The FHLBank System and the enterprises are GSEs. Congress created GSEs to help make credit available to certain sectors of the economy, such as housing and agriculture, in which the private market was perceived as not effectively meeting credit needs. GSEs receive benefits from their federal charters that help them fulfill their missions. The federal government’s creation of and continued relationship with GSEs have created the perception in the financial markets that the government would not allow a GSE to default on its obligations, even though intervention is not required. As a result, GSEs can borrow money in the capital markets at lower interest rates than comparably creditworthy private corporations that do not enjoy federal sponsorship, and market discipline is reduced. In fact, during the 1980s, the government did provide limited regulatory and financial relief to Fannie Mae when it experienced significant financial difficulties, and, in 1987, Congress authorized $4 billion to bail out the Farm Credit System, another GSE. Additional background on the FHLBank System, the enterprises, FHFB, OFHEO, and financial risks are presented in appendix II. Our mandate directs us to analyze interest rate, credit, and operations risks. Interest rate risk is a component of what is commonly called market risk. Market risk is the potential for financial losses due to the increase or decrease in the value or price of an asset or liability resulting from broad movements in prices, such as interest rates, commodity prices, stock prices, or the relative value of foreign exchange. Credit risk is the potential for financial loss because of the failure of a borrower or counterparty to perform on an obligation. Credit risk may arise from either an inability or unwillingness to perform as required by a loan, a bond, an interest rate swap, or any other financial contract. Operations risk is the potential for unexpected financial losses due to inadequate information systems, operational problems, breaches in internal controls, or fraud. It is associated with problems of accurately processing or settling transactions and with breakdowns in controls and risk limits. Individual operating problems are considered small-probability but potentially high-cost events for well-run firms. Operations risk includes many risks that are not easily quantified, but controlling these risks is crucial to a firm’s successful operation. The FHLBank System is establishing a new capital structure that will include new risk-based and leverage capital requirements and will also make capital more permanent. FHLBank capital will continue to differ from capital issued by publicly traded corporations, however, because of the cooperative nature of the FHLBank System. Additionally, each FHLBank’s capital is potentially available throughout the System, because the FHLBanks are jointly and severally liable for the System’s outstanding debt securities. The unique characteristics of FHLBank capital and the potential for risk taking within the System heighten the importance of supervisory oversight by FHFB. The new capital structure being implemented by the FHLBank System will include risk-based and leverage capital standards. In January 2001, FHFB published a final rule to comply with the provisions of GLBA that required regulations prescribing uniform capital standards applicable for all FHLBanks. These new capital standards, when fully implemented, will replace the current “subscription” capital structure for the FHLBanks. Under the current structure, the amount of capital that each FHLBank issued was determined by a statutory formula that dictated how much FHLBank stock each member had to purchase. A principal shortcoming of the subscription capital structure was that the amount of capital each FHLBank maintained bore little relation to the risks inherent in the FHLBank’s assets and liabilities. Under the new structure, FHLBanks will be required to maintain longer-term permanent capital and total capital in amounts sufficient for the FHLBanks to comply with the minimum risk- based and leverage capital requirements established by GLBA. We have consistently supported the concept of risk-based capital standards applied in combination with a leverage ratio that requires a minimum capital-to-asset ratio for the FHLBanks. A risk-based capital standard has a number of benefits. First, it gives the government a mechanism to influence risk-taking without involving itself in the FHLBanks’ daily business. Second, it gives FHLBanks’ shareholders an incentive to demand that management not take undue risks, since increased risk taking would impose additional costs resulting from raising additional capital. Third, it provides a buffer that should be adequate to absorb unforeseen losses to FHLBanks and thus helps prevent or reduce potential taxpayer losses. The new capital structure the FHLBank System is implementing will also result in more permanent capital. After the enactment of GLBA in 1999, membership in the FHLBank System became all voluntary. Voluntary members can generally redeem stock with 6 months’ notice. Capital redeemable on such short notice does not provide a cushion against unexpected losses. Therefore, the change to all voluntary members