Derivatives, 32191-32212 [2013-12638]
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NATIONAL CREDIT UNION
ADMINISTRATION
12 CFR Parts 703, 715, and 741
RIN 3133–AD90
Derivatives
National Credit Union
Administration (NCUA).
ACTION: Proposed Rule.
AGENCY:
This proposed rule permits
credit unions to engage in limited
derivatives activities for the purpose of
mitigating interest rate risk. This
proposed rule applies to federal credit
unions and any federally insured, statechartered credit unions that are
permitted under applicable state law to
engage in derivatives transactions. It
requires any credit union seeking
derivatives authority to submit an
application for one of two levels of
authority. Level I and Level II authority
differ on the permissible levels of
transactions as well as the application,
expertise, and systems requirements
associated with operating a derivatives
program.
DATES: Comments must be received on
or before July 29, 2013.
ADDRESSES: You may submit comments
by any of the following methods (Please
send comments by one method only):
• Federal eRulemaking Portal: https://
www.regulations.gov. Follow the
instructions for submitting comments.
• NCUA Web Site: https://
www.ncua.gov/
RegulationsOpinionsLaws/
proposed_regs/proposed_regs.html.
Follow the instructions for submitting
comments.
• E-Mail: Address to
regcomments@ncua.gov. Include ‘‘[Your
name]—Comments on Proposed Rule—
Derivatives’’ 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.
FOR FURTHER INFORMATION CONTACT:
Justin M. Anderson or Lisa Henderson,
Staff Attorneys, Office of General
Counsel, at the above address or
telephone (703) 518–6540; J. Owen Cole,
Director, Division of Capital and Credit
Markets, or Rick Mayfield, Senior
Capital Markets Specialist, Office of
Examination and Insurance, at the above
address or telephone (703) 518–6360; or
Dr. John Worth, Chief Economist, Office
SUMMARY:
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32191
of the Chief Economist, at the above
address or telephone (703) 518–6660.
SUPPLEMENTARY INFORMATION:
I. Background
A. Introduction
The NCUA Board (Board) is proposing
to allow credit unions to engage in
limited derivatives transactions 1 for the
purpose of mitigating interest rate risk
(IRR). This proposed authority does not,
however, allow credit unions to offer
derivatives. This proposed rule applies
to all federal credit unions (FCUs) and
all federally insured state- chartered
credit unions (FISCUs) that are
expressly permitted by applicable state
law to engage in derivatives
transactions. The Board believes this
proposed rule allows eligible credit
unions to utilize an additional tool to
mitigate IRR, while also reducing risk to
the National Credit Union Share
Insurance Fund (NCUSIF).
The rule requires eligible credit
unions to apply to NCUA or, in the case
of a FISCU, NCUA and the applicable
state supervisory authority (SSA), for
either Level I or Level II derivatives
authority. As discussed in greater detail
below, Level I and Level II authority
differ on the permissible levels of
transactions as well as the application,
expertise, and systems requirements.
B. The Act and NCUA’s Regulations
The Federal Credit Union Act (Act)
provides FCUs with the authority to
invest in certain securities, obligations,
and accounts.2 For safety and soundness
reasons, however, NCUA has adopted
regulatory restrictions on certain
investments and activities permitted by
the Act.3 Currently, derivatives are
among the investments specifically
prohibited by NCUA.4
1 A derivative is an instrument whose price is
dependent on or derived from one or more
underlying assets. A derivatives transaction
involves a contract between two parties, called
counterparties, that exchange value based on the
fluctuation of the underlying asset or index. A
counterparty is the other party to the derivatives
transaction and can include swap dealers and major
swap participants, which are terms to identify
entities that operate primarily in the derivatives
market. These transactions may involve collateral
and a collateral custodian, which is an entity that
holds the collateral for the two contracting parties.
2 12 U.S.C. 1757(7) and (15).
3 12 CFR 703.16.
4 Id. at 703.16(a). Section 703.16(a), however,
provides three exceptions to the general prohibition
on derivatives. First, an FCU may purchase or sell
any derivatives permitted under § 703.14(g) or
under § 701.21(i) of NCUA’s lending regulations.
Second, an FCU may purchase or sell an embedded
option not required under generally accepted
accounting principles (GAAP) to be accounted for
separately from the host contract. Third, an FCU
may enter into interest rate lock commitments or
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NCUA prohibited derivatives because
they are complex financial instruments
that potentially introduce significant
degrees of risk to a credit union.
Accordingly, this risk calls for a more
robust asset/liability management
(ALM) capability that is supported by a
higher degree of sophistication,
analytical rigor and risk management
expertise.
Traditionally, derivatives instruments
have been customizable over-thecounter instruments. They span a wide
variety of types and structures, many of
which are unsuitable for credit unions.
As the financial derivatives markets
have evolved, however, greater
standardization of contracts, collateral
requirements, market participation and
price transparency have made certain
derivatives more suitable for meeting
the risk mitigation needs of some credit
unions. In addition, given the
historically low interest rate
environment of the last few years, IRR
now poses a material risk to many credit
unions.
Recognizing that derivatives can be
beneficial in helping credit unions to
mitigate IRR, the Board believes it is
appropriate to allow credit unions to
use derivatives for the limited purpose
of IRR mitigation. The Board notes,
however, that derivatives are not the
only way for credit unions to control
IRR. Rather, the Board emphasizes that
derivatives are just one tool that credit
unions may employ as part of a
comprehensive ALM strategy.
This rule builds on the IRR rule that
the Board issued in 2012, which
required certain federally insured credit
unions to develop and adopt a written
policy on IRR management and a
program to effectively implement that
policy.5 The IRR rule provides guidance
in developing an effective IRR
management program to identify,
measure, monitor, and control IRR. This
proposed rule does not change any of
the requirements in the IRR rule, but
rather is another measure the Board is
taking to enhance risk management
alternatives.
C. 1998 IRPS
This proposed rule is consistent with
a 1998 Interpretive Ruling and Policy
Statement (IRPS) 98–2, Investment
Securities and End-User Derivatives
issued by NCUA.6 IRPS 98–2 provides
guidance to credit unions on sound
forward sales commitments made in connection
with a loan originated by the FCU. The Board
believed that the benefits of the three exceptions
outweighed the potential risk and recognized these
items were tools FCUs needed.
5 71 FR 5155 (February 2, 2012).
6 IRSP 98–2 (October 1, 1998).
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practices for managing the risks of
investment securities and end-user
derivatives activities, including
transactions in swaps and caps. While
derivatives are generally prohibited by
regulation for FCUs, the IRPS provides
guidance on other investments as well
and applies to FISCUs with derivatives
authority under applicable state law.
The Board, therefore, joined the other
Federal Financial Institutions
Examination Council members in
promulgating the guidance.
The IRPS notes that effective
management of the risks associated with
securities and derivatives instruments
represents an essential component of
safe and sound practice. It identifies
certain elements as fundamental to all
sound risk management programs.
These elements include oversight by a
credit union’s board of directors and
senior management and a
comprehensive risk management
process that effectively identifies,
measures, monitors, and controls risk.
This proposed rule incorporates many
of the guiding principles of IRPS 98–2,
as well as lessons learned from the
derivatives pilot programs and
comments received on two advanced
notices of proposed rulemaking
(ANPRs).
D. Pilot Programs
Since 1999, the Board has been
evaluating pilot programs for limited
derivatives authority. These pilot
programs have provided NCUA with
insight to move from a limited
experimental authority to a more
general regulatory authority. They have
shown the Board that most credit
unions need to develop sufficient
experience, management, and
infrastructure before beginning a
derivatives program. Once these are
developed, however, credit unions can
operate a limited derivatives program in
a safe and sound manner.
In addition, several key lessons
emerged from NCUA’s experience with
the derivative pilot programs. Some
programs were managed directly by
credit unions, while others were
administered by external service
providers. NCUA observed that the
understanding and management of
derivatives transactions, while generally
sound and effective, were rudimentary
in some instances. Various weaknesses
were encountered over time. Some areas
of concern included: lack of, or
inadequate, assessments of the capacity
to absorb losses and establish processes
to proactively limit loss exposure; lack
of due diligence on counterparties and
credit risk mitigation; lack of vigilant
collateral management; heavy reliance
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on external parties to value derivatives
for base and stress scenarios; and lack
of analysis and disclosure for
transaction costs (spreads over market).
These noted areas, which were
addressed through the supervision
process, have influenced the Board’s
current perspective on the need for the
requirements and limits contained in
this rule. These lessons also raise the
need for NCUA’s supervision skills and
resources to be enhanced commensurate
with a broader derivatives authority that
expands beyond limited pilot usage.
This rule is crafted to address these
lessons and the comments received on
the two ANPRs.
E. ANPRs
1. ANPR I
In June 2011, the Board issued an
ANPR (ANPR I) requesting public
comment on whether and how to
modify its rule on investment and
deposit activities to permit FCUs to
enter into derivatives transactions for
the purpose of offsetting IRR.7 The
Board requested comment on five broad
topics, three of which related to NCUA’s
pilot programs and third-party
programs. The other two topics directly
addressed independent derivatives
authority. The following summary
focuses on the topics directly related to
the promulgation of this proposed rule.
First, the Board asked if it should
consider allowing credit unions to
engage in independent derivatives
activities. Ten out of 29 commenters
believed the Board should allow credit
unions to engage in derivatives activity
independently, subject to ability,
expertise, adequate understanding and
controls, so long as the activity is shown
to reduce IRR. Three commenters
supported allowing credit unions to
engage in derivatives activity
independently without further
comment. Three commenters supported
allowing credit unions that have already
demonstrated ability in a third party
program to have independent
derivatives authority. Two supported
independent approval only if limited
and qualified by high standards.
Next, the Board asked what criteria it
should consider in allowing a credit
union to independently engage in
derivatives activities. The Board
suggested criteria such as asset size,
capital adequacy, balance sheet
composition, or risk exposure with and
without derivatives. Nine commenters
believed there should not be numerical
criteria, such as size. Five commenters
thought there should be other criteria
7 76
FR 37030 (June 24, 2011).
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such as experience, correlation testing
and modeling expertise. Two
commenters said the criteria should be
the capital or earnings of the credit
union.
In addition, ten commenters stated
that credit unions applying to engage
independently should follow the
present third party pilot program
standards. Two credit unions said that
NCUA should require credit unions to
prepare succession plans, exit plans,
and to engage independent CPAs. Five
commenters said that approval to
engage independently should be given
on a similar basis as part 704 Expanded
Authorities.8
Finally, the Board asked if it should
require credit unions to demonstrate
enhanced functionality in terms of the
experience of personnel, credit analysis
and reporting infrastructure to evaluate
the creditworthiness of derivative
counterparties. Ten commenters said
that there is no need for enhanced credit
functionality because requirements for
bilateral collateral, credit ratings and
mandatory clearing make this
unnecessary. Three commenters
believed credit unions should show
enhanced credit functionality and that
the standard should be clear and
objective. Twelve commenters argued
credit unions should demonstrate
enhanced hedging expertise including
modeling, live pricing, hedge impact,
trade execution, system capabilities and
reporting balance sheet strategies.
2. ANPR II
The Board issued a second ANPR in
January 2012 (ANPR II) 9 to obtain
further industry input to help ensure
that any rule granting independent
derivatives authority is manageable for
both participating FCUs and NCUA,
while simultaneously protecting the
credit union industry from undue risk.
In ANPR II, the Board asked six
questions regarding the conditions
under which NCUA might grant
authority for an FCU to engage in
derivatives transactions independently.
Question One. The Board asked if
NCUA should require an FCU to
demonstrate a material IRR exposure or
another risk management need, before it
receives independent derivatives
authority. Seven commenters supported
such a requirement, and 19 opposed it.
Eleven of those 19 commenters
expressed concern that such a
requirement would prevent FCUs from
proactively managing IRR through the
use of derivatives before IRR poses a
danger to the FCU.
8 12
9 77
CFR part 704, Appendix B.
FR 5416 (Feb. 3, 2012).
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Question Two. The Board asked if it
was appropriate to require minimum
performance levels, as measured, for
example, by CAMEL ratings and net
worth classifications, when considering
whether to grant an FCU’s application to
independently engage in derivatives
transactions. The Board further asked, if
the answer is yes, what performance
measures and levels would be
appropriate and should the Board
permit waivers from these requirements.
Seventeen commenters stated that
NCUA should require minimum
performance levels before approving an
FCU’s application for independent
derivatives authority. The majority of
the suggested metrics were CAMEL
ratings and net worth classifications.
Four commenters suggested a CAMEL 2
rating as a minimum and one suggested
a CAMEL 3 rating. Some commenters
opposed using CAMEL ratings because
the ratings contain elements that are not
relevant to an FCU’s need or capability
to support an independent derivatives
program.
Eight commenters argued that NCUA
should not require minimum
performance levels. One commenter
stated that poorly capitalized FCUs
would actually benefit from derivatives.
Another stated that standards are not
necessary because the market would not
support an FCU in poor financial health
as a counterparty. Two commenters
supported allowing waivers from
performance standards if an FCU could
demonstrate that it met certain criteria,
such as need, or could show that it had
the ability to transact derivatives.
Question Three. The Board asked
what derivatives experience and
expertise an FCU’s staff should
demonstrate before receiving
independent derivatives authority. The
Board questioned whether NCUA
should require additional experience
and expertise when there is more
complexity in the FCU’s statement of
financial condition and to what extent
an FCU should be allowed to rely on an
outside party to fulfill any such
requirements.
Nineteen commenters stated that
experience or demonstrated skill was
necessary to conduct derivatives
transactions, but they did not want
NCUA to condition approval of
independent derivatives authority on
specific experience requirements.
Several commenters suggested that FCU
boards of directors should define
experience based on each FCU’s
derivatives program. One commenter
stated that FCUs should demonstrate an
advanced level of skill in conducting
derivatives transactions, and one
commenter suggested a broader level of
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experience such as professional
accreditations to satisfy an experience
requirement. Other commenters argued
that, because ‘‘plain vanilla’’ derivatives
instruments present little or no risk, the
Board should not require specific
experience. Seven commenters
supported NCUA allowing third parties
to meet an experience requirement, and
seven were opposed.
Question Four. The Board asked
whether NCUA should limit FCUs to
using interest rate swaps and interest
rate caps and whether interest rate
swaps should be pay-fixed/receivefloating instruments. The Board also
asked what other limits it should
establish to ensure that an FCU does not
transact interest rate derivatives in an
amount greater than the level of its IRR
exposure.
Twenty-five commenters agreed that
NCUA should allow FCUs to use
interest rate caps 10 and pay-fixed/
receive-floating interest rate swaps 11 to
offset and manage IRR. Twenty of these
commenters, however, suggested that
NCUA also allow credit unions to use
other types of derivatives, including
floors, collars, pay-floating/receive-fixed
swaps, pay-variable/receive-fixed
swaps, basis swaps, forwards, futures,
and swaptions.
Question Five. The Board asked
whether NCUA or an FCU’s board of
directors should establish exposure
limits for FCUs and whether there
should 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. The
Board also asked whether limits should
be based on the notional amount of a
derivatives instrument, its mark-tomarket valuation, or both. Twenty-three
commenters suggested that an FCU’s
board of directors should set the
exposure limits, and five supported
regulatory limits.
Question Six. The Board requested
comment on whether there are ways to
mitigate counterparty risk besides
posting collateral and sought
suggestions for appropriate
collateralization conditions. Fourteen
commenters supported collateral
requirements, and four were opposed.
Six credit unions stated that FCUs
10 In an interest rate cap, one party agrees to
compensate another party for the amount by which
an underlying short-term rate exceeds a specified
rate on a series of dates during the life of the
contract.
11 A pay-fixed/receive-floating interest rate swap
is an agreement where a credit union pays the
counterparty a fixed rate of return in exchange for
returns based upon future rates of a floating rate
index for a predetermined period of time.
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should be allowed to use letters of credit
from a Federal Home Loan Bank or
similar institution to meet collateral
requirements. Three credit unions
suggested that NCUA should allow the
use of a non-zero threshold for
collateral 12 posting by the counterparty,
subject to the capital strength of the
credit union.
This proposed rule also adds a
definition of ‘‘derivatives,’’ ‘‘forward
sales commitment,’’ and ‘‘interest rate
lock commitment’’ and updates the
definition of ‘‘fair value.’’ The new
definitions clarify terms that are
currently used in part 703. The updated
definition of ‘‘fair value’’ cross
references the definition used in GAAP.
II. Proposed Amendments
B. Derivatives Authority
Taking into account the lessons
learned from the pilot programs, the
comments from the ANPRs, and the
guiding principles in the IRPS, the
Board is proposing the following
amendments. The Board believes these
amendments achieve a balance between
IRR mitigation, a safe and sound
derivatives program, and flexibility for
credit unions.
This proposed rule allows credit
unions to enter into interest rate swaps
and to purchase interest rate caps, and
it requires pre-approval for all
derivatives users. There will be two
levels of pre-approval, Level I and Level
II, permitting different degrees of
derivatives authority with differing
degrees of regulatory requirements.
law to follow the requirements of this
proposed rule. In addition, if aspects of
a state’s derivatives rule are more
restrictive than this rule, FISCUs in that
state must follow the more restrictive
provisions of the state rule. In all other
cases, a FISCU with derivatives
authority must follow this proposed
rule.
As discussed in more detail below,
this proposed rule requires a FISCU to
submit an application to its SSA. The
SSA will review the application and
forward its decision to NCUA for
concurrence. The Board believes this
approach will create a uniform system
of approval and examination of credit
unions permitted to engage in
derivatives transactions, leading to
greater protection of the NCUSIF.
C. Application of the Proposed Rule
D. Levels of Authority
A. Changes to Part 703
The Act permits the Board to
prescribe rules and regulations for all
federally insured credit unions it deems
are necessary to protect the NCUSIF and
the credit union industry.14 Before
implementing a rule that applies to all
federally insured credit unions, the
Board carefully considers all available
alternatives and the degree of risk posed
to the NCUSIF by an activity the Board
seeks to regulate. In the area of
derivatives, the Board recognizes the
risks inherent in these instruments and
that the unregulated use of derivatives
poses significant risk to the NCUSIF.
For those reasons, this proposed rule
applies to both FCUs and certain
FISCUs described below.
This proposed rule applies to any
FISCU that is permitted by its state law
to engage in derivatives. This proposed
rule does not grant any FISCU authority
to engage in derivatives if applicable
state law does not expressly allow it. It
does, however, require those FISCUs
with derivatives authority under state
As noted above, this proposed rule
requires pre-approval from NCUA or, in
the case of a FISCU, from the applicable
SSA with NCUA’s concurrence. Credit
unions meeting specific eligibility
criteria under this rule are permitted to
apply for Level I or Level II derivatives
authority.
Level I derivatives authority contains
lower permissible transaction limits, but
also entails a more streamlined
application process and less restrictive
requirements with respect to
experience, personnel, and systems.
Conversely, Level II allows for higher
transaction limits set by NCUA up to a
specific ceiling, but entails an onsite
evaluation, higher regulatory
requirements, a higher application fee,
and the necessary personnel and
systems to be in place before a credit
union may apply. The following chart
highlights the differences between Level
I authority and Level II authority. These
differences are discussed in more detail
in other sections of this preamble.
This proposed rule divides part 703
into two subparts. Subpart A consists of
the current part 703, with some minor
modifications. These modifications,
discussed below, include added
definitions the Board believes will add
to the clarity to the rule. Subpart B
consists of rules and requirements
relating to IRR derivatives authority.
As discussed above, current
§ 703.16(a) lists derivatives as a
prohibited investment for FCUs, but
provides three exceptions.13 This
proposed rule deletes the general
prohibition against derivatives in
§ 703.16(a) and moves the exceptions
described there to a new permissible
investments paragraph in § 703.14.
Proposed paragraph (k) of § 703.14
authorizes FCUs to enter into all of the
derivatives transactions permitted in
current § 703.16(a) plus the derivatives
transactions permitted in proposed
subpart B of part 703.
LEVEL I AND LEVEL II COMPARISON
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Level I
Level II
Eligibility: To apply for Level I authority a credit union must:
• Show, in its application, how derivatives are part of the credit
union’s IRR mitigation strategy. IRR mitigation may be of current
or prospective IRR.
• Have a composite CAMEL code rating assigned by NCUA of 1,
2, or 3 with a management component of 1 or 2.
• Have assets of at least $250 million, as of its most recent call
report.
Authorities and Limits:
Eligibility:
• In addition to all of the eligibility criteria under Level I in this
chart, a credit union seeking Level II authority must also be able
to demonstrate in its application why the limits for Level I authority are not sufficient to meet the credit union’s IRR mitigation
needs.
12 A threshold amount is the amount of unsecured
credit each party is prepared to accept before
requiring collateral. A non-zero threshold
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Authorities and Limits:
arrangement means that the parties would be
willing to accept some level of unsecured credit.
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13 12
14 12
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CFR § 703.16(a).
U.S.C. § 1789(11).
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LEVEL I AND LEVEL II COMPARISON—Continued
Level I
Level II
• Interest rate swaps are limited to a notional value of 100% of
net worth.
• Interest rate caps are limited to an aggregate book value of
10% of net worth.
• The combined limit of interest rate swaps and interest rate
caps is limited to 100% of the aggregate limits based on
usage.
• Aggregate fair value loss on all interest rate swap positions
cannot exceed 10% of net worth.15
• Maximum weighted average life of all derivatives transactions
may not exceed 5 years.
• A single derivatives position maturity may not exceed 7
years.
Application Review by Regulators:
• 90 days from the date the appropriate Field Director determines
a credit union’s application is complete or receives a decision
from an SSA, in the case of a FISCU.
Application content. A credit union must demonstrate:
• How derivatives are one part of the credit union’s IRR mitigation
strategy. Mitigation may be of current or prospective IRR.
• How it plans to acquire, employ, and/or create the required resources, policies, processes, systems, internal controls, modeling, and competencies.
• That its senior executive officers and board of directors understand the role derivatives play in the credit union’s balance
sheet management and the risk inherent in derivatives activities.
• How it intends to use external service providers.
External service providers: A credit union may contract with external
service providers to:
• Support:
Æ Evaluating credit risk management.
Æ Evaluating liquidity risk.
Æ Asset/liability risk management.
• Conduct:
Æ Accounting reporting.
Æ Counterparty exposure management.
Æ Collateral management.
Æ Trade execution.
Æ Transaction management.
Æ Financial statement auditing.
Æ Legal services.
Application fee:
As set by NCUA. The Board is considering amounts starting at
$25,000.
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E. Permissible Transactions
As stated above, this proposed rule
limits permissible derivatives
transactions for both Level I and Level
II to interest rate caps and interest rate
swaps. The Board considered all of the
comments requesting additional levels
of derivatives authority. At the present
time, however, the Board believes that
15 A credit union with Level I authority that
exceeds this limit may not enter into any new
derivatives transactions and must submit a
corrective action plan to NCUA (or NCUA and the
applicable SSA, in the case of a FISCU).
16 A credit union with Level II authority that
exceeds this limit may not enter into any new
derivatives transactions and must submit a
corrective action plan to NCUA (or NCUA and the
applicable SSA, in the case of a FISCU).
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• Interest rate swaps are limited to a notional value of 250% of
net worth.
• Interest rate caps are limited to an aggregate book value of 25%
of net worth.
• NCUA will set the combined limit of interest rate swaps and interest rate caps during the approval process.
• Aggregate fair value loss on all interest rate swap positions cannot exceed 25% of net worth.16
• Maximum weighted average life of all derivatives transactions
may not exceed 7 years.
• A single derivatives position maturity may not exceed 10 years.
• Single counterparty notional exposure cannot exceed 100% of
net worth for interest rate swaps and single counterparty book
value may not exceed 10% of net worth for interest rate caps.
Application Review by Regulators:
• 120 days from the date the appropriate Field Director determines a credit union’s application is complete or receives a decision from an SSA, in the case of a FISCU.
Application content. In addition to the content required in an application
for Level I, a credit union applying for Level II authority must also:
• Demonstrate why the limits for Level I authority are not sufficient
for it to use derivatives as part of its IRR mitigation strategy.
• Have the systems and personnel required by this rule in place
before submitting its application.
External service providers: A credit union may contract with external
service providers to:
• Support:
Æ Asset/liability risk management.
Æ Evaluating credit risk.
Æ Counterparty exposure management.
Æ Evaluating liquidity risk.
Æ Collateral management.
Æ Transaction management.
• Conduct:
Æ Accounting reporting.
Æ Trade execution.
Æ Financial statement auditing.
Æ Legal services.
Application fee:
• As set by NCUA. The Board is considering amounts between
$75,000 and $125,000.
credit unions’ capabilities and
experience dictate a targeted approach
to permissible derivatives. In addition,
the Board believes this limited
permissibility achieves the purpose of
this rule, which is to provide credit
unions with a meaningful tool to
mitigate IRR. The Board recognizes and
intends that these proposed limits may
not provide mitigation for 100% of
every credit union’s IRR. Rather, the
Board intends derivatives to be one part
of a broader IRR mitigation and ALM
strategy.
With regard to interest rate swaps, the
Board is proposing to authorize only
standard ‘‘pay-fixed/receive-floating’’
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and ‘‘pay-floating/receive-fixed’’ 17
interest rate swaps. It is currently
anticipated that most interest rate swaps
users would enter into ‘‘pay-fixed/
receive-floating’’ transactions to hedge
against rising interest rates. This ‘‘plain
vanilla’’ interest rate swap affords some
protection against the most common
interest rate exposure experienced by
credit unions with material IRR
sensitivity, namely, a statement of
financial condition with an asset
portfolio that does not reset to external
rate changes as quickly as its liabilities.
17 A pay-floating/receive-fixed interest rate swap
is an agreement where a credit union pays the
counterparty returns based on a floating rate index
in exchange for returns based on a fixed rate of
interest on a predetermined notional amount for a
predetermined period of time.
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Most credit unions use non-maturity
and other short-term shares to fund
longer duration assets creating an
inherent re-pricing mismatch for which
pay-fixed/receive-floating interest rate
swaps can provide some effective
mitigation.
Many variations of swap structures
exist. NCUA is not authorizing any of
the complex variations of the pay-fixed/
receive-floating interest rate swaps
structure because doing so introduces
measures of complexity and risk that are
more difficult to model, measure,
monitor, and control. The Board does
not believe the marginal risk
management utility from more complex
structures is sufficient to warrant the
additional inherent risks. The Board
seeks comment on whether credit
unions believe that complex swap
structures are necessary and, if so,
which structures and why.
The Board is also restricting
derivatives transactions to derivatives
that are not leveraged. In some cases
financial instruments have multipliers
assigned to interest rate payments.
These multipliers create a form of
leverage that can either increase or
decrease exposure to the rate or index
to which the financial instrument is
exposed. For example, a financial
instrument could be structured to pay a
floating rate of 3-month Treasury Bills
times 1.2. This multiplier creates
leverage and is impermissible under this
proposed rule. This proposed rule
allows credit unions to engage in a
limited amount of ‘‘plain vanilla’’
derivatives transactions. Incorporating
leverage could result in derivatives
exposure beyond the limitations in this
rule.
The Board is also excluding from the
definition of interest rate swaps those
where the notional amount varies
because it does not believe the benefits
of these instruments offset their added
complexity. The maturity of instruments
where the notional amounts vary can
change in ways that may be unrelated to
a credit union’s own IRR. The Board
does not intend for derivatives usage to
add layers of complexity to a credit
union’s IRR management. Instead, the
Board intends for credit unions to use
derivatives as one tool in a
comprehensive IRR management
approach.
Consistent with the limitations for
variable rate investments set in
§ 703.14(a),18 NCUA is limiting
permissible indices for interest rate
swaps to domestic interest rates. In
addition, any derivatives transaction
must be denominated in U.S. dollars.
18 12
CFR § 703.14(a).
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These restrictions are consistent with
the use of derivatives to manage IRR, as
a credit union’s IRR is correlated to
changes in domestic interest rates.
The Board is also proposing to set a
three-day settlement requirement for
derivatives transactions. The
counterparties to a derivatives
transaction negotiate many elements of
the transaction, including the settlement
terms. The Board is proposing a threeday limitation based on market
convention and believes it allows
sufficient time to settle, while
preventing forward-settling transactions,
which can be used for speculation
rather than mitigation. The Board
invites comments on the
appropriateness of this limit in the
context of not wanting to allow forwardsettling derivatives transactions.
Finally, this proposed rule prohibits
credit unions from using derivatives to
create structured liability offerings 19 for
members or nonmembers, except as
permitted under § 703.14(g) of NCUA’s
regulations.20 That provision allows
FCUs to purchase equity options for the
purpose of offering their members
dividends based on the performance of
an equity index. Except for such
dividends, FCUs may not use
derivatives to offer structured liability
products.
F. Eligibility
1. IRR Mitigation
As noted above, some commenters to
the ANPRs expressed concerns with the
general concept of requiring credit
unions to demonstrate a material IRR
exposure or another risk management
need as a condition of derivatives
authority. Other commenters supported
requiring a credit union to demonstrate
material IRR exposure before being
granted independent derivatives
authority. Among commenters
expressing concerns with the concept of
demonstrated need, one common
concern was that requiring
demonstrated need will reduce FCUs’
incentives to responsibly manage IRR.
