[Federal Register Volume 66, Number 20 (Tuesday, January 30, 2001)]
[Rules and Regulations]
[Pages 8262-8321]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-1253]



[[Page 8261]]

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Part II





Federal Housing Finance Board





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12 CFR Part 915, et al.



Capital Requirements for Federal Home Loan Banks; Final Rule

Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / 
Rules and Regulations

[[Page 8262]]


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FEDERAL HOUSING FINANCE BOARD

12 CFR Parts 915, 917, 925, 930, 931, 932, 933, 956, 966

[No. 2000-46]
RIN 3069-AB01


Capital Requirements for Federal Home Loan Banks

AGENCY: Federal Housing Finance Board.

ACTION: Final rule.

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SUMMARY: The Federal Housing Finance Board (Finance Board) is amending 
its regulations to implement a new capital structure for the Federal 
Home Loan Banks (Banks), as required by the Gramm-Leach-Bliley Act. The 
final rule establishes risk-based and leverage capital requirements for 
the Banks. It also addresses the different classes of stock that a Bank 
may issue, the rights and preferences that may be associated with each 
class of stock, and the capital plans that each Bank must submit for 
Finance Board approval.

EFFECTIVE DATE: The final rule is effective on March 1, 2001.

FOR FURTHER INFORMATION CONTACT: James L. Bothwell, Managing Director 
and Chief Economist, (202) 408-2821; Scott L. Smith, Acting Director, 
(202) 408-2991; Ellen Hancock, Senior Financial Analyst, (202) 408-
2906; or Julie Paller, Senior Financial Analyst, (202) 408-2842, Office 
of Policy, Research and Analysis; or Deborah F. Silberman, General 
Counsel, (202) 408-2570; Neil R. Crowley, Deputy General Counsel, (202) 
408-2990; Sharon B. Like, Senior Attorney-Advisor, (202) 408-2930; or 
Thomas E. Joseph, Attorney-Advisor, (202) 408-2512, Office of General 
Counsel, Federal Housing Finance Board, 1777 F Street, N.W., 
Washington, D.C. 20006.

SUPPLEMENTARY INFORMATION:

I. Statutory and Regulatory Background

A. The Bank System

    The twelve Banks are instrumentalities of the United States 
organized under the authority of the Federal Home Loan Bank Act (Bank 
Act). 12 U.S.C. 1423, 1432(a), as amended. The Banks are ``government 
sponsored enterprises'' (GSE), i.e., federally chartered but privately 
owned institutions created by Congress to support the financing of 
housing and community lending by their members. See 12 U.S.C. 
1422a(a)(3)(B)(ii), 1430(i), (j)(10) (1994). By virtue of their GSE 
status, the Banks are able to borrow in the capital markets at 
favorable rates. The Banks then pass along that funding advantage to 
their members--and ultimately to consumers--by providing advances 
(secured loans) and other financial services to their members 
(principally, depository institutions) at rates that the members 
generally could not obtain elsewhere.
    The Banks also are cooperatives, meaning that only their members 
may own the capital stock and share in the profits of the Banks and 
only their members, and certain eligible associates (such as state 
housing finance agencies), may borrow from or use the other products 
and services provided by the Banks. 12 U.S.C. 1426, 1430(a), 1430b, as 
amended. An institution that is eligible may become a member of a Bank 
if it satisfies certain statutory criteria and purchases a specified 
amount of the Bank's capital stock. 12 U.S.C. 1424, 1426 (1994). 
Together with the Office of Finance, the twelve Banks comprise the Bank 
System, which operates under the supervision of the Finance Board, an 
independent agency in the executive branch of the U.S. government. The 
primary duty of the Finance Board is to ensure that the Banks operate 
in a financially safe and sound manner; consistent with that duty the 
Finance Board is required to supervise the Banks, ensure that they 
carry out their housing finance mission, and ensure that they remain 
adequately capitalized and able to raise funds in the capital markets. 
12 U.S.C. 1422a(a)(3)(A), (B) (1994).

B. Federal Home Loan Bank Capital Structure

    Since its enactment in 1932, section 6 of the Bank Act has provided 
for a ``subscription'' capital structure for the Banks. Under that 
structure, the amount of capital stock that each Bank issued was 
determined by a statutory formula that dictated how much Bank stock 
each member must purchase. In accordance with that formula, each member 
was required to purchase Bank stock in an amount equal to one percent 
of the member's total mortgage assets or five percent of the advances 
outstanding to the member, whichever was greater. A principal 
shortcoming of the subscription capital structure was that the amount 
of capital maintained by each Bank bore little relation to the risks 
inherent in the assets and liabilities of the Bank.
    With the enactment of the Gramm-Leach-Bliley Act, Pub. Law No. 106-
102, 133 Stat. 1338 (Nov. 12, 1999) (GLB Act), the Congress amended 
section 6 the Bank Act in its entirety, replacing the subscription 
capital provisions with risk-based and leverage capital requirements 
that are similar to those applicable to depository institutions and to 
the other housing GSEs. The GLB Act mandated that the Finance Board 
issue regulations prescribing uniform capital standards applicable to 
each Bank in accordance with the provisions of the GLB Act. When the 
Finance Board's regulations are implemented, each Bank will be required 
to maintain permanent capital and total capital in amounts that are 
sufficient for the Bank to comply with the minimum risk-based and 
leverage capital requirements, respectively, established by the GLB 
Act.
    The GLB Act requires each Bank to maintain ``permanent capital'' in 
an amount that is sufficient to meet the credit risk and market risk to 
which the Bank is subject, with the market risk being based on a stress 
test established by the Finance Board that tests for changes in certain 
specified market variables. Permanent capital is defined by statute to 
include the amounts paid-in for Class B stock plus the retained 
earnings of the Bank, with retained earnings being determined in 
accordance with generally accepted accounting principles (GAAP).
    The GLB Act also requires each Bank to maintain ``total capital'' 
in amounts that are sufficient to comply with a minimum leverage 
requirement. Total capital is defined by the GLB Act to include a 
Bank's permanent capital, plus the amounts paid-in by the members for 
Class A stock, any general loss allowance (if consistent with GAAP and 
not established for specific assets), and other amounts from sources 
determined by the Finance Board as available to absorb losses. When 
measured by weighting the amount paid-in for Class B stock and the 
retained earnings by a factor of 1.5, each Bank must maintain a ratio 
of total capital to total assets of at least 5 percent. When measured 
on an unweighted basis, each Bank must maintain a ratio of total 
capital to total assets of at least 4 percent.
    The GLB Act further requires the capital regulations issued by the 
Finance Board to address a number of other matters, such as the classes 
of stock that a Bank may issue, the rights, terms, and preferences that 
may be established for each class, the issuance, transfer, and 
redemption of Bank stock, and the liquidation of claims against a 
withdrawing member. The rules must permit each Bank to issue either 
Class A or Class B stock, or both, with the board of directors of each 
Bank to determine the rights, terms, and preferences for each class. 
Both Class A and Class B stock may be issued only to

[[Page 8263]]

and held only by members of the Bank, and the regulations are to 
provide the manner in which the stock may be sold, transferred, 
redeemed, or repurchased. The rules also must address the manner in 
which a Bank is to liquidate any claims against its members.
    The GLB Act separately establishes a number of other capital-
related requirements, which pertain to matters such as the termination 
of an institution's Bank membership, the ability of a Bank to 
repurchase excess stock held by a member (i.e., stock that is in excess 
of the minimum stock investment that each member is required to hold), 
restrictions on the ability of a Bank to redeem stock when its capital 
is impaired, restrictions on readmission to membership after 
withdrawing, and the ownership of the retained earnings by the Class B 
stockholders.
    Within 270 days after the publication of this final capital rule, 
the GLB Act requires the board of directors of each Bank to submit for 
Finance Board approval a capital plan that the board determines is best 
suited for the Bank and its members. Subsequent amendments to an 
approved capital plan also must be approved in advance by the Finance 
Board. The GLB Act requires the plan to include certain provisions, 
requires that it be consistent with the regulations adopted by the 
Finance Board, and that when implemented it must provide the Bank with 
sufficient capital to meet both the leverage and risk-based capital 
requirements. Each plan also must include certain provisions specified 
by the GLB Act. Those provisions relate to the minimum investment 
required of each member in order for the Bank to meet its regulatory 
capital requirements, the effective date of the plan and the length of 
any transition period, the classes of stock to be offered by the Bank 
and the rights, terms, and preferences associated with each class, the 
transferability of the Bank stock, the disposition of Bank stock held 
by institutions that withdraw from membership, and review of the plan 
by an independent accountant and a credit ratings agency. Those 
provisions are the minimum required by the GLB Act; the Finance Board 
may require that other provisions be included in each plan, and the 
Banks as well may include other provisions in their plans, provided 
they are consistent with the Bank Act and the regulations of the 
Finance Board.

C. Federal Home Loan Bank Stock

    Section 6 of the Bank Act, as in effect prior to the GLB Act, 
authorized the Banks to issue stock, specified the characteristics of 
the stock, and addressed the manner in which the stock could be issued, 
transferred, and redeemed. 12 U.S.C. 1426 (1994). Since the 
establishment of the Bank System in 1932, each of the Banks has been 
authorized to issue a single class of stock, which could be issued and 
redeemed only at its statutory par value of $100 per share. An 
institution becoming a Bank member was required to subscribe for a 
certain minimum amount of the Bank's stock, for which it was required 
to pay in full and in cash at the time of its application.\1\
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    \1\ A member also was allowed to purchase the stock in 
installments, under which it would pay one-quarter of the full 
amount at the time of application, and the remainder in three 
installments over the following 12 months. 12 U.S.C. 1426(c) (1994).
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    The amount of the initial stock subscription required for 
membership was the greater of $500, 1.0 percent of the member's 
mortgage assets, or 0.3 percent of the member's total assets.\2\ 12 
U.S.C. 1426(b), 1430(e) (1994). If a member were to borrow from its 
Bank, the amount of Bank stock it was required to own could not be less 
than 5.0 percent of the amount of Bank advances outstanding to the 
member. Each Bank was required to adjust the minimum stock investment 
required of each member, as of December 31st of each year, so that each 
member would own at least the required minimum amount of Bank stock, 
based on a percentage of either its assets or advances, whichever 
amount was higher. Each Bank had the discretion to retire any 
``excess'' stock held by a member, i.e., stock in excess of the minimum 
required for that member, upon the application of the member. Once 
issued, the stock of a Bank could be transferred only between the 
member and the Bank or, with the approval of the Finance Board, from 
one member to another member or to an institution in the process of 
becoming a member. The Bank Act required that all stock issued by a 
Bank share in dividends equally and without preference. The Bank Act 
also allowed any member, other than a federal savings and loan 
association, to withdraw from membership by providing six months 
written notice to the Finance Board. At the end of the six-month notice 
period, and provided that all indebtedness owed by the withdrawing 
member to the Bank had been liquidated, a Bank could redeem the stock 
of the withdrawing member, paying cash to the member equal to the par 
value of the stock. Any such withdrawing member could not rejoin the 
Bank system for 10 years, with only limited exceptions.
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    \2\ The Bank Act referred to a member's ``aggregate unpaid loan 
principal,'' which the Finance Board has defined to include a 
variety of mortgage assets, such as home mortgage loans, combination 
loans, and mortgage pass-through securities. 12 U.S.C. 1426(b)(1) 
(1994); 65 FR 8253 (Feb. 18, 2000), 12 CFR 925.1. For purposes of 
applying the 1.0 percent of mortgage assets test, the Bank Act also 
established a statutory presumption that each member had at least 30 
percent of its assets in mortgage related instruments. 12 U.S.C. 
1430(e)(3) (1994). The effect of the presumption was that commercial 
banks (which typically have a lower percentage of their assets in 
mortgage related instruments than do savings associations) were 
required to maintain a minimum investment equal to the greater of 
1.0 percent of mortgage assets, 0.3 percent of total assets, or 5.0 
percent of outstanding advances. Separately, a member that was not a 
``qualified thrift lender'' (QTL), i.e., an institution with less 
than 65 percent of its assets in certain mortgage related 
instruments, was subject to a higher ``percentage of advances'' 
requirement, which varied inversely with its QTL ratio.
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D. Overview of the Proposed Rule

    On July 13, 2000, the Finance Board published a Notice of Proposed 
Rulemaking to amend its regulations to implement the capital 
requirements of the GLB Act. The proposed rule initially included a 90-
day comment period, which would have closed on October 11, 2000. See 65 
FR 43408-43447 (July 13, 2000). On September 19, 2000, the Finance 
Board extended the comment period until November 20, 2000. See 65 FR 
57748 (September 26, 2000).
    The proposed rule contemplated a significantly different capital 
structure than that adopted in this final rule, which was due in large 
part to certain assumptions about how difficult it would be for the 
Banks to sell their new stock, particularly the Class B stock. For 
instance, it was initially envisioned that Class B stockholders would 
demand the ability to control the boards of directors of the Banks if 
they were to commit their capital for five years. In order to protect 
the interests of the Class A stockholders from possible manipulation by 
the Class B stockholders, the proposed rule would have required the 
Class A stock to pay a stated dividend that would have priority over 
the Class B dividends. The Finance Board also provided for maximum 
flexibility in the capital plans to allow for the Class B stock to have 
as many pure equity attributes as a Bank might wish to adopt. During 
the notice and comment period, the Finance Board's initial assumptions 
were challenged, and the concerns became less of an issue for the Banks 
and their members, and, therefore, less of a concern for the Finance 
Board.
    Many provisions of the proposed rule paralleled the requirements of 
the GLB Act, such as authorizing each Bank to issue either or both 
Class A or Class B stock. The proposed rule also

[[Page 8264]]

authorized each Bank to issue subclasses of either Class A or Class B 
stock. The proposed rule would have established certain characteristics 
for the Class A stock, such as a stated dividend, a priority for 
payment of dividends, and a priority in liquidation. The Class A stock 
would be issued and redeemed at par value, but the Class B stock could 
be issued at par or at any other price. By statute, both classes of 
stock may be redeemed only at par value, but the proposed rule would 
have required the Banks to repurchase Class B stock at a negotiated 
price. The proposed rule required that a Bank issue stock only to its 
members and that the initial issuance of the Class A and/or Class B 
stock be done through any fair and equitable method of distribution. 
The Banks would have been permitted to require each member to invest in 
the Class A stock of the Bank as a condition of becoming a member of 
the Bank, though a member would have the option of investing a lesser 
amount in the Class B stock. The Banks also would have been permitted 
to require a member to invest in the Class A or Class B stock as a 
condition to doing business with the Bank. The proposed rule also would 
have required each Bank to specify ``operating capital ratios,'' which 
would be somewhat greater than the Bank's minimum leverage and risk-
based capital ratios. The proposed rule would have prohibited a Bank 
from requiring additional stock purchases by members if doing so would 
cause the Bank to exceed either its operating total capital ratio or 
its operating risk-based capital ratio, though it would have permitted 
a Bank to establish a membership fee in lieu of the minimum stock 
investment. Separately, the proposed rule would have prohibited any 
member (including its affiliates) from owning more than 40 percent of 
any class of Bank stock, or a lower limit established by the Bank.
    Under the proposed rule, each Bank would have been authorized to 
determine the manner in which the members of the Bank were to elect 
directors and how the elected directorships were to be allocated, i.e., 
among the several states in each district or otherwise. The voting 
rights also were to be determined by each Bank, subject to a regulatory 
cap that would have barred any member (including its affiliates) from 
casting more than 20 percent of the votes in any election of directors. 
Those provisions of the proposed rule were premised on an implicit 
repeal of section 7 of the Bank Act (which relates to the designation 
of directorships and the election of directors) by the capital 
provisions of the GLB Act.
    The proposed rule would have permitted a member to transfer Bank 
stock to another member, with such transfers being at a price to be 
agreed to by the members. It also would have barred any transfers of 
stock that would result in any member (including its affiliates) having 
more than 40 percent of any class of the Bank's outstanding stock, 
though it would have permitted a Bank to establish a lower percentage. 
In a similar fashion, the proposed rule would have allowed a Bank to 
repurchase its outstanding stock at any time, but at a negotiated 
price.
    The proposed rule adopted the minimum total capital leverage 
requirement specified by the GLB Act. It also specified that a Bank 
must hold an amount of permanent capital at least equal to the sum of 
the Bank's credit, market, and operations risk charges, calculated as 
specified in the proposal. The Finance Board also proposed to reserve 
the right to require a Bank to hold amounts of total and permanent 
capital above the minimum specified levels, if such higher levels were 
warranted for reasons of safety or soundness.
    The proposed rule set forth the methods to be used for calculating 
credit risk charges for all on-balance sheet assets and off-balance 
sheet items held by a Bank and established risk weightings for these 
assets and items based upon broad categories. In addition, for rated 
assets and off-balance sheet items and for mortgage assets, risk 
weightings were further differentiated by ratings and remaining 
maturity. The proposed rule also set forth broad standards that a Bank 
must meet in developing its internal risk model or cash-flow model to 
be used to calculate the Bank's market risk capital charge. The rule 
also required a Bank to receive Finance Board approval before the model 
could be used, and to undertake an annual validation of its model. The 
proposed rule also would have required a further capital charge equal 
to the amount by which the market value of the Bank's capital, 
calculated using the internal risk model, fell below 95 percent of the 
book value of the Bank's total capital, calculated using GAAP. The 
proposed rule also established an operations risk charge equal to 30 
percent of a Bank's credit and market risk, but allowed a Bank to 
reduce this charge with Finance Board approval by providing an 
alternative method for calculating its operations risk or by obtaining 
insurance to cover it for such risk. The proposed rule, however, 
required that at no time could the operations risk charge be less than 
ten percent of the Bank's credit and market risk charges. The proposed 
rule also required the Banks to calculate their capital levels and 
total risk-based capital charge as of the last business day of each 
month and report this information to the Finance Board by the fifteenth 
of the next month.
    The proposed rule would have required a Bank to maintain sufficient 
liquidity to cover its needs for five days of inability to access the 
consolidated obligation debt markets. Separately, the proposed rule set 
forth limits on a Bank's extension of unsecured credit, both to a 
single counterparty and to affiliated counterparties, and established 
monthly reporting requirements based upon a Bank's extension of 
unsecured credit and combined secured and unsecured credit to a single 
counterparty and to affiliated counterparties. It also proposed 
incorporating into the rule, requirements from the Finance Board's 
Financial Management Policy (FMP) concerning a Bank's use of hedging 
instruments and proposed providing specific authority for the Banks to 
engage in certain off-balance sheet transactions.

E. Overview of Comments Received

    The Finance Board received 143 comments on the proposed rule. Ten 
of those comments were submitted before the proposed rule was 
published. Of the 133 comments received after publication of the 
proposed rule, 25 comments came from the 12 Banks; 1 comment was 
received from a not-for-profit housing association; 73 comments were 
received from member institutions; 25 comments came from banking and 
other trade associations; 6 comments were received from other parties 
associated with the mortgage industry; 2 comments came from members of 
Congress, and 1 comment was submitted by the Department of the 
Treasury.
    To the extent that the comments raised questions about particular 
aspects of the proposed rule, those comments and the Finance Board's 
response to them are discussed below as part of the explanation of the 
relevant provisions of the final rule.
    In general, many commenters recommended that the Finance Board 
preserve the cooperative ownership structure of the Bank System by 
eliminating provisions of the proposed rule that were perceived to 
threaten the cooperative nature of the Bank System. In particular, a 
number of commenters believed that provisions in the proposed rule 
permitting the payment of

[[Page 8265]]

membership fees in lieu of a minimum stock investment, trading of Bank 
stock among the members, the repurchase of Bank stock at a negotiated 
price, and barring the Banks from requiring their members to retain 
Bank stock that was purchased to support a particular transaction with 
the Bank would undermine the cooperative structure of the Bank System 
because such provisions would tend to separate ownership of the Bank 
System from the use of its services.
    Many commenters also recommended that the Finance Board pay close 
attention to the possible tax implications of provisions in the rule, 
principally as they relate to the members of the Banks. For example, 
commenters expressed concern that by establishing a stated dividend for 
the Class A stock and giving it a priority over payment of dividends on 
the Class B stock, the proposed rule might create a taxable event for 
certain members upon the conversion of some of their existing stock to 
Class A stock.
    Commenters expressed other concerns about the capital structure 
provisions of the proposed rule. Nearly all commenters that addressed 
the issue of the operating capital ratios recommended that they be 
eliminated, principally because the manner in which the operating 
ratios would have worked would have resulted in members being treated 
unequally with regard to their stock purchase requirements, depending 
on when they purchased their stock. Many commenters asked, if the final 
regulation were to retain the operating ratio concept, that such limits 
should be more appropriately set as a range, rather than a fixed 
number. With respect to provisions related to the designation of 
directorships and the election of directors, many commenters believed 
that the GLB Act did not repeal by implication any provisions of 
section 7 of the Bank Act, as the Finance Board had proposed. With 
respect to the provision that would have barred any member or its 
affiliates from owning more than 40 percent of the stock of any Bank, 
nearly all commenters that addressed the issue recommended eliminating 
that provision, arguing that any concern about control of a Bank could 
be better addressed by limits on the amount of stock that a member may 
vote.
    Many commenters addressed the risk-based capital provisions in the 
proposed rule. With respect to credit risk, many commenters argued that 
the capital charges assigned in the proposed rule to advances, as well 
as to mortgage assets rated BBB or lower, were too conservative. With 
respect to market risk, many commenters indicated that the value-at-
risk model is inappropriate for measuring the long-term market risk 
profile of a Bank. Many commenters also opposed applying a 95 percent 
of market value to book value test because they believe it fails to 
provide a Bank with sufficient flexibility to manage its entire 
portfolio of activities. Finally, with respect to operations risk, many 
commenters stated that a capital charge of 30 percent of the sum of 
credit and market risk was too high, and that there was no sound 
theoretical basis for linking operations risk to credit and market 
risk.
    The Finance Board has made significant revisions in the final rule 
in response to the comments received, particularly with respect to 
matters of capital structure. The Finance Board also has retained much 
of the substance of the proposed rule with respect to the risk-based 
capital provisions. The changes from the proposed rule, as well as the 
provisions that have been retained, are described in more detail below 
in the discussion of specific provisions of the final rule.

II. The Final Rule

A. Part 915--Designation and Election of Directors

    Certain provisions of part 931 of the proposed rule would have 
authorized each Bank to determine the allocation of the elected 
directorships among the states in the Bank's district, and to determine 
how the members would elect those directors. For the reasons stated 
below, the Finance Board has deleted those provisions from the final 
rule and, apart from the matter of allowing a Bank to establish voting 
preferences, part 931 no longer addresses these issues. Instead, the 
final rule includes a number of revisions to part 915 of the Finance 
Board's elections regulations that conform those regulations to the new 
capital structure required by the GLB Act. Those amendments are 
described below.
    Section 7 of the Bank Act addresses, among other things, the manner 
in which the members of each Bank elect the directors of the Bank and 
the manner in which the Finance Board allocates elected directorships 
among the states in each Bank district. 12 U.S.C. 1427. Section 7(a) of 
the Bank Act establishes the basic size and composition of the boards 
of directors for the Banks, providing that each board shall consist of 
fourteen directors, with eight directors elected by the members and six 
directors appointed by the Finance Board.\3\ 12 U.S.C. 1427(a). Section 
7(b) of the Bank Act requires the Finance Board to designate each 
elected directorship as representing the members located in a 
particular state within the Bank district, and section 7(c) directs the 
Finance Board to make those designations based on the approximate ratio 
of the number of shares of Bank stock ``required to be held'' by the 
members located in each of the respective states as of the end of each 
calendar year. 12 U.S.C. 1427(b), (c). Section 7(c) includes two 
exceptions, one of which requires that each state be allocated at least 
one directorship (but not more than six) and the other of which 
requires each state to be allocated no fewer directorships than were 
allocated to it in 1960. 12 U.S.C. 1427(c). Section 7(b) separately 
provides that in an election to fill a directorship each member may 
cast one vote for each share of Bank stock that it was ``required to 
hold'' as of the end of the prior calendar year, subject to a statutory 
cap. 12 U.S.C. 1427(b). Under that cap, the maximum number of votes 
that any member may cast in such an election is equal to the average 
number of shares of stock ``required to be held'' by all members 
located in the same state as of the end of the prior calendar year.
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    \3\ As a practical matter, the boards of directors at most of 
the Banks have more than 14 directorships, which is due in part to 
the operation of a statutory grandfather provision, and in part to 
the creation of discretionary directorships by the Finance Board in 
certain Bank districts.
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    The GLB Act did not expressly amend section 7 as it relates to the 
designation of directorships or the election of directors. Section 
931.3(b) of the proposed rule, however, would have deemed those 
provisions of section 7 to cease to apply after the new capital 
structure for the Banks had been established. In the SUPPLEMENTARY 
INFORMATION section of the proposed rule, the Finance Board explained 
that it had preliminarily determined to deem those provisions of 
section 7 to have been repealed by implication by the GLB Act 
amendments to section 6 of the Bank Act regarding the capital structure 
of the Bank System. During its initial consideration of the proposed 
rule, the Finance Board had been advised that the members of the Bank 
System would be unlikely to purchase Class B stock unless they received 
some assurance of being able to elect a majority of the directors to 
the board of each Bank. Because the ability to sell the Class B stock 
is an essential aspect of the new capital structure established by the 
GLB Act, the Finance Board had serious concerns that retention of the 
state-based directorship structure would

[[Page 8266]]

discourage the members from purchasing the Class B stock, thereby 
frustrating the intent of the Congress to establish a risk-based 
permanent capital structure for the Banks. Accordingly, the Finance 
Board preliminarily determined that the possibility that the state-
based directorship structure would preclude the sale of sufficient 
amounts of Class B stock to capitalize the Banks created an 
irreconcilable conflict between section 6 and section 7 of the Bank 
Act. The Finance Board deemed that conflict to be sufficient to support 
an implied repeal of those provisions of section 7. In place of the 
directorship structure established by section 7, the Finance Board 
proposed to allow each Bank to specify the manner in which the members 
would elect members to the board of directors, to require each Bank to 
assign voting rights to the Class B stock and allow the Banks to assign 
voting rights to the Class A stock, and to limit the number of votes 
that any member and its affiliates could cast in an election to 20 
percent of the votes eligible to be cast in the election.
    The Finance Board received numerous comments criticizing its 
proposal to deem certain provisions of section 7 to have been 
implicitly repealed by the capital provisions of the GLB Act. Many of 
those comments questioned the factual premise underlying the implicit 
repeal, i.e., that the members would not purchase Class B stock unless 
they had some assurance of being allowed to elect a majority of the 
board of directors for the Bank, and contended that the Finance Board 
could find alternative ways to reconcile the provisions of section 6 
and section 7. A number of comments also noted that unless the Finance 
Board could identify a more demonstrable conflict between section 6 and 
section 7, a determination that provisions of the latter had been 
implicitly repealed by the former would be unlikely to withstand a 
legal challenge.
    Since the Finance Board issued the proposed rule, the staff of the 
Finance Board has had numerous discussions with representatives of the 
Banks, as well as with members and other interested parties, about this 
and other aspects of the proposed rule, and has received prototype 
capital plans from several of the Banks. As a result of those comments 
and those discussions, the Finance Board has been persuaded that the 
retention of the state-based directorship structure would not be likely 
to discourage members from purchasing Class B stock. Indeed, a number 
of the Banks have indicated their intention to issue only Class B stock 
or to require the purchase of Class B stock both as a condition of 
membership and as a condition of transacting business with and 
obtaining services from the Bank. Under any of those approaches, the 
Finance Board's prior concern about the Banks being unable to sell 
Class B stock would become moot. Accordingly, the final rule does not 
deem any provisions of section 7 of the Bank Act to have been 
implicitly repealed by the GLB Act. Because Sec. 931.3 of the proposed 
rule, which would have authorized the boards of directors of each Bank 
to establish as part of the capital plan the manner in which the 
members would elect directors, was premised on an implied repeal of 
certain provisions of section 7, that section has been deleted from the 
final rule.
    As stated in the proposed rule, the Finance Board is mindful of its 
obligation to give effect to the laws as written by the Congress unless 
two provisions are in such irreconcilable conflict that the Finance 
Board cannot as a practical matter give simultaneous effect to both 
provisions. Based on the information currently available, the Finance 
Board no longer perceives any such conflict between the capital 
provisions of section 6 and the directorship provisions of section 7. 
It remains possible, however, as the Banks develop their capital plans 
and offer the Class A and/or Class B stock to their members, that such 
a conflict may arise. If, while attempting to develop or to implement 
their capital plans, the Banks provide demonstrable evidence that they 
have been unable to sell the Class B stock (or have been unable to sell 
sufficient quantities of Class B stock) and that their inability to 
sell the Class B stock has been caused by the retention of the state-
based directorship provisions in section 7, the Finance Board would be 
prepared to revisit the issue of an implied repeal. Absent such 
evidence, the directorship structure of the Banks will not be changed 
in the final rule.
    Because the statutory provisions regarding the designation of 
directorships and the election of directors are linked to the capital 
provisions in section 6 of the Bank Act, however, the GLB Act 
amendments to section 6 do require the Finance Board to amend its 
directorship and elections regulations in certain respects. 
Accordingly, the final rule includes a number of conforming amendments 
to those regulations, including a provision that addresses the 
authority of the board of directors of a Bank to establish voting 
preferences, all of which are described below.
    The first of the conforming amendments to part 915 relates to the 
manner in which the Finance Board designates elected directorships 
among the states of each Bank district. Section 7 of the Bank Act 
requires the Finance Board to designate elected directorships based on 
the amount of Bank stock that section 6 of the Bank Act requires the 
members in each state to hold as of the end of the prior calendar year. 
Under the present single-class capital structure, the determination of 
the number of shares required to be held is relatively straightforward. 
Because the GLB Act authorizes the Banks to issue two classes of stock, 
the final rule adds a new provision to Sec. 915.3(b) to clarify that, 
for any Bank that has two classes of stock outstanding, the Finance 
Board shall conduct the designation of directorships based on the 
combined shares of each class of stock that the members are required to 
hold as of the end of the year.
    Because the GLB Act repealed the statutory stock purchase 
requirements and replaced them with a provision requiring the capital 
plan for each Bank to specify the minimum stock investment required of 
each member, the Finance Board is further amending Sec. 915.3(b) to 
address how the annual designation of directorships will be conducted 
both before and after the implementation of the capital plan. If a 
Bank's capital plan was not in effect on the immediately preceding 
December 31st, the number of shares of Bank stock required to be held 
by the members in each state will be determined pursuant to Sec. 925.20 
and Sec. 925.22, which reflect the stock purchase requirements 
specified by section 6 of the Bank Act, as in effect immediately prior 
to the GLB Act. If a Bank's capital plan was in effect on the 
immediately preceding December 31st, the number of shares of Bank stock 
required to be held by the members in each state will be determined in 
accordance with the minimum investment established by the capital plan 
for that Bank. For any members whose investment in Bank stock is less 
than the minimum investment required by the capital plan (i.e., during 
a transition period), the amount of stock to be used in the designation 
of directorships shall be the number of shares of Bank stock actually 
owned by those members as of December 31st.
    Because the annual designation of directorships is keyed to the 
amount of stock required to be held as of the prior calendar year, the 
earliest possible date that the Finance Board could designate 
directorships under the new capital plans would be in 2002. With regard 
to

[[Page 8267]]

the designation of directorships that the Finance Board must conduct in 
2001, those determinations must be based on the amount of Bank stock 
required to be held as of December 31, 2000, which means that the 
current capital structure will determine how those directorships will 
be allocated.
    Under current law, the amount of Bank stock ``required to be held'' 
by a member as of the end of the calendar year is the greater of $500, 
one percent of the member's mortgage assets, or five percent of the 
member's outstanding advances. As discussed above, once a Bank's 
capital plan has taken effect, the amount of Bank stock required to be 
held will be equal to the minimum investment in Bank stock for each 
member established in the Bank's capital plan. As discussed elsewhere 
in this SUPPLEMENTARY INFORMATION section, Sec. 931.3 of the final rule 
requires a Bank to require each member to maintain a minimum investment 
in the capital stock of the Bank, both as a condition to becoming and 
remaining a member of the Bank and as a condition to transacting 
business with or obtaining advances and other services from the Bank. 
In all cases, both before and after the effective date of a Bank's 
capital plan, the Finance Board would use the information provided to 
it by the Banks in the annual capital stock report, as required by 
Sec. 915.4, as the basis for calculating the relative amounts of stock 
held by the members in the respective states. The final rule also 
includes one technical correction to Sec. 915.3(b)(3), which replaces 
the words ``the Bank'' with ``that State''.
    Another conforming amendment relates to the annual reports 
submitted by the Banks regarding the stock holdings of their members. 
Under current law, Sec. 915.4 requires each Bank to submit, by no later 
than April 10th of each year, a capital stock report that shows the 
amount of Bank stock required to be held by the members in each state 
as of the end of the prior calendar year. 12 CFR 915.4. The Finance 
Board uses that information to conduct the designation of directorships 
for the states in each Bank district. Because the amount of stock that 
each member must hold ultimately will be determined by the capital plan 
approved for each Bank, rather than in accordance with the current 
statutory formula, the final rule amends Sec. 915.4 to address how the 
Banks are to determine the amount of Bank stock that each member is 
required to hold, both before and after the effective date of a Bank's 
capital plan. The final rule amends Sec. 915.4(a) to provide that if a 
Bank has issued more than one class of stock, it shall report to the 
Finance Board the combined number of shares of stock required to be 
held by the members, i.e., the report will not distinguish between the 
required amounts of Class A and Class B stock. The final rule also 
provides that if a Bank's capital plan was not in effect as of the 
record date, the number of shares of Bank stock that the members are 
required to hold shall be determined in accordance with the existing 
stock purchase requirements, as stated in Sec. 925.20 and Sec. 925.22. 
For any record date occurring after the capital plan is in effect, the 
number of shares of required Bank stock will be the minimum investment 
established for each member by the capital plan, provided that, for any 
member whose Bank stock is less than the minimum investment during a 
transition period, the amount of Bank stock to be reported shall be the 
number of shares of Bank stock actually owned by the member as of the 
record date. Thus, if a Bank's capital plan were in effect as of 
December 31st of a given year, the capital stock report to be submitted 
before April 10th of the following year would be based on the amounts 
of Bank stock required to be held by the members as the ``minimum 
investment'' established by the capital plan. If a Bank's plan had not 
taken effect as of December 31st of a given year, then the capital 
stock report to be submitted the following April would be based on the 
amount of stock required to be held pursuant to Sec. 925.20 and 
Sec. 925.22. None of these amendments would affect the authority of a 
Bank to establish voting preferences in favor of either the Class A or 
the Class B stockholders, which it could do as part of its capital plan 
and which is addressed below.
    Because the proposed rule would have deemed certain provision of 
section 7 to have been repealed by implication, the proposed rule would 
have authorized each Bank to determine the manner in which the members 
would elect the directors for each Bank. The proposed rule also would 
have capped the number of votes that any member or its affiliates could 
cast in an election at 20 percent of the number of eligible votes, 
though it would have allowed a Bank to establish a lower cap. As noted 
previously, the Finance Board has determined that there is no need at 
present to deem any provisions of section 7 to have been repealed by 
implication. For that reason, the Finance Board is not adopting the 
proposed amendments that would have allowed each Bank to determine the 
manner in which the members elect the directors of the Bank. Instead, 
the final rule gives effect to the provisions of section 7(b) of the 
Bank Act by retaining the existing regulations regarding the election 
of directors, albeit with a number of revisions to conform them to the 
new two-class capital stock structure established by the GLB Act. A 
number of commenters criticized the Finance Board for proposing to 
determine that certain provisions of section 7 of the Bank Act had been 
implicitly repealed, but nonetheless argued that the matters of how the 
directorships should be allocated among the states and how the members 
should elect directors were best left for the individual Banks to 
determine. Because section 7 of the Bank Act addresses both of those 
issues, the Finance Board cannot allow the Banks to allocate the 
directorships or to determine the manner of electing directors without 
deeming section 7 to have been implicitly repealed, which the Finance 
Board has determined not to do.
    As described previously, section 7(b) of the Bank Act provides that 
each member shall be entitled to cast one vote for each share of Bank 
stock it was required to hold as of the end of the prior year, subject 
to the statutory cap, i.e., the average number of shares of Bank stock 
required to be held by the members in each state as of the end of the 
year. The final rule amends Sec. 915.5(b) to restate those general 
provisions of section 7(b), i.e., for each directorship that is to be 
filled in an election, each member that is located in the state to be 
represented by the directorship and that is eligible to vote in the 
election may cast one vote for each share of Bank stock that it was 
required to own as of the end of the prior calendar year, subject to 
the statutory cap.
    For any Bank that has issued only one class of stock, the statutory 
voting cap will be calculated in the same manner as it is calculated at 
present, which is a simple average of the number of shares of Bank 
stock held by the members in each state as of the record date. For any 
Bank that has issued more than one class of stock, however, the final 
rule provides that the statutory cap will be applied separately for 
each class of stock. Thus, a Bank that has issued two classes of stock 
must determine, for each state, the average amount of Class A stock 
required to be held by the members in that state as of the end of the 
prior year, as well as the average amount of Class B stock required to 
be held by the members in that state as of the end of that year. As 
noted previously, once the capital plan is in effect, the amount of 
stock that each member is required to hold as of the end

[[Page 8268]]

of the year will be the ``minimum investment'' that each member is 
required to maintain in order to remain a member and to do business 
with the Bank. Thus, a member that has purchased both Class A and Class 
B stock would be entitled to cast one vote for each share of Class A 
stock it is required to own, up to the average holdings of the Class A 
stock, plus one vote for each share of Class B stock, up to the average 
holdings of the Class B stock by the members in that state, with the 
combined total being the number of votes that the member is entitled to 
cast in the election. The Finance Board considered, as an alternative 
to the separate caps for each class, using an average of the combined 
amounts of Class A and Class B stock that the members in a particular 
state were required to own as of the end of the year. Because it is 
possible that even in a two-class stock structure there may be members 
that own only one class of Bank stock, the Finance Board believes that 
the most equitable way of calculating the statutory voting cap is to do 
so separately for each class of stock outstanding.
    As with the other conforming amendments, noted above, regarding the 
designation of directorships and the capital stock report, the final 
rule provides that if a Bank's capital plan was not in effect as of the 
record date, the number of shares of Bank stock that a member is 
required to hold as of the record date shall be determined in 
accordance with Sec. 925.20 and Sec. 925.22. If a Bank's capital plan 
was in effect as of the record date, the number of shares of Bank stock 
that a member is required to hold as of the record date shall be 
determined in accordance with the minimum investment established by the 
Bank's capital plan, provided, however, that for any members whose Bank 
stock is less than the minimum investment during a transition period, 
the amount of Bank stock to be counted shall be the number of shares of 
Bank stock actually owned by those members as of the record date.
    As was discussed in the proposed rule, what appeared to be most in 
conflict between the directorship provisions of section 7 and the 
capital provisions of section 6 was the voting rights of the members. 
Specifically, section 6(c)(4)(B) of the Bank Act, as amended by the GLB 
Act, expressly authorizes the board of directors of a Bank to establish 
voting preferences for its capital stock. 12 U.S.C. 1426(c)(4)(b). 
Section 7(b) of the Bank Act, however, provides (subject to the 
statutory cap) that each share of Bank stock entitles the holder to 
cast one vote in an election of directors. 12 U.S.C. 1427(b). Even 
though the Finance Board has determined not to deem any provisions of 
section 7(b) to have been repealed by implication by the GLB Act, the 
issue remains of how best to reconcile these two provisions. Based on 
the statutory language concerning voting preferences, the Finance Board 
has determined that the most appropriate way to strike a balance 
between and reconcile these two provisions is to consider the ``one 
share, one vote'' provisions of section 7(b) as the general rule for 
voting, subject to the statutory cap, but to recognize that the 
provisions of section 6(c)(4)(B) of the Bank Act, as amended, authorize 
the individual Banks to create an exception to the general rule by 
establishing a voting preference.
    The language of section 6(c)(4)(B), as amended by the GLB Act, 
provides that each Bank ``shall include in its capital structure plan 
provisions establishing terms, rights, and preferences, including * * * 
voting * * * preferences for each class of stock issued by the bank, 
consistent with Finance Board regulations and market requirements.'' 12 
U.S.C. 1426(c)(4)(B). That language clearly authorizes the board of 
each Bank to establish voting preferences as part of its capital plan, 
but it does not mandate that a Bank must do so with regard to the 
election of directors. Under the statute, the question of whether to 
establish voting preferences is left to the board of directors of the 
Bank, subject to the regulatory oversight of the Finance Board. Because 
the creation of a voting preference is not mandatory, there is no 
immediate conflict between section 6(c)(4)(B) and section 7(b). Indeed, 
if a Bank declines to establish a voting preference for one class of 
stock over the other there will be no conflict at all. In that case, 
each share of Bank stock will entitle the holder to cast one vote in 
the election of directors, subject to the statutory cap, as implemented 
by the final rule. If, however, a Bank were to exercise the authority 
conferred by section 6(c)(4)(B) to confer a preference, for example, on 
the holders of the Class B stock as part of its capital plan, then the 
voting rights for the Class A and the Class B members would be governed 
by the preference established by that Bank. In effect, the voting 
preferences established by the Bank as part of its approved capital 
plan on the authority of section 6(c)(4)(B) would supercede the 
provisions of section 7(b), which otherwise would grant each member one 
vote for each share of stock that it was required to own as of the 
record date.
    Because the concept of a voting preference relates principally to 
the relative distribution of voting power between two or more classes 
of stockholders, the Finance Board believes that the authority to 
establish voting preferences should not extend to matters beyond that 
distribution of voting power. In other words, a Bank can invoke the 
authority of section 6(c)(4)(B), 12 U.S.C. 1426(c)(4)(B), to establish 
a preference structure that favors the Class B stock, but it should not 
be able to rely on that authority to override other provisions of 
section 7(b), 12 U.S.C. 1427(b), such as the statutory cap on voting, 
which, as noted above, will be applied separately to each class of Bank 
stock. For that reason, the final rule makes clear that, even if a Bank 
invokes its authority to establish voting preferences that vest the 
exclusive or predominant voting power in one class of stock, the 
holders of that class of stock will remain subject to the statutory 
cap. Accordingly, Sec. 915.5(c) of the final rule provides that, 
notwithstanding the general rule for voting in an election of 
directors, a Bank may include as part of its capital plan voting 
preferences for any class of stock issued by the Bank, and that such 
preferences shall supercede the general provisions that otherwise would 
confer one vote for each share of Bank stock, subject to the statutory 
cap. The final rule includes a corresponding amendment to Sec. 933.2, 
which addresses the contents of the capital plans.
    Separately, the final rule includes two other amendments of a 
technical nature. The first amendment, to Sec. 915.6(a)(3), makes a 
conforming change to a citation to another regulation within the text 
of the rule. The second technical amendment adds a sentence to 
Sec. 915.7(b)(2) regarding the terms ``appropriate federal regulator'' 
and ``appropriate State regulator'' that was inadvertently deleted from 
the regulation as part of an earlier rulemaking.

B. Part 917--Powers and Responsibilities of Board of Directors

    The Finance Board is amending Sec. 917.3 to require the Banks to 
include as part of their risk management policies total and risk-based 
capital ratios at which the Banks intend to operate. The final rule 
also amends Sec. 917.9 to conform the existing provisions, which 
require dividends to be paid without preference, to the requirements of 
the GLB Act and Part 931 of the final rule.
    As described elsewhere in this SUPPLEMENTARY INFORMATION section, 
the Finance Board has responded to criticisms about the proposed 
operating capital ratios by deleting them from the final capital rule. 
Although the Finance Board agrees that the final capital rule

[[Page 8269]]

should not impose operating capital ratios, the Finance Board believes 
that the concept of operating capital ratios is useful as a risk 
management tool for the Banks, as well as a supervisory tool for the 
Finance Board. For that reason, the final rule amends Sec. 917.3 to 
require each Bank to include, as part of its risk management policy, a 
provision that establishes the total and risk-based capital levels at 
which the Bank intends to operate. In addition, the Finance Board has 
considered comments suggesting that such operating ratios are better 
expressed as a range, rather than as a fixed number, and believes that 
this approach would provide additional flexibility to the Banks in 
managing their capital levels. Accordingly, the amendments to 
Sec. 917.3 allow the Banks to set their own operating total capital and 
operating risk-based capital ratios as a range.
    Separately, the Finance Board is amending Sec. 917.9, which 
currently requires that dividends on Bank capital stock be computed 
without preference, to conform it to the GLB Act and to other 
provisions in the final rule. The GLB Act authorizes the board of 
directors of each Bank to determine the rights, terms, and preferences 
for each class of stock, consistent with section 6 of the Bank Act, the 
regulations of the Finance Board, and market requirements. Because 
Sec. 931.4 of the final rule permits the board of directors of a Bank 
to establish in the Bank's capital plan different dividend rates or 
preferences for each class or subclass of stock, it is necessary to 
make a corresponding change to Sec. 917.9, so that the current 
requirement that dividends be computed without preference not apply if 
a Bank has established any dividend preferences for one or more classes 
or subclasses of its capital stock. For any such Bank, once the capital 
plan takes effect, the requirement that dividends be computed without 
preference will cease to apply to that Bank.

