## Wednesday, June 17, 2009

### Relative Measures

For this reason, we usually divide the dollar amount of interest rate risk by the total assets. For the example above, that would be an EAR of .005 for the $10 million credit union and .0005 for the $100 million credit union.

These small numbers are awkward to work with, so we normally talk in terms of 'basis points of assets'. A basis point is one percent of one percent - or .0001. An example will make this more clear. If we are talking about a rate of 5.53%, adding one basis point to 5.53% would make 5.54%.

To change our .005 and .0005 to basis points of assets you multiply by 10,000. For the $10 million credit union that gives an EAR exposure of 50 basis points. That is a very high level of exposure. For the $100 million dollar credit union, the EAR exposure is 5 basis points of assets. That is a low level of exposure.

$100,000 of EAR interest rate risk is very meaningful to you. That means if the rates change adversely by the shock amount, your credit union will suffer a loss of income of $100,000. That is critical information no matter how big your credit union is. However, to get a feel for the relative size of this exposure, we need to divide by the assets and then multiply by 10,000 to get the exposure in terms of basis points of assets. As we just demonstrated, $100k of EAR exposure can be either very high or low - depending on the size of the credit union.

By the way, this is how the regulators want you to report your exposure - at least in Ontario.

Whether the exposure is high medium or low is somewhat subjective. We benchmark exposures in terms of a 1.00% shock. Using a 1.00% rate shock for EAR, we say 5 basis points or less is a low exposure, 6 to 10 is a moderate low exposure, 11 to 15 is a moderate high exposure, and over 15 is a high exposure. For EVR, we say 20 basis points or less is a low exposure, 21 to 35 is a moderate low exposure, 36 to 50 is a moderate high exposure, and over 50 is a high exposure.

One more note. Some practitioners divide by total capital instead of total assets. This makes some sense as capital is available to protect the institution should an adverse event occur - and an adverse interest rate move is a good example. This approach especially makes sense if your capital is relatively low. In that case you want to know what effect the change of rates will have on your capital. As an example, a credit union with lots of EAR exposure (say over 15 basis points of assets) should be much more concerned if their capital low are low than if they have lots of capital.

### Interest Rate Risk - From the beginning

There are two types of interest rate risk measurements - Earnings at Risk (EAR) and Economic Value at Risk. In some ways they are polar opposites to each other, and yet they are also good complements of each other. A strength in one measure is a weakness in the other and vice-versa.

Both measures work with an assumed change in interest rates. There are numerous ways to do this, but the most common (and easiest) method is to assume that all interest rates change at once by exactly the same amount. That's called a parallel shock in interest rates.

The next question is how big a change? A one percent change is kind of the standard. Shocks greater than are pretty rare, but two percent is sometimes used as a worse case scenario. Many credit unions use smaller shocks for reporting to their regulators. 25 and 50 basis point parallel rate shocks are pretty common.

Other common rate changes include 'ramps' which mean a constant and steady change of rates over a period of time. 'Tilts' are like ramps, but the shorter rates move at a different pace or direction than the longer rates, resulting in a tilting of the yield curve. Ramps and shocks imply all rates move the same way - this assumption can also be relaxed. In fact, the possibilities are infinite - it's deriving some meaning from the results that frequently means using simple parallel shocks, or perhaps ramps.

Earnings at Risk (EAR)

This is the simpler of the two measures to understand. It measures how many profits the organization will make or lose for a given change in interest rates. The results from an EAR analysis are quite simple to understand. If rates move like this, profits over the next year will rise (or fall) by this many dollars. That kind of statement hits home to many credit union managers.

The measurement process is relatively simple, and closely related to doing a margin budget. Calculate how much you will earn/pay on each asset/liability based on current or forecasted interest rates. The total of earnings less payments is net interest income. (So far, that's analogous to a margin budget.) Now assume those rates change and recalculate net interest income. The difference between the two results is the EAR in dollar terms.

