As required by the Housing and Economic Recovery Act of 2008, the Federal Housing Finance Agency (FHFA) published today an interim final rule defining critical capital levels and criteria for capital classifications for, and outlines FHFA’s prompt corrective action authority over, the Federal Home Loan Banks (FHLB). The rule “clarifies and provides details on how the FHFA intends to implement” capital requirements for the overall safety and soundness of the FHLB system. Under the rule, an FHLB can fall into one of four capital classifications: (i) adequately capitalized, (ii) undercapitalized, (iii) significantly undercapitalized, or (iv) critically undercapitalized.

An FHLB will be adequately capitalized when it “holds sufficient capital to meet both its risk-based and minimum capital requirements.” The rule defines “minimum capital requirement” as the leverage and total capital requirements established under section 6(a)(2) of the Federal Home Loan Bank Act (FHLB Act) – set at 5 percent and 4 percent, respectively – and “risk-based capital requirement” as “any capital requirement established” under section 6(a)(3) of the FHLB Act. Under section 6(a)(3) a bank is required to hold capital equal to the sum of its credit risk capital, market risk capital and operations risk capital requirements.

An FHLB is undercapitalized if it fails to meet either of its risk-based or its minimum capital requirements. Significant undercapitalization exists where the FHLB’s capital is only 75 percent of the capital needed to meet its risk-based or minimum capital requirements. Finally, under the rule an FHLB is critically undercapitalized whenever its total capital is 2 percent or less of its total assets, which represents “one-half of the 4 percent minimum total capital requirement” established for the FHLBs under section 6(a)(2)(B) of the FHLB Act.

Comments have been requested as to whether a fifth category of “well-capitalized” should be added to encourage an FHLB “to hold more than the minimum amounts of capital.” Among other suggestions, the rule proposes that this well-capitalized threshold be set as a percentage (e.g., 110 percent) of the minimum leverage or risk-based capital requirements.

It is unclear what impact the new rule will have on the recently announced capital status of the FHLB of Seattle and the FHLB of Pittsburgh. The interim final rule is effective as of today and comments are due on or before April 30, 2009. We also note that the interim “adequately capitalized” ratios for the FHLBs are materially less than the adequately capitalized requirements for insured depository institutions. Banks and thrifts must maintain 8% total capital against risk-weighted assets and a leverage ratio of 3 or 4% (depending on its supervisory rating) in order to qualify as well-capitalized.