Financial Derivatives Transactions To Offset Interest Rate Risk; Investment and Deposit Activities, 5416-5418 [2012-2092]

Agencies

• National Credit Union Administration

[Federal Register Volume 77, Number 23 (Friday, February 3, 2012)]
[Proposed Rules]
[Pages 5416-5418]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-2092]


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NATIONAL CREDIT UNION ADMINISTRATION

12 CFR Part 703


Financial Derivatives Transactions To Offset Interest Rate Risk; 
Investment and Deposit Activities

AGENCY: National Credit Union Administration.

ACTION: Advance notice of proposed rulemaking.

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SUMMARY: Through this Advance Notice of Proposed Rulemaking (``ANPR''), 
the NCUA Board (Board) requests additional public comments to identify 
the conditions for federal credit unions (FCUs) to engage in certain 
derivatives transactions for the purpose of offsetting interest rate 
risk (IRR).\1\ This ANPR follows an earlier Advance Notice of Proposed 
Rulemaking (ANPR I) on derivatives transactions issued for comment (76 
FR 37030, June 24, 2011). This ANPR asks additional questions regarding 
the conditions under which NCUA may grant authority for an FCU to 
engage in derivatives transactions independently.
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    \1\ Interest rate risk refers to the vulnerability of a credit 
union's financial condition to adverse movements in market interest 
rates. For example, changes to a credit union's funding costs 
generally are considered part of the inherent interest rate risk 
associated with a fixed-rate mortgage loan. A borrower with a fixed-
rate mortgage loan is unaffected by increases in market interest 
rates because his payment is based on a ``fixed'' rate. The credit 
union that originated the mortgage loan, however, is subject to 
losses in the market value of these mortgages from the increases in 
market interest rates. Furthermore, as market interest rates rise, 
there is a concomitant increase in the credit union's funding costs, 
or the interest rate the credit union pays on the money it uses to 
``fund'' the mortgage loan.

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DATES: Comments must be received on or before April 3, 2012.

ADDRESSES: You may submit comments by any one of the following methods.
    (Please send comments by one method only):
     Federal eRulemaking Portal: https://www.regulations.gov. 
Follow the instructions for submitting comments.
     Email: Address to regcomments@ncua.gov. Include ``[Your 
name]--Comments on Advance Notice of Proposed Rulemaking for Part 703, 
Financial Derivatives Transactions To Offset Interest Rate Risk'' in 
the email subject line.
     Fax: (703) 518-6319. Use the subject line described above 
for email.
     Mail: Address to Mary Rupp, Secretary of the Board, 
National Credit Union Administration, 1775 Duke Street, Alexandria, 
Virginia 22314-3428.
     Hand Delivery/Courier: Same as mail address.
    Public Inspection: You can view all public comments on NCUA's Web 
site at https://www.ncua.gov/Legal/Regs/Pages/PropRegs.aspx as 
submitted, except for those we cannot post for technical reasons. NCUA 
will not edit or remove any identifying or contact information from the 
public comments submitted. You may inspect paper copies of comments in 
NCUA's law library at 1775 Duke Street, Alexandria, Virginia 22314, by 
appointment weekdays between 9 a.m. and 3 p.m. To make an appointment, 
call (703) 518-6546 or send an email to OGCMail@ncua.gov.

FOR FURTHER INFORMATION CONTACT: Jeremy Taylor, Senior Capital Markets 
Specialist, at (703) 518-6628; or Lance Noggle, Staff Attorney, Office 
of General Counsel, at (703) 518-6555. You may also contact them at the 
National Credit Union Administration, 1775 Duke Street, Alexandria, 
Virginia 22314.

