Organization; Funding and Fiscal Affairs, Loan Policies and Operations, and Funding Operations; Investment Eligibility

AGENCY:

Farm Credit Administration.

ACTION:

Proposed rule.

SUMMARY:

The Farm Credit Administration (FCA, Agency, us, our, or we) proposes to amend our regulations governing the eligibility of investments held by Farm Credit banks. We propose to strengthen these regulations by reinforcing that only high quality investments may be purchased and held. We also propose to revise these regulations to comply with section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act or DFA) by removing references to and requirements relating to credit ratings and substituting other appropriate standards of creditworthiness. The FCA also proposes to revise its regulatory approach to Farm Credit System (System) association investments in order to limit the type and amount of investments that an association may hold. The proposed rule also addresses investment and risk management practices at associations and funding bank supervision of association investments.

DATES:

You may send us comments by October 23, 2014.

ADDRESSES:

We offer a variety of methods for you to submit comments on this proposed rule. For accuracy and efficiency reasons, commenters are encouraged to submit comments by email or through the Agency's Web site. As facsimiles (fax) are difficult for us to process and achieve compliance with section 508 of the Rehabilitation Act, we are no longer accepting comments submitted by fax. Regardless of the method you use, please do not submit your comment multiple times via different methods. You may submit comments by any of the following methods:

• Email: Send us an email at reg-comm@fca.gov.
• FCA Web site: http://www.fca.gov. Select “Public Commenters,” then “Public Comments,” and follow the directions for “Submitting a Comment.”
• Federal eRulemaking Portal: http://www.regulations.gov. Follow the instructions for submitting comments.
• Mail: Barry F. Mardock, Deputy Director, Office of Regulatory Policy, Farm Credit Administration, 1501 Farm Credit Drive, McLean, VA 22102-5090.

You may review copies of all comments we receive at our office in McLean, Virginia, or on our Web site at http://www.fca.gov. Once you are in the Web site, select “Public Commenters,” then “Public Comments,” and follow the directions for “Reading Submitted Public Comments.” We will show your comments as submitted, but for technical reasons we may omit items such as logos and special characters. Identifying information that you provide, such as phone numbers and addresses, will be publicly available. However, we will attempt to remove email addresses to help reduce Internet spam.

FOR FURTHER INFORMATION CONTACT:

Paul K. Gibbs, Senior Accountant, or Timothy T. Nerdahl, Senior Financial Analyst, Office of Regulatory Policy, Farm Credit Administration, McLean, VA 22102-5090, (703) 883-4414, TTY (703) 883-4056; or

Jennifer A. Cohn, Senior Counsel, or Richard A. Katz, Senior Counsel, Office of General Counsel, Farm Credit Administration, McLean, VA 22102-5090, (703) 883-4020, TTY (703) 883-4056.

SUPPLEMENTARY INFORMATION:

I. Objectives

The objectives of this proposed rule are to:

• Strengthen the safety and soundness of Farm Credit banks and associations;

• Ensure that Farm Credit banks hold sufficient liquidity to continue operations and pay maturing obligations in the event of market disruption;
• Enhance the ability of the Farm Credit banks to supply credit to agricultural and aquatic producers;
• Comply with the requirements of section 939A of the Dodd-Frank Act;
• Modernize the investment eligibility criteria for Farm Credit banks; and
• Revise the investment regulation for associations to improve their investment management practices so they are more resilient to risk.

II. Background

Congress created System institutions, including Farm Credit banks and associations, to provide permanent, stable, and reliable sources of credit and related services to American agricultural and aquatic producers. Associations obtain funds from Farm Credit banks to provide short-, intermediate-, and long-term credit and related services to farmers, ranchers, producers and harvesters of aquatic products, to rural residents for housing, and to farm-related businesses.

Farm Credit banks depend on investments to provide liquidity and to fulfill other needs, and investments also enable associations to manage the risks they confront. Although Farm Credit banks obtain their funding primarily through the issuance of System-wide debt securities, they must have enough available funds, including investments, to continue operations and pay maturing obligations if access to the debt market becomes temporarily impeded.

FCA regulations, at subpart E of part 615, impose comprehensive requirements regarding the investments of System institutions. We have recently revised many of these requirements, particularly those guiding prudent investment management practices. This rulemaking proposes to revise the requirements governing the eligibility of investments for Farm Credit banks and associations, which have been largely unchanged since 1999, as well as the permissible investment amounts and purposes for associations. The regulations this rulemaking proposes to amend should not be viewed in isolation, but rather as part of a comprehensive set of rules guiding the System's liquidity and investment management.

Investment products are becoming increasingly complex, and the financial crisis that began in 2007 made clear that some investments are riskier and less liquid than were previously believed. In addition, in July 2010 the President signed into law the Dodd-Frank Act to strengthen regulation of the financial industry in the wake of the financial crisis. Section 939A of the DFA requires each Federal agency to review all of its regulations that refer to or require the use of credit ratings to assess the creditworthiness of an instrument; to remove the reference or requirement; and to substitute other appropriate creditworthiness standards. FCA's existing investment eligibility regulations use credit ratings as a determinant of eligibility of some investments.

We now propose to comply with the DFA by eliminating the regulations' reliance on credit ratings. The financial crisis that began in 2007 identified flaws in relying on credit ratings to determine credit risk, as many investments with similar labels and ratings exhibited substantially differing underlying risk characteristics, ultimately impacting marketability of the investments. Investment eligibility would no longer depend on external credit ratings, thus enhancing safety and soundness. We also propose other amendments to the provisions governing Farm Credit banks that would strengthen the safety and soundness of their investment activities by more accurately reflecting the risk in particular investments.

Finally, we propose amendments to § 615.5142, which governs the investment activities of associations. We recognize that many associations may need to hold investments for purposes other than managing surplus short-term funds and reducing interest rate risk, which are the only investment purposes authorized by the existing regulations. For this reason, the proposed rule would grant associations greater flexibility to hold investments for other risk management purposes. At the same time, we propose to limit the types and amount of investments that associations may hold.

We first considered revisions to our Farm Credit bank and association investment regulations in 2011. As discussed above, we adopted many of these revisions in 2012, but we did not revise the provisions governing investment eligibility and association investments, which we are now proposing to revise. The revisions we now propose take into consideration the comments we received in response to the earlier rulemaking, as well as the approaches some of the other Federal banking regulatory agencies have taken toward compliance with the DFA credit ratings elimination requirement.

III. Section-by-Section Description of the Proposed Rule

The proposed rule enhances the credit quality standards for eligible investments that Farm Credit banks may hold and revises the regulation governing association investment activities. It also contains conforming amendments to other regulations in parts 611 and 615.

A. Section 615.5131—Definitions

We propose to define asset class as a group of securities that exhibit similar characteristics and behave similarly in the marketplace. Asset classes include, but are not limited to, money market instruments, municipal securities, corporate bond securities, mortgage-backed securities (MBS), asset-backed securities (ABS) (excluding MBS), and any other asset class as determined by the FCA. We discuss this definition later in this preamble.

We propose to define a collateralized debt obligation (CDO) as a debt security collateralized by MBS, ABS, or trust-preferred securities.

One of our proposed criteria for Farm Credit bank investments with an obligor located outside of the United States is a high Country Risk Classification (CRC) (a 0 or a 1) as published by the Organization for Economic Cooperation and Development (OECD). We propose to define CRC, with respect to a sovereign, as the most recent consensus CRC published by the OECD as of December 31 of the prior calendar year that provides a view of the likelihood that the sovereign will service its external debt. This definition is identical to that adopted by the other Federal banking regulators in their capital rules to implement Basel III. We proposed the same definition in the proposed revisions to our regulatory capital rule that the FCA Board adopted on May 8, 2014.

We propose to define a diversified investment fund as an investment company registered under section 8 of the Investment Company Act of 1940, 15 U.S.C. 80a-8. This is consistent with our usage of the term in existing § 615.5140(a)(8).