C. Part 925--Membership Amendments

    Minimum Stock Purchase Requirements. The proposed rule would have 
removed from the existing membership regulation all provisions 
pertaining to the amount of Bank stock an institution must purchase 
upon becoming a member. See 12 CFR 925.19 through 925.23 (Subpart D); 
925.25(d)(2)(ii), (iii). In the final rule, the Finance Board has 
retained all of those provisions because the GLB Act requires the 
existing stock purchase requirements to remain in effect for each Bank 
until the Bank has implemented its capital plan. Because of that 
requirement, the Finance Board anticipates that it will remove those 
provisions from its regulations only after the capital plans for all of 
the Banks have been implemented. As each Bank implements its capital 
plan, the amount of stock that each member of that Bank would be 
required to purchase shall be the minimum investment established by 
that Bank's capital plan.
    Consolidations Involving Members. Section 925.19 of the proposed 
rule would have consolidated existing Secs. 925.24 and 925.25 into one 
provision addressing the consolidation of a member into another member 
or into a nonmember. In the final rule, the Finance Board has 
consolidated the substance of Secs. 925.24 and 925.25 into an amended 
version of Sec. 925.24. The substance of Sec. 925.24 of the final rule 
is much the same as proposed Sec. 925.19; because the final rule does 
not rescind the several provisions that the proposed rule would have 
rescinded, the numbering of the amended provisions in the final rule 
does not correspond to the numbering of the proposed amendments. As 
amended, Sec. 925.24 retains much of the structure of the proposed 
rule, albeit with some technical, clarifying, and organizational 
changes.
    Section 925.24(b)(5) of the final rule addresses the consolidation 
of a member into a nonmember and differs somewhat from the proposed 
rule with regard to the minimum amount of Bank stock that the 
consolidated institution must purchase if it is approved for 
membership. Thus, if the capital plan for the Bank has not taken effect 
when the consolidated institution has been approved for membership, the 
amount of Bank stock that such institution must own shall be as 
provided in Sec. 925.20 and Sec. 925.22, which are the stock purchase 
requirements in effect prior to the enactment of the GLB Act. See 12 
CFR 925.20, 925.22. If the capital plan for the Bank is in effect when 
the consolidated institution has been approved for membership, the 
amount of stock that such institution is required to own shall be equal 
to the minimum investment established by the capital plan for that 
Bank. These provisions reflect the more general transition provisions 
in Sec. 931.9 of the final rule.
    Voluntary Withdrawal. Section 6(d)(1) of the Bank Act, as amended 
by the GLB Act, provides that any member may withdraw from its Bank by 
providing written notice of its intent to do so, provided that on the 
date of the withdrawal there is in effect a certification from the 
Finance Board that the withdrawal will not cause the Bank System to 
fail to meet its required payment toward the debt service for the 
obligations issued by the Resolution Funding Corporation (RefCorp), in 
accordance with section 21B(f)(2)(C) of the Bank Act, 12 U.S.C. 
1441b(f)(2)(C), as amended. (RefCorp Certification). 12 U.S.C. 
1426(d)(1), as amended. The statute further provides that the receipt 
of the withdrawal notice by the Bank commences the applicable stock 
redemption periods for the stock owned by the member, i.e., the 6-month 
and 5-year notice periods for Class A and Class B stock, respectively, 
after which the member may receive the par value of its stock in cash. 
During the notice period, the member remains entitled to receive any 
dividends declared on its stock. Section 925.20 of the proposed rule 
would have implemented these statutory provisions. Section 925.26 of 
the final rule retains these provisions, generally as proposed, but 
with several changes that are discussed below.
    Section 925.26(a)(1) of the final rule provides that any member may 
voluntarily withdraw from membership by providing to the Bank written 
notice of its intent to do so. In response to comments, the Finance 
Board has revised the final rule to make clear that a Bank need not 
commit to providing any further services to a withdrawing member that 
would mature or otherwise terminate subsequent to the effective date of 
the withdrawal. Thus, a Bank could limit the maximum maturity of any 
new advances to a withdrawing member to the amount of time remaining 
until the date of withdrawal. Section 925.26(a)(1) also provides that a 
member may cancel its notice of withdrawal at any time prior to its 
effective date by providing a written cancellation notice to the Bank, 
and further allows a Bank to impose a fee on any member that cancels 
its notice of withdrawal. Any such fee, or the manner of its 
calculation, must be specified in the capital plan. This provision of 
the final rule is in substance as it was proposed.
    Section 925.26(a)(2) of the final rule requires the Banks to notify 
the Finance Board within 10 calendar days of receiving any notices of 
withdrawal or notices canceling a notice of withdrawal. Although 
notification to the Finance Board no longer is mandated by statute as a 
condition to withdrawal, retaining the requirement will allow the 
Finance Board to maintain an accurate membership database (which 
provides the official count of Bank System members), and to maintain 
historical records regarding Bank System membership, withdrawals, and 
cancellations of notices of withdrawal.

[[Page 8270]]

Being advised of member withdrawals also allows the Finance Board to 
anticipate changes in Bank System membership.
    Because the Bank Act, as amended by the GLB Act, does not expressly 
link the withdrawal of membership to the redemption of stock, the 
proposed rule would have allowed a member to specify the date on which 
its membership would terminate, which date could be no later than the 
end of its last stock redemption period. The proposed rule provided 
further that if the notice did not indicate a withdrawal date, 
withdrawal would be deemed to take effect on the date that the last 
applicable stock redemption period ends.
    Commenters criticizing this provision expressed concerns about 
whether a termination in membership prior to the end of the redemption 
periods would result in a nonmember owning Bank stock, which arguably 
would conflict with the provisions of the GLB Act that restrict 
ownership of Bank stock to members. Although the Finance Board believes 
that the appropriate time for determining whether Bank stock is 
lawfully held by a ``member'' of the Bank is the date on which the 
member acquires the Bank stock, the Finance Board is revising the final 
rule to make the date of termination coincide with the expiration of 
the longest stock redemption period, unless the institution cancels its 
notice of withdrawal prior to that date. That approach is consistent 
with current practice at the Banks. In part, the proposed rule was 
premised on the view that under the new capital regime a member that 
wanted to terminate its membership prior to the end of the stock 
redemption periods could simply sell the Bank stock to another member, 
at a price to be negotiated by the two members. Because the final rule 
does not permit the members to establish a trading market for Bank 
stock, the provisions of the proposed rule that would have ``de-
linked'' the termination of membership from the ownership of stock are 
no longer appropriate, and thus have been deleted.
    As was proposed, Sec. 925.26(c) of the final rule provides that the 
receipt by a Bank of a notice of withdrawal shall commence the 
applicable 6-month and 5-year stock redemption periods, respectively, 
for all of the Class A and Class B stock held by that member that is 
not already subject to a pending request for redemption. Also as 
proposed, Sec. 925.26(c) provides that in the case of an institution 
the membership of which has been terminated as a result of a merger or 
other consolidation into a nonmember or into a member of another Bank, 
the applicable stock redemption periods for any stock that is not 
subject to a pending notice of redemption shall be deemed to commence 
on the date on which the charter of the former member is cancelled. The 
final rule makes no substantive changes to this provision.
    As was proposed and as discussed above, Sec. 925.26(d) of the final 
rule implements the Bank Act, as amended by the GLB Act, by providing 
that no institution may withdraw from membership unless, on the date 
that the membership is to terminate, there is in effect a RefCorp 
Certification. This provision is not substantively changed from the 
proposed rule. The GLB Act amended the Bank Act to require each Bank to 
pay 20 percent of its net earnings each year toward the RefCorp debt 
service. 12 U.S.C. 1441b(f)(2)(C), as amended. The GLB Act further 
required that before a member can withdraw from Bank membership, the 
Finance Board must have in effect a certification that the withdrawal 
of the member will not cause the Bank System to fail to make its 
required payments toward the RefCorp debt service. The Finance Board 
has previously addressed this matter by certifying that the withdrawal 
of any member will not cause the Bank System to fail to meet its 
RefCorp payments. Finance Board Resolution No. 2000-32 (June 23, 2000). 
The certification remains in effect until rescinded or superseded by 
the Finance Board. Accordingly, there is no need to revisit the issue 
as part of this final rule, and Bank members may withdraw from 
membership without having to request individual certifications from the 
Finance Board.
    Involuntary Termination. Section 6(d)(2) of the Bank Act, as 
amended by the GLB Act, provides the grounds on which a Bank may 
terminate the membership of an institution, such as in the case of 
violating the Bank Act or Finance Board regulations, or insolvency. 
Section 6(d)(2) also provides that the applicable notice period for 
each class of redeemable stock shall commence on the earlier of: (i) 
The date of such termination; or (ii) the date on which the member 
provided notice of its intent to redeem the stock.
    Section 925.21 of the proposed rule implemented the above statutory 
provisions. Section 925.27 of the final rule retains these provisions 
as proposed, with several changes discussed below. As was proposed, 
Sec. 925.27(a) of the final rule provides that the board of directors 
of a Bank may terminate the membership of any institution that fails to 
comply with any requirement of the Bank Act, any Finance Board 
regulation, or any requirement of the Bank's capital plan, or becomes 
insolvent or otherwise subject to the appointment of a conservator, 
receiver, or other legal custodian under federal or state law. Section 
925.27(a)(3) of the final rule also adds as an additional ground for 
termination any circumstances under which the retention of Bank 
membership would jeopardize the safety or soundness of the Bank, which 
is consistent with existing Sec. 925.27(b)(4). See 12 CFR 925.27(b)(4). 
As was proposed, Sec. 925.27(b) of the final rule provides that the 
applicable 6-month and 5-year stock redemption periods, respectively, 
for all Class A and Class B stock that is not already subject to a 
pending request for redemption, shall commence on the date that the 
Bank terminates the institution's membership. In response to a Bank 
commenter's suggestion, Sec. 925.27(c) of the final rule adds language 
clarifying that an institution whose membership is terminated 
involuntarily shall cease being a member as of the date on which the 
board of directors of the Bank acts to terminate its membership. As was 
proposed, this section provides that the institution shall have no 
right to obtain any of the benefits of membership after that date. In 
response to one comment, the final rule clarifies that the institution 
shall be entitled to receive any dividends declared on its stock until 
the stock is redeemed by the Bank.
    Prior to the GLB Act, section 6(e) of the Bank Act provided the 
Finance Board with the authority to terminate the membership of an 
institution that became insolvent. 12 U.S.C. 1426(e)(ii) (1994). 
Pursuant to that authority, the Finance Board adopted Sec. 925.28(a), 
which provides that the membership of an institution placed in 
receivership (which in all likelihood would be insolvent) automatically 
terminates. 12 CFR 925.28(a). As discussed above, the GLB Act amended 
the Bank Act by vesting in the Banks, rather than the Finance Board, 
the authority to determine whether to terminate involuntarily the 
membership of an institution that is insolvent or placed into 
receivership. 12 U.S.C. 1426(d)(2)(A)(ii), as amended. One Bank 
suggested that the final rule retain the automatic termination 
provision in existing Sec. 925.28 because that procedure has worked 
well and the proposed change would impose operational burdens on the 
Banks and receivers and conservators. The Finance Board has not 
implemented that recommendation in the final rule, because the GLB Act 
vests

[[Page 8271]]

the authority for making such decisions in the board of directors of 
each Bank, rather than in the Finance Board. Thus, if a member is 
placed into receivership or conservatorship or otherwise is determined 
to be insolvent, the board of directors of each Bank must determine 
whether it is most appropriate to allow that institution to remain a 
member of the Bank for some period of time or to terminate its 
membership under these provisions. The final rule also removes existing 
Sec. 925.28(b) and (c) regarding the treatment of outstanding advances 
and Bank stock, and dividends on Bank stock, of a member placed into 
receivership, which are addressed generally in Sec. 925.29 and 
Sec. 931.4, respectively, of the final rule.
    Disposition of Claims. The GLB Act did not amend section 10(c) of 
the Bank Act, which provides that a Bank shall have a lien upon and 
shall hold the stock of a member as further collateral security for all 
indebtedness of the member to the Bank. 12 U.S.C. 1430(c) (1994). The 
GLB Act did amend section 6(d)(3) of the Bank Act, which provides that 
upon the termination of membership for any reason, the outstanding 
indebtedness of the member to the Bank shall be liquidated in an 
orderly manner, as determined by the Bank, and upon the extinguishment 
of all such indebtedness the Bank shall return to the member all 
collateral pledged to secure the indebtedness. Id. Sec. 1426(d)(3), as 
amended. Section 925.22 of the proposed rule would have implemented 
these two statutory provisions, and Sec. 925.29 of the final rule 
retains these provisions, with several changes, as described below.
    Section 925.29(a) of the final rule provides that if an institution 
withdraws from membership or its membership is otherwise terminated, 
the Bank shall determine an orderly manner for liquidating all 
outstanding indebtedness owed by that member to the Bank and for 
settling all other claims against the member. After all such 
obligations and claims have been extinguished or settled, the Bank 
shall return to the member all collateral pledged by the member to the 
Bank to secure its obligations to the Bank.
    Section 925.29(b) of the final rule provides that if an institution 
that has withdrawn from membership or that otherwise has had its 
membership terminated remains indebted to the Bank or has outstanding 
any business transactions with the Bank after the effective date of its 
termination of membership, the Bank shall not redeem or repurchase any 
Bank stock that is required to support the indebtedness or the business 
transactions until after all such indebtedness and business 
transactions have been extinguished or settled.
    Readmission to Membership. Section 6(g)(1) of the Bank Act, as 
amended by the GLB Act, provides that an institution that divests all 
shares of Bank stock may not, after such divestiture, acquire Bank 
stock before the end of the 5-year period beginning on the date of the 
completion of such divestiture, unless the divestiture is a consequence 
of a transfer of membership on an uninterrupted basis between Banks. 12 
U.S.C. 1426(g)(1), as amended. Section 6(g)(2) of the Bank Act, as 
amended by the GLB Act, provides for an exception that allows any 
institution that withdrew from membership in a Bank before December 31, 
1997 to acquire Bank stock at any time after that date, subject to the 
approval of the Finance Board and the requirements of the Bank Act. Id. 
1426(g)(2), as amended.
    Section 925.23 of the proposed rule implemented these statutory 
provisions. Section 925.30 of the final rule retains these provisions 
as proposed, with some clarifying language, described below. Section 
925.30(a) of the final rule provides that an institution that has 
withdrawn from membership or otherwise has had its membership 
terminated, and which has divested all of its shares of Bank stock, may 
not be readmitted to membership in any Bank, or acquire any capital 
stock of any Bank, for a period of 5 years from the date on which its 
membership terminated and it divested all of its shares of Bank stock.
    Section 925.30(b) of the final rule provides that an institution 
that transfers membership between two Banks without interruption shall 
not be deemed to have withdrawn from Bank membership or had its 
membership terminated. Section 925.30(b) further provides that any 
institution that withdrew from Bank membership prior to December 31, 
1997, and for which the 5-year period has not expired, may apply for 
membership in a Bank at any time, subject to the approval of the 
Finance Board and the requirements of part 925.

D. Part 930--Definitions

    As was proposed, Sec. 930.1 of the final rule sets forth the 
definitions for the risk management and capital provisions of parts 
931, 932 and 933. The Finance Board has adopted Sec. 930.1 generally as 
proposed, with the changes discussed below.
    The Finance Board has removed a number of the proposed definitions 
from the final rule because they are no longer relevant, given changes 
that have been adopted to the final capital regulations. The Finance 
Board has also removed the definition of the term ``NRSRO'' because the 
term is defined in Sec. 900.1 of the Finance Board regulations, which 
provides definitions applicable to all parts of the Finance Board 
regulations. 12 CFR 900.1 (as amended by 65 FR 43969, 43981 (July 17, 
2000).\4\ Some changes also have been made in the final rule to clarify 
the meanings of terms, including ``market value at risk,'' ``capital 
plan,'' and ``permanent capital.'' The Finance Board also has added to 
Sec. 930.1 of the final rule, definitions for some additional terms. 
The term ``minimum investment'' is defined as the minimum amount of 
Class A and/or Class B stock that a member is required to own to be a 
member of a Bank and to obtain advances or engage in other activities 
with the Bank, consistent with Sec. 931.3 of the final rule. The term 
``excess stock'' is defined as any amount of stock held by a member in 
excess of the minimum investment. The terms ``redeem or redemption'' 
are defined to mean the acquisition of Class A or Class B stock by a 
Bank at par value following the expiration of the six-month or five-
year statutory redemption period, respectively, for the stock. The 
final rule defines the term ``repurchase'' to mean the acquisition by a 
Bank of excess stock prior to the expiration of the applicable 
statutory redemption period.
---------------------------------------------------------------------------

    \4\ A similar conforming change is adopted herein for part 956 
of the Finance Board regulations.
---------------------------------------------------------------------------

E. Part 931--Federal Home Loan Bank Capital Stock

    In General. As described in the SUPPLEMENTARY INFORMATION section 
of the proposed rule, 65 FR 43412 (July 13, 2000), the GLB Act requires 
the capital regulations to permit each Bank to issue ``any one or 
more'' of Class A or Class B stock. Class A stock is to be redeemable 
at par on six months written notice to the Bank; Class B stock is to be 
redeemable at par on five years written notice to the Bank. The board 
of directors of each Bank is to determine the ``rights, terms, and 
preferences'' for each class of stock, consistent with section 6 of the 
Bank Act, with the regulations of the Finance Board, and with market 
requirements. The regulations must prescribe the manner in which Bank 
stock may be ``sold, transferred, redeemed, or repurchased,'' and must 
restrict the issuance and ownership of Bank stock to members of the 
Bank, prohibit the issuance of other classes of stock, and provide for 
the liquidation of claims and the redemption of stock upon an

[[Page 8272]]

institution's withdrawal from membership.
    Apart from authorizing the issuance of two classes of Bank stock, 
the GLB Act eliminated certain key characteristics of the single class 
of Bank stock that had been established under prior law. For example, 
the Bank Act no longer mandates a statutory par value for all Bank 
stock of $100 per share and no longer requires all Bank stock to be 
issued at par value.\5\ As a result, the Bank Act now authorizes a Bank 
to establish the par value for its Class A and Class B stock (which may 
differ), and permits the issuance of stock at a price other than par 
value.
---------------------------------------------------------------------------

    \5\ 12 U.S.C. 1426(a) (1994). The minimum amount of Bank stock 
that each member was required to purchase had to be issued at par 
value. Any subsequent issuance could be at a price in excess of par 
value, but not less than par value. As a matter of practice, all 
stock of the Banks has been issued at par value.
---------------------------------------------------------------------------

    Classes of Capital Stock. Section 931.1 of the proposed rule set 
forth the essential characteristics of the two classes of Bank stock. 
The proposed rule would have required the Class A stock to have a par 
value of $100 per share, be issued and redeemed only at par value, be 
redeemable in cash only on six-months notice, and pay a stated dividend 
that would have a priority over the Class B dividends. The proposed 
rule would have required each Bank to determine the par value for its 
Class B stock, as well as the price at which it would be issued, which 
could be at par value or at or some other price. The Class B stock also 
would have been redeemable only at par value and with five years 
notice, and would have been subordinated to the stated dividend on the 
Class A stock. The proposed rule also restated the statutory provision 
that grants the Class B stock an ownership interest in the retained 
earnings of the Bank. Although not expressly referenced by the GLB Act, 
the proposed rule would have authorized each Bank to issue one or more 
subclasses of Class A and Class B stock, provided that each subclass 
possessed all of the required characteristics of its class.
    The final rule makes four principal changes to Sec. 931.1 of the 
proposed rule, by eliminating the regulatory par value for Class A 
stock, eliminating the stated dividend for Class A stock, eliminating 
the priority for Class A dividends, and requiring that each Bank issue 
its Class B stock at its stated par value.
    The commenters that addressed the issue of the par value of the 
Class A stock generally opposed having the par value set by regulation, 
contending that each Bank should determine the par value for its stock. 
The Finance Board agrees that it is appropriate to allow each Bank to 
determine the par value and issue price for its stock and has revised 
the final rule accordingly. Thus, for both Class A and Class B stock, 
the final rule provides that par value is to be determined by the board 
of directors of the Bank and stated in the Bank's capital plan. The 
final rule also extends to the Class B stock the requirement from the 
proposed rule that the stock be issued only at its par value, which the 
proposed rule had required only for the Class A stock. The provisions 
of the proposed rule that would have allowed a Bank to issue Class B 
stock at a price other than par value prompted criticism from several 
commenters. Those commenters recommended that the final rule require 
the Banks to issue Class B stock at its par value, and expressed 
concerns about allowing a Bank to issue stock at a price above par 
value when the Bank is required by statute to redeem the stock at its 
par value. Other commenters noted that allowing the Banks to issue 
Class B stock at less than its par value would be inconsistent with 
general corporate practice.
    Some commenters requested that the final rule expressly allow a 
Bank to issue its Class B stock at ``book value,'' rather than at par 
value. Although the issuance of Class B stock at its book value would 
appear to be legally permissible under the Bank Act, such an approach 
would raise other issues, such as how the book value of a Bank would be 
calculated, how frequently the calculation would be made, and how a 
Bank would address the issue of selling stock to its members at prices 
that could vary day to day. Because of those and other issues 
concerning the issuance at book value, the Finance Board has determined 
not to include that as an option under the final rule.
    A number of commenters also objected to the proposed requirement 
that Class A stock pay a stated dividend that would have a priority 
over the payment of dividends on Class B stock. The principal objection 
to that provision was that such a requirement may trigger a taxable 
event for some members upon the conversion of their existing Bank stock 
to Class A stock. One of the reasons for including that provision in 
the proposed rule was a concern that the members owning Class B stock 
might favor themselves over the members owning Class A stock with 
regard to the payment of dividends. The Finance Board received a number 
of comments suggesting that the concern was unfounded because the 
members owning the Class B stock also would be likely to own Class A 
stock, and thus would have no incentive to deprive the Class A stock of 
its dividends. The Finance Board sees merit in these arguments and thus 
has not included in Sec. 931.1 of the final rule the requirement that 
the Class A stock have a stated dividend or a priority over the Class B 
dividend. Section 931.4 of the final rule addresses the issue of 
dividends, and generally allows a Bank to establish a dividend 
preference as part of its capital plan. Thus, the final rule permits, 
but does not require, a Bank to establish a stated dividend with a 
priority. To the extent that any provisions of a Bank's capital plan 
might unfairly disadvantage one class of stockholders, the Finance 
Board will be able to address any such inequities through the approval 
process for the capital plans.
    A number of commenters opposed authorizing the issuance of 
subclasses of the Class A or Class B stock, suggesting that it would 
create a risk of ``cherry-picking'' among the subclasses that could be 
detrimental to the cooperative nature of the Bank System. Other 
commenters questioned the legal authority for subclasses. As explained 
in the SUPPLEMENTARY INFORMATION section of the proposed rule, the 
board of directors of a Bank has the authority under section 6(a)(4)(A) 
and section 6(c)(4)(B) of the Bank Act to establish different rights, 
terms, and preferences for the stock issued by the Bank. 12 U.S.C. 
1426(a)(4)(A), (c)(4)(B), as amended. Those provisions clearly 
authorize a Bank to issue Class A stock with rights, terms, and 
preferences that differ from Class B stock, and there is nothing in 
those provisions that would prohibit a Bank from issuing some shares of 
Class B stock, for example, with rights, terms, and preferences that 
differ from other shares of the Bank's Class B stock. Thus, if the 
board of directors of a Bank wished to issue some shares of Class B 
stock for which the dividend will be determined based on the 
performance of a specific category of Bank assets and other shares of 
Class B stock for which the dividend will be determined based on the 
general profitability of the Bank, it would have the authority to do 
so. Obviously, if some shares of Class B stock were to have rights, 
terms, and preferences different from those of other shares of Class B 
stock, it would be eminently sensible for the Bank to distinguish 
between the two types of Class B stock, such as by giving them 
different names. Section 931.1(c) of the final rule makes clear that a 
Bank can designate such different shares of stock as separate 
``subclasses'' if it wishes to do so. The authority to issue subclasses 
of either the Class A or Class B stock does not at

[[Page 8273]]

all expand the authority of the Bank to issue anything other than Class 
A or Class B stock. Indeed, the proposed rule explicitly required each 
subclass to possess all of the characteristics of the class, and the 
Finance Board has retained that provision in the final rule. 
Accordingly, the Finance Board believes that the Banks have the 
authority to issue subclasses of stock and the final rule allows the 
Banks to do so, subject to the limits described above.
    One other issue raised by commenters on this provision concerned 
the ownership of the retained earnings by the members that have 
purchased a Bank's Class B stock. The commenters asked that the final 
rule clarify that ownership of Class B stock does not confer an 
enforceable right to receive the retained earnings, and that the 
ownership interest extends to all undistributed retained earnings 
existing at the time of conversion as well to those existing 
thereafter. The commenters also sought clarification of how the 
ownership interest would be affected if a Bank were to issue subclasses 
of Class B stock, and who would own the retained earnings if a Bank did 
not issue Class B stock.
    The GLB Act provides expressly that a member shall have no right to 
withdraw or otherwise receive any portion of the Bank's retained 
earnings, except through a dividend or capital distribution by the 
Bank, which resolves the first comment. Similarly, the GLB Act provides 
that the owners of the Class B stock shall own the ``retained earnings, 
surplus, undivided profits, and equity reserves, if any'' of the Bank, 
and does not limit that interest to any particular date in time. 
Accordingly, once a Bank issues any Class B stock, the holders of that 
stock will have an ownership interest in the retained earnings of the 
Bank from that date forward, until they redeem their Bank stock. After 
a member has redeemed (or the Bank has repurchased) all of its Class B 
stock, it no longer would have an ownership interest in the retained 
earnings of the Bank, apart from any dividends declared while the 
member owned the Class B stock. There is nothing in the language of the 
GLB Act that suggests that the interest of a Class B stockholder is 
limited to the retained earnings that exist on the date that the Bank 
converts from its existing stock to the Class A and/or Class B stock. 
The Finance Board believes that Congress intended this to be an ongoing 
interest, such that interest of the Class B stockholders would extend 
to whatever retained earnings are accumulated over time, as well as 
those that exist on the date of conversion to the new capital 
structure. Similarly, there is no reason to distinguish between 
subclasses of Class B stock with regard to the ownership of the 
retained earnings. Because the final rule requires that any subclasses 
of Class B stock must possess all of the characteristics of Class B 
stock, the creation of a subclass of Class B stock cannot extinguish 
ownership interest in the retained earnings of the Bank for that 
subclass, which is created by statute. The GLB Act also contemplates, 
however, that the board of directors of a Bank may establish different 
rights, terms, and preferences for the Bank's stock, which would allow 
the board of directors to establish different dividend rates for 
different subclasses of Class B stock, even though each share of Class 
B stock, including its subclasses, otherwise would have the same 
residual interest in the retained earnings of the Bank. The final rule 
does not address the ownership of the retained earnings of a Bank that 
has issued no Class B stock. The ownership interest in favor of the 
Class B stockholders was created by Congress as part of the GLB Act. 
Although earlier versions of the Bank reform legislation had included 
language that addressed the ownership of the retained earnings by the 
owners of other classes of stock, the GLB Act did not include such a 
default provision for any Bank that does not issue Class B stock. 
Because the ownership of the retained earnings was created by Congress, 
the Finance Board believes that the matter of ownership for those Banks 
without Class B stock is best left to the Congress to resolve.
    As a related matter, Congress' decision to confer an ownership 
interest in the retained earnings on the holders of the Class B stock 
has created some uncertainty about whether a Bank can pay dividends on 
the Class A stock out of its retained earnings. By law, there are only 
two sources from which a Bank may pay dividends: previously retained 
earnings and current net earnings. 12 U.S.C. 1436(a). By giving the 
Class B stockholders the exclusive ownership of the retained earnings, 
the GLB Act appears to preclude the payment of dividends on the Class A 
stock from a Bank's retained earnings. Although by statute a Bank may 
pay dividends on its Class A stock from ``current earnings,'' that may 
not be possible under applicable accounting rules, which dictate that a 
Bank must credit its net earnings to retained earnings when it closes 
its books for the period. The final rule does not resolve this problem, 
which is addressed in somewhat greater detail under the discussion of 
Sec. 931.4. The Finance Board intends to raise the issue of how best to 
reconcile these provisions in a subsequent rulemaking.
    Issuance of capital stock. Section 931.2(a) of the proposed rule 
would have allowed each Bank to issue either Class A or Class B stock, 
or both Class A and Class B stock, as well as any subclasses of either. 
That section also required a Bank to issue stock only to its members, 
barred the issuance of any other class of capital stock, required the 
Bank to act as its own transfer agent, and to issue its capital stock 
only in book-entry form. The Finance Board also requested comments on 
whether the Banks should be allowed to issue stock certificates and, if 
so, what safeguards would be appropriate.
    Several commenters indicated that requiring book-entry form for 
Bank stock is reasonable and would prevent the stock from being 
improperly transferred, though at least one commenter suggested that 
including the requirement in the rule is unnecessary. One Bank 
recommended that the final rule allow the use of stock certificates 
because certain members, such as insurance companies, may be required 
to hold certificates to comply with state law requirements. That Bank 
also recommended that a Bank be allowed to use outside transfer agents, 
indicating that such an option may be particularly helpful for a Bank 
that uses an outside entity to conduct elections.
    The Finance Board is adopting the provisions of Sec. 931.2 largely 
as set forth in the proposal. Although a number of insurance companies 
are members of the Bank System, it is the understanding of the Finance 
Board that all of the Banks currently issue their stock in book-entry 
form, which appears not to have caused any difficulties for such 
members under state law. Because no comments identified specific 
provisions of state law that would require an insurance company to be 
issued stock certificates in order to become a member of a Bank, the 
Finance Board is not prepared to create an exception for such entities 
in the final rule. To the extent that state law may require a 
particular member to hold stock certificates in order to become a 
member of a Bank, the Finance Board would be prepared to consider the 
issue through a waiver request under the Finance Board's existing 
procedures. In that event, the Finance Board would expect the request 
for a waiver to demonstrate that state law allows no alternative but 
for an insurance company to hold physical stock certificates in order 
to become or remain a member of the Bank System.
    When it issued the proposed rule, the Finance Board contemplated 
that Bank stock would have been traded among

[[Page 8274]]

members on a regular basis, which would have presented a more 
compelling need for a Bank to retain an outside source to act as the 
transfer agent for its stock. As discussed below, the final rule has 
eliminated the provisions of the proposed rule that would have required 
Bank stock to be traded among members, as well as between the Bank and 
its members, at a negotiated price. Thus, as in the past, the 
overwhelming majority of stock transactions will be between a Bank and 
a member. As such, the Finance Board does not anticipate that the need 
for an outside transfer agent under the new capital structure than will 
be materially greater than under the current capital structure. The 
Finance Board anticipates further rulemaking in the first quarter of 
2001 on capital issues, and parties who can demonstrate why the Banks 
would still need to retain an outside source to perform the transfer 
agent functions in the absence of a trading market for the Bank stock 
will be able to address the issue at that time.
    Proposed Sec. 931.2(b) would have required each Bank to determine 
the initial method of distribution of its stock in a manner that is 
fair and equitable to all eligible purchasers. The proposed rule 
expressly allowed the Banks to conduct the initial issuance through an 
exchange or conversion but did not mandate either approach. In 
addition, the proposal would have allowed a Bank to distribute its 
then-existing unrestricted retained earnings as shares of Class B 
capital stock.
    These provisions are being adopted in the final rule substantially 
as proposed. A Bank commenter recommended that this section be amended 
to clarify that a Bank may distribute retained earnings that are 
unrestricted at the time of conversion in the form of shares in a 
subclass of Class B stock, in addition to shares of Class B stock as 
the proposed rule provides. Such action would be authorized under the 
rule as written so no change to the rule is required.
    Proposed Sec. 931.2(c) would have required that a Bank issuing 
capital stock as a requirement of membership and as a requirement for 
conducting business with the Bank could do so only in accordance with 
proposed Sec. 931.7 and Sec. 931.8, respectively. The final rule has 
replaced those two provisions with a new provision that addresses the 
minimum investment that each member must maintain in the stock of the 
Bank, and thus has deleted the substance of Sec. 931.2(c) from the 
final rule. The provisions regarding the minimum investment are 
discussed under Sec. 931.3, below.
    Proposed Sec. 931.2(d) would have prohibited a Bank from issuing 
stock to a member or group of affiliated members if the issuance would 
result in such member or group of affiliated members owning more than 
40 percent of any class of the outstanding capital stock of the Bank. 
Section 931.9 of the proposed rule separately would have limited the 
amount of stock that any one member, or group of affiliated members, 
could own to 40 percent of any class of the outstanding capital stock 
of the Bank. Several commenters suggested that the effect of that 
provision would be to limit the amount of advances that large members 
could obtain because they would be barred from purchasing the necessary 
additional stock that would be required to support any new advances. 
Other commenters suggested that the provision would effectively require 
small members to purchase additional stock to support the activities of 
large members of a Bank. A number of commenters requested that the 
Finance Board address how the provision would be applied to members 
that exceeded the 40 percent cap through no action of their own, such 
as if one or more larger members were to withdraw from the Bank.
    The Finance Board agrees the concentration limit could have 
hampered some large members' access to Bank advances and other 
activities. The Finance Board further believes that concerns that one 
member or group of members may exert undue influence over a Bank can be 
addressed adequately by limiting the voting rights of large members, 
which the final rule does by retaining the current statutory cap on the 
number of shares that any one member may vote in an election of 
directors. Because the existing limits on voting rights will remain in 
place in the final rule, the proposed stock ownership limits are no 
longer necessary and have been deleted from the final rule. The 
application of the voting limits under the new capital structure is 
discussed separately under the explanation of the amendments to part 
915 of the Finance Board's regulations.
    Minimum investment. Section 931.3 of the final rule addresses the 
minimum investment in capital stock that is required of each Bank 
member. This section of the final rule replaces two separate provisions 
of the proposed rule, Secs. 931.7 and 931.8, which addressed 
``membership investment'' and ``activity-based'' stock purchase 
requirements, respectively. Each of those provisions included 
limitations based on the concept of a Bank's ``operating capital 
ratios'' (i.e., total and risk-based capital ratios somewhat higher 
than the regulatory minimums). Section 931.7 of the proposed rule would 
have allowed a Bank to require each member to invest in Class A stock 
as a condition to being a member of the Bank, but would have required 
that the Bank also allow each member the option of purchasing a lesser 
proportional amount of Class B stock. If the Bank were at or above 
either of its operating capital ratios, the proposed rule would have 
barred the Bank from requiring its members to purchase any additional 
amounts of Bank stock, though it would have permitted a Bank to assess 
a membership fee in lieu of a mandatory stock investment. Section 931.8 
of the proposed rule would have allowed a Bank to require its members 
to purchase an amount of Class A or Class B stock as a condition to 
doing business with the Bank. The proposed rule also would have allowed 
a Bank to contract with a member for the purchase of stock on a future 
date (as a means of satisfying an activity-based stock purchase 
requirement), required that the amount of Class B stock be based on the 
risk characteristics of the underlying assets, and prohibited a Bank 
from restricting a member's ability to sell stock that it had purchased 
under this requirement. As with the membership requirement, if a Bank 
were at or above either of its operating capital ratios, the proposed 
rule would have barred the Bank from requiring its members to purchase 
any additional Class B stock based on the business conducted with the 
Bank.
    Nearly all commenters who addressed the provisions of the proposed 
rule relating to operating capital ratios recommended that those 
provisions be eliminated from both the membership and activity-based 
stock purchase requirements, or that they be revised to establish an 
operating capital range, rather than a fixed percentage. A principal 
concern was that the operating capital ratios would cause inconsistent 
stock ownership and/or stock purchase requirements among members and 
that they may not be effective in preventing the Banks from becoming 
overcapitalized. By imposing such limits on stock issuance on a Bank 
that had reached its operating capital ratios, the proposed rule also 
would have effectively capped the amount of capital that the Bank would 
have, which a number of commenters suggested was not consistent with 
the safe and sound operation of the Banks.
    The Finance Board continues to believe that operating capital 
ratios are a valid business concept that should be retained in the 
final rule, but has reconsidered the implementation of the concept 
based on the comments. The

[[Page 8275]]

Finance Board believes that operating capital ratios are more 
appropriately described as a risk management tool for establishing 
capital levels at which the Banks intend to operate, rather than as a 
separate regulatory capital requirement for which the Finance Board 
would impose sanctions if the Banks were to operate at different 
levels. Accordingly, the final rule deletes from the capital regulation 
any reference to the operating capital ratios, as well as any reference 
to limits on a Bank's ability to issue capital stock once it has 
reached its operating capital ratios. Instead, the final rule includes 
an amendment to Sec. 917.3 that requires each Bank to include as one 
element of its risk management policy the total and risk-based capital 
levels at which the Bank intends to operate. In effect, the board of 
directors of each Bank must establish the capital ratios or ranges at 
which it intends the management of the Bank to operate. If the Bank 
were to operate at capital levels that were materially above or below 
the operating capital ratios established as part of the risk management 
policy, the Finance Board would address the variance through the 
examination and supervision process. The Finance Board expects that the 
board of directors of each Bank will monitor the Bank's capital level 
to ensure that management complies with the capital ratios established 
by the board of directors.
    A number of commenters who addressed the membership investment 
provisions of the proposed rule objected to requiring the investment to 
be in Class A stock, with the member having an option to invest a 
lesser amount in Class B stock. Nearly all of the commenters who 
addressed the use of a membership fee in lieu of a minimum investment 
in the stock of the Bank opposed the concept, though at least one 
commenter advocated allowing a Bank to assess a fee in addition to a 
minimum investment in Bank stock. As discussed in the proposed rule, 
because the operating ratio provisions would have precluded a Bank from 
issuing additional stock to certain of its members in certain 
circumstances, the Finance Board believed it appropriate to allow the 
Bank to assess an annual membership fee on those members in lieu of the 
stock purchase that otherwise would have been required. In part, these 
provisions were intended to avoid an accumulation of excess capital at 
the Banks. Because the Finance Board has eliminated the concept of 
operating capital ratios from the final rule, there no longer is any 
need to permit membership fees to be assessed in lieu of mandatory 
stock purchases. As described below, Sec. 931.3 of the final rule 
requires each Bank to establish a minimum investment in Bank stock as a 
condition of membership, as well as a condition of doing business with 
the Bank, but leaves to the individual Bank how the minimum investment 
is to be structured. Accordingly, the final rule no longer requires 
that the membership investment be in Class A stock, with an option for 
the member to invest a lesser amount in Class B stock, and does not 
authorize a membership fee in lieu of the minimum investment. This 
revision to the proposed rule would not prevent a Bank from assessing a 
fee on members in other contexts, but it would bar the assessment of a 
membership fee in any form.
    The activity-based stock purchase requirements of proposed 
Sec. 931.8 prompted numerous objections that they would have barred a 
Bank from requiring its members to continue to hold Bank stock that had 
been purchased to support a particular business activity, such as 
advances, with a Bank. Many of the commenters suggested that the Banks 
be allowed to mandate a ``buy-and-hold'' requirement as part of any 
activity-based stock purchase requirement. Those commenters contended 
that allowing a member to sell Bank stock purchased to support a 
particular activity would make it more difficult for Banks to meet 
their risk-based capital requirements. Commenters also expressed 
concern that the proposed rule would threaten the cooperative structure 
of the Bank System by separating stock ownership from the business that 
the members conduct with the Banks, and would move the Banks toward a 
corporate form of business.
    A number of commenters advocated retaining the current activity-
based stock purchase requirement (i.e., a member must own Bank stock at 
least equal to 5 percent of its advances), arguing that such a formula 
would provide adequate capital to cover the credit, market, and 
operational risks associated with advances. One commenter supporting 
that approach argued that any capital supporting an advance is 
``permanent'' because the member cannot redeem the stock while the 
advance is outstanding, and that either Class A or Class B stock could 
be used as ``permanent'' capital for advances. The Congress, however, 
has spoken definitively on these issues and the Finance Board is not at 
liberty to consider Class A stock as permanent capital. The risk-based 
capital requirements for a Bank, i.e., the capital required for credit 
and market risk, may be satisfied only with ``permanent capital,'' 
which is defined to include only the amounts paid in for Class B stock 
plus a Bank's retained earnings (determined in accordance with GAAP). 
The totality of the GLB Act definitions make it clear that Class A 
stock cannot lawfully be used to satisfy a Bank's risk-based capital 
requirements, even if it were to be held for the duration of an 
advance. With regard to the contention that a Bank should be allowed to 
retain the ``5 percent of advances'' requirement from prior law, it 
would be possible under the final rule for a Bank to do so, provided 
that the amount of capital generated by that requirement would be 
sufficient for a Bank to meet its total and risk-based capital 
requirements, both for its outstanding advances as well as for the 
other assets on the balance sheets of the Banks. As discussed below, 
the determination of how to structure the minimum investment is left to 
the individual Banks under the final rule.
    The final rule includes, in Sec. 931.3, much of the substance of 
the proposed membership and activity-based stock purchase requirements, 
albeit with a number of revisions and additions that conform the final 
regulation more closely to the statutory requirements. Consistent with 
a number of comments, Sec. 931.3(a) of the final rule mandates that 
each Bank shall require each member to maintain a ``minimum 
investment'' in the stock of the Bank. The term ``minimum investment'' 
includes whatever amount of Bank stock an institution is required to 
purchase in order to become a member of a Bank, as well as whatever 
amount of Bank stock a member is required to purchase in order to 
obtain an advance or to conduct any other business activity with the 
Bank. The GLB Act expressly requires each member to maintain a minimum 
investment in the stock of its Bank, and requires the manner for 
determining the amount of the minimum investment to be described in the 
Bank's capital plan. The GLB Act does not speak in terms of the minimum 
investment being structured as separate membership and activity-based 
components. The GLB Act does, however, require the amount of capital to 
be generated by the minimum investment to be sufficient to allow the 
Bank to comply with its total and risk-based capital requirements, and 
expressly authorizes a Bank to base the minimum investment on a 
percentage of a member's assets and/or on a percentage of a member's 
outstanding advances, all of which suggest that under the new capital 
structure (as under the existing structure), the minimum investment 
must encompass

[[Page 8276]]

both a membership component and an activity component.
    As a fundamental matter, the Banks are cooperatives, which means 
that the capital to support the business of the Banks must be supplied 
by the members of the cooperative. If an institution becomes a member 
of a Bank, it has immediate access to all of the products and services 
of the Bank even if it does not immediately take advantage of them. 
Nonetheless, the Bank stands ready to provide advances and other 
services to the new member and has an infrastructure in place to 
provide those services. Both the liquid assets that a Bank maintains in 
order to provide services to its members, as well as parts of the 
infrastructure of the Bank (i.e., tangible assets) that enable it to 
provide those services, are assets against which the Bank is required 
to maintain some amount of permanent and total capital. Thus, even a 
non-borrowing member benefits from the availability of these services 
and should be required to purchase some amount of both Class A and 
Class B stock to support the capital requirements associated with the 
Bank serving as a standby lender for the member. Indeed, as a number of 
commenters contended, an institution cannot become a member without 
having invested some amount in the stock of the Bank. Because a Bank 
must maintain permanent capital against assets that benefit non-
borrowing members, the Finance Board believes that the most appropriate 
reading of the GLB Act is to require each member to maintain an 
investment in Bank stock (including Class B stock) regardless of 
whether it has any business outstanding with the Bank.
    Section 931.3(a) of the final rule also requires each Bank to 
require each member to maintain a minimum investment in Bank stock as a 
condition to transacting business with the Bank or obtaining advances 
or other services from the Bank. Under the GLB Act capital provisions, 
a Bank cannot make an advance or obtain Acquired Member Assets (AMA) 
unless it has in place the permanent and total capital required to meet 
the risk-based and leverage capital requirements associated with those 
assets. Because of that requirement, the Finance Board believes that 
the concept of a ``minimum investment'' must include the capital stock 
that is required to support the risks that a member's business 
transactions place on the balance sheet of the Bank. Section 931.3(a) 
of the final rule provides that the specifics of how a ``minimum 
investment'' is to be calculated is to be determined by each Bank as 
part of its capital plan, which reflects the requirements of the GLB 
Act. That provision also provides expressly that each Bank must require 
its members to maintain its minimum investment in Bank stock for as 
long as it remains a member and for as long as it engages in any 
business transaction with a Bank against which the Bank is required to 
maintain capital. Thus, for instance, a member that is required to 
purchase Bank stock as a condition of obtaining an advance or engaging 
in AMA transactions with the Bank, must continue to hold that stock for 
so long as the corresponding asset remains on the Bank's balance sheet.
    Section 931.3(b) of the final rule provides that a Bank may 
establish the minimum investment required of each member as a 
percentage of the total assets of the member or as a percentage of the 
advances outstanding to the member, or based on any other provisions 
approved by the Finance Board as part of the Bank's capital plan. That 
provision of the final rule reflects exactly the requirements of the 
GLB Act. Because the business transactions and services that the Banks 
provide to their members are not limited to advances, the Finance Board 
also has included in Sec. 931.3(b) of the final rule a provision 
allowing the Banks to establish a minimum investment as a percentage of 
any other business activity conducted with the members, which would 
include AMA transactions. In addition, the final rule provides 
expressly that the above bases for determining a minimum investment are 
not mutually exclusive and that a Bank may use any one or more of them 
in any combination as the basis for determining the minimum investment 
required of the members. Accordingly, although the final rule allows 
the Banks several options for structuring the minimum investment that 
is required of all members, the Banks must require the members to 
purchase some amounts of stock in order to conduct business with the 
Banks.
    Section 931.3(c) of the final rule provides that a Bank may require 
a member to satisfy the minimum investment through the purchase of 
either Class A or Class B stock, or through the purchase of any one or 
more combinations of Class A and Class B stock that are authorized by 
the board of directors of the Bank. That section also provides that a 
Bank may establish a lower minimum investment for members that invest 
in Class B stock than for those that invest in Class A stock, provided 
that the reduced investment remains sufficient for the Bank to remain 
in compliance with its minimum capital requirements. As discussed 
previously, even if a member does not borrow or otherwise engage in any 
business with its Bank, the Bank has to maintain assets and 
infrastructure to allow it to stand ready to do business with such 
members, and all of those assets require some amount of permanent 
capital and total capital to comply with the requirements of the GLB 
Act. The same is true with regard to members that borrow from or 
otherwise do business with the Banks, except that the linkage between 
the Bank assets that are created through such business dealings and the 
capital requirements is more apparent. In either case, if a Bank could 
not require its members to purchase some amount of Class A stock and 
some amount of Class B stock, it could not possibly comply with the 
capital requirements of the GLB Act. In theory, a Bank could rely on 
retained earnings to provide the permanent capital to allow it to 
comply with its risk-based capital requirements but, as a practical 
reality, no Bank has or is likely to have in the near term sufficient 
retained earnings to allow that to occur. If the language of the GLB 
Act were read to provide each member with an option to purchase either 
Class A or Class B stock, a Bank could not ``ensure'' that the minimum 
investment it had established would provide sufficient capital for the 
Bank to comply with the GLB Act capital requirements. The Finance Board 
believes that the most appropriate way to construe the GLB Act is to 
allow the members the option of choosing from whatever combinations of 
Class A and Class B stock have been authorized by the board of 
directors of the Bank as a means of satisfying the minimum investment.
    Section 931.3(d) provides that each member of a Bank shall maintain 
an investment in the stock of its Bank in an amount that is sufficient 
to satisfy the minimum investment requirement established by the Bank's 
capital plan. This reflects provisions in the GLB Act that require each 
member to comply with the minimum investment established by the Bank's 
capital plan. It also addresses concerns expressed by a number of 
commenters that certain types of institutions, such as commercial 
banks, which are authorized under state law to invest in Bank stock 
only to the extent that the investment is required as a condition of 
membership, might lack the legal authority to invest in Bank stock if 
the investment were not required as a condition of membership or as a 
condition of obtaining services from the Bank.
    The final rule does not include the provision formerly in 
Sec. 931.8(c) of the proposed rule, which would have