SUPPLEMENTARY INFORMATION:

I. Background
II. Questions for Comment

I. Background

    In June 2011, the Board issued ANPR I (76 FR 37030, June 24, 2011) 
requesting public comment on whether and how to modify its rule on 
investment and deposit activities to permit FCUs to enter derivatives 
transactions for the purpose of offsetting IRR. It now seeks additional 
information to assist in drafting a proposed rule for FCUs to 
independently engage in derivatives transactions (i.e., without program 
oversight by a third-party provider).
    ANPR I requested comment in five areas. Three areas asked for 
comments on NCUA's current pilot program and third-party programs in 
general. Only two areas concentrated on independent derivatives 
authority. As the Board focuses on developing requirements for such 
authority, it seeks additional information to help ensure that a rule 
granting independent derivatives authority is manageable for both 
participating FCUs and NCUA, while simultaneously protecting the credit 
union industry from undue risk.

II. Questions for Comment

    Since the inception of the derivatives pilot program, very few FCUs 
have submitted applications seeking permission to independently engage 
in derivatives to offset IRR. In ANPR I, the Board sought comment on 
whether it should allow FCUs to independently engage in derivatives 
activities. Nearly all commenters who responded to this question 
supported independent derivatives authority for FCUs. As discussed more 
fully below, however, not all commenters agreed on the conditions under 
which the NCUA should grant such authority.
    The Board is assessing the parameters under which NCUA may 
authorize FCUs to independently engage in derivatives activities, and 
invites comment on the issues raised in this ANPR. To facilitate 
consideration of the public's views, please address your comments to 
the specific questions, and organize and identify them by corresponding 
question number so that each question is addressed separately. To 
maximize the value of public input on each issue, it is also important 
that commenters provide and explain the reasons that support each of 
their opinions. There will be a further opportunity to comment on these 
issues should the Board issue a proposed rule.

Eligibility of Applicant FCUs for Independent Derivatives Authority

    The Board is considering eligibility requirements for FCUs seeking 
authority to independently enter into derivatives transactions. ANPR I 
asked several eligibility questions, including what criteria NCUA 
should consider in granting or denying a request for independent 
derivatives authority. As noted above, nearly all commenters who 
addressed the issue of independent derivatives authority supported it. 
Yet

[[Page 5417]]

not all of these commenters agreed on the conditions under which NCUA 
should grant such authority.
    Three commenters supported allowing FCUs to independently engage in 
derivatives activity without further comment. Ten commenters stated 
that NCUA should consider allowing FCUs to independently engage in 
derivatives activity, subject to ability to manage derivatives, 
expertise, and adequate controls, and so long as the activity is shown 
to offset IRR. Three commenters supported allowing independent 
derivatives authority for FCUs, but only after they have participated 
in a third-party program. Two commenters supported independent 
derivatives approval only if it is limited and qualified by high 
standards, although these commenters did not define ``high standards.'' 
Nine commenters discouraged the use of numerical criteria, such as 
asset size. Five commenters suggested that NCUA should consider 
experience, correlation testing, and modeling expertise. Ten commenters 
stated that FCUs applying to engage independently should comply with 
the current third-party pilot program standards.
    The Board is considering eligibility requirements based on at least 
three factors, including need, financial condition, and ability to 
manage derivatives. First, an FCU would need to demonstrate relevant 
IRR exposure. One of the motivations behind the Board's consideration 
of expanded derivatives authority is to reduce potentially excessive 
IRR. The Board, therefore, believes that demonstrating a material 
exposure to IRR, and how an FCU can mitigate it through derivatives 
activity, is an appropriate requirement. Second, an FCU would be 
required to demonstrate a requisite level of financial performance, 
measured in part by its CAMEL rating and net worth classification. 
Third, an FCU would need to demonstrate an ability to effectively 
manage derivatives, including minimum experience requirements for FCU 
staff involved in the analysis and ongoing risk management of a 
derivatives book. The Board considers the second and third requirements 
to be appropriate given the complexity of, and inherent risks in, 
derivatives transactions.
    The Board recognizes that FCUs generally have limited experience 
with derivatives. Only eight FCUs participated in existing derivatives 
pilot programs as of June 2011. Of these, six FCUs participated in 
third-party programs and only two FCUs were authorized to independently 
engage in derivatives transactions. Generally, most credit unions have 
an interest rate sensitivity exposure to rising rates, so the downward 
direction of market rates during the past five years may largely 
account for FCUs' moderated interest in derivatives. With NCUA and FCUs 
themselves increasingly concerned about the impact of future rising 
interest rates on credit unions' balance sheets, especially those with 
heavy concentrations of long-term, fixed-rate assets, the Board expects 
that more FCUs may wish to pursue derivatives as a way to manage IRR. 
Yet, given the complexity of even the most straightforward derivatives 
instruments, the Board believes that an FCU should independently engage 
in derivatives transactions only if FCU management and staff can 
demonstrate adequate derivatives experience. This position is 
consistent with the majority of commenters that responded to the 
independent derivatives authority questions in ANPR I.
    The Board believes that what constitutes ``adequate derivatives 
experience'' will vary depending on the nature and complexity of an 
FCU's balance sheet. As noted in ANPR I, the Board is considering 
whether to limit the types of derivatives instruments that some FCUs 
may transact. If an FCU is limited to relatively simple, ``plain 
vanilla'' derivatives instruments such as interest rate swaps \2\ and 
interest rate caps,\3\ the Board believes that the FCU's staff should 
demonstrate at least three years of effective experience with 
derivatives, including the ability to evaluate key risk factors. A 
commensurate level of additional experience likely would be required 
for FCUs whose assets or liabilities exhibit more complex IRR 
characteristics.
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    \2\ An interest rate swap is a derivatives instrument that 
allows one party to exchange (or swap) its set of interest payments 
(for example, fixed-rate interest payments) for another party's set 
of interest payments (for example, floating-rate interest payments). 
An interest rate swap effectively converts a fixed rate on a loan to 
a floating one, or vice versa.
    \3\ An interest rate cap is a derivatives instrument that limits 
floating interest rate exposure to a specified maximum level for a 
specified period of time. It essentially is an insurance policy 
purchased by a party to protect itself against rising interest 
rates.
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    If an FCU is seeking independent derivatives authority, the Board 
believes it is inappropriate for the FCU to rely exclusively on the 
derivatives experience of an outside party. Instead, the FCU would be 
required to demonstrate sufficient internal knowledge of derivatives, 
perhaps in an onsite review prior to the FCU receiving independent 
derivatives authority.

