NCUA Board Member Todd M. Harper Derivatives Rule Update Notice of Proposed Rulemaking

As Prepared for Delivery on October 15, 2020

Thank you, Tom for your overview of the proposed updates to the NCUA’s 2014 derivatives rule.  And, thank you, Rick and Justin, for lending your expertise for any questions that the Board may have.

The proposal before us would add a timely and useful interest-rate risk-management tool, without the upfront administrative burden, and could provide greater flexibility for tailoring risk mitigation strategies that can immediately benefit federal credit unions seeking to increase hedge effectiveness.

In my view, the targeted updates included in this proposal would streamline our derivatives regulation and, based on our experience, sensibly improve the authority of federal credit unions to purchase and use safe derivatives designed to manage their interest rate risk. As a result, I will support issuing this notice of proposed rulemaking for public comment.

With the growth in long-term mortgage lending within the credit union system, the industry now has half of its assets in long-term real estate loans, and the vast majority of those loans are at fixed rates. The savings-and-loan crisis taught us what happens when an industry lends long and borrows short. Specifically, it can be very problematic when a depository institution moves from a very low interest-rate environment, like we are experiencing now, into a high-rate environment.

In that regard, the proposal before us today is forward looking.  Consistent with safety and soundness, under this proposal, more federal credit unions will gain access to the tools they need to manage interest rate risk. Federal credit unions that use simple derivatives will also still need to have specialized expertise along with appropriate policies and internal controls to support an effective derivatives program, just as they did when the NCUA Board finalized the current derivatives regulation in 2014.

Over time, significant changes in credit union balance sheets primarily resulting from increased mortgage lending raised the NCUA’s concerns about the industry’s exposure to adverse rate moves, especially interest rate risk and the material threat of rising rates. That led the NCUA to issue two advance notices of proposed rulemaking, in 2011 and 2012, to explore potential derivatives authority for hedging purposes. In 2013, the NCUA Board issued for public comment a notice of proposed rulemaking on giving qualified, federal credit unions new expanded authority to hedge interest rate risk with financial derivatives. 

In early 2014, the NCUA Board signed off on a final rule permitting approved federal credit unions to use specified, “plain vanilla” derivatives as interest rate hedges. Recognizing that the use of “plain vanilla” derivatives can be beneficial in helping credit unions to mitigate interest rate risk, the 2014 NCUA Board believed it was appropriate to allow qualified credit unions to use certain types of derivatives for the limited purpose of interest rate risk mitigation.  Rightly so, in my view.

Insights and observations from a pilot program helped shape the criteria contained in the 2014 final rule approved by the NCUA Board, thus reinforcing the approach that authorized derivatives should be limited for interest rate risk mitigation only and not for speculative purposes.

Since the adoption of the 2014 final rule, NCUA staff have gained further knowledge through supervising derivative activities. Their experience helped the NCUA progressively streamline the focus of its examinations while also identifying areas where the NCUA could grant additional flexibility, consistent with safety and soundness.

Based on the responsible track record of derivative transactions observed in the industry over the past six years and on the knowledge and experience gained by both the NCUA examiners and credit union practitioners, NCUA staff have now recommended a transition from the current prescriptive restrictions to a more principles-based regulation which still maintains important guardrails.

Three significant elements of this proposal include:

• Eliminating the preapproval process for complex federal credit unions, those with more than $500 million in assets, and which have a Management CAMEL component rating of 1 or 2;
• Permitting all other federal credit unions to apply to use derivatives; and
• Eliminating the regulatory limits on the amount of derivatives a federal credit union may purchase.

With respect to these volume limits, the NCUA initially constructed these speedbumps to check risk. Over time, however, we have learned that volume limits decrease the ability of a credit union to sufficiently hedge its interest rate risk. The proposal before us addresses this problem by removing these regulatory limits.  This evolution of the NCUA’s derivative rule is appropriate at this time.

I would also like to thank Chairman Hood and Board Member McWatters for agreeing to incorporate several of my suggested changes into the proposal before the Board today. These changes provide important guardrails to protect the safety and soundness of the credit unions using derivatives and safeguard the Share Insurance Fund.

First, I felt it important to clarify that examiners may request and review all comprehensive management reports about derivatives during the supervisory process.  Because of the complex nature of derivatives, credit unions must be transparent and forthcoming with their reports on derivatives transactions during the supervisory process.

Second, I wanted to ensure that we continued regular board training on derivatives. Even “plain vanilla” derivatives are sophisticated financial instruments that require close monitoring.  A “one-and-done” board training requirement would be insufficient. Credit union board directors are the first line of defense of the Share Insurance Fund, and they need to have a firm understanding of derivatives transactions reinforced, from time to time, through training and briefings. The proposal before us strikes a reasonable balance on board education.

Third, the proposal ensures that credit unions using derivatives maintain a separation of duties to ensure effective governance. I appreciate the staff’s suggestion on how best to ensure separation of duties and proper internal controls. A federal credit union’s process, whether conducted internally or by an external service provider, must have appropriate separation of duties for asset-liability management, financial reporting, derivatives execution and oversight, and collateral, counterparty, and margining management. This separation of duties is necessary to ensure the safe-and-sound operation of a derivatives program and to mitigate opportunities for insider fraud and abuse.

In conclusion, I concede that as we live and operate in pandemic-induced economic uncertainty, interest rate risk will continue to be a potential threat, notwithstanding the Federal Reserve Board of Governors recent pronouncements. However, as the proposed rule notes, “The anticipated pressure on earnings and capital over the next few years caused by historically low rates will pressure many institutions to explore both on-balance sheet and off-balance sheet strategies.” 

Federal credit unions cannot rely on luck to manage their interest rate risk, and “plain vanilla” derivatives have become a conventional tool for many depository institutions to hedge their risks through price-fixing and insurance contracts—interest rate swaps and interest rate caps—that serve to better optimize earnings and preserve capital.

For all of these reasons, I will support issuing this notice of proposed rulemaking to update the NCUA derivatives rule that would provide targeted and effective relief for credit unions that hedge their interest rate risk using safe derivatives transactions, while maintaining appropriate guardrails.

Thank you, Mr. Chairman.  I have no further comments.