We propose to replace the definitions for the existing terms “Government-sponsored agency” and “Government agency” with definitions for the new terms “Government-sponsored enterprise (GSE)” and “United States (U.S.) Government agency,” respectively. We would define GSE as an entity established or chartered by the U.S. Government to serve public purposes specified by the U.S. Congress but whose debt obligations are not explicitly guaranteed by the full faith and credit of the U.S. Government. We would define U.S. Government agency as an instrumentality of the U.S. Government whose obligations are fully guaranteed as to the timely payment of principal and interest by the full faith and credit of the U.S. Government. These terminology changes would have no substantive effect.

We propose to replace the defined term “mortgage securities” with “mortgage-backed securities” or “MBS.” We also propose to change “mortgage securities” to “mortgage-backed securities” in the definition of ABS. These technical changes are for consistency with other FCA regulations and would have no substantive effect.

We propose to add a new definition for the term “obligor.” Our existing regulations use this term, as do provisions that we propose to add or revise, but we have no definition for this term. We propose to define the term to ensure a common understanding of its meaning.

We would define obligor as an issuer, guarantor, or other person or entity who has an obligation to pay a debt, including interest due, by a specified date or when payment is demanded. This definition would include the debtor or immediate party that is obligated to pay a debt, as well as a guarantor of the debt. The definition would not include the sponsor (as we propose to define the term) of an investment, unless the sponsor has an obligation to pay the debt.

We propose to define “sponsor” as a person or entity that initiates a transaction by selling or pledging to a specially created issuing entity, such as a trust, a group of financial assets that the sponsor either has originated itself or has purchased; the sponsor may retain the obligation to repay or may transfer that obligation to the trust. An example of a sponsor would be an entity such as a commercial bank that transfers financial assets, such as loans that it has originated or purchased, to a bankruptcy remote trust known as a special purpose vehicle (SPV). In this example, the SPV services the debt and has the obligation to repay.

We propose to delete the following definitions because they will no longer be used in this subpart. We propose to delete “eurodollar time deposits,” “final maturity,” “general obligations,” “liquid investments,” “nationally recognized statistical rating organization,” “revenue bond,” and “weighted average life”.

B. Section 615.5134—Liquidity Reserve

We propose to make technical, non-substantive revisions by adding the new terms “Government-sponsored enterprise (GSE)” and “U.S. Government agency” to our liquidity reserve regulation at § 615.5134, to conform to changes we made to those defined terms in § 615.5131. In addition, we propose changes to clarify that MBS must be fully guaranteed by a U.S. Government agency to qualify for Level 2 liquidity and fully guaranteed by a GSE to qualify for Level 3 liquidity.

C. Section 615.5140—Eligible Investments for Farm Credit Banks

Our existing investment eligibility regulation at § 615.5140 contains a detailed listing of eligible investment asset classes and types of investments within each asset class. The regulation imposes final maturity limits, investment portfolio limits, and other requirements for many of these investments. It also imposes credit rating requirements, based on NRSRO credit ratings, for a number of the investments. The regulation currently applies to both Farm Credit banks and associations.

In revised § 615.5140, we propose to revise the investment eligibility requirements governing Farm Credit banks to strengthen their safety and soundness by more accurately reflecting the risk in particular investments based on recent experience in the marketplace. In addition, to comply with section 939A of the DFA, we propose to replace the regulations' NRSRO credit ratings requirements with other standards of creditworthiness.

1. Paragraph (a)—Investment Eligibility Criteria

We propose the following criteria for Farm Credit banks to determine whether an investment is eligible. These criteria would replace the listing of eligible investments in our existing regulations.

a. Paragraph (a)(1)—Purpose

We propose to formalize our existing requirement that for an investment to be eligible, it must be purchased and held for an authorized purpose as set forth in § 615.5132(a). A Farm Credit bank must be able to identify the authorized purpose or purposes for which each investment is held.

b. Paragraph (a)(2)—Eligible Investments

The proposed regulation would specify the general requirements that investments must satisfy to be eligible. Limiting investments to those that satisfy these general requirements will ensure that investments are of high quality.

i. Paragraph (a)(2)(i)—Non-convertible Senior Debt Securities

Investments in senior debt securities that cannot be converted to any other type of securities would be eligible under the proposed rule. This investment category would include non-convertible U.S. Government agency senior debt securities, including U.S. Treasury securities, and senior non-convertible GSE bonds. Senior debt securities are those securities that have priority of claim over other securities issued. Senior debt securities may be secured by a specific pool of collateral or may be unsecured with priority of claims over other types of debt securities such as subordinated debt, preferred stock, or common equity. To be eligible under this criterion, a senior debt security must not be convertible into a non-senior security or an equity security.

Currently authorized investments such as municipal securities and corporate debt securities would be eligible under this criterion, as long as they are non-convertible senior debt securities. Other non-convertible senior debt securities would also be eligible under this criterion.

ii. Paragraph (a)(2)(ii)—Money Market Instruments

As under our existing rule, investments in money market instruments would be eligible under the proposed rule. The existing rule lists short-term instruments such as Federal funds, negotiable certificates of deposit, bankers acceptances, commercial paper, non-callable term Federal funds and Eurodollar time deposits, master notes, and repurchase agreements collateralized by eligible investments as money market instruments. The proposed rule's use of the term money market contemplates these instruments as well as other short-term instruments. For an investment to be eligible as a money market instrument, it must have a maturity of 1 year or less.

iii. Paragraph (a)(2)(iii)—Mortgage-Backed Securities and Asset-Backed Securities Guaranteed by U.S. Government Agencies

We propose that MBS and ABS that are fully guaranteed as to the timely payment of principal and interest by a U.S. Government agency would be eligible securities because of their high credit quality. MBS and ABS that are partially guaranteed by a U.S. Government agency would not be eligible under this criterion (although they could be eligible under other criteria). Securities labeled “government guaranteed” satisfy this criterion only if they are fully guaranteed as to the timely payment of principal and interest.

iv. Paragraph (a)(2)(iv)—Mortgage-Backed Securities and Asset-Backed Securities Guaranteed by GSEs

Under the proposed rule, MBS and ABS that are fully and explicitly guaranteed as to the timely payment of principal and interest by GSEs would be eligible investments. Farmer Mac MBS would be excluded from eligibility under this provision because they are separately authorized and governed by § 615.5174.

Securities are eligible under this provision only if a GSE fully guarantees the timely payment of both the principal and interest due. A GSE “wrap” (guarantee) does not make a security eligible under this provision unless it is a guarantee of all principal and interest. When considering whether to purchase a security with a GSE guarantee or wrap, an institution must ensure that it is fully guaranteed. This provision carries over and clarifies the existing authorities.

v. Paragraph (a)(2)(v)—Senior-Most Positions of Mortgage-Backed Securities and Asset-Backed Securities Not Guaranteed by U.S. Government Agencies or GSEs

In our 2011 proposed rule on investment management, we proposed that a position in a mortgage security that is not guaranteed by a Government agency or Government-sponsored agency would be eligible only if it is the senior-most position at the time of purchase. In that proposed rule, we said that we consider a position in such a mortgage security to be the senior-most position only if it currently meets both of the following criteria:

• No other remaining position in the securitization has priority in liquidation. Remaining positions that are the last to experience losses in the event of default and which share those losses pro rata meet this criterion.
• No other remaining position in the securitization has a higher priority claim to any contractual cash flows. Remaining positions that have the first priority claim to contractual cash flows (including planned amortization classes), as well as those that share on a pro rata basis a first priority claim to cash flows meet this criterion.

