[Federal Register Volume 65, Number 135 (Thursday, July 13, 2000)]
[Proposed Rules]
[Pages 43408-43447]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-17153]



[[Page 43407]]

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

Part II





Federal Housing Finance Board





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



12 CFR Part 917, et al.



Capital Requirements for Federal Home Loan Banks; Proposed Rule

  Federal Register / Vol. 65, No. 135 / Thursday, July 13, 2000 / 
Proposed Rules  

[[Page 43408]]


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

FEDERAL HOUSING FINANCE BOARD

12 CFR Parts 917, 925, 930, 931, 932, 933, 956, and 960

[No. 2000-23]
RIN 3069-AB01


Capital Requirements for Federal Home Loan Banks

AGENCY: Federal Housing Finance Board.

ACTION: Proposed rule.

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

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

DATES: The Finance Board will accept written comments on the proposed 
rule that are received on or before October 11, 2000.

ADDRESSES: Send comments to: Elaine L. Baker, Secretary to the Board, 
at the Federal Housing Finance Board, 1777 F Street, N.W., Washington, 
D.C. 20006. Comments will be available for 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; Ellen Hancock, Senior Financial Analyst, (202) 408-2906; or 
Christina Muradian, Senior Financial Analyst, (202) 408-2584; or Julie 
Paller, Senior Financial Analyst, (202) 408-2842, Office of Policy, 
Research and Analysis; or Deborah F. Silberman, General Counsel, (202) 
408-2570; Neil R. Crowley, Deputy General Counsel, (202) 408-2990; or 
Thomas E. Joseph, Attorney-Advisor, (202) 408-2512, Office of General 
Counsel, Federal Housing Finance Board, 1777 F Street, N.W., 
Washington, D.C. 20006.

SUPPLEMENTARY INFORMATION:

I. Statutory and Regulatory Background

A. The Bank System

    The twelve Banks are instrumentalities of the United States 
organized under the authority of the Federal Home Loan Bank Act (Bank 
Act). 12 U.S.C. 1423, 1432(a), as amended. The Banks are a ``government 
sponsored enterprise'' (GSE), i.e., a federally chartered but privately 
owned institution created by Congress to serve a public purpose. The 
purpose of the Bank System is to support the financing of housing and 
community lending. See 12 U.S.C. 1422a(a)(3)(B)(ii), 1430(i), (j)(10) 
(1994). As with other GSEs, Congress has granted the Banks certain 
benefits, including an exemption from registration of their securities 
under federal securities laws, an exemption from state and local 
corporate taxation, and an ability to sell debt obligations (at the 
discretion of the Secretary of the Treasury) to the United States 
Treasury, that enable them to borrow in the capital markets on 
favorable terms. Typically, the Banks are able to borrow at a spread 
that is over the rates on U.S. Treasury securities of comparable 
maturity but which is less than the rates available to comparably 
situated private corporate borrowers. The Banks pass along that funding 
advantage to their members--and ultimately to consumers--by providing 
advances (secured loans) and other financial services at rates that 
their members generally could not obtain on their own.
    The Banks also are cooperatives, meaning that only their members 
may own the capital stock and share in the profits of the Banks and 
only their members, and certain eligible associates (such as state 
housing finance agencies), may borrow from or use the other products 
and services provided by the Banks. 12 U.S.C. 1426, 1430(a), 1430b, as 
amended. Each Bank is managed by a board of directors, a majority of 
whom are elected by its members and the remainder of whom are appointed 
by the Finance Board. 12 U.S.C. 1427, as amended. An institution that 
is eligible (typically, an insured depository institution) may become a 
member of a Bank if it satisfies certain statutory criteria and 
purchases a specified amount of the Bank's capital stock. 12 U.S.C. 
1424, 1426 (1994). Together with the Office of Finance, the twelve 
Banks comprise the Bank System, which operates under the supervision of 
the Finance Board, an independent agency in the executive branch of the 
U.S. government. The primary duty of the Finance Board is to ensure 
that the Banks operate in a financially safe and sound manner; 
consistent with that duty the Finance Board is required to supervise 
the Banks, ensure that they carry out their housing finance mission, 
and ensure that they remain adequately capitalized and able to raise 
funds in the capital markets. 12 U.S.C. 1422a(a)(3)(A), (B) (1994).

B. Federal Home Loan Capital Structure

    Since its enactment in 1932, the Bank Act has provided for a 
``subscription'' structure for the capital of the Banks. Under that 
structure, the amount of capital stock each Bank issued was determined 
as a percentage of either the total mortgage assets of each member of 
the Bank or the dollar amount of advances outstanding to each member, 
whichever was greater. The subscription capital structure was deficient 
in certain respects, most notably in that the amount of capital each 
Bank was required to hold bore no relationship to the risks posed by 
its activities. Moreover, the subscription capital structure caused the 
Banks to become substantially overcapitalized in relation to the risks 
they face. The amount of excess capital contributed to an increase in 
the amount of arbitrage investments made by the Banks, i.e., 
investments in assets such as money market instruments or mortgage-
backed securities that do not advance the housing finance and community 
lending mission of the Banks. The substantial amount of the non-mission 
investments held by the Banks collectively, though diminishing in 
recent years as a percentage of their assets, has been the subject of 
much criticism from the Administration and the Congress, and was one 
issue that the Congress intended to address by reforming the capital 
structure and other aspects of the Bank System. The Congress recognized 
that if it were to eliminate mandatory membership for federal savings 
associations, and thus remove the only permanent capital from the Bank 
System, it also would have to create a new capital structure that would 
include capital elements with more permanence than one based solely on 
6-month redeemable stock.

C. The Gramm-Leach-Bliley Act

    On November 12, 1999, the President signed the Gramm-Leach-Bliley 
Act, Pub. Law No. 106-102, 133 Stat. 1338 (Nov. 12, 1999) (GLB Act), 
which, among other things, substantially amended the provisions of the 
Bank Act that relate to the capital structure of the Banks. 12 U.S.C. 
1426, as amended. As a result of those amendments, the existing 
subscription capital structure will be replaced over a period of 
several years by a more modern capital structure, with risk-based and 
leverage capital requirements that are similar to those applicable to 
depository institutions and to the other housing GSEs. The GLB Act 
provides for a transition period to the new capital structure of up to 
approximately five

[[Page 43409]]

years from the date of enactment, during which time the prior capital 
provisions are to remain in effect. The GLB Act requires the Finance 
Board to promulgate uniform capital regulations for the Banks no later 
than November 12, 2000. Under the new structure, each Bank will be 
required to maintain amounts of total capital and permanent capital 
that are sufficient to comply with the minimum leverage and risk-based 
capital requirements, respectively, established by the GLB Act.
    The GLB Act requires each Bank to maintain a ratio of total capital 
to total assets of at least 4 percent. Total capital is defined to 
include a Bank's permanent capital (defined below), plus the amounts 
paid-in by members for Class A stock (which is redeemable on 6 months 
written notice), any general loss allowance (if consistent with 
generally accepted accounting principles (GAAP) and not established for 
specific assets), and other amounts from sources determined by the 
Finance Board as available to absorb losses. Permanent capital is 
defined as the amounts paid-in by members for the Class B stock (which 
is redeemable on 5 years written notice), plus the amount of a Bank's 
retained earnings, as determined in accordance with GAAP. In addition 
to requiring total capital of 4 percent, the GLB Act requires the Banks 
to maintain a leverage ratio of 5 percent. In calculating the leverage 
ratio, the amount paid-in for Class B stock and the amount of retained 
earnings are multiplied by 1.5, while other capital items are counted 
at face value. The risk-based capital provision requires each Bank to 
maintain permanent capital in an amount sufficient to meet the credit 
and market risks to which the Bank is subject, with the market risk 
being based on a stress test established by the Finance Board that 
tests for changes in certain specified market variables.
    The GLB Act further requires the capital regulations to address a 
number of other matters, such as the classes of stock that a Bank may 
issue, the rights, terms, and preferences that may be established for 
each class, the issuance, transfer, and redemption of Bank stock, and 
the liquidation of claims against a withdrawing member. The rules must 
permit each Bank to issue Class A or Class B stock, or both, with the 
board of directors of each Bank to determine the rights, terms, and 
preferences for each class. Both Class A and Class B stock may be 
issued only to and held only by members of the Bank, and the 
regulations are to provide the manner in which the stock may be sold, 
transferred, redeemed, or repurchased. The rules also must address the 
manner in which a Bank is to liquidate any claims against its members.
    The GLB Act separately establishes a number of other capital-
related requirements, which pertain to matters such as the termination 
of an institution's Bank membership, the ability of a Bank to redeem 
excess stock held by a member (i.e., stock that is in excess of the 
amount each member is required to hold), restrictions on the ability of 
a Bank to redeem stock when its capital is impaired, restrictions on 
readmission to membership after withdrawing, and the ownership of the 
retained earnings by the Class B stockholders.
    Within 270 days after the publication of the final capital rule, 
the board of directors of each Bank must submit for Finance Board 
approval a capital plan that the board determines is best-suited for 
the Bank and its members. Any amendments to the plan also must be 
approved in advance by the Finance Board. The law does not specify a 
period of time within which the Finance Board must approve the plans, 
which allows for the possibility that a Bank may be required to revise 
its plan before obtaining Finance Board approval. The GLB Act requires 
the plan to include certain provisions, requires that it be consistent 
with the regulations adopted by the Finance Board, and that when 
implemented it must provide the Bank with sufficient capital to meet 
both the leverage and risk-based capital requirements. Each plan also 
must include certain provisions specified by the GLB Act. Those 
provisions relate to the minimum investment required of each member in 
order for the Bank to meet its regulatory capital requirements, the 
effective date of the plan and the length of its transition period 
(which may be up to 3 years from the effective date of the plan), the 
classes of stock to be offered by the Bank and the rights, terms, and 
preferences associated with each class, the transferability of the Bank 
stock, the disposition of Bank stock held by institutions that withdraw 
from membership, and review of the plan by an independent accountant 
and a credit ratings agency. Those provisions are only the minimum 
contents required by the GLB Act; the Finance Board may require that 
other provisions be included in each plan, and the Banks as well may 
include other provisions in their plans, provided they are consistent 
with the Bank Act and the regulations of the Finance Board.

D. Federal Home Loan Bank Stock

    Section 6 of the Bank Act, as in effect prior to the GLB Act, 
authorized the Banks to issue stock, specified the characteristics of 
the stock, and addressed the manner in which the stock may be issued, 
transferred, and redeemed. 12 U.S.C. 1426 (1994). Since the 
establishment of the Bank System in 1932, each of the Banks has been 
authorized to issue a single class of stock, which could be issued and 
redeemed only at its statutory par value of $100 per share. An 
institution becoming a Bank member was required to subscribe for a 
certain minimum amount of the Bank's stock, for which it was required 
to pay in full and in cash at the time of its application.\1\
---------------------------------------------------------------------------

    \1\ A member also was allowed to purchase the stock in 
installments, under which it would pay one-quarter of the full 
amount at the time of application, and the remainder in three 
installments over the following 12 months. 12 U.S.C. 1426(c) (1994).
---------------------------------------------------------------------------

    The amount of the initial stock subscription required for 
membership was the greater of $500, 1.0 percent of the member's 
mortgage assets, or 0.3 percent of the member's total assets.\2\ 12 
U.S.C. 1426(b), 1430(e) (1994). If a member were to borrow from its 
Bank, the amount of Bank stock it was required to own could not be less 
than 5.0 percent of the amount of Bank advances outstanding to the 
member. Each Bank was required to adjust the minimum stock investment 
required of each member, as of December 31st of each year, so that each 
member would own at least the required minimum amount of Bank stock, 
based on a percentage of either its assets or advances, whichever 
amount was higher. Each Bank had the discretion to retire any 
``excess'' stock held by a member, i.e., stock in excess of the

[[Page 43410]]

minimum required for that member, upon the application of the member.
---------------------------------------------------------------------------

    \2\ The Bank Act referred to a member's ``aggregate unpaid loan 
principal'', which the Finance Board has defined to include a 
variety of mortgage assets, such as home mortgage loans, combination 
loans, and mortgage pass-through securities. 12 U.S.C. 1426(b)(1) 
(1994); 65 Fed. Reg. 8253 (Feb. 18, 2000), to be codified at 12 CFR 
925.1. For purposes of applying the 1.0 percent of mortgage assets 
test, the Bank Act also established a statutory presumption that 
each member had at least 30 percent of its assets in mortgage 
related instruments. 12 U.S.C. 1430(e)(3) (1994). The effect of the 
presumption was that commercial banks (which typically have a lower 
percentage of their assets in mortgage related instruments than do 
savings associations) were required to maintain a minimum investment 
equal to the greater of 1.0 percent of mortgage assets, 0.3 percent 
of total assets, or 5.0 percent of outstanding advances. Separately, 
a member that was not a ``qualified thrift lender'' (QTL), i.e., an 
institution with less than 65 percent of its assets in certain 
mortgage related instruments, was subject to a higher ``percentage 
of advances'' requirement, which would vary inversely with its QTL 
ratio.
---------------------------------------------------------------------------

    Once issued, the stock of a Bank could be transferred only between 
the member and the Bank or, with the approval of the Finance Board, 
from one member to another member or to an institution in the process 
of becoming a member. The Bank Act also required that all stock issued 
by a Bank share in dividends equally and without preference. The Bank 
Act also allowed any member, other than a federal savings and loan 
association, to withdraw from membership by providing six months 
written notice to the Finance Board. At the end of the six-month notice 
period, and provided that all indebtedness owed by the withdrawing 
member to the Bank had been liquidated, a Bank could redeem the stock 
of the withdrawing member, paying cash to the member equal to the par 
value of the stock. Any such withdrawing member could not rejoin the 
Bank system for 10 years, with only limited exceptions.
    The Bank stock currently outstanding carries only limited voting 
rights. The members of each Bank have the right to elect a majority of 
its directors, typically eight of fourteen directorships, but do not 
vote on any other matters. The number of votes each member may cast in 
an election of directors is tied to the amount of Bank stock it is 
``required to hold'' under the subscription capital provisions. Section 
7 of the Bank Act provides that the number of votes each member may 
cast is equal to the number of shares of Bank stock ``required [by 
Section 6 of the Bank Act] to be held by [each] member at the end of 
the calendar year next preceding the election'' of directors. 12 U.S.C. 
1427(b) (1994). As noted above, at the end of each year each member was 
required to hold Bank stock equal to the greater of $500, 1.0 percent 
of its mortgage assets, 0.3 percent of its total assets, or 5.0 percent 
of its outstanding advances. For voting purposes, however, Section 7 
limits the number of votes that any member may cast at the average 
number of shares of Bank stock ``required to be held'' by the members 
located in the same state at the end of the prior calendar year. Thus, 
for any members that hold stock in excess of the average for their 
state, those excess shares are divested of their voting rights.\3\ As 
amended by the GLB Act, all of Section 6 of the Bank Act has been 
revised and no longer requires a member to hold a particular amount of 
Bank stock as of the end of the calendar year. Similarly, the Bank Act 
no longer establishes a required investment for each member. Instead, 
Section 6 of the Bank Act now authorizes each Bank to determine the 
amount and nature of any investment each member must maintain in the 
capital stock of the Bank, and requires each Bank to address the voting 
rights for each class of stock in its capital structure plan, subject 
to the approval of the Finance Board.
---------------------------------------------------------------------------

    \3\ The Bank Act provides generally that each Bank is to have a 
board of fourteen directors, eight of whom are elected by the 
members and six of whom are appointed by the Finance Board. 12 
U.S.C. 1427(a) (1994). The elected directorships for each Bank are 
allocated among the states in each Bank district, based on the 
amount of stock held by members in the respective states, subject to 
certain ``grandfather'' provisions that reserve a specified number 
of directorships to particular states (based on relative stock 
ownership in 1960) and certain discretionary authority conferred on 
the Finance Board to establish a limited number of additional seats 
in certain Bank districts.
---------------------------------------------------------------------------

E. The Financial Management and Mission Achievement Proposal

    In 1999 the Finance Board proposed to adopt a risk-based capital 
requirement as part of its ``Financial Management and Mission 
Achievement'' (FMMA) rulemaking. 64 FR 52163 (Sept. 27, 1999). The 
capital provisions of the FMMA would have established a ``minimum total 
capital requirement'' and a ``minimum total risk-based capital 
requirement'' for each Bank. Under the total risk-based capital 
requirement a Bank would have been required to maintain ``total risk-
based capital'' in an amount sufficient to meet the sum of its credit 
risk, market risk, and operations risk capital requirements, each of 
which would have been established by the proposed rule. The credit risk 
aspect of the FMMA would have addressed the credit risks to which each 
Bank is exposed with respect to both its on- and off-balance sheet 
items, using data from Nationally Recognized Statistical Rating 
Organizations (NRSRO) to estimate the credit losses likely to be 
associated with particular classes of items during periods of extreme 
credit stress. The FMMA would have established the market risk capital 
requirement based on the market value of a Bank's portfolio at risk 
from movements in market prices, such as interest rates, foreign 
exchange rates, commodity prices, or equities prices, that might occur 
during periods of extreme market stress. The proposal would have 
allowed for the use of a Bank's internal market risk model, which was 
to have been approved by the Finance Board. The FMMA would have 
required each Bank to maintain capital in an amount equal to 30 percent 
of the sum of its credit risk capital and market risk capital 
requirements in order to support the operations risks to which the Bank 
is exposed. The FMMA also would have required the Banks to maintain 
both a System-wide and individual Bank credit ratings, at levels 
specified by the proposed rule, and would have required each Bank to 
maintain ``contingency liquidity'' in an amount sufficient to enable 
the Bank to meet its obligations if it were unable to borrow in the 
capital markets for seven consecutive days. The proposal included 
provisions limiting the amount of unsecured credit that a Bank could 
have outstanding to any single counterparty (or to affiliated 
counterparties) and would have addressed the extent to which the Banks 
may use hedging instruments. The Finance Board withdrew the FMMA 
proposal following the enactment of the GLB Act. Board Resolution No. 
99-56 (Nov. 15, 1999); 64 FR 66115 (Nov. 24, 1999).
    With the enactment of the GLB Act, certain aspects of the proposed 
FMMA capital rule, such as those pertaining to the types of capital 
required for the leverage and risk-based capital requirements, no 
longer would be consistent with Section 6 of the Bank Act, as amended. 
Other aspects of the capital rules proposed as a part of FMMA, however, 
remain generally consistent with the amended statute, particularly as 
it relates to the capital required to be held against credit risk and 
market risk. The GLB Act requires the Finance Board to adopt a risk-
based capital regulation that requires the Banks to maintain sufficient 
permanent capital to meet the credit risks to which they are subject, 
but does not otherwise provide how the credit risk is to be measured. 
Similarly, the GLB Act provides that the market risk element of the 
risk-based capital requirement must be based on a stress test developed 
by the Finance Board that ``rigorously tests for changes in market 
variables, including changes in interest rates, rate volatility, and 
changes in the shape of the yield curve.'' The GLB Act does not further 
specify the provisions of the stress test, other than to require that 
the Finance Board give ``due consideration'' to any risk-based capital 
rules promulgated by the Office of Federal Housing Enterprises 
Oversight (OFHEO) with respect to Fannie Mae and Freddie Mac. Moreover, 
the GLB Act does not preclude the Finance Board from incorporating 
other elements into the risk-based capital rules, such as a requirement 
to hold some amount of capital to cover the operations risks to which 
the Banks are subject. In considering the requirements of the GLB

[[Page 43411]]

Act for the credit and market risk elements of the capital rules, the 
Finance Board has determined that in many respects the underlying 
methodology of the credit and market risk provisions of the capital 
rules that were proposed as part of the FMMA are consistent with the 
requirements of the GLB Act. Accordingly, the proposed rule builds on 
those provisions, as well as on the provisions of the FMMA relating to 
operating risk.

II. The Proposed Rule

    A. Issuance of Bank Stock.
    In General. The GLB Act provides that the capital regulations are 
to permit each Bank to issue ``any one or more'' of Class A or Class B 
stock. Class A stock is to be redeemable at par on six months written 
notice to the Bank; Class B stock is to be redeemable at par on five 
years written notice to the Bank. The board of directors of each Bank 
is to determine the ``rights, terms, and preferences'' for each class 
of stock, consistent with Section 6 of the Bank Act, with the 
regulations of the Finance Board, and with market requirements. The 
regulations are required to prescribe the manner in which Bank stock 
may be ``sold, transferred, redeemed, or repurchased.'' The regulations 
also are required to restrict the issuance and ownership of Bank stock 
to the members of the Bank, to prohibit the issuance of other classes 
of stock, and to provide for the liquidation of claims and the 
redemption of stock upon an institution's withdrawal from membership in 
its Bank.
    Apart from authorizing the issuance of two classes of Bank stock, 
the GLB Act eliminated certain key characteristics of the single class 
of Bank stock that had been established under prior law. For example, 
the Bank Act no longer mandates a statutory par value for all Bank 
stock of $100 per share and no longer requires all Bank stock to be 
issued at par value.\4\ As a result, the Bank Act now authorizes a Bank 
to establish the par value for its Class A and Class B stock (which may 
differ), and permits the issuance of stock at a price other than par 
value. The proposed rule includes provisions that implement those 
changes in the law, as described below.
---------------------------------------------------------------------------

    \4\ 12 U.S.C. 1426(a) (1994). The minimum amount of Bank stock 
that each member was required to purchase had to be issued at par 
value. Any subsequent issuance could be at a price in excess of par 
value, but not less than par value. As a matter of practice, the 
stock of the Banks has been issued at par value.
---------------------------------------------------------------------------

    Classes of Stock. In authorizing the new capital structure for the 
Banks, the GLB Act provides that the regulations promulgated by the 
Finance Board ``shall * * * permit each Federal home loan bank to issue 
* * * any 1 or more of * * * Class A stock * * * and * * * Class B 
stock.'' 12 U.S.C. 1426(a)(4)(A), as amended. The GLB Act also provides 
that the capital structure plan for each Bank ``shall afford each 
member * * * the option of maintaining its required investment in the 
bank through the purchase of any combination of classes of stock 
authorized by the board of directors of the bank and approved by the 
Finance Board.'' Id., 1426(c)(4)(A), as amended. Although the GLB Act 
gives the members the option to decide how to allocate their required 
investment if a Bank issues both Class A and Class B stock, that option 
applies only to whatever ``classes of stock [are] authorized by the 
board of directors of the bank'' and must be read in light of the other 
provisions that permit each Bank to issue ``any 1 or more'' classes of 
stock. The directive that the regulations must allow a Bank to issue 
``any 1 or more'' class of stock clearly contemplates that a Bank may 
issue only a single class of stock. Provided that a Bank's board of 
directors were to determine that a single class structure would be in 
the best interest of the Bank and its members, such a stock structure 
would be legally permissible. Accordingly, the proposed rule would 
permit each Bank to issue either Class A stock or Class B stock, or to 
issue both Class A and Class B stock. Whatever classes the board of 
directors of a Bank authorizes, the capital plan must demonstrate that 
the classes of stock to be issued will result in the Bank having 
sufficient amounts of permanent capital (i.e., the amounts paid-in for 
the Class B stock, plus retained earnings) to meet the regulatory risk-
based capital requirement and sufficient amounts of total capital 
(i.e., permanent capital plus the amounts paid-in for Class A stock, 
certain loss allowances, and other items capable of absorbing losses) 
to meet the regulatory total capital requirement. For example, if a 
Bank were to increase its retained earnings to an amount that would 
provide sufficient permanent capital to comply with the regulatory 
risk-based capital requirement it may not need to issue any Class B 
stock. Alternatively, if a Bank were to have only a minimal amount of 
retained earnings it may need to issue only Class B stock in order to 
have sufficient permanent capital to meet the regulatory risk-based 
capital requirement.
    The proposed rule would define the essential characteristics of 
both Class A and Class B stock. As required by the GLB Act, Class A 
stock would be redeemable in cash at its par value on six-months 
written notice to the Bank. The Finance Board is proposing to require 
that the Class A stock have a par value of $100 per share and that it 
be issued at par value. Because the current capital stock of the Banks 
has a par value of $100 per share and is issued and redeemed at par, 
the Finance Board believes that establishing the same characteristics 
for the Class A stock would facilitate the transition to the new 
capital structure. The proposed rule also would require each Bank to 
specify in its capital plan a stated dividend for the Class A stock, 
which would have a priority over the payment of any dividends paid on 
Class B stock. The Finance Board anticipates that the stated dividend 
would be commensurate with the risks of holding an instrument that is 
putable to the issuer on six months notice. By definition, the Class B 
stock entails a greater risk to the member because its investment is 
committed to the Bank for at least five years. The Finance Board 
believes (and has been so advised by a financial consultant retained by 
the Banks) that members will demand some form of control over the 
affairs of the Bank in return for putting their capital at risk for 
five years. In that event, the members holding Class B stock likely 
would control the board of directors of the Bank, and thus would be in 
a position to determine the dividend to be paid on the Class A stock. 
The Finance Board has included the requirement that the Class A stock 
pay a stated dividend as a means of ensuring that the Class B 
stockholders would not be able to reduce or eliminate the dividend for 
the Class A stock, should they control the board of directors.
    Certain of the essential characteristics of Class B stock would 
differ from those established for the Class A stock. As with the Class 
A stock (and as required by the GLB Act) the proposed rule would 
provide that the Class B stock must be redeemable in cash and at par 
value on five-years written notice to the Bank. The Class B stock would 
differ from the Class A stock with regard to its par value and its 
issuance price, which could be different from its par value. Allowing 
the Banks to set an issuance price above the par value of the Class B 
stock should result in a greater degree of permanence for the Class B 
stock that would be more in the nature of common stock. The proposed 
rule would not require a Bank to issue the Class B stock above par 
value, but simply would allow a Bank that option. A Bank could issue 
Class B at par if it wished to do so. The proposed rule also would

