[Federal Register Volume 64, Number 186 (Monday, September 27, 1999)]
[Proposed Rules]
[Pages 52163-52210]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-23416]


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FEDERAL HOUSING FINANCE BOARD

12 CFR Parts 917, 925, 930, 940, 954, 955, 958, 965, 966 and 980

[No. 99-45]
RIN 3069-AA84


Federal Home Loan Bank Financial Management and Mission 
Achievement

AGENCY: Federal Housing Finance Board.

ACTION: Proposed rule.

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SUMMARY: The Federal Housing Finance Board (Finance Board) is proposing 
to adopt new financial management and mission achievement regulations, 
and amend certain existing regulations, for the Federal Home Loan Banks 
(Banks). The proposal would modernize policies governing the business 
activities of the Banks and, for the first time, would establish 
regulatory standards for mission achievement by the Banks and a 
definition of mission assets. The proposal includes a risk-based 
capital requirement, pursuant to which the amount of capital required 
to be maintained by a Bank would be based on the credit, market, and 
operations risks to which it is exposed. The risk-based capital regime 
builds upon the regulatory framework used by other financial 
institution and government-sponsored enterprise (GSE) regulators. The 
mission achievement requirement in the proposal would: codify the 
authority of the Banks to hold mortgage assets, including mortgage-
backed securities; allow mortgage assets meeting certain regulatory 
requirements to be counted as mission assets; and eliminate the use of 
the Banks' GSE advantages in issuing debt to fund arbitrage 
investments. The proposal also sets forth in the regulation the 
responsibilities of the boards of

[[Page 52164]]

directors and senior management of the Banks, as a means of ensuring 
that they fulfill their duties in operating the Banks in a safe and 
sound manner and in furtherance of their mission. The proposal will 
enable the Banks to help their members be more effective competitors in 
the housing finance and community lending marketplace, which in turn 
will assure that benefits accrue to consumers. In a separate 
rulemaking, the Finance Board is proposing to reorganize its 
regulations in a more logical arrangement and to reflect the revisions 
to be made by this proposal.

DATES: Comments on this proposed rule must be received in writing on or 
before December 27, 1999.

ADDRESSES: Comments should be mailed to: Elaine L. Baker, Secretary to 
the Board, Federal Housing Finance Board, 1777 F Street, NW, 
Washington, DC 20006. Comments will be available for public inspection 
at this address.

FOR FURTHER INFORMATION CONTACT: James L. Bothwell, Director and Chief 
Economist, (202) 408-2821; Scott L. Smith, Deputy Director, (202) 408-
2991; Julie Paller, Senior Financial Analyst, (202) 408-2842; Ellen E. 
Hancock, Senior Financial Analyst, (202) 408-2906; Austin Kelly, Senior 
Financial Economist, (202) 408-2541; or Syed Ahmad, Senior Financial 
Economist, (202) 408-2870; Office of Policy, Research and Analysis, 
Federal Housing Finance Board, 1777 F Street, NW, Washington, DC 20006.

SUPPLEMENTARY INFORMATION:

I. Overview of Proposal

    The proposed rule would establish new financial management and 
mission achievement requirements for the Banks, including: (1) a 
capital provision that would incorporate both minimum total capital and 
risk-based capital elements; (2) provisions linking the GSE debt 
funding advantage to activities that further the mission of the Banks 
(as set forth in the new regulatory definition), thus eliminating GSE 
debt-funded arbitrage investments and authorizing the Banks to hold 
``member mortgage assets''; and (3) provisions defining the 
responsibilities--and thus the accountability--of the boards of 
directors and senior management of the Banks. The proposal would give 
the Banks greater flexibility to manage their business so as to better 
serve their members and fulfill their public purpose, while operating 
within a risk-based capital framework that ensures the safety and 
soundness of the Bank System.

A. Capital Requirements

    Under current law, the amount of capital a Bank must hold is 
determined not by the risks inherent in its portfolio or business 
practices, but by the asset size of, or the dollar amount of advances 
outstanding to, its members. Specifically, a member must maintain a 
minimum investment in the capital stock of its Bank in an amount equal 
to the greater of: (1) 1 percent of the member's mortgage assets; (2) 
0.3 percent of the member's total assets; or (3) 5 percent of total 
advances outstanding to the member (with a somewhat higher percentage 
for any member that is not a ``qualified thrift lender''). See 12 
U.S.C. 1426(b)(1), (b)(2), (b)(4); 1430(c), (e)(1), (e)(3); 12 CFR 
933.20(a).
    The Banks currently operate in accordance with the Finance Board's 
Financial Management Policy (FMP), under which risk management is 
accomplished principally through a list of specific restrictions and 
limitations on the Banks' investment practices and a leverage limit 
which prohibits Banks from incurring liabilities in the form of 
consolidated obligations (COs) or unsecured senior liabilities in an 
amount greater than twenty times their capital stock. See 62 FR 13146 
(Mar. 19, 1997); Finance Board Res. No. 96-45 (July 3, 1996), as 
amended by Finance Board Res. No. 96-90 (Dec. 6, 1996), Finance Board 
Res. No. 97-05 (Jan. 14, 1997), and Finance Board Res. No. 97-86 (Dec. 
17, 1997). Though this approach has served the purpose of ensuring the 
safety and soundness of the Bank System, it lacks the flexibility that 
would enable the Banks to fulfill their mission to the maximum extent.
    To ensure that the risks taken by a Bank are adequately supported 
by its capital, the proposal would implement, for the first time, a 
risk-based capital requirement for the Banks, which builds upon the 
risk-based capital regimes of other federal financial institution 
regulators. Under the proposed rules, the amount of capital to be held 
by each Bank would depend, in part, on the risks--credit risk, market 
risk, and operations risk--to which the Bank is exposed. The credit 
risk capital requirement would be set according to credit ratings and 
the associated historical default and recovery data made available by 
nationally-recognized statistical rating organizations (NRSROs). This 
approach would improve on the broad credit risk weighting categories 
set forth in the Basle Accord in 1988 \1\ by determining the credit 
risk capital component based on the risk of an instrument rather than 
the type of instrument.
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    \1\ The risk-based capital standards of the other federal bank 
regulatory agencies are based on the document entitled 
``International Convergence of Capital Measurement and Capital 
Standards'' (July 1988) (the Basle Accord). The Basle Accord was 
agreed to by the Basle Committee on Banking Supervision (BCBS) which 
comprises representatives of the central banks and supervisory 
authorities of the Group of Ten countries (Belgium, Canada, France, 
Germany, Italy, Japan, Netherlands, Sweden, Switzerland, United 
Kingdom, United States and Luxembourg). The BCBS meets at the Bank 
for International Settlements, Basle, Switzerland. The Basle Accord 
defines bank capital and sets credit risk-based capital standards 
for on-and off-balance sheet instruments. The Basle Accord has been 
amended many times with the most significant amendment entitled 
``Amendment to the Capital Accord to Incorporate Market Risks'' 
(Jan. 1996) (the Amendment). The Amendment sets specific risk-based 
capital standards for instruments held in trading portfolios of 
commercial banks. For debt instruments, the specific risk is defined 
by the Amendment as credit and event risk. In addition, the 
Amendment incorporates a measure of the market risk due to interest 
rates, foreign exchange rates, equity prices and commodity prices 
for all instruments held in trading portfolio (trading book); and 
foreign exchange and commodity risks for instruments held in non-
trading portfolio (banking book). The BCBS issued a consultative 
paper entitled ``A New Capital Adequacy Framework'' (June 1999) (the 
Framework) that introduces a new framework to replace the Basle 
Accord.
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    A Bank's market risk capital requirement would be equal to the 
market value of the Bank's portfolio at risk from changes in interest 
rates, foreign exchange rates, and commodity and equity prices during 
periods of extreme market stress, as determined in accordance with 
internal market risk models to be developed by each Bank. A Bank would 
be required to assess its market values at risk regularly through 
stringent stress testing of its entire portfolio, including both on-
balance sheet assets and liabilities and off-balance sheet items, as 
well as related options. By comparison, large commercial banks are 
required to conduct such assessments only for their trading account and 
for certain other assets, leaving out much bank business from the value 
at risk calculation.
    The operations risk capital requirement proposed would be equal to 
30 percent of the combined amount of capital required for credit and 
market risks. This is consistent with the statutory requirement for 
operations risk capital imposed on the Federal National Mortgage 
Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation 
(Freddie Mac). See 12 U.S.C. 4611(c)(2).
    In addition to the risk-based capital requirement, the proposal 
would establish a minimum total capital requirement that would require 
each Bank to maintain total capital of not less than 3.0 percent of its 
total assets, regardless of its risk profile, although

[[Page 52165]]

the Finance Board could require a greater amount in individual 
cases.\2\
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    \2\ By comparison, the statutory minimum total capital 
requirement for the other housing GSEs--Fannie Mae and Freddie Mac--
is 2.5 percent of on-balance sheet assets plus, generally, 0.45 
percent of off-balance sheet items. See 12 U.S.C. 4612(a).
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B. Mission Achievement

    The principal source of funding for the Banks is the COs that are 
issued in the global capital markets and for which the twelve Banks are 
jointly and severally liable. Because of the Banks' GSE status, the 
costs to the Banks of obtaining such funding are substantially less 
than the borrowing costs for comparable debt issued by other entities. 
The Banks pass the benefit of this funding advantage to their members 
through wholesale loans (called advances) priced lower than the members 
could otherwise obtain to provide support for housing finance, 
including community lending, in fulfillment of the Banks' mission.
    The FMP does not expressly require the Banks to use any particular 
percentage of the funds obtained through the issuance of COs to provide 
advances to their members. In large part due to the financial burdens 
imposed on the Banks as a result of the savings and loan crisis, the 
Banks began in 1991 to use a portion of the proceeds from COs to 
finance investments which the Finance Board does not consider to be 
adequately related to their statutory mission. The level of such non-
mission-related investments rose substantially in the early 1990s, but 
has begun to decline appreciably, as a percent of assets, in recent 
years, as the membership base of the Bank System and the level of 
advances outstanding to members have increased.
    To better link the GSE advantages in the capital markets to the 
mission performance of the Bank System, the proposed rule would 
require, by January 1, 2005, that an amount equal to 100 percent of 
each Bank's outstanding COs be held by the Bank in core mission 
activities. ``Core mission activities'' would be defined as those 
activities that assist and enhance members' and eligible nonmember 
borrowers' \3\ financing of housing and community lending. Included in 
this definition are advances and also a newly authorized class of 
investments to be called ``member mortgage assets.'' The transition 
period is intended to allow the Banks sufficient time to restructure 
their balance sheets as necessary to bring the level of core mission 
activities in line with the amount of outstanding COs.
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    \3\ Section 10b of the Federal Home Loan Bank Act, 12 U.S.C. 
1430b, provides that certain nonmember mortgagees making targeted 
housing loans may apply for access to Bank advances.
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    The proposed core mission activity requirement would be subordinate 
to the safe and sound financial operation of the Banks, as mandated by 
the Federal Home Loan Bank Act (Act). See 12 U.S.C. 1422a(a)(3)(A). 
During any specified period in which a Bank's board of directors 
determines that the core mission activities requirement would be 
inconsistent with the safe and sound operation of the Bank, the Bank 
would be permitted to be out of compliance with the core mission 
activities requirement.
    By establishing the core mission activities requirement at 100 
percent of COs outstanding, the proposed rule will both permit and 
encourage the Banks to develop new products and business activities 
(such as member mortgage assets, discussed below) that: further the 
statutory mission of the Banks; build upon the cooperative nature of 
the Bank's relationship with its members; meet the core mission 
activities definition in the proposed rule; and are supported by 
appropriate levels of capital.

C. Responsibilities of Bank Boards of Directors and Senior Management

    Because it allows the Banks substantially greater authority to 
acquire new assets and manage their risks, and to raise member capital 
accordingly, the proposed rule also would articulate certain minimum 
responsibilities of the Banks' boards of directors and senior 
management with regard to operating the Banks in a safe and sound 
manner and ensuring that the Banks achieve their statutory mission. 
These responsibilities include matters such as the adoption and annual 
review of risk management policies, periodic risk assessments, the 
maintenance of effective internal controls, independent audit 
committees, and adoption and review of and compliance with mission 
achievement policies.

D. Reorganization of Finance Board Regulations

    Because of the comprehensive nature of the amendments that would be 
made by the proposal, the Finance Board separately is proposing to 
reorganize its regulations in order that the revised regulations will 
remain internally consistent and will reflect the proposed changes in a 
logical manner. Cross-references appearing in the text of the proposed 
rule are made to the new section and part numbers that would be in 
effect once the reorganization regulation is finalized. Where such 
references are to provisions that currently exist under different 
section or part numbers, the existing citation has been noted in this 
preamble. For ease of reference, this proposed reorganization 
regulation is also being published in this edition of the Federal 
Register.

E. Public Hearing

    The Finance Board will hold a public hearing on this proposal. 
Persons interested in participating in the public discussion of the 
proposed rule should contact Karen H. Crosby, Director, Office of 
Strategic Planning, in writing at the Federal Housing Finance Board, 
1777 F St. NW, Washington, DC, 20006, by the close of business October 
15, 1999.

II. Statutory and Regulatory Background

A. The Bank System

    The twelve Banks are instrumentalities of the United States 
organized under the authority of the Act. See 12 U.S.C. 1423, 1432(a). 
The Banks are cooperatives; only members of a Bank may own the capital 
stock of a Bank and only members or certain eligible nonmember 
borrowers (such as state housing finance agencies) may obtain access to 
the products provided by a Bank. See 12 U.S.C. 1426, 1430(a), 1430b. 
Each Bank is managed by its own board of directors and serves the 
public by enhancing the availability of residential mortgage and 
community lending credit through its members and eligible nonmembers. 
See 12 U.S.C. 1427. Any eligible institution (typically, an insured 
depository institution) may become a member of a Bank by satisfying 
certain criteria and by purchasing a specified amount of the Bank's 
capital stock. See 12 U.S.C. 1424, 1426, 1430(e)(3); 12 CFR part 933. 
As GSEs, the Banks are granted certain privileges that enable them to 
borrow funds in the capital markets on terms more favorable than could 
be obtained by other entities. Typically, the Bank System can borrow 
funds at a modest spread over the rates on U.S. Treasury securities of 
comparable maturity. The Banks pass along their GSE funding advantage 
to their members--and ultimately to consumers--by providing advances 
(secured loans) and other financial services at rates that would not 
otherwise be available to their members.
    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

[[Page 52166]]

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).

B. The Banks' Housing Finance and Community Lending Mission

    Under section 10 of the Act and part 935 of the Finance Board's 
regulations, the Banks have broad authority to make advances in support 
of housing finance, which includes community lending. See 12 U.S.C. 
1430(a), (i), (j); 12 CFR part 935. The Banks also are required to 
offer two programs--the Affordable Housing Program (AHP) and the 
Community Investment Program (CIP)--to provide subsidized or at-cost 
advances, respectively, in support of unmet housing finance or targeted 
economic development credit needs. See 12 U.S.C. 1430(i), (j); 12 CFR 
parts 960, 970. In addition, section 10(j)(10) of the Act, as 
implemented by a recently issued Finance Board regulation, authorizes 
the Banks to establish Community Investment Cash Advance (CICA) 
Programs for community lending, defined as providing financing for 
economic development projects for targeted beneficiaries. See 12 U.S.C. 
1430(j)(10); 12 CFR part 970; 63 FR 65536 (Nov. 27, 1998).

C. Investment Authority and Oversight

    The Banks' investment authority is set forth primarily in sections 
11(h) and 16(a) of the Act, which govern the investment of the Banks' 
surplus and reserve funds, respectively. See 12 U.S.C. 1431(h), 
1436(a). Under both of these sections, the Banks are authorized to 
invest in: obligations of the United States; certain obligations of 
Fannie Mae, the Government National Mortgage Association (Ginnie Mae), 
or Freddie Mac; and in such securities in which fiduciary and trust 
funds may be invested under the law of the state in which the Bank is 
located. Section 11(h) also authorizes investments in the securities of 
certain small business investment companies (SBIC).
    In addition to those permissive investments, the Banks are required 
to have liquidity reserves in an amount equal to deposits from their 
members invested in obligations of the United States, deposits in banks 
or trust companies, and certain specified short-term advances to their 
members. See 12 U.S.C. 1431(g).
    Currently, the Finance Board regulates the Banks' investment 
practices through its regulations, as well as through the FMP. Section 
934.1 of the regulations provides that the Banks may acquire or dispose 
of investments only with the prior approval of the Finance Board, or in 
conformity with authorizations of the Finance Board or ``stated 
[Finance] Board policy.'' 12 CFR 934.1. By resolution, the Finance 
Board adopted the FMP, in part, as its ``stated policy'' regarding 
permissible Bank investments. The FMP generally provides a framework 
within which the Banks may implement their financial management 
strategies in a prudent and responsible manner. Specifically, the FMP 
identifies the types of investments that the Banks may purchase 
pursuant to their statutory investment authority and, therefore, by 
implication, prohibits any investments not specifically identified by 
the FMP. The FMP also includes a series of guidelines relating to the 
funding and hedging practices of the Banks, as well as to the 
management of their credit, interest rate and liquidity risks, and 
establishes liquidity requirements in addition to those required by 
statute, as noted above. See FMP sections III-VII.
    The FMP evolved from a series of policies and guidelines initially 
adopted by the Finance Board's predecessor agency, the Federal Home 
Loan Bank Board (FHLBB), which had adopted guidelines comparable to the 
FMP in the 1970s and revised them a number of times thereafter. The 
Finance Board adopted the FMP in 1991, consolidating into one document 
the previously separate policies on funds management, hedging and 
interest rate swaps, and adding new guidelines on management of 
unsecured credit and interest rate risks. As discussed in considerably 
more detail below, this proposed rule would supersede the FMP as the 
Finance Board's means of overseeing the investment practices and 
mission achievement of the Banks.

III. Analysis of Proposed Rule

A. Part 917--Responsibilities of Bank Boards of Directors and Senior 
Management

1. Overview
    Each state generally has laws of incorporation that require, among 
other things, a corporation to be managed by a board of directors. 
Consistent with this general corporate concept, the Act provides for 
the management of each Bank to be vested in the Bank's board of 
directors. See 12 U.S.C. 1427(a). The Act states that each Bank is a 
corporate body. See id. at 1432(a). In addition to authorizing certain 
enumerated corporate and banking powers, see id. at 1431, 1432, the Act 
grants each Bank all such incidental powers as are consistent with the 
provisions of the Act and customary and usual in corporations 
generally. See id. The Finance Board believes that, attendant to the 
exercise of customary and usual corporate powers, the Banks' boards of 
directors are subject to the same general fiduciary duties of care and 
loyalty to which the board of a state-chartered business or banking 
corporation would be subject, although this previously has not been set 
forth in regulation.
    The duties, responsibilities and privileges of a director of a Bank 
derive from a source different from that of a director of a state-
chartered business or banking corporation. Each Bank is created in 
accordance with Federal law to further public policy, and its statutory 
powers and purposes are not subject to change except by the Congress. A 
Bank's board of directors has neither the right nor the duty to alter 
the purpose of the Bank, whereas an ordinary corporate board of 
directors may approve mergers, consolidations and changes in the 
corporate charter that could drastically alter the objectives and 
nature of the business of the corporation. The directors of a Bank are 
responsible for managing that Bank to achieve the statutorily-mandated 
objectives of promoting housing finance and community lending and 
meeting the Bank's statutory obligations (e.g., paying a portion of the 
interest on obligations of the Resolution Funding Corporation 
(REFCORP), see id. at 1441b, and making contributions to the AHP, see 
id. at 1430(j)), all in a financially safe and sound manner.
    All Banks are subject to the supervision of the Finance Board. 
Although the directors manage and control their Banks, they may act 
only within the parameters established by the Finance Board. The bulk 
of the Banks' corporate powers, duties and responsibilities are 
described in sections 10, 11, 12 and 16 of the Act. Id. at 1430, 1431, 
1432 and 1436. Section 10 of the Act authorizes each Bank to make 
secured advances to its members upon collateral sufficient, in its 
judgment, to fully secure the advance, and to certain eligible 
nonmember borrowers upon statutorily specified collateral. See id. 
1430(a), 1430b. The Banks may conduct correspondent services, establish 
reserves, make investments and pay dividends, all subject to statutory 
limitations. See id. at 1431, 1436. Under section 12(a) of the Act, a 
Bank, and hence any director of that Bank, has the power to sue and be 
sued. See id. at 1432(a). In addition, each Bank has adopted bylaws 
that address such

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matters as: the conduct of meetings of the board of directors; 
existence, composition, conduct and administration of committees of the 
board of directors; and indemnification.
    Proposed part 917 for the first time would set forth in one place 
and in regulation the duties and responsibilities of a Bank's board of 
directors and of senior management of the Bank. It will make clear the 
Finance Board's belief that oversight of management by a strong and 
proactive board of directors is critical to the safe and successful 
operation of a Bank. Under proposed part 917, the board of directors of 
each Bank shall be responsible for: approving and periodically 
reviewing the significant policies of the Bank; understanding the major 
risks taken by the Bank, setting acceptable tolerance levels for these 
risks and ensuring that senior management takes the steps necessary to 
identify, measure, monitor and control these risks; monitoring that the 
Bank is in compliance with applicable statutes, regulation and policy 
(both of the Finance Board and the Bank); ensuring that the Bank 
carries out its housing finance and community lending mission; 
approving the organizational structure and delegations of authority; 
and ensuring that an adequate and effective system of internal controls 
is established and maintained and that senior management is monitoring 
the effectiveness of the internal control system.
    Proposed part 917 provides that senior management of each Bank 
shall be responsible for implementing strategies and policies approved 
by the Bank's board; developing processes that identify, measure, 
monitor and control risks incurred by the Bank; maintaining an 
organizational structure that clearly assigns responsibility, authority 
and reporting relationships; ensuring that delegated responsibilities 
are effectively carried out; setting appropriate internal control 
policies; and monitoring the adequacy and effectiveness of the internal 
control system.
    The proposed requirements for the Banks' boards of directors and 
senior management generally are based on widely accepted best corporate 
practices. They are intended to augment the responsibilities, 
independence and expertise of the boards of directors by requiring them 
to oversee both risk management for safety and soundness and 
achievement of the public purpose of supporting housing and targeted 
economic development. Oversight by both the boards of directors and 
senior management is integral to the overall business operation of the 
Bank. The first line of defense in ensuring safety and soundness has to 
be an effective corporate governance structure within the Banks 
themselves. Having an active, informed and engaged board of directors 
is the cornerstone of a well-run entity.
    In addition, recognition of the importance of mission achievement 
must originate with the board of directors and fulfillment of mission 
at all levels of the Bank must be promoted and encouraged by the board. 
The requirements contained in the proposed rule are intended to ensure 
that the boards of directors of the Banks give serious consideration to 
these important responsibilities.
2. General Duties of Bank Boards of Directors--Sec. 917.2
    Proposed Sec. 917.2 provides that each Bank's board of directors 
shall have the general duty to direct the operations of the Bank in 
conformity with the requirements of the Finance Board's regulations. 
Proposed Sec. 917.2 further provides that each board director shall 
carry out his or her duties as director in good faith, in a manner such 
director believes to be in the best interests of the Bank, and with 
such care, including reasonable inquiry, as an ordinarily prudent 
person in a like position would use under similar circumstances.
3. Risk Management--Sec. 917.3
    Section 917.3 of the proposed rule sets forth the risk management 
responsibilities of Bank boards of directors and senior management. 
Proposed Sec. 917.3(a)(1) would require that, within 180 calendar days 
of the adoption of the rule in final form, each Bank's board of 
directors shall adopt a risk management policy addressing the Bank's 
exposure to credit risk, market risk, liquidity risk, business risk and 
operations risk in a manner consistent with the substantive risk 
management requirements set forth in part 930 of the proposed rule. The 
risk limits set forth in the policy shall be consistent with the Bank's 
capital position and its ability to measure and manage risk. Under 
proposed Sec. 917.3(a)(1), a Bank will be required to submit its 
initial risk management policy to the Finance Board for approval; 
subsequent versions of the policy or amendments would not be required 
to be submitted to, or approved by, the Finance Board. However, Bank 
risk management policies will be reviewed by the Finance Board as part 
of the ongoing examination process.
    Proposed Sec. 917.3(a)(2)(i) would require that the Bank's board of 
directors review the Bank's risk management policy on at least an 
annual basis. Proposed Sec. 917.3(a)(2)(iii) provides that the board of 
directors also would be required to re-adopt the risk management 
policy, including interim amendments, not less often than every three 
years, as appropriate based on the board's reviews of the policy. In 
addition to providing consistency, this requirement is intended to 
ensure that, despite the turnover in board personnel that will occur 
over a number of years, all or most current members of a Bank's board 
of directors will be thoroughly familiar with the Bank's risk 
management policy, will have given meaningful consideration to its 
provisions and will have expressed an opinion regarding the adequacy of 
the policy through the voting process. Proposed Sec. 917.3(a)(2)(iv) 
also would make clear that each Bank's board of directors has the 
ultimate responsibility to ensure that the Bank is in compliance at all 
times with the risk management policy.
    Section 917.3(b) of the proposed rule sets forth several specific 
requirements for each Bank's risk management policy. Proposed 
Sec. 917.3(b)(1) would require that each Bank's risk management policy 
describe how the Bank will comply with the risk-based capital standards 
set forth in proposed part 930. Proposed Sec. 917.3(b)(2) would require 
each Bank's risk management policy to set forth tolerance levels for 
the market and credit risk components.
    Proposed Sec. 917.3(b)(3) requires each Bank's risk management 
policy to set forth standards for the Bank's management of credit, 
market, liquidity, business and operations risks. Credit risk is 
defined in proposed Sec. 930.1 as the risk that an obligation will not 
be paid in full and loss will result. The Banks must assess the 
creditworthiness of issuers, obligors, or other counterparties prior to 
acquiring investments and, under proposed Sec. 917.3(b)(3)(i), the 
Bank's risk management policy would be required to include the 
standards and criteria for such an assessment. In addition, the credit 
risk portion of each Bank's risk management policy also should identify 
the criteria for selecting brokers, dealers and other securities firms 
with which the Bank may execute transactions.
    Market risk is defined in proposed Sec. 930.1 as the risk of loss 
in value of the Bank's portfolio resulting from movements in market 
prices. Under proposed Sec. 930.6, each Bank would be required to have 
in place a comprehensive market risk management model that allows the 
Bank to estimate in a timely manner the value of the portfolio at risk 
from changes in market prices under various stress scenarios.

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Proposed Sec. 917.3(b)(3)(ii) would require that each Bank's risk 
management policy establish standards for the methods and models used 
to measure and monitor market risk, including maximum exposure 
thresholds and scenarios for measuring risk exposure.
    Liquidity risk is defined in proposed Sec. 917.1 as the risk that a 
Bank would be unable to meet its obligations as they come due or meet 
the credit needs of its members and eligible nonmember borrowers in a 
timely and cost-efficient manner. Operational liquidity addresses day-
to-day or ongoing liquidity needs under normal circumstances. 
Operational liquidity needs may be either anticipated or unanticipated. 
Contingency liquidity addresses the same liquidity needs, but under 
abnormal or unusual circumstances in which a Bank's access to the 
capital markets is impeded. This impediment may result from a market 
disruption, operational failure, or real or perceived credit problems. 
Proposed Sec. 917.3(b)(3)(iii) would require that each Bank's risk 
management policy indicate the Bank's sources of liquidity, including 
specific types of investments to be held for liquidity purposes, and 
the methodology to be used for determining the Bank's operational and 
contingency liquidity needs. The proposed new liquidity requirements 
are addressed in more detail below in the discussion of proposed 
Sec. 930.10.
    Operations risk is defined in proposed Sec. 930.1 as the risk of an 
unexpected loss to a Bank resulting from human error, fraud, 
unenforceability of legal contracts, or deficiencies in internal 
controls or information systems. Proposed Sec. 917.3(b)(3)(iv) would 
require each Bank's risk management policy to address operations risk 
by setting forth standards for an effective internal control system (as 
described in more detail below), including periodic testing and 
reporting.
    Business risk is defined in proposed Sec. 930.1 as the risk of an 
adverse impact on a Bank's profitability resulting from external 
factors as may occur in both the short and long run. Such factors 
include: continued financial services industry consolidation; declining 
membership base; concentration of borrowing among members; and 
increased inter-Bank competition. Proposed Sec. 917.3(b)(3)(v) would 
require that each Bank's risk management policy identify these risks 
and include strategies for mitigating such risks, including contingency 
plans where appropriate.
    In order for each Bank to create and maintain a meaningful risk 
management policy, it is important that the boards of directors be 
cognizant of the strategic risks facing the Bank. Therefore, proposed 
Sec. 917.3(c) would require that senior management of each Bank 
perform, at least annually, a written risk assessment that identifies 
and evaluates all material risks, including both quantitative and 
qualitative aspects, that could adversely affect the achievement of the 
Bank's performance objectives and compliance requirements. Proposed 
Sec. 917.3(c) also requires that the risk assessment be in written form 
and be reviewed by the Bank's board of directors promptly upon its 
completion.
4. Internal Control System--Sec. 917.4
    While the existing FMP requires that management of each Bank 
establish internal control systems, there is no guidance provided on 
how to ascertain the sufficiency of the systems. There have been 
several instances where internal control weaknesses have been uncovered 
through the Finance Board's examination process. As a result, the 
Finance Board believes it prudent to provide more specific requirements 
for the internal control process that should be in place at each Bank.
    In developing requirements for internal control processes for the 
Banks, the Finance Board reviewed the available literature on the 
appropriate internal control systems for financial institutions. 
Included in this review was the BCBS's Framework for Internal Control 
Systems published in September 1998 (hereinafter Basle Committee 
Report) and the Committee of Sponsoring Organizations of the Treadway 
Commission's Internal Control--Integrated Framework Report published in 
September 1992 (hereinafter Treadway Commission). The recommendations 
contained in these Reports are considered to be state of the art for 
defining, implementing, monitoring, and evaluating internal control 
systems.
    According to the Basle Committee Report, a system of effective 
internal controls is a critical component of bank management and a 
foundation for safe and sound operation of a banking organization. A 
strong system of internal controls can help a bank meet its goals and 
objectives, achieve long-term profitability targets, and maintain 
reliable financial and managerial reporting. An internal control system 
also can help to: (1) Ensure the bank is in compliance with laws, 
regulations and the bank's internal policies and procedures; (2) 
safeguard assets; and (3) decrease the risk of damage to the bank's 
reputation.
    The Treadway Commission Report defines internal controls as a 
process, effected by the board of directors, management and other 
personnel, designed to provide reasonable assurance regarding the 
achievement of objectives in the: (1) Effectiveness and efficiency of 
operations; (2) reliability of financial reporting; and (3) compliance 
with applicable laws and regulations.
    Both Reports discuss basic components or principles for 
establishing and assessing internal control--management oversight and 
the control environment, risk recognition and assessment, control 
activities and segregation of duties, information and communication, 
and monitoring activities and correcting deficiencies.
    The provisions of Sec. 917.4 of the proposed rule were adapted from 
the basic components and principles in the Basle Committee and Treadway 
Commission Reports. The Finance Board believes that appropriate 
internal controls will be critical to successful implementation of this 
regulation. The proposed rule would provide the framework for an 
effective internal control system, and establish senior management and 
board of directors' responsibilities regarding internal controls.
    Proposed Sec. 917.4 addresses the requirements for a Bank's 
internal control systems. Proposed Sec. 917.4(a)(1) would require each 
Bank to establish and maintain an effective internal control system 
adequate to ensure: the efficiency and effectiveness of Bank 
activities; the safeguarding of assets; the reliability, completeness 
and timely reporting of financial and management information and 
transparency of such information to the Bank's board of directors and 
to the Finance Board; and compliance with applicable laws, regulations, 
policies, supervisory determinations and directives of the Bank's board 
of directors and senior management.
    Proposed Sec. 917.4(a)(2) enumerates certain minimum ongoing 
internal control activities that the Finance Board considers to be 
necessary in order for the internal control objectives described in 
proposed Sec. 917.4(a)(1) to be achieved. These activities include: top 
level reviews by the Bank's board of directors and senior management; 
activity controls, including review of standard performance and 
exception reports; physical controls adequate to ensure the 
safeguarding of assets; monitoring for compliance with the risk 
tolerance limits set forth in the risk management policy that would be 
required under proposed Sec. 917.3(a); any required approvals and 
authorizations for specific activities; and any required

[[Page 52169]]

verifications and reconciliations for specific activities.
    Section 917.4(b) of the proposed rule would charge each Bank's 
board of directors with the responsibility of directing the 
establishment and maintenance of the internal control system by senior 
management, and overseeing senior management's implementation of the 
system on a continuing basis. Under proposed Sec. 917.4(b), specific 
board actions necessary to fulfill these responsibilities would 
include: conducting periodic discussions with senior management 
regarding the effectiveness of the internal control system; ensuring 
that an effective and comprehensive internal audit of the internal 
control system is performed annually; ensuring that the Bank's board of 
directors receives reports on internal control deficiencies in a timely 
manner and that such deficiencies are addressed promptly; conducting a 
timely review of evaluations of the effectiveness of the internal 
control system made by auditors and Finance Board examiners; ensuring 
that senior management promptly and effectively addresses 
recommendations and concerns expressed by auditors and Finance Board 
examiners regarding weaknesses in the internal control system; 
reporting internal control deficiencies, and the corrective action 
taken, to the Finance Board in a timely manner; establishing, 
documenting and communicating an clear and effective organizational 
structure for the Bank; ensuring that all delegations of board 
authority state the extent of the authority and responsibilities 
delegated; and establishing reporting requirements.
    Section 917.4(c) of the proposed rule would charge each Bank's 
senior management with the responsibility to establish, implement and 
maintain the internal control system under the direction of the Bank's 
board of directors. Under proposed Sec. 917.4(c), specific actions on 
the part of senior management that would be necessary to fulfill these 
responsibilities include: establishing, implementing and effectively 
communicating to Bank personnel policies and procedures that are 
adequate to ensure that internal control activities necessary to 
maintain an effective internal control system are an integral part of 
the daily functions of all Bank personnel; ensuring that all Bank 
personnel fully understand and comply with all policies and procedures; 
ensuring that there is appropriate segregation of duties among Bank 
personnel and that personnel are not assigned conflicting 
responsibilities; establishing effective paths of communication 
throughout the organization in order to ensure that Bank personnel 
receive necessary and appropriate information; developing and 
implementing procedures that translate the major business strategies 
and policies established by the board of directors into operating 
standards; ensuring adherence to the lines of authority and 
responsibility established by the Bank's board of directors; overseeing 
the implementation and maintenance of management information and other 
systems; establishing and implementing an effective system to track 
internal control weaknesses and the actions taken to correct them; and 
monitoring and reporting to the Bank's board of directors the 
effectiveness of the internal control system on an ongoing basis.
5. Audit Committees--Sec. 917.5
    Section 917.5 of the proposed rule addresses requirements for the 
establishment of an audit committee by each Bank's board of directors. 
Current Finance Board requirements for audit committees are contained 
in Finance Board Res. No. 92-568.1 (July 22, 1992) and Finance Board 
Advisory Bulletin 96-1 (Feb. 29, 1996).
    Resolution No. 92-568.1 contains guidelines intended to be the 
minimum standards that should be adopted by the Banks for revisions of 
the respective audit charters. The guidelines require that: audit 
committee charters include a statement of the audit committee's 
responsibilities, including a statement of its purpose to assist the 
full board of directors in fulfillment of its fiduciary 
responsibilities; the audit committee shall consist of at least three 
board members and shall include appointed directors and elected 
directors; that in determining the membership of the audit committee, 
the board of directors should provide for continuity of service; the 
audit committee shall meet at least twice annually with the audit 
director and the audit committee shall meet in executive session with 
both the audit director and the external auditors at least annually; 
the audit committee shall oversee the selection, compensation, and 
performance evaluation of the audit director; written minutes shall be 
prepared for each meeting and a copy of such minutes forwarded to the 
Finance Board; and the charters of the audit director and audit 
committee shall be reviewed and approved at least annually by the audit 
committee and the board of directors, respectively.
    Advisory Bulletin 96-1 communicated examination findings regarding 
certain Bank practices that may tend to reduce the independence of the 
internal audit function, specifically the processes by which Bank audit 
director compensation is determined and performance is evaluated. The 
Bulletin indicated that examiners would review measures taken by the 
audit committee to assure the independence from management of the 
internal audit function, and to fulfill its responsibility to select, 
set the compensation of, and evaluate the performance of the audit 
director, and specified that all Bank audit committees should review 
their current practices and revise these as appropriate.
    Proposed Sec. 917.5 codifies into regulation the Finance Board's 
existing policy on requiring the Banks to have audit committees and 
adds requirements addressing their independence and their 
responsibilities for oversight of Bank operations. The proposed 
requirements for audit committees are based on standard corporate 
requirements and best practices. In developing the appropriate 
requirements for Bank audit committees, the Finance Board reviewed the 
audit committee regulations of other financial institution regulatory 
agencies and the Report and Recommendations of the Blue Ribbon 
Committee on Improving the Effectiveness of Corporate Audit Committees 
(February 8, 1999) (hereinafter Blue Ribbon Committee Report). The 
Securities and Exchange Commisssion encouraged the New York Stock 
Exchange and the National Association of Securities Dealers to form a 
private sector body to investigate perceived problems in financial 
reporting. Accordingly, the Blue Ribbon Committee was formed in October 
1998 to take an objective look at U.S. corporate financial reporting, 
specifically assessing the current mechanisms for oversight and 
accountability among corporate audit committees, independent auditors, 
and financial and senior management.
    Proposed Sec. 917.5(a) would require that each Bank's board of 
directors establish an audit committee. Proposed Sec. 917.5(b) would 
require that each Bank's audit committee consist of five or more board 
directors, each of whom meets the independence criteria discussed 
below, and include a balance of representatives of large and small 
members and of appointed and elected directors of the Bank. The 
requirement in proposed Sec. 917.5(b) that the audit committee comprise 
five or more persons differs from the recommendation of the Blue Ribbon 
Committee Report that the audit

