Posts tagged ‘derivatives’

Having “the Talk” … with your IT Team

When Rodney Hood started talking about the importance of cybersecurity for credit unions shortly after becoming Chairman, to me, he sounded like the guy who comes about an hour late to the party. After all, cybersecurity has been a key priority of financial regulators for years now. But the COVID-19 pandemic has proven me wrong. With the number of credit union employees now working remotely, consumers relying more heavily than ever before on electronic transactions, and hackers being so brazen that they now steal from Robinhood (I couldn’t resist), your credit union is dealing with new cyber challenges coming from directions it could never have anticipated. 

This puts the credit union senior management, and ultimately their boards of directors, in the hot seat given they’re the entities ultimately responsible for making sure your IT team is implementing the proper policies and procedures to both protect members and keep the place going. But in order to do this, boards have to know the right questions to ask. At yesterday’s board meeting, Johnny E. Davis, Special Advisor to the Chairman on Cybersecurity, provided an easy-to-understand list of questions in his presentation that a board member could use to zero in on how it’s IT staff has responded to the pandemic. For example, has anyone asked your credit union what policies and procedures it has put in place related to remote access by employees? Another basic but crucial question to consider is how your credit union is preparing in the mid to long-term for the changes that have been accelerated by COVID. For example, in it’s quarterly earnings discussion with financial analysts earlier this week, JP Morgan commented on how it has seen an increased use of online banking resources by consumers, and how it believes that much of the shift is permanent. As a colleague of mine recently said, credit unions better have the technology locked and loaded, because even grandparents are getting used to remote deposit. 

All of this of course introduces a compliance component to consider. Cybersecurity is a point of emphasis for your examiner, and irrespective of your size and sophistication, you should be able to document in your board minutes the steps you are taking with regard to your IT infrastructure. 

NCUA Takes the Wheels Off when it Comes to Derivatives

In yesterday’s board meeting, the NCUA also proposed updates to regulations which would give sophisticated credit unions (with 500 million or more in assets) greater flexibility to use derivatives to hedge against interest rate risk. Under the proposal, these credit unions would no longer require prior approval from NCUA to use derivatives, nor would they be restrained to a specific list of permissible investments. At the same time, board members continue to stress that examiners will evaluate derivative activity to ensure that they are being properly used, and that the credit union and its board have the proper expertise and knowledge required to administer such a program. 

On that note, enjoy your weekend, I’ll be back on Monday.

October 16, 2020 at 9:46 am Leave a comment

What’s The Big Idea?

Yesterday, the NCUA proposed the most far reaching revisions of credit union risk based net worth requirements since they were originally promulgated at the beginning of the last decade. Given the complexity of the issue and the fact that every credit union will be affected differently, it is far too early to give this proposal a thumbs up or thumbs down. But given NCUA’s aggressive use of its authority to create risk-based net worth requirements to deter what it perceives as safety and soundness risks, this proposal will undoubtedly keep more than a few credit union CEOs and CFOs up at night. The changes would take effect 18 months after final approval.

Risk based net worth generally attempts to gauge the stability of a financial institution’s assets by weighting the risk posed to financial institutions in the event of financial trouble. So, for example, cash on hand is not counted against an institution’s strength at all, but member business loans would be. The system is already used by banks and NCUA is putting forward this proposal, in part, to harmonize credit unions with other financial institutions.

First, the good news. This proposal would only affect credit unions with $50 million or more in assets. Second, it is possible that for those of you with a conservative asset composition, the new asset weighting system proposed by NCUA will actually result in your credit unions having to put aside less, not more, capital.

Now for the potentially bad news. As explained by NCUA in the proposal’s preamble, credit unions usually have quality capital; however, the Share Insurance Fund has lost hundreds of millions of dollars due to the failure of individual credit unions holding inadequate levels of capital. According to NCUA, “examiners did warn officials at these credit unions that they needed to hold higher levels of capital to offset the risks in their portfolios, but the credit union officials ignored the examiner’s recommendations, which were unenforceable. This proposal seeks to incorporate the lessons learned from these failures and better account for risks not addressed by the current rule.”

How would the proposal do that? By greatly expanding the use of weightings to better assess the ability of a credit union to absorb potential losses. For instance, NCUA has expressed a concern about excessive concentrations of MBL and mortgage loans on credit union balance sheets, so under the new proposal, credit unions would have to assign a 100% “risk-weight” to member business loans of less than or equal to 15% of assets but a 150% “risk-weighting” to any business loans greater than 15% of a credit union’s assets. For those of you who want to take a closer look, the suggested categories with their accompanying weightings begin on page 138 of NCUA’s draft.

. . . . . . . .

Net worth requirements wasn’t the only issue that NCUA dealt with at its meeting. First, it extended until September 10, 2015 the 18% maximum loan interest rate for federal credit unions. It also finalized a rule permitting credit unions with $250 million or more in assets to apply for authority for limited use of derivatives solely as a hedge against interest rate risk. The rule also permits credit unions under that threshold to exercise this authority with regulatory approval. The final rule expands the number of derivatives originally proposed that can be utilized by credit unions to include, for example, interest rate caps and interest rate floors.