[[Page 8277]]

required that the amount of Class B stock that a member must purchase 
be based on the risk characteristics associated with the type and 
duration of asset to be acquired by the Bank as a result of the 
particular transaction with that member. In order to satisfy the 
requirement in the final rule that the minimum investment shall be 
sufficient to ensure that the Bank remains in compliance with all of 
its minimum capital requirements, the Banks may well have to take into 
account the risk characteristics associated with particular 
transactions with members in determining what investment to require for 
such transactions. Under the final rule, however, that matter is left 
to the board of directors of each Bank to resolve, through the capital 
plan.
    Dividends. As discussed previously, the Finance Board has deleted 
from the final rule the provisions of the proposed rule that would have 
required that the Class A stock pay a stated dividend that would have a 
priority over the dividends on the Class B stock. The final rule also 
deletes all of proposed Sec. 931.4(b), which would have required the 
capital plan of each Bank to address certain issues associated with the 
stated dividend and the priority for the Class A stock, and all of 
proposed Sec. 931.4(c), which separately addressed the dividends on the 
Class B stock. As previously discussed, many commenters recommended 
eliminating the stated dividend and the dividend priority for Class A 
stockholders, citing potential tax consequences to the members. Several 
commenters also suggested that each Bank be permitted to decide the 
dividend structure and preferences, if any, to be assigned to the 
classes of stock that it issues. The Finance Board agrees with those 
comments, and has removed those provisions from the final rule for 
those reasons. Thus, the final rule provides simply that the capital 
plan may establish different dividend rates or preferences for each 
class or subclass of Bank stock, which effectively leaves to the board 
of directors of each Bank the decision as to how to structure dividends 
to the members. To the extent that the dividend structure adopted by a 
Bank might unfairly favor one class of stockholder over another, the 
Finance Board would be prepared to address those issues as part of the 
approval process for the capital plans. The Finance Board expects that 
it will not approve a capital plan if it would allow for the holders of 
either stock class to be treated unfairly. These provisions were 
included in the proposed rule to preclude the possible manipulation of 
the Class A dividend by and for the benefit of Class B shareholders, 
who may well have a greater influence on the Bank's dividend policies 
than the Class A shareholders. The Finance Board continues to believe 
that it is important to ensure that this does not happen, but believes 
that the capital plan review process is the appropriate means to do so.
    One commenter recommended that the final rule bar a Bank from 
paying a dividend if it is not in compliance with its capital 
requirement or would fall out of compliance as a result of paying the 
dividend, explaining that without such a provision a Bank could 
continue to pay dividends in order to forestall stock redemptions, 
notwithstanding its lack of sufficient capital. The GLB Act expressly 
precludes a Bank from distributing its retained earnings unless it 
would continue to meet all applicable capital requirements following 
the distribution. Section 2A(a)(3)(A) of the Bank Act also provides 
that the primary duty of the Finance Board is to ensure that the Banks 
operate in a financially safe and sound manner. 12 U.S.C 
1422a(a)(3)(A). The minimum capital requirements established by the GLB 
Act advance the safety and soundness of the Bank System by ensuring 
that the Banks have sufficient capital to conduct their business. The 
Finance Board believes that a Bank that fails to maintain the minimum 
amounts of capital required by the GLB Act would be operating in an 
unsafe and unsound condition, which would require remedial action by 
the Finance Board. Although it was never the intent of the Finance 
Board to suggest that a Bank could pay dividends while not meeting its 
minimum capital requirements, the Finance Board sees merit in 
explicitly stating so in regulation and has added such language to the 
final rule.
    Section 931.4(a) of the proposed rule also had provided that any 
member, including a member withdrawing from the Bank System, that owns 
Class A or Class B stock, or both, would be entitled to receive 
dividends declared on its stock for as long as it owned the stock. The 
final rule retains that provision. Section 931.4(a) of the proposed 
rule further provided that any dividends on the Class B stock shall be 
payable only from the net earnings or retained earnings of the Bank, 
determined in accordance with GAAP and was silent on the sources 
available for dividends on Class A stock. The final rule includes a 
similar provision, providing that a Bank may pay dividends only from 
its previously retained earnings or its current net earnings. That 
language simply restates the existing statutory requirements and 
applies equally to dividends on Class A and to Class B stock. 12 U.S.C 
1436(a). The final rule also provides that a Bank shall declare and pay 
dividends only in accordance with its capital plan. As previously 
discussed, certain amendments made by the GLB Act may limit the ability 
of a Bank to pay dividends on its Class A stock from retained earnings. 
Section 6(h)(1) of the Bank Act, 12 U.S.C. 1426(h)(1), as amended, 
provides that the ``holders of the Class B stock * * * shall own the 
retained earnings, surplus, undivided profits, and equity reserves * * 
* of the Bank.'' The following paragraph of the statute limits that 
ownership interest, providing that a member has no right to receive any 
portion of the retained earnings, other than through a dividend or a 
capital distribution. The next paragraph bars a Bank from distributing 
any of its retained earnings unless it would continue to meet all of 
its capital requirements following the distribution. Read together, 
those provisions appear to require that the retained earnings of a Bank 
are available only for the payment of dividends to the holders of the 
Class B stock. To allow the retained earnings to be used as a source 
for dividends on the Class A stock would appear to require a Bank to 
use the property of one class of stockholders to pay dividends to 
another class of stockholders, who have been granted no ownership 
interest in those retained earnings.
    Section 16(a) of the Bank Act, 12 U.S.C. 1436(a), provides that 
``no dividends shall be paid except out of previously retained earnings 
or current net earnings.'' That suggests that even if the retained 
earnings are available only for payment of dividends to the holders of 
the Class B stock, a Bank could use its ``current net earnings'' as the 
source for paying dividends on its Class A stock. It appears, however, 
that under generally accepted accounting principles (GAAP), current 
earnings are closed to retained earnings at the close of each 
accounting period, the effect of which is to make current earnings 
unavailable as a source of dividends. Though it appears unlikely that 
the Congress considered how creating a property interest in the 
retained earnings in favor of the Class B stockholders might limit the 
ability of the Banks to pay dividends on their Class A stock, the 
language that Congress used places the ownership of the retained 
earnings with the Class B stockholders. The final rule is silent on 
this issue. As noted previously, the Finance Board anticipates further

[[Page 8278]]

rulemaking in the first quarter of 2001 on capital issues, and believes 
that the resolution of this issue regarding the source of dividends for 
the Class A stock should occur after there has been an opportunity for 
public comment on the issue. To the extent that any Bank intends to 
submit a capital plan that would call for the payment of dividends on 
Class A stock, the Finance Board expects that the plan would identify 
the source for paying such dividends, address the authority of the Bank 
to pay dividends from that source, and describe how the proposal would 
be treated under relevant accounting principles.
    Some commenters expressed concern that any regulatory limits on 
dividends may prove troublesome over time, given the potential for 
increased volatility in reported net income and retained earnings that 
could result from the implementation of Statement of Financial 
Accounting Standards No. 133 (SFAS 133), the new GAAP accounting 
standard for derivatives. One commenter recommended that if the 
transitory income effects associated with SFAS 133 were to prevent the 
payment of a dividend, it would be appropriate for the Bank's board of 
directors to have the authority to declare and pay a dividend from 
earnings without regard to these transitory SFAS 133 effects. Another 
commenter expressed concern about the market and income volatility 
generated by the accounting treatment surrounding mortgage-related 
options, such as those associated with the Mortgage Partnership Finance 
(MPF) program. As noted previously, by statute a Bank may pay dividends 
only from its current earnings or its previously retained earnings. To 
the extent that these comments suggest that the Finance Board should 
allow a Bank to pay dividends from some other source, the Finance Board 
is not prepared to do so. Moreover, the GLB Act requires that in 
calculating risk-based and total capital, the retained earnings of a 
Bank must be calculated in accordance with GAAP. The GLB Act also 
restricts a Bank from making a retained earnings distribution, unless 
following such distribution the Bank would continue to meet all 
applicable capital requirements. These statutory provisions, read 
together, persuade the Finance Board that it should not adopt the 
suggestions raised by these commenters.
    Liquidation, merger, or consolidation. The proposed rule 
established a priority for Class A shareholders over Class B 
shareholders, in the event of a liquidation, merger, or other 
consolidation of a Bank. As previously discussed, many commenters 
recommended eliminating such a preference in order to avoid creating a 
taxable event with respect to stock previously issued as dividends when 
existing stock is converted to Class A stock. The Finance Board has 
eliminated this provision in the final rule, substituting instead a 
requirement that the respective rights of Class A and Class B 
stockholders, in the event that the Bank is liquidated, or is merged or 
otherwise consolidated with another Bank, shall be determined in 
accordance with the capital plan of the Bank.
    Transfer of capital stock. Consistent with current practice, the 
proposed rule would have allowed a member to transfer capital stock 
only to another member of the Bank or to an institution that is in the 
process of becoming a member. Unlike current practice, the proposed 
rule would have required such transfers of stock to be at a price 
agreed to by the parties, which by implication meant that the price 
could be below, at, or above the par value of the stock.
    Several commenters raised issues with allowing stock transfers to 
an institution in the process of becoming a member, citing concerns 
that if it did not become a member, a non-member institution could own 
Bank stock which would be inconsistent with the GLB Act. To address 
concerns raised by the commenters, the Finance Board revised the phrase 
``institution in the process of becoming a member'' in the final rule 
to ``institution that has been approved for membership in that Bank and 
that has satisfied all conditions for becoming a member, other than the 
purchase of the minimum amount of Bank stock that it is required to 
hold as a condition of membership.''
    Many commenters opposed the trading of Bank stock at a negotiated 
price among its members. Such trading, it was argued, would require 
members to hold Bank stock as an available-for-sale asset, which would 
have to be marked to market. The Finance Board agrees that such 
problems outweigh the potential benefits of other than par value 
transfers, at this time, and has thus revised the final rule to require 
that any transfer of stock among members must be at par value.
    Redemption and repurchase of capital stock. Proposed Sec. 931.10 
(Sec. 931.7 in the final rule) set forth requirements for redemption 
and purchase of capital stock and provided that a member may seek to 
have the Bank redeem its Class A and Class B stock with six-months and 
five-years written notice to the Bank, respectively. At the end of the 
notice periods, the Bank would be required to pay the par value of the 
stock to the member in cash. The proposal also would have barred a 
member from having pending at any one time more than one notice of 
redemption for any class of Bank stock. Several commenters expressed 
concerns with this restriction, indicating that it would inhibit a 
Bank's ability to pay stock dividends on Class B stock because a member 
that did not want to hold stock dividends effectively would be 
precluded from requesting redemptions. One Bank commenter suggested 
that, rather than restricting redemption requests, the Bank should be 
allowed to assess a fee for additional redemption requests. To address 
this issue, the Finance Board has revised the final rule to bar a 
member from having more than one notice of redemption outstanding at 
one time for the same shares of Bank stock. This will allow a member 
that has submitted a redemption notice for certain shares of stock to 
file an additional notice for other shares of stock if it receives 
stock dividends or otherwise is holding excess stock that it desires to 
have redeemed.
    The final rule also clarifies that a member may cancel a notice of 
redemption if it does so in writing to the Bank, and the Bank may 
impose a fee (to be specified in the capital plan) on any member that 
cancels a pending notice of redemption. The requirement that a Bank 
shall not be obligated to redeem its capital stock other than in 
accordance with this paragraph also is adopted in the final rule.
    Section 931.7(b) addresses repurchase of capital stock, which was 
referred to in the proposal as purchase of capital stock. Repurchase of 
capital stock differs from redemption in that it is a transaction that 
is initiated by a Bank, whereas a redemption of Bank stock is a 
transaction that is initiated by a member. The proposed rule provided 
that a Bank, in its discretion, may purchase outstanding Class A or 
Class B capital stock from its members at any time at a negotiated 
price. Several commenters expressed concerns about the implications of 
requiring such transactions to occur at a negotiated price, indicating 
that such a requirement would effectively prevent a Bank from 
repurchasing excess Bank stock unless the Bank were willing to pay the 
price demanded by the member. Several commenters also recommended that 
a Bank be given the unilateral right to purchase excess stock from any 
member at par value, so long as the purchase would not result in the 
Bank's failure to comply with any regulatory capital requirement. One 
commenter suggested that the Banks be given the

[[Page 8279]]

right to purchase Class A shares at par value and Class B shares at 
book value.
    The Finance Board agrees that the proposed rule could make it 
unnecessarily difficult for the Banks to manage effectively their 
capital accounts. Accordingly, the final rule authorizes the Banks, in 
their discretion and without regard to the 6-month and 5-year 
redemption periods, to repurchase excess stock from their members. As 
noted previously, the term ``excess stock'' includes any Bank stock 
owned by a member in excess of the amount that the member is required 
to own under the minimum investment provisions of the Bank's capital 
plan. The final rule also addresses an issue raised by the comments by 
requiring the Banks to provide reasonable notice to any member from 
which the Bank intends to repurchase excess stock, with the length of 
such notice being stated in the capital plan. For any such repurchases, 
the Banks must pay to the members the stated par value of the stock in 
cash. The final rule also states expressly that a member's submission 
of a notice of intent to withdraw from membership, or its termination 
of membership in any other manner, shall not, in and of itself, cause 
any Bank stock to be deemed excess stock for purposes of this section. 
That provision reflects a statutory requirement imposed by the GLB Act. 
12 U.S.C. 1426(e)(2), as amended.
    Several Bank commenters recommended that the final rule give the 
Banks clear discretion to approve or deny a member's request for 
redemption, so long as the Bank is in compliance with its regulatory 
capital requirements. It is not apparent from the GLB Act that a Bank 
would have the authority to deny a redemption request if the capital of 
the Bank would not become impaired by the redemption or if the Bank 
would remain in compliance with its regulatory capital requirements 
following the redemption. Thus, the final rule provides that at the 
expiration of the six-month or five-year notice period, as applicable, 
the Bank will be required to pay the par value of the stock to the 
member in cash, assuming that the capital of the Bank is not impaired, 
the Bank meets its minimum capital requirements, and the member is not 
required to hold the stock as a condition of remaining a member or of 
engaging in any business transactions with the Bank. One commenter 
recommended that the redemption provisions of the final rule clarify 
who makes a redemption determination when redemption would cause the 
Bank to fall below its regulatory capital requirement and whether and 
under what circumstances a redemption request may be withdrawn. Under 
the final rule, a member can withdraw a request for redemption at any 
time prior to the expiration of the applicable notice period, though 
the Bank may assess a fee on any member that does so. The Finance Board 
expects that each Bank will monitor its capital levels at all times and 
will not honor a redemption request if doing so would cause it to fail 
to comply with any of its capital requirements. How a Bank would 
address a situation in which multiple members simultaneously submit 
redemption requests that would cause the Bank to fall below any minimum 
capital requirement should be addressed in the Bank's capital plan.
    One commenter suggested amending this section to clarify that a 
Bank that is not in compliance with its regulatory capital requirements 
not be permitted to redeem stock. The final rule precludes a Bank from 
redeeming or repurchasing any stock if, following the redemption or 
repurchase, the Bank would fail to meet any minimum capital 
requirement, or if the member would fail to maintain its minimum 
investment in the stock of the Bank, as required by Sec. 931.3.
    Capital Impairment. The final rule bars a Bank from redeeming or 
repurchasing any capital stock without the prior written approval of 
the Finance Board if the Finance Board or the board of directors of the 
Bank has determined that the Bank has incurred or is likely to incur 
losses that result in or are likely to result in charges against the 
capital of the Bank. The proposed rule had included a comparable 
provision, which would have allowed a Bank to redeem or repurchase 
stock with Finance Board approval even if the Bank thereafter would 
fail to meet its minimum capital requirements. The inclusion of the 
language in the proposed rule that would allow for such transactions 
with Finance Board approval was inadvertent, and the final rule does 
not permit such transactions. The final rule also provides that the 
prohibition on redemption and repurchase will apply even if a Bank is 
in compliance with its minimum capital requirements, and will remain in 
effect for however long the Bank continues to incur such charges or 
until the Finance Board determines that such charges are not expected 
to continue. As stated in the final rule, the provision more closely 
tracks the statutory language.
    Transition Provision. The proposed rule included a general 
transition provision in Sec. 932.1 for the Banks to meet the risk-based 
and leverage capital requirements, as well as a separate transition 
provision in Sec. 933.3, pertaining to the contents of the capital 
plans. Section 932.1 of the proposed rule would have required, by a 
date not later than three years from the effective date of its capital 
plan, that each Bank have sufficient total capital to meet the minimum 
leverage capital requirement in proposed Sec. 932.2, and sufficient 
permanent capital to meet the risk-based capital requirement in 
proposed Sec. 932.3. The proposed rule also would have mandated that 
the minimum stock purchase and stock retention requirements of the Bank 
Act in effect immediately prior to the GLB Act amendments remain in 
effect until the Bank had issued capital stock in accordance with its 
approved capital plan, and that each Bank would continue to be governed 
by certain provisions of the Finance Board's Financial Management 
Policy (FMP) until the Bank had met the proposed regulatory capital 
requirements.
    One Bank commenter recommended that this provision be amended to 
clarify that the new minimum stock purchase and retention requirements 
would not become effective until a Bank had issued all stock under its 
plan, to allow for issuance of stock in tranches or rounds. A few 
commenters questioned whether the current leverage limitation, 12 CFR 
966.3(a) (65 FR 36290, 36299 (June 7, 2000)), is less flexible than the 
leverage authority in the GLB Act, and the total capital provision of 
the proposed and final rule, and requested deletion of Sec. 966.3(a). 
Section 966.3(a) requires a Bank to hold total assets not in excess of 
21 times the total of its paid-in capital stock, retained earnings, and 
reserves (excluding loss reserves and liquidity reserves for deposits 
as required by 12 U.S.C. 1421(g)). In addition, that rule provides 
additional leverage authority by allowing a Bank to have an asset-based 
leverage of up to 25 to 1 if the non-mortgage assets held by the Bank 
after deducting the amount of deposits and capital, do not exceed 11 
percent of the Bank's total assets. 12 CFR 966.3. Several Banks 
commented that the existing leverage limit would prevent them from 
efficiently leveraging the permanent capital base afforded through 
Class B stock, and that the existing leverage limit is more restrictive 
than the GLB Act leverage limit otherwise allowed.
    The transition provision of the final rule has been clarified in 
numerous respects to address issues raised by the commenters, as well 
as other issues. In the final rule, the Finance Board has relocated the 
general transition provision to Sec. 931.9, and has included a 
conforming provision in Sec. 933.4 as part of the capital plan 
requirements. As an

[[Page 8280]]

initial matter, the transition provisions of the final rule are keyed 
to the ``effective date'' of a Bank's capital plan, which is defined as 
the date on which the Bank first issues any Class A or Class B stock. 
Prior to the effective date of a Bank's capital plan, the issuance and 
retention of Bank stock are to be governed by Secs. 925.20 and 925.22, 
which implement the stock purchase requirements of the Bank Act as they 
existed prior to the GLB Act. As of the effective date of a Bank's 
capital plan, the issuance and retention of Bank stock shall be 
governed exclusively by the capital plan for that Bank.
    As a general matter, Sec. 931.9(a) of the final rule requires each 
Bank to comply with the minimum leverage and risk-based capital 
requirements of Secs. 932.2 and 932.3, respectively, as of the 
effective date of the Bank's capital plan. If a Bank is in compliance 
with both the leverage and risk-based capital requirements as of the 
effective date of its capital plan, it shall thereafter be governed 
exclusively by the provisions of its capital plan and the capital 
requirements of Secs. 932.2 and 932.3. For any Bank that is in 
compliance with the GLB Act leverage capital requirements as of the 
effective date, the final rule provides that existing leverage 
requirements at Sec. 966.3(a) shall cease to apply to that Bank as of 
that date.
    If a Bank will be out of compliance with the GLB Act capital 
requirements as of the effective date of its capital plan, then 
Sec. 931.9(b)(1) of the final rule allows the Bank to establish a 
transition period over the course of which it will come into compliance 
with the GLB Act capital requirements. Any such transition period must 
be established as part of the Bank's capital plan and must describe the 
steps that the Bank plans to take during the transition period to come 
into compliance with the new capital requirements. The capital plan 
also must indicate the length of the transition period, which shall not 
exceed three years from the effective date of the capital plan. During 
the period of time that the Bank is out of compliance with the GLB Act 
leverage requirement, the final rule provides that the Bank will remain 
subject to the existing regulatory leverage requirement established by 
Sec. 966.3(a). Once a Bank that has been operating under a transition 
period comes into compliance with the GLB Act leverage capital 
requirement, it will cease to be subject to the regulatory leverage 
requirement of Sec. 966.3(a).
    Though it is clear that the Congress intended the Banks to have the 
option of achieving compliance with the GLB Act capital requirements 
over a period of up to three years from the effective date of the 
capital plan, there is nothing in the GLB Act to suggest that during 
any such transition period the existing leverage requirements should 
cease to apply. The Finance Board believes, as a matter of safety and 
soundness, that it is essential for the Banks always to be subject to a 
leverage requirement, and that the transition provision should not be 
read as authorizing the Banks to operate with no leverage capital 
requirement for up to three years after the effective date of their 
capital plans. The Finance Board believes that the best way of assuring 
continuity between the current regulatory leverage requirement and the 
GLB Act leverage requirements during any transition period is to link 
the termination of the existing leverage requirements to the 
commencement of the new leverage requirements. In effect, the final 
rule leaves to the board of directors of each Bank the ability to 
determine the date on which the existing leverage requirements in 
Sec. 966.3(a) will cease to apply to that Bank. Banks that will achieve 
compliance with the GLB Act capital requirements immediately as of the 
effective date of their capital plans will no longer be subject to the 
current regulatory leverage limits. Banks requiring or desiring 
additional time to come into compliance with the GLB Act leverage 
requirement will have certainty under the final rule as to what 
leverage requirements apply to the Bank during the transition period.
    Section 931.9(a) of the final rule separately requires each member 
to comply with the minimum investment established by the capital plan 
of its Bank as of the effective date of that plan. As was proposed, 
prior to the effective date of the Bank's capital plan the members will 
be required to purchase and hold Bank stock in accordance with 
Secs. 925.20 and 925.22 of the Finance Board's regulations, which 
implement the stock purchase requirements of the Bank Act as in effect 
prior to the GLB Act.
    Although the final rule generally requires members to meet the 
minimum investment as of the effective date of the Bank's capital plan, 
it also authorizes a Bank to include in its capital plan a transition 
provision that would allow members up to three years to purchase the 
amount of Bank stock that is required by the capital plan. The capital 
plan shall specify the length of any transition period established for 
the members and shall describe the actions that the members must take 
during the transition period in order to come into compliance with the 
minimum investment provisions of the capital plan. Consistent with the 
GLB Act, any such transition period will apply only to those 
institutions that were members of the Bank as of November 12, 1999, 
which was the date of enactment of the GLB Act, and whose investment in 
Bank stock as of the effective date is less than the amount required by 
the capital plan for that Bank. Any institutions becoming members of a 
Bank after that date will be required to conform their Bank stock 
ownership to the amounts required by the capital plan as of the 
effective date of the capital plan. Similarly, any members that, as of 
the effective date, own stock in excess of the amount required by the 
capital plan, will be required to comply with the minimum investment 
established by the plan from that date forward. The final rule 
expressly authorizes the Banks to require their members that are 
subject to any such transition provision to purchase additional shares 
of Bank stock in increments over the course of the transition period.
    The final rule includes two separate provisions that relate to new 
members and to new business, respectively. Any new members, i.e., those 
institutions that became members after November 12, 1999 but prior to 
the effective date of the capital plan, as well as those institutions 
that become members after the effective date of the capital plan, will 
be required to comply with the minimum investment requirements of the 
Bank's capital plan as of the effective date of the plan, or upon 
becoming a member, as appropriate.
    Finally, Sec. 931.9(b)(3) requires a Bank's capital plan to require 
any member that obtains an advance or other services from the Bank, or 
that initiates any other business activity with the Bank against which 
the Bank is required to hold capital after the effective date of the 
capital plan to comply with the minimum investment specified in the 
Bank's capital plan for such advance, service, or activity at the time 
the transaction occurs. The Finance Board views the transition 
provisions of the GLB Act as authorizing the Banks to establish a 
period of time during which they, and their members, may increase their 
existing capital, or their existing investment in Bank stock, to the 
levels required by the GLB Act amendments. Thus, the transition 
provision assures that neither the Banks nor their members will be 
required to capitalize their existing business, i.e., the business 
existing as of the effective date, in accordance with the GLB Act 
requirements unless the Banks affirmatively decide to do so. For 
business transactions that are undertaken after the capital plans take

[[Page 8281]]

effect, however, there is no need for a transition period because those 
transactions never would have been subject to the old capital rules. 
Moreover, construing the transition provisions as applying to 
transactions that are initiated after the new capital structure takes 
effect would pose the risk that the Banks could have up to three years 
during which to place assets on their books that would not be supported 
by adequate capital, a risk the Finance Board is not prepared to 
authorize.

F. Part 932--Federal Home Loan Bank Capital Requirements

    Overview. As discussed in the SUPPLEMENTARY INFORMATION section of 
the proposed rule, the Finance Board, in developing the proposed risk-
based capital requirements, drew from and expanded upon work done by 
the Basle Committee on Banking Supervision (BCBS), other federal 
financial regulators, the Office of Federal Housing Enterprise 
Oversight (OFHEO), which supervises the Federal National Mortgage 
Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation 
(Freddie Mac), and other sources as well as the work done in developing 
the Finance Board's Financial Management and Mission Achievement (FMMA) 
rule proposal. See 65 FR at 43410-11, 43419-34 (July 13, 2000). The 
Finance Board has made changes in the final rule to refine and clarify 
its risk-based capital requirement further, although the basic 
framework remains the same as in the proposal. These changes, which are 
discussed in more detail below, were based on comments received as well 
as additional work done by the Finance Board's staff. Changes were also 
made in the final rule to recognize that, given changes required by 
SFAS 133, derivative contracts can no longer be considered solely off-
balance sheet items. In the final capital rule, derivative contracts 
are, therefore, referred to and addressed as transactions distinct from 
assets or off-balance sheet transactions. The Finance Board also 
addresses the comments received on the risk-based capital requirements 
in its discussion below of each individual section of these 
requirements.

Section 932.1--Risk Management and Former Transition Provision

    As previously discussed, proposed Sec. 932.1 contained the 
transition provision for meeting the risk-based and total capital 
requirements. The transition provisions for the capital plans and the 
minimum capital requirements have been consolidated into a single 
section, Sec. 931.9, in the final rule. Proposed Sec. 932.1(c), under 
which the risk management provisions of the FMP would have ceased to 
apply to a Bank at the end of any transition period, has been 
eliminated from the consolidated transition requirements. The Finance 
Board has reconsidered the proposal and has determined that it would be 
more prudent to grant relief from any remaining FMP requirements at the 
time each Bank's capital plan is approved. This would allow the Finance 
Board to consider the specifics of each capital plan, the general 
economic conditions and any other factors that could affect a Bank's 
future operations and ability to fulfill its mission, before 
determining whether any part of the FMP should continue to apply. The 
comments received on the transition provision for the minimum capital 
requirements are addressed in the SUPPLEMENTARY INFORMATION section 
discussion of Sec. 931.9.
    In addition to the transition provision, proposed Sec. 932.1 
contained a requirement that before a Bank's capital plan could take 
effect, the Bank would have to obtain Finance Board approval of its 
internal market risk model or internal cash flow model and for the risk 
assessment procedures and controls that would be used to manage the 
Bank's credit, market and operations risk. An adequate internal model 
must be developed and approved before the risk-based capital 
requirements--a key component underlying the new capital structure--can 
be calculated.\6\ At the same time, adequate internal controls for 
recognizing and managing the risks faced by the Banks will be an 
important factor in the successful implementation of a new capital 
system in which the Banks' required capital levels are closely tied to 
their risk profiles. No comments were received on the approval 
requirement in proposed Sec. 932.1(b). Accordingly, the Finance Board 
continues to view an approved internal market risk or cash flow model 
and adequate internal risk management controls as necessary 
prerequisites for implementation of the Banks' capital plans and has 
adopted this requirement without change in Sec. 932.1 of the final 
rule.
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    \6\ As adopted in the final rule, Sec. 932.5 allows each Bank to 
determine market risk capital charges using an approved internal 
market risk model or internal cash flow model.
---------------------------------------------------------------------------

Section 932.2--Total Capital Requirement

    Proposed Sec. 932.2 set forth the minimum total capital leverage 
requirement contained in the Bank Act, as amended by the GLB Act. 12 
U.S.C. 1426(a)(2). Proposed Sec. 932.2(a) would have required a Bank to 
maintain total capital equal to no less than four percent of its total 
assets, where total capital was computed without regard to the 
weighting factor required by the GLB Act and described in proposed 
Sec. 932(b). This weighting factor would have required a Bank to 
multiply the permanent capital component of its total capital by 1.5. 
(Permanent capital is defined to include the paid-in value of Class B 
stock and retained earnings calculated in accordance with GAAP. 12 
U.S.C. 1426(a)(5).) The provision, consistent with the GLB Act, further 
would have mandated that a Bank's total capital, computed using the 
weighting factor, could not have been less than five percent of its 
total assets. In the proposed rule, the Finance Board also would have 
reserved the right to require a Bank to have and maintain total capital 
in amounts above the minimum required levels if warranted by safety and 
soundness concerns. The proposed provision reserving this authority was 
substantively the same as the provision contained in proposed 
Sec. 932.3 concerning the minimum risk-based capital requirement.
    The Finance Board received several comments on proposed Sec. 932.2, 
but for the reasons discussed below has not changed the provision in 
response to those comments and is, therefore, adopting Sec. 932.2 
substantially as proposed, with certain technical changes. The 
requirement describing the weighting factor has been revised to clarify 
how the weighting factor is applied, and the provision concerning the 
Finance Board's right to require a Bank to hold total capital above the 
minimum levels has been revised to conform to the substantively similar 
provision in Sec. 932.3 of the final rule.
    One commenter requested clarification as to whether total capital 
had to be calculated in accordance with GAAP. The commenter believed 
that implementation of SFAS 133 as part of GAAP would result in a 
Bank's assets being artificially ``grossed up'' because unrealized 
gains on certain derivative contracts would have to be recorded on a 
Bank's balance sheet as assets. The commenter urged the Finance Board 
to allow total capital and the minimum leverage ratios to be calculated 
without taking account of these unrealized gains on derivative 
contracts. However, the GLB Act requires that when deriving permanent 
and total capital, ``retained earnings'' must be calculated in 
accordance with GAAP. 12 U.S.C. 1426(a)(5)(A)(ii). By extension, the 
valuation of all assets and liabilities,

[[Page 8282]]

upon which the calculation of retained earnings is based, would 
likewise have to conform with GAAP. The requested change, therefore, is 
not consistent with the requirements of the GLB Act. Further, the 
Finance Board believes that it would undermine the efficacy of the 
minimum total capital ratios as a regulatory tool if the total asset 
component (i.e., the denominator) of the minimum total capital ratios 
were to be calculated on a different basis than the total capital 
component (i.e., the numerator). Thus, no change in the final rule has 
been made in response to this comment.\7\
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    \7\ A few commenters, also citing the effects of SFAS 133, urged 
the Finance Board to allow a Bank's required payments to the RefCorp 
and to the Affordable Housing Program (AHP) to be assessed based on 
``economic earnings'' rather than GAAP earnings. The Finance Board 
has also received a request for a regulatory interpretation that 
seeks to reduce the potential effects of SFAS 133 on earnings 
calculations used for certain regulatory purposes. That request, 
which raises a number of concerns, including some similar to those 
discussed above with regard to calculating total capital, is now 
being reviewed by Finance Board staff. The issue of whether the 
Finance Board should authorize the Banks to calculate their RefCorp 
and AHP payments by using non-GAAP earnings was not addressed in the 
proposed rule. The Finance Board, therefore, declines to implement 
any rule changes to address the RefCorp and AHP payments issue at 
this time.
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    One commenter also requested clarification of what safety and 
soundness concerns may prompt the Finance Board to require a Bank to 
hold total capital above the minimum required level. The primary duty 
of the Finance Board is to ensure that the Banks operate in a 
``financially safe and sound manner.'' 12 U.S.C. 1422a(a)(3)(A). The 
Bank Act has long provided the Finance Board or its predecessor agency 
the authority to take actions to carry out that duty and other 
responsibilities under the Bank Act. 12 U.S.C. 1422b. Section 932.2(c) 
of the final rule is consistent with the duties and authority of the 
Finance Board under the Bank Act and will be implemented as is 
necessary and authorized to carry out those duties. However, as 
explained more fully below in the discussion of the Minimum Risk-Based 
Capital Requirement, the Finance Board expects that the authority 
granted under this provision rarely will be used, but nonetheless 
believes that the provision is an important safeguard measure in case 
unforeseen events result in anticipated or actual impairment of a 
Bank's capital.

Section 932.3--Risk-Based Capital Requirement

    Proposed Sec. 932.3 would have required each Bank to maintain at 
all times an amount of permanent capital equal to at least the sum of 
the Bank's credit, market and operations capital risk requirements. The 
proposed rule also provided that the Finance Board for reasons of 
safety and soundness could require a Bank to hold a greater amount of 
permanent capital than the required minimum amount.
    The Finance Board received a number of general comments on the 
risk-based capital requirement. Many commenters believed that the paid-
in portion of Class A stock should be considered permanent capital for 
purposes of fulfilling some aspects of the risk-based capital 
requirement. Other commenters felt that, overall, the risk-based 
capital charges were too high and would put the Banks at a competitive 
disadvantage to Fannie Mae and Freddie Mac. One commenter requested 
that the Finance Board delineate more clearly the conditions under 
which it would require a Bank to hold additional permanent capital and 
to clarify whether Finance Board staff could order such an action. 
Another commenter requested clarification concerning the risk weighting 
that would be applied to unrealized gains held as assets for risk-based 
capital purposes. The Finance Board has considered all comments 
received on the minimum risk-based capital requirements and, for the 
reasons discussed below, is adopting Sec. 932.3 substantially as 
proposed.
    One Bank and a number of its members argued that, because Class A 
stock cannot be redeemed if the Bank is operating below its minimum 
capital requirements, Class A stock should be considered permanent 
capital, thus suggesting that the Finance Board allow the paid-in value 
of Class A stock to be used to meet some portion of the minimum risk-
based capital requirement. The Finance Board believes that such a 
change would be inconsistent with the GLB Act. The term ``permanent 
capital'' is specifically defined by the statute to include ``the 
amounts paid for the [C]lass B stock; and the retained earnings of the 
[B]ank (as determined in accordance with generally accepted accounting 
principles).'' 12 U.S.C. 1426(a)(5)(A). As already addressed in this 
SUPPLEMENTARY INFORMATION section in the discussion of Sec. 931.3, the 
Congress has spoken definitively on these issues and the Finance Board 
is not at liberty to consider Class A as permanent capital. Also as 
previously discussed, the risk-based capital requirements for a Bank 
may be satisfied only with permanent capital. 12 U.S.C. 1426(a)(3). The 
totality of the GLB Act definitions make it clear that Class A stock 
cannot lawfully be used to satisfy a Bank's risk-based capital 
requirements.
    Some commenters also urged the Finance Board to allow Banks to 
apply at least some portion of the paid-in value of Class A stock 
against the operations risk capital charge because, unlike the credit 
and market risk requirements, an operations risk requirement was not 
specifically mandated by the GLB Act. However, as addressed elsewhere 
in this SUPPLEMENTARY INFORMATION section, the Finance Board considers 
an operations risk charge to be an integral part of the risk-based 
capital requirement. Further, as just discussed, by statute, Class A 
stock is not suitable risk-bearing capital for credit and market risk. 
Consistent with this approach, the Finance Board continues to believe 
that only permanent capital should be held against the operations risk 
requirement, which, along with the credit and market risk requirements, 
forms the overall risk-based capital requirement.
    More generally, with regard to the magnitude of the risk-based 
capital charges, estimates by the Finance Board staff indicate that the 
total risk-based capital charges will not be onerous to the Banks as 
some commenters have suggested, given the Banks' current balance sheets 
and risk profiles. Even estimates of the market risk capital charges 
produced by the Banks' consultant, which involved stress scenarios that 
would be more rigorous than those required under the proposed rule, did 
not suggest that the capital requirements being adopted here would be 
unreasonable. Specifically, the Finance Board anticipates that at least 
at the time of implementation of the capital plans, the risk-based 
capital requirement for all Banks will be below the minimum total 
capital leverage requirements set forth in the GLB Act. More 
importantly, as addressed more fully in the separate credit, market and 
operations risk sections, the Finance Board believes that the 
approaches adopted for calculating individual risk-based charges are 
reasonable, given available information and the technical capabilities 
of the Banks. Overall, the Finance Board believes that the risk-based 
capital charges will adequately reflect the risks faced by the Banks.
    In addition, as discussed in the SUPPLEMENTARY INFORMATION section 
of the proposed rule, the Finance Board considered all aspects of 
OFHEO's proposed risk-based capital rule in developing the proposed 
rule, as well as in developing the final rule. The GLB Act requires the 
Finance Board to give due consideration to the OFHEO capital rule in 
developing the market risk

[[Page 8283]]

component of the risk-based capital requirement for the Banks, but 
nothing in the GLB Act requires the Finance Board to defer to the OFHEO 
regulation, either with regard to the market risk or other components 
of this rule. See 65 FR at 43426-27 (July 13, 2000); Am. Fed'n of Gov't 
Employees v. Donovan, 1982 WL 2167 *3 (D.D.C.) (the use of the terms 
``due consideration'' in the Service Contract Act of 1965 ``are much 
more nearly precatory than mandatory [and] have a procedural 
implication,'' and do not mean ``equivalent to''). Neither does 
anything in the GLB Act require that the Finance Board's risk-based 
capital requirements result in the same or similar risk-based charges 
for the Banks and for Fannie Mae or Freddie Mac. In fact, Congress 
established a different risk-based capital stress test and different 
minimum capital levels for the Banks than it did for Fannie Mae and 
Freddie Mac.\8\ Compare 12 U.S.C. 1426(a)(2), (a)(3), to 12 U.S.C. 
4611, 4612. Nevertheless, the Finance Board does not believe that the 
capital requirements adopted herein are inconsistent with those 
governing Fannie Mae or Freddie Mac, after taking into account the 
differences in the relevant statutes and the businesses of the three 
GSEs. See 65 FR at 43426.
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    \8\ For example, the GLB Act requires that the Finance Board 
develop a stress test that rigorously tests for changes in interest 
rates, interest rate volatility and changes in the shape of the 
yield curve, while the statutory requirements governing Fannie Mae 
and Freddie Mac set forth specific scenarios for downward and upward 
shocks in interest rates.
---------------------------------------------------------------------------

    Some commenters requested clarification on certain aspects of the 
minimum risk-based capital requirement. One Bank urged the Finance 
Board to specify that, for purposes of the minimum risk-based capital 
requirement of Sec. 932.3(a), unrealized gains recorded as assets on 
the Bank's balance sheet should receive a risk-weighting of zero 
because ``any risks associated with these balances is adequately 
covered by the [risk-based capital] requirements for credit risk.'' The 
minimum risk-based capital charge set forth at Sec. 932.3 as adopted is 
the sum of a Bank's credit, market and operations risk charges 
calculated in accordance Sec. 932.4, Sec. 932.5 and Sec. 932.6. 
Contrary to the commenter's request, Sec. 932.3 does not require a 
charge independent of these components and does not directly assign 
risk weights to assets. However, by way of clarification, the credit 
risk capital charge that will be calculated under Sec. 932.4, as 
adopted herein, will apply to the underlying derivative contract or 
asset, and there will be no additional credit risk capital charge 
applied to the associated unrealized gain that is carried on the Bank's 
balance sheet as an asset. Similarly, when calculating the market risk 
charge using its approved internal model, a Bank will be expected to 
``stress'' the value of the underlying derivative contract or asset 
only.
    Another commenter requested clarification of when and how ``safety 
and soundness'' concerns may prompt the Finance Board to require a Bank 
pursuant to Sec. 932.3(b) to increase its permanent capital above the 
minimum levels mandated by Sec. 932.3(a). The primary duty of the 
Finance Board is to ensure that the Banks operate in a ``financially 
safe and sound manner.'' 12 U.S.C. 1422a(a)(3)(A). The Bank Act has 
long provided the Finance Board or its predecessor agency the authority 
to take actions to carry out that duty and other responsibilities under 
the Bank Act. 12 U.S.C. 1422b. Safety and soundness concerns can arise 
in numerous circumstances and have to be addressed on a case-by-case 
basis or for the Bank System as a whole. Section 932.3(b) of the final 
rule is consistent with the duties and authority of the Finance Board 
under the Bank Act and will be implemented as is necessary and 
authorized to carry out those duties.
    Overall, however, it is highly unlikely that the authority under 
Sec. 932.3(b) will be used, given the degree of oversight exercised by 
the Finance Board, the ability of the Banks to make adjustments in 
their capital plans, the Finance Board's flexibility to make 
adjustments to the capital requirements, and the presence of backstop 
provisions in the capital rule, such as the market value of capital 
test in the market risk capital requirement. Nonetheless, Sec. 932.2(b) 
of the final rule is an additional safeguard against unanticipated 
events that could result in anticipated or actual impairment of a 
Bank's capital. Examples of such events could include a Bank's risk 
profile evolving in such a way that it is not adequately addressed by 
the then-current capital requirements, or a Bank's capital plan failing 
to meet expectations and generate sufficient capital given the risks 
faced by the Bank.