[[Page 52170]]

committee comprise a minimum of three directors. The Finance Board 
believes it is important that the audit committee include 
representatives of large and small members and appointed and elected 
directors of the Bank in order to prevent dominance by one particular 
individual or group of individuals. A minimum of five members is 
necessary to ensure that the audit committee will have such diverse 
representation.
    The terms of audit committee members must be appropriately 
staggered to provide for continuity of service, and to avoid a 
complete, or substantial, turnover of the membership of the audit 
committee in any one year. All members of the audit committee would be 
required to have a working familiarity with basic finance and 
accounting principles, with at least one member having extensive 
accounting or financial management expertise. This requirement is 
intended to ensure that audit committee members have the ability to 
read and understand the Bank's balance sheet and income statement and 
to ask substantive questions of internal and external auditors. The 
Finance Board recognizes that, in some cases, a Bank's board of 
directors may not include enough members with expertise sufficient for 
the demands of service on the audit committee, considering the 
representation requirements. Thus, proposed Sec. 917.5(b)(4) would 
require that, if such familiarity or expertise is lacking among current 
board directors, the board of directors shall, in the case of appointed 
directors, notify the Finance Board or, in the case of elected 
directors, include in the notice of election required under 
Sec. 915.6(a) (existing Sec. 932.6(a)), a statement describing the 
skills or expertise needed.
    In addition, proposed Sec. 917.5(c) would require that any board 
director serving on the audit committee be sufficiently independent of 
the Bank and its management so as to maintain the ability to make the 
type of objective judgments that are required of audit committee 
members. The proposed independence criteria were adapted from the Blue 
Ribbon Committee Report, which states that ``common sense dictates that 
a director without any financial, family, or other material personal 
ties to management is more likely to be able to evaluate objectively 
the propriety of management's accounting, internal control and 
reporting practices.'' The Finance Board agrees that the independence 
of the directors serving on the audit committee is of great importance. 
Proposed Sec. 917.5(c) describes several examples, which are not 
intended to include all possible examples, of relationships that would 
call into question the independence of an audit committee member and 
that, therefore, would disqualify any director having such a 
relationship with the Bank or its management from serving on the audit 
committee. The list is not intended to be exhaustive, because it is 
impossible to foresee all potential individual circumstances that might 
compromise the independence of a particular director. Thus, the Finance 
Board expects that the board of directors will consider all potential 
relationships when qualifying a director for service on the audit 
committee.
    Proposed Sec. 917.5(d) would require that each Bank's audit 
committee adopt a formal written charter setting forth the scope of the 
audit committee's powers and responsibilities and establishing its 
structure, processes and membership requirements. Both the audit 
committee itself and the Bank's full board of directors would be 
required to review the provisions of the audit committee charter 
annually and to adopt the charter, including amendments, not less often 
than every three years, as appropriate based on the board's and audit 
committee's reviews of the policy. Proposed Sec. 917.5(d)(3) would 
require that the audit committee charter contain the following specific 
provisions: that the Bank's internal auditor may be removed only with 
the approval of the audit committee; that the internal auditor shall 
report directly to the audit committee on substantive matters and to 
the Bank President on administrative matters; that the audit committee 
shall be empowered to employ such outside experts as it deems necessary 
to carry out its functions; and that the internal and external auditors 
be allowed unrestricted access to the audit committee without any 
requirement of management knowledge or approval. The proposed 
requirements pertaining to the audit committee charters were adapted 
from the recommendations contained in the Blue Ribbon Committee Report 
and the current Finance Board requirements on audit committees.
    Proposed Sec. 917.5(e) sets forth the duties of each Bank's audit 
committee under the new regulatory structure, including the duties to: 
ensure that senior management maintains the reliability and integrity 
of the accounting policies and financial reporting and disclosure 
practices of the Bank; review the basis for the Bank's financial 
statements and the external auditor's opinion rendered with respect to 
such financial statements and ensure disclosure and transparency 
regarding the Bank's true financial performance and governance 
practices; oversee the internal audit function; oversee the external 
audit function; act as an independent, direct channel of communication 
between the Bank's board of directors and the internal and external 
auditors; conduct or authorize investigations into any matters within 
the audit committee's scope of responsibilities; ensure that senior 
management has established and is maintaining an adequate internal 
control system; ensure that senior management has established and is 
maintaining adequate policies and procedures to ensure that the Bank 
can assess, monitor and control compliance with its mission achievement 
policy as required in Sec. 917.9(b)(1) of the proposed rule; and report 
periodically its findings to the Bank's board of directors.
    Proposed Sec. 917.5(e)(8) requires that the audit committee conduct 
not only financial audits but also audit the controls in place to 
ensure the Bank's compliance with its mission achievement policy. The 
audit committee is not required to assess the mission performance of 
the Bank. Review of the mission performance assessment of the Bank is 
the responsibility of the full board of directors, as more fully 
discussed in proposed Sec. 917.9(b)(3) below.
    An audit of the controls in place to ensure the Bank's compliance 
with its mission achievement policy is considered one type of a 
performance audit. In contrast to a financial audit, which is a 
financial statement or financial related audit, a performance audit is 
an objective and systematic examination of evidence for the purpose of 
providing an independent assessment of the performance of an 
organization, program, activity or function in order to provide 
information to improve public accountability and facilitate decision 
making by parties with responsibility to oversee or initiate corrective 
action. See U.S. General Accounting Office, Government Auditing 
Standards (GAO Yellow Book). Performance audits include economy and 
efficiency, program and compliance audits. Economy and efficiency 
audits evaluate whether the entity is using its resources economically 
and efficiently, and the causes of inefficiencies and uneconomical 
practices. Id. at 14. Program audits evaluate the extent to which the 
desired results as established by the authorized body are being 
achieved, and the effectiveness of organizations, programs, activities 
or functions. Id. Compliance audits

[[Page 52171]]

evaluate whether the entity complied with significant laws and 
regulations applicable to the organization or program. Id. at 13-14.
    The Finance Board requests comments on whether the duties and 
responsibilities of the audit committee and the internal auditor should 
be broadened in the proposed rule to include economy and efficiency and 
program audits, as well as compliance and financial related audits.
    Finally, proposed Sec. 917.5(f) would require that each Bank's 
audit committee prepare written minutes of each audit committee 
meeting.
6. Budget Preparation and Reporting Requirements--Sec. 917.6
    Proposed Sec. 917.6 is carried over unchanged from existing 
Sec. 934.7 of the Finance Board's regulations.
7. Dividends--Sec. 917.7
    Proposed Sec. 917.7 retains in large part the provisions of 
existing Sec. 934.17 of the Finance Board's regulations, with certain 
proposed amendments as discussed below. The existing dividend 
regulation provides that the board of directors of each Bank, with the 
approval of the Finance Board, may declare and pay a dividend from net 
earnings, including previously retained earnings, on the paid-in value 
of capital stock held during the dividend period. See 12 CFR 934.17. 
Proposed Sec. 917.7 would devolve the dividend process to the Banks and 
allow the payment of dividends without prior Finance Board approval, so 
long as such payment will not result in a projected impairment of the 
par value of the capital stock of the Bank. Because, under the 
regulatory regime proposed in this rulemaking, the earning assets of 
the Banks will be either core mission activities or assets that have 
not been acquired through debt issued with the benefit of the Banks' 
GSE status, the Finance Board's concerns about the proper use of the 
Banks' GSE funding advantage will have been addressed, and the need for 
prior Finance Board approval will have been obviated.
    Each Bank's board of directors would then be responsible for 
ensuring that the benefits stemming from membership in the Bank System 
would be distributed in an equitable manner to all members of that 
cooperatively-owned Bank. Benefits can be distributed in the form of 
dividends, but can also be distributed in the form of lower pricing for 
advances and other Bank products. Lower product pricing, however, gives 
greater assurance that the Bank System's benefits are passed along to 
American consumers through increased competition in the housing finance 
marketplace. The Finance Board expects the Banks, as cooperatively-
owned institutions, to pass along a greater proportion of the benefits 
through lower product pricing (as opposed to higher dividends) than if 
the Banks were owned by private, third-party shareholders. The Finance 
Board requests comments on the reasonableness of this expectation or 
whether it should reconsider the need to have some mechanism to review 
or control the Banks' dividend decisions.
    The current dividend regulation also provides that the Bank's 
dividend period may be quarterly, semiannual or annual periods ending 
on March 31, June 30, September 30 or December 31. Proposed Sec. 917.7 
would leave the determination of the dividend period to the discretion 
of the Banks.
    Proposed Sec. 917.7 retains without change the provisions in the 
current dividend regulation that dividends shall be computed without 
preference and only for the period the stock was outstanding during the 
dividend period, and that dividends may be paid in cash or in the form 
of stock. As discussed below under ``Capital Stock Redemption 
Requirements--Sec. 930.9,'' the Finance Board recently published an 
Advance Notice of Proposed Rulemaking (ANPRM) that requested comment on 
whether the Banks should be prohibited from paying dividends in the 
form of stock. For the reasons discussed under that section, proposed 
Sec. 917.7 does not include such a prohibition. Dividend payments by 
the Banks also have been subject to a Finance Board Dividend Policy, 
see Finance Board Res. No. 90-38 (Mar. 15, 1990), which, in addition to 
repeating provisions from the regulation, specifies target dividend 
rate formulae and requires the Banks to submit dividend recommendations 
and a certification that the recommendation is in compliance with the 
Dividend Policy at least 10 days prior to the payment of any dividend. 
These requirements from the Dividend Policy have not been included in 
proposed Sec. 917.7. Furthermore, the Finance Board anticipates that, 
if proposed Sec. 917.7 is adopted as proposed, the Finance Board will 
rescind the Dividend Policy.
8. Approval of Bank Bylaws--Sec. 917.8
    Proposed Sec. 917.8 is carried over unchanged from existing 
Sec. 934.16 of the Finance Board's regulations.
9. Mission Achievement--Sec. 917.9
    Proposed Sec. 917.9 sets forth new requirements that each Bank must 
meet in developing a mission achievement policy and overseeing the 
Bank's mission achievement. The Act establishes the Finance Board's 
primary responsibility for ensuring the safety and soundness of the 
Bank System and consistent with that duty, ensuring that the Banks 
fulfill their public policy mission. See 12 U.S.C. 1422a(a)(3). As with 
the risk management function, a Bank's board of directors must take its 
mission responsibilities seriously and impress the importance of 
mission achievement upon Bank management and staff. The Banks' boards 
of directors must be fully engaged so that there is a focus on mission 
achievement at all levels of the Bank.
    Proposed Sec. 917.9(a)(1) would require that each Bank's board of 
directors adopt and submit to the Finance Board for approval a mission 
achievement policy within 180 calendar days of the effective date of 
the rule in final form. This mission achievement policy would be 
required to detail how the Bank will comply with the core mission 
activity requirements set forth in proposed part 940 (discussed in more 
detail below), including contingent business strategies for meeting the 
core mission activity requirements under different assumptions about 
future economic and mortgage market conditions. The policy also would 
be required to outline a process for developing and implementing new 
mission-related products and services. The board should foster an 
environment that encourages management to be innovative and committed 
in developing products that provide assistance to Bank members in the 
financing of housing and community lending.
    As with the risk management policy, proposed Sec. 917.9(a)(2)(i) 
would require that the Bank's board of directors review the Bank's 
mission achievement policy on at least an annual basis. Proposed 
Sec. 917.9(a)(2)(iii) would require a Bank's board of directors to re-
adopt a mission achievement policy, including interim amendments, not 
less often than every three years, as appropriate based on the board's 
reviews of the policy. Again, as with the similar provision in proposed 
Sec. 917.3(a)(2), this requirement is intended to ensure that, even 
given the turnover in board personnel that will occur over a number of 
years, all or most current members of a Bank's board of directors will 
be thoroughly familiar with the Bank's mission achievement policy, will 
have given meaningful consideration to its provisions and will have 
expressed their opinion regarding the adequacy of the policy through 
the voting process. Proposed Sec. 917.9(a)(2)(iv) also would make clear 
that each Bank's board of directors has the ultimate responsibility to 
ensure

[[Page 52172]]

that the Bank is in compliance at all times with the mission 
achievement policy.
    Under proposed Sec. 917.9(a), each Bank would be required to submit 
its initial mission achievement policy to the Finance Board for 
approval; subsequent versions of the policy adopted thereafter or 
amendments would not be required to be submitted to, or approved by, 
the Finance Board. However, as with the risk management policies, Bank 
mission achievement policies will be reviewed by the Finance Board as 
part of the ongoing examination process.
    Proposed Sec. 917.9(b) would require that each Bank's board of 
directors: (1) direct the establishment and maintenance, by senior 
management, of adequate policies and procedures to ensure that the Bank 
can assess, monitor and control compliance with its mission achievement 
policy; (2) establish a mechanism to measure and assess the Bank's 
performance against its mission achievement goals and objectives; and 
(3) require that performance assessments be conducted at least annually 
that evaluate the Bank's mission achievement and measure its 
performance against the Bank's goals and objectives and that such 
performance assessments be reviewed by the Bank's board of directors.
    These provisions are intended to ensure that the board of directors 
oversees the process of assessing mission achievement, but do not 
require that this responsibility reside with the audit committee or the 
internal auditor. It is not necessary that the requirements for the 
audit committee, which oversees the financial audit of the Bank, be 
applied to the oversight of mission performance. Thus, proposed 
Sec. 917.9(b) requires that the board of directors oversee mission 
performance, but it allows the board to determine how, and by what 
mechanism, it will carry out this responsibility. However, as 
previously discussed, the audit committee shall be responsible for 
ensuring that proper controls exist to ensure that an assessment of 
mission achievement is carried out. In any event, the mission 
management assessments should follow the requirements for program 
audits contained in the GAO Yellow Book.

B. Part 925--Members of the Banks

    Existing part 933 of the Finance Board's regulations, ``Members of 
the Banks,'' has been proposed to be redesignated as new part 925 in 
the Finance Board's proposed rule to reorganize all of the Finance 
Board's regulations published separately in this issue of the Federal 
Register. Part 925 of the proposed reorganization rule retains in large 
part the provisions of existing part 933. Certain proposed amendments, 
which consist primarily of cross-references to sections of this 
proposed financial management and mission achievement regulation, are 
included in this rulemaking and discussed here.
    Specifically, Secs. 933.14, 933.22, and 933.24 through 933.28 of 
the Finance Board's existing membership regulations have been 
redesignated as Secs. 925.14, 925.22, and 925.24 through 925.28 in the 
proposed reorganization regulation. Each of these sections contains 
provisions regarding the treatment of outstanding advances and Bank 
stock in different events: conditional membership approvals of de novo 
insured depository institution applicants deemed void (Sec. 925.14); 
ownership of excess shares of capital stock (Sec. 925.22); 
consolidations of members (Sec. 925.24); consolidations involving 
nonmembers (Sec. 925.25); member withdrawals (Sec. 925.26); removal of 
members (Sec. 925.27); and automatic termination of members placed in 
receivership (Sec. 925.28). In each of these situations, where 
applicable, liquidation of outstanding indebtedness owed to the Bank 
(mainly advances) in which membership has ceased is proposed to be 
handled in accordance with newly designated Sec. 925.29. The redemption 
of stock in each circumstance described in these sections is proposed 
to be conducted pursuant to new Sec. 930.9 (capital stock redemption 
requirements), proposed in this rulemaking.

C. Part 930--Risk Management and Capital Standards

1. Overview
    As discussed previously, the Banks' current capital requirements 
are determined according to a statutory formula, which uses either the 
asset size of a member or the amount of its borrowings from a Bank to 
determine the amount of stock the member must purchase from its Bank. 
See 12 U.S.C. 1426(b)(1), (b)(2), (b)(4); 1430(c), (e)(1), (e)(3). The 
Banks' risk management and investment practices are governed by the 
FMP. This proposal would create a modern risk-based capital system for 
the Banks. The Banks would be allowed greater flexibility to set their 
own risk tolerances, subject to the requirement that they hold 
sufficient capital to support the risks they chose to accept. The 
proposed rule also would allow for a more efficient and effective use 
of the Banks' capital than is currently possible.
    The risk-based capital requirement, together with other provisions 
of this capital proposal, would replace the FMP, which the Finance 
Board currently uses to address the risks inherent in the financial 
management practices of the Banks. Given the advent of the Basle 
Accord, the practices of the other bank regulatory agencies, and the 
Finance Board's proposal for the Banks to become more mission oriented, 
the Finance Board has determined that the development of risk-based 
capital standards for the Banks should be an integral part of any 
comprehensive risk management system for overseeing the Banks. The FMP 
is a prescriptive risk control system with a series of detailed 
business and operating guidelines. It is based on policies originally 
adopted by the FHLBB, the predecessor agency to the Finance Board, and 
has been revised a number of times over the years. The FMP is a product 
of its history and reflects a now outmoded approach that emphasizes in 
considerable detail what is, and what is not, a permissible practice 
for the Banks. It is composed of a series of lists, which address 
matters such as allowable and prohibited assets, reserve requirements, 
funding guidelines, and hedging, credit, and interest rate risk 
guidelines. Federal banking regulation now focuses more on the adequacy 
of the audit and control systems, as well as risk management systems 
and managerial capability. The Finance Board is proposing to adopt a 
modern approach to overseeing the Banks, which would require the Banks 
to implement a comprehensive risk management system (including 
regulatory capital requirements) and would require the Finance Board to 
verify the integrity of those internal systems.
    The bank regulatory authorities in the United States and in other 
industrialized countries have adopted some form of risk-based capital 
structure for the financial institutions they oversee. The basis for 
all of those risk-based capital systems is the Basle Accord, which was 
adopted in July 1988 and which measures credit risk through a system of 
risk-weight categories. As a matter of practice, the Basle Accord has 
been applied to all banks and thrifts in the United States and has 
become the global benchmark for credit risk capital standards.
    The Basle Accord is based principally on a standardized system of 
risk weights, under which the book value of an on-balance sheet asset 
is assigned a particular risk weight based on the relative level of 
credit risk associated with that category of asset. The same method is 
used with respect to off-

[[Page 52173]]

balance sheet items, which are converted to ``credit equivalent 
amounts'' and assigned to the appropriate risk weight category. The 
risk weight categories range from zero percent, for items such as cash 
and Treasury obligations, to 100 percent, which includes claims on 
private obligors. The Basle Accord credit risk capital regime is based 
on an 8 percent benchmark, i.e., that an institution must maintain 
total capital in an amount equal to 8 percent of the book value of any 
asset that is in the 100 percent risk weight category. Assets in lower 
risk-weight categories would carry a correspondingly lower capital 
requirement, such that an asset in the 50 percent category would 
require capital equal to 4 percent of its book value and an asset in 
the zero percent risk weight category would require no capital for 
credit risk. Because the Basle Accord made no explicit provision for 
market risk in the risk weight categorizations, the required capital 
percentage serves as protection against both credit and market risk.
    The Finance Board, and other commentators, believe that the Basle 
Accord has a number of shortcomings. For example, for instruments 
within the same risk weight category, the Basle Accord does not 
distinguish between those instruments with different credit quality 
(i.e., those with different credit ratings), which would, in fact, have 
markedly different credit risks. The Basle Accord also does not take 
into consideration how differences in the maturities of two instruments 
would affect their relative credit risk, nor does it distinguish 
between immediate exposure and possible future credit exposures, or 
between the credit risks associated with a diversified portfolio 
compared to those associated with a concentrated portfolio.
    Under the 1996 amendment to the Basle Accord (the Amendment), debt 
instruments held in the trading portfolios of large banks are exempt 
from the risk-based capital requirements of the Basle Accord. The 
Amendment remedies some of the shortcomings of the 1988 Basle Accord 
discussed above and offers two alternatives for calculating the credit 
risk capital requirements for debt instruments held in the trading 
portfolios of large banks. These alternatives are based on publicly 
available credit ratings, or credit ratings that are internally 
generated by large banks. The first alternative for large banks is to 
use internal credit risk models to calculate value at risk due to 
credit risk on debt instruments held in trading portfolio. A second 
alternative for large banks lacking satisfactory internal models is to 
use standardized credit risk capital percentage requirements specified 
in the Amendment. These percentage requirements are significantly lower 
than the risk-based capital requirements for the non-trading portfolio 
(banking book) and are related to the maturities of the investment 
grade instruments. The smaller percentage requirements mainly reflect 
the fact that holding periods, commonly referred to as default 
horizons, for debt instruments held in trading portfolios are generally 
shorter than the holding periods for the banking book.
    Principally to address some shortcomings of the Basle Accord with 
respect to the banking book, the BCBS recently published the Framework, 
which proposes a system to better correlate regulatory solvency to the 
economic-capital needs of a bank, as well as with the risks and returns 
of their lending activities.\4\ The Framework would base risk-based 
capital requirements more closely on the underlying credit risks, and 
would recognize the improvements in risk measurement and control that 
have occurred in recent years. The Framework would allow for the use of 
internal credit ratings and credit risk models to better assess a 
bank's capital requirement in relation to its risk profile. The BCBS 
also issued a separate paper on internal credit risk modeling, and 
invited comments on the issue of using a portfolio-based approach to 
calculating an overall capital requirement.\5\ Portfolio credit risk 
modeling is a long-term project for the BCBS; ultimately, it is 
anticipated that sophisticated banking institutions would employ a 
comprehensive portfolio risk modeling approach, under which regulatory 
capital requirements would be based entirely on internal models. This 
proposed regulation addresses many of the concerns raised in the recent 
BCBS papers, by closely tying regulatory capital requirements to each 
Bank's level of credit risk.
---------------------------------------------------------------------------

    \4\ New Basle Committee Proposals Have Positive Bank Credit 
Implications, Moody's Credit Perspectives, June 21, 1999, at 1, 18.
    \5\ BCBS, Credit Risk Modeling: Current Practices and 
Applications (Apr. 1999).
---------------------------------------------------------------------------

    As discussed above, the drive to incorporate a measure of general 
market risk into the Basle Accord has been spearheaded by the BCBS. The 
Basle Accord addressed credit risk but did not include a requirement 
for market risk. However, as depository institutions' involvement in 
both on- and off-balance sheet instruments containing structured and 
exotic features as well as complex options grew, the BCBS became 
concerned with the market risk aspect of the risk-based capital 
standards. This led to the Amendment which, in addition to credit risk, 
addressed market risk from interest rates, foreign exchange rates, 
equity prices and commodity prices within the trading book and foreign 
exchange and commodity risks in the banking book. The Amendment is 
limited in that it essentially applies to large commercial banks; 
banking book interest rate risk is still not addressed. However, the 
BCBS has published a separate proposal providing guidance for the 
management of overall interest rate risk in a banking organization, 
including interest rate risk within the banking book.\6\ In the 
recently published Framework, the BCBS has proposed to develop a 
specific capital requirement for interest rate risk in the banking book 
for banks where interest rates risks are significantly above average. 
The bank regulatory authorities in the United States and in other 
industrialized countries have adopted the Amendment to incorporate 
general market risk into the risk-based capital standards.
---------------------------------------------------------------------------

    \6\ See BCBS, Principles for the Management of Interest Rate 
Risk (Jan. 1997).
---------------------------------------------------------------------------

2. Requirements for Bank System and Individual Bank Credit Ratings--
Sec. 930.2
    Proposed Sec. 930.2 addresses credit ratings for Bank System COs 
and for the overall capacity of individual Banks to meet their 
obligations. Section 930.2(a)(1) would require that the Banks, 
collectively, obtain from a NRSRO, and at all times maintain, a current 
credit rating on the Banks' COs. Under Sec. 930.1 of the proposed rule, 
an NRSRO would be defined to include those credit rating organizations 
recognized as NRSROs by the SEC. To date, the SEC regards five credit 
rating organizations as NRSROs: Standard & Poor's; Moody's; Fitch IBCA; 
Duff & Phelps; and (for certain financial institutions) Thompson 
BankWatch, Inc. See 62 FR 68018-24 (Dec. 30, 1997).
    The Banks' COs currently are rated by both Moody's and Standard & 
Poor's and have received the highest credit rating from both NRSROs, 
based upon the conservative management policies and consistent 
profitability of the Banks, both as a group and individually, and the 
status of the Banks as GSEs. Proposed Sec. 930.2(a)(2) would require 
that each Bank operate in such a manner and take any actions necessary 
to ensure that the Banks' COs receive and continue to receive the 
highest credit rating from any NRSRO by which the COs have been then 
rated (e.g., triple-A).

[[Page 52174]]

Regardless of whether any actual downgrade were to occur, a Bank still 
would be considered to be in violation of proposed Sec. 930.2(a)(2) if 
that Bank were to take any action, or were to create a situation 
through a failure to act, that potentially could lead any NRSRO to 
downgrade the rating for COs to a level below that NRSRO's highest 
investment grade.
    In addition to the requirements pertaining to the rating of the 
Banks' COs, Sec. 930.2(b) of the proposed rule would require each Bank, 
individually, to operate in such a manner and take any actions 
necessary to ensure that the Bank has and maintains an individual 
issuer credit rating of not lower than the second highest credit rating 
from any NRSRO by which the Bank is rated (e.g. double-A), where the 
NRSRO states that the rating is a meaningful measure of the Bank's 
financial strength and stability apart from the GSE status of the Bank 
System. The latter requirement is intended to ensure that the Banks' 
boards of directors and senior management focus upon the business 
practices necessary to maintain not lower than the second highest 
credit rating on an individual basis without regard to the GSE status 
of the Bank System.
    Proposed Sec. 930.2(c) would require each Bank to obtain an 
individual issuer credit rating from an NRSRO within one year of the 
effective date of new part 930. In addition, under proposed 
Sec. 930.2(b)(3), each Bank would be required to update its individual 
issuer credit rating on an annual basis, or more frequently, as 
required by the Finance Board. Eleven of the Banks already have 
obtained an individual credit rating from at least one NRSRO and all 
eleven have received the highest long-term credit rating from the 
NRSROs by which they have been rated.
    In order to facilitate the Banks' fulfillment of the core mission 
activities requirements set forth in part 940 of the proposed rule, 
discussed below, the proposed rule would authorize the Banks to make a 
wider range of investments, and to offer their members and eligible 
nonmember borrowers a wider range of products and services, than is 
currently authorized in the absence of specific prior Finance Board 
approval. The risk-based capital requirements set forth in proposed 
part 930, also discussed below, are intended to require the Banks to 
manage effectively the increased risks that could accompany the 
broadened investment and programmatic authority that the Banks would 
enjoy under the proposed rule. As provided for under proposed 
Sec. 930.2, it is of vital importance that the Banks' COs continue to 
receive the highest possible credit rating so as to ensure that the 
Banks remain able to access to the capital markets at the lowest 
possible cost of funds and, consequently, to fund activities that 
safely and soundly further the Banks' housing finance and community 
lending mission.
    At the same time, the Finance Board finds it appropriate to permit 
the Banks to maintain individual issuer credit ratings of at least the 
second highest credit rating given by any NRSRO from which a rating has 
been received, rather than continuing to require the highest credit 
rating, as individual Banks are required to maintain under the FMP. In 
meetings with Finance Board staff, representatives of both Moody's and 
Standard & Poor's indicated that the Bank's COs could continue to 
receive the highest credit rating, even if all of the Banks were to 
receive only the second highest issuer credit rating on an individual 
basis. Both NRSROs confirmed to Finance Board staff that the GSE status 
of the Banks plays a key role in the rating of the Banks' COs. While 
both NRSROs indicated that any significant changes to the Banks' 
management policies and profitability potentially could adversely 
affect the credit rating of the COs, both also stated that the proposed 
new regulatory structure does not give rise to any serious concern that 
the COs will not continue to receive the highest credit rating from 
both organizations.
3. Minimum Total Capital Requirement--Sec. 930.3
    a. Background. Capital serves as a barrier against insolvency. Its 
purpose is to absorb the risks inherent in business endeavors, and to 
provide market discipline to limit risk-taking by management. To be 
effective, capital must be available to offset losses if economic 
conditions are unfavorable.
    The capital requirements in the proposed rule represent a change in 
philosophy from the FMP. Rather than prohibiting certain types of 
investments, and establishing limits on Bank behavior towards risk such 
as duration of equity limits, the proposed rule would allow the Banks 
wide latitude to engage in mission-related activities, so long as they 
hold sufficient capital to cover the risks entailed by such activities.
    The rule proposes two capital-based standards for the Banks. The 
first standard is a requirement that total outstanding Bank capital 
stock must equal at least 3.0 percent of the Bank's total assets. The 
second standard is a requirement generally that the Banks must hold the 
most permanent forms of capital, referred to as risk-based capital, 
against the risks measured in the Bank's portfolio. The risk-based 
capital requirement is discussed further below under Sec. 930.4.
    b. Minimum total capital requirement. Section 930.3(a) of the 
proposed rule provides that each Bank shall have and maintain at all 
times total capital in an amount equal to at least 3.0 percent of the 
Bank's total assets. Total capital is defined in proposed Sec. 930.1 as 
the sum of a Bank's retained earnings and total capital stock 
outstanding, less the Bank's unrealized net losses on available-for-
sale securities. The minimum total capital requirement serves to limit 
the size of a Bank's balance sheet for a given quantity of capital.
    As discussed above in the Overview of Proposal section, the Act 
sets forth minimum capital requirements for the Banks. See 12 U.S.C. 
1426(b)(1), (b)(2), (b)(4); 1430(c), (e)(1), (e)(3); 12 CFR 933.20(a). 
Among these provisions is a requirement that members hold stock equal 
to at least 5 percent of their advances. Currently, the FMP limits the 
holding of mortgage-backed securities by the Banks to three times 
capital. Taken together, these two provisions limit advances plus 
mortgage-backed securities to no more than 23 times capital, as 
advances can be no more than 20 times capital, and mortgage-backed 
securities can be no more than 3 times capital. Thus the ratio of 
capital to advances plus mortgage-backed securities must be at least 
one twenty-third, or 4.35 percent.\7\
---------------------------------------------------------------------------

    \7\ To the extent that a Bank chooses to accumulate retained 
earnings, its assets may be limited to something less than 23 times 
capital. This is because the capital held to support advances can, 
by statute, only be in the form of capital stock, while the capital 
held to support mortgage-backed securities (MBS) holdings can be 
either capital stock or retained earnings. Retained earnings are a 
small percentage of total capital for the Banks.
---------------------------------------------------------------------------

    The numerically operative and, therefore, more important constraint 
contained in current regulations is a leverage limit, such that the 
ratio of COs plus unsecured senior liabilities for a Bank can be no 
more than 20 times capital. See FMP section IV.C. Because assets equal 
capital plus COs plus unsecured senior liabilities, a Bank's assets 
cannot exceed 21 times its capital or, inversely, capital must be at 
least 4.76 percent of assets. The Bank System had an average capital-
to-assets ratio of 5.4 percent during 1998.
    The proposed 3.0 percent minimum total capital requirement for the 
Banks would be more conservative than the 2.5 percent minimum total 
capital

[[Page 52175]]

requirement imposed by statute on the on-balance sheet assets of Fannie 
Mae and Freddie Mac.\8\ Also, the proposed minimum total capital 
requirement of 3.0 percent for the Banks is consistent with the minimum 
total capital requirements imposed by other financial institution 
regulators for the strongest financial institutions without supervisory 
concerns.
---------------------------------------------------------------------------

    \8\ A leverage requirement is imposed on Fannie Mae and Freddie 
Mac such that their capital must be at least 2.5 percent of their 
on-balance sheet assets. 12 U.S.C. 4612(a). Generally, they must 
also hold capital equal to at least .45 percent of their off-balance 
sheet obligations. Unlike the Banks, Fannie Mae and Freddie Mac have 
substantial volumes of guarantees and other off-balance sheet items.
---------------------------------------------------------------------------

