Olson Research Associates, Inc.

Measuring Economic value of Equity-at-Risk (or EVE at risk)
As a means for evaluating long-term interest rate risk, an economic perspective is necessary. This approach focuses on the value of the bank in today’s interest rate environment and that value’s sensitivity to changes in interest rates. This concept is known as Equity-at-Risk. It requires constructing a complete present value balance sheet. This is done by scheduling the cash flows of all assets, liabilities, and off-balance sheet items and applying a set of discount rates to in turn develop the present values. Calculating the difference between the present value of assets and liabilities derives the economic value of equity or EVE.
(Equity = Assets – Liabilities)

Similar to Earnings-at-Risk, two instantaneous, parallel interest rate "shocks" are applied to the base set of rates and all present values are re-computed. Equity-at-Risk is the largest negative change in the present value between the base and one of the "shock" scenarios. This is usually stated as a percentage change or may be presented in dollars as a comparison to a percentage benchmark of the bank’s

Fundamentally, interest rate risk (IRR) is the risk to earnings and capital arising from movements in interest rates. One fundamental way to quantify IRR is by stress-testing a one-year forecast of income and measure earnings at risk. This is generally considered a gauge of short-term IRR because it measures the effect changes in interest rates have on earnings over a one-year time horizon.

But interest rate risk should be viewed from both a short-term and a long-term perspective. To measure long-term IRR we look at a similar measure called Equity Value-at-Risk. Equity Value-at-Risk is sometimes referred to as EVE at risk, which stands for "Economic Value of Equity at Risk". (See side bar)

The impact of rising rates
Over the past several quarters we have seen an increase in the number of banks whose earnings will benefit from rising rates. From December 2000 to March 2003 the percentage of banks that could expect net interest margin to improve, given an increase in market rates, rose from 48% to 54%.

Unfortunately for many banks EVE will decrease given an increase in market rates. In general, most community banks have longer duration assets than liabilities. It is this inherent mismatch or difference in durations that exposes the EVE of many banks to rising rates. From December 2000 to March 2003 the percentage of banks with EVE at risk given rates up has increased from 86% to 92%.

What is interesting about these statistics is that while nearly half of all banks are positioned to increase their margin given rising rates, over 75% of those banks will experience a drop in their EVE. To many bankers, examiners, auditors and analysts this situation seems contradictory. When rates rise does it make sense that short-term earnings will increase and long-term value will decrease? It does when you consider the effects of optionality.

Protecting short-term losses
We can illustrate this phenomenon by looking at a simple example. Over the past several quarters many banks have invested more dollars in mortgage-backed securities. While this was done mostly because they offered the most attractive yields, a side effect is that they can help protect a bank’s earnings against rising rates.

The data in the table shows the prepayment speed, yield, duration, and price of a sample 30-Year Fixed MBS. As rates fall, prepayment speeds will increase. The faster prepayments will have two effects. First, they will shorten the duration of the security from 1.49 years to 1.26 years. Second, the yield will drop since there will be less principal available to earn interest.

If rates begin to rise, prepayments are likely to slow down, which lengthens duration, and increases the yield. In a rising rate environment, the bank that owns this security will earn more than it would if rates remained level or fell.

The trade-off is that as rates rise, the duration of this type of security extends*. This lengthens the overall duration of the bank’s total assets. A longer duration means that the value is more likely to decrease as rates rise. As the bank’s asset value drops so does the EVE of the bank: E = A – L.

Both short-term and long-term measures of IRR count
This mortgage-backed security is a relatively simple example of how optionality can affect IRR. Community banks without an MBS portfolio have many similar instruments on their balance sheets. On the asset side they may have a fixed-rate mortgage portfolio. Or they could have a sizable callable agency portfolio that effectively exhibits the same behavior: if rates stay level or go down, the bond calls; if rates rise the bond doesn’t call, and the duration extends. Again, earnings are higher but more EVE is at risk.

Instruments with embedded options on the funding side also affect IRR. What will happen to earnings and EVE if CD early withdrawal rates rise sharply when market rates rise? How will the many flavors of FHLB advances (those with call dates, strike rates, etc.) impact a bank’s earnings and EVE when rates rise?

With these types of “subtle” options increasingly finding their way onto banks’ balance sheets, it is more important than ever to monitor IRR from both a short-term and a long-term perspective.

* Many investments that behave like this, i.e. many of those with options, are described as having negative convexity.