increased the need for more permanent capital that could not necessarily be redeemed with 6 months notice, and GLBA required implementation of a more permanent capital structure. Under the new capital structure, the FHLBanks are permitted to issue Class A stock, which can be redeemed with 6 months’ notice, and Class B stock, which can be redeemed with 5 years’ notice, or both. To help ensure that capital does not dissipate due to redemption in time of stress, GLBA does not allow a FHLBank to redeem or repurchase capital if following the redemption the FHLBank would fail to satisfy any minimum capital requirement. Based on discussions with FHFB officials and their review of draft capital plans, it appears that a majority of FHLBanks might initially implement an exclusive Class B stock structure, while other FHLBanks might implement a mixed structure. The presence of 5-year capital, combined with the requirement that member institutions lose benefits of membership in the System if they withdraw capital, acts to create a financial interest that mirrors some, though certainly not all, characteristics of publicly traded perpetual equity stock. Permanent capital is defined in GLBA as amounts paid in for Class B stock plus the retained earnings. Class A stock plus permanent capital is to be at least 4 percent of assets. Class A stock plus 1.5 times permanent capital is to be at least 5 percent of assets. Therefore, a FHLBank meeting the 4 percent requirement will also meet the 5 percent requirement if its permanent capital equals at least 2 percent of assets. In addition, only permanent capital is included in the capital definition for the risk-based capital component of the minimum capital standards. Although the new capital structure will result in more permanent capital, FHLBank capital will continue to differ from the capital issued by publicly traded corporations such as the enterprises or banks. The voluntary, cooperative nature of the FHLBank System means that capital in this system has characteristics different from capital issued by publicly traded corporations. First, the FHLBank stock will not be perpetual equity stock like that issued by publicly traded corporations. Stock issued by publicly traded corporations can be bought and sold freely and publicly at a market- determined price. In contrast, a FHLBank member institution can redeem FHLBank stock at par value as long as all restrictions are met. For example, a member can withdraw capital with prior notice (i.e., of 6 months or 5 years) if after redemption the FHLBank satisfies all minimum capital requirements. However, FHLBank member institutions lose benefits of membership in the System if they withdraw minimum capital required for membership. This lessens incentives to remove capital, if, for example, FHLBank earnings declined. Second, investors cannot be obligated to buy the stock of publicly traded corporations. However, FHLBank members can be required to buy additional FHLBank stock to ensure that the FHLBank meets its capital requirements. Third, corporations with publicly traded stock have responsibilities to maximize the value of their stock. In contrast, FHLBanks have incentives to provide the best mix of services and dividend payments to their member-owners. Under the new capital structure, the capital of each FHLBank will continue to be available to other FHLBanks in the System because the FHLBanks are jointly and severally liable for the System’s outstanding debt securities, called consolidated obligations. Joint and several liability for the payment of consolidated obligations gives investors confidence that System debt will be paid. Another related characteristic of joint and several liability is that it potentially creates a large pool of capital from all FHLBanks to provide a cushion in the event of unexpected System losses. However, joint and several liability also puts all FHLBanks at risk because of the possibility that one FHLBank could become troubled and not be able to meet its debt obligations. In such a situation, the troubled FHLBank would have incentives to undertake risky activities because profits would accrue to the FHLBank’s owners, whereas losses and erosion of capital could fall on others. This scenario creates incentives for the FHLBanks to monitor each other’s activities, which FHLBank officials told us they do through a number of System-wide bodies of representatives from the 12 FHLBanks. In theory, joint and several liability appears to make most System capital available in the event of large, unexpected losses in the System. However, concerns about how joint and several liability would operate in the event of a default or delinquency on a consolidated obligation prompted FHFB to issue regulations in 1999. The regulations establish a process by which FHFB will look first to the assets of a FHLBank that received the proceeds of the consolidated obligation. The regulations also contain certification and reporting requirements with which the FHLBanks must comply. For example, the FHLBanks must certify before the end of the each calendar quarter that they will remain in compliance with the liquidity requirements and will remain capable of making full and timely payments on their consolidated obligations.