IR Risk Management for Credit Unions: The Case for Derivatives
Credit unions: Have you considered using derivatives to manage your interest rate risk? Many have generally shied away from this strategy—until now. In this blog, we highlight the benefits and discuss how to get started with this helpful interest rate risk management tool.
Interest Rate Risk Management for Credit Unions
Monitoring and managing fluctuating interest rates is just one of the many day-to-day tasks that credit union treasurers are faced with.
Hedging interest rate risk using derivatives is a helpful but often overlooked strategy for credit unions. Whether you are uncertain about executing derivatives, lack the niche skillset derivative accounting requires or simply do not have the bandwidth to get started, know this: Changes to derivative accounting rules have made derivative use more credit union friendly, and with the right supporting partner, you will be empowered to execute a derivative-based strategy and reap the benefits.
Benefits of Using Derivatives to Hedge IR Risk
Benefit #1: Align Interest Rate Sensitive Assets and Liabilities
Credit unions strive to match the future inflow rate tenor to the outflow rate tenor. There are different levers credit unions can pull to accomplish this—derivatives are one of them.
The most common interest rate derivatives exchange variable cash flows for fixed cash flows enabling users to synthetically fix floating cashflows, lengthen the tenor of short-term fixed cash flows or synthetically turn fixed-rate assets into variable-rate assets.
Benefit #2: Minimize Balance Sheet Impact
Essentially, hedging with derivatives is an alternative to selling an asset or borrowing additional funds at a long-term fixed rate to fix the imbalance. Selling an asset or borrowing funds may dramatically impact your balance sheet. Is that necessary? Derivatives can often accomplish the same thing with a significantly smaller balance sheet impact.
Benefit #3: Stabilize Credit Union Margin
When used appropriately, derivatives reduce financial risk and improve the safety and soundness of your institution.
IR Risk Management for Credit Unions: What Can Be Hedged?
It is evident that derivatives are beneficial tools for interest rate risk management for credit unions.
Interest rate swaps, which are contracts that exchange one stream of future interest payments for another based on a specified principal amount, are the most common instruments used to hedge.
So, here is what credit unions frequently hedge with interest rate swaps—and how to get started.
#1. Federal Home Loan Bank (FHLB) Loans
The right flavor of FHLB loans can be hedged in order to stabilize the cost of funds.
Use a pay-fixed, receive-variable interest rate swap to synthetically turn regular, ongoing floating FHLB advances to long-term fixed-rate borrowings so they better align with long-term fixed-rate earning assets.
#2. Deposits from Members
Some—but not all—deposits from members may be hedged to provide fixed interest expense over a longer horizon, matching the longer-term earning assets.
Use a pay-fixed, receive-variable interest rate swap to synthetically align short-term or indexed deposit receipts with long-term fixed-rate assets.
#3. Mortgage Portfolio
Credit unions can apply a derivative accounting strategy called “last-of-layer” on a portfolio of pre-payable fixed-rate mortgages, exchanging the fixed characteristics for variable to match your variable rate sources of funding.
Use a pay-fixed, receive-variable interest rate swap to exchange the fixed rate on a portion of a pool of pre-payable fixed-rate assets for a variable rate.
How to Get Started with Derivatives
#1. Update Risk Management Policy
First and foremost, you should always base these risk management decisions on a sound risk management policy.
Your risk management policy provides a framework for your credit union’s hedging efforts and protects your organization from taking unnecessary risks. The policy also outlines other essential components, including the types of risks that can be hedged and what types of derivatives you can use to hedge which risks.
Having this policy together early will help you with the next step.
#2. Get NCUA Approval
This is a common roadblock for credit unions who want to deploy derivatives. The application process takes time. Time that many busy credit unions simply do not have.
To get approval, you need:
- Asset-Liability Management (ALM) policy
- Derivatives policy
- Accounting guide to support designations
- Designation examples
- Effectiveness testing examples
- Board of Directors resolution
Note: The NCUA has proposed a change to the approval process, with hopes of making derivatives even more accessible to credit unions. This is still pending. When a decision is finalized, we will send out an update—be sure to sign up to receive our emails.
You can work with a partner to put together many of these documents. Should you get approved to start a hedge program, know that there will be ongoing maintenance required, which the right partner can also help you with—leading us to step three.
#3. Outsource Derivative Accounting
More often than not, credit unions shy away from derivative use due to the accounting that it requires. Even though the accounting rules have changed to make it more accessible for credit unions, it is still a good idea to partner up with experts in the field who have been accounting for derivatives for credit unions since the strategy was first available.
This partner can help you:
- Accurately model and value derivative instruments
- Prepare compliant journal entries
- Ensure compliance with ASC 815 qualifying and testing requirements
- Implement SOX controls
- Stay audit-ready
Your partner can handle the tactical accounting piece, but they should also educate and support you along the way, ensuring that you understand derivatives, valuations and other important technical elements of your program. You still own the overall responsibility and commitment to competence, but your partner should be with you through the entire process, giving your team—and CFO—confidence in the strategy.
With these three steps locked down, you will be well on your way to executing derivatives as a risk management tool.
Derivative use is a conservative yet powerful tool available for credit unions to manage IR risk.
Identifying the appropriate applications for derivatives is the first step. Qualifying and maintaining hedge accounting is essential to ensure that the impact from the hedge and the hedged item are recognized in the P&L in the same period. This is where Hedge Trackers can help.
Hedge Trackers offers a full suite of risk management and derivative accounting solutions to credit unions navigating interest rate risk. We can help you manage the accounting, reporting and on-going hedge effectiveness—and provide support and education every step of the way. We helped the first credit union navigate the NCUA rules, implement and support a hedge program—and we continue today supporting the very large and the very small with their interest rate risk management. We’re ready. Are you?
Contact us to tell us about your needs and get started.