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).

Since its enactment in 1932, section 6 of the Bank Act has provided for a “subscription” capital structure for the Banks. Under that structure, the amount of capital stock that each Bank issued was determined by a statutory formula that dictated how much Bank stock each member must purchase. In accordance with that formula, each member was required to purchase Bank stock in an amount equal to one percent of the member's total mortgage assets or five percent of the advances outstanding to the member, whichever was greater. A principal shortcoming of the subscription capital structure was that the amount of capital maintained by each Bank bore little relation to the risks inherent in the assets and liabilities of the Bank.

With the enactment of the Gramm-Leach-Bliley Act, Pub. Law No. 106-102, 133 Stat. 1338 (Nov. 12, 1999) (GLB Act), the Congress amended section 6 the Bank Act in its entirety, replacing the subscription capital provisions with risk-based and leverage capital requirements that are similar to those applicable to depository institutions and to the other housing GSEs. The GLB Act mandated that the Finance Board issue regulations prescribing uniform capital standards applicable to each Bank in accordance with the provisions of the GLB Act. When the Finance Board's regulations are implemented, each Bank will be required to maintain permanent capital and total capital in amounts that are sufficient for the Bank to comply with the minimum risk-based and leverage capital requirements, respectively, established by the GLB Act.

The GLB Act requires each Bank to maintain “permanent capital” in an amount that is sufficient to meet the credit risk and market risk to which the Bank is subject, with the market risk being based on a stress test established by the Finance Board that tests for changes in certain specified market variables. Permanent capital is defined by statute to include the amounts paid-in for Class B stock plus the retained earnings of the Bank, with retained earnings being determined in accordance with generally accepted accounting principles (GAAP).

The GLB Act also requires each Bank to maintain “total capital” in amounts that are sufficient to comply with a minimum leverage requirement. Total capital is defined by the GLB Act to include a Bank's permanent capital, plus the amounts paid-in by the members for Class A stock, any general loss allowance (if consistent with GAAP and not established for specific assets), and other amounts from sources determined by the Finance Board as available to absorb losses. When measured by weighting the amount paid-in for Class B stock and the retained earnings by a factor of 1.5, each Bank must maintain a ratio of total capital to total assets of at least 5 percent. When measured on an unweighted basis, each Bank must maintain a ratio of total capital to total assets of at least 4 percent.

The GLB Act further requires the capital regulations issued by the Finance Board to address a number of other matters, such as the classes of stock that a Bank may issue, the rights, terms, and preferences that may be established for each class, the issuance, transfer, and redemption of Bank stock, and the liquidation of claims against a withdrawing member. The rules must permit each Bank to issue either Class A or Class B stock, or both, with the board of directors of each Bank to determine the rights, terms, and preferences for each class. Both Class A and Class B stock may be issued only to 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.

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 six-month notice period, and provided that all indebtedness owed by the withdrawing member to the Bank had been liquidated, a Bank could redeem the stock of the withdrawing member, paying cash to the member equal to the par value of the stock. Any such withdrawing member could not rejoin the Bank system for 10 years, with only limited exceptions.

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 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.

The Finance Board received 143 comments on the proposed rule. Ten of those comments were submitted before the proposed rule was published. Of the 133 comments received after publication of the proposed rule, 25 comments came from the 12 Banks; 1 comment was received from a not-for-profit housing association; 73 comments were received from member institutions; 25 comments came from banking and other trade associations; 6 comments were received from other parties associated with the mortgage industry; 2 comments came from members of Congress, and 1 comment was submitted by the Department of the Treasury.

To the extent that the comments raised questions about particular aspects of the proposed rule, those comments and the Finance Board's response to them are discussed below as part of the explanation of the relevant provisions of the final rule.

In general, many commenters recommended that the Finance Board preserve the cooperative ownership structure of the Bank System by eliminating provisions of the proposed rule that were perceived to threaten the cooperative nature of the Bank System. In particular, a number of commenters believed that provisions in the proposed rule permitting the payment of membership fees in lieu of a minimum stock investment, trading of Bank stock among the members, the repurchase of Bank stock at a negotiated price, and barring the Banks from requiring their members to retain Bank stock that was purchased to support a particular transaction with the Bank would undermine the cooperative structure of the Bank System because such provisions would tend to separate ownership of the Bank System from the use of its services.