Section 932.4--Credit Risk Capital Requirement

    General. Proposed Sec. 932.4 set forth a general formula for 
calculating the credit risk capital charge for on-balance sheet assets 
and off-balance sheet items, including derivative contracts, held in a 
Bank's portfolio. For an asset or item, the credit risk capital charge 
would have been equal to the book value of the asset or the credit risk 
equivalent amount for an off-balance sheet item, multiplied by the 
appropriate credit risk percentage requirement. The credit risk 
percentage requirements were provided in four tables. The methodology 
used in developing the tables was discussed in the SUPPLEMENTARY 
INFORMATION section of the proposed rule. See 65 FR at 43421-24.
    The Finance Board received a number of comments about the credit 
risk capital requirement. Generally, the commenters indicated that the 
proposed rule showed sophistication in the treatment of credit risk and 
offered much more detailed credit weightings for various exposure 
classes, maturities and credit ratings than had ever been offered by 
other regulators. Commenters did, however, have a number of comments 
and concerns on specific issues, which are discussed in detail below.
    One general concern noted was that the proposed rule failed to 
capture the correlation between credit and market risk. Under the rule 
as proposed, the Banks would have been required to determine their 
credit and market risk requirements separately based upon different 
historical stress events. This approach is equivalent to assuming that 
the risks are highly and positively correlated, because the historical 
stress periods for each of the two risks are treated as if they 
coincide, regardless of whether they do in fact coincide. The Finance 
Board believes that this assumption is prudent. The Finance Board notes 
that there is research that the correlation in stress events (extremes) 
between market and credit risk is positive. See Mark Carey, 
``Dimensions of Credit Risk and Their Relationship to Economic Capital 
Requirements, to be published in Prudential Supervision: What Works, 
and What Doesn't, Frederic S. Mishkin, ed. (NBER and UC Press, 2001). 
As the commenters noted, this approach ensures that any estimation bias 
associated with overstating the correlation of credit and market risk 
during stress periods will result in capital charges that are 
conservative rather than deficient. From a safety and soundness 
perspective, the Finance Board believes this conservative approach is 
reasonable at this time and is consistent with the OFHEO proposed rule 
on risk-based capital.\9\ Further, although a joint estimation of the 
credit and market risk requirements would seem more appealing 
theoretically in

[[Page 8284]]

that the correlation between credit and market risk can be better 
measured, as a practical matter, joint estimation during stress periods 
is, for now, untested and more challenging analytically, and would not 
provide a technically sound basis for estimating capital charges at 
this time. Thus, the Finance Board believes that the conservative 
approach of the proposed rule best assures that the Banks will remain 
adequately capitalized and will continue to operate in a safe and sound 
manner throughout periods of future market stress.
---------------------------------------------------------------------------

    \9\ Because the OFHEO model examines both an upward and downward 
interest-rate shock, but with each subject to the same benchmark 
credit loss scenario, one of the two interest-rate shocks must be 
positively correlated with the credit risk losses.
---------------------------------------------------------------------------

    Another commenter stated that the Finance Board did not provide in 
the proposed rule sufficient detail of the parameters for internal 
credit models, which models, the commenter believed, will be heavily 
relied upon by the Banks. However, neither the proposed rule nor the 
final rule allow a Bank to calculate its credit risk capital 
requirement using an internal credit risk model. In two narrow 
circumstances, the rule, both as proposed and adopted, allows a Bank to 
use an internal model to calculate the potential future credit exposure 
(PFE) on a derivative contract or the credit equivalent amount on 
certain off-balance sheet items as an alternative to using the tables 
and formulas provided in the rule for estimating those values. In both 
cases, the Finance Board would review the models and the assumptions 
before allowing a Bank to employ the model. Moreover, neither the 
derivative contracts nor the off-balance sheet items in question 
represent a large amount of the Banks' balance sheets.
    Based on the comments received, the Finance Board made a number of 
changes to the credit risk capital requirement in the final rule. These 
changes, which are discussed in detail below, include refinements to 
the methodologies used in estimating the credit risk percentage 
requirements for Table 1.1, Table 1.2, and Table 1.3. The Finance Board 
also has changed in the final rule the method used to calculate the 
credit risk charge for derivative contracts and expanded the situations 
in which the Bank may reduce its capital charge for an asset hedged 
with a credit derivative. As explained below, while the Finance Board 
believes that the new method adopted for calculating the credit risk 
capital charge for derivatives better captures the true risk of the 
Banks' exposure to these instruments, the Finance Board does not 
believe that the change will have much practical effect on the level of 
the credit risk capital requirement because derivative contracts 
represent a very small part of the Banks' balance sheets.\10\ The 
Finance Board has adopted Sec. 932.4 of the final rule with the changes 
discussed below.
---------------------------------------------------------------------------

    \10\ As of December 31, 1999, the Banks' combined maximum credit 
exposure to derivative contracts was approximately $2 billion. This 
was a small amount compared to the Banks' assets of $633 billion or 
their capital of $30 billion.
---------------------------------------------------------------------------

    Table 1.1. The credit risk percentage requirements for Bank 
advances in the proposed rule were based on the general methodology 
used to set credit risk percentage requirements for credit exposures of 
rated assets, off-balance sheet items or derivative contracts other 
than advances and residential mortgages (Table 1.3). As discussed in 
more detail in the discussion of Table 1.3 below, the general 
methodology was based on the highest estimated (proportional) credit 
losses by rating category and maturity class observable over a two-year 
period during the interval 1970 to 1999.
    Several adjustments were made to the general methodology in setting 
the credit risk percentage requirements for advances. The general 
methodology was based on default and downgrade data on corporate bonds. 
For advances, only default data was used. Downgrade data really has no 
meaning because advances are fully collateralized and the Banks can 
require additional collateral at any time. Because the Banks have never 
incurred credit losses on their advances to a member, the Finance Board 
assumed, for purposes of establishing a default rate for advances, that 
advances would exhibit the same default patterns as the highest 
investment grade (triple-A) corporate bonds and that advances would 
have a recovery rate of 90 percent (i.e., a loss severity rate of 10 
percent). A 90 percent recovery rate was considered consistent with the 
over-collateralization and other protections afforded advances. A 
credit risk horizon equal to the remaining maturity of the advance was 
deemed more appropriate than imposing the maximum two-year horizon used 
in the general methodology, because advances are unique products of the 
Banks that cannot readily be sold in the marketplace like most of the 
other investments of the Banks and, therefore, would have to remain on 
the books until maturity. The probability of default was then measured 
as the maximum probability of a triple-A corporate issuer default, but 
over a period extending to the maturity of the advance.
    Adjustments also were made to the credit risk percentage 
requirements assigned to the shortest and longest remaining maturity 
classes. As calculated, the requirement for advances with a maturity of 
four years or less would be zero. However, recognizing that advances 
are not totally risk free, a minimum capital requirement of seven basis 
points was set to ensure that the Banks would hold sufficient capital, 
particularly in view of the GLB Act's recent amendments to the Bank Act 
which expanded the types of collateral available to support advances. 
See 12 U.S.C. 1430(a)(3); 65 FR 44414 (July 18, 2000). Further, as 
calculated for the proposed rule, the requirement for maturities 
greater than 10 years would have been 50 basis points. However, because 
the estimated capital charge for triple-A-rated residential mortgage 
assets (as presented in proposed Table 1.2) was less than 50 basis 
points, and because advances clearly have a better credit loss history 
than residential mortgages, advances with a remaining maturity of 
greater than 10 years were assigned a credit risk percentage 
requirement equivalent to the requirement for triple-A-rated 
residential mortgage assets. In the final rule, the requirement for 
advances with remaining maturities greater than 10 years was adjusted 
to reflect the revised methodology used to calculate credit risk 
requirement percentages for residential mortgage assets for Table 1.2. 
and is set at 35 basis points. The credit risk percentage requirement 
of 20 basis points for remaining maturities greater than 4 years up to 
7 years was based on actual default rates and remains the same in the 
final rule. For maturities of greater than 7 years up to 10 years, the 
credit risk percentage requirement, if based on actual default rates, 
would have been 40 basis points. In the final rule, however, the credit 
risk percentage requirement was reduced to 30 basis points to conform 
with the 35 basis point requirement for maturities greater than 10 
years.
    In the proposed rule, the Finance Board specifically requested 
comment on the methodology that should be used for setting the credit 
risk percentage requirements for advances and whether a more 
satisfactory analytical framework exists that could be used to 
determine more appropriate credit risk percentage requirements for 
advances.
    The Finance Board received several comments on the proposed credit 
risk percentage requirements for advances. One commenter was supportive 
of treating advances independently of underlying collateral; another 
stated that the less-than-four-year maturity advance percentage 
requirement was reasonable. However, commenters generally questioned 
whether the Finance Board had given adequate consideration to the 
nature of member borrowers, the strong collateral position

[[Page 8285]]

of the Banks and the additional security provided by the capital stock 
for advances in developing the credit risk percentage requirements for 
advances.
    Two Banks commented on a possible alternative analytical framework, 
which was suggested by a consultant to the Banks that could be used to 
derive the credit risk percentage requirements for advances. The 
consultant reviewed rating agency data and concluded that financial 
institution default rates are roughly 30 percent to 40 percent of 
corporate bond default rates. The consultant further reasoned that 
because Bank members are regulated financial institutions, and not 
corporate borrowers, default rates based on corporate borrowers were 
overstated.
    Additionally, the Banks believed that using recovery rates of 90 
percent understates the value of collateral pledged to support 
advances, which when properly accounted for on an estimated market 
value approach, would yield a value in excess of the underlying 
advances. One Bank suggested that the Finance Board consider requiring 
that collateral portfolios be further subjected to stress testing as an 
alternative input into the credit risk percentage requirement 
calculations for credit exposures arising from advances. The Bank also 
argued that the proposed rule did not take account of the fact that by 
statute, the capital stock investment of a member acts as additional 
security for advances. The Bank believed that recognition of the 
collateral and capital values available to the Banks should reduce the 
credit risk from advances to zero. The Bank further stated that from a 
safety and soundness perspective, the Finance Board and the Banks 
themselves should be more concerned with the adequacy of collateral 
methods and practices than in trying to determine a capital requirement 
from inappropriate statistics. The Bank asserted that mortgage data, 
which is available and frequently analyzed, should be the basis for 
determining credit exposures from secured advances.
    The Finance Board has considered all comments and believes that the 
methodology, described above, used to determine credit risk percentage 
requirements for advances does adequately consider the unique 
characteristics of advances. The fact that the credit risk percentage 
requirements for advances set forth in Table 1.1 of the final rule are 
lower than those for other residential mortgage assets set forth in 
Table 1.2 of the final rule demonstrates that the Finance Board 
explicitly recognizes that advances have less credit risk than other 
mortgage assets. This view is based upon, among other things, the fact 
that advances are well collateralized and are provided additional 
safeguards under the Bank Act. Further, as is addressed in greater 
detail in the discussion of Table 1.2, the Finance Board has considered 
available mortgage data in developing the credit risk percentage 
requirements for residential mortgage assets other than advances. 
Because this new approach lowered the credit risk percentage 
requirements for these residential mortgages assets, the credit risk 
percentage requirements for advances with remaining maturities in the 
categories of more-than-seven-years-to-ten-years and over-ten-years in 
Table 1.1 also have been lowered so that the credit risk percentage 
requirements for advances remain below the requirements for other 
residential mortgage assets. Thus, the final rule continues to 
recognize that advances have less credit risk than other mortgage 
assets.
    Further, the Finance Board does not believe that it will be 
realistic to eliminate credit risk charges for advances, as some 
commenters have urged. Given that advances are a large part of the 
Banks' total assets, the credit risk capital requirement--and the risk-
based capital requirements more generally--would not be credible if 
risk-based capital were not held against the credit risk of advances. 
Nor have the commenters provided enough information on other suggested 
approaches for estimating the credit risk percentage requirements for 
the Finance Board to implement these methodologies at this time. The 
Finance Board believes that the credit risk percentage requirements 
adopted in Table 1.1 recognize the unique characteristics of advances 
while, given current available information, still provide a 
conservative estimation of the risks presented by these assets. The 
Finance Board will consider amending its current methodology as better 
information and theoretical approaches become available.
    Table 1.2. The credit risk percentage requirements in the proposed 
rule for residential mortgage assets were based on a quantitative 
analysis of the default and downgrade experience of rated corporate 
bonds. However, the Finance Board received comments expressing the view 
that the credit quality of rated residential mortgage backed 
instruments (RMBS) is generally better than corporate bonds with 
similar ratings and tenor. The Finance Board, therefore, reviewed 
available information on rated RMBS downgrades and defaults. This 
information indicated that defaults have been extremely infrequent and 
that there have been proportionately fewer downgrades on RMBS than on 
otherwise similar corporate bonds. The magnitude of the difference in 
credit performance appeared relevant, even given the short history of 
the RMBS market.
    The Finance Board also found that the factors that affect rated 
RMBS are not typical of those that affect the credit quality of 
corporate bonds. Factors that appear to generally benefit the credit 
quality of rated RMBS include: The relative stability of home prices; 
the diversification in the underlying collateral; and the relatively 
predictable performance of the collateral pools. The Finance Board 
found these arguments persuasive and, as explained more fully below, 
has applied in the final rule a different basis on which to determine 
the capital charges for residential mortgage assets.
    Commenters also expressed the view that the capital charges in the 
proposed rule for BBB and lower rated residential mortgage assets 
exceeded the risk of these assets, some noting that bank and thrift 
depositories are only required to hold four percent risk based capital 
against unenhanced residential mortgages. The Finance Board generally 
took this view into account in developing a new basis for determining 
the capital charges in the final rule, but notes that Banks are only 
allowed to invest in investment grade assets and therefore the capital 
charges in the proposed rule for residential mortgage assets rated 
below investment grade would have applied only if the assets were 
downgraded. The Finance Board also adopted in the final rule a lower 
but still stringent credit risk percentage requirement for residential 
mortgage assets rated below B. This final credit risk percentage 
requirement still accounts for the fact that these assets may only 
reside on the books of the Banks as a result of being downgraded from 
investment grade and are presumed to have some material credit quality 
issue.
    The Finance Board also recognizes that some of the concern with the 
credit risk percentage requirements for lower-rated mortgage assets may 
have been prompted by a lack of clarity in the proposed rule. The 
proposed rule did not make clear that the credit risk percentage 
requirements would be assigned for AMA based on the credit rating after 
application of the credit enhancement required under the Finance Board 
rules or application of any additional enhancements obtained by the 
Bank. Section 932.4(e)(2)(ii)(E) has been added to the final rule to

[[Page 8286]]

clarify this point. The final rule assumes the adequacy of the credit 
enhancement provided by members under the AMA requirements, and no 
credit risk capital charge need be applied to any potential exposures 
arising from these member-provided credit enhancements. The Finance 
Board may, however, require a Bank to apply a credit risk capital 
charge to any credit enhancement obtained by a Bank for AMA beyond that 
required under Sec. 955.3(b) if the Finance Board believes that there 
are deficiencies associated with those additional enhancements.
    While the final rule no longer relies upon quantitative data on the 
credit performance of rated corporate bonds as an indicator of the 
credit risk on mortgage assets, the Finance Board was unable to 
identify any adequate similar quantitative data to substitute for rated 
RMBS to conduct a similar analysis. The data is not readily available 
and, because of the brief history of the RMBS market, such data as 
could be found would not provide a robust information source regarding 
periods of economic stress. The Finance Board, therefore, has adopted 
in a final rule a significantly different approach than that employed 
in the proposed rule--one that is necessarily less mechanical in 
applying historical credit losses and one that considers the practices 
of other regulators and market participants. More specifically, the 
credit risk percentage requirements set forth in Table 1.2 of the final 
rule are based on an approach that considers: (1) The risk-based 
capital charges employed by regulated banks and thrifts for residential 
mortgage loan portfolios and for agency mortgage-backed securities 
(MBS); (2) the minimum MBS capital charges for Fannie Mae and Freddie 
Mac; and (3) the capital charges implicitly employed by the nationally 
recognized statistical rating organizations (NRSRO) when rating RMBS 
and mortgage insurance companies. The Finance Board also drew from the 
NRSRO's approach for determining the charges for the different rating 
categories in developing Table 1.2 of the final rule.
    The capital required for performing residential mortgage loans 
varies widely. Commercial banks and thrifts are required to hold 4 
percent risk-based capital against these loans. This requirement was 
enacted after the severe residential mortgage credit problems of the 
1980s. Also, it is applied uniformly to well-diversified, conforming 
loan portfolios and to the often riskier, non-diversified and non-
conforming portfolios. As such, the 4 percent requirement may be viewed 
as a conservative benchmark relative to the residential mortgage assets 
covered by Table 1.2 of the final rule.
    In contrast with the residential loan portfolio risk-based 
requirement, commercial banks and thrifts are only required to hold 1.6 
percent risk-based capital for GSE-issued MBS. The fact that many banks 
and thrift originators do not take advantage of this ability to 
transfer virtually all of their credit exposure on conforming loans to 
Fannie Mae and Freddie Mac may indicate that the banks and thrifts view 
the 2.4 percentage point credit risk differential as larger than the 
actual difference in the credit exposure between conforming loan pools 
and GSE MBS.
    The Finance Board also reviewed information regarding the credit 
enhancement required to raise unenhanced loan pools to the highest 
credit rating as an indication of the capital charge for unenhanced 
loan pools. For example, whole loan RMBS typically have AAA credit 
enhancement requirements ranging from four percent to seven percent. 
However, this may be a conservative indicator relative to the assets 
covered by this rule because many whole loan RMBS have non-conforming 
collateral due to loan size or credit issues, or the loans are 
adjustable rate mortgages (ARMs) or the collateral may have some 
element of geographic concentration. These factors are associated with 
higher loss experience. In contrast to whole loan RMBS, the Finance 
Board has observed that the AAA credit enhancement requirement on many 
Bank AMA pools falls below 4 percent.
    The Finance Board also noted the 0.45 percent statutorily-based 
minimum capital requirement for Fannie Mae and Freddie Mac MBS 
guarantees on conforming loans. This requirement on loans with no 
credit support is less than the Finance Board's credit risk percentage 
requirement for all but the highest rated mortgage asset. However, 
comparison between the OFHEO and the Finance Board requirements is 
difficult because of the different risk-based approaches of the two 
regulators. Moreover, the OFHEO requirement may not be indicative of a 
true risk-based charge. The 0.45 percent requirement is part of the 
statutory minimum total capital requirement for Fannie Mae and Freddie 
Mac. 12 U.S.C. 4612(a). In this respect, it is more comparable to the 
minimum total capital leverage requirements of the GLB Act than a risk-
based charge. Based on the foregoing, the Finance Board has decided to 
adopt in the final rule a benchmark exposure, and therefore a credit 
risk percentage requirement, of 2.4 percent for performing, well 
diversified, prime-quality, conforming residential mortgage loan pools.
    The Finance Board also has decided to use the general rating scheme 
and certain aspects of the RMBS rating process to determine the credit 
risk percentage requirements for residential mortgage assets. The 
Finance Board has found that the RMBS rating process employs useful 
standards for understanding the relative risk of residential mortgage 
pools. The rating process generally relies upon parameters for 
foreclosures and losses on residential mortgages under various economic 
stress scenarios. The rating process is typically systematic and 
appears to be based on a comprehensive review of information bearing on 
residential mortgage credit losses. Moreover, the Finance Board has 
found that the rating process for RMBS has relatively wide acceptance 
in the debt market, among secondary market participants and with 
mortgage insurers. The Finance Board was informed that, during stable, 
moderately favorable economic conditions, the unenhanced whole loan 
pools underlying RMBS could be considered to have credit quality in a 
range between BB and CCC. The Finance Board believes that, in general, 
prime-quality, conforming loan pools typically should have more 
favorable credit quality than RMBS whole-loan pools. Given this, the 
Finance Board has decided that, for purposes of the final rule, well-
diversified conforming loan pools should be considered to have an 
exposure benchmark similar to a BB rating.
    Based on the assumptions that well-diversified, prime-quality, 
conforming residential mortgage loan pools have a credit risk 
percentage requirement of 2.4 percent, and that such pools may be 
assumed to have credit quality similar to a BB-rated mortgage asset, 
the Finance Board has used the relative credit support required by the 
RMBS rating process to assign the credit charges for the other rating 
categories. Using this approach, the credit risk percentage 
requirements are derived based on the relative amount of credit support 
that is generally provided for the different rating grades as a 
percentage of the BB benchmark.
    Table 1.2 of the final rule presents the credit risk percentage 
requirements for FHLBanks' residential mortgage-related exposures. The 
credit risk percentage requirements presented in the final rule are 
based on the assumption that residential mortgage assets will typically 
consist of conforming, prime-quality loans with loan-to-value (LTV)

[[Page 8287]]

ratios below 80 percent or loans with higher LTV ratios that have 
appropriate levels of mortgage insurance. The Finance Board further 
assumes that the performance of any credit enhancement is assured in 
all relevant economic stress scenarios, and that the Banks' portfolios 
of residential mortgage assets will have appropriate diversification, 
and will not have geographic or other concentration factors that 
increase credit risk. Finally, the credit risk percentage requirements 
for mortgage assets adopted in the final rule take into account that 
the Banks are required to invest in mortgage-backed assets that have 
credit quality no less than that of the fourth highest credit rating 
class.
    A uniform application of the standard adopted in the final rule, 
however, would fail to address the fact that the credit risk of pooled 
residential mortgages may be concentrated in subordinated classes and 
support tranches. Support classes may also have longer weighted average 
lives than the senior classes they support. To address this concern, 
the Finance Board adopted a more stringent capital standard for such 
asset classes. It was further observed that AAA and AA classes were 
much less likely to feel the effect of subordination. For these 
reasons, it was determined that, for subordinated residential mortgage 
assets below AA, the credit risk percentage requirements should be the 
same as those for Rated Assets or Rated Items Other Than Advances or 
Residential Mortgage Assets in the 3 to 7 year maturity class of Table 
1.3 of the final rule. Table 1.2 of the final rule has been modified to 
add specific credit risk percentage requirements for these subordinated 
classes and support tranches of residential mortgage assets.
    The above-described approach best accommodates the information now 
available to the Finance Board. However, the Finance Board will 
continue to gather and analyze data on the performance of residential 
mortgage loan pools and RMBS, and intends to amend these capital 
charges if more complete and representative information and analysis 
becomes available.
    Table 1.3. In the proposed rule, the credit risk percentage 
requirements in Table 1.3 for credit exposures of rated assets, off-
balance sheet items or derivative contracts other than advances and 
residential mortgages were calculated from Moody's data on corporate 
bond performance. Specifically, the requirements were based on the 
highest estimated (proportional) credit losses by rating category and 
maturity class observable over a two-year period during the interval 
1970 to 1999. The Finance Board received only one comment on the 
methodology described in the proposed rule used to arrive at the 
requirements listed in Table 1.3. That commenter identified two 
concerns. First, only 30 years of performance data were used, whereas 
80 years of performance data are available. Second, and more 
importantly, single-year maximum default rates rather than long-run 
average default rates were used. The commenter added that the single-
year maximum approach would identify maximum default rates based on 
outlier results, hence the resulting rates need not be representative 
of the true relative differences in proportionate market value losses 
by rating class--the goal of a ratings-based approach.
    The Finance Board continues to believe that the most recent 30 
years of Moody's data includes a sufficient number of observations that 
are representative of the modern era. The Finance Board does see some 
merit in the single-year (actually a two-year period is presented in 
the proposed rule but the point is the same) versus long-run average 
concern. Not all of the changes recommended in this comment have been 
adopted in the final rule because basing requirements only on long-run 
averages would result in too little capital being available to support 
credit risk during periods of economic stress. However, the methodology 
for the final rule has been modified to eliminate the single-year 
concern, thus preserving the true differences in proportionate market 
value losses by rating class, while retaining a capital requirement 
sufficient to support credit risk during periods of economic stress. 
Under the modified approach, the long-run average default and downgrade 
rate of each rating category/maturity class is multiplied by a factor 
that represents an average (over rating category and maturity class) of 
stress-period increases in those rates. This method of determining the 
credit risk percentage requirements in the final rule is described in 
detail below, and resulted in modest changes in both directions to the 
proposed credit risk percentage requirements.
    Two factors were considered in selecting credit risk categories for 
assets on which to impose distinct credit risk capital requirements in 
percentage terms: an objective measure of the credit risk of the asset, 
and the term structure, or maturity, of the asset. The credit ratings 
assigned by NRSROs were used as an objective standard upon which to 
categorize assets by credit risk. Such ratings are generally accepted 
in the market place as well as by other regulators. Of course, not all 
assets are rated by NRSROs, but most Bank investments either are rated 
by an NRSRO or can be evaluated internally and assigned a credit rating 
using models or other methods consistent with the rating methodologies 
used by NRSROs. In keeping with the standards established by 
NRSROs,\11\ the following rating categories were used in the base 
analysis:
---------------------------------------------------------------------------

    \11\ Each category used by the NRSROs has modifiers, either plus 
and minus or 1, 2 or 3. However, the derivation of credit risk 
percentage requirements described here does not take such modifiers 
into consideration because consideration of modifiers would triple 
the number of credit risk categories and significantly reduce the 
historical time period for which data on defaults and credit 
downgrades is available. To achieve more robust estimates of actual 
credit losses by category, the modifiers are ignored.
---------------------------------------------------------------------------

    <bullet> AAA  Highest investment grade.
    <bullet> AA  Second highest investment grade.
    <bullet> A  Third highest investment grade.
    <bullet> BBB  Fourth highest investment grade.
    <bullet> BB  Highest below investment grade.
    <bullet> B  Second highest below investment grade.
    <bullet> CCC-C  Substantial risk of default.
    Credit ratings do not, however, reflect how the credit risk of a 
rated asset might vary according to its remaining maturity. For 
example, actual data indicate that the credit risk of a AA-rated asset 
with a one-year maturity is clearly less than that of an AA-rated asset 
with a 10-year maturity. In fact, other financial regulators have begun 
to recognize the term structure of credit risk in their risk-based 
capital requirements.\12\ Consequently, each of the 7 credit rating 
grades was expanded to reflect 14 different remaining maturity classes 
resulting in 98 credit risk categories overall. The maturity classes 
were selected to show how significantly credit risk percentage 
requirements might change given modest changes in remaining maturity. 
They also capture the entire term structure of credit spreads, but 
primarily include maturities for which data is more readily available 
because there is sufficient trading activity. The remaining maturities 
used were six and nine months, and 1, 1.5, 2, 3, 4, 5, 7, 10, 15, 20, 
25, and 30 years.
---------------------------------------------------------------------------

    \12\ See 65 FR at 43421.
---------------------------------------------------------------------------

    For each of the 98 credit risk categories, credit losses from 
defaults and downgrades were determined as a proportion of face value 
for each two-year horizon between 1970 and 1999. Furthermore, to 
simplify the analysis, beginning dates for each horizon were

[[Page 8288]]

limited to the first day of each month in the sample period. Thus, the 
first historical period covered January 1, 1970 through December 31, 
1971, the second historical period covered February 1, 1970 through 
January 31, 1972, etc., and the last extended from January 1, 1998 
through December 31, 1999, for a total of 336 periods examined for each 
credit risk category.
    A two-year historical period horizon is a more conservative 
assumption than the one-year horizon, which is perhaps more commonly 
assumed by commercial banks. As stated by the Federal Reserve System 
Task Force on Internal Credit Risk Models, ``[I]t is often suggested 
that one year represents a reasonable interval over which a bank--in 
the normal course of business--could mitigate its credit exposures.'' 
\13\ Also, according to a survey conducted by the BCBS, most of the 
responding commercial banks used a one-year horizon for calculating 
economic capital for credit risk in the banking book.\14\ Nonetheless, 
the survey did provide some support for a longer historical period 
horizon. For example, some responding banks used a five-year horizon or 
modeled losses over the maturity of the exposure. In addition, based on 
experience in the U.S. and elsewhere, more than one year is often 
needed to resolve asset-quality problems at troubled banks. Therefore, 
the Finance Board believes that the two-year horizon would better 
assure that adequate capital is maintained against the credit risks 
faced by the Banks than would a shorter time horizon.
---------------------------------------------------------------------------

    \13\ See ``Credit Risk Models at Major U.S. Banking 
Institutions: Current State of the Art and Implications for 
Assessment of Capital Adequacy,'' Federal Reserve System Task Force 
on Internal Credit Risk Models, May 1998, p. 10.
    \14\ See ``Credit Risk Modeling: Current Practices and 
Applications'', BCBS, April 1999.
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    All historical data on defaults and downgrades were obtained from 
Moody's Default Risk Service. The Moody's database contains information 
on defaults, rating downgrades and market prices for bonds in default, 
i.e., recovery rates, that span multiple credit cycles from 1970 to the 
present and covers over 8,000 corporate issuers, 66,000 corporate 
bonds, 196,000 ratings actions, and 1,200 defaulted bonds. The data set 
was restricted to U.S.-based entities, because the Banks are not 
permitted to invest in instruments issued by non-U.S. entities, except 
U.S. branches and agency offices of foreign banks.
    Credit losses associated with defaults were assumed to be 100 
percent of the issues' face value. According to a study of defaults by 
Moody's, the average recovery rate (based on market prices) for bonds 
in default has been observed as low as 21 percent and 30 percent in 
1932 and 1990, respectively, corresponding to peaks in corporate 
default activity.\15\ Furthermore, the average recovery rate for senior 
unsecured public debt was $51.31 per $100 defaulted face value with a 
standard deviation of 26.30 percent during the 1977-98 period.
---------------------------------------------------------------------------

    \15\ See ``Historical Default Rates of Corporate Bond Issuers, 
1920-1998,'' Moody's Investors Service, January 1999.
---------------------------------------------------------------------------

    Credit losses associated with downgrades were determined based on 
approximations of the proportionate difference between the initial 
market value (corresponding to the initial credit rating) and the 
market value subsequent to the downgrade. These approximations were 
derived from the maximum loss in market value associated with 
downgrades, by credit rating category, observed in data covering 1992-
2000. Pre-1992 data were not available. For example, the maximum shift 
in credit spread for a 10-year bond from AAA to AA was observed to be 
29 basis points over the period 1992-2000. Similarly, the shifts from 
AA to A, and A to BBB, were 57 and 70 basis points, respectively. 
Shifts of more than one credit rating within a period, such as from AAA 
to A, were derived as the sum of the corresponding single rating 
shifts, or in this case the sum of the shift in spreads from AAA to AA 
and AA to A, or 86 basis points. For downgrades to CCC-C rating 
categories, a loss in market value of 100 percent was assumed based on 
the historical evidence that, over a specific three-month horizon, all 
of the U.S.-based issuers rated CCC-C in the Moody's database actually 
did default.\16\
---------------------------------------------------------------------------

    \16\ Based on Moody's Default Risk Service database, all issuers 
rated CCC-C defaulted between March 1, 1984 and May 31, 1984.
---------------------------------------------------------------------------

    For each of the 336 periods examined for each of the 98 credit risk 
categories, losses generated by downgrades and defaults were added to 
gains from ratings increases (determined in a like manner to losses 
from downgrades) to determine a change in value. Each change in value 
was then divided by the corresponding face value to arrive at a loss 
rate. The resulting loss rates were aggregated to reduce the number of 
maturity classes from 14 to 5. Specifically, for each credit rating, 
maturity classes of less than or equal to 1 year, more than 1 year to 3 
years, more than 3 years to 7 years, more than 7 years to 10 years, and 
over 10 years were created. The loss rates were aggregated in the 
maturity classes by simple averaging with overlapping endpoints, such 
that the 3 year loss rates were included in the averaging to arrive at 
the 1 to 3 year and 3 to7 year maturity class loss rates. Loss rate 
means, distributions, and maximum values were then calculated for each 
of the 30 remaining credit risk categories (five maturity classes for 
each of the top 6 credit ratings). The loss rate distributions were not 
normally distributed. In addition, no isolated observations that could 
be considered outliers were observed. Consequently, a common stress 
level of loss rates was determined by averaging (for the 30 credit risk 
categories) the distance from the mean of the maximum loss rate divided 
by the standard deviation. The common stress level estimate was 3.22. 
The credit risk percentage requirements for Table 1.3 were then 
determined for each of the 30 credit risk categories as equal to the 
corresponding mean loss rate plus 3.22 times the corresponding standard 
deviation. These percentage requirements, as they appear in Table 1.3 
in the final rule, have been rounded to the nearest 5 hundredths, or, 
if below investment grade, to the nearest whole percent.
    Table 1.4. The proposed rule set forth credit risk percentage 
requirements for certain unrated assets in Table 1.4. These assets, 
which included cash, premises, plant and equipment, and certain debt 
and equity investments, had no relevant loss experience from which to 
calculate a credit risk percentage requirement. In the proposed rule, 
cash was assigned a credit risk percentage requirement of zero percent, 
as it was deemed not to present any credit risk to the Bank. All of a 
Bank's tangible assets, premises, plant and equipment, as well as any 
unrated debt or equity investments made by the Banks pursuant to 
Sec. 940.3(e) and (f),\17\ were assigned an eight percent credit risk 
percentage requirement. See 65 FR at 43423-24. As described below, the 
Finance Board received a few comments on proposed Table 1.4 but has not 
revised the table in the final rule.
---------------------------------------------------------------------------

    \17\ Table 1.4 of the proposed rule made a reference to unrated, 
targeted investments made under Sec. 940.3(a)(5) of the Finance 
Board's regulations. This reference was based on the types of 
targeted investments proposed in Sec. 940.3. See 65 FR 25676 (May 3, 
2000.) The Finance Board, when it adopted Sec. 940.3 in final rule 
form, listed the relevant targeted investments in Sec. 940.3(e), and 
altered the provision somewhat. See 65 FR 43969, 43972-74, 43981 
(July 17, 2000). Table 1.4 of this final rule has been corrected to 
conform its reference to the relevant targeted investments to the 
final version of Sec. 940.3 adopted by the Finance Board and to 
include unrated investments in Small Business Investment Companies 
(SBICs) as set forth in Sec. 940.3(f) which were inadvertently 
omitted from the proposed rule.

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[[Page 8289]]

    One commenter expressed concern that the credit risk percentage 
requirement for unrated assets made by the Banks would discourage 
certain new programs that have been initiated by the Banks, such as 
programs to purchase portions of loans for community economic projects 
or to fund community development. The commenter believed that the Banks 
would have been required to hold capital dollar-for-dollar for such 
investments. However, under both the proposed and the final rule, the 
Banks are required to hold only 8 percent capital for targeted 
investments made pursuant to Sec. 940.3(e) of the Finance Board's 
regulations. 12 CFR 940.3(e). These investments appear to include the 
investments described by the commenter.\18\ The 8 percent credit risk 
percentage requirement for targeted investments made under 
Sec. 940.3(e) is consistent with the capital requirements applicable to 
national banks with regard to public welfare investments. The targeted 
investments included in Table 1.4 would be certain debt or equity 
investments that advance specific public welfare goals. See 65 FR 
43969, 43972-74 (July 17, 2000). In general, under the final version of 
the capital rule, the Banks are required to hold 100 percent capital 
only when rated investments or residential mortgage assets are 
downgraded to below single-B after the Bank has purchased the 
investment.
---------------------------------------------------------------------------

    \18\ Moreover, if the commenter intended to describe investments 
that were not included in Sec. 940.3(e) and (f), the Finance Board 
does not believe, based on its understanding of the comment, that 
the Banks would have authority to make such investments because the 
Banks are not generally allowed to invest in assets that are rated 
below investment grade.
---------------------------------------------------------------------------

    Another commenter expressed concern that the proposed capital 
requirement of 8 percent for investments made under Sec. 940.3(e) of 
the Finance Board's regulations could greatly discourage the Banks from 
making these innovative, mission-oriented investments. The commenter 
believes that the 8 percent requirement for such investments relative 
to the capital requirement of only 0.35 percent for long-term advances 
may cause the Banks to consider making these investments prohibitive. 
The commenter suggested two approaches for remedying this concern. 
First, the commenter suggested that the Finance Board permit each Bank 
to hold a substantially lower level of capital for a limited volume or 
range of targeted investments. The commenter believed that a modest 
volume of from $200 million to $300 million would not pose any risk to 
the safety and soundness of the System, but would greatly encourage the 
Banks to make and become comfortable with targeted investments.
    The commenter's second approach to overcome concerns about whether 
the Banks would make targeted investments given an 8 percent credit 
risk percentage requirement was that the Finance Board permit a much 
lower capital requirement for senior debt investments in community 
development funds that raise at least a dollar of equity for every two 
dollars of such investments. According to the commenter, the community 
development entity could use the proceeds of the Bank investments to 
finance activities eligible under Sec. 940.3(e)(3), and the structure 
would be similar to that for SBICs. The commenter posited that the 
community development fund would have to lose its entire equity stake 
before the Bank's senior debt investment would be jeopardized, so that 
a much smaller risk-based capital requirement would be justified.
    The Finance Board believes that the fact that targeted investments 
are included as Core Mission Activities will serve as adequate 
encouragement for the Banks to make such investments, regardless of the 
credit risk capital charges. See 12 CFR part 940. Further, the Finance 
Board believes that it is imperative to the safety and soundness of the 
Bank System that the Banks hold sufficient capital to cover the risks 
of permissible investments. As discussed above, the 8 percent credit 
risk percentage requirement for targeted investments made under 
Sec. 940.3(e) is consistent with the capital requirements applicable to 
national banks with regard to public welfare investments. The targeted 
investments included in Table 1.4 would be certain debt or equity 
investments that advance specific public welfare goals.
    Derivative contracts. As already discussed, the final rule has been 
changed to reflect the fact that implementation of SFAS 133 means that 
derivative contracts cannot solely be described as off-balance sheet 
items. More importantly, however, and for reasons unrelated to SFAS 
133, the method of calculating the credit risk capital charge and 
assigning the credit risk percentage requirements for derivative 
contracts has been changed, as discussed below.
    Under the proposed rule, the credit risk capital charge for a 
derivative contract would have been calculated by adding the current 
credit exposure to the PFE and then multiplying that sum by the credit 
risk percentage requirement from Table 1.3 corresponding to the 
remaining maturity of the derivative contract and the credit rating of 
the counterparty. This proposed approach was adopted directly from the 
Finance Board's FMMA proposed rulemaking. 64 FR 52163 (September 27, 
1999). The FMMA, however, did not consider the term structure of credit 
risk when calculating credit risk capital charges. Because Sec. 932.4 
of the final rule does consider the term structure of credit risk, the 
Finance Board has adopted an approach to calculating the credit risk 
capital charge for derivative contracts that recognizes the term 
structure of credit risk.
    Under Sec. 932.4(d) of the final rule, the credit risk capital 
charge for a derivative contract will be the sum of two components. The 
first component will equal the product of the current credit exposure 
of the derivative contract multiplied by the applicable credit risk 
percentage requirement for the derivative instrument. However, in 
assigning the correct credit risk percentage requirement, the current 
credit exposure will be assumed to have a maturity of less than one 
year, regardless of the actual remaining maturity of the derivative 
contract. This approach is consistent with the fact that the current 
credit exposure of a derivative contract represents the current market 
value of the derivative contract, and that the value will generally 
change over the short term. The Finance Board believes that it is 
reasonable, therefore, to treat the current credit exposure on a 
derivative contract as a short-term exposure.
    The second component of the credit risk capital charge for a 
derivative contract will equal the product of the PFE for a derivative 
contract multiplied by the assigned credit risk percentage requirement. 
For purposes of calculating the capital charge on the PFE, the credit 
risk percentage requirement under the final rule will be assigned based 
on the remaining maturity of the derivative contract and the credit 
rating of the counterparty. This approach is consistent with the fact 
that the PFE represents the highest future market value that the 
derivative contract may attain during its remaining life. Although the 
highest future market value for a derivative contract rarely will occur 
at the end of the derivative contract's life, the Finance Board is 
adopting a conservative approach to estimating the credit risk capital 
charge and is assuming that it will occur at the end of the life of the 
derivative contract. Thus, the credit risk percentage requirement 
applied to the PFE of a derivative contract will correspond to

[[Page 8290]]

the remaining maturity of the derivative contract.
    The proposed rule also did not differentiate between a derivative 
contract entered into with a counterparty that was a member of the 
Bank, and one entered into with a counterparty that was not a member of 
the Bank. In the final rule, however, the Finance Board has determined 
to treat the credit exposure arising from a derivative contract with a 
member institution like an advance, because the Banks generally apply 
the same collateral requirements to these exposures, and the legal 
rights with regard to the collateral are comparable to those with 
regard to the collateral for advances. See e.g., 12 U.S.C. 1430(e) 
(1994). Thus, the credit risk from the derivative contract should be 
similar to that from an advance. Under Sec. 932.4(d)(2) of the final 
rule, the credit risk capital charge for derivative contracts entered 
into between a Bank and one of its member institutions will be 
calculated as the sum of the credit risk capital charges on the current 
credit exposure and the PFE, as described above, except that the 
applicable credit risk percentage requirements will be found in Table 
1.1, which sets forth the credit risk percentage requirements for 
advances. For example, the credit risk percentage requirements 
applicable to the current credit exposure for a derivative contract 
entered into with a member institution would be that in Table 1.1 
corresponding to an advance with a remaining maturity less than or 
equal to four years, and the credit risk percentage requirement 
applicable to the PFE for the same derivative contract would be that in 
Table 1.1 corresponding to an advance with the same remaining maturity 
as the derivative contract.\19\
---------------------------------------------------------------------------

    \19\ For a derivative contract with a nonmember, the applicable 
credit risk percentage requirement would be found in Table 1.3. For 
the current credit exposure, the applicable credit risk percentage 
requirement under the final rule will be assigned based on the 
credit rating of the counterparty and the assumption that the 
applicable remaining maturity is less than or equal to one year 
(unless, as discussed elsewhere in this section, the exposure is 
collateralized). For the PFE, the applicable credit risk percentage 
requirement will be based on the remaining maturity of the 
derivative contract and the credit rating of the counterparty.
---------------------------------------------------------------------------

    In addition, Sec. 932.4(d) of the final rule provides that 
collateral held against the credit exposure arising from a derivative 
contract can only be applied to reduce the credit risk capital charge 
calculated for the current credit exposure. The collateral must be held 
and the reduced credit risk capital charge calculated in accordance 
with the provisions of Sec. 932.4(e)(2)(ii)(B) of the final rule, which 
are discussed in more detail below. Collateral cannot be used to reduce 
the credit risk capital charge calculated for a derivative contract's 
PFE. This approach is consistent with the fact that the Banks and 
derivative dealers more generally hold collateral against the current 
credit exposure and not against the PFE.
    The final rule also contains a technical change to clarify how the 
calculation of the net PFE for derivative contracts subject to a 
qualifying bilateral netting agreement should be applied \20\ Under the 
proposed rule, one net PFE value would have been calculated for all the 
derivative contracts subject to the same qualifying bilateral netting 
agreement, even though those contracts all may have had different 
remaining maturities. The proposed rule failed to direct how this 
single, net sum could be allocated among the different contracts when 
assigning the credit risk percentage requirement from Table 1.3 (which 
would have been assigned based in part on remaining maturity of the 
derivative contracts) and calculating the credit risk capital charges. 
The Finance Board has addressed this omission in the final rule by 
clarifying that the PFE for derivative contracts subject to a 
qualifying bilateral netting agreement should be calculated on a 
contract-by-contract basis. However, the calculation of the PFE for 
derivative contracts subject to the bilateral netting agreement, both 
as proposed and in the final rule, is based on the same theoretical 
approach recommended by the BCBS and federal banking regulators. See 
e.g., 12 CFR part 3, Appendix A (2000) (regulation of the Office of the 
Comptroller of the Currency, Department of the Treasury). As such, the 
formula for calculating the PFE in the final rule still allows for the 
beneficial effects of netting to reduce the PFE.
---------------------------------------------------------------------------

    \20\ A qualifying bilateral netting agreement must meet the 
requirements set forth at Sec. 932.4(h)(3) of the final rule.
---------------------------------------------------------------------------

    Certain additional technical changes were made to the provisions in 
the final rule concerning the applications of the credit conversion 
factors given in Table 3 of part 932 that are used to calculate the PFE 
for a single derivative contract. Under the final rule, the PFE for a 
single derivative contract (not subject to a qualifying bilateral 
netting contract) is found by multiplying the effective notional amount 
of the contract, rather than just the notional amount as in the 
proposed rule, by the correct credit conversion factor from Table 3. 
The effective notional amount takes account of any added leverage that 
may be built into a derivative contract by multipliers or other means 
and therefore provides a more accurate basis for calculating a Bank's 
credit exposure under a derivative contract.\21\
---------------------------------------------------------------------------

    \21\ For example, if a derivative contract is referenced to a 
multiple of an interest rate index, the contract would contain 
greater leverage (and therefore be potentially riskier) than a 
derivative contract without the multiplier. In such a case, the 
effective notional value would be greater than the notional value to 
account for the higher credit exposure under the more highly 
leveraged contract.
---------------------------------------------------------------------------

    Further, a change in the final rule has been made with regard to 
the credit conversion factor from Table 3 that would be applied in 
order to calculate the PFE of a credit derivative. Under the proposed 
rule, the credit conversion factor used for interest rate contracts 
would have also been applied to calculate the PFE on credit derivative 
contracts. The Federal Reserve System (Federal Reserve), however, 
applies factors applicable to equity or other commodity contracts when 
calculating the PFE for credit derivatives. See SR 97-18 (Gen.), 
Division of Banking Supervision and Regulations, Board of Governors of 
the Federal Reserve System (June 13, 1997). In effect, the Federal 
Reserve is treating the credit derivative contracts as riskier 
instruments than did the Finance Board in the proposed rule. Given the 
conservative approach taken by the Finance Board in developing these 
capital requirements, the final rule calculates the PFE for credit 
derivative contracts using the same approach as that used by the 
Federal Reserve.
    Collateral. Section 932.4(d)(2)(ii)(B) of the proposed rule 
provided that, when an asset or item was not directly rated by a NRSRO, 
the credit rating of an obligor counterparty, third party obligor or of 
the collateral backing the asset or item would have to be used to 
assign the applicable credit risk percentage requirement.\22\ For 
derivative contracts, which are generally not directly rated by an 
NRSRO, the proposed provision would have allowed a Bank to use the 
credit rating of the counterparty or of the collateral, whichever 
rating was more favorable. However, substituting the credit rating of 
the counterparty, third party obligor, or collateral would have been 
allowed only to the extent that the collateral or guarantee backed the 
underlying credit exposure. Further, collateral would had to have been 
held in accordance with the specific requirements set forth in proposed 
Sec. 932.4(d)(2)(ii) to receive the treatment afforded by that 
provision. While the Finance Board has made some clarifying

[[Page 8291]]

changes to the collateral provision in the final rule, it has adopted 
this provision substantially as proposed.
---------------------------------------------------------------------------

    \22\ Because Sec. 932.4 of the final rule has been reorganized, 
the collateral provision is found at Sec. 932.4(e)(2)(ii)(B) of the 
final rule.
---------------------------------------------------------------------------

    The Finance Board received several comments on the proposed 
collateral provision. A number of the commenters requested 
clarification of how collateral should be applied to reduce the credit 
risk capital charge for an instrument. One commenter asked specifically 
if the provision would allow for the reduction of the credit risk 
capital charge for advances if it could be demonstrated that the 
mortgages backing the advances met an AAA or AA rating standard. The 
Finance Board did not intend that the collateral provision would be 
applied to advances. The credit risk percentage requirements for 
advances provided in Table 1.1 of both the proposed and final rule were 
developed based on the assumption that advances are well-
collateralized. No additional reduction in the credit risk capital 
requirement for advances was contemplated. In effect, the collateral 
provision is intended to apply only to assets, items or derivative 
contracts covered by Table 1.3 (i.e., rated assets or items other than 
advances or residential mortgage assets). The final rule has been 
changed to make this clear.
    Further, as already discussed, the final rule treats credit 
exposures arising from derivative contracts entered into between a Bank 
and its member as an advance for the purposes of assigning the credit 
risk percentage requirement. This treatment would not make it 
advantageous for a Bank to apply the collateral provision when 
calculating the credit risk capital charge for derivative contracts 
with a member, unless the collateral was cash or U.S. government 
securities. Where a member provides cash or government securities to 
collateralize a derivative exposure, in accordance with the 
requirements of the collateral provision, the Finance Board will allow 
a Bank to apply the credit risk percentage requirement for cash or 
government securities to that portion of the current credit exposure 
that is backed by the collateral.
    Some commenters believed that collateral held against derivative 
contracts should either reduce the current credit exposure of the 
derivative contract dollar-for-dollar, or reduce the credit risk 
capital charge for a derivative contract dollar-for-dollar. The Finance 
Board disagrees. Obtaining collateral to back an asset, item or 
derivative contract does not eliminate credit risk for the Bank, as 
would be implied if the Finance Board allowed a dollar reduction in the 
credit exposure or the credit risk capital charge for each dollar of 
collateral posted. Instead, the Bank is substituting the credit risk 
associated with the collateral for that associated with the 
counterparty to the derivative contract.\23\ In practice, however, 
under both the proposed and final rule, if the collateral backing the 
credit exposure arising from a derivative contract is cash or U.S. 
government securities, both of which carry a credit risk percentage 
requirement of zero, the credit risk capital charge for that portion of 
the credit exposure backed by the collateral would be zero.
---------------------------------------------------------------------------

    \23\ This argument would apply to any asset, item or derivative 
contract backed by a guarantee or collateral.
---------------------------------------------------------------------------

    The Finance Board also has made revisions in the final rule to the 
conditions that must be met before an asset, item or derivative 
contract will be deemed to be backed by collateral. First, 
Sec. 932.4(e)(2)(ii)(B)(1) of the final rule was changed to make clear 
that collateral could be held by an affiliate of a member if permitted 
under the Bank's collateral agreement. This change is in line with 
practices concerning collateral otherwise allowed by the Finance Board 
and was made in response to a request by a commenter. See 12 CFR 950.7 
(as amended by 65 FR 44414, 44429-30 (July 18, 2000)). The Finance 
Board also has changed the final rule to make clear that to be 
acceptable under the final rule, the required discount, or haircut, 
applied to the value of the collateral must be sufficient to protect 
against price declines during the holding period and to cover the 
likely costs of liquidation of the collateral. A Bank must apply a 
haircut to the value of the collateral before calculating the portion 
of the credit exposure that is deemed to be backed by the collateral.
    To better illustrate how the collateral provision in the final rule 
will be applied, the Finance Board is providing the following examples.