In their comments on the 2011 proposed rule, CoBank, ACB, the Farm Credit Bank of Texas, and The Farm Credit Council commented that the market understands the term “senior-most” to relate to liquidation preference rather than to the priority of claims to contractual cash flows prior to default. This is because investors, such as System institutions, are concerned with whether they receive a pro rata share of cash flows in the event of depleted credit support or issuer/borrower default, not with whether contractual cash flows are paid first in the ordinary course of business. Institutions are able to successfully and safely invest in securities that are not the first priority with respect to contractual cash flows. These commenters, therefore, asked us to delete the second criterion from our understanding of the term “senior-most.”

We agree with these comments and eliminate the second criterion. The first criterion set forth above remains.

In addition, as in the existing rule, we propose to retain the requirement that for a position in an MBS to be eligible, the MBS must satisfy the definition of “mortgage related security” in 15 U.S.C. 78c(a)(41). We propose to delete the alternative that the MBS could instead comply with 15 U.S.C. 77d(5), because that statutory provision was repealed by the Dodd-Frank Act. We note that commercial MBS are included under this proposed eligibility provision.

Private placements may be eligible under this proposed criterion (or other criteria), as long as they satisfy all of the proposed investment eligibility requirements. Private placement refers to the sale of securities to a relatively small number of sophisticated investors without registration with the Securities and Exchange Commission and, in many cases, without the disclosure of detailed financial information or a prospectus. Even private placements that may be eligible are generally not liquid. Farm Credit banks must be able to identify a permissible purpose for holding a private placement.

Our existing eligibility rules limit investments in ABS to those secured by specified assets and with specified weighted average lives. We propose to permit investments in the senior-most position of any ABS, regardless of the secured asset or the weighted average life.

In sum, the proposed rule would permit Farm Credit banks to invest in the senior-most position of any MBS that satisfies the statutory definition of “mortgage related security” and the senior-most position of any ABS.

vi. Paragraph (a)(2)(vi)—International and Multilateral Development Bank Obligations

We retain the authority for Farm Credit banks to invest in obligations of international and multilateral development banks, as long as the United States is a voting shareholder.

vii. Paragraph (a)(2)(vii)—Shares of a Diversified Investment Fund

Under the proposal, shares of a diversified investment fund (DIF) would be eligible if the DIF's portfolio consists solely of securities that are eligible under these eligibility criteria or under § 615.5174. The investment company's risk and return objectives and use of derivatives must be consistent with the investment policies of the Farm Credit bank. This DIF eligibility is unchanged from the existing regulation. As discussed below, however, we propose more restrictive portfolio diversification limits on DIF investments than those that currently exist.

c. Paragraph (a)(3)—Obligors' Capacity To Meet Financial Commitment

Existing § 615.5140 imposes credit rating requirements, based on NRSRO credit ratings, to determine the eligibility of investments in a number of asset classes, including municipal securities, certain money market instruments, non-agency mortgage-backed securities, asset-backed securities, and corporate debt securities.

Section 939A of the DFA requires each Federal agency to revise all of its regulations that refer to or require reliance on credit ratings to assess creditworthiness of an instrument to remove the reference or requirement and to substitute other appropriate creditworthiness standards.

We propose to comply with this requirement in a manner consistent with the approach of some of the Federal banking regulatory agencies. The OCC, for example, previously required national banks to determine whether a security was “investment grade” in order to determine whether purchasing the security was permissible. Under the previous definition of “investment grade,” a security could be characterized as “investment grade” if it was rated in the top four “investment grade” NRSRO ratings.

In its revised regulations to comply with the DFA requirement, the OCC retained the term “investment grade” but eliminated the rating standard. Instead, it defined the term to mean “the issuer of a security has an adequate capacity to meet financial commitments under the security for the projected life of the asset or exposure.”

The OCC stated that it did not intend for the elimination of references to credit ratings to change substantively the standards national banks must follow when deciding whether a security is investment grade. Its new rule permits a national bank to consider credit ratings as part of its “investment grade” determination and due diligence, but the credit rating must be supplemented by the bank's own analysis. And the new rule does not require a national bank to use NRSRO credit ratings to make the “investment grade” determination.

The OCC previously permitted national banks to invest in securities that were rated in one of the top four ratings. The OCC intends that its new definition—the issuer of a security has an adequate capacity to meet financial commitments under the security for the projected life of the asset or exposure—is substantively unchanged from its previous standards.

Except for investments in a few asset classes such as U.S. Government agency and GSE obligations, as discussed above, FCA's existing regulations require that in order to be eligible, investments must meet the highest or the second highest NRSRO rating, depending on the asset class. We want to retain high creditworthiness standards for Farm Credit bank investments. Accordingly, we propose to require that for an investment to be eligible for Farm Credit banks, at least one obligor (whether debtor or guarantor) must have very strong capacity to meet its financial commitment for the expected life of the investment. Obligors that exhibit very strong capacity to meet financial commitments generally have very low probability of default. This standard would apply to all investments, including those that are currently not subject to a credit rating requirement.

Like the OCC's regulations, our proposal permits but does not require Farm Credit banks to consider credit ratings. If a Farm Credit bank does consider credit ratings, it must still conduct its own due diligence to determine whether an investment satisfies this standard. An investment does not automatically satisfy this standard by virtue of its credit rating.

We propose an additional standard for investments if a Farm Credit bank is relying upon the capacity of a non-U.S. obligor to meet the “very strong capacity” standard. Unless such an investment is fully guaranteed as to the timely payment of principal and interest by a U.S. Government agency, the sovereign host country of the obligor whose capacity is being relied upon must have the highest Country Risk Classification (CRC) (a 0 or a 1) as published by the OECD or must be an OECD member that is unrated. If the Farm Credit bank is not relying upon the capacity of a non-U.S. obligor to satisfy the “very strong capacity” standard, then the proposal establishes no requirements regarding that obligor's sovereign host country.

The OECD's CRCs are an assessment of a country's credit risk, used to set interest rate charges for transactions covered by the OECD arrangement on export credits. The OECD uses a scale of 0 to 7 with 0 being the lowest possible risk and 7 being the highest possible risk. Furthermore, the OECD no longer assigns CRCs to certain high income countries that are members of the OECD and that have previously received a CRC of 0. OECD member countries that are no longer assigned a CRC exhibit a similar degree of country risk as that of a jurisdiction with a CRC of 0.

In their capital rules to implement Basel III, the Federal banking regulators adopted provisions basing risk weights for sovereign exposures on OECD CRCs (and on OECD membership, for countries without a CRC). Like these other regulators, we believe that use of CRCs in this manner is permissible under section 939A of the Dodd-Frank Act and that section 939A was not intended to apply to assessments of creditworthiness of organizations such as the OECD. As discussed in those rules, section 939A was targeted at addressing the role, and the conflicts of interest, of commercial credit rating agencies that provide government-sanctioned credit ratings to their fee-paying clients. The OECD is not a commercial entity that produces credit assessments for fee-paying clients, nor does it provide the sort of evaluative and analytical services as credit rating agencies. Additionally, we propose to use CRCs only for this limited purpose.

d. Paragraph (a)(4)—Credit and Other Risk in the Investment

In addition to imposing standards on obligors, we also propose to require that for an investment to be eligible, it must itself exhibit low credit risk and other risk characteristics consistent with the purposes for which it is held. The other risks that institutions must consider include, but are not limited to, those listed in § 615.5133(c).

We believe that all investments held by Farm Credit banks must have low credit risk. We do not propose to require that other risks in the investment be low in all cases. Instead, the risk characteristics in the investment must be consistent with the purposes for which the investment is held. Accordingly, Farm Credit banks must understand the purpose for which they purchase and hold an investment.

For instance, if an investment is held for the purpose of liquidity, it would have to be marketable or liquid and would generally have to have low price volatility. On the other hand, an investment that is high quality but has high price volatility and questionable marketability or liquidity would not be appropriate for a liquidity investment, but it might be used effectively to manage interest rate risk, which is a permissible purpose for Farm Credit banks under § 615.5132(a). Farm Credit banks must also consider whether other risks are consistent with the purpose for which an investment is held.

e. Paragraph (a)(5)—Denomination

As in our existing rule, the denomination of all investments must be in U.S. dollars. We propose no change from our existing rule.