    Section 930.3(b) of the proposed rule provides that, for reasons of 
safety and soundness, the Finance Board may require an individual Bank 
to have and maintain a higher minimum capital ratio than 3.0 percent.
4. Minimum Total Risk-Based Capital Requirement--Sec. 930.4
    a. General requirement. Section 930.4(a) of the proposed rule 
provides that each Bank shall have and maintain at all times total 
risk-based capital in an amount at least equal to the sum of its credit 
risk capital requirement, its market risk capital requirement, and its 
operations risk capital requirement, calculated in accordance with 
Secs. 930.5, 930.6 and 930.7, respectively. As discussed above under 
the Overview of Proposal section, the proposed rule would implement, 
for the first time, a risk-based capital requirement for the Banks 
related to the risks inherent in the Banks' portfolios and business 
practices. The three separate capital components are discussed further 
below under their respective sections.
    b. Definition of Total Risk-Based Capital. In order to serve as the 
primary barrier against insolvency, risk-based capital must be 
permanent in nature, i.e., available to cover losses which may occur 
under adverse conditions without being subject to redemption by 
members. Proposed Sec. 930.1 contains a definition of total risk-based 
capital for a Bank, the elements of which are discussed below.
    The first element of total risk-based capital under the definition 
in proposed Sec. 930.1 is retained earnings, less unrealized net losses 
on available-for-sale securities. Retained earnings clearly are 
permanent in nature because they are not subject to withdrawal at the 
request of individual member shareholders.
    The second element of total risk-based capital under the definition 
in proposed Sec. 930.1 is any outstanding non-redeemable capital stock 
of the Bank. The Finance Board has authority under the Act to allow the 
Banks to create additional classes of stock if the Banks wish to 
include such other classes of stock as a part of their capital 
structure. Any non-redeemable outstanding capital stock that a Bank may 
be authorized to issue would be permanent by its non-redeemable nature.
    The third element of total risk-based capital under the definition 
in proposed Sec. 930.1 is all outstanding capital stock satisfying the 
minimum capital stock purchase requirement for membership under 
sections 6(b)(1) and 10(e)(3) of the Act (12 U.S.C. 1426(b)(1), 
1430(e)(3)) for all mandatory members. Outstanding capital stock of 
mandatory members has permanent features, because a mandatory member 
may have its stock redeemed only if it changes its charter to a form 
that would make the member a voluntary member and withdraws from 
membership in the Bank System. Charter conversions generally are not 
effected by a member solely for the purpose of withdrawing from Bank 
membership and redeeming Bank stock. A charter conversion would have a 
serious impact on all aspects of an institution's business operations, 
and would require a significant amount of time and cost to complete. 
Mandatory members that convert to voluntary status also may be 
discouraged from withdrawing from the Bank System because the Act 
prohibits withdrawing members from rejoining the Bank System for ten 
years. See 12 U.S.C. 1426(h).
    The fourth element of total risk-based capital under the definition 
in proposed Sec. 930.1 is a percentage of the minimum capital stock 
purchase requirement for membership under sections 6(b)(1) and 10(e)(3) 
of the Act (12 U.S.C. 1426(b)(1), 1430(e)(3)) for all voluntary 
members. Each Bank may designate a percentage, not to exceed 50 
percent, of the minimum capital stock of voluntary members as risk-
based capital. The required capital stock of voluntary members is less 
permanent than the required capital stock of mandatory members, but is 
more permanent than stock which supports member borrowing. Although the 
ten-year prohibition on rejoining the Bank System after withdrawing may 
discourage voluntary members from withdrawing from the Bank System and 
redeeming their capital, they may, if they decide to withdraw, have 
their capital stock redeemed at par, provided that the Finance Board 
finds no impairment or likely impairment of the Bank's capital. See 12 
U.S.C. 1426(e). This capital stock, therefore, has more limited use as 
a loss absorber than the other forms of capital stock discussed above. 
However, a Bank may need more than its retained earnings and 
outstanding minimum capital stock of mandatory members in order to meet 
its risk-based capital requirement. Therefore, a percentage not to 
exceed 50 percent of minimum required voluntary member stock may serve 
as an element of total risk-based capital only if the Bank is willing 
to subject its redemption to Finance Board approval.
    The fifth and final element of total risk-based capital under the 
definition in proposed Sec. 930.1 is a percentage of the remaining 
capital stock of mandatory and voluntary members. Each Bank may 
designate a percentage, not to exceed 50 percent, of the remaining 
capital stock of mandatory and voluntary members as risk-based capital 
only if the Bank is willing to subject its redemption to Finance Board 
approval. The Act provides that a Bank has discretion, unless 
prohibited by the Finance Board, to determine whether to redeem a 
mandatory or voluntary member's capital stock that exceeds its 
statutory minimum capital stock purchase requirement. See 12 U.S.C. 
1426(b)(1). Because a Bank can decline to redeem excess capital stock 
of members, such stock can serve as a permanent capital loss absorber.
    The proposed definition allows each Bank to designate different 
percentages of stock as elements of total risk-based capital under the 
fourth and fifth elements of the definition (that is, up to 50 percent 
of the membership stock of voluntary members, and up to 50 percent of 
all remaining outstanding capital stock of mandatory and voluntary 
members). Therefore, some Banks may choose to designate a larger 
percentage of the minimum capital stock of voluntary members as risk-
based capital stock, as this stock has a greater degree of permanence. 
This would allow a smaller percentage of capital stock which supports 
advance borrowing to be designated as an element of total risk-based 
capital, so that the use of advances by members would not be 
discouraged.
    c. Transition provisions. The transition provisions in the proposed 
rule ensure that the Banks will continue to operate in a safe and sound 
manner, under proven standards, until such time as they have 
demonstrated the capacity to operate under the more flexible proposed 
regulation. Specifically, each Bank must demonstrate to the Finance 
Board that it has risk management policies and internal controls in 
place which are sufficient to manage its credit, market, and operations 
risk. Each

[[Page 52176]]

Bank must also have an internal market risk model approved by the 
Finance Board. Finally, each Bank must have sufficient capital to meet 
the capital requirements in the proposed rule. Until these conditions 
are met by a Bank, the current rules as contained in the FMP will 
apply. See proposed Secs. 930.4(b)(1) and 930.4(b)(2).
5. Credit Risk Capital Requirement--Sec. 930.5
    a. Background. Unlike commercial banks and savings associations, 
the Banks currently are not subject to statutory or regulatory risk-
based capital requirements. As discussed previously, the Banks' capital 
requirements are determined according to a statutory formula, which 
uses either the asset size of a member or the amount of its borrowings 
from a Bank to determine the amount of stock the member must purchase 
from its Bank. The risk-based capital requirement for the Banks 
established in this proposal would include as one component a separate 
capital requirement to address the credit risk to which a Bank is 
exposed. The credit risk component of the capital requirement would 
encompass the credit risks associated with both on-balance sheet assets 
and off-balance sheet items of each Bank.
    The objective of the Finance Board in proposing this credit risk 
capital standard for Banks is to provide a regulatory framework that 
would: (i) assess capital charges based on the extent of the underlying 
credit exposure; (ii) address on-and off-balance sheet exposures 
consistently; (iii) allow for changes to the portfolios of the Banks, 
as well as in the markets; and (iv) reflect improvements in risk 
measurement and control systems, as they develop and become available 
for use by the Banks. To the extent the proposed rule achieves these 
objectives, it would improve upon the Basle Accord.
    b. Finance Board determination of specific credit risk percentage 
requirements. Proposed Sec. 930.5(b) provides that for an on-balance 
sheet asset, the credit risk capital requirement would be equal to the 
book value of the asset multiplied by the ``credit risk percentage 
requirement'' to which the asset is assigned. Proposed Sec. 930.5(c) 
provides that for off-balance sheet items, the credit risk capital 
requirement would be the ``credit equivalent amount'' of the item, 
multiplied by the specific credit risk percentage requirement to which 
the item is assigned.
    Proposed Sec. 930.5(d) provides that the Finance Board shall 
determine initially, and update periodically, credit risk percentage 
requirements for various categories of credit risk for on-balance sheet 
assets and off-balance sheet items, using data from NRSROs and any 
other relevant sources to calculate estimates of credit losses 
associated with the particular categories. The estimates of credit risk 
are required to represent the credit losses that could be expected to 
occur on the particular categories of instruments during periods of 
extreme credit stress, based on historical data that reflect the 
longer-term nature of credit cycles and span multiple credit cycles. 
The periodic updates to initial credit risk percentage requirements 
will be implemented by the Finance Board as amendments to 
Sec. 930.5(d)(3).
    The proposal includes, in Table 1 of proposed Sec. 930.5(d)(3), the 
percentages to be applied to the book value of on-balance sheet assets, 
or the credit equivalent amounts of off-balance sheet items, in 
determining a Bank's credit risk capital requirement. Cash and 
government securities are assigned to the zero percent category, 
meaning that they are deemed not to present any credit risk to the 
Bank. The proposal assigns increasing percentages (0.3, 0.6, 1.0, and 
1.3) to each of the four levels of investment grade ratings assigned by 
an NRSRO (i.e., triple-A, double-A, single-A, triple-B), and treats 
credit risk from advances as equivalent to credit risk associated with 
the highest category of investment grade credit ratings. The proposal 
also includes a credit risk percentage for a Bank's tangible assets, 
``Premises, Plant and Equipment,'' to be set at 8.0 percent, which is 
consistent with the Basle Accord. Investments that are downgraded below 
investment grade after being acquired by a Bank would be assigned 
higher credit risk percentages: 12.0 percent for assets with the 
highest rating below investment grade; 50.0 percent for assets with the 
second highest rating below investment grade; and 100 percent for all 
other assets downgraded below investment grade.
    In assigning only cash and direct obligations of the U.S. 
government to the zero credit risk category, the proposal is more 
restrictive than the Basle Accord, which assesses zero credit risk 
capital for all Organization for Economic Cooperation and Development 
(OECD) government obligations, although proposed revisions to the Basle 
Accord would treat all triple-A and double-A rated sovereign 
obligations as free of credit risk. The proposal would treat Bank 
advances as a triple-A rated credit exposure. The assignment of 
advances to a triple-A credit risk category is based on factors such as 
the historical credit loss record for Bank advances (no credit losses 
have been incurred on the advance portfolio), the conservative lending 
and collateral management policies of each Bank (all classes of 
collateral are discounted based on risk), the blanket lien arrangements 
that some Banks employ with certain members over all of the assets of 
that member, the statutory priority lien, which gives the Banks 
priority over other secured creditors (so long as those secured 
interests are not perfected, see 12 U.S.C. 1430(e)), and a statutory 
stock purchase requirement that requires a member to maintain an 
investment in the Bank at least equal to 5 percent of its outstanding 
advances. See id.
    The Finance Board considered treating advances as cash or direct 
obligations of the U.S. government and assigning a zero credit risk 
capital requirement. However, two credit rating agencies expressed 
their opinion that such treatment is not appropriate for advances--
i.e., that advances should not be treated as equivalent to credit risk 
free investments. The two rating agencies expressed their preference 
for advances being treated as triple-A rated assets. Based on the 
historical (over 60 years) experience of zero credit losses for 
advances versus rating downgrades leading to eventual credit losses on 
triple-A rated corporate securities, an argument can be made that 
advances are a better credit than triple-A rated assets. As a result, 
advances may be treated as assets that pose credit risk somewhere 
between U.S. government securities and triple-A rated corporate 
securities. At this time, the Finance Board is proposing to treat 
advances as triple-A rated assets and is requesting comments from 
interested parties as to whether a satisfactory analytical framework 
exists that can be used to determine a more appropriate capital charge 
for the credit risk of advances.
    Based on data obtained from Moody's, the worst default frequency 
over a two-year horizon for triple-A rated corporate debt is 0.0. In 
fact, a triple-A rated security has never defaulted at the time it was 
still rated triple-A. Given a sufficiently long period of time, 
however, even triple-A rated corporate credits will default following 
rating downgrades.\9\ In fact, some triple-A rated credits have been 
downgraded within a year after receiving the triple-A rating. In 
addition, the market credit spreads for triple-A rated securities can 
widen without any change in credit

[[Page 52177]]

ratings.\10\ Credit deterioration and spread widening can lead to 
losses in market value for triple-A rated securities within a 
relatively short time after such securities are assigned a triple-A 
rating. Because such risks exist and the holding periods associated 
with long-term held-to-maturity securities are relatively long, the 
proposal adopts a conservative approach and requires 0.3 percent 
capital to be maintained for triple-A rated credit exposures. This 
number is a linear interpolation of the estimated credit losses for 
U.S. government securities and double-A rated debt. Moreover, this 
requirement is consistent with the results from an internal models-
based estimate for credit risk capital for triple-A rated corporate 
bonds held in a diversified trading portfolio of a large commercial 
bank, which is 0.26 percent.\11\
---------------------------------------------------------------------------

    \9\ According to Moody's data from 1970 to 1998, over a 4-year 
default horizon, the worst historical probability of default 
(default rate) for triple-A rated debt is 1.21 percent.
    \10\ This applies equally to triple-A rated securities issued by 
GSEs.
    \11\ This estimate is based on a 10 business day horizon and a 
99th percentile of the value at risk distribution as required under 
the Amendment for calculating credit risk capital for debt 
instruments held in the trading portfolios of large banks. The 
estimate of 0.26 percent reflects a multiplier of 4 which is the 
highest multiplier that may be required under the Amendment. In 
addition to the possibility of default, this estimate captures 
potential deterioration in credit risk and widening of credit 
spreads in the market. If the underlying distribution of value at 
risk is approximately normal, the multiplier of 4 effectively 
extends the 10 day horizon to 160 business days, or approximately 8 
months. The holding periods relevant to long-term debt instruments 
held in banking portfolios are longer and commercial banks generally 
use 1 year for calculating economic capital requirements.
---------------------------------------------------------------------------

    Credit risk capital requirements for double-A, single-A, triple-B 
and double-B rated credit exposures in the proposal are generally equal 
to the worst default rate observed over two-years by Moody's in data 
collected from 1970-1998. To preserve consistency between credit 
ratings and capital requirements, the proposed requirement for a 
single-A rated credit exposure is set equal to the average of the 
capital requirements for double-A and triple-B rated instruments.\12\ 
Also, a conservative zero recovery rate in default has been assumed for 
purposes of calculating the credit risk capital requirements. Defaulted 
bond price data from Moody's provides support for the zero recovery 
rate assumption under extreme credit stress conditions.\13\
---------------------------------------------------------------------------

    \12\ This is because over a 2 year horizon, the worst single-A 
rated default rate is lower than the corresponding double-A rated 
default rate.
    \13\ As for triple-A rated instruments, the proposed capital 
requirements for double-A, single-A, triple-B and double-B rated 
credit exposures are generally consistent with the results from an 
internal models-based estimate for credit risk capital for corporate 
bonds held in a diversified trading portfolio of a large commercial 
bank, which are 0.77, 1.00, 2.40 and 5.24 percent, respectively.
---------------------------------------------------------------------------

    Under proposed Sec. 955.3(a)(3), the Banks would not be authorized 
to invest in debt instruments rated below investment grade. If an 
investment were to be downgraded after acquisition by a Bank to the 
second highest rating below investment grade (single-B rating), the 
proposal would assign it to the 50 percent credit risk percentage, 
which the Finance Board believes to be a conservative level for such an 
exposure. Any credit exposures rated at triple-C or below would be 
placed in the 100 percent credit risk capital category.
    Under proposed Secs. 940.3(e) and 955.2(e), a Bank may make equity 
investments in the stock of a SBIC, in government-aided economic 
development entities, and in certain entities that are permissible 
investments for national banks, that are not rated but are defined in 
this proposal as core mission activities of the Banks. The proposal 
would assign investments in these types of entities to the 8.0 percent 
credit risk percentage category. This requirement is based upon, and is 
consistent with, the risk-based capital requirements for investments in 
such entities by national banks established by the OCC. For SBICs, the 
8 percent requirement is likely conservative given changes to the SBIC 
program implemented in 1994. In addition, consistent with the public 
purpose of GSEs, the Finance Board wants to encourage the Banks to give 
every consideration to investments that will provide targeted 
assistance to people in underserved low and moderate-income 
communities.
    The following table, which is set forth in proposed 
Sec. 930.5(d)(3), presents the credit risk percentage capital 
requirements for each category of credit exposures described above:

               Credit Risk Capital Requirements for Banks
------------------------------------------------------------------------
                                                              Percent of
                                                              on-balance
                    Credit risk category                        sheet
                                                              equivalent
                                                                value
------------------------------------------------------------------------
                   Authorized Investments
Cash and U.S. Government Securities........................          0.0
Advances...................................................          0.3
Highest Investment Grade--triple-A.........................          0.3
Second Highest Investment Grade--double-A..................          0.6
Third Highest Investment Grade--single-A...................          1.0
Fourth Highest Investment Grade--triple-B..................          1.3
Premises, Plant, and Equipment.............................          8.0
Core Mission Equity Investments Under Sec.  940.3(e).......          8.0
   Investments Downgraded to Below Investment Grade After
                   Acquisition by a Bank
Highest Below Investment Grade--double-B...................         12.0
Second Highest Below Investment Grade--single-B............         50.0
All Other Below Investment Grade--At or Below triple-C.....        100.0
------------------------------------------------------------------------

    The Finance Board expects that the above capital requirements may 
change as comments on proposed Sec. 930.5(d)(3) are received and 
further research is undertaken before a final rule is published. Even 
after a final rule is adopted, the Finance Board anticipates that it 
will periodically amend the capital requirements reflected in the chart 
above as additional data is available and new methodologies become 
feasible.
    One of the limitations of the Basle Accord was its failure to 
consider the term structure of credit risk, such that an overnight 
exposure would receive the same capital charge as a 2 or a 10 year 
exposure. However, under the Amendment, the term structure of credit 
risk can be fully recognized for trading portfolios of large banks with 
satisfactory internal models and is partially recognized for others 
through a standardized table. In addition, the recently proposed 
Framework addresses this limitation in the Basle Accord by according 
limited recognition to the term structure of credit risk. The Farm 
Credit Administration similarly accords limited recognition to the term 
structure of credit risk in their risk-based capital requirements for 
the farm credit banks. In proposed Sec. 930.5(d)(3), there is no such 
recognition given to the term structure of credit risk. However, the 
Finance Board realizes that a significant proportion of the Banks' 
assets have maturities within 1 month and, therefore, intends to 
undertake further research on incorporating term structure of credit 
risk into Sec. 930.5(d)(3). At this time, the Finance Board requests 
comments on the treatment of term structure of credit risk.
    c. Bank determination of specific credit risk percentage 
requirements. Section 930.5(d)(4)(i) of the proposed rule would require 
each Bank to determine the credit risk capital requirement for each 
asset and item first by determining its type and its credit rating (if 
any), then by determining its

[[Page 52178]]

appropriate risk category and applying the applicable credit risk 
percentage for that risk category under Table 1. The proposal includes 
guidance for the Banks on how to determine the credit rating for a 
particular asset or item. If an asset or item is directly rated by an 
NRSRO, the Banks must use that rating. If an asset or item is not rated 
directly by an NRSRO, but its issuer or guarantor is so rated or the 
asset or item is backed by collateral that is so rated, then a Bank may 
use the highest rating given to the issuer, guarantor, or collateral, 
to the extent that the issuer, guarantor, or collateral supports the 
asset or item held by the Bank. If the asset or item is not fully 
backed by a rated issuer, guarantor, or collateral, then only the 
portion to which such rated support applies may receive the highest 
rating noted above; the portion of the asset or item that is not so 
supported must be assigned to the category that would be appropriate 
for such an asset on a stand alone basis. For example, if up to 25 
percent of a triple-B asset is guaranteed by a triple-A-rated entity, 
then 25 percent of the value of the asset may be assigned to the 
highest investment grade category with a capital requirement of 0.3 
percent and the remaining 75 percent of the value of the asset will be 
assigned to the fourth highest investment grade category with a capital 
requirement of 1.3 percent.
    The proposal further provides that the Banks shall disregard 
modifiers attached to a particular credit rating. Thus, an asset with 
an A+ rating and an asset with an A- rating would both be placed in the 
A category for risk-based capital purposes. NRSROs generally assign 
rating modifiers such as ``1'', ``2'' and ``3'' or ``+'' and ``-'' 
along with letter grades. Such modifiers are provided to further 
distinguish among credit risks that are assigned identical letter 
grades. Consequently, historical samples containing default activity 
for each modified letter grade are smaller than what they would be if 
modifiers were ignored. The smaller sample size makes it difficult to 
calculate credit risk capital requirements corresponding to modified 
ratings with some degree of statistical precision and confidence. 
Therefore, the Finance Board is proposing to disregard rating 
modifiers. This is consistent with the treatment specified for 
investment grade credit exposures under the Amendment and the 
Framework.
    The proposal also provides that where a particular asset or item 
has been rated multiple times by the same NRSRO, the Bank must use the 
most recent rating from that NRSRO, and that if an asset or item has 
received ratings from multiple NRSROs, the Bank must use the lowest of 
those ratings. If an asset is not rated by an NRSRO and does not fall 
within one of the categories in Table 1, the proposal would require a 
Bank to determine its own credit rating for the asset or item or 
relevant portion thereof using credit rating standards available from 
an NRSRO or other similar standards.
    As a general matter, collateral may be used to enhance the 
creditworthiness of a particular asset or item, which can result in a 
lower credit risk capital requirement for a Bank. The BCBS has 
recognized that the Basle Accord did not provide sufficient incentive 
for banks to reduce their credit risk by taking an interest in other 
collateral, and recently has proposed to extend the scope of collateral 
recognition to all financial assets--not just marketable securities. 
The Finance Board proposal would allow a Bank to look through to the 
collateral supporting a given asset or instrument for risk-based 
capital purposes if certain conditions are met. In order to recognize 
such collateral for capital purposes, the collateral must be held by 
the Bank (which could include being held by a third party custodian or 
by the member), must be legally available to absorb losses (i.e., the 
Bank must have a legal right to liquidate the collateral), must have a 
readily determinable value at which it can be liquidated, and must be 
held in conformance with the Bank's collateral management policy. This 
would include arrangements under which a third-party custodian holds 
collateral from a Bank's counterparty and may not return the collateral 
to the counterparty without the express permission of the Bank. In 
using collateral to reduce the credit risk capital requirement, a bank 
must make appropriate allowance for haircuts or overcollateralization 
reflecting the market risk underlying the collateral.
    With respect to third-party guarantees, the proposal would 
recognize all third-party guarantees provided by any counterparty with 
an investment grade rating. This is consistent with that aspect of the 
proposal that would limit investments by the Banks to those with an 
investment grade rating. See proposed Sec. 955.3(a)(3).
    The proposed rule would allow on-balance sheet assets (underlying 
assets) that are hedged with credit derivatives to be assigned to the 
zero risk category under three scenarios specified in the rule. Even if 
the credit risk capital requirement for the underlying asset is 
decreased through the use of a credit derivative, the applicable credit 
risk capital required for the derivative contract still would apply.
    Within an internal credit risk model in which credit risks are 
marked-to-market, recognition of offsets, or credit hedges, whether 
perfect or imperfect, can be readily accommodated. Large commercial 
banks have accomplished this as part of their credit risk, value at 
risk models for trading portfolios. Under the proposed rule, some of 
the offsets will be recognized. If the offset is perfect (i.e., the two 
positions are of identical remaining maturity and relate to exactly the 
same instrument) it is straightforward to reduce the credit risk 
capital requirement for the underlying asset to zero (i.e., to grant 
full capital relief). For example, if a Bank purchases a triple-B rated 
corporate bond with a maturity of 5 years and at the same time enters 
into a 5-year credit default option contract based on the same bond 
(reference asset), the credit risk capital requirement for the 
underlying asset will be zero. The net credit risk capital requirement 
for the pair will equal the counterparty risk capital for credit 
exposure on the derivative contract.
    If the underlying asset and the referenced asset of a credit 
derivative are identical, but the remaining maturities are different, 
the capital relief in the proposed rule would depend on a maturity 
comparison between the two. If the same triple-B rated 5-year corporate 
bond was hedged with a credit derivative with a remaining maturity of 
2-years or longer, there would be no credit risk on the underlying 
asset within the Finance Board's proposed default horizon, which is 2 
years. Therefore, such a hedge would be fully recognized and the 
capital requirement on the underlying asset would be zero. However, if 
the derivative maturity were less than 2 years, no capital relief would 
be granted under the proposal. In all cases, there will be a 
counterparty risk capital requirement for credit exposure on the 
derivative contract. This issue will continue to be researched by the 
Finance Board during the comment period.
    If the remaining maturities of the underlying asset and a credit 
derivative are the same, but the underlying asset is different from the 
asset referenced in the credit derivative, capital relief for the 
underlying asset may or may not be granted. It is proposed that the 
capital requirement on the underlying asset be reduced to zero only if 
the referenced and the underlying assets have been issued by the same 
obligor, the referenced asset ranks pari passu to or more junior than 
the underlying asset, and cross-default clauses are in effect.
    If the remaining maturities of the two assets are identical but the 
underlying

[[Page 52179]]

asset and the referenced asset have been issued by different obligors, 
the proposed rule does not provide any capital relief for the 
underlying asset. For example, a Bank may invest in a triple-B rated 
bond issued by corporate entity X, but hedge the credit risk with a 
derivative based on triple-B rated bond issued by corporate entity Y, 
and where X and Y belong to the same industry. The Finance Board 
recognizes that such a hedge may provide significant credit protection 
to the Bank as there may be a high degree of default correlation 
between X and Y, and that capital relief for such hedges can be 
accommodated under an internal portfolio credit risk model. Thus, the 
Finance Board requests comments on whether to allow affected Banks to 
petition the Finance Board for capital relief on a case by case basis, 
provided the petition is accompanied by adequate data and analysis.
    d. Credit risk percentage requirements for off-balance sheet items. 
Off-balance sheet items may expose a Bank to credit risks similar to 
those associated with on-balance sheet assets. The Finance Board is 
proposing to apply the credit risk capital framework consistently to 
all on- and off-balance sheet instruments. Under proposed Secs. 930.5 
(e) and (f), the Banks are required to convert all off-balance sheet 
credit exposures into equivalent on-balance-sheet credit exposures 
(credit equivalent amounts) and then apply the ratings-based framework 
in Table 1 to estimate the credit risk capital requirement. The Finance 
Board would allow the Banks to use Finance Board approved internal 
models to convert some or all off-balance sheet credit exposures into 
equivalent on-balance-sheet credit exposures. For Banks that lack 
appropriate internal models, the Finance Board is proposing to adopt 
the Basle Accord treatment for such instruments as used by the other 
federal bank regulatory agencies to convert an off-balance sheet credit 
exposure into an equivalent on-balance-sheet exposure.
    Under the Basle Accord as incorporated by the federal bank 
regulatory agencies, off-balance sheet instruments, other than 
derivative contracts, that are substitutes for loans (e.g., standby 
letters of credit serving as financial guarantees for loans and 
securities) have the same credit risk as an on-balance sheet direct 
loan. For some off-balance sheet instruments, the full face value, or 
notional amount, is not exposed to credit risk. This means that a 
dollar of off-balance sheet exposure may be equivalent to less than a 
dollar of on-balance sheet exposure. The following table (Table 2 in 
proposed Sec. 930.5(e)), which includes the same categories as are used 
by the federal bank regulatory agencies and those proposed under the 
Framework, presents credit exposure conversion factors that are to be 
multiplied by the face amount of an off-balance sheet instrument other 
than a derivative contract.

    Credit Conversion Factors for Off-Balance Sheet Items Other Than
                          Derivative Contracts
------------------------------------------------------------------------
                                                                Credit
                                                              conversion
                         Instrument                           factor (in
                                                               percent)
------------------------------------------------------------------------
Standby letters of credit..................................          100
Asset sales with recourse, where credit risk remains with    ...........
 the Bank..................................................
Sale and repurchase agreements.............................  ...........
Forward asset purchases....................................  ...........
Commitments to make advances or other loans with certain     ...........
 drawdown \1\..............................................
Other commitments with original maturity of over one year..           50
Other commitments with original maturity of one year or              20
 less......................................................
------------------------------------------------------------------------
\1\ I.e., where it is known during the pendency of the commitment that
  the advance or loan funds definitely will be drawn in full.

    The credit conversion factor would be zero for Other Commitments 
that are unconditionally cancelable, or that effectively provide for 
automatic cancellation, due to deterioration in a borrower's 
creditworthiness, at any time by the Bank without prior notice. The 
Finance Board would allow the Banks to use Finance Board approved 
internal models to calculate credit conversion factors instead of those 
specified in Table 2. These factors were developed by the BCBS and 
adopted by other federal bank regulatory agencies. Under the Basle 
Accord, a 100 percent conversion factor is assigned to an off-balance 
sheet instrument where the instrument is a direct credit substitute and 
the credit risk is equivalent to that of an on-balance sheet exposure 
to the same counterparty. A 50 percent conversion factor is assigned to 
an off-balance sheet instrument where there is a significant credit 
risk but mitigating circumstances exist which suggest less than full 
credit risk. A 20 percent conversion factor is assigned to an off-
balance sheet instrument where there is a small credit risk but not one 
which can be ignored. The Finance Board intends to undertake further 
research on the magnitude and appropriateness of the credit conversion 
factors set forth in proposed Sec. 930.5(e) and may revise them before 
a final rule is published.
    e. Credit risk percentage requirements for derivative contracts. 
Proposed Sec. 930.5(f) provides that for market driven instruments 
(over-the-counter derivative contracts such as swaps, forwards, 
options, etc.) subject to counterparty default, the credit risk capital 
requirement will be based on both current and potential credit 
exposures. In recognizing collateral, the haircuts requirement under 
proposed Sec. 930.5(d)(4)(iv) to reflect the market risk embedded in 
the collateral would apply. The derivatives contracts may be based on 
underlying market interest rates or prices and may include credit-
linked contracts. The credit equivalent amount for a derivative 
contract is equal to the sum of: the current credit exposure (sometimes 
referred to as the replacement cost) of the contract; and the potential 
future credit exposure (sometimes referred to as the potential future 
replacement cost) of the contract.
    Proposed Sec. 930.5(f)(1) provides that the current credit exposure 
is equal to the maximum of the mark-to-market value of the contract and 
zero, as contracts with negative mark-to-market values do not create 
any current credit exposure for a Bank.
    Proposed Sec. 930.5(f)(2) provides that the potential future credit 
exposure (PFE) of a contract shall be determined by using an internal 
market risk model approved by the Finance Board or, in the case of 
Banks that lack appropriate internal models to calculate PFE, using the 
Basle Accord's standardized approach set forth in Table 3 of the 
proposed rule.\14\ Under this approach, the PFE of a contract, 
including a contract with a negative mark-to-market value, is estimated 
by multiplying the effective notional principal amount of the contract 
by a credit conversion factor for the underlying market risk as 
specified in Table 3, as follows:
---------------------------------------------------------------------------

    \14\ See BCBS, Basle Capital Accord: Treatment of Potential 
Credit Exposure for Off-Balance Sheet Items (Apr. 1995). The BCBS 
ran Monte Carlo simulations on numerous contracts before determining 
the conversion factors included in Table 3.

[[Page 52180]]



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

    Under the proposed rule, forwards, swaps, purchased options and 
similar derivative contracts that are not included in the Interest 
Rate, Foreign Exchange and Gold, Equity, or Precious Metals except Gold 
categories shall be treated as Other Commodities for purposes of Table 
3. If a Bank determines not to use an internal model for single 
currency interest rate swaps in which payments are made based upon two 
floating indices (floating/floating or basis swaps), the PFE for such 
swaps shall be zero. If a Bank determines to use Table 3 for credit 
derivative contracts, the credit conversion factors applicable to 
Interest Rate Contracts under Table 3 shall apply.\15\ If a Bank 
determines to use an internal model for a particular type of derivative 
contract, the Bank shall use the same model for all other similar types 
of contracts. However, the Bank may use an internal model for one type 
of derivative contract and Table 3 for another type of derivative 
contract. In other words, within each category of market risks, a Bank 
would not be allowed to arbitrage between capital requirements based on 
Table 3 and internal models.\16\
---------------------------------------------------------------------------

    \15\ The BCBS has yet to determine conversion factors for credit 
derivatives. Given that fluctuations in investment grade credit 
spreads are generally of a smaller magnitude than shifts in the 
level of interest rates, it appears that the potential future 
changes in the market value of credit-linked contracts should not 
generally exceed potential shifts in the market value of interest 
rate linked contracts. The Finance Board plans to examine any credit 
derivative contracts that the Banks may enter into and require 
larger conversion factors for credit derivatives, if necessary.
    \16\ A Bank that uses an internal model for simple interest rate 
contracts may utilize Table 3 for interest rate contracts with 
embedded options, stand-alone interest rate options or other 
complex/structured contracts. The reverse may not be allowed as a 
Bank that is capable of internally calculating PFE for complex/
structured contracts must use such internal model for simple 
contracts.
---------------------------------------------------------------------------

    The proposed rule does not contain any specific means to account 
for portfolio diversification effects. Consequently, the proposal would 
require the same regulatory capital charge for two portfolios that are 
of the same credit quality, but where the credit risk of one is 
significantly more concentrated than that of the other. However, as 
noted by the BCBS, this limitation may be effectively addressed in a 
portfolio-based internal credit risk capital framework. Portfolio 
credit risk modeling is a long-term project for the BCBS; ultimately, 
it is anticipated that sophisticated banking institutions would employ 
a comprehensive portfolio risk modeling approach under which regulatory 
capital requirements would be based entirely on internal models. 
Similarly, the Finance Board will encourage the Banks to develop 
internal credit risk models. Building such an internal model should not 
be a formidable task for the Banks, given that their portfolios largely 
consist of credit exposures that may be rated and almost all the Banks' 
counterparties are financial institutions. The remaining unrated 
exposures are insignificant and may be dealt with outside a credit risk 
model.
    Proposed Sec. 930.5(g) sets forth the requirements for calculation 
of credit equivalent amounts for multiple derivative contracts subject 
to a qualifying bilateral netting contract. The provisions in the 
proposal are consistent with the requirements set forth in the risk-
based capital guidelines of the federal bank regulatory agencies.
6. Market Risk Capital Requirement--Sec. 930.6
    a. Background. Section 930.6(a) of the proposed rule provides that 
a Bank's market risk capital requirement shall equal the market value 
of the Bank's portfolio at risk from movements in market prices, i.e., 
interest rates, foreign exchange rates, commodity prices and equity 
prices, as could occur during periods of extreme market stress, as 
determined using the Bank's internal market risk model approved by the 
Finance Board.
    Market risk may be defined as the risk that the market value of a 
Bank's portfolio will decline as a result of changes in the general 
level of interest rates, foreign exchange rates, equity and commodity 
prices.
    The Banks engage in activities that carry complex on- and off-
balance sheet market risks. For example, CO issuances, for which the 
Banks are jointly and severally liable, include: structured notes 
having embedded options and exotic features; callable, putable and 
index amortizing bonds; bonds that amortize based on a particular 
mortgage pool; bonds denominated in foreign currencies; and bonds 
linked to equity prices or foreign interest rates. To hedge the market 
risk on such complex instruments, the Banks enter into off-balance 
sheet derivative contracts that reflect the risks embedded in those 
bonds.
    The Banks also make advances on a simple fixed or floating rate 
basis, as well as callable, putable/convertible and amortizing 
advances. The Banks also have invested in agency bonds with callable 
and structured features, mortgage and mortgage-backed instruments with 
embedded options, and collateralized mortgage obligations.
    Given that the Banks undertake transactions that carry market risks 
similar to the risks incurred by large banks or securities dealers, the 
Finance Board believes that the capital regime for the Banks' market 
risks should be similar to the market risk capital requirements 
established or recommended by the Basle Committee and other financial 
institution regulatory agencies, but broader in scope.
    As previously discussed, the drive to institute a risk-based 
capital system for general market risk has been spearheaded by the 
BCBS. Following the BCBS's lead, the federal bank regulatory agencies 
(Office of the Comptroller of the Currency (OCC), Federal Reserve Board 
(FRB) and Federal Deposit Insurance Corporation (FDIC)) issued a joint 
final rule in September 1996 (12 CFR parts 3, 208, 225 and 325) to 
incorporate a measure for market risk, effective as of January 1, 1998 
(Joint Rule). Institutions whose trading activity (defined in the Joint 
Rule as total assets plus total liabilities in the trading portfolio) 
equals 10

