By Ray Birch
DALLAS—With margins continuing to shrink, a proposal from NCUA that would make hedging simpler for credit unions is being called a “big deal” by one analyst.
As CUToday.info reported here,in October the NCUA board unanimously approved a proposal the agency said would ease regulations on derivative use, open the scope of permissible derivatives, and make it easier for federal credit unions to hedge their balance sheet interest rate risk using the tools. Institutions that already have derivative approval would be subject to the terms and conditions of the final ruling.
“This is a big deal,” said Robert Perry, principal partner at ALM First. “This rule had to happen…The big takeaway for credit unions is NCUA is making it less difficult for institutions to hedge their interest rate risk. They're removing the notional limits to capital. They are removing the prescriptive nature of the application process.”
The preapproval process for derivative use will be eliminated for FCUs with more than $500 million in assets that have a CAMEL rating of 1 or 2. The proposal also removes references to specific product types that are permissible, as well as entry limits and standard limits authority pertaining to fair value loss, Perry explained.
“If the proposed rule is finalized, a big takeaway will be the elimination of the preapproval process,” said Perry.
Five Days Notice
Credit unions that qualify under the new rule could begin using derivatives by providing their regional director a written notification within five days of entering the first derivative transaction.
“It is important to note that there will still be due diligence needed from an institution prior to engaging in a derivatives transaction,” said Perry. “This would include getting the board and staff comfortable with derivatives, ensuring the accounting for derivatives is squared away, and reporting is handled.”
Under the proposed rule, such steps would be best practices—not regulatory requirements for approval, noted Perry.
“The removal of the preapproval process would make derivatives more accessible and provide institutions with a useful tool for the management of their interest rate risk,” he said.
Perry said the proposed rule is similar to the banking industry rules regarding derivatives.
“The banks don't have to ask for permission all the time to use derivatives,” said Perry, noting the restrictions CUs faced prior to the proposal. “What this does for credit unions is allow them to better offer products and manage their balance sheet.”
Next Best Strategy
Perry said credit unions are well aware that if they can't hedge interest rate risk directly using derivatives, the next best strategy is to limit product offerings to those instruments that better manage risk.
“Making it simpler for credit unions to offer derivatives keeps them from limiting their product offerings, especially in this type of very low interest rate environment,” Perry said.
Robert Perry
Perry stressed today’s rate environment combined with concerns around margin compression, credit unions have been focused on the short end of the yield curve.
“Being limited to one part of the curve restricts institutions’ ability to make strategic decisions regarding balance sheet direction,” Perry said. “This can lead to adding products to the balance sheet that are not beneficial to the overall profitability of the institution. In addition, removing barriers to the products that can be offered will ultimately benefit the members of an institution.”
Perry pointed to a 2020 lending trend that makes NCUA’s proposal even more important for credit unions.
“This year we have seen an increase in mortgages on the balance sheet due to the extremely low-interest-rate-induced refinancing,” noted Perry. “This could add interest rate risk to balance sheets. We believe using derivatives can be a worthwhile tool for any institution with mortgages on the balance sheet, or those simply looking to manage margins in the low-rate environment. If the rule is finalized, it would provide federally chartered credit unions with greater flexibility in managing interest rate risk, and making more profitable decisions.”
A Frequent Question
Perry told CUToday.info that over the years credit unions have often asked him about costs related to hedging.
“I've had plenty of people say to me it’s going to cost me something to hedge. But in reality it really doesn't,” said Perry. “There's a very profitable side to risk management, and that means credit unions can now offer products to members that have longer durations that they may not have offered before. They may have said, ‘I can offer you a 30-year mortgage but if I can't sell it to Fannie or Freddie I can't put it on my balance sheet.’ Now you can. In a much more direct way, with hedging, you can manage the interest rate risk. Instead of managing the interest rate risk on balance sheet, institutions can now do it off balance sheet.”
Perry added the rule makes credit unions more competitive with banks.
“Consider commercial loans. There's a lot of commercial lending going on with 30-year amortizations and 15- and 20-year balloons,” said Perry. “That's a pretty long duration asset. But if you can match it you can manage it.”
A Strategy to Consider
Perry outlined a strategy that would address the liquidity building up in credit unions today.
“There's two different ways to have a portfolio with a six-month duration,” explained Perry. “One of them is you build a portfolio with a bunch of six-month assets. The other one is you build a portfolio for the balance sheet with a bunch of three- to five- to ten-year assets. Then you hedge it back to a six-month T-bill duration. I'll tell you which one has the higher expected return.”