by
Catalyst Corporate | Apr 06, 2023
When market volatility is high and deposit growth is slow, it’s crucial that credit union management make calculated, strategic decisions for the financial health of their members. While growth is important, growth at the expense of longevity, safety and soundness will leave you “up the creek without a paddle.”
Although interest rate derivatives have not received the industry traction they deserve thus far, current market conditions could make them a prudent strategy to consider.
What are interest rate derivatives?
Interest rate derivatives are financial contracts between two parties (your credit union and a counterparty). The most common derivative credit unions use is interest rate swaps in which the two parties agree to exchange interest rate payments based on a particular index. One party makes a fixed rate payment (fixed payer) to the counterparty, and the counterparty makes a floating rate payment back. Even though a number of credit unions already use interest rate swaps to help manage their balance sheets, more credit unions could benefit from this type of transaction.
How can interest rate derivatives help credit unions?
The benefit of an interest rate swap is that you can effectively convert your fixed (or floating) rate assets into floating rate (or fixed) assets. This enables you to originate mortgage loans to your members without adding the full interest rate risk exposure of those mortgages.
If you feel the current interest rate cycle is at its peak, you may want your higher-rate member term deposits (already issued) to reprice down as interest rates decline; interest rate derivatives can help make this happen. Similarly, if you want to extend the duration of your assets but do not have the lending volume or capital to execute this plan, you could use an interest rate derivative against your adjustable-rate assets to create synthetic fixed-rate assets.
Interest rate derivatives offer a number of flexible options, but those unfamiliar with derivatives may not recognize their potential.
Why shouldn’t I use borrowings instead?
The use of Federal Home Loan Bank (FHLB), or other, advances to manage interest rate risk exposure has a long tradition within the credit union industry. However, while borrowings can produce the same effect as interest rate derivatives, they are not always the best choice for a few key reasons:
- Borrowing capacity is a critical secondary liquidity source that should be protected. Using a liquidity source to reduce interest rate risk is a risk transfer, not a pure risk reduction. In this case, you are increasing your liquidity risk exposure at the sake of lowering your interest rate risk exposure, because you now have less total liquidity available to you.
- Borrowings increase total assets, and, therefore, reduce your net worth ratios. Because borrowings represent a true financial liability, they are added to the balance sheet and, subsequently, increase total assets. Assuming net worth does not increase (as with subordinated debt), your net worth ratio will decline. In difficult times when net worth is lower, this is typically not an optimal strategy.
- Borrowings tie up your collateral to secure the amount borrowed. While borrowings are effective, you must pledge assets to secure them. If you need to sell those financial assets later or use them for other purposes, they will not be available.
Ready to start managing interest rate risk with tools made for that purpose?
Interest rate derivatives are designed to help institutions manage their interest rate risk exposure, and their use is slowly on the rise.
If you are looking to improve your overall interest rate risk management process, your credit union may want to consider interest rate derivatives.
Whether just getting started, or needing assistance with strategy development and execution, the Advisory Service team at Catalyst Strategic Solutions can help you. For more information, contact us today.