Low Rate EAR

As the prime rate dropped further and further, cutting into spreads and reducing profitability, some credit unions made the unilateral decision to freeze their prime rate. The moment they made that decision, their Earnings at Risk (EAR) exposure immediately became zero. Why? Most credit unions have a lot of variable assets and too few variable liabilities to offset them. That's why they are exposed to falling interest rates and that's why their income was getting decimated as the Bank of Canada kept on cutting rates. By freezing their asset rates, the problem was solved - most variable asset rates would no drop, so the exposure was eliminated.

Let's be careful with our terms here. What is an exposure to interest rates? If your organization has an exposure to interest rates, that means it will lose something (earnings or economic value) when interest rates change. Of course, interest rate changes could also mean that you gain something (earnings or economic value), but that is not an exposure. Exposures only concern themselves with the downside, favourable results are not a concern - so favourable results are not an exposure.

For the credit unions that froze their prime rates, interest rates rising to higher levels was not an exposure. And rates falling was not an exposure either, after prime was frozen. But their EAR was not zero. They would make more income (or economic value) when rates rose and, somewhat surprisingly, some credit unions would make more income when rates fell - substantially more.

To see why, we have to take a closer look at a very popular demand account - the premium savings account. The simple fact is that the rate on premium savings accounts is too high. In normal market conditions, no deposit rate should be higher than the swap curve, which is the same as the BA curve for terms under one year. Why? Because the swap curve is roughly where the major banks can borrow (or invest) as much money as they desire. Why pay a retail investor more for their $1,000 deposit than the rate where you can borrow millions, even billions of dollars? That should mean the rate for this account should be under 0.50%. And yet the rate persists as a full percent higher. Even the major banks offer premium savings account deposit rates higher than 1.00%.

So why is the rate on premium savings accounts so high? Most likely it is competition - everyone is offering high savings account rates, so not doing so likely means losing market share. But why is anyone paying such high rates? The premium savings account was practically invented by ING. They raised tons of money with this account and used those funds to finance loans - mostly mortgages. So they tend to watch the spread between 5 year mortgages and this savings account rate. So, this rate tends to change with 5 year mortgage rates rather than prime. Mortgage rates remained stubbornly high, as prime rates fell. And so did the rate on the premium savings account remain stubbornly high.

The chart to the left shows the Bank prime rate and ING's savings and 5 year mortgage rates. It may not be obvious (you get a clear picture by clicking the graphic), but prime rates fell 4% while mortgages rate only fell 2.15% and the prmium savings rate only fell 2.25%. That was very bad news for many credit unions. Many credit unions finance their variable rate assets with variable rate deposits, like the premium savings account. While their variable rate returns on prime-based assets fell off a cliff, the savings account rate only fell half as much. In fact, the chart shows how the savings rate was almost touched the prime rate at one point - for almost a month there was only 30 basis points difference between prime and the savings account rate, as compared to the more normal 2 or 3 percent. (You can see that the relationship between mortgage and savings account rates stayed relatively in synch for the entire period.) It was only when mortgage rates started to crack, that there was any relief on the savings account rates. That's the reason for the high savings account rate - it is tracking the 5 year mortgage rate rather than short term rates like BAs or prime.

No wonder, many credit unions took the unusual step of freezing prime to preserve income. Let's say the credit union froze their prime at 3.50%. Since then, the prime rate has fallen 1.25% and the premium savings account rate has fallen 1.20%. That represented a gain in income for these credit unions. The variable asset rates were stuck, but the variable liability rates continued to fall. That created interest rate risk. Now when prime rises, the variable asset rates will stay constant as they did on the way down. But chances are the savings account rates will also rise. And, in many cases, there is nothing to hedge this expense that is due to interest rates changing. That is a rising rate EAR exposure.

And this is a very unusual interest rate risk.

