Compliance Blog

Jun 07, 2021
Categories: Operations

NCUA Derivatives Rule Application Requirements

In its May 2021 meeting, the National Credit Union Administration (NCUA) Board approved a final rule that amended its derivatives rule. A derivative is “a financial contract which derives its value from the value and performance of some other underlying financial instrument or variable, such as an index or interest rate[.]” The final rule was published in the Federal Register on May 26, 2021 and will be effective June 25, 2021.

Subpart B of Part 703 of NCUA’s rules and regulations explains a federal credit union’s authority to use derivatives to manage interest rate risk. NCUA notes that interest rate risk “refers to the current and prospective risk to a credit union’s capital and earnings arising from movements in interest rates.” In its Examiner’s Guide, NCUA explains why interest rate risk is problematic:

“When interest rates change, the present value and timing of future cash flows may change. This, in turn, changes the underlying value of a credit union’s assets, liabilities, and off-balance-sheet items and thus its overall net economic value. Changes in interest rates also affect a credit union’s earnings by altering interest rate-sensitive income and expenses, which affects its net interest income. Excessive IRR can present a significant threat to a credit union’s current capital and projected earnings if not managed appropriately.”

The final rule was designed to modernize the derivatives rule and make it less prescriptive and more principles based. The final rule does a number of things to accomplish this, including changing the process by which federal credit unions apply to NCUA to use derivatives to manage interest rate risk, removing regulatory limits on the usage of derivatives that are currently set forth in section 703.103 of NCUA’s rules and regulations, and reorganizing the rules governing loan pipeline management.

For more guidance about the final rule, please see this NAFCU Final Regulation on the rule that was issued late last month. I am going to focus on the changes to the application process. Under the current rule, a federal credit union is eligible to apply for the authority to use derivatives to manage interest rate risk if:

  • Its most recent composite CAMEL rating is 1, 2, or 3;
  • Its most recent management component in the CAMEL rating is 1 or 2; and
  • Its most recent call report indicates that the federal credit union has assets greater than or equal to $250 million.

The current rule, however, permits federal credit unions with less than $250 million in assets to request permission to apply for derivatives authority.

Under the new rule, federal credit unions with at least $500 million in assets as of its most recent call report that have a management CAMEL component rating of 1 or 2 are exempt from the requirement to apply to use derivatives in order to manage interest rate risk. Instead, the rule requires that these federal credit unions notify their Regional Directors in writing or by email within 5 business days after entering into their first derivatives transaction. The new rule requires federal credit unions that do not qualify for the exemption to apply to their Regional Directors for approval to use derivatives to manage interest rate risk.

But what happens if a federal credit union experiences a change in conditions under the new rule and either no longer qualifies for the exemption from the application requirement or now has an approved application that is no longer accurate? Section 703.108(d) of the new rule bars entering into new derivative activity and requires notifying the applicable Regional Director. That said, it does not necessarily prohibit continuing to engage in existing derivative activity:

“The Board notes that the cease and notify procedures in § 703.108(d) are not an absolute bar to continuation of Derivatives transactions. Rather, the procedures provide an opportunity for the Regional Director to evaluate the condition of the FCU and determine if it is safe and sound for the FCU to continue using Derivatives. To that end, the Board notes that this final rule provides for more flexibility than the current rule.”

That determination would be left in the hands of the applicable Regional Director.

About the Author

David Park, NCCO, Senior Regulatory Compliance Counsel, NAFCU

David joined NAFCU in September 2018.  As part of the Regulatory Compliance Team, he provides daily compliance assistance to member credit unions on a variety of topics. 
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