Many commenters also recommended that the Finance Board pay close attention to the possible tax implications of provisions in the rule, principally as they relate to the members of the Banks. For example, commenters expressed concern that by establishing a stated dividend for the Class A stock and giving it a priority over payment of dividends on the Class B stock, the proposed rule might create a taxable event for certain members upon the conversion of some of their existing stock to Class A stock.

Commenters expressed other concerns about the capital structure provisions of the proposed rule. Nearly all commenters that addressed the issue of the operating capital ratios recommended that they be eliminated, principally because the manner in which the operating ratios would have worked would have resulted in members being treated unequally with regard to their stock purchase requirements, depending on when they purchased their stock. Many commenters asked, if the final regulation were to retain the operating ratio concept, that such limits should be more appropriately set as a range, rather than a fixed number. With respect to provisions related to the designation of directorships and the election of directors, many commenters believed that the GLB Act did not repeal by implication any provisions of section 7 of the Bank Act, as the Finance Board had proposed. With respect to the provision that would have barred any member or its affiliates from owning more than 40 percent of the stock of any Bank, nearly all commenters that addressed the issue recommended eliminating that provision, arguing that any concern about control of a Bank could be better addressed by limits on the amount of stock that a member may vote.

Many commenters addressed the risk-based capital provisions in the proposed rule. With respect to credit risk, many commenters argued that the capital charges assigned in the proposed rule to advances, as well as to mortgage assets rated BBB or lower, were too conservative. With respect to market risk, many commenters indicated that the value-at-risk model is inappropriate for measuring the long-term market risk profile of a Bank. Many commenters also opposed applying a 95 percent of market value to book value test because they believe it fails to provide a Bank with sufficient flexibility to manage its entire portfolio of activities. Finally, with respect to operations risk, many commenters stated that a capital charge of 30 percent of the sum of credit and market risk was too high, and that there was no sound theoretical basis for linking operations risk to credit and market risk.

The Finance Board has made significant revisions in the final rule in response to the comments received, particularly with respect to matters of capital structure. The Finance Board also has retained much of the substance of the proposed rule with respect to the risk-based capital provisions. The changes from the proposed rule, as well as the provisions that have been retained, are described in more detail below in the discussion of specific provisions of the final rule.

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 state-based directorship structure would 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 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 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.

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 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.

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. 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 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.

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 five-year statutory redemption period, respectively, for the stock. The final rule defines the term “repurchase” to mean the acquisition by a Bank of excess stock prior to the expiration of the applicable statutory redemption period.

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 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 “cherry-picking” among the subclasses that could be detrimental to the cooperative nature of the Bank System. Other commenters questioned the legal authority for subclasses. As explained in the SUPPLEMENTARY INFORMATION section of the proposed rule, the board of directors of a Bank has the authority under section 6(a)(4)(A) and section 6(c)(4)(B) of the Bank Act to establish different rights, terms, and preferences for the stock issued by the Bank. 12 U.S.C. 1426(a)(4)(A), (c)(4)(B), as amended. Those provisions clearly authorize a Bank to issue Class A stock with rights, terms, and preferences that differ from Class B stock, and there is nothing in those provisions that would prohibit a Bank from issuing some shares of Class B stock, for example, with rights, terms, and preferences that differ from other shares of the Bank's Class B stock. Thus, if the board of directors of a Bank wished to issue some shares of Class B stock for which the dividend will be determined based on the performance of a specific category of Bank assets and other shares of Class B stock for which the dividend will be determined based on the general profitability of the Bank, it would have the authority to do so. Obviously, if some shares of Class B stock were to have rights, terms, and preferences different from those of other shares of Class B stock, it would be eminently sensible for the Bank to distinguish between the two types of Class B stock, such as by giving them different names. Section 931.1(c) of the final rule makes clear that a Bank can designate such different shares of stock as separate “subclasses” if it wishes to do so. The authority to issue subclasses of either the Class A or Class B stock does not at 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 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 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 risk-based capital requirements, even if it were to be held for the duration of an advance. With regard to the contention that a Bank should be allowed to retain the “5 percent of advances” requirement from prior law, it would be possible under the final rule for a Bank to do so, provided that the amount of capital generated by that requirement would be sufficient for a Bank to meet its total and risk-based capital requirements, both for its outstanding advances as well as for the other assets on the balance sheets of the Banks. As discussed below, the determination of how to structure the minimum investment is left to the individual Banks under the final rule.