[[Page 43412]]

provide that a fundamental characteristic of the Class B stock is that 
it would confer on the member an ownership interest in the retained 
earnings of the Bank upon acquisition of the stock. The GLB Act 
provides that the holders of the Class B stock shall own the retained 
earnings of each Bank, which is consistent with the attributes of 
permanent equity capital in a corporate setting.
    Subclasses of Stock. The GLB Act requires the capital regulations 
to provide that a Bank may not issue stock other than as authorized by 
Section 6 of the Bank Act, and that the stock is to have ``such rights, 
terms, and preferences * * * as the board of directors of that Bank may 
approve.'' Separately, the GLB Act requires the capital plan for each 
Bank to establish the ``terms, rights, and preferences, including 
minimum investment, dividends, voting, and liquidation preferences for 
each class of stock issued by the bank.'' 12 U.S.C. 1426(a)(4)(A), 
(c)(4)(B), as amended. The Finance Board construes this language as 
authorizing a Bank to establish rights, terms, and preferences for 
Class A stock that differ from those established for the Class B stock. 
The Finance Board also believes that the authority to establish 
different rights, terms, or preferences for the stock should apply 
within a particular class of stock as well as between the two different 
classes. For example, the repeal of the requirement that all stock must 
be issued at par would allow a Bank to issue two types of Class B 
stock--one type that was issued at par and another that was issued 
above par. Although both types of stock would possess the minimum 
characteristics required for Class B stock, i.e., they would be 
redeemable on five years written notice to the Bank, they would have 
been issued on materially different terms. The same rationale would 
apply if a Bank were to issue one type of Class B stock for which the 
dividend is to be determined based on the performance of a specific 
category of Bank assets and other Class B stock for which the dividend 
would be determined on the general profitability of the Bank. Because 
the board of directors of a Bank clearly has the authority to establish 
different rights, terms, and preferences for the Bank stock, the 
Finance Board believes it would be appropriate to allow a Bank to 
designate stock of the same class that possesses different rights as 
separate subclasses of that class.
    Issuance of Capital Stock. The proposed rule would allow each Bank 
to determine whether to issue either Class A or Class B stock, or both 
Class A and Class B stock, and whether to issue any subclasses of 
stock. In accordance with the GLB Act, the proposed rule also would 
provide that a Bank may issue its capital stock only to its members, 
and may not issue any other types or classes of capital stock. The 
proposal would require a Bank to act as its own transfer agent, and to 
issue its capital stock only in book-entry form, which is consistent 
with the current practice at each of the Banks, and is intended to 
ensure that the stock is held only by members. The Finance Board is not 
aware of any business necessity that would require the Banks to issue 
stock certificates, especially given the limited universe of potential 
stockholders, and believes that certificates would only increase the 
possibility that third parties might acquire the stock. The Finance 
Board requests comments on whether there are any sound reasons why the 
Banks should be permitted to issue stock certificates to their members, 
and if so what safeguards would be appropriate.
    In order to allow each Bank to determine the method of distribution 
that is best suited to its business requirements and to the needs of 
its members, the Finance Board is not proposing to prescribe the manner 
in which the Banks must conduct the initial issuance of the Class A and 
Class B stock. Instead, the proposed rule would require each Bank to 
determine the manner in which to issue its stock, and would require 
only that the method of distribution be fair and equitable to all 
eligible purchasers. The proposal would expressly allow the Banks to 
conduct the initial issuance through an exchange or conversion, but 
would not mandate either approach. Whatever method a Bank adopts for 
the initial stock issuance must be included in the Bank's capital plan, 
as set forth in Sec. 933.2. Additionally, because a fundamental 
characteristic of Class B stock is that it confers on the member an 
ownership interest in the retained earnings of the Bank, the Finance 
Board is proposing to allow a Bank to distribute its then-existing 
unrestricted retained earnings as shares of Class B capital stock.
    The Finance Board is further proposing to establish concentration 
limits that would preclude any one member, or group of affiliated 
members, from controlling the Bank. Thus, the proposed rule would 
provide that a Bank shall not issue stock to a member or group of 
affiliated members if it were to result in such member or group of 
affiliated members owning more than 40 percent of any class or subclass 
of its outstanding capital stock. Other provisions of the rule would 
bar a Bank from approving a transfer of stock that would result in a 
member or group of affiliated members owning more than 40 percent of 
any class or subclass of its stock. The proposed rule also would allow 
a Bank to include in its capital plan an ownership cap lower than 40 
percent.
    The investment by one Bank in the assets of another Bank, such as 
Acquired Member Assets, has been increasing in recent years. As these 
``joint assets'' increase, capital issues under the new structure will 
exist. One such issue would be whether two or more Banks jointly 
managing assets through a participation agreement could jointly issue 
stock. Another issue would be whether two or more Banks jointly 
managing assets could pool their capital stock in order to meet the 
regulatory capital requirements. The Finance Board specifically 
requests comments on whether the Banks should be allowed to issue stock 
jointly or to pool stock to meet regulatory capital requirements for 
assets that are being jointly managed by two or more Banks.
    B. Voting rights. Section 7 of the Bank Act addresses, among other 
things, the manner in which the members of each Bank elect directors 
and the manner in which the Finance Board allocates directorships among 
the states in each Bank district. The GLB Act did not expressly amend 
Section 7 as it relates to those issues, but it did include certain 
amendments to Section 6 that conflict with those provisions of Section 
7. In the proposed rule, the Finance Board has attempted to strike a 
balance between the conflicting provisions of Sections 6 and 7, 
respectively, by giving full effect to the more recent amendments to 
Section 6, while preserving as much as possible the provisions of 
Section 7. The approach taken in the proposed rule represents one means 
of reconciling the competing provisions of Section 6 and Section 7. The 
Finance Board recognizes that there may be other approaches to 
balancing the requirements of these provisions and specifically 
requests public comment on how else the provisions might be harmonized, 
and how the proposed rule may affect the cooperative structure of the 
Bank System. The Finance Board also would like to know whether there 
are any other restrictions on voting rights or allocation of 
directorships that should be incorporated into the rule as mandatory 
requirements, or whether there are other restrictions or requirements 
that the Finance Board should encourage the Banks to include as part of 
their capital plans.

[[Page 43413]]

    Since 1932, the Banks have been authorized to issue only one class 
of stock. Ownership of Bank stock has conferred on a member the right 
to participate in the election of directors. In 1961, Congress amended 
Section 7 of the Bank Act to provide that the number of votes each 
member may cast in an election of directors, and the manner in which 
the elected directorships are to be allocated among the states, would 
be determined on the basis of the subscription capital provisions of 
Section 6. Specifically, Section 7 was amended to provide that ``each 
such member may cast * * * a number of votes equal to the number of 
shares of stock in [the Bank] required by this Act to be held by such 
member at the end of the calendar year next preceding the 
election''.\5\ At that time, Congress also amended Section 7 to require 
that the allocation of elected directorships, like the method for 
determining the number of votes, be determined based on the 
proportionate amounts of Bank stock ``required to be held'' by the 
members in each state as of the end of the preceding calendar year, 
subject to a ``grandfather'' provision that reflected the allocation of 
directorships as of December 31, 1960. See 12 U.S.C. 1427 (a)-(c) 
(1994).
---------------------------------------------------------------------------

    \5\ Act of September 8, 1961, Pub. Law No. 87-211; see, 12 
U.S.C. 1427(b) (1994). Although each share of Bank stock carried one 
vote, the Bank Act also limited the number of votes any one member 
could cast to the average number of shares of Bank stock ``required 
to be held'' by each member in that state as of the end of the 
preceding calendar year. That provision had the effect of partially 
disenfranchising any members that owned Bank stock in excess of the 
average stockholdings within that state.
---------------------------------------------------------------------------

    The language in Section 7 regarding the amount of Bank stock 
``required to be held'' by the members as of the preceding December 
31st refers to the subscription capital provisions of Section 6, as in 
effect prior to the GLB Act. As described previously, the subscription 
capital provisions required each member to purchase an amount of Bank 
stock based on a statutory formula (i.e., the greater of $500, 1.0 
percent of mortgage assets, 0.3 percent of total assets, or 5.0 percent 
of advances) that was to be applied to each member as of December 31st 
of each year. By incorporating into Section 7 a principal component of 
Section 6--i.e., the amount of Bank stock ``required to be held'' by 
each member as of the end of each year--the Congress in 1961 
effectively linked the process of electing Bank directors to the 
subscription capital structure. In the GLB Act the Congress removed the 
subscription capital provisions from Section 6, but made no conforming 
amendments to Section 7. As a result, Section 7 of the Bank Act 
continues to require that the allocation of directorships and the 
determination of member votes be based solely on the subscription 
capital provisions, which will no longer exist when the new capital 
plans take effect. The Congress has provided no guidance on how, if at 
all, it intended the references to the subscription capital provisions 
within Section 7 to be applied in conjunction with the new risk-based 
capital provisions of Section 6.
    The most apparent conflict between Section 7 and Section 6 (as 
amended) pertains to the number of votes each member may cast in an 
election of directors. Though Section 7 provides that the number of 
votes each member may cast shall equal the number of shares of Bank 
stock that the member is required to own, Section 6 expressly 
authorizes each Bank to establish voting preferences for its capital 
stock. As amended, Section 6 would authorize a Bank to assign voting 
rights exclusively to either its Class A or Class B stock, or to the 
Class A and Class B stock equally, or to both Class A and Class B but 
with a disproportionate weighting. The Finance Board believes that it 
is not possible to reconcile these provisions, as a Bank cannot 
establish a system of voting preferences (which, by definition, results 
in disparate voting rights for each class) while at the same time 
adhering to a requirement that all shares of its stock are to have 
uniform voting rights (subject only to the cap on members with large 
stockholdings). \6\ In order to give effect to the GLB Act capital 
amendments that have authorized each Bank to establish voting 
preferences, the Finance Board is of the opinion that the provisions of 
Section 7(b) of the Bank Act that establish a ``one share, one vote'' 
structure must be considered to have been impliedly repealed by Section 
6(c)(4)(B), as amended by the GLB Act.
---------------------------------------------------------------------------

    \6\ As a technical matter, members with large amounts of Bank 
stock cannot vote all of their shares of stock due to the cap based 
on the average holdings within each state. For those shares that can 
be voted, however, all votes count equally.
---------------------------------------------------------------------------

    In a similar fashion, there are conflicts between provisions of 
Section 7(b), (c), and (e), regarding the designation of directorships 
among the states, and Section 6, as amended by the GLB Act. The former 
provisions are premised on the assumption that the Banks are to be 
capitalized in accordance with a statutory formula, whereas the latter 
provisions require the Banks to be capitalized in relation to their 
risks. As described previously, Section 7 continues to require the 
Finance Board to designate the elected directorships of each Bank among 
the states in the approximate ratio of the Bank stock required to be 
held by the members in each state to the total stock outstanding, as of 
the end of the calendar year. The Finance Board cannot determine those 
ratios in the manner required by the literal language of Section 7, 
however, because under the new capital structure the members will no 
longer be required to maintain an investment in Bank stock in 
accordance with the statutory formula and as of December 31st of each 
year. The Finance Board has considered whether it would be feasible to 
calculate the Section 7 ratios for the allocation of directorships on 
the basis of Section 6, as it has been amended, but believes that doing 
so likely would create a host of uncertainties that are not addressed 
by the Bank Act and which the Finance Board would be required to 
resolve.
    As amended by the GLB Act, Section 6 does refer to a ``minimum 
investment'' that each member must maintain in the stock of the Bank, 
but it does not specify what that term means, other than indicating 
that it may be based on a percentage of a member's assets or a 
percentage of its advances, or any other provision approved by the 
Finance Board. The Finance Board could define the term, but there 
likely are several ways in which to do so, none of which would be 
compelled by statute. However the term is to be defined, it would have 
to be correlated in some fashion to the risks to which the Bank is 
exposed, i.e., it should not result in a Bank having too little or too 
much capital in relation to its risks. Thus, a bare formulaic 
definition of the term (as formerly included in the subscription 
capital provisions) likely would not be appropriate because it would 
have no relation to the risks to which the Banks are exposed.
    As one possibility, the Finance Board could define ``minimum 
investment'' to mean an amount of Bank stock required to be held as a 
condition of membership in the Bank. That approach, however, would be 
complicated by the issuance of the two classes of Bank stock authorized 
by the GLB Act. The existence of two classes of stock means that for 
every state within a Bank district each member located in that state 
would hold a certain percentage of the Bank's Class A stock and a 
certain percentage of the Bank's Class B stock. Because the GLB Act 
gives each member the option of determining which class of stock to 
buy, it is likely that if a Bank issues both Class A and Class B stock 
there will be some members that purchase only one class of Bank stock 
and other members that purchase both

[[Page 43414]]

classes of stock but in varying combinations. As a result, for each 
state in a Bank district it is unlikely that the percentage of Class A 
stock held by the members located in that state will be identical to 
the percentage of Class B stock held by the members in that state. 
Indeed, it appears probable that the relative percentages of Class A 
and Class B stock held by the members in a particular state will 
differ, and may well differ substantially. Thus, it would be possible, 
and perhaps probable, that the Class A stock of a Bank may be 
concentrated in certain states while the Class B stock would be 
concentrated in other states within the Bank district. In that event, 
the Finance Board should be able to determine the ratio of Class A 
stock held by members in a given state, and separately should be able 
to determine the ratio of Class B stock held by the members in that 
state. It is not at all clear, however, how the Finance Board could 
apply those ratios to allocate the elected directorships in the manner 
required by Section 7, especially if there are material differences 
among the ratios for the various states in the Bank district. The 
possibility of having two different ratios would be further complicated 
by the provisions of the GLB Act that allow a Bank to set a lower 
minimum investment for the B stock than for the Class A stock. Thus, 
even if the Finance Board could readily calculate the ratios for the 
Class A and Class B stock, respectively, for each state, the ratio for 
the Class B stock most likely would have to be adjusted in some 
fashion.
    As an alternative to viewing the term ``minimum investment'' as an 
investment required as a condition of membership, it could be defined 
in terms of the amount of Bank stock required to support the credit, 
market, and operations risks created for the Bank as a result of 
entering into business transactions (such as making advances, acquiring 
mortgage assets, or issuing letters of credit) with a member. Because 
all Bank assets entail some degree of risk, a member could be required 
to purchase Class A and Class B stock in whatever amounts are necessary 
to provide the total capital and permanent capital required to cover 
the risks associated with the assets created by its business 
transaction with the Bank. If the Finance Board were to define 
``minimum investment'' on the basis of the risk placed on the balance 
sheet, such an approach would result in most members investing in both 
Class A and Class B stock. The relative amounts of each class of stock 
held by a member under such an approach would vary with the degree of 
risk associated with the underlying assets. Thus, one would expect that 
a member placing somewhat more risky assets on the balance sheet of the 
Bank would be required to purchase a correspondingly greater amount of 
Class B stock than a member creating the same amount of a less risky 
asset. Because the leverage requirement applies independently of risk, 
however, an equal amount of assets with different risk characteristics 
should require the same amount of Class A stock for leverage purposes. 
Thus, defining ``minimum investment'' in this manner also would be 
likely to result in the ratio of Class A stock held by the members in a 
particular state differing from the ratio of Class B stock held by the 
members in that state, which would present the same difficulties in 
calculating the individual state ratio described previously. Moreover, 
it is likely that the term ``minimum investment'' could not be defined 
solely on the basis of a member's transactions with the Bank because 
not all members will at all times be engaged in a business transaction 
with the Bank. For that reason, it is likely that a definition of 
``minimum investment'' would have to incorporate both membership and 
risk aspects. If so, the Finance Board then would be faced with using 
as many as four different stock ratios for each state if it were to 
determine the allocation of directorships in accordance with the 
literal language of Section 7.
    Apart from those definitional concerns, the Finance Board has a 
more general concern that requiring the allocation of elected 
directorships among the states, regardless of how it is done, could 
impair the ability of the Banks to sell Class B stock in amounts 
sufficient to comply with their risk-based capital requirements. If 
that were to occur, the adherence to the state-based allocation formula 
clearly would frustrate the intent of Congress in establishing a risk-
based capital structure for the Banks. In requiring the Banks to have 
sufficient permanent capital to meet their risk-based capital 
requirements, the GLB Act has effectively mandated that the Banks, 
through sale or conversion, issue a significant amount of Class B 
stock.\7\ In tension with this requirement is another provision of the 
GLB Act, which requires that each Bank's capital plan allow each member 
the option of determining what combination of classes of authorized 
Bank stock to purchase. In effect, the GLB Act requires the Banks to 
issue Class B stock but does not compel the members to purchase the 
Class B stock. The GLB Act does provide that each Bank is to establish 
the terms, rights, and preferences for each class of stock that are 
``consistent with Finance Board regulations and market requirements.'' 
That provision recognizes that if the purchase of Class B stock is to 
be voluntary, then the Banks must be authorized to establish terms for 
the Class B stock, such as voting and dividend preferences, that 
provide economic incentives for the members to purchase the Class B 
stock.
---------------------------------------------------------------------------

    \7\ Although a Bank may include its retained earnings as 
permanent capital, no Bank has sufficient retained earnings to 
comply with the risk based capital requirements at present or is 
likely to have sufficient retained earnings in the near future. 
Since the enactment of FIRREA in 1989, the Banks have maintained 
only nominal amounts of retained earnings. Moreover, in the six 
months since the enactment of the GLB Act, some Banks have paid out 
significant portions of their retained earnings to their members. As 
of March 31, 2000, the retained earnings of the Bank System were 
equal to 0.11 percent of the total assets of the Banks, and the 
amounts at the individual Banks ranged from 0.03 percent to 0.20 
percent of total assets.
---------------------------------------------------------------------------

    The paramount intent of Congress in revising the capital structure 
for the Banks was to ensure that the risks to which each Bank are 
exposed are supported by permanent capital, i.e., Class B stock and 
retained earnings. Because Class B stock is the only practical source 
of permanent capital for the immediate future, the intent of the 
Congress cannot be implemented unless the Banks are able to sell Class 
B stock. To the extent that other provisions of the Bank Act might 
impair the ability of the Banks to do so, the application of those 
provisions would frustrate the intent of Congress in creating the new 
risk-based permanent capital structure. The Finance Board believes that 
requiring the allocation of the elected directorships of each Bank 
exclusively on a state-based formula would make the Class B stock a 
less attractive economic option for the members because there would be 
no assurance that the Class B stock would be distributed in the same 
proportion that the directorships would be allocated among the states.
    Because of the difficulties in using a ``minimum investment'' as a 
proxy for the amount of stock ``required to be held'' as of each 
December 31st, and the likelihood that a state-based allocation of 
directorships would make the sale of Class B stock more difficult, the 
Finance Board has preliminarily determined that it cannot apply the 
provisions of Section 7 regarding the allocation of directorships 
without frustrating the intent of Congress to create a workable risk-
based permanent capital structure

[[Page 43415]]

for the Banks. The Finance Board believes that there is no practical 
way to give simultaneous effect to one provision of law that would 
require the preservation of the subscription capital structure for the 
purpose of allocating directorships and voting rights and another 
provision of law that would repeal the subscription capital structure 
in its entirety. The Finance Board is proposing to resolve that 
conflict by giving precedence to the provisions of Section 6 of the 
Bank Act, as amended by the GLB Act, over those provisions of Section 
7(b), (c), and (e) relating to voting and the allocation of 
directorships.\8\ The Finance Board does not believe that any other 
provisions of Section 7 are inconsistent with Section 6, as amended. 
Thus, the other provisions of Section 7, such as those regarding the 
size of the board of directors (including both elected and appointed 
directors), the requirements applicable to individual directors, the 
terms of office, term limits, vacancies, compensation, duties, and 
indemnification, would not be affected by the application of Section 6, 
as amended.
---------------------------------------------------------------------------

    \8\ Puerto Rico presents a unique situation of a prior Finance 
Board establishment of a directorship, which has been made permanent 
by statute. In 1962, Congress amended Section 7(e) to authorize the 
Finance Board to establish an additional elected directorship for 
the Bank in which the Commonwealth of Puerto Rico was located, which 
directorship was required to be designated to Puerto Rico. The 
Finance Board exercised that authority, creating an additional 
elected directorship for the New York Bank, which it designated as 
representing the members located in Puerto Rico. Although the 
designation of that seat to Puerto Rico is inconsistent with the 
risk-based capital amendments to Section 6, for the same reasons 
that the other state-based designations are inconsistent with 
Section 6, the preservation of the additional directorship can be 
reconciled with Section 6, as amended. Accordingly, the New York 
Bank would continue to have an additional elected directorship 
pursuant to Section 7(e), and the proposed rule would allow the Bank 
to accommodate the representation of members located in Puerto Rico 
as part of its capital plan. As provided in Section 7(e), if the 
Finance Board ever were to relocate the Commonwealth of Puerto Rico 
to another Bank district, the additional elected directorship 
created by Section 7(e) would cease to exist.
---------------------------------------------------------------------------

    In cases of conflicting statutory provisions, it is an ordinary 
rule of statutory construction that later-enacted provisions take 
precedence over older provisions, to the extent that the older 
provision is inconsistent with the later-enacted provision. See 
Tennessee Gas Pipeline Co. v. Federal Energy Regulatory Comm'n, 626, 
F.2d 1020, 1022 (D.C. Cir. 1980); Estate of Flanigan v. Commissioner of 
Internal Revenue, 743 F.2d 1526, 1532 (11th Cir. 1984). The Finance 
Board believes, as described above, that the provisions of Section 6 
must take precedence over the provisions of Section 7 that relate to 
the allocation of directorships and voting. The U.S. Supreme Court has 
made clear, however, that it is also a ``cardinal rule'' of statutory 
construction that judicial findings of such implied repeals of 
statutory provisions are not favored. Morton v. Mancari, 417 U.S. 535, 
549 (1974); Posadas v. National City Bank, 296 U.S. 497, 503 (1936). 
The Court has explained that effect should be given to both provisions 
wherever possible and that absent a ``clear and manifest'' intention on 
the part of Congress to repeal a statutory provision, the only 
permissible justification for a repeal by implication is when the 
earlier and later statutes are ``irreconcilable.'' Morton, 417 U.S. at 
550-51; see Georgia v. Pennsylvania RR Co., 324 U.S. 439, 456-57; FAIC 
Securities v. United States, 768 F.2d 352, 362 (D.C. Cir. 1985); United 
Ass'n of Journeymen and Apprentices v. Thornburgh, 768 F. Supp. 375, 
379-80 (D.D.C. 1991).
    In determining whether an ``irreconcilable'' conflict exists 
between statutory provisions, a court will first look to the plain 
language of the statutes. See Flanigan, 743 F.2d at 1532 (finding that 
two provisions of the Internal Revenue Code were, on their face, 
plainly irreconcilable). Only when the language of two provisions 
leaves the court in doubt as to whether they represent truly 
irreconcilable intentions will a court resort to any legislative 
history that may be pertinent to the issue. See Demby v. Schweiker, 671 
F.2d 507, 510 (D.C. Cir. 1981) (wherein the court resorted to the 
legislative history of the newer act in finding that the provisions in 
question were not irreconcilable).
    An administrative agency charged with the implementation of a 
particular statute may implement an administrative resolution of two 
conflicting provisions in that statute through a proper APA notice-and-
comment rulemaking. Citizens to Save Spencer County v. Environmental 
Protection Agency, 600 F.2d 844, 875-78 (D.C. Cir. 1979). In 
undertaking such a rulemaking, an agency should determine, based on the 
plain language of the provisions and, if necessary, on the legislative 
history of the statutes, that the provisions are irreconcilable. Id. at 
863-68. The agency should then consider the statute as a whole and the 
purposes of the provisions in question in order to fashion a solution 
that avoids unnecessary hardship or surprise to affected parties and 
remains within the general bounds of the statute in question. Id. at 
870-71. The Finance Board believes that the provisions of Sections 6 
and 7 of the Bank Act described above are in conflict and is proposing 
through this rulemaking to give precedence to the capital provisions of 
Section 6. The legislative history of the GLB Act does not address the 
interrelationship between Section 6 and Section 7, though the language 
of the statute and the legislative history do suggest strongly that the 
creation of a sound system of permanent capital was of paramount 
concern to the Congress in amending Section 6. The proposed rule has 
been structured to give effect to Section 7 to the greatest degree 
possible, and would not preclude a Bank from establishing a state-based 
structure if it believed that approach would be consistent with 
capitalizing the Bank in the manner required by the GLB Act.
    The proposed rule would require that the capital plan for each Bank 
specify the manner in which the members are to elect directors and the 
other corporate matters, if any, on which the members will be entitled 
to vote. The capital plan also must describe the voting preferences, if 
any, to be assigned to any particular class or subclass of stock, and 
whether the Bank will permit cumulative voting by its members and, if 
so, the matters on which members may vote cumulatively.
    If a Bank were to issue any Class B stock, the proposed rule would 
require that the Bank assign some voting rights to the Class B stock. 
The proposed rule would not specify what voting rights should be 
assigned to the Class B stock, and thus would allow each Bank to 
determine whether the Class B stock would have exclusive voting power 
or shared voting power. If a Bank were to issue Class B stock, the 
proposed rule would allow the Bank, in its discretion, also to assign 
some voting rights to the Class A stock, and would allow some voting 
rights to be assigned to the members generally, i.e., without regard to 
the amount or class of Bank stock that each member owns. Within each 
class or subclass of stock, however, the proposed rule would require 
that all shares have equal voting rights, although a Bank could give 
preferences to one or more classes. Thus, all Class B stock would vote 
equally, although a Bank could authorize the Class B members to elect a 
majority of the elected directors by giving Class B a preference over 
the Class A stock. As suggested to the Finance Board by an independent 
consultant retained by the Banks to study the GLB Act capital issues, a 
Bank may find that such preferences are necessary in order to sell the 
Class B stock because it bears more of the risks than does the Class A 
stock.
    As a means of preventing undue concentration of voting power within 
a

