[Federal Register Volume 66, Number 208 (Friday, October 26, 2001)]
[Proposed Rules]
[Pages 54168-54170]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-26934]


 ========================================================================
 Proposed Rules
                                                 Federal Register
 ________________________________________________________________________
 
 This section of the FEDERAL REGISTER contains notices to the public of 
 the proposed issuance of rules and regulations. The purpose of these 
 notices is to give interested persons an opportunity to participate in 
 the rule making prior to the adoption of the final rules.
 
 ========================================================================
 

  Federal Register / Vol. 66, No. 208 / Friday, October 26, 2001 / 
Proposed Rules  

[[Page 54168]]



NATIONAL CREDIT UNION ADMINISTRATION

12 CFR Part 703


Investment and Deposit Activities

AGENCY: National Credit Union Administration (NCUA).

ACTION: Advance notice of proposed rulemaking.

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

SUMMARY: NCUA is soliciting public comment on whether it should revise 
its rules governing federal credit union (FCU) investment authorities 
and practices. As part of its regulatory review process, NCUA has 
identified provisions that may warrant clarification or revision. NCUA 
is also considering permitting certain activities that are currently 
prohibited by its rules.

DATES: Comments must be received on or before January 24, 2002.

ADDRESSES: Direct comments to Becky Baker, Secretary of the Board. Mail 
or hand-deliver comments to: National Credit Union Administration, 1775 
Duke Street, Alexandria, Virginia 22314-3428. You may fax comments to 
(703) 518-6319, or e-mail comments to [email protected]. Please send 
comments by one method only.

FOR FURTHER INFORMATION CONTACT: Scott Hunt, Senior Investment Officer, 
Office of Investment Services at the above address or telephone (703) 
518-6620; Dan Gordon, Senior Investment Officer, Office of Investment 
Services at the above address or telephone (703) 518-6620; Kim Iverson, 
Program Officer, Office of Examination and Insurance, at the above 
address or telephone (703) 518-6360; or Frank Kressman, Staff Attorney, 
Office of General Counsel, at the above address or telephone (703) 518-
6540.

SUPPLEMENTARY INFORMATION:

A. Background

    The NCUA has identified areas of part 703 that it is considering 
revising or clarifying and believes it would be helpful to receive 
public comment before preparing proposed changes to the rule. NCUA also 
welcomes comments on other issues related to part 703 not specifically 
addressed in this advance notice.

B. Areas for Review

    As explained more fully below, NCUA seeks comment on the following 
issues: broker requirements, safekeeper requirements, expanded 
investment authorities, limitations on accounts under discretionary 
control of an investment advisor, investment credit ratings, borrowing 
repurchase agreements, variable rate investments, and purchasing 
options to offer equity-linked certificates of deposit.
    In addition, NCUA is also seeking comment on ways to change the 
format of part 703 to make it more user friendly. To that end, NCUA 
seeks comment on whether the current
    ``Question and Answer'' format is beneficial. We also seek comment 
on whether part 703 would be easier to read if existing sections were 
divided into smaller sections each covering fewer topics, and whether 
incorporating additional topic headings would make information easier 
to find.

Broker Requirements

    Section 703.50(a) describes the minimum criteria a broker must meet 
in order for an FCU to purchase and sell investments using a broker. 12 
CFR 703.50(a). NCUA is considering more clearly defining these 
requirements to remove ambiguity and establish suitable minimum 
standards. NCUA is concerned that the current language may permit a 
broker to engage in purchasing and selling activities with an FCU 
without having demonstrated it possesses the skills, knowledge, and 
understanding to conduct investment transactions. In particular, NCUA 
has identified cases where brokers have engaged in deceptive practices 
in the sale of investments to FCUs, such as misrepresenting yields, 
providing misleading information about the terms of the investment, and 
inducing purchases of unsuitable investments. FCUs have asked NCUA to 
intervene and pursue remedies on their behalf.
    NCUA is considering setting standards for FCUs so that any 
brokerage firm that transacts purchases or sales of investments with an 
FCU must have at least one General Securities Principal (refer to the 
National Association of Securities Dealers'(NASD) Manual, section 1022 
(a)) registered with the NASD. Alternatively, if a depository 
institution transacts purchases and sales of securities with an FCU, 
its broker-dealer activities must be regulated by a federal or state 
regulatory agency. An individual broker (whether the broker works for a 
brokerage firm with a General Securities Principal or a depository 
institution where its brokerage activities are regulated by a state or 
federal regulatory agency) who conducts purchases or sales of 
investments with an FCU must be registered with the NASD as a General 
Securities Representative (refer to the NASD Manual, section 1032 (a)). 
These requirements would extend to an FCU using an introducing broker 
or a person who receives financial remuneration from a broker for 
referring an FCU to a broker to transact a purchase or sale of an 
investment.
    NCUA would not require an FCU that uses a person or firm to 
purchase and sell investments to comply with the above requirements if 
the person or firm acts only as a certificate of deposit or share 
certificate finder. In this regard, a finder would only identify the 
institution offering the certificate of deposit or share certificate 
and would not take custody of funds or the investment at any time. The 
FCU would be required to remit payment to the financial institution 
directly, the account would be established in the FCU's name at the 
financial institution, and all principal and interest payments would be 
remitted directly to the FCU or the FCU's designated account.
    NCUA seeks comments on whether these standards represent prudent 
minimum criteria for FCUs to adopt when using a broker or whether there 
are other standards NCUA could put in place. NCUA is interested in 
commenters' views on the effect these standards would have on an FCU's 
ability to purchase and sell securities at competitive prices.