[[Page 52181]]

percent or more of their total assets, or whose trading activity equals 
$1 billion or more, must use an internal model (with standardized 
parameters as set in the Joint Rule) to calculate the capital they must 
hold to support their exposure to general market risk. Positions 
covered by the rule include: (i) all positions in an institution's 
trading account; and (ii) foreign exchange and commodity positions 
whether or not in the trading account.
    Overall, the Joint Rule implements market risk based capital 
requirements that are based on actual risks undertaken by large banks. 
This is the only market risk capital framework that has been both 
agreed to internationally and implemented in a number of countries. 
Under the Joint Rule, large banks in the United States generally have 
adopted a simulation-based approach that is capable of capturing market 
risks from holding a wide range of simple, exotic and structured 
instruments--with or without options and based on mortgages or other 
types of transactions.
    Financial institutions regulated by the Office of Thrift 
Supervision (OTS) (12 CFR 567.5) and the Farm Credit Administration (12 
CFR 615.5205, 615.5210) currently are subject to the Basle Accord's 
credit risk capital requirements that contain no market risk capital 
components (consistent with the small bank regulatory capital 
framework). However, the Office of Federal Housing Enterprise Oversight 
(OFHEO) recently published a Notice of Proposed Rulemaking including 
its regulatory model for calculating risk-based capital for Fannie Mae 
and Freddie Mac; that model does account for both interest rate risk 
and credit risk. See 12 CFR part 1750. The OFHEO interest rate risk 
based capital rule is based on the Federal Housing Enterprise Financial 
Safety and Soundness Act of 1992 (1992 Act), which requires that 
capital requirements account for market risks. The market risk capital 
requirement is determined by a stress test, which examines the effects 
of two specified interest rate shocks. See 12 U.S.C. 4611(a)(2).
    Currently, the Banks are not subject to any market risk capital 
requirements. The FMP requires that the Banks limit their interest rate 
risk based on a methodology that uses interest rate shocks similar to 
those proposed but never adopted by the three U.S. bank regulatory 
agencies (the OCC, the FRB and the FDIC) and the OTS. The FMP requires 
the Banks to limit interest rate risk by maintaining the duration of 
their equity to within +/-5 years. The FMP also requires the Banks to 
maintain the duration of their equity to +/-7 years under an assumed 
change in interest rates of +/-200 basis points.
    The Finance Board does not believe that the FMP interest rate risk 
methodology is sufficiently flexible to continue to capture the market 
risks undertaken by the Banks in line with the developments in market 
risk measurement and management. Accordingly, this proposed rule sets 
forth market risk measures consistent with the value at risk (VAR) 
framework for calculation of market risk capital adopted by the BCBS 
and other financial institution regulators, an approach that can be 
implemented with commercially available models, is practical, and is 
sufficiently rigorous.
    b. Measurement of market value at risk under Bank internal market 
risk model. Section 930.6(b)(1) of the proposed rule requires each Bank 
to measure, as the market risk component of its risk-based capital 
requirement, the market value at risk using an internal VAR model, 
subject to the parameters in the proposed rule. The VAR must be 
calculated for interest rate, foreign exchange rate, equity price, and 
commodity price risks undertaken by the Bank, including related 
options. Currently, the Banks are required by the FMP to hedge risk 
associated with foreign exchange rates, equity prices, and commodity 
prices with matching derivative contracts. Therefore, the bulk of the 
proposed market risk capital requirement will reflect interest rate and 
related options risks. Although the Banks will have to consistently 
apply the VAR framework to instruments linked to foreign exchange 
rates, equity prices, and commodity prices, these other market risks 
currently pose a smaller amount of risk, relative to interest rate 
risk.
    Under proposed Sec. 930.6(b)(1), each Bank must use an internal 
market risk model that measures the market value of its portfolio at 
risk during periods of extreme market stress arising from all sources 
of market risks based on the Bank's holdings of on-balance sheet assets 
and liabilities and off-balance sheet items, including risks associated 
with related options. Proposed Sec. 930.6(b)(2) provides that the 
Bank's internal market risk model may use any generally accepted 
measurement technique, such as variance-covariance models, historical 
simulations, or Monte Carlo simulations, for estimating the market 
value of the Bank's portfolio at risk, provided that any measurement 
technique used must cover the Bank's material risks. Proposed 
Sec. 930.6(b)(3) provides that the Bank's internal market risk model 
must measure the risks arising from the non-linear price 
characteristics of options and the sensitivity of the market value of 
options to changes in the volatility of the option's underlying rates 
or prices. For example, a variance-covariance methodology may be 
sufficient for instruments that contain no optionality, while it would 
be essential to use a simulation technique for instruments with options 
characteristics.
    Section 930.6(b)(4) of the proposed rule provides that the Bank's 
internal market risk model must use interest rate and market price 
scenarios for estimating the market value of the Bank's portfolio at 
risk, but must at a minimum include: (i) Monthly estimates of the 
market value of the Bank's portfolio at risk so that the probability of 
a loss greater than that estimated shall be no more than 1 percent; 
(ii) scenarios that reflect changes in rates and market prices 
equivalent to those that have been observed over 90-business day 
periods of extreme market stress \17\ (for interest rates, the relevant 
historical observation period specified in Sec. 930.6(b)(4) is to start 
from the end of the previous month and go back to the beginning of 1978 
and the VAR measure may incorporate empirical correlations among 
interest rates, subject to a Finance Board determination that the 
model's system for measuring such correlations is sound); and (iii) the 
two interest rate scenarios required to be used by OFHEO to determine 
the risk-based capital requirements for Fannie Mae and Freddie Mac, 
pursuant to 12 U.S.C. 4611(a)(2).
---------------------------------------------------------------------------

    \17\ If the underlying distribution for VAR is approximately 
normal, the multiplier of 3 effectively extends the 10 business day 
horizon required under the Amendment to 90 business days and applies 
to large banks with satisfactory internal models, as determined by 
regulators.
---------------------------------------------------------------------------

    Proposed Sec. 930.6(b)(5) provides that if a Bank participates in 
COs denominated in a currency other than U.S. Dollars or linked to 
equity or commodity prices, and these instruments have been hedged for 
foreign exchange, equity and commodity risks, the Bank's internal 
market risk model must be used to calculate the market value of its 
portfolio at risk due to these market risks and using the qualitative 
and quantitative requirements specified in the proposed rule, i.e., the 
probability of a loss greater than that estimated must not exceed 1 
percent and must include scenarios that reflect changes in rates and 
market prices that have been observed over 90-business day periods of 
extreme market stress. This requirement reflects the conservative 
approach adopted by the Finance Board

[[Page 52182]]

with respect to the Banks' safety and soundness and the comprehensive 
measurement of all market risks throughout each Bank.
    The market valuations for COs may differ from valuations for 
matching hedging instruments in the derivative market because of 
different assumptions concerning the underlying discount curves, 
volatilities and correlations. Prices in the two markets may not be the 
same and may fail to move in perfect correlation over time. Therefore, 
some measure of market risk remains even if the foreign exchange, 
equity or commodity risks are hedged with matching derivative 
contracts. The Finance Board believes foreign exchange rates, equity 
prices, and commodity prices pose a relatively small amount of market 
risk to the Banks at this time. For calculation of value at risk due to 
foreign exchange rates, equity and commodity prices, historical 
observation data from an appropriate period satisfactory to the Finance 
Board must be used. The value at risk measure may incorporate empirical 
correlations within foreign exchange rates, equity prices, and 
commodity prices, but not among the three risk categories, subject to a 
Finance Board determination that the model's system for measuring such 
correlations is sound.
    Proposed Sec. 930.6(b)(5)(iv) provides that if there is a default 
on the part of a counterparty to a derivative contract linked to 
foreign exchange rates, equity prices or commodity prices, the Bank 
must enter into a replacement contract in a timely manner and as soon 
as market conditions permit. Besides strengthening safety and 
soundness, this requirement formalizes the long standing practice at 
the Banks under which the Banks have not assumed an open (unhedged) 
foreign exchange, equity or commodity position and is consistent with 
the requirement in proposed Sec. 955.3(b) that the Banks shall not 
engage in an open foreign exchange, equity and commodity position.
    c. Independent validation of Bank internal market risk model. 
Section 930.6(c) of the proposed rule provides that each Bank shall 
conduct an independent validation of its internal market risk model 
within the Bank or obtain independent validation by an outside party 
qualified to make such determinations, on an annual basis, or more 
frequently as required by the Finance Board. In order for validations 
conducted within the Bank to be considered independent, the validation 
must be carried out by personnel not reporting to the business line 
responsible for conducting business transactions for the Bank. Such 
validation may include periodic comparisons, such as on a quarterly 
basis, of model generated mark-to-market values with values obtained 
from dealers/markets and periodic comparisons, such as on an annual 
basis, of model generated VAR values with values obtained from an 
independent third-party source. A Bank may use a representative sample 
of its on- and off-balance sheet instruments for this source. An 
integral part of this process is the necessity to validate key 
assumptions and associated parameters underlying the Bank's market risk 
models. For example, a Bank must periodically determine the impact on 
VAR of shifts in key parameters such as correlations or regime shifts 
in volatility parameters. The results of such validations must be 
reviewed by the Bank's board of directors and provided to the Finance 
Board.
    d. Finance Board approval of Bank internal market risk model. 
Section 930.6(d)(1) of the proposed rule provides that each Bank must 
obtain approval from the Finance Board of its internal market risk 
model, including subsequent material adjustments to the model made by 
the Bank, prior to the model's use. A Bank must make any subsequent 
adjustments to its model that may be directed by the Finance Board.
    e. Basis risk. Banks are exposed to basis risk, which is the risk 
that rates or prices of different instruments on the two sides of the 
balance sheet (after taking associated off-balance instruments into 
account) do not change in perfect correlation over time. The BCBS has 
emphasized the importance of basis risk as part of a comprehensive 
process for the management of interest rate risk.\18\ In the final 
rule, the Finance Board may require the Banks to submit a monthly 
report identifying the relevant interest rate or price indices along 
with related basis risk exposures. Based on an analysis of such reports 
and with the help of other relevant data, an assessment will be made as 
to the necessity of developing a basis risk measure to incorporate into 
the market risk capital requirement as an amendment to the final 
regulation. At this time, the Finance Board is requesting comments on 
the treatment of basis risk.
---------------------------------------------------------------------------

    \18\ See Principles for the Management of Interest Rate Risk 
(Jan. 1997).
---------------------------------------------------------------------------

    f. Transition provision. Section 930.6(d)(2) of the proposed rule 
would require each Bank to submit its initial internal market risk 
model to the Finance Board for approval within one calendar year of the 
effective date of the final rule.
7. Operations Risk Capital Requirement--Sec. 930.7
    Proposed Sec. 930.7 provides that each Bank's operations risk 
capital requirement shall at any time equal 30 percent of the sum of 
the Bank's credit risk capital requirement and market risk capital 
requirement at such time. Operations risk is defined in proposed 
Sec. 930.1 as the risk of an unexpected loss to a Bank resulting from 
human error, fraud, unenforceability of legal contracts, or 
deficiencies in internal controls or information systems. There is 
currently no generally accepted methodology for measuring the magnitude 
of operations risk. Therefore, the proposed rule adopts the same 
requirement imposed by statute on Fannie Mae and Freddie Mac. See 12 
U.S.C. 4611(c)(2).
8. Reporting Requirements--Sec. 930.8
    Proposed Sec. 930.8 provides that each Bank shall report to the 
Finance Board by the 15th day of each month its minimum total risk-
based capital requirement, by component amounts (credit risk capital, 
market risk capital, and operations risk capital), and its actual total 
capital amount and risk-based capital calculated as of the last day of 
the preceding month, or more frequently as may be required by the 
Finance Board.
9. Capital Stock Redemption Requirements--Sec. 930.9
    a. General. The Act establishes minimum stock purchase requirements 
for members for purposes of membership, see 12 U.S.C. 1426(b)(1), 
1430(e)(3), and for purposes of taking advances. Id. at 1430 (c), 
(e)(1). For a variety of reasons, such as a member's anticipation of a 
seasonal increase in advance borrowing, many members of the Bank System 
currently hold stock in a Bank in excess of the statutory minimum 
requirements.
    Pursuant to proposed Sec. 930.1 (definition of ``total risk-based 
capital for a Bank''), a Bank may allocate a percentage not exceeding 
50 percent of all outstanding capital stock satisfying the minimum 
capital stock purchase requirements for membership under sections 
6(b)(1) and 10(e)(3) of the Act of all voluntary members, and a 
percentage not exceeding 50 percent of all other outstanding capital 
stock, towards meeting the Bank's total risk-based capital requirement.
    Proposed Sec. 930.9(a) provides that the capital stock designated 
by a Bank to meet the Bank's total risk-based capital

[[Page 52183]]

can only be redeemed by the Bank with the approval of the Finance 
Board. This would be true even for institutions withdrawing from 
membership in the Bank System pursuant to section 6(e) of the Act. Id. 
at 1426(e). Proposed Sec. 930.9(b) provides that a Bank may at any time 
redeem any portion of a member's capital stock not included in or 
allocated by the Bank to the Bank's total risk-based capital, provided 
that the member's minimum capital stock purchase requirement for 
membership in the Bank System under sections 6(b)(1) and 10(e)(3) of 
the Act, id. at 1426(b)(1), 1430(e)(3), is maintained. The Bank may 
subject such redemptions to the six-month notice provision in section 
6(e) of the Act, id. at 1426(e), or may shorten or waive the six-month 
notice provision.
    The Finance Board's current regulations allow a Bank, after 
providing 15 calendar days advance written notice to a member, to 
conduct mandatory, unilateral redemption of excess stock, provided that 
the minimum stock requirements for membership under the Act are 
maintained. See 12 CFR 935.15(b)(1). This provision is retained in the 
proposed rule as Sec. 930.9(b)(3). Section 935.15(b)(2) of the Finance 
Board's current regulations, 12 CFR 935.15(b)(2), provides that a Bank 
may not impose on or accept from a member a fee in lieu of the 
mandatory redemption of the member's capital stock. This provision also 
is being retained in the proposed rule as Sec. 930.9(b)(4).
    The redemption scheme in the proposed rule is designed to maintain 
a level of permanence in the Bank's capital within the flexible overall 
risk-based capital framework of the proposal. In this way, the most 
permanent forms of capital are measured and used as a limitation on 
risk-taking activity. The permanent capital of each Bank, retained 
earnings and the minimum stock requirement of mandatory members, may be 
supplemented by less permanent capital only to the extent that each 
Bank designates it as risk-based and imposes on its members the risk 
that capital impairment will impede its redemption.
    b. Advance Notice of Proposed Rulemaking; Interim Final Rule. The 
Finance Board recently published an ANPRM requesting comment on whether 
each Bank should be required to unilaterally redeem its members' excess 
Bank capital stock to help achieve the goal of reducing the excess 
capital stock in each Bank and thereby to reduce each Bank's arbitrage 
of its GSE status in non-core mission assets. See 64 FR 16792 (Apr. 6, 
1999). Each of the Banks today holds investments that would not be core 
mission assets under the proposed rule. Banks with relatively high 
amounts of such investments also tend to have relatively high levels of 
excess capital stock. See id. at 16793-94.
    As discussed in the ANPRM, the Finance Board believes that the 
Banks' arbitrage activities for the purpose of generating sufficient 
earnings to pay adequate dividends on excess capital stock detract from 
the mission of the Banks to promote housing finance and community 
lending, by encouraging activities not related to the Banks' mission 
and thereby detracting from the financial incentive to engage in 
mission-related activity. See id. at 16794. A reduction in the amount 
of excess capital stock would reduce the amount of capital stock on 
which dividends must be paid, thereby reducing the level of arbitrage 
activities conducted in order to generate earnings to pay dividends on 
such capital stock. See id. Accordingly, the ANPRM requested comment on 
whether the Banks should be required to unilaterally redeem members' 
excess capital stock as a way to reduce excess capital stock in the 
Bank System and thereby reduce arbitrage activities in non-core mission 
assets by the Banks. See id. at 16795.
    For the reasons discussed above, the Finance Board also adopted an 
interim final rule amending Sec. 935.15(b) of its Advances Regulation 
to prohibit the Banks from imposing or accepting a fee in lieu of 
redeeming a member's excess capital stock. See 64 FR 16788 (Apr. 6, 
1999) (to be codified in 12 CFR 935.15(b)(2)).
    The Finance Board received 68 comment letters on the ANPRM, mostly 
opposing requiring the Banks to unilaterally redeem members' excess 
capital stock, for reasons including that it would adversely impact the 
Banks' financial management, daily operations, long-term customer 
relationships and flexibility in responding to market needs. The 
Finance Board received 4 comment letters on the interim final rule, 
with two commenters supporting and two commenters opposing the rule. 
The concerns about a Bank's arbitrage of its GSE status with non-core 
mission assets that the ANPRM and interim final rule attempted to 
address through mandatory reduction of excess capital stock, are 
addressed in a different fashion under the financial management and 
mission achievement provisions of this proposed rule. Accordingly, the 
Finance Board does not intend to pursue at this time the proposals 
raised for comment in the ANPRM, but is retaining Sec. 935.15(b)(2) of 
its Advances Regulation regarding the fee in lieu prohibition (as 
proposed Sec. 930.9(b)(4)).
10. Minimum Liquidity Requirements--Sec. 930.10
    Liquidity risk is defined in proposed Sec. 917.1 as the risk that a 
Bank would be unable to meet its obligations as they come due or meet 
the credit needs of its members and eligible nonmember borrowers in a 
timely and cost-efficient manner. In general, the liquidity needs of 
the Banks may be classified as: (1) operational liquidity; and (2) 
contingency liquidity. Operational liquidity addresses day-to-day or 
ongoing liquidity needs under normal circumstances, and may be either 
anticipated or unanticipated. Contingency liquidity addresses liquidity 
needs under abnormal or unusual circumstances in which a Bank's access 
to the capital markets is temporarily impeded. Under such unusual 
circumstances, a Bank may still need funds to meet all of its 
obligations that are due or to meet some of the credit needs of its 
members and eligible nonmember borrowers.
    Currently, the Banks operate under two general liquidity 
requirements. Both are easily met by the Banks. However, neither is 
structured to meet the Banks' liquidity needs should their access to 
the capital markets be limited for any reason. The first requirement is 
statutory and requires the Banks to maintain an amount equal to total 
deposits invested in either obligations of the United States, deposits 
in banks or trusts, or advances to members that mature in 5 years or 
less. See 12 U.S.C. 1421(g). The second liquidity requirement is in the 
FMP. It requires each Bank to maintain a daily average liquidity level 
each month in an amount not less than 20 percent of the sum of the 
Bank's daily average demand and overnight deposits and other overnight 
borrowings during the month, plus 10 percent of the sum of the Bank's 
daily average term deposits, COs, and other borrowings that mature 
within one year. See FMP section III.C.
    The proposed rule specifies a contingency liquidity requirement, 
but does not specify an operational liquidity requirement. However, 
proposed Sec. 917.3(b)(3)(iii) would require that each Bank's risk 
management policy indicate the Bank's sources of liquidity, including 
specific types of investments to be held for liquidity purposes, and 
the methodology to be used for determining the Bank's operational 
liquidity needs.
    Section 930.10 of the proposed rule provides that the Banks must 
meet not only the statutory liquidity

[[Page 52184]]

requirements contained in section 11(g) of the Act, 12 U.S.C. 1431(g), 
but also each Bank shall hold contingency liquidity in an amount 
sufficient to enable the Bank to cover its liquidity risk, assuming a 
period of not less than seven calendar days of inability to borrow in 
debt markets. Contingency liquidity may be provided through Banks: (1) 
selling liquid assets; (2) pledging government, agency and mortgage-
backed securities as collateral for repurchase agreements; and (3) 
borrowing in the federal funds market. Consequently, contingency 
liquidity is defined in proposed Sec. 930.1 as: (1) marketable assets 
with a maturity of one year or less; (2) self-liquidating assets with a 
maturity of seven days or less; and (3) assets that are generally 
accepted as collateral in the repurchase agreement market. Proposed 
Sec. 930.10 provides that an asset that has been pledged under a 
repurchase agreement cannot be used to satisfy the contingency 
liquidity requirement, since such an asset will not be available to 
provide liquidity should a contingency arise.
    The proposed seven-day contingency liquidity requirement would help 
to ensure that the Banks maintain sufficient liquidity to meet their 
funding needs should their access to the capital markets be temporarily 
limited by occurrences such as: (1) a power outage at the Bank System's 
Office of Finance (OF); (2) a natural disaster; or (3) a real or 
perceived credit problem. This requirement was calculated using daily 
data on CO redemptions during 1998. The Finance Board found that the 
99th percentile of the 5-business day CO redemption distribution 
resulted in liquidity requirements that ranged from about 5 percent to 
17 percent of each Bank's total assets.
    It is expected that the contingency liquidity requirement and the 
Banks' operational liquidity needs can be met within the core mission 
activities requirement in proposed Sec. 940.4. The Banks' capital and 
deposits are available to fund liquidity assets, and some core mission 
assets may also serve as liquidity assets. In addition, the Finance 
Board expects that the Banks' liquidity requirements will generally 
decline as they restructure their balance sheets to comply with the 
core mission activities requirements in proposed Sec. 940.4.
    The seven-day requirement may be viewed as conservative when 
examined in the context of events which could impair the normal 
operations of the OF. The likelihood that there would be no access to 
the capital markets for as long as five business days is extremely 
remote, given OF contingency plans to be back in operation within the 
same business day following a disaster. The OF contingency plans 
include back-up power sources and two back-up facilities, plus 
procedures to back-up their databases at both their main location as 
well as the primary alternative site. A back-up data tape from OF's 
main location is sent and stored off-site on a daily basis.
    Real or perceived concerns about creditworthiness of the Bank 
System could lead to a widening of the spreads to U.S. Treasury 
securities at which the Bank System COs are issued. Depending on the 
size of the increase in credit spreads, such an event could 
substantially impair the Banks' ability to carry out their mission. Two 
such episodes affecting other GSEs took place in the 1980s. In both 
cases, the interest rate spread narrowed back to normal levels only 
after the GSEs received assistance from the federal government.\19\ In 
the first instance, the spread to comparable U.S. Treasury securities 
for a Farm Credit System issue increased approximately 80 basis points 
within a 6 month period during 1985 as the Farm Credit System ran into 
financial difficulty and started posting losses. Fannie Mae underwent a 
similar episode in which its debt spread widened substantially.
---------------------------------------------------------------------------

    \19\ See Federal Reserve Bank of Richmond, Instruments of the 
Money Market 153 (1993).
---------------------------------------------------------------------------

    The likelihood that such an event could take place with respect to 
the Banks is remote and, in any event, would need to be addressed with 
resources beyond those dedicated to the contingency liquidity 
requirement. The seven-day contingency liquidity requirement provides 
policy makers with some time to address the underlying problem. 
Further, should a crisis arise affecting liquidity at all financial 
institutions, assistance would be needed from the Federal Reserve 
System, the U.S. Treasury, or the Congress.
    Other regulators also recognize the importance of adequate levels 
of liquidity but, for the most part, have not imposed liquidity 
requirements with the degree of specificity contained in the proposed 
rule. Specifically, depository institution regulators have not 
implemented any numeric ratios or other quantitative requirements with 
respect to liquidity. However, the importance of liquidity is reflected 
in the fact that it is one of the six components of the Uniform 
Financial Institutions Rating System (UFIRS) that was adopted by the 
Federal Financial Institutions Examination Council (FFIEC) on November 
13, 1979 and revised as of January 1, 1997. The UFIRS has been used as 
an internal supervisory tool for evaluating the soundness of financial 
institutions and for identifying those institutions requiring special 
attention or concern. Under 12 CFR 615.5134, each banking institution 
regulated by the Farm Credit Administration is required to maintain a 
minimum liquidity reserve. This liquidity reserve requirement ensures 
that Farm Credit System banks have a pool of liquid investments to fund 
their operations for approximately 15 days should their access to the 
capital markets become impeded. OFHEO has not published any regulation 
concerning liquidity requirements for Fannie Mae and Freddie Mac.
    Rating agencies also consider adequate liquidity an important 
component in a financial institution's rating. Liquid investments held 
by the Banks are stated by Moody's as one of the reasons behind the 
triple-A rating for the Banks.\20\
---------------------------------------------------------------------------

    \20\ Moody's Investor Service, Global Credit Research, Moody's 
Credit Opinions--Financial Institutions, (June 1999).
---------------------------------------------------------------------------

11. Limits on Unsecured Extensions of Credit to One Counterparty or 
Affiliated Counterparties; Reporting Requirements For Total Secured and 
Unsecured Extensions of Credit to One Counterparty or Affiliated 
Counterparties--Sec. 930.11
    a. Limits on unsecured extensions of credit. Section 930.11(a) of 
the proposed rule establishes maximum capital exposure limits for 
unsecured extensions of credit by a Bank to a single counterparty or to 
affiliated counterparties. Section 930.11(b) of the proposed rule 
establishes reporting requirements for total unsecured extensions of 
credit and total secured and unsecured extensions of credit to single 
counterparties and affiliated counterparties that exceed certain 
thresholds.
    Concentrations of unsecured credit by a Bank with a limited number 
of counterparties or group of affiliated counterparties raise safety 
and soundness concerns. Unlike Bank advances, which must be secured, 
unsecured credit extensions are more likely to result in limited 
recoveries in the event of default. Thus, significant credit exposures 
to a few counterparties increase the probability that a Bank may 
experience a catastrophic loss in the event of default by one of the 
counterparties. In contrast, holding small credit exposures in a large 
number of counterparties, while making a small

[[Page 52185]]

loss more likely, reduces the probability of a catastrophic loss to a 
Bank.
    Safety and soundness concerns also arise where a Bank's credit 
extensions are concentrated in a single counterparty whose debt, in 
turn, is concentrated in one or a few lenders. The fact that the 
counterparty's debt is concentrated may suggest that other lenders have 
declined to lend to such counterparty due to concerns about the 
counterparty's ability to repay a loan. The Bank's concentration of 
credit in such a counterparty may put the Bank's extensions of credit 
more at risk.
    In addition, where a Bank's extensions of credit to a single 
counterparty are in jeopardy of nonpayment, the Bank may be reluctant 
to take appropriate actions to reduce losses, such as declaring a 
default, or selling the loans, which could depress their price. 
Further, a Bank may even be tempted to lend additional funds to the 
counterparty to keep the counterparty in business, if that Bank has a 
significant credit exposure to the counterparty.
    Affiliated counterparties generally share aspects of common 
ownership, control or management. Thus, if one member of a group of 
affiliates defaults, the likelihood is high that other members of the 
affiliated group also are under financial stress. A Bank's unsecured 
extensions of credit to a group of affiliated counterparties thus 
should be aggregated in considering the Bank's unsecured credit 
exposure to any one counterparty in the affiliated group.
    Concentrations of credit by multiple Banks in a few counterparties 
also may raise safety and soundness concerns at the Bank System level. 
Several Banks in recent years have had unsecured credit exposures to 
affiliated counterparties that exceeded 20 percent of each Bank's 
capital. These credit exposures were to counterparties ranked at the 
second highest investment grade. A few counterparties have spread their 
exposure among several Banks. Such credit concentrations may result in 
large aggregate credit exposures for the Bank System, raising concerns 
regarding the liquidity of such debt in the event of adverse 
information regarding a counterparty.
    The risk-based capital requirements in the proposed rule do not 
take into account the increase in credit risk associated with 
concentrations of unsecured credit. Therefore, the Finance Board 
believes that it is necessary, for safety and soundness reasons, to 
impose separate limits on unsecured extensions of credit by a Bank to 
single counterparties and to affiliated counterparties. This is 
consistent with the regulatory approaches of other financial 
institution regulators. See, e.g., 12 CFR 32 (OCC's loans-to-one-
borrower limit is generally 15 percent of a national bank's capital and 
surplus).
    Currently, the FMP limits Bank unsecured extensions of credit to a 
single counterparty based on the credit rating of the counterparty. See 
FMP section VI. Under the FMP, the lower the credit rating of the 
counterparty, the lower the maximum permissible credit exposure limit, 
because the probability of default increases as the counterparty's 
rating decreases. The FMP does not impose limits on unsecured lending 
to affiliated counterparties, but does require the Banks to monitor 
such lending and impose limits if necessary. As of December 31, 1998, 
five Banks had adopted explicit unsecured credit exposure limits to 
affiliated counterparties.
    Consistent with the general approach of the FMP, 
Sec. 930.11(a)(1)(i) of the proposed rule provides that unsecured 
extensions of credit by a Bank to a single counterparty that arise from 
authorized Bank investments or hedging transactions shall be limited to 
the maximum capital exposure percent limit applicable to such 
counterparty, as set forth in Table 4 of the proposed rule, multiplied 
by the lesser of: (i) the Bank's total capital; or (ii) the 
counterparty's Tier 1 capital, or total capital if Tier 1 capital is 
not available. The maximum capital exposure percent limits applicable 
to specific counterparties in Table 4 range from a high of 15 percent 
for counterparties with the highest investment grade rating, to a low 
of 1 percent for counterparties with a below investment grade rating. 
These limits are consistent with those established internally by large 
lenders.
    Section 930.11(a)(1)(ii)(D) of the proposed rule provides that 
where a counterparty has received different credit ratings for its 
transactions with short-term and long-term maturities: (i) the higher 
credit rating shall apply for purposes of determining the allowable 
maximum capital exposure limit under Table 4 applicable to the total 
amount of unsecured credit extended by the Bank to such counterparty; 
and (ii) the lower credit rating shall apply for purposes of 
determining the allowable maximum capital exposure limit under Table 4 
applicable to the amount of unsecured credit extended by the Bank to 
such counterparty for the transactions with maturities governed by that 
rating. For example, if a counterparty has received a lower rating on 
its long-term debt than its short-term debt, the Bank will be more 
severely limited in the amount of the counterparty's long-term debt 
that it can hold. If the Bank wishes to hold any more of this 
counterparty's debt, it will be limited to holding the higher rated 
short term debt, up to a total amount of credit exposure governed by 
proposed Sec. 930.11(a)(1)(ii)(D)(1).
    Section 930.11(a)(1)(ii)(E) of the proposed rule provides that if a 
counterparty is placed on a credit watch for a potential downgrade by 
an NRSRO, the Bank shall determine its remaining available credit line 
for unsecured credit exposures under Table 4 by assuming a rating from 
that NRSRO at the next lower grade.
    Section 930.11(a)(2) of the proposed rule provides that the total 
amount of unsecured extensions of credit by a Bank to all affiliated 
counterparties may not exceed: (i) the maximum capital exposure limit 
applicable under Table 4 based on the highest credit rating of the 
affiliated counterparties; (ii) multiplied by the lesser of: (A) the 
Bank's total capital; or (B) the combined Tier 1 capital, or total 
capital if Tier 1 capital is not available, of all of the affiliated 
counterparties.
    b. Reporting requirement for total unsecured credit concentrations. 
Currently, there is no centralized mechanism for maintaining and 
measuring aggregate unsecured credit concentration exposure data at the 
Bank System level. As discussed above, Bank unsecured credit 
concentrations raise safety and soundness concerns at the Bank System 
level, as well as at the individual Bank level. The FMP does not 
establish maximum unsecured credit exposure limits or reporting 
requirements for aggregate unsecured credit concentrations at the Bank 
System level.
    Accordingly, Sec. 930.11(b)(1) of the proposed rule requires each 
Bank to report monthly to the Finance Board the amount of the Bank's 
total unsecured extensions of credit to any single counterparty or 
group of affiliated counterparties that exceeds 5 percent of: (i) the 
Bank's total capital; or (ii) the counterparty's Tier 1 capital (or 
total capital if Tier 1 capital is not available), or in the case of 
affiliated counterparties, the combined Tier 1 capital (or total 
capital if Tier 1 capital is not available) of all of the affiliated 
counterparties.
    The Finance Board will be considering limits on aggregate unsecured 
credit concentration exposures at the Bank System level for the final 
rule. The Finance Board specifically requests comments on whether such 
limits should be imposed and what the size and form of such limits 
should be.

[[Page 52186]]

    c. Reporting requirement for total secured and unsecured credit 
concentrations. Bank concentrations of secured credit, primarily 
advances, to a single counterparty or group of affiliated 
counterparties also may present safety and soundness concerns for 
individual Banks and the Bank System. Other financial institution 
regulators impose loans-to-one-borrower limits for secured as well as 
unsecured extensions of credit, with exceptions for loans secured by 
high-quality collateral. See, e.g., 12 CFR 932. There may be reasons to 
exclude concentrations of advances from such limits, given the extent 
of their overcollateralization, their statutory superlien protection 
and core mission activity status.
    Accordingly, Sec. 930.11(b)(2) of the proposed rule requires each 
Bank to report monthly to the Finance Board the amount of the Bank's 
total secured and unsecured extensions of credit to any single 
counterparty or group of affiliated counterparties that exceeds 5 
percent of the Bank's total assets. Because secured credit is supported 
by collateral, not capital, in the first instance, the Finance Board 
believes that exposures as a percent of assets rather than of capital 
is a more appropriate measure of the size of the exposure.
    The Finance Board will be considering limits on total secured and 
unsecured credit concentration exposures applicable to the Banks or the 
Bank System for the final rule. The Finance Board specifically requests 
comments on whether such limits should be imposed and what the size and 
form of such limits should be.