The concern suggests that CUs will
either proactively increase IRR in order
to demonstrate need or will be less
vigilant in managing IRR.
The purpose of this rule is to provide
credit unions that meet certain
standards with interest rate derivatives
as an additional tool to reduce IRR
exposure. As suggested by commenters,
the Board recognizes that requiring the
19 A structured liability is an offering with
contractual option features, such as periodic caps
and calls, similar to those found in structured
securities or structured notes.
20 12 CFR § 703.14(g).
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demonstration of material need for IRR
reduction may create perverse
incentives and lead to unintended
consequences.
As discussed below, rather than
demonstrate material interest rate risk
exposure, a credit union must present a
comprehensive risk management
strategy, and articulate how the
inclusion of interest rate derivatives will
complement existing risk mitigation
tools. In addition, a credit union
applying for Level II authority must
show why the limits in Level I authority
are not sufficient to meet its IRR
mitigation needs. The Board believes
these requirements eliminate the
unintended consequences cited by
commenters, while ensuring a credit
union fully considers how derivatives
fit within its overall IRR mitigation
strategy.
2. CAMEL Requirements
This proposed rule also requires a
credit union’s most recent composite
CAMEL code rating, assigned by NCUA,
to be a 1, 2, or 3, with a management
component rating of 1 or 2. The Board
believes that a high management
component rating accounts for credit
unions that may have a weak financial
position because of IRR, but have the
management in place to effectively
identify, measure, monitor, and control
significant risks. The Board intends this
eligibility requirement to ensure that
well-managed credit unions that need
derivatives to mitigate IRR are able to
obtain this authority.
3. Asset Threshold
As an eligibility requirement, the
Board is also proposing an asset
threshold of $250 million. An asset
threshold of $250 million includes most
credit unions with IRR exposure and the
capacity to use derivatives. The Board
arrived at this threshold by analyzing
interest rate exposure at credit unions of
varying asset size, the share of these
credit unions’ assets as a share of the
credit union system, and the use of
interest rate derivatives by similarlysized community banks.
a. IRR Exposure
The Board notes that IRR is more
prevalent among credit unions with
assets over $250 million. Table 1
provides the average share of fixed rate
assets, average share of money market
deposits, and average share of non-core
deposits (e.g., deposits other than
regular share and share draft accounts).
These assets and liabilities represent the
primary drivers of IRR exposure in a
credit union’s portfolio. Credit unions
with more than $250 million in total
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assets have nearly twice the exposure to
fixed rate assets and hold a much
greater share of non-core deposits than
credit unions with $250 million or less
in assets.
Credit unions with more than $250
million in total assets represent 78% of
32197
the system-wide assets. With much of
the IRR in these larger credit unions, the
rule covers the vast majority of the IRR
in the credit union system.
TABLE 1—IRR EXPOSURE AT CREDIT UNIONS BY ASSET CATEGORY (2012Q4) 21
Asset category
< $250M
$250M–$1B
$1B–$5B
$5B+
Share of Loans in Fixed Rate Mortgages ...............................
Share of Deposits in Money Market Accts ..............................
Share of Non-Core Deposits ...................................................
18%
8%
32%
35%
22%
54%
38%
27%
60%
36%
26%
61%
Number of Credit Unions .........................................................
Share of Systemwide Assets ...................................................
6,066
22%
556
27%
180
33%
17
18%
b. Capacity
contracts, restricts most of these
transactions to large commercial banks
and community banks with more than
$250 million in total assets. The Board
believes this also holds true with credit
The cost to build staff and execute
trades, and the counterparty
requirements for many derivatives
unions. Table 2 below demonstrates the
increasing likelihood of derivatives
participation among larger financial
institutions.
TABLE 2—CAPACITY FOR DERIVATIVES BASED ON BANK USE RATES 22
Asset category
< $250M
Number of Banks and Thrifts ..................................................
Number of Banks and Thrifts Holding Any Interest Rate Derivatives ................................................................................
Derivatives Use Rate ...............................................................
Average Notional Amount Held ...............................................
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G. Proposed Requirements
The following discussion outlines the
proposed requirements for credit unions
with Level I and Level II authority. The
Board points out the distinctions
between the two levels and explains the
reason for the differences. As discussed
above, the difference between the two
levels is in the permissible levels of
transactions, as well as the application,
expertise, and systems requirements.
This proposed rule requires a credit
union applying for Level I or Level II
21 Data
from the 2012Q4 NCUA Call Report.
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$1B–$5B
$5B+
4,506
1,918
490
178
347
8%
$0.7M
535
28%
$12M
280
57%
$94M
148
83%
$1.0T
authority to operate according to written
policies and procedures. These policies
and procedures must, at a minimum,
address managerial oversight, scope of
activities, approved counterparties, risk
management, legal issues, accounting
standards, limits, counterparty
exposure, margin requirements, and
reporting requirements. The proposed
rule requires that a credit union’s board
of directors review these policies and
procedures annually and update them
when necessary.
The Board believes it is important for
everyone involved in a credit union’s
derivatives program, including external
service providers, to be aware of the
derivatives program’s requirements,
restrictions, and parameters. In
addition, the Board believes written
policies help ensure a credit union’s
board of directors contemplates every
aspect of a derivatives program and the
effect each will have on the credit
union. An annual review will ensure the
policies are updated to reflect the
changing environment and the credit
union’s needs and goals.
2. Collateral Requirements
22 Data calculated from the 2012Q4 FDIC Call
Report and is calculated for all banks and thrifts
Based on these considerations, the
Board believes an asset threshold of
$250 million is appropriate. It will
allow those credit unions with the need
and capacity to take advantage of this
additional IRR mitigation tool.
In addition, a threshold of $250
million is a benchmark NCUA uses in
other supervision areas, such as for
annual examinations for FISCUs. The
Board believes this figure represents a
relative distinction between credit
unions with more complex assetliability structures and risks.
1. Policies and Procedures
$250M–$1B
that report non-zero notional amounts outstanding
for interest rate derivatives contracts.
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The Board is proposing requirements
for collateral to ensure credit unions are
fully protected in the event of market
disruptions or counterparty defaults.
These proposed collateral requirements
include limiting collateral to highly
liquid instruments permitted under the
Act.
The proposed rule restricts the forms
of collateral that are permitted for a
credit union to the most liquid and
easily valued instruments so that they
can be easily negotiated even in times
of market illiquidity. In addition,
collateral arrangements must be bilateral
and collateral may not be held by
counterparties except at a legally
separate affiliate. These requirements
ensure that a credit union’s exposure is
de minimis by specifying that
derivatives positions are priced daily,
that the threshold amounts at which
collateral is required are zero, and that
mandatory triggers for transfer amounts
are low. The Board has also included a
proposed requirement that accounts for
cases where a credit union lacking
financial strength may be required to
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post additional collateral for a
counterparty to be willing to transact.
The Board notes that all of these
proposed collateral provisions are based
on common practices in the derivatives
market. In addition, the Board believes
these provisions will help protect the
safety and soundness of a credit union
with derivatives authority and will not
pose an unreasonable burden.
This proposed rule limits eligible
collateral to cash, Treasury securities,
fixed-rate non-callable agency
debentures, and zero-coupon noncallable agency debentures. Eligible
collateral must also be permissible
under the Act, part 703 of NCUA’s
regulations, and the credit union’s own
investment policy. NCUA is aware that
these collateral restrictions are more
limited than the permissible
investments in the Act and NCUA’s
regulations, but the Board believes
implementing narrower limitations is
necessary to ensure collateral will be
both highly liquid and easy to value.
The Board notes that both Treasury and
agency securities are generally
considered the most liquid debenture
sectors within the fixed-income arena.
Furthermore, limiting agencies to fixedrate and zero-coupon, non-callable
structures further increases liquidity
and ease of valuations. The importance
of collateral in a derivatives transaction
is to protect a credit union in the event
the derivatives counterparty fails.
Requiring highly liquid and easy to
value securities, or cash, will help
ensure credit unions are protected in the
event of a counterparty default. The
Board believes these restrictions will
provide ample collateral options to
derivatives counterparties.
In addition, the proposed rule
requires that derivatives exposures be
fully collateralized. This requirement is
also an integral part of derivatives
clearing requirements for banking
organizations participating in the
derivatives markets, including margins
on collateral. Collateral management
integrally reinforces good counterparty
management.
Credit unions also need to consider
the possible effects of derivatives
transactions on liquidity. This includes
the use of liquid assets as collateral for
transactions which may reduce assets
available for other liquidity needs.
Margin requirements can fluctuate and
require increasing amounts of collateral.
Credit unions with Level II derivatives
authority in particular should be aware
of additional liquidity pressure from
increased margin requirements for
counterparty exposure under potential
stress conditions where the credit
union’s loss on a derivatives position
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increases significantly. The replacement
cost for a terminated or defaulted
derivative transaction can also impinge
on liquidity.
The proposed rule also limits a
collateral custodian to an entity that is
not the counterparty to the transaction
(except for affiliates that are separate
legal entities organized under U.S. law),
is authorized to be a custodian, is
subject to federal or state examination,
and has equity of at least $50 million.
Like the restrictions on counterparties
discussed below, the Board is proposing
this limitation to ensure that any entity
holding collateral in a derivatives
transaction is qualified and well
capitalized so as not to add undue risk
to a derivatives transaction.
3. Counterparty Requirements
In addition to the proposed collateral
requirements to reduce risk to credit
unions, the Board is proposing
counterparty requirements with the
same intent. First, the proposed rule
limits credit risk by limiting permissible
counterparties to swap dealers and
major swap participants as defined by
the Commodity Futures Trading
Commission (CFTC).23 At the time of
this proposed rule, more than 70
domestic swap dealers have
provisionally registered with the CFTC
under its clearing requirements. By
restricting counterparties to swap
dealers and major swap participants, the
Board is limiting counterparties to
established institutions that meet the
standards of and are subject to oversight
by the CFTC. This pool of
counterparties is sufficiently broad for
credit unions to access the derivatives
markets. The proposed rule also limits
counterparties to those doing business
under the laws of the United States to
protect credit unions in case of
counterparty dispute.
Second, the Board is proposing to
require credit unions to develop the
internal capacity to conduct a credit risk
analysis of any potential counterparty.
This means that a credit union must be
able to carefully assess the likelihood of
default and timely repayment of
derivatives obligations. In addition, a
credit union must be aware of the
financial strength of its counterparties,
as well as the counterparty’s capital
buffers to absorb losses and access
liquidity.
4. Reporting
The proposed rule requires the senior
executive officers to deliver a monthly
report to the credit union’s board of
directors on certain aspects of the
23 17
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derivatives program. The proposed rule
defines a credit union’s senior executive
officers as a credit union’s chief
executive officer (typically this
individual holds the title of president or
treasurer/manager), any assistant chief
executive officer (e.g., any assistant
president, any vice president or any
assistant treasurer/manager), and the
chief financial officer (controller) that
are directly within the chain of
command for the oversight of a credit
union’s derivatives program, as
identified in a credit union’s process
and responsibility framework.
This report must include an
identification of noncompliance with
the credit union’s policies or any
applicable law or regulation, including
this rule, utilization limits, an
itemization of the credit union’s
individual positions, a comprehensive
view of the credit union’s balance sheet,
and the cost of executing new
derivatives transactions. The Board
believes it is important for a credit
union’s board of directors to be timely
and accurately informed about the
condition of the derivatives program so
that it can make adjustments in the
derivatives strategy to ensure the short
and long-term goals of the credit union
are met.
The Board also expects that senior
executive officers would receive daily
and weekly reports from individuals
responsible for managing transactions
and tracking risk compliance. While not
included in the rule, the Board believes
this is a prudent strategy to ensure
adequate supervision of the derivatives
program.
5. Systems, Processes, Personnel
The Board believes that appropriate
systems, processes, and personnel are
vital to a safe and successful derivatives
program. The Board, therefore, has
proposed several related requirements.
The Board notes certain differences
between systems, processes, and
personnel requirements for Level I and
those for Level II. The Board believes
that the Level II requirements should be
greater because of the higher transaction
limits. The specific requirements are
discussed below.
a. Personnel
Having the proper personnel in place
at a credit union is fundamental to
ensuring the safety and soundness of a
derivatives program. To ensure a
derivatives program is well managed
and achieves the goals of the credit
union, the board of directors, senior
executive officials, and qualified
derivatives personnel need to have
varying degrees of knowledge and
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expertise to carry out their respective
functions.
i. A Credit Union’s Board of Directors
A credit union’s board of directors is
responsible for establishing the business
plan for the credit union and ensuring
that the policies and programs achieve
the goals of that plan. A credit union’s
board of directors must receive training
before the credit union enters into any
derivatives transactions, and annually
thereafter. This training should educate
the board members on the benefits and
risks associated with derivatives, as well
as how derivatives fit within a credit
union’s balance sheet and can be used
as an effective IRR mitigation tool. The
Board expects this training will provide
a credit union’s board of directors with
the knowledge necessary to fulfill its
fiduciary responsibility and provide
strategic oversight of a derivatives
program. A credit union must make
evidence of this training available
during its next NCUA or SSA
examination.
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ii. Senior Executive Officers
A credit union’s senior executive
officers are tasked with carrying out the
credit union board’s plan for using
derivatives. This includes
understanding the benefits and risks
associated with derivatives as well as
knowing how derivatives fit within the
credit union’s business model and
balance sheet. As these officers are
directly overseeing the day-to-day
operation of a credit union’s derivatives
program, the Board expects them to
have a comprehensive understanding of
derivatives. During a credit union’s
application process, NCUA will
evaluate each senior executive officer
responsible for overseeing the credit
union’s derivatives program to ensure
that each person has the education,
skills, and experience necessary to
oversee a derivatives program that is
managed safely and effectively.
A credit union must immediately
notify NCUA (and, if applicable, the
appropriate SSA) when a senior
executive officer position as defined in
this rule becomes vacant.24 A credit
union must also immediately provide
NCUA (and, if applicable, the
24 Senior executive officer is, for the purposes of
this proposed rule, a credit union’s chief executive
officer (typically this individual holds the title of
president or treasurer/manager), any assistant chief
executive officer (e.g., any assistant president, any
vice president or any assistant treasurer/manager),
and the chief financial officer (controller) that are
directly within the chain of command for the
oversight of a credit union’s derivatives program, as
identified in a credit union’s process and
responsibility framework, discussed in
§ 703.108(b)(2) of the proposed rule.
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appropriate SSA) with documentation
evidencing knowledge and experience
for any person who becomes a senior
executive officer as defined in this rule
while the credit union has derivatives
authority. This supporting
documentation must demonstrate that
the new senior executive officer has the
skill and experience required by the
rule. Failure to provide this
documentation or to show that the new
senior executive officer is qualified
under the rule will mean the credit
union is no longer in compliance with
the rule, and would be subject to the
regulatory violation provisions,
discussed below.
iii. Qualified Derivatives Personnel
In order to engage in any new activity,
it is incumbent on the credit union to
ensure that personnel with appropriate
training and experience are responsible
for the day-to-day activity. The risk of
a derivatives program is not limited by
the complexity of permissible products.
While the Board is proposing ‘‘plain
vanilla’’ interest rate swaps and interest
rate caps as a way to mitigate a credit
union’s IRR, these tools still present
complex issues with the transaction,
risk management, and the operational
aspects of a derivatives program.
The proposed rule requires three
years of experience for qualified
derivatives personnel at a credit union
seeking Level I authority and five years
of experience for Level II. The Board
believes that increased limits correlate
with increased risk, which necessitates
additional experience by a credit
union’s qualified derivatives personnel.
To satisfy the experience requirement of
the proposed rule, qualified derivatives
personnel must have at least the
requisite number of years of direct
transactional experience in the trading,
structuring, analyzing, monitoring, or
auditing of financial derivatives
transactions at a financial institution, a
risk management advisory practice, or a
financial regulatory organization. Staff
must also have the demonstrated
expertise in statement of financial
condition analysis. The Board believes
that direct experience with derivatives
allows a credit union to effectively
manage risk and properly execute all
derivatives transactions.
The Board recognizes the comments
on ANPR II stating that NCUA should
not condition approval on experience
requirements. The Board believes that
without qualified staff, however, a
credit union will not be able to safely
and effectively manage a derivatives
program.
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32199
6. Internal Controls Structure
In addition to having the proper
personnel in place, it is imperative that
a credit union be organized in a way
that ensures the proper level of
oversight, separation of duties, and
reviews and audits. As discussed below,
this proposed rule has six requirements
the Board believes will ensure a credit
union’s derivatives program is operated
safely and soundly.
a. Separation of Duties
An important internal controls
principle is dividing duties so that no
one person has sole control over any
transaction and its recording and
accounting. Separation of duties helps
reduce an employee’s opportunity to
commit and conceal fraud or errors.
Errors in derivatives operations can
result in significant losses because of
the effect of leverage. Accordingly, the
proposed rule requires that as part of its
derivatives management and internal
controls structure, a credit union
maintain separation of duties for the
functions of: (1) Derivatives execution
and oversight; (2) accounting for and
confirmation of derivatives transactions;
(3) ALM; and (4) credit, collateral, and
liquidity management. The Board
believes these core functions must be
accomplished by different people to
ensure an effective system of checks and
balances.
b. Framework
This proposed rule also requires a
credit union with derivatives authority
to maintain, in its written derivatives
policy, a written and schematic
description of the derivatives decision
process. This framework description
must show how decisions on derivatives
are made, starting with the board’s
decision to use derivatives to mitigate
IRR, to the senior executives
formulating a derivatives plan and
choosing the counterparties and
derivatives, to the execution of the
derivatives transaction and the
monitoring and accounting through the
life of the transaction. The Board is
requiring that this framework be both
written and in a schematic or flow chart
form. A visual depiction of a credit
union’s decision process provides the
credit union’s employees and examiners
with a useful summary of who is
making and executing all of the
decisions and functions associated with
the credit union’s derivatives program.
c. Internal Controls Audit
A credit union with Level I or Level
II derivatives authority must, at least
annually, have an internal controls
audit conducted by an external service
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provider. The credit union must ensure
the external service provider is
experienced in auditing derivatives
transactions, including, but not limited
to, valuation methods and risk
management modeling techniques, and
is familiar with the credit union’s IRR
model and the related assumptions and
inputs to test for reasonableness.
The scope of the audit must include
coverage of the accounting, legal,
operating and risk controls. The legal
audit section should ensure executed
contracts are in place with all
counterparties and external service
providers used in the derivatives
program. The auditors will need to
ensure all material contracts have been
reviewed by counsel.
Scoping for operating and risk
controls should include at a minimum
a review of and testing for segregation
of duties to ensure no one party or
department is responsible for executing,
documenting (accounting), and risk
reporting of derivatives transactions
along with compliance with policies
and procedures. In addition, the audit
must address collateral management to
ensure the credit union is adequately
monitoring and valuing its positions
with counterparties. This includes
independent valuations and review of
counterparty pricing reports.
d. Financial Statement Audit
Currently, NCUA only requires
financial statement audits for credit
unions with assets of $500 million or
more.25 The Board, however, is
proposing to require financial statement
audits for any credit union with
derivatives authority. Financial
statement audits express an opinion as
to whether the financial statements
fairly present the credit union’s
financial position and the results of the
operations and its cash flows in
conformity with GAAP. The licensed
certified public accountants responsible
for the financial statement audit must
have experience evaluating derivatives
transactions.
Using derivatives exposes credit
unions to a variety of risks, including
market, counterparty, credit, and
liquidity risks. Consequently, the review
of written policies, internal controls,
financial reporting, and regulatory
requirements is imperative. Because
accurate financial reporting is
paramount to effectively manage risk
and make sound business decisions, the
Board believes it is prudent to require
financial statement audits for all credit
unions with approved derivatives
authority. This is a new requirement
25 12
CFR § 715.5.
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only for those credit unions with assets
between $250 million and $500 million.
The Board is also proposing a
conforming change to part 715 to clarify
that credit unions with assets over $500
million and any credit union engaged in
derivatives must obtain a financial
statement audit.
e. Legal Review
The proposed rule requires a credit
union to obtain a legal opinion from
qualified counsel before executing any
derivatives transaction. Qualified
counsel means an attorney with at least
five years of experience reviewing
derivatives transactions. This attorney
may be the credit union’s in-house
counsel or the credit union may need to
retain outside counsel. The Board is
proposing this requirement to ensure
that any attorney providing a legal
opinion on a credit union’s derivatives
program has the requisite skills and
experience to properly evaluate
International Swap Dealers Association
(ISDA) agreements and compliance.
The legal opinion must conclude that
the credit union’s ISDA agreements are
enforceable and the credit union is in
compliance with all applicable laws and
regulations relating to its derivatives
program. Like the 1998 IRPS, this
proposed rule also requires that a credit
union ensure any counterparty is
authorized to enter into the transaction.
f. Hedge Review 26
The proposed rule requires a credit
union to conduct a hedge review before
executing a derivatives transaction. This
review entails identifying and
documenting the circumstances leading
to the decision to hedge, specifying the
derivatives strategy, and demonstrating
that the derivatives transaction is
protecting against the loss it was
intended to mitigate. The Board
included this requirement to ensure that
two conditions are met: (1) A credit
union with derivatives authority is
using derivatives for their intended
purpose, the mitigation of IRR; and (2)
the credit union has a well thought out
and documented plan of how and why
it will hedge particular IRR on its
balance sheet. The Board believes this
requirement achieves both of these
goals.
7. Transaction Management
The proposed rule requires credit
unions to have support systems in place
to provide accurate and timely
transaction processing. The Board
26 Hedge review means an analysis of the specific
derivatives transaction a credit union is
considering, to ensure that the transaction will
mitigate IRR on the credit union’s balance sheet.
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believes this requirement will help
credit unions ensure that derivatives
transactions are executed in a timely
manner and in accordance with the
policy of the credit union’s board of
directors. Under this requirement, credit
unions should be able to document a
derivatives transaction, including the
price paid, collateral requirements,
identification of the counterparty, life of
the transaction, and reason for the
hedge. Under the reporting section of
the proposed rule, these items must be
included in the monthly report to the
credit union’s board of directors.
Further, the Board believes a credit
union must be able to accurately
account and record a derivatives
transaction, just as it would any other
transaction.
8. Asset Liability Management (ALM)
The proposed rule describes the
management of derivatives as part a
credit union’s overall ALM. It is critical
for the credit union to have staff with
sufficient expertise to perform this
function. It is equally important for the
credit union to have an ALM function
in place that is sufficiently welldeveloped to measure, monitor, and
control all aspects of the credit union’s
statement of financial condition,
including the credit union’s derivatives
activities. A credit union will need to
manage the risk of derivatives
transactions itself, within a clearly
stated ALM strategy, while testing and
demonstrating the effectiveness of these
transactions in reducing IRR exposure.
Therefore, as well as testing past
effectiveness, a credit union must assess
the likely effectiveness of its derivatives
transactions in reducing IRR exposure
going forward under a range of stressed
rate and statement of financial condition
scenarios. The credit union will also
need to consider a variety of alternative
strategies to reduce IRR in order to
perform this function successfully.
The proposed rule identifies a number
of ALM process elements that are
necessary to successfully manage
derivatives activity. Clear,
comprehensive reporting by senior
management to the credit union’s board
of directors is essential to identify any
policy exceptions and to ensure that
management of derivatives is clear and
transparent at the highest level. The
credit union should state individual and
aggregate derivatives exposure within
the context of the overall balance sheet
of the credit union. The credit union
should clearly capture, monitor, and
report the cost of these transactions.
Appropriate separation of duties is
necessary to maintain accurate review
and disclosure. The credit union will
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need ALM systems that are able to
identify the value of any of its
derivatives transactions, and must have
the capacity to state this value as part
of a net economic value calculation of
the credit union’s balance sheet.
9. External Service Providers
The Board believes external service
providers (ESPs) 27 can play a vital role
in the overall success of a derivatives
program. The Board, however, is
concerned that overreliance on ESPs in
the complex area of derivatives may
lead to additional risk to the credit
union. Potential conflicts exist because
external parties do not share the same
fiduciary responsibility as the credit
union and they have financial objectives
and incentives that are different as well.
The Board, therefore, is proposing to
allow credit unions to utilize ESPs in
limited ways, provided that credit
unions meet certain conditions and
restrictions. In addition, the Board is
proposing differing levels of ESP
involvement for credit unions with
Level I and Level II authority. As noted
above, credit unions with Level II
authority must have a higher degree of
infrastructure and experience to obtain
a higher level of authority. Behind this
requirement is the idea that these credit
unions should have more internal
capacity, and, therefore, less reliance on
ESPs, than credit unions with Level I
authority.
First, the proposed rule prohibits
credit unions from using ESPs that are
principals or agents to derivatives
transactions involving the credit union.
NCUA is aware that some credit unions
have ESP relationships with firms that
provide services and act as agents or
principals for securities trades. Unlike
securities, derivatives transactions are
unique agreements between two parties
and pricing transparency is typically
considerably more limited. This limited
transparency makes it harder for a credit
union to determine what fees are being
charged to execute the transaction.
Additionally, principals or agents may
have an incentive to enter into
derivatives trades to generate income for
themselves. The potential conflicts of
interest and the limited transparency are
the primary reasons for the prohibition
on ESPs being principals or agents in
derivative transactions. The Board
further believes that credit unions have
sufficient alternatives for ESPs beyond
principals or agents in derivative
transactions.
Second, the Board believes that credit
unions can make responsible use of
contractual services provided by
independent ESPs, as part of an
effective derivatives and balance sheet
management process. Responsible use of
ESPs requires a credit union to have the
internal capacity, experience and skills
to oversee and manage any ESP
activities. More generally, a credit union
must retain responsibility and control
over the derivatives and balance sheet
management process and decision
making. The credit union is responsible
for managing ESP work products and
must have a full understanding of ESPs’
activities.
While the Board supports the use of
ESPs, there are some activities that the
Board believes are so central to
demonstrating effective managerial
control that the credit union must
conduct them.28 The Board is proposing
to allow Level II credit unions more
restricted use of ESPs because it
believes that institutions able to take
greater risks must have greater in-house
risk-management capabilities.
The proposed rule classifies a number
of activities into two categories of
permissible use of contractual services
and support. The functions in each
classification vary between Level I and
Level II authority. The two
classifications are:
Support: A credit union is required to
conduct the functions in this category.
ESPs can provide assistance and input,
but a credit union is prohibited from
allowing an ESP to conduct the function
or activity in lieu of the credit union.
Conduct: A credit union may contract
with an ESP to conduct a function or
activity in this category as part of the
management and internal controls
structure. While a credit union is
responsible for managing an ESP’s work
quality and must have full
understanding of all ESP activities and
work products, it is not required to
maintain in-house capacity for the
function or activity. The table below
summarizes the permissible uses of
ESPs outlined in the proposed rule.
Level I
Level II
Function
Support
Conduct
Support
Conduct
Asset Liability Management .............................................................................................................
Accounting and Reporting ...............................................................................................................
Credit Risk .......................................................................................................................................
Counterparty Exposure Management ..............................................................................................
Collateral Management ....................................................................................................................
Liquidity Risk ....................................................................................................................................
Trade Execution ...............................................................................................................................
Transaction Management ................................................................................................................
Financial Statement Auditing ...........................................................................................................
Legal Services .................................................................................................................................
X
................
X
................
................
X
................
................
................
................
................
X
................
X
X
................
X
X
X
X
X
................
X
X
X
X
................
X
................
................
................
X
................
................
................
................
X
................
X
X
10. Limits
intended to provide credit unions with
sufficient tools to manage IRR based on
the credit union’s ability to
independently manage its derivatives
program. The Board, in establishing the
limits, is also trying to limit the amount
of potential loss exposure derivatives
transactions may cause the credit union
and NCUSIF. Derivatives exposure
limits are measured differently for
interest rate caps and interest rate
swaps. The Board chose relatively
simple measurement tools and
acknowledges they may not fully
capture all risks associated with
derivative exposure. However, the
wholly owned by the credit union receiving the
services.
28 For purposes of this rule, a wholly owned
credit union service organization may perform these
functions for the credit union that wholly owns it.
If the CUSO provides services to other credit
unions, it will be an ESP and subject to the
restrictions in the proposed rule.
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a. Interest Rate Swaps and Interest Rate
Caps
The proposed rule includes limits for
Level I and Level II authorities on the
amount of derivatives exposure a credit
union may take. These limits are
27 An external service provider is any entity that
provides services to assist a credit union in carrying
out its derivatives program and the requirements of
this rule. An external service provider does not
include a credit union service organization that is
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Board is comfortable that the
methodology limits loss exposure, is
easy to understand, and will allow
credit unions to manage their IRR
exposure. In addition, the Board chose
these proposed limits with the intent
that derivatives would not provide
every credit union with complete IRR
mitigation. Rather, the Board intends
derivatives to be one part of an overall
IRR mitigation strategy.
