8262 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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.

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 GrammLeach-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 paidin 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

Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations 8263

1A 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).

2The 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.

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

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 sixmonth 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.

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

8264 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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-forprofit 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

Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations 8265

3As 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.

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 riskbased 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.

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 statebased directorship structure would

8266 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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 § 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 § 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

§ 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 § 925.20 and § 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

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

§ 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 § 925.20 and § 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 § 925.20 and § 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

§ 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

8268 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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 § 925.20 and § 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, § 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 § 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 § 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

§ 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

§ 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 § 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

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

§§ 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 §§ 925.24 and 925.25 into

an amended version of § 925.24. The

substance of § 925.24 of the final rule is

much the same as proposed § 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, § 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 § 925.20

and § 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 § 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.

8270 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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, § 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, § 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, § 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,

§ 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 § 925.27(b)(4).

See 12 CFR 925.27(b)(4). As was

proposed, § 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, § 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 § 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 § 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

Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations 8271

4A similar conforming change is adopted herein

for part 956 of the Finance Board regulations.

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 § 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 § 925.29 and § 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.

§ 1426(d)(3), as amended. Section

925.22 of the proposed rule would have

implemented these two statutory

provisions, and § 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, § 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 § 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

§ 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 § 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 § 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 fiveyear 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.

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

8272 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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.

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.

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 § 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

§ 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 ‘‘cherrypicking’’ 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

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

8274 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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 § 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 § 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 § 931.7

and § 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

§ 931.2(c) from the final rule. The

provisions regarding the minimum

investment are discussed under § 931.3,

below.

Proposed § 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, §§ 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

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

§ 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

8276 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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

§ 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 § 931.8(c) of the

proposed rule, which would have

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

§ 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 § 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

8278 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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-forsale 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 § 931.10 (§ 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

Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations 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 § 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 § 932.1 for the Banks to

meet the risk-based and leverage capital

requirements, as well as a separate

transition provision in § 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 § 932.2, and sufficient

permanent capital to meet the risk-based

capital requirement in proposed § 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 § 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 § 931.9, and has included a

conforming provision in § 933.4 as part

of the capital plan requirements. As an

8280 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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 §§ 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, § 931.9(a) of the

final rule requires each Bank to comply

with the minimum leverage and riskbased capital requirements of §§ 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 §§ 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 § 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 § 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 § 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

§ 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

§ 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

§§ 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, § 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

Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations 8281

6As adopted in the final rule, § 932.5 allows each

Bank to determine market risk capital charges using

an approved internal market risk model or internal

cash flow model.

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

§ 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, § 931.9, in the final

rule. Proposed § 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 § 931.9.

In addition to the transition provision,

proposed § 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

§ 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 § 932.1 of the final

rule.

Section 932.2—Total Capital

Requirement

Proposed § 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 § 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

§ 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

§ 932.3 concerning the minimum riskbased capital requirement.

The Finance Board received several

comments on proposed § 932.2, but for

the reasons discussed below has not

changed the provision in response to

those comments and is, therefore,

adopting § 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 § 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,

8282 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

7A 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.

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

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 RiskBased 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 § 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 riskbased 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

§ 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 § 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 riskbased 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 riskbased charges are reasonable, given

available information and the technical

capabilities of the Banks. Overall, the

Finance Board believes that the riskbased 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

Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations 8283

8For 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.

9Because 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.

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 riskbased 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.

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 § 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 § 932.3 as adopted is the sum

of a Bank’s credit, market and

operations risk charges calculated in

accordance § 932.4, § 932.5 and § 932.6.

Contrary to the commenter’s request,

§ 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 § 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 § 932.3(b) to increase its

permanent capital above the minimum

levels mandated by § 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 § 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, § 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 § 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

8284 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

10As 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.

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.

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 § 932.4 of

the final rule with the changes

discussed below.

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 (tripleA) 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 overcollateralization 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

Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations 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-toten-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 riskbased capital requirements more

generally—would not be credible if riskbased 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 lowerrated 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

8286 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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 memberprovided 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 § 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 riskbased 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 nonconforming 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 nonconforming 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 riskbased 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 riskbased 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, primequality, 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, welldiversified conforming loan pools

should be considered to have an

exposure benchmark similar to a BB

rating.