D. Part 940--Core Mission Activities Requirements

1. Bank Investment Practices
    By virtue of their GSE status, the Banks enjoy two major advantages 
over non-GSE borrowers in the capital markets: (1) the ability to 
borrow in the capital markets at rates only slightly above U.S. 
Department of the Treasury borrowing rates; and (2) the ability to 
issue large amounts of debt, including debt with complex structures. 
Given its duty under the Act to ensure that the Banks carry out their 
housing finance mission, the Finance Board has been concerned for some 
time that the Banks have used substantial amounts of the proceeds of 
their GSE borrowings to finance arbitrage investments.
    Prior to the thrift crisis of the late 1980s and the enactment of 
the Financial Institutions Reform, Recovery, and Enforcement Act of 
1989 (FIRREA), Pub. L. 101-73, 103 Stat. 183 (1989), the Banks' assets 
were primarily advances to thrift members for the purpose of funding 
home mortgage loans. The Banks' balance sheets expanded and contracted 
with thrift member demand for advances, and thus, generally reflected 
the cyclical nature of the housing and credit markets. During this 
period, the Banks maintained relatively small portfolios of investments 
in assets other than advances, generally for liquidity purposes. For 
the period from 1980 through 1988, advances represented, on average, 
about 84 percent of Bank System total assets, while total investments 
other than advances represented about 14 percent of Bank System total 
assets. Over the same time period, advances averaged 118 percent of 
COs, indicating that the Banks funded advances not only with COs, but 
also with a portion of deposits and capital. As a result of using all 
COs issued to fund advances, the Banks were using their GSE funding 
advantage only to enhance the availability of housing finance.
    Significant and rapid changes in the structure of the Bank System's 
balance sheet and its profitability occurred following the enactment of 
FIRREA. Among other things, the results of FIRREA included: (1) the 
liquidation of hundreds of failed thrift institutions, and the 
concomitant advance prepayments and stock redemptions; (2) the 
imposition of new and higher statutory capital requirements for thrifts 
that caused many Bank System thrift members to either reduce their 
asset size and prepay advances or to stop growing and reduce their 
demand for new advances during the early 1990s; (3) the transfer of 
$2.5 billion in Bank System retained earnings to the Resolution Funding 
Corporation (REFCorp) to help pay for the cost of thrift resolutions 
(in addition to the Banks' payment of $700 million in retained earnings 
to defease the Financing Corporation bonds as required under the 
Competitive Equality Banking Act of 1987); (4) the requirement that the 
Bank System make a $300 million annual payment of interest on the 
REFCorp bonds; and (5) the requirement that the Bank System make a 
payment, beginning in 1990, of the greater of five percent of net 
income or $50 million, and increasing by steps to the greater of ten 
percent of net income or $100 million in 1995 and thereafter, to fund 
the newly-required Affordable Housing Program (AHP). One other 
important provision of FIRREA allowed federally-insured commercial 
banks with at least ten percent of their assets in residential mortgage 
loans to join the Bank System.
    After the enactment of FIRREA, the Banks needed to generate a level 
of income sufficient to cover the decline in earnings associated with 
the transfer of over $3 billion in retained earnings to other 
government agencies, the statutorily mandated annual fixed REFCorp 
obligation of $300 million, contributions to the AHP and the prepayment 
of advances as a result of resolutions of insolvent members, while 
still providing dividends and benefits, primarily in the form of 
advances priced to reflect the Banks' GSE funding advantage, that would 
attract and retain member institutions. Reduced spreads on earning 
assets and a lower interest rate environment also contributed to the 
decline in System net income during the early 1990s. For these reasons, 
Bank investments in assets bearing little or no relation to the Banks' 
public purpose (primarily money market investments and mortgage backed 
securities (MBS)) increased during the years following the enactment of 
FIRREA. Of these two investment options, MBS have been appreciably more 
profitable per dollar invested.
    Therefore, to assist the Banks during this time, the Finance Board 
increased the Banks' MBS investment authority from 50 percent to 200 
percent of capital when it adopted the FMP in 1991. See Finance Board 
Res. No. 91-214 (June 25, 1991). In December 1993, the Finance Board 
again raised the Banks' MBS investment authority from 200 percent to 
300 percent of capital based on continuing concerns about the Banks' 
ability to generate income. See Finance Board Res. No. 93-133 (Dec. 15, 
1993). The Finance Board also increased the Bank System's regulatory 
leverage limit during this period. See Finance Board Res. No. 93-074 
(Sept. 22, 1993).
    The Finance Board initially limited MBS investment, as described 
above, in part because of concern about the Banks' ability to manage 
the interest rate and options risk associated with these assets. 
However, now that the Banks have developed more effective techniques 
for hedging these risks, and there are policy limits in place 
constraining the Banks' interest rate risk exposure, the MBS limit can 
be viewed less as a safety and soundness constraint and more as a means 
to restrain a non-mission related activity. Although MBS are housing-
related, the extent to which these investments support the Banks' 
housing finance mission is debatable. MBS generally are traded in 
large, well-established and liquid markets. The Banks' presence in 
these markets may not result in increased availability of funds for 
housing, or in lower cost of funds. Moreover, and perhaps most 
importantly for the Finance Board, the Banks' MBS investments generally 
do

[[Page 52187]]

not involve the Banks working with or through Bank System members and 
thus do not contribute to the cooperative nature of the Bank System as 
advances do.
    Another major change in the Bank System following the enactment of 
FIRREA was the growth of commercial bank membership. Until 1989, Bank 
System membership consisted almost exclusively of thrift institutions. 
Bank System membership declined from 1989 to 1990 due to the closing of 
failed institutions, but rose rapidly thereafter as commercial banks 
joined the Bank System. Total Bank System membership increased from 
2,855 at year-end 1990 to 6,884 at year-end 1998. Voluntary members, 
primarily commercial banks, represented over 86 percent of total 
membership at December 31, 1998. Voluntary members held $143 billion in 
advances, representing almost 50 percent of total advances, and held 
$13 billion (59 percent) of the capital stock of the Bank System as of 
December 31, 1998. Given the large increase in voluntary members since 
1989, maintaining dividends and membership benefits to retain voluntary 
members has been considered necessary for ensuring a stable Bank 
System.
    The increase in investments not directly related to the Banks' 
public purpose was a rational response to the sharp fall-off in Bank 
System advances and net income that occurred during the period 
following the enactment of FIRREA. However, Bank System earnings and 
advances are now at record levels. Outstanding advances, surpassing the 
previous all time high of $167 billion in the second quarter of 1997, 
reached $288 billion at year end 1998. Net income has steadily 
increased to $1.8 billion in 1998 after dropping to a low of $850 
million in 1992.
    In addition, although the Banks initially grew investments as a 
substitute for advances, Bank investments generally have increased 
since 1992 along with advances. Investments grew 73 percent between 
1992 and 1998, increasing from $79 billion to $137 billion over the 
period. To some extent, this growth was because of lower spreads on 
advances due to increased funding competition from other sources. At 
the end of 1998, advances represented 66 percent of Bank System total 
assets while investments represented 32 percent of Bank System total 
assets. Bank System liabilities also increased over this period to fund 
the growth in investments and advances. Bank System COs outstanding 
increased over 225 percent between 1992 and 1998, growing from $115 
billion at year end 1992 to $377 billion at year end 1998, however, 
only 76 percent of COs funded advances at year end 1998.
    Once the Banks' ability to generate income had demonstrably 
improved, the Finance Board initiated steps to address the Bank System-
wide growth of non-mission related investments. A first step was to 
recognize that, while the detailed list of restrictions and limits 
placed on the Banks' investment authority by the FMP successfully 
ensured safety and soundness, it provided little, if any, flexibility 
and incentive for the Banks to seek out and develop new assets and 
activities that are permissible under the Act and that are consistent 
with the mission of the Bank System.
    Therefore, to address the lack of flexibility in developing mission 
related investments, the Finance Board amended the FMP in 1996 to 
permit the Banks, among other things, to engage in new activities 
designed in part to add higher yielding and more mission-related assets 
to their balance sheets that would also preserve and promote the 
cooperative nature of the Bank System. See FMP section II.B.12. These 
activities were first approved on a pilot program basis in 1996 and 
1997 and have been in operation since then. The Finance Board has 
determined, based on the experience of these programs, that certain 
mortgage assets, as further discussed below, can be acquired by the 
Banks from their members while preserving and promoting the cooperative 
nature of the Bank System and providing for greater mission 
achievement. It is anticipated that expansion of these activities will 
permit the Banks to reduce their holdings of money market investments 
and MBS.
    In May 1998, the Finance Board held a public hearing on Bank 
investment practices in response to concerns about the growth of money 
market investments and MBS. In preparation for the hearing, the Finance 
Board published a staff paper on the implications of Bank investment 
practices for Finance Board investment policy which discussed several 
options for limiting money market and MBS investments, including 
limiting money market investments to the amount of deposits and capital 
held by the Banks. See 63 FR 16505-37 (Apr. 3, 1998).
    A second major step taken by the Finance Board to address concerns 
about the Bank System-wide growth of non-mission related investments is 
the proposed rule, which provides the Banks even greater flexibility, 
as well as an incentive, to acquire mission related assets compared to 
what now exists in the FMP. Greater flexibility is provided in proposed 
Sec. 955.2, as limited by proposed Sec. 955.3 discussed below, which, 
among other things, expands the allowable credit rating for authorized 
investments from primarily triple-A in the FMP to triple-B. Incentive 
to acquire mission related assets is provided in proposed Sec. 940.4, 
discussed below, which requires that 100 percent of Bank System COs 
must be used to finance mission related activities. The Finance Board 
has determined that this requirement is appropriate in view of the 
improved financial condition of the Bank System. The process for 
implementing this requirement is discussed below.
2. Mission of the Banks--Sec. 940.2
    Part 940 of the proposed rule sets forth the core mission 
activities (CMA) requirements that would apply to the Banks under the 
proposed new regulatory regime. Proposed Sec. 940.2 defines the mission 
of the Banks as providing to members and eligible nonmember borrowers, 
i.e., entities that have been approved as a nonmember mortgagee 
pursuant to subpart B of part 950 of the Finance Board's regulations, 
financial products and services, including but not limited to advances, 
that assist and enhance such members' and eligible nonmember borrowers' 
financing of: (a) housing in the broadest sense including single-family 
and multi-family housing serving consumers at all income levels, and 
(b) community lending as defined in Sec. 953.3 of the Finance Board's 
regulations. This statement of mission and the regulatory provisions 
that would implement it are intended to ensure maximum use of the 
cooperative structure of the Bank System to provide funds for housing 
finance and community lending.
3. Core Mission Activities--Sec. 940.3
    Proposed Sec. 940.3 lists those Bank activities that would qualify 
as CMA. Under proposed Sec. 940.3(a)(1), all Bank advances and 
commitments to make advances with certain drawdown to members or 
eligible nonmember borrowers with assets of $500 million or less would 
qualify as CMA. There were 6,207 members, representing 89 percent of 
all members, with assets of $500 million or less as of March 31, 1999.
    Under proposed Sec. 940.3(a)(2), advances and commitments to make 
advances with certain drawdown to members or eligible nonmember 
borrowers with assets greater than $500 million would qualify as CMA in 
an amount up to the total book value of certain assets held by such 
member or eligible nonmember borrower. These assets are: (1) housing-
related whole loans; (2) loans and investments that are

[[Page 52188]]

generated by community lending (as that term is used in the Finance 
Board's CICA regulation, see 12 CFR 970); and (3) MBS that comprise the 
types of loans falling into either of the preceding two asset 
categories and that are originated by the member or eligible nonmember 
borrower. The term ``housing-related whole loans'' is defined in 
proposed Sec. 940.1 to include all whole loans, or participation 
interests in whole loans (excluding mortgage backed-securities), 
secured by one-to-four family property, multifamily property, or 
manufactured housing. The definition mentions loans for the 
construction, purchase, improvement, rehabilitation, or refinancing of 
housing as a non-exclusive list of loans that would be considered 
housing-related under the proposed rule. This broad definition 
corresponds with the mission of the Banks, stated in proposed 
Sec. 940.2, to finance housing in the broadest sense.
    Thus, if a member with over $500 million in assets were to have on 
its books such loans and investments in an amount equal to or exceeding 
that member's total advances outstanding, the Bank would be able to 
count all advances to that member as CMA. On the other hand, if the 
member were to have on its books such loans and investments in an 
amount less than its total advances outstanding, the Bank would be able 
to count as CMA only those advances to that member equal to the amount 
of such loans and investments. A review of members with assets greater 
than $500 million shows that, as of June 30, 1999, only 54 members had 
advances outstanding that exceeded their holdings of residential 
mortgage loans (as defined in existing 12 CFR 933.1(bb), but excluding 
MBS), a narrower group of assets than allowed under proposed 
Sec. 940.3(a)(2). Excess advances over residential mortgage loans were 
only $14 billion or 4 percent of total advances outstanding as of June 
30, 1999.
    The purpose of proposed Sec. 940.3(a)(1) and (2) is to ensure that 
those advances that will count as CMA are, at the very least, aligned 
with housing and community lending assets held by the member. The 
provision allows all advances to members with assets of $500 million or 
less to qualify as CMA so that the CMA designation does not result in 
any restrictions or limits being imposed on the access of smaller 
institutions to advances from the Banks. This provision recognizes that 
smaller banks face substantial hurdles in obtaining funds because they 
lack access on their own to the capital markets and have been subjected 
to a prolonged decline in deposits. This provision also is consistent 
with provisions of H.R. 10, passed by the House of Representatives on 
July 1, 1999, and S. 900, passed by the U.S. Senate on May 6, 1999, 
each of which provides substantially greater latitude to Bank members 
with assets equal to or less than $500 million with respect to how they 
can use the proceeds of Bank advances.
    The methodology proposed for institutions with assets of over $500 
million is necessary since it is not possible to track advances to 
specific member loans. Limiting the advances that such members may 
count as CMA to the amount that can be supported by specific types of 
loans and securities, mitigates against including advances that support 
large commercial and business loans that do not otherwise qualify as 
community lending under the CICA regulation, and securities supported 
by such loans, as CMA. It is likely that such loans are not related to 
community lending in the community where the large member is located. 
The Finance Board requests comments on the practicality of this 
provision and suggestions for any alternative methodology.
    Under proposed Secs. 940.3(b) and 940.4(c), standby letters of 
credit (SLOCs) would count as CMA at a partial value of their face 
amount, to be gradually phased out over the transition period. 
Following the transition period, SLOCs would qualify as CMA valued at 
the fee charged to members for issuance or confirmation of the SLOC 
(see discussion below of Sec. 940.4(c)).
    Under proposed Sec. 940.3(c), intermediary derivative contracts 
(primarily interest rate swaps) valued at the fee charged to members 
would qualify as CMA because the fee represents the value of a risk-
management related service provided by the Banks to the members.
    Under proposed Sec. 940.3(d), member mortgage assets (MMA) held 
pursuant to proposed part 954 (discussed in detail below) would qualify 
as CMA.
    Three general types of equity investments also would count as CMA 
under proposed Sec. 940.3(e). First, equity investments that primarily 
benefit low-or moderate-income individuals, or areas, or other areas 
targeted for redevelopment by local, state, tribal or Federal 
government, would be considered to be CMA if the investment provides or 
supports: affordable housing; community services; permanent jobs for 
low- or moderate-income individuals; or area revitalization or 
stabilization. This type of equity investment is included within the 
definition of CMA based on the regulatory definition of equity 
investments that are permitted to national banks. See 12 CFR 24.3(a). 
Second, investments in the stock of SBICs formed pursuant to 15 U.S.C. 
681(d) would qualify as CMA to the extent that the investment is 
structured to be matched by an investment in the same SBIC by a member 
or eligible nonmember borrower of the Bank making the investment in 
SBIC stock. This is also explicitly authorized under section 11(h) of 
the Act. See 12 U.S.C. 1431(h). The member matching requirement will 
satisfy the statutory requirement that Bank investments in SBICs be for 
the purpose of aiding members. Third, equity investments in 
governmentally-aided economic development entities structured similarly 
to SBICs, and where the investment primarily benefits low- or moderate-
income individuals or areas, would qualify as CMA.
    Three other specific investments would be considered CMA under 
proposed Secs. 940.3 (f), (g), and (h): the short-term tranche of SBIC 
securities guaranteed by the Small Business Administration (SBA); 
Section 108 Interim Notes and Participation Certificates guaranteed by 
HUD pursuant to section 108 of the Housing and Community Development 
Act of 1994 (as amended); and investments and obligations for housing 
and community development issued or guaranteed under Title VI of the 
Native American Housing Assistance and Self-Determination Act of 1996 
(NAHASDA). These investments are all related to housing and community 
lending and supported by various government programs at the federal 
level. The Finance Board proposes to treat these special equity 
investments as CMA because of their potential to move the private 
markets to better assist low- and moderate-income communities to become 
more prosperous. By treating these investments as CMA, the Board is 
intentionally creating a greater incentive for the Banks to make these 
investments.
    The Finance Board specifically requests comment on whether any 
other investment instruments, which are products of federal programs 
designed to support housing and community lending programs, should also 
be included.
    Proposed Sec. 940.3(i) includes as CMA certain assets previously 
acquired, or authorized to be acquired, under the FMP. Assets acquired 
under section II.B.11 of the FMP, primarily state and local housing 
finance agency (HFA) bonds acquired from out-of-district HFAs that may 
or may not be eligible

[[Page 52189]]

nonmember borrowers, would be considered to be CMA if acquired before 
the effective date of the final rule. Any new investments in state and 
local HFA bonds would need to meet the requirements for MMA under 
proposed part 954, as discussed below, to continue to qualify as CMA. 
This means that only state and local HFA bonds acquired from in-
district eligible nonmember borrowers, or from or through another Bank 
that acquired such bonds from eligible nonmember borrowers in its 
district, would be considered to be MMA under part 954 of the proposed 
rule and, therefore, would qualify as CMA.
    Assets authorized by the Finance Board, by resolution or otherwise, 
to be acquired or held pursuant to Finance Board approval under section 
II.B.12 of the FMP will be considered to be CMA up to the greater of: 
(1) the amount permitted under the authorization; or (2) the amount 
acquired prior to the effective date of this section. Pilot programs 
approved under section II.B.12 may continue to operate under their 
authorizing resolutions until the dollar cap prescribed in the 
applicable resolution is reached. Any subsequent transactions would 
need to meet the requirements for MMA under proposed part 954 in order 
to qualify as CMA.
4. CMA Requirement--Sec. 940.4
    Proposed Sec. 940.4(a) provides that, following a transition period 
that ends on January 1, 2005, each Bank must maintain an annual average 
ratio of at least 100 percent of CMA to the book value of the Bank's 
total outstanding COs. For purposes of this calculation, on-balance 
sheet CMA (i.e., certain advances, MMA, certain equity investments, the 
short-term tranche of SBIC securities guaranteed by SBA, Section 108 
Interim Notes and Participation Certificates guaranteed by HUD, 
investments and obligations for housing and community development 
issued or guaranteed under Title VI of NAHASDA, and grandfathered 
assets acquired under sections II.B.11 and II.B.12 of the FMP) would be 
counted at book value. Off-balance sheet CMA (i.e., SLOCs, intermediary 
derivative contracts and commitments to make advances with certain 
drawdown) would be counted at an amount prescribed in the off-balance 
sheet conversion factor chart contained in proposed Sec. 940.4(c) 
discussed below. This ratio would be calculated based on a 12-month 
moving average. Proposed Sec. 940.4(b) would require that each Bank 
report to the Finance Board its actual CMA ratio as of the last day of 
each calendar quarter, based on the preceding 12 months. A Bank would 
be free to undertake authorized activities that do not qualify as CMA, 
so long as the ratio of its CMA to its total COs outstanding meets the 
requirement of proposed Sec. 940.4(b).
    While it is unrealistic to expect a return to the pre-FIRREA ratios 
of advances to COs for a number of reasons, the Finance Board considers 
the 100 percent CMA ratio requirement to be both appropriate public 
policy and economically feasible. The primary source of funds for the 
Banks is the issuance of COs in the capital markets at rates reflecting 
the Banks' GSE funding advantage. Therefore, as a matter of public 
policy, the Finance Board believes that 100 percent of the assets 
funded with COs should be mission-related. In developing the CMA 
requirement, the Finance Board generated simulations that applied a CMA 
requirement, i.e., a stated percentage of COs invested in CMA, to each 
Bank's average balance sheet for the first six months of 1999. For 
these simulations, capital, deposits, and advances were held constant. 
Further, the simulations did not incorporate any behavioral responses 
on the part of the Banks. Thus, while the results should not be 
considered predictions of what will happen as a result of the proposed 
rule, they should be considered an indication of the magnitude and 
feasibility of the Banks' required balance sheet adjustments. The 
simulation results were evaluated based on the aggregate balance sheet 
and aggregate earnings for the Bank System as a whole. The CMA 
requirement, however, would be imposed separately on each Bank. As the 
proposed rule allows Banks to buy and sell CMA among each other, Banks 
with CMA ratios below the required CMA ratio would be permitted to 
purchase CMA from Banks with CMA ratios above the required CMA ratio. 
For this reason simulations at the Bank System level are appropriate.
    Based on analysis of empirical data and discussions with Bank 
staff, spreads over the CO rate for money market instruments (MMI) were 
assumed to be approximately one-seventh that assumed for MBS, and 
spreads for MMA, which are discussed in connection with proposed part 
954 below, were assumed to be roughly comparable to those for MBS, 
based on their similar risk characteristics. The low return on MMI 
relative to MMA would allow the Banks to roll-off substantial amounts 
of MMI, which could be replaced with relatively smaller amounts of MMA, 
while earning the same net income.
    A simulation imposing the 100 percent CMA requirement indicates 
that the Bank System could continue to pay a dividend comparable to the 
annualized dividend for the first half of 1999 and achieve the 100 
percent CMA requirement. To do so would require the Banks to reduce MMI 
by $43 billion and increase MMA by $65 billion.\21\
---------------------------------------------------------------------------

    \21\ MBS holdings would be reduced by $59 billion. Essentially, 
the Banks would replace MBS with MMA on a dollar for dollar basis, 
and add an additional $6 billion in MMA to compensate for the 
reduced income from the reduction in MMI. The $65 billion of MMA to 
be acquired would equal about 1.5 percent of residential mortgage 
debt outstanding at the end of 1998.
---------------------------------------------------------------------------

    Currently, the Banks' ratios of advances to COs, a more 
conservative measurement than total CMA to COs, range from 50 percent 
to 85 percent. The Finance Board believes it is reasonable and 
necessary that there should be a graduated phase-in of the 100 percent 
CMA requirement to allow the Banks time to restructure their balance 
sheets to include more profitable CMA and to accomplish the transition 
in such a manner as to ensure the continued safety and soundness of the 
Banks. A simulation of the transition period indicates that by reducing 
MMI by $43 billion (a reduction of almost 50 percent from current 
levels) so that the level of MMI would equal the sum of deposits and 
capital for the Bank System, and increasing MMA by $10 billion,\22\ the 
Bank System could continue to pay a dividend comparable to the 
annualized dividend for the first half of 1999 while raising the ratio 
of CMA to COs from its current level of 75 percent to the 85 percent 
transition target for January 1, 2002, as set forth in Sec. 940.4(d) of 
the proposed rule discussed below.
---------------------------------------------------------------------------

    \22\ MBS holdings would be reduced by $4 billion, which could be 
achieved by a run-off of the Banks' existing holdings. The level of 
COs is reduced by $37 billion, the difference between the $43 
billion decrease in MMI and the $6 billion increase in the net 
holding of mortgage assets, so that assets would continue to equal 
liabilities plus capital.
---------------------------------------------------------------------------

    If the level of advances or deposits were to increase over the 
transition period, then the target CMA to CO ratios could be achieved 
with smaller increases in MMA than indicated in the above simulations. 
In both the transition and the final simulations, capital substantially 
exceeds 3 percent of Bank System assets. Therefore, Bank System assets 
and earnings could expand substantially beyond the amounts in the 
simulation without the need to attract more total capital.\23\
---------------------------------------------------------------------------

    \23\ Bank System assets growth may be constrained by risk-based 
capital. As both the risk-based capital requirement and the level of 
risk-based capital would be determined by decisions made by each 
Bank under the proposed rule, the Finance Board has not included the 
effects of the proposed risk-based capital requirements in these 
simulations.

---------------------------------------------------------------------------

[[Page 52190]]

    The Finance Board expects, however, that in order to comply with 
the CMA requirement, the Banks will need to adjust the management of 
their operational liquidity in some way, perhaps by acquiring assets 
that qualify as CMA and also contribute to operational liquidity. The 
Banks also may need to adjust their balance sheets by acquiring assets 
that qualify as CMA and also meet liquidity requirements to ensure 
continued compliance with the contingency liquidity requirements in 
proposed Sec. 930.10. For example, certain GNMA securities would 
qualify as CMA and could also meet operational and contingency 
liquidity needs. The Finance Board requests comment on how the CMA 
requirement is likely to impact the ability of the Banks to achieve 
their liquidity needs.
    In addition, the Finance Board requests comment and empirically-
based analyses regarding the potential impact of the CMA ratio 
requirement on the Banks' earnings, dividends and membership benefits 
in the form of the pricing of advances, and whether there might be an 
effect on voluntary members' decisions to join, remain in, or leave the 
Bank System. The Finance Board also requests comment and empirically-
based analyses on whether there will be an impact on the level of 
funding for the Bank System's AHP, and if so, whether the Bank System's 
contribution to the AHP should be maintained, at a minimum, at 1998 
levels, either by voluntary agreement by the Banks or by Finance Board 
regulation.
    The Finance Board also requests comments on whether all types of 
CMA should receive equal weight in calculating a CMA total book value. 
Imposing different weights could serve as an incentive for the Banks to 
pursue classes of CMA, particularly CMA that might be targeted to 
harder-to-serve needs or populations, but in which the Banks might 
otherwise hesitate to invest because such classes of CMA may be less 
profitable or more risky. However, weighting could undermine the 
meaningfulness of a 100 percent CMA target, as the 100 percent target 
would no longer represent a true maximum with respect to the allocation 
of CO funding to CMA.
5. Conversion of Off-Balance Sheet Items--Sec. 940.4(c)
    Proposed Sec. 940.4(c) sets forth conversion factors in Table 1 for 
the conversion of off-balance sheet items to on-balance sheet value 
equivalents for inclusion in the overall CMA ratio calculation required 
under proposed Sec. 940.4(a). Intermediary derivative contracts would 
count in the CMA calculation at 100 percent of the value of the fee 
charged to members on such transactions. This fee is an objective 
measure of value to the members for these instruments given that the 
Banks do not need to fund these transactions. Advance commitments with 
certain drawdown will count in the CMA calculation at 100 percent of 
the value of the contractual commitment, given that a Bank would be 
likely to fund the commitment with COs ahead of the commitment date.
    During the transition, SLOCs would count at the current year's CMA 
ratio requirement (expressed as a percentage) subtracted from 100 
percent, then multiplied by the face amount of the SLOC. Thus, for 
SLOCs, the conversion factor would be 20 percent or 0.20 in the first 
year of the rule's effectiveness (100 percent or 1.00 minus CMA ratio 
requirement of 80 percent or 0.80) and would shrink to zero by the end 
of the transition period (100 percent minus CMA ratio requirement of 
100 percent). The intent of this conversion provision is to ensure that 
the financial nature of the transaction, rather than its regulatory 
treatment, determines whether a Bank issues an SLOC or an advance. The 
conversion factor leaves a Bank indifferent in terms of financial 
opportunity as to whether it issues an advance or SLOC, because either 
instrument would then have the same impact on the ratio of CMA to COs. 
An alternative weighting mechanism could create an incentive for the 
Bank to distort the prices of advances and SLOCs such that the nature 
of the transaction might no longer guide the choice of instrument. When 
the transition period ends, SLOCs would be valued at the fee charged to 
members to make this off-balance sheet item consistent with the 
treatment of intermediary derivative contracts.
6. Transition Period--Sec. 940.4(d)
    Proposed Sec. 940.4(d) sets forth the transition period that would 
apply to the CMA ratio requirement. Beginning on January 1, 2001, each 
Bank would be required to have a CMA in an amount equal to at least 80 
percent of the average book value of the Bank's total outstanding COs. 
The CMA ratio requirement would increase by five percentage points on 
January 1 of every year until the full 100 percent requirement would 
take effect on January 1, 2005.
7. Transfers of CMA to Another Bank--Sec. 940.5
    Section 940.5 of the proposed rule makes clear that a CMA of a 
Bank, if transferred to another Bank, retains its status as a CMA with 
respect to the transferee Bank. This provision allows the Banks to 
improve the diversification of the various risks associated with the 
CMA by redirecting CMA from one Bank district to another Bank district.
8. Safe Harbor for Anticipated Noncompliance--Sec. 940.6
    Under Sec. 940.6(a) of the proposed rule, if a Bank's board of 
directors determines that the Bank cannot meet the CMA ratio 
requirement for a specified future period without jeopardizing the 
safety and soundness of the Bank, the Bank would not be considered to 
be out of compliance with the rule for the time period specified. In 
order for a Bank to qualify for this safe harbor, the board of 
directors' determination would need to be based upon an objective 
finding that the Bank: (1) would likely be unable to meet the liquidity 
requirement of proposed Sec. 930.10, or any other regulatory 
requirement related to safety and soundness of its financial operation; 
or (2) would likely be unable to provide a return on equity sufficient 
to retain members intending to make use of such Bank's products and 
services. The decision-making process of the Bank's board of directors 
and the bases for its conclusions, including justification for the time 
period that the Bank anticipates being out of compliance, would need to 
be fully documented. In addition, the Bank's board of directors would 
be required to adopt a plan to achieve compliance with the CMA ratio 
requirement at the earliest feasible and prudent date.
    The Finance Board believes that proposed Sec. 940.6(a) will provide 
regulatory flexibility when business conditions are not amenable to 
achieving CMA compliance consistent with the safe and sound operation 
of the Bank. However, this safe harbor provision is not intended to 
provide regulatory immunity for lack of effort on the part of Bank 
management or for reaching such conclusions based on analysis found by 
the Finance Board through the examination process to be inadequate as 
to substance or documentation.
9. Waivers--Sec. 940.6(b)
    Proposed Sec. 940.6(b) would make explicit that, under 
circumstances that do not meet the safe harbor requirements of proposed 
Sec. 940.6(a), a Bank may request a waiver of the

[[Page 52191]]

requirements in part 940, pursuant to the regulatory waiver provisions 
of the Finance Board's regulations that would appear at 12 CFR part 907 
(existing part 903).

E. Part 950--Advances

    The proposed rule would delete existing Sec. 935.2 of the Finance 
Board's Advances regulation, which states the primary credit mission of 
the Banks and how the Banks must fulfill such mission. Section 940.2 of 
the proposed rule, as discussed above, defines the mission of the 
Banks, and no separate or duplicative statements or definitions would 
be necessary under the new regulatory structure.
    Proposed Sec. 950.1 would amend the definition of ``long-term 
advance'' in existing Sec. 935.1 of the Finance Board's Advances 
regulation from advances with maturity terms over five years to 
advances with maturity terms of greater than one year. The Act provides 
that all long-term advances shall only be made for the purpose of 
providing funds for residential housing finance. See 12 U.S.C. 1430(a). 
This provision is implemented by existing Sec. 935.14, which provides 
that prior to approving an application for a long-term advance, a Bank 
shall determine that the principal amount of all long-term advances 
currently held by the member does not exceed the total value of 
residential housing finance assets held by such member. See 12 CFR 
935.14(b)(1).

F. Part 954--Member Mortgage Assets

1. Definition of MMA--Sec. 954.2
    Part 954 of the proposed rule addresses MMA, that is, generally 
mortgages and interests in mortgages that a Bank may acquire from its 
members or eligible nonmember borrowers in a transaction that is in 
purpose and economic substance functionally equivalent to the business 
of making advances in that: (1) it allows the member or eligible 
nonmember borrower to use its mortgage assets to access liquidity for 
further mortgage lending; and (2) all or a material portion of the 
credit risk attached to the mortgage asset is being borne by the member 
or eligible nonmember borrower.
    Proposed Sec. 954.2 authorizes a Bank to hold MMA acquired from or 
through its members or eligible nonmember borrowers, either by 
purchasing MMA from the member or eligible nonmember borrower, or 
funding the loan through the member or eligible nonmember borrower. 
Proposed Sec. 954.2 sets forth a three-part test to be used in 
determining which assets qualify as MMA. First, under proposed 
Sec. 954.2(a), an asset must fall within one of the following 
categories of assets: (1) mortgages, or interests in mortgages, 
excluding one-to-four family mortgages where the loan amounts exceed 
the conforming loan limits that apply to Fannie Mae and Freddie Mac, 
see 12 U.S.C. 1717(b)(2), but including community lending mortgages; 
(2) loans, or interests in loans, secured by manufactured housing, even 
if the manufactured housing is considered to be personal property in 
the state in which the home is located; or (3) state and local HFA 
bonds.
    Second, under proposed Sec. 954.2(b), a connection of the asset 
with the member or eligible nonmember borrower from whom the asset is 
acquired must exist, i.e., there must be a member or eligible nonmember 
borrower nexus. Specifically, the asset must be either: (1) originated, 
if a loan, or issued, if bonds, by or through the member or eligible 
nonmember borrower; or (2) held for a valid business purpose by the 
member or eligible nonmember borrower prior to acquisition by the Bank. 
Assets held for a valid business purpose would not include, for 
example, loans that are passed from a nonmember through a member to a 
Bank with the intended purpose of extending the benefits of membership 
to the nonmember. The valid business purpose requirement is intended to 
acknowledge that a member may acquire loans from a nonmember and then 
sell them to a Bank.
    Third, under proposed Sec. 954.2(c), the member or eligible 
nonmember borrower must bear a material portion of the credit risk 
attached to the mortgage asset. Through this requirement, MMA 
activities would serve to promote and preserve the basic business 
relationship between the Banks and their members that has been 
established and maintained throughout the history of the Bank System 
through advance transactions. The Bank would manage the interest rate 
risk while the member would bear all or a material portion of the 
credit risk. This requirement emphasizes the cooperative nature of the 
Bank System by ensuring that the member or eligible nonmember borrower 
shares with the Bank the financial benefits and responsibilities of the 
asset. Furthermore, it does so in a rational manner because such shares 
are allocated between the Bank and the member or eligible nonmember 
borrwer in a way that best employs their respective core competencies 
in managing risk.
    An asset will be considered to fulfill this requirement if it meets 
the ``credit risk-sharing'' test set forth in proposed Sec. 954.2(c). 
First, under proposed Sec. 954.2(c)(1), the member or eligible 
nonmember borrower must bear the amount of credit risk necessary to 
raise the asset or pools of assets to the fourth highest credit rating 
category (e.g., triple-B), which is the minimum credit rating for any 
asset that may be acquired by a Bank under the safety and soundness 
provisions of proposed Sec. 955.3(a)(3). Second, under proposed 
Sec. 954.2(c)(2), to the extent that the Bank requires, either at the 
time of acquisition or subsequently, that the assets or pools of assets 
have a credit rating higher than the fourth highest credit rating 
category, the member or eligible nonmember borrower must bear at least 
50 percent of any credit risk necessary to raise the assets or pools of 
assets from the fourth highest credit rating category to such higher 
credit rating category, up to the second highest credit rating category 
(e.g., double-A.). Third, under proposed Sec. 954.2(c)(3), 
notwithstanding the first two parts of the credit risk-sharing test, 
the member or eligible nonmember borrower must bear a material portion 
of any credit risk up to the second highest credit rating. This 
provision is intended to ensure that the member or eligible nonmember 
borrower does bear enough credit risk to share in the financial 
consequences of the asset quality no matter what transaction structure 
might be devised with a consequence of mitigating the credit risk-
sharing requirement of the first two parts.
    Under proposed Sec. 954.2(c)(4), to the extent that the U.S. 
government has insured or guaranteed the credit risk of the asset or 
pool of assets, the member or eligible nonmember borrower may rely upon 
that insurance or guarantee to meet all or part of the above-mentioned 
credit risk-sharing requirements. For example, loans that are fully 
insured by the Federal Housing Administration (FHA), and GNMA 
securities, which are fully guaranteed by the U.S. government, would be 
considered to meet the credit risk-sharing requirement. Such loans and 
securities, however, also would have to meet the member or eligible 
nonmember borrower nexus requirement in proposed Sec. 954.2(b) in order 
to qualify as MMA. To the extent that the U.S. government insurance or 
guarantee is insufficient or incomplete to cover the member's or 
eligible nonmember borrower's credit risk-sharing requirement, that 
portion of the requirement not so covered must be borne by the member 
or eligible nonmember borrower. This provision allows that the federal 
government,

[[Page 52192]]

alone, may substitute for the member or eligible nonmember borrower in 
meeting the credit risk-sharing requirement.
    The Finance Board specifically requests comment on whether 
authorizing the Banks to acquire federally-insured or guaranteed 
mortgages or mortgage pools without any such member or eligible 
nonmember borrower nexus would enhance the liquidity of the marketplace 
for investments that promote housing and targeted economic development 
sufficiently to justify any diminution in the cooperative nature of the 
Bank System that may result. The Finance Board also seeks comment on 
whether loans originated by municipalities, pursuant to section 108 of 
the Housing and Community Development Act of 1974 (amended in 1994), or 
by tribes pursuant to Title VI of NAHASDA, where the municipalities or 
tribes are not eligible nonmember borrowers, should be authorized to be 
acquired by the Banks because of the enhancement to the liquidity of 
the marketplace for such housing, notwithstanding any diminution in the 
cooperative nature of the Bank System that might result.
    The MMA tests set forth in proposed part 954 are intended to allow 
the Banks and their members and eligible nonmember borrowers the 
freedom to employ a variety of transactional structures so long as the 
transaction involves a qualifying asset or pool of assets, is acquired 
by a Bank pursuant to a transaction with a member or eligible nonmember 
borrower, and satisfies the credit risk-sharing requirement. Examples 
of two types of purchases that would meet the requirements are: (1) the 
Bank originates a loan or pool of loans and gets the needed credit 
enhancement from the member (i.e., the member provides a direct credit 
substitute); or (2) the member or eligible nonmember borrower sells the 
loan to the Bank with recourse.
2. MPF
    The purchase by a Bank of one-to-four family mortgages that fall 
within the conforming loan limits applicable to the secondary market 
GSEs was approved by the Finance Board under section II.B.12 of the FMP 
in December 1996. See Finance Board Res. No. 96-111 (Dec. 23, 1996). At 
that time, the Finance Board approved a pilot program proposed by the 
Federal Home Loan Bank of Chicago (Chicago Bank), known as the Mortgage 
Partnership Finance program (MPF), to fund one-to-four family 
residential mortgage loans originated by member institutions. The 
objective of the pilot program was to unbundle the risks associated 
with home mortgage lending and allocate the individual risk components 
between the Chicago Bank and its members in a manner that best employs 
their respective core competencies. That is, the members would continue 
to manage the customer relationship and the credit risk, while the 
Chicago Bank would retain the liquidity, interest rate and options 
risks-the risks that the Banks have the most expertise in managing.
    MPF transactions are functionally equivalent to, though technically 
more sophisticated than, advances transactions authorized under section 
10(a) of the Act. The Finance Board considered the two transactions to 
be functionally equivalent because, in both cases, the Bank takes an 
interest in mortgages originated by its member or eligible nonmember 
borrower and, in return, provides that member or eligible nonmember 
borrower with liquidity for further mortgage lending. In both cases, 
the member or eligible nonmember borrower bears all or a significant 
portion of the credit risk: in the case of advances, because the member 
or eligible nonmember borrower still owns the mortgage; in the case of 
MPF, because the member or eligible nonmember borrower provides a 
credit enhancement when selling the mortgage to, or funding the 
mortgage through, the Bank. Although, under the MPF program, the Bank 
acquires an ownership interest in the mortgage loans--as opposed to a 
mere security interest, as it would in the case of an advance 
transaction--the Finance Board found this structure to be permissible 
because the Banks may invest in mortgages pursuant to their statutory 
investment powers.
    Based on the experience with the MPF program to date, the Finance 
Board has concluded that this line of business could constitute a major 
business activity for the Banks that, along with their more traditional 
advances business, is consistent with the cooperative structure of the 
Banks--i.e., that does not cause the Banks to compete with members and, 
in fact, makes members participating in the program more competitive. 
As a result, mortgage acquisition activities by the Banks that meet the 
requirements of proposed part 954 will no longer be treated as pilot 
activities.
    The proposed rule will thus encourage the Banks to purchase more 
MMA, with the anticipated consequence of increasing competition in the 
home mortgage markets and thus lowering home prices for consumers. The 
Finance Board requests comment on whether this anticipated benefit to 
consumers is a reasonable expectation.
    The Finance Board also specifically requests comment on whether all 
MBS should be counted in whole or in some limited amount as CMA, and 
how counting such MBS could be reconciled with the member or eligible 
nonmember borrower nexus and credit risk-sharing requirements of MMA.
    Once the Banks have developed more experience in acquiring MMA, the 
Finance Board intends to set housing targets for MMA similar to those 
that HUD is required by statute to set for Fannie Mae and Freddie Mac. 
The Federal Housing Enterprises Financial Safety and Soundness Act of 
1992 directed HUD to establish housing goals for the GSEs' mortgage 
purchases in three specific areas: (1) housing for low-and moderate-
income families; (2) housing located in central cities, rural areas, 
and other underserved areas; and (3) special affordable housing to meet 
unaddressed needs of low-income families in low-income areas and very-
low-income families. See 12 U.S.C. 4541 et seq. The purpose of 
subjecting the Banks to such targets would be to assure that all GSE-
funded mortgage originators have similar incentives and pressures to 
reach underserved markets. This is an element of creating a level 
playing field among the housing GSEs.

