NCUA's Derivatives Proposal

It's a good step, but big changes are needed.

July 10, 2013

Increasingly, financial regulators are highlighting their concerns about whether financial institutions will manage interest-rate risks when rates inevitably return to higher levels.

That includes the NCUA Board, which at the urging of CUNA and others took an important step in May toward regulating the use of derivatives to hedge against rising rates. In the wake of a pilot program and two previous rounds of input on the subject generally, NCUA issued a new proposal on derivatives. To comment, visit CUNA's Legislative & Regulatory Advocacy page. Comments are due July 29.

The proposal’s approach raises concerns, and CUNA is pursuing significant changes to achieve authority that’s meaningful for participating credit unions yet avoids undue risk exposure for the credit union system. CUNA’s Examination and Supervision Subcommittee took the lead for CUNA in reviewing the proposal and developing recommendations for improvements.

As proposed, credit unions’ authority would be limited to instruments known as interest rate swaps and caps. Credit unions would have to apply to NCUA for approval under Level I or Level II derivatives authority, with Level II providing more flexibility and imposing more requirements.

One issue that provoked early responses is whether credit unions applying for derivatives authority would pay additional fees. The agency has determined it would have to establish a new supervisory program, which would cost between $6 million and $11 million. As a result, NCUA is considering a Level I application fee starting at $25,000 and a Level II application fee ranging from $75,000 to $125,000.

NCUA has never proposed such an approach before, directly for credit unions, and this could set a precedent for fees for other activities. “Where would it end?” one credit union CEO inquired.

For either level, among other things, a credit union must:

  • Maintain a composite CAMEL rating of 1, 2, or 3, with a management component of 1 or 2;
  • Have assets of at least $250 million;
  • Develop board policies and training;
  • Acquire and maintain staff expertise on derivatives (three years for Level I and five years for Level II);
  • Comply with internal controls, GAAP (generally accepted accounting principles), and new reporting and financial statement audit provisions; and
  • Conduct a legal review by an experienced derivatives attorney.

The proposed rule would place tough collateral and counterparty requirements on participating credit unions and would limit the use of external service providers.

The restrictions on transactions are at the heart of the rule. Credit unions not in compliance with these or other proposed requirements would be subject to corrective sanctions.

Level I
  • Interest-rate (IR) swaps limited to notional value of 100% of net worth; IR caps limited to aggregate book value of 10% of net worth.
  • Combined limit of swaps and caps is 100% of the aggregate limits based on usage.
  • Fair value loss on all swap positions cannot exceed 10% of net worth.
  • Maximum weighted average life of all derivatives transactions—five years.
  • A single derivatives position maturity—seven years.
Level II
  • IR swaps limited to a notional value of 250% of net worth; IR caps limited to aggregate book value of 25% of net worth.
  • Combined limit of swaps and caps to be set by NCUA.
  • Fair value loss on all swap positions cannot exceed 25% of net worth.
  • Maximum weighted average life of all derivatives transactions—seven years.
  • A single derivatives position maturity—10 years.
  • Single counterparty notional exposure limited to 100% of net worth for swaps and to 10% of net worth for caps. 

The proposal represents a significant step, but the final rule must incorporate a number of changes. These would include limitations that are much more reasonable to allow better matching between assets and liabilities, ensuring credit unions that can manage derivatives authority won’t be excluded, and a timely effective date.

These may constitute a tall order but one well worth pursuing.

MARY MITCHELL DUNN is CUNA’s senior vice president/deputy general counsel for regulatory affairs.