By Roy Urrico
In a May 2021 meeting, the NCUA Board approved the modernization of its existing derivatives rules, making them more principles-based and flexible for many federal credit unions (FCUs) to manage interest rate risk. The final rule removed the lengthy application process and simplified the use of common hedging tools.
Finopotamus sought the help of Matthew Tevis, a managing partner and global head of financial institutions at Kennett Square, Penn.-based Chatham Financial, an independent derivatives advisory firm, to help break down the significance of this highly complex topic.
The industry considers derivatives as a financial contract which obtains its worth from the value and performance of some other underlying monetary instrument or variable, such as an index or interest rate. Hedging is a risk management approach that is often used to manage cash flows and valuation changes in assets and liabilities due to interest rate movements.
The NCUA Board’s finalized changes (effective June 25, 2021) to the derivatives rules included eliminating:
· The pre-approval process for FCUs that are “complex” with a management CAMEL component rating of 1 or 2. The term “complex” refers to any federally insured credit union having assets greater than $500 million.
· The specific product permissibility.
· The regulatory limits on the amount of derivatives usage.
Under the new rule, FCUs with at least $500 million in assets that have a management CAMEL component rating of 1 or 2 are exempt from the requirement to apply to use derivatives in order to manage interest rate risk. Five critical elements − capital adequacy, asset quality, management, earnings, and liquidity/asset-liability management – define the CAMEL rating system used for the evaluation.
“In the years ahead, a credit union’s ability to manage interest-rate risk will play a crucial role in its financial performance,” NCUA Chairman Todd M. Harper said. “As such, this 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.”
CUs Not Racing to Take Advantage of Rule Change
The revised rule requires FCUs to notify their regional directors in writing or by email within five business days after entering into their first derivatives transaction. FCUs that do not qualify for the exemption must apply to their regional directors for approval to use derivatives to manage interest rate risk.
Chatham Financial’s Tevis acknowledged the underwhelming response to the rule change. “We actually thought it was going to (have) a pretty big impact on the industry. Definitely [some] credit unions have taken advantage of it, but not as many as we thought. We thought this was really going to be kind of a waterfall event.”
Tevis blamed the credit union industry’s lackluster response to the rule change partially on COVID-19. Many institutions, he said, were just trying to figure out how to operate in a new normal and probably were not able to focus on the rule change as much.
Nevertheless, the change provided credit unions more flexibility to utilize derivatives as an interest rate risk management tool and removed the application and approval process. Even those credit unions not considered “complex” had their application process time shortened almost in half. Instead of 120 days-plus to go through the derivative process, today it is closer to 60 days. “It's much more measured,” pointed out Tevis.
What It Means for Credit Unions
The NCUA derivation rules changes alleviate some of the operational burdens of managing an interest rate hedging program. It made the process more principles based and much less prescriptive on what credit unions could and could not do in the derivative space. “Generally, it just gave more alternatives for the types of derivatives they could use in hedging,” Tevis said. In addition, there is also less reporting requirements and measurement tests, and gave credit unions more flexibility. “A pretty attractive change for the industry.”
The new rule also allowed firms like Chatham Financial to partner with more credit unions to educate and support interest rate hedging activities. Said Tevis, “Because really at the end of the day it helps them manage their rate risk without having to either change their core business or pass on new opportunities. You are meeting customer demand, whether that be for a loan or deposit, (and) know you can manage the associated rate risk with that.”
Tevis described three of the most probable uses of derivatives at credit unions:
· Reducing funding costs. For those credit unions utilizing funding to support loan growth, they could borrow on a floating rate basis from Federal Home Loan Banks (FHLB) or in the brokered market and combine with a hedging strategy to lock-in lower funding costs. Tevis said this approach could save credit unions anywhere from 25 to 75 basis points relative to other fixed rate funding structures that include term premiums.
· Enhancing the yield. “They [credit unions] could use a hedging strategy to convert floating rate loans and securities to a higher fixed rate for a specific period of time. The underlying assets could stay in place and would not need to be sold prior to maturity.
· Managing asset duration. Hedging strategies could also be used to swap fixed rate loans and securities to a floating rate which could be beneficial in this rising rate environment. Many credit unions are looking at ways to protect against mark-to-market risk in their investment portfolios.
Getting Hedging to Work
Tevis explained there is so much education needed on the front end to build and implement the framework to use hedging strategies. Organizations, he added, need to add structure and price, as well as documentation, servicing and accounting. “We really do all of that and it is all in house. That is what makes us pretty unique.” Chatham’s financial institutions practice works with over 200 financial institutions, mainly community and regional banks, as well as credit unions throughout the U.S. He continued, “As a firm we help clients with rates, currencies and commodity risk. But in the financial institution space probably 90 to 95% of the work Chatham does revolves around interest rate risk.”
For credit unions to incorporate the new derivatives rules at a policy level, this typically means board approval and CEOs involvement. “The boards for a lot of credit unions may or may not have financial experience. So, the education piece is a pretty important one,” said Tevis. “We probably spend more time than most on the education side, especially when it comes to credit unions. You just wanna make sure that they fully understand what they are considering.”
Chatham Financial helps credit unions throughout the whole derivatives process, revealed Tevis. That includes educating the board, management team, the asset-liability committees (ALCOs) and other departments in the organization possibly affected such as accounting, operations, risk management, and legal. “Anyone who may be impacted by a hedging strategy,” he said.
Once Chatham Financial gets to the point where everyone is comfortable, it can help the organization structure its strategy. “We can run analysis for them. If you were to use a swap or a cap or a collar strategy around these types of assets or liabilities, what is the net effect, applying almost like an overlay on what they have on their balance sheet to show them the difference,” stated Tevis. “That helps them size the strategy and think about the term and even the specific type of product that they might want to use.”
Tevis noted, “once we agree upon that, we will help them go out to the market and actually get a price for it. We do everything as an advisor, but we do not make a price in the derivative. There are swap providers or dealers out there that do that. We have purposely chosen not to play that role because we never want to be on the other side of the table from our clients. We are always on their side of the table looking out for them.”
Chatham Financial: A Fintech Pioneer
Founded in 1991, Chatham Financial, which has close to 650 employees and about 3,000 clients globally, bills itself as “the world’s largest independent derivatives advisory firm.” It executes over $750 billion in transaction volume annually and helps clients across industries maximize their value in the capital markets.
Chatham can deliver training, trade structuring, pricing execution, hedge accounting, and regulatory advisory support, among other services. The firm has four different industry groups: financial institutions, real estate, corporate and private equity that focus on strategic ways for its clients to use hedging strategies and derivatives to manage risks. Those risks tend to fall in three categories: rates, currencies, and commodities. Said Tevis, “Not many, advisory or technology firms can help clients throughout the whole life cycle or process of a hedging transaction.” He also described Chatham Financial as “one of the original fintechs if you think about how that is defined today, because we are truly a combination of an advisory firm and cloud-based technology.”
Most of Chatham Financial clients fall in the $1 to $20 billion asset range. “Our smallest client is definitely under a half a billion and our largest is over $200 billion,” said Tevis. “That is a testament to that full service we can provide so people can utilize us for everything we have to offer, or just use us to fill in gaps,” explained Tevis. Beside their headquarters right outside of Philadelphia, Chatham has offices in Denver, Toronto, London, Krakow (Poland), Singapore and Melbourne, Australia.