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.