Conversation around interest rate derivatives has slowly gained more traction within the credit union industry over the last year. In October 2020, Catalyst Strategic Solutions outlined the benefits of derivatives as an effective tool for managing credit union interest rate risk (IRR). And most recently, explained why they might be worth a second look.
Since then, the NCUA Board approved a final rule that modernizes the proposed derivatives rule, making it more of a principles-based approach, while retaining essential safety and soundness components. The amended rule, which took effect June 21, 2021, provides more flexibility for federal credit unions (FCUs) to effectively and efficiently manage IRR. It should be noted, however, that the rule applies only to FCUs. State-chartered credit unions may be required to seek approval from their governing body prior to derivative usage.
Let’s take a closer look at some of the key takeaways of the updated rule.
The latest NCUA-approved changes enact the following:
An FCU may not engage in embedded options required under U.S. generally accepted accounting principles (GAAP) to be accounted for separately from the host contract.
For a more comprehensive overview of the amended rule, credit unions are encouraged to review the NCUA’s final rule. As NCUA Chairman Todd Harper stated, “This [amended] rule is a timely and appropriate measure that ensures complex federal credit unions can manage a variety of interest rate scenarios. It also provides a way for smaller credit unions, which demonstrate proficiency and obtain regulatory approval, to use simple derivatives to hedge their loan portfolios.”
With this amended rule now in effect, why would a credit union consider using derivatives to manage IRR? As we know, the Fed’s actions in March 2020 had a significant impact on lending rates. Rates fell precipitously and continue to remain at or near historic lows. The impact of new origination and refinancing of real estate loans has been and will continue to be felt for several years on both earnings and IRR. A credit union has the option of either retaining the loan(s) on their balance sheet or selling them to the secondary market. The use of derivatives can assist in hedging interest rate risk for both options.
Ultimately, the recent amendment to the NCUA Derivative Rule provides greater access to hedging opportunities for all credit unions. And while hedging is a complex strategy, the proper application can help keep a credit union’s interest rate risk in check.
As an advisor at Catalyst Strategic Solutions, Chris Shipman assists client credit unions with meeting their goals in the areas of financial management, ALM analysis, investment portfolio analysis and strategic planning. For more information on IRR management or tailored hedging strategies, contact us today.
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