The updated rule will allow more credit unions to use this balance sheet management tool while managing interest rate risk and pursuing income strategies.
In late May, the National Credit Union Administration board approved a final ruling on derivatives use that aims to offer some federal credit unions more flexibility to manage interest rate risk.
Credit unions that are at least $500 million in assets and carry a CAMEL management rating of 1 or 2 are no longer required to receive pre-approval before entering derivatives transactions. However, if a credit union falls below either of the thresholds, it would be required to cease derivatives activity and apply for approval to continue. Credit unions with at least $250 million in assets are still able to apply for approval if they have the requisite infrastructure to safely manage a derivatives program.
The ruling aims to provide credit unions more tools to manage interest rate risk, which can be challenging in an ongoing low interest rate environment. Over the last year, credit unions have seen significant increased demand for both new and refinanced mortgages, which typically carry fixed rates and long durations. The mismatch between such assets and typical credit union liabilities can push interest rate risk metrics to levels beyond those permitted in the institution’s policies. In such instances, management would need to limit the number of mortgages added to the loan portfolio, likely at the cost of potential income.
Derivatives can be used to modify the interest rate risk profile of the loan portfolio. For example, an interest rate swap contract may be purchased to convert future interest payments on a pool of loans from fixed to floating rate for a predetermined term. In this case, the credit union would engage with a counterparty to exchange a stream of payments, effectively sacrificing a portion of the fixed-rate yield on the mortgages in order to receive floating-rate payments based on an index such as LIBOR (but now more frequently SOFR, Fed Funds, or CMT).
Such an arrangement is attractive in today’s environment, as credit union management teams weigh the implications of adding 30-year loans fixed at historically low rates to the balance sheet. Put simply, an interest rate swap could be used to convert longer-term fixed-rate mortgages into a payment stream that resembles adjustable-rate mortgages. Put another way, derivative products can be used to tailor opportunities along the full length of the yield curve, a very attractive prospect when short-term yields are so depressed.
The new ruling also expands the types of derivatives that credit unions can use. Instead of approving specific product types, permissible derivatives will need to meet the following qualifications:
- Denominated in U.S. dollars
- Based on domestic interest rates or LIBOR (The NCUA board will consider revising this requirement upon the expected cessation of USD LIBOR publication in 2023.)
- A contract maturity equal to or less than 15 years
- Not used to create structured liability offerings for members or nonmembers
NCUA regulation §703.102 limits current derivative products to interest rate swaps, basis swaps, caps and floors, and Treasury futures. This revised section also removes a requirement that derivative products settle within 90 days. With the new language, "swaptions" may be considered to hedge against the interest rate risk of a mortgage portfolio. Swaptions are an option (e.g., the legal right) to enter an interest-rate swap at some future date.
Using our previous example, a credit union may not find it attractive to convert the interest payments for a pool of mortgages to a floating rate today, but purchasing a swaption would give the institution the opportunity to do so at some future date, perhaps closer to when interest rates are expected to be higher. If interest rates remain low for longer than expected, the holder of the swaption could simply let it expire.
NCUA has emphasized the infrastructure requirements needed to participate in a derivatives program. This includes that the credit union board has a firm understanding of the subject and regular briefings to ensure thorough oversight. §703.10 addresses the significant operational support requirements, which include special accounting considerations (derivatives are covered in FASB ASC 815), ensuring the ALM model can address derivatives, internal controls and review processes.
Because the operational and reporting requirements are significant, it may be attractive for credit unions to seek an external service provider to support or conduct the process. However, contracting with such a provider does not alleviate the responsibility of the credit union to have qualified staff in accordance with the reg. Careful consideration should be made to evaluate if the opportunities presented by running a derivatives program outweigh the potential operational costs.
Only about 30 credit unions currently use derivatives to manage risk, but we anticipate that number will grow under the revised ruling. NCUA has indicated that it is working on training materials for credit unions that are interested in pursuing derivatives strategies. While there are more conventional balance sheet strategies to manage interest rate risk, the expanded derivatives authority may prove a useful tool for the credit union industry as we continue to navigate the difficulties of a pervasive low interest rate environment.
By Phil Lucas