The final rule includes, in § 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 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 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 rulemaking in the first quarter of 2001 on capital issues, and believes that the resolution of this issue regarding the source of dividends for the Class A stock should occur after there has been an opportunity for public comment on the issue. To the extent that any Bank intends to submit a capital plan that would call for the payment of dividends on Class A stock, the Finance Board expects that the plan would identify the source for paying such dividends, address the authority of the Bank to pay dividends from that source, and describe how the proposal would be treated under relevant accounting principles.

Some commenters expressed concern that any regulatory limits on dividends may prove troublesome over time, given the potential for increased volatility in reported net income and retained earnings that could result from the implementation of Statement of Financial Accounting Standards No. 133 (SFAS 133), the new GAAP accounting standard for derivatives. One commenter recommended that if the transitory income effects associated with SFAS 133 were to prevent the payment of a dividend, it would be appropriate for the Bank's board of directors to have the authority to declare and pay a dividend from earnings without regard to these transitory SFAS 133 effects. Another commenter expressed concern about the market and income volatility generated by the accounting treatment surrounding mortgage-related options, such as those associated with the Mortgage Partnership Finance (MPF) program. As noted previously, by statute a Bank may pay dividends only from its current earnings or its previously retained earnings. To the extent that these comments suggest that the Finance Board should allow a Bank to pay dividends from some other source, the Finance Board is not prepared to do so. Moreover, the GLB Act requires that in calculating risk-based and total capital, the retained earnings of a Bank must be calculated in accordance with GAAP. The GLB Act also restricts a Bank from making a retained earnings distribution, unless following such distribution the Bank would continue to meet all applicable capital requirements. These statutory provisions, read together, persuade the Finance Board that it should not adopt the suggestions raised by these commenters.

Liquidation, merger, or consolidation. The proposed rule established a priority for Class A shareholders over Class B shareholders, in the event of a liquidation, merger, or other consolidation of a Bank. As previously discussed, many commenters recommended eliminating such a preference in order to avoid creating a taxable event with respect to stock previously issued as dividends when existing stock is converted to Class A stock. The Finance Board has eliminated this provision in the final rule, substituting instead a requirement that the respective rights of Class A and Class B stockholders, in the event that the Bank is liquidated, or is merged or otherwise consolidated with another Bank, shall be determined in accordance with the capital plan of the Bank.

Transfer of capital stock. Consistent with current practice, the proposed rule would have allowed a member to transfer capital stock only to another member of the Bank or to an institution that is in the process of becoming a member. Unlike current practice, the proposed rule would have required such transfers of stock to be at a price agreed to by the parties, which by implication meant that the price could be below, at, or above the par value of the stock.

Several commenters raised issues with allowing stock transfers to an institution in the process of becoming a member, citing concerns that if it did not become a member, a non-member institution could own Bank stock which would be inconsistent with the GLB Act. To address concerns raised by the commenters, the Finance Board revised the phrase “institution in the process of becoming a member” in the final rule to “institution that has been approved for membership in that Bank and that has satisfied all conditions for becoming a member, other than the purchase of the minimum amount of Bank stock that it is required to hold as a condition of membership.”

Many commenters opposed the trading of Bank stock at a negotiated price among its members. Such trading, it was argued, would require members to hold Bank stock as an available-for-sale asset, which would have to be marked to market. The Finance Board agrees that such problems outweigh the potential benefits of other than par value transfers, at this time, and has thus revised the final rule to require that any transfer of stock among members must be at par value.

Redemption and repurchase of capital stock. Proposed § 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 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 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 risk-based 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 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.

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.

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.

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 risk-based 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, 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 Risk-Based Capital Requirement, the Finance Board expects that the authority granted under this provision rarely will be used, but nonetheless believes that the provision is an important safeguard measure in case unforeseen events result in anticipated or actual impairment of a Bank's capital.

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 risk-based capital purposes. The Finance Board has considered all comments received on the minimum risk-based capital requirements and, for the reasons discussed below, is adopting § 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 risk-based capital requirements.

Some commenters also urged the Finance Board to allow Banks to apply at least some portion of the paid-in value of Class A stock against the operations risk capital charge because, unlike the credit and market risk requirements, an operations risk requirement was not specifically mandated by the GLB Act. However, as addressed elsewhere in this SUPPLEMENTARY INFORMATION section, the Finance Board considers an operations risk charge to be an integral part of the risk-based capital requirement. Further, as just discussed, by statute, Class A stock is not suitable risk-bearing capital for credit and market risk. Consistent with this approach, the Finance Board continues to believe that only permanent capital should be held against the operations risk requirement, which, along with the credit and market risk requirements, forms the overall risk-based capital requirement.

