FHLBanks have a strong, independent regulator with the resources to ensure the FHLBanks' safety and soundness. Risk Management of the FHLBanks As 12 independent institutions, all the FHLBanks are responsible for their own risk management activities. Each FHLBank has its own risk profile and approaches management of its risks in a slightly different way. However, there are a number of factors that are held in common across the FHLBanks that enable each FHLBank individually, as well as the Consolidated Obligations (CO's) issued by the 12 FHLBanks collectively in the capital markets, to be rated triple-A. The cooperative structure of the FHLBanks eliminates many of the incentives a publicly traded company might have to raise its risk profile, and in fact discourages FHLBanks from taking excessive risk. Just as FHLBank members do not expect equity investment returns on their capital stock investment in a FHLBank, they also do not expect equity investment risk in that investment. Members purchase FHLBank capital stock in order to obtain access to FHLBank funding products, and must maintain capital stock investments in the FHLBank as long as they maintain advances outstanding. That is, members provide the capital that supports their advances transactions with the FHLBanks. In that environment, members expect stability, reliability, and consistency of returns and credit product pricing. These member expectations are reflected in the oversight provided by each FHLBank's board of directors, a majority of which is comprised of directors representing and elected by member institutions. In large part due to the incentives created by the FHLBanks' cooperative structure, risk aversion and conservative risk management practices are ingrained in the corporate culture. That same conservative approach to risk management is also reflected in both the legal restrictions and the Finance Board's regulatory regime. For instance, the Bank Act and the Finance Board's implementing regulations clearly describe and mandate the various limitations on the types of collateral the FHLBanks may accept to secure advances. Regulations limit the types, amounts, and required credit ratings on both short and long term investments the FHLBanks make with surplus funds. Finance Board regulations include separate additional restrictions on the aggregate amount, ratings, and characteristics of mortgage-backed securities the FHLBanks may purchase and hold. In addition, Finance Board regulations require that each FHLBank maintain a Risk Management Policy, reviewed at least annually and readopted at least every 3 years by its board of directors, which identifies specific risk management practices and limits for the individual FHLBank. These practices and limits are monitored by the FHLBanks' internal audit departments, which report their findings directly to the FHLBanks' boards of directors. The Finance Board also monitors FHLBank compliance with these and other regulatory requirements through monthly call reports, constant off-site monitoring, and annual on-site examinations. The FHLBanks are also subject to very conservative capital requirements imposed by statute in the GLB Act and by Finance Board regulations implementing those statutory requirements. These requirements specify that FHLBanks must have total capital equal to at least 4.0 percent of their total assets, and must have sufficient permanent capital (as defined by the GLB Act) to meet a risk-based capital regime established by Finance Board regulation. 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 AMA 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 triple-A or the corresponding highest short-term ratings. In addition, due in large part to the risk sharing structure of the AMA programs, the FHLBanks' loss experience on AMA assets has been very favorable. Since each FHLBank's primary activity is to serve as a financial intermediary, the FHLBanks are also subject to market (or interest rate) risk. To the extent the individual maturities of a FHLBank's assets are not exactly matched by the individual maturities of its liabilities, the FHLBank's future earnings stream is subject to fluctuation due to changes in the relationship between yields on its assets and the cost of its liabilities. Complicating the picture is the fact that the FHLBanks hold assets (such as mortgage loans and securities) or have issued liabilities (such as callable debt) that can be repaid prior to their stated maturities. Further complicating the issue is the fact that the FHLBanks' narrow interest spreads do not provide a large margin of error. risks, each FHLBank uses sophisticated financial models to connagnitude of the risk to the FHLBank's estimated market value rious changes in interest rates. This information is reported to rd of directors on a regular basis and to the Finance Board as nd is summarized in the FHLBanks' combined financial stateHLBanks' conservative approach to interest rate risk manageanks' "duration gaps," or (generally) the difference between the maturity of a FHLBank's assets and the estimated average matu, ranged from negative 1.4 months to positive 1.6 months as of ration gap of 1.6 months generally means that the weighted avturity of a FHLBank's assets is 1.6 months longer than the <pected maturity of its liabilities. se interest rate derivatives extensively to maintain their conate risk profile. While much has been written about the potential reated by the improper use of derivatives, the manner in which derivatives is a key component of their risk management activi_cts are germane to an understanding of the FHLBanks' use of oard regulations prohibit the use of derivatives for speculative ans that every derivative instrument entered into by a FHLBank ge (that is, reduce) an identified risk. Second, a majority of the t rate derivative transactions are structured to exactly offset anaction. For instance, a FHLBank may use an interest rate swap rest payments on a particular fixed rate advance to a floating et payment stream will float in a manner that matches the debt issued to fund the advance. Similarly, much of the debt the s long term, fixed rate, and often