NCUA finalizes more flexible derivatives rules

Finalized changes

The NCUA Board finalized many of the proposed changes to the derivatives rules, which include:

• Eliminating the pre-approval process for FCUs that are “complex” with a Management CAMEL component rating of 1 or 2
• Eliminating the specific product permissibility
• Eliminating the regulatory limits on the amount of derivatives usage

The pre-approval (or application) process for derivatives authority is discontinued for any FCU that is “complex” and has a Management CAMEL component rating of 1 or 2. The term “complex” refers to any federally insured credit union having assets greater than $500 million. For those FCUs not meeting this requirement, they will need to complete an application. However, they no longer need to obtain interim approval, reducing the overall process from up to 120 days to less than 60 days.

The new principles-based methodology broadens the parameters for permissible hedging instruments. Specifically, acceptable derivatives must have all the following characteristics: 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. Additionally, the rule change removes the limitation of a forward-start date beyond 90 days as well as the limitation on floating notional amounts.

The finalized rules also eliminate certain requirements related to the measurement and reporting of position limits, specifically the fair value loss limit and weighted average remaining maturity notional (WARMN) limit. The Board believes removing the burden of measuring and reporting these limits outweighs the potential benefits. However, the NCUA will still review derivative exposures when conducting exams and could determine excess exposures to be a safety and soundness concern.

The NCUA Board also withdrew some proposed changes to the derivatives rules which resulted in:

• Eliminating the collateral requirements for cleared derivative with deference to established clearinghouse parameters
• Eliminating the prohibition on written options provided that such options are used to manage interest rate risk
• Eliminating the requirement that all counterparties be domiciled in the United States

FCUs are still required to work with a CFTC-registered swap dealer, futures commission merchant, introducing broker or a clearing house as counterparty for any derivative transaction. A major swap participant does not meet that requirement. Additionally, FCUs may continue to use external service providers (ESPs) to support many aspects of their derivatives program. ESPs may not act as a counterparty, principal, or agent in any derivative transactions involving the FCU.

Why use derivatives

“In the years ahead, a credit union’s ability to manage interest-rate risk will play a crucial role in its financial performance,” NCUA Chairman Todd M. Harper said. “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 are cost-effective tools that can be customized and quickly applied to help credit unions manage asset and liability risks, lower funding costs, and enhance margins. Over the last year, many credit unions have experienced a significant increase in member deposits, leading to excess liquidity and low-yielding cash balances. Simple hedging tools like a swap can extend asset duration in the loan or securities portfolio and improve margins while also managing exposure to higher rates.

Swaps can manage the rate risk of an individual mortgage loan or investment security. A pooled hedging approach using a similar swap structure may create even more efficiencies from a pricing and accounting perspective, especially if the underlying fixed-rate assets are prepayable. A credit union would create a closed pool of fixed-rate, prepayable mortgages or securities and hedge a portion of the pool based on a prepayment analysis. This approach is commonly referred to as a “last of layer” strategy and has become very popular given more flexible accounting rules.

A credit union can use current or forward-starting swaps to achieve the preferred mix of fixed and floating-rate exposures. The NCUA’s new derivatives rules no longer limit the forward-starting period to 90 days. A longer forward-starting period would allow credit unions to recognize the fixed-rate coupons on a pool of mortgages or securities until the swap would become effective on the future start date. At that time, the institution would have protection to help mitigate the potential impact of a rising rate environment.

How to get started

Putting together an interest rate hedging program can be intimidating and overwhelming. Many credit unions partner with an ESP like Chatham to help them build the infrastructure and provide the training needed for a successful program. The ESP should be a trusted advisor with broad experience and deep resources that can provide support throughout the lifecycle of an interest rate hedge.

Some common areas that an ESP will provide credit unions with assistance include:

• Developing a hedging policy
• Evaluating potential strategies from both an economic and accounting perspective
• Negotiating ISDA agreements with dealer counterparties
• Supporting trade execution and document review
• Providing valuations and hedge accounting
• Servicing existing trades including rate resets, payments, and collateral management
• Complying with regulatory requirements including ongoing reporting

NCUA Vice Chairman Kyle S. Hauptman shared this commentary after the new derivatives rules were finalized, “Derivatives aren’t inherently frightening. They are indeed a powerful tool, and anything that’s powerful can probably cause harm. But there’s also harm in not allowing people to use the best available tool. For example, 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.”

Conclusion

NCUA’s new derivatives rules provide a more principles-based approach to managing interest rate risk while maintaining a safety and soundness framework. The additional flexibility and ease of use should be well received by many FCUs currently utilizing derivatives and those considering hedging tools. Credit unions can partner with an experienced ESP for assistance with building and supporting a successful program. Note the final derivatives rules are effective 30 days after publication in the Federal Register.

This on-demand webinar reviews the NCUA’s new derivatives rules in more detail and discusses hedging strategies that credit unions can apply to manage their interest rate risk. We also identify the advantages of adding derivatives to the ALCO toolkit while also considering some challenges credit unions could face.

About Chatham

Founded in 1991, Chatham Financial is the world’s largest independent derivatives advisory firm, executing over $750 billion in transaction volume annually and helping clients across industries maximize their value in the capital markets. Chatham partners with credit unions throughout the U.S. to support their interest rate hedging activities. As an external service provider, we are equipped to deliver training, trade structuring, pricing execution, hedge accounting, and regulatory advisory support, among other services. Having an independent and transparent approach allows us to bring a partnership mentality to every client engagement.