July 12, 2006


Federal Housing Finance Board
1625 Eye Street, N.W.
Washington, DC 20006

Attention: Public Comments

RE: Federal Housing Finance Board
       Proposed Rule: Excess Stock Restrictions and Retained Earnings Requirements for the
       Federal Home Loan Banks.
       RIN Number 3069-AB30
       Docket No. 2006-03
       71FR 13306 (March 15, 2006)

Dear Sir or Madam:

America’s Community Bankers (ACB) is pleased to comment on the Federal Housing Finance Board’s (Finance Board) proposed rule on excess stock restrictions and retained earnings requirements for the Federal Home Loan Banks (FHLBanks). ACB appreciates the efforts of the Finance Board to ensure a safe and sound Federal Home Loan Bank System (FHLBank System). We renew our request that the Finance Board withdraw the proposal and issue an Advance Notice of Proposed Rulemaking to address the numerous issues raised by the current proposal. We believe that an Advance Notice of Proposed Rulemaking provides a better opportunity for discussion and dialogue between the Finance Board and the stakeholders of the FHLBank System.

ACB strongly opposes the current proposed rulemaking. ACB has serious concerns about the proposal and believes that the rule, if adopted as currently proposed, could have significant negative consequences for the FHLBanks, their member institutions and the communities they serve. We believe that this rule has great potential to fundamentally alter the direction and makeup of the FHLBank System for many years to come, and limit the FHLBank System’s ability to adapt to future financial challenges and demands.

Summary of Proposed Rule

The Finance Board proposes three principal changes to the existing regulations implementing the capital standards provisions of the Federal Home Loan Bank Act (Bank Act).

1. Prohibition on Excess Capital Stock. The Proposed Rule would impose a limit on the amount of excess capital stock an FHLBank could have outstanding. Proposed § 934.1(a). The aggregate amount of an FHLBank’s outstanding excess stock could not exceed one percent of its total assets.
   
   To implement this provision, Proposed § 900.2 would define "excess stock" to mean the amount of an FHLBank ‘s capital stock held by a member in excess of the minimum investment in capital stock that is required by the FHLBank’s capital plan, the Bank Act, or the Finance Board’s regulations.
    
2. Prohibition on Stock Dividends. The Proposed Rule would prohibit the FHLBanks from paying stock dividends. Proposed § 934.1(b).
    
3. Mandatory Minimum Amount of Retained Earnings. Each FHLBank would be required to maintain as part of its capital a minimum amount of retained earnings, equal to $50 million plus one percent of its non-advance assets. (The retained earnings minimum or REM). Proposed § 934.2(a)-(b).

Until a Bank reaches its mandatory retained earnings minimum, it may not pay a dividend that exceeds 50 percent of its current net earnings without the prior approval of the Finance Board. Proposed § 934.3(a). If an FHLBank fails to maintain the REM after it has reached that target, it is prohibited from paying any dividend without prior approval of the Finance Board. Proposed § 934.3(b).

Position Summary

ACB strongly opposes the Proposed Rule and requests it be withdrawn and reissued as an Advance Notice of Proposed Rulemaking.

Excess Stock Limitation

ACB opposes the limits on excess stock for the following reasons:

• The excess stock provision treats Class B member stock as quick-take out capital rather than the stable source of permanent capital mandated by Congress in the Gramm-Leach-Bliley Act (GLBA) .
• The proposal assumes that FHLBanks’ investments to ensure adequate liquidity in the FHLBank System are not mission related investments, when, in fact, the liquidity that these investments provide assures members access to ever-ready advances. The Proposed Rule implies that the acquired member assets (AMA) program is not a core mission of the FHLBanks, which is contrary to the Finance Board’s own regulations.
• The excess stock restriction is a destabilizing shift in policy by the Finance Board. Having approved some FHLBank capital plans that utilize excess stock to capitalize AMA programs and other activities, the Finance Board is changing course without any factual and legal basis.
• ACB has advocated that the FHLBank System would be better served by a system that places greater reliance on membership and activity-based stock requirements to capitalize the FHLBank System, rather than on excess stock purchases. Nevertheless, the Finance Board approved a range for activity-based stock that began at zero, thus permitting excess stock in lieu of activity-based stock for the AMA programs. The Finance Board cannot now change the policy without first undertaking a rulemaking to change the capital regulations governing activity-based stock (12 CFR part 930), and permitting the FHLBanks to resubmit capital plans for approval.
• The rapidity with which FHLBanks must comply with the Proposed Rule is a grave concern. In order to meet regulatory requirements, FHLBanks may be required to liquidate assets at an imprudently quick pace or be required to substitute inferior forms of capital for excess member stock.
• The mandatory redemptions caused by the restrictions on excess stock will cause serious tax consequences for many member institutions, and impose a deadweight loss on FHLBank member institutions.

Prohibition on Stock Dividend

ACB opposes the prohibition on stock dividends for the following reasons:

• Dividends paid in the form of Class B stock arguably create the most stable form of member stock. It is not only subject to the five-year redemption requirement, but is among the last stock a member would seek to redeem because of the tax event that would be triggered.
• Stock dividends have for several decades enhanced the stability of the FHLBank System capital, while providing member institutions a valuable tax savings. Stock dividends clearly benefit both the FHLBanks and their members and should be retained as an option for FHLBanks.
• The Finance Board asked for comments on whether it would be appropriate to permit an FHLBank to pay stock dividends, as long as the FHLBank were in compliance with the excess stock restrictions. We do not believe that this is a realistic middle ground. In order not to run afoul of the excess stock limit, it is unlikely that any FHLBank would issue stock dividends.

Retained Earnings Requirement and Dividend Restriction

While ACB agrees that retained earnings are an essential component of capital for the FHLBanks, we oppose the REM requirement and the restrictions on dividends that are part of that requirement for the following reasons:

• The proposal on retained earnings fails to recognize that Class B stock is permanent capital, as provided by Congress in GLBA.
• The proposal incorrectly assumes that capital in forms other than retained earnings is not available to protect against losses.
• The methodology employed by the Finance Board in developing the REM is seriously flawed.
• Since the REM requirement fails to distinguish among the widely–varying relative risks of non-advance assets, the requirement could have the unintended consequence of encouraging the FHLBanks to hold riskier assets on their balance sheets.
• The proposal diminishes the individual cooperative owners’ equity in the FHLBank System by transferring a substantial amount of earnings of the FHLBanks to the retained earnings accounts of the FHLBanks, permanently depriving the individual cooperative owners of their interest in those earnings.
• The proposal hinders the FHLBanks’ ability to manage liquidity.
• The dividend restriction will result in a destabilizing increase in the cost of advances and other FHLBank services, over the intermediate term, with possibly long-term adverse consequences.
• The dividend restriction will cause large member institutions with funding choices to reduce their use of the FHLBank System, which, in turn, will reduce earnings and increase the costs of the FHLBanks.
• The reduction in dividend income and increase in costs of FHLBank services will have a disproportionately greater impact on small member institutions.
• The proposal fails to recognize that dividends are an essential component of a cooperative.