callable. The FHLBanks typige portion of this fixed rate debt to floating rates by executing nterest rate swaps simultaneously with the issuance of the debt. percent of the FHLBanks' outstanding derivatives as of June 30, hese two types of transactions. interest rate derivatives is critical to managing the FHLBanks' derivatives can cause problems if not managed appropriately. The te these risks in several ways. The appropriateness of the ives activities for risk management purposes are validated interf internal valuation models, by internal audits that often employ validate a FHLBank's valuation model and hedging practices, by the FHLBank's derivative valuations, and through the Finance site examination process. vatives can also increase credit and operational risks that must ally. For instance, derivatives pose credit risk created by the poby derivative counterparties. The FHLBanks mitigate this risk by atives transactions only with highly rated counterparties, and eral collateral agreements with each counterparty that require alue of derivatives positions be calculated periodically and collatthe extent that the FHLBank is exposed to risk of default beyond old. ted that the magnitude of the potential counterparty credit risk ortfolio has little to do with the aggregate notional amount of the otential credit risk is represented by the net fair value of the portbetween a FHLBank and a particular counterparty. For instance, ional amount of the FHLBanks' interest rate derivatives as of as $694 billion. However, the net fair value of those derivatives value loss to the FHLBanks (not including offsetting fair value struments) of $16 billion. is credit exposure created by its derivatives portfolio is determined mary operational risks related to derivatives is the risk of inac- Statement of Financial Accounting Standard 133, Accounting for Derivatives and Certain Hedging Transactions (SFAS 133) in 2001. That statement requires generally that derivatives be carried on the balance sheet at fair value, prescribes the appropriate income recognition for changes in fair value of derivatives, and specifies criteria that must be met in order for hedged instruments to qualify for hedge accounting. The FHLBanks have gone to great lengths to apply SFAS 133 appropriately and ensure that all derivatives accounting complies with generally accepted accounting practices (GAAP). Prior to implementation of the accounting standard, the FHLBanks' controllers formed an inter-FHLBank task force, which included representatives from the FHLBanks' external audit firm, to catalogue the various types of derivatives transactions on the books of the FHLBanks, identify the appropriate accounting treatment for each, and develop an accounting guide used across the 12 FHLBanks to ensure consistency. This task force has remained in place since the implementation of the standard to ensure ongoing accounting consistency and compliance with GAAP. In addition, the FHLBanks' external audit firm reviews each FHLBanks' derivatives accounting as part of its quarterly reviews and annual audits of their financial statements. FHLBank Financial Reporting and Disclosure There has been much discussion recently about the appropriate forum for the FHLBanks' financial reporting and disclosure. We believe that it is most important to focus carefully on the precise nature of the issue under consideration. All 12 FHLBanks are fundamentally committed to provide complete and state of the art disclosure consistent with the unique characteristics of the FHLBanks as established by Congress. Under the FHLBanks' current financial reporting and disclosure regime, the FHLBanks' combined financial statements are required by Finance Board regulation to comply with most Securities and Exchange Commission (SEC) reporting requirements, except those specifically excluded by the regulation. The individual FHLBanks' financial statements are required to be consistent in form and content with the combined financial statements. Both the FHLBanks' combined statements and their individual financial statements comply with GAAP as certified by the FHLBanks' external auditor. In addition, all 12 FHLBanks are evaluating ways to enhance their financial reporting and disclosure in accordance with evolving best practices. As part of that consideration, for instance, it is my understanding that all 12 FHLBanks are currently preparing to voluntarily comply with the requirement for attestation of internal controls as set forth in Section 404 of the SarbanesOxley Act, and evaluating the applicability of other aspects of that legislation. The matter under discussion is not disclosure, but rather the request by the Chairman of the Finance Board and others within the Administration that the FHLBanks voluntarily register with the SEC. The FHLBanks take these requests very seriously and have devoted a great deal of time and resources to considering the appropriate application of SEC standards-designed for publicly traded companies to cooperatives whose capital stock is not traded, has a fixed value and is only held by member financial institutions. In order for our boards of directors to carry out their legal fiduciary duty, they must carefully consider the potential effects of voluntary registration on the FHLBanks, their members and the fulfillment of the FHLBanks' mission. We are involved in ongoing discussions with SEC staff on how voluntary registration of the FHLBanks would be implemented. While some key threshold issues appear to have been resolved in a workable way, other important issues remain to be resolved, as does the form of the agreement between the FHLBanks and the SEC that would memorialize the resolution of those issues. Conclusion Over its long history, the Federal Home Loan Banks have played a vitally important role in supporting their member financial institutions' ability to meet the housing finance and credit needs of their local communities. The FHLBanks remain economically strong today and continue to serve a vital function for their financial institution members and the communities they serve. ARED STATEMENT OF DAVID W. HEMINGWAY SEPTEMBER 9, 2003 Chairman