[[Page 43416]]

small number of members, the proposed rule would cap the number of 
votes any member (including affiliated members) may cast in an election 
at 20 percent of the votes eligible to be cast in that election. The 
Finance Board recognizes that in some Bank districts a member with less 
than 20 percent of the vote may be able to control the Bank and 
therefore is proposing to allow any Bank to establish a lower 
percentage as part of its capital plan.
    As noted above, in order to ensure that the new capital structure 
is workable and the Banks are able to sell the Class B stock, the 
proposed rule would state expressly that the elected directorships for 
a Bank need not be allocated among the states on the basis of the 
amount of stock required to be held under the now-repealed subscription 
capital requirements, and that the number of votes for each member also 
need not be based on the amount of stock each member was required to 
hold as of the end of the prior year. Notwithstanding that provision 
the proposed rule would not preclude a Bank from allocating voting 
rights among its members on a state-by-state basis, provided such an 
allocation were approved as part of the Bank's capital plan. A Bank 
also could adopt any other reasonable method of electing directors, 
such as authorizing each class of stock to elect a specified number of 
directors, or allocating the directors among the members based on the 
asset size of the members. The proposed rule also would require that 
each Bank include in its capital plan, to the extent feasible, a 
provision for the representation of small members that own Class B 
stock, particularly members that are community financial institutions 
(CFI), as that term is defined by the GLB Act.
    Although the proposed rule includes provisions addressing 
concentration of stock ownership, limits on voting rights, and 
representation of CFIs on the boards of directors, the Finance Board is 
especially interested in receiving comments on these issues and whether 
there may be other ways to address each of them. The approach taken in 
the proposed rule regarding voting would allow each Bank to determine 
the manner in which the members are to elect directors, which 
recognizes that the board of each Bank may be best suited to 
determining how to balance the interests of its members against the 
need to raise the capital required by the GLB Act. Notwithstanding the 
approach embodied in the proposed rule, the Finance Board requests 
public comments on whether there might be a need to include some 
limitations in the rule such that it does not have any untoward 
consequences for the cooperative structure of the Bank System.
    On the issue of board composition, the Finance Board would like to 
receive comments on whether the rule should include a provision 
requiring certain types of members, such as CFIs, to be represented on 
the boards of the Banks. As proposed, the rule would require the Banks 
to ensure that small members, specifically including CFIs, that own 
Class B stock be represented on the board, to the extent it is feasible 
to do so. The Finance Board would like to know whether this type of 
requirement should be made mandatory on the Banks, such that some 
number of the elected directorships should be assigned permanently to 
the CFIs within that district. The Finance Board also would like to 
receive comments on whether the rule should mandate some form of state-
based representation on the boards of the Banks. With the removal of 
barriers to interstate banking, it is less clear what purpose is served 
by retaining a state-based board of directors, especially when there is 
no requirement that the members within a particular state hold any 
Class B stock. The Finance Board requests that any comments advocating 
a requirement for state-based representation address the details of how 
that should be accomplished, especially in light of the varying number 
of states in each Bank district, which range from two to eight, and the 
cooperative structure of the Bank System. The Finance Board also would 
like to know whether it would be advantageous to increase the size of 
the boards of directors to accommodate the representation of small 
members, which the Finance Board can do in the five Bank districts that 
include five or more states, and if so, what actions might be 
appropriate in the other seven Bank districts, for which the Finance 
Board cannot increase the number of directors on the boards.
    One issue on which the Finance Board would like to receive comment 
is whether the rule should allow a Bank to include advisory directors 
on its board, i.e., directors who are not elected by the members and 
who do not vote on board matters, but who may participate in the 
deliberations of the full board of directors. Advisory directors are 
neither expressly authorized nor expressly prohibited by the Bank Act, 
but the Finance Board believes that it could authorize such directors, 
provided that the management of the Bank (i.e., the ability to vote) 
remained vested exclusively in the elected and appointed directors. 
Although an advisory director could not vote on matters before the 
board of the Bank, the Finance Board believes that there may be some 
value to the Bank in having such individuals on the board, as they 
could present the views of members who might not otherwise have a voice 
at the meetings of the boards of directors. For example, if the members 
were to elect directors predominantly from certain states or from 
certain sized institutions, the board could appoint advisory directors 
from states or classes of members that were not otherwise represented. 
The proposed rule does not include any provisions regarding advisory 
directors, but the Finance Board would appreciate comments on whether 
such directorships, or other advisory panels, might be appropriate to 
address in the final rule.
    The proposed rule would bar any member or affiliated members from 
owning more than 40 percent of any class of Bank stock and would bar 
any member or affiliated members from casting more than 20 percent of 
the eligible votes in any election. Although the proposed rule would 
allow each Bank to establish lower limits as part of its capital plan, 
the Finance Board requests comments on whether the percentages used in 
the proposal are appropriate or whether the Finance Board should adopt 
some other percentages as a means of preserving the cooperative 
structure of the Bank System.
    With regard to voting rights, the proposed rule would require that 
the Class B stockholders be assigned some voting rights, but would 
leave to each individual Bank the responsibility to decide exactly what 
voting rights the Class B stock shall be assigned. The rule expressly 
allows a Bank to assign voting rights as well to the Class A 
stockholders and further allows a Bank to assign voting rights on the 
basis of membership, i.e., without regard to what class or how much 
stock a particular member owns. The Finance Board would like to receive 
comments on whether those matters that are at present left to the 
discretion of the Banks should be included in the rule as a mandatory 
requirement, i.e., whether the Banks should be required to assign some 
portion of the voting rights on a one-member one-vote basis, or should 
otherwise require that the members generally be allowed to elect some 
number of directors. Similarly, the Finance Board requests comments on 
whether some number of directorships or some proportion of the vote 
should be assigned by regulation to the Class A stockholders.

[[Page 43417]]

    With regard to all such issues, the Finance Board requests that 
commenters elaborate on how any alternative voting arrangements 
recommended by the commenters would work in conjunction with Section 6 
and how they would facilitate, or at least not impair, the ability of 
the Banks to raise the permanent and total capital required by the GLB 
Act. If the Finance Board ultimately adopts a final rule addressing the 
voting rights and directorship structure generally as proposed, the 
final rule also would include conforming amendments to certain 
provisions of the current election rules, 12 CFR Part 915. Those rules 
address matters such as the allocation of directorships, the annual 
capital stock report, the determination of member votes, and the 
election process. If the final rule authorizes each Bank to determine 
the manner of electing directors, several of the existing regulations 
in Part 915 would have to be rescinded or revised, to the extent that 
they are based on the subscription capital provisions incorporated in 
Section 7. Assuming that the final rule were to address voting rights 
and the allocation of directorships in the manner proposed, the Finance 
Board requests comment on what conforming amendments to the existing 
elections regulations would be appropriate.
    C. Dividends. Under the proposed rule, any member, including those 
withdrawing from the Bank System, that owns Class A or Class B stock, 
or both, would be entitled to receive dividends declared on its stock 
for as long as it owned the stock. The Class A stock would be required 
to pay a stated dividend, and the capital plan would specify the basis 
on which the stated dividend would be calculated. Any Bank wishing to 
change the basis on which the stated Class A dividend is calculated 
would be required to amend its capital plan and submit the amendment to 
the Finance Board for approval. Payment of the stated dividend on the 
Class A stock would have priority over the payment of dividends on 
Class B stock. By providing Class A stockholders a dividend priority, 
the Finance Board intends to preclude the possible manipulation of the 
Class A dividend by and for the benefit of Class B shareholders, who 
are likely to have greater influence on the Bank's dividend policies 
than Class A stockholders. After a Bank pays its stated Class A 
dividend, the board of directors of a Bank may augment the stated 
dividend. This additional payment may be paid, at the discretion of the 
Bank's board of directors, before, concurrently with, or after payment 
of dividends on paid-in Class B stock. Along with specifying the basis 
on which the stated dividend would be calculated, a Bank's board of 
directors would have to determine, prior to issuance of the stock, 
whether such dividends are to be cumulative or non-cumulative.
    Under the proposed rule, the Bank's board of directors could 
authorize the payment of a dividend to Class B stockholders and would 
determine the amount of the dividend to be paid. The board of directors 
would also be able to establish different dividend rates or preferences 
for different subclasses of Class B stock. A dividend established for a 
different subclass could, for example, track the performance of 
specific Bank assets, such as Acquired Member Assets or advances. Any 
dividend that tracks the performance of a Bank asset, however, must be 
proportionately appropriate for the level of risk and profitability 
associated with the underlying asset. For example, the lower the risk 
and profitability of an asset, the lower the dividend payment should 
be.
    The payment of any Class B dividends would only be permitted after 
the payment of the stated Class A dividend. Any dividends to Class B 
stockholders must be payable from GAAP net earnings of the Bank plus 
the GAAP retained earnings of the Bank (after the payment of Class A 
dividends). GAAP net earnings are the net earnings of the Bank after 
the payment of the Resolution Funding Corporation (RefCorp) and 
Affordable Housing Program obligations. Any dividends on Class B stock 
would be non-cumulative. Cumulative dividends on Class B stock would 
not be necessary because the board of directors would set the dividend 
rate anew each year and could, therefore, effectively treat dividends 
as cumulative, but only if there were sufficient earnings to do so.
    D. Preferences on Liquidation, Merger, or Consolidation. Under the 
proposed rule, in the event of a liquidation, merger, or other 
consolidation of a Bank, Class A stockholders would be entitled to 
receive the par value of their stock, plus any accumulated dividends. 
Class A stockholders would be paid before the Bank (or its successor) 
could redeem any Class B stock or pay dividends on the outstanding 
Class B stock that had been issued by the Bank that had been 
liquidated, merged, or consolidated. The preference given to Class A 
stockholders in such cases is consistent with the priority given to the 
payment of the stated dividend to Class A stockholders and with the 
role of Class B stock as bearing the greater risk.
    E. Transfer of Capital Stock. As required by the GLB Act, the 
proposed rule would allow a member to transfer capital stock only to 
another member of the Bank or to an institution that is in the process 
of becoming a member. The Finance Board considers the transfer of stock 
to an institution in the process of becoming a member as an opportunity 
to minimize the likelihood of a Bank becoming overcapitalized. Any such 
transfer of stock would be at a price agreed to by the parties, and 
could be below, at, or above the par value of the stock.
    Additionally, the proposed rule would prohibit a Bank from allowing 
the transfer of Bank stock to a member or group of affiliated members 
if, after the transfer, the member or group of affiliated members would 
own more than 40 percent of any class or subclass of capital stock. The 
proposed rule also would allow a Bank, through its capital plan, to 
establish an ownership cap lower than 40 percent. The ownership cap is 
intended to preclude the possibility that a single member or group of 
affiliated members could control a Bank. If a merger, acquisition, or 
other consolidation of two or more members of a Bank were to result in 
the surviving member holding more than 40 percent of any class of 
stock, or any lower cap set by the Bank, the Bank and member(s) would 
be required to agree to a plan for the member to divest any stock in 
excess of the ownership cap in an orderly manner. The Finance Board 
requests comments on how else the concentration limits might be applied 
in the case of a merger of members, as well as on how to apply such 
limits if a member were to exceed the limits as a result of actions 
taken by a third party, such as the withdrawal of a large member that 
causes the percentages of all other members to increase.
    F. Membership Investment in Capital Stock. The GLB Act requires 
each member to maintain an investment in its Bank. Under the proposed 
rule, a Bank may require an institution to invest in Class A stock as a 
condition to becoming and remaining a member of the Bank, or a Bank may 
establish a membership fee to be assessed in lieu of mandatory stock 
investment. As noted below, after a Bank reaches its operating capital 
ratios it could no longer continue to require any additional membership 
investments, though it would be able to continue to assess annual 
membership fees. If a Bank were to require a membership investment in 
Class A stock, the Bank also must provide the member the option of

[[Page 43418]]

investing in a lesser proportional amount of Class B stock, which 
amount would be as determined by the Bank. For example, a lesser 
proportional amount of Class B stock could be calculated by multiplying 
the amount of Class A stock otherwise required for membership by a 
Bank-determined percentage.
    If a Bank were at or above its operating total capital ratio and 
its operating risk-based capital ratio, the proposed rule would provide 
that the Bank could not require a member to purchase capital stock, but 
it still could require a member to pay an annual membership fee in lieu 
of the mandatory stock purchase. Because the amounts paid as membership 
fees do not constitute total capital or permanent capital under the GLB 
Act, the proposed rule would not preclude a Bank from assessing an 
annual membership fee after it has reached or exceeded its operating 
capital ratios. Both of these provisions have been included in the 
proposed rule in an effort to avoid a Bank becoming over-capitalized. 
The Finance Board believes that allowing a Bank to accumulate excessive 
amounts of capital, i.e., amounts of capital beyond what is required to 
support the risks inherent in the business of the Bank, plus the 
marginal amount of additional capital carried as a result of the Bank's 
operating total capital and risk-based capital ratios, would lead to 
increased arbitrage investments, which the Congress clearly intended to 
address as part of the GLB Act capital restructuring. The Finance Board 
would allow the Banks to operate at higher capital ratios than are 
required by the GLB Act and this regulation, i.e., higher percentages 
of total and permanent capital, which the Finance Board does not 
believe would lead to increased arbitrage investments. Also, by 
providing the Bank with various options to offer its members, the 
Finance Board believes members would have the flexibility necessary to 
accommodate the membership investment requirement that is required by 
the GLB Act.
    G. Activity-Based Stock Purchase Requirement. The proposed rule 
provides that a Bank may require a member to purchase either or both 
Class A or Class B stock as a condition to entering into a specific 
business transaction with the Bank. Such an activity-based stock 
purchase requirement would not be inconsistent with other provisions of 
the GLB Act, which provide generally that a member shall have the 
option of purchasing either Class A or Class B stock. Any business 
transaction between a Bank and a member, such as an advance, is a 
voluntary transaction initiated by the member that results in an asset 
being placed on the books of the Bank. Under the risk-based capital 
provisions of the GLB Act and the proposed rule, every on-balance sheet 
asset and off-balance sheet item of a Bank must be supported by some 
amount of permanent capital to cover the credit, market, and operations 
risks associated with the asset or item. Ultimately, whatever amount of 
permanent capital is required by each Bank to meet its regulatory risk-
based capital ratio and its operating risk-based capital ratio must be 
provided by the members; if a Bank lacks sufficient capital to engage 
in a particular transaction, it cannot enter into the transaction. If 
the provision of the GLB Act allowing each member the option of 
purchasing either Class A or Class B stock were read to allow each 
member to decline to purchase any Class B stock, the Banks would be 
unable to engage in any transactions with their members beyond the 
amount that could be supported by their retained earnings, the only 
other source of permanent capital. There is nothing in the GLB Act or 
its legislative history that suggests that the provision allowing 
members the option of purchasing Class A or Class B stock was intended 
to override the other provisions of the GLB Act that require every 
asset and off-balance sheet item to be supported, at least in part, by 
some amount of permanent capital. As noted above, the provisions of 
this proposed rule regarding each member to maintain some investment in 
the Bank preserves for the members the option of maintaining that 
investment in either Class A or Class B stock. To ensure that the Banks 
have sufficient permanent and total capital to cover the risks of their 
business, the proposed rule would authorize a Bank to require a member, 
as a condition to doing business with the Bank, to purchase whatever 
amount of Class A and Class B stock is necessary for the Bank to comply 
with the regulatory capital requirements (and operating capital ratios) 
that would be associated with the Bank asset (or off-balance sheet 
item) to be generated by the transaction with the member. If a member 
would prefer not to purchase any Class B stock, it would not be 
required to do so, but the Bank would not be required to make an 
advance or enter into any other transaction with a member that declined 
to provide the capital needed for the business it wished to conduct 
with the Bank.
    The activity-based stock purchase requirement also should provide 
the Banks with some additional flexibility in managing their capital 
accounts, such that the levels of capital correspond more closely to 
the risks generated by the business of the Bank. The proposed rule 
would impose certain limitations on activity-based stock purchases. 
First, the amount of Class B stock that a member may be required to 
purchase in order to engage in a certain transaction must be based on 
the risk characteristics of the asset being acquired by the Bank. 
Second, a Bank could not require a member entering into a transaction 
to purchase Class B stock if the amount of the purchase would cause the 
Bank to exceed its operating total capital ratio and operating risk-
based capital ratio, as established in the Bank's capital plan. 
Although a Bank could not impose an activity-based stock purchase 
requirement if doing so would cause it to exceed its operating capital 
ratios, the proposed rule would allow a Bank to enter into a written 
agreement with a member under which the member would commit to purchase 
a specific number of shares of Class A or Class B stock at a specified 
price, but with the purchase to be completed and all payments made at a 
future date to be determined by the Bank. Any such arrangement would 
have to be included in the Bank's approved capital plan. Under such an 
arrangement, if a Bank were to fall below its operating capital ratios 
it could require the members to honor their commitment to provide the 
capital that otherwise would have been required at the time they 
entered into the commitments. These provisions are intended to prevent 
the Banks from building excessive amounts of capital, which the Finance 
Board believes would lead to arbitrage investments.
    Additionally, the proposed rule would bar a Bank from prohibiting a 
member that had purchased capital stock in compliance with an activity-
based purchase requirement from selling the stock to another member. 
The members would remain subject to the other provisions of the rule, 
under which no member may redeem any capital stock if doing so would 
cause the Bank to fail to comply with any regulatory capital 
requirement.
    H. Concentration limits. Under the proposed rule, no member, or 
group of affiliated members, of a Bank would be permitted to own more 
than 40 percent of any class or subclass of the outstanding capital 
stock of the Bank. A Bank would be able, through its capital plan, to 
establish an ownership cap lower than 40 percent. If at a given time, a 
member, or group of affiliated members, of a Bank were to acquire stock 
such that they owned more than 40 percent of any class or subclass of

[[Page 43419]]

stock (or any lower amount as established by the Bank) the Bank and 
member (including any affiliated members) would be required to agree to 
a plan under which the member would divest sufficient shares of such 
stock as necessary to comply with the limit. The Finance Board requests 
comment on the need to include concentration limits in the rule and 
what percentage limits might be most appropriate to ensure that the 
Bank cannot be dominated by a small number of members.
    I. Redemption and Purchase of Capital Stock. As required by the GLB 
Act, a member may redeem its Class A stock with six-months written 
notice to the Bank. Class B stock may be redeemed with five-years 
written notice to the Bank. At the end of the notice periods, a member 
would be entitled to receive the par value of the stock in cash. The 
proposed rule would bar a member from having pending at any one time 
more than one notice of redemption for any class of Bank stock. For 
example, a member may have pending a notice to redeem 50 shares of 
Class A stock, as well as a notice to redeem 50 shares of Class B 
stock. A member, however, could not have two separate notices to redeem 
only Class B (or only Class A) stock. A Bank would be permitted to 
impose a fee, as specified in its capital plan, on a member that 
cancels a pending notice of redemption. The imposition of a fee would 
be at the discretion of a Bank, as specified in its capital plan. The 
Finance Board is proposing the option of establishing a fee in order to 
minimize a Bank's cost associated with canceling a notice of 
redemption.
    J. Capital Impairment. Under the proposed rule, the Bank would not 
be permitted to redeem or purchase any capital stock without prior 
written approval from the Finance Board if the Bank were not in 
compliance with any of its regulatory capital requirements. The Bank 
would also not be permitted to redeem or purchase any capital stock 
without prior written approval from the Finance Board if such a 
redemption or purchase of stock would cause the Bank to fail to comply 
with any of its regulatory capital requirements. These provisions 
reflect the requirement of the GLB Act that the Bank shall maintain 
both total and permanent capital that is sufficient to meet its 
regulatory capital requirements.
    K. Part 932--Federal Home Loan Bank Capital Requirements.
    Overview. As discussed previously, the Banks' current capital 
requirements have been determined according to a statutory formula, 
which has used either the assets held by a member or the amount of the 
member's borrowings from a Bank to determine the amount of Bank stock 
that the member must hold. 12 U.S.C. 1426(b)(1), (b)(2), and (b)(4); 
1430(c), (e)(1), and (e)(3) (1994). The capital provisions of the GLB 
Act replace this approach with a modern risk-based capital system for 
the Banks and mandate a capital structure that is more in line with the 
risk-based capital standards developed under the Basle Accord and with 
the practices of other bank regulatory agencies.\9\ Under the GLB Act 
amendments, 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 choose to accept. The 
Finance Board is proposing to implement the capital provisions of the 
GLB Act by adopting a modern approach to overseeing the Banks, which 
would require the Banks to implement regulatory capital requirements as 
part of a comprehensive risk management system. In developing the 
proposed regulations, the Finance Board has reviewed the Basle Accord, 
the regulations of other banking regulators, the OFHEO proposed capital 
regulations,\10\ and other papers drafted by the BCBS and other bodies.
---------------------------------------------------------------------------

    \9\ 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.
    \10\ On April 13, 1999, OFHEO published a notice of proposed 
rule-making with respect to the required risk-based capital 
standards. See 64 FR 18083 (Apr. 13, 1999). The original deadline 
for comments on this proposal was August 11, 1999, but that deadline 
was extended. The comment period ultimately closed on March 10, 
2000. See 64 FR 56274 (Oct. 19, 1999). On March 13, 2000, OFHEO 
solicited reply comments in response to the comments received on the 
proposed rule. See 65 FR 13251 (Mar. 13, 2000). The deadline for 
these reply comments was April 14, 2000.
---------------------------------------------------------------------------

    The capital requirements of proposed Part 932 also would replace 
the risk management provisions of the Finance Board's Financial 
Management Policy (FMP) under which the Banks currently operate. The 
FMP imposes specific restrictions and limitations on the Banks' 
investment practices and includes a leverage limit to regulate the risk 
management practices of the Banks. 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), Finance Board Res. No. 
97-86 (Dec. 17, 1997) and 65 FR 36305 (June 7, 2000). Although the FMP 
has served the purpose of ensuring the safety and soundness of the Bank 
System, it lacks sufficient flexibility to enable the Banks to fulfill 
their mission to the maximum extent possible.
    The Basle Accord forms the basis for risk-based capital standards 
for banks in the world's industrialized countries. Its approach 
principally involves 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-
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 U.S. 
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., 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.
    The Finance Board, and other commentators, believe that the Basle 
Accord has a number of shortcomings. For example, the risk weight 
categories are so broad that instruments with markedly different credit 
risks may be subject to the same risk weighting. The Basle Accord also 
does not take into consideration how differences in the maturities 
between two instruments within the same category 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.
    The January 1996 amendment to the Basle Accord (the Amendment) 
remedies some of these shortcomings, especially with respect to debt 
instruments held in the trading portfolios of large banks.\11\ The 
Amendment offers large banks the

[[Page 43420]]

alternative either to use internal credit risk models to calculate 
value at risk due to credit risk on debt instruments held in its 
trading portfolio, or, if the bank lacks satisfactory internal models, 
to use standardized credit risk capital percentage requirements 
specified in the Amendment.
---------------------------------------------------------------------------

    \11\ The Amendment, entitled ``Amendment to the Capital Accord 
to Incorporate Market Risks,'' 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).
---------------------------------------------------------------------------

    In order to address some shortcomings of the Basle Accord with 
respect to the non-trading portfolio, i.e., the banking book, the BCBS 
published in June 1999 a consultative paper entitled ``A New Capital 
Adequacy Framework'' (the Framework), which proposed a system to better 
correlate regulatory solvency with the economic-capital needs of a bank 
and with the risks and returns of a bank's lending activities.\12\ The 
Framework would calibrate a bank's risk-based capital requirements more 
closely with its underlying credit risks, and would recognize the 
improvements in risk measurement and control that have occurred in 
recent years. The Framework would also 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.
---------------------------------------------------------------------------

    \12\ New Basle Committee Proposals Have Positive Bank Credit 
Implications, Moody's Credit Perspectives, June 21, 1999, at 1, 18.
---------------------------------------------------------------------------

    General Capital Requirements. Section 6(a)(1) of the Bank Act, 12 
U.S.C. 1426(a), as amended, requires that each Bank maintain a minimum 
ratio of total capital to total assets and that each Bank maintain 
permanent capital in an amount that is sufficient, as determined in 
accordance with the regulations of the Finance Board, to cover the 
credit risk and market risk to which a Bank is subject. 12 U.S.C. 
1426(a)(1), (3), as amended.
    The GLB Act defines ``permanent capital'' as the amounts paid for a 
Bank's Class B stock, plus the Bank's retained earnings (as determined 
in accordance with GAAP). 12 U.S.C. 1426(a)(5)(A), as amended. The term 
``total capital'' includes permanent capital, the amounts paid for 
Class A stock, any general allowance for losses that are not held 
against specific assets (determined in accordance with GAAP and Finance 
Board regulations), and any other amounts available to absorb losses 
that the Finance Board determines by regulation to be appropriate to be 
included in total capital. 12 U.S.C. 1426(a)(5)(B), as amended.
    The definitions for ``permanent capital'' and ``total capital'' 
proposed in Sec. 930.1 conform with the statutory definitions. Proposed 
Sec. 930.1 also defines the term ``general allowance for losses'' to 
require that such allowances be consistent with GAAP and not include 
any amounts held against specific assets of the Bank. The restrictions 
would be the same as the statutory restrictions placed on loan loss 
reserves.
    Capital requirement transition provisions. The proposed rule would 
require that by a date not later than three years from the effective 
date of the its capital plan, each Bank shall have sufficient total 
capital to meet the total capital requirement in proposed Sec. 932.2 
and sufficient permanent capital to meet the risk-based capital 
requirement in proposed Sec. 932.3. Before the new total capital and 
risk-based capital requirements could be implemented, however, each 
Bank must first obtain Finance Board approval for its internal risk 
model or its cash flow model, which would be used to calculate the 
market risk component of its risk-based capital requirement, and for 
the risk assessment procedures and controls that would be used to 
manage the Bank's credit, market, and operations risks.
    The capital rule would not supercede the risk management provisions 
of the FMP until after the Finance Board has approved the models and 
procedures, discussed above, for each Bank and the Bank has met its 
regulatory capital requirements. Thus, each Bank would continue to be 
governed by the Hedging Transaction Guidelines and the Interest Rate 
Risk guidelines of the FMP until those conditions are met. See FMP 
Sections V and VII. The provisions of the FMP that limit the purchase 
of mortgage-backed securities (MBS), collateralized mortgage 
obligations (CMOs), real estate mortgage investment conduits (REMICs), 
and eligible asset-backed securities to 300 percent of capital, Section 
II.C.2, also would remain in effect until the Bank had met the proposed 
regulatory capital requirements.
    The proposed rule also would mandate that the minimum stock 
purchase and stock retention requirements of the Bank Act in effect 
immediately prior to the GLB amendments would remain in effect until 
the Bank has issued capital stock in accordance with its approved 
capital plan. (See discussion of proposed Part 933.) This provision is 
consistent with the GLB Act requirement that the pre-GLB Act stock 
purchase and stock retention requirements shall continue in effect 
until the capital plan of a Bank has been approved and implemented. 12 
U.S.C. 1426(a)(6), as amended. Under the proposed rule, the new capital 
structure for each Bank would take effect (subject to any transition 
provision) once a Bank has issued its Class A or Class B capital stock. 
Any other Finance Board regulations that may affect stock purchase or 
retention would also apply.\13\
---------------------------------------------------------------------------

