Ok, so we are starting with the Gap interest rate risk calculation. Remember that there are two main models for calculating your Earnings at Risk (EAR) exposure. There is the gap model and there is income simulation.
Of the two methods, income simulation is the superior technique. The gap model has assumptions that are clearly incorrect in some circumstances. Gap assumes that the growth rate for all accounts is zero. Gap also assumes that any account that matures over the next year will roll over for exactly the same term and at exactly the same amount. For instance, a mortgage with a 6% rate that matures in the next month will be replaced with a new mortgage that matures in one month and has a rate of 6%. Clearly these assumptions are often wrong and that's the model's weakness. Income simulation can correctly model these assumptions and that is why it is a superior technique. Many believe that these frequently incorrect assumptions are the reason for the expression 'Gap is crap.' I disagree, in fact I think these assumptions are one of the gap model's strength.
More than any other interest rate risk model, income simulation is assumption driven. These assumptions are the income simulation technique's greatest strength and also its greatest weakness. Three main assumptions are made for each account - 1) growth, 2) maturity rollovers, and 3) a model of how each account's rates change with changing rates in the marketplace. These assumptions allow you to get a very accurate estimate of future profitability. That's why income simulation is ideal for annual budgets. The weakness is that there is a natural tendency for income simulation to assume away interest rate risk - that's why many income simulation models result in lower interest rate risk measures than gap models. But, is thsi the true measure of ineterest rate risk? That's a future blog topic.
So, income simulation has three main sets of assumptions. The gap model replaces the first two sets of assumptions with (perhaps) overly simplistic and frequently incorrect assumptions. Surprisingly though, these extremely simplified, incorrect assumptions are not a huge source of inaccuracy in the measure of interest rate risk. Many of these simplified assumptions effects on interest rate risk are minimal or they are cancelled out by similar assumptions on the other side of the balance sheet - net/net there is often not much actual effect on interest rate risk. Surprising, but true. And, because income simulation tends to assume away interest rate risk with these first two sets of assumptions, gap modelling can actually be superior to income simulation or, at the very least, gap results can supply a much needed reasonability test for income simulation results.
It's the third set of assumptions that can have a huge effect on the interest rate risk measure - the modelling of how each account's rates are affected by changing rates in the marketplace. Many gap models skip this modelling, and those gap models are indeed crap. It's my opinion that this third set of assumptions is the source of the expression that 'gap is crap'.
Like income simulation, gap models can make assumptions about how an account's rates change with market rate changes. Good assumptions here make the gap model's interest rate risk results approximate income simulation measures. These assumptions are the topic of the next post, but first we need to understand the basics.
First let's look at the rate shock. Interest rate risk models assume that current rates get shocked by a given amount, 1.00% is a standard. That interest rate shock is assumed to be immediate; it is assumed to be parallel effecting all points on the yield curve by the exact amount of the shock; it is assumed to effect all yield curves equally by the exact amount of the shock; and it is assumed to last for a full year without any other interest rate risk changes. Pretty extreme assumptions, but that is the basis for most interest rate risk modelling. (Although income simulation often looks at other rate scenarios, like 'interest rate ramps' where rates rise or fall at given constant rate for the full year.)
For interest rate risk modelling, all accounts are divided into three basic types - fixed, variable, and non-interest rate sensitive (NIS). Of the three, NIS accounts are the easiest to model because, as is suggested by their name, NIS accounts have no effect on interest rate risk. In fact, you can be largely ignore these accounts once you have used them to balance your account amounts. An example of an NIS account would be your fixed assets account containing items like the credit union's building and its furniture.
Variable rate accounts have the biggest effect on interest rate risk as measured by income simulation or gap models. Variable rate accounts have rates that change in lock step with prime rates (or some other market rate) - if the prime rate rises by 1.00%, the rate on these accounts also rise by 1.00%. A good example would be a variable rate mortgage.
Here's how the gap model handles these variable accounts. In the event of a 1% rate shock to the downside, a variable mortgage account's rate will also fall 1%. That means that the credit union's income will fall 1% for a full year for variable mortgages and that income change represents interest rate risk. The interest rate risk exposure amount would be the amount of variable mortgages times 1%. For $10 million dollars of variable rate mortgages, that would be $100,000 of interest rate risk. Simple, eh?
However, note that there might also be a variable deposit (perhaps an investment savings account) that also has a rate that moves in lock step with prime. A 1% rate rise, means that the credit union will lose 1% times the amount of the variable deposit. That offsets the variable mortgage account's income gain. In fact, a simplification would be to subtract the variable deposits amount from the variable mortgage amount and multiply that difference by the 1% rate shock.
In fact, you can take that simplification further and add all of the variable asset account amounts and subtract all the variable liability account amounts and multiply the difference by 1% to get the interest rate risk caused by all of the variable accounts. This difference between assets and liabilities is also called the gap - and that is where the gap model gets its name. If the gaps (between asset totals and liability totals) are all zero, there is no interest rate risk. And that is where the out-moded concept of matching came from - the idea being to match the amounts of assets with an equal amount of liabilities to eliminate interest rate risk. So, the gap model simplifies by concentrating only on the gaps.
Ok, now we have figured out the interest rate risk for NIS accounts (equals zero) and variable accounts (equals net variable gap multiplied by rate shock). That leaves fixed accounts. A fixed account is an account with a fixed rate of interest that doesn't change for a period of time. An example would be a fixed rate mortgage or a term deposit.
Modelling fixed accounts is a bit like modelling NIS accounts and a bit like modelling variable accounts. For the period until the term deposit matures, there is no interest rate risk and after that, it behaves like a variable account. For example, take a term deposit that matures in 5 months. There is no effect on interest rate risk for the first 5 months, but the full rate shock takes place for the final 7 months. So there is an effect on the estimated future income for those final 7 months. The formula to calculate that interest rate risk would be the amount of the mortgage multiplied by the rate shock (say 1%) multiplied by 7/12 (the final 7 months remaining of the next 12 months where interest rate changes can have an effect.)