G. Part 955--Bank investments

1. Authorized Investments--Sec. 955.2
    As previously discussed, the Banks' investment authority is derived 
from sections 11(g), 11(h) and 16(a) of the Act. 12 U.S.C. 1431(g), 
1431(h), 1436(a). Section 934.1 of the Finance Board's current 
regulations limits the Banks' investment authority by requiring Finance 
Board approval for investments not already authorized by stated policy 
or otherwise. See 12 CFR 934.1(a). The Finance Board adopted the FMP as 
its stated investment policy pursuant to the regulation. The FMP 
restricts Bank investments to those listed in the FMP. Sections 955.2 
and 955.3 of the proposed rule would establish the parameters of the 
Banks' investment authority under the proposed new regulatory 
structure.
    Proposed Sec. 955.2 would authorize the Banks to invest in all 
instruments in which they are permitted to invest under the Act (with 
the exception of Fannie Mae common stock), see 12 U.S.C. 1431(g), 
1431(h), 1436(a), subject to the restrictions set forth in proposed 
Sec. 955.3. These investments include: (a) obligations of the United 
States, see 12 U.S.C. 1431(g), 1431(h) and 1436(a); (b) deposits in 
banks or trust companies (as

[[Page 52193]]

defined in proposed Sec. 955.1), see id. at 1431(g); (c) obligations, 
participations or other instruments of, or issued by, Fannie Mae or 
Ginnie Mae, see id. at 1431(h), 1436(a); (d) mortgages, obligations, or 
other securities that are, or ever have been sold by Freddie Mac, see 
id. at 1431(h), 1436(a); (e) stock, obligations, or other securities of 
any SBIC formed pursuant to 15 U.S.C. 681(d) (to the extent such 
investment is made for purposes of aiding Bank members),\24\ see 12 
U.S.C. 1431(h); and (f) instruments that the Bank has determined are 
permissible investments for fiduciary and trust funds under the laws of 
the state in which the Bank is located, see id. at 1431(h), 1436(a).
---------------------------------------------------------------------------

    \24\ The Finance Board has determined that the phrase ``for the 
purpose of aiding members of the . . . Bank System'' relates not 
just to the formation of the SBIC but also to the nature and purpose 
of the investment.
---------------------------------------------------------------------------

    The Banks' investment authority under the proposed rule essentially 
tracks the parameters of that which may be permitted under the Act. 
Because several different provisions of the Act address the investment 
powers of the Banks, the Finance Board has consolidated and restated 
the substance of these investment authorities in proposed Sec. 955.2. 
The only investment that is explicitly mentioned in the Act that is not 
permitted under proposed Sec. 955.2 is investment in the stock of 
Fannie Mae. As discussed in more detail below, proposed 
Sec. 955.3(a)(1) would restrict equity investments to those that 
qualify as CMA under proposed part 940. Because the Finance Board does 
not believe that Fannie Mae stock could under any circumstances qualify 
as a CMA, and because Fannie Mae stock is not an authorized investment 
under the FMP and is not currently held as an investment by any Bank, 
it has simply been omitted from the list of authorized investments in 
proposed Sec. 955.2 in order to avoid confusion.
    Both sections 11(h) and 16(a) of the Act state that the Banks may 
be authorized to invest in ``such securities as fiduciary and trust 
funds may be invested in under the laws of the state in which the . . . 
Bank is located.'' See id. at 1431(h), 1436(a). In restating this 
authority in Sec. 955.2(f) of the proposed rule, the word 
``instruments'' has been substituted for the word ``securities'' to 
reflect in the rule the Finance Board's construction of the term 
``securities'' as it is used in sections 11(h) and 16(a) of the Act to 
encompass the broad range of financial investment instruments and not 
merely those instruments that are within the technical definition of 
``securities'' set forth in the federal securities laws. See 15 U.S.C 
77b(1).
2. Prohibited Investments and Prudential Rules--Sec. 955.3
    The broad investment authority established under proposed 
Sec. 955.2 would be limited by a number of safety and soundness- and 
mission-related restrictions set forth in proposed Sec. 955.3. Proposed 
Sec. 955.3(a)(1) would prohibit the Banks from making any investment in 
instruments that would provide an ownership interest in an entity 
(e.g., common or preferred stock, rights, warrants or convertible 
bonds), other than those investments that would qualify as CMA under 
proposed Sec. 940.3, as discussed more fully above. Thus, under the 
proposed rule, the actual equity investment powers of the Banks will be 
quite narrow and focused upon core mission activities.
    Proposed Sec. 955.3(a)(2) would prohibit the Banks from investing 
in instruments issued by foreign entities, except United States 
branches and agency offices of foreign commercial banks. Such 
instruments conceivably could qualify as permissible investments for 
fiduciary and trust funds and, therefore, would be permissible Bank 
investment unless specifically prohibited. This is consistent with the 
current prohibition in the FMP. See Finance Board Res. No. 97-05 (Jan. 
14, 1997).
    Proposed Sec. 955.3(a)(3) would prohibit the Banks from investing 
in debt instruments that are not rated as investment grade (i.e., one 
of the four highest rating categories given by an NRSRO). Despite the 
risk management provisions in the proposed rule under which the Banks 
are expected to manage whatever risks they might incur as part of their 
business operations, the Finance Board is imposing this specific 
prohibition on the acquisition of non-investment grade debt as a 
further safety and soundness measure. Under proposed Sec. 955.3(a)(3), 
the Banks would not be required to divest themselves of debt 
instruments that are downgraded to below investment grade after they 
already have been acquired by the Bank. Any additional risk that would 
arise from such a scenario would be managed through the application of 
the higher credit risk capital requirement applicable to the downgraded 
instrument. See proposed Sec. 930.4(d)(3).
    Finally, proposed Sec. 955.3(a)(4) would prohibit the Banks from 
acquiring whole mortgages or other whole loans, or interests in 
mortgages or loans, except for: (i) MMA, as defined under part 954 of 
the proposed rule; (ii) MBS that would meet the definition of 
``securities'' in the Securities Act of 1933, 15 U.S.C. 77b(a)(1); and 
(iii) loans held or acquired pursuant to section 12(b) of the Act, 12 
U.S.C. 1432(b). As described in detail above, proposed part 954 
establishes parameters regarding the types of mortgages and loans, or 
interests in mortgages and loans, that the Banks may acquire and the 
nature of the transactions through which such assets may be acquired. 
Proposed Sec. 955.3(a)(4) is designed to prohibit the holding, purchase 
or acquisition of jumbo mortgages and whole mortgages other than MMA, 
and otherwise prevent the Banks from circumventing the requirements of 
part 954. However, the Banks are not prohibited from holding, 
purchasing and acquiring MBS that would meet the definition of that 
term under the federal securities laws.
    The reference in proposed Sec. 955.3(a)(4)(ii) to the definition of 
securities in the Securities Act of 1933 is consistent with the Finance 
Board's analysis of the term securities as it is used in the Bank 
investment authority provisions of the Act. See discussion above of 
proposed Sec. 955.2. As discussed above, for purposes of the Bank's 
investment authority generally, the Finance Board has construed the 
term ``securities'' as it is used in sections 11(h) and 16(a) of the 
Act, 12 U.S.C. 1431(h), 1436(a), to encompass the broad range of 
financial investment instruments in a common business sense, and not 
merely to mean those instruments that are within the technical 
definition of ``securities'' in the federal securities laws. However, 
for purposes of proposed Sec. 955.3, the Finance Board has proposed 
limitations and restrictions on otherwise-authorized investments, which 
it is explicitly authorized to do under sections 11(h) and 16(a) of the 
Act. Limiting investments in mortgage-backed securities to those that 
would meet a narrower definition of the term ``securities'' than is 
contemplated under the investment authority provisions of the Act only 
serves to emphasize the differences in the use of the term under the 
different statutes and to bolster the Finance Board's construction of 
the term under the Act.
    Proposed Sec. 955.3(b) would prohibit a Bank from taking a position 
in any commodity or foreign currency. Proposed Sec. 955.3(b) also 
provides that, in the event that a Bank becomes exposed to currency, 
commodity or equity risks through participation in COs that are linked 
to a foreign currency or to equity or commodity prices, such risks must 
be hedged. The Banks currently do not have expertise in these areas and 
the Finance Board can discern no reason for the Banks to have or 
develop expertise in managing the risks

[[Page 52194]]

associated with foreign exchange rates or commodities.
    Section 955.3(c) of the proposed rule prohibits a Bank from making 
investments that are not permitted under the FMP as to such Bank until 
the Bank: (1) has received Finance Board approval of its initial 
internal market risk model; (2) demonstrates to the Finance Board that 
it has sufficient risk-based capital to meet the minimum total risk-
based capital requirement under proposed Sec. 930.4(b) for its then-
current portfolio; and (3) demonstrates to the Finance Board adequate 
credit risk assessment and procedures and controls sufficient to show 
control over credit, market and operations risks.
    As discussed above, one of the reasons that the Finance Board is 
proposing to allow the Banks broadened investment authority is because, 
under the proposed rule, the Banks will have risk-based capital and 
other risk management requirements to counterbalance any increased risk 
that might be associated with new investments. Therefore, until a Bank 
has sufficient risk-based capital in place to support its current 
portfolio, and until the Bank demonstrates to the Finance Board that it 
has adequate risk management capabilities, the Finance Board finds it 
necessary, as a safety and soundness measure, to continue to require 
the Banks to operate within the existing FMP framework.
    Although proposed Sec. 955.3 would impose several safety and 
soundness-and mission-related restrictions upon the Banks' general 
investment authority set forth in proposed Sec. 955.2, the overall 
effect of these proposed investment provisions would be to allow the 
Banks considerably more freedom in making investment decisions within 
the statutory parameters than is currently permitted. Under the FMP, 
the Banks are authorized to invest in a list of specific investments 
that is narrower than that in which the Banks may invest under the 
parameters set by the Act. Under the FMP, Banks wishing to make 
investments that may be permissible under the statute, but that are not 
specifically enumerated in the FMP, must obtain the permission of the 
Finance Board before making the investment.
    The approach to Bank investment authorizations reflected in the FMP 
allows for little discretion on the part of Banks' senior management 
and boards of directors in determining the appropriate investments and 
optimal risk/return strategy for their Banks. This approach was 
designed to limit the Banks' exposure to risk because the Banks do not 
currently operate under a risk-based capital structure, which would 
allow the Banks to assume more investment risk, provided that there is 
sufficient capital in place to support that risk. Because, under the 
proposed rule, the Banks would operate under such a risk-based capital 
structure, it would no longer be necessary to impose such stringent 
limits on the investment authority for safety and soundness purposes.
    Some of the limits on the investment authority reflected in the FMP 
also were intended, to some extent, to focus the Banks' investments on 
mission-related activities. As more fully described above, under 
proposed part 940, each Bank would be required to invest 100 percent of 
the proceeds from its share of the COs in CMA. This requirement would 
eliminate the need to focus the Banks' investments upon mission 
activities through the use of a specific list of authorized investments 
and specific limits on certain types of investments. In addition, a 
specific list intended to include all authorized investments would not 
provide the Banks with the flexibility to adapt to new developments in 
the marketplace and would stifle the development of new types of 
mission-related activities and investments.
    Under the proposed rule, the Banks would be permitted to make any 
authorized investment with sources of funds other than those provided 
by the COs. Consistent with the Finance Board's ongoing devolution of 
management and governance functions to the Banks, the Finance Board 
believes that the selection of appropriate investments to be made with 
that portion of a Bank's funds that are not obtained through use of the 
capital market funding advantage that arises from the Banks' status as 
GSEs is an area more appropriate for oversight by the Banks' boards of 
directors (subject to safety and soundness constraints imposed by the 
proposed rule) than by their regulator. Nonetheless, it is expected 
that the Banks' boards of directors would establish appropriate 
guidelines for investments when adopting the risk management policy 
required under this proposed rule.
3. Use of Hedging Instruments--Sec. 955.4
    Section 955.4 of the proposed rule addresses the Banks' use of 
hedging instruments. Proposed Sec. 955.4(a) would prohibit the Banks 
from making speculative use of hedging instruments. This is not an 
activity that is appropriate for the Banks to enter, as it would do 
nothing to further the mission of the Banks, while posing risks to the 
safety and soundness of the Banks.
    Section 955.4(b) of the proposed rule would subject all Bank hedge 
transactions to the hedge requirements set forth in Generally Accepted 
Accounting Principles (GAAP) and statements promulgated by the 
Financial Accounting Standards Board (FASB). Because GAAP prescribes 
extensive rules for hedging transactions that are followed by most 
market participants, the Finance Board finds it prudent to subject the 
Banks to these same requirements, rather than attempting to establish 
separate rules over such a complex subject.
    Section 955.4(c) of the proposed rule would govern the 
documentation that each Bank must have and maintain during the life of 
each hedge. Proposed Sec. 955.4(c)(1) would require that each Bank's 
hedging strategies be explicitly documented at the time of the 
execution of the hedge, and adequate documentation of the hedge must be 
maintained for the life of the hedge. Proposed Sec. 955.4(c)(2) would 
require that transactions with a single counterparty be governed by a 
single master agreement when practicable. Proposed Sec. 955.4(c)(3) 
would govern Bank agreements with counterparties for over-the-counter 
derivative contracts by requiring each agreement to include: (i) a 
requirement that market value determinations and subsequent adjustments 
of collateral be made on at least a monthly basis; (ii) a statement 
that failure of a counterparty to meet a collateral call will result in 
an early termination event; (iii) a description of early termination 
pricing and methodology; and (iv) a requirement that the Bank's consent 
be obtained prior to the transfer of an agreement or contract by a 
counterparty.
    All of these requirements are carried over from the FMP. The 
requirements are intended to ensure that the Banks monitor and manage 
their exposure to counterparties and that the agreements in place with 
counterparties provide adequate legal protection to the Banks. Because 
the risk-based capital requirements contained in the proposed rule do 
not directly alter or replace the need to address these issues, the 
Finance Board finds it appropriate to continue to impose these 
requirements on Bank hedge transactions.
    Under the FMP, the Banks' use of hedging instruments is limited to 
a specific list of hedging instruments. The use of the various hedging 
instruments by the Banks is permitted provided they assist the Bank in 
achieving its interest rate and/or basis risk management objectives. 
Like the FMP's Investment Guidelines, the Hedge Transaction Guidelines 
of the FMP contain some

[[Page 52195]]

detailed requirements that are no longer necessary. The unsecured 
credit concentration limits set forth in proposed Sec. 930.11 and the 
credit risk-based capital requirements set forth in proposed Sec. 930.5 
would eliminate the need for provisions addressing unsecured credit 
exposure and collateralization. In addition, because the Finance Board 
is removing the restrictions on certain types of investments, it would 
be inconsistent to continue to restrict swaps with characteristics 
similar to those investments.

H. Part 958--Off-Balance Sheet Items

    Proposed Sec. 958.2(a) authorizes the Banks to enter into the 
following types of off-balance sheet transactions: SLOCs; derivative 
contracts; forward asset purchases and sales; and commitments to make 
advances or other loans. This authorization essentially codifies the 
types of off-balance transactions that already have been authorized by 
the Finance Board. The Finance Board specifically requests comment on 
whether there are additional types of off-balance sheet transactions 
that it should consider authorizing.
    Proposed Sec. 958.2(b) prohibits the Banks from making speculative 
use of derivative contracts. As previously discussed in the general 
context of hedging instruments, speculating with derivatives contracts 
is not an activity that would be appropriate for the Banks to enter, as 
it would do nothing to further the mission of the Banks, while posing 
risks to the safety and soundness of the Banks.

I. Part 965--Sources of Funds

    Proposed Sec. 965.2 sets forth the types of liabilities authorized 
for Bank business operations. The Funding Guidelines section of the FMP 
sets forth the parameters for the use of alternative funding sources 
and structures by the Banks in funding their activities. The guidelines 
differentiate between Bank specific liabilities and COs, which are the 
joint and several liabilities of the Banks. See FMP sections IV.B. and 
C.
    Under the FMP, authorized Bank specific liabilities generally 
include: (1) deposits from members, from any institution for which a 
Bank is providing correspondent services, from another Bank, and from 
other instrumentalities of the United States; (2) federal funds 
purchased from any financial institution that participates in the 
federal funds market; and (3) repurchase agreements, with the provision 
that those requiring the delivery of collateral by a Bank may be only 
with Federal Reserve Banks, U.S. Government Sponsored Agencies and 
Instrumentalities, primary dealers recognized by the Federal Reserve 
Bank of New York, eligible financial institutions,\25\ and states and 
municipalities with a Moody's Investment Grade rating of 1 or 2.
---------------------------------------------------------------------------

    \25\ Eligible financial institutions include Banks and FDIC-
insured financial institutions, including U.S. subsidiaries of 
foreign commercial banks, whose most recently published financial 
statements exhibit at least $100 million of Tier I (or tangible) 
capital if the institution is a member of the investing Bank or at 
least $250 million of tangible capital for all other FDIC-insured 
institutions, and which have been rated at least a level III 
institution as defined in section VI.C of the FMP.
---------------------------------------------------------------------------

    Under the FMP, a Bank is authorized to participate in the proceeds 
from COs, so long as entering into such transactions will not cause the 
Bank's total COs and unsecured senior liabilities to exceed 20 times 
its capital. See id. at IV.C. The FMP authorizes a Bank to participate 
in certain types of standard and non-standard debt issues. See id. 
Specifically, the FMP requires that Banks participating in non-standard 
debt issues must enter into a contemporaneous hedging arrangement that 
allows the interest rate and/or basis risk to be passed through to the 
hedge counterparty unless the Bank is able to document that the debt 
will: (a) be used to fund mirror-image assets in an amount equal to the 
debt; or (b) offset or reduce interest rate or basis risk in the Bank's 
portfolio, or otherwise assist the Bank in achieving its interest rate 
and/or basis risk management objectives. If a Bank participates in debt 
denominated in a currency other than U.S. Dollars, it is required to 
hedge the currency exchange risk. See id. at IV.C.3.
    The FMP also prohibits a Bank from directly placing COs with 
another Bank. See id. at IV.C.4.
    Proposed Sec. 965.2(a) sets forth each Bank's authority to act as 
joint and several obligor with other Banks on COs, as authorized under 
proposed part 966. The proposed rule does not draw the distinction 
between standard and non-standard debt issues contained in the FMP. 
Instead, proposed Sec. 955.3(b) requires that some types of debt issues 
previously defined as non-standard be hedged. The types of debt issues 
that must be hedged under the proposed rule are those linked to equity 
or commodity prices or those denominated in foreign currencies. Other 
types of debt issues previously defined as non-standard need not be 
hedged, but these debt issues will be included in the market risk 
calculation in the proposed rule. The proposed rule does not include 
the 20 to 1 leverage limit from Sec. 910.1(b) of the Finance Board's 
existing regulations, or the 20 to 1 leverage limit on each Bank 
contained in the FMP. Instead, the proposed rule requires each Bank to 
have total capital in an amount equal to at least 3 percent of total 
assets, and requires each Bank to hold risk-based capital to meet a 
risk-based capital requirement. See proposed Secs. 930.3(a) and 
930.4(a).
    Proposed Sec. 965.2(b) continues the existing prohibition on 
directly placing COs with another Bank. It is the opinion of the 
Finance Board that such placements do not further the mission of the 
Bank System.
    COs have been the traditional source for most of the funds required 
for Bank operations. The remaining sources of funds have been deposits 
and member capital. As discussed above under proposed part 940, once 
the rule is fully phased in, 100 percent of COs would be required to be 
invested in CMA. The Banks, therefore, still would be able to invest 
deposits and member capital in any assets authorized under the proposed 
rule. Growing sophistication in the creation of off-balance sheet 
instruments could lead to efforts to circumvent the CMA requirement. 
For example, it may be possible to create tradeable deposits, which 
would be more similar to bonds than to deposits as the term is 
traditionally understood. The Banks also could use repurchase 
agreements to leverage deposits or capital. COs used to finance MBS may 
be replaced with repurchase agreements, using the MBS as collateral. In 
this way, the letter of the CMA requirement, but not the substance of 
the requirement--a shift in the composition of the balance sheet 
towards CMA--might be met. A Bank could hold non-CMA assets, including 
MBS, equal to several times its level of deposits plus capital.
    Therefore, proposed Sec. 965.2(b) continues each Bank's authority 
to accept deposits from members, other Banks and instrumentalities of 
the United States, but provides that the deposit transaction may not be 
conducted in such a way as to result in the offer or sale of a security 
in a public offering as those terms are used in 15 U.S.C. 77b(3). In 
addition, recognizing the importance of federal funds and repurchase 
agreements for the Banks' liquidity management, proposed Sec. 965.2(c) 
allows a Bank to purchase federal funds and enter into repurchase 
agreements, but only in order to satisfy the Banks' short-term 
liquidity needs.
    Proposed Sec. 965.3 would require each Bank to invest an amount 
equal to current deposits received from members in: (1) Obligations of 
the United States; (2) deposits in banks or trust companies;

[[Page 52196]]

and (3) advances with a maturity of five years or less made to members 
in conformity with the advances provisions of the Finance Board 
regulations (existing part 935; redesignated part 950).
    Section 11(g) of the Act, 12 U.S.C. 1431(g), requires each Bank to 
maintain deposit reserves in: (1) obligations of the United States; (2) 
deposits in banks or trust companies; (3) advances with a maturity of 
five years or less made to members, upon such terms and conditions as 
the Finance Board may prescribe; or (4) unsecured advances with a 
maturity of not to exceed five years which are made to members whose 
creditor liabilities do not exceed five percent of their net assets. 
Proposed Sec. 965.3 is intended to implement this statutory requirement 
and to clarify the types of advances that count toward the deposit 
reserve requirement (the Banks currently are not permitted to make 
unsecured advances). The definition of the term ``deposits in banks or 
trust companies'' contained in proposed Sec. 965.1 is identical to the 
definition of that term set forth in existing Sec. 934.4.

J. Part 966--Consolidated Obligations and Debentures

    Existing part 910 of the Finance Board's regulations, 
``Consolidated Bonds and Debentures,'' has been proposed to be 
redesignated as new part 966 in the proposed reorganization regulation. 
Part 966 of this proposed rule retains in large part the provisions of 
existing part 910, with certain proposed amendments, which are included 
in this rulemaking and discussed here.
    Specifically, Secs. 910.0 through 910.6 of the Finance Board's 
existing regulations, would be redesignated as Secs. 966.1 through 
966.7 and existing Sec. 910.1(b) (which imposes a 20-to-1 COs and 
unsecured senior liabilities to capital stock leverage limit on the 
Bank System) would be deleted. Proposed Sec. 966.7 has been revised 
from existing Sec. 910.6 to: delete references to the leverage limit; 
clarify and simplify the provision whereby the Finance Board may 
implement changes to the negative pledge requirement \26\ in 
Sec. 966.2(b) if the principal and interest on outstanding senior bonds 
have been fully defeased; and delete current Sec. 910.6(b)(2), which 
purports to impose limitations on the Finance Board's ability to change 
the leverage limit provision in current Sec. 910.1(b). In connection 
with these proposed amendments, it is the intention of the Finance 
Board to preserve the existence of the special asset accounts at the 
Banks established when the leverage limit in current part 910 was 
raised in 1992 from 12-to-1 to 20-to-1. See Finance Board Res. No. 92-
751 (Dec. 21, 1992). Current Sec. 910.6(b)(2) provides that current 
Sec. 910.1(b) may be changed by the Finance Board if the Finance Board 
receives either: (i) written evidence from at least one major 
nationally recognized securities rating agency that the proposed change 
will not result in the lowering of that rating agency's then-current 
rating or assessment on senior bonds outstanding or next to be issued; 
or (ii) a written opinion from an investment banking firm that the 
proposed change would not have a materially adverse effect on the 
creditworthiness of senior bonds outstanding or next to be issued. The 
Finance Board has consulted with the ratings agencies in developing 
this proposed rule. The proposal requires that the Banks maintain the 
triple-A rating of Bank System COs.
---------------------------------------------------------------------------

    \26\ The ``negative pledge requirement'' is the regulatory 
requirement that the Banks maintain certain types of unpledged 
assets in an amount equal to the amount of the Banks' senior bonds 
(as defined in existing Sec. 910.0(c)) outstanding.
---------------------------------------------------------------------------

K. Part 980--New Business Activities

    The proposed changes to the Banks' authorized investment authority 
would create opportunities for the Banks to undertake new business 
activities that they have not undertaken in the past and, therefore, 
could expose the Banks to risks that they have not had to manage in the 
past. In order to ensure that entering into new types of business 
activities will not create safety and soundness concerns, Sec. 980.2 of 
the proposed rule would require each Bank to provide 30 days notice to 
the Finance Board of any new business activity that the Bank wishes to 
undertake--including investing in new types of instruments--so that the 
Finance Board may disapprove or restrict such activities, as necessary, 
on a case-by-case basis. Proposed Sec. 980.1 defines a ``new business 
activity'' as meaning, with respect to a particular Bank's activities: 
(1) an activity that was not previously undertaken by that Bank, or was 
undertaken under materially different terms and conditions; (2) an 
activity that entails risks not previously and regularly managed by 
that Bank or its members; or (3) an activity that introduces operations 
not substantially equivalent to operations currently managed by that 
Bank. The test of what constitutes a new activity for a particular Bank 
is intended to focus attention on worthy new activities. The prior 
notice requirement would apply to any Bank desiring to pursue a new 
activity, even if another Bank has already undertaken the same 
activity.

IV. Regulatory Flexibility Act

    The proposed rule applies only to the Banks, which do not come 
within the meaning of ``small entities,'' as defined in the Regulatory 
Flexibility Act (RFA). See 5 U.S.C. 601(6). Therefore, in accordance 
with section 605(b) of the RFA, see id. at 605(b), the Finance Board 
hereby certifies that this proposed rule, if promulgated as a final 
rule, will not have a significant economic impact on a substantial 
number of small entities.

V. Paperwork Reduction Act

    This proposed rule does not contain any collections of information 
pursuant to the Paperwork Reduction Act of 1995. See 44 U.S.C. 3501 et 
seq. Therefore, the Finance Board has not submitted any information to 
the Office of Management and Budget for review.

List of Subjects in 12 CFR Parts 917, 925, 930, 940, 950, 954, 955, 
958, 965, 966 and 980

    Community development, Credit, Housing and Federal home loan banks.
    Accordingly, the Finance Board hereby proposes to amend title 12, 
chapter IX, Code of Federal Regulations, as follows:
    1. New part 917 is added to subchapter C to read as follows:

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

Sec.
917.1  Definitions.
917.2  General duties of Bank boards of directors.
917.3  Risk management.
917.4  Internal control system.
917.5  Audit committees.
917.6  Budget preparation and reporting requirements.
917.7  Dividends.
917.8  Approval of Bank bylaws.
917.9  Mission achievement.

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


Sec. 917.1  Definitions.

    As used in this part:
    Business risk means the risk of an adverse impact on a Bank's 
profitability resulting from external factors as may occur in both the 
short and long run.
    Contingency liquidity has the meaning set forth in Sec. 930.1 of 
this chapter.
    Credit risk has the meaning set forth in Sec. 930.1 of this 
chapter.
    Eligible nonmember borrower has the meaning set forth in Sec. 930.1 
of this chapter.

[[Page 52197]]

    Immediate family member means a parent, sibling, spouse, child, 
dependent, or any relative sharing the same residence.
    Liquidity risk means the risk that a Bank is unable to meet its 
obligations as they come due or meet the credit needs of its members 
and eligible nonmember borrowers in a timely and cost-efficient manner.
    Market risk has the meaning set forth in Sec. 930.1 of this 
chapter.
    Operations risk has the meaning set forth in Sec. 930.1 of this 
chapter.


Sec. 917.2  General duties of Bank boards of directors.

    The board of directors of each Bank shall have the duty to direct 
the operations of the Bank in conformity with the requirements set 
forth in this chapter. Each board director shall carry out his or her 
duties as director in good faith, in a manner such director believes to 
be in the best interests of the Bank, and with such care, including 
reasonable inquiry, as an ordinarily prudent person in a like position 
would use under similar circumstances.


Sec. 917.3  Risk management.

    (a) Adoption of risk management policy. (1) Within 180 calendar 
days of the effective date of this section, each Bank's board of 
directors shall adopt, and submit to the Finance Board for approval, a 
risk management policy that addresses the Bank's exposure to credit 
risk, market risk, liquidity risk, business risk and operations risk 
and that conforms to the requirements of paragraph (b) of this section 
and part 930 of this chapter.
    (2) Review and compliance. Each Bank's board of directors shall:
    (i) Review the Bank's risk management policy at least annually;
    (ii) Have the authority to amend the risk management policy at any 
time;
    (iii) Re-adopt the Bank's risk management policy, including interim 
amendments, not less often than every three years; and
    (iv) Ensure Bank compliance at all times with the risk management 
policy.
    (b) Risk management policy requirements. In addition to meeting any 
other requirements set forth in this part, or in part 930 of this 
chapter, each Bank's risk management policy shall:
    (1) Describe how the Bank will comply with the risk-based capital 
standards set forth in part 930 of this chapter;
    (2) Set forth the Bank's tolerance levels for the market and credit 
risk components; and
    (3) Set forth standards for the Bank's management of each risk 
component, including but not limited to:
    (i) Regarding credit risk arising from all secured and unsecured 
transactions, standards and criteria for, and timing of, periodic 
assessment of the creditworthiness of issuers, obligors, or other 
counterparties including identifying the criteria for selecting 
dealers, brokers and other securities firms with which the Bank may 
execute transactions; and
    (ii) Regarding market risk, standards for the methods and models 
used to measure and monitor such risk;
    (iii) Regarding day-to-day operational liquidity needs and 
contingency liquidity needs for periods during which the Bank's access 
to capital markets is impaired:
    (A) An enumeration of specific types of investments to be held for 
such liquidity purposes; and
    (B) The methodology to be used for determining the Bank's 
operational and contingency liquidity needs;
    (iv) Regarding operations risk, standards for an effective internal 
control system, including periodic testing and reporting; and
    (v) Regarding business risk, strategies for mitigating such risk, 
including contingency plans where appropriate.
    (c) Risk assessment. The senior management of each Bank shall 
perform, at least annually, a risk assessment that identifies and 
evaluates all material risks, including both quantitative and 
qualitative aspects, that could adversely affect the achievement of the 
Bank's performance objectives and compliance requirements. The risk 
assessment shall be in written form and shall be reviewed by the Bank's 
board of directors promptly upon its completion.


Sec. 917.4  Internal control system.