    \13\ The Finance Board recently approved a final rule that, 
among other things, established an asset-based leverage limit under 
which the aggregate amount of assets of any Bank shall not exceed 21 
times the total of paid-in capital stock, retained earnings and 
reserves (or a capital to assets ratio of at least 4.76 percent). 
The rule also extended and made permanent the additional leverage 
authority originally permitted to the Banks for Year 2000 liquidity, 
i.e., a Bank may have asset-based leverage of up to 25 to 1 (or a 
capital to assets ratio of at least 4.0 percent) if that Bank's 
ratio of non-mortgage assets does not exceed 11 percent of the 
Bank's total assets minus deposits and capital. See 65 FR 36290, 
36299 (June 7, 2000). Non-mortgage assets equal total assets after 
deduction of core mission activity assets, as defined in proposed 
Sec. 940.3, and assets described in sections II.B.8 though II.B.11 
of the FMP. See 65 FR 25676, 25688 (May 3, 2000). This 25 to 1 limit 
is in line with the requirements of the GLB Act.
---------------------------------------------------------------------------

    Total capital requirement. The GLB Act requires each Bank to 
maintain a ratio of total capital to total assets of no less than four 
percent. 12 U.S.C. 1426(a)(2), as amended. The statute also requires 
each Bank to maintain a leverage ratio of total capital to total assets 
of five percent, where in calculating this ratio, the amounts paid in 
for the class B stock and the amounts of retained earnings are 
multiplied by 1.5 and all other items of total capital are included at 
face value. Id. Section 932.2 of the proposed rule would implement 
these statutory provisions.
    Risk-based capital requirement. The GLB Act requires each Bank to 
maintain permanent capital in an amount that is sufficient, as 
determined in accordance with the regulations of the Finance Board, to 
cover the credit risk and market risk to which a Bank is subject. 12 
U.S.C. 1426(a)(1), (3), as amended. Section 932.3 of the proposed rule 
would require each Bank to maintain sufficient permanent capital to 
meet the combined credit, market, and operations risks to which it is 
subject, as determined under proposed Sec. 932.4, Sec. 932.5, and 
Sec. 932.6, respectively.
    Although the GLB Act does not address operations risk, the Finance 
Board is proposing to adopt an operations risk component to the risk-
based capital requirements in order to assure that the Banks ``operate 
in a financially safe and sound manner'' and ``remain adequately 
capitalized.'' 12 U.S.C. 1422a(a)(3)(A), (B), as amended. The Finance 
Board believes that the risk of loss from business operations exists 
with regard to the Banks and that it is necessary to require the Banks 
to maintain capital against that risk. Under the new credit and market 
risk capital provisions in the GLB Act, the amount

[[Page 43421]]

of capital held by the Banks will be closely aligned to the expected 
losses associated with those risks, and is not meant to cover the 
unexpected losses that may result from human error, fraud, 
unenforceability of legal contracts, or deficiencies in internal 
controls or information systems or other operations risks. Without an 
operations risk requirement, the proposed rule would be deficient and 
the Banks could be exposed to losses arising from these operational 
failures. Thus, the Finance Board considers the operations risk 
requirement necessary to ensuring the continued safe and sound 
operation of the Bank system.
    Credit Risk Capital Requirement. The GLB Act mandates that each 
Bank maintain sufficient permanent capital, as determined in accordance 
with Finance Board regulations, to meet the credit risk to which the 
Bank is subject. 12 U.S.C. Sec. 6(a)(3)(A)(i), as amended. The GLB Act, 
however, does not specify the elements that make up credit risk or the 
charges that must be applied to cover such risk, leaving to the Finance 
Board the responsibility to define the elements of credit risk.
    Proposed Sec. 932.4 would implement the credit risk requirements of 
the GLB Act. In developing these requirements, the Finance Board has 
reviewed the Basle Accord, the regulations of other banking regulators, 
OFHEO's proposed capital regulations, and other information prepared by 
the BCBS and other relevant bodies. As already discussed, the Finance 
Board has revised the credit risk provisions contained in the proposed 
FMMA both to meet the GLB requirements and to further enhance the 
accuracy of the provisions.
    The credit risk component of the risk-based capital requirement 
proposed by the Finance Board would encompass the credit risks 
associated with both on-balance sheet assets and off-balance sheet 
items of each Bank. The objective of this credit risk capital standard 
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) be 
responsive to 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.
    Finance Board determination of specific credit risk percentage 
requirements. The credit risk capital requirement would be equal to the 
sum of a Bank's credit risk capital charges for all on-balance sheet 
assets and off-balance sheet items. For an on-balance sheet asset, the 
credit risk capital charge would equal the book value of the asset 
multiplied by the ``credit risk percentage requirement'' assigned to 
the asset. For off-balance sheet items, the credit risk capital charge 
would be the ``credit equivalent amount'' of the item, multiplied by 
the credit risk percentage requirement assigned to the item.
    The proposed rule would include credit risk percentage requirements 
for various categories of on-balance sheet assets and the credit 
equivalent amount of off-balance sheet items based on the type of asset 
or item, its credit rating and, if appropriate, its remaining maturity. 
The Finance Board has used data from NRSROs and other relevant sources 
to calculate estimates of credit losses associated with the particular 
categories. The estimates of credit risk percentage requirements 
represent the expected credit losses for the particular categories of 
instruments during periods of credit stress, based on historical data 
that reflect the longer-term nature of credit cycles, and span multiple 
credit cycles. The credit losses are estimated after identifying time 
periods with the highest losses stemming from downgrades and defaults. 
The loss in market value from a downgrade is estimated for each 
maturity category of the investment using credit spreads from 1992 to 
the present that were available to the Finance Board. For defaults, 
assumptions for loss severity are based on exposure type and maturity 
as indicated by available data. Periodic updates to the initial credit 
risk percentage requirements will be implemented by the Finance Board 
as amendments to the credit risk capital requirement.
    In the proposed FMMA, the credit risk percentage requirements did 
not consider the term structure of credit risk. This limitation 
mirrored the initial failure of the Basle Accord to consider the term 
structure of credit risk, such that an overnight exposure on a 
particular instrument would receive the same capital charge as a two- 
or a ten-year exposure on another instrument from the same issuer. 
Recently, however, the BCBS as well as other financial regulators have 
begun to address this failure. 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 problem 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 its risk-based capital requirements for the 
farm credit banks. In the proposed rule, the Finance Board would give 
recognition to the term structure of credit risk.
    While consideration of term structure is not necessary for all 
credit risk categories, the Finance Board incorporated term structure 
in the percentage requirements for advances and ``rated assets or items 
other than advances or residential mortgage assets.'' The Finance Board 
also has incorporated specific credit risk percentage requirements for 
residential mortgage assets, which include MBS, by investment grade. As 
a result, four tables are included in proposed Sec. 932.4(d)(2)(i): 
Table 1.1--Requirement for Advances; Table 1.2--Requirement for 
Residential Mortgage Assets; Table 1.3--Requirement for Rated Assets or 
Items Other Than Advances or Residential Mortgage Assets; and Table 
1.4--Requirement for Unrated Assets. These tables set forth 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. The Finance Board 
seeks comment on its proposed recognition of asset maturity in its 
calculation of credit risk percentage requirement for certain types of 
assets or items. The Finance Board also generally requests comment on 
any aspect of the tables included in the proposed rule.
    Table 1.1. The proposed FMMA assigned advances to a triple-A credit 
risk category 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), and a 
statutory stock purchase requirement that required a member to maintain 
an investment in the Bank at least equal to 5 percent of its 
outstanding advances. 12 U.S.C. 1430(e) (1994).
    In developing the FMMA, the Finance Board considered treating 
advances in the same manner as cash or as securities that are backed by 
the full faith and credit of the U.S. government, both of which are 
assigned zero credit risk. Two credit rating agencies, however, have

[[Page 43422]]

expressed their opinion to the Finance Board that such treatment would 
not be appropriate for advances, i.e., that advances should not be 
treated as equivalent to assets that have no credit risk. The two 
rating agencies recommended that advances be treated as triple-A rated 
assets. They noted, in particular, that legislative authority for the 
Banks to accept new types of collateral from certain members as one 
reason why advances should not be rated higher than triple-A. Based on 
the historical experience of zero credit losses for advances over the 
past 60 years, however, compared to the experience with triple-A rated 
corporate securities, some of which have had rating downgrades that 
have lead to eventual credit losses, it would appear that advances are 
a better credit than are triple-A rated corporate securities. 
Accordingly, the proposed rule would treat advances as having somewhat 
greater credit risk than securities that are backed by the full faith 
and credit of the U.S. government, but somewhat less than triple-A 
rated corporate securities. The proposed rule, in Table 1.1, provides 
unique credit risk percentage requirements for advances by their 
maturity.
    The determination of credit risk percentage requirements or credit 
losses for advances under stress conditions would require estimates of 
the default rate and the loss severity rate under such stress 
conditions. Because the Banks have incurred no credit losses on their 
advances, the Finance Board has assumed, for purposes of establishing a 
default rate for advances, that advances would exhibit the same default 
patterns as the highest investment grade corporate bonds in Moody's 
Default Risk Service database, and that advances would have a recovery 
rate of 90 percent (i.e., a loss severity rate of 10 percent). A 
recovery rate of 90 percent is consistent with the conservative lending 
and collateral management policies and the historical credit loss 
record of the Banks with respect to advances. Thus, the credit risk 
percentage requirements in Table 1.1 for advances are based on the 
maximum default rates for the highest investment grade exposures from 
Moody's Default Risk Service database and a recovery of 90 percent.\14\ 
The Finance Board seeks comment on the methodology used for setting the 
credit risk percentage requirements for advances and whether a more 
satisfactory analytical framework exists that could be used to 
determine more appropriate credit risk percentage requirements for 
advances.
---------------------------------------------------------------------------

    \14\ The credit risk percentage requirement for advances with 
maturities above 10 years has been capped at the maximum credit risk 
percentage requirement for the highest investment grade residential 
mortgage exposures as historical loss rates for advances have been 
below the loss rates for residential mortgages.
---------------------------------------------------------------------------

    Table 1.2 and Table 1.3. Table 1.2 includes the credit risk 
percentage requirements for residential mortgage assets, which category 
includes both mortgages and MBS, while Table 1.3 sets forth credit risk 
percentage requirements for rated assets or items other than advances 
or residential mortgage assets. The credit risk percentage requirements 
in Table 1.3 were developed for instruments without embedded options. 
As explained in more detail following the discussion of Table 1.3, 
residential mortgage assets have prepayment options, and, therefore, 
require a separate set of credit risk percentage requirements.
    The proposed credit risk percentage requirements in Table 1.3 for 
credit exposures of rated assets or items other than advances and 
residential mortgages are calculated by examining data from Moody's 
which includes the rating and default history for rated assets over the 
time period 1970-1999. In calculating the values in Table 1.3, the 
worst time period for credit losses is found for each rating category, 
where credit losses are estimated as the sum of defaults, assuming a 
100 percent loss severity, and losses in market value from rating 
downgrades during a specified period or credit risk horizon.\15\ See 
``Historical Default Rates of Corporate Bond Issuers, 1920-1998,'' 
Moody's Investor Service, January 1999.
---------------------------------------------------------------------------

    \15\ Based on Moody's data from 1977-98, historical defaulted-
bond prices display a great deal of volatility and are zero at two 
standard deviations below the mean. Unless more data is examined and 
a positive recovery rate under credit stress conditions can be 
established with confidence, the Finance Board would adopt a 
recovery rate of zero for estimation of credit losses that are to be 
used for credit risk capital requirements.
---------------------------------------------------------------------------

    A maximum of a two year credit risk horizon has been used for 
calculating the default and downgrade probabilities, because this is 
the expected period of time, based on experience, needed to resolve 
asset-quality problems at troubled commercial banks. Furthermore, both 
the default and downgrade probabilities increase as the horizon is 
increased from six months to two years. For credit exposures longer 
than two years, the default and downgrade probabilities remain constant 
at the two year maximum horizon. The loss in market value from a 
downgrade is estimated from calculations of market values of corporate 
bonds at initial credit ratings and market values subsequent to the 
downgrade. These losses tend to increase with the maturity of the 
asset.
    The probability of a rating downgrade (of one or more categories), 
and the probability of default, are taken from the worst historical 
period as defined above. These probabilities, and available credit 
spread data, are used to estimate the possible loss in value from 
defaults and downgrades in future stressful environments. Assets with 
longer maturities will generally have higher credit risk percentage 
requirements to reflect higher credit risk associated with longer 
maturities. Even though the default and downgrade probabilities are 
constant for maturities above two years, the downgrades will have a 
greater impact on the market value of longer lived assets.
    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, no triple-A rated security has ever defaulted while it was rated 
triple-A. Given a sufficiently long period of time, however, even 
triple-A rated corporate credits may default following rating 
downgrades.\16\ 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 ratings.\17\ 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 capital to be maintained for triple-A rated credit exposures.
---------------------------------------------------------------------------

    \16\ According to Moody's data from 1970 to 1998, over a 4-year 
default horizon, the worst historical probability of default for 
assets initially rated triple-A is 1.21 percent.
    \17\ This applies equally to triple-A rated securities issued by 
GSEs.
---------------------------------------------------------------------------

    For Bank assets that are downgraded to below investment grade after 
being acquired by the Bank, the proposed rule would assign increasingly 
higher credit risk percentage requirements. The percentage requirements 
would range from 5.0 percent to 20.0 percent for assets or items that 
are downgraded to the highest rating below investment grade. For assets 
or items that are downgraded to the second highest rating below 
investment grade, the percentages would range from 22.0 percent to 37.0 
percent. The proposed rule would assign a percentage requirement of 100 
percent for all other assets or items that

[[Page 43423]]

are downgraded below investment grade. Table 1.3 includes U.S. 
government securities that are backed by the full faith and credit of 
the U.S. government. These securities, which would include Government 
National Mortgage Association (GNMA) MBS, are assigned to the zero 
percentage category regardless of their maturity, because they are 
deemed not to present any credit risk to the Bank.
    Credit risk capital requirements in Table 1.3 were developed for 
instruments without embedded prepayment options.\18\ Instruments with 
prepayment options, such as residential mortgage assets, would require 
a separate set of capital charges. Therefore, credit risk percentage 
requirements for residential mortgage related exposures are presented 
in Table 1.2.\19\ Due to prepayment features, the expected or weighted 
average maturity for 30-year, fixed-rate mortgages is significantly 
less than 30 years. Therefore, the credit risk percentage requirements 
in Table 1.3 would be too high for residential mortgage exposures. In 
addition, the pattern or timing of defaults between corporate bonds and 
residential mortgages significantly differ. The default rates for 
corporate bonds generally increase with the time horizon, whereas, 
mortgage defaults tend to be concentrated between years three and 
eight. See ``Moody's Approach to Rating Residential Mortgage Pass-
Through Securities,'' Moody's Investor Service, November 1996 
(hereinafter Moody's). Based on Moody's analysis of the lifetime 
default curve for 30-year residential mortgages, the default rate 
becomes very small after 14 years and is zero after 22 years. Due to 
the build up of borrower equity in residential assets, the loss 
severity rates generally decline after the first few years of a 
residential mortgage's life. The Fitch IBCA Residential Mortgage-Backed 
Securities model utilizes a 14 year credit loss horizon. See ``Fitch 
IBCA Residential Mortgage-Backed Securities Criteria'' Fitch IBCA, 
December 1998 (hereinafter Fitch IBCA). Somewhat similar default and 
loss patterns are found in Duff & Phelps model. See ``The Rating of 
Residential Mortgage-Backed Securities'' Duff & Phelps Credit Rating 
Co.
---------------------------------------------------------------------------

    \18\ The proposed credit risk percentage requirements in Table 
1.3 are based on the credit risk from typical bonds that carry 
normal coupons. Zero or low coupon exposures would require credit 
risk percentage requirements higher than those being proposed. The 
Banks' holdings of such exposures and other complex credit-related 
instruments would be monitored and assigned appropriate credit risk 
percentage requirements on a case-by-case basis.
    \19\ Conceptually, the data in Table 1.2 should be based on 
historical mortgage default data. Because sufficient data on 
historical mortgage default rates was not available, however, the 
percentages in the table are derived from corporate bond default 
rates and mortgage loss recovery rates, adjusted to approximate 
mortgage default rates. The Finance Board believes that the use of 
corporate bond data is less than ideal and intends to seek better 
sources of historical mortgage default data for purposes of the 
final rule. The Finance Board requests comment on any other methods 
of obtaining accurate data on historical mortgage loan defaults.
---------------------------------------------------------------------------

    As required by the Federal Housing Enterprises Financial Safety and 
Soundness Act of 1992 (1992 Housing Enterprises Act), OFHEO has 
identified a ``benchmark loss experience'' for fixed rate mortgages 
(defined as conventional, 30-year, fixed-rate loans secured by first 
liens) on single-family properties (defined as single unit, owner 
occupied, detached properties) that were originated from 1979 to 1993 
by the secondary market housing enterprises. OFHEO proposed to base its 
benchmark credit loss estimates on a 10 year credit loss horizon See 61 
FR 29616. (June 11, 1996).
    In the proposed rule, residential mortgage assets, including MBS, 
held by Banks that are not rated directly for credit quality by rating 
agencies (NRSROs) must be rated for credit quality internally by Banks 
based on NRSRO criteria for rated MBS. The determination of credit risk 
percentage requirements or credit losses for residential mortgages 
under stress conditions would require estimates of the lifetime default 
rate corresponding to each rating category and the loss severity rate 
under stress conditions. In grading the relative credit risk of MBS, 
rating agencies employ the same symbol system as used for corporate 
bonds and counterparty obligations. As stated by Moody's, ``The overall 
expected loss for a security of any rating should be the same, whether 
applied to an unsecured corporate instrument, a senior class of an MBS 
transaction (where losses would be of small magnitude), or a 
subordinate tranche.'' Moody's at 2. To determine the appropriate 
thresholds on the distribution of mortgage default rates to be 
associated with each rating level, Fitch IBCA calibrated the lifetime 
mortgage default rate curve to the default rate curves for corporate 
bonds. Fitch IBCA at 4. This means that the corporate bond default rate 
data could provide a means of determining default rates comparable to 
mortgage default rates at each credit rating level. Based on the above 
analysis and conversations with rating agencies, it appears that a 
credit loss horizon of 15 years would be sufficient to capture the 
credit risk from residential mortgages. Therefore, the maximum default 
rate for a 15 year horizon from Moody's Default Risk Service is 
utilized for calculation of credit risk percentage requirements for 
residential mortgage assets with prepayment features.
    The loss severity rates for residential mortgages can be 
significantly different from the loss severity rates for corporate 
exposures. Private label mortgage issues rated single-B have had loss 
severity rates of 100 percent even though the private label market has 
yet to cope with a period of serious stress or a prolonged recession. 
In addition, the actual loss rates for some of the single-B rated 
issues have been 100 percent. Conversations with credit rating agencies 
indicate that the loss severity rates for mortgages are associated with 
credit ratings. Mortgage issues rated triple-A would be expected to 
have relatively small losses even under a severe recession, and loss 
severity rates increase with a decline in credit rating. Thus, a loss 
severity rate of 100 percent is assumed for residential mortgage assets 
rated single-B or below. Loss severity rates for investment grade 
mortgage assets are derived by calibrating them to the pattern of loss 
rates for long corporate bonds.
    Credit risk percentage requirements in Table 1.2 for residential 
mortgage assets are based on 15-year maximum default rate from Moody's 
Default Risk Service database and the rating specific loss severity 
rate. Unless separate credit risk percentage requirements are 
determined by the Finance Board for other classes of mortgages, such as 
multifamily and commercial properties, the percentages in Table 1.3 
would apply to such rated credit exposures. The Finance Board seeks 
comment on the methodology used for setting credit risk percentage 
requirements, as well as alternative approaches for setting such 
percentages, that are linked to specific credit ratings from NRSROs.
    Table 1.4. To the extent possible, credit risk percentage 
requirements are derived from actual loss experience during periods of 
financial stress. For several asset categories, however, there is no 
relevant loss experience from which to calculate the credit risk 
percentage. The credit risk percentage requirements for certain unrated 
assets are set forth in Table 1.4, and are the same as previously 
proposed in the FMMA. Cash would be assigned to the zero percent 
category, as it is deemed not to present any credit risk to the Bank. 
All of a Bank's tangible assets, ``Premises, Plant and Equipment,'' as 
well as any unrated targeted debt or equity investments made by the 
Banks

[[Page 43424]]

pursuant to proposed Sec. 940.3(a)(5),\20\ would be assigned an 8.0 
percent requirement. The targeted investments included in this category 
would be certain non-securitized debt or equity investments that 
advance certain specific public welfare goals. The 8 percent credit 
risk percentage requirement for these categories is consistent with the 
Basle Accord (with regard to tangible assets) and with the capital 
requirements applicable to national banks (with regard to public 
welfare investments).
---------------------------------------------------------------------------

    \20\ See 65 FR 25676, 25688 (May 3, 2000).
---------------------------------------------------------------------------

    Bank determination of specific credit risk percentage requirements. 
The proposed rule would require each Bank to determine the credit risk 
capital requirement for each asset and item, first by identifying its 
type, its credit rating, and, its remaining maturity (as appropriate), 
then by identifying its appropriate risk category and applying the 
applicable credit risk percentage for that risk category under Tables 
1.1 through 1.4. The proposal includes guidance for the Banks on how to 
determine the credit rating for a particular asset or item.
    The proposed rule would require the Banks to apply certain criteria 
when determining the credit rating to be used in finding the applicable 
credit risk percentage requirement from Tables 1.2 and 1.3. 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 rated or the asset or item is backed by collateral that 
is 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, and the portion of the asset or item 
that is not 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 with a maturity of less than one 
year 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 maturity equal to or less than one year, which would 
carry a credit risk percentage requirement from Table 1.3 of 0.15 
percent, and the remaining 75 percent of the value of the asset will be 
assigned to the fourth highest investment grade category with a 
maturity equal to or less than one year, which would carry a credit 
risk percentage requirement of 1.30 percent.
    The proposal further provides that the Banks must 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, or third highest investment grade, for credit risk-based 
capital charge 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 more difficult to calculate credit risk percentage 
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 Tables 1.1 or 1.4 (which do not need to 
be rated), 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 percentage requirement for the particular asset or 
item. 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 collateral other than marketable securities, 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 credit risk 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 and have a superior priority to 
all other parties with competing claims to the asset), must have a 
readily determinable value at which it can be liquidated, and must be 
held in conformance with the Bank's member product policy. See 12 CFR 
Sec. 917.4. 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 
percentage requirement, a bank must make appropriate allowance for 
discounts, such as haircuts or overcollateralization, to reflect the 
price risk underlying the collateral.
    Credit equivalent amounts 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. The proposed rule would require the 
Banks to convert all off-balance sheet credit exposures into equivalent 
on-balance-sheet credit exposures or credit equivalent amounts, 
determine the type of the item, and then apply the appropriate credit 
risk percentage requirement from the tables to estimate the 
instrument's credit risk capital charge. The Finance Board would allow 
the Banks to use Finance Board approved internal models to convert some 
or all off-balance sheet credit exposures into on-balance-sheet credit 
equivalents. For Banks that lack appropriate internal models, the 
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. Table 2 in proposed 
Sec. 932.4(e)(1), which

[[Page 43425]]

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 used to calculate the credit 
equivalent amount of an off-balance sheet instrument other than a 
derivative contract. The conversion factors are given in percentage 
form so that a conversion factor of 50 results in the face value of the 
off-balance sheet instrument being multiplied by 0.50 to calculate the 
credit equivalent amount.
    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 it is not one that can be ignored. The proposed 
rule would assign a credit conversion factor of zero percent for other 
commitments that are unconditionally cancelable by the Bank without 
prior notice, or that effectively provide for automatic cancellation, 
due to deterioration in a borrower's creditworthiness. The proposed 
rule also would allow the Banks to use Finance Board approved internal 
models to calculate credit conversion factors instead of those 
specified in Table 2.
    Under the proposed FMMA, a standby letter of credit (SLOC) would 
have been assigned a 100 percent conversion. Because a SLOC issued by a 
Bank is rarely drawn down, and if drawn down it converts to an advance, 
the Finance Board believes that it would be more appropriate to assign 
a Bank SLOC a 50-percent conversion factor, and has done so in the 
proposed rule. The Finance Board intends to undertake further research 
on the magnitude and appropriateness of the credit conversion factors 
set forth in proposed Table 2 and may make revisions in the final rule 
based on this research. The Finance Board requests comment on the 
credit conversion factors generally, and what issues might be 
appropriate to address as part of the anticipated research on this 
issue.
    Credit equivalent amounts for derivative contracts. The proposed 
rule provides that for market driven instruments such as over-the-
counter derivative contracts, i.e., swaps, forwards, and options, 
subject to counterparty default, the credit risk percentage requirement 
will be based on both current and potential future credit exposures 
(PFEs). 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 PFE (sometimes referred to as 
the potential future replacement cost) of the contract.
    The proposed rule provides that the current credit exposure is 
equal to the maximum of the mark-to-market value of the contract, if 
that value is positive. A current credit exposure of zero is applied 
for contracts with a zero or negative mark-to-market value because such 
contracts do not create any current credit exposure for a Bank.
    The proposed rule provides that the 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.\21\ Under this approach, the 
PFE of a contract, including a contract with a negative mark-to-market 
value, is estimated by multiplying the notional amount of the contract 
by a credit conversion factor for the underlying market risk, as 
specified in proposed Table 3 of proposed Sec. 932.4(f)(3)(i). The 
credit conversion factors are given in percentage terms such that a 
conversion factor of 7 would require the notional amount of a 
derivative contract to be multiplied by 0.07 to calculate the PFE for 
the contract.
---------------------------------------------------------------------------

