By Matthew Tevis
This past May, the National Credit Union Administration approved proposed changes to modernize existing derivative rules. These changes aim to make derivatives more flexible and principle-based for federal credit unions to help them manage interest rate risk.
Furthermore, these updated regulations remove the lengthy application process for those qualifying institutions and help FCUs more easily implement hedging programs.
So, what rule changes went into effect? The changes:
- Eliminated the pre-approval process for FCUs that are “complex” with a Management CAMEL component rating of 1 or 2
- Eliminated the regulatory limits on the amount of derivatives usage
- Eliminated the specific product permissibility
And what exactly do they mean for credit unions? Let’s dig in.
Any federal credit union having assets greater than $500 million is considered “complex.” If these institutions also have a Management CAMEL component rating of 1 or 2, they are no longer required to undergo the derivatives application process. While any FCU not meeting the criteria would still need to complete an application, they no longer need to receive interim approval, meaning the process goes from roughly four months to only about two.
Additional Changes
The new guidelines have also eliminated specific requirements involving position limits, including how they’re measured and reported, specifically impacting weighted average remaining maturity notional (WARMN) and fair value loss limits.
The NCUA recognized the benefits of removing some of these reporting requirements while also stressing the need to maintain safety and soundness. Derivative usage will continue to be reviewed during routine exams to ensure exposure amounts are appropriate for institutions.
Finally, by moving to a more principles-based model, federal credit unions have more flexibility to use hedging tools to manage their specific interest rate risks. According to the NCUA, acceptable derivatives must meet the following criteria: “denominated in U.S. dollars, based on domestic interest rates (or dollar-denominated LIBOR), contract maturity of 15 years or less, and may not be used to create Structured Liability Offerings.”
The rule change also removes the previous requirement of having to limit a forward-start date beyond 90 days and the limitation on floating notional amounts.
What’s Been Eliminated
It's also worth noting that the NCUA withdrew some of the proposed changes from the final draft, resulting in the elimination of:
- The collateral requirements for cleared derivatives with deference to established clearinghouse parameters
- The prohibition on written options provided that such options are used to manage interest rate risk
- The requirement that all counterparties be domiciled in the United States
Why Credit Unions Should Consider Derivatives
So, why should FCUs consider derivatives as a part of their overall interest rate risk management strategy? Todd Harper, chairman of the NCUA said, “In the years ahead, a credit union’s ability to manage interest-rate risk will play a crucial role in its financial performance. As such, this rule is a timely and appropriate measure that ensures complex federal credit unions can manage a variety of interest-rate scenarios. It also provides a way for smaller credit unions, which demonstrate proficiency and obtain regulatory approval, to use simple derivatives to hedge their loan portfolios.”
Interest rate derivatives can help credit unions effectively manage risk, increase margins and even lower funding costs. Not only is a derivative-based approach cost effective, but it’s also completely customizable to meet the needs of a specific institution and can quickly be applied.
One Step Further
Going one step further, with many institutions experiencing excess liquidity and low-yielding cash balances, these rule changes allow credit unions to implement hedging techniques such as swaps. They can be used to enhance margins by extending the duration of assets in a loan or securities portfolio while also managing the incremental rate risk.
Forward-starting swaps can also be used to customize the effective date of the hedging strategy to meet the specific needs of the institution.
NCUA Vice Chairman Kyle S. Hauptman shared this commentary after the new derivatives rules were finalized: “You can try to manage interest rate risk without using derivatives, but it can be a bit like dealing with a fly on the window by throwing a brick at it. So, it’s great to see that credit unions have already demonstrated safe derivatives usage. Not to mention, it’s human nature to switch to better tools when they’re available… the same reason we don’t commute via horseback anymore.”
Matthew Tevis is managing partner and Global Head of Financial Institutions, Chatham Financial. For info: www.chathamfinancial.com.