As Prepared for Delivery on May 20, 2021
Thanks to Tom and his colleagues for today’s presentation and for crafting this rule that provides Federal Credit Unions greater flexibility to manage interest rate risk. Today’s rulemaking comes after several years of pilot programs while NCUA & credit unions dipped our toes in the water to figure out how to proceed. I will be supporting this rule today.
It's indisputable that some credit unions face significant interest rate risk. If they didn’t, NCUA wouldn’t be talking about adding an “S” to our CAMEL ratings such that we’d specifically grade credit unions’ sensitivity to interest rates. Bank regulators already do this.
Regarding derivatives in general, I know they sometimes have a scary reputation and we’ve heard some wariness. So please forgive me for literally one minute, as I’d like to take a step back and comment on how people talk about derivatives, although I’m probably not saying anything you all don’t already know.
- Derivatives aren’t inherently frightening. They are indeed a powerful tool, and anything that’s powerful can probably cause harm. But there’s also harm in not allowing people to use the best available tool. For example, you can try to manage interest rate risk without using derivatives, but it can be a bit like dealing with a fly on the window by throwing a brick at it. So, it’s great to see that credit unions have already demonstrated safe derivatives usage. Not to mention, it’s human nature to switch to better tools when they’re available… the same reason we don’t commute via horseback anymore.
- In the United States, derivatives gained popularity partly due to agriculture. Imagine you’re a small-time corn farmer who needs a loan, yet lenders are nervous because your entire income is based on the price of corn. The solution is derivatives that are ‘derived’ from the price of corn allow the small farmer to survive and prosper. That connection to agriculture is also why Chicago is America’s center of derivatives trading, given that the city was the distribution hub for Midwest farmers. And like many aspects of finance, derivatives developed in what we now call the Middle East. The word “interest” comes from the Aramaic word for calf —a baby cow — since interest grows and ‘reproduces’ similar to livestock; i.e those calves grow up to have their own offspring, which is the concept we refer to as ‘compound interest.’
For years now, the financial services industry has used derivatives to manage interest rate risk. NCUA, in 2014, took a measured and prescriptive approach to this subject. Since then, the more limited derivates usage hasn’t resulted in material losses or red flags, and meanwhile NCUA has learned a lot. When employed appropriately, derivatives safely improve a credit union’s risk management capabilities.
We’ve seen a steady growth in mortgage lending by credit unions in the past decade with a crescendo in the past year. Credit unions should be congratulated for their efforts to provide more Americans the dream of owning their home, but of course, the tradeoff is more risk. Providing credit unions with a more aggressive tool to manage the risks associated with fixed rate mortgages is prudent. That said, derivatives are a powerful instrument and must be used correctly.
A terrific use of derivatives is obviously to mitigate mortgage risk, especially in America’s unique mortgage market. As long as our norm is a 30-year fixed-rate mortgage, and the borrower basically has a free option to refinance if rates decline, then credit unions definitely need ways lower their risk.
NCUA staff have put together a rule that keeps us on a deliberative path while providing welcome flexibility to both credit unions and NCUA. And someday, if we see the return of very steep interest-rate curves, we’ll be especially happy we did this rule.
Before I close, I’d like to talk about the transition away from LIBOR and what interest rates credit unions can use as LIBOR fades away. The main recommended alternative rate is SOFR, the Secured Overnight Financing Rate (opens new window) (You will be leaving NCUA.gov and accessing a non-NCUA website. We encourage you to read the NCUA's exit link policies. (opens new page).) . It’s a repo rate, which means it represents the cost of a loan that is collateralized by US Treasury bonds. But while repo rates are common funding cost on Wall Street – and I worked for years as a Wall Street repo trader - may not represent the cost of funding for some Main Street lenders who rely on unsecured funding markets, which is what LIBOR is.
While I’m aware there is an adjustment mechanism to SOFR that attempts to replicate unsecured markets. But as accurate as that adjustment may be, some financial institutions feel the adjustments are trying to take an apple and adjust it into an orange instead of just letting people use the orange.
I’m not endorsing or recommending any particular replacement rate, and consistent with other banking agencies, NCUA is neutral on the issue. I have confirmed that after we approve this rule today, a credit union may use an unsecured, U.S. dollar domestic interest rate as a replacement for LIBOR if the credit union felt it was appropriate for its risk management and member needs.
Thank you, Mr. Chairman, this concludes my remarks.