NCUA Rule Would Allows Derivatives as Interest-Rate Risk Hedge in Limited Circumstances

As part of its strategy for helping credit unions manage interest-rate risk, the NCUA Board proposes allowing certain well-managed credit unions with assets above $250 million, and with appropriate safeguards in place, to purchase limited amounts of simple derivatives—interest rate swaps and interest rate caps—as a hedge against that risk.

Board Chairman Debbie Matz explained the agency’s action comes after years of careful analysis and several advance notices of proposed rule-making seeking public comment. Currently, derivatives are among the instruments specifically prohibited by NCUA.

“Working with credit unions to manage interest-rate risk exposure is a top priority for NCUA,” Matz said. “The negative impact on balance sheets when rates rise, especially if they rise rapidly, will significantly reduce the earnings and net worth of exposed credit unions. NCUA urges credit unions to prepare for this event. After careful evaluation, the NCUA Board is proposing to allow eligible credit unions, which hold nearly 80 percent of industry assets, to purchase simple types of derivatives with certain safeguards to hedge interest-rate risk.”

NCUA has been evaluating pilot programs for limited derivatives use since 1999. That evaluation process satisfied the Board that certain credit unions can operate a limited derivatives program to hedge interest-rate risk in a safe and sound manner, provided they have sufficient experience, management capacity and infrastructure in place before beginning such a program. The Board proposes to allow the use of external service providers in limited ways when credit unions meet particular conditions and observe particular restrictions. NCUA coordinated with representatives of state credit union supervisors to develop the proposed rule.

Eligible federally chartered credit unions must apply and obtain approval from NCUA through their applicable Regional Director or the Office of National Examinations and Supervision. Eligible credit unions that are federally insured and state-chartered and are located in states that permit these investments must obtain approval from NCUA and their state supervisory authority. Credit unions applying for the authority must demonstrate how derivatives will be part of an overall interest-rate risk mitigation plan.

Credit unions may apply for one of two levels of authority under the proposed rule. The levels differ in the amount of transactions permitted, the expertise and systems requirements associated with operating a derivatives program, and certain application requirements. Only credit unions with a CAMEL code of 1, 2, or 3 and a management component of 1 or 2 may apply. Credit unions seeking Level II authority must demonstrate why Level I authority is insufficient to meet their interest-rate risk mitigation needs.

The Board is requesting specific comment on whether to institute a fee structure for credit unions that take advantage of this rule once it is finalized. Total program costs will vary based on the number of applications received, which NCUA initially estimates will range between 75 to 150 credit unions for 2014. NCUA estimates a program cost range for 2014 between $6.25 million and $10.75 million, reflecting one-time start-up costs and costs of qualifying, processing and supervising a variable number of credit unions seeking derivatives authority. Thereafter, program costs are projected to decline in 2015 to between $2.05 million to $3.85 million.

The Board issued the proposed rule with a 60-day comment period, once published in the Federal Register.