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management. Under our current regulatory regime, the Finance Board's primary duty is “to ensure that the FHLBanks operate in a financially safe and sound manner.” The Finance Board is not limited by funding constraints in carrying out its declared focus of ensuring the FHLBanks' safety and soundness. Its funding is provided by assessments on the FHLBanks that are not subject to review or challenge by the FHLBanks.

Finance Board regulations govern a broad range of FHLBanks' operations including advances pricing, risk management, capital plan approval, directors' responsibilities and new business activities. The Finance Board also collects and monitors financial and risk management data from the FHLBanks each month, performs ongoing reviews of all aspects of the FHLBanks' operations and conducts annual on-site examinations of all 12 FHLBanks. The Finance Board's 2004 budget would include a $4.3 million increase devoted to the supervision function. The FHLBanks all believe that it is essential to have a strong, independent regulator with the resources to ensure the FHLBanks' continued safety and soundness as well as to oversee the housing mission.

Corporate Governance

Finance Board regulations require that the FHLBanks' boards of directors fulfill the typical corporate director duties including, but not limited to, the responsibility to select and oversee management, the responsibility to ensure the establishment and maintenance of an adequate internal control system, the responsibility to adopt a risk management policy, a strategic business plan, and a member products policy that details the Bank's credit and pricing policies, and the responsibility to approve the FHLBanks' annual operating and capital budgets and quarterly dividends.

In carrying out their responsibilities, the boards of directors typically establish and act through committees. Finance Board regulations require each FHLBank's board of directors to have an audit committee with very specific regulatory responsibilities, including direct oversight of the FHLBank's internal and external audit functions. The boards of directors also typically establish other committees to facilitate their oversight of management. Committees vary from FHLBank to FHLBank, but typically include risk management, human resources and housing

oversight functions. The various elements of the FHLBanks' corporate governance structure combine to provide boards of directors that are active, knowledgeable, and engaged, and that are fully aware of their responsibilities and take them very seriously. The Finance Board recently completed a Systemwide study of corporate governance across all 12 FHLBanks. The results and recommendations of this study were presented to our Board for review and approval this past


Risk Management

As 12 independent institutions, each of the FHLBanks is responsible for its own risk management activities. Each FHLBank has its own risk profile guided by a number of factors that are held in common across the FHLBanks. This approach enables each FHLBank individually, as well as the Consolidated Obligations (COs) issued by the 12 FHLBanks collectively in the capital markets, to be rated AAA.

The cooperative structure of the FHLBanks eliminates many of the incentives a publicly traded company might have to raise its risk profile in search of higher returns. In my opinion, this cooperative structure discourages FHLBanks from taking excess risk. The mission of the cooperative is to provide member institutions the funding and financial services they need to meet the credit needs of their underserved communities. At the same time, the FHLBank must generate an adequate return for member shareholders that meets their opportunity cost of investing capital in a AAA-rated cooperative enterprise. Rates of retum on FHLBank stock will average in the neighborhood of four percent in 2003, far below the rate of return expected from publicly traded corporations.

FHLBanks are required by regulation to maintain a Risk Management Policy, reviewed at least annually and a Financial Management Policy, which governs permissible investment and derivative activities and overall risk management limitations. FHLBanks are subject to very conservative capital requirements with total capital equal to at least 4.0 percent of total assets and must have sufficient permanent capital to meet a risk-based capital requirement established by the Finance Board. The FHLBanks minimize credit risk by ensuring that advances are fully secured, that their investments are limited to issuers or securities that are highly rated at the time

the investments are made, and that their AMAs have appropriate risk-sharing features. No FHLBank has ever suffered a credit loss on an advance to a member in the FHLBanks' 71-year history. As of June 30, 98 percent of the FHLBanks' investment securities have long term ratings of AAA or the corresponding highest short term ratings. In addition, due to the risk sharing structure of the AMA programs, the FHLBanks' loss experience on AMA assets has been virtually nonexistent. Exposure to market risk is controlled by the Financial Management Policy's conservative limits. The incentive to maintain the conservative limits arises through the cooperative, non-publicly-traded-stock structure of the FHLBank.

Because history is not always an accurate predictor of future performance, each FHLBank uses sophisticated, high quality financial models to continually assess the magnitude of the risk to each FHLBank's estimated market value of equity and earnings from various changes in interest rates, mortgage prepayment speeds and other market variables. These models are provided primarily by market-tested third-party companies with expertise in measuring market risk of mortgage instruments, advances, corporate debt and derivatives. The FHLBanks monitor and manage market risk continuously throughout every month. The market risk position is reported and discussed with each FHLBanks' boards of directors at each board meeting. The integrity of the process is ensured through close board oversight, annual Finance Board examinations, internal and external audits, and separation of personnel responsibilities. Personnel responsible for assessing market risk are separate from personnel responsible for dayto-day risk management activities and are further separated from personnel preparing FHLBank monthly financial statements.

Legislative Reform of GSES

The combination of congressionally determined financial requirements, an independent regulator, engaged boards of directors and extensive risk management tools have proven to be a successful model. However, adherence to this model is not mutually exclusive to aversion to change. The Cincinnati FHLBank wants to do what is best for the financial quality of our institution and, by extension, for the public it serves.

At its regularly scheduled meeting last month, the Cincinnati FHLBank Board of Directors concluded that it is in the best interest of its shareholders and the public they serve to retain the present independent regulatory structure for the FHLBanks. The structure and performance of the Finance Board has resulted in 12 healthy, AAA-rated regional FHLBanks that currently support $500 billion worth of credit activity, serving virtually every neighborhood in America.

The Finance Board's independence alleviates political and department-specific affiliations that may bias its oversight function. The current post-FIRREA Finance Board has presided over the most expansive and prosperous period of FHLBank history against a backdrop of extreme volatility in the market place. During this time, each FHLBank has maintained a AAA rating and continued the 71-year tradition of never having experienced a loan loss. The current Finance Board Chairman has more than doubled supervisory staff to 17 examiners and has budgeted for a total of 30. Further, the structure of the Finance Board allows for safety and soundness as well as mission oversight of the $1.7 billion Affordable Housing Program and multi-million dollar community investment programs to fall under one regulatory roof. This independent, comprehensive regulatory structure tailored for the System works, and works well.

At the same time the Cincinnati FHLBank Board of Directors affirmed its support of our independent regulator, it also directed management to begin immediately the process of registering its stock under Section 12 of the Securities and Exchange Act of 1934. This statement of direction came after preliminary meetings with SEC officials to discuss issues arising from the unique nature of the FHLBanks and the equity shares held by its members. The Cincinnati FHLBank strongly believes that registration of stock with the SEC is the best method to provide both bond and stock investors the necessary financial information they require to assess the condition of our FHLBank.

Some critics of the current regulatory structure have argued that the FHLBanks will be disadvantaged in their funding decisions if their regulator operates outside of the Treasury Department. While we appreciate that position, we do not share it. In fact, at the present time the debt issued by the FHLBanks trades at a premium relative to other GSEs. We are confident

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the financial markets will continue to recognize that the FHLBank System consists of financially sound and conservatively managed, well capitalized institutions whose primary goal is to serve its housing finance mission through its members. This current position will be further strengthened with SEC registration.


The FHLBanks are strong, conservatively run enterprises without a single credit loss in their 71-year history. There is no problem in need of a solution. The System's current independent regulator is best positioned to provide both safety and soundness as well as mission oversight for our cooperative enterprise.

Mr. Chairman, thank you for the opportunity to address the Committee on this important matter. I will be happy to answer questions at the appropriate time.

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