Interest rate risk is measured through two approaches. This ALM 101 post describes the value at risk(VAR)/economic value of equity (EVE) risk perspective (long-term risk to market value of capital). It is the third in a series.
Interest rate risk for financial institutions is the risk that earnings and market value may decline as market interest rates change.
Defining and measuring value at risk (VAR) or economic value of equity (EVE) begins with understanding present values.
Financial institutions use VAR/EVE analysis to weed out "quick fixes," or strategies that look attractive but can be harmful in the long run.
Economic value of equity
In our previous segment of this “Introduction to ALM” blog series, we briefly discussed the sources of interest rate risk, as well as the difference between the two ways that regulators expect a well-managed financial institution to look at interest rate risk:
ALM 101: Introduction to Asset/Liability Management
Both are measures of interest rate risk, with the differentiator being the time horizon that each considers. As discussed in part 2 of the asset/liability management (ALM) blog series, EAR measures short-term changes to the income statement from interest rate movements. Value at risk or economic value of equity, the focus of this article, considers a longer-term horizon and is a measure of changes to the market value of the institution’s capital, rather than its margin.
Exactly what do we mean when we say market value? Take this example. It’s early in 2020 and the winds of the COVID-19 pandemic are getting stronger and stronger. You see grocery store parking lots packed to full capacity, but you think nothing of it. The next thing you know, the whole country is on lockdown, grocery store runs only happen out of sheer necessity, and right now you need toilet paper. You scour every local grocery store and can’t find a single roll on the shelves. You start to panic when, like an oasis in the desert, you see a pop-up stand on the side of the road that says, “Toilet Paper - $10/roll”. You pull over and buy every single roll that stand has to offer.
How in the world does this ridiculous example relate to ALM? Well, let’s say for example that the average price (or book value) of toilet paper is $1 per roll. In a non-pandemic world, you would never pay $10 for a toilet paper roll but given the environment you were in and the toilet paper availability, $10 was a reasonable price to pay. In that environment, the market value of toilet paper increased significantly.
To relate back to banking, changing rates affect the market value of a financial instrument in the same way that changing rates affect earnings. If you originated a fixed rate mortgage loan at 5% and market rates went up, and now you could make a new loan with those same loan characteristics for 7%, then the market value of your 5% loan has decreased, even though nothing has changed about the actual cash flows of the instrument. Rates and value have an inverse relationship. When rates go up, values go down and vice versa.
Value at risk is important because it provides management with a long-term view of income statement performance and potential pitfalls, which wouldn’t be apparent in the shorter-term earnings at risk analysis.
Measuring financial instruments this way gives a management a long-term view of the income statement and exposure to changing market rates. It also allows management to assess whether strategies implemented have significant long-term risks. This helps institutions avoid “quick fix” strategies that may increase earnings in the short-term to address the current environment but may cause significant issues in different economic environments in the future. Additionally, in order for institutions to receive a “Well-Managed” rating on the S component of the CAMELS rating, the impact of changing market rates to economic value must be considered as well.
Measuring VAR/EVE
To properly define value at risk, we must first define present value. Present value is the current worth of a future sum of money or stream of cash flows given a specified rate of return. The formula for present value is:
Measure value at risk by taking the present value of cash flows from all assets and subtracting the present value of cash flows from all liabilities, and then adding in the present value of net cash flows of any off-balance sheet activities.
Take this example below for an institution running a one-year value at risk analysis:
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As the example shows, to generate a positive economic value of equity, the present value of the cash flows on assets must outpace the present value of cash flows on liabilities.
This means that environments in which the cash flows on assets would decrease (e.g., from market rate decreases or negative rate environments) relative to the current cash flows in the portfolio would be ideal for institutions from a valuation perspective. For example, if a loan was on the books for 5% and a change in market rates resulted in a new loan with similar loan characteristics being made for 3.5% in the current environment, the value of the existing asset increases since more cash is coming into the bank from that asset.
This also means that environments where the cash flows on liabilities would increase (increasing rate environments) relative to the current cash flows in the portfolio would be ideal environments for institutions. If an institution had a CD with a rate of 1% and a change in rates resulted in that same CD costing an institution 2%, the value of that liability increases as less is owed the depositor from a valuation perspective.
However, it would be unusual to have an environment where both the rates on assets decreased and the rates on liabilities increased, so the values of assets and liabilities will almost always be working against each other. Institutions will always have more assets than liabilities. The question is, on which side of the balance sheet is the institution most sensitive? Is the institution too sensitive on one side or the other to the point where certain environments could cause significant concern to the impact on long-term value of the portfolio?
Measuring economic value of equity/value at risk and the changes that might occur under different rate environments helps financial institutions answer these questions and identify potential actions to mitigate risk.
Similar to earnings at risk, the most common way to measure value at risk is by running simulations on the portfolio through different rate environments and seeing the impact to the change in economic value of equity in each environment as compared to a base (typically a flat-rate environment).
Below is an example of an analysis done on an immediate, parallel and permanent (I&P) simulation.
Management can apply board-established policy limits to the “% Chg from Flat” metric and any environments where the percentage change exceeds the policy limit could signal potential danger should the institution find itself in those environments. As is the case with earnings at risk analysis, management is encouraged to look at reasonable and relevant economic scenarios when performing EVE analysis and making decisions based on the results.
VAR/EVE yields full picture
Any time the projected balance sheet changes, both earnings at risk and value at risk will change. When assessing impacts of changes on the future, an analysis of both will help give management a full picture of the risk profile within the new future balance sheet.
Specifically, EVE helps weed out “quick fix” ideas since it forces management to consider the full horizon of risk strategies. For example, say an institution is looking to boost short-term earnings and finds a market for cheap fixed-rate mortgages with ample volume. They decide to originate a large amount of these mortgages at a cheap fixed rate, which boosts their short-term earnings.
However, interest rates in the subsequent years rise steadily, and those same mortgages could be originated at 2% to 3% more than what they originated them for. Their value is going to decline significantly, and the lost opportunity cost could be crushing.
As another example, suppose an institution purchases an ample number of long-term CDs at a certain rate to boost short-term funding. Interest rates decline steadily in the following few years, and they could secure those same CDs for 2% to 3% less than what they’re paying. Their economic value of equity would take a hit as well.
On the other hand, prior to executing either of the above-mentioned strategies, management can review an EVE analysis and assess the potential risk in the strategy. It can conclude how the reward trade-off fits in to the institution’s risk tolerance and overall capital plan, making a more informed risk management decision.
Both earnings at risk and value at risk can measure earnings performance, but the difference in horizon assessed between the two allows an institution to have a holistic view of the risk present in the portfolio.
For both analyses, remember these three main takeaways:
Some institutions find it helpful to utilize outside asset/liability management expertise when conducting earnings at risk or value at risk analyses. Others choose to perform EAR and VAR analyses themselves. Regardless, financial institutions in this changing environment can benefit from knowing both the short- and long-term impact of their strategies on their banks or credit unions.
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