Based on the assumptions that welldiversified, 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, primequality loans with loan-to-value (LTV)

Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations 8287

11Each 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.

12See 65 FR at 43421.

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 longrun 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 longrun 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 longrun 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:

• AAA Highest investment grade.

• AA Second highest investment

grade.

• A Third highest investment grade.

• BBB Fourth highest investment

grade.

• BB Highest below investment

grade.

• B Second highest below

investment grade.

• 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 AArated 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.

For each of the 98 credit risk

categories, credit losses from defaults

and downgrades were determined as a

proportion of face value for each twoyear horizon between 1970 and 1999.

Furthermore, to simplify the analysis,

beginning dates for each horizon were

8288 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

13See ‘‘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.

14See ‘‘Credit Risk Modeling: Current Practices

and Applications’’, BCBS, April 1999.

15See ‘‘Historical Default Rates of Corporate Bond

Issuers, 1920–1998,’’ Moody’s Investors Service,

January 1999. 16Based on Moody’s Default Risk Service

database, all issuers rated CCC–C defaulted between

March 1, 1984 and May 31, 1984.

17Table 1.4 of the proposed rule made a reference

to unrated, targeted investments made under

§ 940.3(a)(5) of the Finance Board’s regulations.

This reference was based on the types of targeted

investments proposed in § 940.3. See 65 FR 25676

(May 3, 2000.) The Finance Board, when it adopted

§ 940.3 in final rule form, listed the relevant

targeted investments in § 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

§ 940.3 adopted by the Finance Board and to

include unrated investments in Small Business

Investment Companies (SBICs) as set forth in

§ 940.3(f) which were inadvertently omitted from

the proposed rule.

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 twoyear horizon would better assure that

adequate capital is maintained against

the credit risks faced by the Banks than

would a shorter time horizon.

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.

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

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 § 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.

Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations 8289

18Moreover, if the commenter intended to

describe investments that were not included in

§ 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.

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 § 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 § 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 singleB after the Bank has purchased the

investment.

Another commenter expressed

concern that the proposed capital

requirement of 8 percent for

investments made under § 940.3(e) of

the Finance Board’s regulations could

greatly discourage the Banks from

making these innovative, missionoriented 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 § 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 riskbased 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 § 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 § 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 § 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

8290 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

19For 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.

20A qualifying bilateral netting agreement must

meet the requirements set forth at § 932.4(h)(3) of

the final rule.

21For 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.

22Because § 932.4 of the final rule has been

reorganized, the collateral provision is found at

§ 932.4(e)(2)(ii)(B) of the final rule.

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

§ 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

In addition, § 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

§ 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-bycontract 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.

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

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

§ 932.4(d)(2)(ii) to receive the treatment

afforded by that provision. While the

Finance Board has made some clarifying

Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations 8291

23This argument would apply to any asset, item

or derivative contract backed by a guarantee or

collateral.

changes to the collateral provision in

the final rule, it has adopted this

provision substantially as proposed.

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 wellcollateralized. 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.

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,

§ 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

§ 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

§ 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

8292 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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 shortterm 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

§ 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, § 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 offbalance sheet items. As proposed,

§ 932.4(f), would have required the

Banks to convert all off-balance sheet

credit exposures into equivalent onbalance 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 § 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 offbalance sheet items under § 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 offbalance 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

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

8294 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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, § 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

§ 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 § 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 § 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

§ 932.5(a)(2) of the final rule that a Bank

may use an internal cash flow model in

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

§ 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 § 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 § 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, offbalance 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 § 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 longterm earnings that would result, all

things being equal, from such market

8296 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

24The 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.

25The 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).

changes. In this respect, the marketvalue 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 marketvalue 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

A few commenters believed that the

120 business day holding period

stipulated for the stress test in proposed

§ 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, § 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.

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, § 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 § 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 ongoing 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

§ 932.5 and has determined to make

some changes in the final rule.

Primarily, the Finance Board has

changed the criteria in proposed

§ 932.5(b)(4)(ii) regarding the data time

series from which a Bank must draw the

relevant historical scenarios in

Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations 8297

26As 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.

27The 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.

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 § 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 § 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 § 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

§ 932.5(b)(4)(ii).

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 § 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.

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.