    \21\ 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.
---------------------------------------------------------------------------

    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 must be treated as Other Commodities for purposes of 
applying proposed Table 3. If a Bank determines to use proposed Table 3 
for credit derivative contracts, the credit conversion factors 
applicable to Interest Rate Contracts under proposed Table 3 would 
apply.\22\ Within each category of market risks, a Bank would not be 
allowed to arbitrage between capital requirements based on proposed 
Table 3 and internal models.\23\ If a Bank were to use an internal 
model for a particular type of derivative contract, the Bank would be 
required to use the same model for all other similar types of 
contracts. The Bank, however, could use an internal model for one type 
of derivative contract and proposed Table 3 for another type of 
derivative contract. Adjustments to the credit conversion factors 
provided in Table 3 are specified in the proposed rule for contracts 
with multiple payment dates or that automatically reset to zero 
following a payment.
---------------------------------------------------------------------------

    \22\ 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.
    \23\ 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 would 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 include 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, even where the credit risk of one is 
significantly more concentrated than that of the other. As noted by the 
BCBS, however, this limitation may be effectively addressed in a 
portfolio-based internal credit risk model 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 their 
counterparties are financial institutions. The remaining unrated 
exposures are insignificant and may be dealt with outside a credit risk 
model. The Finance Board requests comment on whether the rule should 
take into account the diversification of a Bank's portfolio, and if so, 
how that should be done.
    The proposed rule sets forth specific requirements for calculation 
of credit equivalent amounts for multiple derivative contracts subject 
to a

[[Page 43426]]

qualifying bilateral netting contract, as defined in the proposed rule. 
The provisions in the proposal are consistent with the requirements set 
forth in the risk-based capital guidelines of the federal bank 
regulatory agencies.
    Zero credit risk charge for assets and items. The proposed rule 
would allow on-balance sheet assets that are hedged with credit 
derivatives to be assigned a zero credit risk capital charge under 
three specified scenarios. Even if the credit risk capital requirement 
for the on-balance sheet asset were decreased through the use of a 
credit derivative, the applicable credit risk capital required for the 
derivative contract still would be applied.
    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 and value at 
risk models for trading portfolios. Under the proposed rule, only some 
of the offsets would 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 charge for the on-balance sheet asset to zero. For example, if 
a Bank purchases a triple-B rated corporate bond with a maturity of 
five years and at the same time enters into a five-year credit default 
option contract based on the same bond, the credit risk capital charge 
for the underlying asset will be zero. The net credit risk capital 
charge for the pair will equal the credit risk capital charge for the 
credit exposure on the derivative contract.
    If the on-balance sheet asset and the asset referenced in a credit 
derivative are identical, but the remaining maturities for the asset 
and the credit derivative are different, the capital relief in the 
proposed rule would depend on a maturity comparison between the two. 
For example, if the same triple-B rated five-year corporate bond was 
hedged with a credit derivative referenced to the same five-year 
corporate bond with a remaining maturity of two years or longer, there 
would be no credit risk associated with the underlying asset given the 
Finance Board's proposed default horizon of two years. Therefore, such 
a hedge would be fully recognized and the credit risk capital charge on 
the underlying asset would be zero. If the credit derivative maturity 
were less than two years, however, no capital relief would be granted 
because the credit derivative would not off-set the exposure associated 
with the asset for the complete term of the proposed default horizon. 
In all cases, there will be a credit risk capital charge for the credit 
exposure on the derivative contract.
    If the remaining maturities of the on-balance sheet asset and a 
credit derivative are the same, but the on-balance sheet asset is 
different from the asset referenced in the credit derivative, capital 
relief for the on-balance asset may or may not be granted. It is 
proposed that the credit risk capital charge for the on-balance sheet 
asset be reduced to zero only if the asset referenced in the credit 
derivative and the on-balance sheet asset have been issued by the same 
obligor, the asset referenced in the credit derivative ranks pari passu 
or more junior to the on-balance sheet asset, and cross-default clauses 
are in effect.
    Where the on-balance sheet asset and the asset referenced in the 
credit derivative 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. The Finance Board also more generally 
requests comment on how it should account for credit derivatives in 
calculating credit risk capital charges.
    The proposed rule also would allow foreign exchange rate contracts 
with an original maturity of 14 calendar days or less to be assigned a 
zero credit risk capital charge. Gold contracts would not be considered 
exchange rate contracts. Derivative contracts that are traded on 
regulated exchanges that require daily collection of variation margin 
for the contract also would be assigned a zero credit risk capital 
charge.
    The credit risk capital charge calculations required by the 
proposed rule, unless otherwise directed by the Finance Board, must be 
performed based on a Bank's on-balance sheet assets and off-balance 
sheet items as of the close of business on the last business day of the 
month for which the credit risk capital requirement is being 
calculated. Where applicable, calculations of credit risk capital 
charges must use the most current NRSRO credit risk ratings available 
as of the last business day of the month for which the credit risk 
capital requirement is being calculated.
    Market Risk Capital Requirement. The GLB Act requires each Bank to 
maintain sufficient permanent capital, as determined in accordance with 
Finance Board regulations, to cover the market risk to which the Bank 
is subject. 12 U.S.C. 1426(a)(3)(A)(ii), as amended. It further 
specifies that each Bank's market risk be determined:

based on a stress test established by the Finance Board that 
rigorously tests for changes in market variables, including changes 
in interest rates, rate volatility, and changes in the shape of the 
yield curve.

Id. Beyond requiring that the stress test include the effects of 
changes in the interest rates, rate volatility and changes in the shape 
of the yield curve, neither the elements of market risk nor specific 
elements of the stress test are further defined in the statute, leaving 
the Finance Board with a degree of discretion to determine the terms 
and elements of the market risk stress test.
    The GLB Act also directs the Finance Board, in developing the 
market risk stress test, to ``take due consideration'' of any risk-
based capital test established by OFHEO for Fannie Mae and Freddie Mac, 
with such modifications as are appropriate to reflect differences in 
operations between the Banks and Fannie Mae and Freddie Mac. 12 U.S.C. 
1426(a)(3)(B), as amended. This provision requires the Finance Board to 
take ``due consideration'' of the OFHEO capital rule only as it may 
relate to market risk. It does not require consideration of other 
aspects of the OFHEO rule, such as those relating to credit risk, nor 
does it mandate deference to OFHEO in any respect. The Finance Board 
has included the proposed OFHEO market risk test among the factors it 
has considered in developing the proposed market risk provisions of its 
capital rules. The Finance Board has modeled a hypothetical $100 
billion asset Bank with a portfolio composition similar to the 
portfolio composition of Freddie Mac and Fannie Mae. The results of 
this simulation show that the Finance Board's risk-based capital 
requirement is consistent with what OFHEO has proposed to require for 
Freddie Mac and Fannie Mae. Given this consideration, the Finance Board 
believes that it has complied with its legal obligations under the GLB 
Act. Further, although

[[Page 43427]]

OFHEO has not yet adopted a risk-based capital test, the Finance Board 
intends to consider the substance of the final rule once it is adopted 
by OFHEO.
    Market risk may be defined as the risk that the market value, or 
estimated fair value if market value is not available, of a Bank's 
portfolio will decline as a result of changes in interest rates, 
foreign exchange rates, equity prices and commodity prices. The Banks 
engage in activities that carry complex on-and off-balance sheet market 
risks. For example, outstanding consolidated obligations (COs), for 
which the Banks are jointly and severally liable, include bonds having 
embedded options, callable and index amortizing bonds, bonds 
denominated in foreign currencies, and bonds linked to equity prices. 
To hedge the market risk on such instruments, the Banks typically enter 
into off-balance sheet derivative contracts that convert the bonds to 
simple fixed-rate or floating rate bonds or convert the exposure to 
U.S. dollars. 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 needed to address market 
risks should be similar to the market risk capital requirements 
established or recommended by the BCBS and other financial institution 
regulatory agencies, but broader in scope. The Finance Board further 
believes that the general approach to market risk developed by the 
BCBS, as modified in this proposed rule, is consistent with the 
statutory requirements of the GLB Act.
    As previously discussed, the BCBS has led the drive to institute a 
risk-based capital system for general market risk. 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 to incorporate a measure for market risk, effective as of January 
1, 1998 (Joint Rule). 61 FR 47358 (Sept. 6, 1996). Institutions whose 
trading activity (defined in the Joint Rule as total assets plus total 
liabilities in the trading portfolio) equals 10 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, including mortgages or other 
similar types of instruments.
    Financial institutions regulated by the Office of Thrift 
Supervision (OTS) and by the Farm Credit Administration (FCA) currently 
are subject to credit risk capital requirements that contain no market 
risk capital components (consistent with the small bank regulatory 
capital framework). See 12 CFR 567.5 (OTS), 615.5205, 615.5210 (FCA). 
OFHEO, however, has published a Notice of Proposed Rulemaking including 
its regulatory model for calculating risk-based capital for Fannie Mae 
and Freddie Mac, which model does account for both interest rate risk 
and credit risk. See 64 FR 18083 (Apr. 3, 1999). The OFHEO interest 
rate risk based capital rule is mandated by the 1992 Housing 
Enterprises Act, which requires that capital requirements account for 
market risks. Under the proposed OFHEO test, the market risk capital 
requirement would be determined by a stress test, which examines the 
effects of two specified interest rate shocks. See 12 U.S.C. 
4611(a)(2). The 1992 Housing Enterprises Act establishes parameters 
that OFHEO must meet in developing the model used to implement its 
stress test such that many aspects of OFHEO's stress test are dictated 
by legislation. This legislative approach is in contrast to the greater 
flexibility afforded the Finance Board in developing its stress test 
under the GLB Act. While the 1992 Housing Enterprises Act reflected the 
state of the art in risk measurement at the time it was drafted, the 
Finance Board's proposed regulation seeks to incorporate improvements 
in risk measurement that have been made since then. Furthermore, the 
statutory constraints imposed on OFHEO have rendered it difficult for 
OFHEO to develop and implement its capital requirements in a timely 
manner. The Finance Board believes that its proposed approach would 
reach the same goal as OFHEO's proposal--that of providing sound 
capital requirements based on the economic risks undertaken by the 
regulated entities--albeit with inevitable differences in the 
underlying methodology. Nonetheless, the Finance Board also notes that 
its proposed market risk rule would provide Banks with the opportunity 
to develop a cash flow model, similar to that proposed by OFHEO, as 
long as the cash flow model is consistent with the requirements of the 
GLB Act and the Finance Board's proposed requirements governing 
internal market risk models, and is approved by the Finance Board.
    Currently, the FMP limits the Banks' interest rate risk based on a 
methodology that uses interest rate shocks similar to those proposed 
but never adopted by the four federal bank regulatory agencies (the 
OCC, the FRB, the FDIC, and the OTS). Specifically, the FMP requires 
the Banks to maintain the duration of their equity to within 
5 years and to maintain the duration of their equity to 
7 years under an assumed change in interest rates of 
200 basis points. See FMP Section VII.
    In the view of the Finance Board, the methodology underlying the 
FMP is not sufficiently flexible to capture the Banks' market risks as 
they currently exist, or as they are likely to evolve given the recent 
proposal to expand their investment authority. See 65 FR 25676 (May 3, 
2000). Additionally, the risk management approach of the FMP is not 
consistent with a risk-based capital structure, nor would it allow the 
Finance Board to establish a market risk capital requirement based on a 
stress test that ``rigorously tests for changes in market variables'' 
and captures the risks to which a Bank is subject, as required by the 
GLB Act. Accordingly, the proposed rule sets forth an approach to 
measuring market risk that is based on the value at risk (VAR) 
framework adopted by the BCBS and other financial institution 
regulators. This approach can be implemented with commercially 
available models, is practical, and is sufficiently rigorous to comply 
with the requirements of the GLB Act. In particular, the proposed rule 
would require each Bank's internal market risk model to capture the 
effects of various shifts in the interest rate yield curve beyond 
parallel shocks, and to account for other financial and market shocks 
that could be experienced by the Banks given historic experience.

[[Page 43428]]

    Components of the market risk capital requirement. The proposed 
market risk capital requirement is the sum of two separate components. 
One component is the amount by which the current market value of a 
Bank's total capital is less than 95 percent of the book value of the 
Bank's total capital. The current market value of a Bank's total 
capital would be estimated by using the Bank's internal risk model to 
calculate the market value of the Bank's on-balance sheet assets, 
liabilities and off-balance sheet items. In essence, these values would 
be the base line values for the Bank's portfolio prior to running any 
stress tests required by the proposed rule. The ``book value'' of total 
capital would equal the Bank's total capital where all on-balance 
assets, liabilities and off-balance sheet items are accounted for under 
GAAP. The second component of the proposed market risk requirement 
would be the market value of the Bank's portfolio at risk, as estimated 
by the Bank's approved internal risk model. This value would equal the 
maximum loss in the market value of a Bank's portfolio under various 
stress scenarios, where the Bank's portfolio would be comprised of all 
its on-balance sheet assets and liabilities, and all off-balance sheet 
items.
    The 95 percent test. The Finance Board believes that significant 
impairment in a Bank's market value of capital, to the extent that it 
is not reflected in the book value of capital, must be taken into 
account in developing an adequate market risk capital requirement. To 
address this issue, the Finance Board proposes to increase the market 
risk capital requirement by the amount, if any, that a Bank's market 
value of total capital is less than 95 percent of its book value of its 
total capital. Thus, given the proposed test, if the current value of a 
Bank's total capital were significantly diminished by adverse market 
changes, a Bank's ability to take on risk would be restrained even if 
the impact of such adverse market events were not reflected in the book 
value of a Bank's total capital.
    Generally, the proposed rule requires a Bank to measure and report 
its capital adequacy based upon the book value of total or permanent 
capital, calculated in accordance with GAAP. Because the Banks have 
large portfolios of long-term on- and off-balance sheet positions that 
are held-to-maturity, however, a Bank's financial strength, expressed 
by its market value, can decline significantly without that decline 
being reflected in the Bank's book value of capital.\24\ This is 
because under GAAP, held-to-maturity positions would generally be 
valued at historic cost. Without the proposed 95 percent market value 
test, a Bank could incur a significant loss in financial strength due 
to adverse market changes, but not alter its market risk profile in 
response to that loss. The Finance Board is proposing this 95 percent 
test as a safeguard measure and believes that it will have little 
effect on Bank operations because most Banks have a market value of 
capital above 95 percent of book value. The charge associated with the 
95 percent test would only limit a Bank's risk taking activities if its 
market value of capital were to fall below the 95 percent benchmark, 
and the Bank had otherwise fully leveraged its permanent capital.
---------------------------------------------------------------------------

    \24\ The held-to-maturity items in a Bank's portfolio would 
typically include 15 and 30 year fixed-rate mortgage loans and 
fixed-rate pass-through MBS.
---------------------------------------------------------------------------

    Measurement of market value at risk under a Bank's internal market 
risk model. The proposed rule requires each Bank to estimate the 
current market value of its portfolio and measure the market value of 
the portfolio at risk using an internal VAR model, subject to the 
parameters in the proposed rule. Each Bank's internal model must 
calculate the value of a Bank's portfolio at risk during periods of 
market stress, given the interest rate, foreign exchange rate, equity 
price, and commodity price risks undertaken by the Bank, including 
risks of related options positions.
    The Finance Board notes that even where foreign exchange, equity or 
commodity price exposures are hedged, the market valuations may differ 
from valuations for hedging instruments 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 would generally remain. Under the proposed rule, 
however, a Bank is not required to determine the market value of its 
portfolio at risk from its exposure to interest rate, foreign exchange 
rate, equity price, and commodity price risk if those risks are not 
material. For example, such risks may be effectively eliminated through 
matching hedges such as ``mirror swaps'' arranged in conjunction with 
the issuance of consolidated obligations denominated in foreign 
currencies or linked to equity or commodity prices, which typically 
reduce a Bank's market risk exposure to foreign exchange, equity or 
commodity price risk to an immaterial amount.
    The proposed rule would require the Banks to calculate the market 
value of their portfolios at risk associated with these risks except, 
as discussed below, in the narrow circumstances where such risks may be 
immaterial. The proposed rule would allow the value at risk measure to 
incorporate empirical correlations within and among foreign exchange 
rates, equity prices, and commodity prices, subject to a Finance Board 
determination that the model's system for measuring such correlations 
is sound. The Finance Board is requesting comment on whether the final 
rule should require the Banks to account for basis risk by 
incorporating the correlations across risk categories in the market 
risk model.
    The Finance Board believes that it is appropriate to exempt a 
Bank's exposure to certain hedged risks from the market value at risk 
calculation. The Finance Board emphasizes that this proposed exception 
is a narrow one, and the Banks would be expected consistently to 
estimate a market value at risk measurement for instruments linked to 
foreign exchange rates, equity prices, and commodity prices unless the 
hedging of those risks in each instrument results in those risks being 
immaterial. Given the Banks' portfolios, however, the Finance Board 
does not expect that the Banks' overall exposure to interest rate risk 
could ever be considered immaterial.\25\ If the proposed 
``immateriality'' exception is adopted, the Finance Board intends to 
direct its staff to monitor the Banks' implementation of the exception 
to assure that it is applied strictly in accordance with its underlying 
purpose.
---------------------------------------------------------------------------

    \25\ 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. As a result market risks 
associated with foreign exchange rates, equity prices, and commodity 
prices are currently small relative to interest rate risk. 
Therefore, the bulk of the proposed market risk capital requirement 
will reflect interest rate and related options risks.
---------------------------------------------------------------------------

    As proposed, the rule would allow each Bank to develop an internal 
market risk model that uses any generally accepted measurement 
technique, such as variance-covariance models, historical simulations, 
or Monte Carlo simulations, provided that the measurement technique 
covers the Bank's material risks. In this respect, the proposed rule 
specifically 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. Thus, for 
example, while

[[Page 43429]]

a variance-covariance methodology may be sufficient for estimating the 
market value at risk associated with instruments that contain no 
optionality, it would be essential to use a simulation technique for 
instruments with options characteristics.
    The proposed rule also provides that a Bank's internal market risk 
model must use interest rate and market price scenarios of the Bank's 
choosing for estimating the market value of the Bank's portfolio at 
risk, subject to certain minimum requirements. These requirements are 
that the internal risk model must incorporate: (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 
one percent; and (ii) scenarios that reflect changes in interest rates, 
interest rate volatility and the shape of the yield curve equivalent to 
those that have been observed over 120-business day periods of market 
stress. The proposed rule specifies that for interest rates, the 
relevant historical observation period would start at the end of the 
month prior to the month for which the market risk capital requirement 
is being calculated and go back to the beginning of 1978. This time 
frame represents a modern period with a relatively liquid debt market 
that also includes periods of market stress. The rule would also allow 
the market value at risk measure to incorporate empirical correlations 
among interest rates, subject to a Finance Board determination that the 
model's system for measuring such correlations is sound. These required 
scenarios assure that the stress tests performed using the Bank's 
models will be rigorous and fulfill the statutory requirements of the 
GLB Act.
    The proposed rule provides that if a Bank participates in COs 
denominated in a currency other than U.S. Dollars or linked to equity 
or commodity prices, 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 such that the probability of a loss greater than that 
estimated must not exceed one percent and must include scenarios that 
reflect changes in rates and market prices that have been observed over 
120-business day periods of market stress. For foreign exchange, equity 
and commodity prices, the relevant historic observation period can be 
chosen by the Banks, but such period must be acceptable to the Finance 
Board. The chosen time periods generally must reflect periods of 
stress, which given the risk exposures of a Bank, could have resulted 
in a strong negative impact on the Bank's financial position. Although 
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, this requirement reflects the conservative approach 
adopted by the Finance Board with respect to the Banks' safety and 
soundness.
    The proposed rule also makes clear that Banks are required to hedge 
risk arising from consolidated obligations that are denominated in 
foreign currencies or otherwise linked to foreign exchange, equity or 
commodity prices, and to enter into a replacement contract if there is 
a default by a counterparty on an existing hedging contract. Besides 
strengthening safety and soundness, the proposed requirement formalizes 
the long standing practice at the Banks under which the Banks do not 
assume unhedged foreign exchange, equity or commodity positions and is 
consistent with the requirement in proposed Sec. 956.3(b). See 65 FR 
25676, 25692 (May 3, 2000).
    Independent validation of Bank internal market risk model. The 
proposed rule provides that each Bank annually 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. The Finance Board would be 
able, however, to require such reviews to occur more frequently. In 
order for validations conducted within the Bank to be considered 
independent, the validation would have to be carried out by personnel 
not reporting to persons responsible for conducting or overseeing 
business transactions for the Bank. As contemplated by the Finance 
Board, the required validation could include periodic comparisons, such 
as on a quarterly basis or annual basis, of model-generated mark-to-
market values with values obtained from dealers/markets or of model-
generated market value at risk measurements obtained from an 
independent third-party source. An integral part of this process, 
however, is the necessity to validate key assumptions and associated 
parameters underlying the Bank's market risk models. For example, the 
Finance Board would expect a Bank to determine periodically the impact 
on its market value at risk measurements from shifts in key parameters 
such as correlations or regime shifts in volatility parameters. The 
results of such validations would be reviewed by the Bank's board of 
directors and provided to the Finance Board.
    Under the proposed rule, 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 initial use or to implementing the subsequent adjustments. A 
Bank would be required to make any adjustments to its model that may be 
directed by the Finance Board. In addition, the calculations required 
by the proposed rule, unless otherwise directed by the Finance Board, 
must be performed based on the Bank's portfolio as of the close of 
business on the last business day of the month for which the market 
risk capital requirement is being calculated.
    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.\26\ While certain 
modeling techniques may capture the effects of basis risk on a Bank's 
portfolio, the proposed rule does not require a Bank's model to capture 
basis risk. At this time, the Finance Board is requesting comment on 
how best to treat basis risk in the final rule.
---------------------------------------------------------------------------

    \26\  See Principles for the Management of Interest Rate Risk 
(Jan. 1997).
---------------------------------------------------------------------------

    Operations Risk Capital Requirement. Operations risk is 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 statutory requirement 
imposed on Fannie Mae and Freddie Mac, 12 U.S.C. 4611(c)(2), but will 
allow the Banks the option of demonstrating to the Finance Board that a 
lower requirement should apply.
    As proposed, Sec. 932.6 provides that each Bank's operations risk 
capital requirement shall equal 30 percent of the sum of the Bank's 
credit risk capital requirement and market risk capital requirement. 
The proposed provision, however, allows a Bank to substitute an 
alternative methodology for calculating the operations risk capital 
requirement if such methodology is approved by the Finance Board. In 
addition, a Bank may obtain insurance to cover it for operations risk 
and, with Finance Board approval, proportionately reduce the

[[Page 43430]]

operations risk capital requirement. Any insurance obtained must be 
from an insurer that has at least the second highest investment grade 
credit rating by an NSRSO. As proposed, however, the rule specifies 
that in no case may a Bank's operations risk requirement be reduced to 
less than 10 percent of the sum of the Bank's credit risk capital 
requirement and market risk capital requirement.
    Reporting Requirements. Proposed Sec. 932.7 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 permanent capital 
calculated as of the last day of the preceding month, or more 
frequently as may be required by the Finance Board.
    L. Minimum Liquidity Requirements. Liquidity risk is the risk that 
a Bank would be unable to meet its obligations as they come due or to 
meet the credit needs of its members and associates in a timely and 
cost-efficient manner. See 65 FR 25267, 25274 (May 1, 2000), to be 
codified at 12 CFR 917.1. 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. Neither, however, 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 obligations of the United States, deposits in 
banks or trusts, or advances to members that mature in 5 years or less. 
12 U.S.C. 1431(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.\27\ The 
Finance Board requests comment on whether the rule should address the 
issue of operational liquidity, and if so, how it should do so. The 
proposed rule provides that the Banks not only must meet the statutory 
liquidity requirements, 12 U.S.C. 1431(g), but also must hold 
contingency liquidity in an amount sufficient to enable the Bank to 
cover its liquidity risk, assuming a period of not less than five 
business days of inability to borrow in the capital markets. 
Contingency liquidity may be provided, for example, by 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; (3) assets that are generally accepted 
as collateral in the repurchase agreement market; and (4) irrevocable 
lines of credit from financial institutions rated not lower than the 
second highest credit rating by a NRSRO. The proposed rule specifically 
states that an asset that has been pledged under a repurchase agreement 
cannot be used to satisfy the contingency liquidity requirement, 
because such an asset will not be available to provide liquidity should 
a contingency arise.
---------------------------------------------------------------------------

    \27\ Recently adopted 12 CFR Sec. 917.3(b)(3)(iii) requires 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. See 65 FR 25267, 25275 (May 
1, 2000).
---------------------------------------------------------------------------

    The proposed five business 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 determined from 
calculations using daily data on CO redemptions during 1998. The 
Finance Board found that the 99th percentile of the five-business day 
CO redemption distribution resulted in liquidity requirements that 
ranged from about 5 percent to 17 percent of each Bank's total assets.
    Other regulators recognize the importance of adequate levels of 
liquidity but, for the most part, have not always 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. For example, each institution regulated by the 
Farm Credit Administration is required to maintain a minimum liquidity 
reserve. 12 CFR 615.5134. 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. The importance of liquidity is also 
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. OFHEO has not published any regulation 
concerning liquidity requirements for Fannie Mae and Freddie Mac.
    Liquidity problems may arise from concerns about the 
creditworthiness of the Banks or from events that may temporarily 
disrupt the Banks' access to the credit markets. 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 GSE in question received 
assistance from the federal government.\28\ 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

[[Page 43431]]

similar episode in which its debt spread widened substantially.
---------------------------------------------------------------------------

