enhancement for the more senior positions in the structure.

For residential mortgages sold through certain Federally-sponsored mortgage programs, a Federal government agency or Federal government-sponsored enterprise (GSE) guarantees the securities sold to investors and may assume the credit risk on the underlying mortgages. However, many of today's asset securitization programs involve assets that are not Federally supported in any way. Sellers of these privately securitized assets therefore often provide other forms of credit enhancement—that is, they take first or second dollar loss positions—to reduce investors' credit risk.

A seller may provide this credit enhancement itself through recourse arrangements. The proposed rule uses the term “recourse” to refer to the credit risk that a banking organization or credit union retains in connection with the transfer of its assets. Banks and credit unions have long provided recourse in connection with sales of whole loans or loan participations; today, recourse arrangements frequently are also associated with asset securitization programs. Depending on the type of securitization transaction, the sponsor of a securitization may provide a portion of the total credit enhancement internally, as part of the securitization structure, through the use of excess spread accounts, overcollateralization, retained subordinated interests, or other similar on-balance sheet assets. When these or other on-balance sheet internal enhancements are provided, the enhancements are “residual interests” for regulatory capital purposes. Such residual interests are a form of recourse.

A seller may also arrange for a third party to provide credit enhancement in an asset securitization.

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If the third-party enhancement is provided by another banking organization, that organization assumes some portion of the assets' credit risk. In this final rule, all forms of third-party enhancements, i.e., all arrangements in which a banking organization assumes credit risk from third-party assets or other claims that it has not transferred, are referred to as “direct credit substitutes.”

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The economic substance of the credit risk from providing a direct credit substitute can be identical to its credit risk from retaining recourse on assets transferred.

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As used in this proposed rule, the terms “credit enhancement” and “enhancement” refer to both recourse arrangements, including residual interests, and direct credit substitutes.

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For purposes of this rule, purchased credit-enhancing interest-only strips are also “residual interests.”

Many asset securitizations use a combination of recourse and third-party enhancements to protect investors from credit risk. When third-party enhancements are not provided, the transferring entity often retains credit risk on the assets transferred.

Risk Management of Exposures Arising From Securitization Activities

While asset securitization can enhance both credit availability and profitability, managing the risks associated with this activity can pose significant challenges. The risks involved, while not new to banking organizations and credit unions, may be less obvious and more complex than the risks of traditional lending. Specifically, securitization can involve credit, liquidity, operational, legal, and reputational risks in concentrations and forms that may not be fully recognized by management or adequately incorporated into a credit union's risk management systems.

Risk-Weighting of Direct Credit Substitutes and Recourse Obligations (Including Residual Interests and Credit Enhancing IO Strips)

The proposal defines four key terms: direct credit substitute, recourse obligations, residual interests, and credit enhancing interest only (IO) strips. The proposal defines a direct credit substitute as any arrangement in which a corporate assumes, in form or in substance, credit risk associated with an on-balance sheet or off-balance sheet asset or exposure that was not previously owned by the corporate (third-party asset) and the risk assumed by the corporate exceeds the

pro rata

share of the corporate's interest in the third-party asset.

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If a corporate has no claim on the third-party asset, then the corporate's assumption of any credit risk is a direct credit substitute. As stated in the definition, direct credit substitutes include:

(1) Financial standby letters of credit that support financial claims on a third party that exceed a corporate's

pro rata

share in the financial claim;

(2) Guarantees, surety arrangements, credit derivatives, and similar instruments backing financial claims that exceed a corporate's

pro rata

share in the financial claim;

(3) Purchased subordinated interests that absorb more than their

pro rata

share of losses from the underlying assets, including any tranche of asset backed securities that is not the most senior tranche;

(4) Credit derivative contracts under which the corporate assumes more than its

pro rata

share of credit risk on a third-party asset or exposure;

(5) Loans or lines of credit that provide credit enhancement for the financial obligations of a third party;

(6) Purchased loan servicing assets if the servicer is responsible for credit losses or if the servicer makes or assumes credit-enhancing representations and warranties with respect to the loans serviced. Servicer cash advances as defined in this section are not direct credit substitutes;

(7) Clean-up calls on third party assets. However, clean-up calls that are 10 percent or less of the original pool balance and that are exercisable at the option of the corporate are not direct credit substitutes; and

(8) Liquidity facilities that provide support to asset-backed commercial paper (other than eligible ABCP liquidity facilities).

The proposal generally defines

recourse obligations

as a corporate's retention, in form or in substance, of any credit risk directly or indirectly associated with an asset it has sold (in accordance with Generally Accepted Accounting Principles) that exceeds a

pro rata

share of that corporate's claim on the asset. A recourse obligation typically arises when a corporate transfers assets in a sale and retains an explicit obligation to repurchase assets or to absorb losses due to a default on the payment of principal or interest or any other deficiency in the performance of the underlying obligor or some other party. Recourse may also exist implicitly if a corporate provides credit enhancement beyond any contractual obligation to support assets it has sold.

