Credit union leaders are taking an interest in derivatives

Frank Gargano

Credit union executives and financial strategists are underscoring the importance of derivatives and pricing control to combat the risks associated with rising interest rates.

The National Credit Union Administration highlighted the effects of the Federal Reserve's continuous rate hikes as one of its chief concerns earlier this year when the agency released its 2023 list of supervisory priorities. Worries about liquidity and credit rounded out the NCUA's top three items. 

To hedge against these risks, many credit unions increasingly are using derivatives, which are leveraged financial instruments traditionally traded between two parties. These include rate swaps, futures contracts, options and other agreements.

Emily Hollis, chief executive of the Dallas-based financial advisory firm ALM First, said that "asset and liability management is not the practice of predicting rates, it's the practice of alignment of price volatility of assets and liabilities" and explained how derivatives are a valuable option for credit unions to guard against unrealized losses.

"It is a help with liquidity because if a credit union chooses to sell assets that have unrealized losses, they can also choose to unwind the derivative and [in a few days, they] would have those gains within their accounts in a few days time," Hollis said during the NCUA's capital markets symposium at the New York Stock Exchange on April 11.

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The NCUA approved a final modified rule on derivatives in May 2022 as part of what it called a "more flexible, principles-based approach" following adjustments to its original legislation that debuted more than nine years ago. The new rule eased up on restricting the types of derivative products eligible for use as well as the maximum allowable threshold of contracts that a credit union can buy.

As useful as these tools are, executives should be thoughtful about how they employ derivatives and other financial instruments — rather than an immediate jump due to an emergent need — according to April Clobes, president and chief executive officer of the $7.3 billion-asset Michigan State University Federal Credit Union in East Lansing.

Asset and liability management "for us is a constant, active management in utilizing tools for liquidity and for matching our pricing on both deposits and loans," Clobes said. "To me, it's really important that we tell the story from our perspective inside the organization as well as to the board for education, because pricing is the biggest tool that we have and that is what we use all the time."

In the wake of the failures of Silicon Valley Bank and Signature Bank, credit unions and community banks became increasingly vulnerable to unrealized losses as rates continued rising. 

"Interest rate risk management has always been a hallmark of sound risk management, and while it may have been fundamental over the last few years, it should never be ignored as evidenced with the surge in rates in 2022," and over the last year with the most recent banking crisis, said Tom Fay, supervisory financial analyst for the NCUA.

To maximize the efficiency of asset and liability committees, the groups are best positioned as sounding boards for identifying potential risk-creating situations and drafting action plans that address these challenges should these events come to pass, said Leah Viault, managing director of financial strategies for the Minneapolis, Minnesota-based investment banking firm Piper Sandler.

"Depository institutions are in the business of creating interest rate risk [as] that's what [they] do when they make loans to members or take in member deposits," Viault said. "Our business is not risk avoidance, but acceptance of the interest rate risk our business creates and making sure we manage that interest rate risk into a tolerable band that allows us to serve our members throughout changing environments."

Credit union leaders are also turning to the secondary capital market, which involves subordinated debt issuances and access to federal funding through the NCUA's Central Liquidity Facility, as part of their strategies for proper liquidity management.