1. The magnitude of this EAR will vary as prime rates rise, such that this EAR will be zero again when bank prime equals the credit union's prime. The magnitude of normal EAR does not change significantly with interest rates.
2. This EAR is an exposure to rising rates, whereas credit unions are normally exposed to falling rates. The falling rate exposure still exists, but is currently hidden by the low rate environment. Eventually, rates will rise again and the falling rate exposure will be there again.
3. This new EAR is pretty tricky to hedge.

So we now have two types of EAR. We need to give this new form of EAR a name to avoid confusion with the completely different normal EAR. As this EAR will only occur when rates are low, we'll call it Low Rate EAR. So we have normal EAR and, now, Low Rate EAR.

What to do about Low Rate EAR next.

New EAR and Masked EAR

Let's review the main points of the last post.

1. It seems that the prime rate will not go down anymore. The Bank of Canada indicates that a 2.25% prime rate is the floor; we will not see prime at 2.00%.


2. Most credit unions have a falling rate exposure. That falling rate exposure is now $0 because rates likely will not drop any further. In other words, most credit unions now have no Earnings at Risk (EAR) interest rate risk.


3. The Bank of Canada forecasts rates will stay at these levels for a year. If true, credit unions will have zero falling rate interest rate risk for the next year.

So falling rate exposures have been eliminated, but that doesn't mean they should be ignored. When rates rise again, they will come back. Instead of relaxing, take this time as an excellent opportunity to optimize (or eliminate) your EAR interest rate risk.

EAR falling rate exposures is temporarily hidden, but when rates rise again it will reappear. Depending on your credit unions shock test and depending how quickly the Bank of Canada raises rates this might be a step-wise process. Here's a few cases:

1. If the shock test at your credit union is 25 basis points, the next rise in rates will immediately bring back all of your falling rate EAR.


2. If the shock test is 50 basis points and the next move in rates is 25 basis points higher, your falling rate EAR will be one-half of normal. The next move higher after that brings all your EAR all back.


3. If the shock test is 100 basis points and the next move in rates is 25 basis points higher, your falling rate EAR will be one-quarter of normal. Each quarter point move higher adds another quarter of EAR exposure.

Having said all that, chances are good that no matter your shock test level, the next move in rates will bring all of your EAR exposure back. Why? The Bank of Canada has engineered rates all the way down to what it calls the effective lower bound - in effect, as low as they can. This would obviously be tremendously inflationary in a normal economy, and one of the main functions of the Bank of Canada is to keep inflation within a tight range. On the other hand, we are in such a bad recession right now that the Bank has lowered rates to the very lowest level it can go. Any rise in rates now could make things worse and could squelch any emerging economic growth. So the Bank won't move rates higher until it is convinced that the economy is rebounding. But, when the economy does seem to be coming back, it will want to move quickly to keep inflation in check. For those reasons, the first rate change is unlikely to be a quarter-point move - more likely it will jump a half percent or more.

If that is correct, the next move in rates will bring back all of your credit union's falling rate EAR. So, it is definitely not a good idea to ignore it. That's why you should take this time of zero EAR to get this masked/hidden exposure under control.

Another thought. As mentioned last time, most interest rate risk models have a 0.0% interest rate floor. This prevents the possibility of negative interest rates. Given the Bank of Canada's last statement, this now seems incorrect. The floor should be set at .25%, which roughly where the current over night rate is. 0.25% is where the Bank of Canada has set the floor. Also, clearly the floor is much higher for variable rate assets. For loans at the prime rate, the floor is 2.25%. If there is a loan with spread over prime, the floor would be 2.25% plus the spread. Some savings account rates are already below 0.25%. For those cases, the floor is the current rate.

Next post we will cover the very interesting ramifications for those credit unions that froze their prime rate at higher levels.

Ramifications of Zero EAR

The last post promised a discussion on ramifications of zero Earnings at Risk (EAR). There are two cases: those credit unions who froze their variable asset rates some time ago and every other credit union with a falling rate exposure. Each case will be handled in separate posts.