I’m not much for Westerns, but whenever I think of derivatives I think of the movie Shane. Alan Ladd plays a gun slinging good guy who protects the town from a bunch of ruffians while gaining the admiration of an impressionable young boy and his pacifist mother, who despises guns. At one point in the movie Shane explains that a gun is a tool, as good or as bad as the man who uses it. That’s pretty much the way I feel about derivatives. By allowing financial institutions to trade one expected revenue stream for another, derivatives makes sense and actually enhance financial stability if used properly. I’m glad NCUA finalized this proposal and now its up to eligible credit unions not to abuse the privilege.

Happy trails.

January 24, 2014 at 8:38 am Leave a comment

Who Knew Vanilla Was So Expensive?

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.

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

What Can Be Gleaned From The Town Hall Meeting?

Yesterday, NCUA Chairwoman Debbie Matz and senior staff fielded questions from credit union personnel for an hour and a half.  Here are my takeaways.

It appears that the Board will decide at its November meeting that credit unions will not have to pay a share insurance fund premium next year.  But remember this is distinct from the assessment that credit unions pay into the Corporate Stabilization Fund.  The industry is currently committed to paying into that fund until 2021.

The agency is working on a guidance to clarify when a Document of Resolution should be issued as opposed to just an examiner finding.  In order for the guidance be successful, NCUA is trying to define when a credit union’s failure represents a material risk to the safety and soundness of the credit union.  Judging by the number of questions about examiners and examination procedures, as well as the perception among some credit unions that examiners are more aggressively issuing DOR’s than they had in the past, a more uniform definition would be in everyone’s best interest.

NCUA will be issuing guidance on expanded use of MBL exemptions.  While it would, of course, be better to see Congress raise the cap, NCUA can expedite the process by granting MBL waivers and reminding credit unions that such waivers are available.

As I pointed out in a previous blog, one of the real potential advantages to those credit unions with under $30 million in assets being classified as “small” credit unions for regulatory purposes-as NCUA proposed at its last meeting – is the possibility that NCUA will expand its plan to streamline the examination process for well functioning credit unions with under $10 million in assets to this larger class of small credit unions.  This may happen, and is certainly under consideration, but is by no means a done deal.

I was happy that someone asked for an update on NCUA’s consideration of authorizing the expanded use of derivatives by credit unions for the purpose of hedging against interest-rate spikes.  It seems to me that if you’re going to stress the dangers posed by interest-rate volatility, then you have to provide credit unions the financial tools to deal with the problem.  Properly used, interest rate swaps could help guard against too much exposure to long-term mortgages.  However, the speakers pointed out that the use of derivatives requires a degree of sophistication not only for the credit unions that would use them but for the staff that would be responsible for monitoring their use.  The bottom line is NCUA seems to recognize the benefit of these products, but is still trying to decide if the benefit is outweighed by the potential costs both to the safety and soundness of individual credit unions and the examination process for the agency.

Finally, the webinar talked about a legal opinion letter issued yesterday opining that NCUA may approve a credit union’s request to receive a change in its charter and subsequently merge with another credit union with the same type of field of membership.

Have a nice weekend, I’ll be popping back into your inbox on Tuesday.


October 5, 2012 at 7:10 am Leave a comment

What’s Making Examiners Queasy

Another day, another fresh batch of evidence that the world economy is on shaky ground.  First, China’s economic growth is slowing.  And an intriguing analysis points out that the fate of the Euro may come down to a giant game of chicken between Italy and Germany, which both sides could lose.  Is there any wonder that treasury yields hit record lows as investors looked for the safest place to put their money other than under the mattress?  Against that cheery backdrop, it’s an excellent day to discuss the OCC’s recently released semi-annual risk perspective.

Many of the concerns highlighted are not unique to commercial banks and they are consistent with points of interest highlighted by the NCUA over the past year. 

The single greatest risk is that “the search for higher profitability may lead to taking on inappropriate risk.”  There’s nothing all that surprising about examiners fretting about interest rate risk, but what’s interesting about the OCC report is that it highlights some of the indirect consequences of the search for higher returns.  For instance, the search for profits puts even more emphasis on proper due diligence as banks seek out new products and vendors to provide them.  As a result, the OCC is going to be double checking to make sure that boards are engaging in adequate planning and product assessment.

A second danger highlighted in the report is the resetting of HELOCs.  According to the OCC, the end of draw volumes for home equity loans will significantly decrease starting in 2014.  It estimates that approximately 58% of all HELOC balances are due to start amortizing between 2014 and 2017.  What this means is that a sudden spike in interest rates would create a double whammy for financial institutions since their members may have increased difficulty keeping current on their loans precisely when interest rates are already putting a squeeze on those financial institutions locked in to long-term lending.

While all these concerns are legitimate, the question remains:  what can credit unions do about it?  We got some good news earlier this week when the Commodities Futures Trading Commission (CFTC) finalized regulations exempting smaller institutions from the requirement that they clear derivative trades through a clearinghouse.  Why is this important?  Because for several months now, the NCUA has been cautiously considering expanding the authority of credit unions to use interest rate swaps.  Now that the regulatory structure is clear, I am hoping that NCUA gives the go ahead to credit unions that may be able to use interest rate swaps to effectively sell off some of their longer-termed interest obligations.  It is not a panacea, but it should help.

July 13, 2012 at 7:52 am Leave a comment

Authored By:

Henry Meier, Esq., Senior Vice President, 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. In addition, although Henry strives to give his readers useful and accurate information on a broad range of subjects, many of which involve legal disputes, his views are not a substitute for legal advise from retained counsel.

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