CUNA Regulatory Comment Call


September 29, 2006

Federal Housing Finance Board Proposal on Exam Rating System for Federal Home Loan Banks

EXECUTIVE SUMMARY

  • The Federal Housing Finance Board (Board) has requested comments on a proposed examination rating system that will apply to its examinations of the Federal Home Loan Banks (Banks). This risk-based rating system will be known as the Federal Home Loan Bank Rating System (Rating System).

  • Under the Rating System, each Bank will be assigned a composite rating based on an evaluation and rating of five key components. These components will be corporate governance, credit risk, market risk, operational risk, and financial condition and performance.

  • Comments in response to the proposed rule are due by October 23, 2006. Please submit your comments to CUNA by October 17, 2006.

Please feel free to fax your responses to CUNA at 202-638-7052; e-mail them to Senior Vice President and Deputy General Counsel Mary Dunn at mdunn@cuna.coop and to Senior Assistant General Counsel Jeff Bloch at jbloch@cuna.coop; or mail them to Mary and Jeff in c/o CUNA’s Regulatory Advocacy Department, 601 Pennsylvania Avenue, NW, South Building, Suite 600, Washington, DC 20004-2601. You may also contact us at 800-356-9655, ext. 6732, if you have questions or would like a copy of the proposed rule. You may also access a copy of the proposed rule at the following address:

http://www.fhfb.gov/GetFile.aspx?FileID=6039

BACKGROUND

The Banks are privately capitalized, government-sponsored enterprises that provide wholesale credit to their members for use in mortgage lending and related activities. This is accomplished be providing long-term, flexible financing for their member financial institutions, including nearly 900 credit unions.

The primary duty of the Board is to ensure that the Banks operate in a financially safe and sound manner. The Board monitors the performance, condition, and risk profile of each Bank through on-site examinations and other supervisory activities. In an effort to identify and address current and emerging risks to the Banks, the Board plans to implement the Rating System beginning in 2007.

BRIEF DESCRIPTION OF THE PROPOSAL

The Rating System will be a risk-based system under which each Bank will be assigned a composite rating based on an evaluation of various aspects of their operations. The composite rating of each Bank will be based on an evaluation and rating of five key components, which will be corporate governance, market risk, credit risk, operational risk, and financial condition and performance. The ratings for the individual Banks will not be made public or released to the other Banks.

Each Bank’s affordable housing and community investment activities will be taken into account in assigning ratings for the corporate governance and operational risk components. After gaining experience with the Rating System, the Board may at a later time consider a separate rating system or separate rating component to evaluate the affordable housing and community investment programs at each Bank.

The Rating System is intended to serve the following purposes:

  • Reflect the overall condition and performance of an institution, taking into consideration all significant financial, operational, and compliance factors.

  • Enhance communication and transparency between the Board and each Bank regarding the results of the examination process.

Under the rating system, each of the five components will receive a numeric rating on a scale from 1 to 4, with a 1 indicating the lowest level of supervisory concern and 5 indicating the highest level of supervisory concern. The composite, or overall, rating for each Bank will also be on a scale from 1 to 4 and will be based on the ratings of the five underlying components. The overall rating will not be a simple average. The relative weight accorded to each component for purposes of the composite rating will be determined on a case-by-case basis.

The corporate governance component will be rated based on the following factors:

  • For board of directors and senior management:
    • Whether the board is actively engaged in carrying out its duties, including monitoring senior management performance, providing strategic direction, establishing risk parameters, and governing the institution’s affordable housing and community investment activities.
    • The effectiveness of the board of directors.
    • The quality, expertise, and effectiveness of management.
    • Whether the board and senior management have established an operating structure that facilitates a sound risk management program.
    • Management depth and the adequacy of management succession plans.
    • The quality of strategic planning and the ability of management to integrate strategy with risk and return objectives.
    • The overall “tone at the top,” including the quality of risk management culture and the existence of high ethical standards.
    • The Bank’s responsiveness to supervisory criticism.

  • For risk management and controls:
    • The quality of risk management oversight and the soundness of risk management policies, practices, and procedures.
    • The accuracy, timeliness, and effectiveness of management information and risk monitoring systems.
    • The quality of internal controls and the effectiveness of the internal audit and control units in identifying and communicating internal control deficiencies to management and the board.

  • For compliance:
    • Compliance with laws, regulations, supervisory guidance, and Bank policies.
    • The responsiveness of the board and management to internal audit and independent auditors.
    • The responsiveness of the board and management to supervisory authorities.