The Proposed Rule is Not Legally Supportable

ACB submits that the Proposed Rule does not comport with the laws governing the operation of the FHLBanks and the Finance Board for the following reasons:

• The Finance Board may not use its general safety and soundness authority to adopt de facto capital standards that trump the capital provisions that are explicitly set forth in statute.
• The Proposed Rule is inconsistent with the express provisions of the Bank Act, including the FHLBank capital provisions enacted in GLBA, that contain specific Congressional mandates regarding the capital structure for the FHLBanks.
• If the Proposed Rule were adopted in its current form, it would be deemed “arbitrary and capricious” under the Administrative Procedure Act because they have no rational basis.
• If the Finance Board believes that the capital rules that it promulgated in 2001 to implement GLBA do not adequately protect the FHLBank System against risk, then the proper solution is for the Finance Board to initiate the process to revise those regulations in accordance with GLBA.

Background – Gramm-Leach-Bliley Capital Regime

It is important to place the Proposed Rule in its historical context. The proposal follows extensive work by both the Finance Board and the FHLBanks to put in place the new capital structure for the FHLBank System created by GLBA. That capital scheme included the development of individual capital plans for the 12 FHLBanks and the individual approval of those plans by the Finance Board.

In 1999, GLBA was enacted and made a number of changes to the structure and authorities of all entities in the financial services arena. Among the changes were fundamental organizational changes to the FHLBank System. Under Title VI of GLBA (the Federal Home Loan Bank Modernization Act), after decades in which federal savings associations were captive members, all membership in the FHLBank System became voluntary. The shift to an all-voluntary membership necessitated the development of a new capital structure. Other changes included a shift of authority for governance of the FHLBs to their boards of directors and away from their regulator, the Finance Board. An intended consequence was to make the FHLBanks more responsive to the business needs of the cooperative membership.

Because the FHLBank System is organized into 12 FHLBanks, the business of each of the FHLBanks focuses on the needs of its own members and the communities they serve. The local and regional emphasis on activities of the FHLBanks has enabled the FHLBanks and their members to provide extensive community support. The local nature of the focus of the FHLBanks led to differences in operation and business strategy. Further, although there are 12 FHLBanks, the Bank Act provides that there is joint and several liability for certain activities of the FHLBanks. This distinguishing feature of the FHLBank System leads to the result that every one of the 12 FHLBanks has an interest in the activities of each of the other FHLBanks.

As has been the case throughout its history, the FHLBank System continues today to be a critical source of funding for member institutions that are not large enough to obtain funding from other sources at prices that are affordable. As additional banks joined the FHLBank System, the GLBA capital provisions gave the FHLBank System greater flexibility to evolve to meet the needs of all members, while maintaining the cooperative structure and the critical source of liquidity. The banking supervisory agencies have recognized the importance of this source of liquidity for their regulated entities, both big and small.

The differences in operating strategy of each of the FHLBanks was one of the reasons that rather than imposing a strict capital regime that contained the same elements for every FHLBank, the law provides that each of the FHLBanks adopt a capital plan that meets the needs of its membership, within the parameters of the statute and implementing regulations.

Another important change made as part of GLBA was the devolution of much of the organizational responsibilities for each of the FHLBanks to the FHLBanks themselves. The Finance Board retains safety and soundness oversight, but the individual FHLBanks’ boards of directors are to determine the “rights, terms, and preferences” for each class of stock, consistent with 12 U.S.C. § 1426, with the regulations of the Finance Board, and with market requirements.

The board of directors of the each of the FHLBanks is comprised of elected representatives of member institutions and appointed directors representing other public interests. GLBA requires the boards of directors of the FHLBanks to adopt the capital plans within specified limits, subject to Finance Board review and approval.

In 2001, the Finance Board promulgated a capital standards rule that set forth in great detail the requirements of the risk-based capital and leverage rules to address the risks presented by the lines of business in which the FHLBanks were engaged, including the risks of investments in mortgages. That rule also established a process for Finance Board review and approval of a capital plan for each FHLBank.

Pursuant to that rule, in 2002 the Finance Board reviewed the individual capital plans by which each FHLBank would comply with the requirements of the Bank Act and the agency’s implementing rule. During the development of the capital plans, each of the FHLBanks adopted plans that were within the parameters of the statute and regulations. Although the statute and regulations contain elements that are required for all FHLBanks, it also permits each of the FHLBanks some flexibility in establishing the capital structure of the FHLBank. As noted in more detail later in this comment letter, in approving the plans of the FHLBanks, the Finance Board necessarily approved each FHLBank’s plan for using excess capital and retained earnings to satisfy its legal obligation to maintain "permanent capital" sufficient to meet all the FHLBanks’ statutory and regulatory obligations.

The Finance Board has approved the capital plans for the 12 FHLBanks. Eleven of the 12 have implemented their plans. Despite this enormous effort, the Finance Board has proposed the current rulemaking as another layer of capital regulation on top of the GLBA capital requirements, the regulations implementing the GLBA requirements and the 12 FHLBanks’ capital plans. The proposals conflict with critical elements of GLBA, and the Finance Board has provided no explanation for its fundamental departure from the approvals it so recently granted the FHLBanks in connection with their capital plans.

ACB Opposes the Proposed Rule

Excess Stock Restriction

ACB opposes the limit on excess stock proposed in the Proposed Rule for the following reasons.

The Proposal Fails to Treat Member Class B Stock as Permanent Capital

The Finance Board’s rationale for the excess stock restriction is highly speculative and ignores provisions of the law that make member stock a stable source of capital to protect the FHLBanks against losses. The Finance Board argues that excess stock is not stable because the FHLBanks have traditionally honored in a timely fashion requests of members to redeem stock before the end of the redemption period associated with the stock. The Finance Board argues that this practice could lead to capital instability, if an FHLBank were to experience large-scale requests to repurchase stock.

The Finance Board’s assertion ignores several important features of the capital in the FHLBank System. In accordance with capital plans approved by the Finance Board, ten of the eleven FHLBanks that have completed the conversion process rely solely on Class B stock for member investments in the FHLBank System, and the eleventh FHLBank requires members to purchase Class B stock to meet activity-based stock requirements. GLBA provides that Class B stock is a form of permanent capital, which is redeemable in five years after redemption is requested. Although the Banks have the discretion to redeem before five years have elapsed, the five-year redemption period allows an FHLBank time to honor repurchase requests gradually and adjust its operations and balance sheet to meet the redemption requests and to minimize any impact.

The Finance Board’s argument assumes that the board of directors of an FHLBank would fail to utilize the full five-year redemption period in times of stress. Moreover, after the five-year redemption period, a board of directors of an FHLBank is restricted from redeeming stock under certain circumstances, which are described in more detail elsewhere in this letter.

Additionally, the argument ignores the tools available to the Finance Board itself to handle cases of instability in individual FHLBanks. The Finance Board has ample authority to step in and stop redemptions, in specific cases, whenever an FHLBank has incurred or is likely to incur losses that result in a charge against the capital of the FHLBank, or the FHLBank would fail to meet any capital standard after the redemption. The Finance Board should not base a drastic change in policy on an assumption that the tools that Congress created to stabilize the capital of the FHLBank System will not be utilized.