The proposed limit on interest rate
caps is measured by the exposure of
book value to net worth. The Board
chose book value as the limit’s
measurement basis since it measures the
amount of net worth at risk if the cap
becomes worthless through the event of
a default by the counterparty. Interest
rate caps are typically purchased with
strike rates 29 above current rates and
pay the purchaser when interest rates
increase above the strike rate. The
premium that a purchaser pays at
inception of the interest rate cap
represents the maximum amount of
potential loss to net worth on day one
of the transaction. This premium will
fluctuate over time, and value changes
are reflected through changes in the
income statement. GAAP hedge
accounting treatment dictates whether
the premium can be amortized or is
subject to changes in fair value. The
Board considered using notional value
as a limitation, but decided book value
was a more appropriate measurement
because it accurately captures the risk
associated with interest rate caps
without unreasonably limiting a credit
union’s ability to mitigate IRR. The
Board specifically requests that
interested stakeholders provide
suggestions of alternative methodologies
to measure and limit cap exposure for
credit unions and explain why the
alternative is better than book value.
The Board requests that any alternative
measurement for credit unions to
measure and report be straightforward.
The proposed limit on interest rate
swaps is measured using notional
exposure and fair value loss. Both
measurements use the credit union’s net
worth as the basis. The Board chose two
separate types of limitations for interest
rate swaps based on lessons learned
from the corporate credit union crisis.
Unlike interest rate caps, an interest rate
swap can result in the credit union
owing the counterparty if rates move the
opposite way from which the credit
union is hedging. This loss can be
magnified if the value of the hedged
assets declines. Therefore, the Board is
proposing to limit the notional amount
29 Strike rate means the interest rate that triggers
payments to the credit union under the contract.
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of swap exposure a credit union may
have regardless of whether the credit
union is in a fair value gain or loss
position. Further, the Board is
proposing fair value loss limits that
trigger a suspension of derivatives
transactions and the submission of a
corrective action plan if the credit union
reaches certain levels of losses. As noted
above, the proposed rule contains
different loss limits for Level I and Level
II.
The proposed rule allows credit
unions with Level I authority to have
book value of up to 10% of net worth
in caps and up to a notional value of
100% of net worth in swaps exposure
with a total fair value loss limit on
swaps of 10% of net worth. A credit
union with Level I authority using both
interest rate swaps and interest rate caps
will be subject to a combined limit. The
combined limit requires that the sum of
the percentage utilization of the interest
rate swaps limit and interest rate caps
limit is less than or equal to 100%. For
example, consider a credit union that
holds interest rate swaps with a notional
balance equal to 75% of net worth (or
75% of the interest rate swaps limit) and
interest rate caps with an aggregate book
value equivalent 2.5% of net worth (or
25% of the interest rate caps limit).
Combining the interest rate caps and
interest rate swaps limits utilization
percentages (75% + 25%) equals 100%.
Therefore this credit union is at the
limit and unable to add additional
derivative positions.
Both the interest rate swaps limit and
the interest rate caps limit are designed
to make identifying and tracking
exposure easy for credit unions. The
Board believes these limits are
appropriate given the risks, personnel,
and systems required under the
proposed rule for Level I authority,
which are discussed above. The Board
also believes these limits are sufficient
for credit unions with lower levels of
IRR and infrastructure to adequately use
derivatives as an additional IRR
mitigation tool.
The proposed rule allows credit
unions with Level II authority to have
book value of up to 25% of net worth
in interest rate caps and up to a notional
value of 250% of net worth in interest
rate swaps exposure with a total fair
value loss limit on interest rate swaps of
25% of net worth. NCUA will establish
a combined limit for credit unions with
Level II authority up to the maximum
limit for caps and swaps. NCUA will
establish this limit during the approval
process based on the resources and need
of the applying credit union. The Board
believes these higher limits, in contrast
to those for Level I, are appropriate
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given the added requirements for Level
II credit unions. These higher limits will
allow a credit union with considerably
more infrastructure and experience to
utilize additional derivatives to mitigate
higher levels of IRR.
As identified in the discussion of the
Level I and Level II limits on swaps, the
proposed rule includes limits on a
credit union’s loss on swaps. The Board
believes it is appropriate to include this
additional limit on swaps given their
riskier nature and the potential for
losses. The Board’s goal is to ensure the
financial health of a credit union is not
jeopardized by the declining value of
swaps positions. The difference in the
individual limits in this area reflects a
higher level of experience and
derivatives management capability at
Level II credit unions, as well as a
higher level of regulatory due diligence
at the time NCUA reviews a credit
union applying for Level II authority.
b. Maturity
In addition to the limits discussed
above, the proposed rule includes limits
on the individual maturities of
derivatives transactions and the
combined weighted average life of
derivatives transactions for both Level I
and Level II. Unlike exposure limits,
these limits are applied equally to
interest rate caps and interest rate swaps
and are based on the notional amount.
The Board notes that, like bonds, the
risk of derivatives transactions increases
as the maturity length increases. The
Board believes that limiting the term of
individual transactions and the
weighted average life of the portfolio is
an additional way to limit losses for a
credit union and the NCUSIF, while not
hindering a credit union’s ability to
mitigate IRR.
The proposed rule prohibits a credit
union with Level I derivatives authority
from having individual derivatives
transactions that exceed a maturity of
seven years. Further, the weighted
average life of all derivatives in the
credit union’s portfolio cannot exceed
five years. The Board believes these
limits are appropriate given the risks,
personnel, and systems required for
Level I authority.
Conversely, the proposed rule
prohibits credit unions with Level II
derivatives authority from having
derivatives transactions that have a
maturity longer than ten years or a
weighted average life of all derivatives
in its portfolio greater than seven years.
These longer maturities reflect the
increased requirements for and
supervision of a credit union with Level
II authority.
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The following table illustrates the
differing limits between Level I and
Level II:
Authority
Level I
Level II
Interest Rate Caps ..........................
Interest Rate Swaps ........................
Book value of up to 10% of net worth ......................
• Notional value of up to 100% of net worth ............
• Must suspend derivative activity if total fair value
of swap loss position exceeds 10% of net worth.
A weighting between both limits to equal 100%. For
example, 50% of cap limit would allow for 50% of
swap limit.
• Derivative portfolio weighted average life limit of
5-years.
• Single transaction maturity limit of 7-years ...........
Book value of up to 25% of net worth.
• Notional value of up to 250% of net worth.
• Must suspend derivative activity if total fair value
of swap loss position exceeds 25% of net worth.
Determined during approval process.
Combined Limits .............................
Tenor Limits ....................................
G. Application Procedures and Content
and Review
The Board is proposing an application
process that requires an applying credit
union to demonstrate the requisite
systems and expertise to support
derivatives. In accordance with the
increased levels for a credit union
applying for Level II authority, the
application process for this authority
will be more thorough and will include
an NCUA on-site review of the
derivatives program infrastructure.
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1. Application Content
The application process begins with
the credit union submitting
comprehensive documentation
demonstrating that it meets the
requirements for the level of authority it
is applying for. The Board considers
derivatives authority as an advanced
ALM tool and expects a credit union’s
infrastructure to sufficiently support the
activity. Application requirements
represent items the Board regards as
necessary components of enhanced
ALM and critical derivatives program
functions.
A credit union applying for either
level must provide an IRR mitigation
plan, which demonstrates how
derivatives fit within that plan. The
Board notes that while the need to
mitigate IRR may be a prospective need,
a credit union may not use derivatives
to speculate. A credit union’s plan
should show that derivatives are an
effective part of a credit union’s IRR
mitigation plan and that the credit
union has other tools it is using to
mitigate IRR. In addition to this
requirement, a credit union applying for
Level II authority must demonstrate
why the limits in Level I are insufficient
for its IRR mitigation needs. A credit
union should be able to show in its
application that even after employing
other mitigation strategies it still has a
need for derivatives limits that are
higher than under Level I.
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• Derivative portfolio weighted average life limit of
7-years.
• Single transaction maturity limit of 10-years.
A credit union’s senior executive
officers and board of directors must
understand how derivatives fit within
the credit union’s business model and
balance sheet and be able to articulate
how they intend to use ESPs. A credit
union applying for Level I must
demonstrate how it plans to acquire and
employ the necessary systems,
personnel and infrastructure, and do so
before transacting in derivatives. A
credit union, however, applying for
Level II authority must have these in
place before it applies. This requirement
for Level II ensures that NCUA can
adequately evaluate all of the
components of the proposed derivatives
program during its onsite review.
2. Application Review
After a credit union has compiled all
of the information for its application, it
must submit it to NCUA, or its SSA in
the case of a FISCU. An SSA will
evaluate an application and send its
decision to NCUA for concurrence.
Once the Field Director receives a
complete application or a decision from
an SSA, as applicable, NCUA will begin
its review process. The Board notes that
NCUA will not begin its review of an
application until the appropriate Field
Director determines that the application
is complete and in compliance with the
regulation and any applicable
supervisory guidance. The proposed
rule requires that a Field Director make
this determination within 30 days of the
date it receives an application from a
credit union. NCUA will use its best
efforts to review every application as
quickly as possible.
The proposed rule provides that
NCUA will approve or deny a credit
union’s application within 90 days for
Level I and 120 days for Level II. These
time limits begin when a Field Director
determines it has a complete application
from an FCU or a decision from an SSA
for FISCU applicants.
Given the complex nature of
derivatives and the level of due
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diligence the agency must perform to
ensure derivatives programs are safe and
sound, the Board believes these time
frames are reasonable. The Board
recognizes that a review of a derivatives
program will vary between credit
unions and the Board wants to ensure
field staff has adequate time to conduct
a thorough review. In addition, while
not required under the proposed rule, it
may be necessary for NCUA to conduct
an onsite review of a credit union
applying for Level I authority.
3. Appeals
The proposed rule also permits a
credit union that has had its application
denied by a Field Director to appeal to
NCUA’s Supervisory Review Committee
within 60 days from the date of denial.
For any final rule that becomes
effective, the Board would make a
corresponding change to IRPS 11–1,
which lists the issues that credit unions
may appeal to NCUA’s Supervisory
Review Committee.
H. Pilot Program Participants and
FISCUs With Derivatives
The Board recognizes that current
participants in the various derivatives
pilot programs and FISCUs with active
positions may not meet the
requirements of a final rule promulgated
by the Board. The Board wants to
provide these credit unions with
sufficient time to bring their programs
into compliance with a final rule. This
proposed rule, therefore, includes a
section addressing this goal.
Specifically, the proposed rule
provides that any credit union that, as
of January 1, 2013, is holding
derivatives under an NCUA derivatives
pilot program or state law has 12months from the effective date of a final
rule to come into compliance with the
rule’s requirements. The Board set a
date of January 1, 2013, to ensure that
only credit unions with active positions
before publication of this proposed rule
could take advantage of the 12-month
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grace period. Compliance would
include submitting an application for
review under the provisions of the rule.
During this 12-month period, a pilot
participant is permitted to continue
operating its derivatives program in
accordance with its pilot program terms
and conditions. A FISCU may also
continue to operate its derivatives
program under the applicable state law
during this time period.
If a credit union fails to meet the
requirements of the rule after 12
months, the rule requires that the credit
union immediately cease entering into
new derivatives transactions and within
30 days present a corrective action plan
to NCUA (and SSA, in the case of a
FISCU) outlining how and when it will
cure any deficiencies or how it will
unwind its derivatives program. A
credit union under a corrective action
plan is not permitted to enter into any
new derivatives transactions until
notified by NCUA.
A credit union that is otherwise in
compliance with the rule, but is holding
active positions it purchased prior to
January 1, 2013, will not be subject to
the corrective action plan requirements
discussed above. Rather, the credit
union will be required to inform NCUA
and the SSA, in the case of a FISCU,
how it will handle these active
positions.
I. Regulatory Violation
The proposed rule provides a system
of corrective action if a credit union
with derivatives authority fails to
comply with the rule, has safety or
soundness concerns identified by
NCUA, or fails to employ the resources,
policies, processes, and competencies
that it identified in its application for
approval. If NCUA determines a credit
union has failed any of these aspects,
the credit union must immediately
cease entering into any new derivatives
transactions and must also present a
corrective action plan to NCUA and the
SSA, in the case of a FISCU, within 30
days.
A credit union’s corrective action
plan must address the deficiencies
identified by NCUA and how the credit
union will promptly fix these
deficiencies. NCUA will evaluate all
corrective action plans to determine if
they are realistic and sufficient to
remedy the deficiencies. In the case of
a FISCU, this plan must also be
approved by the applicable SSA. If
NCUA, and the SSA, if applicable,
approve a credit union’s corrective
action plan, NCUA will also notify the
credit union when it is permitted to
begin entering into new derivatives
transactions.
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In addition to or in lieu of a corrective
action plan, NCUA may terminate a
credit union’s derivatives authority
based on a violation of NCUA’s
regulations or safety and soundness
concerns. NCUA will only require
divestiture if it determines that doing so
would not pose additional risks to the
credit union.
J. Application Fees
The Board is considering instituting a
fee structure for those credit unions that
apply for derivatives authority. As
discussed above, NCUA’s application
review process and ongoing enhanced
supervision is labor and resource
intensive. Rather than pass this cost on
to the credit union industry as a whole,
the Board believes it may be prudent to
pass this cost directly to the credit
unions seeking approval. Application
fees may also serve as a deterrent to
credit unions that are unsure whether or
not they can meet all of the
qualifications required to implement a
safe and sound derivatives program.
The Board is considering a Level I
application fee with amounts starting at
$25,000 and a Level II application fee
with amounts ranging from $75,000 to
$125,000 based on the complexity of the
application. The Board would set this
fee in periodic guidance based on the
evolving costs of processing an
application.
In addition, the Board will maintain
authority to modify the Level II
application fee if the credit union
operates under Level I authority for a
period of time. The Board notes that
NCUA will expend fewer resources to
review the Level II application of a
Level I credit union due to familiarity
with the credit union’s current
practices. This situation may warrant a
reduced Level II application fee. This
reduction in application fee would
largely depend on the length of time a
credit union operates under Level I
authority before applying for Level II
authority. The Board also notes that this
application fee would be in addition to
any fees charged by an SSA for an
application by a FISCU. The Board is
interested in comments on this
approach.
K. Supervision and/or Examination Fees
In addition to application fees, the
Board is seeking comments on the pros
and cons of recovering the costs of
ongoing supervision of credit unions
engaged in derivatives. The Board is
particularly interested in comments as
to whether annual NCUA costs for staff,
contractors, and/or examination hours
should be borne entirely by the credit
unions engaged in derivatives.
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For example:
• Should NCUA charge an annual
licensing fee to the credit unions
approved to engage in derivatives?
• Should NCUA charge credit unions
that have purchased derivatives for
examination time spent evaluating their
derivatives activity?
• How would NCUA isolate and
determine the staff hours involved in
supervision of derivatives activity?
• Would an annual licensing fee or
additional yearly charge act as a
deterrent to qualified credit unions from
using derivatives to mitigate IRR?
In responding to the above questions,
it should be noted that the Board would
not intend for any annual charges to act
as a deterrent to qualified credit unions
but rather as a more equitable way of
assessing the cost of the derivatives
program. The Board intends to
encourage qualified credit unions to
purchase risk-mitigating derivatives.
Commenters might want to consider
who would benefit if more credit unions
engage in risk-mitigating derivatives and
if NCUA enhances derivatives
supervision:
• Would credit unions that purchase
derivatives and successfully mitigate
IRR benefit directly from a reduction in
potential losses?
• Would that reduction in potential
losses at credit unions with more than
$250 million in assets benefit the
NCUSIF?
• Would all federally insured credit
unions benefit indirectly from NCUA’s
enhanced supervision of derivatives?
L. Changes to Part 715
As noted above, the Board is also
proposing a change to § 715.2 to clarify
the financial statement audit
requirement. Currently, this section
only requires a credit union over $500
million in assets to obtain a financial
statement audit. The proposed change
clarifies that this requirement is in
addition to the requirement in this rule
that any credit union with derivatives
authority, regardless of size, must obtain
a financial statement audit.
M. Changes to Part 741
Subpart B of part 741 contains a list
of regulations that, by their terms, apply
only to FCUs but that NCUA has
determined, for safety and soundness
reasons, apply to FISCUs. Section 219 of
part 741 addresses investments,
providing that FISCUs must follow the
requirements in part 703 regarding
purchasing shares or deposits in
corporate credit unions.30 The proposed
rule designates that provision as
30 12
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paragraph (a) of section 219 and adds a
new paragraph (b) which requires
FISCUs, which are permitted by state
law to engage in derivatives
transactions, to follow the requirements
in subpart B of part 703.
III. Regulatory Procedures
a. Regulatory Flexibility Act
The Regulatory Flexibility Act
requires NCUA to prepare an analysis of
any significant economic impact any
proposed regulation may have on a
substantial number of small entities
(primarily those under $50 million in
assets).31 The proposed rule allows
credit unions to enter into certain
derivatives transactions to reduce IRR.
Since the proposed rule requires credit
unions seeking derivatives authority to
have at least $250 million in assets, it
will not have a significant economic
impact on a substantial number of small
credit unions.
tkelley on DSK3SPTVN1PROD with PROPOSALS
b. Paperwork Reduction Act
The Paperwork Reduction Act of 1995
(PRA) applies to rulemakings in which
an agency by rule creates a new
paperwork burden on regulated entities
or increases an existing burden.32 For
purposes of the PRA, a paperwork
burden may take the form of a reporting
or recordkeeping requirement, both
referred to as information collections.
The proposed changes to part 703
impose new information collection
requirements. As required by the PRA,
NCUA is submitting a copy of this
proposal to OMB for its review and
approval. Persons interested in
submitting comments with respect to
the information collection aspects of the
proposed rule should submit them to
OMB at the address noted below.
1. Estimated PRA Burden
For the purposes of calculating the
PRA burden, NCUA estimates that 150
credit unions will apply for and be
granted derivatives authority. NCUA
further estimates that approximately 75
percent of this number, or 113, will be
Level I credit unions and 25 percent, or
37, will be Level II credit unions.
Section 703.104 of the proposed rule
requires a credit union to operate
according to written, comprehensive
policies and procedures for control,
measurement, and management of
derivatives transactions. To do so, a
credit union must first develop such
policies and procedures. NCUA
estimates that it will take a credit union
seeking Level I derivatives authority an
average of 40 hours to develop
31 5
U.S.C. 603(a).
U.S.C. 3507(d); 5 CFR part 1320.
32 44
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appropriate policies and procedures and
a credit union seeking Level II authority
80 hours to do so. This is a one-time
recordkeeping burden.
Section 703.104(b) of the proposed
rule requires a credit union’s board of
directors to review the derivatives
policies and procedures annually and
update them when necessary. NCUA
estimates this ongoing recordkeeping
burden will take an average of 10 hours
per year per Level I or Level II
respondent.
Section 703.107 of the proposed rule
requires a credit union’s senior
executive officers to provide a monthly,
comprehensive derivatives report to the
credit union’s board of directors. NCUA
estimates this ongoing recordkeeping
burden will take an average of 2 hours
per month (24 hours per year) per Level
I or Level II respondent.
Section 703.108(a)(1) of the proposed
rule requires that a credit union retain
evidence of annual derivatives training
for its board of directors. NCUA
estimates this ongoing recordkeeping
requirement will take an average of 4
hours per year per Level I or Level II
respondent.
Section 703.108(b)(2) of the proposed
rule requires that a credit union
maintain a written and schematic
description of the derivatives decision
process. NCUA estimates that the onetime recordkeeping burden of creating
the description will take 10 hours per
Level I respondent and 20 hours per
Level II respondent. The ongoing
burden of maintaining the description
will take 2 hours per year per Level I or
II respondent.
Section 703.108(b)(4) of the proposed
rule requires a credit union engaging in
derivatives transactions to obtain an
annual financial statement audit by a
certified public accountant. Section
715.5(a) of NCUA’s Regulations already
requires FCUs with assets of $500
million or greater to obtain an annual
financial statement audit. Currently,
approximately 60 credit unions with
assets between $250 million and $500
million that meet the proposed CAMEL
ratings requirements do not obtain
annual financial statement audits. Due
to the overhead costs associated with
derivatives activity, NCUA estimates
that 20 percent, or 12, of these credit
unions will apply for and be granted
derivatives authority. NCUA further
estimates that a financial statement
audit for a credit union of this size
would cost approximately $50,000.
Section 703.108(b)(6) of the proposed
rule requires a credit union, before
executing a derivatives transaction, to
identify and document the
circumstances leading to the decision to
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32205
hedge, specify the derivatives strategy
the credit union will employ, and
demonstrate the economic effectiveness
of the hedge. NCUA estimates a credit
union will execute an average of 2
transactions per year and that it will
take an average of 2 hours per
transaction to complete the preexecution analysis. This results in an
ongoing recordkeeping burden of 4
hours per year per respondent.
Sections 703.111 and 703.112 of the
proposed rule require a credit union
seeking Level I or Level II derivatives
authority to submit a detailed
application to NCUA. NCUA estimates
that this one-time recordkeeping burden
will take an average of 50 hours per
respondent to prepare. This estimate
does not include developing policies
and procedures for operating a
derivatives program and creating and
maintaining a written and schematic
description of the derivatives decision
process, as those recordkeeping
requirements are already accounted for
above.
Section 703.117 of the proposed rule
requires a credit union that no longer
meets the requirements of subpart B of
part 703 to submit a corrective action
plan to NCUA. NCUA estimates that 6
credit unions may have to submit an
action plan each year and that a plan
will take an average of 10 hours to
prepare.
Summary of Collection Burden
Written policies and procedures:
113 Level I credit unions × 40 hours
= 4520 hours (one-time burden).
37 Level II credit unions × 80 hours
= 2960 hours (one-time burden).
Board review of policies and
procedures:
150 credit unions × 10 hours = 1500
hours.
Monthly derivatives report:
150 credit unions × 24 hours = 3600
hours.
Evidence of Board training:
150 credit unions × 4 hours = 600
hours.
Derivatives process description:
113 Level I credit unions × 10 hours
= 1130 hours (one-time burden).
37 Level II credit unions × 20 hours
= 740 hours (one-time burden).
150 credit unions × 2 hours = 300
hours.
Financial statement audit:
12 credit unions × $50,000 =
$600,000.
Pre-execution analysis:
150 credit unions × 4 hours = 600
hours.
Application:
150 credit unions × 50 hours = 7500
hours (one-time burden).
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Corrective action plan:
6 credit unions × 10 hours = 60 hours.
Total Annual Hours Burden:
23,510 (16,850 one-time only).
Total Annual Cost Burden:
$600,000.
2. Submission of Comments
NCUA considers comments by the
public on this proposed collection of
information in:
• Evaluating whether the proposed
collection of information is necessary
for the proper performance of the
functions of NCUA, including whether
the information will have a practical
use;
• Evaluating the accuracy of NCUA’s
estimate of the burden of the proposed
collection of information, including the
validity of the methodology and
assumptions used;
• Enhancing the quality, usefulness,
and clarity of the information to be
collected; and
• Minimizing the burden of collection
of information on those who are to
respond, including through the use of
appropriate automated, electronic,
mechanical, or other technological
collection techniques or other forms of
information technology; e.g., permitting
electronic submission of responses.
The Paperwork Reduction Act
requires OMB to make a decision
concerning the collection of information
contained in the proposed regulation
between 30 and 60 days after
publication of this document in the
Federal Register. Therefore, a comment
to OMB is best assured of having its full
effect if OMB receives it within 30 days
of publication. This does not affect the
deadline for the public to comment to
NCUA on the substantive aspects of the
proposed regulation.
Comments on the proposed
information collection requirements
should be sent to: Office of Information
and Regulatory Affairs, OMB, New
Executive Office Building, Washington,
DC 20503; Attention: NCUA Desk
Officer, with a copy to Mary Rupp,
Secretary of the Board, National Credit
Union Administration, 1775 Duke
Street, Alexandria, Virginia 22314–
3428.
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c. Executive Order 13132
Executive Order 13132 encourages
independent regulatory agencies to
consider the impact of their actions on
state and local interests. NCUA, an
independent regulatory agency as
defined in 44 U.S.C. 3502(5), voluntarily
complies with the executive order to
adhere to fundamental federalism
principles. The proposed rule does not
have substantial direct effects on the
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states, on the relationship between the
national government and the states, or
on the distribution of power and
responsibilities among the various
levels of government. While the Board
notes that this proposed rule applies to
certain FISCUs, the Board does not
believe that this rule rises to the level
of a regulation ‘‘that has substantial
direct effects on the States, on the
relationship between the national
government and the States, or on the
distribution of power and
responsibilities among the various
levels of government. This rule does not
grant any authority to FISCUs that has
not been granted by applicable state
law. In addition, any FISCU applying
must apply to its state first and NCUA
must concur with the state’s
determination. NCUA has, therefore,
determined that this proposal does not
constitute a policy that has federalism
implications for purposes of the
executive order.
d. Assessment of Federal Regulations
and Policies on Families
NCUA has determined that this
proposed rule will not affect family
well-being within the meaning of § 654
of the Treasury and General
Government Appropriations Act, 1999,
Pub. L. 105–277, 112 Stat. 2681 (1998).
e. Agency Regulatory Goals
NCUA’s goal is to promulgate clear
and understandable regulations that
impose minimal regulatory burden. The
Board requests comments on whether
this rule is understandable and
minimally intrusive.
List of Subjects
Authority: 12 U.S.C. 1757(7), 1757(8),
1757(15).
2. Existing sections §§ 703.1 through
703.20 are redesignated under the
following subpart A heading:
■
Subpart A—General Investment and
Deposit Activities
*
*
*
*
*
3. Amend § 703.2 by revising the
definitions of ‘‘derivatives’’ and ‘‘fair
value’’ and adding definitions of
‘‘forward sales commitment’’ and
‘‘interest rate lock commitment’’ to read
as follows:
■
§ 703.2
Definitions.
*
*
*
*
*
Derivatives means an instrument that
has its price based on or derived from
one or more underlying assets.
*
*
*
*
*
Fair value means the price that would
be received to sell an asset or paid to
transfer a liability in an orderly
transaction between market participants
at the measurement date, as defined by
GAAP.
*
*
*
*
*
Forward sales commitment means an
agreement to sell a property at a price
and future date specified in the
agreement.
*
*
*
*
*
Interest rate lock commitment means
an agreement by a credit union to hold
a certain interest rate and points for a
specified amount of time while a
borrower’s application is processed.
*
*
*
*
*
■ 4. Add paragraph (k) to § 703.14 to
read as follows:
§ 703.14
12 CFR Part 703
Credit unions, Investments.
Permissible investments.
*
12 CFR Part 715
Audits, Credit unions, Supervisory
committees.
12 CFR Part 741
Credit, Credit unions, Reporting and
recordkeeping requirements, Share
insurance.
By the National Credit Union
Administration Board, on May 16, 2013.
Mary F. Rupp,
Secretary of the Board.
For the reasons discussed above, the
National Credit Union Administration
proposes to amend parts 703, 715, and
741 as follows:
*
*
*
*
(k) Derivatives. A federal credit union
may only enter into in the following
derivatives transactions:
(1) Any derivatives permitted under
§ 701.21(i) of this chapter, § 703.14(g), or
subpart B of this part;
(2) Embedded options not required
under generally accepted accounting
principles (GAAP) adopted in the
United States to be accounted for
separately from the host contract; and
(3) Interest rate lock commitments or
forward sales commitments made in
connection with a loan originated by a
federal credit union.
§ 703.16
[Amended]
PART 703—INVESTMENT AND
DEPOSIT ACTIVITIES
5. Remove paragraph (a) of § 703.16
and redesignate paragraphs (b), (c), (d),
as (a), (b), (c), respectively.
■ 6. Add subpart B to read as follows:
1. The authority citation for part 703
continues to read as follows:
Subpart B—Derivatives Authority
Sec.
■
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■
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703.100 Purpose and Scope.
703.101 Definitions.
703.102 Permissible derivatives
transactions.
703.103 Eligibility.
703.104 Policies and procedures for
operating a Level I or Level II program.
703.105 Collateral requirements for
operating a Level I or Level II program.
703.106 Counterparty requirements for
operating a Level I or Level II program.
703.107 Reporting requirements for
operating a Level I or Level II program.
703.108 Systems, processes, and personnel
requirements for operating a Level I or
Level II derivatives program.
703.109 Specific Level I limits and
requirements.
703.110 Specific Level II limits and
requirements.
703.111 Applying for Level I or Level II
authority.
703.112 Application content.
703.113 Application review by regulators.
703.114 Pilot program participants and
FISCUs with active derivatives positions.
703.115 Regulatory violation.
Authority: 12 U.S.C. 1757(7), 1757(8), 1757
(15).
Subpart B—Derivatives Authority
§ 703.100
Purpose and Scope.
(a) Application of this subpart. Unless
explicitly specified otherwise, the
requirements of this subpart apply to:
(1) Federal credit unions; and
(2) Federally insured, state-chartered
credit unions that are permitted to
engage in derivatives transactions under
applicable state law.
(b) Sections 703.101–703.109 and
703.111–703.116 apply to a Level I
derivatives program. Sections 703.101–
703.108 and 703.110–703.116 apply to a
Level II derivatives program.
