Thanks to changes in accounting rules and the NCUA’s derivatives rule, more and more credit unions are empowered to use derivatives to hedge interest rate risk. In this blog, we discuss three reasons why you should include hedging in your interest rate risk management strategy.
Now is a great time for credit unions to get started with using derivatives to hedge risk.
The combination of eased hedge accounting rules—circa 2017—and the National Credit Union Administration’s (NCUA) modernized derivatives rule as of May 2021 has brought new interest to the strategy for credit unions.
What was once considered a taboo, risky strategy can be a beneficial tool when used appropriately.
In fact, according to NCUA Chairman Todd M. Harper, “in the years ahead, a credit union’s ability to manage interest-rate risk will play a crucial role in its financial performance.”
So, now more than ever, this strategy is essential to add to the IR risk management toolkit. Harper continues: “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.”
Regulatory authorities in the industry have made the value of using derivatives to hedge risk clear. Here’s why.
#1. Align Interest Rate Sensitive Assets & Liabilities
To manage interest rate risk, credit unions want to match the future inflow rate tenor to the outflow rate tenor. This Asset-Liability Management function is crucial for credit unions.
One way to align interest rate sensitive assets and liabilities is to use interest rate derivatives.
For example, credit unions often enter into pay-fixed, receive-variable swaps to increase the tenor of their short-term fixed-rate certificates of deposit.
When this strategy is combined with hedge accounting, you can take your portfolio of three- or six-month certificates of deposit and turn them into fixed-rate obligations for years. This is currently limited to 15 years, per part 703 of the NCUA rules. The interest that you pay quarterly or semi-annually is offset by the floating receipts on your swap, and you pay a fixed rate instead.
Recent changes to the NCUA’s derivatives rule remove the traditional limits on floating notional amounts and forward-starting hedging instruments beyond 90 days. As a result of these changes, credit unions have an opportunity to broaden their hedging portfolios to better match their long-term goals.
#2. Minimize Balance Sheet Impact
COVID-19 continues to have an indirect impact on credit unions. During the pandemic, credit unions have seen a steady increase in member low-yielding deposit balances and correlated access to unexpected liquidity.
Derivatives are not only a tool that you can use to minimize the impact of other strategies typically deployed to better align interest rate sensitive assets and liabilities. When combined with the last-of-layer designation strategy, you can ensure that your balance sheet doesn’t end up inflated—especially pertinent during this time of excess liquidity.
Traditional cash flow hedges require credit unions to maintain minimum balances. If the minimum balances are not maintained, it can lead to significant adverse accounting impacts (a three-strikes and you’re out mentality).
The last-of-layer strategy, which is a fair value designation, avoids this nuance. Hedge accounting improvements from ASU-2017-12 give credit unions the ability to proactively de-designate hedges and not worry about maintaining the original hedged amount.
Credit unions are able to apply a pay-fixed, receive-variable interest rate swap to hedge a portion of their fixed-rate mortgages under last-of-layer. This strategy combines several fair value elections and enables users to hedge a closed portfolio of pre-payable fixed-rate assets.
Beyond just the hedge accounting benefits, taking a pooling approach to hedging similar types of pre-payable instruments can lead to significantly improved pricing. Given its positive economic and hedge accounting impacts, last-of-layer is continuously increasing in popularity.
#3. Stabilize Credit Union Margin
Fluctuations in interest rates impact near-term earnings and the net economic value of a credit union’s assets and liabilities. Often, there is a tradeoff between earnings and future capital adequacy due to the mismatch in the reprice-ability of assets and liabilities. Derivatives can be used to help manage the mismatch within acceptable volatility levels set by management.
For example, a pay-fixed, receive-variable swap can be used to synthetically create fixed-rate liabilities, which line up with the credit union’s fixed-rate assets. When you take this a step further and make sure that the derivative qualifies for hedge accounting, the end result is greater margin stability over the hedge period.
Using derivatives to hedge interest rate risk is especially relevant today because, following the August 2021 Federal Reserve meeting, interest rate hikes appear to be more likely.
Conclusion: Use Derivatives to Hedge Risk
Recent changes to the NCUA’s derivative rule and simplified hedge accounting have made derivatives more appealing than ever for credit unions. By using derivatives to hedge risk, you can effectively align interest rate sensitive assets and liabilities, minimize balance sheet impact and stabilize credit union margin—no matter what’s happening in the market.
Now that you know why you should use derivatives to hedge interest rate risk… how do you actually make it happen?
Your best next step is to work with a supportive partner who can:
- Help you develop a derivatives policy.
- Compile all the materials you need should you require NCUA approval.
- Manage derivative accounting, reporting and ongoing hedge effectiveness.