8298 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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 § 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 marketto-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

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

§ 932.5 requirements, the Finance Board

expects that the staff of the Banks and

the Finance Board will maintain an ongoing 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, § 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 § 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 § 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

8300 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

28Contingency 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) selfliquidating assets with a maturity of seven days or

less; (3) assets that are generally accepted as

collateral in the repurchase agreement market; and

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 § 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 § 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 tenpercent 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 § 932.7 as proposed.

Section 932.8—Minimum liquidity

requirements

As proposed, § 932.8 would require

each Bank to hold contingency

liquidity 28 in an amount sufficient to

Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations 8301

(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.

29Operational 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.

30 ‘‘Moody’s Investor Service, Global Credit

Research, Moody’s Credit Opinions—Financial

Institutions’’, (June 1999).

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

§ 965.3 of the Finance Board’s

regulations. 12 CFR 965.3. Proposed

§ 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 § 932.8, but did

not alter the proposed provision in

response. The Finance Board is,

therefore, adopting § 932.8 as proposed.

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 § 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 § 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 § 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).

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 § 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 § 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.

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 § 917.3

and § 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

8302 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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 longterm 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 § 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

§ 933.1(a) and (b) without any material

changes, though it has added a new

§ 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

Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations 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 § 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 § 933.2

to the revisions that have been made to

part 931 of the final rule. The most

significant change to § 933.2 is the

inclusion of § 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 § 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

§ 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

8304 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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, § 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 openended 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,

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

§ 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 § 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, § 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

8306 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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 § 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 riskbased 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 § 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 § 932.5(b)(5). Because § 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

§ 932.5(b) are being adopted in the final

rule without substantive change as a

new paragraph (d) to § 966.8.

Conforming changes to § 956.3(b),

which reference the requirements of

new § 966.8(d), have also been adopted.

These conforming changes to § 956.3(b)

were not part of the proposed regulation

but do not alter the substance of

recently adopted § 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 offbalance sheet transactions in proposed

part 960 are now authorized under new

§ 956.5. The Finance Board also made a

conforming change to the list of

transactions authorized under § 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 §§ 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

Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations 8307

certain proposed provisions in the final

rule, the information collections are

now located in §§ 931.3 and 933.2(e)(4)

of the final rule. Proposed § 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 § 915.3 by revising the

introductory text of paragraph (b) and

paragraph (b)(3) to read as follows:

§ 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 § 925.20 and § 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

§ 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 § 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 § 915.4 to read as follows:

§ 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 § 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 § 925.20 and § 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

8308 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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 § 915.5 to read as follows:

§ 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 § 925.20 and

§ 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 § 915.6 by revising

paragraph (a)(3) to read as follows:

§ 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 § 915.5.

* * * * *

6. Amend § 915.7 by adding a new

sentence at the end of paragraph (b)(2)

to read as follows:

§ 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 § 917.3(b)(1) to read as

follows:

§ 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-toassets 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 § 917.9 by designating the

existing text as paragraph (a) and adding

a new paragraph (b) to read as follows:

§ 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 § 925.24 to read as follows:

§ 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

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

§ 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

§ 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 § 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

§ 925.20 and § 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

§ 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 § 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.)

§ 925.25 [Removed]

12. Remove § 925.25.

13. Revise § 925.26 to read as follows:

§ 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 § 925.27 to read as follows:

§ 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

8310 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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.

§ 925.28 [Removed]

15. Remove § 925.28.

16. Revise § 925.29 to read as follows:

§ 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 § 925.30 to read as follows:

§ 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.

§ 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

§ 931.1(a) of this subchapter.

Class B stock means capital stock

issued by a Bank, including subclasses,

that has the characteristics specified by

§ 931.1(b) of this subchapter.

Contingency liquidity has the meaning

set forth in § 917.1 of this chapter.

Credit derivative contract means a

derivative contract that transfers credit

risk.

Credit risk has the meaning set forth

in § 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

§ 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 § 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

§ 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 § 931.3 of this chapter.

Operations risk has the meaning set

forth in § 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

Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations 8311

Class A or Class B stock at par value

following the expiration of the sixmonth 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

§ 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 § 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 paidin 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.

§ 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 sixmonths 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.

§ 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 § 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.

§ 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.)

§ 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

8312 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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.

§ 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.

§ 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.

§ 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 sixmonths 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 § 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.)

§ 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.

§ 931.9 Transition provision.