The Finance Board further speculatively argues that if the board of directors of an FHLBank prudently delayed the redemption of stock as provided in the law, then member institutions’ confidence in the FHLBank could be eroded. The argument ignores the fact that the members of the FHLBanks are knowledgeable investors and understand that FHLBanks have the right to delay redemption of the Class B stock for five years and that redemption is not available under the circumstances cited above. In fact, as part of each Bank’s conversion to the GLBA capital regime, any member not wishing to convert its then existing stock to the new classes of stock was given the right to opt out of conversion and an opt-out deadline was set. Prior to the opt-out deadline, each FHLBank was required to disclose to member institutions the terms under which the new Class A and Class B stock could be redeemed or repurchased, including the limitations on redemptions and repurchases in times of stress.

The Finance Board’s rationale for the excess stock restriction disregards what is obvious: (1) the vast majority of the FHLBank System capital consists of very stable Class B stock; and (2) Congress has given the boards of the FHLBanks and the Finance Board very powerful tools to stabilize FHLBank System capital in times of stress.

While the Finance Board uses as support for the proposed excess stock limitation a concern about stability, in fact the excess stock restriction itself has great potential to create capital instability in those FHLBanks with significant amounts of excess stock. The Proposed Rule potentially forces an FHLBank to repurchase any Class B excess stock over one percent of assets in 60 days, making the stock less permanent than even Class A stock, and prevents such an FHLBank from utilizing the full five-year redemption period. Moreover, while the intent of the Proposed Rule is to replace excess stock with retained earnings, the effect will be to force excess stock out quickly while retained earnings will accumulate slowly. The net effect will be to force capital out of the FHLBank System, having an immediate, direct and adverse effect on safety and soundness of the entire FHLBank System.

Indeed, the irony is that the overall impact of the proposal, and, particularly, the dividend restrictions on the FHLBanks that have not met the REM, is likely to shake members’ confidence in the FHLBank System by increasing the overall costs of advances and other services, and lead to reduced use of the FHLBank System by members with alternative sources of funding.

About-Face in Policy

In connection with the post-GLBA capital plan approval process (and in other contexts), the Finance Board has approved the use of excess stock to capitalize investments in assets, including AMA programs. For example, the capital plan of the FHLBank of Cincinnati expressly used shared pooling of excess stock to capitalize its AMA program and a portion of its advances. The Finance Board approved FHLB Cincinnati’s plan on a 5-to-0 vote on November 13, 2002. The FHLBank of Cincinnati plan enhances the stability of the excess stock by paying dividends through the distribution of stock dividends. The tax benefits associated with stock dividends provide incentives to members to avoid redemption requests. Cincinnati also caps an individual member’s use of pooled stock at $200 million worth of Class B stock. The FHLBank Cincinnati plan demonstrates that excess stock can be used effectively to capitalize AMA activities and advances without an adverse impact on safety and soundness. As explained more fully in our legal analysis below, the Finance Board cannot now reverse its decisions with respect to the affected FHLBanks based on some generalized, unsupported, system-wide safety and soundness concerns.

Mission Rationale is Flawed

The Finance Board cites as support for the excess stock limitation the use of excess stock to invest in not readily saleable assets (AMA assets) and money-market securities and other non-core mission assets used to earn arbitrage profits. ACB disagrees with the assumptions that underlie this argument. The acquisition of money-market securities and similar highly liquid assets is fundamental to the mission of the FHLBanks. The FHLBanks provide community banks with efficient and quick access to liquidity. In order to maintain the ever-ready access to advances, the FHLBanks need the flexibility that these more liquid investments allow them. Moreover, ACB believes that the spread on such investments versus comparable FHLBank System liabilities is minimal and provides little incentive to arbitrage, contrary to the Finance Board’s assertion.

The AMA programs are core mission activities under Finance Board regulations defining core mission activities. In fact, the Finance Board has repeatedly argued this point, including in a lawsuit in which the legality of the AMA programs was challenged. In Texas Savings and Community Bankers Ass’n v. Federal Housing Finance Board, the federal court of appeals upheld the AMA programs based, in part, on a 1996 Finance Board Memorandum which states that the MPF program is “simply a method of empowering member institutions to channel funds into residential housing finance in a manner that is technically more sophisticated than, yet functionally similar to, that which occurs when a FHLBank makes an advance.”

It appears that the Finance Board has completely reversed its position, implying that the AMA programs are now to be considered non-core mission activities. The Finance Board has for more than a decade promoted AMA programs in the FHLBanks. It cannot now reverse the direction of the policy through restrictions on excess stock. If a change is warranted to the AMA program, the Finance Board must first undertake a rulemaking to propose changing its regulations defining core mission activities.

Capital Standards Should Be Amended

In the past, ACB has advocated that the FHLBank System would be better served by a system that places greater reliance on membership and activity-based stock requirements to capitalize the FHLBank System, rather than on excess stock purchases. We argued that greater reliance on properly calibrated membership and activity-based stock creates a capital regime that grows and contracts organically with membership and usage of FHLB services. Members would then provide capital in a manner proportional to the risk-taking activities into which they require the FHLBank System to enter. The approach also reinforces the cooperative structure of the system by requiring ownership stakes that are proportional to usage and exposure of the FHLBank System.

The Finance Board cannot justify a draconian shift that would require a rapid adjustment to what amounts to a 180-degree reversal by the agency. Instead, having allowed the FHLBanks to hold zero activity-based stock against acquired member assets and having permitted the FHLBanks to capitalize the activity with excess stock purchases, the Finance Board cannot now change the policy without first undertaking a rulemaking to change the capital regulations governing activity-based stock and permitting the FHLBanks to resubmit capital plans for approval.

Additionally, as noted above, Class B stock requires no early redemption before its five-year redemption period ends. Therefore, any adjustments to excess stock and activity-based purchase rules as applied to AMA programs, to the extent warranted and subject to a rulemaking, should be permitted, at the discretion of the FHLBanks, over a phase-in period of five years.

Rapidity of Change in Policy is a Cause of Concern

The rapidity with which the Finance Board expects compliance with the excess stock restriction is in and of itself a concern. Notably, the Proposed Rule does not provide any period of transition. Instead, once the rule becomes effective, four of the 12 FHLBanks will immediately (or by the end of the quarter) be in non-compliance with the restriction. Those FHLBanks (and FHLBanks in the future that run afoul of the prohibition) would have 60 days to either correct the violation, or devise a plan, subject to Finance Board approval, to correct the violation.

We are concerned that the pace of correction anticipated by the proposal is likely to lead to an imprudently rapid liquidation of assets and restructuring of balance sheet assets at these four FHLBanks, and in the future, as other FHLBanks slip above the one percent mark. Additionally, the proposal could lead to the substitution of inferior forms of capital for equity in order to comply with the excess stock restriction.