2. Paragraph (b)—Investments That Do Not Satisfy Requirements

We propose technical revisions to the regulatory provision authorizing institutions to hold other investments with FCA's prior approval. We intend no substantive change with these revisions.

3. Paragraph (c)—Ineligible Investments

We propose to prohibit Farm Credit banks from purchasing CDOs, as that term is defined in § 615.5131. Based on the experience of CDO investors during the recent financial crisis, we believe investments in CDOs pose unacceptable risk to System institutions.

4. Paragraph (d)—Reservation of Authority

We propose to make explicit our authority, on a case-by-case basis, to determine that a particular investment imposes inappropriate risk, notwithstanding that it satisfies the investment eligibility criteria. The proposal also provides that FCA will notify a Farm Credit bank as to the proper treatment of any such investment.

5. Application of Investment Eligibility Criteria to Existing Farm Credit Bank Investments

As discussed below, the FCA is contemplating that Farm Credit banks would have to comply with the rule's requirements pertaining to their own investments 6 months after the effective date of the rule. New Farm Credit bank investments made after that compliance date would be subject to the investment eligibility criteria in § 615.5140(a).

Existing Farm Credit bank investments (investments made before the compliance date) that were not eligible under the investment eligibility criteria that were in effect at the time of purchase (or that the FCA did not approve) would continue to be subject to the requirements of § 615.5143(a), which governs the treatment of investments that are ineligible when purchased.

Existing Farm Credit bank investments (investments made before the compliance date) that were eligible under the investment eligibility criteria that were in effect at the time of purchase but that are ineligible under the revised § 615.5140(a) investment eligibility criteria would be treated as follows, unless the FCA specified different treatment. If an investment is not eligible because it does not satisfy the criteria in revised § 615.5140(a)(2)—that is, it is a type of investment that was eligible under the previous criteria but is not eligible under the revised criteria—the Farm Credit bank may continue to hold the investment with no restriction. If an investment is not eligible because it does not satisfy the criteria in revised § 615.5140(a)(1), (a)(3), or (a)(4)—which pertain to permissible investment purposes and to credit quality—the Farm Credit bank may continue to hold the investment subject to § 615.5143(b), which governs the treatment of investments that were eligible to purchase but that no longer satisfy the eligibility criteria.

We remind the Farm Credit banks that under § 615.5143(c), the FCA would retain the authority to require divestiture of any investment at any time for failure to comply with § 615.5132(a) or for safety and soundness reasons.

D. Section 615.5133—Investment Management

1. Overview

Existing § 615.5133 applies to all System institutions—Farm Credit banks, associations, and service corporations. Most of proposed revised § 615.5133 would also apply to all System institutions. However, as discussed in greater detail below, proposed § 615.5133(f) and (g), which govern portfolio diversification requirements and obligor limits, would apply only to Farm Credit banks. Additionally, we propose to modify § 615.5133(c), which addresses risk tolerance in investment policies, so it clearly distinguishes how liquidity is managed at Farm Credit banks from its treatment at associations. The investment management provisions of proposed § 615.5133 would apply to service corporations to the extent they are appropriate to the size, complexity, and risks of their investments.

2. Appropriate Use of Off-Balance Sheet Derivatives

Off-balance sheet derivatives can be appropriate and useful for the purposes of hedging and risk management. While our regulations do not prohibit a System bank from using off-balance sheet derivatives to build an investment portfolio, use of these derivatives must be consistent with an authorized investment purpose and not be for speculative purposes. We note that such derivatives generally do not provide a significant source of liquidity.

3. Paragraph (a)—Responsibilities of Board of Directors and Paragraph (b)—Investment Policies—General Requirements

The FCA proposes no changes to § 615.5133(a), which governs the responsibilities of the boards of directors of System institutions. We propose only minor stylistic and non-substantive changes to § 615.5133(b), which identifies the general requirements that System institutions must address in their investment policies.

4. Paragraph (c)—Investment Policies—Risk Tolerance

We propose several technical modifications to § 615.5133(c) that would enhance its clarity and provide better guidance to System institutions about compliance with it. For example, we propose a technical change to paragraph (c) to clarify that while operational risk must be addressed in investment policies, the policies do not need to establish quantitative risk limits for operational risk. Quantitative risk limits would continue to be required for the other identified risks—credit, market, and liquidity.

We propose to split the requirements regarding credit quality standards and concentration risk in existing paragraph (c)(1)(i) into two paragraphs. We propose to incorporate the existing general requirements regarding risk diversification standards and counterparty (obligor) risk limits into more specific requirements contained in proposed paragraphs (f) and (g). We propose these revisions in order to clarify our requirements in this area and ensure that institutions are considering risk appropriately.

Proposed paragraph (c)(1)(i) would address credit quality standards. It would require that an institution's investment policies establish credit quality standards for single or related obligors, sponsors, secured and unsecured exposures, and asset classes or obligations with similar characteristics. We propose to add sponsors to the existing requirements because, even though sponsors have no obligation to pay the debt (unless they are also obligors), we are concerned that a sponsor of low credit quality could present risk in a transaction that it initiates. We propose to add secured and unsecured investments to the existing requirements because we believe institutions should consider the differing levels of risk that these investments present.

Proposed paragraph (c)(1)(ii) would address concentration risk. It would require that an institution's investment policies establish concentration limits for single or related obligors, sponsors, geographical areas, industries, unsecured exposures, and asset classes or obligations with similar characteristics. We propose to add sponsors to the existing requirements because we believe undue concentration in a sponsor could present excessive risk. We propose to add unsecured investments to the existing requirements because institutions should carefully consider the amount of unsecured investments they are prepared to hold. Concentration limits should be commensurate with the types and complexity of investments that an institution holds.

We propose to revise § 615.5133(c)(1)(iv), which addresses collateral margin requirements on repurchase agreements. Currently, this provision requires System institutions to regularly mark collateral to market and to ensure that they maintain appropriate control over collateral that they hold. We propose to modify § 615.5133(c)(1)(iv) to clarify that this provision would apply only to System institutions that engage in repurchase agreements.

We propose to revise § 615.5133(c), which governs investment policies pertaining to liquidity, into two separate paragraphs. We propose this revision to take into account the differences in how liquidity is managed at Farm Credit banks from its treatment at associations.

Generally, Farm Credit banks hold liquidity reserves and manage liquidity risks for themselves, their affiliated associations, and certain service corporations. In contrast, System associations are not exposed to the same liquidity risks and they do not manage liquidity in the same way as their funding banks because their only substantial liability is their debt obligation to their funding bank.

Existing § 615.5133(c)(3) requires investment policies of all System institutions to describe the liquidity characteristics of eligible investments that the institutions will hold to meet their liquidity needs and other institutional objectives. Under proposed § 615.5133(c)(3)(i), Farm Credit banks would remain subject to this existing requirement. This requirement is appropriate because of the liquidity needs and liquidity risk of Farm Credit banks.

Under proposed § 615.5133(c)(3)(ii), the investment policies of System associations would have to describe the liquid characteristics of their investments. Although System associations do not have the same liquidity needs and liquidity risk as Farm Credit banks do, if they invest their funds in investments authorized by § 615.5142 they must be aware of the liquid characteristics of the assets that they purchase and hold. Proposed conforming changes throughout § 615.5133(c) would require System institutions to consider and address how investment decisions affect their liquidity risk, if and when applicable.

Except for other minor stylistic and technical changes, we propose no other changes to paragraph (c).

5. Paragraph (d)—Delegation of Authority and Paragraph (e)—Internal Controls

We propose no changes to paragraphs (d) and (e).