Safekeeper Requirements

    Section 703.60 states the minimum criteria for safekeeping firms 
FCUs may use. 12CFR 703.60. Because safekeepers that do not operate 
safely and scrupulously can pose a risk to FCUs, NCUA is considering 
clarifying these requirements to remove ambiguity and

[[Page 54169]]

establish suitable standards. NCUA is concerned that the current 
language may not fulfill its intended purpose to ensure that the 
safekeeper is an independent entity, either in form or in function, 
that protects the FCU's beneficial ownership interest in its 
investments. FCUs incur significant risk of loss when a safekeeping 
firm does not maintain independence from the broker, is not bound by 
prudent practices, or is not subject to sufficient supervisory 
oversight. Therefore, NCUA is considering requiring that a safekeeper 
must be either a clearing broker-dealer (i.e., a broker-dealer that 
clears trades from its own inventory) that is registered, regulated, 
and supervised by the Securities Exchange Commission, or a depository 
institution regulated by a state or federal depository institution 
regulatory agency, if it is used to hold investments for an FCU.
    NCUA seeks comments on whether this standard represents prudent 
minimum criteria and if this standard affords FCUs protection from 
dealings with safekeepers that have not adopted prudent practices. NCUA 
is also interested in understanding how this standard may impede an 
FCU's ability to engage a safekeeping firm at a reasonable cost, and if 
there are alternative standards NCUA could establish to reduce the risk 
an FCU would face if it engages a safekeeper that has not adopted 
prudent practices.

Expanded Investment Authorities

    The Federal Credit Union Act specifies the statutory investment 
powers for FCUs. 12 U.S.C. 1757. NCUA has adopted regulatory 
prohibitions against certain investments and investment activities on 
the basis of safety and soundness concerns. 12 CFR 703.100 and 703.110. 
These include variable rate instruments where the interest rate is not 
tied to a domestic interest rate (e.g., foreign currencies or interest 
rates, commodity prices, equity prices, or inflation rates), financial 
derivatives, short sales, mortgage-backed security interest and 
principal strips, residual interests in collateralized mortgage 
obligations, mortgage servicing rights, commercial mortgage-related 
securities, and zero coupon securities with remaining maturities 
greater than 10 years.
    Section 703.140 provides for investment pilot programs permitting 
FCUs, on a limited basis, to engage in investment activities permitted 
by statute, but prohibited by part 703. 12 CFR 703.140. Currently, 
pilot programs have been approved such as permitting credit unions to 
engage in derivative activities and to purchase equity-linked options 
in order to offer their members share certificates where the dividend 
is tied to the performance of the S&P 500 equity index. In keeping with 
the agency's objective of providing regulatory relief while maintaining 
safety and soundness standards, NCUA is considering streamlining the 
process and expanding investment authorities.
    While expanding the authorities would permit more flexibility for 
FCUs, these transactions bear considerable risks. NCUA is not 
considering granting blanket approval to all FCUs. Instead, NCUA would 
consider permitting an FCU to engage in an activity after it has 
demonstrated it has the ability and expertise to manage these 
investments or investment transactions in a safe and sound manner. This 
approach is similar to the procedures for corporate credit unions 
applying for expanded authorities.12 CFR part 704, Appendix B.
    NCUA is considering developing minimum standards and criteria that 
an FCU would have to meet to gain approval through an application 
process. By developing these standards for credit unions, NCUA believes 
it may encourage credit unions to seek expanded investment authorities. 
These standards would be made publicly available to assist FCUs in 
preparing an application for approval. This differs from the current 
pilot program approach where a credit union submits proposed standards 
to NCUA for approval.
    NCUA would develop standards based on the experience gained from 
previously approved pilot programs and standard industry practices. By 
way of example, a credit union that requests approval to engage in 
derivative authority to hedge interest rate risk may be subject to 
standards such as:
    1. Thorough policies and procedures pertaining to derivatives and 
risk management.
    2. Minimum reporting requirements including a pre-execution 
analysis of risk, monthly evaluation of hedge effectiveness, and 
quarterly analysis of the earnings and value impact from
+/- 100, 200, and 300 basis point interest rate shocks.
    3. Approved counterparties must have a rating of AAA, or 
equivalent, and the credit union must perform annual credit reviews.
    4. Pre-execution approval of each derivative transaction by 
executive management.
    5. Maximum notional amounts of derivatives in total and by 
counterparty.
    6. Staff experienced with analyzing and purchasing derivatives, 
including requirements for on-going training.
    7. An independent audit of accounting systems to ensure compliance 
with generally accepted accounting principles pertaining to derivatives 
(i.e., FAS 138).
    8. Risk measurement systems capable of measuring the interest rate 
risk associated with derivatives (e.g., option pricing or option-
adjusted spread functionality).
    9. Sound internal control systems that provide for adequate 
segregation of duties, independence of the risk measurement and risk 
taking functions, and performance monitoring by executive management 
and the board.
    These standards and criteria may differ for each type of investment 
dependent upon the pertinent risks.
    NCUA seeks comments on whether there are investments or investment 
transactions identified in Secs. 703.100 and 703.110 that NCUA should 
continue to prohibit. NCUA seeks comments on whether the proposal to 
develop an application and approval process to engage in the currently 
prohibited activities is appropriate and reasonable, and what criteria 
or standards NCUA should require to participate in these activities.
    NCUA is also interested in commenters' views on whether certain 
investments or investment transactions should be permitted without 
having to submit an application for approval and reasons supporting 
such a position.