Serious Tax Consequences for Member Institutions

The restrictions on excess stock will cause serious tax consequences for many member institutions. The Proposed Rule would force the early redemption of excess stock above one percent of assets, creating a taxable distribution for many members who otherwise likely would have chosen to hold the stock in anticipation of future borrowing or other FHLBank mission-related activity. The Finance Board estimated that as of December 31, 2005, there was approximately $2.44 billion in member stock at four FHLBanks in excess of the proposed limitation. Although that estimate may not currently be accurate and, as a result, it is difficult to determine the extent of the tax liability for the members of the four FHLBanks, it is safe to say that the precipitous redemption of this stock will create a significant tax liability for those member institutions in the year the stock is redeemed.

Stock Dividend Prohibition

Proposed § 934.1(b) would ban the payment of dividends though the distribution of stock, or stock dividends. The Finance Board’s reasoning for the prohibition as stated in the Proposed Rule is that, “Stock dividends, along with the sale of excess stock to members, are the main causes of growth in excess stock on the FHLBanks’ balance sheets.” ACB opposes the Proposed Rule because the use of stock dividends actually enhances capital stability and reduces member institutions’ all-in cost of using the products of the FHLBanks.

Stock Dividends Enhance Capital Stability

Stock dividends enhance capital stability in the FHLBank System. Unlike cash dividends, stock dividends actually maintain the level of capital in an FHLBank. Stock dividends are not taxed until the stock is actually redeemed. The tax treatment associated with stock dividends provides an incentive for members to leave the stock in the FHLBank System. Moreover, the tax savings reduces members’ net cost of using FHLBank advances and other services. Stock dividends clearly benefit both the FHLBanks and their members and should be retained as an option for FHLBanks.

Comment on Specific Question

The Finance Board asked for comments on whether it would be appropriate to permit an FHLBank to pay stock dividends, as long as the FHLBank were in compliance with the excess stock restrictions. We do not believe that this is a realistic middle ground. In order not to run afoul of the excess stock limit, it is unlikely that any FHLBank would issue stock dividends. ACB strongly believes the stock dividend option should be preserved, without qualification.

Proposal is an Arbitrary Change in Policy

For many years, several FHLBanks have customarily paid stock dividends to their members – with no adverse effects – in large part because of more flexible tax treatment accorded members receiving dividends in this manner. The use of stock dividends has occurred with the approval of the Finance Board and its predecessor, the Federal Home Loan Bank Board. For example, the Finance Board expressly approved the use of stock dividends in connection with the approval of capital plans after the passage of GLBA. In fact, in 2005, seven of the 12 FHLBanks distributed stock dividends. It is arbitrary for the Finance Board to now prohibit stock dividends on a system-wide basis without a clearer justification for the change.

Retained Earnings Requirement

ACB agrees that retained earnings are an essential component of capital for the FHLBanks. However, ACB opposes the REM requirement and the restrictions on dividends that are part of that requirement for the reasons detailed below.

Fails to Treat Class B Stock as Permanent Capital

The Finance Board’s primary policy rationale for the REM requirement is that only retained earnings can provide a cushion protecting against the risk of capital stock impairment. In part this is because the Finance Board treats Class B stock as something other than permanent capital, contrary to GLBA. As a result of the Finance Board’s proposal, a manageable loss, accompanied by a “run” on Class B stock, could dramatically shrink the size and earning capacity of the FHLBank, magnifying what would be an otherwise manageable loss into one causing impairment of the remaining stock. The Finance Board’s rationale does not properly take into account the tools provided under the law and regulations that protect the par value of member stock: five-year redemption period and the prohibition on redemptions in times of stress.

The five-year redemption period allows an FHLBank time to recover from losses or allows for an orderly unwinding of operations. Additionally, 12 U.S.C. § 1426(f) prohibits an FHLBank from redeeming or repurchasing stock, if the FHLBank or the Finance Board determines that the FHLBank has incurred or is likely to incur losses that result in or are expected to result in a charge against capital. Under the provision, the FHLBank cannot redeem or repurchase member stock while the situation continues, except with permission of the Finance Board. The provision absolutely prohibits any stock redemption or repurchase, if the FHLBank would fail any minimum capital requirement following the redemption. All of these provisions make Class B stock a real economic buffer against losses.

The Finance Board argues that Class B stock is not stable because the FHLBanks have traditionally honored requests to redeem stock prior to the expiration of the redemption period. The FHLBanks have the discretion to redeem stock before the end of the redemption period, and do so routinely in normal times. The Finance Board’s argument is based on an assumption that an FHLBank’s board of directors would ignore its duties in times of stress and redeem stock. It further assumes that the Finance Board itself would not exercise its authority to shutoff redemptions and repurchases, under the appropriate circumstances. A regulation with such far-reaching implications for the FHLBank System cannot be based on an assumption that every tool put in place by Congress to protect the capital of the FHLBank System will be ignored.

Incorrectly Assumes that Capital in Forms Other than Retained Earnings is Unavailable to Protect Against Loss

The Finance Board’s proposal implies that retained earnings are the only form of capital available to protect against loss, at least with respect to risks associated with non-advance assets. The Finance Board also implies that risks of loss from the advance business can be readily absorbed if necessary by resort to collateral protection and confiscation of membership and activity-based stock purchases in the event of default on advances obligations. This idea of bifurcating different forms of capital to match against different forms of risk is faulty. Different forms of capital, while not identical, are highly fungible at the margin. It is incorrect to regard retained earnings as the only form of capital available to protect against risks arising from non-advance asset holdings, or the businesses that necessitate trading in such assets.

Unexpected losses from non-advance businesses could be absorbed against retained earnings, or could be absorbed by a reduction or suspension of dividend payments. In fact, over the history of the FHLBank System, losses have been addressed by one or both methods.

Absorbing a significant loss wholly or partly through a significant reduction in dividends requires evaluation of possible of impairment, but does not imply impairment, particularly in the case of FHLBank stock. The primary source of GAAP that should be used in accounting for FHLB stock is SOP 01-6 Accounting by Certain Entities (Including Entities With Trade Receivables) That Lend to or Finance the Activities of Others. SOP 01-6 provides that FHLBank and Federal Reserve Bank stock should be classified as a restricted investment security, carried at cost, and evaluated for impairment. FHLBank stock is generally viewed as a long-term investment.

Accordingly, when evaluating FHLBank stock for impairment, its value should be determined based on the ultimate recoverability of the par value rather than by recognizing temporary declines in value. The determination of whether the decline affects the ultimate recoverability is influenced by criteria such as the following:

• The significance of the decline in net assets of the FHLBanks as compared to the capital stock amount for the FHLBanks and the length of time this situation has persisted;
• Commitments by the FHLBanks to make payments required by law or regulation and the level of such payments in relation to the operating performance of the FHLBanks;
• The impact of legislative and regulatory changes on institutions and, accordingly, on the customer base of the FHLBanks; and
• The liquidity position of the FHLBanks.

Despite the fact that FHLBanks have “suspended” dividend payments on occasion, member institutions historically have not had to recognize impairment on FHLBank stock, based on the above criteria. Holders of FHLBank stock historically have always recovered the par value of the stock, notwithstanding limited or suspended dividend payments for a certain time. These holders may have realized a lower return on investment, and perceived value, but based on experiences to date have not lost their initial investment. Dividends are not guaranteed, but are set quarterly based on profitability and other financial considerations.

