The NCUA recently published the final derivatives rule in the Federal Register, which is applicable to only federal credit unions and effective March 3. Different from the proposed rule, the use of derivatives by FCUs does not require the credit union to pay fees. Along with other revisions made in the final rule, this was something MCUL & Affiliates strongly advocated for in its comment letter.
FCUs wishing to purchase derivatives will be required to apply with the NCUA. There is a two-stage process in place. In the first stage, the credit union will have to present an IRR mitigation plan that demonstrates how derivatives fit within the plan and how it will utilize or acquire the appropriate resources, controls and systems to implement a sound derivatives program. In the second stage of the approval process, the NCUA will evaluate the credit union on its actual readiness to engage in derivatives transactions based on the personnel, controls and systems in place. Credit unions must operate safely for one year under limited derivative authority before moving to full authority.
Additionally, the types of interest-rate derivatives that FCUs can purchase were expanded in the final rule. As opposed to just interest rate swaps and caps, FCUs are now permitted to purchase interest rate floors, basis swaps and treasury futures. FCUs will need to specify which type of derivative authority they are requesting under the final rule, with the ability to apply for additional derivative authority if needed.
The NCUA increased the maximum maturity to 15 years, as opposed to the 10-year limit (for Tier II) in the proposed rule. The proposed rule also included a notional limit for interest rate swaps and book value limit for interest rate caps. The final rule replaced those limits with a consolidated fair value loss limit and weighted average remaining maturity notional (WARMN) limit for all derivative transactions.
The fair value loss limit is 15 percent of net worth for FCUs in their first year of derivatives activity (the “entry” level) and 25 percent of net worth for credit unions beyond their first year (“standard” level). This is calculated by totaling the fair value gains and losses on all outstanding derivatives positions and if the result is an aggregate net loss, the FCU will compare the loss amount, expressed as a percentage of net worth, to the applicable fair value loss limit.
The WARMN limit is on the notional amount of derivatives outstanding and takes into account the type of derivative and time to maturity. The WARMN calculation is designed to correspond to the net worth at risk (15 percent and 25 percent) in an interest rate shift of three percent or 300 basis points. The WARMN limit corresponds to a fixed percentage of net worth (65 percent for entry and 100 percent for standard) and the maturing weighting method provides for higher gross notional amounts for shorter duration derivatives, but lower gross notional amounts for longer duration derivatives.
The reporting requirements to the FCU’s board of directors were also revised with the final rule. The rule now requires that senior executive officers, and if applicable, the credit union’s asset liability committee, receive derivative reports on a monthly basis, but the board of directors is only required to receive reports from the senior executives quarterly. The final rule requires that overall experience of the credit union staff overseeing the credit union’s derivatives program have commensurate experience in ALM, accounting and financial reporting, derivatives trade execution and oversight and counterparty, collateral and margining. The final rule does not require a credit union to have one or more employees with a specific number of years of experience. However, the training requirement for the board is retained in the final rule, with the exception that the credit union provide notification to the NCUA when positions become vacant and documentation evidencing knowledge and experience for any new senior executive officer.
The final rule amended the section on internal reviews to indicate that a credit union must only obtain an independent review for the first two years of the derivatives program. The final rule also provides that this review can be conducted by a credit union’s internal auditor. A financial statement audit and hedge review is still required under the final rule, but the requirement that the auditor have two years of experience with derivatives was removed.
In the final rule, the use of external service providers was expanded and the final rule permits a credit union to use an ESP for most functions, provided the credit union complies with the other requirements related to ESPs. However, the NCUA did retain the requirement that a credit union internally and independently conduct ALM and liquidity risk management.
FCUs still need to have assets of over $250 million to apply for derivatives authority, unless an NCUA field director permits a credit union under that threshold to apply. A camel rating of 1, 2 or 3 is necessary for credit unions to participate, along with a management component camel rating of 1 or 2. FCUs wishing to engage in derivatives authority, will still be required to submit an application to their field director. Credit unions approved by the NCUA will be granted “interim approval,” allowing them time to comply with any infrastructure components outlined. When they have complied with these requirements, they will submit a notice of readiness to the NCUA which will then provide the final approval.
MCUL is actively working with DIFS to provide for derivatives authority for state-chartered credit unions and will update credit unions as communications progress.