(a) In general. Each Bank shall comply

with the minimum leverage and riskbased capital requirements specified in

§ 932.2 and § 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 § 925.20 and

§ 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 § 932.2 and § 932.3 of this

chapter as of the effective date of its

capital plan shall maintain compliance

with the leverage limit requirements in

§ 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 § 932.2

and § 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 § 932.2 of this chapter,

the leverage limit requirements of

§ 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

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

§ 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.

§ 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.

§ 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 §§ 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.

§ 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, offbalance 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 offbalance 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, offbalance 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

Type of advances

Percentage

applicable

to advances

Advances with:

Remaining maturity <= 4

years .................................. 0.07

Remaining maturity > 4 years

to 7 years .......................... 0.20

8314 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

TABLE 1.1.—REQUIREMENT FOR

ADVANCES—Continued

Type of advances

Percentage

applicable

to advances

Remaining maturity > 7 years

to 10 years ........................ 0.30

Remaining maturity > 10

years .................................. 0.35

TABLE 1.2.—REQUIREMENT FOR

RATED RESIDENTIAL MORTGAGE ASSETS

Type of residential mortgage

asset

Percentage

applicable

to residential mortgage assets

Highest Investment Grade ........ 0.37

Second Highest Investment

Grade .................................... 0.60

TABLE 1.2.—REQUIREMENT FOR

RATED RESIDENTIAL MORTGAGE ASSETS—Continued

Type of residential mortgage

asset

Percentage

applicable

to residential mortgage assets

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

TABLE 1.2.—REQUIREMENT FOR

RATED RESIDENTIAL MORTGAGE ASSETS—Continued

Type of residential mortgage

asset

Percentage

applicable

to residential mortgage assets

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

TM 1 year >1 yr to 3

yrs

>3 yrs to

7yrs

>7 yrs to 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

Type of unrated asset Applicable

percentage

Cash ......................................... 0.00

Premises, Plant, and Equipment ...................................... 8.00

Investments Under § 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 § 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

§ 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

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

§ 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 § 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

Instrument

Credit conversion

factor

(in percent)

Asset sales with recourse

where the credit risk remains

with the Bank ........................ 100

Commitments to make advances

Commitments to make or purchase other loans

Standby letters of credit ........... 50

TABLE 2.—CREDIT CONVERSION FACTORS FOR OFF-BALANCE SHEET

ITEMS—Continued

Instrument

Credit conversion

factor

(in percent)

Other commitments with original maturity of over one year

Other commitments with original maturity of one year or

less ........................................ 20

(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 markto-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]

Residual maturity Interest rate

Foreign

exchange

and gold

Equity

Precious

metals except gold

Other 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

8316 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

(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 markto-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:

Anet = 0.4 × Agross + (0.6 × NGR × Agross),

where:

(i) Anet is the potential future credit

exposure for an individual derivative

contract subject to the qualifying

bilateral netting contract;

(ii) Agross 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-tomarket 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

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

§ 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 § 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, offbalance 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 nonlinear 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

8318 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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.

§ 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.

§ 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.

§ 932.8 Minimum liquidity requirements.

In addition to meeting the deposit

liquidity requirements contained in

§ 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.

§ 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 offbalance 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

Credit rating of counterparty

category

Maximum

capital 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

Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations 8319

be the credit rating without the

modifier;

(iii) If a counterparty has received

different credit ratings for its

transactions with short-term and longterm 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.

§ 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.

§ 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 § 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

8320 Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations

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 § 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 § 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 § 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.)

§ 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 writedown 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.

§ 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

§ 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 § 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:

§ 956.1 Definitions.

* * * * *

Derivative contract has the meaning

set forth in § 930.1 of this chapter.

* * * * *

Repurchase agreement has the

meaning set forth in § 930.1 of this

chapter.

21. Revise the last sentence of

paragraph (b) of § 956.3 to read as

follows:

§ 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 § 966.8(d) of this

chapter, and all other applicable

requirements related to issuing

consolidated obligations.

22. Add a new § 956.5 to read as

follows:

Federal Register / Vol. 66, No. 20 / Tuesday, January 30, 2001 / Rules and Regulations 8321

§ 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 § 956.6, to read as

follows:

§ 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 overthe-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 § 966.8 by adding new

paragraph (d) to read as follows:

§ 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 § 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