Insights from Catalyst

By Mark DeBree , CFA, Managing Principal, Catalyst Strategic Solutions 

At its October 15 meeting, the NCUA Board proposed a new derivative rule that greatly eases the prescriptive nature of the previous rule and credit unions’ burden for gaining authority.

Although it contains a number of changes, the spirit and intent of the proposed rule are clear. NCUA has gained comfort with how derivatives have been used in the industry, and they are now open to credit unions employing derivatives to manage interest rate risk. I applaud this effort from NCUA. Interest rate derivatives are an important and valuable tool for credit unions to consider when faced with sharp changes in economic environments and extremely volatile times – both of which we’ve had in spades over the past decade. 

The most significant changes credit unions should note lie in three main areas:

1. Easing and complete elimination (for some credit unions) of the application process to obtain hedging authority
2. Removal of the specification of allowable derivative instruments
3. Elimination of position limitations

Let’s take a closer look at these areas:

1. Adjustments to the current application process for authority

   One of the most significant changes in the proposed regulation relates to complex credit unions (>$500 million in assets) with a CAMEL management score of a 1 or 2. These credit unions will no longer need to submit an application for derivatives approval. While this does not eliminate the application process for all credit unions, it certainly eases the burden for many. Credit unions able to bypass the application process will simply need to provide written notification to their Regional Director within five days of the first derivatives transaction.

   It’s worth noting that this is not a blanket, permanent approval. NCUA plans to introduce a provision that requires credit unions to cease further derivatives transactions if qualifications change. That means if the CAMEL management score ever falls below a 2 or total assets drop below $500 million, the credit union must cease further activity and notify the Regional Examiner. The credit union would then be required to reapply to establish derivative authority – the same process required today.

2. Broadening the universe of allowable derivatives

   In NCUA’s effort to adopt a more principles-based process, they are proposing to eliminate the specific limitations on permissible derivative instruments. The proposed regulation will allow all derivative instruments that meet the following criteria:

   1. Are U.S. dollar denominated
   2. Are based off domestic interest rates or dollar denominated LIBOR
   3. Have a maturity less than or equal to 15 years
   4. Are not used to create structured liability offerings

   There is one key exception. The NCUA does intend to continue prohibiting the use of writing options, but requests comment on this position.

3. Removing position limitations

This proposed rule also suggests removing the position limitations imposed: the weighted average remaining maturity notional (WARMN) and fair value loss. The idea behind these limitations was to ensure that credit unions do not use derivative positions large enough to cause material harm to their institution, the industry or the share insurance fund. NCUA noted the vast majority of credit unions engaged in derivatives did not approach the limitations. Those that did so did not present a material risk.

In addition to these three key changes, NCUA adjusted many other areas of the regulation to pave a clearer path for credit unions to engage in derivative hedging. Other changes include removing the prohibition on forward start dates, floating notional amounts, adding GSE MBS as acceptable collateral (they noted this was an oversight), and even easing the annual training burden for credit union boards and management.

Working with credit unions for almost two decades, I have encouraged them to gain derivative authority. It is simply too important to have access to this tool when managing interest rate risk. I am pleased the NCUA concurred that credit unions need access to this critical tool by easing the burden for gaining authority.

Read the new proposed derivatives rule and learn more about all the proposed changes here.

 

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