By Ray Birch
DALLAS—One ALM expert believes NCUA’s new rule on derivatives not only solves a “classic” dilemma for many of the very largest credit unions, it may also provide some assistance for credit unions further down the asset scale.
“These fairly simple instruments can go a long way in fixing this problem,” said Robert Perry, principal partner with ALM First.
Perry noted that many of the very biggest credit unions have substantial mortgage operations, and regulations previously in place that restricted the use of derivatives has hampered their growth.
“The numbers were just too small in the previous rule for a big mortgage lending credit union. So, that's been removed,” he noted. “The instruments have been broadened a little bit, which will help on mortgage risk. And if you really think about it, the risk in the credit union space comes from mortgages. You have consumer loans of fairly short duration, and then you have loans in the 10- and 15-year part of the yield curve. It's the classic derivatives dilemma—there's a lot of funding on the short end of the yield curve and there's a fair amount of risk that's on the longer part of the yield curve. NCUA’s new rule can go a long way to fixing the problem.”
As CUToday.info reported, the NCUA board approved 3-0 a new rule that updates the derivative investment authority for credit unions.
According to NCUA staff, approximately 30 credit unions are currently using derivatives to manage risk, but feedback indicates that number will grow. To take advantage of the new authority, credit unions below $500 million in assets must apply to the agency, and all CUs must apply to use derivatives if they have a management rating below two.
‘Pretty Simple’ Process
As CUToday.info also reported, NCUA staff said the application process will be “pretty simple” and will require an ALM model that incorporates a swap or a cap.
“We applaud NCUA for passing what they passed, moving to a more principles based rule,” Perry said. “The industry should be able to hedge its interest rate risk, that's the bottom line. And any barrier to entry that's put out there should be removed and make things simpler and easier for credit unions to use derivatives. That's been our position the whole time.”
NCUA, when it passed the rule during its May open board meeting, emphasized boards at CUs investing in derivatives must educate themselves and be knowledgeable about what’s involved before the agency will approve.
“It’s pretty clear this is going to require a lot of board education,” said Perry. “You can't avoid the responsibility of doing your due diligence, and have things in place--ALM models, systems and board training and policies to successfully use derivatives. This new rule does not remove that need for an institution to have those things in place, which were required in the previous rule.”
Extended Low Rates
Robert Perry
NCUA Chairman Todd Harper, who suggested during the May meeting that as the credit union industry grows and becomes more complex, the final derivatives rule is a good example of the agency working to innovate and scale its regulations, noted credit unions likely face a prolonged period of very low interest rates, meaning the ability manage interest-rate risk will be “crucial” to financial performance.
“As a firm, we don't like to bet on the direction of rates,” stated Perry. “If I'm a mortgage lender and I have interest rate risk building in my balance sheet, and it's quantifiable, I'm going to hedge it regardless of where I think interest rates are going. I'm going to run my balance sheet with a low to moderate amount of interest rate risk all the time regardless of where I think rates are going. If I was riding a lot of mortgages six months ago I'd be hedging them anyway. It doesn't matter where I think rates are going. That’s just sound risk management.”
As a new Fannie Mae survey also noted, Perry reminded that when interest rates are low margins are typically lower.
“Because the deposit franchise value and the funding benefit from a deposit franchise is a lot lower when rates are lower,” he said. “Net interest margins at most institutions are higher when interest rates are higher, independent of a pandemic, or anything…When rates are higher the value of cheap funding really pays off.”
Helping ‘Smaller’ Institutions
Perry believes the new rule will help smaller credit unions, as well, although “smaller” can be a relative term.
“I think this will help smaller credit unions too, as there is clearly evidence on the bank side of the business, where $500-million to $700-million community banks have hedged their interest rate risk regularly and successfully.”
But the real difficulty for smaller CUs in using derivatives will likely come from derivative counterparties, asserted Perry.
“It may be difficult for smaller organizations to find counterparties—meaning the other institution I'm going to execute with, as an approved swap dealer,” said Perry. “These counterparties are a lot more leery of doing transactions with smaller institutions. So, there may be an issue on that front at some point down the road. We know that the larger institutions, on the opposite side of the swap, know that small and midsize institutions get themselves in trouble a lot.”
Broader Product Lines
In addition to hedging risk, derivatives also allow financial institutions to broaden their product line, according to Perry.
“Hedging is profitable,” he said. “You can do a lot more things because you can manage the risk more directly. Therefore, you don't have to try to push your customers or your borrowers into certain products. You can open up your product mix, and then you can price things fairly along the yield curve because you know you can hedge up and down the curve. You can drive out the product mix and you can say here's all the products on the lending side that you can offer downstream.
“I’m in a lot of conversations with clients right now and there are some commercial loans structures that clients shy away from because they might have a 25-year amortization with a 10- or 15-year balloon,” continued Perry. “That's a pretty long loan. But if you can hedge that you can price fairly and just pull that interest rate risk component out. That's what we're talking about when we talk about the profitable side of risk management.”