Who Knew Vanilla Was So Expensive?

May 17, 2013 at 8:17 am Leave a comment

Remind me not to pick up the bill if I ever go to an ice cream parlor with Chairwoman Matz.  The vanilla she likes is way too expensive for me and the vast majority of credit unions.

NCUA released its long-awaited and long overdue regulations ostensibly designed to give credit unions expanded authority to engage in limited use of derivative investments as a way of hedging interest rate risk.  I say ostensibly because if the regulation goes through as proposed — assuming one is actually ever promulgated — it is designed to cater to between 75 and 150 credit unions for whom an application fee of between $25,000 and $125,000 and agreeing to policies and procedures that allow NCUA to micromanage their investment activities every step of the way are worth it.  All this in return for what the regulation’s preamble repeatedly refers to as plain vanilla derivative investment authority.  One has to wonder what credit unions would have to do if they wanted to buy Haagen-Dazs.

Under the proposed regulation, credit unions with $250 million or more in assets with CAMEL ratings of 1 or 2 would be eligible to apply for authority to engage in the purchase of interest rate swap and interest rate cap derivatives.  These instruments are basically contracts.  Interest rate swaps would allow a credit union to trade one revenue stream, let’s say a portion of its portfolio of fixed-rate mortgages, for a counter party’s agreement to provide a revenue stream of adjustable rate mortgages, for example.  The interest rate cap derivative is a contract whereby the credit union gets compensated if interest rates increase beyond the level established in the contract.  The downside is that credit unions basically pay a premium in return for this protection so it is possible that they would pay for protection without receiving a benefit.  Credit unions could only utilize this authority to hedge against interest rate risk, meaning they couldn’t be buying these as investments.

How do you get the authority to engage in these transactions?  In addition to the asset threshold and application fee, credit unions would have to be willing to implement a detailed framework for overseeing these investments.  Credit unions seeking level one investment authority would have to hire personnel with at least three years of direct experience with derivatives.  Credit unions seeking level two authority would need to get someone with five years of experience.  Other requirements would mandate that responsibilities for overseeing derivative investments be shared among designated staff so as to ensure  that one person is not the lynchpin of the entire program.  Read between the lines and the cost of hedging your interest rate risk includes having resources to hire personnel primarily responsible for just these investments.

But this just scratches the surface and many of the requirements go well beyond what you would reasonably expect in such a proposal.  If you think I am exaggerating, then I would point out that NCUA is going to require not only that credit unions have policies and procedures showing how derivative investment decisions are going to be made, but also that such procedures be put in flow chart form.  Why?  Because “a visual depiction of a credit union’s decision making process provides a credit union’s employees and examiners a useful summary of who is making and executing all the decisions and functions.”  I honestly can’t wait to hear about examiners suggesting improvements to the layout of a credit union’s flow chart.

Bottom line with NCUA’s proposal is that it is a poor first draft for an institution that has gone through two notices asking for feedback on how to design a derivatives program and has had experience monitoring derivative use, albeit through a small number of credit unions, through its pilot program.  Most importantly, the idea that only credit unions with $250 million or more in assets need this authority is ridiculous.  The criteria shouldn’t be how great a threat a credit union potentially poses to the Share Insurance Fund but how well prepared a credit union is to manage the risk inherent in these types of investments.  Second, the piecemeal pricing out of individual regulations is an awful idea whose time should never come.  The application fees have gotten most of the attention, but NCUA wants credit union feedback on whether individual credit unions should pay a yearly licensing fee in return for this derivative authority.

A licensing fee!  A lot of football teams impose these now on season ticket holders, but at least if you’re a season ticket holder like my brother, you get to watch live football in return.  Then again, he’s a Jets fan so that’s debatable.

Derivatives are tricky and I can certainly appreciate NCUA’s desire to make sure that only competent credit unions engage in this activity.  But it’s one thing to strive for safety and soundness, it’s another to purposely design a regulation so onerous that its benefits will outweigh its cost for only a handful of credit unions.  Many more proposals like this one and NCUA will do a better job of splitting the industry between large and small credit unions than the bankers ever could.

Entry filed under: Advocacy, Compliance, Regulatory. Tags: , , .

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Authored By:

Henry Meier, Esq., General Counsel, New York Credit Union Association.

The views Henry expresses are Henry’s alone and do not necessarily reflect the views of the Association.

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