The market risk component will be rated based on the following factors:

  • For the level of or market risk exposure:
    • The sensitivity of the institution’s earnings and market value of the equity to changes in interest rates and other market risk factors.
    • The sensitivity of the institution’s earnings and market value of the equity to changes in interest rates and other market risk factors in relation to its retained earnings and capital.

  • For the quality of market risk management:
    • The quality of board and senior management oversight of market risk.
    • The effectiveness of risk management policies, procedures, and internal controls.
    • The effectiveness of risk measurement, monitoring, and reporting systems.
    • The effectiveness of the institution’s hedging activities.

The credit risk component will be rated based on the following factors:

  • For the level of or credit risk exposure:
    • The level and trend of nonperforming and nonaccrual assets.
    • The overall quality and diversification of the advance, investment, and acquired member assets portfolio.
    • The volume and nature of credit documentation exceptions.

  • For the quality of credit risk management:
    • The quality of credit review performed by the board of directors and senior management.
    • The quality and effectiveness of credit risk management policies and procedures.
    • The quality and effectiveness of credit underwriting policies and procedures.
    • The quality, timeliness, and effectiveness of collateral evaluation and testing procedures.
    • The quality of the methodologies for evaluation and maintaining reserves for credit losses.
    • The quality of the institution’s credit risk self-assessment and internal risk rating processes.
    • The quality of credit information systems.

The operational risk component will be rated based on the following factors:

  • For the level of or operational risk exposure:
    • The level and frequency of losses resulting from inadequate or failed internal processes or systems, fraud or human error, or from external events.
    • The severity and frequency of accounting, financial, and regulatory reporting errors.
    • Whether the institution’s operational risk losses are increasing, decreasing, or stable.
    • The degree to which processes are automated to minimize error.
    • The level of operational risk arising from the administration of the institution’s principal lines of business and its affordable housing and community investment activities.

  • For the quality of operational risk management:
    • Whether appropriate policies, procedures, and systems are in place to measure, manage, and control operational risk.
    • Whether operational risks are being effectively measured, monitored, and controlled.
    • The quality of policies and procedures in place to ensure secure, efficient, and effective information and data processing.
    • The quality of contingency and business continuity planning.
    • The quality of the institution’s operational risk reports.
    • The effectiveness of processes for identifying and controlling risk to business activities.
    • The quality of the institution’s operational risk self assessment, including whether key operational risks in all products, activities, processes, and systems have been clearly identified.
    • The quality of operational risk management in the administration of the institution’s affordable housing and community investment activities.

The condition and performance component will be rated based on the following factors:

  • For earnings and profitability:
    • The level, trend, and stability of earnings.
    • Risk-adjusted returns on assets and equity.
    • Net interest margins and spreads.
    • The quality of earnings.

  • For operating efficiency:
    • Non-interest operating expenses in relation to average assets.
    • The extent to which the Bank is taking advantage of technological advances.

  • For capital and retained earnings:
    • The risk-based capital and leverage ratios.
    • The relative stability of capital.
    • The level of retained earnings in relation to the institution’s earnings stability and future prospects.

  • For liquidity:
    • The level of liquidity instruments relative to risk exposures.
    • Compliance with regulatory liquidity requirements.

QUESTIONS TO CONSIDER REGARDING THE FEDERAL HOUSING FINANCE BOARD’s PROPOSAL ON THE EXAM RATING SYSTEM FOR FEDERAL HOME LOAN BANKS

(The Board has specifically requested comments on these issues.)

  1. Does the Rating System capture the essential components of an institution’s performance and condition that are relevant to assigning a composite rating to the Bank? What additional or different components should be considered?











  2. Do the factors to be considered under each of the five components address the factors that should be considered in assessing each of the components? What additional or different factors should be considered?











  3. Other comments?











Eric Richard • EVP &General Counsel • (202) 508-6742 • erichard@cuna.com
Mary Mitchell Dunn • SVP & Deputy General Counsel • (202) 508-6736 • mdunn@cuna.com
Jeffrey Bloch • Senior Assistant General Counsel • (202) 508-6732 • jbloch@cuna.com
Lilly Thomas • Assistant General Counsel • (202) 508-6733 • lthomas@cuna.com
Catherine Orr • Senior Regulatory Counsel • (202) 508-6743 • corr@cuna.com
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