NCUA proposes changes to derivatives rules

Overview

The National Credit Union Administration (NCUA) Board recently met and unanimously approved a proposed rule to modernize the agency’s existing derivatives rules and take a more principles-based approach. The proposed changes would allow more flexibility for federal credit unions (FCUs) to manage their interest rate risk through hedging instruments.

NCUA Chairman Rodney E. Hood said, “Managing balance sheet risks through a time of disruption and uncertainty underscores how important it is for credit unions to have tools, like financial derivatives, at their disposal to help guard against volatile economic periods that can hurt liquidity, earnings and capital.”

Proposed changes

The proposed changes to the derivatives rules include:

• Eliminating the pre-approval process for FCUs that are “complex” with a Management CAMEL component rating of 1 or 2;
• Eliminating the specific product permissibility; and
• Eliminating the regulatory limits on the amount of derivatives usage

The pre-approval or application process for derivatives authority would be removed for any FCU that is “complex” and has a Management CAMEL component rating of 1 or 2. The term “complex” refers to any federally insured credit union having assets greater than $500 million. For those FCUs not meeting this requirement, they would need to complete an application. However, they no longer need to obtain interim approval which would reduce the overall process from up to 120 days to less than 60 days.

The parameters for permissible instruments have been broadened in accordance with the new principles-based methodology. Specifically, the Board is proposing derivatives must have all of the following characteristics: denominated in U.S. dollars, based on domestic interest rates (or dollar-denominated LIBOR), contract maturity of 15 years or less, and may not be used to create Structured Liability Offerings. Additionally, the proposal removes the limitation of a forward-start date beyond 90 days as well as the limitation on floating notional amounts.

Lastly, the proposal removes certain requirements related to the measurement and reporting of position limits, specifically the fair value loss limit and weighted average remaining maturity notional (WARMN) limit. The Board believes removing the burden of measuring and reporting these limits outweighs the potential benefits. However, the NCUA will still review derivative exposures when conducting exams and could determine excess exposures to be a safety and soundness concern.

Other considerations

The proposed rule retains the experience and competency requirements for the Board and senior executive team at each FCU, although the annual training requirement for the Board was removed. Similarly, the current rules regarding transaction review and internal controls remain largely in place, except a change that allows for internal control reviews only in the first year. These changes would alleviate some of the operational burdens of managing an interest rate hedging program.

FCUs will still be required to work with a registered swap dealer domiciled in the U.S. or a clearing house/organization as counterparty for any derivative transaction. A major swap participant does not meet that requirement. Additionally, FCUs may continue to use external service providers (ESP) like Chatham to support many aspects of their derivatives program. ESPs may not act as a counterparty, principal, or agent in any derivative transactions involving the FCU.

Conclusion

The NCUA Board believes these proposed changes to the derivatives rule are consistent with a more principles-based approach to managing interest rate risk while maintaining safety and soundness. The additional flexibility and ease of use should be well received by many FCUs currently utilizing derivatives as well as those considering these hedging tools. Comments on the proposed derivatives rule are due 60 days after publication in the Federal Register.

About Chatham

Founded in 1991, Chatham Financial is the world’s largest independent derivatives advisory firm, executing over $750 billion in transaction volume annually and helping clients across industries maximize their value in the capital markets. Chatham partners with credit unions throughout the U.S. to support their interest rate hedging activities. As an external service provider, we are equipped to deliver training, trade structuring, pricing execution, hedge accounting, and regulatory advisory support among other services. Having an independent and transparent approach allows us to bring a partnership mentality to every client engagement.