More generally, with regard to the magnitude of the risk-based capital charges, estimates by the Finance Board staff indicate that the total risk-based capital charges will not be onerous to the Banks as some commenters have suggested, given the Banks' current balance sheets and risk profiles. Even estimates of the market risk capital charges produced by the Banks' consultant, which involved stress scenarios that would be more rigorous than those required under the proposed rule, did not suggest that the capital requirements being adopted here would be unreasonable. Specifically, the Finance Board anticipates that at least at the time of implementation of the capital plans, the risk-based capital requirement for all Banks will be below the minimum total capital leverage requirements set forth in the GLB Act. More importantly, as addressed more fully in the separate credit, market and operations risk sections, the Finance Board believes that the approaches adopted for calculating individual risk-based charges are reasonable, given available information and the technical capabilities of the Banks. Overall, the Finance Board believes that the risk-based capital charges will adequately reflect the risks faced by the Banks.

In addition, as discussed in the SUPPLEMENTARY INFORMATION section of the proposed rule, the Finance Board considered all aspects of OFHEO's proposed risk-based capital rule in developing the proposed rule, as well as in developing the final rule. The GLB Act requires the Finance Board to give due consideration to the OFHEO capital rule in developing the market risk component of the risk-based capital requirement for the Banks, but nothing in the GLB Act requires the Finance Board to defer to the OFHEO regulation, either with regard to the market risk or other components of this rule. See 65 FR at 43426-27 (July 13, 2000); Am. Fed'n of Gov't Employees v. Donovan, 1982 WL 2167 *3 (D.D.C.) (the use of the terms “due consideration” in the Service Contract Act of 1965 “are much more nearly precatory than mandatory [and] have a procedural implication,” and do not mean “equivalent to”). Neither does anything in the GLB Act require that the Finance Board's risk-based capital requirements result in the same or similar risk-based charges for the Banks and for Fannie Mae or Freddie Mac. In fact, Congress established a different risk-based capital stress test and different minimum capital levels for the Banks than it did for Fannie Mae and Freddie Mac.8 Compare 12 U.S.C. 1426(a)(2), (a)(3), to 12 U.S.C. 4611, 4612. Nevertheless, the Finance Board does not believe that the capital requirements adopted herein are inconsistent with those governing Fannie Mae or Freddie Mac, after taking into account the differences in the relevant statutes and the businesses of the three GSEs. See 65 FR at 43426.

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.

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 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 (triple-A) corporate bonds and that advances would have a recovery rate of 90 percent (i.e., a loss severity rate of 10 percent). A 90 percent recovery rate was considered consistent with the over-collateralization and other protections afforded advances. A credit risk horizon equal to the remaining maturity of the advance was deemed more appropriate than imposing the maximum two-year horizon used in the general methodology, because advances are unique products of the Banks that cannot readily be sold in the marketplace like most of the other investments of the Banks and, therefore, would have to remain on the books until maturity. The probability of default was then measured as the maximum probability of a triple-A corporate issuer default, but over a period extending to the maturity of the advance.

Adjustments also were made to the credit risk percentage requirements assigned to the shortest and longest remaining maturity classes. As calculated, the requirement for advances with a maturity of four years or less would be zero. However, recognizing that advances are not totally risk free, a minimum capital requirement of seven basis points was set to ensure that the Banks would hold sufficient capital, particularly in view of the GLB Act's recent amendments to the Bank Act which expanded the types of collateral available to support advances. See 12 U.S.C. 1430(a)(3); 65 FR 44414 (July 18, 2000). Further, as calculated for the proposed rule, the requirement for maturities greater than 10 years would have been 50 basis points. However, because the estimated capital charge for triple-A-rated residential mortgage assets (as presented in proposed Table 1.2) was less than 50 basis points, and because advances clearly have a better credit loss history than residential mortgages, advances with a remaining maturity of greater than 10 years were assigned a credit risk percentage requirement equivalent to the requirement for triple-A-rated residential mortgage assets. In the final rule, the requirement for advances with remaining maturities greater than 10 years was adjusted to reflect the revised methodology used to calculate credit risk requirement percentages for residential mortgage assets for Table 1.2. and is set at 35 basis points. The credit risk percentage requirement of 20 basis points for remaining maturities greater than 4 years up to 7 years was based on actual default rates and remains the same in the final rule. For maturities of greater than 7 years up to 10 years, the credit risk percentage requirement, if based on actual default rates, would have been 40 basis points. In the final rule, however, the credit risk percentage requirement was reduced to 30 basis points to conform with the 35 basis point requirement for maturities greater than 10 years.