(c) Purpose. This subpart allows
credit unions to purchase interest rate
caps and enter into interest rate swap
transactions exclusively for the purpose
of reducing their interest rate risk
exposure.
tkelley on DSK3SPTVN1PROD with PROPOSALS
§ 703.101
Definitions.
For purposes of this subpart:
(a) Book value means the value at
which the derivative is carried on a
statement of financial condition
prepared in accordance with GAAP;
(b) Counterparty means the other
party that participates in a derivatives
transaction;
(c) Derivative means an instrument
that has its price based on or derived
from one or more underlying assets;
(d) Economic effectiveness means the
extent to which a derivatives transaction
results in offsetting changes in the
interest rate risk that the transaction
was, and is, intended to provide;
(e) External service provider means
any entity that provides services to
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assist a credit union in carrying out its
derivatives program and the
requirements of this rule;
(f) Fair value has the meaning
specified in § 703.2 of subpart A of this
part;
(g) Field Director means an NCUA
Regional Director, the Director of the
Office of National Examinations and
Supervision, or any other NCUA
Director designated to directly supervise
credit unions eligible to apply for this
authority;
(h) Hedge means to enter into a
derivatives transaction to protect against
loss created by changes in interest rates;
(i) Interest rate cap means a contract,
based on an interest rate, for payment to
the purchaser when the interest rate
rises above a level specified in the
contract;
(j) Interest rate risk means the
estimated change in earnings or value of
an asset, liability, portfolio, or statement
of financial condition as measured in
terms of price, net interest income, or
net economic valuation change from
current levels;
(k) Interest rate swap means an
agreement to exchange future payments
of interest on a notional amount at
specific times and for a specified time
period, paid in U.S. dollars. The
exchange may be fixed to floating or
floating to fixed;
(l) ISDA agreement means an
agreement specified by the International
Swaps and Derivatives Association that
consists of a master agreement, a
schedule, confirmations, definition
booklets, and a credit support annex;
(m) Leveraged derivative means a
derivative with interest rates that
change proportionally with the
contractual rate or index;
(n) Major swap participant has the
meaning defined by the Commodity
Futures Trading Commission in 17 CFR
§ 1.3(hhh);
(o) Minimum transfer amount means
the amount of collateral that can be
required per transfer to cover exposure
in excess of the collateral threshold;
(p) Net economic value means the
economic value of assets minus the
economic value of liabilities;
(q) Net worth has the meaning
specified in § 702.2 of this chapter;
(r) Notional amount means the
predetermined dollar amount on which
exchanged interest payments are based;
(s) Novate means the substitution of
an old obligation with a new one that
either replaces an existing obligation
with a new obligation or replaces an
original party with a new party;
(t) Structured liability offering means
an offering with contractual option
features, such as periodic caps and calls,
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32207
similar to those found in structured
securities or structured notes;
(u) Senior executive officer is, for the
purposes of this rule, a credit union’s
chief executive officer (typically this
individual holds the title of president or
treasurer/manager), any assistant chief
executive officer (e.g., any assistant
president, any vice president or any
assistant treasurer/manager), and the
chief financial officer (controller) that
are directly within the chain of
command for the oversight of a credit
union’s derivatives program, as
identified in a credit union’s process
and responsibility framework, discussed
in § 703.108(b)(2) of this subpart;
(v) Swap dealer has the meaning
defined by the Commodity Futures
Trading Commission in 17 CFR 1.3(ggg);
(w) Threshold amount means an
unsecured credit exposure that the
parties are prepared to accept before
asking for collateral; and
(x) Weighted average life means the
weighted average length of time to the
final maturity of derivatives contracts,
calculated by multiplying the notional
amount of each contract by the time to
maturity and then adding each of those
numbers together and dividing by the
total notional amount of the contracts.
§ 703.102 Permissible derivatives
transactions.
As part of its regulator approved
strategy, a credit union may only
purchase interest rate caps or enter into
interest rate swap transactions that are:
(a) For the purpose of managing
interest rate risk;
(b) Not leveraged;
(c) Based on domestic rates, as
defined in § 703.14(a) of subpart A of
this part;
(d) Denominated in U.S. dollars;
(e) Except as provided in § 703.14(g)
of subpart A of this part, not used to
create structured liability offerings for
members or nonmembers;
(f) Settled within three business days
of entering into the transaction; and
(g) Interest rate swaps that do not
have fluctuating notional amounts.
§ 703.103
Eligibility.
(a) A credit union may apply for Level
I or Level II derivatives authority if it
meets the following criteria:
(1) It provides an interest rate risk
mitigation plan, which includes
derivatives and shows how derivatives
are one aspect of its overall interest rate
risk mitigation strategy;
(2) Its most recent composite CAMEL
code rating assigned by NCUA is 1, 2,
or 3 with a management component of
1 or 2; and
(3) It has assets of at least $250
million, as of its most recent call report.
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(b) A credit union seeking Level II
authority must also show why the limits
under Level I authority are insufficient
for it to effectively mitigate interest rate
risk.
§ 703.104 Policies and procedures for
operating a Level I or Level II program.
A credit union must operate
according to written, comprehensive
policies and procedures for control,
measurement, and management of
derivatives transactions.
(a) At a minimum, the policies and
procedures must cover:
(1) Managerial oversight and
responsibilities;
(2) Scope of activities;
(3) Approved counterparties;
(4) Risk management (market, credit,
liquidity, settlement, and operations);
(5) Legal issues;
(6) Accounting and financial reporting
in accordance with GAAP;
(7) Derivatives limits;
(8) Aggregate counterparty exposure;
(9) A limit on the amount of exposure
the credit union will have to any single
counterparty, expressed as a percentage
of net worth;
(10) Margin requirements; and
(11) Reporting requirements.
(b) A credit union’s board of directors
must review the derivatives policies and
procedures annually and update them
when necessary.
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§ 703.105 Collateral requirements for
operating a Level I or Level II program.
(a) A credit union’s collateral
arrangements must be supported by a
bilateral ISDA credit support annex and
comply with all applicable requirements
of the Commodity Futures Trading
Commission.
(b) A credit union may only accept
collateral to secure a derivatives
transaction that is permissible for a
credit union to hold as enumerated in
the Federal Credit Union Act, subpart A
of this part, and its investment policies.
Acceptable collateral is limited to cash,
Treasury securities, fixed-rate noncallable agency debentures, and zerocoupon non-callable agency debentures.
(c) Daily, a credit union must price
derivatives positions and calculate its
fair value exposure.
(d) Daily, a credit union must be
collateralized for all transactions to at
least 100 percent of the transactions,
based on the risk of the collateral.
(e) A credit union must set threshold
amounts to zero.
(f) A counterparty to a derivatives
transaction cannot hold or be the
custodian of the collateral, except for
affiliates of the counterparty that are
separate legal entities. In any custodial
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arrangement, the custodian must: be
organized and doing business under the
laws of the United States or any state
thereof; authorized under such laws to
exercise corporate trust or custodial
powers; have equity of at least
$50,000,000; and be subject to
supervision or examination by a federal
or state authority.
(g) The minimum transfer amount
must be less than or equal to $250,000.
(h) A credit union using collateral
netting arrangements must have the
ability to disaggregate and report
individual exposures within and across
all counterparties.
(i) A credit union may agree to
provide additional collateral to a
counterparty in a credit support annex
so long as the credit union complies
with all other collateral provisions in
this subpart.
(j) A credit union must have systems
in place to effectively manage collateral.
(1) A credit union’s collateral
management process must monitor its
collateral daily and ensure that its
derivatives positions are collateralized
at all times in accordance with the
collateral requirements of this subpart
and the credit union’s ISDA agreement
with its counterparty. This includes the
posting, tracking, valuing, and reporting
of collateral to state positive and
negative exposure using a daily fair
value.
(2) A credit union must have the
ability to analyze and measure potential
liquidity needs related to its derivatives
program and stemming from additional
collateral requirements due to changes
in interest rates. It must also be able to
calculate and track contingent liquidity
needs in the event a derivatives
transaction needs to be novated or
terminated. A credit union’s senior
executive officers must establish
effective controls for liquidity exposures
arising from both market or product
liquidity and instrument cash flows.
§ 703.106 Counterparty requirements for
operating a Level I or Level II program.
(a) A credit union must have an ISDA
agreement in place to establish a credit
relationship with any counterparty.
(b) Any derivatives counterparty must
be either a ‘‘swap dealer’’ or ‘‘major
swap participant,’’ and:
(1) Organized and doing business
under the laws of the United States or
any state thereof; or
(2) A United States branch of a foreign
depository institution, licensed to do
business under the laws of the United
States or any state thereof.
(c) A credit union must calculate and
manage individual counterparty
exposure by book value and fair value.
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A credit union must conduct stress tests
of counterparty exposures.
(d) A credit union must analyze
counterparty credit risks, including, but
not limited to: counterparty exposures,
concentrations, credit exceptions, and
nonperforming contracts. The credit
union’s board of directors must receive
monthly, detailed reports addressing
aggregate counterparty credit exposures.
§ 703.107 Reporting requirements for
operating a Level I or Level II program.
At least monthly, a credit union’s
senior executive officers must deliver to
the credit union’s board of directors,
separately or as part of the standard
funds management or asset/liability
report, a comprehensive derivatives
report. At a minimum, this report must
include:
(a) Identification of any areas of
noncompliance with any provision of
this subpart or the credit union’s
policies;
(b) Utilization of the limits in
§ 703.109 or § 703.110, as applicable,
and the limits in the credit union’s
policies;
(c) An itemization of the credit
union’s individual positions and
aggregate fair and book values;
(d) A comprehensive view of the
credit union’s statement of financial
condition, including, but not limited to,
net economic value calculations for the
credit union’s statement of financial
condition done with derivatives
included and excluded; and
(e) The cost of executing new
derivatives transactions. A credit union
can express this cost through a
comparison with observed market
quotes and/or offering levels from other
counterparties. Observed market quotes
can include swap rates or external
service provider modeled cap prices.
§ 703.108 Systems, processes, and
personnel requirements for operating a
Level I or Level II derivatives program.
(a) Required experience and
competencies. A credit union operating
a derivatives program must internally
possess the following experience and
competencies:
(1) Board. Before entering into any
derivatives transactions, and annually
thereafter, a credit union’s board
members must receive training to
provide a general understanding of
derivatives and knowledge to provide
strategic oversight of the credit union’s
derivatives program. This includes
understanding how derivatives fit into
the credit union’s business model and
risk management process. The credit
union must maintain evidence of this
training, in accordance with its
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document retention policy, until its next
NCUA or state supervisory authority
examination.
(2) Senior executive officers. A credit
union’s senior executive officers must
have sufficient knowledge and
experience to understand, approve, and
provide oversight for the derivatives
activities commensurate with the
complexity of the derivatives program.
These individuals must have a
comprehensive understanding of how
derivatives fit into the credit union’s
business model and risk management
process. A credit union must
immediately notify NCUA (and, if
applicable, the appropriate SSA) when
a senior executive officer position as
defined in this rule becomes vacant. A
credit union must also immediately
provide NCUA (and, if applicable, the
appropriate SSA) with documentation
evidencing knowledge and experience
for any person who becomes a senior
executive officer as defined in this rule
while the credit union has derivatives
authority.
(3) Qualified derivatives personnel.
To engage in derivatives transactions
with Level I authority, a credit union
must have knowledgeable and
experienced employees that, except as
provided in § 703.110(f) of this subpart
for Level II authority, have at least three
years of direct transactional experience
in the trading, structuring, analyzing,
monitoring, or auditing of financial
derivatives transactions at a financial
institution, a risk management advisory
practice, or a financial regulatory
organization. Staff must also have the
demonstrated expertise in the statement
of financial condition analysis described
in § 703.107(d) of this subpart. These
employees must, at a minimum,
accomplish the following:
(i) Asset/liability risk management.
Staff must be qualified to understand
and oversee asset/liability risk
management including the appropriate
role of derivatives. This includes
identifying and assessing risk in
transactions, developing asset/liability
risk management strategies, testing the
effectiveness of asset/liability risk
management, determining the
effectiveness of managing interest rate
risk under a range of stressed rate and
statement of financial condition
scenarios, and evaluating the relative
effectiveness of alternative strategies;
(ii) Accounting and financial
reporting. Staff must be qualified to
understand and oversee appropriate
accounting and financial reporting for
derivatives transactions in accordance
with GAAP;
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(iii) Trade execution and oversight.
Staff must be qualified to undertake or
oversee trade executions; and
(iv) Credit, collateral, and liquidity
management. Staff must be qualified to
evaluate credit risk, manage collateral,
and evaluate liquidity risk, as described
in §§ 703.105 and 703.106 of subpart B
of this part.
(b) Required management and
internal controls structure. To
effectively manage its derivatives
activities, a credit union must allocate
resources sufficient to support the scope
and complexity of its derivatives
activities. An effective management and
internal controls structure includes, at a
minimum, the following:
(1) Separation of duties. A credit
union’s process, whether conducted
internally or by an external service
provider, must have appropriate
separation of duties for the following
functions:
(i) Derivatives execution and
oversight;
(ii) Accounting for and confirmation
of the derivatives transactions;
(iii) Asset/liability risk management;
and
(iv) Credit, collateral, and liquidity
management.
(2) Process and responsibility
framework. A credit union must
maintain, in its derivatives policies and
procedures, a written and schematic
(e.g. flow chart or organizational chart)
description of the derivatives decision
process. The process must include the
roles of staff, external advisors, senior
executive officers, the board of
directors, and any others involved in the
derivatives program and demonstrate
separation of duties, independent risk
management, and effective oversight.
(3) Internal controls review. A credit
union must have an internal controls
audit at least annually that ensures the
timely identification of weaknesses in
internal controls, modeling
methodologies, and the risk oversight
process. This internal controls review
must be performed by external
individuals qualified to evaluate the
attributes of a derivatives program. An
internal controls audit must incorporate
an evaluation of the effectiveness of
internal controls relevant to measuring,
monitoring, reporting, and limiting
risks. The scope of the internal controls
review must also include coverage of
the accounting, legal, operating, and risk
controls.
(4) Financial statement audit. A credit
union must obtain an annual financial
statement audit, as defined in § 715.2(d)
of this chapter, by an independent statelicensed certified public accountant
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32209
with at least two years of experience
evaluating derivatives transactions.
(5) Legal review. Before executing any
transactions under this subpart, a credit
union must receive a legal opinion from
qualified counsel stating that the credit
union’s ISDA agreements are
enforceable and that the credit union is
complying with applicable laws and
regulations relating to operating a
derivatives program. Qualified counsel
means an attorney with at least five
years of experience reviewing
derivatives transactions. A credit union
must also ensure any counterparty is
authorized to enter into such
transactions.
(6) Hedge review. Before executing
any derivatives transaction, a credit
union must identify and document the
circumstances leading to the decision to
hedge, specify the derivatives strategy
the credit union will employ, and
demonstrate the economic effectiveness
of the hedge.
(c) Transactions management. A
credit union must have support systems
in place to provide accurate and timely
transaction processing.
(d) Asset/liability risk management. A
credit union must have the systems and
operational capacity to derive net
economic value and understand interest
rate risk.
(e) Use of external service providers.
As specified in § 703.109 and § 703.110,
as applicable, a credit union may use
external service providers to support or
conduct certain aspects of its derivatives
program, provided:
(1) The external service provider,
including affiliates, cannot:
(i) Be a counterparty to any
derivatives transactions involving the
credit union;
(ii) Be a principal or agent in any
derivatives transaction involving the
credit union; or
(iii) Have discretionary authority to
execute any of the credit union’s
derivatives transactions.
(2) The credit union has the internal
capacity, experience, and skills to
oversee and manage any external service
providers it uses; and
(3) The credit union documents the
specific uses of external service
providers in its process and
responsibility framework, as described
in § 703.108(b)(2) of this subpart.
§ 703.109 Specific Level I limits and
requirements.
A credit union with Level I
derivatives authority must comply with
the following specific limits and
requirements:
(a) A credit union approved only to
enter into interest rate swaps must
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(c) A credit union approved to
transact interest rate swaps and
purchase interest rate caps may not
exceed a combined limit of 100 percent
of the aggregate amount of each limit the
credit union used under paragraphs (a)
and (b) of this section. For example, a
credit union may hold 80 percent of the
limit for interest rate caps and 20
percent of the limit for interest rate
swaps, but cannot hold 100 percent of
the limit for each. This combined limit
can be represented as:
(d) The aggregate fair value loss of all
swap positions into which the credit
union has entered cannot exceed 10
percent of net worth.
(e) The maximum permissible
weighted average life on all derivatives
positions may not exceed five years and
the maximum permissible maturity for
any single derivatives position may not
exceed seven years.
(f) Use of external service providers. A
credit union may use external service
providers to support or conduct certain
processes, subject to the following
restrictions:
(1) Support. A credit union must
internally and independently carry out
and conduct the following functions,
but may obtain assistance and input
from an external service provider,
provided the external service provider
does not conduct the functions in lieu
of the credit union:
(i) Evaluating credit risk management;
(ii) Evaluating liquidity risk; and
(iii) Asset/liability management.
(2) Conduct. Provided a credit union
maintains responsibility for the
following activities and an
understanding of all of an external
service provider’s activities and work
product, a credit union may contract
with an external service provider to
conduct these functions in lieu of the
credit union:
(i) Accounting and financial
reporting;
(ii) Counterparty exposure
management;
(iii) Trade execution;
(iv) Transaction management;
(v) Legal services;
(vi) Collateral management; and
(vii) Financial statement audit.
will establish the aggregate notional
amount of its interest rate swap
transactions at an amount not to exceed
250 percent of net worth.
(b) For a credit union approved only
to purchase interest rate caps, NCUA
will establish the aggregate book value
of its interest rate cap transactions at an
amount not to exceed 25 percent of net
worth.
(c) For a credit union approved to
transact interest rate swaps and interest
rate caps, NCUA will establish the
appropriate cumulative limit not to
exceed individual limits in paragraphs
(a) and (b) of this section.
(d) The aggregate fair value loss of all
swap positions into which the credit
union has entered cannot exceed 25
percent of net worth.
(e) The maximum permissible
weighted average life on all derivatives
positions may not exceed seven years
and the maximum permissible maturity
for any single derivatives position may
not exceed ten years.
(f) The qualified derivatives personnel
described in § 703.108(a)(3) must have
at least five years of direct transactional
experience in the trading, structuring,
analyzing, monitoring, or auditing of
financial derivatives transactions at a
financial institution, a risk management
advisory practice, or a financial
regulatory organization. In addition to
the activities the qualified derivatives
personnel are required to conduct in
§ 703.108(a)(3), they must also price
options and undertake statement of
financial condition simulations under
multiple interest rate scenarios.
(g) The exposure by notional amount
to any single derivatives counterparty
cannot exceed 100 percent of net worth
for interest rate swaps and the book
value may not exceed ten percent of net
worth for interest rate caps.
(h) Use of external service providers.
A credit union may use external service
providers to support or conduct certain
processes, subject to the following
restrictions:
(1) Support. A credit union must
internally and independently carry out
and conduct the following functions,
but may obtain assistance and input
from an external service provider,
provided the external service provider
does not conduct the functions in lieu
of the credit union:
(i) Asset/liability risk management;
(ii) Evaluating credit risk;
(iii) Counterparty exposure
management;
(iv) Evaluating liquidity risk;
(v) Collateral management; and
(vi) Transaction management.
(2) Conduct. Provided a credit union
maintains responsibility for the
following activities and an
understanding of all of an external
service provider’s activities and work
product, the credit union may contract
with an external service provider to
conduct these functions in lieu of the
credit union:
(i) Accounting and financial
reporting;
(ii) Trade execution;
(iii) Financial statement audit; and
(iv) Legal services.
§ 703.110 Specific Level II limits and
requirements.
A credit union with Level II
derivatives authority must comply with
the following specific limits and
requirements:
(a) For a credit union approved only
to enter into interest rate swaps, NCUA
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§ 703.111 Applying for Level I or Level II
authority.
An eligible credit union must submit
a request for Level I or Level II authority
and a detailed application, consistent
with this subpart, before engaging in
any derivatives transactions. The
application must include draft policies
and procedures, the process and
responsibility framework, and the
proposed systems and personnel needed
to efficiently and effectively manage the
credit union’s derivatives activities. A
credit union must submit its application
to:
(a) The applicable Field Director, in
the case of an FCU; or
(b) The applicable state supervisory
authority, in the case of a FISCU.
§ 703.112
Application content.
A credit union applying for
derivatives authority must demonstrate
all of the following in its application:
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restrict the aggregate notional amount of
its interest rate swap transactions to 100
percent of net worth.
(b) A credit union approved only to
purchase interest rate caps must restrict
the aggregate book value of its interest
rate cap transactions to 10 percent of net
worth.
Federal Register / Vol. 78, No. 103 / Wednesday, May 29, 2013 / Proposed Rules
(a) An interest rate risk mitigation
plan, which includes derivatives and
shows how derivatives are one aspect of
its overall interest rate risk mitigation
strategy. A credit union applying for
Level II authority must also show why
the limits under Level I authority are
not sufficient for it to mitigate interest
rate risk.
(b) How it plans to acquire, employ,
and/or create the resources, policies,
processes, systems, internal controls,
modeling, and competencies to meet the
requirements of this subpart. A credit
union applying for Level II authority
must have the systems and personnel
required under this subpart in place
before submitting its application.
(c) That it has senior executive
officers and a board of directors that
understand the role derivatives play in
the credit union’s interest rate risk
management and the risk inherent in
derivatives activities.
(d) How it intends to use external
service providers as part of its
derivatives program.
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§ 703.113 Application review by
regulators.
(a) State supervisory authority review.
A state supervisory authority will
review an application submitted under
this subpart and forward its decision to
the applicable Field Director for
concurrence.
(b) NCUA review. After receiving an
FCU’s application or a state supervisory
authority’s decision, within 30 days
from the date of its receipt, the Field
Director will determine if the
application is complete and meets the
requirements of this subpart. The Field
Director will notify the credit union
within the following time frames if
NCUA has approved or denied its
application and the reason(s) for any
denial:
(1) Level I. 90 days from the date the
appropriate Field Director determines a
credit union’s application is complete
or, in the case of a FISCU, receives a
decision from the applicable SSA; or
(2) Level II. 120 days from the date the
appropriate Field Director determines a
credit union’s application is complete
or, in the case of a FISCU, receives a
decision from the applicable SSA.
(c) Right to appeal. Within 60 days
from the date of denial by the Field
Director, a credit union may submit a
written appeal to NCUA’s Supervisory
Review Committee.
§ 703.114 Pilot program participants and
FISCUs with active derivatives positions.
(a) A credit union that, as of January
1, 2013, is holding derivatives under
NCUA’s derivatives pilot program or
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applicable state law must comply with
the requirements of this subpart,
including the application procedures,
within 12 months from the effective
date of this subpart. During the 12month interim period, the credit union
may continue to operate its derivatives
program in accordance with its pilot
program terms and conditions or
applicable state law.
(b) A credit union holding derivatives
under NCUA’s derivatives pilot program
or state law that does not comply with
the requirements of this subpart within
12 months or does not want to continue
engaging in derivatives transactions
must:
(1) Stop entering into new derivatives
transactions; and
(2) Within 30 days, present a
corrective action plan to the appropriate
Field Director (and SSA in the case of
a FISCU) describing how it will cure
any deficiencies or unwind its
derivatives program.
(c) A credit union that is otherwise
compliant with this subpart except that
it is holding impermissible active
derivatives positions it entered into
before January 1, 2013, may enter into
new derivatives transactions in
accordance with this subpart, provided
it provides NCUA (or NCUA and the
SSA, in the case of a FISCU) with a plan
accounting for the active positions in
violation of this subpart.
§ 703.115
Regulatory violation.
(a) A credit union engaging in
derivatives transactions that no longer
meets the requirements of subpart B of
this part; fails to fully comply with its
approved strategy, including employing
the resources, policies, processes, and
competencies that formed the basis for
the approval; or has safety and
soundness concerns identified by
NCUA:
(1) Must present a corrective action
plan to the appropriate Field Director
(and state supervisory authority in the
case of a FISCU) within 30 days of the
determination of the violation; and
(2) May not enter into any new
derivatives transactions until the Field
Director (and state supervisory authority
in the case of a FISCU) approves the
corrective action plan.
(b) NCUA may revoke a credit union’s
derivatives authority at any time for
failure to comply with the requirements
of this section or for any other safety
and soundness reasons. Revocation will
prohibit a credit union from entering
into any new derivatives transactions.
Revocation will not require the credit
union to terminate existing derivatives
transactions if, at the discretion of the
Field Director (and state supervisory
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32211
authority in the case of a FISCU), doing
so would not be practicable or deemed
unsafe or unsound. The Field Director
(and state supervisory authority in the
case of a FISCU) may require a credit
union to terminate existing derivatives
transactions if doing so would not pose
a safety and soundness concern.
(c) Within 60 days of NCUA’s written
notice of revocation of a credit union’s
derivatives authority, a credit union
may appeal this decision to the NCUA
Board. During the appeals process, the
credit union does not have to terminate
existing derivatives transactions, but it
may not enter into any new derivatives
transactions.
PART 715—SUPERVISORY
COMMITTEE AUDITS AND
VERIFICATIONS
7. The authority citation for part 715
continues to read as follows:
■
Authority: 12 U.S.C. 1761(b), 1761(d),
1782(a)(6).
8. Revise paragraph (a) of § 715.5 to
read as follows:
■
§ 715.5
Audit of Federal Credit Unions.
(a) Total assets of $500 million or
greater. To fulfill its Supervisory
Committee audit responsibility, a
federal credit union having total assets
of $500 million or greater, except as
provided in § 703.108(b)(4) of this
chapter, must obtain an annual audit of
its financial statements performed in
accordance with Generally Accepted
Auditing Standards by an independent
person who is licensed to do so by the
State or jurisdiction in which the credit
union is principally located.
*
*
*
*
*
PART 741—REQUIREMENTS FOR
INSURANCE
9. The authority citation for part 741
is revised to read as follows:
■
Authority: 12 U.S.C. 1757, 1766(a), 1781–
1790, .31 U.S.C. 3717.
10. Revise § 741.219 to read as
follows:
■
§ 741.219
Investment requirements.
(a) Any credit union which is insured
pursuant to title II of the Act must
adhere to the requirements stated in part
703 of this chapter concerning
transacting business with corporate
credit unions.
(b) Derivatives. Any credit union
which is insured pursuant to Title II of
the Act and permitted by its state law
to engage in derivatives must follow the
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requirements of subpart B of part 703 of
this chapter.
[FR Doc. 2013–12638 Filed 5–28–13; 8:45 am]
BILLING CODE 7535–01–P
DEPARTMENT OF TRANSPORTATION
Federal Aviation Administration
14 CFR Part 71
[Docket No. FAA–2013–0345; Airspace
Docket No. 13–AEA–6]
Proposed Amendment of Class E
Airspace; Factoryville, PA
Federal Aviation
Administration (FAA), DOT.
ACTION: Notice of proposed rulemaking
(NPRM).
AGENCY:
This action proposes to
amend Class E Airspace at Factoryville,
PA, as the Lake Henry VORTAC has
been decommissioned, requiring
airspace redesign at Seamans Field
Airport. This action would enhance the
safety and airspace management of
Instrument Flight Rules (IFR) operations
at the airport.
DATES: Comments must be received on
or before July 15, 2013.
ADDRESSES: Send comments on this rule
to: U.S. Department of Transportation,
Docket Operations, West Building
Ground Floor, Room W12–140, 1200
New Jersey SE., Washington, DC 20590–
0001; Telephone: 1–800–647–5527; Fax:
202–493–2251. You must identify the
Docket Number FAA–2013–0345;
Airspace Docket No. 13–AEA–6, at the
beginning of your comments. You may
also submit and review received
comments through the Internet at https://
www.regulations.gov.
FOR FURTHER INFORMATION CONTACT: John
Fornito, Operations Support Group,
Eastern Service Center, Federal Aviation
Administration, P.O. Box 20636,
Atlanta, Georgia 30320; telephone (404)
305–6364.
SUPPLEMENTARY INFORMATION:
SUMMARY:
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Comments Invited
Interested persons are invited to
comment on this rule by submitting
such written data, views, or arguments,
as they may desire. Comments that
provide the factual basis supporting the
views and suggestions presented are
particularly helpful in developing
reasoned regulatory decisions on the
proposal. Comments are specifically
invited on the overall regulatory,
aeronautical, economic, environmental,
and energy-related aspects of the
proposal.
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Communications should identify both
docket numbers (FAA Docket No. FAA–
2013–0345; Airspace Docket No. 13–
AEA–6) and be submitted in triplicate to
the Docket Management System (see
ADDRESSES section for address and
phone number). You may also submit
comments through the Internet at https://
www.regulations.gov.
Persons wishing the FAA to
acknowledge receipt of their comments
on this action must submit with those
comments a self-addressed stamped
postcard on which the following
statement is made: ‘‘Comments to
Docket No. FAA–2013–0345; Airspace
Docket No. 13–AEA–6.’’ The postcard
will be date/time stamped and returned
to the commenter.