The Finance Board fails to recognize the extent to which the total capital stock of the FHLBanks is available to absorb losses. This error has resulted in an excessive and erroneous focus on retained earnings as a sole means of absorbing certain potential losses, and a proposed solution that requires an unnecessarily high proportion of retained earnings in total capital.

Flawed REM Formula

In developing the REM formula in the Proposed Rule, the Office of Supervision prepared an overly simplistic analysis of the credit and market risks of FHLBank non-advance assets and then conducted a linear regression analysis based on a very limited number of observations over a short period of time (three quarters for the twelve FHLBanks, for a total of 36 observations.) In an undated memo, the Office of Supervision admits the less than precise nature of its REM formula and its scientific limitations, stating “The proposed REM formula principally reflects a supervisory judgment of an appropriate framework to set retained earnings levels at the 12 FHLBanks.” (Emphasis added).

ACB consulted an expert in economics and finance, Dr. James J. Clarke, to review the empirical analysis on which the Finance Board relied when it set the proposed REM formula. Dr. Clarke concluded as follows:

“The Finance Board is using a panel study to determine if variations in non-advance assets could account for differences in the credit and market risk exposures among the FHLBanks. In order to measure risky assets, the study uses as a proxy non-advance assets. To determine the credit risk, the study uses the Basel II Accord, which by the way, has not been implemented in the US and will not be implemented for a number years partially due to the concern over the methodology used for credit risk weighting. The study specifically uses the Internal Ratings Based Approach, which is one of the methods a bank can choose under Basel II. Under this method, the capital charge for each asset is based on maturity, credit rating or probability of default and the expected loss given default. The sum of these charges for all non-advance assets resulted in a risk-weighted measure of the credit risk exposure for each FHLBank in a given quarter.

“In order to calculate the market risk, the Finance Board uses standard shock methodology based on parallel shifts in the yield curve. The three largest variations in capital are averaged and used to determine the measure of market risk. Most of the FHLBanks are effectively matched on their advances, so if there is significant market risk, it is assumed to arise from the non-advance assets.

"The credit and market risk exposure are summed for each FHLBank on a quarterly basis. The Finance Board performed a linear regression analysis using 12 Home Loan Banks and three quarters. Actually it appears to be a 3 by 12 panel study based on thirty-six observations. This is a relative small sample to achieve reliable results. Also, the regression itself appears flawed. The dependent variable is the risk exposure or the sum of the credit and market risk. The independent variable is the level of non-advance assets. But, the non-advance assets were used to determine the credit and market risk. The two variables are obviously going to be co-linear based on the definitions of the variables. The model’s estimated coefficients are statistically significant. Well, of course they are, since the measure of risk was defined by the non-advanced assets, one would expect that the higher the amount of non-advanced assets the higher the risk. This is a tautology.

“The model uses no control variables to adjust for differences between the FHLBanks, and there are large differences in the makeup of their non-advance assets; and the model has no control variables for the three time periods. The lack of control variable leads to questions concerning heteroscedasticity, which further reduces reliability of the statistical technique.

“In conclusion, the model appears very naïve, and a rather simple theoretical basis for such a significant policy change. The change in policy offered by the Finance Board will have serious impacts on both the FHLBanks and member banks. One would expect a more robust analysis rather than a small sample regression analysis.”

ACB concurs with this finding, and has been provided with no other information that can be used to justify the specific parameters of the REM, despite a Freedom of Information Act (FOIA) request and appeal to the Finance Board seeking whatever rationale might exist. Consequently, we conclude that those parameters, specifically the requirement that retained earnings equal $50 billion plus one percent of non-advance assets, constitute an arbitrary determination.

Proposal Diminishes the Cooperative Owners’ Equity

Shareholders gain the benefits of ownership through the distribution of dividends, lower prices for FHLBank services, or a combination of both. Provided that the proposed build up of retained earnings is not intended to increase capital above statutory levels, a build up of retained earnings beyond prudent levels diminishes the value of the FHLBank shareholders’ equity by transferring what would otherwise be member equity positions to the FHLBanks. The cooperative owners will never be able to recapture this equity. Moreover, the Finance Board’s proposal seeks to deprive the owners of their equity without a clearly articulated and supported rationale for doing so.

The FHLBank owners are particularly sensitive to a build up of retained earnings because of the federal government’s history of expropriation of FHLBank earnings to fund the deposit insurance system. In 1987, Congress took $3 billion in retained earnings from the FHLBank System to fund the Financing Corporation. In 1989, Congress took $2.5 billion of retained earnings to fund the Resolution Funding Corporation (REFCORP). Moreover, since 1989, part of the FHLBank earnings have been used to defease REFCORP bonds. Currently, 20 percent of the FHLBanks earnings are used to pay REFCORP obligations. Although GLBA provides that the retained earnings of the FHLBank System belong to the Class B stockholders, a level of retained earnings beyond the statutory mandate and economic necessity could again tempt placement of an additional direct tax on the earnings of the FHLBanks.

Proposal Hinders FHLBanks’ Ability to Manage Liquidity

In the past, the Finance Board has recognized the importance of managing liquidity risks, and in 2001 promulgated a rule that requires each FHLB to hold contingency liquidity in an amount sufficient to meet its liquidity needs for at least five business days without access to the consolidated obligation debt markets. Most FHLBs, for prudential reasons, exceed this requirement. However, given the penalty the Proposed Rule imposes on such investments, FHLBanks will have incentives to reduce their liquidity investments to the bare minimum – a result that does not promote safety and soundness. In fact, the FHLBank of Topeka has indicated it will reduce its highly liquid money market assets to comply with the Proposed Rule.

Dividend Restriction Will Result in a Destabilizing Cost Increase for Advances and Other Services

The REM requirement and the restriction on dividends will have a significant adverse impact on member institutions and will have great potential to create instability within the FHLBank System. At least one analyst estimates that the amount of forgone dividends over the first 18 to 36 months following the effective date of the Proposed Rule to be between $2 billion and $3.1 billion. The FHLBanks will have to target an amount of retained earnings above the actual REM requirement because the consequences of falling out of compliance once the target is obtained. The proposal harms member institutions by decreasing member income and by increasing the all-in cost of advances and other FHLBank services. We estimate that the return on assets of the average member is likely to be reduced by about 3 basis points, the return on equity by about 40 basis points, and the all-in cost of advances to be increased by about 15 basis points.

Impact on Large Member Institutions

The increase in cost of using the FHLBank System will lead to diminished use of the FHLBank System by large members. Large members with access to other wholesale funding sources will seek those alternatives and reduce their use of FHLBank advances and other services. Reduced use by the larger members will deprive the FHLBanks of a valuable source of earnings. The net result is that the proposal’s dividend restriction frustrates the Finance Board’s overall goal of increasing retained earnings. The FHLBanks with the largest retained earnings deficit under the proposal are the ones most likely to see a reduced presence of larger members. Moreover, those larger financial institutions that are eligible to borrow from more than one FHLBank may move their borrowing away from the FHLBanks with the largest retained earnings deficit to FHLBanks with no deficits or relatively smaller deficits. The shift will make it more difficult for those FHLBanks to comply with the REM requirement.

