A.M. Best Special Report: Recently Proposed FHLB Regulation Creates Uncertainty For Many U.S. Banks That Rely on the System for Funding.

OLDWICK, N.J. -- For more than 70 years, the Federal Home Loan Bank System (FHLBanks) has been an important source of cost-effective funding and correspondent banking services for community-based financial institutions in the United States. A recent proposal by FHLBanks' regulator, the Federal Housing Finance Board (FHFB), has created uncertainty for the FHLBanks' members as to whether the current level of funding and services will remain available, according to a special report by A.M. Best Co.

Among the primary components of the proposal, the FHLBanks would be required to maintain a minimum level of retained earnings. In addition, if an individual district bank's retained earnings fall below the required level, the amount of dividends it could pay to its members would be limited to 50% of the bank's net income, until its minimum-retained earnings requirement is met.

The proposed rule also would place new restrictions on the timing of dividend payments, would limit the amount of "excess" stock in any district bank to 1% of that bank's total assets, and would prohibit the issuance of stock dividends.

The limitation on the amount of excess stock that a bank may have outstanding will be an issue to watch, especially in the Chicago District Bank, which has one of the highest levels of excess stock, at an estimated $2.4 billion. As part of an agreement with the FHFB to reduce its excess stock, the Chicago District Bank recently received approval to issue $1 billion in securities for which it is the sole obligor. Historically, all securities issued by the FHLBanks were joint obligations of all 12 district banks.

Several aspects of the proposal that are likely to have the most direct impact on the member institutions are the limitation on excess stock, the prohibition on the issuance of stock dividends, and the potential restriction on the amount of dividends payable. The limitations on the amount of excess stock and the issuance of stock dividends both create tax implications that member institutions would likely view as unfavorable. For those members that hold excess stock, a repurchase of the stock would essentially create a taxable distribution. However, by receiving dividends in the form of stock, instead of cash, the taxes on the stock dividend can be deferred. By receiving a cash dividend, taxes are payable for the period in which the dividends were received.

As with any regulation, the final form and ultimate effect cannot readily be determined when it is initially proposed. In addition, the impact of the proposal on individual institutions may be uneven. Nonetheless, the uncertainty surrounding this proposal is especially keen as all 12 of the district banks and many member institutions already have voiced their opposition to it. Once the final form is known, member institutions can then begin to assess its ultimate impact on their operations and can make any necessary adjustments to their funding and balance sheet management strategies.

This study is available electronically from the A.M. Best Co. Web site at www.ambest.com/banks. Call customer service for more information, [phone], ext. 5742.

A.M. Best Co., established in 1899, is the world's oldest and most authoritative insurance rating and information source. For more information, visit A.M. Best's Web site at www.ambest.com.