In the proposed rule, the Finance Board specifically requested comment on the methodology that should be used for setting the credit risk percentage requirements for advances and whether a more satisfactory analytical framework exists that could be used to determine more appropriate credit risk percentage requirements for advances.

The Finance Board received several comments on the proposed credit risk percentage requirements for advances. One commenter was supportive of treating advances independently of underlying collateral; another stated that the less-than-four-year maturity advance percentage requirement was reasonable. However, commenters generally questioned whether the Finance Board had given adequate consideration to the nature of member borrowers, the strong collateral position of the Banks and the additional security provided by the capital stock for advances in developing the credit risk percentage requirements for advances.

Two Banks commented on a possible alternative analytical framework, which was suggested by a consultant to the Banks that could be used to derive the credit risk percentage requirements for advances. The consultant reviewed rating agency data and concluded that financial institution default rates are roughly 30 percent to 40 percent of corporate bond default rates. The consultant further reasoned that because Bank members are regulated financial institutions, and not corporate borrowers, default rates based on corporate borrowers were overstated.

Additionally, the Banks believed that using recovery rates of 90 percent understates the value of collateral pledged to support advances, which when properly accounted for on an estimated market value approach, would yield a value in excess of the underlying advances. One Bank suggested that the Finance Board consider requiring that collateral portfolios be further subjected to stress testing as an alternative input into the credit risk percentage requirement calculations for credit exposures arising from advances. The Bank also argued that the proposed rule did not take account of the fact that by statute, the capital stock investment of a member acts as additional security for advances. The Bank believed that recognition of the collateral and capital values available to the Banks should reduce the credit risk from advances to zero. The Bank further stated that from a safety and soundness perspective, the Finance Board and the Banks themselves should be more concerned with the adequacy of collateral methods and practices than in trying to determine a capital requirement from inappropriate statistics. The Bank asserted that mortgage data, which is available and frequently analyzed, should be the basis for determining credit exposures from secured advances.

The Finance Board has considered all comments and believes that the methodology, described above, used to determine credit risk percentage requirements for advances does adequately consider the unique characteristics of advances. The fact that the credit risk percentage requirements for advances set forth in Table 1.1 of the final rule are lower than those for other residential mortgage assets set forth in Table 1.2 of the final rule demonstrates that the Finance Board explicitly recognizes that advances have less credit risk than other mortgage assets. This view is based upon, among other things, the fact that advances are well collateralized and are provided additional safeguards under the Bank Act. Further, as is addressed in greater detail in the discussion of Table 1.2, the Finance Board has considered available mortgage data in developing the credit risk percentage requirements for residential mortgage assets other than advances. Because this new approach lowered the credit risk percentage requirements for these residential mortgages assets, the credit risk percentage requirements for advances with remaining maturities in the categories of more-than-seven-years-to-ten-years and over-ten-years in Table 1.1 also have been lowered so that the credit risk percentage requirements for advances remain below the requirements for other residential mortgage assets. Thus, the final rule continues to recognize that advances have less credit risk than other mortgage assets.

Further, the Finance Board does not believe that it will be realistic to eliminate credit risk charges for advances, as some commenters have urged. Given that advances are a large part of the Banks' total assets, the credit risk capital requirement—and the risk-based capital requirements more generally—would not be credible if risk-based capital were not held against the credit risk of advances. Nor have the commenters provided enough information on other suggested approaches for estimating the credit risk percentage requirements for the Finance Board to implement these methodologies at this time. The Finance Board believes that the credit risk percentage requirements adopted in Table 1.1 recognize the unique characteristics of advances while, given current available information, still provide a conservative estimation of the risks presented by these assets. The Finance Board will consider amending its current methodology as better information and theoretical approaches become available.

Table 1.2. The credit risk percentage requirements in the proposed rule for residential mortgage assets were based on a quantitative analysis of the default and downgrade experience of rated corporate bonds. However, the Finance Board received comments expressing the view that the credit quality of rated residential mortgage backed instruments (RMBS) is generally better than corporate bonds with similar ratings and tenor. The Finance Board, therefore, reviewed available information on rated RMBS downgrades and defaults. This information indicated that defaults have been extremely infrequent and that there have been proportionately fewer downgrades on RMBS than on otherwise similar corporate bonds. The magnitude of the difference in credit performance appeared relevant, even given the short history of the RMBS market.