    Question 1: Should the Board require an FCU to demonstrate a 
material IRR exposure or another evident risk management need before 
it is granted independent derivatives authority?
    Question 2: Is it appropriate to require minimum performance 
levels, as measured, for example, by CAMEL ratings and net worth 
classifications, when considering whether to grant or deny an FCU's 
application to independently engage in derivatives transactions? If 
so, what performance measures are appropriate and what should those 
levels be?
    Question 3: What is the minimum kind and amount of derivatives 
experience and expertise that an FCU's staff should demonstrate 
before the FCU receives independent derivatives authority? For 
example, if an FCU has a less complex balance sheet, is it 
sufficient for that FCU's staff to demonstrate a minimum of three 
years transacting derivatives? Should NCUA require additional kinds 
and amounts of experience when there is more complexity in the FCU's 
balance sheet (e.g., prepayments and call options)? To what extent 
should an FCU seeking independent derivatives authority be allowed 
to rely on an outside party to fulfill an experience and expertise 
requirement?

Safety and Soundness Requirements

    The Board believes that, when transacted properly, derivatives can 
be an effective tool for FCUs to use in IRR mitigation. The Board 
further believes that transacting derivatives for other purposes, such 
as speculation, could present unforeseen risks. Accordingly, the Board 
considers it appropriate to limit the types of derivatives that an FCU 
may transact to interest rate derivatives instruments that serve to 
mitigate IRR, namely interest rate swaps and interest rate caps.
    Most credit unions with material IRR exposures use short-term 
liabilities to fund long-term fixed assets. FCUs can mitigate this type 
of IRR exposure by using interest rate swaps and interest rate caps. 
Interest rate swaps, particularly ``pay-fixed/receive-floating'' swaps 
in which one party pays a fixed rate of interest and receives a 
floating rate, can offset IRR resulting from cash flows received on 
fixed, long-term assets such as fixed-rate mortgage loans. Interest 
rate caps can offset IRR resulting from cash flows paid on liabilities 
that are either short term or associated with nonmaturity shares on 
which interest rates may vary by limiting the risk exposure to the 
capped rate. Other derivatives instruments, such as credit derivatives 
(e.g., credit default swaps), provide limited IRR mitigation value and 
potentially could be used for speculation. For these reasons, the Board 
believes that only interest rate derivatives instruments are

[[Page 5418]]

appropriate for FCUs to use in managing IRR.