    (a) Establishment and maintenance. (1) Each Bank shall establish 
and maintain an effective internal control system that is adequate to 
ensure:
    (i) The efficiency and effectiveness of Bank activities;
    (ii) The safeguarding of assets;
    (iii) The reliability, completeness and timely reporting of 
financial and management information and transparency of such 
information to the Bank's board of directors and to the Finance Board; 
and
    (iv) Compliance with applicable laws, regulations, policies, 
supervisory determinations and directives of the Bank's board of 
directors and senior management.
    (2) Ongoing internal control activities necessary to maintain the 
internal control system required under paragraph (a)(1) of this section 
shall include, but are not limited to:
    (i) Top level reviews by the Bank's board of directors and senior 
management, including review of financial presentations and performance 
reports;
    (ii) Activity controls, including review of standard performance 
and exception reports by department-level management on an appropriate 
periodic basis;
    (iii) Physical controls adequate to ensure the safeguarding of 
assets;
    (iv) Monitoring for compliance with the risk tolerance limits set 
forth in the Bank's risk management policy;
    (v) Any required approvals and authorizations for specific 
activities; and
    (vi) Any required verifications and reconciliations for specific 
activities.
    (b) Internal control responsibilities of Banks' boards of 
directors. Each Bank's board of directors shall direct the 
establishment and maintenance of the internal control system required 
under paragraph (a)(1) of this section, and oversee senior management's 
implementation of such a system on an ongoing basis, by:
    (1) Conducting periodic discussions with senior management 
regarding the effectiveness of the internal control system;
    (2) Ensuring that an effective and comprehensive internal audit of 
the internal control system is performed annually;
    (3) Ensuring that internal control deficiencies are reported to the 
Bank's board of directors in a timely manner and are addressed 
promptly;
    (4) Conducting a timely review of evaluations of the effectiveness 
of the internal control system made by internal auditors, external 
auditors and Finance Board examiners;
    (5) Ensuring that senior management promptly and effectively 
addresses recommendations and concerns expressed by internal auditors, 
external auditors and Finance Board examiners regarding weaknesses in 
the internal control system;
    (6) Reporting any internal control deficiencies found, and the 
corrective action taken, to the Finance Board in a timely manner;
    (7) Establishing, documenting and communicating an organizational 
structure that clearly shows lines of authority within the Bank, 
provides for effective communication throughout the Bank, and ensures 
that there are no gaps in the lines of authority;
    (8) Ensuring that all delegations of authority to specific 
personnel or committees state the extent of the authority and 
responsibilities delegated; and

[[Page 52198]]

    (9) Establishing reporting requirements, including specifying the 
nature and frequency of reports it receives.
    (c) Internal control responsibilities of Banks' senior management. 
Each Bank's senior management shall be responsible for carrying out the 
directives of the Bank's board of directors, including the 
establishment, implementation and maintenance of the internal control 
system required under paragraph (a)(1) of this section, by:
    (1) Establishing, implementing and effectively communicating to 
Bank personnel policies and procedures that are adequate to ensure that 
internal control activities necessary to maintain an effective internal 
control system, including the activities enumerated in paragraph (a)(2) 
of this section, are an integral part of the daily functions of all 
Bank personnel;
    (2) Ensuring that all Bank personnel fully understand and comply 
with all policies and procedures;
    (3) Ensuring that there is appropriate segregation of duties among 
Bank personnel and that personnel are not assigned conflicting 
responsibilities;
    (4) Establishing effective paths of communication upward, downward 
and across the organization in order to ensure that Bank personnel 
receive necessary and appropriate information, including:
    (i) Information relating to the operational policies and procedures 
of the Bank;
    (ii) Information relating to the actual operational performance of 
the Bank;
    (iii) Adequate and comprehensive internal financial, operational 
and compliance data; and
    (iv) External market information about events and conditions that 
are relevant to decision making;
    (5) Developing and implementing procedures that translate the major 
business strategies and policies established by the Bank's board of 
directors into operating standards;
    (6) Ensuring adherence to the lines of authority and responsibility 
established by the Bank's board of directors;
    (7) Overseeing the implementation and maintenance of management 
information and other systems;
    (8) Establishing and implementing an effective system to track 
internal control weaknesses and the actions taken to correct them; and
    (9) Monitoring and reporting to the Bank's board of directors the 
effectiveness of the internal control system on an ongoing basis.


Sec. 917.5  Audit committees.

    (a) Establishment. The board of directors of each Bank shall 
establish an audit committee, consistent with the requirements set 
forth in this section.
    (b) Composition. (1) The audit committee shall comprise five or 
more persons drawn from the Bank's board of directors, each of whom 
shall meet the criteria of independence set forth in paragraph (c) of 
this section.
    (2) The audit committee shall include representatives of large and 
small members and appointive and elective directors of the Bank.
    (3) The terms of audit committee members shall be appropriately 
staggered so as to provide for continuity of service.
    (4) All members of the audit committee shall have a working 
familiarity with basic finance and accounting practices, and at least 
one member of the audit committee shall have extensive accounting or 
financial management expertise. If the board of directors determines 
that there are not a sufficient number of board directors possessing 
the necessary skills and expertise to qualify for service on the audit 
committee (considering the representation requirements of paragraph 
(b)(2) of this section), the board of directors shall:
    (i) In the case of audit committee representation of appointive 
directors, provide written notification to the Finance Board for 
consideration when appointing directors; and
    (ii) In the case of audit committee representation of elective 
directors, include in the Election Announcement required under 
Sec. 915.6(a) of this chapter, a statement describing the skills or 
expertise needed.
    (c) Independence. Any member of the Bank's board of directors shall 
be considered to be sufficiently independent to serve as a member of 
the audit committee if that director does not have a disqualifying 
relationship with the Bank or its management that would interfere with 
the exercise of that director's independent judgment. Such 
disqualifying relationships shall include, but shall not be limited to:
    (1) Being employed by the Bank in the current year or any of the 
past five years;
    (2) Accepting any compensation from the Bank other than 
compensation for service as a board director;
    (3) Serving or having served in any of the past five years as a 
consultant, advisor, promoter, underwriter, or legal counsel of or to 
the Bank; or
    (4) Being an immediate family member of an individual who is, or 
has been in any of the past five years, employed by the Bank.
    (d) Charter. (1) The audit committee of each Bank shall adopt, and 
the Bank's board of directors shall approve, a formal written charter 
that specifies the scope of the audit committee's powers and 
responsibilities, as well as the audit committee's structure, processes 
and membership requirements.
    (2) The audit committee and the board of directors of each Bank 
shall:
    (i) Review the Bank's audit committee charter on an annual basis; 
and
    (ii) Have the authority to adopt and approve, respectively, 
amendments to the audit committee charter at any time; and
    (iii) Re-adopt and re-approve, respectively, the Bank's audit 
committee charter not less often than every three years.
    (3) Each Bank's audit committee charter shall:
    (i) Provide that the internal auditor may be removed only with the 
approval of the audit committee;
    (ii) Provide that the internal auditor shall report directly to the 
audit committee on substantive matters and to the Bank President on 
administrative matters;
    (iii) Empower the audit committee to retain outside counsel, 
independent accountants, or other outside consultants; and
    (iv) Provide that both the internal auditor and the external 
auditor shall have unrestricted access to the audit committee without 
the need for any prior management knowledge or approval.
    (e) Duties. Each Bank's audit committee shall have the duty to:
    (1) Ensure that senior management maintains the reliability and 
integrity of the accounting policies and financial reporting and 
disclosure practices of the Bank;
    (2) Review the basis for the Bank's financial statements and the 
external auditor's opinion rendered with respect to such financial 
statements (including the nature and extent of any significant changes 
in accounting principles or the application therein) and ensure 
disclosure and transparency regarding the Bank's true financial 
performance and governance practices;
    (3) Oversee the internal audit function by:
    (i) Reviewing the scope of audit services required, significant 
accounting policies, significant risks and exposures, audit activities 
and audit findings;
    (ii) Assessing the performance, and determining the compensation, 
of the internal auditor; and
    (iii) Reviewing and approving the internal auditor's work plan;
    (4) Oversee the external audit function by:
    (i) Approving the external auditor's annual engagement letter;

[[Page 52199]]

    (ii) Reviewing the performance of the external auditor; and
    (iii) Making recommendations to the Bank's board of directors 
regarding the appointment, renewal, or termination of the external 
auditor;
    (5) Provide an independent, direct channel of communication between 
the Bank's board of directors and the internal and external auditors;
    (6) Conduct or authorize investigations into any matters within the 
audit committee's scope of responsibilities;
    (7) Ensure that senior management has established and is 
maintaining an adequate internal control system within the Bank by:
    (i) Reviewing the adequacy of the Bank's internal control system 
and the resolution of identified material weaknesses and reportable 
conditions in the internal control system, including the prevention or 
detection of management override or compromise of the internal control 
system; and
    (ii) Reviewing the programs and policies of the Bank designed to 
ensure compliance with applicable laws, regulations and policies and 
monitoring the results of these compliance efforts;
    (8) Ensure that senior management has established and is 
maintaining adequate policies and procedures to ensure that the Bank 
can assess, monitor and control compliance with its mission achievement 
policy; and
    (9) Report periodically its findings to the Bank's board of 
directors.
    (f) Meetings. The audit committee shall prepare written minutes of 
each audit committee meeting.


Sec. 917.6  Budget preparation and reporting requirements.

    (a) Adoption of annual Bank budgets. (1) Each Bank's board of 
directors shall be responsible for the adoption of an annual operating 
expense budget and a capital expenditures budget for the Bank, and any 
subsequent amendments thereto, consistent with the requirements of the 
Act, this section, other regulations and policies of the Finance Board, 
and with the Bank's responsibility to protect both its members and the 
public interest by keeping its costs to an efficient and effective 
minimum.
    (2) Pursuant to the requirement of section 12(a) of the Act (12 
U.S.C. 1432(a)), a Bank must obtain prior approval of the Finance Board 
before purchasing or erecting, or leasing for a term of more than 10 
years, a building to house the Bank.
    (3) A Bank's board of directors may not delegate the authority to 
approve the Bank's annual budgets, or any subsequent amendments 
thereto, to Bank officers or other Bank employees.
    (4) A Bank's annual budgets shall be prepared based upon an 
interest rate scenario as determined by the Bank.
    (5) A Bank may not exceed its total annual operating expense budget 
or its total annual capital expenditures budget without prior approval 
by the Bank's board of directors of an amendment to such budget.
    (b) Budget reports. Each Bank shall submit to the Finance Board, by 
January 31 of each year, in a format and as further prescribed by the 
Finance Board, such Bank budgets and other financial information as the 
Finance Board shall require, including the following:
    (1) Balance sheet projections;
    (2) Income statement projections, including operating expense 
budget data and staffing levels;
    (3) Capital expenditures budget data;
    (4) Management discussion of expected financial performance;
    (5) Strategic or business plan;
    (6) Interest rate assumptions; and
    (7) A copy of the Bank's board of directors resolution adopting the 
Bank's annual operating expense budget and capital expenditures budget.
    (c) Report on amendments to total annual budgets. A Bank shall 
submit promptly to the Finance Board a copy of the Bank's board of 
directors resolution adopting any amendment increasing a Bank's total 
annual operating expense budget or total annual capital expenditures 
budget above originally-approved budget limits.
    (d) Mid-year reforecasting report. Each Bank shall submit to the 
Finance Board, by July 31 of each year, in a format and as further 
prescribed by the Finance Board, a report containing a balance sheet 
and income statement setting forth reforecasted projections for the 
year relative to the budget projections for that year as originally 
approved or amended, including a management discussion explaining any 
significant changes in the reforecasted projections from the budget 
projections as originally approved or amended.
    (e) Annual actual performance results report. Each Bank shall 
submit to the Finance Board, by January 31 of each year, in a format 
and as further prescribed by the Finance Board, a report containing a 
balance sheet and income statement setting forth the actual performance 
results for the prior year relative to the budget projections for that 
year as originally approved or amended, including a management 
discussion explaining any significant changes in the actual performance 
results from the budget projections as originally approved or amended.


Sec. 917.7  Dividends.

    The board of directors of each Bank may, without the Finance 
Board's prior approval, declare and pay a dividend from net earnings, 
including previously retained earnings, on the paid-in value of capital 
stock held during the dividend period, as determined by the Bank, so 
long as such payment will not result in a projected impairment of the 
par value of the capital stock of the Bank. Dividends on such stock 
shall be computed without preference and only for the period such stock 
was outstanding during the dividend period. Dividends may be paid in 
cash or in the form of stock.


Sec. 917.8  Approval of Bank bylaws.

    The board of directors of a Bank may prescribe, amend, or repeal 
bylaws governing the manner in which the Bank administers its affairs 
without the Finance Board's prior approval, provided that the bylaws or 
amendments are consistent with applicable statutes, regulations and 
Finance Board policies.


Sec. 917.9  Mission achievement.

    (a) Mission achievement policy. (1) Adoption. Within 180 calendar 
days of the effective date of this section, each Bank's board of 
directors shall adopt, and submit to the Finance Board for approval, a 
mission achievement policy that:
    (i) Details how the Bank will comply with the core mission activity 
requirements set forth in part 940 of this chapter, including 
contingent business strategies for meeting such requirements under 
different assumptions about future economic and mortgage market 
conditions; and
    (ii) Outlines a process for developing and implementing new 
mission-related products and services.
    (2) Review and compliance. Each Bank's board of directors shall:
    (i) Review the Bank's mission achievement policy at least annually;
    (ii) Have the authority to amend the mission achievement policy at 
any time;
    (iii) Re-adopt the Bank's mission achievement policy, including 
interim amendments, not less often than every three years; and
    (iv) Ensure Bank compliance at all times with the mission 
achievement policy.
    (b) Mission achievement oversight. Each Bank's board of directors 
shall:
    (1) Direct the establishment and maintenance, by senior management, 
of adequate policies and procedures to ensure that the Bank can assess, 
monitor and control compliance with its mission achievement policy;

[[Page 52200]]

    (2) Establish a mechanism to measure and assess the Bank's 
performance against its mission achievement goals and objectives;
    (3) Require that performance assessments be conducted at least 
annually that evaluate the Bank's mission achievement and measure its 
performance against the Bank's goals and objectives, which performance 
assessments shall be reviewed by the Bank's board of directors.

PART 925--MEMBERS OF THE BANKS

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

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

    3. Amend Sec. 925.14 by revising paragraph (a)(4)(iv) to read as 
follows:


Sec. 925.14  De novo insured depository institution applicants.

* * * * *
    (a) * * *
    (4) * * *
    (iv) Treatment of outstanding advances and Bank stock. If the 
applicant's conditional membership approval is deemed null and void 
pursuant to paragraph (a)(4)(ii) of this section:
    (A) The liquidation of any outstanding indebtedness owed by the 
applicant to the Bank shall be carried out in accordance with 
Sec. 925.29; and
    (B) The redemption of stock of such Bank shall be carried out in 
accordance with Sec. 930.9.
* * * * *
    4. Amend Sec. 925.22 by removing paragraph (b)(2) and redesignating 
paragraph (b)(1) as paragraph (b).
    5. Amend Sec. 925.24 by revising paragraph (b)(2) to read as 
follows:


Sec. 925.24  Consolidation of members.

* * * * *
    (b) * * *
    (2) Treatment of outstanding advances and Bank stock. (i) The 
liquidation of any outstanding indebtedness owed to the disappearing 
institution's Bank shall be carried out in accordance with Sec. 925.29.
    (ii) The redemption of stock of the disappearing institution's Bank 
shall be carried out in accordance with Sec. 930.9 of this chapter.
* * * * *
    6. Amend Sec. 925.25 by revising paragraph (d)(3) to read as 
follows:


Sec. 925.25  Consolidations involving nonmembers.

* * * * *
    (d) * * *
    (3) Upon failure to apply for or be approved for membership. If the 
consolidated institution does not apply for membership, or if its 
application for membership is denied, then:
    (i) The liquidation of any outstanding indebtedness owed to the 
disappearing institution's Bank shall be carried out in accordance with 
Sec. 925.29; and
    (ii) The redemption of stock of the disappearing institution's Bank 
shall be carried out in accordance with Sec. 930.9 of this chapter, and 
the consolidated institution shall have the limited rights associated 
with such stock in accordance with paragraph (e) of this section.
* * * * *
    7. Amend Sec. 925.26 by revising paragraphs (a), (b) and (c) to 
read as follows:


Sec. 925.26  Procedure for withdrawal.

    (a) Notice of withdrawal. Any member that is eligible under 
applicable law to withdraw from Bank membership may do so after 
providing its Bank with written notice of the member's intention to 
withdraw from membership in accordance with the requirements of 
Sec. 930.9 of this chapter.
    (b) Cancellation of notice of withdrawal. A member may cancel its 
notice of withdrawal by providing its Bank written notice of 
cancellation any time before the effective date of the withdrawal.
    (c) Treatment of outstanding advances and Bank stock. (1) The 
liquidation of any outstanding indebtedness owed to the Bank in which 
membership has been terminated shall be carried out in accordance with 
Sec. 925.29.
    (2) The redemption of stock of the Bank in which membership has 
been terminated shall be carried out in accordance with Sec. 930.9 of 
this chapter.
* * * * *
    8. Amend Sec. 925.27 by revising paragraph (e) to read as follows:


Sec. 925.27  Procedure for removal.

* * * * *
    (e) Treatment of outstanding advances and Bank stock. (1) The 
liquidation of any outstanding indebtedness owed to the Bank in which 
membership has been terminated shall be carried out in accordance with 
Sec. 925.29.
    (2) The redemption of stock of the Bank in which membership has 
been terminated shall be carried out in accordance with Sec. 930.9 of 
this chapter.
* * * * *
    9. Amend Sec. 925.28 by revising paragraph (b) to read as follows:


Sec. 925.28  Automatic termination of membership for institutions 
placed in receivership.

* * * * *
    (b) Treatment of outstanding advances and Bank stock. (1) The 
liquidation of any outstanding indebtedness owed to the Bank in which 
membership has been terminated shall be carried out in accordance with 
Sec. 925.29.
    (2) The redemption of stock of the Bank in which membership has 
been terminated shall be carried out in accordance with Sec. 930.9 of 
this chapter.
* * * * *

Subpart G--Orderly Liquidation of Advances

    10. Revise the heading of subpart G to read as set forth above.
    11. Amend Sec. 925.29 by:
    a. Revising the heading;
    b. Removing paragraphs (b) and (c);
    c. Redesignating paragraphs (a)(1) and (a)(2) as paragraphs (a) and 
(b), respectively; and
    d. Revising newly designated paragraph (b).
    The revisions read as follows:


Sec. 925.29  Orderly liquidation of advances.

    (b) The indebtedness of the institution that has ceased to be a 
member of a Bank owed to such Bank shall be liquidated in an orderly 
manner as determined by the Bank in accordance with Sec. 950.19 of this 
chapter.
* * * * *
    12. New part 930 is added to subchapter E to read as follows:

PART 930--RISK MANAGEMENT AND CAPITAL STANDARDS

Sec.
930.1  Definitions.
930.2  Bank System and individual Bank credit ratings.
930.3  Minimum total capital requirement.
930.4  Minimum total risk-based capital requirement.
930.5  Credit risk capital requirement.
930.6  Market risk capital requirement.
930.7  Operations risk capital requirement.
930.8  Reporting requirements.
930.9  Capital stock redemption requirements.
930.10  Minimum liquidity requirements.
930.11  Limits on unsecured extensions of credit to one counterparty 
or affiliated counterparties; reporting requirements for total 
extensions of credit to one counterparty or affiliated 
counterparties.

    Authority: 12 U.S.C. 1422a(a)(3), 1422b(a), 1426, 1429, 1430, 
1430b, 1431, 1436, 1440.


Sec. 930.1  Definitions.

    As used in this part:
    Affiliated counterparty means a counterparty that is an affiliate 
of

[[Page 52201]]

another counterparty, as the term ``affiliate'' is defined in 12 U.S.C. 
371c(b) (as amended).
    Certain drawdown means, in relation to commitments to make advances 
or other loans, that it is known during the pendency of the commitment 
that the advance or loan funds definitely will be drawn in full.
    Contingency liquidity means:
    (1) Marketable assets with a maturity of one year or less;
    (2) Self-liquidating assets with a maturity of seven days or less; 
and
    (3) Assets that are generally accepted as collateral in the 
repurchase agreement market.
    Credit derivative contract means a derivative contract that 
transfers credit risk.
    Credit risk means the risk that an obligation will not be paid in 
full and loss will result.
    Derivative contract means generally a financial contract whose 
value is derived from the values of one or more underlying assets, 
reference rates, or indexes of asset values, or credit-related events. 
Derivative contracts include interest rate, foreign exchange rate, 
equity, precious metals, commodity, and credit contracts, and any other 
instruments that pose similar risks.
    Eligible nonmember borrower means an entity that has been approved 
as a nonmember mortgagee pursuant to subpart B of part 950 of this 
chapter.
    Exchange rate contracts include cross-currency interest rate swaps, 
forward foreign exchange rate contracts, currency options purchased, 
and any similar instruments that gives rise to similar risks.
    Financial Management Policy means the Financial Management Policy 
For The Federal Home Loan Bank System approved by the Finance Board 
pursuant to Finance Board Resolution No. 96-45 (July 3, 1996), as 
amended by Finance Board Resolution No. 96-90 (Dec. 6, 1996), Finance 
Board Resolution No. 97-05 (Jan. 14, 1997), and Finance Board Res. No. 
97-86 (Dec. 17, 1997).
    GSE, or Government Sponsored Enterprise, means a United States 
Government-sponsored agency originally established or chartered to 
serve public purposes specified by the United States Congress, but 
whose obligations are not obligations of the United States and are not 
guaranteed by the United States.
    Interest rate contracts include: Single currency interest rate 
swaps; basis swaps; forward rate agreements; interest rate options; and 
any similar instrument that gives rise to similar risks, including 
when-issued securities.
    Investment grade means:
    (1) A credit quality rating in one of the four highest credit 
rating categories by an NRSRO and not below the fourth highest rating 
category by any NRSRO; or
    (2) If there is no credit quality rating by an NRSRO, a 
determination by a Bank that the issuer, asset or instrument is the 
credit equivalent of investment grade using credit rating standards 
available from an NRSRO or other similar standards.
    Issuer credit rating means an opinion issued by an NRSRO of an 
institution's overall capacity to meet its obligations (i.e., the 
institution's creditworthiness).
    Market risk means the risk that the market value of a Bank's 
portfolio will decline as a result of changes in the general level of 
interest rates, foreign exchange rates, equity and commodity prices.
    Marketable means, with respect to an asset, that the asset can be 
sold with reasonable promptness at a price that corresponds reasonably 
to its fair value.
    Market value at risk is calculated as the maximum loss in the 
market value of a portfolio under various stress scenarios.
    NRSRO means a credit rating organization regarded as a Nationally 
Recognized Statistical Rating Organization by the Securities and 
Exchange Commission.
    OFHEO means the Office of Federal Housing Enterprise Oversight.
    Operations risk means the risk of an unexpected loss to a Bank 
resulting from human error, fraud, unenforceability of legal contracts, 
or deficiencies in internal controls or information systems.
    Repurchase agreement means an agreement between a seller and a 
buyer whereby the seller agrees to repurchase a security at an agreed 
upon price, with or without a stated time for repurchase.
    Retained earnings means the retained earnings required to be 
reported by a Bank to the Finance Board for regulatory purposes.
    Total assets means the total assets required to be reported by a 
Bank to the Finance Board for regulatory purposes.
    Total capital means the sum of a Bank's retained earnings and total 
capital stock outstanding, less the Bank's unrealized net losses on 
available-for-sale securities.
    Total capital stock outstanding means all forms and types of 
outstanding capital stock required to be reported by a Bank to the 
Finance Board for regulatory purposes.
    Total risk-based capital for a Bank means the sum of:
    (1) Such Bank's retained earnings, less unrealized net losses on 
available-for-sale securities;
    (2) Any outstanding non-redeemable capital stock of such Bank;
    (3) All outstanding capital stock satisfying the minimum capital 
stock purchase requirements for membership under sections 6(b)(1) and 
10(e)(3) of the Act (12 U.S.C. sections 1426(b)(1), 1430(e)(3)) for all 
institutions required by law to be members of such Bank (mandatory 
members);
    (4) A percentage not exceeding 50 percent, as determined by such 
Bank's board of directors, of all outstanding capital stock satisfying 
the minimum capital stock purchase requirements for membership under 
sections 6(b)(1) and 10(e)(3) of the Act (12 U.S.C. sections 
1426(b)(1), 1430(e)(3)) for all Bank members not required by law to be 
members of the Bank (voluntary members); and
    (5) A percentage (which is not required to be identical to any 
percentage determined for purposes of paragraph (4) of this definition 
not exceeding 50 percent, as determined by such Bank's board of 
directors, of all remaining outstanding capital stock.
    Unrealized net losses on available-for-sale securities means the 
unrealized net losses on available-for-sale securities required to be 
reported by a Bank to the Finance Board for regulatory purposes.
    Walkaway clause means a provision in a bilateral netting contract 
that permits a nondefaulting counterparty to make a lower payment than 
it would make otherwise under the bilateral netting contract, or no 
payment at all, to a defaulter or the estate of a defaulter, even if 
the defaulter or the estate of the defaulter is a net creditor under 
the bilateral netting contract.


Sec. 930.2  Bank System and individual Bank credit ratings.

    (a) Bank System credit rating. (1) The Banks, collectively, shall 
obtain from an NRSRO, and at all times maintain, a current credit 
rating on the Banks' consolidated obligations.
    (2) Each Bank shall operate in such a manner and take any actions 
necessary to ensure that the Banks' consolidated obligations receive 
and continue to receive the highest credit rating from any NRSRO by 
which the consolidated obligations have been then rated.
    (b) Individual Bank credit rating. Each Bank shall operate in such 
a manner and take any actions necessary to ensure that the Bank has and 
maintains an individual issuer credit rating of at least the second 
highest credit rating from any NRSRO providing a rating, where such 
rating is:

[[Page 52202]]

    (1) A meaningful measure of the individual Bank's financial 
strength and stability, apart from the GSE status of the Bank System;
    (2) Obtained from an NRSRO that states in writing to the Bank that 
its rating conforms with paragraph (b)(1) of this section; and
    (3) Updated at least annually, or more frequently as required by 
the Finance Board to reflect any material changes in the condition of 
the Bank.
    (c) Transition provision. Each Bank shall obtain the credit rating 
from an NRSRO required under paragraph (b) of this section within one 
calendar year of the effective date of this part.


Sec. 930.3  Minimum total capital requirement.

    (a) Minimum total capital ratio. Each Bank shall have and maintain 
at all times total capital in an amount equal to at least 3.0 percent 
of the Bank's total assets.
    (b) Safety and soundness exception. For reasons of safety and 
soundness, the Finance Board may require an individual Bank to have and 
maintain a higher minimum capital ratio than the ratio set forth in 
paragraph (a) of this section.


Sec. 930.4  Minimum total risk-based capital requirement.

    (a) General. Each Bank shall have and maintain at all times total 
risk-based capital in an amount at least equal to the sum of its credit 
risk capital requirement, its market risk capital requirement, and its 
operations risk capital requirement, calculated in accordance with 
Secs. 930.5, 930.6 and 930.7, respectively.
    (b) Transition provisions. (1) Each Bank shall be required to meet 
its minimum total risk-based capital requirement under paragraph (a) of 
this section within 90 calendar days after the Finance Board's approval 
of the Bank's internal market risk model.
    (2) No Bank shall be governed by the capital requirements of this 
part, and each Bank shall continue to be governed by the Financial 
Management Policy, until:
    (i) The Bank has received Finance Board approval of the Bank's 
internal market risk model and the Bank's risk management policy;
    (ii) The Bank demonstrates to the Finance Board that it has 
sufficient risk-based capital to meet the minimum total risk-based 
capital requirement under paragraph (a) of this section for its then-
current portfolio; and
    (iii) The Bank demonstrates to the Finance Board, in its risk 
management policy or otherwise, risk assessment procedures and controls 
sufficient to manage the Bank's credit, market and operations risks.


Sec. 930.5  Credit risk capital requirement.

    (a) General requirement. A Bank's credit risk capital requirement 
equals the sum of the Bank's credit risk capital requirements for all 
on-balance sheet assets and off-balance sheet items.
    (b) Credit risk capital requirements for on-balance sheet assets. A 
Bank's credit risk capital requirement for a specific on-balance sheet 
asset shall be equal to the book value of the asset multiplied by the 
specific credit risk percentage requirement assigned to that category 
of credit risk pursuant to paragraph (d) of this section.
    (c) Credit risk capital requirement for off-balance sheet items. A 
Bank's credit risk capital requirement for a specific off-balance sheet 
item shall be equal to the credit equivalent amount of such item, as 
determined pursuant to paragraphs (e), (f), or (g) of this section, as 
applicable, multiplied by the specific credit risk percentage 
requirement assigned to that category of credit risk pursuant to 
paragraph (d) of this section.
    (d) Determination of specific credit risk percentage requirements--
(1) Finance Board determination of specific credit risk percentage 
requirements. The Finance Board shall determine, and update 
periodically, specific credit risk percentage requirements for 
particular credit risk categories applicable to on-balance sheet assets 
and off-balance sheet items, based on the type of asset or item and its 
credit rating, if any, as set forth in paragraph (d)(3) of this 
section.
    (2) Finance Board underlying methodology. (i) In determining the 
specific credit risk percentage requirements, the Finance Board shall 
use data made available by NRSROs and other relevant sources to derive 
estimates of credit risk (or, ``credit losses'') corresponding to 
particular categories of credit risks.
    (ii) The estimates of credit risk shall represent credit losses as 
could occur during periods of extreme credit stress. Historical data 
used in deriving estimates of credit losses shall reflect the longer-
term nature of credit cycles and span multiple credit cycles. Estimates 
of credit losses shall be equal to the product of extreme values of the 
distributions of both the default frequency and the recovery rate in 
default for each credit risk category.
    (3) Specific credit risk capital requirements by credit risk 
category. The specific credit risk percentage requirements applicable 
to a Bank's on-balance sheet assets and off-balance sheet items are as 
provided in the following Table 1:

   Table 1.--Credit Risk Capital Requirements by Credit Risk Category
------------------------------------------------------------------------
                                                              Percent of
                                                              on-balance
                    Credit risk category                        sheet
                                                              equivalent
                                                                value
------------------------------------------------------------------------
(i) Authorized Investments
(A) Cash; Government Securities............................          0.0
(B) Advances...............................................          0.3
(C) Highest Investment Grade...............................          0.3
(D) Second Highest Investment Grade........................          0.6
(E) Third Highest Investment Grade.........................          1.0
(F) Fourth Highest Investment Grade........................          1.3
(G) Premises, Plant, and Equipment.........................          8.0
(H) Core Mission Equity Investments Under Sec.  940.3(e)...          8.0
(ii) Investments Downgraded to Below Investment Grade After
                    Acquisition By Bank
(A) Highest Below Investment Grade.........................         12.0
(B) Second Highest Below Investment Grade..................         50.0
(C) All Other Below Investment Grade.......................        100.0
------------------------------------------------------------------------

    (4) Bank determination of specific credit risk percentage 
requirements. (i) General requirement. Each Bank shall determine the 
credit risk capital requirement for each on-balance sheet asset and 
off-balance sheet item by determining the type of asset or item and its 
credit rating, if any (as provided in paragraph (d)(4)(ii) of this 
section) determining the applicable credit risk category for such asset 
or item as set forth in Table 1 of paragraph (d)(3) of this section, 
and applying the applicable credit risk percentage requirement for such 
credit risk category contained in Table 1.
    (ii) Bank determination of credit rating. (A) For assets or items 
that are rated directly by an NRSRO, the credit rating that shall apply 
for purposes of determining the applicable credit risk category under 
Table 1 shall be the credit rating of the asset or item, respectively.
    (B) For an asset or item, or relevant portion of an asset or item, 
that is not rated directly by an NRSRO, but for which an NRSRO rating 
has been assigned to any of the corresponding obligor counterparty, 
third party guarantor or underlying collateral, the credit rating that 
shall apply to the asset or item or portion of the asset or item 
corresponding to a particular rating, for purposes of determining the 
applicable

[[Page 52203]]

credit risk category under Table 1, shall be the highest of the credit 
ratings corresponding to such asset or item or portion or such asset or 
item.
    (C) Where a credit rating has a modifier, e.g., A+ or A-, the 
credit rating is deemed to be the credit rating without the modifier, 
e.g., A+ or A-= A.
    (D) In determining the applicable credit risk category under Table 
1 for a specific asset or item that has received more than one credit 
rating from a given NRSRO, the most recent credit rating shall be used.
    (E) If a specific asset or item has received credit ratings from 
more than one NRSRO, the lowest credit rating shall be used in 
determining the applicable credit risk category for such asset or item 
under Table 1.
    (F) If an asset or item, or relevant portion of an asset or item, 
does not meet the requirements of paragraphs (d)(4)(ii)(A) or (B) of 
this section, and does not fall within the credit risk categories of 
Cash, Government Securities, Advances, Premises, Plant, Equipment, or 
Core Mission Equity Investments, for purposes of determining the 
applicable credit risk category under Table 1, the Bank shall determine 
its own credit rating for the asset or item or relevant portion of the 
asset or item using credit rating standards available from an NRSRO or 
other similar standards.
    (iii) Recognition of collateral. Assets or items shall be deemed to 
be backed by collateral for purposes of this paragraph (d)(4)(iii) if 
the collateral is:
    (A) Actually held by the Bank or an independent, third-party 
custodian, or by the Bank's member or eligible nonmember borrower if 
permitted under the Bank's collateral agreement with such party;
    (B) Legally available to absorb losses;
    (C) Has a readily determinable value at which it can be liquidated 
by the Bank; and
    (D) Is held in accordance with the provisions of the Bank's 
collateral management policy.
    (iv) Collateral haircut. In recognizing collateral, appropriate 
allowance for haircuts (over collateralization) reflecting the market 
risk underlying the collateral must be made.
    (5) Specific credit risk capital requirements for on-balance sheet 
assets hedged with credit derivatives.
    (i) If a credit derivative is used to lower (hedge) the credit risk 
on an asset, the credit derivative and such underlying asset are of 
identical remaining maturity, and the asset being referenced in the 
credit derivative (reference asset) is identical to the underlying 
asset, the credit risk capital requirement for the underlying asset 
shall be zero.
    (ii) If the underlying asset and the reference asset are identical, 
but their remaining maturities are different, the credit risk capital 
requirement for the underlying asset shall be zero, provided the 
remaining maturity of the credit derivative is two years or more.
    (iii) If the remaining maturities of the underlying asset and the 
credit derivative are identical, but the underlying asset is different 
from the asset referenced in the credit derivative, the credit risk 
capital requirement for the underlying asset shall be zero, provided 
that the reference asset and the underlying asset have been issued by 
the same obligor, the reference asset ranks pari passu to or more 
junior than the underlying asset, and cross-default clauses apply.
    (iv) If the credit risk capital requirement for the underlying 
asset is decreased in recognition of a credit derivative, the credit 
risk capital requirement for the derivative contract pursuant to 
paragraphs (f) and (g) of this section shall still apply.
    (e) Calculation of credit equivalent amount for off-balance sheet 
items other than derivative contracts. The credit equivalent amount for 
an off-balance sheet item other than a derivative contract shall be 
determined by a Finance Board approved model or equal to the face 
amount of the instrument multiplied by the credit conversion factor 
assigned to such risk category of instruments provided in the following 
Table 2:

  Table 2.--Credit Conversion Factors for Off-Balance Sheet Items Other
                        Than Derivative Contracts
------------------------------------------------------------------------
                                                                Credit
                                                              conversion
                         Instrument                           factor (in
                                                               percent)
------------------------------------------------------------------------
(1) Standby letters of credit..............................          100
(2) Asset sales with recourse where the credit risk remains          100
 with the Bank.............................................
(3) Sale and repurchase agreements.........................          100
(4) Forward asset purchases................................          100
(5) Commitments to make advances, or other loans, with               100
 certain drawdown..........................................
(6) Other commitments with original maturity of over one           \1\50
 year......................................................
(7) Other commitments with original maturity of one year or       \1\20
 less......................................................
------------------------------------------------------------------------
\1\ The credit conversion factor would be zero for other commitments
  that are unconditionally cancelable, or that effectively provide for
  automatic cancellation, due to the deterioration in a borrower's
  creditworthiness, at any time by the Bank without prior notice.