    \28\ 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 case, the proposed contingency 
requirement is not meant to address such an event. The five business 
day contingency liquidity requirement could, however, provide 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.
    The proposed requirement is meant to address principally events 
that may temporarily disrupt a Bank's access to credit markets. It may 
be viewed as conservative when examined in the context of events which 
could impair the normal operations of the 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.
    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.\29\ Thus, the Finance Board believes 
that the proposed liquidity requirement is important to maintaining a 
sound credit rating for the Banks and assuring continued safe and sound 
operation of the Bank System and access to the capital markets.
---------------------------------------------------------------------------

    \29\ Moody's Investor Service, Global Credit Research, Moody's 
Credit Opinions--Financial Institutions, (June 1999).
---------------------------------------------------------------------------

    M. Limits on Unsecured Extensions of Credit. The proposed rule also 
would establish maximum capital exposure limits for unsecured 
extensions of credit by a Bank to a single counterparty or to 
affiliated counterparties. As proposed, the rule also establishes 
reporting requirements for total unsecured credit exposures and total 
secured and unsecured credit exposures 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 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 the counterparty because of concerns about the 
counterparty's ability to repay a loan. The Bank's concentration of 
credit in such a counterparty may indicate that the Bank's extensions 
of credit are 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 the value of the 
Bank's remaining loans to the counterparty. Further, a Bank may even be 
tempted to lend additional funds to the counterparty to keep the 
counterparty in business, in order to protect its existing 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 
credit exposures 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 requirement in the proposed rule does not 
take into account the increase in credit risk associated with 
concentrations of credit exposures. Therefore, the Finance Board 
believes that it is necessary, for safety and soundness reasons, to 
impose separate limits on unsecured credit exposures of a Bank to 
single counterparties and to affiliated counterparties. This is 
consistent with the regulatory approaches of other financial 
institution regulators. See, e.g., 12 U.S.C. 84; 12 CFR Part 32 (the 
lending limit for a national bank is generally 15 percent of its 
capital and surplus).
    Currently, the FMP limits Bank unsecured credit exposures 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 exposure 
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. 932.9(a)(1) of the proposed rule provides that unsecured 
credit exposure by a Bank to a single counterparty that arises 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 information on Tier 
1 capital is not available.\30\ 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 one percent for counterparties with a below

[[Page 43432]]

investment grade rating. These limits are consistent with those 
established internally by large lenders. Section 932.9(a)(3)(iii) 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. 932.9(a)(3)(iii)(A).
---------------------------------------------------------------------------

    \30\ For the purposes of the proposed requirements related to 
limits on and reporting of credit concentrations, the term ``total 
capital'' when used in reference to capital held by a Bank's 
counterparty (or an affiliate of such counterparty) would have the 
same meaning as in regulations issued by the counterparty's (or the 
affiliate's) principal regulator and not as defined in proposed 
Sec. 930.1. The proposed rule makes clear in the affected sections 
when the meaning of ``total capital'' differs from that in proposed 
Sec. 930.1.
---------------------------------------------------------------------------

    The proposed rule also provides that if a counterparty is placed on 
a credit watch for a potential downgrade by an NRSRO, the Bank would 
determine the maximum capital exposure under Table 4 by first assuming 
that an NRSRO had already downgraded the rating to the next lower grade 
and then choosing the exposure limit that corresponds to that next 
lower rating. Section 932.9(b) 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 information on Tier 1 capital is not available, of 
all of the affiliated counterparties.
    Reporting requirement for total unsecured credit concentrations. 
Currently, there is no Finance Board requirement establishing a 
centralized mechanism for maintaining and measuring specific data on 
the aggregate unsecured credit concentration exposure 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.
    Accordingly, 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 
information on Tier 1 capital is not available), or in the case of 
affiliated counterparties, the combined Tier 1 capital (or total 
capital if information on 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.
    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 U.S.C. 84; 12 CFR Part 32. 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, the proposed rule requires each Bank to report monthly 
to the Finance Board the amount of the Bank's total secured and 
unsecured credit exposures to any single counterparty or group of 
affiliated counterparties that exceeds 5 percent of the Bank's total 
assets. 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.
    N. Part 933--Capital Plans.
    Approval of Plans. The GLB Act requires the board of directors of 
each Bank to submit to the Finance Board a capital plan within 270 days 
after the date of publication of the final capital rule. Each capital 
plan must establish the details for the new capital structure, which 
must provide sufficient capital for the Bank to comply with its 
regulatory total capital and regulatory risk-based capital 
requirements. The proposed rule would allow the Finance Board to 
approve a reasonable extension of the 270-day period upon a 
demonstration of good cause as to why the Bank does not expect to meet 
the statutory deadline. The Finance Board would determine what 
constitutes ``good cause'' on a case-by-case basis. As required by the 
GLB Act, a Bank must receive approval from the Finance Board prior to 
implementing its capital plan, or any amendment to the plan. As part of 
that approval process, the Finance Board would reserve the right to 
determine the effective date for each capital plan.
    If a Bank, for any reason, were to fail to submit a capital plan to 
the Finance Board within the 270-day period, including any Finance 
Board approved extension, the proposed rule would authorize the Finance 
Board to establish a capital plan for that Bank, and the Finance Board 
also would have the discretion to take any enforcement action against 
the Bank, its directors, or its executive officers authorized by 
Section 2B(a)(5) of the Bank Act, or to merge the Bank in accordance 
with Section 26 of the Bank Act into another Bank that has submitted an 
acceptable capital plan.
    Contents of Plan. The GLB Act sets forth requirements regarding the 
contents of each Bank's capital plan. The proposed rule would follow 
the statutory requirements and require that each Bank's capital plan 
address, at a minimum, the classes of capital stock, capital stock 
issuance, membership investment or fee structure, transfer of capital 
stock, termination of membership, independent review of the capital 
plan, and implementation of the plan. In addressing the classes of 
stock, the Finance Board is proposing that the capital plan shall, at a 
minimum, describe each class or subclass of capital stock to be issued 
to the members; establish the terms, rights, and preferences for each 
class and subclass of capital stock to be issued; establish the voting 
rights and preferences; and provide the basis on which the stated Class 
A dividends are to be calculated and whether such dividends are to be 
cumulative. In general, the Finance Board believes the inclusion of 
each of these items in the Banks' capital plans is necessary for the 
Bank to transition

[[Page 43433]]

smoothly to the new capital structure mandated by the GLB Act.
    The proposed rule also would require each Bank to include in its 
capital plan a description of the manner in which the Bank intends to 
solicit its members for voluntary purchases of its capital stock. By 
requiring that the Banks address the issue of solicitations of 
voluntary purchases in its capital plan, the Finance Board would have 
the opportunity to ensure that the methods used are fair and equitable. 
The proposed rule also would require each Bank's capital structure plan 
to specify ``operating capital ratios,'' i.e., an ``operating total 
capital ratio'' and an ``operating risk-based capital ratio,'' each of 
which would be set at a higher percentage than the regulatory total 
capital and the regulatory risk-based capital requirements, 
respectively, as established by the Finance Board. Because it is 
necessary that each Bank manage its risk portfolio such that it 
complies with its regulatory capital requirements, the Finance Board 
believes each Bank must establish target ratios at which to operate 
that are sufficiently higher than the minimum regulatory capital 
requirements. Doing so would allow each Bank to manage its capital 
accounts in a manner that affords a capital ``cushion'' within which to 
conduct its operations while ensuring its compliance with the 
regulatory capital requirements.
    The GLB Act requires that each Bank's capital plan specify the 
minimum investment required of the members. The proposed rule requires 
that each Bank's capital plan allow for the fulfillment of this 
requirement through either the purchase of Class A stock or the payment 
of an annual membership fee, as set forth in Sec. 931.7. The Finance 
Board is proposing that a Bank's capital plan must allow a member to 
substitute the purchase of Class B stock for its membership investment 
of Class A stock. The capital plans also would be required to specify 
the methodology used by the Bank to determine the level of the 
membership investment or the annual membership fee. The Finance Board 
is proposing to allow the Banks to offer the option of a membership fee 
in order to provide additional flexibility to both the Banks and its 
members. By providing an option, the Banks would have more flexibility 
in controlling their capital accounts while meeting the needs of their 
members.
    If, to fulfill its membership investment requirement, a member were 
to elect to invest in the capital stock of the Bank, the Finance Board 
is proposing that the member be provided the option of investing in 
Class B stock, if authorized by the Bank, at a proportionately lesser 
amount than would be required if the member purchased Class A stock. 
The terms of Class A and Class B stock, as specified in the Bank's 
capital plan, will dictate an appropriate rate of substitution of Class 
B stock for Class A stock to fulfill the membership investment 
requirement. For example, one term imposed by the GLB Act is to weight 
Class B stock at 1.5 times of Class A stock for purposes of determining 
compliance with the five percent leverage requirement, which, taken 
alone, suggests that one share of Class B stock should substitute for 
more than one share of Class A stock. In proposing that this provision 
be included in the Banks' capital plans, the Finance Board is providing 
the Banks the opportunity to offer members different membership 
investment options.
    Additionally, the proposed rule requires that each Bank's capital 
plans specify that the board of directors of the Bank review and adjust 
the membership investment periodically to ensure that the Bank complies 
with the regulatory capital requirements and, further requires members 
to comply promptly with any adjusted membership investment.
    The Finance Board is also proposing that a Bank's capital plan may 
specify a fee to be imposed on a member that cancels a notice of 
withdrawal or a notice of redemption. The decision to impose a fee 
structure would be at a Bank's discretion, but the methodology used to 
calculate such fees would need to be specified in the capital plan. The 
conditions under which a Bank may impose a fee also must be specified 
in its capital plan to ensure the fair and equitable imposition of fees 
among members. The Finance Board is proposing the option of 
establishing a fee in order to minimize the Bank's costs associated 
with canceling a notice of withdrawal or redemption.
    As required in the GLB Act, the capital plan must establish the 
criteria for the issuance, redemption, retirement, or purchase of Bank 
stock by the Bank, and for the transfer of Bank stock between members 
of the Bank. The capital plan must also specify that the stock of the 
Bank may only be issued to or held by the members of the Bank, and that 
no entities other than the Bank may trade the stock of the Bank.
    Under the proposed rule, as required in the GLB Act, the plan must 
address the manner in which the Bank will provide for the disposition 
of its capital stock that is held by institutions that terminate their 
membership, and the manner in which the Bank will liquidate claims 
against its members, including claims resulting from prepayment of 
advances prior to their stated maturity. Also as required in the GLB 
Act, the plan must include a report from an independent certified 
public accountant regarding the extent to which the implementation of 
the plan would affect the redeemable stock issued by the Bank and a 
report from an NRSRO regarding the extent to which the implementation 
of the plan would affect the credit rating of the Bank. The plan must 
also demonstrate that the Bank has made a good faith determination that 
the Bank will be able to implement the plan as submitted and that the 
Bank will be in compliance with its regulatory total capital 
requirement and regulatory risk-based capital requirement.
    Implementation of Plan. The Finance Board is proposing that each 
Bank's capital plan must specify the manner in which the members of the 
Bank may convert or exchange their existing Bank capital stock into 
either, or both, Class A and Class B capital stock. The plans should 
address how the conversion or exchange will take place and the likely 
outcome in terms of total Class A and Class B stock, as demonstrated by 
prior commitments of members, surveys, or other quantifiable means. The 
proposed rule also requires that the capital plan specify what will 
happen to existing Bank stock owned by a member that does not 
affirmatively elect to convert or exchange its existing Bank stock into 
either Class A or Class B stock or some combination of both.
    As required by the GLB Act, each Bank's plan must include a 
transition provision that specifies the date on which the plan is to 
take effect, as well as the date, not to exceed three years from the 
effective date of the plan, on which the Bank must be in full 
compliance with its regulatory total capital requirement and regulatory 
risk-based capital requirement. The GLB Act further requires that the 
capital plan for each Bank may include a provision allowing any 
institution that was a member of the Bank on November 12, 1999, a 
period of up to three years from the effective date of the plan in 
which to comply with the membership investment requirements of the 
capital structure plan. Any institution that was approved for 
membership after November 12, 1999, will be required to comply with the 
membership investment requirements as soon as the Bank's capital 
structure plan becomes effective. The Finance Board also requests 
comment on whether it would be appropriate for the final rule to allow

[[Page 43434]]

institutions becoming members after November 12, 1999 to be provided 
with a similar transition period.
    O. Part 925 Membership Amendments.
    The proposed rule would revise several provisions of the Finance 
Board's membership regulations to reflect changes made by the GLB Act. 
The existing membership regulations include provisions regarding the 
amount of Bank stock an institution must purchase upon becoming a 
member. Because that issue would be addressed by the capital 
regulations and the capital plan for each Bank, the proposed rule would 
remove all stock purchase requirements from the membership regulations.
    The proposed rule also would revise the existing provisions that 
pertain to the effect of a merger or other consolidation of a member 
into another member of the same Bank, a member of another Bank, or a 
nonmember. Generally speaking, the Bank membership of an institution 
terminates when its charter is cancelled in connection with its merger 
or consolidation into another institution. The proposed rule would 
retain that concept, but would consolidate the substance of the two 
sections that deal separately with the consolidation into another 
member and into a nonmember, respectively. The proposed rule also would 
remove from the membership regulation provisions that address the 
treatment of the member's Bank stock, dividends, and advances, each of 
which is to be covered by other provisions of the regulations. For 
example, Sec. 950.19 of the advances regulations provides that upon an 
institution's termination of membership, the Bank shall determine an 
orderly schedule for the liquidation of any indebtedness owed by the 
member to the Bank, and may allow the debt to run until its maturity. 
The Finance Board believes that the general requirement in Sec. 950.19 
for an orderly liquidation of indebtedness is sufficient and is 
proposing to remove the existing references to such liquidation from 
the provisions dealing with consolidation of members as being 
duplicative.
    The proposed rule also would implement the provisions of the GLB 
Act that address the withdrawal of a member from a Bank. Section 6(d) 
of the Bank Act, 12 U.S.C. 1426(d), as amended, provides that any 
member may withdraw from its Bank by providing written notice of its 
intent to do so, provided that on the date of the withdrawal there is 
in effect a certification from the Finance Board (RefCorp 
certification) that the withdrawal will not cause the Bank System to 
fail to meet its obligations to contribute to the debt service for the 
obligations issued by RefCorp, in accordance with Section 21B(f)(2)(C) 
of the Bank Act, 12 U.S.C. 1441b(f)(2)(C), as amended. The GLB Act 
further provides that the receipt of the notice by the Bank commences 
the applicable stock redemption periods for the stock owned by that 
member, i.e., the 6-month and 5-year notice periods for Class A and 
Class B stock, respectively, and allows the member to receive the par 
value of its stock in cash at the end of the redemption period. During 
the notice period, the member may continue to receive dividends on its 
stock.
    The proposed rule would require a member to specify in its notice 
of withdrawal the date on which it intends its termination of 
membership to become effective, which date may be no later than the 
date on which the last of its stock redemption periods end. If the 
notice does not indicate a withdrawal date, the proposed rule would 
provide that the withdrawal is deemed to take effect on the date that 
the last applicable stock redemption period ends. Because the Bank Act 
no longer links the withdrawal from membership to the redemption of 
stock, the proposed rule would allow an institution to terminate its 
membership in a Bank as early as upon the Bank's receipt of the 
member's notice of withdrawal, if the member so chose. The effect of an 
immediate withdrawal would be that an institution would cease to be 
eligible to obtain any further services from the Bank and would be at 
risk that the Bank would call due any advances outstanding to the 
member. Such an institution, however, could not redeem its Bank stock 
until the end of the applicable stock redemption period, 
notwithstanding its earlier termination of membership, but would be 
entitled to continue to receive dividends on its Bank stock for as long 
as it were to hold the stock. The proposed rule would allow a member to 
cancel a notice of withdrawal at any time before its effective date, by 
providing a written cancellation notice to the Bank. The proposed rule 
also would permit a Bank to impose a fee, which would be specified in 
its capital plan, on any member that withdraws a notice of termination.
    As amended by the GLB Act, the obligation of the Banks to 
contribute to the annual RefCorp debt service was changed from a fixed 
dollar amount of $300 million per year to a percentage amount, 20 
percent of the net earnings of each Bank. In effect, the RefCorp 
certification requires the Finance Board to certify that the withdrawal 
of a member would not cause the Bank System to fail to pay 20 percent 
of its annual earnings (on an aggregate basis) to discharge its RefCorp 
obligation. Because the GLB Act has changed the method of calculating 
the RefCorp obligation to a percentage formula, there are no 
circumstances in which the Bank System could ever fail to meet its 
RefCorp obligations, i.e., if the obligation is to pay 20 percent of 
annual net earnings, and the net earnings for a given year were to be 
zero or negative, the obligation for that year would be zero. Moreover, 
if one or more Banks were to have zero or negative earnings, and zero 
contributions, for a particular year, the RefCorp obligation, as 
amended by the GLB Act, would be extended for some additional number of 
years, based on a present value calculation. The Finance Board 
anticipates addressing this matter by issuing a certification that the 
withdrawal of any member will not cause the Bank System to fail to meet 
its RefCorp obligation. That certification would remain in effect, thus 
allowing members to withdraw from membership without requesting 
individual certifications, until rescinded by the Finance Board.
    The GLB Act also provides grounds on which the Bank may terminate 
the membership of an institution, such as in the case of violating the 
Bank Act or Finance Board regulations, or insolvency. The proposed rule 
would provide that the stock redemption periods commence on the date 
that a Bank removes an institution from membership, during which time 
the institution could continue to receive dividends on its stock, but 
not any other membership benefits.
    If a member withdraws from membership, the proposed rule would 
require the Bank to determine an orderly manner for liquidating all 
indebtedness owed to the Bank and for unwinding other transactions with 
the member, and would provide that the Bank's lien on any stock held by 
the member would remain in effect until the debts are paid, the effect 
of which could be to delay the redemption of stock until the member has 
satisfied its indebtedness to the Bank. Once an institution terminates 
its membership, it may not again become a member of any Bank for five 
years, as required by the GLB Act amendments.
    P. Part 956--Hedging Provisions and Part 960 Off Balance Sheet 
Items.
    Use of hedging Instruments--Sec. 956.6: Section 956.6 of the 
proposed rule addresses the Banks' use of hedging instruments, such as 
interest rate swaps, options, and futures contracts. Hedging

[[Page 43435]]

instruments are derivative contracts or securities used to offset the 
risks associated with asset-liability management by financial 
institutions and others, typically relating to interest rate risk. 
Proposed Sec. 956.6(a) would require that derivatives instruments that 
do not qualify as hedging instruments pursuant to GAAP may be used only 
if a non-speculative use is documented by the Bank. Because GAAP 
prescribes extensive rules for hedging transactions that are required 
to be followed by most market participants, the Finance Board finds it 
prudent that the Banks also should be subject to these same 
requirements. The Banks, however, enter into derivatives contracts with 
members in order to assist those members with their asset-liability 
management. In addition, certain derivatives that currently are used by 
the Banks for hedging purposes, would not meet the requirements of FAS 
133.\31\ The Finance Board recognizes that allowing the Banks to serve 
as intermediaries in derivatives contracts with members is a benefit 
that is valued by members, and that the Banks may benefit from the 
ability to use certain instruments to hedge actual balance sheet risks, 
even if the hedge transactions would not meet the requirements of FAS 
133. Therefore, the Finance Board is proposing to permit such 
transactions, provided that the Bank documents that the use of the 
hedging instruments is non-speculative.
---------------------------------------------------------------------------

    \31\ Financial Accounting Standards No. 133, ``Accounting for 
Derivative Instruments and Hedging Activities'' (FAS 133), which 
provides a comprehensive framework of accounting and reporting 
standards for derivatives. It requires that all derivatives must be 
carried on the balance sheet at fair value. The only exception is 
for derivatives that qualify as hedges in accordance with FAS 133. 
Certain derivatives used by the Banks would not meet the 
requirements for hedge accounting. For example, macro or portfolio 
hedging would not be allowed hedge accounting treatment under FAS 
133 because a specific identification of the hedged item, which must 
be a specific asset or liability or a pool of similar assets or 
liabilities is required.
---------------------------------------------------------------------------

    Section 956.6(b) of the proposed rule would govern the 
documentation that each Bank must have and maintain during the life of 
each hedge. Proposed Sec. 956.6(c)(1) would require that transactions 
with a single counterparty be governed by a single master agreement 
when practicable. Proposed Sec. 956.6(c)(2) 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 currently exist in 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 hedging transactions.
    Under the FMP, the Banks are limited to using a specific list of 
hedging instruments. The use of the listed hedging instruments by the 
Banks is permitted provided it is for the purpose of assisting the Bank 
in achieving its interest rate or basis risk management objectives. 
Like the FMP's Investment Guidelines, the Hedge Transaction Guidelines 
of the FMP contain detailed requirements that will no longer be 
necessary. The unsecured credit concentration limits set forth in 
proposed Sec. 932.9 and the credit risk-based capital requirements set 
forth in proposed Sec. 932.4 would eliminate the need for provisions 
addressing unsecured credit exposure and collateralization in the FMP. 
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.
    Q. Part 960--Off-Balance Sheet Items.
    Proposed Sec. 960.2(a) would authorize the Banks to enter into the 
following types of off-balance sheet transactions, subject to any 
requirements or restrictions set forth by the Finance Board: standby 
letters of credit; derivative contracts; forward asset purchases and 
sales; and commitments to make advances or other loans. This 
authorization essentially would codify 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. 960.2(b) prohibits the Banks from making speculative 
use of derivative contracts by requiring that derivative instruments 
that do not qualify as hedging instruments pursuant to GAAP may be used 
only if a non-speculative use is documented by the Bank. As previously 
discussed in the general context of hedging instruments, speculating 
with derivatives contracts is inappropriate for the Banks, as it would 
do nothing to further their mission, while posing risks to their safety 
and soundness.

III. Paperwork Reduction Act

    The Finance Board has submitted to the Office of Management and 
Budget (OMB) an analysis of the collection of information contained in 
Secs. 931.7 through 931.9 and 933.2 of the proposed rule, described 
more fully in part II of the Supplementary Information. The Banks will 
use the information collection to determine whether Bank members 
satisfy the statutory and regulatory capital stock requirements. The 
Banks will use the information collection to implement its new capital 
structure and limit member ownership of Bank stock. See 12 U.S.C. 1426; 
12 CFR parts 931 and 933. Responses are mandatory and are required to 
obtain or retain a benefit. See 12 U.S.C. 1426.
    Likely respondents and/or record keepers will be Banks and Bank 
members. Potential respondents are not required to respond to the 
collection of information unless the regulation collecting the 
information displays a currently valid control number assigned by OMB. 
See 44 U.S.C. 3512(a).
    The estimated annual reporting and recordkeeping hour burden is:

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

    The estimated annual reporting and recordkeeping cost burden is:

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

The Finance Board will accept written comments concerning the accuracy 
of the burden estimates and suggestions for reducing the burden at the 
address listed above.
    The Finance Board has submitted the collection of information to 
OMB for review. Comments regarding the proposed collection of 
information may be submitted in writing to the Office of Information 
and Regulatory Affairs of OMB, Attention: Desk Officer for Federal 
Housing Finance Board, Washington, D.C. 20503 by September 11, 2000.

[[Page 43436]]

IV. Regulatory Flexibility Act

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

List of Subjects

12 CFR Part 917

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

12 CFR Part 925

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

12 CFR Parts 930, 931, 932 and 933

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

12 CFR Part 956

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

12 CFR Part 960

    Credit, Federal home loan banks, Investments.

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

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

    1. The authority citation for part 917 continues to read as 
follows:

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


Sec. 917.9  [Removed]


Sec. 917.10  [Redesignate as Sec. 917.9]

    2. In part 917, remove Sec. 917.9 and redesignate Sec. 917.10 as 
Sec. 917.9.

PART 925--MEMBERS OF THE BANKS

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

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

Part 925 [Remove Subpart D]

    4. Remove subpart D from part 925.


Secs. 925.24 and 925.28  [Removed]

    5. Remove Secs. 925.24 and 925.28.


Secs. 925.25 through 925.27  [Redesignated as Secs. 925.19 through 
925.21]

    6. Redesignate Secs. 925.25 through 925.27 as Secs. 925.19 through 
925.21.


Secs. 925.29 through 925.32  [Redesignated as Secs. 925.22 through 
925.25]

    7. Redesignate Secs. 925.29 through 925.32 as Secs. 925.22 through 
925.25.


Subparts E through J  [Redesignate as subparts D through I]

    8. Redesignate subparts E through J as subparts D through I.
    9. Amend newly designated Sec. 925.19 by revising the heading and 
paragraphs (a), (b) and (d), and by removing paragraph (e), to read as 
follows:


Sec. 925.19  Consolidations involving members.

    (a) Consolidation of members. (1) Upon the consolidation of two or 
more institutions that are members of the same Bank into one 
institution operating under the charter of one of the consolidating 
institutions, the membership of the surviving institution shall 
continue and the membership of the disappearing institutions shall 
terminate on the cancellation of their charter. Upon the consolidation 
of two or more institutions each of which is a member of a different 
Bank, into one institution operating under the charter of one of the 
consolidating institutions, the membership of the surviving institution 
shall continue and the membership of each disappearing institution 
shall terminate upon cancellation of its charter, provided, however, 
that that if more than 80 percent of the assets of the consolidated 
institution are derived from the assets of a disappearing institution, 
then the consolidated institution shall continue to be a member of the 
Bank of which the disappearing institution was a member prior to the 
consolidation and the membership of the other institutions shall 
terminate upon the effective date of the consolidation.
    (2) Upon the consolidation of a member into an institution that is 
not a member of a Bank, where the consolidated institution operates 
under the charter of the nonmember institution, the membership of the 
disappearing institution shall terminate upon the cancellation of its 
charter.
    (b) Notification of decision to seek membership. When a 
consolidated institution resulting from a consolidation described in 
paragraph (a)(2) of this section has its principal place of business in 
a state in the same Bank district as the disappearing institution, the 
consolidated institution shall have 60 calendar days after the 
cancellation of the charter of the disappearing institution to notify 
the disappearing institution's Bank that it intends to apply for 
membership in such Bank.
* * * * *
    (d) Treatment of outstanding indebtedness. (1) Prior to membership 
approval. If the membership of an institution has been terminated 
pursuant to paragraph (a)(2) of this section, the Bank need not require 
the institution (or its successor) to liquidate any outstanding 
indebtedness owed to the Bank, as otherwise may be required pursuant to 
Sec. 950.19, during:
    (i) The initial 60-day notification period;
    (ii) The 60 calendar day period following receipt of a notification 
that the consolidated institution intends to apply for membership; and
    (iii) The period of time during which the Bank processes the 
application for membership.
    (2) Failure to apply for or be approved for membership. If the 
consolidated institution does not apply for membership within the 
required period of time, or if its application for membership is 
denied, then the liquidation of any outstanding indebtedness owed to 
the disappearing institution's Bank shall be carried out in accordance 
with Sec. 950.19.
* * * * *
    10. Revise newly designated Sec. 925.20 to read as follows:


Sec. 925.20  Withdrawal from membership.