First up - all the credit unions with a falling rate exposure. In our experience this is the vast majority of credit unions. Even those credit unions that carefully measure and control their interest rate risk likely have falling rate exposures, so that they can take advantage of the eventual runup in rates.

The latest Bank of Canada statement (well worth reading here) had some very interesting statements. Here's one:

With monetary policy now operating at the effective lower bound (emphasis mine) for the overnight policy rate, it is appropriate to provide more explicit guidance than is usual regarding its future path so as to influence rates at longer maturities. Conditional on the outlook for inflation, the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010 in order to achieve the inflation target. The Bank will continue to provide such guidance in its scheduled interest rate announcements as long as the overnight rate is at the effective lower bound.


The Bank is calling current interest rates the ' effective lower bound'. The main rate that the Bank of Canada uses in monetary policy is the overnight rate, or the rate for a one-day loan from the Bank of Canada. The major banks and other financial institutions then set their prime rates based on that rate. So indirectly, the Bank of Canada sets prime rates. The current target overnight rate is 0.25% and it is this level that the Bank is calling the effective lower bound.

The Bank of Canada changes its targeted rate in 1/4% increments. So, at 0.25%, there is only one more downward move that is possible. (Negative interest rates are an interesting concept, but who will lend and then pay the borrower interest - it just won't happen.)

The bank is taking this negative rate fact one step further by calling 0.25% the effective lower bound. This is a statement that overnight rate won't drop any further. Why can't it go to 0.0%? Because of the simple fact that those with money may not lend if they cannot get a return and that would be the case at 0.0% interest. A 0.0% interest rate could jam the money markets, stopping the flow of funds. This could reduce credit availability, which is exactly what the Bank has been trying to improve since the credit crunch. So, the Bank will not drop its overnight rate any further. And thus, 0.25% is the effective floor for interest rates.

Now for ramifications. If you have a falling rate exposure, your EAR is now zero. The risk of rates falling any further is close to zero, because the Bank of Canada will not drop its rate any more and so prime will not go down anymore. Hopefully your interest rate risk advisor advisor is telling you this so you can report a zero interest rate exposure to your regulator.

That means a prime of 2.25% is also the floor. There won't be a 2% prime. And this is true for all your variable interest rates - all their interest rates are at effective floors. Their rates will not drop any further. This has considerable meaning for interest rate risk measurement. Most models will not allow rates to fall below zero, but they will assume that car loans at 6% can still go down. Ignoring credit spreads, that is now incorrect.

One of the big mistakes in early interest rate risk models was that they allowed negative interest rates. Say your Plan 24 savings account rate was 0.15% and your interest rate risk model used a shock rate of 50 basis points, the model assumed your Plan 24 rate could go to -0.35%. An impossible negative interest rate. (It's dangerous to use the word impossible these days when discussing interest rate movements, so let's say impossible, unless you think that your members will pay you when they invest their money). So interest rate risk models quickly incorporated a 0.0% rate floor. The effect was a huge jump in the EAR measure. Here's why. If interest rates dropped 0.50%, asset rates would fall 0.50% (reducing income), but Plan 24 rates could only fall 0.15% (not reducing expenses). Overall resulting in a drop in expected income - EAR interest rate risk. Further model refinements would prevent the 0.15% rate from falling at all. And that modification resulted in even more falling rate EAR.

And now that is true on the asset side. And that suggests a big drop in falling rate EAR. Falling rate exposures are now zero, as stated above. But falling rate exposures will be low even when rates start rising again. Say rates go up 0.25%. Now they can drop 0.25% again, but if your rate shock is at 0.50%, then EAR falling rate exposure is still cut in roughly in half.

At BiLd Solutions, we like to use a 2 percent shock/change in rates as a worst case scenario. Obviously, these floors have implications for this measurement. Prime will have to be 4.25% (up 2 percent from the current floor) before the full 2 percent worst case drop in rates is possible.

That's a lot to digest. More on this topic next time.