    (f) Calculation of credit equivalent amount for single derivative 
contracts. The credit equivalent amount for a derivative contract that 
is not subject to a qualifying bilateral netting contract (single 
derivative contract) shall be the sum of the current credit exposure 
(replacement cost) and the potential future credit exposure of the 
derivative contract.
    (1) Current credit exposure. If the mark-to-market value of the 
contract is positive, the current credit exposure shall equal that 
mark-to-market value. If the mark-to-market value of the contract is 
zero or negative, the current credit exposure shall be zero.
    (2) Potential future credit exposure. (i) The potential future 
credit exposure for a single derivative contract, including a 
derivative contract with a negative mark-to-market value, shall be 
calculated using an internal model approved by the Finance Board or, in 
the alternative, by multiplying the effective notional principal of the 
derivative contract by one of the assigned credit conversion factors 
for the appropriate category as provided in the following Table 3:

        Table 3.--Credit Conversion Factors for Potential Future Credit Exposure Derivative Contracts \1\
                                                  (In percent)
----------------------------------------------------------------------------------------------------------------
                                                     Foreign                         Precious
     Residual maturity \2\       Interest rate     exchange and       Equity       metals except       Other
                                                       gold                            gold         commodities
----------------------------------------------------------------------------------------------------------------
(A) One year or less..........              0                1                 6               7              10

[[Page 52204]]

 
(B) Over 1 year to five years.               .5              5                 8               7              12
(C) Over five years...........              1.5              7.5              10               8             15
----------------------------------------------------------------------------------------------------------------
\1\ For derivative contracts with multiple exchanges of principal, the conversion factors are multiplied by the
  number of remaining payments in the derivative contract.
\2\ For derivative contracts that automatically reset to zero value following a payment, the residual maturity
  equals the time until the next payment. However, interest rate contracts with remaining maturities of greater
  than one year shall be subject to a minimum conversion factor of 0.5 percent.

    (ii) If a Bank determines to use an internal model for a particular 
type of derivative contract, the Bank shall use the same model for all 
other similar types of contracts. However, the Bank may use an internal 
model for one type of derivative contract and Table 3 for another type 
of derivative contract.
    (iii) Forwards, swaps, purchased options and similar derivative 
contracts not included in the Interest Rate, Foreign Exchange and Gold, 
Equity, or Precious Metals Except Gold categories shall be treated as 
Other Commodities contracts for purposes of Table 3.
    (iv) If a Bank determines to use Table 3 for credit derivatives 
contracts, the credit conversion factors applicable to Interest Rate 
contracts under Table 3 shall apply to such credit derivative 
contracts.
    (v) If a Bank determines not to use an internal model for single 
currency interest rate swaps in which payments are made based upon two 
floating indices (floating/floating or basis swaps), the potential 
future credit exposure for such swaps shall be zero.
    (g) Calculation of credit equivalent amount for multiple derivative 
contracts subject to a qualifying bilateral netting contract.--(1) 
Netting calculation. The credit equivalent amount for multiple 
derivative contracts executed with a single counterparty and subject to 
a qualifying bilateral netting contract described in paragraph (g)(2) 
of this section, shall be calculated by adding the net current credit 
exposure and the adjusted sum of the potential future credit exposure 
for all derivative contracts subject to the qualifying bilateral 
netting contract.
    (i) Net current credit exposure. The net current credit exposure 
shall be the net sum of all positive and negative mark-to-market values 
of the individual derivative contracts subject to a qualifying 
bilateral netting contract. If the net sum of the mark-to-market value 
is positive, then the net current credit exposure shall equal that net 
sum of the mark-to-market value. If the net sum of the mark-to-market 
value is zero or negative, then the net current credit exposure shall 
be zero.
    (ii) Adjusted sum of the potential future credit exposure. (A) The 
adjusted sum of the potential future credit exposure (Anet) 
shall be calculated as follows:

Anet = 0.4 x Agross + (0.6 x NGR x 
Agross).

    (B) Agross is the gross potential future credit 
exposure, i.e., the sum of the potential future credit exposure for 
each individual derivative contract subject to the qualifying bilateral 
netting contract. NGR is the net to gross ratio, i.e., the ratio of the 
net current credit exposure to the gross current credit exposure. The 
gross current credit exposure equals the sum of the positive current 
credit exposures of all individual derivative contracts subject to the 
qualifying bilateral netting contract.
    (2) Qualifying bilateral netting contract. A bilateral netting 
contract shall be considered a qualifying bilateral netting contract if 
the following conditions are met:
    (i) The netting contract is in writing;
    (ii) The netting contract is not subject to a ``walkaway'' clause;
    (iii) The netting contract provides that the Bank would have a 
single legal claim or obligation either to receive or to pay only the 
net amount of the sum of the positive and negative mark-to-market 
values on the individual derivative contracts covered by the netting 
contract in the event that a counterparty, or a counterparty to whom 
the netting contract has been assigned, fails to perform due to 
default, insolvency, bankruptcy, or other similar circumstance;
    (iv) The Bank obtains a written and reasoned legal opinion that 
represents, with a high degree of certainty, that in the event of a 
legal challenge, including one resulting from default, insolvency, 
bankruptcy, or similar circumstances, the relevant court and 
administrative authorities would find the Bank's exposure to be the net 
amount under:
    (A) The law of the jurisdiction by which the counterparty is 
chartered or the equivalent location in the case of noncorporate 
entities, and if a branch of the counterparty is involved, then also 
under the law of the jurisdiction in which the branch is located;
    (B) The law of the jurisdiction that governs the individual 
derivative contracts covered by the netting contract; and
    (C) The law of the jurisdiction that governs the netting contract;
    (v) The Bank establishes and maintains procedures to monitor 
possible changes in relevant law and to ensure that the netting 
contract continues to satisfy the requirements of this section; and
    (vi) The Bank maintains in its files documentation adequate to 
support the netting of a derivative contract.
    (h) Exceptions. The following derivative contracts are not included 
in the credit risk capital requirement:
    (1) An exchange rate contract with an original maturity of 14 
calendar days or less (gold contracts do not qualify for this 
exception); and
    (2) A derivative contract that is traded on an exchange requiring 
the daily payment of any variations in the market value of the 
contract.


Sec. 930.6  Market risk capital requirement.

    (a) General requirement. A Bank's market risk capital requirement 
shall equal the market value of the Bank's portfolio at risk from 
movements in interest rates, foreign exchange rates, commodity prices 
and equity prices as could occur during periods of extreme market 
stress, as determined using the Bank's internal market risk model 
approved by the Finance Board.
    (b) Measurement of market value at risk under Bank internal market 
risk model. (1) Each Bank shall use an internal market risk model that 
measures the market value at risk, from all sources of the Bank's 
market risks, of its holdings of on-balance sheet assets

[[Page 52205]]

and liabilities and of off-balance sheet items, including related 
options.
    (2) The Bank's internal market risk model may use any generally 
accepted measurement technique, such as variance-covariance models, 
historical simulations, or Monte Carlo simulations, for estimating the 
market value of the Bank's portfolio at risk, provided that any 
measurement technique used must cover the Bank's material risks.
    (3) The value at risk measures shall include the risks arising from 
the non-linear price characteristics of options and the sensitivity of 
the market value of options to changes in the volatility of the 
option's underlying rates or prices.
    (4) The Bank's internal market risk model shall use interest rate 
and market price scenarios for estimating the market value of the 
Bank's portfolio at risk, but must at a minimum include the following:
    (i) Monthly estimates of the market value of the Bank's portfolio 
at risk so that the probability of a loss greater than that estimated 
shall be no more than 1 percent;
    (ii) Scenarios that reflect changes in rates and market prices 
equivalent to those that have been observed over 90-business day 
periods of extreme market stress. For interest rates, the relevant 
historical observation period is to start from the end of the previous 
month and go back to the beginning of 1978;
    (iii) The value at risk measure may incorporate empirical 
correlations among interest rates, subject to a Finance Board 
determination that the model's system for measuring such correlations 
is sound; and
    (iv) The two interest rate scenarios required to be used by OFHEO 
to determine the risk-based capital requirements for the Federal 
National Mortgage Association and the Federal Home Loan Mortgage 
Corporation, pursuant to 12 U.S.C. 4611(a)(2).
    (5) If the Bank participates in consolidated obligations 
denominated in a currency other than U.S. Dollars or linked to equity 
or commodity prices, and these instruments have been hedged for foreign 
exchange, equity and commodity risks:
    (i) The Bank's internal market risk model must calculate the market 
value of its portfolio at risk due to these market risks and using the 
qualitative and quantitative requirements specified in this section, 
i.e., the probability of a loss greater than that estimated must not 
exceed 1 percent and must include scenarios that reflect changes in 
rates and market prices that have been observed over 90-business day 
periods of extreme market stress.
    (ii) The historical data from an appropriate period and 
satisfactory to the Finance Board must be used.
    (iii) The value at risk measure may incorporate empirical 
correlations within foreign exchange rates, equity prices, and 
commodity prices, but not among the three risk categories, subject to a 
Finance Board determination that the model's system for measuring such 
correlations is sound.
    (iv) If there is a default on the part of a counterparty to a 
derivative (hedging) contract linked to foreign exchange rates, equity 
prices or commodity prices, the Bank must enter into a replacement 
contract in a timely manner and as soon as market conditions permit.
    (c) Independent validation of Bank internal market risk model. (1) 
Each Bank shall conduct an independent validation of its internal 
market risk model within the Bank that is carried out by personnel not 
reporting to the business line responsible for conducting business 
transactions for the Bank, or obtain independent validation by an 
outside party qualified to make such determinations, on an annual 
basis, or more frequently as required by the Finance Board.
    (2) The results of such independent validations shall be reviewed 
by the Bank's board of directors and provided promptly to the Finance 
Board.
    (d) Finance Board approval of Bank internal market risk model. (1) 
General. Each Bank shall obtain approval from the Finance Board of its 
internal market risk model, including subsequent material adjustments 
to the model made by the Bank prior to its use. A Bank shall make any 
subsequent adjustments to its model that may be directed by the Finance 
Board.
    (2) Transition provision. Each Bank shall submit its initial 
internal market risk model required to be adopted under paragraph 
(d)(1) of this section to the Finance Board for approval within one 
calendar year of the effective date of this section.


Sec. 930.7  Operations risk capital requirement.

    A Bank's operations risk capital requirement shall at any time 
equal 30 percent of the sum of the Bank's credit risk capital 
requirement and market risk capital requirement at such time.


Sec. 930.8  Reporting requirements.

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


Sec. 930.9  Capital stock redemption requirements.

    (a) Redemption with Finance Board approval. A Bank may redeem that 
portion of a member's capital stock allocated by the Bank to the Bank's 
total risk-based capital pursuant to Sec. 930.1 only if the Finance 
Board has approved such redemption.
    (b) Redemption without Finance Board approval. (1) A Bank may at 
any time redeem any portion of a member's capital stock not included in 
or allocated by the Bank to the Bank's total risk-based capital 
pursuant to Sec. 930.1, provided that the member's minimum capital 
stock purchase requirement under sections 6(b)(1) and 10(e)(3) of the 
Act (12 U.S.C. 1426(b)(1), 1430(e)(3)) is maintained.
    (2) A Bank may subject redemptions under paragraph (b)(1) of this 
section to the six-month notice provision in section 6(e) of the Act 
(12 U.S.C. 1426(e)), or may shorten or waive such six-month notice 
provision.
    (3) A Bank, after providing 15 calendar days advance written notice 
to a member, may require redemptions under paragraph (b)(1) of this 
section, provided the minimum capital stock requirement under sections 
6(b)(1) and 10(e)(3) of the Act (12 U.S.C. sections 1426(b)(1), 
1430(e)(3)) is maintained. The Bank's implementation of such unilateral 
redemption policy shall be consistent with the requirement of section 
7(j) of the Act (12 U.S.C. 1427(j)) that the affairs of the Bank shall 
be administered fairly and impartially and without discrimination in 
favor of or against any member borrower.
    (4) A Bank may not impose on or accept from a member a fee in lieu 
of redeeming the member's capital stock under paragraph (b)(3) of this 
section.


Sec. 930.10  Minimum liquidity requirements.

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

[[Page 52206]]

Sec. 930.11  Limits on unsecured extensions of credit to one 
counterparty or affiliated counterparties; reporting requirements for 
total extensions of credit to one counterparty or affiliated 
counterparties.

    (a) Maximum capital exposure limits--(1) Unsecured extensions of 
credit to a single counterparty--(i) General requirement. Unsecured 
extensions of credit by a Bank to a single counterparty that arise from 
authorized Bank on- and off-balance sheet transactions shall be limited 
to the maximum capital exposure limit applicable to such counterparty, 
as set forth in Table 4 of this paragraph (a), multiplied by the lesser 
of:
    (A) The Bank's total capital; or
    (B) The counterparty's Tier 1 capital, or total capital if Tier 1 
capital is not available.
    (ii) Bank determination of credit ratings and applicable maximum 
exposure limits. (A) The applicable maximum capital exposure limits for 
specific counterparties are specific maximum percentage limits assigned 
to such counterparties based on the credit rating of the counterparty, 
as provided in the following Table 4:

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

    (B) In determining the applicable credit rating category under 
Table 4 for a specific counterparty that has received more than one 
rating from a given NRSRO, the most recent credit rating shall be used.
    (C) If a specific counterparty has received credit ratings from 
more than one NRSRO, the lowest credit rating shall be used in 
determining the applicable credit rating category for such counterparty 
under Table 4.
    (D) In the event a counterparty has received different credit 
ratings for its transactions with short-term and long-term maturities:
    (1) The higher credit rating shall apply for purposes of 
determining the allowable maximum capital exposure limit under Table 4 
applicable to the total amount of unsecured credit extended by the Bank 
to such counterparty;
    (2) The lower credit rating shall apply for purposes of determining 
the allowable maximum capital exposure limit under Table 4 applicable 
to the amount of unsecured credit extended by the Bank to such 
counterparty for the transactions with maturities governed by that 
rating.
    (E) If a counterparty is placed on a credit watch for a potential 
downgrade by an NRSRO, the Bank shall determine its remaining available 
credit line for unsecured credit concentration exposures under Table 4 
by assuming a credit rating from that NRSRO at the next lower grade.
    (2) Unsecured extensions of credit to affiliated counterparties. 
The total amount of unsecured extensions of credit by a Bank to all 
affiliated counterparties may not exceed:
    (i) The maximum capital exposure limit applicable under Table 4 
based on the highest credit rating of the affiliated counterparties;
    (ii) Multiplied by the lesser of:
    (A) The Bank's total capital; or
    (B) The combined Tier 1 capital, or total capital if Tier 1 capital 
is not available, of all of the affiliated counterparties.
    (b) Reporting requirements--(1) Total unsecured extensions of 
credit. Each Bank shall report monthly to the Finance Board the amount 
of the Bank's total unsecured extensions of credit to any single 
counterparty or group of affiliated counterparties that exceeds 5 
percent of:
    (i) The Bank's total capital; or
    (ii) The counterparty's, or affiliated counterparties' combined, 
Tier 1 capital, or total capital if Tier 1 capital is not available.
    (2) Total secured and unsecured extensions of credit. Each Bank 
shall report monthly to the Finance Board the amount of the Bank's 
total secured and unsecured extensions of credit to any single 
counterparty or group of affiliated counterparties that exceeds 5 
percent of the Bank's total assets.
    13. New part 940 is added to subchapter F to read as follows:

PART 940--CORE MISSION ACTIVITIES REQUIREMENTS

Sec.
940.1  Definitions.
940.2  Mission of the Banks.
940.3  Core mission activities.
940.4  Core mission activities requirements.
940.5  Transfers of core mission activities to another Bank.
940.6  Safe harbor for anticipated noncompliance.

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


Sec. 940.1  Definitions.

    As used in this part:
    Certain drawdown has the meaning set forth in Sec. 930.1 of this 
chapter.
    Community lending has the meaning set forth in Sec. 952.3 of this 
chapter.
    Eligible nonmember borrower has the meaning set forth in Sec. 930.1 
of this chapter.
    Financial Management Policy has the meaning set forth in Sec. 930.1 
of this chapter.
    Housing-related whole loans means all whole loans, or participation 
interests in whole loans (excluding mortgage-backed securities), 
secured by one-to-four family property, multifamily property, or 
manufactured housing, including loans for the construction, purchase, 
improvement, rehabilitation, or refinancing of housing.
    Member mortgage assets means those mortgage-related assets that may 
be acquired by a Bank under part 954 of this chapter.


Sec. 940.2  Mission of the Banks.

    The mission of the Banks is to provide to members and eligible 
nonmember borrowers financial products and services, including but not 
limited to advances, that assist and enhance such members' and eligible 
nonmember borrowers' financing of:
    (a) Housing in the broadest sense, including single-family and 
multi-family housing serving consumers at all income levels; and
    (b) Community lending.


Sec. 940.3  Core mission activities.

    The following Bank activities qualify as core mission activities:
    (a) Advances and advance commitments. (1) Advances, and commitments 
to make advances with certain drawdown, to members or eligible 
nonmember borrowers with assets of $500 million or less; and
    (2) Advances, and commitments to make advances with certain 
drawdown, to members or eligible nonmember borrowers with assets 
greater than $500 million, up to the total book value of the following 
assets held by such member or eligible nonmember borrower:
    (i) Housing-related whole loans;
    (ii) Loans and investments that are generated by community lending; 
and
    (iii) Mortgage-backed securities that comprise the types of loans 
described in paragraphs (a)(2) (i) and (ii) of this section originated 
by the member or eligible nonmember borrower;

[[Page 52207]]

    (b) Standby letters of credit;
    (c) Intermediary derivative contracts;
    (d) Member mortgage assets;
    (e) Certain equity investments. Equity investments:
    (1) That primarily benefit low- or moderate-income individuals or 
areas, or other areas targeted for redevelopment by local, state, 
tribal or Federal government (including Federal enterprise communities 
and Federal empowerment zones) by providing or supporting one or more 
of the following activities:
    (i) Affordable housing, community services, or permanent jobs for 
low- or moderate-income individuals; or
    (ii) Area revitalization or stabilization;
    (2) In small business investment companies formed pursuant to 15 
U.S.C. 681(d) (SBICs), but only to the extent that the equity 
investment is structured to be matched by an equity investment in the 
same activity by a member or eligible nonmember borrower of the Bank 
making the equity investment; or
    (3) In governmentally-aided economic development entities 
comparable to SBICs where the investment primarily benefits low- or 
moderate-income individuals or areas;
    (f) The short-term tranche of SBIC securities guaranteed by the 
Small Business Administration, which guarantee is backed by the full 
faith and credit of the United States;
    (g) Section 108 Interim Notes and Participation Certificates 
guaranteed by the Department of Housing and Urban Development pursuant 
to section 108 of the Housing and Community Development Act of 1974 (as 
amended);
    (h) Investments and obligations for housing and community 
development issued or guaranteed under Title VI of the Native American 
Housing Assistance and Self-Determination Act of 1996; and
    (i) Certain assets acquired under the Financial Management Policy. 
Assets acquired pursuant to:
    (1) Section II.B.11 of the Financial Management Policy prior to the 
effective date of this section; or
    (2) Section II.B.12 of the Financial Management Policy, up to the 
greater of:
    (i) The amount authorized by resolution of the Finance Board; or
    (ii) The amount acquired prior to the effective date of this 
section.


Sec. 940.4  Core mission activities requirements.

    (a) Core mission activities ratio. Subject to the transition period 
set forth in paragraph (d) of this section, and pursuant to the Bank's 
mission achievement policy required to be adopted under Sec. 917.9(a) 
of this section, each Bank shall have and maintain total core mission 
activities, as defined in Sec. 940.3, (i.e., an average book value of 
core mission on-balance sheet assets and off-balance sheet items 
converted to an on-balance sheet asset value equivalent as prescribed 
in paragraph (c) of this section) equal to a minimum of 100 percent of 
the average book value of the Bank's total outstanding consolidated 
obligations. The Bank's core mission activities ratio shall be 
calculated based on a moving 12-month average.
    (b) Reporting requirement. Each Bank shall report to the Finance 
Board as of the last day of each calendar quarter its actual core 
mission activities ratio for the previous 12 months.
    (c) On-balance sheet asset value equivalents for off-balance sheet 
items. The on-balance sheet asset value equivalent for each core 
mission off-balance sheet item is the measure of value of the item 
multiplied by its percent conversion factor as provided in the 
following Table 1:

  Table 1.--Conversion Factors for Core Mission Off-Balance Sheet Items
------------------------------------------------------------------------
Core mission off-balance sheet                     Conversion factor (in
             item                Measure of value         percent)
------------------------------------------------------------------------
(1) Standby Letters of Credit   Face amount......  100 minus that year's
 (during transition period).                        core mission
                                                    activities
                                                    requirement (in
                                                    percent)
(2) Standby Letters of Credit   Fee Charged to     100
 (after transition period).      Members.
(3) Intermediary Derivative     Fee Charged to     100
 Contracts.                      Members.
(4) Commitments to Make         Contractual......  100
 Advances with Certain
 Drawdown.
------------------------------------------------------------------------

    (d) Transition provision. (1) Pursuant to paragraph (b)(1) of this 
section, by January 1, 2001, each Bank shall have a minimum core 
mission activities ratio of 80 percent.
    (2) Thereafter, each Bank's required minimum core mission 
activities ratio shall increase annually, on January 1 of each year, by 
5 percentage points, up to a required minimum core mission activities 
ratio of 100 percent.


Sec. 940.5  Transfers of core mission activities to another Bank.

    A core mission activity of a Bank, if transferred to another Bank, 
retains its status as a core mission activity with respect to the 
transferee Bank.


Sec. 940.6  Safe harbor for anticipated noncompliance.

    (a) Safe harbor requirements. If, after conducting the annual risk 
management policy review and risk assessment required under Sec. 917.3 
of this chapter and the annual mission achievement policy review 
required under Sec. 917.9 of this chapter, a Bank's board of directors 
determines that, for a certain time period, it will not be consistent 
with continued safe and sound operation for the Bank to meet the core 
mission activities requirements of Sec. 940.4(a), the Bank shall not be 
deemed to be out of compliance with Sec. 940.4(a) for the time period 
specified by the Bank's board of directors, provided that:
    (1) The determination by the Bank's board of directors that 
compliance will not be consistent with continued safe and sound 
operation is based upon a finding that, if the Bank were to comply with 
the core mission activities requirements during such time period, the 
Bank:
    (i) Would likely be unable to meet the liquidity requirement of 
Sec. 930.10 of this chapter, or any other regulatory requirement 
related to the safety and soundness of its financial operation; or
    (ii) Would likely be unable to provide a return on equity 
sufficient to retain members intending to make use of such Bank's 
products and services;
    (2) The Bank fully documents the process of review, consideration 
and decision-making leading to such determination, including the 
reasons for the establishment of a specific time period as the minimum 
period of anticipated noncompliance; and
    (3) The Bank's board of directors adopts a plan to achieve 
compliance with the core mission activities requirement at the earliest 
feasible and prudent date.
    (b) Waivers. Under other circumstances, a Bank may request a waiver 
of the requirements in this part 940, pursuant to part 907 of this 
chapter (12 CFR part 907).

[[Page 52208]]

PART 950--ADVANCES

    14. The authority citation for part 950 continues to read as 
follows:

    Authority: 12 U.S.C. 1422a(a)(3), 1422b(a)(1), 1426, 1429, 1430, 
1430b and 1431.

    15. Amend Sec. 950.1 by revising the definition of ``long-term 
advance'' to read as follows:


Sec. 950.1  Definitions.

* * * * *
    Long-term advance means an advance with an original term to 
maturity greater than one year.
* * * * *
    16. Remove Sec. 950.2.
    17. Amend Sec. 950.15 by:
    a. Removing paragraphs (b)(1) and (b)(2); and
    b. Redesignating paragraphs (a)(1) and (a)(2) as paragraphs (a) and 
(b), respectively.
    18. New parts 954, 955 and 958 are added to subchapter G to read as 
follows:

PART 954--MEMBER MORTGAGE ASSETS

Sec.
954.1  Definitions.
954.2  Authorization to hold member mortgage assets.

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


Sec. 954.1  Definitions.

    As used in this section:
    Eligible nonmember borrower has the meaning set forth in Sec. 940.1 
of this chapter.
    Residential real property has the meaning set forth in Sec. 950.1 
of this chapter.


Sec. 954.2  Authorization to hold member mortgage assets.

    Each Bank may hold assets or pools of assets acquired from or 
through its members or eligible nonmember borrowers, by means of either 
a purchase or a funding transaction involving the Bank and such member 
or eligible nonmember borrower, that meet each of the following 
requirements:
    (a) The assets or pools of assets are either:
    (1) Mortgages, or interests in mortgages, excluding one-to-four 
family mortgages where the loan amounts exceed the limits established 
pursuant to 12 U.S.C. 1717(b)(2);
    (2) Loans, or interests in loans, secured by manufactured housing, 
regardless of whether such housing qualifies as residential real 
property; or
    (3) State and local housing finance agency bonds; and
    (b) The assets or pools of assets are either:
    (1) Originated or issued by or through the member or eligible 
nonmember borrower; or
    (2) Held for a valid business purpose by the member or eligible 
nonmember borrower prior to acquisition by the Bank; and
    (c) The transactions through which the Bank acquires the assets or 
pools of assets are structured such that:
    (1) The member or eligible nonmember borrower bears the amount of 
credit risk necessary to raise the assets or pools of assets to the 
fourth highest credit rating category;
    (2) To the extent that the Bank requires, either at the time of 
acquisition or subsequently, that the assets or pools of assets have a 
higher credit rating, the member or eligible nonmember borrower bears 
at least 50 percent of any credit risk necessary to raise the assets or 
pools of assets from the fourth highest credit rating category to such 
higher credit rating category, up to the second highest credit rating 
category;
    (3) If the credit risk-sharing requirements of paragraphs (c)(1) or 
(c)(2) of this section do not result in the member or eligible 
nonmember borrower bearing a material portion of the credit risk, the 
member or eligible nonmember borrower bears a material portion of the 
credit risk, up to the second highest credit rating; and
    (4) To the extent that the U.S. government has insured or 
guaranteed the credit risk of the asset or pool of assets, the member 
or eligible nonmember borrower may rely upon that insurance or 
guarantee to meet all or part of the risk-bearing requirements of 
paragraphs (c)(1) and (c)(2) of this section; however, to the extent 
that the U. S. government insurance or guarantee is insufficient or 
incomplete, the portion of the risk-bearing requirements not met by the 
government insurance or guarantee must be borne by the member or 
eligible nonmember borrower.

PART 955--FEDERAL HOME LOAN BANK INVESTMENTS

Sec.
955.1  Definitions.
955.2  Authorized investments.
955.3  Prohibited investments and prudential rules.
955.4  Use of hedging instruments.

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


Sec. 955.1  Definitions.

    As used in this part:
    Deposits in banks or trust companies has the meaning set forth in 
Sec. 965.1 of this chapter.
    Financial Management Policy has the meaning set forth in Sec. 930.1 
of this chapter.
    GAAP means Generally Accepted Accounting Principles.
    Investment grade has the meaning set forth in Sec. 930.1 of this 
chapter.
    Member mortgage assets means those mortgage-related assets that may 
be acquired by a Bank under part 954 of this chapter.


Sec. 955.2  Authorized investments.

    Except as provided in Sec. 955.3, and subject to the applicable 
limitations set forth in this part and in part 954, each Bank may 
invest in:
    (a) Obligations of the United States;
    (b) Deposits in banks or trust companies;
    (c) Obligations, participations or other instruments of, or issued 
by, the Federal National Mortgage Association or the Government 
National Mortgage Association;
    (d) Mortgages, obligations, or other securities that are, or ever 
have been, sold by the Federal Home Loan Mortgage Corporation pursuant 
to 12 U.S.C. 1454 or 1455;
    (e) Stock, obligations, or other securities of any small business 
investment company formed pursuant to 15 U.S.C. 681(d), to the extent 
such investment is made for purposes of aiding members of such Bank; 
and
    (f) Instruments that the Bank has determined are permissible 
investments for fiduciary or trust funds under the laws of the state in 
which the Bank is located.


Sec. 955.3  Prohibited investments and prudential rules.

    (a) Prohibited investments. A Bank may not invest in:
    (1) Instruments that provide an ownership interest in an entity and 
that do not qualify as a core mission activity under Sec. 940.3 of this 
chapter;
    (2) Instruments issued by non-United States entities, except United 
States branches and agency offices of foreign commercial banks;
    (3) Debt instruments that are not rated as investment grade, except 
for debt instruments that were downgraded to a below investment grade 
rating after purchase by the Bank; or
    (4) Whole mortgages or other whole loans, or interests in mortgages 
or loans, except:
    (i) Member mortgage assets;
    (ii) Mortgage-backed securities that meet the definition of the 
term ``securities'' under 15 U.S.C. 77b(a)(1); and
    (iii) Loans held or acquired pursuant to section 12(b) of the Act 
(12 U.S.C. 1432(b)).

[[Page 52209]]

    (b) Foreign currency or commodity positions prohibited. A Bank may 
not take a position in any commodity or foreign currency. If a Bank 
participates in consolidated obligations denominated in a currency 
other than U.S. Dollars or linked to equity or commodity prices, the 
currency, commodity and equity risks must be hedged.
    (c) Transition provision. A Bank may not make any investments that 
were not permitted under the Finance Board's Financial Management 
Policy in effect prior to the effective date as to such Bank of this 
part 955 until:
    (1) The Bank has received Finance Board approval of the Bank's 
initial internal market risk model;
    (2) The Bank demonstrates to the Finance Board that it has 
sufficient risk-based capital to meet the minimum total risk-based 
capital requirement under Sec. 930.4(b) of this chapter for its then-
current portfolio; and
    (3) The Bank demonstrates to the Finance Board adequate credit risk 
assessment and procedures and controls sufficient to show control over 
credit, market and operations risks.


Sec. 955.4  Use of hedging instruments.

    (a) Speculative use prohibited. A Bank shall not make speculative 
use of hedging instruments.
    (b) Applicability of GAAP. All transactions entered into by a Bank 
for hedging purposes shall meet the requirements for a hedge under 
GAAP.
    (c) Documentation requirements. (1) A Bank's hedging strategies 
must be explicitly stated at the time of execution of the hedge, and 
adequate documentation of the hedge must be maintained during the life 
of the hedge.
    (2) Transactions with a single counterparty shall be governed by a 
single master agreement when practicable.
    (3) A Bank's agreement with the counterparty for over-the-counter 
derivative contracts shall include:
    (i) A requirement that market value determinations and subsequent 
adjustments of collateral be made at least on a monthly basis;
    (ii) A statement that failure of a counterparty to meet a 
collateral call will result in an early termination event;
    (iii) A description of early termination pricing and methodology, 
with the methodology reflecting a reasonable estimate of the market 
value of the over-the-counter derivative contract at termination 
(Standard International Swaps and Derivatives Association, Inc. 
language relative to early termination pricing and methodology may be 
used to satisfy this requirement); and
    (iv) A requirement that the Bank's consent be obtained prior to the 
transfer of an agreement or contract by a counterparty.

PART 958--OFF-BALANCE SHEET ITEMS

Sec.
958.1  Definitions.
958.2  Authorized off-balance sheet items.

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


Sec. 958.1  Definitions.

    As used in this part:
    Derivative contracts has the meaning set forth in Sec. 930.1 of 
this chapter.
    Repurchase agreement has the meaning set forth in Sec. 930.1 of 
this chapter.


Sec. 958.2  Authorized off-balance sheet items.

    (a) Authorization. A Bank may enter into the following types of 
off-balance sheet transactions:
    (1) Standby letters of credit, pursuant to the requirements of 12 
CFR part 959;
    (2) Derivative contracts;
    (3) Forward asset purchases and sales; and
    (4) Commitments to make advances or other loans.
    (b) Speculative use prohibited. A Bank shall not make speculative 
use of derivative contracts.
    19. New part 965 is added to subchapter H to read as follows:

PART 965--SOURCES OF FUNDS

Sec.
965.1  Definitions.
965.2  Authorized liabilities.
965.3  Liquidity reserves for deposits.

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


Sec. 965.1  Definitions.

    As used in this part:
    Deposits in banks or trust companies means:
    (1) A deposit in another Bank;
    (2) A demand account in a Federal Reserve Bank;
    (3) A deposit in, or a sale of federal funds to:
    (i) An insured depository institution, as defined in section 
2(12)(A) of the Act (12 U.S.C. 1422(12)(A)), that is designated by a 
Bank's board of directors;
    (ii) A trust company that is a member of the Federal Reserve System 
or insured by the Federal Deposit Insurance Corporation, and is 
designated by a Bank's board of directors; or
    (iii) A U.S. branch or agency of a foreign bank, as defined in the 
International Banking Act of 1978, as amended (12 U.S.C. 3101 et seq.), 
that is subject to the supervision of the Board of Governors of the 
Federal Reserve System, and is designated by a Bank's board of 
directors.
    Repurchase agreement has the meaning set forth in Sec. 930.1 of 
this chapter.


Sec. 965.2  Authorized liabilities.

    (a) As a source of funds for business operations, each Bank is 
authorized to incur liabilities by:
    (1) Acting as joint and several obligor with other Banks on 
consolidated obligations, as authorized under part 966 of this chapter;
    (2) Accepting time or demand deposits from members, other Banks and 
instrumentalities of the United States, so long as the deposit 
transaction is not conducted in such a way as to result in the offer or 
sale of a security in a public offering as those terms are used in 15 
U.S.C. 77b(3); or
    (3) Solely in order to satisfy the Bank's short-term liquidity 
needs:
    (i) Purchasing federal funds; and
    (ii) Entering into repurchase agreements.
    (b) Consolidated obligations shall not be directly placed with any 
Bank.


Sec. 965.3  Liquidity reserves for deposits.

    Each Bank shall at all times have at least an amount equal to the 
current deposits received from its members invested in:
    (a) Obligations of the United States;
    (b) Deposits in banks or trust companies; or
    (c) Advances with a maturity of not to exceed five years that are 
made to members in conformity with part 950 of this chapter.

PART 966--CONSOLIDATED OBLIGATIONS

    20. The authority citation for part 966 continues to read as 
follows:

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

    21. Amend Sec. 966.2 by:
    a. Removing paragraph (b);
    b. Redesignating paragraph (c) as paragraph (b); and
    c. Revising the reference to ``paragraphs (c)(1) through (6)'' in 
the last sentence of Sec. 966.2 to read ``paragraphs (b)(1) through 
(6).''
    22. Amend Sec. 966.7 by revising paragraph (b) to read as follows:


Sec. 966.7  Reservation of right to revoke or amend; limitations 
thereon.

* * * * *
    (b) Limitation on amendment of negative pledge requirement. No

[[Page 52210]]

revocation or relaxation of any of the restrictions or requirements 
contained in or imposed by Sec. 966.2(b) shall be effected except if 
there are no senior bonds then outstanding or the principal of and 
interest to date of maturity or to such date designated for redemption 
and any redemption premium on all senior bonds the holders of which 
have not consented to such revocation or relaxation has been fully 
defeased.
    23. New part 980 is added to subchapter J to read as follows:

PART 980--NEW BUSINESS ACTIVITIES

Sec.
980.1  Definitions.
980.2  Prior notice to Finance Board.

    Authority: 12 U.S.C. 1422a(a)(3), 1422b(a), 1431(a), 1432(a).

Sec. 980.1  Definitions.

    As used in this part:
    New business activity means, with respect to a particular Bank's 
activities:
    (1) An activity that was not previously undertaken by that Bank, or 
was undertaken under materially different terms and conditions;
    (2) An activity that entails risks not previously and regularly 
managed by that Bank or its members; or
    (3) An activity that introduces operations not substantially 
equivalent to operations currently managed by that Bank.


Sec. 980.2  Prior notice to Finance Board.

    A Bank may undertake a new business activity after providing 30 
days notice of such new business activity to the Finance Board, unless 
otherwise directed by the Finance Board.

    Dated: September 1, 1999.

    By the Board of Directors of the Federal Housing Finance Board.
Bruce A. Morrison,
Chairman.
[FR Doc. 99-23416 Filed 9-24-99; 8:45 am]
BILLING CODE 6725-01-P