All communications received before
the specified closing date for comments
will be considered before taking action
on the proposed rule. The proposal
contained in this notice may be changed
in light of the comments received. A
report summarizing each substantive
public contact with FAA personnel
concerned with this rulemaking will be
filed in the docket.
Availability of NPRMs
An electronic copy of this document
may be downloaded from and
comments submitted through https://
www.regulations.gov. Recently
published rulemaking documents can
also be accessed through the FAA’s Web
page at https://www.faa.gov/
airports_airtraffic/air_traffic/
publications/airspace_amendments/.
You may review the public docket
containing the proposal, any comments
received, and any final disposition in
person in the Dockets Office (see the
ADDRESSES section for address and
phone number) between 9:00 a.m. and
5:00 p.m., Monday through Friday,
except Federal Holidays. An informal
docket may also be examined between
8:00 a.m. and 4:30 p.m., Monday
through Friday, except Federal Holidays
at the office of the Eastern Service
Center, Federal Aviation
Administration, Room 350, 1701
Columbia Avenue, College Park, Georgia
30337.
Persons interested in being placed on
a mailing list for future NPRM’s should
contact the FAA’s Office of Rulemaking,
(202) 267–9677, to request a copy of
Advisory circular No. 11–2A, Notice of
Proposed Rulemaking distribution
System, which describes the application
procedure.
The Proposal
The FAA is considering an
amendment to Title 14, Code of Federal
Regulations (14 CFR) part 71 to amend
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Class E airspace extending upward from
700 feet above the surface at Seamans
Field Airport, Factoryville, PA. Airspace
reconfiguration within an 8.2-mile
radius of the airport is necessary due to
the decommissioning of the Lake Henry
VORTAC, and for continued safety and
management of IFR operations at the
airport.
Class E airspace designations are
published in Paragraph 6005 of FAA
Order 7400.9W, dated August 8, 2012,
and effective September 15, 2012, which
is incorporated by reference in 14 CFR
71.1. The Class E airspace designation
listed in this document will be
published subsequently in the Order.
The FAA has determined that this
proposed regulation only involves an
established body of technical
regulations for which frequent and
routine amendments are necessary to
keep them operationally current. It,
therefore, (1) is not a ‘‘significant
regulatory action’’ under Executive
Order 12866; (2) is not a ‘‘significant
rule’’ under DOT Regulatory Policies
and Procedures (44 FR 11034; February
26, 1979); and (3) does not warrant
preparation of a Regulatory Evaluation
as the anticipated impact is so minimal.
Since this is a routine matter that will
only affect air traffic procedures and air
navigation, it is certified that this
proposed rule, when promulgated,
would not have a significant economic
impact on a substantial number of small
entities under the criteria of the
Regulatory Flexibility Act.
The FAA’s authority to issue rules
regarding aviation safety is found in
Title 49 of the United States Code.
Subtitle I, Section 106 describes the
authority of the FAA Administrator.
Subtitle VII, Aviation Programs,
describes in more detail the scope of the
agency’s authority. This proposed
rulemaking is promulgated under the
authority described in Subtitle VII, Part,
A, Subpart I, Section 40103. Under that
section, the FAA is charged with
prescribing regulations to assign the use
of airspace necessary to ensure the
safety of aircraft and the efficient use of
airspace. This proposed regulation is
within the scope of that authority as it
would amend Class E airspace at
Seamans Field Airport, Factoryville, PA.
This proposal would be subject to an
environmental analysis in accordance
with FAA Order 1050.1E,
‘‘Environmental Impacts: Policies and
Procedures’’ prior to any FAA final
regulatory action.
Lists of Subjects in 14 CFR Part 71
Airspace, Incorporation by reference,
Navigation (air).
E:\FR\FM\29MYP1.SGM
29MYP1
Agencies
[Federal Register Volume 78, Number 103 (Wednesday, May 29, 2013)]
[Proposed Rules]
[Pages 32191-32212]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2013-12638]
=======================================================================
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NATIONAL CREDIT UNION ADMINISTRATION
12 CFR Parts 703, 715, and 741
RIN 3133-AD90
Derivatives
AGENCY: National Credit Union Administration (NCUA).
ACTION: Proposed Rule.
-----------------------------------------------------------------------
SUMMARY: This proposed rule permits credit unions to engage in limited
derivatives activities for the purpose of mitigating interest rate
risk. This proposed rule applies to federal credit unions and any
federally insured, state-chartered credit unions that are permitted
under applicable state law to engage in derivatives transactions. It
requires any credit union seeking derivatives authority to submit an
application for one of two levels of authority. Level I and Level II
authority differ on the permissible levels of transactions as well as
the application, expertise, and systems requirements associated with
operating a derivatives program.
DATES: Comments must be received on or before July 29, 2013.
ADDRESSES: You may submit comments by any of the following methods
(Please send comments by one method only):
Federal eRulemaking Portal: https://www.regulations.gov.
Follow the instructions for submitting comments.
NCUA Web Site: https://www.ncua.gov/RegulationsOpinionsLaws/proposed_regs/proposed_regs.html. Follow the
instructions for submitting comments.
E-Mail: Address to regcomments@ncua.gov. Include ``[Your
name]--Comments on Proposed Rule--Derivatives'' 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.
FOR FURTHER INFORMATION CONTACT: Justin M. Anderson or Lisa Henderson,
Staff Attorneys, Office of General Counsel, at the above address or
telephone (703) 518-6540; J. Owen Cole, Director, Division of Capital
and Credit Markets, or Rick Mayfield, Senior Capital Markets
Specialist, Office of Examination and Insurance, at the above address
or telephone (703) 518-6360; or Dr. John Worth, Chief Economist, Office
of the Chief Economist, at the above address or telephone (703) 518-
6660.
SUPPLEMENTARY INFORMATION:
I. Background
A. Introduction
The NCUA Board (Board) is proposing to allow credit unions to
engage in limited derivatives transactions \1\ for the purpose of
mitigating interest rate risk (IRR). This proposed authority does not,
however, allow credit unions to offer derivatives. This proposed rule
applies to all federal credit unions (FCUs) and all federally insured
state- chartered credit unions (FISCUs) that are expressly permitted by
applicable state law to engage in derivatives transactions. The Board
believes this proposed rule allows eligible credit unions to utilize an
additional tool to mitigate IRR, while also reducing risk to the
National Credit Union Share Insurance Fund (NCUSIF).
---------------------------------------------------------------------------
\1\ A derivative is an instrument whose price is dependent on or
derived from one or more underlying assets. A derivatives
transaction involves a contract between two parties, called
counterparties, that exchange value based on the fluctuation of the
underlying asset or index. A counterparty is the other party to the
derivatives transaction and can include swap dealers and major swap
participants, which are terms to identify entities that operate
primarily in the derivatives market. These transactions may involve
collateral and a collateral custodian, which is an entity that holds
the collateral for the two contracting parties.
---------------------------------------------------------------------------
The rule requires eligible credit unions to apply to NCUA or, in
the case of a FISCU, NCUA and the applicable state supervisory
authority (SSA), for either Level I or Level II derivatives authority.
As discussed in greater detail below, Level I and Level II authority
differ on the permissible levels of transactions as well as the
application, expertise, and systems requirements.
B. The Act and NCUA's Regulations
The Federal Credit Union Act (Act) provides FCUs with the authority
to invest in certain securities, obligations, and accounts.\2\ For
safety and soundness reasons, however, NCUA has adopted regulatory
restrictions on certain investments and activities permitted by the
Act.\3\ Currently, derivatives are among the investments specifically
prohibited by NCUA.\4\
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\2\ 12 U.S.C. 1757(7) and (15).
\3\ 12 CFR 703.16.
\4\ Id. at 703.16(a). Section 703.16(a), however, provides three
exceptions to the general prohibition on derivatives. First, an FCU
may purchase or sell any derivatives permitted under Sec. 703.14(g)
or under Sec. 701.21(i) of NCUA's lending regulations. Second, an
FCU may purchase or sell an embedded option not required under
generally accepted accounting principles (GAAP) to be accounted for
separately from the host contract. Third, an FCU may enter into
interest rate lock commitments or forward sales commitments made in
connection with a loan originated by the FCU. The Board believed
that the benefits of the three exceptions outweighed the potential
risk and recognized these items were tools FCUs needed.
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[[Page 32192]]
NCUA prohibited derivatives because they are complex financial
instruments that potentially introduce significant degrees of risk to a
credit union. Accordingly, this risk calls for a more robust asset/
liability management (ALM) capability that is supported by a higher
degree of sophistication, analytical rigor and risk management
expertise.
Traditionally, derivatives instruments have been customizable over-
the-counter instruments. They span a wide variety of types and
structures, many of which are unsuitable for credit unions. As the
financial derivatives markets have evolved, however, greater
standardization of contracts, collateral requirements, market
participation and price transparency have made certain derivatives more
suitable for meeting the risk mitigation needs of some credit unions.
In addition, given the historically low interest rate environment of
the last few years, IRR now poses a material risk to many credit
unions.
Recognizing that derivatives can be beneficial in helping credit
unions to mitigate IRR, the Board believes it is appropriate to allow
credit unions to use derivatives for the limited purpose of IRR
mitigation. The Board notes, however, that derivatives are not the only
way for credit unions to control IRR. Rather, the Board emphasizes that
derivatives are just one tool that credit unions may employ as part of
a comprehensive ALM strategy.
This rule builds on the IRR rule that the Board issued in 2012,
which required certain federally insured credit unions to develop and
adopt a written policy on IRR management and a program to effectively
implement that policy.\5\ The IRR rule provides guidance in developing
an effective IRR management program to identify, measure, monitor, and
control IRR. This proposed rule does not change any of the requirements
in the IRR rule, but rather is another measure the Board is taking to
enhance risk management alternatives.
---------------------------------------------------------------------------
\5\ 71 FR 5155 (February 2, 2012).
---------------------------------------------------------------------------
C. 1998 IRPS
This proposed rule is consistent with a 1998 Interpretive Ruling
and Policy Statement (IRPS) 98-2, Investment Securities and End-User
Derivatives issued by NCUA.\6\ IRPS 98-2 provides guidance to credit
unions on sound practices for managing the risks of investment
securities and end-user derivatives activities, including transactions
in swaps and caps. While derivatives are generally prohibited by
regulation for FCUs, the IRPS provides guidance on other investments as
well and applies to FISCUs with derivatives authority under applicable
state law. The Board, therefore, joined the other Federal Financial
Institutions Examination Council members in promulgating the guidance.
---------------------------------------------------------------------------
\6\ IRSP 98-2 (October 1, 1998).
---------------------------------------------------------------------------
The IRPS notes that effective management of the risks associated
with securities and derivatives instruments represents an essential
component of safe and sound practice. It identifies certain elements as
fundamental to all sound risk management programs. These elements
include oversight by a credit union's board of directors and senior
management and a comprehensive risk management process that effectively
identifies, measures, monitors, and controls risk. This proposed rule
incorporates many of the guiding principles of IRPS 98-2, as well as
lessons learned from the derivatives pilot programs and comments
received on two advanced notices of proposed rulemaking (ANPRs).
D. Pilot Programs
Since 1999, the Board has been evaluating pilot programs for
limited derivatives authority. These pilot programs have provided NCUA
with insight to move from a limited experimental authority to a more
general regulatory authority. They have shown the Board that most
credit unions need to develop sufficient experience, management, and
infrastructure before beginning a derivatives program. Once these are
developed, however, credit unions can operate a limited derivatives
program in a safe and sound manner.
In addition, several key lessons emerged from NCUA's experience
with the derivative pilot programs. Some programs were managed directly
by credit unions, while others were administered by external service
providers. NCUA observed that the understanding and management of
derivatives transactions, while generally sound and effective, were
rudimentary in some instances. Various weaknesses were encountered over
time. Some areas of concern included: lack of, or inadequate,
assessments of the capacity to absorb losses and establish processes to
proactively limit loss exposure; lack of due diligence on
counterparties and credit risk mitigation; lack of vigilant collateral
management; heavy reliance on external parties to value derivatives for
base and stress scenarios; and lack of analysis and disclosure for
transaction costs (spreads over market). These noted areas, which were
addressed through the supervision process, have influenced the Board's
current perspective on the need for the requirements and limits
contained in this rule. These lessons also raise the need for NCUA's
supervision skills and resources to be enhanced commensurate with a
broader derivatives authority that expands beyond limited pilot usage.
This rule is crafted to address these lessons and the comments received
on the two ANPRs.
E. ANPRs
1. ANPR I
In June 2011, the Board issued an ANPR (ANPR I) requesting public
comment on whether and how to modify its rule on investment and deposit
activities to permit FCUs to enter into derivatives transactions for
the purpose of offsetting IRR.\7\ The Board requested comment on five
broad topics, three of which related to NCUA's pilot programs and
third-party programs. The other two topics directly addressed
independent derivatives authority. The following summary focuses on the
topics directly related to the promulgation of this proposed rule.
---------------------------------------------------------------------------
\7\ 76 FR 37030 (June 24, 2011).
---------------------------------------------------------------------------
First, the Board asked if it should consider allowing credit unions
to engage in independent derivatives activities. Ten out of 29
commenters believed the Board should allow credit unions to engage in
derivatives activity independently, subject to ability, expertise,
adequate understanding and controls, so long as the activity is shown
to reduce IRR. Three commenters supported allowing credit unions to
engage in derivatives activity independently without further comment.
Three commenters supported allowing credit unions that have already
demonstrated ability in a third party program to have independent
derivatives authority. Two supported independent approval only if
limited and qualified by high standards.
Next, the Board asked what criteria it should consider in allowing
a credit union to independently engage in derivatives activities. The
Board suggested criteria such as asset size, capital adequacy, balance
sheet composition, or risk exposure with and without derivatives. Nine
commenters believed there should not be numerical criteria, such as
size. Five commenters thought there should be other criteria
[[Page 32193]]
such as experience, correlation testing and modeling expertise. Two
commenters said the criteria should be the capital or earnings of the
credit union.
In addition, ten commenters stated that credit unions applying to
engage independently should follow the present third party pilot
program standards. Two credit unions said that NCUA should require
credit unions to prepare succession plans, exit plans, and to engage
independent CPAs. Five commenters said that approval to engage
independently should be given on a similar basis as part 704 Expanded
Authorities.\8\
---------------------------------------------------------------------------
\8\ 12 CFR part 704, Appendix B.
---------------------------------------------------------------------------
Finally, the Board asked if it should require credit unions to
demonstrate enhanced functionality in terms of the experience of
personnel, credit analysis and reporting infrastructure to evaluate the
creditworthiness of derivative counterparties. Ten commenters said that
there is no need for enhanced credit functionality because requirements
for bilateral collateral, credit ratings and mandatory clearing make
this unnecessary. Three commenters believed credit unions should show
enhanced credit functionality and that the standard should be clear and
objective. Twelve commenters argued credit unions should demonstrate
enhanced hedging expertise including modeling, live pricing, hedge
impact, trade execution, system capabilities and reporting balance
sheet strategies.
2. ANPR II
The Board issued a second ANPR in January 2012 (ANPR II) \9\ to
obtain further industry input to help ensure that any rule granting
independent derivatives authority is manageable for both participating
FCUs and NCUA, while simultaneously protecting the credit union
industry from undue risk. In ANPR II, the Board asked six questions
regarding the conditions under which NCUA might grant authority for an
FCU to engage in derivatives transactions independently.
---------------------------------------------------------------------------
\9\ 77 FR 5416 (Feb. 3, 2012).
---------------------------------------------------------------------------
Question One. The Board asked if NCUA should require an FCU to
demonstrate a material IRR exposure or another risk management need,
before it receives independent derivatives authority. Seven commenters
supported such a requirement, and 19 opposed it. Eleven of those 19
commenters expressed concern that such a requirement would prevent FCUs
from proactively managing IRR through the use of derivatives before IRR
poses a danger to the FCU.
Question Two. The Board asked if it was appropriate to require
minimum performance levels, as measured, for example, by CAMEL ratings
and net worth classifications, when considering whether to grant an
FCU's application to independently engage in derivatives transactions.
The Board further asked, if the answer is yes, what performance
measures and levels would be appropriate and should the Board permit
waivers from these requirements.
Seventeen commenters stated that NCUA should require minimum
performance levels before approving an FCU's application for
independent derivatives authority. The majority of the suggested
metrics were CAMEL ratings and net worth classifications. Four
commenters suggested a CAMEL 2 rating as a minimum and one suggested a
CAMEL 3 rating. Some commenters opposed using CAMEL ratings because the
ratings contain elements that are not relevant to an FCU's need or
capability to support an independent derivatives program.
Eight commenters argued that NCUA should not require minimum
performance levels. One commenter stated that poorly capitalized FCUs
would actually benefit from derivatives. Another stated that standards
are not necessary because the market would not support an FCU in poor
financial health as a counterparty. Two commenters supported allowing
waivers from performance standards if an FCU could demonstrate that it
met certain criteria, such as need, or could show that it had the
ability to transact derivatives.
Question Three. The Board asked what derivatives experience and
expertise an FCU's staff should demonstrate before receiving
independent derivatives authority. The Board questioned whether NCUA
should require additional experience and expertise when there is more
complexity in the FCU's statement of financial condition and to what
extent an FCU should be allowed to rely on an outside party to fulfill
any such requirements.
Nineteen commenters stated that experience or demonstrated skill
was necessary to conduct derivatives transactions, but they did not
want NCUA to condition approval of independent derivatives authority on
specific experience requirements. Several commenters suggested that FCU
boards of directors should define experience based on each FCU's
derivatives program. One commenter stated that FCUs should demonstrate
an advanced level of skill in conducting derivatives transactions, and
one commenter suggested a broader level of experience such as
professional accreditations to satisfy an experience requirement. Other
commenters argued that, because ``plain vanilla'' derivatives
instruments present little or no risk, the Board should not require
specific experience. Seven commenters supported NCUA allowing third
parties to meet an experience requirement, and seven were opposed.
Question Four. The Board asked whether NCUA should limit FCUs to
using interest rate swaps and interest rate caps and whether interest
rate swaps should be pay-fixed/receive-floating instruments. The Board
also asked what other limits it should establish to ensure that an FCU
does not transact interest rate derivatives in an amount greater than
the level of its IRR exposure.
Twenty-five commenters agreed that NCUA should allow FCUs to use
interest rate caps \10\ and pay-fixed/receive-floating interest rate
swaps \11\ to offset and manage IRR. Twenty of these commenters,
however, suggested that NCUA also allow credit unions to use other
types of derivatives, including floors, collars, pay-floating/receive-
fixed swaps, pay-variable/receive-fixed swaps, basis swaps, forwards,
futures, and swaptions.
---------------------------------------------------------------------------
\10\ In an interest rate cap, one party agrees to compensate
another party for the amount by which an underlying short-term rate
exceeds a specified rate on a series of dates during the life of the
contract.
\11\ A pay-fixed/receive-floating interest rate swap is an
agreement where a credit union pays the counterparty a fixed rate of
return in exchange for returns based upon future rates of a floating
rate index for a predetermined period of time.
---------------------------------------------------------------------------
Question Five. The Board asked whether NCUA or an FCU's board of
directors should establish exposure limits for FCUs and whether there
should 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. The Board also asked whether limits
should be based on the notional amount of a derivatives instrument, its
mark-to-market valuation, or both. Twenty-three commenters suggested
that an FCU's board of directors should set the exposure limits, and
five supported regulatory limits.
Question Six. The Board requested comment on whether there are ways
to mitigate counterparty risk besides posting collateral and sought
suggestions for appropriate collateralization conditions. Fourteen
commenters supported collateral requirements, and four were opposed.
Six credit unions stated that FCUs
[[Page 32194]]
should be allowed to use letters of credit from a Federal Home Loan
Bank or similar institution to meet collateral requirements. Three
credit unions suggested that NCUA should allow the use of a non-zero
threshold for collateral \12\ posting by the counterparty, subject to
the capital strength of the credit union.
---------------------------------------------------------------------------
\12\ A threshold amount is the amount of unsecured credit each
party is prepared to accept before requiring collateral. A non-zero
threshold arrangement means that the parties would be willing to
accept some level of unsecured credit.
---------------------------------------------------------------------------
II. Proposed Amendments
Taking into account the lessons learned from the pilot programs,
the comments from the ANPRs, and the guiding principles in the IRPS,
the Board is proposing the following amendments. The Board believes
these amendments achieve a balance between IRR mitigation, a safe and
sound derivatives program, and flexibility for credit unions.
A. Changes to Part 703
This proposed rule divides part 703 into two subparts. Subpart A
consists of the current part 703, with some minor modifications. These
modifications, discussed below, include added definitions the Board
believes will add to the clarity to the rule. Subpart B consists of
rules and requirements relating to IRR derivatives authority.
As discussed above, current Sec. 703.16(a) lists derivatives as a
prohibited investment for FCUs, but provides three exceptions.\13\ This
proposed rule deletes the general prohibition against derivatives in
Sec. 703.16(a) and moves the exceptions described there to a new
permissible investments paragraph in Sec. 703.14. Proposed paragraph
(k) of Sec. 703.14 authorizes FCUs to enter into all of the
derivatives transactions permitted in current Sec. 703.16(a) plus the
derivatives transactions permitted in proposed subpart B of part 703.
---------------------------------------------------------------------------
\13\ 12 CFR Sec. 703.16(a).
---------------------------------------------------------------------------
This proposed rule also adds a definition of ``derivatives,''
``forward sales commitment,'' and ``interest rate lock commitment'' and
updates the definition of ``fair value.'' The new definitions clarify
terms that are currently used in part 703. The updated definition of
``fair value'' cross references the definition used in GAAP.
B. Derivatives Authority
This proposed rule allows credit unions to enter into interest rate
swaps and to purchase interest rate caps, and it requires pre-approval
for all derivatives users. There will be two levels of pre-approval,
Level I and Level II, permitting different degrees of derivatives
authority with differing degrees of regulatory requirements.
C. Application of the Proposed Rule
The Act permits the Board to prescribe rules and regulations for
all federally insured credit unions it deems are necessary to protect
the NCUSIF and the credit union industry.\14\ Before implementing a
rule that applies to all federally insured credit unions, the Board
carefully considers all available alternatives and the degree of risk
posed to the NCUSIF by an activity the Board seeks to regulate. In the
area of derivatives, the Board recognizes the risks inherent in these
instruments and that the unregulated use of derivatives poses
significant risk to the NCUSIF. For those reasons, this proposed rule
applies to both FCUs and certain FISCUs described below.
---------------------------------------------------------------------------
\14\ 12 U.S.C. Sec. 1789(11).
---------------------------------------------------------------------------
This proposed rule applies to any FISCU that is permitted by its
state law to engage in derivatives. This proposed rule does not grant
any FISCU authority to engage in derivatives if applicable state law
does not expressly allow it. It does, however, require those FISCUs
with derivatives authority under state law to follow the requirements
of this proposed rule. In addition, if aspects of a state's derivatives
rule are more restrictive than this rule, FISCUs in that state must
follow the more restrictive provisions of the state rule. In all other
cases, a FISCU with derivatives authority must follow this proposed
rule.
As discussed in more detail below, this proposed rule requires a
FISCU to submit an application to its SSA. The SSA will review the
application and forward its decision to NCUA for concurrence. The Board
believes this approach will create a uniform system of approval and
examination of credit unions permitted to engage in derivatives
transactions, leading to greater protection of the NCUSIF.
D. Levels of Authority
As noted above, this proposed rule requires pre-approval from NCUA
or, in the case of a FISCU, from the applicable SSA with NCUA's
concurrence. Credit unions meeting specific eligibility criteria under
this rule are permitted to apply for Level I or Level II derivatives
authority.
Level I derivatives authority contains lower permissible
transaction limits, but also entails a more streamlined application
process and less restrictive requirements with respect to experience,
personnel, and systems. Conversely, Level II allows for higher
transaction limits set by NCUA up to a specific ceiling, but entails an
onsite evaluation, higher regulatory requirements, a higher application
fee, and the necessary personnel and systems to be in place before a
credit union may apply. The following chart highlights the differences
between Level I authority and Level II authority. These differences are
discussed in more detail in other sections of this preamble.
Level I and Level II Comparison
------------------------------------------------------------------------
Level I Level II
------------------------------------------------------------------------
Eligibility: To apply for Level I Eligibility:
authority a credit union must: In addition to all of
Show, in its application, how the eligibility criteria under
derivatives are part of the credit Level I in this chart, a
union's IRR mitigation strategy. IRR credit union seeking Level II
mitigation may be of current or authority must also be able to
prospective IRR.. demonstrate in its application
Have a composite CAMEL code why the limits for Level I
rating assigned by NCUA of 1, 2, or 3 authority are not sufficient
with a management component of 1 or 2.. to meet the credit union's IRR
mitigation needs.
Have assets of at least
$250 million, as of its most
recent call report.
Authorities and Limits: Authorities and Limits:
[[Page 32195]]
Interest rate swaps are Interest rate swaps
limited to a notional value of are limited to a notional
100% of net worth. value of 250% of net worth.
Interest rate caps are Interest rate caps are
limited to an aggregate book value limited to an aggregate book
of 10% of net worth. value of 25% of net worth.
The combined limit of NCUA will set the
interest rate swaps and interest combined limit of interest
rate caps is limited to 100% of rate swaps and interest rate
the aggregate limits based on caps during the approval
usage. process.
Aggregate fair value loss Aggregate fair value
on all interest rate swap loss on all interest rate swap
positions cannot exceed 10% of net positions cannot exceed 25% of
worth.\15\. net worth.\16\
Maximum weighted
average life of all
derivatives transactions may
not exceed 7 years.
Maximum weighted average A single
life of all derivatives derivatives position
transactions may not exceed 5 maturity may not exceed 10
years. years.
A single derivatives Single counterparty
position maturity may not exceed 7 notional exposure cannot
years. exceed 100% of net worth for
interest rate swaps and single
counterparty book value may
not exceed 10% of net worth
for interest rate caps.
Application Review by Regulators: Application Review by
Regulators:
90 days from the date the 120 days from the
appropriate Field Director date the appropriate Field
determines a credit union's Director determines a
application is complete or credit union's application
receives a decision from an SSA, is complete or receives a
in the case of a FISCU. decision from an SSA, in
the case of a FISCU.
Application content. A credit union Application content. In
must demonstrate: addition to the content
How derivatives are one part required in an application for
of the credit union's IRR mitigation Level I, a credit union
strategy. Mitigation may be of current applying for Level II
or prospective IRR. authority must also:
How it plans to acquire, Demonstrate why the
employ, and/or create the required limits for Level I authority
resources, policies, processes, are not sufficient for it to
systems, internal controls, modeling, use derivatives as part of its
and competencies. IRR mitigation strategy.
Have the systems and
personnel required by this
rule in place before
submitting its application.
That its senior executive
officers and board of directors
understand the role derivatives
play in the credit union's balance
sheet management and the risk
inherent in derivatives
activities.
How it intends to use
external service providers.
External service providers: A credit External service providers: A
union may contract with external credit union may contract with
service providers to: external service providers to:
Support: Support:
[cir] Evaluating credit risk [cir] Asset/liability risk
management. management.
[cir] Evaluating liquidity risk. [cir] Evaluating credit risk.
[cir] Asset/liability risk management. [cir] Counterparty exposure
management.
[cir] Evaluating liquidity
risk.
Conduct: [cir] Collateral
[cir] Accounting reporting......... management.
[cir] Counterparty exposure [cir] Transaction management.
management.. Conduct:
[cir] Collateral management........ [cir] Accounting reporting.
[cir] Trade execution.............. [cir] Trade execution.
[cir] Financial statement
auditing.
[cir] Transaction management.
[cir] Financial statement auditing. [cir] Legal services.
[cir] Legal services.
Application fee: Application fee:
As set by NCUA. The Board is As set by NCUA. The
considering amounts starting at Board is considering
$25,000. amounts between $75,000 and
$125,000.
------------------------------------------------------------------------
---------------------------------------------------------------------------
\15\ A credit union with Level I authority that exceeds this
limit may not enter into any new derivatives transactions and must
submit a corrective action plan to NCUA (or NCUA and the applicable
SSA, in the case of a FISCU).
\16\ A credit union with Level II authority that exceeds this
limit may not enter into any new derivatives transactions and must
submit a corrective action plan to NCUA (or NCUA and the applicable
SSA, in the case of a FISCU).
---------------------------------------------------------------------------
E. Permissible Transactions
As stated above, this proposed rule limits permissible derivatives
transactions for both Level I and Level II to interest rate caps and
interest rate swaps. The Board considered all of the comments
requesting additional levels of derivatives authority. At the present
time, however, the Board believes that credit unions' capabilities and
experience dictate a targeted approach to permissible derivatives. In
addition, the Board believes this limited permissibility achieves the
purpose of this rule, which is to provide credit unions with a
meaningful tool to mitigate IRR. The Board recognizes and intends that
these proposed limits may not provide mitigation for 100% of every
credit union's IRR. Rather, the Board intends derivatives to be one
part of a broader IRR mitigation and ALM strategy.