6. Paragraph (f)—Farm Credit Bank Portfolio Diversification

We propose to add a new paragraph (f) to govern investment portfolio diversification. This paragraph would apply only to Farm Credit banks.

a. Paragraph (f)(1)—Well Diversified Portfolio

Portfolio diversification is a key concept in ensuring the safety and soundness of investors such as Farm Credit banks. We propose requirements to ensure, at a minimum, that the investment portfolios of these institutions do not pose significant risk of loss due to excessive concentrations among asset classes, maturities, industries, geographic areas, and obligors. We also propose exemptions for certain investments from these portfolio diversification requirements. These exemptions would apply where the level of risk from concentration is low.

b. Paragraph (f)(2)—Exemptions

We propose that certain investments would not be subject to our diversification requirements. In this preamble, we refer to investments that are not subject to diversification requirements as “exempt” investments. We refer to all other investments as “covered” investments, because they are subject to our proposed diversification requirements.

i. Paragraph (f)(2)(i)—Investments Guaranteed by U.S. Government Agencies

Under the proposal, investments that are fully guaranteed as to the timely payment of principal and interest by a U.S. Government agency would be exempt from the proposed diversification requirements. We propose this exemption because we believe these types of investments are of the highest quality. Our existing rules impose no portfolio diversification requirements on such investments.

ii. Paragraph (f)(2)(ii)—Investments Guaranteed by GSEs

Under the proposal, investments, other than MBS, that are fully and explicitly guaranteed as to the timely payment of principal and interest by a GSE would be exempt from the proposed portfolio diversification requirements. No more than 50 percent of an institution's investment portfolio could be comprised of GSE MBS. These provisions are substantively unchanged from our existing regulations with respect to the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) MBS. Investments in Farmer Mac securities are governed by § 615.5174 and would not be subject to this limitation.

Our 2011 proposed investment management rule had also proposed to retain our 50-percent portfolio limit on Fannie Mae and Freddie Mac MBS. The Farm Credit Council, the Farm Credit Bank of Texas and CoBank, ACB commented in response to that proposal that this limit was too restrictive in light of the safe and liquid nature of these investments (especially since those GSEs were under U.S. Government conservatorship) and the positive yield that those investments provide. They asked us to eliminate portfolio limits for investments in these GSEs. The Council also expressed concern with language in our preamble suggesting that we might consider further restrictions on MBS investments in these GSEs in the future.

We believe no portfolio limits are needed for non-MBS investments in GSEs, such as general obligations. We are concerned, however, about concentration in housing-related investments, and accordingly we propose to retain the 50-percent limit on GSE MBS. We do not contemplate further restrictions on investments in GSE MBS at this time.

c. Paragraph (f)(3)—Investment Portfolio Diversification Requirements

We are proposing investment portfolio diversification requirements for covered investments. Under the proposal, a well-diversified investment portfolio would mean that, at a minimum, covered investments are comprised of different asset classes, maturities, industries, geographic areas, and obligors.

Although we are not proposing specific maturity, industry, or geographic area requirements, the regulation would require each Farm Credit bank to diversify its investments by maturity, industry, and geographic area based on its risk profile.

Covered investments would have to satisfy specified asset class and obligor diversification requirements. These diversification requirements would be calculated based on the entire investment portfolio. This means that both exempt and covered investments would be included in the denominator. The numerator would consist only of those investments that are covered investments for the asset class and obligor diversification requirements. These diversification parameters would be based on the portfolio valued at amortized cost.

We note that these diversification requirements are regulatory maximums; each Farm Credit bank should establish diversification limits that fit its risk profile and that may be more restrictive than regulatory requirements.

Our current regulations impose no investment portfolio limits on investments in DIFs, as long as an institution's shares in each DIF comprise 10 percent or less of its investment portfolio. Otherwise, the portfolio limits for each asset class apply. As discussed below, we now propose different treatment for DIF investments.

i. Paragraph (f)(3)(i)—Asset Class Diversification

We propose to require Farm Credit banks to diversify their investment portfolios among various asset classes; no more than 15 percent of their investment portfolios could be invested in any one asset class. As discussed above, we propose to define an asset class as a group of securities that exhibit similar characteristics and behave similarly in the marketplace.

For purposes of this proposed asset class diversification requirement, we consider MBS to be an asset class. We also consider ABS (excluding MBS) to be an asset class that includes instruments such as student loans and car loans. In addition, we consider money market securities to be an asset class that includes securities such as federal funds and commercial paper. Other asset classes would include municipal securities, corporate bond securities, and any other asset class as determined by the FCA. Each of these asset classes is limited to 15 percent of the investment portfolio of a Farm Credit bank, regardless of the different types of instruments that comprise the asset class.

For purposes of this proposed asset class diversification requirement, we do not consider DIFs to be an asset class, and therefore this requirement would impose no restrictions on the relative amount of DIF investments a Farm Credit bank could hold. The securities within DIFs, however, would be subject to the asset class diversification requirements.

Our existing rule imposes portfolio limits of 15 percent, 20 percent, or 50 percent, depending on the asset class. In our proposed rule in 2011 for banks and associations, we proposed asset class limits for investments that were similar to but generally more restrictive than our existing regulations. To simplify the rule, we are proposing a 15-percent limit for all asset classes.

We believe that diversification of investments is a fundamental part of risk management and that a 15-percent portfolio limit for asset classes is appropriate. Because the vast majority of System investments are in exempt securities, a 15-percent limit on investments in each asset class should provide sufficient flexibility for institutions to manage their investment portfolios.

We seek comment on the reasonableness of this proposed limitation.

ii. Paragraph (f)(3)(ii)—Obligor Diversification

We propose to require Farm Credit banks to diversify their investment portfolios among various obligors; no more than 3 percent of their investment portfolios could be invested in any one obligor. As discussed above, we propose to define obligor as an issuer, guarantor, or other person or entity who has an obligation to pay a debt, including interest due, by a specified date or when payment is demanded. This definition would include the debtor or immediate party that is obligated to pay a debt, as well as a guarantor of the debt. Under this requirement, a Farm Credit bank must consider both the DIF itself and the entity or entities obligated to pay the underlying debt to be obligors. This requirement would ensure that an institution would not be able to use DIF investments to hold an excessively concentrated investment portfolio.

Our existing regulations contain no portfolio diversification requirements by obligor (although, as discussed below, they do limit the amount of total capital that institutions can invest in a single obligor). We propose this diversification requirement because we believe that concentration among obligors could lead to significant risk.

We believe that this proposal would likely not require changes in the current investment portfolios of Farm Credit banks, although it might have required changes to those portfolios in the past. We believe that this requirement would provide these institutions with sufficient flexibility to manage their investment portfolios while ensuring adequate diversification to further safety and soundness. We seek comment on the reasonableness of this proposed limitation.

7. Paragraph (g)—Farm Credit Bank Obligor Limit

We propose to limit the amount of capital that Farm Credit banks may invest in any one obligor. For Farm Credit banks, the limit would be 10 percent of total capital. This obligor limit would not apply to investments in obligations that are fully guaranteed as to the payment of principal and interest by a U.S. Government agency or fully and explicitly guaranteed as to the payment of principal and interest by a GSE. Under this requirement, a Farm Credit bank must consider both the DIF itself and the entity or entities obligated to pay the underlying debt to be obligors.

Our existing regulations allow Farm Credit banks to invest up to 20 percent of their total capital in eligible investments issued by any single institution, issuer, or obligor; this obligor limit does not apply to obligations, including mortgage securities, that are issued or guaranteed as to interest and principal by the United States, its agencies, instrumentalities, or corporations.

The lower obligor limit that we propose for Farm Credit banks would enhance safety and soundness by ensuring that if an obligor were to default, only a small portion of capital would be at risk. For simplicity, we propose to continue to base the Farm Credit bank investment amount on total capital. As discussed above, however, the FCA Board adopted proposed revisions to our regulatory capital rule on May 8, 2014, and we may revise the basis for the obligor limit to incorporate any revisions to our regulatory capital rule that are adopted in final in the future.

