How Low Rate EAR works

We just finished defining Low Rate EAR - an exposure that develops for credit unions that have frozen their prime rates to protect margins. The minute that the decision was made to freeze prime rates at the credit union, the credit unions falling rate EAR (Earnings at Risk) was eliminated. (And make no mistake - those credit unions definitely had a falling rate exposure, otherwise why freeze prime?). And then a funny thing happened, bank prime continued on down and the rate on variable liabilities (mostly premium savings accounts) also went down. This meant more income. Prime continued all the way down to the point where it could go no lower - apparently 2.25% is the bottom. And the credit unions that froze prime have captured income from falling variable liabilities. But look where we are now.

Prime can go no lower, so logically the next change in prime will be to higher rates. When rates rise, the premium savings account rates will likely rise too. What have the credit unions got to offset this increase in costs? Not their variable assets - these were frozen on the way down, so the credit union could hardly raise them when rates rise again. Take away variable assets and there is not much else, so the next change in rates will increase expenses / reduce profits. That's the Low Rate EAR exposure - an exposure to rising rates.

Let's review. Credit union freezes their prime. Falling rate EAR eliminated. Bank prime continues to fall. Credit union makes additional income because premium savings rates also fall while variable rates remain constant. This additional income is a bit like found money - a surprise benefit from freezing the credit union prime rate. The prime rate continue to fall to their lowest possible point. The 'found money' profits are maximized from changes in prime (although they could go even higher, should mortgage rates drop some more likely causing the premium savings rates to fall again). The next move will be to higher rates and that will mean that the credit unions will need to give back this 'found money' as profits are reduced from current levels. A rising rate EAR exposure.

So what to do? First of all measure this risk and model it - try to understand it. Unlike the IRR we are used to (that requires balance sheet changes to make a difference), Low Rate EAR changes dramatically with rate changes even if the balance sheet stays the same. Here's an example to illustrate this Low Rate EAR behaviour and how to model it.

Assume a $100 million credit union with a normal EAR of10 basis points to falling rates (a moderate/high level of interest rate risk. The credit union froze its prime when bank prime was 3.5%. It has $15 million of premium savings accounts with a rate of 1.25%. There is nothing on the asset side to offset increased deposit costs that will occur when prime rises.

Bank prime has fallen 1.25% since credit union prime was frozen (the credit union froze prime at 3.50% and bank prime has fallen to 2.25% or a 1.25% change). So that is how much profit is at risk when rates rise - $15 million x 1.25% or $187,500 per annum. That's a lot of profits to be lost in anyone's books. Using a 1% shock that is typical in interest rate risk analysis, the amount at risk is $15 million x 1.00% or $150,000 or 15 basis points of rising rate exposure. That is the credit union's Low Rate EAR - 15 basis points. Two things to mention. One, that's a high level of interest rate risk. Two, this risk is to rising rates compared to the credit union's normal falling rate EAR of 10 basis points. In effect, interest rate risk has swung 25 basis points from the time before prime was frozen.

Let's move rates up 0.25% - bank prime to 2.50%. Forecasted net interest income just fell by $15 million x 0.25% or $37,500. There is still a full 1.00% (3.50% - 2.50%) that can be lost, so EAR remains at 15 basis points to rising rates and the normal falling rate EAR remains at zero. Now rates move up another 0.25% to 2.75%. Another $37,500 is lost, but now there is only 0.75% that can be lost, Low Rate EAR falls to 11.3 basis points - a moderate/high level. When bank prime becomes 3.50% again, EAR becomes zero again. At 3.75%, the falling rate exposure returns, but not all of it. After all, credit union prime will get frozen again at 3.50%, so the most that prime can fall is 0.25%. That means only one-quarter of the normal EAR is there, the rest is still masked by low interest rates and the floor on primes. At 4.50% prime, the falling rate exposure is all back - 10 basis points to falling rates. Higher rates have no further effect. Clicking the graphic at the left, shows all the data points.

So what have learned:

1. Low Rate EAR changes dramatically when prime changes.
2. Low Rate EAR only applies to credit unions that froze their prime rate at higher levels.
3. Low Rate EAR can have a big effect on your profitability.
4. 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.