With regard to interest rate swaps, the Board is proposing to
authorize only standard ``pay-fixed/receive-floating'' and ``pay-
floating/receive-fixed'' \17\ interest rate swaps. It is currently
anticipated that most interest rate swaps users would enter into ``pay-
fixed/receive-floating'' transactions to hedge against rising interest
rates. This ``plain vanilla'' interest rate swap affords some
protection against the most common interest rate exposure experienced
by credit unions with material IRR sensitivity, namely, a statement of
financial condition with an asset portfolio that does not reset to
external rate changes as quickly as its liabilities.
[[Page 32196]]
Most credit unions use non-maturity and other short-term shares to fund
longer duration assets creating an inherent re-pricing mismatch for
which pay-fixed/receive-floating interest rate swaps can provide some
effective mitigation.
---------------------------------------------------------------------------
\17\ A pay-floating/receive-fixed interest rate swap is an
agreement where a credit union pays the counterparty returns based
on a floating rate index in exchange for returns based on a fixed
rate of interest on a predetermined notional amount for a
predetermined period of time.
---------------------------------------------------------------------------
Many variations of swap structures exist. NCUA is not authorizing
any of the complex variations of the pay-fixed/receive-floating
interest rate swaps structure because doing so introduces measures of
complexity and risk that are more difficult to model, measure, monitor,
and control. The Board does not believe the marginal risk management
utility from more complex structures is sufficient to warrant the
additional inherent risks. The Board seeks comment on whether credit
unions believe that complex swap structures are necessary and, if so,
which structures and why.
The Board is also restricting derivatives transactions to
derivatives that are not leveraged. In some cases financial instruments
have multipliers assigned to interest rate payments. These multipliers
create a form of leverage that can either increase or decrease exposure
to the rate or index to which the financial instrument is exposed. For
example, a financial instrument could be structured to pay a floating
rate of 3-month Treasury Bills times 1.2. This multiplier creates
leverage and is impermissible under this proposed rule. This proposed
rule allows credit unions to engage in a limited amount of ``plain
vanilla'' derivatives transactions. Incorporating leverage could result
in derivatives exposure beyond the limitations in this rule.
The Board is also excluding from the definition of interest rate
swaps those where the notional amount varies because it does not
believe the benefits of these instruments offset their added
complexity. The maturity of instruments where the notional amounts vary
can change in ways that may be unrelated to a credit union's own IRR.
The Board does not intend for derivatives usage to add layers of
complexity to a credit union's IRR management. Instead, the Board
intends for credit unions to use derivatives as one tool in a
comprehensive IRR management approach.
Consistent with the limitations for variable rate investments set
in Sec. 703.14(a),\18\ NCUA is limiting permissible indices for
interest rate swaps to domestic interest rates. In addition, any
derivatives transaction must be denominated in U.S. dollars. These
restrictions are consistent with the use of derivatives to manage IRR,
as a credit union's IRR is correlated to changes in domestic interest
rates.
---------------------------------------------------------------------------
\18\ 12 CFR Sec. 703.14(a).
---------------------------------------------------------------------------
The Board is also proposing to set a three-day settlement
requirement for derivatives transactions. The counterparties to a
derivatives transaction negotiate many elements of the transaction,
including the settlement terms. The Board is proposing a three-day
limitation based on market convention and believes it allows sufficient
time to settle, while preventing forward-settling transactions, which
can be used for speculation rather than mitigation. The Board invites
comments on the appropriateness of this limit in the context of not
wanting to allow forward-settling derivatives transactions.
Finally, this proposed rule prohibits credit unions from using
derivatives to create structured liability offerings \19\ for members
or nonmembers, except as permitted under Sec. 703.14(g) of NCUA's
regulations.\20\ That provision allows FCUs to purchase equity options
for the purpose of offering their members dividends based on the
performance of an equity index. Except for such dividends, FCUs may not
use derivatives to offer structured liability products.
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\19\ A structured liability is an offering with contractual
option features, such as periodic caps and calls, similar to those
found in structured securities or structured notes.
\20\ 12 CFR Sec. 703.14(g).
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F. Eligibility
1. IRR Mitigation
As noted above, some commenters to the ANPRs expressed concerns
with the general concept of requiring credit unions to demonstrate a
material IRR exposure or another risk management need as a condition of
derivatives authority. Other commenters supported requiring a credit
union to demonstrate material IRR exposure before being granted
independent derivatives authority. Among commenters expressing concerns
with the concept of demonstrated need, one common concern was that
requiring demonstrated need will reduce FCUs' incentives to responsibly
manage IRR. The concern suggests that CUs will either proactively
increase IRR in order to demonstrate need or will be less vigilant in
managing IRR.
The purpose of this rule is to provide credit unions that meet
certain standards with interest rate derivatives as an additional tool
to reduce IRR exposure. As suggested by commenters, the Board
recognizes that requiring the demonstration of material need for IRR
reduction may create perverse incentives and lead to unintended
consequences.
As discussed below, rather than demonstrate material interest rate
risk exposure, a credit union must present a comprehensive risk
management strategy, and articulate how the inclusion of interest rate
derivatives will complement existing risk mitigation tools. In
addition, a credit union applying for Level II authority must show why
the limits in Level I authority are not sufficient to meet its IRR
mitigation needs. The Board believes these requirements eliminate the
unintended consequences cited by commenters, while ensuring a credit
union fully considers how derivatives fit within its overall IRR
mitigation strategy.
2. CAMEL Requirements
This proposed rule also requires a credit union's most recent
composite CAMEL code rating, assigned by NCUA, to be a 1, 2, or 3, with
a management component rating of 1 or 2. The Board believes that a high
management component rating accounts for credit unions that may have a
weak financial position because of IRR, but have the management in
place to effectively identify, measure, monitor, and control
significant risks. The Board intends this eligibility requirement to
ensure that well-managed credit unions that need derivatives to
mitigate IRR are able to obtain this authority.
3. Asset Threshold
As an eligibility requirement, the Board is also proposing an asset
threshold of $250 million. An asset threshold of $250 million includes
most credit unions with IRR exposure and the capacity to use
derivatives. The Board arrived at this threshold by analyzing interest
rate exposure at credit unions of varying asset size, the share of
these credit unions' assets as a share of the credit union system, and
the use of interest rate derivatives by similarly-sized community
banks.
a. IRR Exposure
The Board notes that IRR is more prevalent among credit unions with
assets over $250 million. Table 1 provides the average share of fixed
rate assets, average share of money market deposits, and average share
of non-core deposits (e.g., deposits other than regular share and share
draft accounts). These assets and liabilities represent the primary
drivers of IRR exposure in a credit union's portfolio. Credit unions
with more than $250 million in total
[[Page 32197]]
assets have nearly twice the exposure to fixed rate assets and hold a
much greater share of non-core deposits than credit unions with $250
million or less in assets.
Credit unions with more than $250 million in total assets represent
78% of the system-wide assets. With much of the IRR in these larger
credit unions, the rule covers the vast majority of the IRR in the
credit union system.
Table 1--IRR Exposure at Credit Unions by Asset Category (2012Q4) 21
----------------------------------------------------------------------------------------------------------------
Asset category
---------------------------------------------------------------------------
< $250M $250M-$1B $1B-$5B $5B+
----------------------------------------------------------------------------------------------------------------
Share of Loans in Fixed Rate 18% 35% 38% 36%
Mortgages..........................
Share of Deposits in Money Market 8% 22% 27% 26%
Accts..............................
Share of Non-Core Deposits.......... 32% 54% 60% 61%
----------------------------------------------------------------------------------------------------------------
Number of Credit Unions............. 6,066 556 180 17
Share of Systemwide Assets.......... 22% 27% 33% 18%
----------------------------------------------------------------------------------------------------------------
b. Capacity
The cost to build staff and execute trades, and the counterparty
requirements for many derivatives contracts, restricts most of these
transactions to large commercial banks and community banks with more
than $250 million in total assets. The Board believes this also holds
true with credit unions. Table 2 below demonstrates the increasing
likelihood of derivatives participation among larger financial
institutions.
---------------------------------------------------------------------------
\21\ Data from the 2012Q4 NCUA Call Report.
Table 2--Capacity for Derivatives Based on Bank Use Rates 22
----------------------------------------------------------------------------------------------------------------
Asset category
---------------------------------------------------------------------------
< $250M $250M-$1B $1B-$5B $5B+
----------------------------------------------------------------------------------------------------------------
Number of Banks and Thrifts......... 4,506 1,918 490 178
Number of Banks and Thrifts Holding 347 535 280 148
Any Interest Rate Derivatives......
Derivatives Use Rate................ 8% 28% 57% 83%
Average Notional Amount Held........ $0.7M $12M $94M $1.0T
----------------------------------------------------------------------------------------------------------------
Based on these considerations, the Board believes an asset
threshold of $250 million is appropriate. It will allow those credit
unions with the need and capacity to take advantage of this additional
IRR mitigation tool.
---------------------------------------------------------------------------
\22\ Data calculated from the 2012Q4 FDIC Call Report and is
calculated for all banks and thrifts that report non-zero notional
amounts outstanding for interest rate derivatives contracts.
---------------------------------------------------------------------------
In addition, a threshold of $250 million is a benchmark NCUA uses
in other supervision areas, such as for annual examinations for FISCUs.
The Board believes this figure represents a relative distinction
between credit unions with more complex asset-liability structures and
risks.
G. Proposed Requirements
The following discussion outlines the proposed requirements for
credit unions with Level I and Level II authority. The Board points out
the distinctions between the two levels and explains the reason for the
differences. As discussed above, the difference between the two levels
is in the permissible levels of transactions, as well as the
application, expertise, and systems requirements.
1. Policies and Procedures
This proposed rule requires a credit union applying for Level I or
Level II authority to operate according to written policies and
procedures. These policies and procedures must, at a minimum, address
managerial oversight, scope of activities, approved counterparties,
risk management, legal issues, accounting standards, limits,
counterparty exposure, margin requirements, and reporting requirements.
The proposed rule requires that a credit union's board of directors
review these policies and procedures annually and update them when
necessary.
The Board believes it is important for everyone involved in a
credit union's derivatives program, including external service
providers, to be aware of the derivatives program's requirements,
restrictions, and parameters. In addition, the Board believes written
policies help ensure a credit union's board of directors contemplates
every aspect of a derivatives program and the effect each will have on
the credit union. An annual review will ensure the policies are updated
to reflect the changing environment and the credit union's needs and
goals.
2. Collateral Requirements
The Board is proposing requirements for collateral to ensure credit
unions are fully protected in the event of market disruptions or
counterparty defaults. These proposed collateral requirements include
limiting collateral to highly liquid instruments permitted under the
Act.
The proposed rule restricts the forms of collateral that are
permitted for a credit union to the most liquid and easily valued
instruments so that they can be easily negotiated even in times of
market illiquidity. In addition, collateral arrangements must be
bilateral and collateral may not be held by counterparties except at a
legally separate affiliate. These requirements ensure that a credit
union's exposure is de minimis by specifying that derivatives positions
are priced daily, that the threshold amounts at which collateral is
required are zero, and that mandatory triggers for transfer amounts are
low. The Board has also included a proposed requirement that accounts
for cases where a credit union lacking financial strength may be
required to
[[Page 32198]]
post additional collateral for a counterparty to be willing to
transact.
The Board notes that all of these proposed collateral provisions
are based on common practices in the derivatives market. In addition,
the Board believes these provisions will help protect the safety and
soundness of a credit union with derivatives authority and will not
pose an unreasonable burden.
This proposed rule limits eligible collateral to cash, Treasury
securities, fixed-rate non-callable agency debentures, and zero-coupon
non-callable agency debentures. Eligible collateral must also be
permissible under the Act, part 703 of NCUA's regulations, and the
credit union's own investment policy. NCUA is aware that these
collateral restrictions are more limited than the permissible
investments in the Act and NCUA's regulations, but the Board believes
implementing narrower limitations is necessary to ensure collateral
will be both highly liquid and easy to value. The Board notes that both
Treasury and agency securities are generally considered the most liquid
debenture sectors within the fixed-income arena. Furthermore, limiting
agencies to fixed-rate and zero-coupon, non-callable structures further
increases liquidity and ease of valuations. The importance of
collateral in a derivatives transaction is to protect a credit union in
the event the derivatives counterparty fails. Requiring highly liquid
and easy to value securities, or cash, will help ensure credit unions
are protected in the event of a counterparty default. The Board
believes these restrictions will provide ample collateral options to
derivatives counterparties.
In addition, the proposed rule requires that derivatives exposures
be fully collateralized. This requirement is also an integral part of
derivatives clearing requirements for banking organizations
participating in the derivatives markets, including margins on
collateral. Collateral management integrally reinforces good
counterparty management.
Credit unions also need to consider the possible effects of
derivatives transactions on liquidity. This includes the use of liquid
assets as collateral for transactions which may reduce assets available
for other liquidity needs. Margin requirements can fluctuate and
require increasing amounts of collateral. Credit unions with Level II
derivatives authority in particular should be aware of additional
liquidity pressure from increased margin requirements for counterparty
exposure under potential stress conditions where the credit union's
loss on a derivatives position increases significantly. The replacement
cost for a terminated or defaulted derivative transaction can also
impinge on liquidity.
The proposed rule also limits a collateral custodian to an entity
that is not the counterparty to the transaction (except for affiliates
that are separate legal entities organized under U.S. law), is
authorized to be a custodian, is subject to federal or state
examination, and has equity of at least $50 million. Like the
restrictions on counterparties discussed below, the Board is proposing
this limitation to ensure that any entity holding collateral in a
derivatives transaction is qualified and well capitalized so as not to
add undue risk to a derivatives transaction.
3. Counterparty Requirements
In addition to the proposed collateral requirements to reduce risk
to credit unions, the Board is proposing counterparty requirements with
the same intent. First, the proposed rule limits credit risk by
limiting permissible counterparties to swap dealers and major swap
participants as defined by the Commodity Futures Trading Commission
(CFTC).\23\ At the time of this proposed rule, more than 70 domestic
swap dealers have provisionally registered with the CFTC under its
clearing requirements. By restricting counterparties to swap dealers
and major swap participants, the Board is limiting counterparties to
established institutions that meet the standards of and are subject to
oversight by the CFTC. This pool of counterparties is sufficiently
broad for credit unions to access the derivatives markets. The proposed
rule also limits counterparties to those doing business under the laws
of the United States to protect credit unions in case of counterparty
dispute.
---------------------------------------------------------------------------
\23\ 17 CFR Sec. Sec. 1.3(ggg) and (hhh).
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Second, the Board is proposing to require credit unions to develop
the internal capacity to conduct a credit risk analysis of any
potential counterparty. This means that a credit union must be able to
carefully assess the likelihood of default and timely repayment of
derivatives obligations. In addition, a credit union must be aware of
the financial strength of its counterparties, as well as the
counterparty's capital buffers to absorb losses and access liquidity.
4. Reporting
The proposed rule requires the senior executive officers to deliver
a monthly report to the credit union's board of directors on certain
aspects of the derivatives program. The proposed rule defines a credit
union's senior executive officers as a credit union's chief executive
officer (typically this individual holds the title of president or
treasurer/manager), any assistant chief executive officer (e.g., any
assistant president, any vice president or any assistant treasurer/
manager), and the chief financial officer (controller) that are
directly within the chain of command for the oversight of a credit
union's derivatives program, as identified in a credit union's process
and responsibility framework.
This report must include an identification of noncompliance with
the credit union's policies or any applicable law or regulation,
including this rule, utilization limits, an itemization of the credit
union's individual positions, a comprehensive view of the credit
union's balance sheet, and the cost of executing new derivatives
transactions. The Board believes it is important for a credit union's
board of directors to be timely and accurately informed about the
condition of the derivatives program so that it can make adjustments in
the derivatives strategy to ensure the short and long-term goals of the
credit union are met.
The Board also expects that senior executive officers would receive
daily and weekly reports from individuals responsible for managing
transactions and tracking risk compliance. While not included in the
rule, the Board believes this is a prudent strategy to ensure adequate
supervision of the derivatives program.
5. Systems, Processes, Personnel
The Board believes that appropriate systems, processes, and
personnel are vital to a safe and successful derivatives program. The
Board, therefore, has proposed several related requirements. The Board
notes certain differences between systems, processes, and personnel
requirements for Level I and those for Level II. The Board believes
that the Level II requirements should be greater because of the higher
transaction limits. The specific requirements are discussed below.
a. Personnel
Having the proper personnel in place at a credit union is
fundamental to ensuring the safety and soundness of a derivatives
program. To ensure a derivatives program is well managed and achieves
the goals of the credit union, the board of directors, senior executive
officials, and qualified derivatives personnel need to have varying
degrees of knowledge and
[[Page 32199]]
expertise to carry out their respective functions.
i. A Credit Union's Board of Directors
A credit union's board of directors is responsible for establishing
the business plan for the credit union and ensuring that the policies
and programs achieve the goals of that plan. A credit union's board of
directors must receive training before the credit union enters into any
derivatives transactions, and annually thereafter. This training should
educate the board members on the benefits and risks associated with
derivatives, as well as how derivatives fit within a credit union's
balance sheet and can be used as an effective IRR mitigation tool. The
Board expects this training will provide a credit union's board of
directors with the knowledge necessary to fulfill its fiduciary
responsibility and provide strategic oversight of a derivatives
program. A credit union must make evidence of this training available
during its next NCUA or SSA examination.
ii. Senior Executive Officers
A credit union's senior executive officers are tasked with carrying
out the credit union board's plan for using derivatives. This includes
understanding the benefits and risks associated with derivatives as
well as knowing how derivatives fit within the credit union's business
model and balance sheet. As these officers are directly overseeing the
day-to-day operation of a credit union's derivatives program, the Board
expects them to have a comprehensive understanding of derivatives.
During a credit union's application process, NCUA will evaluate each
senior executive officer responsible for overseeing the credit union's
derivatives program to ensure that each person has the education,
skills, and experience necessary to oversee a derivatives program that
is managed safely and effectively.
A credit union must immediately notify NCUA (and, if applicable,
the appropriate SSA) when a senior executive officer position as
defined in this rule becomes vacant.\24\ A credit union must also
immediately provide NCUA (and, if applicable, the appropriate SSA) with
documentation evidencing knowledge and experience for any person who
becomes a senior executive officer as defined in this rule while the
credit union has derivatives authority. This supporting documentation
must demonstrate that the new senior executive officer has the skill
and experience required by the rule. Failure to provide this
documentation or to show that the new senior executive officer is
qualified under the rule will mean the credit union is no longer in
compliance with the rule, and would be subject to the regulatory
violation provisions, discussed below.
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\24\ Senior executive officer is, for the purposes of this
proposed rule, a credit union's chief executive officer (typically
this individual holds the title of president or treasurer/manager),
any assistant chief executive officer (e.g., any assistant
president, any vice president or any assistant treasurer/manager),
and the chief financial officer (controller) that are directly
within the chain of command for the oversight of a credit union's
derivatives program, as identified in a credit union's process and
responsibility framework, discussed in Sec. 703.108(b)(2) of the
proposed rule.
---------------------------------------------------------------------------
iii. Qualified Derivatives Personnel
In order to engage in any new activity, it is incumbent on the
credit union to ensure that personnel with appropriate training and
experience are responsible for the day-to-day activity. The risk of a
derivatives program is not limited by the complexity of permissible
products. While the Board is proposing ``plain vanilla'' interest rate
swaps and interest rate caps as a way to mitigate a credit union's IRR,
these tools still present complex issues with the transaction, risk
management, and the operational aspects of a derivatives program.
The proposed rule requires three years of experience for qualified
derivatives personnel at a credit union seeking Level I authority and
five years of experience for Level II. The Board believes that
increased limits correlate with increased risk, which necessitates
additional experience by a credit union's qualified derivatives
personnel. To satisfy the experience requirement of the proposed rule,
qualified derivatives personnel must have at least the requisite number
of years of direct transactional experience in the trading,
structuring, analyzing, monitoring, or auditing of financial
derivatives transactions at a financial institution, a risk management
advisory practice, or a financial regulatory organization. Staff must
also have the demonstrated expertise in statement of financial
condition analysis. The Board believes that direct experience with
derivatives allows a credit union to effectively manage risk and
properly execute all derivatives transactions.
The Board recognizes the comments on ANPR II stating that NCUA
should not condition approval on experience requirements. The Board
believes that without qualified staff, however, a credit union will not
be able to safely and effectively manage a derivatives program.
6. Internal Controls Structure
In addition to having the proper personnel in place, it is
imperative that a credit union be organized in a way that ensures the
proper level of oversight, separation of duties, and reviews and
audits. As discussed below, this proposed rule has six requirements the
Board believes will ensure a credit union's derivatives program is
operated safely and soundly.
a. Separation of Duties
An important internal controls principle is dividing duties so that
no one person has sole control over any transaction and its recording
and accounting. Separation of duties helps reduce an employee's
opportunity to commit and conceal fraud or errors. Errors in
derivatives operations can result in significant losses because of the
effect of leverage. Accordingly, the proposed rule requires that as
part of its derivatives management and internal controls structure, a
credit union maintain separation of duties for the functions of: (1)
Derivatives execution and oversight; (2) accounting for and
confirmation of derivatives transactions; (3) ALM; and (4) credit,
collateral, and liquidity management. The Board believes these core
functions must be accomplished by different people to ensure an
effective system of checks and balances.
b. Framework
This proposed rule also requires a credit union with derivatives
authority to maintain, in its written derivatives policy, a written and
schematic description of the derivatives decision process. This
framework description must show how decisions on derivatives are made,
starting with the board's decision to use derivatives to mitigate IRR,
to the senior executives formulating a derivatives plan and choosing
the counterparties and derivatives, to the execution of the derivatives
transaction and the monitoring and accounting through the life of the
transaction. The Board is requiring that this framework be both written
and in a schematic or flow chart form. A visual depiction of a credit
union's decision process provides the credit union's employees and
examiners with a useful summary of who is making and executing all of
the decisions and functions associated with the credit union's
derivatives program.
c. Internal Controls Audit
A credit union with Level I or Level II derivatives authority must,
at least annually, have an internal controls audit conducted by an
external service
[[Page 32200]]
provider. The credit union must ensure the external service provider is
experienced in auditing derivatives transactions, including, but not
limited to, valuation methods and risk management modeling techniques,
and is familiar with the credit union's IRR model and the related
assumptions and inputs to test for reasonableness.
The scope of the audit must include coverage of the accounting,
legal, operating and risk controls. The legal audit section should
ensure executed contracts are in place with all counterparties and
external service providers used in the derivatives program. The
auditors will need to ensure all material contracts have been reviewed
by counsel.
Scoping for operating and risk controls should include at a minimum
a review of and testing for segregation of duties to ensure no one
party or department is responsible for executing, documenting
(accounting), and risk reporting of derivatives transactions along with
compliance with policies and procedures. In addition, the audit must
address collateral management to ensure the credit union is adequately
monitoring and valuing its positions with counterparties. This includes
independent valuations and review of counterparty pricing reports.
d. Financial Statement Audit
Currently, NCUA only requires financial statement audits for credit
unions with assets of $500 million or more.\25\ The Board, however, is
proposing to require financial statement audits for any credit union
with derivatives authority. Financial statement audits express an
opinion as to whether the financial statements fairly present the
credit union's financial position and the results of the operations and
its cash flows in conformity with GAAP. The licensed certified public
accountants responsible for the financial statement audit must have
experience evaluating derivatives transactions.
---------------------------------------------------------------------------
\25\ 12 CFR Sec. 715.5.
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Using derivatives exposes credit unions to a variety of risks,
including market, counterparty, credit, and liquidity risks.
Consequently, the review of written policies, internal controls,
financial reporting, and regulatory requirements is imperative. Because
accurate financial reporting is paramount to effectively manage risk
and make sound business decisions, the Board believes it is prudent to
require financial statement audits for all credit unions with approved
derivatives authority. This is a new requirement only for those credit
unions with assets between $250 million and $500 million. The Board is
also proposing a conforming change to part 715 to clarify that credit
unions with assets over $500 million and any credit union engaged in
derivatives must obtain a financial statement audit.
e. Legal Review
The proposed rule requires a credit union to obtain a legal opinion
from qualified counsel before executing any derivatives transaction.
Qualified counsel means an attorney with at least five years of
experience reviewing derivatives transactions. This attorney may be the
credit union's in-house counsel or the credit union may need to retain
outside counsel. The Board is proposing this requirement to ensure that
any attorney providing a legal opinion on a credit union's derivatives
program has the requisite skills and experience to properly evaluate
International Swap Dealers Association (ISDA) agreements and
compliance.
The legal opinion must conclude that the credit union's ISDA
agreements are enforceable and the credit union is in compliance with
all applicable laws and regulations relating to its derivatives
program. Like the 1998 IRPS, this proposed rule also requires that a
credit union ensure any counterparty is authorized to enter into the
transaction.
f. Hedge Review \26\
---------------------------------------------------------------------------
\26\ Hedge review means an analysis of the specific derivatives
transaction a credit union is considering, to ensure that the
transaction will mitigate IRR on the credit union's balance sheet.
---------------------------------------------------------------------------
The proposed rule requires a credit union to conduct a hedge review
before executing a derivatives transaction. This review entails
identifying and documenting the circumstances leading to the decision
to hedge, specifying the derivatives strategy, and demonstrating that
the derivatives transaction is protecting against the loss it was
intended to mitigate. The Board included this requirement to ensure
that two conditions are met: (1) A credit union with derivatives
authority is using derivatives for their intended purpose, the
mitigation of IRR; and (2) the credit union has a well thought out and
documented plan of how and why it will hedge particular IRR on its
balance sheet. The Board believes this requirement achieves both of
these goals.
7. Transaction Management
The proposed rule requires credit unions to have support systems in
place to provide accurate and timely transaction processing. The Board
believes this requirement will help credit unions ensure that
derivatives transactions are executed in a timely manner and in
accordance with the policy of the credit union's board of directors.
Under this requirement, credit unions should be able to document a
derivatives transaction, including the price paid, collateral
requirements, identification of the counterparty, life of the
transaction, and reason for the hedge. Under the reporting section of
the proposed rule, these items must be included in the monthly report
to the credit union's board of directors. Further, the Board believes a
credit union must be able to accurately account and record a
derivatives transaction, just as it would any other transaction.
8. Asset Liability Management (ALM)
The proposed rule describes the management of derivatives as part a
credit union's overall ALM. It is critical for the credit union to have
staff with sufficient expertise to perform this function. It is equally
important for the credit union to have an ALM function in place that is
sufficiently well-developed to measure, monitor, and control all
aspects of the credit union's statement of financial condition,
including the credit union's derivatives activities. A credit union
will need to manage the risk of derivatives transactions itself, within
a clearly stated ALM strategy, while testing and demonstrating the
effectiveness of these transactions in reducing IRR exposure.
Therefore, as well as testing past effectiveness, a credit union must
assess the likely effectiveness of its derivatives transactions in
reducing IRR exposure going forward under a range of stressed rate and
statement of financial condition scenarios. The credit union will also
need to consider a variety of alternative strategies to reduce IRR in
order to perform this function successfully.
The proposed rule identifies a number of ALM process elements that
are necessary to successfully manage derivatives activity. Clear,
comprehensive reporting by senior management to the credit union's
board of directors is essential to identify any policy exceptions and
to ensure that management of derivatives is clear and transparent at
the highest level. The credit union should state individual and
aggregate derivatives exposure within the context of the overall
balance sheet of the credit union. The credit union should clearly
capture, monitor, and report the cost of these transactions.
Appropriate separation of duties is necessary to maintain accurate
review and disclosure. The credit union will
[[Page 32201]]
need ALM systems that are able to identify the value of any of its
derivatives transactions, and must have the capacity to state this
value as part of a net economic value calculation of the credit union's
balance sheet.
9. External Service Providers
The Board believes external service providers (ESPs) \27\ can play
a vital role in the overall success of a derivatives program. The
Board, however, is concerned that overreliance on ESPs in the complex
area of derivatives may lead to additional risk to the credit union.
Potential conflicts exist because external parties do not share the
same fiduciary responsibility as the credit union and they have
financial objectives and incentives that are different as well. The
Board, therefore, is proposing to allow credit unions to utilize ESPs
in limited ways, provided that credit unions meet certain conditions
and restrictions. In addition, the Board is proposing differing levels
of ESP involvement for credit unions with Level I and Level II
authority. As noted above, credit unions with Level II authority must
have a higher degree of infrastructure and experience to obtain a
higher level of authority. Behind this requirement is the idea that
these credit unions should have more internal capacity, and, therefore,
less reliance on ESPs, than credit unions with Level I authority.
---------------------------------------------------------------------------
\27\ An external service provider is any entity that provides
services to assist a credit union in carrying out its derivatives
program and the requirements of this rule. An external service
provider does not include a credit union service organization that
is wholly owned by the credit union receiving the services.