We note that this obligor limit would be a regulatory maximum; each Farm Credit bank should establish obligor limits that fit its overall risk profile and risk-bearing capacity, including earnings capacity, as well as the risks in individual types and classes of investments. For example, more restrictive obligor limits may be warranted on unsecured investments.

We seek comment on whether our proposed 10-percent obligor limit is appropriate. If you believe it is not appropriate, what should the regulatory maximum be, and why?

8. Paragraph (h)—Due Diligence

We propose to redesignate existing paragraph (f) as paragraph (h).

In paragraph (h)(1)(iii), we propose that a System institution must document its assessment of each investment at the time of purchase. While the assessment must be commensurate with the type of each investment, at a minimum the assessment must include an evaluation of the credit risk, liquidity risk as applicable, market risk, interest rate risk, and underlying collateral of the investment.

The nature and degree of due diligence and documentation that is required under this provision to assess eligibility varies based on the risks inherent in different types of securities. For example, institutions should assess securities that they believe are guaranteed by a U.S. Government agency or a GSE to ensure they satisfy our definitions and eligibility requirements for such securities. As another example, institutions do not need to assess the creditworthiness of U.S. Government agency securities, because they exhibit low sovereign default (credit) risk; however, institutions should assess and document all other potential risks associated with these securities. Securities that are not guaranteed by a U.S. Government agency generally present varying degrees of credit risk as well as other types of risk, and the assessment and level of documentation should be sufficient to support the investment decision.

All other changes that we propose to this paragraph are non-substantive.

9. Paragraph (i)—Reports to the Board of Directors

We propose to redesignate existing paragraph (g) as paragraph (i). We also propose to add the word “risk” to redesignated § 615.5133(i)(3) so it would require quarterly reports to the board or a designated board committee to address the current composition, quality, and the risk and liquidity profiles of the investment portfolio. This revision would ensure more comprehensive reporting to the board about how the current composition and quality of investments affect the risk and liquidity profile of the bank or association, which would enhance safety and soundness. We propose no other changes to this provision.

E. Section 615.5142—Association Investments

The FCA proposes to revise § 615.5142, which governs association investments. Existing § 615.5142 does not impose a portfolio limit on the total amount of investments that each association is authorized to hold. Additionally, existing § 615.5140 permits associations to hold the same types of investments as Farm Credit banks even though associations are not subject to the liquidity reserve requirement in § 615.5134, and they are not exposed to the same liquidity and market risks as their funding banks. Accordingly, the FCA proposes to revise its regulatory approach to association investments in order to limit the type and amount of investments that an association may hold.

As discussed in more detail below, the proposed rule generally would limit association investments to obligations that are issued or fully guaranteed or insured as to the timely payment of principal and interest by the United States or any of its agencies in an amount that does not exceed 10 percent of its total outstanding loans. The proposed rule also addresses: (1) Core investment and risk management practices at System associations; (2) funding bank supervision of association investments; (3) requests by associations to the FCA to hold other investments; and (4) transition requirements for System associations to come into compliance with the new rule.

Currently, § 615.5142 authorizes each association to hold eligible investments listed in § 615.5140, with the approval of its funding bank, for the purposes of reducing interest rate risk and managing surplus short-term funds. The existing regulation also requires each Farm Credit bank to review annually the investment portfolio of every association it funds.

Most System associations have increased in size and complexity over the past two decades, offering a diversity of products and services to accommodate a changing and increasingly competitive agricultural sector. The changes in agriculture have introduced new risks to the associations. For example, while the associations have adopted adequate risk management strategies to effectively adapt to this changing environment, they are concentrated in agriculture and have limited ability to manage concentration risk. The associations currently can use investments to manage surplus short-term funds and reduce interest rate risk but cannot use investments to manage concentration risk. The proposed rule strikes a balance by granting associations greater flexibility in the purposes for which they may hold investments, while placing more limits on the amounts and types of investments they may hold. Accordingly, the proposed changes would provide the associations the flexibility to use full faith and credit instruments to manage concentration risk by diversifying assets. We believe the proposed change would help improve association risk management practices and, therefore, strengthen the safety and soundness of the System.

The Farm Credit Act of 1971, as amended, (Farm Credit Act) specifically authorizes System associations to buy and sell obligations of, or insured by, the United States or any agency thereof, and make other investments as may be approved by their respective funding banks under regulations issued by the Farm Credit Administration.

1. Paragraph (a)—Investment Eligibility Criteria

The proposed rule would: (1) Revise the investment purposes for System associations; (2) limit the types of investments that associations may purchase and hold; and (3) impose a cap on the amount of such enumerated investments that each association may hold. Specifically, proposed § 615.5142(a) would authorize each System association, with the approval of its funding bank, to manage risk by purchasing and holding obligations that are issued by, or are fully guaranteed or insured as to the timely payment of principal and interest by, the United States or any of its agencies in an amount that does not exceed 10 percent of its total outstanding loans.

We are proposing to eliminate our requirements in the existing regulation, which authorize associations to hold investments for the purposes of reducing interest rate risks and managing surplus short-term funds, because we believe these requirements are: (1) Too restrictive; and (2) do not provide associations flexibility to manage their risks in today's environment.

As a result of mergers and consolidations, and the evolution of agricultural credit and financial management practices, System associations encounter various risk management environments. A few larger associations now have the capacity to manage interest rate risk separately from their funding banks. For many associations, a small portfolio of high quality investments could help diversify risks they experience as lenders that primarily lend to a single industry—agriculture.

Whereas the existing rule authorizes associations to hold investments for the purposes of reducing interest rate risks and managing surplus short-term funds, the proposed rule authorizes associations to hold investments to manage risks. We invite your comments about whether this proposed rule should identify specific purposes for associations to purchase and hold investments. If you believe that our rule should expressly identify and require specific purposes, please state which ones and why.

Proposed § 615.5142(a) would authorize System associations to invest solely in obligations that are issued, or are fully guaranteed or insured as to the timely payment of principal and interest by the United States or of any of its agencies. Obligations issued, insured, or guaranteed by the United States are expressly mentioned in the provisions of the Act governing association investments. Obligations issued or fully guaranteed or insured as to the timely payment of principal and interest by the United States and its agencies are usually liquid and many are actively traded, although MBS issued by Federal agencies could expose investors to significant market risks. These obligations pose virtually no credit risk to investors because they are backed by the full faith and credit of the United States, although they may expose investors to other risks, especially market risks. For these reasons, obligations issued or fully guaranteed or insured as to the timely payment of principal and interest by the United States and its agencies are suitable for risk management at System associations.

Proposed § 615.5142(a) limits association investments to 10 percent of total outstanding loans. This portfolio limit would ensure that loans to eligible borrowers always constitute the vast majority of System assets, which is consistent with the mission of each association. In this context, the FCA is imposing portfolio limits on investments so that loans to eligible borrowers always constitute a majority of assets at all System banks and associations. Our regulations authorize Farm Credit banks to hold significantly larger investment portfolios than System associations because the: (1) Banks maintain liquidity and manage interest rate risk for all System institutions operating in the district; and (2) associations borrow exclusively from their funding banks.

At the same time, the proposed 10-percent portfolio limit on investments should be sufficient to enable associations to develop robust strategies to manage risks, as long as association investment activities are supported by strong investment policies, management practices and procedures, and appropriate internal controls. Furthermore, the proposed 10-percent limit should help associations manage their concentration risk as single-industry lenders. The policies at some System associations with active investment programs typically establish a 15-percent portfolio limit for investments, while in practice, investments at most associations rarely equal or exceed 10 percent of total outstanding loans. For all these reasons, the FCA believes that the proposed 10-percent portfolio limit on investments strikes an appropriate balance by enabling associations to appropriately manage and diversify risks while continuing to serve their primary mission of funding agriculture and rural America.