    Example 1: Assume that a Bank entered a derivative contract with 
a counterparty rated at the highest investment grade by all NRSROs. 
The remaining maturity on the derivative contract is 5 years. Assume 
further that at the time the credit risk capital charge was being 
calculated, the derivative contract had a current credit exposure 
equal to $10 million and the Bank held U.S. government securities 
valued at $4 million after applying an acceptable haircut to those 
securities, to collateralize that derivative exposure. In this case, 
the collateral would be deemed to back $4 million of the current 
credit exposure. To calculate the credit risk capital charge on the 
current credit exposure, the $4 million of the credit equivalent 
amount backed by collateral would be multiplied by the credit risk 
percentage requirements assigned to U.S. government securities, 
which is zero. The remaining $6 million would be multiplied by the 
credit risk percentage requirement as shown in Table 1.3 for the 
highest investment grade credit rating and a remaining maturity 
equal to one year or less. To calculate the credit risk capital 
charge on the PFE, the PFE would be calculated under Sec. 932.4(g) 
or (h) of the final rule, as applicable, and that amount would be 
multiplied by the credit risk percentage requirement from Table 1.3 
corresponding to the highest investment grade and a remaining 
maturity equal to 5 years (i.e., the remaining maturity category in 
Table 1.3 of greater than 3 years up to and including 7 years).
    Example 2: Assume the same facts as in Example 1 but instead the 
Bank holds U.S. government securities valued at $12 million after 
applying the appropriate haircut. The collateral would be sufficient 
to cover the total current credit exposure so that the current 
credit exposure would be multiplied by the credit risk percentage 
requirement for government securities, which is zero. The resulting 
capital risk credit charge on the current credit exposure would be 
zero. The fact that the exposure is overcollateralized does not 
affect the calculation of the credit risk capital charge for the 
PFE, which must be calculated as required in Example 1.
    Example 3: Assume the same facts as under Example 1, but assume 
that the collateral is not held in accordance with 
Sec. 932.4(e)(2)(ii)(B)(1)-(5). In this case, the current credit 
exposure would be deemed not to be collateralized and the credit 
risk capital charge for the current credit exposure would be 
calculated based on the credit risk percentage requirement in Table 
1.3 corresponding to the credit rating of the counterparty (i.e., 
the highest investment grade) and a remaining maturity less than or 
equal to one year. The credit risk capital charge for the PFE would 
be calculated as in Example 1.

    Short term credit rating. The proposed rule did not provide 
specific credit risk percentage requirements for assets, such as 
commercial paper, that have stated maturities of less than one year 
and, therefore, may have a short-term credit rating from an NRSRO. 
Generally, NRSROs use three short-term credit ratings that are 
considered investment grade, including A-1, A-2 or A-3 (used by S&P), 
or P-1, P-2 or P-3 (used by Moody's). Research done by Moody's 
demonstrates that the three investment grade short-term credit ratings 
correspond to the four investment grade long-term credit ratings. See 
``Commercial Paper Defaults and Rating Transactions,'' 1972-1998, 
Moody's Investors Service (May 1998); ``Moody's Credit Opinions: 
Financial Institutions,'' Moody's Investors Service (December 1999). In 
rating short-term commercial paper, Moody's assigns the highest short-
term credit rating (P-1) to issuers that have long-term senior 
unsecured ratings ranging from the highest investment grade (Aaa) to 
the third highest investment grade (A), and assigns the second highest 
short-term

[[Page 8292]]

rating (P-2) to long-term credit ratings ranging from the third highest 
investment grade to the fourth highest investment grade. Id. The lowest 
investment grade short-term rating (P-3) is reserved solely for the 
fourth highest long-term credit rating. Id. A comparison of U.S. 
financial institutions' short-term ratings by Moody's shows that the 
highest short-term credit rating (P-1) is more commonly associated with 
the third highest long-term credit rating (A) than the highest (Aaa) or 
second highest (Aa) long-term credit-ratings. Id. Based on this 
research and the fact that credit risk percentage requirements for 
long-term credit risk ratings have been developed, the Finance Board 
has added Sec. 932.4(e)(2)(ii)(C) to the final rule to address assets 
with short-term credit ratings. Under this new provision, the 
applicable credit risk percentage requirement from Table 1.3 for an 
asset with a short-term credit rating from a given NRSRO will be based 
on the remaining maturity of the asset and the long-term credit rating 
assigned by the same NRSRO to the issuer of the asset.
    Although highly unlikely, there are also occasional situations 
where the issuer of a short-term instrument with a short-term credit 
rating from an NRSRO does not issue long-term instruments or has not 
obtained a long-term credit rating for any long-term instruments and, 
therefore, will not have a long-term credit rating from an NRSRO. In 
this situation, Sec. 932.4(e)(2)(ii)(C) of the final rule states that 
the long-term equivalent rating will be determined as follows:

    (1) The highest short-term rating shall be equivalent to the 
third highest long-term rating; (2) The second highest short-term 
rating shall be equivalent to the fourth highest long-term rating; 
(3) The third highest short-term rating shall be equivalent to the 
fourth highest long-term rating; and (4) If the short-term rating is 
downgraded to below investment grade after acquisition by the Bank, 
the short-term rating shall be equivalent to the second highest 
below investment grade long-term rating.

    This approach is consistent with the research discussed above. The 
provision regarding downgrades of short-term credit ratings is also 
consistent with the way that downgrades of long-term ratings are 
addressed under Table 1.3.
    Credit equivalent amounts for off-balance sheet items. As proposed, 
Sec. 932.4(f), would have required the Banks to convert all off-balance 
sheet credit exposures into equivalent on-balance sheet credit 
exposures or credit equivalent amounts, determine the type of the item, 
and then apply the appropriate credit risk percentage requirement from 
the tables to estimate the instrument's credit risk capital charge. The 
proposed rule would have allowed the Banks to use Finance Board 
approved internal models to convert some or all off-balance sheet 
credit exposures into on-balance sheet credit equivalents. For Banks 
that lack appropriate internal models, the proposed rule provided a 
table of credit conversion factors for off-balance sheet items. The 
Finance Board received no comments on the specific credit conversion 
factors in Table 2 of the proposed rule. The Finance Board, however, 
has incorporated certain changes to Table 2, as discussed below, and 
has adopted Sec. 932.4(f) with these changes.
    Table 2 in the proposed rule provided a 100 percent credit 
conversion factor for four separate categories: asset sales with 
recourse where the credit risk remains with the Bank, sale and 
repurchase agreements, forward asset purchases, and commitments to make 
advances or other loans. However, if a Bank treats sale and repurchase 
agreements as an off-balance sheet item, then the Bank would actually 
report such agreements as asset sales with recourse where the credit 
risk remains with the Bank. Because any off-balance sheet sale and 
repurchase agreements are reported under the category ``asset sales 
with recourse where the credit risk remains with the Bank,'' a separate 
category in Table 2 for ``sale and repurchase agreements'' is redundant 
and has been removed. Additionally, under SFAS 133, forward asset 
purchases will qualify as derivative contracts and will appear on the 
balance sheet. In any case, derivative contracts are addressed 
independently of off-balance sheet items under Sec. 932.4(d). 
Therefore, the forward asset purchases category has also been removed 
from Table 2.
    Commitments to make advances or other loans has been expanded into 
two categories: commitments to make advances, and commitments to make 
or purchase other loans. This change recognizes the fact that under AMA 
programs, the Banks may enter into certain commitments to purchase 
loans that may be recorded as off-balance sheet items.
    The Finance Board received one comment regarding standby letters of 
credit (SLOCs), an off-balance sheet item included in Table 2 with a 
credit conversion factor of 50 percent. The commenter apparently 
believed that under the proposed rule, the credit risk percentage 
requirement for this off-balance sheet item would be determined by 
applying the credit conversion factor and finding the appropriate 
credit risk percentage requirement in Table 1.3 (Requirement for Rated 
Assets or Rated Items other than Advances or Residential Mortgage 
Assets). The commenter argued that because SLOCs are in fact 
``contingent advances,'' the credit risk percentage requirement should 
be the same as advances as presented in Table 1.1 (Requirement for 
Advances). The Finance Board intended that the credit risk percentage 
requirement for SLOCs would be determined from Table 1.1. In fact, the 
proposed SUPPLEMENTARY INFORMATION section of the proposed rule 
indicated that SLOCs were given a 50 percent conversion factor, rather 
than the 100 percent conversion factor assigned to SLOCs by federal 
banking regulators, because SLOCs issued by the Banks are rarely drawn 
down and if drawn down, would convert to an advance. See 65 FR at 
43425. The Finance Board concurs with the commenter, and the final rule 
has been changed to clarify that Table 1.1 should be used in 
determining the credit risk percentage requirement applicable to the 
credit equivalent amount of any Bank SLOCs.
    Reduced credit risk charge for assets hedged with credit 
derivatives. The proposed rule would have allowed assets hedged with 
credit derivatives to be assigned a zero credit risk capital charge 
under limited circumstances. These were: (1) if the asset referenced in 
the credit derivative (referenced asset) and the hedged asset were the 
same and the remaining maturity of the hedged asset and the credit 
derivative was the same; (2) the hedged asset and the referenced asset 
were the same but the remaining maturity of the hedged asset and the 
credit derivative were different, but only if the remaining maturity of 
the credit derivative was two years or more; and (3) if the remaining 
maturity of the hedged asset and the credit derivative contract was the 
same, and the hedged asset and the referenced asset were different but 
only if certain additional conditions were met. In all these cases, the 
proposed rule would have required the applicable credit risk capital 
charge for the credit derivative contract to be applied. The Finance 
Board requested general comments regarding the treatment of credit 
derivatives and specific comments regarding the methodology that should 
be used to incorporate the benefit of credit derivatives that did not 
meet the three circumstances described above. See 65 FR at 43426. The 
Finance Board received no specific comments regarding its treatment of 
credit derivatives in the proposed capital rule. However, the Finance 
Board has

[[Page 8293]]

realized that its approach may have been somewhat inconsistent with its 
approach to collateral and third parties guarantees, which allowed for 
a proportional reduction in the credit risk capital charge on an asset 
if the collateral or guarantee did not cover 100 percent of the book 
value of the asset. The Finance Board, therefore, has refined its 
approach to credit derivatives in the final rule to allow a similar 
proportional reduction in the credit risk capital charge for assets 
partially hedged with a credit derivative, under appropriate 
conditions. This refinement is based on discussions with other 
financial regulators and a review of proposals by organizations 
representing capital market participants, such as the International 
Swaps and Derivatives Association (ISDA). The final rule otherwise 
retains an emphasis on recognizing credit derivative activities only if 
they are undertaken in a clear and straightforward manner and used to 
reduce the credit risk of specific assets. For example, the new 
approach does not incorporate the use of internal credit models. 
Further, while the change adds to the consistency in treatment in the 
capital rule between credit derivatives and other types of credit 
enhancements, such as collateral and third party guarantees, the change 
adopted in the final rule, in practical terms, is likely to have little 
or no effect on the Banks' overall credit risk capital requirement at 
this time, because the Banks presently have few, if any, credit 
derivatives on their balance sheets.
    The Finance Board also adopted in the final rule an additional 
general condition governing whether a credit derivative can be used to 
reduce the capital charge on an asset. Specifically, the final rule 
requires a credit derivative contract to provide substantial protection 
against credit losses before the reduction can be taken. Because credit 
derivative contracts are bilaterally negotiated, the Finance Board 
believes that in some rare circumstances conditions may be added to the 
contract that may call into question the ability of the Bank to 
collect, under all likely scenarios, the amount expected under the 
credit derivative contract, if there were a default on the hedged 
asset. Further, there may be questions as to the ability of the 
counterparty to actually fulfill the terms of the credit derivative 
contract. The Finance Board, therefore, has added as a safeguard, the 
condition that the credit derivative contract provide substantial 
protection against credit losses. As already discussed, the Finance 
Board does not think that this condition would affect the beneficial 
treatment afforded relatively straightforward credit derivative 
instruments under most circumstances.
    Under the final rule, as in the proposed rule, credit derivatives 
that are referenced to an asset that perfectly matches the asset being 
hedged may fully offset the credit risk capital charge of the hedged 
asset, if the credit derivative has a remaining maturity equal to or 
greater than that of the hedged asset. A credit risk capital charge for 
the credit derivative must still be applied, however to account for the 
Bank's credit exposure to the credit derivative counterparty. For 
example, if a Bank purchases a triple-B-rated corporate bond with a 
remaining maturity of five years and at the same time enters into a 5-
year credit default option contract based on the same bond, the credit 
risk capital charge for the underlying asset will be zero. The net 
credit risk capital charge for the pair will equal the credit risk 
capital charge for the credit exposure on the derivative contract.
    This same treatment may be accorded positions in which the credit 
derivative contract references a different obligation from the same 
obligor but only if: (1) the credit derivative contract has the same or 
a longer remaining maturity as the hedged asset; and (2) the referenced 
asset ranks pari passu or junior to the hedged asset, is subject to a 
cross-default clause with the hedged asset and has the same maturity as 
the hedged asset. These conditions on the referenced asset are the same 
in the final rule as in the proposed rule except for one new condition 
that the referenced asset and the hedged asset have the same remaining 
maturity. This new condition helps assure that the value of the hedged 
asset and the credit derivative will move in a similar fashion.
    The final rule expands upon the relief offered in the proposed rule 
by allowing a Bank to take a proportionally reduced capital charge for 
an asset hedged with a credit derivative even if the remaining maturity 
of the credit derivative is less than that of the hedged asset. 
However, the credit derivative must have a remaining maturity of at 
least one year for this new provision to be applied. The requirement 
that credit derivatives with a shorter remaining maturity than the 
hedged asset have at least a one-year minimum remaining maturity is 
more strict than the six month minimum remaining maturity that has been 
suggested in work done by ISDA for similar circumstances, but is less 
strict than the two-year minimum requirement that was applied under the 
proposed rule. The Finance Board believes that the one-year minimum 
requirement is in line with the generally conservative approach adopted 
in this rule.
    Further, the beneficial treatment allowed when calculating a hedged 
asset's credit risk capital charge if the applicable credit derivative 
contract has a remaining maturity less than that of the hedged asset 
may be applied if the hedged asset and the referenced asset are the 
same. This treatment may also be applied if the hedged asset and the 
referenced asset are different but only if the referenced asset ranks 
pari passu or junior to the hedged on-balance sheet asset, is subject 
to a cross-default clause with the hedged on-balance sheet asset and 
has the same maturity as the hedged asset. Where the above conditions 
are met, the credit risk capital charge for an asset hedged with a 
credit derivative that has a remaining maturity less than that of the 
hedged asset will equal the sum of the capital charges for the unhedged 
portion of the asset and the hedged portion of the asset.
    For example, assume a Bank holds a triple-B-rated corporate bond 
with a remaining maturity of 5 years and has hedged that position with 
a credit derivative that is referenced to the same corporate bond but 
that has a remaining maturity of two years. Under the final rule, the 
capital charge for the unhedged portion of the asset would equal the 
credit risk percentage requirement for the asset, assigned based on its 
credit rating (BBB) and remaining maturity (5 years), multiplied by the 
book value of the asset minus the product of the credit risk percentage 
requirement for the asset, assigned based on its credit rating (BBB) 
but on the remaining maturity of the credit derivative contract (2 
years), multiplied by the book value of the asset. The credit risk 
capital charge for the hedged portion of the asset will equal the 
credit risk capital charge for the credit derivative contract, 
calculated in accordance with Sec. 932.4(d) of the final rule.
    As in the proposed rule, where the on-balance sheet asset and the 
asset referenced in the credit derivative have been issued by different 
obligors, the final rule does not provide capital relief for the 
underlying asset. See 65 FR at 43426. In the SUPPLEMENTARY INFORMATION 
section of the proposed rule, the Finance Board requested comment on 
whether it should allow Banks to petition for relief on a case-by-case 
basis on the credit risk capital charge applied to assets hedged with 
credit derivatives but that do not meet the specific conditions set 
forth in the rule, if the petition is accompanied by adequate data and 
analysis. Id.

[[Page 8294]]

Although no specific comments were received in response to this 
request, the Finance Board believes that Banks should be allowed to 
seek such relief. The Finance Board emphasizes that any petition for 
relief must be accompanied by evidence that demonstrates with a high 
degree of certainty that the credit derivative contract will provide 
protection should there be a default on the hedged asset. The Finance 
Board also emphasizes that it will be conservative in its approach when 
reviewing such petitions and will consider all available evidence 
including any information about how the situation may be handled by 
other financial regulators before making any decision.
    Reduced charges for derivative contracts. As was proposed, the 
final rule also allows foreign exchange rate contracts with an original 
maturity of 14 calendar days or less to be assigned a zero credit risk 
capital charge. Gold contracts would not be considered exchange rate 
contracts. Derivative contracts that are traded on regulated exchanges 
that require daily collection of variation margin for the contract also 
would be assigned a zero credit risk capital charge.

Section 932.5--Market Risk Capital Requirement

    General. As proposed, Sec. 932.5 set forth the basic requirements 
for calculating each Bank's market risk capital charge. Under the 
proposed rule, each Bank would be required to develop either an 
internal market risk model, or as an alternative, a cash flow model, 
that would calculate the Bank's market risk capital charge and to have 
the model reviewed and approved by the Finance Board. The proposed rule 
required the Bank to use its internal market risk model to estimate the 
market value of its portfolio at risk. As proposed, the market value of 
the Bank's portfolio at risk would have been defined as the maximum 
loss in market value of a Bank's portfolio under various stress 
scenarios. This loss would have been measured from a base line case 
such that the probability of loss greater than that estimated was not 
more than one percent. If a Bank opted to use the alternate cash flow 
model, the proposed rule would have required the Bank to demonstrate 
that the cash flow model subjected the Bank's portfolio to a degree of 
stress comparable to that required for the internal market risk model 
and to demonstrate how the Bank intended to measure its market risk 
capital charge using the cash flow approach.
    When using an internal market risk model, the proposed rule further 
stipulated that the Bank's capital charge would equal the sum of two 
components: the capital charge estimated by the Bank's internal market 
risk or cash flow model plus the amount by which the current market 
value of a Bank's total capital was less than 95 percent of the value 
of the Bank's total capital calculated in accordance with the GLB Act 
(the 95 percent test). The proposed rule also would have required the 
Banks to conduct an annual, independent validation of its internal 
market risk model or internal cash flow model and submit the results of 
the validation to the Finance Board.
    The proposed rule also established broad parameters and standards 
for the internal risk model and for the stress testing that would be 
performed using that model. In general, the proposed rule would have 
required the Bank's internal risk model to cover all material risks 
arising from a Bank's portfolio of assets, liabilities and off-balance 
sheet items, including derivative contracts and options. As 
contemplated by the proposed rule, the Bank would have used the 
internal market risk model first to estimate the market value of its 
portfolio as of the last business day of the month for which the market 
risk capital charge was being calculated and then to stress that 
baseline market value to calculate the market value of its portfolio at 
risk. The proposed rule also required that the stress test account for 
changes in interest rates, interest rate volatility, the shape of the 
yield curve and changes in market prices equivalent to those that have 
been observed over 120 business-day periods of market stress. Under the 
proposed rule, the relevant historic observation period would have 
begun at the end of the month prior to the month for which the market 
risk charge was being calculated and extend back to 1978. Further, if 
the Bank had issued consolidated obligations denominated in foreign 
currency or linked to equity or commodity prices, the proposed rule 
would have required the Bank to estimate the market value of its 
portfolio at risk due to changes in foreign exchange rates, and equity 
and commodity prices as relevant.
    The Finance Board received a large number of comments on proposed 
Sec. 932.5. Generally, most commenters objected to a market risk 
capital charge based on changes in market value of a Bank's portfolio 
as inappropriate given that the Banks hold their assets to maturity. 
For similar reasons, commenters objected to the Finance Board requiring 
use of a value-at-risk (VAR) model for calculating the capital charge. 
Almost all commenters also expressed opposition to the 95 percent test 
for a number of reasons, including that the test ``double charged'' the 
Banks for market risks and that the ``artificial'' volatility in GAAP 
earnings created by implementation of SFAS 133 could make it difficult 
for Banks to comply with the 95 percent test. Comments were also 
received on a number of other aspects of the proposed market risk 
requirement. The Finance Board has considered all the comments received 
on proposed Sec. 932.5 and will address these comments in more detail 
below.
    Furthermore, the Finance Board has determined to make a number of 
changes to the proposed rule both in response to comments and based 
upon its reconsideration of certain aspects of the proposal. The 
Finance Board discusses these changes more fully below. Among the more 
important changes, the final rule has revised the 95 percent test so 
that it now requires a Bank to calculate its market risk capital charge 
by adding the market value of its portfolio at risk and the amount, if 
any, by which the market value of the Bank's total capital, estimated 
using its internal market risk model, falls below 85 percent of the 
value of the Bank's total capital as defined in the GLB Act (85 percent 
test). In addition, the final rule explicitly states that the Finance 
Board may exercise flexibility in determining the appropriate minimum 
number of scenarios that shall be used in estimating the market value 
of their portfolio at risk. The Finance Board, however, anticipates 
increasing the minimum number of required simulations in proportion to 
the nature and level of market risk taken by the Banks, and as the 
Banks gain expertise in using their models and available modeling 
techniques become more sophisticated. Furthermore, as with other 
provisions, the final rule has revised Sec. 932.5 to reflect the fact 
that because of SFAS 133, derivatives contracts can no longer be 
considered strictly off-balance sheet items.
    Internal cash flow model. Many commenters expressed a concern that 
the proposed rule was unclear regarding the conditions under which an 
internal cash flow model could be substituted for an internal risk 
model. Additionally, commenters indicated a preference for the final 
rule to include explicit requirements about the parameters that would 
be required for such a model.
    In response to these comments, the Finance Board has clarified in 
Sec. 932.5(a)(2) of the final rule that a Bank may use an internal cash 
flow model in

[[Page 8295]]

place of an internal market risk model, provided that the Bank obtains 
prior Finance Board approval of the internal cash flow model and of the 
imbedded assumptions in the model. In principle, because both the 
internal market risk model and the alternate internal cash flow model 
calculate loss estimates based upon the present value of the cash flows 
of the current assets and liabilities, the market risk capital 
requirement should be the same whichever model is used. However, even 
though the Finance Board expects the two methods to be theoretically 
consistent, it recognizes that, in practice, it is unlikely that the 
market risk capital requirements calculated by an approved internal 
cash flow model would be exactly the same as the requirement calculated 
by an internal market risk model. Further, and contrary to the 
perception of some commenters, the Finance Board is not requiring a 
Bank to develop both an internal market risk model and an internal cash 
flow model to verify that the market risk capital charges calculated by 
each are equivalent.
    Instead, the Finance Board will review the assumptions and time 
horizon chosen by a Bank in its internal cash flow model to assure that 
the model captures all material risks faced by the Bank and that the 
stress applied by the model is comparable to that required by the 
modeling parameters and by the 85 percent test set forth in 
Sec. 932.5(a)(1), (b) and (c) of the final rule. However, the final 
rule does not require a Bank to apply separately the 85 percent test if 
the Bank uses an alternative cash flow model.
    The Finance Board's review of a Bank's proposed internal cash flow 
model will focus on the assumptions of the cash flow model concerning 
future business activities, e.g., the acquisition of new assets and 
their financing. The assumptions concerning future business activities 
must be well defined, prudent, and consistent with the Bank's practice. 
The Finance Board has determined, however, that with respect to the 
internal cash flow model approach, the final rule adopted herein should 
not include specific assumptions, parameters, or time horizon 
requirements in recognition of the possibility that such inputs need 
not be constant across different portfolios and/or business plans. The 
Finance Board may judge the adequacy of the model's output in various 
ways including comparing the estimates produced by the internal cash 
flow model to modeling results from other Banks which may display 
similar risk profiles to the Bank seeking approval of an internal cash 
flow model. The Finance Board will reject an internal cash flow model 
if after consideration of all relevant factors, it believes that the 
model fails to calculate an adequate market risk capital charge for a 
given Bank.
    The Finance Board also notes that under the final rule the internal 
cash flow model will be used to calculate only the market risk capital 
requirements. A Bank using an internal cash flow model will still 
calculate its credit risk capital requirements pursuant to Sec. 932.4 
of the final rule. Thus, in developing an internal cash flow model, a 
Bank would want to use the expected cash flows from its assets and not 
simulate changes in cash flows that would come from changes in credit 
quality. The expected cash flows, however, could still take into 
account the credit quality of the asset, e.g., the expected cash flows 
from a triple A rated bond would be greater than the expected cash 
flows from a similar single B rated bond.
    Measurement of market value at risk under a Bank's internal market 
risk model. The Finance Board received many comments concerning the 
requirements for the internal market risk model and its proposed 
approach for estimating the market value of the Banks' portfolios at 
risk, including comments from all of the Banks, two trade groups, and a 
housing GSE. Commenters generally expressed opposition and confusion 
regarding the type of internal market risk model contemplated under the 
proposed rule. Several commenters asked for clarification of the 
definition of market value at risk. Most commenters opposed the use of 
a traditional VAR framework to measure market risk for the Banks. They 
expressed concern that the VAR framework, which federal banking 
regulators require commercial banks to use for their trading portfolios 
under certain conditions, was inappropriate for the held-to-maturity 
portfolios that are more characteristic of the Banks. More generally 
and for similar reasons, a number of commenters felt that it was 
inappropriate to base the market risk capital charge on changes in the 
market value of the Banks' portfolios. Several commenters also 
expressed concern that using a traditional VAR model would result in 
the Banks holding significantly more capital for market risk than OFHEO 
requires under its proposed capital regulations for Fannie Mae and 
Freddie Mac, a result that could put the Banks at a competitive 
disadvantage to the other housing GSEs. A number of commenters also 
urged the Finance Board not to express a preference for the VAR-like 
approach over a cash flow approach.
    In proposing Sec. 932.5, the Finance Board did not intend to imply 
that the Banks were required to use any specified or ``typical'' VAR 
approach to calculate the market value of their portfolios at risk. 
Instead, the Finance Board intends that each Bank uses its internal 
market risk model to undertake a stress test. As envisioned by the 
Finance Board, the test is applied such that each Bank will first use 
its internal market risk model to estimate a base case market value for 
its portfolio, where the portfolio would consist of all of the Bank's 
assets and liabilities, off-balance sheet items and derivative 
contracts. In estimating this base case market value, each Bank's 
internal risk models could employ actual market prices, and assumptions 
and methodologies for estimating the value or prices of instruments 
that would be consistent with approaches that are generally accepted in 
the financial industry. Then, each Bank will use the internal market 
risk model to apply market shock scenarios that are based on historical 
scenarios and data, as specified in Sec. 932.5(b)(4) and (b)(5) of the 
final rule. The model-derived portion of the market risk capital charge 
(i.e., the market value of a Bank's portfolio at risk) equals the loss 
in the market value of a Bank's portfolio measured from a base line 
case, as determined from market-value loss calculations that are based 
on more than 20 years of historical experience and that must include an 
adequate number of stress scenarios derived from these historically 
stressful periods, such that the probability of loss greater than the 
determined amount is not more than one percent. This approach generally 
differs from the traditional VAR approach, which estimates the 
potential loss of a portfolio given relatively more current market 
conditions.
    Furthermore, the Finance Board believes that estimating the market 
risk charge based on a stress test of the kind described above is 
reasonable, even when, as the commenters stated, the Banks' portfolios 
consist largely of ``held-to-maturity'' instruments. From a regulatory 
perspective, the Finance Board is concerned that the Banks hold 
sufficient capital to withstand historically extreme market conditions 
that may persist over multi-year periods. The market-value approach 
adopted in this final rule satisfies this regulatory concern. 
Specifically, the measure of a decline in market value during a stress 
period incorporates the decline in long-term earnings that would 
result, all things being equal, from such market

[[Page 8296]]

changes. In this respect, the market-value approach parallels the way 
the debt markets bid up or down the value of a financial instrument 
based on its expected earnings relative to the yield expectations of 
similar instruments in the current market. The arguments voiced by 
commenters that the Finance Board's approach misstates the capital 
charge for ``held-to-maturity'' assets, relies on the expectation that 
a Bank could regain lost market value if markets ``returned to normal'' 
following any stressful conditions. The weakness of this argument is 
that a Bank must risk further declines in market value in order to 
position itself to gain from ``expected'' market corrections. Thus, for 
the purposes of the Market Risk Capital Requirement, it is irrelevant 
that the Bank may generally hold its assets to maturity because the 
regulator is concerned with, and must address, the likelihood that the 
market will not behave ``as expected'' and that the losses in market 
value will eventually be realized through earnings over time. By 
requiring that an acceptable internal cash flow model subject a Bank's 
portfolio to a comparable degree of stress as that required for the 
internal market risk model, the Finance Board also intends to ensure 
that these regulatory goals are met if a Bank decides to use an 
internal cash flow model to estimate its market risk capital charge. As 
was explained in the discussion of the Minimum Risk-Based Capital 
Requirement, the Finance Board also does not believe that the market-
value approach will lead to an onerous market risk capital charge. 
Given its regulatory goals, the Finance Board, therefore, continues to 
believe that its general approach to the internal market risk model 
adopted in the final rule is reasonable.\24\
---------------------------------------------------------------------------

    \24\ The Finance Board provides additional background 
information about the modeling requirement in the SUPPLEMENTARY 
INFORMATION section of the Federal Register release proposing the 
capital rule. This information helps further clarify the Finance 
Board's reasoning for adopting the internal market risk model 
approach in this final rule. See 65 FR at 43427-29.
---------------------------------------------------------------------------

    A few commenters believed that the 120 business day holding period 
stipulated for the stress test in proposed Sec. 932.5 was excessive. At 
least one commenter based this view on the fact that most VAR models 
stipulate a holding period of only one or two days. As already 
discussed, Sec. 932.5 of the final rule does not mandate a specific VAR 
approach for estimating the market value of its portfolio at risk. 
Nevertheless, the 120 business day horizon is also within the range of 
the holding periods adopted by other federal bank regulatory agencies 
for the VAR models used in their market risk test, which, once the 
mandated multiplier is taken into account, is effectively between 90 
and 160 days.\25\ Moreover, the Finance Board believes that the 120 
business day holding period is reasonable given the goal underlying the 
market risk capital charge discussed above. For these reasons, the 
Finance Board remains satisfied that the mandated 120 business day 
holding period stipulated for the internal market risk model is the 
correct approach.
---------------------------------------------------------------------------

    \25\ The federal bank regulatory agencies (Office of the 
Comptroller of the Currency (OCC), Federal Reserve Board (FRB), and 
Federal Deposit Insurance Corporation (FDIC)) issued a joint final 
rule in September 1996 to incorporate a measure for market risk, 
effective as of January 1, 1998. See 61 FR 47358 (Sept. 6, 1996).
---------------------------------------------------------------------------

    A number of commenters requested clarification as to when a Bank 
should apply the required stress test using a historical simulation 
approach or when it should use a path-generating approach such as Monte 
Carlo simulations. In both the proposed and final rule, 
Sec. 932.5(b)(2) provides that a Bank may use any ``generally accepted 
measurement technique'' in its modeling approach. The choice of an 
approach is subject to the general requirement that the internal market 
risk model be able to capture all material market risks faced by the 
Bank. In this regard, the Finance Board has determined that simulations 
of historical market changes will comply with the regulation. 
Historical simulations may assume rate changes as a percentage of the 
prior rate level rather than as changes in the absolute level of the 
index in question. The Finance Board has also determined that such 
simulations should encompass market changes for all instruments and 
indexes. In doing so, such simulation will address general changes in 
interest rates and basis differences.
    The parameters for a Monte Carlo rate path generating process would 
be derived from and consistent with periods of market stress identified 
from the same historical time-frame and data, which stretches from 1978 
to the month prior to the month for which a market risk capital charge 
is being calculated, as provided in Sec. 932.5(b)(4) and (5) of the 
final rule, that would be used in a historical simulation. The process 
should generate a sufficient number of paths to estimate the 99th 
percentile in the distribution of losses for the market value of a 
Bank's portfolio at risk using the same types of calculations as those 
used in an historical simulation.
    Commenters have also asked for guidance on how the Finance Board 
intends to define material risks. In general, a material risk is any 
risk that has a potential, substantive effect on a Bank's earnings or 
capital portfolio, or could potentially have a significant impact on 
the Bank's market risk capital charge from a regulatory prospective. A 
determination concerning the materiality of specific risks would 
include consideration of a Bank's general risk profile and relevant 
historic data and experience.
    Along these same lines, some commenters expressed concern that the 
Finance Board has not provided sufficient technical specifications for 
the internal market risk model. As a result, some commenters felt that 
the Banks cannot be sure if the models used for day-to-day risk 
management purposes would be sufficient for calculating the market risk 
capital charge, and at least one commenter believed that without more 
specificity it would be impossible to judge the adequacy of the market 
risk capital requirements. The quantitative modeling parameters 
provided by the Finance Board in the proposed and final rule are 
consistent with those provided by other Bank regulators for required 
market risk models. See 61 FR 47358 (Sept. 6, 1996). The Finance Board 
believes that the quantitative specifications set forth in the final 
rule provide a degree of flexibility for the Banks in developing their 
models, yet ensures that the Banks will hold a prudential level of 
capital with respect to their market risk and that the market risk 
capital charges will be consistent across the twelve Banks. Further, 
the adequacy of both the models and the estimates of the market risk 
produced by those models will be assured through supervisory oversight 
and the requirement that the Finance Board approve both the Banks' 
internal models and any subsequent material adjustment to the models. 
In addition, the Finance Board expects that there will be on-going 
dialogue between the staffs of the Finance Board and the Banks during 
the developments of the internal risk-based models so that formal or 
informal guidance may be provided on issues such as the sufficiency of 
individual modeling efforts.
    The Finance Board has also reconsidered some aspects of proposed 
Sec. 932.5 and has determined to make some changes in the final rule. 
Primarily, the Finance Board has changed the criteria in proposed 
Sec. 932.5(b)(4)(ii) regarding the data time series from which a Bank 
must draw the relevant historical scenarios in

[[Page 8297]]

executing a stress test. The change provides greater flexibility for 
the Finance Board to determine an appropriate minimum number of 
scenarios to be used in the modeling exercise, but intends that the 
minimum number of scenarios shall be increased as the Bank's risk 
exposure increases and as the Bank's expertise and the general 
sophistication of available modeling technology improves. As proposed, 
the criteria in Sec. 932.5(b)(4)(ii) required an unspecified number of 
tests to cover the relevant data period from 1978 until the 
present.\26\ The Finance Board recognizes that this requirement may 
have created a great hardship for the Banks as they try to conform 
their modeling technology and capabilities to the requirements of the 
capital rule. The changes to Sec. 932.5(b)(4)(ii) in the final rule are 
intended to allow the Finance Board to require a Federal Home Loan Bank 
to use a minimum acceptable but manageable number of scenarios. The 
periods chosen, however, must be satisfactory to the Finance Board, 
encompass the periods of the greatest potential market stress, given a 
Bank's portfolio and the data from the period of 1978 to the month 
prior to the month for which the market risk capital charge is being 
calculated, and be comprehensive given the modeling capabilities 
available to the Bank. The Finance Board will judge whether a Bank's 
given choice of historic scenarios is comprehensive, based not only on 
the Bank's internal capabilities at any point in time, but also on the 
state-of-the-art modeling technology and theory employed by other Banks 
and within the financial industry, generally. In addition, the Banks 
will be expected to increase steadily over time the number of scenarios 
used in calculating the market risk capital charge. The Finance Board 
will monitor compliance with the requirements of Sec. 932.5(b)(4)(ii) 
through its general supervisory oversight, and a Bank will not be 
required to seek specific Finance Board approval each time it increases 
the number of scenarios used unless the change involves a material 
adjustment to the model. However, Banks will be expected to defend 
their choice of stress scenarios and document that their choice meets 
the requirements of Sec. 932.5(b)(4)(ii).
---------------------------------------------------------------------------

    \26\ As proposed and adopted, the relevant historical period set 
forth in the capital rule by the Finance Board would encompass the 
period from the beginning of 1978 to the end of the month prior to 
the month for which the capital charge is being calculated. Each 120 
business day period would start at the first of each month. Thus, 
the first stress period would run from January 1, 1978 forward 120 
business days, the second, February 1, 1978 forward 120 business 
days, etc. The 1978 date was selected to ensure that the most 
stressful period in recent times is included. 65 FR at 43429.
---------------------------------------------------------------------------

    A similar change has been made to 932.5(b)(5)(iii) to conform the 
requirements for the stress scenarios used to model foreign exchange, 
and equity and commodity price risk to those used for interest rate 
risks. Section 932.5(b)(5)(iii), however, only applies if a Bank has 
issued consolidated obligations denominated in a foreign currency or 
linked to equity or commodity prices, and the resulting relevant 
foreign exchange or equity or commodity price risk is material.
    The Finance Board has also changed the final rule to remove a 
reference which suggested that a Bank had to seek specific approval for 
empirical correlations included in its model (i.e., approval beyond 
that required in the final rule under Sec. 932.5(d)). Instead, the 
Finance Board intends to review the theoretical and empirical basis for 
including any correlations among variables in the internal model as 
part of its initial approval of the model or its subsequent approval of 
any material adjustments to the model. In general, additions of, or 
adjustments to, correlations used in the model would be considered a 
material adjustment by the Finance Board.
    Basis Risk. In the proposed rule, the Finance Board specifically 
requested comment on how best to treat basis risk in the final rule. 
The Finance Board received several comments on basis risk. One 
commenter suggested that basis risk is not significant enough to 
require special modeling and capital charges. Another commenter 
suggested that each Bank should establish its own basis risk management 
framework, and the Finance Board should review this framework as part 
of its examination process. However, a review of historical rate 
changes indicated that some periods of stressful markets were 
characterized, not only by changes in the general level of rates, but 
also by significant changes in the relative spread between indices that 
affect financial positions held by the Banks. The Finance Board, 
therefore, has determined that basis risk is a material risk for the 
Banks and should be incorporated into the stress tests. Furthermore, 
the Finance Board believes that the historical simulation approach that 
the Banks are most likely to employ, at least initially, can reasonably 
incorporate the changes in the different market indexes that most 
affect the Banks' financial strength, and thereby can adequately 
incorporate basis risk into the required stress tests.
    The 95 percent test. As discussed briefly above, the Finance Board 
received many comments on the proposed 95 percent test. All commenters 
were generally opposed to the inclusion of the 95 percent test in the 
market risk capital requirement, often claiming that the proposed test 
was not required by other financial institutions or was unnecessary 
from a safety and soundness perspective.
    One commenter stated that if the intention of the requirement was 
to ensure that Bank management takes appropriate action when a Bank's 
market value of capital falls below some threshold, the proposed 
requirement may actually exacerbate the problem. If the Bank were 
forced to increase its market risk capital requirement when its market 
value deteriorates, then, according to the commenter, the Bank would 
have the incentive to further increase risk to generate an acceptable 
return on the additional capital.\27\ Commenters suggest that rather 
than including the 95 percent market to book value test in the rule, 
the Finance Board should consider requiring that each Bank's Risk 
Management Policy establish a threshold market to book value of capital 
ratio that would require the Bank's board of directors to review and 
determine a plan of action if necessary.
---------------------------------------------------------------------------

    \27\ The commenter failed to recognize that if a Bank actually 
engaged in the type of behavior described, its risk-based capital 
requirement would rise in relation to the added risk incurred. Thus, 
the Finance Board does not believe that the 85 percent test adopted 
in the final rule will create a perverse incentive as described by 
the commenter.
---------------------------------------------------------------------------

    Several commenters stated that while such a requirement may have 
some conceptual appeal, potential adverse effects outweighed any 
benefits. They argued that the required test forces a mark-to-market 
accounting framework on the Banks which are primarily required to 
report their financial condition on an accrual basis under GAAP and 
that the conflicting requirements to reconcile accounting conventions 
to market valuation could lead to adverse consequences. They cite the 
implementation of SFAS 133 where a Bank may face asymmetrical 
accounting of its hedged positions that could lead to an increase in 
book value without any change in a Bank's market value and, therefore, 
a decrease in the Bank's market to book value below the 95 percent 
requirement without any change in its underlying economic risk. One 
commenter, however, agreed that it was ``prudent to mandate that 
capital be held to assure an adequate market to book value capital 
ratio,'' but suggested that the test should require a ratio of market 
to book value of 85 percent.