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First, the proposed rule prohibits credit unions from using ESPs
that are principals or agents to derivatives transactions involving the
credit union. NCUA is aware that some credit unions have ESP
relationships with firms that provide services and act as agents or
principals for securities trades. Unlike securities, derivatives
transactions are unique agreements between two parties and pricing
transparency is typically considerably more limited. This limited
transparency makes it harder for a credit union to determine what fees
are being charged to execute the transaction. Additionally, principals
or agents may have an incentive to enter into derivatives trades to
generate income for themselves. The potential conflicts of interest and
the limited transparency are the primary reasons for the prohibition on
ESPs being principals or agents in derivative transactions. The Board
further believes that credit unions have sufficient alternatives for
ESPs beyond principals or agents in derivative transactions.
Second, the Board believes that credit unions can make responsible
use of contractual services provided by independent ESPs, as part of an
effective derivatives and balance sheet management process. Responsible
use of ESPs requires a credit union to have the internal capacity,
experience and skills to oversee and manage any ESP activities. More
generally, a credit union must retain responsibility and control over
the derivatives and balance sheet management process and decision
making. The credit union is responsible for managing ESP work products
and must have a full understanding of ESPs' activities.
While the Board supports the use of ESPs, there are some activities
that the Board believes are so central to demonstrating effective
managerial control that the credit union must conduct them.\28\ The
Board is proposing to allow Level II credit unions more restricted use
of ESPs because it believes that institutions able to take greater
risks must have greater in-house risk-management capabilities.
---------------------------------------------------------------------------
\28\ For purposes of this rule, a wholly owned credit union
service organization may perform these functions for the credit
union that wholly owns it. If the CUSO provides services to other
credit unions, it will be an ESP and subject to the restrictions in
the proposed rule.
---------------------------------------------------------------------------
The proposed rule classifies a number of activities into two
categories of permissible use of contractual services and support. The
functions in each classification vary between Level I and Level II
authority. The two classifications are:
Support: A credit union is required to conduct the functions in
this category. ESPs can provide assistance and input, but a credit
union is prohibited from allowing an ESP to conduct the function or
activity in lieu of the credit union.
Conduct: A credit union may contract with an ESP to conduct a
function or activity in this category as part of the management and
internal controls structure. While a credit union is responsible for
managing an ESP's work quality and must have full understanding of all
ESP activities and work products, it is not required to maintain in-
house capacity for the function or activity. The table below summarizes
the permissible uses of ESPs outlined in the proposed rule.
----------------------------------------------------------------------------------------------------------------
Level I Level II
Function -----------------------------------------------
Support Conduct Support Conduct
----------------------------------------------------------------------------------------------------------------
Asset Liability Management...................................... X .......... X ..........
Accounting and Reporting........................................ .......... X .......... X
Credit Risk..................................................... X .......... X ..........
Counterparty Exposure Management................................ .......... X X ..........
Collateral Management........................................... .......... X X ..........
Liquidity Risk.................................................. X .......... X ..........
Trade Execution................................................. .......... X .......... X
Transaction Management.......................................... .......... X X ..........
Financial Statement Auditing.................................... .......... X .......... X
Legal Services.................................................. .......... X .......... X
----------------------------------------------------------------------------------------------------------------
10. Limits
a. Interest Rate Swaps and Interest Rate Caps
The proposed rule includes limits for Level I and Level II
authorities on the amount of derivatives exposure a credit union may
take. These limits are intended to provide credit unions with
sufficient tools to manage IRR based on the credit union's ability to
independently manage its derivatives program. The Board, in
establishing the limits, is also trying to limit the amount of
potential loss exposure derivatives transactions may cause the credit
union and NCUSIF. Derivatives exposure limits are measured differently
for interest rate caps and interest rate swaps. The Board chose
relatively simple measurement tools and acknowledges they may not fully
capture all risks associated with derivative exposure. However, the
[[Page 32202]]
Board is comfortable that the methodology limits loss exposure, is easy
to understand, and will allow credit unions to manage their IRR
exposure. In addition, the Board chose these proposed limits with the
intent that derivatives would not provide every credit union with
complete IRR mitigation. Rather, the Board intends derivatives to be
one part of an overall IRR mitigation strategy.
The proposed limit on interest rate caps is measured by the
exposure of book value to net worth. The Board chose book value as the
limit's measurement basis since it measures the amount of net worth at
risk if the cap becomes worthless through the event of a default by the
counterparty. Interest rate caps are typically purchased with strike
rates \29\ above current rates and pay the purchaser when interest
rates increase above the strike rate. The premium that a purchaser pays
at inception of the interest rate cap represents the maximum amount of
potential loss to net worth on day one of the transaction. This premium
will fluctuate over time, and value changes are reflected through
changes in the income statement. GAAP hedge accounting treatment
dictates whether the premium can be amortized or is subject to changes
in fair value. The Board considered using notional value as a
limitation, but decided book value was a more appropriate measurement
because it accurately captures the risk associated with interest rate
caps without unreasonably limiting a credit union's ability to mitigate
IRR. The Board specifically requests that interested stakeholders
provide suggestions of alternative methodologies to measure and limit
cap exposure for credit unions and explain why the alternative is
better than book value. The Board requests that any alternative
measurement for credit unions to measure and report be straightforward.
---------------------------------------------------------------------------
\29\ Strike rate means the interest rate that triggers payments
to the credit union under the contract.
---------------------------------------------------------------------------
The proposed limit on interest rate swaps is measured using
notional exposure and fair value loss. Both measurements use the credit
union's net worth as the basis. The Board chose two separate types of
limitations for interest rate swaps based on lessons learned from the
corporate credit union crisis. Unlike interest rate caps, an interest
rate swap can result in the credit union owing the counterparty if
rates move the opposite way from which the credit union is hedging.
This loss can be magnified if the value of the hedged assets declines.
Therefore, the Board is proposing to limit the notional amount of swap
exposure a credit union may have regardless of whether the credit union
is in a fair value gain or loss position. Further, the Board is
proposing fair value loss limits that trigger a suspension of
derivatives transactions and the submission of a corrective action plan
if the credit union reaches certain levels of losses. As noted above,
the proposed rule contains different loss limits for Level I and Level
II.
The proposed rule allows credit unions with Level I authority to
have book value of up to 10% of net worth in caps and up to a notional
value of 100% of net worth in swaps exposure with a total fair value
loss limit on swaps of 10% of net worth. A credit union with Level I
authority using both interest rate swaps and interest rate caps will be
subject to a combined limit. The combined limit requires that the sum
of the percentage utilization of the interest rate swaps limit and
interest rate caps limit is less than or equal to 100%. For example,
consider a credit union that holds interest rate swaps with a notional
balance equal to 75% of net worth (or 75% of the interest rate swaps
limit) and interest rate caps with an aggregate book value equivalent
2.5% of net worth (or 25% of the interest rate caps limit). Combining
the interest rate caps and interest rate swaps limits utilization
percentages (75% + 25%) equals 100%. Therefore this credit union is at
the limit and unable to add additional derivative positions.
Both the interest rate swaps limit and the interest rate caps limit
are designed to make identifying and tracking exposure easy for credit
unions. The Board believes these limits are appropriate given the
risks, personnel, and systems required under the proposed rule for
Level I authority, which are discussed above. The Board also believes
these limits are sufficient for credit unions with lower levels of IRR
and infrastructure to adequately use derivatives as an additional IRR
mitigation tool.
The proposed rule allows credit unions with Level II authority to
have book value of up to 25% of net worth in interest rate caps and up
to a notional value of 250% of net worth in interest rate swaps
exposure with a total fair value loss limit on interest rate swaps of
25% of net worth. NCUA will establish a combined limit for credit
unions with Level II authority up to the maximum limit for caps and
swaps. NCUA will establish this limit during the approval process based
on the resources and need of the applying credit union. The Board
believes these higher limits, in contrast to those for Level I, are
appropriate given the added requirements for Level II credit unions.
These higher limits will allow a credit union with considerably more
infrastructure and experience to utilize additional derivatives to
mitigate higher levels of IRR.
As identified in the discussion of the Level I and Level II limits
on swaps, the proposed rule includes limits on a credit union's loss on
swaps. The Board believes it is appropriate to include this additional
limit on swaps given their riskier nature and the potential for losses.
The Board's goal is to ensure the financial health of a credit union is
not jeopardized by the declining value of swaps positions. The
difference in the individual limits in this area reflects a higher
level of experience and derivatives management capability at Level II
credit unions, as well as a higher level of regulatory due diligence at
the time NCUA reviews a credit union applying for Level II authority.
b. Maturity
In addition to the limits discussed above, the proposed rule
includes limits on the individual maturities of derivatives
transactions and the combined weighted average life of derivatives
transactions for both Level I and Level II. Unlike exposure limits,
these limits are applied equally to interest rate caps and interest
rate swaps and are based on the notional amount. The Board notes that,
like bonds, the risk of derivatives transactions increases as the
maturity length increases. The Board believes that limiting the term of
individual transactions and the weighted average life of the portfolio
is an additional way to limit losses for a credit union and the NCUSIF,
while not hindering a credit union's ability to mitigate IRR.
The proposed rule prohibits a credit union with Level I derivatives
authority from having individual derivatives transactions that exceed a
maturity of seven years. Further, the weighted average life of all
derivatives in the credit union's portfolio cannot exceed five years.
The Board believes these limits are appropriate given the risks,
personnel, and systems required for Level I authority.
Conversely, the proposed rule prohibits credit unions with Level II
derivatives authority from having derivatives transactions that have a
maturity longer than ten years or a weighted average life of all
derivatives in its portfolio greater than seven years. These longer
maturities reflect the increased requirements for and supervision of a
credit union with Level II authority.
[[Page 32203]]
The following table illustrates the differing limits between Level
I and Level II:
------------------------------------------------------------------------
Authority Level I Level II
------------------------------------------------------------------------
Interest Rate Caps.............. Book value of up Book value of up
to 10% of net to 25% of net
worth. worth.
Interest Rate Swaps............. Notional Notional
value of up to value of up to
100% of net worth. 250% of net
worth.
Must Must
suspend suspend
derivative derivative
activity if total activity if total
fair value of fair value of
swap loss swap loss
position exceeds position exceeds
10% of net worth. 25% of net worth.
Combined Limits................. A weighting Determined during
between both approval process.
limits to equal
100%. For
example, 50% of
cap limit would
allow for 50% of
swap limit.
Tenor Limits....................
Derivative Derivative
portfolio portfolio
weighted average weighted average
life limit of 5- life limit of 7-
years. years.
Single Single
transaction transaction
maturity limit of maturity limit of
7-years. 10-years.
------------------------------------------------------------------------
G. Application Procedures and Content and Review
The Board is proposing an application process that requires an
applying credit union to demonstrate the requisite systems and
expertise to support derivatives. In accordance with the increased
levels for a credit union applying for Level II authority, the
application process for this authority will be more thorough and will
include an NCUA on-site review of the derivatives program
infrastructure.
1. Application Content
The application process begins with the credit union submitting
comprehensive documentation demonstrating that it meets the
requirements for the level of authority it is applying for. The Board
considers derivatives authority as an advanced ALM tool and expects a
credit union's infrastructure to sufficiently support the activity.
Application requirements represent items the Board regards as necessary
components of enhanced ALM and critical derivatives program functions.
A credit union applying for either level must provide an IRR
mitigation plan, which demonstrates how derivatives fit within that
plan. The Board notes that while the need to mitigate IRR may be a
prospective need, a credit union may not use derivatives to speculate.
A credit union's plan should show that derivatives are an effective
part of a credit union's IRR mitigation plan and that the credit union
has other tools it is using to mitigate IRR. In addition to this
requirement, a credit union applying for Level II authority must
demonstrate why the limits in Level I are insufficient for its IRR
mitigation needs. A credit union should be able to show in its
application that even after employing other mitigation strategies it
still has a need for derivatives limits that are higher than under
Level I.
A credit union's senior executive officers and board of directors
must understand how derivatives fit within the credit union's business
model and balance sheet and be able to articulate how they intend to
use ESPs. A credit union applying for Level I must demonstrate how it
plans to acquire and employ the necessary systems, personnel and
infrastructure, and do so before transacting in derivatives. A credit
union, however, applying for Level II authority must have these in
place before it applies. This requirement for Level II ensures that
NCUA can adequately evaluate all of the components of the proposed
derivatives program during its onsite review.
2. Application Review
After a credit union has compiled all of the information for its
application, it must submit it to NCUA, or its SSA in the case of a
FISCU. An SSA will evaluate an application and send its decision to
NCUA for concurrence. Once the Field Director receives a complete
application or a decision from an SSA, as applicable, NCUA will begin
its review process. The Board notes that NCUA will not begin its review
of an application until the appropriate Field Director determines that
the application is complete and in compliance with the regulation and
any applicable supervisory guidance. The proposed rule requires that a
Field Director make this determination within 30 days of the date it
receives an application from a credit union. NCUA will use its best
efforts to review every application as quickly as possible.
The proposed rule provides that NCUA will approve or deny a credit
union's application within 90 days for Level I and 120 days for Level
II. These time limits begin when a Field Director determines it has a
complete application from an FCU or a decision from an SSA for FISCU
applicants.
Given the complex nature of derivatives and the level of due
diligence the agency must perform to ensure derivatives programs are
safe and sound, the Board believes these time frames are reasonable.
The Board recognizes that a review of a derivatives program will vary
between credit unions and the Board wants to ensure field staff has
adequate time to conduct a thorough review. In addition, while not
required under the proposed rule, it may be necessary for NCUA to
conduct an onsite review of a credit union applying for Level I
authority.
3. Appeals
The proposed rule also permits a credit union that has had its
application denied by a Field Director to appeal to NCUA's Supervisory
Review Committee within 60 days from the date of denial. For any final
rule that becomes effective, the Board would make a corresponding
change to IRPS 11-1, which lists the issues that credit unions may
appeal to NCUA's Supervisory Review Committee.
H. Pilot Program Participants and FISCUs With Derivatives
The Board recognizes that current participants in the various
derivatives pilot programs and FISCUs with active positions may not
meet the requirements of a final rule promulgated by the Board. The
Board wants to provide these credit unions with sufficient time to
bring their programs into compliance with a final rule. This proposed
rule, therefore, includes a section addressing this goal.
Specifically, the proposed rule provides that any credit union
that, as of January 1, 2013, is holding derivatives under an NCUA
derivatives pilot program or state law has 12-months from the effective
date of a final rule to come into compliance with the rule's
requirements. The Board set a date of January 1, 2013, to ensure that
only credit unions with active positions before publication of this
proposed rule could take advantage of the 12-month
[[Page 32204]]
grace period. Compliance would include submitting an application for
review under the provisions of the rule. During this 12-month period, a
pilot participant is permitted to continue operating its derivatives
program in accordance with its pilot program terms and conditions. A
FISCU may also continue to operate its derivatives program under the
applicable state law during this time period.
If a credit union fails to meet the requirements of the rule after
12 months, the rule requires that the credit union immediately cease
entering into new derivatives transactions and within 30 days present a
corrective action plan to NCUA (and SSA, in the case of a FISCU)
outlining how and when it will cure any deficiencies or how it will
unwind its derivatives program. A credit union under a corrective
action plan is not permitted to enter into any new derivatives
transactions until notified by NCUA.
A credit union that is otherwise in compliance with the rule, but
is holding active positions it purchased prior to January 1, 2013, will
not be subject to the corrective action plan requirements discussed
above. Rather, the credit union will be required to inform NCUA and the
SSA, in the case of a FISCU, how it will handle these active positions.
I. Regulatory Violation
The proposed rule provides a system of corrective action if a
credit union with derivatives authority fails to comply with the rule,
has safety or soundness concerns identified by NCUA, or fails to employ
the resources, policies, processes, and competencies that it identified
in its application for approval. If NCUA determines a credit union has
failed any of these aspects, the credit union must immediately cease
entering into any new derivatives transactions and must also present a
corrective action plan to NCUA and the SSA, in the case of a FISCU,
within 30 days.
A credit union's corrective action plan must address the
deficiencies identified by NCUA and how the credit union will promptly
fix these deficiencies. NCUA will evaluate all corrective action plans
to determine if they are realistic and sufficient to remedy the
deficiencies. In the case of a FISCU, this plan must also be approved
by the applicable SSA. If NCUA, and the SSA, if applicable, approve a
credit union's corrective action plan, NCUA will also notify the credit
union when it is permitted to begin entering into new derivatives
transactions.
In addition to or in lieu of a corrective action plan, NCUA may
terminate a credit union's derivatives authority based on a violation
of NCUA's regulations or safety and soundness concerns. NCUA will only
require divestiture if it determines that doing so would not pose
additional risks to the credit union.
J. Application Fees
The Board is considering instituting a fee structure for those
credit unions that apply for derivatives authority. As discussed above,
NCUA's application review process and ongoing enhanced supervision is
labor and resource intensive. Rather than pass this cost on to the
credit union industry as a whole, the Board believes it may be prudent
to pass this cost directly to the credit unions seeking approval.
Application fees may also serve as a deterrent to credit unions that
are unsure whether or not they can meet all of the qualifications
required to implement a safe and sound derivatives program.
The Board is considering a Level I application fee with amounts
starting at $25,000 and a Level II application fee with amounts ranging
from $75,000 to $125,000 based on the complexity of the application.
The Board would set this fee in periodic guidance based on the evolving
costs of processing an application.
In addition, the Board will maintain authority to modify the Level
II application fee if the credit union operates under Level I authority
for a period of time. The Board notes that NCUA will expend fewer
resources to review the Level II application of a Level I credit union
due to familiarity with the credit union's current practices. This
situation may warrant a reduced Level II application fee. This
reduction in application fee would largely depend on the length of time
a credit union operates under Level I authority before applying for
Level II authority. The Board also notes that this application fee
would be in addition to any fees charged by an SSA for an application
by a FISCU. The Board is interested in comments on this approach.
K. Supervision and/or Examination Fees
In addition to application fees, the Board is seeking comments on
the pros and cons of recovering the costs of ongoing supervision of
credit unions engaged in derivatives. The Board is particularly
interested in comments as to whether annual NCUA costs for staff,
contractors, and/or examination hours should be borne entirely by the
credit unions engaged in derivatives.
For example:
Should NCUA charge an annual licensing fee to the credit
unions approved to engage in derivatives?
Should NCUA charge credit unions that have purchased
derivatives for examination time spent evaluating their derivatives
activity?
How would NCUA isolate and determine the staff hours
involved in supervision of derivatives activity?
Would an annual licensing fee or additional yearly charge
act as a deterrent to qualified credit unions from using derivatives to
mitigate IRR?
In responding to the above questions, it should be noted that the
Board would not intend for any annual charges to act as a deterrent to
qualified credit unions but rather as a more equitable way of assessing
the cost of the derivatives program. The Board intends to encourage
qualified credit unions to purchase risk-mitigating derivatives.
Commenters might want to consider who would benefit if more credit
unions engage in risk-mitigating derivatives and if NCUA enhances
derivatives supervision:
Would credit unions that purchase derivatives and
successfully mitigate IRR benefit directly from a reduction in
potential losses?
Would that reduction in potential losses at credit unions
with more than $250 million in assets benefit the NCUSIF?
Would all federally insured credit unions benefit
indirectly from NCUA's enhanced supervision of derivatives?
L. Changes to Part 715
As noted above, the Board is also proposing a change to Sec. 715.2
to clarify the financial statement audit requirement. Currently, this
section only requires a credit union over $500 million in assets to
obtain a financial statement audit. The proposed change clarifies that
this requirement is in addition to the requirement in this rule that
any credit union with derivatives authority, regardless of size, must
obtain a financial statement audit.
M. Changes to Part 741
Subpart B of part 741 contains a list of regulations that, by their
terms, apply only to FCUs but that NCUA has determined, for safety and
soundness reasons, apply to FISCUs. Section 219 of part 741 addresses
investments, providing that FISCUs must follow the requirements in part
703 regarding purchasing shares or deposits in corporate credit
unions.\30\ The proposed rule designates that provision as
[[Page 32205]]
paragraph (a) of section 219 and adds a new paragraph (b) which
requires FISCUs, which are permitted by state law to engage in
derivatives transactions, to follow the requirements in subpart B of
part 703.
---------------------------------------------------------------------------
\30\ 12 CFR 741.219.
---------------------------------------------------------------------------
III. Regulatory Procedures
a. Regulatory Flexibility Act
The Regulatory Flexibility Act requires NCUA to prepare an analysis
of any significant economic impact any proposed regulation may have on
a substantial number of small entities (primarily those under $50
million in assets).\31\ The proposed rule allows credit unions to enter
into certain derivatives transactions to reduce IRR. Since the proposed
rule requires credit unions seeking derivatives authority to have at
least $250 million in assets, it will not have a significant economic
impact on a substantial number of small credit unions.
---------------------------------------------------------------------------
\31\ 5 U.S.C. 603(a).
---------------------------------------------------------------------------
b. Paperwork Reduction Act
The Paperwork Reduction Act of 1995 (PRA) applies to rulemakings in
which an agency by rule creates a new paperwork burden on regulated
entities or increases an existing burden.\32\ For purposes of the PRA,
a paperwork burden may take the form of a reporting or recordkeeping
requirement, both referred to as information collections. The proposed
changes to part 703 impose new information collection requirements. As
required by the PRA, NCUA is submitting a copy of this proposal to OMB
for its review and approval. Persons interested in submitting comments
with respect to the information collection aspects of the proposed rule
should submit them to OMB at the address noted below.
---------------------------------------------------------------------------
\32\ 44 U.S.C. 3507(d); 5 CFR part 1320.
---------------------------------------------------------------------------
1. Estimated PRA Burden
For the purposes of calculating the PRA burden, NCUA estimates that
150 credit unions will apply for and be granted derivatives authority.
NCUA further estimates that approximately 75 percent of this number, or
113, will be Level I credit unions and 25 percent, or 37, will be Level
II credit unions.
Section 703.104 of the proposed rule requires a credit union to
operate according to written, comprehensive policies and procedures for
control, measurement, and management of derivatives transactions. To do
so, a credit union must first develop such policies and procedures.
NCUA estimates that it will take a credit union seeking Level I
derivatives authority an average of 40 hours to develop appropriate
policies and procedures and a credit union seeking Level II authority
80 hours to do so. This is a one-time recordkeeping burden.
Section 703.104(b) of the proposed rule requires a credit union's
board of directors to review the derivatives policies and procedures
annually and update them when necessary. NCUA estimates this ongoing
recordkeeping burden will take an average of 10 hours per year per
Level I or Level II respondent.
Section 703.107 of the proposed rule requires a credit union's
senior executive officers to provide a monthly, comprehensive
derivatives report to the credit union's board of directors. NCUA
estimates this ongoing recordkeeping burden will take an average of 2
hours per month (24 hours per year) per Level I or Level II respondent.
Section 703.108(a)(1) of the proposed rule requires that a credit
union retain evidence of annual derivatives training for its board of
directors. NCUA estimates this ongoing recordkeeping requirement will
take an average of 4 hours per year per Level I or Level II respondent.
Section 703.108(b)(2) of the proposed rule requires that a credit
union maintain a written and schematic description of the derivatives
decision process. NCUA estimates that the one-time recordkeeping burden
of creating the description will take 10 hours per Level I respondent
and 20 hours per Level II respondent. The ongoing burden of maintaining
the description will take 2 hours per year per Level I or II
respondent.
Section 703.108(b)(4) of the proposed rule requires a credit union
engaging in derivatives transactions to obtain an annual financial
statement audit by a certified public accountant. Section 715.5(a) of
NCUA's Regulations already requires FCUs with assets of $500 million or
greater to obtain an annual financial statement audit. Currently,
approximately 60 credit unions with assets between $250 million and
$500 million that meet the proposed CAMEL ratings requirements do not
obtain annual financial statement audits. Due to the overhead costs
associated with derivatives activity, NCUA estimates that 20 percent,
or 12, of these credit unions will apply for and be granted derivatives
authority. NCUA further estimates that a financial statement audit for
a credit union of this size would cost approximately $50,000.
Section 703.108(b)(6) of the proposed rule requires a credit union,
before executing a derivatives transaction, to identify and document
the circumstances leading to the decision to hedge, specify the
derivatives strategy the credit union will employ, and demonstrate the
economic effectiveness of the hedge. NCUA estimates a credit union will
execute an average of 2 transactions per year and that it will take an
average of 2 hours per transaction to complete the pre-execution
analysis. This results in an ongoing recordkeeping burden of 4 hours
per year per respondent.
Sections 703.111 and 703.112 of the proposed rule require a credit
union seeking Level I or Level II derivatives authority to submit a
detailed application to NCUA. NCUA estimates that this one-time
recordkeeping burden will take an average of 50 hours per respondent to
prepare. This estimate does not include developing policies and
procedures for operating a derivatives program and creating and
maintaining a written and schematic description of the derivatives
decision process, as those recordkeeping requirements are already
accounted for above.
Section 703.117 of the proposed rule requires a credit union that
no longer meets the requirements of subpart B of part 703 to submit a
corrective action plan to NCUA. NCUA estimates that 6 credit unions may
have to submit an action plan each year and that a plan will take an
average of 10 hours to prepare.
Summary of Collection Burden
Written policies and procedures:
113 Level I credit unions x 40 hours = 4520 hours (one-time
burden).
37 Level II credit unions x 80 hours = 2960 hours (one-time
burden).
Board review of policies and procedures:
150 credit unions x 10 hours = 1500 hours.
Monthly derivatives report:
150 credit unions x 24 hours = 3600 hours.
Evidence of Board training:
150 credit unions x 4 hours = 600 hours.
Derivatives process description:
113 Level I credit unions x 10 hours = 1130 hours (one-time
burden).
37 Level II credit unions x 20 hours = 740 hours (one-time burden).
150 credit unions x 2 hours = 300 hours.
Financial statement audit:
12 credit unions x $50,000 = $600,000.
Pre-execution analysis:
150 credit unions x 4 hours = 600 hours.
Application:
150 credit unions x 50 hours = 7500 hours (one-time burden).
[[Page 32206]]
Corrective action plan:
6 credit unions x 10 hours = 60 hours.
Total Annual Hours Burden:
23,510 (16,850 one-time only).
Total Annual Cost Burden:
$600,000.
2. Submission of Comments
NCUA considers comments by the public on this proposed collection
of information in:
Evaluating whether the proposed collection of information
is necessary for the proper performance of the functions of NCUA,
including whether the information will have a practical use;
Evaluating the accuracy of NCUA's estimate of the burden
of the proposed collection of information, including the validity of
the methodology and assumptions used;
Enhancing the quality, usefulness, and clarity of the
information to be collected; and
Minimizing the burden of collection of information on
those who are to respond, including through the use of appropriate
automated, electronic, mechanical, or other technological collection
techniques or other forms of information technology; e.g., permitting
electronic submission of responses.
The Paperwork Reduction Act requires OMB to make a decision
concerning the collection of information contained in the proposed
regulation between 30 and 60 days after publication of this document in
the Federal Register. Therefore, a comment to OMB is best assured of
having its full effect if OMB receives it within 30 days of
publication. This does not affect the deadline for the public to
comment to NCUA on the substantive aspects of the proposed regulation.
Comments on the proposed information collection requirements should
be sent to: Office of Information and Regulatory Affairs, OMB, New
Executive Office Building, Washington, DC 20503; Attention: NCUA Desk
Officer, with a copy to Mary Rupp, Secretary of the Board, National
Credit Union Administration, 1775 Duke Street, Alexandria, Virginia
22314-3428.
c. Executive Order 13132
Executive Order 13132 encourages independent regulatory agencies to
consider the impact of their actions on state and local interests.
NCUA, an independent regulatory agency as defined in 44 U.S.C. 3502(5),
voluntarily complies with the executive order to adhere to fundamental
federalism principles. The proposed rule does not have substantial
direct effects on the states, on the relationship between the national
government and the states, or on the distribution of power and
responsibilities among the various levels of government. While the
Board notes that this proposed rule applies to certain FISCUs, the
Board does not believe that this rule rises to the level of a
regulation ``that has substantial direct effects on the States, on the
relationship between the national government and the States, or on the
distribution of power and responsibilities among the various levels of
government. This rule does not grant any authority to FISCUs that has
not been granted by applicable state law. In addition, any FISCU
applying must apply to its state first and NCUA must concur with the
state's determination. NCUA has, therefore, determined that this
proposal does not constitute a policy that has federalism implications
for purposes of the executive order.
d. Assessment of Federal Regulations and Policies on Families
NCUA has determined that this proposed rule will not affect family
well-being within the meaning of Sec. 654 of the Treasury and General
Government Appropriations Act, 1999, Pub. L. 105-277, 112 Stat. 2681
(1998).
e. Agency Regulatory Goals
NCUA's goal is to promulgate clear and understandable regulations
that impose minimal regulatory burden. The Board requests comments on
whether this rule is understandable and minimally intrusive.
List of Subjects
12 CFR Part 703
Credit unions, Investments.
12 CFR Part 715
Audits, Credit unions, Supervisory committees.
12 CFR Part 741
Credit, Credit unions, Reporting and recordkeeping requirements,
Share insurance.
By the National Credit Union Administration Board, on May 16,
2013.
Mary F. Rupp,
Secretary of the Board.
For the reasons discussed above, the National Credit Union
Administration proposes to amend parts 703, 715, and 741 as follows:
PART 703--INVESTMENT AND DEPOSIT ACTIVITIES
0
1. The authority citation for part 703 continues to read as follows:
Authority: 12 U.S.C. 1757(7), 1757(8), 1757(15).