The Finance Board also found that the factors that affect rated RMBS are not typical of those that affect the credit quality of corporate bonds. Factors that appear to generally benefit the credit quality of rated RMBS include: The relative stability of home prices; the diversification in the underlying collateral; and the relatively predictable performance of the collateral pools. The Finance Board found these arguments persuasive and, as explained more fully below, has applied in the final rule a different basis on which to determine the capital charges for residential mortgage assets.

Commenters also expressed the view that the capital charges in the proposed rule for BBB and lower rated residential mortgage assets exceeded the risk of these assets, some noting that bank and thrift depositories are only required to hold four percent risk based capital against unenhanced residential mortgages. The Finance Board generally took this view into account in developing a new basis for determining the capital charges in the final rule, but notes that Banks are only allowed to invest in investment grade assets and therefore the capital charges in the proposed rule for residential mortgage assets rated below investment grade would have applied only if the assets were downgraded. The Finance Board also adopted in the final rule a lower but still stringent credit risk percentage requirement for residential mortgage assets rated below B. This final credit risk percentage requirement still accounts for the fact that these assets may only reside on the books of the Banks as a result of being downgraded from investment grade and are presumed to have some material credit quality issue.

The Finance Board also recognizes that some of the concern with the credit risk percentage requirements for lower-rated mortgage assets may have been prompted by a lack of clarity in the proposed rule. The proposed rule did not make clear that the credit risk percentage requirements would be assigned for AMA based on the credit rating after application of the credit enhancement required under the Finance Board rules or application of any additional enhancements obtained by the Bank. Section 932.4(e)(2)(ii)(E) has been added to the final rule to clarify this point. The final rule assumes the adequacy of the credit enhancement provided by members under the AMA requirements, and no credit risk capital charge need be applied to any potential exposures arising from these member-provided credit enhancements. The Finance Board may, however, require a Bank to apply a credit risk capital charge to any credit enhancement obtained by a Bank for AMA beyond that required under § 955.3(b) if the Finance Board believes that there are deficiencies associated with those additional enhancements.

While the final rule no longer relies upon quantitative data on the credit performance of rated corporate bonds as an indicator of the credit risk on mortgage assets, the Finance Board was unable to identify any adequate similar quantitative data to substitute for rated RMBS to conduct a similar analysis. The data is not readily available and, because of the brief history of the RMBS market, such data as could be found would not provide a robust information source regarding periods of economic stress. The Finance Board, therefore, has adopted in a final rule a significantly different approach than that employed in the proposed rule—one that is necessarily less mechanical in applying historical credit losses and one that considers the practices of other regulators and market participants. More specifically, the credit risk percentage requirements set forth in Table 1.2 of the final rule are based on an approach that considers: (1) The risk-based capital charges employed by regulated banks and thrifts for residential mortgage loan portfolios and for agency mortgage-backed securities (MBS); (2) the minimum MBS capital charges for Fannie Mae and Freddie Mac; and (3) the capital charges implicitly employed by the nationally recognized statistical rating organizations (NRSRO) when rating RMBS and mortgage insurance companies. The Finance Board also drew from the NRSRO's approach for determining the charges for the different rating categories in developing Table 1.2 of the final rule.

The capital required for performing residential mortgage loans varies widely. Commercial banks and thrifts are required to hold 4 percent risk-based capital against these loans. This requirement was enacted after the severe residential mortgage credit problems of the 1980s. Also, it is applied uniformly to well-diversified, conforming loan portfolios and to the often riskier, non-diversified and non-conforming portfolios. As such, the 4 percent requirement may be viewed as a conservative benchmark relative to the residential mortgage assets covered by Table 1.2 of the final rule.

In contrast with the residential loan portfolio risk-based requirement, commercial banks and thrifts are only required to hold 1.6 percent risk-based capital for GSE-issued MBS. The fact that many banks and thrift originators do not take advantage of this ability to transfer virtually all of their credit exposure on conforming loans to Fannie Mae and Freddie Mac may indicate that the banks and thrifts view the 2.4 percentage point credit risk differential as larger than the actual difference in the credit exposure between conforming loan pools and GSE MBS.

The Finance Board also reviewed information regarding the credit enhancement required to raise unenhanced loan pools to the highest credit rating as an indication of the capital charge for unenhanced loan pools. For example, whole loan RMBS typically have AAA credit enhancement requirements ranging from four percent to seven percent. However, this may be a conservative indicator relative to the assets covered by this rule because many whole loan RMBS have non-conforming collateral due to loan size or credit issues, or the loans are adjustable rate mortgages (ARMs) or the collateral may have some element of geographic concentration. These factors are associated with higher loss experience. In contrast to whole loan RMBS, the Finance Board has observed that the AAA credit enhancement requirement on many Bank AMA pools falls below 4 percent.