Smaller Institutions Hit the Hardest

The adverse impacts are significant for all users of the FHLBank System, but fall hardest on small financial institutions that rely on the dividend income that comes from FHLBank stock ownership and that are unable to access the markets directly for funding.

In an evaluation of the impact of the proposal on publicly traded financial institutions, one analyst estimated that smaller banks and savings associations could suffer a five percent reduction of net income until full dividends are restored. Additionally, smaller institutions that are highly dependent on FHLBank advances have few alternatives during the period of dividend restrictions. They cannot easily raise additional deposits. Moreover, they do not have the same access to wholesale funding as larger institutions. Because the dividend restriction will increase smaller banks’ all-in cost of funding, they will become less competitive with their larger rivals.

The net effect is that these smaller institutions will end up bearing a relatively greater proportion of the cost of meeting the REM. The proposal could create a “free-rider” effect at the expense of the smaller banks. Once the REM requirements are met, and the dividend restrictions disappear, any larger member that previously reduced its use of the FHLBank System would be free to ramp up its use of the FHLBank System, taking advantage of the retained earnings base built up by the member institutions that stayed in the FHLBank System.

Dividends are a Fundamental Part of the Cooperative Business Model

The FHLBank System has operated as a cooperative since its inception. Cooperative owners share the net earnings of the enterprise through the distribution of patronage dividends. Patronage dividends not only allow the cooperative owners to share in the profits of the enterprise created by the owners’ use of its services and products, but dividends also reduce the cost of those services and products. The distribution of patronage dividends is a fundamental part of the cooperative business model. Similar to other cooperatives, the distribution of dividends is a fundamental part of the cooperative structure of the FHLBank System. The Proposed Rule fails to recognize the role that dividends play in the FHLBank System’s cooperative business model.

Impact on Affordable Housing Programs

The Proposed Rule would result in a decrease in funds available for the FHLBank affordable housing program (AHP). Under the Bank Act, each year the FHLBanks must contribute the greater of ten percent of their net earnings for the prior year or $100 million to the FHLBank AHP. Last year the FHLBanks contributed a total of $280 million to this program. As noted above, the Proposed Rule is likely to lead to reduced use of the system by larger member institutions with access to alternative sources of wholesale funding. As a result, the earnings of many of the FHLBanks would be reduced, which would reduce the funds available for the FHLBank AHP. We note that several housing groups and at least two prominent Members of Congress have raised concerns about the Proposed Rule’s impact on the FHLBank AHP.

The Proposal Is Not Legally Supportable

ACB submits that the Proposed Rule does not comport with the laws governing the operation of the FHLBanks and the Finance Board.

First, the Finance Board relies heavily on its general “safety and soundness” authority under 12 U.S.C. §§ 1422a(a)(3) and 1422b(a) as legal support for its proposals regarding retained earnings, excess stock and dividends. While safety and soundness supervision is critical to the regulation of all financial institutions, as a legal matter, we do not believe that the Finance Board’s safety and soundness authority can be used to supplant or negate other sections of the Bank Act. In short, we do not believe that the Finance Board may use its general safety and soundness authority to adopt de facto capital standards that trump the capital provisions that are explicitly set forth elsewhere in the statute.

Second, ACB believes that portions of the Proposed Rule are inconsistent with the express provisions of the Bank Act that contain specific Congressional mandates regarding the capital structure for the Federal Home Loan Banks.

Finally, we believe that the Proposed Rule, if adopted in its current form, would be deemed “arbitrary and capricious” under the Administrative Procedure Act because it has no rational basis.

Each of these points is discussed separately below.

The Proposed Rule Cannot Be Legally Justified under the Finance Board’s General “Safety and Soundness” Authority

In attempting to justify its proposals, the Finance Board has relied primarily on the general grant of authority given by Congress in 12 U.S.C. §§ 1422a(a)(3) and 1422b(a) to ensure that the FHLBanks operate in a financially safe and sound manner. While safety and soundness is a crucial part of the Finance Board’s supervision of the FHLBanks, the scope of that authority is not limitless. In particular, the specific capital standards that apply to the FHLBanks are set forth in 12 U.S.C. § 1426. Those capital standards reflect the choices made by Congress regarding capital. The Finance Board cannot properly invoke its safety and soundness authority to trump statutory capital requirements.

Congress could have, but chose not to, given the Finance Board authority to make a discretionary decision about the minimum level and composition of capital that each FHLBank should have. Instead, in GLBA, Congress decided to exercise its authority directly and to specify in detail the capital requirements with which each FHLBank must comply. It did not give the Finance Board discretionary authority to modify or ignore those rules if the agency came to believe, for policy reasons, that a different approach to capital might be preferable.

For example, 12 U.S.C. § 1426(a)(2)(A) sets in statute the leverage requirement for each FHLBank at 5 percent total capital based on total assets. Retained earnings are used as part of the permanent capital allowed for the 5 percent calculation. The statute does not contain any other authority for the Finance Board to change make up of the leverage requirement of the FHLBanks — which is exactly what the Proposed Rule seeks to do through use of general safety and soundness authority.

Similarly, 12 U.S.C. § 1426(a)(3) requires risk-based capital to be set by the Finance Board taking into account specific risks faced by each FHLBank. Indeed, as required by statute, the Finance Board in 2001 promulgated a capital standards rule that set forth in great detail the requirements of the risk-based capital and leverage rules to address the risks presented by the lines of business in which the FHLBanks were engaged, including the risks of investments in mortgages. In 2002, the Finance Board approved the individual capital plans under which each FHLBank would comply with the requirements of the Bank Act and the agency’s implementing rule. The agency’s separate approval of each capital plan was based on its review of the specific market-based risk and the leverage risk that each individual FHLBank faced and the approach that institution had developed to provide the permanent capital required to offset those risks. In approving the capital plans, the Finance Board necessarily approved each FHLBank’s strategy for using excess capital and retained earnings to satisfy its legal requirement to maintain "permanent capital" sufficient to meet all its statutory and regulatory obligations.

Through the Proposed Rule, the Finance Board seeks to apply its safety and soundness authority to all FHLBanks on a system-wide, one-size-fits-all basis to require changes in the types and amounts of regulatory capital they must hold and the capital plans for each FHLBank that the Finance Board has approved. These mandatory modifications to the current capital requirements for the FHLBanks are not tailored to the current capital position of an individual FHLBank, or to the lines of business in which it is engaged, or to the credit and interest rate risks it faces. The Finance Board would impose these new requirements without a particularized finding that a specific FHLBank’s safety and soundness would be threatened if these changes in the composition of its regulatory capital were not required.

The Finance Board simply cannot, as a matter of law, ignore the express mandates contained in statute and use its more general “safety and soundness” authority to clear the way for a different policy approach to capital adequacy that the agency apparently prefers to the standards Congress actually enacted in GLBA.

