Should My Credit Union Use Derivatives to Manage Interest Rate Risk?

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1 Should My Credit Union Use Derivatives to Manage Interest Rate Risk? On January 23, 2014, the NCUA Board adopted a final rule that allows federal credit unions to mitigate interest rate risk with permissible derivatives including: Interest rate swaps Interest rate caps Interest rate floors Basis swaps Treasury note futures The rationale for the new rule is that the NCUA is concerned about the risk of rising interest rates and wants to enhance the financial tools and strategies available to credit unions to manage the risk of interest rates rising significantly from their historic lows. We note the following for changes in interest rates over one-year time periods from 1955 to 2008: 30% of the time periods experienced changes in interest rates of over 200 basis points 16% of the time periods experienced changes in interest rates of over 300 basis points 9% of the time periods experienced changes in interest rates of over 400 basis points 1 While new to credit unions, the use of derivatives to offset interest rate risk is used extensively by other types of entities. For example, according to the Bank for International Settlements, the notional amounts outstanding for interest rate swaps were upwards of $364 trillion at the end of The program is available to credit unions with: CAMEL current code composite rating of 1, 2, or 3 CAMEL management component of 1 or 2 Asset size of $250 million or greater (smaller asset size permissible with regional NCUA director approval) Should a federal credit union use derivative strategies to manage its interest rate risk? The answer to this question begins with the Asset Liability Management ( ALM ) profile of the institution. More specifically, how much net interest income is lost relative to the base case in rising interest rate scenarios? If an institution's ALM modeling shows significant reductions of net interest income in the rising interest rate scenarios, then derivatives could be an effective way to mitigate interest rate risk. Before it moves forward with derivatives, a federal credit union should examine non-derivative strategies to manage undue exposure to rising interest rates. The non-derivative strategies can be used in conjunction with or instead of derivative strategies. Non-derivative strategies to manage interest rate risk due to rising interest rates include: 1 FDIC Supervisory Insights Nowhere to Go but Up: Managing Interest Rate Risk in a Low Rate Environment December 2009

2 Origination of floating-rate loan products Purchase of floating-rate securities Sale of long-term fixed rate assets Purchase of short-term assets Increased use of certificates longer term with high early withdrawal penalties Assuming that the non-derivative strategies that a credit union elects to employ do not sufficiently lessen the reduction in net interest income in the rising rate scenarios, then moving forward with a derivative strategy can make sense. The next step in deciding whether or not to pursue a derivative strategy is to understand the trade-offs associated with implementation of a derivative interest rate risk management, or hedging strategy. The first trade-off relates to net interest income earned in the other interest rate scenarios. While derivatives provide additional cash flow and income in certain interest scenarios, income will be reduced in the other interest rate scenarios. If the organization is willing to accept this trade-off then a derivative strategy can make sense. Following is a sample 2 year net interest income ALM profile of a $500 MM credit union. According to the forecast, this particular institution loses net interest income relative to its base case scenario in the +100, +200 and +300 basis point scenarios. Balance Sheet 2 Year Net Interest Income Position $ MM Assets $ MM Base Cash Investments Loans Other Assets Liabilities Non maturity Time Net In order to offset the loss of income in the rising rate scenarios, the credit union enters into an interest rate swap for two years in which the credit union pays a fixed rate of interest and receives interest payments based upon a floating rate. The example below shows base case cash flows related to a pay fixed, receive floating interest rate swap. The swap is based on a notional amount of $50 MM with payments made on a quarterly basis. 2

3 $50 MM Interest Rate Swap - Base Case Cash Flow Pay Date Pmts (Rcv) Rate (Rcv) Pmts (Pay) Rate (Pay) Net Pmts Discount PV Q , (69,706) 0.56 (40,600) (40,576) Q , (69,706) 0.56 (36,967) (36,921) Q , (72,804) 0.56 (34,164) (34,094) Q , (66,608) 0.56 (22,907) (22,840) Q , (69,706) 0.56 (8,138) (8,104) Q , (69,706) , ,978 Q , (72,804) , ,486 Q , (69,706) , ,071 Total / Avg. 561, , ,156 0 If the actual floating rates match the base case forecast, then the cash flows will match the table above. If rates move from the forecast, then the cash flows will work to the benefit of one of the swap s counterparties. Assuming that rates move instantaneously and parallel, below is the hedged profile of the example institution with the swap. 2 Year Net Interest Income Position $ MM Base Interest Income Interest Expense Net Change from Base (3.84) (0.20) (0.91) (0.99) (1.99) Swap Impact * (0.56) (0.54) Change from Base w/ Swap (4.40) (0.74) * Assumes adjustable leg re set rates cannot go below zero for the 100 and 200 scenarios As shown by the previous table, the example credit union is better off in the rising rate scenarios based upon its pay fixed, receive floating 2 year interest rate swap. The next trade-off associated with derivatives relates to the time and effort needed to implement and manage a successful hedging program. Certain permissible derivatives - treasury note futures for example - are traded on an exchange. Purchase and sales of these derivatives must be made in accordance with the rules of the Commodity Futures Trading Commission. Other derivative contracts - interest rate swaps for example - are often not cleared, are offered over-the-counter ("OTC") and are not cleared on an exchange. OTC transactions are executed via International Swaps and Derivatives Association ("ISDA") master service agreements. In addition, the credit unions that plan to use derivatives must have the following internal controls in place: Transaction support - must identify hedging transaction and show how it will be effective Internal controls review of derivatives transactions must perform review for 2 years (internal audit or external auditor) Financial statement audit must have financial statement audit performed 3

