Consultant: Use Derivatives to Hedge Interest Rate Risk
Using derivatives to hedge against interest rate risk is not a strategy that looms large on many credit unions’ horizons. However, those that pursue it may find significant advantages, according to Emily Hollis, a partner with ALM First, a Dallas consulting firm.
“Derivatives can serve as a valuable tool for some credit unions, offsetting the interest rate risk inherent in today’s financial environment,” Hollis said. “When used properly, derivatives allow eligible credit unions to compete more effectively, but their restrictions and guidelines must be understood and followed.”
Understanding and applying the newly available hedging tools was the focus of ALM First’s Feb. 20 webinar “The Use of Derivatives.” Hollis led 95 participants through the strategies of hedging balance sheet risk with various kinds of derivatives in compliance with the NCUA’s newly released guidelines.
ALM First is currently the only organization that has approved derivative credit union clients, according to an earlier release from the firm. NCUA’s new ruling limits derivative use to federally regulated credit unions with assets of more than $250 million, a CAMEL rating of 1, 2 or 3 and a management rating of 1 or 2.
The final rule differs significantly from the earlier Notice of Proposal Rule, Hollis told webinar participants. The final rule contains added interest rate swaps, purchased interest rate caps, purchased interest rate floors and Treasury note futures to investment authorities for qualified credit unions, she explained.
Many credit unions need stable, long-duration funding, Hollis told webinar participants. Deposits and borrowed funds are, at best, average hedging sources. Interest rates swaps and caps can be great interest rate management tools for credit unions prepared and authorized to use them, she said.
The use of derivatives originally was not condoned by the NCUA except under very limited circumstances. The regulator approved a much broader use of derivatives within its revised guidelines on Jan. 23.
In order to be approved to use derivatives, credit unions must present the NCUA with an interest rate risk mitigation plan that demonstrates the role derivatives will play and how credit unions will acquire the necessary resources to use them.
The agency will then evaluate the credit union on its readiness to engage in derivative transactions based on its personnel, control mechanisms and systems in place to manage the program. This readiness includes understanding and approval by the credit union’s board, Hollis told webinar attendees.
“The board will have to approve the credit union’s entry into the derivatives market before NCUA will undertake the final approval process,” Hollis said. “The regulator doesn’t want to go through the efforts if the board is likely to say ‘no’ to derivatives later on.”
The NCUA’s goal is to respond within 120 days of the initial application with final approval for the program, she added