We are proposing that the 10-percent limit be computed based upon the 30-day average daily balance of investments divided by loans. Investments would be calculated at amortized cost. Loans would be calculated as defined in § 615.5131, which provides that loans are calculated quarterly (as of the last day of March, June, September, and December) by using the average daily balance of loans during the quarter. For the purpose of this calculation, loans would include accrued interest and not include any allowance for loan loss adjustments. Compliance with the calculation would be measured on the last day of every month.

We also request your comments on whether using the average daily balance of loans during the quarter for computing the limit is adequate to limit any distortions caused by seasonality fluctuations in the amount of total loans.

2. Paragraph (b)—Risk Management Requirements

The following provisions would help to ensure that System associations comply with prudent investment management practices. Therefore, we are proposing to require that each association evaluate its investment management policies, and determine and document how its investment activities are conducted in accordance with the risk management processes and procedures identified in proposed § 615.5142(b)(1), (b)(2), and (b)(3).

3. Paragraph (b)(1)—Compliance With Investment Management Requirements

Proposed § 615.5142(b)(1) would require each association to comply with proposed § 615.5133(a), (b), (c), (d), (e), (h), and (i), which govern investment management practices at all System institutions. From the FCA's perspective, these provisions of proposed § 615.5133 would ensure that System associations always follow prudent investment management practices. Additionally, compliance with these provisions of § 615.5133 would instill discipline in investment management practices at each System association, which protects its safety and soundness. Therefore, we are proposing to require that each association document its compliance with the applicable provisions of § 615.5133.

Under proposed § 615.5142(b)(1), each association's investment management processes must be appropriate for the size, risk characteristics, and complexity of the association and its investment portfolio. These risk management processes must take into account the association's unique circumstances, risk tolerances, and objectives. An association's board would not need to develop an investment policy if it elects not to hold investments authorized under § 615.5142(a).

We are particularly interested in comments on how the FCA can structure the documentation requirements so they do not impose undue regulatory burden on funding banks or associations.

4. Paragraph (b)(2)—Compliance With Interest Rate Risk Management Requirements

Proposed § 615.5142(b)(2) would require any association with significant interest rate risk exposure to comply with §§ 615.5180 and 615.5182. More specifically, § 615.5182 requires any association with interest rate risk that could lead to significant declines in net income or in the market value of capital to comply with § 615.5180, which establishes specific criteria for System banks to follow for managing interest rate risk. Under this regulatory framework, the interest rate risk management program must be commensurate with the level of interest rate risk at the association.

The fiduciary responsibilities of association boards of directors obligate them to develop appropriate investment management policies and practices to manage interest rate risk. Additionally, it is incumbent upon each association's investment managers to fully understand the risks of its investments and make independent and objective evaluations of investments prior to purchase.

Interest rate risk management is an important part of the overall financial management of investments at an association, and includes involvement by both senior management and the association's board of directors. To the extent an association has investments, its board must develop and implement an interest rate risk management program that is tailored to the association's needs and establishes a risk management process that effectively identifies, measures, monitors, and controls interest rate risk.

5. Paragraph (b)(3)—Other Relevant Factors

Proposed § 615.5142(b)(3) would require each association to consider and evaluate other relevant factors that are unique to its circumstances or to the nature of investments that could affect its risk-bearing capacity. Such factors include, but are not limited to, its management experience and capability to understand and manage complex structures and unique risks in the investments it purchases and holds. In this context, the size, risk characteristics, and complexity of the investment portfolio are other relevant factors that could affect an association's risk-bearing capacity when its unique circumstances, risk tolerance, and objectives are taken into account. Associations are authorized to purchase and hold investments only for the purpose of managing risks. Although the FCA does not expect associations to suffer losses or break even on investments, using investments primarily for speculative purposes or generating gains from trading is an impermissible activity. Likewise, the intentional mismatched funding of investments and the resulting increase in interest rate risk would typically be inappropriate unless used as an effective hedge against other risks in the balance sheet. Other factors that associations should consider and evaluate include option, premium and call risks of certain investments that they may acquire.

6. Paragraph (c)—Funding Bank Supervision of Association Investments

Sections 2.2(10) and 2.12(18) of the Farm Credit Act require each association to obtain its funding bank's approval of the association's investment activities in accordance with FCA regulations. Accordingly, proposed § 615.5142(c) addresses funding bank review, approval, and oversight of the investment activities of its affiliated associations. As required by statute, each association must request from its funding bank prior approval to buy and hold investments under this section. This proposed provision would not require that an association request approval for each and every investment. Instead, this proposed provision would provide flexibility for each association to choose whether it would prefer to request funding bank approval for each specific investment or instead request approval of a type or class of investments.

7. Paragraph (c)(1)—Funding Bank Review, and Approval or Denial of Association Investments

Proposed § 615.5142(c)(1) would require each funding bank to review and approve or deny requests by its affiliated associations to buy and hold investments. Additionally, the proposed rule would require the bank to explain in writing its reasons for approving or denying the association's request. Once an association has established a satisfactory investment management program under § 615.5142(b), which has been approved by its funding bank, the association would be permitted to buy and hold obligations that are issued, or are fully guaranteed or insured as to the timely payment of principal and interest by the United States government or any of its agencies. The intent of this proposed provision is to balance the funding needs of the associations with the funding capacity of the funding bank.

8. Paragraph (c)(2)—Bank Approval Process

As part of the approval process, the funding bank must evaluate, determine and document that the association has: (1) Adequate policies, procedures, internal controls, and accounting and reporting systems for its investments; (2) the capability and expertise to effectively manage risks in investments; and (3) complied with requirements of § 615.5142(b). Any existing System association investment management program previously reviewed and approved by the funding bank would need to be re-reviewed and re-approved if proposed § 615.5142 becomes final and effective.

The intent of this proposed provision is to balance the risk management needs of the associations with the funding and oversight role of the funding bank. A number of satisfactory methods exist for System banks to oversee association investment activities under our regulatory framework. A bank may take an active role in advising and approving an association's investment decisions and strategies. For example, banks may provide research, analytical or advisory services that help associations to manage their investment portfolios.

9. Paragraph (c)(3)—Annual Review of Investment Portfolio

Proposed § 615.5142(c)(3) also retains the existing requirement that each System bank annually review the investment portfolio of every association that it funds. As part of its annual review, the bank must evaluate whether the association's: (1) Investments mitigate and manage its risks; and (2) risk management practices continue to be adequate.

The FCA notes that the General Financing Agreement (GFA) (including any attached, referenced, or related documents) could establish covenants governing the investment activities of an affiliated association. As such, the GFA can be a useful tool for funding banks to review and monitor the investment activities of their affiliated associations.

10. Paragraph (d)—Other Investments Approved by the FCA

Proposed § 615.5142(d) would continue to allow an association to request the FCA's approval to purchase and hold other investments. We note that this provision represents no substantive change from current § 615.5140(e), which allows all System institutions to hold other investments that the FCA approves on a case-by-case basis. Consistent with current practice, the request for our approval must explain the risk characteristics of the investment and the purpose and objectives for making the investment.

These other investments approved by the FCA under proposed § 615.5142(d) would be subject to the portfolio limit on association investments under proposed § 615.5142(a) unless otherwise provided for by the FCA. Furthermore, these other investments could also be subject to specific conditions of approval and subject to other limits on a case-by-case basis.

11. Paragraph (e)(1)—Transition and Divestiture Issues for Association Investments

Under proposed § 615.5142(e)(1), an association would not be required to divest of any investments held on or before the date this rule becomes effective if they were previously authorized under former § 615.5140 or otherwise authorized by official written Agency action that allowed the association to continue to hold such investments. This transition rule would permit an association to continue to hold pre-existing investments that would no longer be authorized if proposed § 615.5142 is adopted as a final rule and becomes effective. However, after this proposed rule is effective, once such investments mature, the association would not be permitted to renew them unless they are authorized pursuant to proposed § 615.5142(a) or (d).