Discretionary Control of Investments

    Currently, an FCU may delegate discretionary control of investments 
to an investment advisor so long as the aggregate amount does not 
exceed 100 percent of the FCU's net capital at the time of delegation. 
12 CFR 703.40. NCUA is considering raising the cap to provide FCUs more 
flexibility in managing their investments. An investment adviser can 
augment an FCU's investment expertise and assist the FCU in making 
sound and prudent investment decisions. However, NCUA also recognizes 
that raising the cap can lead to safety and soundness concerns for FCUs 
that may abdicate responsibility for making responsible investment 
decisions, and fail to understand and manage the risks associated with 
these investments.
    Should NCUA raise the cap, it may set minimum criteria FCUs must 
meet or require FCUs to seek approval prior to exceeding the limit. 
Criteria that may be considered include the FCU's financial 
performance, policies and procedures governing the investment advisor, 
an assessment of management's ability to monitor the investment 
advisor's

[[Page 54170]]

actions, and the quality of the credit union's risk management 
procedures.
    NCUA is seeking comments whether the cap should be raised. If the 
cap should be raised, commenters should address whether it is 
appropriate for NCUA to set minimum criteria in its rules or require 
FCUs to seek NCUA approval prior to exceeding the current cap. For 
those commenters supporting minimum criteria, NCUA is interested in 
specific criteria that would be appropriate.

Investment Credit Ratings

    Currently, an FCU must conduct a credit analysis for any investment 
that is not issued by or fully guaranteed as to principal and interest 
by the U.S. government or its agencies, enterprises, or corporations, 
or fully insured by the NCUA or the Federal Deposit Insurance 
Corporation. 12 CFR 703.40(d). FCUs are not required to express credit 
exposure in terms of risk to capital and, except for municipal bonds 
and privately issued mortgage related securities, FCUs are not required 
to obtain or monitor credit ratings on the issue or issuer.
    FCUs are not exposed to significant credit risk if they invest in 
obligations of or guaranteed by the U.S. government or its agencies, or 
if investments are insured by federal deposit insurance or are 
collateralized by high quality assets. However, credit risk exposure 
increases as FCUs purchase certificates of deposit and deposit notes 
exceeding insured limits, and invest in obligations that are not 
insured or guaranteed, such as bank notes and sales of federal funds. 
Also, in 2001, the Federal NationaL Lortgage Association (FNMA) and 
Federal Home Loan Mortgage Corporation (FHLMC) began issuing 
subordinated debt. While national credit rating organizations have 
assigned high quality ratings to both FNMA's and FHLMC's subordinated 
debt, the subordinated debt rating is lower than the senior unsecured 
debt rating.
    NCUA is contemplating refining the requirements for evaluating 
credit risk, such as requiring FCUs to establish limits in terms of 
capital at risk or setting minimum credit criteria for all investments 
not fully guaranteed or insured. Many FCUs have adopted one or both 
practices as part of their credit analysis procedures. By establishing 
a regulatory requirement, NCUA would establish consistency in approach 
for all FCUs.
    NCUA is seeking comments on whether it is reasonable to require 
credit risk to be expressed in terms of minimum credit ratings, risk to 
capital, or other standards. For those commenters supporting credit 
ratings, NCUA is interested in their views on acceptable minimum credit 
ratings and if FCUs should be permitted to define the minimum 
acceptable credit ratings. For those commenters in support of requiring 
credit exposure to be stated in terms of capital-at-risk, NCUA is 
seeking comments on whether NCUA or the FCU should establish the 
minimum capital-at-risk standards.