    Question 4: Should FCUs be limited to using interest rate swaps 
and interest rate caps to offset and manage IRR? Should interest 
rate swaps be limited to pay-fixed/receive-floating instruments? 
What other limits should be established to ensure that an FCU does 
not transact interest rate derivatives in an amount greater than the 
level of its IRR exposure?

    There are numerous risks inherent in any derivatives activity, 
including market risk and counterparty risk. The constant fluctuation 
of the mark-to-market value of a derivatives position represents the 
most significant market risk. Mark-to-market valuation requires the 
value of a derivatives instrument to be set at discrete points in time 
as prescribed by generally accepting accounting principles. This 
valuation represents the then-current market sales price for that 
instrument, which reflects any unrealized gain or loss for the FCU in 
the derivatives transaction.
    The Board is considering whether to establish exposure limits as a 
way to guard against such volatility in the value of a derivatives 
portfolio. For example, if an FCU experiences mark-to-market losses in 
excess of a specified threshold, NCUA could limit the FCU's authority 
to transact derivatives. These limits may be based on the notional 
amount of a derivatives instrument or on its mark-to-market valuation. 
The Board notes that the third-party pilot program includes exposure 
limits that are based on the notional amount of the derivatives 
portfolio, expressed as a percentage of the credit union's net worth. 
Some commenters to ANPR I, however, have suggested that exposure limits 
should be based on mark-to-market valuation.

    Question 5: Should NCUA establish exposure limits for FCUs or 
should it require an FCU's board of directors to establish exposure 
limits? Should there be limits on the aggregate amount of each type 
of derivatives instrument in the portfolio or on the aggregate 
amount of derivatives transacted with any counterparty? Should 
limits be based on the notional amount of a derivatives instrument, 
its mark-to-market valuation, or both?

    Another significant risk in derivatives activity is counterparty 
risk, also known as ``default risk'' or ``credit risk.'' Counterparty 
risk is the risk that losses will occur due to a counterparty's failure 
to fulfill its obligations under the derivatives contract. The Board 
believes that, to manage counterparty risk, an FCU should, on an 
ongoing basis, monitor counterparties and their creditworthiness, as 
well as the credit risk mitigation features inherent in the derivatives 
transaction (e.g., margin requirements, daily valuations of collateral, 
and performance of third parties).
    Consistent with the need to carefully monitor credit features, the 
Board believes that counterparty risk can be substantially mitigated 
through effective collateral management. In derivatives transactions, 
parties may be required to post collateral to secure their obligations 
under the derivatives contract. Posting collateral protects either 
party in a derivatives transaction from the risk of loss, which may 
occur for a number of reasons including counterparty default. The 
Board, therefore, believes it is appropriate for an FCU to include the 
following collateral management standards in the related derivatives 
contract:
     Bilateral collateral, in which both parties to a 
derivatives contract agree to post collateral to cover mark-to-market 
gains and losses.
     Tri-party custody, in which posted collateral is delivered 
to a third party acting as custodian.
     Zero thresholds, in which parties are required to post 
collateral at any level of loss over a minimum amount specified in the 
derivatives contract.
     Restricting the type of assets used as posted collateral 
to instruments permitted for investment by an FCU.

    Question 6: Are there ways to mitigate counterparty risk besides 
posting collateral? Are there additional or alternate 
collateralization conditions that NCUA should require beyond those 
described in this ANPR?

    By the National Credit Union Administration Board on January 26, 
2012.
Mary F. Rupp,
Secretary of the Board.
[FR Doc. 2012-2092 Filed 2-2-12; 8:45 am]
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