The Finance Board also noted the 0.45 percent statutorily-based minimum capital requirement for Fannie Mae and Freddie Mac MBS guarantees on conforming loans. This requirement on loans with no credit support is less than the Finance Board's credit risk percentage requirement for all but the highest rated mortgage asset. However, comparison between the OFHEO and the Finance Board requirements is difficult because of the different risk-based approaches of the two regulators. Moreover, the OFHEO requirement may not be indicative of a true risk-based charge. The 0.45 percent requirement is part of the statutory minimum total capital requirement for Fannie Mae and Freddie Mac. 12 U.S.C. 4612(a). In this respect, it is more comparable to the minimum total capital leverage requirements of the GLB Act than a risk-based charge. Based on the foregoing, the Finance Board has decided to adopt in the final rule a benchmark exposure, and therefore a credit risk percentage requirement, of 2.4 percent for performing, well diversified, prime-quality, conforming residential mortgage loan pools.

The Finance Board also has decided to use the general rating scheme and certain aspects of the RMBS rating process to determine the credit risk percentage requirements for residential mortgage assets. The Finance Board has found that the RMBS rating process employs useful standards for understanding the relative risk of residential mortgage pools. The rating process generally relies upon parameters for foreclosures and losses on residential mortgages under various economic stress scenarios. The rating process is typically systematic and appears to be based on a comprehensive review of information bearing on residential mortgage credit losses. Moreover, the Finance Board has found that the rating process for RMBS has relatively wide acceptance in the debt market, among secondary market participants and with mortgage insurers. The Finance Board was informed that, during stable, moderately favorable economic conditions, the unenhanced whole loan pools underlying RMBS could be considered to have credit quality in a range between BB and CCC. The Finance Board believes that, in general, prime-quality, conforming loan pools typically should have more favorable credit quality than RMBS whole-loan pools. Given this, the Finance Board has decided that, for purposes of the final rule, well-diversified conforming loan pools should be considered to have an exposure benchmark similar to a BB rating.

Based on the assumptions that well-diversified, prime-quality, conforming residential mortgage loan pools have a credit risk percentage requirement of 2.4 percent, and that such pools may be assumed to have credit quality similar to a BB-rated mortgage asset, the Finance Board has used the relative credit support required by the RMBS rating process to assign the credit charges for the other rating categories. Using this approach, the credit risk percentage requirements are derived based on the relative amount of credit support that is generally provided for the different rating grades as a percentage of the BB benchmark.

Table 1.2 of the final rule presents the credit risk percentage requirements for FHLBanks' residential mortgage-related exposures. The credit risk percentage requirements presented in the final rule are based on the assumption that residential mortgage assets will typically consist of conforming, prime-quality loans with loan-to-value (LTV) ratios below 80 percent or loans with higher LTV ratios that have appropriate levels of mortgage insurance. The Finance Board further assumes that the performance of any credit enhancement is assured in all relevant economic stress scenarios, and that the Banks' portfolios of residential mortgage assets will have appropriate diversification, and will not have geographic or other concentration factors that increase credit risk. Finally, the credit risk percentage requirements for mortgage assets adopted in the final rule take into account that the Banks are required to invest in mortgage-backed assets that have credit quality no less than that of the fourth highest credit rating class.

A uniform application of the standard adopted in the final rule, however, would fail to address the fact that the credit risk of pooled residential mortgages may be concentrated in subordinated classes and support tranches. Support classes may also have longer weighted average lives than the senior classes they support. To address this concern, the Finance Board adopted a more stringent capital standard for such asset classes. It was further observed that AAA and AA classes were much less likely to feel the effect of subordination. For these reasons, it was determined that, for subordinated residential mortgage assets below AA, the credit risk percentage requirements should be the same as those for Rated Assets or Rated Items Other Than Advances or Residential Mortgage Assets in the 3 to 7 year maturity class of Table 1.3 of the final rule. Table 1.2 of the final rule has been modified to add specific credit risk percentage requirements for these subordinated classes and support tranches of residential mortgage assets.

The above-described approach best accommodates the information now available to the Finance Board. However, the Finance Board will continue to gather and analyze data on the performance of residential mortgage loan pools and RMBS, and intends to amend these capital charges if more complete and representative information and analysis becomes available.