The Finance Board’s Proposals Violate Other Explicit Statutory Provisions of the Federal Home Loan Bank Act and the Gramm-Leach-Bliley Act of 1999

ACB submits that none of the other legal rationales suggested by the Finance Board supports the substance of the proposal. In fact, the proposal is in direct conflict with the statutory capital requirements mandated by Congress.

Prohibition on Excess Capital Stock

In addition to its safety and soundness authority, the agency also relies upon its authority under the capital standards that permit the FHLBanks to issue capital stock "with such rights, terms and preferences not inconsistent with . . . [the Finance Board’s] regulations." 12 U.S.C. § 1426(a)(4). Finally, the Finance Board justifies this proposal under its authority under 12 U.S.C. § 1426(a)(4) to determine the manner in which FHLBank stock may be sold or redeemed and to permit each FHLBank to issue Class A and Class B stock with various rights, terms and preferences. 71 Fed. Reg. at 13310.

Congress addressed "excess stock" in only one place in the Bank Act. 12 U.S.C. § 1426(e)(1) provides:

A Federal home loan bank, in its sole discretion, may redeem or repurchase, as appropriate, any shares of Class A or Class B stock issued by the bank and held by a member that are in excess of the minimum stock investment required of that member. (Emphasis added).

12 U.S.C. § 1426(e)(3) further provides that an FHLBank may not redeem any excess Class B stock prior to the end of the five-year notice period, unless the member has no Class A stock outstanding that could be redeemed as excess.

By granting each FHLBank discretion to determine the amount of excess stock that it might repurchase at any time, the capital standard provision expressly authorizes each FHLBank to have "excess stock" outstanding and does not explicitly impose any limitation on its amount. If Congress had wanted to limit the excess stock outstanding for each FHLBank, it would presumably have done so in this section of the statute. Instead, Congress left the decision on redemption of any outstanding excess stock to each individual FHLBank.

Further, the excess stock proposal ignores the capital structure for the FHLBanks adopted by Congress in GLBA. In GLBA, Congress addressed capital adequacy by (1) authorizing the issuance of Class B stock, subject to a five-year redemption period; (2) establishing risk-based and leverage requirements geared to the particular investments an individual FHLBank holds; and (3) requiring individual FHLBanks to hold "permanent capital" – Class B stock or retained earnings – that Congress deemed sufficient to satisfy the capital requirements.

Thus, when the Proposed Rule asserts that some FHLBanks have relied on excess stock to capitalize balance sheet activities that are long-term in nature and not readily saleable, 71 Fed. Reg. at 13308, the Finance Board has ignored an important fact — that through the capital standards established in 12 U.S.C. § 1426, Congress already has addressed directly the concern that an FHLBank might invest in long-term assets that would not be readily saleable.

Under the Finance Board-approved capital plans, ten of the eleven FHLBanks that have implemented their capital plans have only Class B stock outstanding, and the eleventh requires members to meet the activity-based requirement through the purchase of Class B stock. This means that the vast majority of the current capital in the FHLBank System has a degree of permanence that Congress deemed to be adequate to address the long-term risks presented by their investments.

The Finance Board’s reliance on the “terms and conditions” language of 12 U.S.C. § 1426(a)(4) as authority to drastically limit excess stock is an attempt to use implementation tools to override of the explicit will of Congress as embodied in 12 U.S.C. § 1426. For example, if the Finance Board issued an across-the-board rule that purported to extend the minimum notice period for redemption of Class B stock from five to ten years under its "redemption" power or under the "rights, terms and preferences" clause, its action would clearly be contrary to the terms of GLBA. Its proposed across-the-board rule to prevent each FHLBank from exercising the "in its sole discretion" provision is no different.

Prohibition on Stock Dividends

The proposal to prohibit stock dividends is expressly tied to the limit of excess capital and necessarily falls if the excess capital proposal is not consistent with statute. See 71 Fed. Reg. at 13309 (“Stock dividends, along with the direct sale of excess stock to members, are the main causes of growth in excess stock on the FHLBanks’ balance sheets.”)

In any event, the Proposed Rule’s proposal to prohibit all stock dividends, on a system-wide basis and under all circumstances, violates the explicit provisions of the Bank Act.

12 U.S.C. § 1426 does not expressly grant the Finance Board authority to limit the amount of stock dividends declared by the FHLBanks or to prohibit them altogether. The only provision of the capital standards addressing stock dividends is 12 U.S.C. § 1426(h)(2). It provides that a member of an FHLBank has "no right to . . . receive distribution of any portion of the retained earnings of the bank” except through “the declaration of a dividend or a capital distribution” by the FHLBank. (Emphasis added)

A stock dividend constitutes a "capital distribution" in the form of new shares of the FHLBank. Payment of stock dividends therefore is expressly authorized by 12 U.S.C. § 1426. Further, elsewhere in the capital standards, Congress adopted limitations that determine when an FHLBank may pay stock dividends. In particular:

–the dividend must be consistent an FHLBank’s capital plan approved by Finance Board; and

— an FHLBank may not distribute its retained earnings in any form if, following such a distribution, the bank would no longer meet all applicable capital requirements. Section 1426(h)(3).

In light of the explicit Congressional decisions on the circumstances in which stock dividends may be paid, the Finance Board may not impose limits of its own creation on a system-wide basis without violating the capital standards. Moreover, the Finance Board has already approved the payment of stock dividends through its approval of the capital plans after the passages of GLBA. In 2005, seven of the 12 FHLBanks distributed stock dividends.

Mandatory Minimum Amount of Retained Earnings

To support its retained earnings proposal, the Finance Board relies primarily upon its authority to supervise the FHLBanks and to ensure that they are operated in a safe and sound manner. 12 U.S.C. §§ 1422a(a)(3), 1422b(a)(1). The agency states that a larger, mandatory level of retained earnings is justified under these provisions because of the safety and soundness and mission concerns that could result from the value of an FHLBank’s stock falling below par value and because of the increased risks on the balance sheets of the FHLBanks since the existing rule was adopted. Id. at 13314.

As discussed above, ACB does not believe that the Finance Board’s safety and soundness authority legally supports the Proposed Rule.

Moreover, the Proposed Rule directly conflicts with the express language of 12 U.S.C. § 1426. The legislative history of GLBA shows that Congress considered various ways in which to bolster the capital requirements applicable to FHLBanks, including requiring members to contribute capital that could not be withdrawn for various periods of time; creation of a risk-based capital requirement, in combination with a leverage ratio; and requiring a mandatory level of retained earnings in each FHLBank. Congress ultimately decided to adopt a system with two components: (1) a new structure of permanent capital (Class B stock and retained earnings) to address the increased risks presented by the lines of business in which the FHLBanks were engaged; and (2) leverage and risk-based capital standards that were fine tuned to reflect the specific risks that each FHLBank faces.

Congress explicitly considered, but ultimately did not adopt, a requirement that the FHLBanks must maintain a minimum level of retained earnings. Congress determined instead to require that each FHLBank maintain “permanent capital” sufficient to satisfy risk-based capital and leverage standards. 12 U.S.C. § 1426(a)(3)(A).