4 Must have written processes in place, including schematic diagrams or flowcharts Must ensure appropriate segregation of duties Must have legal review of derivatives contracts Must have written policies and procedures The NCUA also specifies rules associated with posting collateral, permissible counterparties, and other operational and staffing requirements. For example, the credit union's board must receive training on the use of derivatives and the training must be updated annually. Senior executive officers must understand, approve and provide oversight. The credit union must also have qualified derivatives personnel in place who: Understand ALM, including the use of derivatives Know how to evaluate counterparty, collateral and margining risks Understand the accounting and financial reporting of derivatives in accordance with GAAP This third bullet bears additional explanation because the GAAP rules relating to derivatives are extremely complex. The accounting rules governing derivatives are covered in FASB Accounting Standards Codification ( FASB ASC ) Topic 815 Derivatives and Hedging. We strongly encourage organizations that are considering entering into hedging to modify their ALM policy to permit the use of derivatives and to adopt a separate derivatives policy that details: Key participants Participants responsibilities and internal controls - including who is permitted to enter into derivatives transaction Objective of hedge and nature of risk being hedged Hedge period Authority for implementation of the derivatives program Purpose and implementation guidelines Permissible derivative instruments Hedge limits Hedge designations Hedge effectiveness Reporting requirements Specific references to FASB ASC 815 should be included in the derivatives policy if a credit union wants to follow best practices. Failure to go through this process up front can lead to poor hedge execution and unexpected and unfavorable accounting results. We note that the NCUA rules regarding hedging require many of these same elements, including: Quarterly board reports Monthly reporting to senior executives and ALCO, if applicable. At a minimum, the reports must show: Any areas of noncompliance Comparison to internal limits Itemization of individual positions and current fair values with comparison to NCUA limits NEV calculations with and without derivatives 4

5 Evaluation of effectiveness in mitigating IRR Evaluation of hedge accounting Derivatives must be measured and reported at fair value. To minimize the resulting income statement volatility a credit union can elect "hedge" accounting or it can elect to account for an existing financial asset or liability at fair value. Hedge accounting is performed under one of two methods - the fair value method or the cash flow method. Under the fair value method, the gain or loss on the hedging instrument, as well as the gain or loss on the hedged item are recognized in current earnings. With cash flow hedges, the effective portion of the hedge is reported in other comprehensive income while the ineffective portion is reported in current earnings. Effectiveness is a measure of how closely the change in the value of the derivative matched the change in the value of the financial instrument being hedged. The type of accounting used depends on the nature of the item being hedged. For example, a credit union that wants to hedge against the decrease in the fair value of a fixed rate loan rate loan portfolio can enter into a fair value hedge. One alternative is to enter into an interest rate swap agreement in which the credit unions pays a fixed rate of interest and receives a floating rate of interest (LIBOR) as in our economic example above. The credit union can designate the hedge as the risk in the change of the benchmark interest rate (LIBOR). If market interest rates increase, the fair value of the loans will increase and the fair value of the swap will increase. The change in each will run through the income statement. The change in the value of the loans will be limited to the change in fair value based on the change in LIBOR. Hedge accounting is elective and can be discontinued at any time. Alternatively, a credit union could elect to account for the loan portfolio at fair value. In this case, it is making an irrevocable fair value election. Any change in fair value will also run through the income statement, but the change in fair value is not limited to the change in market interest rates. The fair value determination must also include credit risk. On the other hand, let us assume that a credit union wants to hedge against an increase in the cost of its floating non-maturity deposits. It can enter into an interest rate swap in which it pays fixed and receives floating. In this case, the credit union will designate the transaction as a cash flow hedge. It is hedging against an increase in the forecasted payments to its shareholders. Hedge accounting requires formal designation and documentation at inception. This means you must identify the risk to be hedged, identify the hedging instruments to be used, and document how you believe the hedge will be effective before you enter into the transaction. The preceding paragraphs are intended to introduce the accounting concepts. The rules are much more complex, please see our related white paper on hedge accounting for more details. 5