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As stated in the definition, recourse obligations include:

(1) Credit-enhancing representations and warranties made on transferred assets;

(2) Loan servicing assets retained pursuant to an agreement under which the corporate will be responsible for losses associated with the loans serviced. Servicer cash advances as defined in this section are not recourse obligations;

(3) Retained subordinated interests that absorb more than their

pro rata

share of losses from the underlying assets;

(4) Assets sold under an agreement to repurchase, if the assets are not already included on the balance sheet;

(5) Loan strips sold without contractual recourse where the maturity of the transferred portion of the loan is shorter than the maturity of the commitment under which the loan is drawn;

(6) Credit derivatives that absorb more than the corporate's

pro rata

share of losses from the transferred assets;

(7) Clean-up calls on assets the corporate has sold. However, clean-up calls that are 10 percent or less of the original pool balance and that are exercisable at the option of the corporate are not recourse arrangements; and

(8) Liquidity facilities that provide support to asset-backed commercial paper (other than eligible ABCP liquidity facilities).

As stated above, the primary difference between direct credit substitutes and recourse obligations is that recourse obligations involve the assumption of credit risk associated with assets that the corporate once owned but transferred, while direct credit substitutes involve the assumption of credit risk related to assets that the corporate does not own. Both direct credit substitutes and recourse obligations, however, can involve similar, and significant, credit risk. Accordingly the proposal outlines the same general process (with some exceptions) for risk-weighting both direct credit substitutes and recourse obligations.

The proposal requires that the corporate multiply the full amount of the credit-enhanced assets for which the corporate directly or indirectly retains or assumes credit risk by a 100 percent conversion factor. The corporate will then assign this credit equivalent amount to the risk-weight category appropriate to the obligor in the underlying transaction, after considering any associated guarantees or collateral, in accordance with the risk-weight categories in Section II(a) of the Appendix. The proposal states that, for a direct credit substitute that is an on-balance sheet asset (e.g., a purchased subordinated security), a corporate must use the amount of the direct credit substitute and the full amount of the asset it supports,

i.e.

, all the more senior positions in the structure). This means, for example, that if a corporate invests in a senior mezzanine security that supports a more senior tranche, the corporate must use the full amount of the supported tranche, without regard for the existence or not of tranches subordinate to the mezzanine tranche. This can result in a risk-weighting several times greater than the risk-weighting for the most senior tranche.

There are two subsets of recourse obligations that receive special treatment for risk-weighting purposes: residual interests and credit enhancing interest only strips. In addition, in some asset transfers the transferring entity might retain two or more different recourse obligations on the same transferred assets, and the rule provides for a special risk-weighting calculation in this case. These situations are discussed further below.

The proposal defines

residual interests,

a form of recourse obligation, as any on-balance sheet asset that:

(1) Represents an interest (including a beneficial interest) created by a transfer that qualifies as a sale (in accordance with Generally Accepted Accounting Principles) of financial assets, whether through a securitization or otherwise; and

(2) Exposes a corporate to credit risk directly or indirectly associated with the transferred asset that exceeds a

pro rata

share of that corporate's claim on the asset, whether through subordination provisions or other credit enhancement techniques.

Residual interests generally include credit-enhancing interest-only strips, spread accounts, cash collateral accounts, retained subordinated interests (and other forms of overcollateralization), and similar assets that function as a credit enhancement. Residual interests further include those exposures that, in substance, cause the corporate to retain the credit risk of an asset or exposure that had qualified as a residual interest before it was sold. While residual interests generally do not include assets purchased from a third

party, the definition does include a credit-enhancing interest-only strip that is acquired in any asset transfer as a residual interest.

The proposal provides that a corporate must maintain risk-based capital for a residual interest equal to the face amount of the residual interest, even if the amount of risk-based capital that must be maintained exceeds the full risk-based capital requirement for the assets transferred. For residual interests in the form of credit enhancing interest only strips, the rule further provides that a corporate must maintain risk-based capital equal to the remaining amount of the

strip

(emphasis added) even if the amount of risk-based capital that must be maintained exceeds the full risk-based capital requirement for the assets transferred.

Where a corporate transfers assets, and holds both a residual interest (including a credit-enhancing interest-only strip) and another recourse obligation in connection with that transfer, the corporate must maintain risk-based capital equal to the greater of the risk-based capital requirement for the residual interest or the full risk-based capital requirement for the assets transferred.

Ratings-Based Approach to Risk-Weighting

In lieu of the general risk-weighting approach described above, the proposal would allow a corporate to employ a ratings based approach to certain asset-backed securities, direct credit substitutes, or residual interests.

To apply a ratings based approach to one of these particular assets, the asset must generally be a

traded position,

and if a long term position, must be rated by an NRSRO as one grade below investment grade or better or, if a short-term position, must be publicly rated by an NRSRO as investment grade or better.

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To obtain the risk-weighted asset amount, the corporate will multiply the face amount of the asset by the appropriate risk-weight determined in accordance with Table A or B below:

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The proposal defines a

traded position

as a position retained, assumed, or issued in connection with a securitization that is rated by a NRSRO, where there is a reasonable expectation that, in the near future, the rating will be relied upon by:

(1) Unaffiliated investors to purchase the security; or

(2) An unaffiliated third party to enter into a transaction involving the position, such as a purchase, loan, or repurchase agreement.

Also, if two or more NRSROs assign ratings to a traded position, the corporate must use the lowest rating to determine the appropriate risk-weight category.

Table A

Long-term rating category

Risk-weight

(in percent)

Highest or second highest investment grade

20

Third highest investment grade

50

Lowest investment grade

100

One category below investment

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