    (a) Notice of withdrawal. Any institution may terminate its 
membership by providing to the Bank written notice of its intent to 
withdraw from membership. A member that has so notified its Bank shall 
be entitled to have continued access to the benefits of membership 
until the effective date of its withdrawal. A withdrawing member may 
cancel its notice of withdrawal at any time prior to its effective date 
by providing a written cancellation notice to the Bank. A Bank may 
impose a fee, to be specified in its capital plan, on a member that 
cancels its notice of withdrawal.
    (b) Termination of membership. The notice of withdrawal shall 
indicate the date on which the membership is to terminate, which may be 
no later than the date on which the last of the applicable stock 
redemption periods ends. If the notice fails to specify an effective 
date for the withdrawal, the Bank shall deem the withdrawal to take 
effect on the date the last of the

[[Page 43437]]

applicable stock redemption periods ends.
    (c) Stock redemption periods. The receipt by a Bank of a notice of 
withdrawal shall commence the applicable 6-month and 5-year stock 
redemption periods for all Bank stock held by that member, unless the 
member previously has provided a notice of stock redemption. In the 
case of an institution the membership of which has been terminated as a 
result of a merger or other consolidation into a nonmember or into a 
member of another Bank, the applicable stock redemption periods shall 
be deemed to commence on the date on which the member's charter is 
cancelled, unless the member previously has provided a notice of stock 
redemption.
    (d) Certification. No institution may withdraw from membership 
unless, on the date that the membership is to terminate, there is in 
effect a certification from the Finance Board that the withdrawal of a 
member will not cause the Bank System to fail to satisfy its 
obligations under 12 U.S.C. 1441b(f)(2)(C) to contribute toward the 
interest payments owed on obligations issued by the Resolution Funding 
Corporation.
    11. Revise newly designated Sec. 925.21 to read as follows:


Sec. 925.21  Removal from membership.

    (a) Grounds for removal. The board of directors of a Bank may 
terminate the membership of any institution that fails to comply with 
any requirement of the Bank Act, any regulation adopted by the Finance 
Board, or any requirement of the Bank's capital plan, or that becomes 
insolvent or otherwise subject to the appointment of a conservator, 
receiver, or other legal custodian under federal or state law.
    (b) Stock redemption. The applicable 6-month and 5-year stock 
redemption periods shall commence on the date that the Bank removes an 
institution from membership, unless the institution previously has 
provided a notice of stock redemption to the Bank.
    (c) Membership rights. An institution whose membership is 
terminated involuntarily under this section shall have no right to 
obtain any of the benefits of membership after the effective date of 
its removal.
    12. Revise newly designated Sec. 925.22 to read as follows:


Sec. 925.22  Liquidation of indebtedness.

    (a) In general. If an institution withdraws from membership or its 
membership is otherwise terminated, the Bank shall determine an orderly 
manner for liquidating all indebtedness owed by that member to the 
Bank, as well as all other items, including letters of credit, 
derivatives, or deposits. After all such obligations relating to the 
member have been extinguished, the Bank shall return to the member all 
collateral pledged by the member to the Bank to secure its obligations 
to the Bank.
    (b) Lien on Bank stock. If a withdrawing member is indebted or 
otherwise obligated to a Bank, the Bank shall not redeem any Bank stock 
held by the member until after the indebtedness and other obligations 
to the Bank have been extinguished.
    13. Revise newly designated Sec. 925.23 to read as follows:


Sec. 925.23  Readmission to membership.

    (a) In general. An institution that has withdrawn from membership, 
or otherwise has terminated its membership, may not be readmitted to 
membership in any Bank for a period of 5 years from the date on which 
its membership terminated.
    (b) Exceptions. An institution that transfers membership between 
two Banks without interruption shall not be deemed to have withdrawn 
from Bank membership. Any institution that withdrew from Bank 
membership prior to December 31, 1997, and for which the 5-year period 
has not expired, may apply for membership in a Bank at any time, 
subject to the approval of the Finance Board and the requirements of 12 
CFR part 925.
    14. In subchapter E, add new parts 930, 931, 932 and 933 to read as 
follows:

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

Sec.
930.1   Definitions.

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


Sec. 930.1  Definitions.

    As used in this subchapter:
    Affiliated counterparty means a counterparty that is an affiliate 
of another counterparty, as the term ``affiliate'' is defined in 12 
U.S.C. 371c(b).
    Capital plan means the approved capital structure plan that each 
Bank is required to develop and submit to the Finance Board for 
approval pursuant to 12 CFR 933.1.
    Class A stock means capital stock issued by a Bank, including 
subclasses, that has the characteristics specified by Sec. 931.1(a) of 
this subchapter.
    Class B stock means capital stock issued by a Bank, including 
subclasses, that has the characteristics specified by Sec. 931.1(b) of 
this subchapter.
    Contingency liquidity has the meaning set forth in Sec. 917.1 of 
this chapter.
    Credit derivative contract means a derivative contract that 
transfers credit risk.
    Credit risk has the meaning set forth in Sec. 917.1 of this 
chapter.
    Derivative contract means generally a financial contract the value 
of which is derived from the values of one or more underlying assets, 
reference rates, or indices of asset values, or credit-related events. 
Derivative contracts include interest rate, foreign exchange rate, 
equity, precious metals, commodity, and credit contracts, and any other 
instruments that pose similar risks.
    Exchange rate contracts include cross-currency interest-rate swaps, 
forward foreign exchange rate contracts, currency options purchased, 
and any similar instruments that give rise to similar risks.
    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).
    GAAP means generally accepted accounting principles.
    General allowance for losses means an allowance established by a 
Bank in accordance with GAAP for losses, but which does not include any 
amounts held against specific assets of the Bank.
    Government Sponsored Enterprise, or GSE, means a United States 
Government-sponsored agency 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

[[Page 43438]]

available from an NRSRO or other similar standards.
    Market risk has the meaning set forth in Sec. 917.1 of this 
chapter.
    Marketable means, with respect to an asset, that the asset can be 
sold with reasonable promptness at a price that corresponds reasonably 
to its fair value.
    Market value at risk is 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.
    Operating risk-based capital ratio means the ratio of permanent 
capital to total assets at which the Bank intends to operate.
    Operating total capital ratio means the ratio of total capital to 
total assets at which the Bank intends to operate.
    Operations risk has the meaning set forth in Sec. 917.1 of this 
chapter.
    Permanent capital of a Bank means the amount paid-in for Class B 
stock plus its retained earnings.
    Regulatory risk-based capital requirement means the amount of 
permanent capital that a Bank is required to maintain in accordance 
with Sec. 932.3 of this chapter.
    Regulatory total capital requirement means the amount of total 
capital that a Bank is required to maintain in accordance with 
Sec. 932.2 of this chapter.
    Repurchase agreement means an agreement between a seller and a 
buyer whereby the seller agrees to repurchase a security or similar 
securities at an agreed upon price, with or without a stated time for 
repurchase.
    Retained earnings means the retained earnings, as determined in 
accordance with GAAP.
    Total assets means the total assets of a Bank, as determined in 
accordance with GAAP.
    Total capital of a Bank means the sum of permanent capital, the 
amounts paid-in for Class A stock, the amount of any general allowance 
for losses, and the amount of other instruments identified in a Bank's 
capital plan that the Finance Board has determined to be available to 
absorb losses incurred by such Bank.
    Unrealized net losses on available-for-sale securities means the 
unrealized net losses on available-for-sale securities, as determined 
in accordance with GAAP.
    Walkaway clause means a provision in a bilateral netting contract 
that permits a nondefaulting counterparty to make a lower payment than 
it would make otherwise under the bilateral netting contract, or no 
payment at all, to a defaulter or the estate of a defaulter, even if 
the defaulter or the estate of the defaulter is a net creditor under 
the bilateral netting contract.

PART 931--FEDERAL HOME LOAN BANK CAPITAL STOCK

Sec.
931.1   Classes of capital stock.
931.2   Issuance of capital stock.
931.3   Voting rights.
931.4   Dividends.
931.5   Preferences on liquidation, merger, or consolidation.
931.6   Transfer of capital stock.
931.7   Membership investment in capital stock.
931.8   Activity-based stock purchase requirement.
931.9   Concentration limits.
931.10   Redemption and purchase of capital stock.
931.11   Capital impairment.

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


Sec. 931.1  Classes of capital stock.

    The authorized capital stock of a Bank shall consist of the 
following instruments:
    (a) Class A stock, which shall:
    (1) Have a par value of $100 per share;
    (2) Be issued and redeemed only at its par value;
    (3) Be redeemable in cash only on six-months written notice to the 
Bank; and
    (4) Pay a stated dividend that has a priority over the payment of 
dividends on the Class B stock.
    (b) Class B stock, which:
    (1) Shall have a par value that is to be determined by the Bank and 
is to be included in the capital plan;
    (2) May be issued at its par value or at a price other than its par 
value, as determined by the Bank;
    (3) Shall be redeemable in cash and at par value only on five-years 
written notice to the Bank;
    (4) Shall be subordinated to the stated dividend payable on the 
Class A stock; and
    (5) Shall confer an ownership interest in the retained earnings and 
paid-in surplus of the Bank upon acquisition of the stock by a member; 
and
    (c) Any one or more subclasses of Class A or Class B stock, each of 
which may have different rights, terms, conditions, or preferences, but 
each subclass also shall have all of the characteristics of its 
respective class, as specified in paragraph (a) or (b) of this section.


Sec. 931.2  Issuance of capital stock.

    (a) In general. A Bank may issue any one or more classes or 
subclasses of capital stock authorized by Sec. 931.1 and shall not 
issue any other class of capital stock. A Bank shall issue its stock 
only to its members and only in book-entry form, and the Bank shall act 
as its own transfer agent. All issuances of capital stock shall be in 
accordance with the provisions of an approved capital plan.
    (b) Initial issuance. In connection with the initial issuance of 
Class A or Class B stock (or any subclass of either), a Bank may issue 
such stock in exchange for its existing stock, through a conversion of 
its existing stock, or through any other fair and equitable method of 
distribution to the eligible purchasers, and may distribute its then-
existing unrestricted retained earnings as shares of Class B capital 
stock.
    (c) Membership and activity-based issuance. A Bank may issue 
capital stock as a requirement of membership only in accordance with 
Sec. 931.7, and may issue capital stock as a requirement for conducting 
business with the Bank only in accordance with Sec. 931.8.
    (d) Limitation on issuance. A Bank shall not issue stock to a 
member or group of affiliated members if the issuance would result in 
such member or group of affiliated members owning more than 40 percent 
of any class (including its subclasses) of the outstanding capital 
stock of the Bank, or such lesser percentage established in its capital 
plan pursuant to Sec. 931.9.


Sec. 931.3  Voting rights.

    (a) In general. (1) The capital plan of each Bank shall specify the 
manner in which the members of the Bank are to elect directors, shall 
specify the other corporate matters, if any, on which the members of 
the Bank may vote, shall describe the voting preferences, if any, to be 
given to any particular class or subclass of capital stock, and shall 
indicate whether any class or subclass of capital stock may be voted 
cumulatively and, if so, the matters on which such cumulative voting 
would be permitted.
    (2) A Bank that has issued any Class B stock shall assign voting 
rights to the Class B stock and, in its discretion, also may assign 
voting rights to its outstanding Class A stock or may assign voting 
rights to all members generally without regard to the class or number 
of shares of stock held by the members.
    (3) Within each class or subclass of capital stock to which the 
capital plan has assigned voting rights, each share of stock shall have 
equal voting rights, but a Bank may give voting preferences to one or 
more classes or subclasses of capital stock and may permit any class or 
subclass of capital stock to vote separately from the other classes and 
subclasses of capital stock.
    (4) No member or group of affiliated members of a Bank shall be 
permitted to

[[Page 43439]]

cast more than 20 percent of the votes eligible to be cast in any 
election by any class or subclass of capital stock on any matter on 
which the stockholders may vote. A Bank may establish a lower 
percentage limit in its capital plan.
    (b) Election of directors. (1) The number of elected directors for 
each Bank shall be as provided by section 7 of the Act (12 U.S.C. 
1427), except that the provisions of section 7 that require the elected 
directorships to be designated as representing the members located in 
each of the states within the Bank district and those provisions that 
require the number of votes each member may cast in an election to be 
determined based on the number of shares of Bank stock held by the 
member (or by the average number of shares held by all members in that 
state) as of the most recent year end shall not apply.
    (2) With regard to the election of directors, the capital plan may 
allocate the voting rights among the members on any reasonable basis, 
such as on the basis of the class (or subclass) of capital stock 
outstanding, the asset size of the members, or the states in which the 
members are located. The capital plan shall, to the extent feasible, 
provide for the representation on the board of directors of smaller 
members that own Class B stock, especially members that are community 
financial institutions.


Sec. 931.4  Dividends.

    (a) In general. A member, including a withdrawing member, shall be 
entitled to receive any dividends that a Bank declares on its capital 
stock for as long as the member owns the stock.
    (b) Class A stock. The capital plan of a Bank shall establish the 
basis on which the stated dividends on the Class A stock are to be 
calculated, and shall provide whether such dividends are to be 
cumulative or non-cumulative. Thereafter, the Bank shall pay dividends 
on the Class A stock in accordance with that method and shall pay such 
dividends before paying any dividends on the Class B stock of the Bank. 
After payment of the stated Class A dividend, the board of directors of 
the Bank, in its discretion, may augment the stated dividend, which may 
be paid before, concurrently with, or after payment of dividends on the 
Class B stock.
    (c) Class B stock. The board of directors of a Bank may authorize 
the payment of a dividend on the Class B stock, and shall determine the 
amount of such dividend. The board of directors may establish different 
dividend rates or preferences for different subclasses of the Class B 
stock, and may establish a dividend for one or more subclasses of the 
Class B stock that tracks the economic performance of certain Bank 
assets, such as Acquired Member Assets. Any dividend that tracks the 
performance of specific Bank assets shall be proportionately 
appropriate for the level of risk and profitability associated with the 
underlying assets. Any dividends on the Class B stock shall be payable 
only from the net earnings or retained earnings of the Bank, determined 
in accordance with GAAP, shall be paid only after the payment of the 
stated dividend on the Class A stock, and shall be non-cumulative.


Sec. 931.5  Preferences on liquidation, merger, or consolidation.

    In the event of a liquidation, merger, or other consolidation of a 
Bank, the holders of the Class A stock shall be entitled to receive the 
par value of their stock, plus any accumulated dividends, before the 
Bank or its successor may redeem, or pay any dividends on, the 
outstanding Class B stock that had been issued by the Bank that has 
been liquidated, merged, or consolidated.


Sec. 931.6  Transfer of capital stock.

    (a) A member of a Bank may transfer the capital stock of the Bank 
only to another member of the Bank or to an institution that is in the 
process of becoming a member of the Bank. Any such stock transfers 
shall be at a price agreed to by the parties.
    (b) No Bank shall permit the transfer of any class (including 
subclasses) of its capital stock to a member, or group of affiliated 
members, to the extent that such transfer would result in that member 
or group of members owning more than 40 percent of such class or 
subclass of the capital stock of the Bank, or such lesser percentage 
established in its capital plan pursuant to Sec. 931.9. In the event of 
a transfer of Bank stock that occurs as a result of a merger, 
acquisition, or other consolidation of two or more members of a Bank 
that results in the surviving member holding more than 40 percent of 
any class or subclass of Bank stock, the Bank and the member shall 
agree to a plan for the member to divest any stock pursuant to 
Sec. 931.9.


Sec. 931.7  Membership investment in capital stock.

    A Bank may require each member to invest in the Class A stock of 
the Bank as a condition to becoming and remaining a member of the Bank. 
If a Bank establishes such a mandatory membership investment, it shall 
allow each member the option of satisfying the requirement by investing 
a lesser proportional amount in Class B stock, as determined by the 
Bank. If a Bank is at or above its operating total capital ratio and 
its operating risk-based capital ratio, it shall not require members to 
purchase capital stock. A Bank also may establish an annual membership 
fee to be assessed in lieu of a mandatory stock investment for its 
members.

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


Sec. 931.8  Activity-based stock purchase requirement.

    (a) In general. As a condition for entering into a particular 
business transaction with a member, a Bank may require the member to 
purchase an amount of Class A or Class B stock.
    (b) Alternative arrangements. A Bank may enter into a written 
contractual agreement with a member under which the member commits to 
purchase a specific number of shares of a particular class or classes 
of Bank stock at a specified price, with the purchase to be completed 
and all payments made at a future date to be determined by the Bank, 
and such agreement may be used to satisfy the activity-based stock 
purchase requirement in paragraph (a) of this section, if the use of 
such alternative arrangements is approved as part of the Bank's capital 
plan.
    (c) Limitations. The amount of Class B stock that a Bank may 
require a member to purchase under paragraph (a) of this section shall 
be based on the risk characteristics associated with the type and 
duration of asset to be acquired by the Bank as a result of the 
particular transaction with that member. A Bank shall not require a 
member to purchase any Class B capital stock either under paragraph (a) 
or paragraph (b) of this section to the extent that the amount of stock 
to be purchased would cause the Bank to exceed its operating total 
capital ratio and operating risk-based capital ratio.
    (d) Retention of stock. A Bank shall not prohibit a member that has 
purchased capital stock in accordance with this section from selling 
the stock to another member, subject to the limitations of Sec. 931.11.

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


Sec. 931.9  Concentration limits.

    No member, or group of affiliated members, of a Bank shall own more 
than 40 percent of any class (including,

[[Page 43440]]

in the aggregate, all subclasses of a class) of the outstanding capital 
stock of the Bank, or such lower limit established in the capital plan. 
If at a given time, a member, or group of affiliated members, of a Bank 
acquires stock such that they own more than 40 percent of any class 
(including, in the aggregate, all subclasses of any class) of the 
outstanding capital stock of the Bank, or such lower limit established 
in the capital plan, the Bank and member (or members) shall agree to a 
plan under which the member (or members) will divest sufficient shares 
of such stock as necessary to comply with this section.

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


Sec. 931.10  Redemption and purchase of capital stock.

    (a) Redemption. A member may redeem capital stock of the Bank by 
providing the requisite written notice to the Bank of its intent to 
redeem the stock. For Class A stock, a member shall provide 6 months 
written notice, and for Class B stock a member shall provide 5 years 
written notice. At the expiration of the applicable notice period, the 
member shall be entitled to receive from the Bank the par value of the 
stock in cash. A member shall not have pending at any one time more 
than one notice of redemption for any class of Bank stock. A Bank may 
impose a fee, as specified in its capital plan, on a member that 
cancels a pending notice of redemption.
    (b) Purchase. A Bank shall not be obligated to redeem its capital 
stock other than in accordance with paragraph (a) of this section, but 
a Bank, in its discretion, may purchase its outstanding Class A or 
Class B capital stock at any time at a negotiated price.


Sec. 931.11  Capital impairment.

    A Bank may not redeem or purchase any capital stock without the 
prior written approval of the Finance Board if the Bank is not in 
compliance with any regulatory capital requirement or would fall out of 
compliance with any regulatory capital requirement as a result of the 
redemption or purchase.

PART 932--FEDERAL HOME LOAN BANK CAPITAL REQUIREMENTS

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

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


Sec. 932.1  Capital provisions transition requirements.

    (a) General transition provision. Not later than three years after 
the effective date of its capital plan, each Bank shall:
    (1) Have sufficient total capital to comply with the requirement of 
Sec. 932.2 and
    (2) Have sufficient permanent capital to comply with the 
requirement of Sec. 932.3.
    (b) Risk management. Before its new capital structure may take 
effect, each Bank shall obtain the approval of the Finance Board for 
the internal market risk model or a cash flow model used to calculate 
the market risk component of its risk-based capital requirement, and 
for the risk assessment procedures and controls (whether established as 
part of its risk management policy or otherwise) to be used to manage 
its credit, market, and operations risks.
    (c) Financial Management Policy. After obtaining the approvals 
required by paragraph (b) and as of the end of the transition period 
specified in its capital plan, a Bank shall be governed exclusively by 
the capital requirements of Sec. 932.2 or Sec. 932.3. Until such date, 
the risk management requirements of the Financial Management Policy 
shall continue to apply to that Bank.
    (d) Issuance of capital stock. Until a Bank has issued capital 
stock in accordance with its approved capital plan, it shall continue 
to be governed by the minimum stock purchase and stock retention 
requirements of the Act, as in effect on November 11, 1999. Upon the 
initial issuance of stock in accordance with its capital plan, the 
minimum stock purchase and stock retention requirements of the Act as 
in effect on November 11, 1999, will cease to apply to that Bank and 
the purchase and retention of capital stock by its members shall be 
governed by the approved capital plan and other applicable regulations.


Sec. 932.2  Total capital requirement.

    (a) Each Bank shall maintain at all times total capital in an 
amount equal to at least 4.0 percent of the Bank's total assets.
    (b) Each Bank also shall maintain at all times a leverage ratio of 
total capital to total assets of at least 5.0 percent of the Bank's 
total assets, where the ratio is computed by multiplying the Bank's 
permanent capital by 1.5 and all other components of total capital are 
included at face value.
    (c) For reasons of safety and soundness, the Finance Board may 
require an individual Bank to have and maintain more total capital than 
mandated by paragraph (a) of this section.


Sec. 932.3  Risk-based capital requirement.

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


Sec. 932.4  Credit risk capital requirement.

    (a) General requirement. A Bank's credit risk capital requirement 
shall be equal to the sum of the Bank's credit risk capital charges for 
all on-balance sheet assets and off-balance sheet items.
    (b) Credit risk capital charge for on-balance sheet assets. Except 
as provided in paragraph (h)(1) of this section, a Bank's credit risk 
capital charge 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 asset pursuant to paragraph 
(d)(2) of this section.
    (c) Credit risk capital charge for off-balance sheet items. Except 
as provided in paragraph (h)(2) of this section, a Bank's credit risk 
capital charge 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 
item pursuant to paragraph (d)(2) 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, the specific credit risk percentage requirements set 
forth in Tables 1.1 through 1.4 of this part applicable to a Bank's on-
balance sheet assets and credit equivalent amounts of its off-balance 
sheet items.
    (2) Bank determination of specific credit risk percentage 
requirements. (i) Each Bank shall determine the credit risk percentage 
requirement applicable

[[Page 43441]]

to the book value of each on-balance sheet asset and the on-balance 
sheet equivalent value of each off-balance sheet item by identifying 
the category set forth in Table 1.1, Table 1.2, Table 1.3 or Table 1.4 
of this part to which the asset or item belongs based upon, as 
applicable, the type of asset or item, its demonstrated credit rating 
(as determined in accordance with paragraphs (d)(2)(ii) and (d)(2)(iii) 
of this section), and its remaining maturity. The applicable credit 
risk percentage requirement for a specific on-balance sheet asset or 
off-balance sheet item shall be used to calculate the credit risk 
capital charge for such asset or item in accordance with paragraphs (b) 
or (c) of this section respectively. The relevant categories and credit 
risk percentage requirements are provided in the following Tables 1.1 
through 1.4 of this part:

                  Table 1.1.--Requirement for Advances
------------------------------------------------------------------------
                                                            Percentage
                                                           applicable to
                                                            on-balance
                    Type of Advances                           sheet
                                                            equivalent
                                                               value
------------------------------------------------------------------------
Advances with:
    Remaining maturity = 4 years........................            0.07
    Remaining maturity > 4 years to 7 years.............            0.20
    Remaining maturity > 7 years to 10 years............            0.40
    Remaining maturity > 10 years.......................            0.45
------------------------------------------------------------------------


         Table 1.2.--Requirement for Residential Mortgage Assets
------------------------------------------------------------------------
                                                            Percentage
                                                           applicable to
                                                            on-balance
           Type of residential mortgage asset                  sheet
                                                            equivalent
                                                               value
------------------------------------------------------------------------
Highest Investment Grade................................            0.45
Second Highest Investment Grade.........................            0.55
Third Highest Investment Grade..........................            0.90
Fourth Highest Investment Grade.........................            3.40
If Downgraded to Below Investment Grade After
 Acquisition By Bank:
    Highest Below Investment Grade......................           35.00
    Second Highest Below Investment Grade...............          100.00
    All Other Below Investment Grade....................          100.00
------------------------------------------------------------------------


                          Table 1.3.--Requirement for Rated Assets or Items Other Than Advances or Residential Mortgage Assets
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                               Percentage applicable to on-balance sheet equivalent value
                                                              ------------------------------------------------------------------------------------------
                                                                    =year        >1 yr to 3 yrs     >3 yrs to 7yrs     >7 yrs to 10 yrs       >10 yrs
--------------------------------------------------------------------------------------------------------------------------------------------------------
U.S. Government Securities...................................            0.00               0.00               0.00                 0.00            0.00
Highest Investment Grade.....................................            0.15               0.44               0.88                 1.45            2.05
Second Highest Investment Grade..............................            0.15               0.47               1.00                 1.50            2.35
Third Highest Investment Grade...............................            0.20               1.80               2.50                 3.30            4.30
Fourth Highest Investment Grade..............................            1.30               2.90               4.20                 5.20            6.80
If Downgraded Below Investment Grade After Acquisition by
 Bank:
    Highest Below Investment Grade...........................            5.00              15.00              17.00                18.00           20.00
    Second Highest Below Investment Grade....................           22.00              35.00              37.00                37.00           37.00
    All Other................................................          100.00             100.00             100.00               100.00          100.00
--------------------------------------------------------------------------------------------------------------------------------------------------------