0
2. Existing sections Sec. Sec. 703.1 through 703.20 are redesignated
under the following subpart A heading:
Subpart A--General Investment and Deposit Activities
* * * * *
0
3. Amend Sec. 703.2 by revising the definitions of ``derivatives'' and
``fair value'' and adding definitions of ``forward sales commitment''
and ``interest rate lock commitment'' to read as follows:
Sec. 703.2 Definitions.
* * * * *
Derivatives means an instrument that has its price based on or
derived from one or more underlying assets.
* * * * *
Fair value means the price that would be received to sell an asset
or paid to transfer a liability in an orderly transaction between
market participants at the measurement date, as defined by GAAP.
* * * * *
Forward sales commitment means an agreement to sell a property at a
price and future date specified in the agreement.
* * * * *
Interest rate lock commitment means an agreement by a credit union
to hold a certain interest rate and points for a specified amount of
time while a borrower's application is processed.
* * * * *
0
4. Add paragraph (k) to Sec. 703.14 to read as follows:
Sec. 703.14 Permissible investments.
* * * * *
(k) Derivatives. A federal credit union may only enter into in the
following derivatives transactions:
(1) Any derivatives permitted under Sec. 701.21(i) of this
chapter, Sec. 703.14(g), or subpart B of this part;
(2) Embedded options not required under generally accepted
accounting principles (GAAP) adopted in the United States to be
accounted for separately from the host contract; and
(3) Interest rate lock commitments or forward sales commitments
made in connection with a loan originated by a federal credit union.
Sec. 703.16 [Amended]
0
5. Remove paragraph (a) of Sec. 703.16 and redesignate paragraphs (b),
(c), (d), as (a), (b), (c), respectively.
0
6. Add subpart B to read as follows:
Subpart B--Derivatives Authority
Sec.
[[Page 32207]]
703.100 Purpose and Scope.
703.101 Definitions.
703.102 Permissible derivatives transactions.
703.103 Eligibility.
703.104 Policies and procedures for operating a Level I or Level II
program.
703.105 Collateral requirements for operating a Level I or Level II
program.
703.106 Counterparty requirements for operating a Level I or Level
II program.
703.107 Reporting requirements for operating a Level I or Level II
program.
703.108 Systems, processes, and personnel requirements for operating
a Level I or Level II derivatives program.
703.109 Specific Level I limits and requirements.
703.110 Specific Level II limits and requirements.
703.111 Applying for Level I or Level II authority.
703.112 Application content.
703.113 Application review by regulators.
703.114 Pilot program participants and FISCUs with active
derivatives positions.
703.115 Regulatory violation.
Authority: 12 U.S.C. 1757(7), 1757(8), 1757 (15).
Subpart B--Derivatives Authority
Sec. 703.100 Purpose and Scope.
(a) Application of this subpart. Unless explicitly specified
otherwise, the requirements of this subpart apply to:
(1) Federal credit unions; and
(2) Federally insured, state-chartered credit unions that are
permitted to engage in derivatives transactions under applicable state
law.
(b) Sections 703.101-703.109 and 703.111-703.116 apply to a Level I
derivatives program. Sections 703.101-703.108 and 703.110-703.116 apply
to a Level II derivatives program.
(c) Purpose. This subpart allows credit unions to purchase interest
rate caps and enter into interest rate swap transactions exclusively
for the purpose of reducing their interest rate risk exposure.
Sec. 703.101 Definitions.
For purposes of this subpart:
(a) Book value means the value at which the derivative is carried
on a statement of financial condition prepared in accordance with GAAP;
(b) Counterparty means the other party that participates in a
derivatives transaction;
(c) Derivative means an instrument that has its price based on or
derived from one or more underlying assets;
(d) Economic effectiveness means the extent to which a derivatives
transaction results in offsetting changes in the interest rate risk
that the transaction was, and is, intended to provide;
(e) External service provider means any entity that provides
services to assist a credit union in carrying out its derivatives
program and the requirements of this rule;
(f) Fair value has the meaning specified in Sec. 703.2 of subpart
A of this part;
(g) Field Director means an NCUA Regional Director, the Director of
the Office of National Examinations and Supervision, or any other NCUA
Director designated to directly supervise credit unions eligible to
apply for this authority;
(h) Hedge means to enter into a derivatives transaction to protect
against loss created by changes in interest rates;
(i) Interest rate cap means a contract, based on an interest rate,
for payment to the purchaser when the interest rate rises above a level
specified in the contract;
(j) Interest rate risk means the estimated change in earnings or
value of an asset, liability, portfolio, or statement of financial
condition as measured in terms of price, net interest income, or net
economic valuation change from current levels;
(k) Interest rate swap means an agreement to exchange future
payments of interest on a notional amount at specific times and for a
specified time period, paid in U.S. dollars. The exchange may be fixed
to floating or floating to fixed;
(l) ISDA agreement means an agreement specified by the
International Swaps and Derivatives Association that consists of a
master agreement, a schedule, confirmations, definition booklets, and a
credit support annex;
(m) Leveraged derivative means a derivative with interest rates
that change proportionally with the contractual rate or index;
(n) Major swap participant has the meaning defined by the Commodity
Futures Trading Commission in 17 CFR Sec. 1.3(hhh);
(o) Minimum transfer amount means the amount of collateral that can
be required per transfer to cover exposure in excess of the collateral
threshold;
(p) Net economic value means the economic value of assets minus the
economic value of liabilities;
(q) Net worth has the meaning specified in Sec. 702.2 of this
chapter;
(r) Notional amount means the predetermined dollar amount on which
exchanged interest payments are based;
(s) Novate means the substitution of an old obligation with a new
one that either replaces an existing obligation with a new obligation
or replaces an original party with a new party;
(t) Structured liability offering means an offering with
contractual option features, such as periodic caps and calls, similar
to those found in structured securities or structured notes;
(u) Senior executive officer is, for the purposes of this rule, a
credit union's chief executive officer (typically this individual holds
the title of president or treasurer/manager), any assistant chief
executive officer (e.g., any assistant president, any vice president or
any assistant treasurer/manager), and the chief financial officer
(controller) that are directly within the chain of command for the
oversight of a credit union's derivatives program, as identified in a
credit union's process and responsibility framework, discussed in Sec.
703.108(b)(2) of this subpart;
(v) Swap dealer has the meaning defined by the Commodity Futures
Trading Commission in 17 CFR 1.3(ggg);
(w) Threshold amount means an unsecured credit exposure that the
parties are prepared to accept before asking for collateral; and
(x) Weighted average life means the weighted average length of time
to the final maturity of derivatives contracts, calculated by
multiplying the notional amount of each contract by the time to
maturity and then adding each of those numbers together and dividing by
the total notional amount of the contracts.
Sec. 703.102 Permissible derivatives transactions.
As part of its regulator approved strategy, a credit union may only
purchase interest rate caps or enter into interest rate swap
transactions that are:
(a) For the purpose of managing interest rate risk;
(b) Not leveraged;
(c) Based on domestic rates, as defined in Sec. 703.14(a) of
subpart A of this part;
(d) Denominated in U.S. dollars;
(e) Except as provided in Sec. 703.14(g) of subpart A of this
part, not used to create structured liability offerings for members or
nonmembers;
(f) Settled within three business days of entering into the
transaction; and
(g) Interest rate swaps that do not have fluctuating notional
amounts.
Sec. 703.103 Eligibility.
(a) A credit union may apply for Level I or Level II derivatives
authority if it meets the following criteria:
(1) It provides an interest rate risk mitigation plan, which
includes derivatives and shows how derivatives are one aspect of its
overall interest rate risk mitigation strategy;
(2) Its most recent composite CAMEL code rating assigned by NCUA is
1, 2, or 3 with a management component of 1 or 2; and
(3) It has assets of at least $250 million, as of its most recent
call report.
[[Page 32208]]
(b) A credit union seeking Level II authority must also show why
the limits under Level I authority are insufficient for it to
effectively mitigate interest rate risk.
Sec. 703.104 Policies and procedures for operating a Level I or Level
II program.
A credit union must operate according to written, comprehensive
policies and procedures for control, measurement, and management of
derivatives transactions.
(a) At a minimum, the policies and procedures must cover:
(1) Managerial oversight and responsibilities;
(2) Scope of activities;
(3) Approved counterparties;
(4) Risk management (market, credit, liquidity, settlement, and
operations);
(5) Legal issues;
(6) Accounting and financial reporting in accordance with GAAP;
(7) Derivatives limits;
(8) Aggregate counterparty exposure;
(9) A limit on the amount of exposure the credit union will have to
any single counterparty, expressed as a percentage of net worth;
(10) Margin requirements; and
(11) Reporting requirements.
(b) A credit union's board of directors must review the derivatives
policies and procedures annually and update them when necessary.
Sec. 703.105 Collateral requirements for operating a Level I or Level
II program.
(a) A credit union's collateral arrangements must be supported by a
bilateral ISDA credit support annex and comply with all applicable
requirements of the Commodity Futures Trading Commission.
(b) A credit union may only accept collateral to secure a
derivatives transaction that is permissible for a credit union to hold
as enumerated in the Federal Credit Union Act, subpart A of this part,
and its investment policies. Acceptable collateral is limited to cash,
Treasury securities, fixed-rate non-callable agency debentures, and
zero-coupon non-callable agency debentures.
(c) Daily, a credit union must price derivatives positions and
calculate its fair value exposure.
(d) Daily, a credit union must be collateralized for all
transactions to at least 100 percent of the transactions, based on the
risk of the collateral.
(e) A credit union must set threshold amounts to zero.
(f) A counterparty to a derivatives transaction cannot hold or be
the custodian of the collateral, except for affiliates of the
counterparty that are separate legal entities. In any custodial
arrangement, the custodian must: be organized and doing business under
the laws of the United States or any state thereof; authorized under
such laws to exercise corporate trust or custodial powers; have equity
of at least $50,000,000; and be subject to supervision or examination
by a federal or state authority.
(g) The minimum transfer amount must be less than or equal to
$250,000.
(h) A credit union using collateral netting arrangements must have
the ability to disaggregate and report individual exposures within and
across all counterparties.
(i) A credit union may agree to provide additional collateral to a
counterparty in a credit support annex so long as the credit union
complies with all other collateral provisions in this subpart.
(j) A credit union must have systems in place to effectively manage
collateral.
(1) A credit union's collateral management process must monitor its
collateral daily and ensure that its derivatives positions are
collateralized at all times in accordance with the collateral
requirements of this subpart and the credit union's ISDA agreement with
its counterparty. This includes the posting, tracking, valuing, and
reporting of collateral to state positive and negative exposure using a
daily fair value.
(2) A credit union must have the ability to analyze and measure
potential liquidity needs related to its derivatives program and
stemming from additional collateral requirements due to changes in
interest rates. It must also be able to calculate and track contingent
liquidity needs in the event a derivatives transaction needs to be
novated or terminated. A credit union's senior executive officers must
establish effective controls for liquidity exposures arising from both
market or product liquidity and instrument cash flows.
Sec. 703.106 Counterparty requirements for operating a Level I or
Level II program.
(a) A credit union must have an ISDA agreement in place to
establish a credit relationship with any counterparty.
(b) Any derivatives counterparty must be either a ``swap dealer''
or ``major swap participant,'' and:
(1) Organized and doing business under the laws of the United
States or any state thereof; or
(2) A United States branch of a foreign depository institution,
licensed to do business under the laws of the United States or any
state thereof.
(c) A credit union must calculate and manage individual
counterparty exposure by book value and fair value. A credit union must
conduct stress tests of counterparty exposures.
(d) A credit union must analyze counterparty credit risks,
including, but not limited to: counterparty exposures, concentrations,
credit exceptions, and nonperforming contracts. The credit union's
board of directors must receive monthly, detailed reports addressing
aggregate counterparty credit exposures.
Sec. 703.107 Reporting requirements for operating a Level I or Level
II program.
At least monthly, a credit union's senior executive officers must
deliver to the credit union's board of directors, separately or as part
of the standard funds management or asset/liability report, a
comprehensive derivatives report. At a minimum, this report must
include:
(a) Identification of any areas of noncompliance with any provision
of this subpart or the credit union's policies;
(b) Utilization of the limits in Sec. 703.109 or Sec. 703.110, as
applicable, and the limits in the credit union's policies;
(c) An itemization of the credit union's individual positions and
aggregate fair and book values;
(d) A comprehensive view of the credit union's statement of
financial condition, including, but not limited to, net economic value
calculations for the credit union's statement of financial condition
done with derivatives included and excluded; and
(e) The cost of executing new derivatives transactions. A credit
union can express this cost through a comparison with observed market
quotes and/or offering levels from other counterparties. Observed
market quotes can include swap rates or external service provider
modeled cap prices.
Sec. 703.108 Systems, processes, and personnel requirements for
operating a Level I or Level II derivatives program.
(a) Required experience and competencies. A credit union operating
a derivatives program must internally possess the following experience
and competencies:
(1) Board. Before entering into any derivatives transactions, and
annually thereafter, a credit union's board members must receive
training to provide a general understanding of derivatives and
knowledge to provide strategic oversight of the credit union's
derivatives program. This includes understanding how derivatives fit
into the credit union's business model and risk management process. The
credit union must maintain evidence of this training, in accordance
with its
[[Page 32209]]
document retention policy, until its next NCUA or state supervisory
authority examination.
(2) Senior executive officers. A credit union's senior executive
officers must have sufficient knowledge and experience to understand,
approve, and provide oversight for the derivatives activities
commensurate with the complexity of the derivatives program. These
individuals must have a comprehensive understanding of how derivatives
fit into the credit union's business model and risk management process.
A credit union must immediately notify NCUA (and, if applicable, the
appropriate SSA) when a senior executive officer position as defined in
this rule becomes vacant. A credit union must also immediately provide
NCUA (and, if applicable, the appropriate SSA) with documentation
evidencing knowledge and experience for any person who becomes a senior
executive officer as defined in this rule while the credit union has
derivatives authority.
(3) Qualified derivatives personnel. To engage in derivatives
transactions with Level I authority, a credit union must have
knowledgeable and experienced employees that, except as provided in
Sec. 703.110(f) of this subpart for Level II authority, have at least
three years of direct transactional experience in the trading,
structuring, analyzing, monitoring, or auditing of financial
derivatives transactions at a financial institution, a risk management
advisory practice, or a financial regulatory organization. Staff must
also have the demonstrated expertise in the statement of financial
condition analysis described in Sec. 703.107(d) of this subpart. These
employees must, at a minimum, accomplish the following:
(i) Asset/liability risk management. Staff must be qualified to
understand and oversee asset/liability risk management including the
appropriate role of derivatives. This includes identifying and
assessing risk in transactions, developing asset/liability risk
management strategies, testing the effectiveness of asset/liability
risk management, determining the effectiveness of managing interest
rate risk under a range of stressed rate and statement of financial
condition scenarios, and evaluating the relative effectiveness of
alternative strategies;
(ii) Accounting and financial reporting. Staff must be qualified to
understand and oversee appropriate accounting and financial reporting
for derivatives transactions in accordance with GAAP;
(iii) Trade execution and oversight. Staff must be qualified to
undertake or oversee trade executions; and
(iv) Credit, collateral, and liquidity management. Staff must be
qualified to evaluate credit risk, manage collateral, and evaluate
liquidity risk, as described in Sec. Sec. 703.105 and 703.106 of
subpart B of this part.
(b) Required management and internal controls structure. To
effectively manage its derivatives activities, a credit union must
allocate resources sufficient to support the scope and complexity of
its derivatives activities. An effective management and internal
controls structure includes, at a minimum, the following:
(1) Separation of duties. A credit union's process, whether
conducted internally or by an external service provider, must have
appropriate separation of duties for the following functions:
(i) Derivatives execution and oversight;
(ii) Accounting for and confirmation of the derivatives
transactions;
(iii) Asset/liability risk management; and
(iv) Credit, collateral, and liquidity management.
(2) Process and responsibility framework. A credit union must
maintain, in its derivatives policies and procedures, a written and
schematic (e.g. flow chart or organizational chart) description of the
derivatives decision process. The process must include the roles of
staff, external advisors, senior executive officers, the board of
directors, and any others involved in the derivatives program and
demonstrate separation of duties, independent risk management, and
effective oversight.
(3) Internal controls review. A credit union must have an internal
controls audit at least annually that ensures the timely identification
of weaknesses in internal controls, modeling methodologies, and the
risk oversight process. This internal controls review must be performed
by external individuals qualified to evaluate the attributes of a
derivatives program. An internal controls audit must incorporate an
evaluation of the effectiveness of internal controls relevant to
measuring, monitoring, reporting, and limiting risks. The scope of the
internal controls review must also include coverage of the accounting,
legal, operating, and risk controls.
(4) Financial statement audit. A credit union must obtain an annual
financial statement audit, as defined in Sec. 715.2(d) of this
chapter, by an independent state-licensed certified public accountant
with at least two years of experience evaluating derivatives
transactions.
(5) Legal review. Before executing any transactions under this
subpart, a credit union must receive a legal opinion from qualified
counsel stating that the credit union's ISDA agreements are enforceable
and that the credit union is complying with applicable laws and
regulations relating to operating a derivatives program. Qualified
counsel means an attorney with at least five years of experience
reviewing derivatives transactions. A credit union must also ensure any
counterparty is authorized to enter into such transactions.
(6) Hedge review. Before executing any derivatives transaction, a
credit union must identify and document the circumstances leading to
the decision to hedge, specify the derivatives strategy the credit
union will employ, and demonstrate the economic effectiveness of the
hedge.
(c) Transactions management. A credit union must have support
systems in place to provide accurate and timely transaction processing.
(d) Asset/liability risk management. A credit union must have the
systems and operational capacity to derive net economic value and
understand interest rate risk.
(e) Use of external service providers. As specified in Sec.
703.109 and Sec. 703.110, as applicable, a credit union may use
external service providers to support or conduct certain aspects of its
derivatives program, provided:
(1) The external service provider, including affiliates, cannot:
(i) Be a counterparty to any derivatives transactions involving the
credit union;
(ii) Be a principal or agent in any derivatives transaction
involving the credit union; or
(iii) Have discretionary authority to execute any of the credit
union's derivatives transactions.
(2) The credit union has the internal capacity, experience, and
skills to oversee and manage any external service providers it uses;
and
(3) The credit union documents the specific uses of external
service providers in its process and responsibility framework, as
described in Sec. 703.108(b)(2) of this subpart.
Sec. 703.109 Specific Level I limits and requirements.
A credit union with Level I derivatives authority must comply with
the following specific limits and requirements:
(a) A credit union approved only to enter into interest rate swaps
must
[[Page 32210]]
restrict the aggregate notional amount of its interest rate swap
transactions to 100 percent of net worth.
(b) A credit union approved only to purchase interest rate caps
must restrict the aggregate book value of its interest rate cap
transactions to 10 percent of net worth.
(c) A credit union approved to transact interest rate swaps and
purchase interest rate caps may not exceed a combined limit of 100
percent of the aggregate amount of each limit the credit union used
under paragraphs (a) and (b) of this section. For example, a credit
union may hold 80 percent of the limit for interest rate caps and 20
percent of the limit for interest rate swaps, but cannot hold 100
percent of the limit for each. This combined limit can be represented
as:
[GRAPHIC] [TIFF OMITTED] TP29MY13.001
(d) The aggregate fair value loss of all swap positions into which
the credit union has entered cannot exceed 10 percent of net worth.
(e) The maximum permissible weighted average life on all
derivatives positions may not exceed five years and the maximum
permissible maturity for any single derivatives position may not exceed
seven years.
(f) Use of external service providers. A credit union may use
external service providers to support or conduct certain processes,
subject to the following restrictions:
(1) Support. A credit union must internally and independently carry
out and conduct the following functions, but may obtain assistance and
input from an external service provider, provided the external service
provider does not conduct the functions in lieu of the credit union:
(i) Evaluating credit risk management;
(ii) Evaluating liquidity risk; and
(iii) Asset/liability management.
(2) Conduct. Provided a credit union maintains responsibility for
the following activities and an understanding of all of an external
service provider's activities and work product, a credit union may
contract with an external service provider to conduct these functions
in lieu of the credit union:
(i) Accounting and financial reporting;
(ii) Counterparty exposure management;
(iii) Trade execution;
(iv) Transaction management;
(v) Legal services;
(vi) Collateral management; and
(vii) Financial statement audit.
Sec. 703.110 Specific Level II limits and requirements.
A credit union with Level II derivatives authority must comply with
the following specific limits and requirements:
(a) For a credit union approved only to enter into interest rate
swaps, NCUA will establish the aggregate notional amount of its
interest rate swap transactions at an amount not to exceed 250 percent
of net worth.
(b) For a credit union approved only to purchase interest rate
caps, NCUA will establish the aggregate book value of its interest rate
cap transactions at an amount not to exceed 25 percent of net worth.
(c) For a credit union approved to transact interest rate swaps and
interest rate caps, NCUA will establish the appropriate cumulative
limit not to exceed individual limits in paragraphs (a) and (b) of this
section.
(d) The aggregate fair value loss of all swap positions into which
the credit union has entered cannot exceed 25 percent of net worth.
(e) The maximum permissible weighted average life on all
derivatives positions may not exceed seven years and the maximum
permissible maturity for any single derivatives position may not exceed
ten years.
(f) The qualified derivatives personnel described in Sec.
703.108(a)(3) must have at least five years of direct transactional
experience in the trading, structuring, analyzing, monitoring, or
auditing of financial derivatives transactions at a financial
institution, a risk management advisory practice, or a financial
regulatory organization. In addition to the activities the qualified
derivatives personnel are required to conduct in Sec. 703.108(a)(3),
they must also price options and undertake statement of financial
condition simulations under multiple interest rate scenarios.
(g) The exposure by notional amount to any single derivatives
counterparty cannot exceed 100 percent of net worth for interest rate
swaps and the book value may not exceed ten percent of net worth for
interest rate caps.
(h) Use of external service providers. A credit union may use
external service providers to support or conduct certain processes,
subject to the following restrictions:
(1) Support. A credit union must internally and independently carry
out and conduct the following functions, but may obtain assistance and
input from an external service provider, provided the external service
provider does not conduct the functions in lieu of the credit union:
(i) Asset/liability risk management;
(ii) Evaluating credit risk;
(iii) Counterparty exposure management;
(iv) Evaluating liquidity risk;
(v) Collateral management; and
(vi) Transaction management.
(2) Conduct. Provided a credit union maintains responsibility for
the following activities and an understanding of all of an external
service provider's activities and work product, the credit union may
contract with an external service provider to conduct these functions
in lieu of the credit union:
(i) Accounting and financial reporting;
(ii) Trade execution;
(iii) Financial statement audit; and
(iv) Legal services.
Sec. 703.111 Applying for Level I or Level II authority.
An eligible credit union must submit a request for Level I or Level
II authority and a detailed application, consistent with this subpart,
before engaging in any derivatives transactions. The application must
include draft policies and procedures, the process and responsibility
framework, and the proposed systems and personnel needed to efficiently
and effectively manage the credit union's derivatives activities. A
credit union must submit its application to:
(a) The applicable Field Director, in the case of an FCU; or
(b) The applicable state supervisory authority, in the case of a
FISCU.
Sec. 703.112 Application content.
A credit union applying for derivatives authority must demonstrate
all of the following in its application:
[[Page 32211]]
(a) An interest rate risk mitigation plan, which includes
derivatives and shows how derivatives are one aspect of its overall
interest rate risk mitigation strategy. A credit union applying for
Level II authority must also show why the limits under Level I
authority are not sufficient for it to mitigate interest rate risk.
(b) How it plans to acquire, employ, and/or create the resources,
policies, processes, systems, internal controls, modeling, and
competencies to meet the requirements of this subpart. A credit union
applying for Level II authority must have the systems and personnel
required under this subpart in place before submitting its application.
(c) That it has senior executive officers and a board of directors
that understand the role derivatives play in the credit union's
interest rate risk management and the risk inherent in derivatives
activities.
(d) How it intends to use external service providers as part of its
derivatives program.
Sec. 703.113 Application review by regulators.
(a) State supervisory authority review. A state supervisory
authority will review an application submitted under this subpart and
forward its decision to the applicable Field Director for concurrence.
(b) NCUA review. After receiving an FCU's application or a state
supervisory authority's decision, within 30 days from the date of its
receipt, the Field Director will determine if the application is
complete and meets the requirements of this subpart. The Field Director
will notify the credit union within the following time frames if NCUA
has approved or denied its application and the reason(s) for any
denial:
(1) Level I. 90 days from the date the appropriate Field Director
determines a credit union's application is complete or, in the case of
a FISCU, receives a decision from the applicable SSA; or
(2) Level II. 120 days from the date the appropriate Field Director
determines a credit union's application is complete or, in the case of
a FISCU, receives a decision from the applicable SSA.
(c) Right to appeal. Within 60 days from the date of denial by the
Field Director, a credit union may submit a written appeal to NCUA's
Supervisory Review Committee.
Sec. 703.114 Pilot program participants and FISCUs with active
derivatives positions.
(a) A credit union that, as of January 1, 2013, is holding
derivatives under NCUA's derivatives pilot program or applicable state
law must comply with the requirements of this subpart, including the
application procedures, within 12 months from the effective date of
this subpart. During the 12-month interim period, the credit union may
continue to operate its derivatives program in accordance with its
pilot program terms and conditions or applicable state law.
(b) A credit union holding derivatives under NCUA's derivatives
pilot program or state law that does not comply with the requirements
of this subpart within 12 months or does not want to continue engaging
in derivatives transactions must:
(1) Stop entering into new derivatives transactions; and
(2) Within 30 days, present a corrective action plan to the
appropriate Field Director (and SSA in the case of a FISCU) describing
how it will cure any deficiencies or unwind its derivatives program.
(c) A credit union that is otherwise compliant with this subpart
except that it is holding impermissible active derivatives positions it
entered into before January 1, 2013, may enter into new derivatives
transactions in accordance with this subpart, provided it provides NCUA
(or NCUA and the SSA, in the case of a FISCU) with a plan accounting
for the active positions in violation of this subpart.
Sec. 703.115 Regulatory violation.
(a) A credit union engaging in derivatives transactions that no
longer meets the requirements of subpart B of this part; fails to fully
comply with its approved strategy, including employing the resources,
policies, processes, and competencies that formed the basis for the
approval; or has safety and soundness concerns identified by NCUA:
(1) Must present a corrective action plan to the appropriate Field
Director (and state supervisory authority in the case of a FISCU)
within 30 days of the determination of the violation; and
(2) May not enter into any new derivatives transactions until the
Field Director (and state supervisory authority in the case of a FISCU)
approves the corrective action plan.
(b) NCUA may revoke a credit union's derivatives authority at any
time for failure to comply with the requirements of this section or for
any other safety and soundness reasons. Revocation will prohibit a
credit union from entering into any new derivatives transactions.
Revocation will not require the credit union to terminate existing
derivatives transactions if, at the discretion of the Field Director
(and state supervisory authority in the case of a FISCU), doing so
would not be practicable or deemed unsafe or unsound. The Field
Director (and state supervisory authority in the case of a FISCU) may
require a credit union to terminate existing derivatives transactions
if doing so would not pose a safety and soundness concern.
(c) Within 60 days of NCUA's written notice of revocation of a
credit union's derivatives authority, a credit union may appeal this
decision to the NCUA Board. During the appeals process, the credit
union does not have to terminate existing derivatives transactions, but
it may not enter into any new derivatives transactions.
PART 715--SUPERVISORY COMMITTEE AUDITS AND VERIFICATIONS
0
7. The authority citation for part 715 continues to read as follows:
Authority: 12 U.S.C. 1761(b), 1761(d), 1782(a)(6).
0
8. Revise paragraph (a) of Sec. 715.5 to read as follows:
Sec. 715.5 Audit of Federal Credit Unions.
(a) Total assets of $500 million or greater. To fulfill its
Supervisory Committee audit responsibility, a federal credit union
having total assets of $500 million or greater, except as provided in
Sec. 703.108(b)(4) of this chapter, must obtain an annual audit of its
financial statements performed in accordance with Generally Accepted
Auditing Standards by an independent person who is licensed to do so by
the State or jurisdiction in which the credit union is principally
located.
* * * * *
PART 741--REQUIREMENTS FOR INSURANCE
0
9. The authority citation for part 741 is revised to read as follows:
Authority: 12 U.S.C. 1757, 1766(a), 1781-1790, .31 U.S.C. 3717.
0
10. Revise Sec. 741.219 to read as follows:
Sec. 741.219 Investment requirements.
(a) Any credit union which is insured pursuant to title II of the
Act must adhere to the requirements stated in part 703 of this chapter
concerning transacting business with corporate credit unions.
(b) Derivatives. Any credit union which is insured pursuant to
Title II of the Act and permitted by its state law to engage in
derivatives must follow the
[[Page 32212]]
requirements of subpart B of part 703 of this chapter.
[FR Doc. 2013-12638 Filed 5-28-13; 8:45 am]
BILLING CODE 7535-01-P