Improving Economy Puts New Emphasis On Managing Risk
As the economy starts to turn around and we enter a period of rising interest rates, managing interest-rate risk will become increasingly important to many credit unions. Unmanaged, interest-rate risk can quickly erode both the net interest margin (NII) and the net equity value (NEV) of a credit union. Fluctuations in interest rates can cause earnings volatility, which may limit a credit union's ability to forecast, manage and plan for growth.
Hedging Risk On Member Share Accounts
Understanding and managing interest-rate risk must become a core competency at most credit unions. Historically, the tools available to credit unions have been limited to conventional methods of balance sheet risk management. However, today, derivative instruments are readily available to credit unions as risk-management tools. For instance, WesCorp's NCUA-approved Pilot Derivative Hedging Program is an option available to all credit unions.
Bloomberg defines interest-rate risk for depository institutions as the risk that spread income will suffer because of a change in interest rates. For credit unions much of this exposure arises as a result of funding long-term, fixed-rate loans (mortgages, home equity, auto, etc.) with short-term, interest-rate sensitive liabilities (primarily money market shares and short-term CDs).
Lack of access to the derivative markets historically has forced credit unions to mitigate interest-rate risk by selling member loans, taking down long-term, fixed-rate borrowings, or by keeping a higher level of short-term investments than most other depository institutions. However, many credit unions have begun to look to derivative hedges in order to mitigate interest-rate risk (measured as reduced NEV and NII fluctuations under interest-rate shock scenarios) without stripping their balance sheets of their high quality loan assets or reducing their desire for member deposits.
Although the net cash flows of an interest-rate swap and the underlying hedged liability are similar to those of a fixed-rate borrowing, the balance sheet implications are far different, and there are some added accounting considerations. However, the advantages may well justify the extra effort required to utilize the derivatives market. Derivatives allow credit unions to manage spread and growth while growing their balance sheet.
Interest-rate swaps are the most common and least complex method of managing interest-rate risk for member deposit accounts and CDs. While most credit unions choose to hedge short-term liabilities, the maturity structure of the swap(s) should match the runoff profile of the long-term, fixed-rate assets that are causing the interest rate mismatch.
It is important to avoid becoming over hedged, as this will increase interest rate sensitivity to declining interest rates. This method exchanges, or swaps, the variable rate paid on short-term accounts for a fixed rate that can then be matched against the fixed rate received on long-term, fixed-rate loan assets. Credit unions rarely choose to match the hedge against the fixed-rate asset because the accounting treatment is much more onerous.
In an interest-rate swap, two parties agree to pay each other interest on a notional principal amount for a specified number of years. One party pays fixed and the other pays variable per an index (i.e., one month LIBOR). There is no exchange of the principal, which is merely established for calculation purposes. The credit unions that have implemented hedging programs to reduce NEV and NII volatility under the pilot program have typically agreed to pay fixed rates and receive variable rates over a combination of two, three, five and seven years. These hedges synthetically altered a component of the deposit liabilities from a variable rate to a fixed-rate liability.
Under the swap, the credit union receives interest payments reflecting the prevailing short-term interest rate environment (e.g., one-month LIBOR minus 20 basis points or three-month T-bills plus 20 basis points, etc.). The actual spread to a specific index and the frequency of reset is chosen to closely match the rates paid on the member accounts being hedged.
The credit union in turn pays a fixed rate of interest for the entire life of the swap. The net cash flow to the credit union then equals the fixed rate paid to the counterparty minus the spread the credit union paid members on deposits below the benchmark variable rate index. One important note regarding utilizing interest-rate swaps is that the characteristics of the derivative hedge should closely match the underlying liability to qualify for hedge accounting. For example, if there is an effective floor on the rates paid on a member account, then the interest-rate swap should also include a similar floor component on the variable rate received.
Accounting For Swaps
Around the time the NCUA first approved its pilot program at WesCorp, the Financial Accounting Standards Board (FASB) issued new accounting standards for accounting for derivatives. The new rule, and its subsequent amendments and interpretive guidance are known collectively as FAS 133. FAS 133 has key concepts directly applicable to interest-rate hedging with swaps. The fair value of the derivative must be reflected on the balance sheet as an asset or liability in each accounting period.
Effectiveness testing is a critical component of FAS 133 accounting. If the index rate is directly linked to the variable rate on the swap, and other critical terms of the swap reflect the liability's characteristics, the designated risk will be the "benchmark interest rate" under FAS 133 and will be highly effective. If the criteria above are not met, a regression test must be completed to determine the effectiveness.
If the correlation is less than 0.8, the hedge is deemed ineffective and 100 percent of the derivative is recorded in earnings. If the correlation is between 0.8 and1.0, an allocation based on the mismatch between the performance of the interest-rate swap and the underline is recorded in earnings, (i.e., the derivative is recorded at fair value less the uncorrelated portion). To minimize this potential, the liability being hedged should be linked closely to an index that can be offset with an interest-rate swap tied to that index as described above.
Credit unions have several alternatives for managing derivative hedge programs. In all cases, it is important that the credit union work closely with its external auditors and regulators to develop mutually acceptable accounting procedures, comprehensive hedge documentation, and acceptable methods for correlation testing.
Jeremy Calva is Director of Investment Operations with WesCorp, San Dimas, Calif.