12. Paragraph (e)(2)—Impact on Existing Investments of Subsequent Declines in Total Outstanding Loans

Under proposed § 615.5142(e)(2), an association would not be required to divest of investments purchased on or after the date this proposed rule becomes effective if a subsequent decline in total outstanding loans causes it to exceed the 10-percent portfolio limit in § 615.5142(a).

Accordingly, once an association purchases an eligible investment, it would not be required to dispose of such investment just because of a subsequent decline in total outstanding loans. This provision would help to ensure that an association would not have to divest of a previously purchased asset when loan demand is reduced.

13. Paragraph (e)(3)—Management of Ineligible Investments and Divestiture Under § 615.5143

Proposed § 615.5142(e)(3) would apply to all investments that an association acquires after the new regulation becomes effective. More specifically, all investments that an association purchases after proposed § 615.5142 becomes effective as a final rule would be subject to § 615.5143 of this part, which governs the management and divestiture of ineligible investments. As a result, an association would need to comply with § 615.5143 if any investment acquired after the effective date of this rule did not meet the investment criteria in § 615.5142(a) on or after the date of purchase, if it was not approved by the FCA pursuant to § 615.5142(d), or if it was approved by the FCA pursuant to § 615.5142(d) but later failed to satisfy the conditions of approval.

F. Section 615.5143—Management of Ineligible Investments and Reservation of Authority To Require Divestiture

We propose to revise § 615.5143 to add references to proposed § 615.5142, to reflect that associations are generally governed by the requirements of § 615.5143. In addition, we propose to tailor § 615.5143 to the investment and other authorities of Farm Credit banks as compared to associations. Specifically, we clarify that an association that purchases an ineligible investment would not be subject to the requirements relating to liquidity, collateral, and net collateral, because associations have no regulatory requirements in those areas. In addition, we propose to clarify that no investment is ineligible if it has been approved by the FCA, but an FCA-approved investment would be subject to the requirements of § 615.5143(b) if it no longer satisfied the conditions of approval.

G. Conforming Changes to Other Regulation Sections

We propose conforming changes to references in §§ 611.1153, 611.1155, 615.5174, and 615.5180.

IV. Compliance Date

We recognize that Farm Credit banks may require time to bring their policies and procedures into compliance with the new requirements in the proposed rule. Accordingly, we are contemplating that Farm Credit banks would be required to comply with the requirements governing their investments 6 months after the effective date of the rule, if it is adopted as final. We invite your comments as to whether this delayed compliance timeframe is appropriate. We also invite your comments on whether a delayed compliance date would be appropriate for associations as well.

V. Regulatory Flexibility Act

Pursuant to section 605(b) of the Regulatory Flexibility Act (5 U.S.C. 601 et seq.), the FCA hereby certifies that the proposed rule will not have a significant economic impact on a substantial number of small entities. Each of the banks in the System, considered together with its affiliated associations, has assets and annual income in excess of the amounts that would qualify them as small entities. Therefore, System institutions are not “small entities” as defined in the Regulatory Flexibility Act.

List of Subjects

12 CFR Part 611

• Agriculture
• Banks, banking
• Rural areas

12 CFR Part 615

• Accounting
• Agriculture
• Banks, banking
• Government securities
• Investments
• Rural areas

For the reasons stated in the preamble, parts 611 and 615 of chapter VI, title 12 of the Code of Federal Regulations are proposed to be amended as follows:

PART 611—ORGANIZATION

1. The authority citation for part 611 continues to read as follows:

Authority: Secs. 1.2, 1.3, 1.4, 1.5, 1.12, 1.13, 2.0, 2.1, 2.2, 2.10, 2.11, 2.12, 3.0, 3.1, 3.2, 3.3, 3.7, 3.8, 3.9, 3.21, 4.3A, 4.12, 4.12A, 4.15, 4.20, 4.21, 4.25, 4.26, 4.27, 4.28A, 5.9, 5.17, 5.25, 7.0-7.13, 8.5(e) of the Farm Credit Act (12 U.S.C. 2002, 2011, 2012, 2013, 2020, 2021, 2071, 2072, 2073, 2091, 2092, 2093, 2121, 2122, 2123, 2124, 2128, 2129, 2130, 2142, 2154a, 2183, 2184, 2203, 2208, 2209, 2211, 2212, 2213, 2214, 2243, 2252, 2261, 2279a-2279f-1, 2279aa-5(e)); secs. 411 and 412 of Pub. L. 100-233, 101 Stat. 1568, 1638; sec. 414 of Pub. L. 100-399, 102 Stat. 989, 1004.

2. Section 611.1153 is amended by removing in paragraph (i)(1) the reference “§ 615.5140(e)” and adding in its place, the reference “§ 615.5140(b) or § 615.5142(d)”.

3. Section 611.1155 is amended by removing in paragraph (a)(1) the reference “§ 615.5140(e)” and adding in its place the reference “§ 615.5140(b) or § 615.5142(d)”.

PART 615—FUNDING AND FISCAL AFFAIRS, LOAN POLICIES AND OPERATIONS, AND FUNDING OPERATIONS

4. The authority citation for part 615 is revised to read as follows:

Authority: Secs. 1.5, 1.7, 1.10, 1.11, 1.12, 2.2, 2.3, 2.4, 2.5, 2.12, 3.1, 3.7, 3.11, 3.25, 4.3, 4.3A, 4.9, 4.14B, 4.25, 5.9, 5.17, 6.20, 6.26, 8.0, 8.3, 8.4, 8.6, 8.7, 8.8, 8.10, 8.12 of the Farm Credit Act (12 U.S.C. 2013, 2015, 2018, 2019, 2020, 2073, 2074, 2075, 2076, 2093, 2122, 2128, 2132, 2146, 2154, 2154a, 2160, 2202b, 2211, 2243, 2252, 2278b, 2278b-6, 2279aa, 2279aa-3, 2279aa-4, 2279aa-6, 2279aa-7, 2279aa-8, 2279aa-10, 2279aa-12); sec. 301(a), Pub. L. 100-233, 101 Stat. 1568, 1608; sec. 939A, Pub. L. 111-203, 124 Stat. 1326, 1887 (15 U.S.C. 78o-7 note).

5. Section 615.5131 is amended by:

a. Removing the definitions for “eurodollar time deposit”, “final maturity”, “general obligations”, “Government agency”, “Government-sponsored agency”, “liquid investments”, “mortgage securities”, “Nationally Recognized Statistical Rating Organization (NRSRO)”, “revenue bond”, and “weighted average life (WAL)”;

b. In the definition of “asset-backed securities (ABS)”, remove the words “mortgage securities” and add in their place, the words “mortgage-backed securities;”

c. Adding in alphabetical order the new definitions for “ Asset class”, “Collateralized debt obligation (CDO)”, “Country risk classification (CRC)”, “Diversified investment fund (DIF)”, “Government-sponsored enterprise (GSE)”, “Mortgage-backed securities (MBS)”, “Obligor”, “Sponsor”, and “United States (U.S.) Government agency” to read as follows:

6. Section 615.5133 is revised to read as follows:

7. In § 615.5134 paragraph (b) is amended by revising the table to read as follows:

8. Section 615.5140 is revised to read as follows:

9. Section 615.5142 is revised to read as follows:

10. Section 615.5143 is revised to read as follows:

11. Section 615.5174 paragraph (d) is amended by removing the reference “§ 615.5133(f)(1)(iii) and § 615.5133(f)(4)” and adding in its place, “§ 615.5133(h)(1)(iii) and § 615.5133(h)(4)”.

12. Section 615.5180 paragraph (c)(3) is amended by removing the reference “§ 615.5133(f)(4)” and adding in its place, the reference “§ 615.5133(h)(4)”.