               TABLE 1.4.--Requirement for Unrated Assets
------------------------------------------------------------------------
                                                            Percentage
                                                           applicable to
                                                            on-balance
                  Type of unrated asset                        sheet
                                                            equivalent
                                                               value
------------------------------------------------------------------------
Cash....................................................            0.00
Premises, Plant, and Equipment..........................            8.00
Investments Under Sec.  940.3(a)(5) of this chapter.....            8.00
------------------------------------------------------------------------

    (ii) When determining the credit rating used to identify the 
applicable credit risk percentage requirement from Tables 1.2 and 1.3 
of this part, each Bank shall apply the following criteria:

[[Page 43442]]

    (A) For assets or items that are rated directly by an NRSRO, the 
credit rating shall be the NRSRO's credit rating for the asset or item 
as determined in accordance with paragraph (d)(2)(iii) of this section.
    (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 corresponding obligor counterparty, third 
party guarantor, or collateral backing the asset or item, the credit 
rating that shall apply to the asset or item, or portion of the asset 
or item, so guaranteed or collateralized, shall be the credit rating 
corresponding to such obligor counterparty, third party guarantor, or 
underlying collateral, as determined in accordance with paragraphs 
(d)(2)(iii) of this section. If there are multiple obligor 
counterparties, third party guarantors, or collateral instruments 
backing an asset or item not rated directly by an NRSRO, or any 
specific portion thereof, then the credit rating that shall apply to 
that asset or item, or specific portion thereof, shall be the highest 
credit rating among such obligor counterparties, third party 
guarantors, or collateral instruments, as determined in accordance with 
paragraph (d)(2)(iii) of this section. Assets or items shall be deemed 
to be backed by collateral for purposes of this paragraph if the 
collateral is:
    (1) Actually held by the Bank or an independent, third-party 
custodian, or by the Bank's member if permitted under the Bank's 
collateral agreement with such party;
    (2) Legally available to absorb losses;
    (3) Of a readily determinable value at which it can be liquidated 
by the Bank;
    (4) Held in accordance with the provisions of the Bank's member 
products policy established pursuant to Sec. 917.4 of this chapter; and
    (5) Subject to an appropriate discount reflecting the price risk 
underlying the collateral.
    (C) For residential mortgage assets and other assets or items, or 
relevant portion of an asset or item, that do not meet the requirements 
of paragraphs (d)(2)(ii)(A) or (d)(2)(ii)(B) of this section, and are 
not identified in Tables 1.1 or Table 1.4 of this part, the Bank shall 
determine its own credit rating for such assets or items, or relevant 
portion thereof, using credit rating standards available from an NRSRO 
or other similar standards. This credit rating, as determined by the 
Bank, shall be used to identify the correct credit risk percentage 
requirement under Table 1.2 of this part for residential mortgage 
assets, or under Table 1.3 of this part for all other assets or items.
    (iii) In determining the credit ratings under paragraph 
(d)(2)(ii)(A) and (d)(2)(ii)(B) of this section, a Bank shall apply the 
following criteria:
    (A) 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);
    (B) Where a specific asset or item has received more than one 
credit rating from a given NRSRO, the most recent credit rating shall 
be used;
    (C) Where a specific asset or item has received credit ratings from 
more than one NRSRO, the lowest credit rating shall be used.
    (e) Calculation of credit equivalent amount for off-balance sheet 
items other than derivative contracts. (1) General requirement. 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 shall be equal to the face amount of the instrument multiplied 
by the credit conversion factor assigned to such risk category of 
instruments, subject to the exceptions in paragraph (e)(2) of this 
section, provided in the following Table 2 of this part:

  Table 2.--Credit Conversion Factors for Off-Balance Sheet Items Other
                        Than Derivative Contracts
------------------------------------------------------------------------
                                                              Credit
                                                            conversion
                       Instrument                           factor  (in
                                                             percent)
------------------------------------------------------------------------
Asset sales with recourse where the credit risk remains              100
 with the Bank..........................................
Sale and repurchase agreements
Forward asset purchases
Commitments to make advance, or other loans
Standby letters of credit...............................              50
Other commitments with original maturity of over one
 year
Other commitments with original maturity of one year or               20
 less...................................................
------------------------------------------------------------------------

    (2) Exceptions. The credit conversion factor shall be zero for 
Other Commitments With Original Maturity of Over One Year and Other 
Commitments With Original Maturity of One Year or Less, for which 
credit conversion factors of 50 percent or 20 percent would otherwise 
apply, that are unconditionally cancelable, or that effectively provide 
for automatic cancellation, due to the deterioration in a borrower's 
creditworthiness, at any time by the Bank without prior notice.
    (f) Calculation of credit equivalent amount for single derivative 
contracts. (1) General requirement. The credit equivalent amount for a 
derivative contract that is not subject to a qualifying bilateral 
netting contract shall be the sum of the current credit exposure and 
the potential future credit exposure of the derivative contract, where 
the current credit exposure is determined in accordance with paragraph 
(f)(2) of this section and the potential future credit exposure is 
determined in accordance with paragraph (f)(3) of this section.
    (2) 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.
    (3) 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 notional amount of the derivative 
contract by one of the assigned credit conversion factors, modified as 
may be required by paragraph (f)(3)(ii) of this section, for the 
appropriate category as provided in the following Table 3 of this part:

[[Page 43443]]



          Table 3.--Credit Conversion Factors for Potential Future Credit Exposure Derivative Contracts
                                                  [Iin percent]
----------------------------------------------------------------------------------------------------------------
                                                     Foreign                         Precious
       Residual maturity         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
----------------------------------------------------------------------------------------------------------------

    (ii) In applying the credit conversion factors in Table 3 of this 
part the following modifications shall be made:
    (A) For derivative contracts with multiple exchanges of principal, 
the conversion factors are multiplied by the number of remaining 
payments in the derivative contract; and
    (B) For derivative contracts that automatically reset to zero value 
following a payment, the residual maturity equals the time until the 
next payment; however, interest rate contracts with remaining 
maturities of greater than one year shall be subject to a minimum 
conversion factor of 0.5 percent.
    (iii) If a Bank uses an internal model to determine the potential 
future credit exposure for a particular type of derivative contract, 
the Bank shall use the same model for all other similar types of 
contracts. However, the Bank may use an internal model for one type of 
derivative contract and Table 3 of this part for another type of 
derivative contract.
    (iv) Forwards, swaps, purchased options and similar derivative 
contracts not included in the Interest Rate, Foreign Exchange and Gold, 
Equity, or Precious Metals Except Gold categories shall be treated as 
Other Commodities contracts when determining potential future credit 
exposures using Table 3 of this part.
    (v) If a Bank uses Table 3 of this part to determine the potential 
future credit exposures for credit derivatives contracts, the credit 
conversion factors provided in Table 3 for Interest Rate contracts 
shall also apply to the credit derivative contracts.
    (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, where:
    (i) The net current credit exposure equals:
    (A) The net sum of all positive and negative mark-to-market values 
of the individual derivative contracts subject to a qualifying 
bilateral netting contract, if the net sum of the mark-to-market values 
is positive; or
    (B) Zero, if the net sum of the mark-to-market values is zero or 
negative; and
    (ii) The adjusted sum of the potential future credit exposure 
(Anet) is calculated as follows:

Anet = 0.4  x  Agross + (0.6  x  NGR  x  
Agross), where:

(A) Agross is the gross potential future credit exposure, 
i.e., the sum of the potential future credit exposure, calculated in 
accordance with paragraph (f)(3) of this section, for each individual 
derivative contract subject to the qualifying bilateral netting 
contract;
(B) NGR is the net to gross ratio, i.e., the ratio of the net current 
credit exposure to the gross current credit exposure; and
(C) 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 non-corporate 
entities, and if a branch of the counterparty is involved, then also 
under the law of the jurisdiction in which the branch is located;
    (B) The law of the jurisdiction that governs the individual 
derivative contracts covered by the netting contract; and
    (C) The law of the jurisdiction that governs the netting contract;
    (v) The Bank establishes and maintains procedures to monitor 
possible changes in relevant law and to ensure that the netting 
contract continues to satisfy the requirements of this section; and
    (vi) The Bank maintains in its files documentation adequate to 
support the netting of a derivative contract.
    (h) Exceptions. (1) Specific credit risk capital charge for on-
balance sheet assets hedged with credit derivatives. The credit risk 
capital charge for an on-balance sheet asset shall be zero if a credit 
derivative is used to hedge the credit risk on that asset, provided 
that:
    (i) Either:
    (A) The credit derivative and the on-balance sheet asset are of 
identical remaining maturity, and the asset being referenced in the 
credit derivative is identical to the underlying asset;
    (B) If the on-balance sheet asset and the asset referenced in the 
credit derivative are identical, but the remaining maturities of the 
on-balance sheet asset and the credit derivative are different, the 
remaining maturity of the credit derivative is two years or more; or
    (C) If the remaining maturities of the on-balance sheet asset and 
the credit derivative are identical, but the on-balance sheet asset is 
different from the asset referenced in the credit derivative,

[[Page 43444]]

the asset referenced in the credit derivative and the on-balance sheet 
asset have been issued by the same obligor, the asset referenced in the 
credit derivative ranks pari passu to or more junior than the on-
balance sheet asset, and cross-default clauses apply; and
    (ii) The credit risk capital charge for the credit derivative 
contract calculated pursuant to paragraph (c) of this section is still 
applied.
    (2) Specific credit risk capital charge for certain derivative 
contracts. The credit risk capital charge for the following derivative 
contracts shall be zero:
    (i) An exchange rate contract with an original maturity of 14 
calendar days or less (gold contracts do not qualify for this 
exception); and
    (ii) A derivative contract that is traded on an exchange requiring 
the daily payment of any variations in the market value of the 
contract.
    (i) Date of calculations. Unless otherwise directed by the Finance 
Board, a Bank must perform all calculations required by this section 
using the assets and off-balance sheet items held by the Bank, and, if 
applicable, the values or credit ratings of such assets or items, as of 
the close of business of the last business day of the month for which 
the credit risk capital charge is being calculated.


Sec. 932.5  Market risk capital requirement.

    (a) General requirement. (1) A Bank's market risk capital 
requirement shall equal the sum of:
    (i) The market value of the Bank's portfolio at risk from movements 
in interest rates, foreign exchange rates, commodity prices, and equity 
prices that could occur during periods of market stress, where the 
market value of the Bank's portfolio at risk is determined using an 
internal market risk model that fulfills the requirements of paragraph 
(b) of this section and that has been approved by the Finance Board; 
and
    (ii) The amount, if any, by which the Bank's current market value 
of total capital is less than 95 percent of the Bank's book value of 
total capital, where:
    (A) The current market value of the total capital is calculated by 
the Bank after determining the current market value of its assets, 
liabilities and off-balance sheet items using the internal market risk 
model, or cash flow model, approved by the Finance Board under 
paragraph (d) of this section; and
    (B) The book value of the Bank's total capital is calculated in 
accordance with GAAP.
    (2) A Bank may substitute a cash-flow model to derive a market risk 
capital requirement comparable to that calculated using an internal 
risk model under paragraph (a)(1) of this section, provided that:
    (i) The Bank obtains Finance Board approval of the cash-flow model 
and of the assumptions to be applied to the model; and
    (ii) The Bank demonstrates to the Finance Board that the cash flow 
model considers the same factors and a comparable degree of stress as 
required for an internal market risk model and as set forth in 
paragraph (b) of this section, taking into account the difference in 
model structure.
    (b) Measurement of market value at risk under a Bank's internal 
market risk model. (1) Each Bank shall use an internal market risk 
model that estimates the market value of the Bank's on-balance sheet 
assets and liabilities and off-balance sheet items, including related 
options, and measures the market value of the Bank's portfolio at risk 
of its on-balance sheet assets and liabilities and of off-balance sheet 
items, including related options, from all sources of the Bank's market 
risks, except that a Bank's model need only incorporate those risks 
that are material.
    (2) The Bank's internal market risk model may use any generally 
accepted measurement technique, such as variance-covariance models, 
historical simulations, or Monte Carlo simulations, for estimating the 
market value of the Bank's portfolio at risk, provided that any 
measurement technique used must cover the Bank's material risks.
    (3) The measures of the market value of the Bank's portfolio at 
risk shall include the risks arising from the non-linear price 
characteristics of options and the sensitivity of the market value of 
options to changes in the volatility of the options' underlying rates 
or prices.
    (4) The Bank's internal market risk model shall use interest rate 
and market price scenarios for estimating the market value of the 
Bank's portfolio at risk, but at a minimum:
    (i) The Bank's internal market risk model must provide an estimate 
of the market value of the Bank's portfolio at risk such that the 
probability of a loss greater than that estimated shall be no more than 
one percent;
    (ii) The Bank's internal market risk model must incorporate 
scenarios that reflect changes in interest rates, interest rate 
volatility, and shape of the yield curve, and changes in market prices, 
equivalent to those that have been observed over 120-business day 
periods of market stress. For interest rates, the relevant historical 
observation period is to start from the end of the previous month and 
to go back to the beginning of 1978; and
    (iii) The measure of the market value of the Bank's portfolio at 
risk may incorporate empirical correlations among interest rates, 
subject to a Finance Board determination that the model's system for 
measuring such correlations is sound.
    (5) For any consolidated obligations denominated in a currency 
other than U.S. Dollars or linked to equity or commodity prices, the 
Bank must meet the following requirements:
    (i) The relevant foreign exchange, equity price or commodity price 
risks associated with the consolidated obligations must be hedged in 
accordance with Sec. 956.6:
    (ii) In addition to fulfilling the criteria of paragraph (b)(4) of 
this section, the Bank's internal market risk model must calculate an 
estimate of the market value of the Bank's portfolio at risk due to the 
material foreign exchange, equity price or commodity price risk, such 
that, at a minimum:
    (A) The probability of a loss greater than that estimated must not 
exceed one percent;
    (B) The scenarios reflect changes in foreign exchange, equity, or 
commodity market prices that have been observed over 120-business day 
periods of market stress, as determined using historical data that is 
from an appropriate period and satisfactory to the Finance Board; and
    (C) The measure of the market value of the Bank's portfolio at risk 
may incorporate empirical correlations within or among foreign exchange 
rates, equity prices, or commodity prices, subject to a Finance Board 
determination that the model's system for measuring such correlations 
is sound; and
    (iii) If there is a default on the part of a counterparty to a 
derivative or hedging contract linked to foreign exchange, equities or 
commodities, 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 or 
cash flow model. (1) Each Bank shall conduct an independent validation 
of its internal market risk model or cash flow model within the Bank 
that is carried out by personnel not reporting to the business line 
responsible for conducting business transactions for the Bank. 
Alternatively, the Bank may obtain independent validation by an outside 
party qualified to make such determinations. Validations will be done 
on an annual

[[Page 43445]]

basis, or more frequently as required by the Finance Board.
    (2) The results of such independent validations shall be reviewed 
by the Bank's board of directors and provided promptly to the Finance 
Board.
    (d) Finance Board approval of Bank internal market risk model or 
cash flow model. Each Bank shall obtain approval from the Finance Board 
of its internal market risk model or its cash flow model, including 
subsequent material adjustments to the model made by the Bank prior to 
its use. A Bank shall make all adjustments to its model that may be 
directed by the Finance Board.
    (e) Date of calculations. Unless otherwise directed by the Finance 
Board, a Bank must perform any calculations or estimates required under 
this section using the on-balance sheet assets and liabilities and off-
balance sheet items held by the Bank, and if applicable, the values of 
any such holdings, as of the close of business of the last business day 
of the month for which the market risk capital requirement is being 
calculated.


Sec. 932.6  Operations risk capital requirement.

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


Sec. 932.7  Reporting requirements.

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


Sec. 932.8  Minimum liquidity requirements.

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


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

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

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

    (3) Bank determination of applicable credit ratings. In determining 
the applicable credit rating category under Table 4 of this part, the 
following criteria shall be applied:
    (i) If a counterparty has received more than one rating from a 
given NRSRO, the most recent credit rating shall be used;
    (ii) If a counterparty has received credit ratings from more than 
one NRSRO, the lowest credit rating shall be used;
    (iii) If a counterparty has received different credit ratings for 
its transactions with short-term and long-term maturities:
    (A) The higher credit rating shall apply for purposes of 
determining the allowable maximum capital exposure limit applicable to 
the total amount of unsecured credit extended by the Bank to such 
counterparty; and
    (B) The lower credit rating shall apply for purposes of determining 
the allowable maximum capital exposure limit applicable to the amount 
of unsecured credit extended by the Bank to such counterparty for the 
transactions with maturities governed by that rating.
    (iv) If a counterparty is placed on a credit watch for a potential 
downgrade by an NRSRO, the credit rating from that NRSRO at the next 
lower grade shall be used; and
    (v) If a counterparty is not rated by a NRSRO, the Bank shall 
determine the applicable credit rating by using credit rating standards 
available from an NRSRO or other similar standards.
    (b) Unsecured extensions of credit to affiliated counterparties. 
The total amount of unsecured extensions of credit by a Bank to all 
affiliated counterparties shall not exceed the product of the maximum 
capital exposure limit provided under Table 4 of this part based upon 
the highest credit rating of the affiliated counterparties, as 
determined in accordance with paragraph (a)(3) of this section, 
multiplied by the lesser of:
    (1) The Bank's total capital; or
    (2) The combined Tier 1 capital, or total capital (as defined by 
each affiliated counterparty's principal regulator) if Tier 1 capital 
is not available, of all of the affiliated counterparties.
    (c) Reporting requirements. (1) Total unsecured extensions of 
credit. Each Bank shall report monthly to the Finance Board the amount 
of the Bank's total unsecured extensions of credit arising from on- and 
off-balance sheet transactions to any single counterparty or group of 
affiliated counterparties that exceeds 5 percent of:
    (i) The Bank's total capital; or
    (ii) The counterparty's, or affiliated counterparties' combined, 
Tier 1 capital, or total capital (as defined by each counterparty's 
principal regulator) if Tier 1 capital is not available.
    (2) Total secured and unsecured extensions of credit. Each Bank 
shall

[[Page 43446]]

report monthly to the Finance Board the amount of the Bank's total 
secured and unsecured extensions of credit arising from on- or off-
balance sheet transactions to any single counterparty or group of 
affiliated counterparties that exceeds 5 percent of the Bank's total 
assets.

PART 933--BANK CAPITAL STRUCTURE PLANS

Sec.
933.1   Submission of plan.
933.2   Contents of plan.
933.3   Implementation of plan.

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


Sec. 933.1  Submission of Plan.

    (a) In general. Within 270 days after the date of publication of 
the final capital rule, the board of directors of each Bank shall 
submit to the Finance Board a capital plan that would establish a new 
capital structure for the Bank and that would provide sufficient 
capital for the Bank to comply with its regulatory total capital 
requirement and regulatory risk-based capital requirement. The Finance 
Board, upon a demonstration of good cause, may approve a reasonable 
extension of the 270-day period for submission of the plan. A Bank may 
not implement its capital plan, or any amendment to the plan, until 
after the Finance Board has approved the plan or amendment, and the 
Finance Board shall determine the effective date for each capital plan.
    (b) Failure to submit a capital plan. If a Bank fails to submit a 
capital plan to the Finance Board within the 270 day period, including 
any approved extension, the Finance Board may establish a capital plan 
for that Bank, take any enforcement action against the Bank, its 
directors, or its executive officers section 2B(a)(5) of the Act (12 
U.S.C. 1422b(a)(5)), or merge the Bank in accordance with section 26 of 
the Act (12 U.S.C. 1446) into another Bank that has submitted an 
acceptable capital plan.


Sec. 933.2  Contents of Plan.

    The capital plan for each Bank shall include, at a minimum, the 
following provisions:
    (a) Classes of capital stock. The capital plan shall:
    (1) Indicate each class or subclass of capital stock that the Bank 
will offer to its members;
    (2) Indicate the terms, rights, and preferences for each class and 
subclass of capital stock to be issued by the Bank;
    (3) Provide that the payment for Class B stock confers on the 
member an ownership interest in the retained earnings and paid-in 
surplus of the Bank;
    (4) Specify the manner in which the members of the Bank are to 
elect directors, specify the other corporate matters, if any, on which 
the members of the Bank may vote, describe the voting preferences, if 
any, to be given to any particular class or subclass of capital stock, 
and indicate whether any class or subclass of capital stock may be 
voted cumulatively and, if so, the matters on which such cumulative 
voting would be permitted; and
    (5) Establish the basis on which the stated dividends on the Class 
A stock are to be calculated, and provide whether such dividends are to 
be cumulative or non-cumulative.
    (b) Capital stock issuance. The capital plan shall:
    (1) Describe the manner in which the Bank intends to solicit its 
members for voluntary purchases of its capital stock; and
    (2) Specify the operating total capital ratio and the operating 
risk-based capital ratio at which the Bank intends to operate, which 
shall be greater than the regulatory total capital requirement and 
regulatory risk-based capital requirement, respectively.
    (c) Membership investment or fee structure. The capital plan shall:
    (1) Require, as a condition of membership, that a member either 
maintain a specified investment in the Class A stock of the Bank or pay 
to the Bank an annual membership fee, and describe the method used by 
the Bank to calculate such investment or fee;
    (2) Allow each member that is required to invest in the capital 
stock of the Bank the option of investing in Class B stock, if 
authorized by the Bank, rather than in the Class A stock, in some 
lesser amount as determined by the Bank, subject to Sec. 931.7 of this 
subchapter;
    (3) Require the board of directors of the Bank to review and adjust 
the membership investment periodically to ensure that the Bank complies 
with the regulatory total capital requirement and the regulatory risk-
based capital requirement;
    (4) Require members to comply promptly with any adjusted membership 
investment; and
    (5) Specify a fee, if any, on a member that cancels a notice of 
withdrawal or a notice of redemption and describe the method used by 
the Bank to calculate such fees.
    (d) Transfer of Bank stock. The capital plan shall:
    (1) Establish the criteria for the issuance, redemption, 
retirement, or purchase of Bank stock by the Bank, and for the transfer 
of Bank stock between members of the Bank;
    (2) Provide that the stock of the Bank may only be issued to or 
held by the members of the Bank, and that no entities other than the 
Bank or its members may trade the stock of the Bank; and
    (3) Specify the maximum percentage of a class or subclass of stock 
a Bank may transfer to a member, or group of affiliated members, not to 
exceed 40 percent of any class or subclass of stock.
    (e) Termination of membership. The capital plan shall address the 
manner in which the Bank will provide for the disposition of its 
capital stock that is held by institutions that terminate their 
membership, and the manner in which the Bank will liquidate claims 
against its members, including claims resulting from prepayment of 
advances prior to their stated maturity.
    (f) Independent review of plan. The capital plan shall include the 
report from an independent certified public accountant regarding the 
extent to which the implementation of the plan would affect the 
redeemable stock issued by the Bank and the report from an NRSRO 
regarding the extent to which the implementation of the plan would 
affect the credit rating of the Bank.
    (g) Implementation. The capital plan shall demonstrate that the 
Bank has made a good faith determination that the Bank will be able to 
implement the plan as submitted and that the Bank will be in compliance 
with its regulatory total capital requirement and its regulatory risk-
based capital requirement after the plan is implemented.

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


Sec. 933.3  Implementation of Plan.

    (a) In general. Each Bank's capital plan shall:
    (1) Provide for the manner in which the Bank shall issue Class A or 
Class B stock (or any subclass of either), which may be through an 
exchange for its existing stock, a conversion of its existing stock, or 
any other fair and equitable method of distribution to eligible 
purchasers;
    (2) Provide what shall happen to the existing Bank stock owned by a 
member that does not affirmatively elect to convert or exchange its 
existing Bank stock into either Class A or Class B stock, or some 
combination thereof; and
    (3) Include a transition provision that specifies the date on which 
the plan is to take effect, and that specifies the date,

[[Page 43447]]

not to exceed three years from the effective date of the plan, on which 
the Bank shall be in full compliance with its regulatory total capital 
requirement and regulatory risk-based capital requirement.
    (b) Member transition. The capital plan for each Bank may include a 
provision allowing any institution that was a member of the Bank on 
November 12, 1999, a period of up to three years from the effective 
date of the plan in which to comply with the membership investment 
requirements of the capital plan.

PART 956--FEDERAL HOME LOAN BANK INVESTMENTS

    15. The authority citation for part 956 continues to read as 
follows:

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

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


Sec. 956.4  Use of hedging instruments.

    (a) Applicability of GAAP. Derivative instruments that do not 
qualify as hedging instruments pursuant to GAAP may be used only if a 
non-speculative use is documented by the Bank.
    (b) Documentation requirements. (1) Transactions with a single 
counterparty shall be governed by a single master agreement when 
practicable.
    (2) A Bank's agreement with the counterparty for over-the-counter 
derivative contracts shall include:
    (i) A requirement that market value determinations and subsequent 
adjustments of collateral be made at least on a monthly basis;
    (ii) A statement that failure of a counterparty to meet a 
collateral call will result in an early termination event;
    (iii) A description of early termination pricing and methodology, 
with the methodology reflecting a reasonable estimate of the market 
value of the over-the-counter derivative contract at termination 
(Standard International Swaps and Derivatives Association, Inc. 
language relative to early termination pricing and methodology may be 
used to satisfy this requirement); and
    (iv) A requirement that the Bank's consent be obtained prior to the 
transfer of an agreement or contract by a counterparty.
    17. In subchapter G, add a new part 960 to read as follows:

PART 960--OFF-BALANCE SHEET ITEMS

Sec.
960.1   Definitions.
960.2   Authorized off-balance sheet items.

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


Sec. 960.1  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. 960.2  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 961;
    (2) Derivative contracts;
    (3) Forward asset purchases and sales; and
    (4) Commitments to make advances or other loans.
    (b) Speculative use prohibited. Derivative instruments that do not 
qualify as hedging instruments pursuant to GAAP may be used only if a 
non-speculative use is documented by the Bank.

    Dated: May 22, 2000.

    By the Board of Directors of the Federal Housing Finance Board.
Bruce A. Morrison,
Chairman.
[FR Doc. 00-17153 Filed 7-12-00; 8:45 am]
BILLING CODE 6725-01-P