Economic Value at Risk (EVR)

Unfortunately, this form of interest rate risk has many names and even different methods of calculating it. Having stated that, they all ultimately translate into pretty much the same thing. So, to keep it simple, we'll just stay with EVR.

Economic value is somewhat similar to other valuation terms of an organization - market value or stock price, book value, liquidation value, going concern value. Basically you are trying to derive the value of the credit union. Subtracting liabilities from assets is one technique - that's the accounting book value. Economic value goes one step - it is calculated by subtracting the present value of all the liabilities less the present value of all the assets.

An EVR measurement states how much the economic value of the credit union will change for a given change in rates. Taking the present value involves an interest rate - in this case the rate on the specific asset or liability. And like EAR, you calculate a new economic value after changing the rates by a given amount. The difference between the two economic values is your EVR.

Comparison of EAR and EVR

EAR is concerned with risks to the next year's net interest income. EVR is concerned with risks to economic value of the credit union. It's something like owning a stock or bond. EAR is similar to a concern about risks of loss on interest or dividends. EVR is similar to a concern about risks of loss on the market price of the stock or bond.

EAR only considers the next year's income, so items with a maturity beyond 1 year have no effect on EAR. Variable items have the biggest effect on EAR. The shorter the term of a fixed item, the bigger the effect on EAR. The longer the term of a fixed item, the smaller the effect, such that after one year there is no effect on EAR.

EVR considers all items on the balance sheet, but variable items have almost negligible effect. The longer the term of a fixed item, the bigger the effect on EVR. The smaller the term of a fixed item, the smaller the effect on EVR.

So, to properly consider all the terms exposed to interest rate risk, you need to use both measures.

## Wednesday, June 3, 2009

### Low Rate EAR solutions

The first step is measuring how much income you will lose. Here's how:

- Add up all your variable liabilities - those deposits that have rates that changed as the bank prime rate fell. Chances are that these consist mostly of the premium savings account and perhaps the floating side of a receive the fixed swap.
- Now total all your variable assets. Chances are that these are pretty rare. One example would be the floating side of a pay the fixed swap. (By the way, the floating side of swap is normally considered fixed not floating, but if the swap's reset period is 3 months or less, then it is close enough to floating for our purposes.)
- Take the difference between the total variable liabilities and the total variable assets. That difference is the source of your Low Rate EAR exposure.
- Now calculate how much is at risk. That is how much bank prime has dropped from the level where you froze rates. That would be the difference between your credit union' s prime rate and bank prime rate (currently 2.25%). For instance, if your credit union froze prime at 3.50%, there is 1.25% at risk.
- Calculate the dollar amount at risk per annum. That is the difference calculated in #3 multiplied by the percentage at risk calculated in #4.

That's how much income you will lose as the prime rate rises again to the level where you froze rates. So what to do?

Well, one choice is to do nothing about this Low Rate EAR and just concentrate on lowering your falling rate EAR that is currently masked. Here's the logic - you froze prime to prevent losing income from further drops in prime and that worked very well. Then there was a bonus as prime dropped further and you actually made more income as the rate on your premium savings account fell. That was great - the last blog called it found money. This is the income now at risk and it really means you will be back where you were when you froze prime - so why worry about it? You're just losing income that you weren't expecting to have.

Besides, there is no guarantee that when the prime rate starts to rise that the premium savings account rate will be forced higher. We saw that when prime rates were falling, that the premium savings account rate wasn't always in synch. Prime rate fell 4% whereas these rate only fell 2.00% to 2.50%. Perhaps the savings account rate will not rise when prime rate rises. However, there was a pretty good relationship between premium savings account rates and prime for the last few drops. Also, I think there is a pretty good chance that these rates will rise before prime does - in response to the economy turning and mortgage rates rising. (We saw the majors raised mortgage rates yesterday.)

Yeah, but what about solutions? We need something that will pay more when rates rise, but that will not be a burden when the normal EAR exposure to falling rates returns. That is difficult because many solutions that reduce Low Rate EAR will increase the normal falling rate EAR. Fixing one often makes the other worse.