Bennett, Ranking Member Johnson, and Members of thank Chairman Bennett and the Subcommittee for the oppor- unity banker for the better part of three decades, and an elected ard of directors of the Federal Home Loan Bank of Seattle, the al application-of board governance is of paramount importance titutions and communities we serve every day, and to me, personam accountable for the safety and soundness of the Seattle Bank. alone in that role-I share it with 17 other directors and the manthe company-I consider it my job to ensure that the financial is $47 billion bank is effective over the long-term, including propour shareholders' capital. ering responsibility when you consider that the funding provided Bank district fuels housing finance, affordable housing initiatives elopment in communities from Pago Pago to Walla Walla, Washv 400 member institutions rely on the Federal Home Loan Bank eir partner in helping their communities and local economies not hrive. ral Home Loan Bank System, we partner with nearly 8,000 comnstitutions in extending affordable credit to communities in every ed States. The Federal Home Loan Banks hold nearly $800 billion nearly a half trillion dollars in advances annually, issue about ffordable housing grants yearly, and hold nearly $100 billion in to serve as a director of the Federal Home Loan Bank of Seattle, critical importance of my role and what I needed to bring to the y personal integrity and accountability, and my financial services anking expertise. everal years, we have witnessed corporate failures of historic prol disasters brought on by a combination of inept business pracship and financial oversight, and fraudulent and unethical behavell aware that a quantum shift has occurred in how American corand small, privately held or publicly traded—will be run. Must be most these days is "corporate governance." It is now in our busiIt makes headlines in The Wall Street Journal; it comes out of the k anchors on a frequent basis. But I believe there is another way t goes something like this: Those who get to exercise the power ble to those who are affected by it. our regulator, the Federal Housing Finance Board, the Treasury, e sense of urgency that is so pervasive today regarding the need ountability and responsibility. And we have worked hard over the s to significantly strengthen the leadership and oversight of our understand that corporate governance is a process; a discipline 1st be constantly improved, I am personally and professionally enntensity of our efforts and the progress being made. e of the last year, the Seattle Bank board has created, adopted, and a set of Core Principles and Guidelines relating to board governur board committee structure to more effectively oversee all facets rations, upgraded our education and training program for directors, website that provides directors with faster access to a wider range itical to their board roles. ciples and Guidelines provide us with a corporate governance roadkeeping us focused on: policies, risk assessments, internal controls and decisions are effecng risk and are administered fairly. • Operating in an independent and active manner. • Setting the strategic direction of the bank and managing progress against goals. Determining if management is capable and if the business is being properly managed. • Evaluating our own board effectiveness. Our regulator, the Federal Housing Finance Board, is also diligent in overseeing and supporting sound corporate governance practices across the Bank System. The Finance Board just recently completed a horizontal review designed to assist the Agency in directing and developing its supervisory and regulatory initiatives. The comprehensive review provided all 12 banks with a valuable resource for identifying practices that contribute to effective governance programs. The Finance Board interviewed management and board members, and reviewed a wide range of bank documents with respect to board policies, practices, and decisions. I offer these comments to underscore the ongoing value of having boards and bank management teams focused on enhancing corporate governance standards, and a regulator performing its supervisory duty in a way that provides additional information and resources that further enhance the safety and soundness of the Bank System. As we all know, it is one thing to say your house is in order and quite another to prove it. As a director-and a member and owner of the Seattle Bank-it is my job to prove it. Does your board audit committee provide effective oversight of the internal and external audit functions? Is the audit function independent, reporting only to the board, and is it supported appropriately by directors? Does the board ensure that material risks are accurately and consistently assessed by management and reported to the board in compliance with regulation and prudent business practice? Are all directors working responsibly in carrying out their duties? Are board and management actively involved in strategic planning? I am pleased to say the Seattle Bank has "yes" answers to these questions posed by the Finance Board in its recent horizontal review. But that is today. Our job is to ensure that we have "yes" answers tomorrow, the next day, and the day after that. Which is a much tougher proposition. But that is our job. We are fortunate within the Federal Home Loan Bank System when it comes to corporate governance and responsibility. We were never starting from scratch. We have had the advantage of enhancing practices and standards that have, for more than 70 years, protected the Bank System against even a single member credit loss. But I would emphasize again that we are fully aware that a new era has dawned in American business-one that looks on corporate governance as an ongoing, rigorous discipline that demands, at all times, review and accountability. As one of 216 directors of the Bank System cooperative, I wouldn't have it any other way. Mr. Chairman, this concludes my written testimony. Thank you, again, for allowing me the opportunity to speak with you today. I would be happy to answer any questions you or other Members of the Subcommittee may have. |