[[Page 8298]]

    The Finance Board finds merit in some of the concerns expressed by 
the commenters, especially those related to the potential effects of 
SFAS 133 on the Banks' balance sheets. Therefore, the Finance Board has 
adopted the one commenter's suggestion and has changed the final rule 
so that in calculating the market risk capital charge a Bank will have 
to add to the market risk charge estimated by its internal market risk 
model the amount, if any, that the market value of its total capital 
falls below 85 percent of the book value of its total capital.
    The final rule has also been changed to make clear that in applying 
the 85 percent test, what the proposed rule referred to as ``the book 
value of total capital'' is the value of total capital required to be 
reported to the Finance Board under Sec. 932.7 of the final rule and 
for other regulatory purposes. The Finance Board also wishes to clarify 
that in applying the 85 percent test, the market value of total capital 
should be calculated using the Bank's internal market risk model and 
should be equal to the value of total capital as estimated for the base 
case market value of a Bank's portfolio (i.e., the value before 
applying the required stress scenarios).
    While the Finance Board has made some changes to the proposed 
market-to-book value capital test in the final rule, the Finance Board 
continues to believe that a capital charge is needed to protect against 
a significant impairment in a Bank's market value of capital, to the 
extent that it is not reflected in the reported values of total and 
permanent capital. The provisions of the final rule require a Bank to 
measure and report its capital adequacy based upon the book value of 
total or permanent capital, calculated in accordance with GAAP. It is 
precisely because the Banks have large portfolios of long-term on- and 
off-balance sheet positions that are held-to maturity, which under GAAP 
would generally be valued at historic cost, that a Bank's financial 
strength, expressed by its market value of capital, can decline 
significantly without that decline being reflected in the Bank's book 
value of capital. A market-to-book value capital test assures that the 
reported values of total and permanent capital are representative of 
the value of the capital available to absorb losses should a Bank have 
to liquidate or unwind its positions at any given point in time.
    Moreover, contrary to some comments, the portion of capital charge 
calculated using the internal market risk model (i.e., the market value 
of the Bank's portfolio at risk) does not, in the absence of the 85 
percent test, adequately protect for a decline in the market value of a 
Bank's total and permanent capital. As discussed above, the market 
value of a Bank's portfolio at risk equals the maximum loss between a 
baseline calculation, which estimates the current market value of a 
Bank's portfolio as of a certain date, and the worst case loss derived 
from among all the shock scenarios, where the probability of loss 
greater than that estimated does not exceed one percent. Because the 
baseline starting point for the stress test is based on current market 
value, the stress test does not account for any decline that may have 
occurred between the book value of capital and the market value of 
capital as estimated for the baseline starting point. However, the 85 
percent test, as adopted in the final rule, is stipulated so that the 
market value of total capital used in the test equals the market value 
of total capital determined by the model for the baseline (pre-shock) 
case.
    Based on the above reasoning, the Finance Board believes that the 
85 percent test, as adopted, covers the Bank against excessive declines 
in the current market value of capital while being flexible enough to 
assure that normal fluctuations in market values do not lead to 
excessive volatility in the required market risk capital charge.
    Independent validation of a Bank's internal market risk model or 
cash flow model. Section 932.5(c) of the proposed rule would have 
required each Bank to conduct, on an annual basis, an independent 
validation of its internal market risk model or internal cash flow 
model. The validation would have to be carried out by personnel not 
reporting to the business line responsible for conducting business 
transactions for the Bank or by an outside party qualified to make such 
determinations. The proposed rule would have required the results of 
the independent validation to be reviewed by each Bank's board of 
directors and provided to the Finance Board. As discussed below, the 
Finance Board has considered the comments received on the validation 
requirement and continues to believe that the validation requirement is 
necessary to assure the continued adequacy of each Bank's internal 
market risk model or internal cash flow model. In addition, the Finance 
Board does not view the requirement as unduly burdensome given the 
critical function that the internal models perform. Therefore, the 
annual validation requirement has been adopted as proposed.
    Generally, commenters asked for clarification of the minimum 
criteria that should be used in the model validation process. One 
commenter stated that the requirement to validate the model annually 
was excessive and suggested that conducting the validation every two 
years would be more practical. Another commenter suggested that the 
rule should explicitly allow the validation to be performed by either 
an outside party or the Bank's internal audit department as long as 
whoever performs the validation demonstrates appropriate expertise. 
Another commenter asked whether a letter from a recognized expert in 
the area of market risk will satisfy the validation requirement or 
whether each Bank must provide a detailed report.
    Given that each Bank most likely will have a market risk model that 
is customized to its needs and given the expected evolution of 
sophistication in market risk modeling, the Finance Board does not 
believe that it is appropriate to provide a list of minimum criteria 
for the validation process in the rule. However, in view of the 
comments, following is a general discussion of the validation process 
as contemplated by the Finance Board at this time.
    The Banks should establish a systematic validation procedure. This 
procedure should take into account the complexity and sensitivity of 
the Banks' instruments, the level of overall market risk and the Banks' 
proximity to capital limits. The procedure should include testing, 
review of input procedures, review of specific modeling assumptions, 
and review of modeling methodology. Some longer-term planning should 
also be involved in the validation process so that over a two or three 
year cycle all major assumptions and components of the model are 
subject to review and rigorous testing. Further, the Finance Board 
expects that Banks will treat the validation exercise as an on-going 
process throughout the year and not confine the exercise to a narrow, 
few-week period.
    The Finance Board also does not intend that Banks back-test the 
full model, as is often required for traditional VAR models. However, 
the Banks should have criteria and procedures for reviewing significant 
variations between the estimations generated by the model and actual 
changes in the value of the Bank's portfolio or its income. In general, 
significant unexplained variances should result in an expansion of the 
scope of the validation and review process. The validation process 
should be documented, including documenting any reviewer-recommended 
action, findings, analysis, or any responses to identified problems 
taken by the Bank and any other relevant supporting

[[Page 8299]]

information. However, the Finance Board would expect each Bank only to 
submit a letter confirming that the required validation exercise has 
been completed for a given year and highlighting any problems that may 
have been identified and any actions that were taken by the board of 
directors in response. The more extensive documentation, however, 
should be available for inspection by Finance Board staff. As with 
other aspects of the Sec. 932.5 requirements, the Finance Board expects 
that the staff of the Banks and the Finance Board will maintain an on-
going discussion of the validation process so that the Banks can be 
provided with informal or formal guidance on issues that arise.
    The final rule also retains the requirement that the independent 
valuation must be conducted by personnel not reporting to the business 
line responsible for conducting business transactions for the Bank or 
by an outside party qualified to make such determinations. The Finance 
Board believes that this language implies that the validation may be 
conducted by personnel from the Bank's internal audit department, if 
qualified, and that it is not necessary to explicitly state so in the 
rule. Given the newness of the modeling requirement and the rapid 
evolution of model sophistication, the Finance Board does not consider 
the validation requirement as clarified here to be overly burdensome.

Section 932.6--Operations Risk.

    Operations risk is the risk of an unexpected loss resulting from 
human error, fraud, unenforceability of legal contracts, or 
deficiencies in internal controls or information systems. As proposed, 
Sec. 932.6 provided that each Bank's operations risk capital 
requirement would equal 30 percent of the sum of the Bank's credit and 
market risk capital requirements, but would have allowed a Bank to 
substitute an alternative methodology for calculating the operations 
risk charge if such methodology was approved by the Finance Board. The 
proposed rule also allowed a Bank, with Finance Board approval, to 
reduce the operations risk capital requirement by obtaining insurance 
to cover it for operations risk. In no event, however, would a Bank 
have been permitted to reduce its capital charge for operations risk to 
less than 10 percent of the sum of its credit and market risk 
requirements.
    Almost all of the comments received by the Finance Board addressed 
the proposed operations risk capital charge. Commenters generally 
disagreed with at least some aspect of the proposed requirement, 
although one trade association supported the proposal as reasonable. 
One of the most often voiced comment was that the Finance Board lacked 
a sound theoretical basis for linking operations risk to market and 
credit risk. One commenter noted, however, that this approach had some 
support in regulatory circles. A number of commenters felt that a 
charge equal to 30 percent of the market and credit risk charges was 
too onerous, either as a percentage or in absolute terms. A few 
commenters welcomed the flexibility afforded by proposed Sec. 932.6(b) 
to allow the Banks to develop alternative methods of measuring the 
operations risk capital charge. A substantial number of commenters also 
requested that the operations risk charge be eliminated from the 
capital regulation altogether. After considering all of the comments 
received, the Finance Board is not persuaded that the operations risk 
charge should be eliminated and has decided to adopt the regulation as 
proposed.
    In the proposed rule, the Finance Board stated that although not 
required by the GLB Act, the operations risk capital charge was 
necessary to assure that the Banks remained adequately capitalized and 
able to operate in a safe and sound manner. The Finance Board noted 
that the credit and market risk capital charges in the proposed rule 
were not meant to cover unexpected losses that may arise from 
operations failures, and that a separate capital charge was needed to 
protect the Banks from such losses. See 65 FR at 43420-21. The Finance 
Board continues to believe that an operations risk capital charge is a 
necessary part of any complete and adequate risk-based capital 
regulation, and therefore, that it is authorized to adopt the 
operations risk capital charge in fulfillment of its statutory duties 
to assure that the Banks ``operate in a financially safe and sound 
manner'' and ``remain adequately capitalized.'' 12 U.S.C. 
1422a(a)(3)(A) and (B), 1422b.
    Moreover, in proposing the operations risk charge, the Finance 
Board recognized that there are theoretical difficulties in measuring 
operations risk. As a number of commenters pointed out, the Finance 
Board stated in the preamble to the proposed regulation that there was 
``currently no generally accepted methodology for measuring the 
magnitude of operations risk.'' 65 FR at 43429. However, in 
acknowledging a lack of consensus concerning a methodology for 
quantifying operations risk, the Finance Board was not in any way 
conceding that difficulties in measuring operations risk either 
lessened the potential for losses from such risks, or reduced the 
importance of mandating an adequate operations risk capital charge. 
Further, while many commenters questioned the theoretical basis for the 
operations risk charge, none provided alternative empirical methods or 
analysis for quantifying operations risk or assessing an adequate 
operations risk charge.
    Given the difficulties in measuring operations risk, the Finance 
Board proposed to use the same approach to operations risk as that 
provided for Fannie Mae and Freddie Mac by statute, 12 U.S.C. 
4611(c)(2), reasoning that Congress considered and deemed reasonable 
for regulatory purposes a linkage between an operations risk charge and 
credit and market risk charges. The Finance Board continues to believe 
that the statutory requirement established for the other housing GSEs 
provides a reasonable basis for assessing an operations risk charge. 
Further, in allowing a Bank to reduce its operations risk charge by 
providing an alternative method for calculating the operation risk 
charge, the regulation affords the Banks an opportunity to demonstrate 
that their operations are less risky than the other housing GSEs or 
that their business lines present little operations risk, and thereby, 
qualify for a lower operations risk charge.
    One of the housing GSEs criticized the provision of the proposed 
rule that would allow the Banks to reduce their operations risk 
charges, stating that it would significantly reduce a Bank's capital. 
Instead, the GSE suggested that the Finance Board compare the Banks' 
operations risks to those of leading financial institutions and allow 
for a reduction in the operations risk charge only if a Bank could 
demonstrate that it exceeds best practices with regard to controlling 
such risks. In response to this comment, the Finance Board wishes to 
clarify that before it will approve an alternative methodology for 
measuring operations risk under Sec. 932.6(b) of the final rule, it 
will expect a Bank to demonstrate, using a comprehensive, empirically-
based approach, that the alternative methodology adequately quantifies 
the Bank's operations risk. Any analysis would have to take into 
account the complexity of a particular Bank's business and hedging 
activities as well as its internal controls, in-house expertise and 
other factors that relate to operations risks. Similarly, in order to 
receive a reduction in the operations risk charge for insurance, the 
Bank would have to demonstrate that the insurance covers the specific 
risks faced by the Bank and provide a comprehensive analysis to justify 
the

[[Page 8300]]

reduction in the operations risk requirement sought by the Bank. While 
the Finance Board will be flexible in the types of approaches that it 
is willing to consider under Sec. 932.6(b), it expects rigorous 
analysis to support any Bank claims before it will approve a reduced 
capital charge for operations risk, and will in every case require the 
Banks to hold operations risk capital equal to at least ten percent of 
credit and market risk. Therefore, the Finance Board believes that the 
flexibility provided in 932.6(b) will be consistent with achieving 
sound levels of capital for the Banks.
    A few commenters also criticized the approach proposed in 
Sec. 932.6(b) as not being flexible enough and suggested that that the 
regulation should allow a Bank to decrease its operations risk charge 
to zero, where justified. They believed that the ten percent minimum 
charge would create a disincentive for the Banks to insure against 
operations risk or take added steps to control operations risk. 
However, in general, a business can not realistically expect to 
identify or eliminate all potential losses from computer ``glitches,'' 
human error, fraud, natural disasters or other similar unforeseen, and 
in many cases, uncontrollable events. Nor does it appear possible to 
insure against events that may arise as part of new technology, new 
business processes or that otherwise may not be identified at any point 
in time. Thus, the Finance Board believes that it would be unrealistic, 
and in the long-run unsafe, to remove the minimum operations risk 
charge contained in the rule. Further, the Finance Board believes that 
the ten-percent floor is in keeping with its conservative approach to 
assessing capital charges.
    A substantial number of commenters felt that the operations risk 
charge was too high and should be reduced or eliminated. A number of 
commenters urged the Finance Board to delete the operations risk charge 
and instead, to rely on its supervisory oversight to protect the Bank 
System against this risk. While supervision is an important component 
of any regulatory system, the changes mandated by the GLB Act require a 
Bank to hold capital against the losses from the risks that it faces. 
This assures that the enterprise, i.e., the Bank System, and not 
taxpayers generally, will bear the risk associated with the Banks' 
activities and operations. Thus, consistent with this goal of the GLB 
Act, the Finance Board believes that permanent capital should be held 
by a Bank against potential losses arising from operations risk, and 
that the Finance Board should not rely solely on a supervisory approach 
to guard against such losses.
    In support of their requests for a reduced operations risk capital 
charge, some Banks also cited a study done by one of their consultants 
that estimated an operations risk capital charge at about ten percent 
of credit and market risk (Study). The Study relied on loss estimates 
from a small number of publicly acknowledged operations risk failures 
and made some broad assumptions about the Banks' operations. The 
Finance Board has reviewed the Study, which is a useful initial attempt 
to measure the Banks' operations risk. However, while recognizing the 
time constraints under which the Study was completed and the inherent 
difficulties of measuring operations risk, the Finance Board finds that 
the Study is not comprehensive, or more specifically, that the data 
used is incomplete and many of the assumptions made were not adequately 
supported by empirical evidence. Thus, the Finance Board does not 
believe that the results of the Study provide a sufficient basis for 
changing the proposed rule.
    Along similar lines, some commenters argued that the proposed 
capital charge was too onerous given the Banks' historical lack of 
losses from operational problems. However, without having to address 
the accuracy of such views, it is clear that the Banks recently have 
received additional investment authority and are entering into new 
business areas. See, e.g., 65 FR 43969 (July 17, 2000) (adopting rules 
governing acquired member asset program), 65 FR 44414 (July 18, 2000) 
(adopting rules expanding eligible collateral to support advances and 
procedures for approval of new business activities). While these new 
activities may not present new or unique credit or market risks, they 
are likely to result in changes in existing business and hedging 
operations and in the development of new or more complex operational 
processes. The Finance Board believes that the likelihood of such 
changes further supports the conservative approach embodied in the 
operations risk capital charge as adopted. Moreover, as with all 
aspects of the capital regulation, the Finance Board is willing to 
consider changes to the operations risk capital requirements if it is 
presented with sufficient evidence to justify such amendments.

Section 932.7--Reporting Requirements

    Section 932.7 of the proposed rule would have required each Bank to 
report to the Finance Board by the 15th day of each month its risk-
based capital requirement by component amounts, and its actual total 
capital amount and permanent capital amount. These reported values 
would have been calculated as of the last day of the preceding month. 
In the proposed rule, the Finance Board also reserved the right to 
require the Banks to report this information more frequently. Comments 
received on the reporting requirement indicated that commenters found 
reporting capital requirements by the 15th day of each month to be 
unrealistic. Most commenters suggested that a reporting date later in 
the month would be more practical. Several commenters recommended 
eliminating the requirement, but said that if the Finance Board 
retained the requirement, it should be moved to the final calendar day 
of the month. One commenter recommended moving the reporting 
requirement to the 20th of the month.
    The Finance Board believes that it is important to monitor the 
capital requirements of the Banks to ensure that they remain in 
compliance with the requirements and to identify any potential 
situations that may require remedial action, but recognizes that 
sufficient time must be provided if the reported information is to be 
accurate. As a result, the Finance Board has retained the reporting 
requirement in the final rule, but has changed the reporting date from 
the 15th day of the month to the 15th business day of the month 
providing more time for the Banks to prepare their capital 
calculations. Currently, the Banks report duration of equity and market 
value of equity calculations for the previous month to the Finance 
Board on the 15th business day of each month. The change in the 
reporting date in the final rule to the 15th business day would add 
approximately five days providing more time for the Banks to prepare 
their calculations and would be in conformance with current reporting 
requirements for the Banks for market risk measures. Except for the 
change in the reporting date, the Finance Board is adopting Sec. 932.7 
as proposed.

Section 932.8--Minimum liquidity requirements

    As proposed, Sec. 932.8 would require each Bank to hold contingency 
liquidity \28\ in an amount sufficient to

[[Page 8301]]

enable it to cover its liquidity risk, assuming a period of not less 
than five business days of inability to borrow in the capital markets. 
This requirement is in addition to meeting the deposit liquidity 
requirements contained in Sec. 965.3 of the Finance Board's 
regulations. 12 CFR 965.3. Proposed Sec. 932.8 also specifically stated 
that an asset that has been pledged under a repurchase agreement cannot 
be used to satisfy the contingency liquidity requirement. As discussed 
below, the Finance Board received several comments on proposed 
Sec. 932.8, but did not alter the proposed provision in response. The 
Finance Board is, therefore, adopting Sec. 932.8 as proposed.
---------------------------------------------------------------------------

    \28\ Contingency liquidity, as defined in the Finance Board 
regulations, means the sources of cash a Bank may use to meet its 
operational requirements when its access to the capital markets is 
impeded, and includes: (1) marketable assets with a maturity of one 
year or less; (2) self-liquidating assets with a maturity of seven 
days or less; (3) assets that are generally accepted as collateral 
in the repurchase agreement market; and (4) irrevocable lines of 
credit from financial institutions rated not lower than the second 
highest credit rating category by a credit rating organization 
regarded as a NRSRO by the Securities and Exchange Commission. 12 
CFR 917.1.
---------------------------------------------------------------------------

    Generally, commenters indicated that because there are already 
regulations that require each Bank to develop a liquidity policy, 
additional liquidity requirements are not necessary. One commenter 
indicated that if the Finance Board determines to have additional 
liquidity requirements, such a regulation should be postponed until 
after the capital regulation is finalized. Another commenter stated 
that if the liquidity regulation is adopted, then the Finance Board 
should provide guidance on how to measure compliance with the 
regulation. In this regard, the Finance Board believes that the 
analytical framework on liquidity measurement and management specified 
in the 1992 Basle paper serves as a useful guide in the measurement of 
contingency liquidity. See ``A Framework for Measuring and Managing 
Liquidity,'' Basle Committee on Banking Supervision (September 1992).
    Another commenter believed that the proposed Sec. 932.8 requirement 
would not be sufficient to avoid the risk that a Bank's operations 
would be disrupted during a significant financial crisis and 
recommended that to adhere to the Basle Accord Capital Standards, the 
Bank should hold sufficient capital against liquidity risk to withstand 
a period of one-to-three months' inability to access debt markets. The 
contingency liquidity requirement set forth in Sec. 932.8 is not 
intended to fully resolve a situation where the Bank System's access to 
the capital markets is effectively limited for a period of time 
extended more than a few days. See 65 FR at 43430-31. Furthermore, 
neither the Basle Committee nor the banking regulators in the U.S. have 
indicated any desire to propose risk-based capital standards for 
liquidity risk. Therefore, the Finance Board has decided not to require 
a specific liquidity risk capital for the Banks, as suggested by the 
commenter.
    The Banks currently operate under two general liquidity 
requirements, both of which are easily met by the Banks. Under 
Sec. 965.3 of the Finance Board rules, which implements 12 U.S.C. 
1431(g), the Banks must maintain investments in obligations of the 
United States, deposits in banks or trusts, or advances to members that 
mature in 5 years or less in an amount equal to the total deposits 
received from its members. In addition, the Banks must meet a liquidity 
requirement set forth in the FMP that requires each Bank to maintain a 
daily average liquidity level each month in an amount not less than 20 
percent of the sum of the Bank's daily average demand and overnight 
deposits and other overnight borrowings during the month, plus 10 
percent of the sum of the Bank's daily average term deposits, COs, and 
other borrowings that mature within one year. See FMP section III.C. In 
addition to these specific requirements, each Bank also must set 
standards in its risk management policy for day-to-day operational 
liquidity \29\ and contingency liquidity needs that enumerate the 
specific types of investments to be held for such liquidity needs and 
establish the methodology to be used for determining the Bank's 
operational and contingency liquidity needs. 12 CFR 917.3(b)(3)(iii).
---------------------------------------------------------------------------

    \29\ Operational liquidity, as defined in the Finance Board's 
regulations, means sources of cash from both a Bank's ongoing access 
to the capital markets and its holdings of liquid assets to meet 
operational requirements in a Bank's normal course of business. 12 
CFR 917.1.
---------------------------------------------------------------------------

    Neither of the existing liquidity requirements is structured to 
meet the Bank's liquidity needs should their access to the capital 
markets be limited in the short term for any reason. The requirement 
adopted in Sec. 932.8 is meant to address principally events that may 
temporarily disrupt a Bank's access to credit markets. It may be viewed 
as conservative when examined in the context of events which could 
impair the normal operations of the Office of Finance (OF). The 
likelihood that there would be no access to the capital markets for as 
long as five business days is extremely remote, given OF's contingency 
plans to be back in operation within the same business day following a 
disaster. The OF contingency plans include back-up power sources and 
two back-up facilities, plus procedures to back-up their databases at 
both their main location as well as the primary alternative site. A 
back-up data tape from OF's main location is sent and stored off-site 
on a daily basis.
    Rating agencies also consider adequate liquidity an important 
component in a financial institution's rating. Liquid investments held 
by the Banks are stated by Moody's as one of the reasons behind the 
triple-A rating for the Banks.\30\ Thus, the Finance Board believes 
that the contingency liquidity requirement set forth in Sec. 932.8 is 
important to maintaining a sound credit rating for the Banks and 
assuring continued safe and sound operation of the Bank System and 
access to the capital markets.
---------------------------------------------------------------------------

    \30\ ``Moody's Investor Service, Global Credit Research, Moody's 
Credit Opinions--Financial Institutions'', (June 1999).
---------------------------------------------------------------------------

    In the SUPPLEMENTARY INFORMATION section of the proposed rule, the 
Finance Board asked for comment on whether the rule should address the 
issue of operational liquidity, and if so, how it should do so. One 
commenter specifically addressed the question posed in the 
SUPPLEMENTARY INFORMATION section of the proposed rule. The commenter 
stated that each Bank should establish its own operational liquidity 
policy and that the Finance Board should not specify a specific 
requirement. After further consideration, the Finance Board believes 
that the requirements in Sec. 917.3 and Sec. 965.3 of the Finance 
Board's regulations sufficiently cover operational liquidity and will 
not address it further in its regulations at this time. 12 CFR 917.3, 
965.3.

Section 932.9--Limits on Unsecured Extensions of Credit

    Section 932.9 of the proposed rule established maximum capital 
exposure limits for unsecured extensions of credit by a Bank to a 
single counterparty or to affiliated counterparties and reporting 
requirements for total unsecured credit exposures and total secured and 
unsecured credit exposures to single counterparties and affiliated 
counterparties that exceed certain thresholds.
    The proposed rule provided that unsecured credit exposure by a Bank 
to a single counterparty that would arise from authorized Bank 
investments or hedging transactions must not exceed the maximum capital 
exposure percent limit applicable to such counterparty, as set forth in 
Table 4 of the proposed rule, multiplied by the lesser of: (i) the 
Bank's total capital; or (ii) the counterparty's Tier 1 capital, or 
total capital if information on Tier 1 capital is not available. The 
maximum capital

[[Page 8302]]

exposure percent limits applicable to specific counterparties in Table 
4 ranged from a high of 15 percent, for counterparties with the highest 
investment grade rating, to a low of one percent for counterparties 
with a below investment grade rating.
    The proposed rule also provided that where a counterparty has 
received different credit ratings for its transactions with short-term 
and long-term maturities: (i) the higher credit rating shall apply for 
purposes of determining the allowable maximum capital exposure limit 
under Table 4 applicable to the total amount of unsecured credit 
extended by the Bank to such counterparty; and (ii) the lower credit 
rating shall apply for purposes of determining the allowable maximum 
capital exposure limit under Table 4 applicable to the amount of 
unsecured credit extended by the Bank to such counterparty for the 
transactions with maturities governed by that rating. The proposed rule 
also provided that if a counterparty is placed on a credit watch for a 
potential downgrade by an NRSRO, the Bank would use the credit rating 
from that NRSRO at the next lower grade. The proposed rule also 
required that the total amount of unsecured extensions of credit by a 
Bank to all affiliated counterparties may not exceed: (i) the maximum 
capital exposure limit applicable under Table 4 based on the highest 
credit rating of the affiliated counterparties; (ii) multiplied by the 
lesser of: (A) the Bank's total capital; or (B) the combined Tier 1 
capital, or total capital if information on Tier 1 capital is not 
available, of all of the affiliated counterparties.
    The proposed rule required that the Banks report monthly to the 
Finance Board the amount of the Bank's total secured and unsecured 
credit exposures to any single counterparty or group of affiliated 
counterparties that exceeds 5 percent of the Bank's total assets.
    The principal change made by the Finance Board in the final rule 
refined the calculation of the maximum allowable credit exposure to a 
counterparty. The proposed rule required that the determination be made 
on the basis of the counterparty's Tier 1 capital, or if Tier 1 capital 
is not available, total capital (as defined by the counterparty's 
principal regulator). The final rule adds another option in situations 
where Tier 1 capital and regulatory capital are not available and 
allows a Bank to use in these cases some comparable measure identified 
by the Bank. This was added in recognition that there may be 
unregulated counterparties that don't have regulatory capital (because 
they do not have a principal regulator) and allows a Bank to use some 
other comparable measurement such as equity, owners equity, or net 
worth.
    Most of the commenters that addressed this section of the proposed 
rule opposed the implementation of unsecured credit limits. One 
commenter indicated that the limits are tolerable, but not necessary. 
Others commented that this section is not pertinent to the 
restructuring of Bank capital and therefore should be eliminated from 
the final rule, and one indicated a belief that limits on unsecured 
extensions of credit should be established by each Bank's board of 
directors, subject to review by the Finance Board during the 
examination process.
    The Finance Board has long maintained limits on unsecured 
extensions of credit, which currently are contained in the FMP, and 
other financial institution regulatory agencies also limit the amount 
of credit that can be extended to one borrower. As explained in the 
proposed rule, concentrations of unsecured credit by a Bank with a 
limited number of counterparties or group of affiliated counterparties 
raise safety and soundness concerns because unsecured credit extensions 
are more likely to result in limited recoveries in the event of default 
that secured extensions of credit. Significant credit exposures to a 
few counterparties increase the probability that a Bank may experience 
a catastrophic loss in the even of default by one of the 
counterparties. In contrast, holding small credit exposures in a large 
number of counterparties reduces the probability of a catastrophic loss 
to a Bank.
    Concentrations of credit by multiple Banks in a few counterparties 
also may raise safety and soundness concerns at the Bank System level. 
It is conceivable that some counterparties spread their exposure among 
several Banks, which may result in large aggregate credit exposures for 
the Bank System. Such exposures raise concerns regarding the liquidity 
of such debt in the event of adverse information regarding a 
counterparty.
    Because the risk-based capital requirement does not take into 
account the increase in credit risk associated with concentrations of 
credit exposures, the Finance Board believes it is necessary, for 
safety and soundness reasons, to impose separate limits on unsecured 
credit exposures of a Bank to single counterparties and to affiliated 
counterparties. The Finance Board also believes that the limits 
established in this rule are appropriate in order to limit Bank System 
exposure to a counterparty or group of affiliated counterparties. The 
Finance Board is not imposing System-wide limits due to the operational 
difficulties in tracking and allocating exposure and thus feels that 
the limits applied to individual Banks must be low enough to limit 
System exposure. The Finance Board may solicit additional comments 
regarding the appropriateness of the limits in a future rulemaking and 
may consider revising them at that time.

G. Part 933--Bank Capital Structure Plans

    Submission of Plans. Section 933.1(a) of the proposed rule would 
have required the board of directors of each Bank to submit to the 
Finance Board within 270 days after the date of publication of the 
final rule a capital plan that complies with part 931 and that, when in 
effect, would provide the Bank with sufficient total and permanent 
capital to meet the minimum regulatory capital requirements established 
by part 932. The proposed rule also would have allowed the Finance 
Board to approve a reasonable extension of the 270-day period upon a 
demonstration of good cause. As set forth in the GLB Act, the proposal 
would have required a Bank to receive Finance Board approval prior to 
implementing its capital plan or any subsequent amendment to the plan.
    Proposed Sec. 933.1(b) also stated that if a Bank, for any reason, 
were to fail to submit a capital plan to the Finance Board within the 
270-day period, including any Finance Board approved extension, the 
Finance Board would be authorized to establish a capital plan for that 
Bank, and the Finance Board also would have the discretion to take any 
enforcement action against the Bank, its directors, or its executive 
officers authorized by section 2B(a) of the Bank Act, 12 U.S.C. 
1422b(a), or to merge the Bank in accordance with section 26 of the 
Bank Act, 12 U.S.C. 1446, into another Bank that has submitted a 
capital plan.
    The Finance Board is adopting Sec. 933.1(a) and (b) without any 
material changes, though it has added a new Sec. 933.1(c), which deals 
with Finance Board consideration of the capital plans. Section 933.1(c) 
provides that upon receipt of a capital plan from a Bank, the Finance 
Board may return the plan to the Bank if it does not comply with 
section 6 of the Bank Act or with any regulatory requirement, or if it 
is incomplete or materially deficient in any other respect. If the 
Finance Board accepts a plan for review, it still may require the Bank 
to submit additional information, as needed to review the

[[Page 8303]]

plan, or to amend the plan, as necessary to comply with the statute or 
regulations. The final rule also provides that the Finance Board may 
approve the capital plan conditionally, i.e., the approval is 
contingent upon the Bank complying with certain conditions stated in 
the approval resolution from the Finance Board. It is well established 
that an agency's authority to deny a regulatory submission includes the 
authority to approve an application subject to certain conditions, 
which the Finance Board will do as circumstances dictate. The final 
rule further provides that the Finance Board may require that the 
capital plans for all twelve Banks take effect on the same date. This 
issue was raised by several commenters, who contended that the joint-
and-several liability of the Banks on their consolidated obligations 
may require that the individual Banks not operate under materially 
different capital structures, as such an arrangement could result in 
some Banks bearing a portion of the risks created by the other Banks. 
The Finance Board believes that the concern expressed by the commenters 
merits some consideration and has addressed the issue by reserving to 
itself the right to set a uniform effective date for the capital plans 
of all of the Banks. The Finance Board will decide whether to do so 
after reviewing the plans submitted by the Banks, and is not prepared 
to mandate in the final rule that all of the plans must take effect on 
the same date. Most of the comments on Sec. 933.1 dealt with timeframes 
for review of capital plans, and the ``commonality'' of plans. Two Bank 
commenters suggested that the final rule impose a time limit for 
Finance Board review of the plans, while another Bank recommended a 
procedure and timeframe for addressing capital plan amendments. Other 
commenters suggested an expedited review process, or possibly pre-
approval, for certain types of amendments to the capital plan during 
the initial implementation period and recommended that the rule require 
each Bank to include in its plan provisions to address simply and 
quickly any unintended consequences that may arise as the Banks 
implement their capital plans.
    Many commenters suggested, to assure safety and soundness, 
coordination of the System as a whole and an appropriate degree of 
commonality among plans, that the Finance Board approve all of the 
Banks' capital plans at the same time or not approve any one plan until 
it has received plans from all of the Banks. Commonality was a common 
theme among commenters, who sought coordination of the final capital 
plans across the Bank System to avoid a potentially destabilizing 
competition and arbitrage of membership and to preserve the cooperative 
nature of the Bank System. The Finance Board intends to assess the 
issue of commonality as part of the approval process, and will 
consider, for example, differences between the plans on matters such as 
the minimum investment, including both membership and activity-based 
stock purchase requirements, dividend policy, and voting preferences. 
It is only by making such comparisons that the Finance Board will be 
able to assess accurately the possibility that the differences among 
the plans might encourage members of one Bank to relocate to another 
Bank in order to benefit from what they perceive to be a more 
advantageous Bank capital structure.
    The Finance Board has not imposed any time limits for its review of 
the individual capital plans. Though the Congress spoke precisely to 
when the Finance Board must promulgate the final rule and when the 
Banks must submit their capital plans for review, it was silent on the 
issue of Finance Board review of the individual plans. Given that 
silence, and the possible variables that could affect the Finance 
Board's review of each plan, the Finance Board is not prepared to 
establish time periods in the final rule within which it must act on 
the capital plans. The length of time that it will take the Finance 
Board to review each capital plan will depend on a number of factors, 
including the quality of the initial submission, the timing of the 
submissions, and the approval of certain models to be used by the Banks 
on which capital plan approvals are contingent. For all of those 
reasons, and with so many unknown factors, the Finance Board does not 
believe that it is in the best interest of the agency or the Banks to 
establish a time limit for Finance Board review of the plans. 
Nonetheless, the Finance Board is committed to reviewing each plan in 
as expeditious a manner as is possible and encourages the Banks to 
communicate with the Finance Board as issues arise during the 
development of their capital plans. The Finance Board believes such 
communication during the development of the plans can aid immeasurably 
in eliminating potential problems that might otherwise delay the 
Finance Board's consideration of the capital plans. That approach will 
ensure that the Finance Board has the opportunity to fully and 
completely review each Bank's capital plan and to deal with unforeseen 
issues that may arise during the review period without imperiling the 
quality of its review.
    Contents of Plans. Section 933.2 of the proposed rule would have 
implemented the GLB Act provisions regarding the contents of capital 
plans by requiring each Bank's capital plan to address, at a minimum, 
the classes of capital stock, capital stock issuance, membership 
investment or fee structure, transfer of capital stock, termination of 
membership, independent review of the capital plan, and implementation 
of the plan. The Finance Board received relatively few comments on this 
provision. Among those parties commenting, one Bank contended that the 
GLB Act requirement that members promptly comply with any amendments to 
the minimum investment would constitute an ``unlimited capital call'' 
on the assets of the members should the financial condition of the Bank 
deteriorate. Other commenters recommended that the final rule require 
each Bank to submit the capital plans to its members for their approval 
prior to submitting the plan to the Finance Board, and that the plans 
themselves be subject to public comment. Most of the revisions made in 
the final rule have been added in order to conform Sec. 933.2 to the 
revisions that have been made to part 931 of the final rule. The most 
significant change to Sec. 933.2 is the inclusion of Sec. 933.2(a), 
which relates to the minimum investment that each Bank must establish 
for its members. Generally speaking, those changes reflect the 
amendments made to Sec. 931.3 of the final rule, which added the 
minimum investment provisions to part 931 and which have been described 
previously. The final rule provides that each Bank's capital plan must 
require each member to purchase and maintain a minimum investment in 
the capital stock of the Bank in accordance with Sec. 931.3, and must 
prescribe the manner in which the minimum investment is to be 
calculated. The capital plan must require each member to maintain its 
minimum investment in the Bank's stock for as long as it remains a 
member and, with regard to Bank stock purchased to support an advance 
or other business activity, for as long as the advance or business 
activity remains outstanding.
    The final rule also requires the capital plan to specify the amount 
and class (or classes) of Bank stock that an institution is required to 
own in order to become and remain a member of the Bank, as well as the 
amount and class (or classes) that a member must own in order to obtain 
advances from, or to engage in

[[Page 8304]]

other business transactions with, the Bank. If a Bank issues both Class 
A and Class B stock and the board of directors of that Bank authorizes 
the members to satisfy their minimum investment through the purchase of 
some combination of Class A and Class B stock, the capital plan must 
specify what combinations of stock are authorized. If the Bank were to 
authorize only one combination of Class A and Class B stock for the 
members to purchase, the members would be limited to whatever 
combination had been approved by the Bank's board of directors. 
Consistent with part 931, as well as with the GLB Act, Sec. 933.2(a)(3) 
of the final rule provides the Banks with several alternatives for 
structuring their minimum investment. Thus, a capital plan may 
establish a minimum investment that is calculated as a percentage of 
the total assets of the member, as a percentage of the advances 
outstanding to the member, as a percentage of the other business 
activities conducted with the member, on any other basis approved by 
the Finance Board, or on any combination of the above. This affords 
each Bank the latitude to tailor its minimum investment to the needs of 
its members, and recognizes that each Bank may have a different 
operating philosophy and may wish, for example, to establish relatively 
lower activity-based stock purchase requirements and relatively higher 
membership stock purchase requirements, or vice versa. However a Bank 
decides to structure its minimum investment, the final rule requires 
that the minimum investment be set at such a level as to provide 
sufficient capital for the Bank to comply with its minimum capital 
requirements, as specified in part 932. The final rule also requires 
the plan to require the board of directors of the Bank to monitor and, 
as necessary, to adjust, the minimum investment to ensure that the 
stock that the members are required to purchase remains sufficient to 
allow the Bank to comply with its minimum capital requirements. The 
final rule further provides that the plan shall require each member to 
comply with any such adjusted minimum investment, but may permit a 
member a reasonable period of time within which to come into compliance 
with the adjusted minimum investment. The final rule expressly provides 
that a Bank may permit a member to comply with an adjusted minimum 
investment by reducing its outstanding business with the Bank to a 
level that would be fully supported by its existing investment in the 
stock of the Bank.
    A number of commenters criticized the provision in the proposed 
rule that would have required members to ``comply promptly'' with any 
adjustment to the minimum investment required under the capital plan 
for a Bank. The principal objection was that the provision is 
tantamount to an ``unlimited call'' by the Bank on the assets of the 
members to support the capital of the Bank, which could discourage 
institutions from remaining members after the capital plans take 
effect. As an initial matter, the requirements that each capital plan 
``impose a continuing obligation on the board of directors of the bank 
to review and adjust the minimum investment required of each member of 
that bank, as necessary to ensure that the bank remains in compliance 
with applicable minimum capital levels'' and to ``require each member 
to comply promptly with any adjustments to the required minimum 
investment'' are statutory requirements and the Finance Board cannot 
delete them from the final rule. 12 U.S.C. 1426(c)(1)(D).
    Historically, the amount of Bank stock that each member must own 
was set by statute as the greater of 1 percent of the member's mortgage 
assets or 5 percent of the advances outstanding to the member. In the 
GLB Act, the Congress repealed the statutory stock purchase 
requirements and replaced them with provisions directing each Bank to 
establish a ``minimum investment'' for its members. Aside from giving 
the Banks different options for how the minimum investment could be 
structured, Congress largely left the details of the minimum investment 
to the Banks. That delegation to the Banks was subject, however, to a 
statutory requirement that whatever method a Bank chose for its minimum 
investment must provide sufficient permanent and total capital for the 
Bank to meet the risk-based and leverage capital requirements 
established by the GLB Act. As a trade-off for allowing the Banks to 
establish the details of the minimum investment, the Congress imposed 
two new requirements. One requirement imposed on the board of directors 
of each Bank a ``continuing obligation'' to review and, as necessary, 
to adjust the minimum investment required of each member to ensure that 
the Bank remains in compliance with the GLB Act capital requirements. 
The other requirement imposed on the members an obligation to ``comply 
promptly'' with any revisions to the minimum investment established by 
that Bank.
    As the Finance Board understands the criticisms of this aspect of 
the law, the requirement to ``comply promptly'' with the revised 
minimum investment is viewed by some as creating an open-ended 
obligation on the part of the members to guarantee the capital adequacy 
of the Banks. To those parties, this obligation would effectively 
require the members to pay to the Banks, for the purchase of additional 
Bank stock, whatever amounts might be demanded by the Banks. The 
Finance Board does not share the view of those commenters that this 
provision constitutes an ``unlimited call'' on the assets of the 
members of each Bank. Although the GLB Act does require the members of 
a Bank to comply promptly with any increased minimum investment 
requirement, it does not provide any means for a Bank to compel payment 
from any members that decline to purchase the additional amounts of 
Bank stock. Indeed, it is not clear that either the Banks or the 
Finance Board has any legal authority to compel a member to pay to its 
Bank any amounts that the member does not want to pay. In the absence 
of any ability of either the Bank or the Finance Board to compel 
payment, the Finance Board does not believe that this provision can 
reasonably be construed to impose an unlimited call on the assets of 
any member.
    That is not to say that a member's refusal to comply promptly with 
the stock purchase requirement of the Bank's capital plan would be 
without consequences for the member. For instance, a member that 
refused to comply with an amended minimum investment requirement would 
be in violation of section 6(c)(1)(D) of the Bank Act, as well as with 
the provisions of the capital regulations. If a member violates those 
provisions, it will provide the Bank with grounds to terminate its 
membership involuntarily, in accordance with section 6(d)(2) of the 
Bank Act, as amended by the GLB Act. 12 U.S.C. 1426(c)(1)(D), (d)(2). 
Moreover, depending on the terms of the advances agreements or other 
agreements between the Bank and its member, a refusal to comply with 
the minimum investment may constitute an event of default under such 
agreements that would allow the Bank to take certain other actions, 
such as calling due all outstanding advances to that member, 
liquidating its collateral, or suspending dividend payments to that 
member, or may give the Bank grounds for a civil action against the 
member. How the Banks and members resolve these issues will depend in 
large part on the particular circumstances of each case. As a 
fundamental matter, however,

[[Page 8305]]

the Banks are cooperatives and as such must look solely to their 
members as the source of the capital needed to support the business 
conducted by the Banks with their members. As members of a cooperative, 
the members of a Bank have an obligation to provide the Bank with the 
capital that the Banks are required to hold in order to support the 
risks attendant to the business that they conduct with their members. 
Under the GLB Act, membership is voluntary for all institutions, as are 
the transactions that a member initiates with its Bank. If an 
institution wishes to remain a member of a Bank, or if it wishes to 
obtain (or retain) advances from its Bank, it simply cannot refuse to 
provide the Bank with the capital that the GLB Act requires the Bank to 
have for such transactions. That does not mean that the Bank has an 
unlimited call on the assets of the member. It does mean that the Banks 
will be required to manage actively the important relationships they 
maintain with their members, and that members may be required, from 
time to time, to reevaluate the economics of remaining a member of the 
Bank. If the costs of continued membership exceed the benefits that the 
member expects to receive from being a member, then the member can 
withdraw voluntarily from membership or can allow the Bank to terminate 
its membership for noncompliance with the Bank Act. In either event, 
the decision of the member will be a voluntary decision based on the 
economics of the situation, which is precisely the type of decision 
that the members make every day in the conduct of their business.
    The Finance Board recognizes that ``comply promptly'' does not 
necessarily mean that a member must comply with an adjusted minimum 
investment immediately, and has included in the final rule a provision 
that allows a Bank to establish a reasonable period of time for the 
members to comply with the new minimum investment. As a practical 
matter, this is most apt to be an issue only with regard to advances or 
other transactions that are already on the books of the Bank at the 
time that the minimum investment is adjusted. With respect to advances 
and other transactions initiated subsequent to the revised minimum 
investment provisions, the Finance Board expects that the members will 
purchase the required amount of Bank stock prior to closing the new 
transaction. With respect to outstanding transactions, the Bank will 
determine what constitutes a reasonable period of time, and may take 
into consideration the fact that advances or other transactions may 
mature or otherwise terminate in the short term. The Finance Board 
notes, however, that it would not be a safe or sound practice for the 
Bank to carry undercapitalized assets on its books for more than a 
relatively brief period, nor would it be equitable to other members 
that promptly purchase the additional stock to allow disparate stock 
purchase requirements to remain outstanding for a significant period.
    It also should be noted that a Bank cannot unilaterally increase 
the minimum investment that it requires of its members. By law, the 
minimum investment must be specified in the capital plan, which must be 
approved by the Finance Board. Thus, in order for a Bank to increase 
its minimum investment, the board of directors of the Bank would have 
to authorize the amendment to the capital plan and its submission to 
the Finance Board. Moreover, it is by no means certain that the Bank 
will ask to apply the increased minimum investment to all of its 
outstanding business with its members. Depending on the circumstances, 
it is possible that a Bank could ask that the minimum investment be 
approved only for new business and that it could ask for a transition 
period for the members to adjust their stock holdings for their 
existing business with the Banks. Regardless of the content of the 
submission, the Finance Board would review the amendment in the same 
manner as it reviews the initial capital plan and, presumably, would 
approve the plan. It will only be after the Finance Board has approved 
the amendment that the Bank could impose the revised minimum investment 
on its members.
    As required by the GLB Act, Sec. 933.2(b) of the final rule also 
requires that the capital plan specify the class or classes of stock 
(including subclasses, if any) that the Bank will issue, and establish 
the par value, rights, terms, and preferences associated with each 
class (or subclass) of stock. The final rule allows a Bank to establish 
preferences that are related to, but not limited to, the dividend, 
voting, or liquidation rights for each class or subclass of Bank stock. 
Any voting preferences established by the Bank pursuant to Sec. 915.5 
shall expressly identify the voting rights that are conferred on each 
class of stock with regard to the election of Bank directors. As 
specified in the GLB Act, the final rule also requires that the capital 
plan provide that the owners of the Class B stock own the retained 
earnings, and paid-in surplus of the Bank, but shall have no right to 
withdraw or otherwise receive distribution of any portion of such 
retained earnings or paid-in surplus of the Bank except through the 
declaration of a dividend or a capital distribution approved by the 
board of directors of the Bank, or through the liquidation of the Bank.
    Section 933.2(c) of the final rule requires the capital plan to 
establish the manner in which the Bank will pay dividends, if any, on 
each class or subclass of stock, and shall provide that the Bank may 
not declare or pay any dividends if it is not in compliance with any 
capital requirement or if, after paying the dividend, it would not be 
in compliance with any capital requirement.
    Section 933.2(d) of the final rule requires the capital plan to 
address issues relating to initial issuance of the Class A and/or Class 
B capital stock, to specify the date on which the Bank will implement 
the new capital structure, to establish the manner in which the Bank 
will issue stock to its existing members, as well as to eligible 
institutions that subsequently become members, and to address how the 
Bank will retire the stock that is outstanding as of the effective 
date, including stock held by a member that does not affirmatively 
elect to convert or exchange its existing stock to either Class A or 
Class B stock, or some combination thereof.
    Section 933.2(e) of the final rule requires the capital plan to set 
forth the criteria for stock transactions, including the issuance, 
redemption, repurchase, transfer, and retirement of all Bank stock. The 
capital plan also must provide that the Bank may not issue stock other 
than in accordance with Sec. 931.2; that the stock of the Bank may be 
issued only to and held only by the members of that Bank; and that the 
stock of the Bank may be transferred only in accordance with 
Sec. 931.6, and may be traded only between the Bank and its members. 
The capital plan may provide for a minimum investment for members that 
purchase Class B stock that is lower than the minimum investment for 
members that purchase Class A stock, provided that the level of 
investment is sufficient for the Bank to comply with its regulatory 
capital requirements. The capital plan must specify the fee, if any, to 
be imposed on a member that cancels a request to redeem Bank stock, and 
must specify the period of notice that the Bank will provide to a 
member before the Bank, on its own initiative, determines to repurchase 
any excess Bank stock from a member.
    As required by the GLB Act, Sec. 933.2(f) of the final rule 
requires the capital plan to address the manner in which the Bank will 
provide for the disposition of

[[Page 8306]]

its capital stock that is held by institutions that terminate their 
membership, and the manner in which the Bank will liquidate claims 
against its members, including claims resulting from the prepayment of 
advances prior to their stated maturity.
    Under Sec. 933.2(g) of the final rule, each Bank's capital plan 
must demonstrate that the Bank has made a good faith determination that 
the Bank will be able to implement the plan as submitted and that the 
Bank will be in compliance with its regulatory total capital 
requirement and its regulatory risk-based requirement after the plan is 
implemented. As required by the GLB Act, the final rule requires each 
Bank to conduct a review of its plan by an independent certified public 
accountant prior to submission to the Finance Board, to ensure, to the 
extent possible, that implementation of the plan would not result in 
the write-down of the redeemable stock owned by its members, and must 
conduct a separate review by at least one NRSRO to determine, to the 
extent possible, whether the implementation of the plan would have a 
material effect on the credit rating of the Bank. The final rule 
requires each Bank to submit a copy of each report to the Finance Board 
at the time it submits its proposed capital plan.
    Though some commenters recommended that the final rule require the 
Banks to submit their capital plans to their members for approval prior 
to submitting the plans to the Finance Board, the Finance Board has not 
included such a requirement in the final rule. Nothing in the GLB Act 
requires member approval of capital plans, nor indicates how such a 
vote would be conducted. The Finance Board notes that the interests of 
the members are represented by the elected directors of each Bank, each 
of whom is an officer or a director of a member and who collectively 
constitute a majority of the board of each Bank. Moreover, the GLB Act 
expressly charges the board of directors of each Bank with the 
responsibility for developing a capital plan that, among other things, 
``is best suited for the condition and operation of the bank and the 
interest of the members of the bank.'' The Finance Board further notes, 
however, that there is nothing in the GLB Act that would prohibit a 
Bank from soliciting the views of its members in creating the capital 
plan or from seeking the approval of the members prior to submitting 
the capital plan to the Finance Board. Regardless of how a Bank 
addresses the issue of member involvement, the Finance Board expects 
that each Bank will submit its capital plan to the Finance Board on or 
before the statutory deadline.

