NCUA’s derivatives rule could be boon for large credit unions

Only a handful of the nation’s largest credit unions dabble in derivatives, but proposed changes from the National Credit Union Administration could give federally chartered institutions another tool to manage interest rate risk.

The NCUA board approved the proposed revisions to the rule in October and can take final action any time now that the 60-day comment period has ended. An NCUA spokesman would only say that further action on the rule is pending, and a specific timeline on the issue is unclear. Board member Todd Harper is expected to be elevated to the chairmanship now that President Joe Biden has been inaugurated, and he would have the power to determine when the issue gets placed on the agency’s agenda.

Only 23 federal credit unions had active derivative contracts, according to an October statement from current NCUA Chairman Rodney Hood. The agency’s revisions are widely expected to be taken advantage of by larger institutions. Credit unions with assets of $500 million or more make up only about 12% of the industry but hold about 81% of total assets. Broader use of derivatives could widen the gap between large and small shops.

But John Hecht, managing director with Artisan Advisors, said credit unions of any size should be pleased to have another avenue to change the underlying interest rate characteristics of a pool of loans or deposit products.

“It’s powerful,” he said. “For most financial institutions, net interest income comprises the majority of their earnings, and using derivatives to reduce balance sheet interest rate sensitivity can minimize earnings at risk when used effectively.”

Hecht said that because interest rate changes are outside the control of the credit union, it only makes sense for them to look to derivatives as a way to manage risk without having to impact members or otherwise engage in large balance sheet transactions.

And credit unions seem to agree.

The NCUA received 18 comment letters on the proposed rule, including one from SchoolsFirst Federal Credit Union in Santa Ana, Calif., the nation’s fifth-largest credit union, according to NCUA data. Francisco Nebot, CFO for the $22.6 billion-asset company, said it sees value in the use of derivatives as a hedging strategy for loan pipeline management for all loans — not just mortgages.

“Derivatives permit the reduction of risk associated with duration that may also occur in non-mortgage lending, including consumer-based lending. In these congruent scenarios, derivatives are an effective risk management tool,” Nebot wrote.

Many of the other commenters were generally supportive of the proposed language and welcomed the more flexible, principles-based approach. The institutions emphasized the need for credit unions to have the ability to use hedging tools to better manage rate risks, which would also help strengthen liquidity and capital positions.

Credit unions of all sizes have experienced a significant increase in member deposits during the pandemic, and that has led to excess liquidity and low-yielding cash balances. Many institutions have begun increasing duration in their investment and loan portfolios to enhance margins.

So hedging tools such as interest rate swaps may help them utilize that excess liquidity while also managing their incremental rate risk, said Matthew Tevis, managing director and global head of sales for Chatham Financial. He added that the rule could also streamline the approval process to use the tools, expand the types of acceptable hedging structures and simplify the measurement and ongoing reporting requirements.

For example, the pre-approval or application process for derivatives authority would be removed for any federal credit union that is “complex,” or under $500 million of assets and has a Camel rating of 1 or 2.

Credit unions also would no longer need to obtain interim approval, which would reduce the overall process from up to 120 days to less than 60 days. The NCUA board clearly believes removing the burden of some measuring and reporting requirements outweighs the potential risks, Tevis said.

“But the NCUA will still review derivative exposures when conducting exams and could determine excess exposures to be a safety and soundness concern,” he added.

There are not typically minimum trade requirements, but most financial institutions will execute strategies involving at least $5 million to $10 million in order for them to be meaningful from a risk management perspective, Tevis said.

The proposal is far from perfect, however, said Michael Macchiarola, CEO of investment firm Olden Lane.

The NCUA continues to insist that credit unions enter hedging transactions only with domestic counterparties, he said, which excludes the rest of the developed world. This limits credit unions’ ability to diversify counterparty risk across geography and jurisdiction, and limits the available counterparties for price shopping.

For instance, he said, Canadian institutions such as TD, RBC and Bank of Nova Scotia have a reputation for some of the most careful risk management and strongest balance sheets from a creditworthiness perspective. Those companies are regular counterparties in the U.S. market.

“We believe the NCUA is being too prescriptive in this regard, and we would welcome some liberalization to at least include Canadian, Japanese and EuroZone counterparties,” he said.

One downside of derivatives use is their perceived complexity and accounting requirements, Hecht said. But he added that those issues can be overcome with proper education and training and by enlisting the support of third parties that have successfully helped companies use derivatives to manage asset/liability committee responsibilities.

And a recent Financial Accounting Standards Board change will relax some hedge accounting rules while removing barriers and providing institutions with simplified approaches to measuring their risk management effectiveness.

For all the potential positives, Hecht said institutions that lack experience with derivatives – in other words, the vast majority of the industry – need to tread carefully.

“Look at it this way, if I had to choose to build a home using a hand saw or a power tool I know which I would choose,” he said. “But like every power tool, it’s important to read the safety instructions first.”

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