6 Once an eligible federal credit union thoroughly understands the risks it wants to hedge, the hedge instruments it plans to use, and the accounting implications related to hedge accounting, it can seek approval from the NCUA to undertake a derivatives program. A credit union's approval request must include a: Demonstration on how derivatives function within a federal credit union s interest rate risk management mitigation plan Demonstration on how the credit union will control and manage the derivatives process from a resources and systems perspective After derivative authority is received, a credit union operates for one year under entry limits. Thereafter, standard limits apply. The limits relate to permissible notional amounts and fair value losses. The weighted average remaining maturity notional limit is 65% of net worth and the total fair value loss limit is 15% of net worth under the entry limits. After one year, the limits increase to 100% and 25% of net worth, respectively. The following tables reflect the entry fair value loss limit and notional amount limit for a $500 MM credit union with $50 MM of net worth. The notional limit in the table below relates to a 2-year interest rate swap. Fair Value Limit Notional Amount Limit $ MM $ MM Net Worth 50.0 Net Worth 50.0 Fair Value Limit 15% Notional Limit 65% Limit $ 7.5 Maximum 32.5 Maximum Notional Adjustment Factor 100% Time to Maturity 2.00 Time Factor 20% Verification

7 If this same example credit union wishes to enter into a 5-year interest rate swap, it may do so. However, the notional amount limit is less in comparison to the 2-year interest rate swap, $65 MM as compared to $162.5 MM. The notional amount limit for the 5-year swap is shown in the following table. Notional Amount Limit $ MM Net Worth 50.0 Notional Limit 65% Maximum 32.5 Maximum Notional 65.0 Adjustment Factor 100% Time to Maturity 5.00 Time Factor 50% Verification 32.5 A final consideration is the actual execution associated with the purchase. The pricing on a plain vanilla interest rate swap generally varies considerably in the market. The swaps are traded over-the-counter and the best way to avoid overpaying is to work with an independent third party provider swap advisor. This type of adviser works for the benefit of the credit union by obtaining bids from multiple counterparties. With multiple bids to select, the credit union can obtain more favorable pricing. The third party swap advisor can also help with the swap documents. We recommend that a credit union also use an advisor to help purchase interest rate caps and floors. Treasury futures, another NCUA permissible derivative, are exchange traded. Because they are traded on an exchange, the price is same for all parties. This is because all parties are required to post a margin account which is subject to daily maintenance. Treasury futures can be purchased from a dealer with access to the exchange. WW Risk Management believes that it is prudent for credit union to prepare for an upward movement in market interest rates. While derivative strategies may not be the right answer for all institutions, they are an effective way to reduce exposures to rising interest rates. The key to all derivative strategies is a thorough understanding of the process from the high level strategy resulting from the ALM position itself, to the detailed regulatory and accounting rules. 7

8 Authors Douglas Winn President and Co-founder Mr. Winn has more than twenty-five years of executive level financial experience and has served as a management consultant for the most recent fifteen years. Areas of expertise include financial strategy, capital markets, and asset liability management. Mr. Winn co-founded Wilary Winn in the summer of 2003 and his primary responsibility is to set the firm's strategic direction. Since inception, Wilary Winn has grown rapidly and currently has more than 375 clients located in 47 states and the District of Columbia. Wilary Winn s clients include community banks, 43 of which are publicly traded, and credit unions, including 25 of the top 100. Mr. Winn is a nationally recognized expert regarding the accounting and regulatory rules related to fair value and has recently led seminars on the subject for many of the country's largest public accounting firms, the AICPA, the FDIC, and the NCUA. Frank Wilary Principal and Co-founder Mr. Wilary has over twenty years of diversified experience in the financial services industry. Areas of expertise include asset-liability management, capital markets, asset-backed securitization, derivatives and information systems. Mr. Wilary's primary responsibility is to lead the research, development and implementation of Wilary Winn's new business lines. Frank works to ensure that new products and services meet our firm's standards for quality before transferring primary responsibility to one of our business line leaders. Mr. Wilary makes the critical determination of whether to buy or build valuation software and how to best utilize the system selected. Frank ensures that valuation models are consistent, and that best practices are used, across the firm's lines of business. He is currently focused on building our asset liability management business. 8