H. Parts 956, 960 and 966

    The final rule amends Sec. 966.8 by adding new paragraph (d) which 
sets forth requirements for the issuance of consolidated obligations 
denominated in foreign currencies or linked to equity or commodity 
prices. This provision was proposed in the capital regulation as part 
of Sec. 932.5(b)(5). Because Sec. 932.5 generally addresses 
requirements governing the Banks' internal market risk capital models, 
the Finance Board has determined that it would be more appropriate for 
these requirements relating to the issuance of consolidated obligations 
to appear in part 966 of the Finance Board's regulations, which 
concerns the issuance of consolidated obligations. As such, the 
requirements governing the issuance of consolidated obligations 
denominated in foreign currencies or linked to equity or commodity 
prices that were proposed in Sec. 932.5(b) are being adopted in the 
final rule without substantive change as a new paragraph (d) to 
Sec. 966.8.
    Conforming changes to Sec. 956.3(b), which reference the 
requirements of new Sec. 966.8(d), have also been adopted. These 
conforming changes to Sec. 956.3(b) were not part of the proposed 
regulation but do not alter the substance of recently adopted 
Sec. 956.3. 65 FR 43969, 43986 (July 17, 2000). Instead, they merely 
provide a cross reference to the requirements in part 966. The Finance 
Board also proposed to add new part 960 of its regulations in the 
proposed capital regulation. The new part would have authorized the 
Banks to engage in specific off-balance sheet transactions, including 
derivative contracts, and set forth requirements that the Banks must 
document non-speculative use of any derivative instruments that do not 
qualify as hedging instruments under GAAP. These changes would have 
adopted authority that already existed in the FMP.
    As already discussed, recent changes in accounting standards for 
derivatives means that derivatives can no longer be considered purely 
off-balance sheet items. Further, some of the other transactions that 
would have been authorized under proposed part 960 could also be on-
balance sheet under certain circumstances. The Finance Board did not 
wish to imply that if accounting treatment required one of the 
transactions listed in proposed part 960 to be on the Bank's balance 
sheet that the transaction would not be authorized. Thus, in the final 
rule the Finance Board has combined proposed part 960 with part 956, 
which sets forth the authority for the Banks to make specific 
investments. The items that would have been authorized as off-balance 
sheet transactions in proposed part 960 are now authorized under new 
Sec. 956.5. The Finance Board also made a conforming change to the list 
of transactions authorized under Sec. 956.5 of the final rule to 
recognize that under the AMA programs, Banks may enter into commitments 
to purchase loans that may be recorded as off-balance sheet items.
    In addition, one comment was received on proposed part 960. It 
requested the Finance Board to add standby bond purchase agreements to 
the list of authorized off-balance sheet transactions. Given the 
brevity of the comment, Finance Board staff has sought additional 
information and clarification from the commenters on this request and 
is still studying the issues involved. Thus, the Finance Board has 
determined not to address this issue at this time but may do so at some 
future date.
    The Finance Board did not receive any specific comments on the 
amendments to part 956 that were proposed as part of the capital 
regulation. These proposed amendments were adopted with the changes 
discussed above.

III. Paperwork Reduction Act

    As part of the notice of proposed rulemaking, the Finance Board 
published a request for comments concerning the collection of 
information contained in Secs. 931.7 through 931.9 and 933.2(c)(2) of 
the proposed rule. The Finance Board submitted the proposed collection 
of information, and accompanying analysis, to the Office of Management 
and Budget (OMB) for review in accordance with section 3507(d) of the 
Paperwork Reduction Act, 44 U.S.C. 3507(d). The Finance Board received 
no comments on the proposed information collection.
    OMB has approved the proposed information collection without 
conditions and assigned control number 3069-0059 with an expiration 
date of November 30, 2003. Likely respondents and/or record keepers 
will be Banks and Bank members. The Banks will use the information 
collection to implement their new capital structures, determine 
requirements for member ownership of Bank stock, and determine whether 
Bank members satisfy the statutory and regulatory capital stock 
requirements. See 12 U.S.C. 1426. Responses are mandatory and are 
required to obtain or retain a benefit. See 12 U.S.C. 1426. As a result 
of reorganization and revision of

[[Page 8307]]

certain proposed provisions in the final rule, the information 
collections are now located in Secs. 931.3 and 933.2(e)(4) of the final 
rule. Proposed Sec. 931.9, which required a Bank and member to agree on 
a plan to divest Bank stock to meet certain concentration limits, is 
not included in the final rule and, therefore, there is no information 
collection required in this connection.
    The final capital rule does not substantively or materially modify 
the approved information collection. Potential respondents are not 
required to respond to the collection of information unless the 
regulation collecting the information displays a currently valid 
control number assigned by OMB. See 44 U.S.C. 3512(a).
    The following is the estimated annual reporting and recordkeeping 
hour burden as approved by OMB:

a. Number of respondents: 7,512
b. Total annual responses: 52,500
Percentage of these responses collected electronically: 0%
c. Total annual hours requested: 900,648

    The following is the estimated annual reporting and recordkeeping 
cost burden as approved by OMB:

a. Total annualized capital/startup costs: 0
b. Total annual costs (O&M): 0
c. Total annualized cost requested: $46,717,758.48

    Comments regarding the collection of information may be submitted 
in writing to the Finance Board at 1777 F Street, N.W., Washington, 
D.C. 20006, and to the Office of Information and Regulatory Affairs of 
OMB, Attention: Desk Officer for Federal Housing Finance Board, 
Washington, D.C. 20503.

IV. Regulatory Flexibility Act

    The final rule would apply only to the Finance Board and to the 
Banks, which do not come within the meaning of small entities as 
defined in the Regulatory Flexibility Act (RFA). See 5 U.S.C. 601(6). 
Thus, in accordance with section 605(b) of the RFA, 5 U.S.C. 605(b), 
the Finance Board hereby certifies that the final rule will not have a 
significant impact on a substantial number of small entities.

List of Subjects

12 CFR Part 915

    Banks, banking, Conflict of interests, Elections, Ethical conduct, 
Federal home loan banks, Financial disclosure, Reporting and 
recordkeeping requirements.

12 CFR Part 917

    Community development, Credit, Federal home loan banks, Housing, 
Reporting and recordkeeping requirements.

12 CFR Part 925

    Credit, Federal home loan banks, Reporting and recordkeeping 
requirements.

12 CFR Parts 930, 931, 932 and 933

    Capital, Credit, Federal home loan banks, Investments, Reporting 
and recordkeeping requirements.

12 CFR Part 956

    Community development, Credit, Federal home loan banks, Housing, 
Investments, Reporting and recordkeeping requirements.

12 CFR Part 966

    Federal home loan banks, Securities.

    Accordingly, the Federal Housing Finance Board amends title 12, 
chapter IX of the Code of Federal Regulations, as follows:

PART 915--BANK DIRECTOR ELIGIBILITY, APPOINTMENT AND ELECTIONS

    1. The authority citation for part 915 continues to read as 
follows:

    Authority: 12 U.S.C. 1422a(a)(3), 1422b(a), 1426, 1427, and 
1432.


    2. Amend Sec. 915.3 by revising the introductory text of paragraph 
(b) and paragraph (b)(3) to read as follows:


Sec. 915.3  Director elections.

* * * * *
    (b) Designation of elective directorships. The Finance Board 
annually shall designate each elective directorship as representing the 
members that are located in a particular state. The Finance Board shall 
conduct the annual designation of directorships for each Bank based on 
the number of shares of Bank stock required to be held by the members 
in each state as of December 31 of the preceding calendar year. If a 
Bank has issued more than one class of stock, the Finance Board shall 
designate the directorships for that Bank based on the combined number 
of shares required to be held by the members in each state. For 
purposes of conducting the designation, if a Bank's capital plan was 
not in effect on the immediately preceding December 31st, the number of 
shares of Bank stock that the members were required to hold as of that 
date shall be determined in accordance with Sec. 925.20 and 
Sec. 925.22. If a Bank's capital plan was in effect on the immediately 
preceding December 31st, the number of shares of Bank stock that the 
members were required to hold as of that date shall be determined in 
accordance with the minimum investment established by the capital plan 
for that Bank, provided, however, that for any members whose Bank stock 
is less than the minimum investment during a transition period, the 
amount of stock to be used in the designation of directorships shall be 
the number of shares of Bank stock actually owned by those members as 
of December 31st. In all cases, the Finance Board shall designate the 
directorships by using the information provided by the Banks in the 
capital stock report required by Sec. 915.4. The Finance Board shall 
allocate the elective directorships among the states as follows:
* * * * *
    (3) If the number of elective directorships allocated to any State 
pursuant to paragraphs (b)(1) and (b)(2) of this section is less than 
the number allocated to that State on December 31, 1960, as specified 
in Sec. 915.15, the Finance Board shall allocate such additional 
elective directorships to that State until the total allocated equals 
the number allocated to that State on December 31, 1960;
* * * * *

    3. Revise Sec. 915.4 to read as follows:


Sec. 915.4  Capital stock report.

    (a) On or before April 10 of each year, each Bank shall submit to 
the Finance Board a capital stock report that indicates, as of the 
record date, the number of members located in each voting state in the 
Bank's district, the number of shares of Bank stock that each member 
(identified by its docket number) was required to hold, and the number 
of shares of Bank stock that all members located in each voting state 
were required to hold. If a Bank has issued more than one class of 
stock, it shall report the total shares of stock of all classes 
required to be held by the members. The Bank shall certify to the 
Finance Board that, to the best of its knowledge, the information 
provided in the capital stock report is accurate and complete, and that 
it has notified each member of its minimum capital stock holdings 
pursuant to Sec. 925.22(b)(1) of this chapter.
    (b) If a Bank's capital plan was not in effect as of the record 
date, the number of shares of Bank stock that the members are required 
to hold as of the record date shall be determined in accordance with 
Sec. 925.20 and Sec. 925.22. If a Bank's capital plan was in effect as 
of the record date, the number of shares of Bank stock that the members 
were required to hold as of that date shall be determined in accordance 
with the minimum investment established by the

[[Page 8308]]

capital plan for that Bank, provided, however, that for any members 
whose Bank stock is less than the minimum investment during a 
transition period, the amount of Bank stock to be reported shall be the 
number of shares of Bank stock actually owned by those members as of 
the record date.

    4. Revise Sec. 915.5 to read as follows:


Sec. 915.5  Determination of member votes.

    (a) In general. Each Bank shall determine, in accordance with this 
section, the number of votes that each member of the Bank may cast for 
each directorship that is to be filled by the vote of the members that 
are located in a particular state.
    (b) Number of votes. For each directorship that is to be filled in 
an election, each member that is located in the state to be represented 
by the directorship shall be entitled to cast one vote for each share 
of Bank stock that the member was required to hold as of the record 
date. Notwithstanding the preceding sentence, the number of votes that 
any member may cast for any one directorship shall not exceed the 
average number of shares of Bank stock that were required to be held by 
all members located in that state as of the record date. If a Bank has 
issued more than one class of stock, it shall calculate the average 
number of shares separately for each class of stock and shall apply 
those limits separately in determining the maximum number of votes that 
any member owning that class of stock may cast in the election. If a 
Bank's capital plan was not in effect as of the record date, the number 
of shares of Bank stock that a member was required to hold as of the 
record date shall be determined in accordance with Sec. 925.20 and 
Sec. 925.22. If a Bank's capital plan was in effect as of the record 
date, the number of shares of Bank stock that a member was required to 
hold as of the record date shall be determined in accordance with the 
minimum investment established by the Bank's capital plan, provided, 
however, that for any members whose Bank stock is less than the minimum 
investment during a transition period, the amount of Bank stock to be 
used shall be the number of shares of Bank stock actually owned by 
those members as of the record date.
    (c) Voting preferences. If the board of directors of a Bank 
includes any voting preferences as part of its approved capital plan, 
those preferences shall supercede the provisions of paragraph (b) of 
this section that otherwise would allow a member to cast one vote for 
each share of Bank stock it was required to hold as of the record date. 
If a Bank establishes a voting preference for a class of stock, the 
members with voting rights shall remain subject to the provisions of 
Section 7(b) of the Act that prohibit any member from casting any vote 
in excess of the average number of shares of stock required to be held 
by all members in its state.

    5. Amend Sec. 915.6 by revising paragraph (a)(3) to read as 
follows:


Sec. 915.6  Elective director nominations.

    (a) * * *
    (3) An attachment indicating the name, location, and docket number 
of every member in the member's voting state, and the number of votes 
each such member may cast for each directorship to be filled in the 
election, as determined in accordance with Sec. 915.5.
* * * * *

    6. Amend Sec. 915.7 by adding a new sentence at the end of 
paragraph (b)(2) to read as follows:


Sec. 915.7  Eligibility requirements for elective directors.

* * * * *
    (b) * * *
    (2) * * * For purposes of this paragraph, the term appropriate 
federal regulator has the same meaning as the term ``appropriate 
Federal banking agency'' in section 3(q) of the Federal Deposit 
Insurance Act (12 U.S.C. 1813(q)), and, for federally insured credit 
unions, shall mean the National Credit Union Administration, and the 
term appropriate State regulator means any State officer, agency, 
supervisor, or other entity that has regulatory authority over, or is 
empowered to institute enforcement action against, a member.
* * * * *

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

    7. The authority citation for part 917 is revised to read as 
follows:

    Authority: 12 U.S.C. 1422a(a)(3), 1422b(a)(1), 1426, 1427, 
1432(a), 1436(a), 1440.


    8. Amend Sec. 917.3(b)(1) to read as follows:


Sec. 917.3  Risk management.

* * * * *
    (b) * * *
    (1) After the Finance Board has approved a Bank's capital plan, but 
before the plan takes effect, the Bank shall amend its risk management 
policy to describe the specific steps the Bank will take to comply with 
its capital plan and to include specific target ratios of total capital 
and permanent capital to total assets at which the Bank intends to 
operate. The target operating capital-to-assets ratios to be specified 
in the risk management policy shall be in excess of the minimum 
leverage and risk-based capital ratios and may be expressed as a range 
of ratios or as a single ratio;
* * * * *

    9. Amend Sec. 917.9 by designating the existing text as paragraph 
(a) and adding a new paragraph (b) to read as follows:


Sec. 917.9  Dividends.

* * * * *
    (b) The requirement in paragraph (a) of this section that dividends 
shall be computed without preference shall cease to apply to any Bank 
that has established any dividend preferences for one or more classes 
or subclasses of its capital stock as part of its approved capital 
plan, as of the date on which the capital plan takes effect.

PART 925--MEMBERS OF THE BANKS

    10. The authority citation for part 925 continues to read as 
follows:

    Authority: 12 U.S.C. 1422, 1422a, 1422b, 1423, 1424, 1426, 1430, 
1442.

    11. Revise Sec. 925.24 to read as follows:


Sec. 925.24  Consolidations involving members.

    (a) Consolidation of members. Upon the consolidation of two or more 
institutions that are members of the same Bank into one institution 
operating under the charter of one of the consolidating institutions, 
the membership of the surviving institution shall continue and the 
membership of each disappearing institution shall terminate on the 
cancellation of its charter. Upon the consolidation of two or more 
institutions, at least two of which are members of different Banks, 
into one institution operating under the charter of one of the 
consolidating institutions, the membership of the surviving institution 
shall continue and the membership of each disappearing institution 
shall terminate upon cancellation of its charter, provided, however, 
that if more than 80 percent of the assets of the consolidated 
institution are derived from the assets of a disappearing institution, 
then the consolidated institution shall continue to be a member of the 
Bank of which that disappearing institution was a member prior to the 
consolidation, and the membership of the other institutions shall 
terminate upon the effective date of the consolidation.
    (b) Consolidation into nonmember--(1) In general. Upon the 
consolidation of a member into an institution that is not a member of a 
Bank, where the

[[Page 8309]]

consolidated institution operates under the charter of the nonmember 
institution, the membership of the disappearing institution shall 
terminate upon the cancellation of its charter.
    (2) Notification. If a member has consolidated into a nonmember 
that has its principal place of business in a state in the same Bank 
district as the former member, the consolidated institution shall have 
60 calendar days after the cancellation of the charter of the former 
member within which to notify the Bank of the former member that the 
consolidated institution intends to apply for membership in such Bank. 
If the consolidated institution does not so notify the Bank by the end 
of the period, the Bank shall require the liquidation of any 
outstanding indebtedness owed by the former member, shall settle all 
outstanding business transactions with the former member, and shall 
redeem or repurchase the Bank stock owned by the former member in 
accordance with Sec. 925.29.
    (3) Application. If such a consolidated institution has notified 
the appropriate Bank of its intent to apply for membership, the 
consolidated institution shall submit an application for membership 
within 60 calendar days of so notifying the Bank. If the consolidated 
institution does not submit an application for membership by the end of 
the period, the Bank shall require the liquidation of any outstanding 
indebtedness owed by the former member, shall settle all outstanding 
business transactions with the former member, and shall redeem or 
repurchase the Bank stock owned by the former member in accordance with 
Sec. 925.29.
    (4) Outstanding indebtedness. If a member has consolidated into a 
nonmember institution, the Bank need not require the former member or 
its successor to liquidate any outstanding indebtedness owed to the 
Bank or to redeem its Bank stock, as otherwise may be required under 
Sec. 925.29, during:
    (i) The initial 60 calendar-day notification period;
    (ii) The 60 calendar-day period following receipt of a notification 
that the consolidated institution intends to apply for membership; and
    (iii) The period of time during which the Bank processes the 
application for membership.
    (5) Approval of membership. If the application of such a 
consolidated institution is approved, the consolidated institution 
shall become a member of that Bank upon the purchase of the amount of 
Bank stock required by section 6 of the Act. If a Bank's capital plan 
has not taken effect, the amount of stock that the consolidated 
institution is required to own shall be as provided in Sec. 925.20 and 
Sec. 925.22. If the capital plan for the Bank has taken effect, the 
amount of stock that the consolidated institution is required to own 
shall be equal to the minimum investment established by the capital 
plan for that Bank.
    (6) Disapproval of membership. If the Bank disapproves the 
application for membership of the consolidated institution, the Bank 
shall require the liquidation of any outstanding indebtedness owed by, 
and the settlement of all other outstanding business transactions with, 
the former member, and shall redeem or repurchase the Bank stock owned 
by the former member in accordance with Sec. 925.29.
    (c) Dividends on acquired Bank stock. A consolidated institution 
shall be entitled to receive dividends on the Bank stock that it 
acquires as a result of a consolidation with a member in accordance 
with Sec. 931.4(a) of this Chapter.
    (d) Stock transfers. With regard to any transfer of Bank stock from 
a disappearing member to the surviving or consolidated member, as 
appropriate, for which the approval of the Finance Board is required 
pursuant to section 6(f) of the Act, 12 U.S.C. 1426(f), as in effect 
prior to November 12, 1999, such transfer shall be deemed to be 
approved by the Finance Board by compliance in all applicable respects 
with the requirements of this section.

(The Office of Management and Budget has approved the information 
collection contained in this section and assigned control number 
3069-0004 with an expiration date of April 30, 2001.)


Sec. 925.25  [Removed]

    12. Remove Sec. 925.25.

    13. Revise Sec. 925.26 to read as follows:


Sec. 925.26  Voluntary withdrawal from membership.

    (a) In general. (1) Any institution may withdraw from membership by 
providing to the Bank written notice of its intent to withdraw from 
membership. A member that has so notified its Bank shall be entitled to 
have continued access to the benefits of membership until the effective 
date of its withdrawal, but the Bank need not commit to providing any 
further services, including advances, to a withdrawing member that 
would mature or otherwise terminate subsequent to the effective date of 
the withdrawal. A member may cancel its notice of withdrawal at any 
time prior to its effective date by providing a written cancellation 
notice to the Bank. A Bank may impose a fee on a member that cancels a 
notice of withdrawal, provided that the fee or the manner of its 
calculation is specified in the Bank's capital plan.
    (2) A Bank shall notify the Finance Board within 10 calendar days 
of receipt of any notice of withdrawal or notice of cancellation of 
withdrawal from membership.
    (b) Effective date of withdrawal. The membership of an institution 
that has submitted a notice of withdrawal shall terminate as of the 
date on which the last of the applicable stock redemption periods ends, 
unless the institution has cancelled its notice of withdrawal prior to 
that date.
    (c) Stock redemption periods. The receipt by a Bank of a notice of 
withdrawal shall commence the applicable 6-month and 5-year stock 
redemption periods, respectively, for all of the Class A and Class B 
stock held by that member that is not already subject to a pending 
request for redemption. In the case of an institution the membership of 
which has been terminated as a result of a merger or other 
consolidation into a nonmember or into a member of another Bank, the 
applicable stock redemption periods for any stock that is not subject 
to a pending notice of redemption shall be deemed to commence on the 
date on which the charter of the former member is cancelled.
    (d) Certification. No institution may withdraw from membership 
unless, on the date that the membership is to terminate, there is in 
effect a certification from the Finance Board that the withdrawal of a 
member will not cause the Bank System to fail to satisfy its 
requirements under 12 U.S.C. 1441b(f)(2)(C) to contribute toward the 
interest payments owed on obligations issued by the Resolution Funding 
Corporation.

(The Office of Management and Budget has approved the information 
collection contained in this section and assigned control number 
3069-0004 with an expiration date of April 30, 2001.)

    14. Revise Sec. 925.27 to read as follows:


Sec. 925.27  Involuntary termination of membership.

    (a) Grounds. The board of directors of a Bank may terminate the 
membership of any institution that:
    (1) Fails to comply with any requirement of the Act, any regulation 
adopted by the Finance Board, or any requirement of the Bank's capital 
plan;
    (2) Becomes insolvent or otherwise subject to the appointment of a

[[Page 8310]]

conservator, receiver, or other legal custodian under federal or state 
law; or
    (3) Would jeopardize the safety or soundness of the Bank if it were 
to remain a member.
    (b) Stock redemption periods. The applicable 6-month and 5-year 
stock redemption periods, respectively, for all of the Class A and 
Class B stock owned by a member and not already subject to a pending 
request for redemption, shall commence on the date that the Bank 
terminates the institution's membership.
    (c) Membership rights. An institution whose membership is 
terminated involuntarily under this section shall cease being a member 
as of the date on which the board of directors of the Bank acts to 
terminate the membership, and the institution shall have no right to 
obtain any of the benefits of membership after that date, but shall be 
entitled to receive any dividends declared on its stock until the stock 
is redeemed by the Bank.


Sec. 925.28  [Removed]

    15. Remove Sec. 925.28.
    16. Revise Sec. 925.29 to read as follows:


Sec. 925.29  Disposition of claims.

    (a) In general. If an institution withdraws from membership or its 
membership is otherwise terminated, the Bank shall determine an orderly 
manner for liquidating all outstanding indebtedness owed by that member 
to the Bank and for settling all other claims against the member. After 
all such obligations and claims have been extinguished or settled, the 
Bank shall return to the member all collateral pledged by the member to 
the Bank to secure its obligations to the Bank.
    (b) Bank stock. If an institution that has withdrawn from 
membership or that otherwise has had its membership terminated remains 
indebted to the Bank or has outstanding any business transactions with 
the Bank after the effective date of its termination of membership, the 
Bank shall not redeem or repurchase any Bank stock that is required to 
support the indebtedness or the business transactions until after all 
such indebtedness and business transactions have been extinguished or 
settled.
    17. Revise Sec. 925.30 to read as follows:


Sec. 925.30  Readmission to membership.

    (a) In general. An institution that has withdrawn from membership 
or otherwise has had its membership terminated and which has divested 
all of its shares of Bank stock, may not be readmitted to membership in 
any Bank, or acquire any capital stock of any Bank, for a period of 5 
years from the date on which its membership terminated and it divested 
all of its shares of Bank stock.
    (b) Exceptions. An institution that transfers membership between 
two Banks without interruption shall not be deemed to have withdrawn 
from Bank membership or had its membership terminated. Any institution 
that withdrew from Bank membership prior to December 31, 1997, and for 
which the 5-year period has not expired, may apply for membership in a 
Bank at any time, subject to the approval of the Finance Board and the 
requirements of this part 925.

    18. In subchapter E, add new parts 930, 931, 932, and 933 to read 
as follows:

PART 930--DEFINITIONS APPLYING TO RISK MANAGEMENT AND CAPITAL 
REGULATIONS

    Authority: 12 U.S.C. 1422a(a)(3), 1422b(a), 1426, 1440, 1443, 
1446.


Sec. 930.1  Definitions.

    As used in this subchapter:
    Affiliated counterparty means a counterparty that is an affiliate 
of another counterparty, as the term ``affiliate'' is defined in 12 
U.S.C. 371c(b).
    Capital plan means the capital structure plan required for each 
Bank by Section 6(b) of the Act, 12 U.S.C. 1426(b), as approved by the 
Finance Board, unless the context of the regulation refers to the 
capital plan prior to its approval by the Finance Board.
    Class A stock means capital stock issued by a Bank, including 
subclasses, that has the characteristics specified by Sec. 931.1(a) of 
this subchapter.
    Class B stock means capital stock issued by a Bank, including 
subclasses, that has the characteristics specified by Sec. 931.1(b) of 
this subchapter.
    Contingency liquidity has the meaning set forth in Sec. 917.1 of 
this chapter.
    Credit derivative contract means a derivative contract that 
transfers credit risk.
    Credit risk has the meaning set forth in Sec. 917.1 of this 
chapter.
    Derivative contract means generally a financial contract the value 
of which is derived from the values of one or more underlying assets, 
reference rates, or indices of asset values, or credit-related events. 
Derivative contracts include interest rate, foreign exchange rate, 
equity, precious metals, commodity, and credit contracts, and any other 
instruments that pose similar risks.
    Excess stock means that amount of capital stock of a Bank held by a 
member in excess of the minimum investment in Bank stock required by 
Sec. 931.3 of this chapter.
    Exchange rate contracts include cross-currency interest-rate swaps, 
forward foreign exchange rate contracts, currency options purchased, 
and any similar instruments that give rise to similar risks.
    GAAP means accounting principles generally accepted in the United 
States.
    General allowance for losses means an allowance established by a 
Bank in accordance with GAAP for losses, but which does not include any 
amounts held against specific assets of the Bank.
    Government Sponsored Enterprise, or GSE, means a United States 
Government-sponsored agency or instrumentality originally established 
or chartered to serve public purposes specified by the United States 
Congress, but whose obligations are not obligations of the United 
States and are not guaranteed by the United States.
    Interest rate contracts include, single currency interest-rate 
swaps, basis swaps, forward rate agreements, interest-rate options, and 
any similar instrument that gives rise to similar risks, including 
when-issued securities.
    Investment grade means:
    (1) A credit quality rating in one of the four highest credit 
rating categories by an NRSRO and not below the fourth highest rating 
category by any NRSRO; or
    (2) If there is no credit quality rating by an NRSRO, a 
determination by a Bank that the issuer, asset or instrument is the 
credit equivalent of investment grade using credit rating standards 
available from an NRSRO or other similar standards.
    Market risk has the meaning set forth in Sec. 917.1 of this 
chapter.
    Marketable means, with respect to an asset, that the asset can be 
sold with reasonable promptness at a price that corresponds reasonably 
to its fair value.
    Market value at risk is the loss in the market value of a Bank's 
portfolio measured from a base line case, where the loss is estimated 
in accordance with Sec. 932.5 of this chapter.
    Minimum investment means the minimum amount of Class A and/or Class 
B stock that a member is required to own in order to be a member of a 
Bank and in order to obtain advances and to engage in other business 
activities with the Bank in accordance with Sec. 931.3 of this chapter.
    Operations risk has the meaning set forth in Sec. 917.1 of this 
chapter.
    Permanent capital means the retained earnings of a Bank, determined 
in accordance with GAAP, plus the amount paid-in for the Bank's Class B 
stock.
    Redeem or Redemption means the acquisition by a Bank of its 
outstanding

[[Page 8311]]

Class A or Class B stock at par value following the expiration of the 
six-month or five-year statutory redemption period, respectively, for 
the stock.
    Regulatory risk-based capital requirement means the amount of 
permanent capital that a Bank is required to maintain in accordance 
with Sec. 932.3 of this chapter.
    Regulatory total capital requirement means the amount of total 
capital that a Bank is required to maintain in accordance with 
Sec. 932.2 of this chapter.
    Repurchase means the acquisition by a Bank of excess stock prior to 
the expiration of the six-month or five-year statutory redemption 
period for the stock.
    Repurchase agreement means an agreement between a seller and a 
buyer whereby the seller agrees to repurchase a security or similar 
securities at an agreed upon price, with or without a stated time for 
repurchase.
    Total assets means the total assets of a Bank, as determined in 
accordance with GAAP.
    Total capital of a Bank means the sum of permanent capital, the 
amounts paid-in for Class A stock, the amount of any general allowance 
for losses, and the amount of other instruments identified in a Bank's 
capital plan that the Finance Board has determined to be available to 
absorb losses incurred by such Bank.
    Walkaway clause means a provision in a bilateral netting contract 
that permits a nondefaulting counterparty to make a lower payment than 
it would make otherwise under the bilateral netting contract, or no 
payment at all, to a defaulter or the estate of a defaulter, even if 
the defaulter or the estate of the defaulter is a net creditor under 
the bilateral netting contract.

PART 931--FEDERAL HOME LOAN BANK CAPITAL STOCK

Sec.
931.1  Classes of capital stock.
931.2  Issuance of capital stock.
931.3  Minimum investment in capital stock.
931.4  Dividends.
931.5  Liquidation, merger, or consolidation.
931.6  Transfer of capital stock.
931.7  Redemption and repurchase of capital stock.
931.8  Capital impairment.
931.9  Transition provision.

    Authority: 12 U.S.C. 1422a(a)(3), 1422b(a), 1426, 1440, 1443, 
1446.


Sec. 931.1  Classes of capital stock.

    The authorized capital stock of a Bank shall consist of the 
following instruments:
    (a) Class A stock, which shall:
    (1) Have a par value as determined by the board of directors of the 
Bank and stated in the Bank's capital plan;
    (2) Be issued, redeemed, and repurchased only at its stated par 
value; and
    (3) Be redeemable in cash only on six-months written notice to the 
Bank.
    (b) Class B stock, which shall:
    (1) Have a par value as determined by the board of directors of the 
Bank and stated in the Bank's capital plan;
    (2) Be issued, redeemed, and repurchased only at its stated par 
value;
    (3) Be redeemable in cash only on five-years written notice to the 
Bank; and
    (4) Confer an ownership interest in the retained earnings, surplus, 
undivided profits, and equity reserves of the Bank; and
    (c) Any one or more subclasses of Class A or Class B stock, each of 
which may have different rights, terms, conditions, or preferences as 
may be authorized in the Bank's capital plan, provided, however, that 
each subclass of stock shall have all of the characteristics of its 
respective class, as specified in paragraph (a) or (b) of this section.


Sec. 931.2  Issuance of capital stock.

    (a) In general. A Bank may issue either one or both classes of its 
capital stock (including subclasses), as authorized by Sec. 931.1, and 
shall not issue any other class of capital stock. A Bank shall issue 
its stock only to its members and only in book-entry form, and the Bank 
shall act as its own transfer agent. All capital stock shall be issued 
in accordance with the Bank's capital plan.
    (b) Initial issuance. In connection with the initial issuance of 
its Class A and/or Class B stock (or any subclass of either), a Bank 
may issue such stock in exchange for its existing stock, through a 
conversion of its existing stock, or through any other fair and 
equitable transaction or method of distribution. As part of its initial 
stock issuance transaction, a Bank may distribute any portion of its 
then-existing unrestricted retained earnings as shares of Class B 
stock.


Sec. 931.3  Minimum investment in capital stock.

    (a) A Bank shall require each member to maintain a minimum 
investment in the capital stock of the Bank, both as a condition to 
becoming and remaining a member of the Bank and as a condition to 
transacting business with the Bank or obtaining advances and other 
services from the Bank. The amount of the required minimum investment 
shall be determined in accordance with the Bank's capital plan and 
shall be sufficient to ensure that the Bank remains in compliance with 
its minimum capital requirements. A Bank shall require each member to 
maintain its minimum investment for as long as the institution remains 
a member of the Bank and for as long as the member engages in any 
activity with the Bank against which the Bank is required to maintain 
capital.
    (b) A Bank may establish the minimum investment required of each 
member as a percentage of the total assets of the member, as a 
percentage of the advances outstanding to the member, as a percentage 
of any other business activity conducted with the member, on any other 
basis that is approved by the Finance Board, or any combination 
thereof.
    (c) A Bank may require each member to satisfy the minimum 
investment requirement through the purchase of either Class A or Class 
B stock, or through the purchase of one or more combinations of Class A 
and Class B stock that have been authorized by the board of directors 
of the Bank in its capital plan. A Bank, in its discretion, may 
establish a lower minimum investment for members that invest in Class B 
stock than is required for members that invest in Class A stock, 
provided that such reduced investment provides sufficient capital for 
the Bank to remain in compliance with its minimum capital requirements.
    (d) Each member of a Bank shall at all times maintain an investment 
in the capital stock of the Bank in an amount that is sufficient to 
satisfy the minimum investment required for that member in accordance 
with the Bank's capital plan.

(The Office of Management and Budget has approved the information 
collection contained in this section and assigned control number 
3069-0059 with an expiration date of November 30, 2003.)


Sec. 931.4  Dividends.

    (a) In general. A Bank may pay dividends on its capital stock only 
out of previously retained earnings or current net earnings, and shall 
declare and pay dividends only as provided by its capital plan. The 
capital plan may establish different dividend rates or preferences for 
each class or subclass of stock, which may include a dividend that 
tracks the economic performance of certain Bank assets, such as 
Acquired Member Assets. A member, including a member that has provided 
the Bank with a notice of intent to withdraw from membership or one 
whose membership is otherwise terminated, shall be entitled to receive 
any dividends that a

[[Page 8312]]

Bank declares on its capital stock while the member owns the stock.
    (b) Limitation on payment of dividends. In no event shall a Bank 
declare or pay any dividend on its capital stock if after doing so the 
Bank would fail to meet any of its minimum capital requirements, nor 
shall a Bank that is not in compliance with any of its minimum capital 
requirements declare or pay any dividend on its capital stock.


Sec. 931.5  Liquidation, merger, or consolidation.

    The respective rights of the Class A and Class B stockholders, in 
the event that the Bank is liquidated, or is merged or otherwise 
consolidated with another Bank, shall be determined in accordance with 
the capital plan of the Bank.


Sec. 931.6  Transfer of capital stock.

    A member of a Bank may transfer any excess capital stock of the 
Bank to another member of that Bank or to an institution that has been 
approved for membership in that Bank and that has satisfied all 
conditions for becoming a member, other than the purchase of the 
minimum amount of Bank stock that it is required to hold as a condition 
of membership. Any such stock transfers shall be at par value and shall 
be effective upon being recorded on the appropriate books and records 
of the Bank.


Sec. 931.7  Redemption and repurchase of capital stock.

    (a) Redemption. A member may have its capital stock in a Bank 
redeemed by providing written notice to the Bank in accordance with 
this section. For Class A stock, a member shall provide six-months 
written notice, and for Class B stock a member shall provide five-years 
written notice. The notice shall indicate the number of shares of Bank 
stock that are to be redeemed, and a member shall not have more than 
one notice of redemption outstanding at one time for the same shares of 
Bank stock. A member may cancel a notice of redemption by so informing 
the Bank in writing, and the Bank may impose a fee (to be specified in 
its capital plan) on any member that cancels a pending notice of 
redemption. At the expiration of the applicable notice period, the Bank 
shall pay the stated par value of that stock to the member in cash. A 
Bank shall not be obligated to redeem its capital stock other than in 
accordance with this paragraph.
    (b) Repurchase. A Bank, in its discretion and without regard to the 
applicable redemption periods, may repurchase from a member any 
outstanding Class A or Class B capital stock that is in excess of the 
amount of that class of Bank stock that the member is required to hold 
as a minimum investment, in accordance with the capital plan of that 
Bank. A Bank undertaking such a stock repurchase at its own initiative 
shall provide the member with reasonable notice prior to repurchasing 
any excess stock, with the period of such notice to be specified in the 
Bank's capital plan, and shall pay the stated par value of that stock 
to the member in cash. For purposes of this section, any Bank stock 
owned by a member shall be considered to be excess stock if the member 
is not required to hold such stock either as a condition of remaining a 
member of the Bank or as a condition of obtaining advances or 
transacting other business with the Bank. A member's submission of a 
notice of intent to withdraw from membership, or its termination of 
membership in any other manner, shall not, in and of itself, cause any 
Bank stock to be deemed excess stock for purposes of this section.
    (c) Limitation. In no event may a Bank redeem or repurchase any 
stock if, following the redemption or repurchase, the Bank would fail 
to meet any minimum capital requirement, or if the member would fail to 
maintain its minimum investment in the stock of the Bank, as required 
by Sec. 931.3.

(The Office of Management and Budget has approved the information 
collection contained in this section and assigned control number 
3069-0004 with an expiration date of April 30, 2001.)


Sec. 931.8  Capital impairment.

    A Bank may not redeem or repurchase any capital stock without the 
prior written approval of the Finance Board if the Finance Board or the 
board of directors of the Bank has determined that the Bank has 
incurred or is likely to incur losses that result in or are likely to 
result in charges against the capital of the Bank. This prohibition 
shall apply even if a Bank is in compliance with its minimum capital 
requirements, and shall remain in effect for however long the Bank 
continues to incur such charges or until the Finance Board determines 
that such charges are not expected to continue.


Sec. 931.9  Transition provision.

    (a) In general. Each Bank shall comply with the minimum leverage 
and risk-based capital requirements specified in Sec. 932.2 and 
Sec. 932.3 of this chapter, respectively, and each member shall comply 
with the minimum investment established in the capital plan, as of the 
effective date of that Bank's capital plan. The effective date of a 
Bank's capital plan shall be the date on which the Bank first issues 
any Class A or Class B stock. Prior to the effective date, the issuance 
and retention of Bank stock shall be as provided in Sec. 925.20 and 
Sec. 925.22 of this chapter.
    (b) Transition period. (1) Bank transition. A Bank that will not be 
in compliance with the minimum leverage and risk-based capital 
requirements specified in Sec. 932.2 and Sec. 932.3 of this chapter as 
of the effective date of its capital plan shall maintain compliance 
with the leverage limit requirements in Sec. 966.3(a) of this chapter 
and shall include in its capital plan a description of the steps that 
the Bank will take to achieve compliance with the minimum capital 
requirements specified in Sec. 932.2 and Sec. 932.3 of this chapter. 
The period of time for compliance with the minimum capital requirements 
shall be stated in the plan and shall not exceed three years from the 
effective date of the capital plan. When the Bank has achieved 
compliance with the leverage requirement of Sec. 932.2 of this chapter, 
the leverage limit requirements of Sec. 966.3(a) of this chapter shall 
cease to apply to that Bank.
    (2) Member transition. (i) Existing members. A Bank's capital plan 
shall require any institution that was a member on November 12, 1999, 
and whose investment in Bank stock as of the effective date of the 
capital plan will be less than the minimum investment required by the 
plan, to comply with the minimum investment by a date specified in the 
Bank's capital plan. The length of the transition period shall be 
specified in the capital plan and shall not exceed three years. The 
capital plan shall describe the actions that the existing members are 
required to take to achieve compliance with the minimum investment, and 
may require such members to purchase additional Bank stock periodically 
over the course of the transition period.
    (ii) New members. A Bank's capital plan shall require any 
institution that became a member after November 12, 1999, but prior to 
the effective date of the capital plan, to comply with the minimum 
investment specified in the Bank's capital plan as of the effective 
date of the plan. A Bank's capital plan shall require any institution 
that becomes a member after the effective date of the capital plan, to 
comply with the minimum investment upon becoming a member.
    (3) New business. A Bank's capital plan shall require any member 
that obtains an advance or other services from the Bank, or that 
initiates any other business activity with the Bank against which the 
Bank is required to hold

[[Page 8313]]

capital, after the effective date of the capital plan to comply with 
the minimum investment specified in the Bank's capital plan for such 
advance, services, or activity at the time the transaction occurs.

PART 932--FEDERAL HOME LOAN BANK CAPITAL REQUIREMENTS

Sec.
932.1  Risk management.
932.2  Total capital requirement.
932.3  Risk-based capital requirement.
932.4  Credit risk capital requirement.
932.5  Market risk capital requirement.
932.6  Operations risk capital requirement.
932.7  Reporting requirements.
932.8  Minimum liquidity requirements.
932.9  Limits on unsecured extensions of credit to one counterparty 
or affiliated counterparties; reporting requirements for total 
extensions of credit to one counterparty or affiliated 
counterparties.

    Authority: 12 U.S.C. 1422a(a)(3), 1422b(a), 1426, 1440, 1443, 
1446.


Sec. 932.1  Risk management.

    Before its new capital plan may take effect, each Bank shall obtain 
the approval of the Finance Board for the internal market risk model or 
the internal cash flow model used to calculate the market risk 
component of its risk-based capital requirement, and for the risk 
assessment procedures and controls (whether established as part of its 
risk management policy or otherwise) to be used to manage its credit, 
market, and operations risks.


Sec. 932.2  Total capital requirement.

    (a) Each Bank shall maintain at all times:
    (1) Total capital in an amount at least equal to 4.0 percent of the 
Bank's total assets; and
    (2) A leverage ratio of total capital to total assets of at least 
5.0 percent of the Bank's total assets. For purposes of determining the 
leverage ratio, total capital shall be computed by multiplying the 
Bank's permanent capital by 1.5 and adding to this product all other 
components of total capital.
    (b) For reasons of safety and soundness, the Finance Board may 
require an individual Bank to have and maintain a greater amount of 
total capital than mandated by paragraph (a)(1) of this section.


Sec. 932.3  Risk-based capital requirement.

    (a) Each Bank shall maintain at all times permanent capital in an 
amount at least equal to the sum of its credit risk capital 
requirement, its market risk capital requirement, and its operations 
risk capital requirement, calculated in accordance with Secs. 932.4, 
932.5 and 932.6, respectively.
    (b) For reasons of safety and soundness, the Finance Board may 
require an individual Bank to have and maintain a greater amount of 
permanent capital than required by paragraph (a) of this section.


Sec. 932.4  Credit risk capital requirement.