Borrowing Repurchase Agreements

    Borrowing repurchase agreements enable an FCU to sell securities 
under an agreement to repurchase in order to borrow funds. Section 
703.100(j)(2) prohibits an FCU from purchasing an investment with the 
proceeds from a borrowing repurchase agreement if the purchased 
investment matures after the maturity of the borrowing repurchase 
agreement. 12 CFR 703.100(j)(2). This restriction was initially adopted 
years ago to address problems where FCUs incurred significant interest 
rate risk by borrowing funds at short-term interest rates and investing 
in long-term fixed rate instruments. 44 FR 42673, July 20, 1979. 
Problems resulted when changes in interest rates adversely impacted 
earnings and capital.
    NCUA has not established similar prohibitions for other borrowing 
arrangements. For example, if an FCU borrowed funds without engaging in 
a borrowing repurchase agreement, it would not be limited by the 
maturity limit of Sec. 703.100(j)(2) when it invests the proceeds. 
Also, many FCUs have improved their understanding and management of 
balance sheet risk since the time the restriction was enacted, and NCUA 
can address safety and soundness concerns pertaining to borrowing 
during supervisory examinations. For these reasons, NCUA is considering 
removing this prohibition so that an FCU has the flexibility to invest 
the proceeds from a borrowing repurchase agreement at its discretion.
    NCUA seeks comments on whether removing this restriction would 
raise any liquidity or safety and soundness concerns. If an approval 
process is recommended instead of removing the restriction, NCUA seeks 
comments on suggested standards that an FCU should meet in order to be 
excluded from the current restriction.

Purchase of Equity-Linked Options

    While Sec. 703.110(a) prohibits an FCU from purchasing financial 
derivatives, including options,12 CFR 703.110(a), NCUA has approved an 
investment pilot program permitting a vendor to act as an agent for 
FCUs to purchase equity-based options. In the pilot program, FCUs can 
offer share certificates where the dividend rate is tied to the 
performance of the S&P 500 stock index. NCUA established constraints to 
minimize risks, and prohibit FCUs from investing in options for their 
own accounts.
    NCUA is considering expanding part 703 to permit FCUs to purchase 
equity options for the sole purpose of offering equity-linked dividends 
to their members. Because options bear considerable risks, NCUA would 
likely develop regulatory guidelines and constraints based on the 
experience gained from the pilot program. Based on NCUA's experience in 
overseeing the pilot program, these guidelines and constraints may 
include the following:
    The FCU may purchase financial options contracts to fund the 
payment of dividends on member share accounts provided:
    a. The option is a European option;
    b. The option is based on a domestic equity index;
    c. Dividends on the share accounts are derived solely from the 
change in the domestic equity index over a specified period;
    d. Proceeds from the option are only used to fund dividends on the 
share accounts, and counterparty expenses and broker commissions 
associated with the option transaction.
    e. The counterparty to the transaction is a domestic counterparty 
with a long-term senior unsecured debt rating from a nationally 
recognized statistical rating organization in one of the two highest 
rating categories (e.g., higher than A+ by Standard & Poors or higher 
than A1 by Moody's) and,
    f. The program must be structured such that there can be no loss of 
principal to the member as a result of changes in the value of the 
option; and,
    g. The options must be entered into pursuant to written policies 
and procedures pertaining to this program.
    NCUA is interested in receiving comments on these and other 
standards an FCU should meet to engage in this activity. Also, NCUA 
would like to receive comments on what other indices would be 
appropriate for FCUs.

    By the National Credit Union Administration Board on October 18, 
2001.
Becky Baker,
Secretary of the Board.
[FR Doc. 01-26934 Filed 10-25-01; 8:45 am]
BILLING CODE 7535-01-U