A natural solution is to use your liquidity investments. Keep them short. When rate rise, their rates will also rise. If you have enough short investments to cover the difference calculated in #3, then you problem is solved. The shorter the term the better the match to your exposure. It would even be a good idea to sell longer investments and buyer shorter ones. Also, when rates rise to the extent that your normal EAR returns, you can reduce that exposure by investing longer. This really is the easiest/best approach to the problem, but chances are it is not enough.

Here's a very common thought process I hear about as an interest rate risk consultant. There is a price to pay when you keep your investments short. Shorter terms have lower yields than longer terms. So there is an immediate income loss if you invest short. Why not invest long and get the higher rate when you are pretty sure that rates will be stable for a while? Here's the problem - there is no telling when rates will start to rise again. When they do your credit union will lose income. A short investment will be able to offset that loss with higher rates on rollover.

If you have a one year term investment though, and rates rise say 1.00%, then you have to wait a year with a very low rate investment before your income will return. And remember that rates will not likely increase by 25 basis point increments - they cam down much faster and they will probably go up very quickly - perhaps as much as 2% in a couple of months. If you feel you can predict when rates will start to rise - go ahead and invest longer for more yield, but this is not recommended. We suggest terms of 3 months or less and again, shorter is better.

Interest rate swaps are another possibility. If you pay the fixed on a swap, the floating side will be like a variable rate that will rise when prime rates ascend again. That will hedge Low Rate EAR exposures. And, fixed pay swaps are a great idea right now because they effectively lock in these low rates for the long term. A five year fixed pay swap is like a five year deposit in that it locks in the rate for five years. But, and its a big BUT, this will also increase you normal EAR exposure to falling rates. (And your falling rate EVR exposure too.) You will also find that the amount you are paying is higher than the amount you are receiving - a loss that starts the moment your swap starts. And there is some pretty ugly accounting for swaps these days. However, this is an effective hedge for Low Rate EAR and a great way to lock in long term rates, so it is a good approach provided that the effects on the normal falling rate EAR and EVR are manageable. Otherwise, a pay fixed swap is not recommended.

Is there a way to get BA (not prime) based loans on your books? These would work, but they also will impact your normal falling rate EAR adversely. Can you convince members to convert their premium savings deposits to longer term deposits (preferably longer than one year) in this environment? Probably a hard sell and again, it will add to your normal falling rate EAR So there really are not many good solutions For Low Rate EAR.

Here's one more approach. As prime rates start to rise, can you also increase the rates on your variable assets? That too is a tough sell to members, as these rates didn't fall when prime fell so how will you explain that to the members affected? Even increasing your prime a portion of the prime rate increase would help. If prime was to increase 1.00%, you could cut this Low Rate EAR in half if you could raise you prime rate by 50 basis points. One way to help sell this would be to promise to get credit union prime back to the levels of bank prime by increasing less than the banks after bank prime reaches the level where you froze rates. Of course that means you would still lose the full amount of annual income calculated in step #5 above, but you have spread the losses to a period where you have higher income.

Finally, you can increase margins the old fashioned way - by increasing spreads on variable loans. This too will offset losses from Low Rate EAR. That is what the banks have done and that is one way they are able to make money with a 2.25% prime rate.

So, the two best methods are to shorten investment terms and to increase loan spreads. Other methods impact member relations or add to the normal EAR that will return when rates rise. They should only be considered with that in mind.

## Monday, June 1, 2009

### How Low Rate EAR works

- Low Rate EAR changes dramatically when prime changes.
- Low Rate EAR only applies to credit unions that froze their prime rate at higher levels.
- Low Rate EAR can have a big effect on your profitability.
- Normal EAR is still there, lurking in the background. It will return in full when credit union prime is 1.00% higher than the level where credit union prime rate was frozen. So, you definitely want keep measuring it.

Next time strategies to manage Low Rate EAR. Promise.