Table 1.3. In the proposed rule, the credit risk percentage requirements in Table 1.3 for credit exposures of rated assets, off-balance sheet items or derivative contracts other than advances and residential mortgages were calculated from Moody's data on corporate bond performance. Specifically, the requirements were based on the highest estimated (proportional) credit losses by rating category and maturity class observable over a two-year period during the interval 1970 to 1999. The Finance Board received only one comment on the methodology described in the proposed rule used to arrive at the requirements listed in Table 1.3. That commenter identified two concerns. First, only 30 years of performance data were used, whereas 80 years of performance data are available. Second, and more importantly, single-year maximum default rates rather than long-run average default rates were used. The commenter added that the single-year maximum approach would identify maximum default rates based on outlier results, hence the resulting rates need not be representative of the true relative differences in proportionate market value losses by rating class—the goal of a ratings-based approach.

The Finance Board continues to believe that the most recent 30 years of Moody's data includes a sufficient number of observations that are representative of the modern era. The Finance Board does see some merit in the single-year (actually a two-year period is presented in the proposed rule but the point is the same) versus long-run average concern. Not all of the changes recommended in this comment have been adopted in the final rule because basing requirements only on long-run averages would result in too little capital being available to support credit risk during periods of economic stress. However, the methodology for the final rule has been modified to eliminate the single-year concern, thus preserving the true differences in proportionate market value losses by rating class, while retaining a capital requirement sufficient to support credit risk during periods of economic stress. Under the modified approach, the long-run average default and downgrade rate of each rating category/maturity class is multiplied by a factor that represents an average (over rating category and maturity class) of stress-period increases in those rates. This method of determining the credit risk percentage requirements in the final rule is described in detail below, and resulted in modest changes in both directions to the proposed credit risk percentage requirements.

Two factors were considered in selecting credit risk categories for assets on which to impose distinct credit risk capital requirements in percentage terms: an objective measure of the credit risk of the asset, and the term structure, or maturity, of the asset. The credit ratings assigned by NRSROs were used as an objective standard upon which to categorize assets by credit risk. Such ratings are generally accepted in the market place as well as by other regulators. Of course, not all assets are rated by NRSROs, but most Bank investments either are rated by an NRSRO or can be evaluated internally and assigned a credit rating using models or other methods consistent with the rating methodologies used by NRSROs. In keeping with the standards established by NRSROs,11 the following rating categories were used in the base analysis:

• 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 AA-rated asset with a one-year maturity is clearly less than that of an AA-rated asset with a 10-year maturity. In fact, other financial regulators have begun to recognize the term structure of credit risk in their risk-based capital requirements.12 Consequently, each of the 7 credit rating grades was expanded to reflect 14 different remaining maturity classes resulting in 98 credit risk categories overall. The maturity classes were selected to show how significantly credit risk percentage requirements might change given modest changes in remaining maturity. They also capture the entire term structure of credit spreads, but primarily include maturities for which data is more readily available because there is sufficient trading activity. The remaining maturities used were six and nine months, and 1, 1.5, 2, 3, 4, 5, 7, 10, 15, 20, 25, and 30 years.

For each of the 98 credit risk categories, credit losses from defaults and downgrades were determined as a proportion of face value for each two-year horizon between 1970 and 1999. Furthermore, to simplify the analysis, beginning dates for each horizon were limited to the first day of each month in the sample period. Thus, the first historical period covered January 1, 1970 through December 31, 1971, the second historical period covered February 1, 1970 through January 31, 1972, etc., and the last extended from January 1, 1998 through December 31, 1999, for a total of 336 periods examined for each credit risk category.

A two-year historical period horizon is a more conservative assumption than the one-year horizon, which is perhaps more commonly assumed by commercial banks. As stated by the Federal Reserve System Task Force on Internal Credit Risk Models, “[I]t is often suggested that one year represents a reasonable interval over which a bank—in the normal course of business—could mitigate its credit exposures.” 13 Also, according to a survey conducted by the BCBS, most of the responding commercial banks used a one-year horizon for calculating economic capital for credit risk in the banking book.14 Nonetheless, the survey did provide some support for a longer historical period horizon. For example, some responding banks used a five-year horizon or modeled losses over the maturity of the exposure. In addition, based on experience in the U.S. and elsewhere, more than one year is often needed to resolve asset-quality problems at troubled banks. Therefore, the Finance Board believes that the two-year horizon would better assure that adequate capital is maintained against the credit risks faced by the Banks than would a shorter time horizon.

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.