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.