    (a) General requirement. Each Bank's credit risk capital 
requirement shall be equal to the sum of the Bank's credit risk capital 
charges for all assets, off-balance sheet items and derivative 
contracts.
    (b) Credit risk capital charge for assets. Except as provided in 
paragraph (i) of this section, each Bank's credit risk capital charge 
for an asset shall be equal to the book value of the asset multiplied 
by the credit risk percentage requirement assigned to that asset 
pursuant to paragraph (e)(2) of this section.
    (c) Credit risk capital charge for off-balance sheet items. Each 
Bank's credit risk capital charge for an off-balance sheet item shall 
be equal to the credit equivalent amount of such item, as determined 
pursuant to paragraph (f) of this section multiplied by the credit risk 
percentage requirement assigned to that item pursuant to paragraph 
(e)(2) of this section, except that the credit risk percentage 
requirement applied to the credit equivalent amount for a stand-by 
letter of credit shall be that for an advance with the same remaining 
maturity as that stand-by letter of credit.
    (d) Derivative contracts. (1) Derivative contracts with non-member 
counterparties. Except as provided in paragraph (j) of this section, 
each Bank's credit risk capital charge for a specific derivative 
contract entered into between a Bank and a non-member institution shall 
equal the sum of :
    (i) The current credit exposure for the derivative contract, 
calculated in accordance with paragraph (g) or (h) of this section, as 
applicable, multiplied by the credit risk percentage requirement 
assigned to that derivative contract pursuant to paragraph (e)(2) of 
this section, provided that:
    (A) The remaining maturity of the derivative contract shall be 
deemed to be less than one year for the purpose of applying Table 1.1 
or 1.3 of this part; and
    (B) Any collateral held against an exposure from the derivative 
contract shall be applied to reduce the portion of the credit risk 
capital charge corresponding to the current credit exposure in 
accordance with the requirements of paragraph (e)(2)(ii)(B) of this 
section; plus
    (ii) The potential future credit exposure for the derivative 
contract calculated in accordance with paragraph (g) or (h) of this 
section, as applicable, multiplied by the credit risk percentage 
requirement assigned to that derivative contract pursuant to paragraph 
(e)(2) of this section, where the actual remaining maturity of the 
derivative contract is used to apply Table 1.1 or Table 1.3 of this 
part.
    (2) Derivative contracts with a member. Except as provided in 
paragraph (j) of this section, the credit risk capital charge for any 
derivative contract entered into between a Bank and one of its member 
institutions shall be calculated in accordance with paragraph (d)(1) of 
this section. However, the credit risk percentage requirements used in 
the calculations shall be found in Table 1.1 of this part, which sets 
forth the credit risk percentage requirements for advances.
    (e) Determination of credit risk percentage requirements.--(1) 
Finance Board determination of credit risk percentage requirements. The 
Finance Board shall determine, and update periodically, the credit risk 
percentage requirements set forth in Tables 1.1 through 1.4 of this 
part applicable to a Bank's assets, off-balance sheet items, and 
derivative contracts.
    (2) Bank determination of credit risk percentage requirements. (i) 
Each Bank shall determine the credit risk percentage requirement 
applicable to each asset, each off-balance sheet item and each 
derivative contract by identifying the category set forth in Table 1.1, 
Table 1.2, Table 1.3 or Table 1.4 of this part to which the asset, item 
or derivative belongs, given, if applicable, its demonstrated credit 
rating and remaining maturity (as determined in accordance with 
paragraphs (e)(2)(ii) and (e)(2)(iii) of this section). The applicable 
credit risk percentage requirement for an asset, off-balance sheet item 
or derivative contract shall be used to calculate the credit risk 
capital charge for such asset, item, or derivative contract in 
accordance with paragraphs (b), (c) or (d) of this section 
respectively. The relevant categories and credit risk percentage 
requirements are provided in the following Tables 1.1 through 1.4 of 
this part:

                  Table 1.1.--Requirement for Advances
------------------------------------------------------------------------
                                                              Percentage
                      Type of advances                        applicable
                                                             to advances
------------------------------------------------------------------------
Advances with:
  Remaining maturity = 4 years.............................         0.07
  Remaining maturity > 4 years to 7 years..................         0.20

[[Page 8314]]

 
  Remaining maturity > 7 years to 10 years.................         0.30
  Remaining maturity > 10 years............................         0.35
------------------------------------------------------------------------


      Table 1.2.--Requirement for Rated Residential Mortgage Assets
------------------------------------------------------------------------
                                                              Percentage
                                                              applicable
                                                                  to
             Type of residential mortgage asset              residential
                                                               mortgage
                                                                assets
------------------------------------------------------------------------
Highest Investment Grade...................................         0.37
Second Highest Investment Grade............................         0.60
Third Highest Investment Grade.............................         0.86
Fourth Highest Investment Grade............................         1.20
If Downgraded to Below Investment Grade After Acquisition
 By Bank:
  Highest Below Investment Grade...........................         2.40
  Second Highest Below Investment Grade....................         4.80
  All Other Below Investment Grade.........................        34.00
Subordinated Classes of Mortgage Assets:
  Highest Investment Grade.................................         0.37
  Second Highest Investment Grade..........................         0.60
  Third Highest Investment Grade...........................         1.60
  Fourth Highest Investment Grade..........................         4.45
If Downgraded to Below Investment Grade After Acquisition
 By Bank:
  Highest Below Investment Grade...........................        13.00
  Second Highest Below Investment Grade....................        34.00
  All Other Below Investment Grade.........................       100.00
------------------------------------------------------------------------


   Table 1.3.--Requirement for rated Assets or Rated Items Other Than Advances or Residential Mortgage Assets
                                          [Based on remaining maturity]
----------------------------------------------------------------------------------------------------------------
                                                                      Applicable percentage
                                                ----------------------------------------------------------------
                                                               >1 yr to 3   >3 yrs to    >7 yrs to
                                                   : 1 year       yrs          7yrs        10 yrs      >10 yrs
----------------------------------------------------------------------------------------------------------------
U.S. Government Securities.....................         0.00         0.00         0.00         0.00         0.00
Highest Investment Grade.......................         0.15         0.40         0.90         1.40         2.20
Second Highest Investment Grade................         0.20         0.45         1.00         1.45         2.30
Third Highest Investment Grade.................         0.70         1.10         1.60         2.05         2.95
Fourth Highest Investment Grade................         2.50         3.70         4.45         5.50         7.05
If Downgraded Below Investment Grade After
 Acquisition by Bank:
    Highest Below Investment Grade.............        10.00        13.00        13.00        13.00        13.00
    Second Highest Below Investment Grade......        26.00        34.00        34.00        34.00        34.00
    All Other..................................       100.00       100.00       100.00       100.00       100.00
----------------------------------------------------------------------------------------------------------------


               Table 1.4.--Requirement for Unrated Assets
------------------------------------------------------------------------
                                                              Applicable
                   Type of unrated asset                      percentage
------------------------------------------------------------------------
Cash.......................................................         0.00
Premises, Plant, and Equipment.............................         8.00
Investments Under Sec.  940.3(e) & (f).....................         8.00
------------------------------------------------------------------------

    (ii) When determining the applicable credit risk percentage 
requirement from Tables 1.2 or 1.3 of this part, each Bank shall apply 
the following criteria:
    (A) For assets or items that are rated directly by an NRSRO, the 
credit rating shall be the NRSRO's credit rating for the asset or item 
as determined in accordance with paragraph (e)(2)(iii) of this section.
    (B) When using Table 1.3 of this part, for an asset, off-balance 
sheet item, or derivative contract that is not rated directly by an 
NRSRO, but for which an NRSRO rating has been assigned to any 
corresponding obligor counterparty, third party guarantor, or 
collateral backing the asset, item, or derivative, the credit rating 
that shall apply to the asset, item, or derivative, or portion of the 
asset, item, or derivative so guaranteed or collateralized, shall be 
the credit rating corresponding to such obligor counterparty, third 
party guarantor, or underlying collateral, as determined in accordance 
with paragraph (e)(2)(iii) of this section. If there are multiple 
obligor counterparties, third party guarantors, or collateral 
instruments backing an asset, item, or derivative not rated directly by 
an NRSRO, or any specific portion thereof, then the credit rating that 
shall apply to that asset, item, or derivative or specific portion 
thereof, shall be the highest credit rating among such obligor 
counterparties, third party guarantors, or collateral instruments, as 
determined in accordance with paragraph (e)(2)(iii) of this section. 
Assets, items or derivatives shall be deemed to be backed by collateral 
for purposes of this paragraph if the collateral is:
    (1) Actually held by the Bank or an independent, third-party 
custodian, or, if permitted under the Bank's collateral agreement with 
such party, by the Bank's member or an affiliate of that member where 
the term ``affiliate'' has the same meaning as in Sec. 950.1 of this 
chapter;
    (2) Legally available to absorb losses;
    (3) Of a readily determinable value at which it can be liquidated 
by the Bank;
    (4) Held in accordance with the provisions of the Bank's member 
products policy established pursuant to Sec. 917.4 of this chapter; and
    (5) Subject to an appropriate discount to protect against price 
decline during the holding period, as well as the costs likely to be 
incurred in the liquidation of the collateral.
    (C) When using Table 1.3 of this part, for an asset with a short-
term credit rating from a given NRSRO, the credit

[[Page 8315]]

risk percentage requirement shall be based on the remaining maturity of 
the asset and the long-term credit rating provided for the issuer of 
the asset by the same NRSRO. Should the issuer of the short-term asset 
not have a long-term credit rating, the long-term equivalent rating 
shall be determined as follows:
    (1) The highest short-term credit rating shall be equivalent to the 
third highest long-term rating;
    (2) The second highest short-term rating shall be equivalent to the 
fourth highest long-term rating;
    (3) The third highest short-term rating shall be equivalent to the 
fourth highest long-term rating; and
    (4) If the short-term rating is downgraded to below investment 
grade after acquisition by the Bank, the short-term rating shall be 
equivalent to the second highest below investment grade long-term 
rating.
    (D) For residential mortgage assets and other assets or items, or 
relevant portion of an asset or item, that do not meet the requirements 
of paragraphs (e)(2)(ii)(A), (e)(2)(ii)(B) or (e)(2)(ii)(C) of this 
section, and are not identified in Tables 1.1 or Table 1.4 of this 
part, each Bank shall determine its own credit rating for such assets 
or items, or relevant portion thereof, using credit rating standards 
available from an NRSRO or other similar standards. This credit rating, 
as determined by the Bank, shall be used to identify the applicable 
credit risk percentage requirement under Table 1.2 of this part for 
residential mortgage assets, or under Table 1.3 of this part for all 
other assets or items.
    (E) The credit risk percentage requirement for mortgage assets that 
are acquired member assets described in Sec. 955.1(a) of this chapter 
shall be assigned from Table 1.2 of this part based on the rating of 
those assets after taking into account any credit enhancement required 
by Sec. 955.3 of this chapter. Should a Bank further enhance a pool of 
loans through the purchase of insurance or by some other means, the 
credit risk percentage requirement shall be based on the rating of such 
pool after the supplemental credit enhancement, except that the Finance 
Board retains the right to adjust the credit capital charge to account 
for any deficiencies with the supplemental enhancement on a case-by-
case basis.
    (iii) In determining the credit ratings under paragraph 
(e)(2)(ii)(A), (e)(2)(ii)(B) and (e)(2)(ii)(C) of this section, each 
Bank shall apply the following criteria:
    (A) The most recent credit rating from a given NRSRO shall be 
considered. If only one NRSRO has rated an asset or item, that NRSRO's 
rating shall be used. If an asset or item has received credit ratings 
from more than one NRSRO, the lowest credit rating from among those 
NRSROs shall be used.
    (B) Where a credit rating has a modifier (e.g., A-1+ for short-term 
ratings and A+ or A- for long-term ratings) the credit rating is deemed 
to be the credit rating without the modifier (e.g., A-1+ = A-1 and A+ 
or A-= A);
    (f) Calculation of credit equivalent amount for off-balance sheet 
items. (1) General requirement. The credit equivalent amount for an 
off-balance sheet item shall be determined by a Finance Board approved 
model or shall be equal to the face amount of the instrument multiplied 
by the credit conversion factor assigned to such risk category of 
instruments, subject to the exceptions in paragraph (f)(2) of this 
section, provided in the following Table 2 of this part:

     Table 2.--Credit Conversion Factors for Off-Balance Sheet Items
------------------------------------------------------------------------
                                                                Credit
                                                              conversion
                         Instrument                          factor  (in
                                                               percent)
------------------------------------------------------------------------
Asset sales with recourse where the credit risk remains              100
 with the Bank.............................................
Commitments to make advances
Commitments to make or purchase other loans
Standby letters of credit..................................           50
Other commitments with original maturity of over one year
Other commitments with original maturity of one year or               20
 less......................................................
------------------------------------------------------------------------

    (2) Exceptions. The credit conversion factor shall be zero for 
Other Commitments With Original Maturity of Over One Year and Other 
Commitments With Original Maturity of One Year or Less, for which 
credit conversion factors of 50 percent or 20 percent would otherwise 
apply, that are unconditionally cancelable, or that effectively provide 
for automatic cancellation, due to the deterioration in a borrower's 
creditworthiness, at any time by the Bank without prior notice.
    (g) Calculation of current and potential future credit exposures 
for single derivative contracts. (1) Current credit exposure. The 
current credit exposure for a derivative contract that is not subject 
to a qualifying bilateral netting contract described in paragraph 
(h)(3) of this section shall be:
    (i) If the mark-to-market value of the contract is positive, the 
mark-to-market value of the contract; or (ii) If the mark-to-market 
value of the contract is zero or negative, zero.
    (2) Potential future credit exposure. (i) The potential future 
credit exposure for a single derivative contract, including a 
derivative contract with a negative mark-to-market value, shall be 
calculated using an internal model approved by the Finance Board or, in 
the alternative, by multiplying the effective notional amount of the 
derivative contract by one of the assigned credit conversion factors, 
modified as may be required by paragraph (g)(2)(ii) of this section, 
for the appropriate category as provided in the following Table 3 of 
this part:

          Table 3.--Credit Conversion Factors for Potential Future Credit Exposure Derivative Contracts
                                                  [In percent]
----------------------------------------------------------------------------------------------------------------
                                                                Foreign                   Precious
              Residual maturity                  Interest    exchange and     Equity       metals       Other
                                                   rate          gold                   except gold  commodities
----------------------------------------------------------------------------------------------------------------
One year or less.............................           0             1              6            7           10
Over 1 year to five years....................            .5           5              8            7           12
Over five years..............................           1.5           7.5           10            8           15
----------------------------------------------------------------------------------------------------------------


[[Page 8316]]

    (ii) In applying the credit conversion factors in Table 3 of this 
part the following modifications shall be made:
    (A) For derivative contracts with multiple exchanges of principal, 
the conversion factors are multiplied by the number of remaining 
payments in the derivative contract; and
    (B) For derivative contracts that automatically reset to zero value 
following a payment, the residual maturity equals the time until the 
next payment; however, interest rate contracts with remaining 
maturities of greater than one year shall be subject to a minimum 
conversion factor of 0.5 percent.
    (iii) If a Bank uses an internal model to determine the potential 
future credit exposure for a particular type of derivative contract, 
the Bank shall use the same model for all other similar types of 
contracts. However, the Bank may use an internal model for one type of 
derivative contract and Table 3 of this part for another type of 
derivative contract.
    (iv) Forwards, swaps, purchased options and similar derivative 
contracts not included in the Interest Rate, Foreign Exchange and Gold, 
Equity, or Precious Metals Except Gold categories shall be treated as 
other commodities contracts when determining potential future credit 
exposures using Table 3 of this part.
    (v) If a Bank uses Table 3 of this part to determine the potential 
future credit exposures for credit derivative contracts, the credit 
conversion factors provided in Table 3 for equity contracts shall also 
apply to the credit derivative contracts entered into with investment 
grade counterparties. If the counterparty is downgraded to below 
investment grade, the credit conversion factor provided in Table 3 of 
this part for other commodity contracts shall apply.
    (h) Calculation of current and potential future credit exposures 
for multiple derivative contracts subject to a qualifying bilateral 
netting contract--
    (1) Current credit exposure. The current credit exposure for 
multiple derivative contracts executed with a single counterparty and 
subject to a qualifying bilateral netting contract described in 
paragraph (h)(3) of this section, shall be calculated on a net basis 
and shall equal:
    (i) The net sum of all positive and negative mark-to-market values 
of the individual derivative contracts subject to a qualifying 
bilateral netting contract, if the net sum of the mark-to-market values 
is positive; or
    (ii) Zero, if the net sum of the mark-to-market values is zero or 
negative.
    (2) Potential future credit exposure. The potential future credit 
exposure for each individual derivative contract from among a group of 
derivative contracts that are executed with a single counterparty and 
subject to a qualifying bilateral netting contract described in 
paragraph (h)(3) of this section shall be calculated as follows:

A<INF>net</INF> = 0.4  x  A<INF>gross</INF> + (0.6  x  NGR  x  
A<INF>gross</INF>),


where:
    (i) A<INF>net</INF> is the potential future credit exposure for an 
individual derivative contract subject to the qualifying bilateral 
netting contract;
    (ii) A<INF>gross</INF> is the gross potential future credit 
exposure, i.e., the potential future credit exposure for the individual 
derivative contract, calculated in accordance with paragraph (g)(2) of 
this section but without regard to the fact that the contract is 
subject to the qualifying bilateral netting contract;
    (iii) NGR is the net to gross ratio, i.e., the ratio of the net 
current credit exposure of all the derivative contracts subject to the 
qualifying bilateral netting contract, calculated in accordance with 
paragraph (h)(1) of this section, to the gross current credit exposure; 
and
    (iv) The gross current credit exposure is the sum of the positive 
current credit exposures of all the individual derivative contracts 
subject to the qualifying bilateral netting contract, calculated in 
accordance with paragraph (g)(1) of this section but without regard to 
the fact that the contract is subject to the qualifying bilateral 
netting contract.
    (3) Qualifying bilateral netting contract. A bilateral netting 
contract shall be considered a qualifying bilateral netting contract if 
the following conditions are met:
    (i) The netting contract is in writing;
    (ii) The netting contract is not subject to a walkaway clause;
    (iii) The netting contract provides that the Bank would have a 
single legal claim or obligation either to receive or to pay only the 
net amount of the sum of the positive and negative mark-to-market 
values on the individual derivative contracts covered by the netting 
contract in the event that a counterparty, or a counterparty to whom 
the netting contract has been assigned, fails to perform due to 
default, insolvency, bankruptcy, or other similar circumstance;
    (iv) The Bank obtains a written and reasoned legal opinion that 
represents, with a high degree of certainty, that in the event of a 
legal challenge, including one resulting from default, insolvency, 
bankruptcy, or similar circumstances, the relevant court and 
administrative authorities would find the Bank's exposure to be the net 
amount under:
    (A) The law of the jurisdiction by which the counterparty is 
chartered or the equivalent location in the case of non-corporate 
entities, and if a branch of the counterparty is involved, then also 
under the law of the jurisdiction in which the branch is located;
    (B) The law of the jurisdiction that governs the individual 
derivative contracts covered by the netting contract; and
    (C) The law of the jurisdiction that governs the netting contract;
    (v) The Bank establishes and maintains procedures to monitor 
possible changes in relevant law and to ensure that the netting 
contract continues to satisfy the requirements of this section; and
    (vi) The Bank maintains in its files documentation adequate to 
support the netting of a derivative contract.
    (i) Credit risk capital charge for assets hedged with credit 
derivatives--(1) Credit derivatives with a remaining maturity of one 
year or more. The credit risk capital charge for an asset that is 
hedged with a credit derivative that has a remaining maturity of one 
year or more may be reduced only in accordance with paragraph (i)(3) or 
(i)(4) of this section and only if the credit derivative provides 
substantial protection against credit losses.
    (2) Credit derivatives with a remaining maturity of less than one 
year. The credit risk capital charge for an asset that is hedged with a 
credit derivative that has a remaining maturity of less than one year 
may be reduced only in accordance with paragraph (i)(3) of this section 
and only if the remaining maturity on the credit derivative is 
identical to or exceeds the remaining maturity of the hedged asset and 
the credit derivative provides substantial protection against credit 
losses.
    (3) Capital charge reduced to zero. The credit risk capital charge 
for an asset shall be zero if a credit derivative is used to hedge the 
credit risk on that asset in accordance with paragraph (i)(1) or (i)(2) 
of this section, provided that:
    (i) The remaining maturity for the credit derivative used for the 
hedge is identical to or exceeds the remaining maturity for the hedged 
asset, and either:
    (A) The asset referenced in the credit derivative is identical to 
the hedged asset; or
    (B) The asset referenced in the credit derivative is different from 
the hedged asset, but only if the asset referenced in the credit 
derivative and the hedged asset have been issued by the same obligor, 
the asset referenced in the credit derivative ranks pari passu to or 
more junior than the hedged asset and

[[Page 8317]]

has the same maturity as the hedged asset, and cross-default clauses 
apply; and
    (ii) The credit risk capital charge for the credit derivative 
contract calculated pursuant to paragraph (d) of this section is still 
applied.
    (4) Capital charge reduction in certain other cases. The credit 
risk capital charge for an asset hedged with a credit derivative in 
accordance with paragraph (i)(1) of this section shall equal the sum of 
the credit risk capital charges for the hedged and unhedged portion of 
the asset provided that:
    (i) The remaining maturity for the credit derivative is less than 
the remaining maturity for the hedged asset and either:
    (A) The asset referenced in the credit derivative is identical to 
the hedged asset; or
    (B) The asset referenced in the credit derivative is different from 
the hedged asset, but only if the asset referenced in the credit 
derivative and the hedged asset have been issued by the same obligor, 
the asset referenced in the credit derivative ranks pari passu to or 
more junior than the hedged asset and has the same maturity as the 
hedged asset, and cross-default clauses apply; and
    (ii) The credit risk capital charge for the unhedged portion of the 
asset equals:
    (A) The credit risk capital charge for the hedged asset, calculated 
as the book value of the hedged asset multiplied by the hedged asset's 
credit risk percentage requirement assigned pursuant to paragraph 
(e)(2) of this section where the appropriate credit rating is that for 
the hedged asset and the appropriate maturity is the remaining maturity 
of the hedged asset; minus
    (B) The credit risk capital charge for the hedged asset, calculated 
as the book value of the hedged asset multiplied by the hedged asset's 
credit risk percentage requirement assigned pursuant to paragraph 
(e)(2) of this section where the appropriate credit rating is that for 
the hedged asset but the appropriate maturity is deemed to be the 
remaining maturity of the credit derivative; and
    (iii) The credit risk capital charge for the hedged portion of the 
asset is equal to the credit risk capital charge for the credit 
derivative, calculated in accordance with paragraph (d) of this 
section.
    (j) Zero Credit risk capital charge for certain derivative 
contracts. The credit risk capital charge for the following derivative 
contracts shall be zero:
    (1) A foreign exchange rate contract with an original maturity of 
14 calendar days or less (gold contracts do not qualify for this 
exception); and
    (2) A derivative contract that is traded on an organized exchange 
requiring the daily payment of any variations in the market value of 
the contract.
    (k) Date of calculations. Unless otherwise directed by the Finance 
Board, each Bank shall perform all calculations required by this 
section using the assets, off-balance sheet items, and derivative 
contracts held by the Bank, and, if applicable, the values or credit 
ratings of such assets, items, or derivatives as of the close of 
business of the last business day of the month for which the credit 
risk capital charge is being calculated.


Sec. 932.5  Market risk capital requirement.

    (a) General requirement. (1) Each Bank's market risk capital 
requirement shall equal the sum of:
    (i) The market value of the Bank's portfolio at risk from movements 
in interest rates, foreign exchange rates, commodity prices, and equity 
prices that could occur during periods of market stress, where the 
market value of the Bank's portfolio at risk is determined using an 
internal market risk model that fulfills the requirements of paragraph 
(b) of this section and that has been approved by the Finance Board; 
and
    (ii) The amount, if any, by which the Bank's current market value 
of total capital is less than 85 percent of the Bank's book value of 
total capital, where:
    (A) The current market value of the total capital is calculated by 
the Bank using the internal market risk model approved by the Finance 
Board under paragraph (d) of this section; and
    (B) The book value of total capital is the same as the amount of 
total capital reported by the Bank to the Finance Board under 
Sec. 932.7 of this part.
    (2) A Bank may substitute an internal cash flow model to derive a 
market risk capital requirement in place of that calculated using an 
internal market risk model under paragraph (a)(1) of this section, 
provided that:
    (i) The Bank obtains Finance Board approval of the internal cash 
flow model and of the assumptions to be applied to the model; and
    (ii) The Bank demonstrates to the Finance Board that the internal 
cash flow model subjects the Bank's assets and liabilities, off-balance 
sheet items and derivative contracts, including related options, to a 
comparable degree of stress for such factors as will be required for an 
internal market risk model.
    (b) Measurement of market value at risk under a Bank's internal 
market risk model. (1) Except as provided under paragraph (a)(2) of 
this section, each Bank shall use an internal market risk model that 
estimates the market value of the Bank's assets and liabilities, off-
balance sheet items, and derivative contracts, including any related 
options, and measures the market value of the Bank's portfolio at risk 
of its assets and liabilities, off-balance sheet items, and derivative 
contracts, including related options, from all sources of the Bank's 
market risks, except that the Bank's model need only incorporate those 
risks that are material.
    (2) The Bank's internal market risk model may use any generally 
accepted measurement technique, such as variance-covariance models, 
historical simulations, or Monte Carlo simulations, for estimating the 
market value of the Bank's portfolio at risk, provided that any 
measurement technique used must cover the Bank's material risks.
    (3) The measures of the market value of the Bank's portfolio at 
risk shall include the risks arising from the non-linear price 
characteristics of options and the sensitivity of the market value of 
options to changes in the volatility of the options' underlying rates 
or prices.
    (4) The Bank's internal market risk model shall use interest rate 
and market price scenarios for estimating the market value of the 
Bank's portfolio at risk, but at a minimum:
    (i) The Bank's internal market risk model shall provide an estimate 
of the market value of the Bank's portfolio at risk such that the 
probability of a loss greater than that estimated shall be no more than 
one percent;
    (ii) The Bank's internal market risk model shall incorporate 
scenarios that reflect changes in interest rates, interest rate 
volatility, and shape of the yield curve, and changes in market prices, 
equivalent to those that have been observed over 120-business day 
periods of market stress. For interest rates, the relevant historical 
observations should be drawn from the period that starts at the end of 
the previous month and goes back to the beginning of 1978;
    (iii) The total number of, and specific historical observations 
identified by the Bank as, stress scenarios shall be:
    (A) Satisfactory to the Finance Board;
    (B) Representative of the periods of the greatest potential market 
stress given the Bank's portfolio, and
    (C) Comprehensive given the modeling capabilities available to the 
Bank; and
    (iv) The measure of the market value of the Bank's portfolio at 
risk may

[[Page 8318]]

incorporate empirical correlations among interest rates.
    (5) For any consolidated obligations denominated in a currency 
other than U.S. Dollars or linked to equity or commodity prices, each 
Bank shall, in addition to fulfilling the criteria of paragraph (b)(4) 
of this section, calculate an estimate of the market value of its 
portfolio at risk due to the material foreign exchange, equity price or 
commodity price risk, such that, at a minimum:
    (i) The probability of a loss greater than that estimated shall not 
exceed one percent;
    (ii) The scenarios reflect changes in foreign exchange, equity, or 
commodity market prices that have been observed over 120-business day 
periods of market stress, as determined using historical data that is 
from an appropriate period; and
    (iii) The total number of, and specific historical observations 
identified by the Bank as, stress scenarios shall be:
    (A) Satisfactory to the Finance Board;
    (B) Representative of the periods of greatest potential stress 
given the Bank's portfolio; and
    (C) Comprehensive given the modeling capabilities available to the 
Bank; and
    (iv) The measure of the market value of the Bank's portfolio at 
risk may incorporate empirical correlations within or among foreign 
exchange rates, equity prices, or commodity prices.
    (c) Independent validation of Bank internal market risk model or 
internal cash flow model. (1) Each Bank shall conduct an independent 
validation of its internal market risk model or internal cash flow 
model within the Bank that is carried out by personnel not reporting to 
the business line responsible for conducting business transactions for 
the Bank. Alternatively, the Bank may obtain independent validation by 
an outside party qualified to make such determinations. Validations 
shall be done on an annual basis, or more frequently as required by the 
Finance Board.
    (2) The results of such independent validations shall be reviewed 
by the Bank's board of directors and provided promptly to the Finance 
Board.
    (d) Finance Board approval of Bank internal market risk model or 
internal cash flow model. Each Bank shall obtain Finance Board approval 
of an internal market risk model or an internal cash flow model, 
including subsequent material adjustments to the model made by the 
Bank, prior to the use of any model. Each Bank shall make such 
adjustments to its model as may be directed by the Finance Board.
    (e) Date of calculations. Unless otherwise directed by the Finance 
Board, each Bank shall perform any calculations or estimates required 
under this section using the assets and liabilities, off-balance sheet 
items, and derivative contracts held by the Bank, and if applicable, 
the values of any such holdings, as of the close of business of the 
last business day of the month for which the market risk capital 
requirement is being calculated.


Sec. 932.6  Operations risk capital requirement.

    (a) General requirement. Except as authorized under paragraph (b) 
of this section, each Bank's operations risk capital requirement shall 
at all times equal 30 percent of the sum of the Bank's credit risk 
capital requirement and market risk capital requirement.
    (b) Alternative requirements. With the approval of the Finance 
Board, each Bank may have an operations risk capital requirement equal 
to less than 30 percent but no less than 10 percent of the sum of the 
Bank's credit risk capital requirement and market risk capital 
requirement if:
    (1) The Bank provides an alternative methodology for assessing and 
quantifying an operations risk capital requirement; or
    (2) The Bank obtains insurance to cover operations risk from an 
insurer rated at least the second highest investment grade credit 
rating by an NRSRO.


Sec. 932.7  Reporting requirements.

    Each Bank shall report to the Finance Board by the 15th business 
day of each month its risk-based capital requirement by component 
amounts, and its actual total capital amount and permanent capital 
amount, calculated as of the close of business of the last business day 
of the preceding month, or more frequently, as may be required by the 
Finance Board.


Sec. 932.8  Minimum liquidity requirements.

    In addition to meeting the deposit liquidity requirements contained 
in Sec. 965.3 of this chapter, each Bank shall hold contingency 
liquidity in an amount sufficient to enable the Bank to meet its 
liquidity needs, which shall, at a minimum, cover five business days of 
inability to access the consolidated obligation debt markets. An asset 
that has been pledged under a repurchase agreement cannot be used to 
satisfy minimum liquidity requirements.


Sec. 932.9  Limits on unsecured extensions of credit to one 
counterparty or affiliated counterparties; reporting requirements for 
total extensions of credit to one counterparty or affiliated 
counterparties.

    (a) Unsecured extensions of credit to single counterparty. (1) 
General requirement. Unsecured extensions of credit by a Bank to a 
single counterparty that arise from the Bank's on-and off-balance sheet 
transactions shall not exceed the product of the maximum capital 
exposure limit applicable to such counterparty, as set forth in 
paragraph (a)(2) and Table 4 of this part, multiplied by the lesser of:
    (i) The Bank's total capital; or
    (ii) The counterparty's Tier 1 capital, or if Tier 1 capital is not 
available, total capital (as defined by the counterparty's principal 
regulator) or some similar comparable measure identified by the Bank.
    (2) Bank determination applicable maximum exposure limits. The 
applicable maximum capital exposure limits for specific counterparties 
are assigned to each counterparty based upon the credit rating of the 
counterparty, as determined in accordance with paragraph (a)(3) of this 
section, and are provided in the following Table 4 of this part:

 Table 4.--Maximum Limits on Unsecured Extensions of Credit to a Single
           Counterparty by Counterparty Credit Rating Category
------------------------------------------------------------------------
                                                               Maximum
                                                               capital
          Credit rating of counterparty category              exposure
                                                             limit  (in
                                                              percent)
------------------------------------------------------------------------
Highest Investment Grade..................................          15
Second Highest Investment Grade...........................          12
Third Highest Investment Grade............................           6
Fourth Highest Investment Grade...........................           1.5
Below Investment Grade or Other...........................           1
------------------------------------------------------------------------

    (3) Bank determination of applicable credit ratings. In determining 
the applicable credit rating category under Table 4 of this part, the 
following criteria shall be applied:
    (i) The most recent credit rating from a given NRSRO shall be 
considered. If only one NRSRO has rated the counterparty, that NRSRO's 
rating shall be used. If a counterparty has received credit ratings 
from more than one NRSRO, the lowest credit rating from among those 
NRSROs shall be used;
    (ii) Where a credit rating has a modifier, the credit rating is 
deemed to

[[Page 8319]]

be the credit rating without the modifier;
    (iii) If a counterparty has received different credit ratings for 
its transactions with short-term and long-term maturities:
    (A) The higher credit rating shall apply for purposes of 
determining the allowable maximum capital exposure limit applicable to 
the total amount of unsecured credit extended by the Bank to such 
counterparty; and
    (B) The lower credit rating shall apply for purposes of determining 
the allowable maximum capital exposure limit applicable to the amount 
of unsecured credit extended by the Bank to such counterparty for the 
transactions with maturities governed by that rating.
    (iv) If a counterparty is placed on a credit watch for a potential 
downgrade by an NRSRO, the credit rating from that NRSRO at the next 
lower grade shall be used; and
    (v) If a counterparty is not rated by a NRSRO, the Bank shall 
determine the applicable credit rating by using credit rating standards 
available from an NRSRO or other similar standards.
    (b) Unsecured extensions of credit to affiliated counterparties. 
The total amount of unsecured extensions of credit by a Bank to all 
affiliated counterparties shall not exceed the product of the maximum 
capital exposure limit provided under Table 4 of this part based upon 
the highest credit rating of the affiliated counterparties, as 
determined in accordance with paragraph (a)(3) of this section, 
multiplied by the lesser of:
    (1) The Bank's total capital; or
    (2) The combined Tier 1 capital, or if Tier 1 capital is not 
available, the combined total capital (as defined by each affiliated 
counterparty's principal regulator) or some similar comparable measure 
identified by the Bank, of all of the affiliated counterparties.
    (c) Reporting requirements--(1) Total unsecured extensions of 
credit. Each Bank shall report monthly to the Finance Board the amount 
of the Bank's total unsecured extensions of credit arising from on- and 
off-balance sheet transactions to any single counterparty or group of 
affiliated counterparties that exceeds 5 percent of:
    (i) The Bank's total capital; or
    (ii) The counterparty's, or affiliated counterparties' combined, 
Tier 1 capital, or if Tier 1 capital is not available, total capital 
(as defined by each counterparty's principal regulator) or some similar 
comparable measure identified by the Bank.
    (2) Total secured and unsecured extensions of credit. Each Bank 
shall report monthly to the Finance Board the amount of the Bank's 
total secured and unsecured extensions of credit arising from on- or 
off-balance sheet transactions to any single counterparty or group of 
affiliated counterparties that exceeds 5 percent of the Bank's total 
assets.

PART 933--BANK CAPITAL STRUCTURE PLANS

Sec.
933.1  Submission of plan.
933.2  Contents of plan.
933.3  Independent review of capital plan.
933.4  Transition provisions.

    Authority: 12 U.S.C. 1422a(a)(3), 1422b(a), 1426, 1440, 1443, 
1446.


Sec. 933.1  Submission of Plan.

    (a) In general. By no later than October 29, 2001, the board of 
directors of each Bank shall submit to the Finance Board a plan to 
establish and implement a new capital structure for that Bank, which 
plan shall comply with part 931 of this chapter and under which, when 
implemented, the Bank shall have sufficient total and permanent capital 
to comply with the regulatory capital requirements established by part 
932 of this chapter. The Finance Board, upon a demonstration of good 
cause submitted by the board of directors of a Bank, may approve a 
reasonable extension of the 270-day period for submission of the 
capital plan. A Bank shall not implement its capital plan, or any 
amendment to the plan, without Finance Board approval.
    (b) Failure to submit a capital plan. If a Bank fails to submit a 
capital plan to the Finance Board by October 29, 2001, including any 
approved extension, the Finance Board may establish a capital plan for 
that Bank, take any enforcement action against the Bank, its directors, 
or its executive officers authorized by section 2B(a) of the Act (12 
U.S.C. 1422b(a)), or merge the Bank pursuant to section 26 of the Act 
(12 U.S.C. 1446) into any other Bank that has submitted a capital plan.
    (c) Consideration of the plan. After receipt of a Bank's capital 
plan, the Finance Board may return the plan to the Bank if it does not 
comply with section 6 of the Act (12 U.S.C. 1426) or any regulatory 
requirement or is otherwise incomplete or materially deficient. If the 
Finance Board accepts a capital plan for review, it may require the 
Bank to submit additional information regarding its plan or to amend 
the plan, prior to determining whether to approve the plan. The Finance 
Board may approve a capital plan as submitted or as amended, or may 
condition its approval on the Bank's compliance with certain stated 
conditions, and may require that the capital plans of all Banks take 
effect on the same date.


Sec. 933.2  Contents of plan.

    The capital plan for each Bank shall include, at a minimum, 
provisions addressing the following matters:
    (a) Minimum investment. (1) The capital plan shall require each 
member to purchase and maintain a minimum investment in the capital 
stock of the Bank, in accordance with Sec. 931.3, of this chapter and 
shall prescribe the manner in which the minimum investment is to be 
calculated. The plan shall require each member to maintain its minimum 
investment in the Bank's stock for as long as it remains a member and, 
with regard to Bank stock purchased to support an advance or other 
business activity, for as long as the advance or business activity 
remains outstanding.
    (2) The capital plan shall specify the amount and class (or 
classes) of Bank stock that an institution is required to own in order 
to become and remain a member of the Bank, and shall specify the amount 
and class (or classes) of Bank stock that a member is required to own 
in order to obtain advances from, or to engage in other business 
transactions with, the Bank. If a Bank requires its members to satisfy 
its minimum investment through the purchase of one or more combinations 
of Class A and Class B stock, the authorized combinations of stock 
shall be specified in the capital plan, which shall afford the members 
the option of satisfying the minimum investment through the purchase of 
any such combination of stock.
    (3) The capital plan may establish a minimum investment that is 
calculated as a percentage of the total assets of the member, as a 
percentage of the advances outstanding to the member, as a percentage 
of the other business activities conducted with the member, on any 
other basis approved by the Finance Board, or on any combination of the 
above.
    (4) The minimum investment established by the capital plan shall be 
set at a level that, when applied to all members, provides sufficient 
capital for the Bank to comply with its minimum capital requirements, 
as specified in part 932 of this chapter. The capital plan shall 
require the board of directors of the Bank to monitor and, as 
necessary, to adjust, the minimum investment to ensure that the stock 
required to be purchased and maintained by the members is sufficient to 
allow the Bank to comply with its minimum capital requirements. The 
plan shall require each member to

[[Page 8320]]

comply promptly with any adjusted minimum investment established by the 
board of directors of the Bank, but may allow a member a reasonable 
time to do so and may allow a member to reduce its outstanding business 
with the Bank as an alternative to purchasing additional stock.
    (b) Classes of capital stock. The capital plan shall specify the 
class or classes of stock (including subclasses, if any) that the Bank 
will issue, and shall establish the par value, rights, terms, and 
preferences associated with each class (or subclass) of stock. A Bank 
may establish preferences relating to, but not limited to, the 
dividend, voting, or liquidation rights for each class or subclass of 
Bank stock. Any voting preferences established by the Bank pursuant to 
Sec. 915.5 of this chapter shall expressly state the voting rights of 
each class of stock with regard to the election of Bank directors. The 
capital plan shall provide that the owners of the Class B stock own the 
retained earnings, surplus, undivided profits, and equity reserves of 
the Bank, but shall have no right to receive any portion of those 
items, except through declaration of a dividend or capital distribution 
approved by the board of directors or through the liquidation of the 
Bank.
    (c) Dividends. The capital plan shall establish the manner in which 
the Bank will pay dividends, if any, on each class or subclass of 
stock, and shall provide that the Bank may not declare or pay any 
dividends if it is not in compliance with any capital requirement or if 
after paying the dividend it would not be in compliance with any 
capital requirement.
    (d) Initial issuance. The capital plan shall specify the date on 
which the Bank will implement the new capital structure, and shall 
establish the manner in which the Bank will issue Class A and/or Class 
B stock to its existing members, as well as to eligible institutions 
that subsequently become members. The capital plan shall address how 
the Bank will retire the stock that is outstanding as of the effective 
date, including stock held by a member that does not affirmatively 
elect to convert or exchange its existing stock to either Class A or 
Class B stock, or some combination thereof.
    (e) Stock transactions. The capital plan shall establish the 
criteria for the issuance, redemption, repurchase, transfer, and 
retirement of stock issued by the Bank. The capital plan also:
    (1) Shall provide that the Bank may not issue stock other than in 
accordance with Sec. 931.2 of this chapter;
    (2) Shall provide that the stock of the Bank may be issued only to 
and held only by the members of that Bank;
    (3) Shall provide that the stock of the Bank may be transferred 
only in accordance with Sec. 931.6 of this chapter, and may be traded 
only between the Bank and its members;
    (4) May provide for a minimum investment for members that purchase 
Class B stock that is lower than the minimum investment for members 
that purchase Class A stock, provided that the level of investment is 
sufficient for the Bank to comply with its regulatory capital 
requirements;
    (5) Shall specify the fee, if any, to be imposed on a member that 
cancels a request to redeem Bank stock; and
    (6) Shall specify the period of notice that the Bank will provide 
to a member before the Bank, on its own initiative, determines to 
repurchase any excess Bank stock from a member.
    (f) Termination of membership. The capital plan shall address the 
manner in which the Bank will provide for the disposition of its 
capital stock that is held by institutions that terminate their 
membership, and the manner in which the Bank will liquidate claims 
against its members, including claims resulting from prepayment of 
advances prior to their stated maturity.
    (g) Implementation. The capital plan shall demonstrate that the 
Bank has made a good faith determination that the Bank will be able to 
implement the plan as submitted and that the Bank will be in compliance 
with its regulatory total capital requirement and its regulatory risk-
based capital requirement after the plan is implemented.

(The Office of Management and Budget has approved the information 
collection contained in this section and assigned control number 
3069-0059 with an expiration date of November 30, 2003.)

Sec. 933.3  Independent review of capital plan.

    Prior to submitting its capital plan, each Bank shall conduct a 
review of the plan by an independent certified public accountant to 
ensure, to the extent possible, that the implementation of the plan 
would not result in any write-down of the redeemable stock owned by its 
members, and shall conduct a separate review by at least one NRSRO to 
determine, to the extent possible, whether the implementation of the 
plan would have a material effect on the credit rating of the Bank. The 
Bank shall submit a copy of each report to the Finance Board as part of 
its proposed capital plan.


Sec. 933.4  Transition provisions.

    (a) The capital plan of a Bank may include a transition provision 
that would allow a period of time, not to exceed three years, during 
which the Bank shall increase its total and permanent capital to levels 
that are sufficient to comply with its minimum leverage capital 
requirement and its minimum risk-based capital requirement. The capital 
plan of a Bank may also include a transition provision that would allow 
a period of time, not to exceed three years, during which institutions 
that were members of the Bank on November 12, 1999, shall increase the 
amount of Bank stock to a level that is sufficient to comply with the 
minimum investment established by the capital plan. The length of the 
transition periods need not be identical.
    (b) Any transition provision shall comply with the requirements of 
Sec. 931.9.

PART 956--FEDERAL HOME LOAN BANK INVESTMENTS

    19. The authority citation for part 956 is revised to read as 
follows:

    Authority: 12 U.S.C. 1422a(a)(3), 1422b(a), 1429, 1430, 1430b, 
1431, 1436.


    20. Amend Sec. 956.1 by removing the definition of the term 
``NRSRO'' and by adding, in alphabetical order, definitions of the term 
``derivative contracts'' and ``repurchase agreement'' to read as 
follows:


Sec. 956.1  Definitions.

* * * * *
    Derivative contract has the meaning set forth in Sec. 930.1 of this 
chapter.
* * * * *
    Repurchase agreement has the meaning set forth in Sec. 930.1 of 
this chapter.

    21. Revise the last sentence of paragraph (b) of Sec. 956.3 to read 
as follows:


Sec. 956.3  Prohibited investments and prudential rules.

* * * * *
    (b) * * * A Bank may participate in consolidated obligations 
denominated in a currency other than U.S. Dollars or linked to equity 
or commodity prices, provided that the Bank meets the requirements of 
Sec. 966.8(d) of this chapter, and all other applicable requirements 
related to issuing consolidated obligations.

    22. Add a new Sec. 956.5 to read as follows:

[[Page 8321]]

Sec. 956.5  Authorization for derivative contracts and other 
transactions.

    A Bank may enter into the following types of transactions:
    (a) Derivative contracts;
    (b) Standby letters of credit, pursuant to the requirements of 12 
CFR part 961;
    (c) Forward asset purchases and sales;
    (d) Commitments to make advances; and
    (e) Commitment to make or purchase other loans.

    23. Add a new Sec. 956.6, to read as follows:


Sec. 956.6  Use of hedging instruments.

    (a) Applicability of GAAP. Derivative instruments that do not 
qualify as hedging instruments pursuant to GAAP may be used only if a 
non-speculative use is documented by the Bank.
    (b) Documentation requirements. (1) Transactions with a single 
counterparty shall be governed by a single master agreement when 
practicable.
    (2) A Bank's agreement with the counterparty for over-the-counter 
derivative contracts shall include:
    (i) A requirement that market value determinations and subsequent 
adjustments of collateral be made at least on a monthly basis;
    (ii) A statement that failure of a counterparty to meet a 
collateral call will result in an early termination event;
    (iii) A description of early termination pricing and methodology, 
with the methodology reflecting a reasonable estimate of the market 
value of the over-the-counter derivative contract at termination 
(standard International Swaps and Derivatives Association, Inc. 
language relative to early termination pricing and methodology may be 
used to satisfy this requirement); and
    (iv) A requirement that the Bank's consent be obtained prior to the 
transfer of an agreement or contract by a counterparty.

PART 966--CONSOLIDATED OBLIGATIONS

    24. The authority citation of part 966 continues to read as 
follows:

    Authority: 12 U.S.C. 1422a, 1422b, and 1431.

    25. Revise Sec. 966.8 by adding new paragraph (d) to read as 
follows:


Sec. 966.8  Conditions for issuance of consolidated obligations.

* * * * *
    (d) If a Bank participates in any CO denominated in a currency 
other than U.S. Dollars or linked to equity or commodity prices, then 
the Bank shall meet the following requirements:
    (1) The relevant foreign exchange, equity price or commodity price 
risks associated with the CO must be hedged in accordance with 
Sec. 956.6 of this chapter;
    (2) If there is a default on the part of a counterparty to a 
contract hedging the foreign exchange, equity or commodity price risk 
associated with a CO, the Bank shall enter into a replacement contract 
in a timely manner and as soon as market conditions permit.

    Dated: December 20, 2000.

    By the Board of Directors of the Federal Housing Finance Board.
William C. Apgar,
HUD Secretary Designee to the Board.
[FR Doc. 01-1253 Filed 1-29-01; 8:45 am]
BILLING CODE 6725-01-P