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Is a Derivative Program Right for Your Federal Credit Union?
The National Credit Union Administration (NCUA) issued a rule last year allowing federal credit unions to engage in limited derivatives activities to offset interest rate risk.
So far, only a small percentage of credit unions have chosen to use derivatives, which are contracts that derive value from the performance of an underlying asset. Although they can be risky and developed a bad reputation during the recent financial crisis, many credit unions may benefit by using them, because they can help protect against currently volatile interest rates.
However, there are additional approval and regulatory requirements to participate in a derivative program. The time and cost it takes to implement these requirements may be cumbersome, particularly for small credit unions with limited resources.
What derivatives are allowed?
Only a few types of derivatives are permitted under the rule:
- Interest rate swaps — an agreement between two parties where one stream of future interest payments is exchanged for another based on a specified principal amount.
- Basis swaps — a type of swap in which two parties swap variable interest rates based on different money markets.
- Purchased interest rate caps — a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price.
- Purchased interest rate floors — same as above, except the interest rate is below the agreed strike price.
- U.S. Treasury note futures — a contract between two parties to buy or sell an asset for a price agreed upon today (the futures price) with delivery and payment occurring at a future point.
Credit unions that want to apply for derivative authority must have the most recent NCUA-assigned composite CAMELS rating of 1, 2, or 3 with a management component of 1 or 2, and at least $250 million in assets as of the most recent call report.
If a credit union does not meet these criteria, it may request permission from the appropriate NCUA field director to apply for derivatives authority.
How to apply
When applying to the NCUA for derivatives authority, credit unions must document how they will comply with the requirements by providing:
- An interest rate risk mitigation plan that shows how derivatives are one aspect of its overall interest rate risk mitigation strategy, and an analysis showing how it will use derivatives in conjunction with other on-balance sheet instruments and strategies to effectively manage its interest rate risk.
- A list of the products and characteristics it is seeking approval to use, a description of how it intends to use them, an analysis of how they fit within its interest rate risk mitigation plan, and a justification for each one listed.
- Draft policies and procedures.
- A description of how it plans to acquire, employ, and/or create the resources, policies, processes, systems, internal controls, modeling, experience, and competencies to meet the requirements. This includes how it will ensure that senior executive officers, board of directors, and personnel have the knowledge and experience in accordance with the requirements.
- A description of how it intends to use external service providers as part of its derivatives program, and a list of the name(s) and service(s) provided by the external service providers it intends to use.
- A description of how it will support the operations of margining and collateral.
- A description of how it will comply with GAAP.
Credit unions that participate in the program must have senior executive officers deliver a comprehensive derivatives report to the board of directors on a quarterly basis, and have staff deliver a comprehensive derivatives report to senior executive officers and, if applicable, to the asset liability committee on a monthly basis.
The reports must include:
- Any areas of noncompliance with the regulations or credit union policies.
- Utilization of limits set.
- Itemization of the individual positions and aggregate current fair values, and a comparison with the credit union’s fair value loss and notional limit authority.
- A comprehensive view of the statement of financial condition, including net economic value calculations with derivatives included and excluded.
- Evaluation of the effectiveness of the derivatives transactions in mitigating interest rate risk.
- Evaluation of effectiveness of the hedge relationship.
- Assessment of compliance with GAAP.
For the first two years in the program, a credit union must have an internal controls review that is focused on the integration and introduction of derivatives functions. The review must ensure timely identification of weaknesses in internal controls, modeling methodologies, risk, and all operational and oversight processes. An independent external unit or the credit union’s internal auditor must conduct the review.
In addition, board members must receive training on derivatives and their oversight role before entering the program and annually thereafter.
Credit unions must also obtain an annual financial statement audit and be compliant with GAAP for all derivatives-related accounting and reporting.
How we can help
CLA can help you understand the advantages and possible risks involved in investing in derivatives. We can perform a range of services for credit unions involved in the derivatives program, including verifying compliance with GAAP requirements, reviewing derivatives reports for accuracy, training board members, and conducting an internal controls review.