Government Regulators Should Not Expand Derivatives Trading at Credit Unions

Depositors save with federal credit unions instead of banks largely because federal credit unions are known for their fiscal austerity and risk-averse investment philosophy. It might surprise many federal credit union members, then, that the NCUA already permits credit unions to invest in derivatives, and is now proposing to allow federal credit unions to greatly expand their derivatives exposures. The proposal is a wrong-headed deregulatory move that has gone largely unnoticed in the financial press.

In many respects, federal credit unions are real-life embodiments of the beloved Bailey Savings and Loan from the holiday classic “It’s a Wonderful Life.” As member-owned financial cooperatives, credit unions are community-oriented organizations that put the interests of their members above sheer profit.

Still, the non-profit nature of credit unions is no guarantee that these institutions are free from incentives to take on excessive risk. A report by CUNA revealed that compensation for credit union CEOs approaches 90% of the compensation received by bank CEOs, on average. While incentive-based bonuses are more common at banks, they are not unusual at credit unions. Thus, many credit union managers have incentives to engage in the same kind of speculative behavior that caused the Great Recession of 2008.

The NCUA weaponizes these incentives by greatly expanding the range of derivatives trading that federal credit unions can conduct. The NCUA first authorized federal credit unions to use interest rate derivatives as hedging vehicles in 2014, while establishing fixed limits on notional value and estimated fair value loss. The latest NCUA proposal explodes these limitations entirely, in favor of an amorphous, “principles-based” approach to regulation.

Under the proposal, a federal credit union engaging in derivatives trading would have limited clarity as to whether a particular hedging transaction would satisfy the NCUA’s scrutiny. Federal credit unions are often small-scale, under-manned businesses that cannot afford the legal uncertainty that is inherent in any principles-based regulatory regime. Rather, they want to know exactly what is legal and what is not. The NCUA proposal eschews simplicity in favor of complexity and risk. The proposal encourages a Wild West attitude within institutions that have heretofore been the exemplars of safety and soundness.

One might argue that the NCUA proposal does not introduce federal credit unions to heightened risk because any derivatives investment program covered by the NCUA’s regulations must be geared toward hedging against interest rate risk. Interest rate derivatives are among the most liquid and safest derivatives available. But still, the idea that interest rate derivatives are risk-free is a myth.

Interest rate derivatives allow federal credit unions to theoretically convert variable interest rate exposures to fixed ones, and vice versa. However, this is done synthetically, not directly, and is entirely dependent on liquid and well-functioning capital markets.  The market for interest rate swaps may collapse during a credit crunch, leaving the federal credit union unprepared to handle its interest rate exposures. This is particularly problematic for noncentrally cleared derivatives, which are permitted under the proposal.  Interest rate derivatives can also involve delayed settlement, liquidity premiums or early termination provisions that can likewise catch even sophisticated federal credit unions by surprise. Federal credit unions entering into uncleared derivatives must also concern themselves with monitoring their counterparties’ well-being to minimize counterparty risk – hardly the kind of activity that one expects of local credit unions. JP Morgan’s London Whale fiasco revealed that even the most “sophisticated” parties can suffer unexpected losses while supposedly hedging. Also, even genuine hedges that are working properly can create cash flow problems as the derivatives are often marked-to-market while the underlying assets being hedged are not.

To make matters worse, the proposal reduces the numbers of internal controls that federal credit unions must maintain to mitigate derivative risk. It also relaxes the amount of annual training that federal credit union managers must undertake in the area of derivatives. Adding fuel to the fire, the proposal endorses the usage of leveraged products to magnify a federal credit union’s unexpected exposures, and eliminates strict loss limits or notional limits. These ingredients comprise a potential recipe for disaster for federal credit union members during the next financial crisis. If the NCUA finalizes its proposal, as is expected, risk-averse savers might want to think twice before placing their deposits in credit unions.

Akshat Tewary, Esq. is an attorney practicing in New Jersey, a Financial Industry Regulatory Authority arbitrator and President of Occupy the SEC, a non-profit advocating for financial reform.