Congress defined “permanent capital” to include the amounts paid by the FHLBank’s members for its Class B stock and the retained earnings of the FHLBank. 12 U.S.C. § 1426(a)(5)(A). Rather than require a minimum level of retained earnings, Congress established a method of determining the overall level of "permanent capital" that each FHLBank must satisfy, but did not authorize the Finance Board to impose a mandatory allocation of capital between Class B stock and retained earnings on a system-wide basis. Congress instead gave each FHLBank discretion to determine, subject to Finance Board approval of its capital plan, the precise combination of Class B stock and retained earnings that it would utilize to satisfy its capital requirement.

The Proposed Rule also asserts that not all the FHLBanks have increased their retained earnings as quickly as the agency would have liked in response to an Advisory Bulletin it issued in 2003; that “there is a general lack of consistency among the FHLBanks’ retained earnings policies and target retained earnings levels” under the capital plans that the Finance Board previously approved; and that the FHLBanks “manage arguably riskier balance sheets” than previously because of increased holdings of mortgage assets. 71 Fed. Reg. at 13311. As a legal matter, the Advisory Bulletin did not supplant the capital plans that the Finance Board had approved shortly before the Bulletin was issued.
Moreover, 12 U.S.C. § 1426 does not require, nor envision, that there be “consistency” among the retained earnings policies of each FHLBank. 12 U.S.C. § 1426 grants each FHLBank discretion as to the combination of Class B stock and retained earnings that it will use to satisfy its capital requirements, subject to Finance Board approval through the capital plan process.

In addition to its safety and soundness authority, the Finance Board relies upon its authority under 12 U.S.C. § 1436 to justify the retained earnings requirement. That provision allows the Finance Board to direct an FHLBank "to establish such other reserves . . . as [it] shall require." The agency asserts that 12 U.S.C. § 1436 "does not limit the reasons for which it can require the FHLBanks to establish these additional reserves" and notes that historically, reserves required under this provision were included in retained earnings. 71 Fed. Reg. at 13314.

This assertion is not supportable, however, because the Proposed Rule does not propose the creation of a "reserve." Rather, it seeks to impose a mandatory allocation between the two statutory components of “permanent capital.” If the proposal were implemented and unless the Finance Board intends to set the minimum leverage ratio at a level higher than that authorized by statute, an FHLBank would have no more permanent capital available to offset potential losses after the rule was implemented than under the current rules. There would only be a reallocation of capital between categories on the balance sheets of the FHLBanks.

The Proposed Rule Has No Rational Basis and is Therefore Arbitrary

ACB submits that the Finance Board has not provided sufficient rationale for the new limitations regarding retained earnings, excess stock and dividends. In some cases, the Proposed Rule itself undermines the Finance Board’s justifications for the proposals.

In addition, the Finance Board also refuses to release information concerning the factual underpinnings and analysis of the Proposed Rule, and in one case has indicated that it has not performed any analysis at all of the impact of the Proposed Rule on the members of the Federal Home Loan Bank System.

FOIA Requests

On April 3, 2006, ACB submitted a FOIA request to the Finance Board for any documents and analyses prepared by the Finance Board that demonstrate the factual underpinnings of the numerical limitations on retained earnings and excess stock contained in the Proposed Rule. The Finance Board released some documents that contained the flawed analysis discussed in the section on retained earnings above. The Finance Board withheld many more documents under the “deliberative exemption” contained in section 910.5(a)(5) of the Finance Board’s regulations.

ACB appealed this determination by the Finance Board on June 5, 2006, asserting that the deliberative exception does not cover factual documents. The Finance Board provided no response to the appeal request within the timeframe for response as required by the agency’s own regulation at 12 CFR § 910.8. However, on July 6, 2006, the Finance Board by letter denied ACB’s appeal, continuing to assert that the Finance Board would withhold responsive material under section 910.5(a)(5) of the agency’s regulations.

The Analysis Released by the Finance Board Is Flawed and Does Not Support the Proposal

As discussed above, the Finance Board has released, in response to ACB’s FOIA request, an undated document that sets forth a simplistic analysis of how the agency developed its retained earnings proposal. The document states that “the proposed REM formula principally reflects a supervisory judgment of an appropriate framework to set retained earnings levels at the 12 FHLBanks.” This type of analysis does not support adoption of a rule that will have far-reaching consequences on the operations of the FHLBanks and their members. An agency cannot simply choose arbitrary limits to constrain the lawful operation of its regulatees.

The Proposed Rule Is Not Supported by the Finance Board’s Statements

Significantly, the Finance Board admits in the Proposed Rule that all FHLBanks satisfy the capital standards and that the risk of insolvency is de minimis. Each FHLBank now operates under a capital plan approved by the Finance Board. Each FHLBank now maintains sufficient permanent capital to meet its regulatory requirements, as determined by the risk-based capital and leverage tests established by the Finance Board. The agency itself concedes that “its capital rules and the FHLBanks’ overall capital levels remain adequate and the risk of capital insolvency at any FHLBank in the foreseeable future is de minimis.” 71 Fed. Reg. at 13311. Accordingly, there is no basis for invocation of the agency’s safety and soundness powers even assuming that authority could be used to change statutory capital standards.

Further, the safety and soundness rationale does not support what the Finance Board actually has proposed. The Proposed Rule does not seek to increase the amount of capital that each FHLBank holds, so it is difficult to understand why the Proposed Rule is needed at all. The Finance Board admittedly seeks only to change the composition of capital between its two permissible components. Since Congress determined that capital represented by Class B stock, with a five year notice requirement prior to redemption, was sufficient to support the long-term investments of the FHLBanks, the retained earnings proposal amounts to an agency effort to second guess the congressional policy decision reflected in Section 1426(a)(5) that either Class B stock or retained earnings could be used to support those investments.

In fact, the Proposed Rule contains provisions that would weaken the capital position of the FHLBank System as a whole. In a rule that invokes the agency’s safety and soundness rationale to strengthen the capital of the FHLBanks, it is completely irrational to start with a provision that requires the FHLBanks to pay out billions of dollars to redeem excess capital stock, and then to require those FHLBanks to build up retained earning to compensate for the capital that the Finance Board required them to disperse.

Finally, the Finance Board fails to provide any explanation as to why the agency has dramatically shifted its policies regarding capital since 2001. The Proposed Rule represents a 180-degree shift from the well-crafted capital regulations adopted by the Finance Board in 2001, and the detailed process conducted in 2002, to approve the capital plans for each FHLBank. Under Motor Vehicle Mfgrs. Ass’n v. State Farm Mut. Life Ins. Co., 463 U.S. 29 (1983), an agency is permitted to change its position on an issue, as long as it provides a rational explanation for its action. The Finance Board has not met this obligation in the Proposed Rule.

Conclusion

Thank you for the opportunity to comment on this important matter. As we have previously requested in our joint letter of June 16, 2006, we request that the Finance Board withdraw this proposal because of its potential significant negative impact on the FHLBank System and reissue an Advance Notice of Proposed Rulemaking that takes into consideration the policy issues and facts raised during this comment period. Should you have any questions, please contact Ike Jones at 202-857-3132 or [email protected].

Sincerely,

Diane Casey-Landry
President & CEO