So far, we have been talking about interest rate risk measurements in terms of dollars of risk to earnings or economic value. The problem with absolute dollars is that it is hard to compare the amount to previous risk levels at your credit union or to risk levels at other credit unions. For instance, $50,000 of EAR interest rate risk is quite different for a credit union with $10 million of total assets as compared to a credit union with $100 million of total assets. We need a method to compare these two credit unions.
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.