As Prepared for Delivery on October 15, 2020
Earlier this year, the Derivatives rule was identified as possible relief to help credit unions given the low rate environment and mortgage activity to give credit unions more flexibility to help members during the economic downturn and low rate environment and be able to hedge the interest rate risk from putting these loans in portfolio.
I am pleased that we have been able to refine the derivative rule and make it more flexible for federal credit unions. This is indeed an unprecedented and uncertain time for all credit unions as they are facing the economic fallout from the COVID-19 pandemic.
The financial challenges that arise from high unemployment, falling interest rates, and compressed net interest margins are happening right before our eyes and are making it increasingly challenging for credit unions. Any tool that can efficiently and effectively improve financial performance and strengthen liquidity and capital is a sound pursuit, provided it can be done safely and affordably.
On its surface, the derivative rule may not seem like an obvious action for responding to the current financial pressures facing credit unions during this crisis. However, I believe that enhancing the ability of federal credit unions to better protect themselves against market risks is critically important at all times. In fact, managing balance sheet risks through a time of disruption and uncertainty underscores how important it is for credit unions to have tools, like financial derivatives, at their disposal to help guard against volatile economic periods that can hurt liquidity, earnings and capital.
I know the very word “derivative” can have a negative connotation and carries a high-risk stigma. So, let us be clear, we are talking about a conservatively utilized subset of financial derivatives within a prudential framework that are used to strengthen a credit union’s risk management. And, we are only talking about the kind of derivatives that offer straightforward interest rate risk protection, such as interest rate swaps, futures and caps. We never contemplated permitting non-interest rate risk contracts or allowing credit unions to speculate by underwriting options to generate income or by doing transactions that were not hedging their own balance sheets.
I support this rule because we have observed credit unions successfully using derivatives to hedge risk arising from changes in market interest rates. These institutions have navigated the learning curve and built up their systems and expertise in a way that demonstrates it can be safely done. After years of supervising Derivatives and seeing these successes, we can reasonably conclude they play a critical role in helping to reduce the uncertainty that comes from changing interest rates for credit unions that use them.
One area that does concern me is the prominence of the LIBOR rate in the realm of the interest rate swap market. The fact that LIBOR is going to be discontinued in the near future raises significant questions about its replacement and the impact on outstanding contracts written with the LIBOR index. I know staff is continuously monitoring the eventual cessation of LIBOR scheduled by the end of 2021 and we have made this one of the NCUA’s supervisory priorities.
We know that derivatives can range from the most basic type of simple fixed-to-floating interest rate swaps, to more complex products like credit-default swaps, options and commodities futures. Again, we are relegating credit unions to the basic and simple varieties. As of the June 30, 2020 Call Report, we had 23 credit unions with outstanding derivative transactions in interest rate swaps and interest rate caps, totaling approximately $10.3 billion in notional amount. That’s a decent level of activity from which to guide our understanding of current derivatives use.
I know we’ve come a long way since we adopted the first rule. I appreciate the approach taken by the Board in 2014. That rule was our first comprehensive regulatory framework for these transactions and it provided a large number of Federal credit unions with the ability to pursue derivative authority through an application process. It is now almost seven years later. Now, we have the benefits of having observed the industry’s use of derivatives, our buildup of staff’s experience in supervising those activities, and the rollout of specialized training to increase our staff's knowledge of derivatives and keep it current.
The past six years have seen some significant financial trends that support the need for enhancing the derivatives rule. The industry had significant asset growth during this period increasing by 57% since the Q1 2014, with over $1.7 trillion in total assets today. Most notably, real estate assets are now 33% of all assets in the industry and a critical source of income for credit unions. Helping to protect against further net interest margin compression in a low interest rate environment continues to be a monumental challenge and I think having tools, like derivative authority, is increasingly important.
I mentioned that the safety and soundness considerations also remain paramount. I’m comfortable with the approach in this proposal, while removing the more prescriptive elements of the current rule, it retains the critical safety & soundness requirements in assessing the quality of a credit union’s personnel and internal controls for managing their derivatives program.
In summary, I believe this proposed rule will provide responsible regulatory relief without posing undue risk to the Share Insurance Fund. I will be supporting it.