And, once again you can simplify the process by take the gap between all the 5 month assets and all the 5 month liabilities and multiply that by 1% further multiplied by 7/12. This process must be repeated for all maturities with terms out to 12 month maturities.
What about items that mature beyond one year? Income simulation and gap models only look at the effects of interest rate changes on the next year's income. Anything maturing beyond 12 months has no effect on EAR. It's the great weakness of EAR models and why you really must measure EVR as well as EAR. Some credit unions believe that you can control risks beyond one year by gap matching, but that is really an old fashioned interest rate risk management technique that EVR handles much, much better.
Now we have measured the interest rate risk for all the possibilities - fixed, variable and NIS. Add up all the interest rate risks (some positive, some negative) and that is EAR as measured by the gap model. Big problem though - this gap measure truly is crap. This simple measure can be so misleading that it is quite possible that your credit union might look like you it is exposed to rising rates when your credit union is actually exposed to falling interest rates. In such circumstances, taking corrective actions to lower your credit union's interest rate risk exposure can actually increase your interest rate risk.
There are many complications to be considered. Most complications are related to that third set of assumptions used in income simulation - modelling how the account's rate changes with market rates. The next post discusses these complications and how to handle and measure them.
Tuesday, July 7, 2009
Wednesday, July 1, 2009
Why Measure Interest Rate Risk?
So why measure interest rate risk? One obvious reason is that the regulators require you to measure it. Even if that wasn't the case, you should still measure your interest rate risk - using both measures EAR and EVR. Why?
The main reason you should be concerned about interest rate risk is that it can affect your bottom line more than just about anything else you can do as a credit union manager. This latest plunge in rates should have driven that lesson home. Since most credit unions are exposed to falling interest rates, most credit unions have lost money (lots of money) as the Bank of Canada drove rates down to their lowest possible level.
Was this loss of income preventable? Yes - it was entirely preventable. Even further, protecting yourself from falling interest rates usually increases income. To protect yourself from falling interest rates, you normally seek longer investments and shorter deposits. Longer investments typically have higher rates and shorter deposits typically have lower rates - hence more profits. So, not only could you have prevented the latest drop in income, you could have benefited from even more profits. You could have had your cake and eaten it too. With hind sight, a clear no brainer. That is why you should measure and control interest rate risk.
Some credit unions were forced to freeze their prime rate to prevent a further erosion of income. That too was entirely preventable. Your borrowing members could have had the entire reduction in interest rates. Today, you could be offering new clients a 2.25% prime loan on their mortgages. Member satisfaction and new member attraction is another reason why you should measure and control interest rate risk.
It is all hindsight now. Consider it a lesson learned. Start seriously measuring and controlling interest rate risk.
While on the topic of lessons learned, here's another. You can't consistently predict interest rates (although some people pretend they can). I didn't see anyone calling for this recession and I didn't see anyone calling for the dramatic plunge in interest rates to record low levels. That's why we endorse the philosophy of getting immunized from interest rate risk - then you don't care which way rates go. Then you can simply manage your credit union without worrying (or caring) about what the Bank of Canada will do next.
Get control of your interest rate risk and you can concentrate on serving your members. There is no better reason than that.
The main reason you should be concerned about interest rate risk is that it can affect your bottom line more than just about anything else you can do as a credit union manager. This latest plunge in rates should have driven that lesson home. Since most credit unions are exposed to falling interest rates, most credit unions have lost money (lots of money) as the Bank of Canada drove rates down to their lowest possible level.
Was this loss of income preventable? Yes - it was entirely preventable. Even further, protecting yourself from falling interest rates usually increases income. To protect yourself from falling interest rates, you normally seek longer investments and shorter deposits. Longer investments typically have higher rates and shorter deposits typically have lower rates - hence more profits. So, not only could you have prevented the latest drop in income, you could have benefited from even more profits. You could have had your cake and eaten it too. With hind sight, a clear no brainer. That is why you should measure and control interest rate risk.
Some credit unions were forced to freeze their prime rate to prevent a further erosion of income. That too was entirely preventable. Your borrowing members could have had the entire reduction in interest rates. Today, you could be offering new clients a 2.25% prime loan on their mortgages. Member satisfaction and new member attraction is another reason why you should measure and control interest rate risk.
It is all hindsight now. Consider it a lesson learned. Start seriously measuring and controlling interest rate risk.
While on the topic of lessons learned, here's another. You can't consistently predict interest rates (although some people pretend they can). I didn't see anyone calling for this recession and I didn't see anyone calling for the dramatic plunge in interest rates to record low levels. That's why we endorse the philosophy of getting immunized from interest rate risk - then you don't care which way rates go. Then you can simply manage your credit union without worrying (or caring) about what the Bank of Canada will do next.
Get control of your interest rate risk and you can concentrate on serving your members. There is no better reason than that.
Earnings at Risk (EAR) from the beginning
As we have been discussing, EAR is a measure of interest rate risk that measures the effect that interest rate changes might have on your next year's income.
If we look at the measure a little closer, we realize that it more accurately can be said to be a measure of the effect on net interest income, or financial margin. That is because the main things that effect EAR are those balance sheet items with interest rates. So, non interest expenses and revenues (like salary expense or fee revenue) usually do not impact on the calculation of EAR.
There are two measurement tools for EAR - gap and income simulation.
Income simulation is the better of the two approaches, but it is more complicated and asumption bound. Income simulation works by modelling the income statement and then seeing how the chnaging of rates affects the bottom line. It's a superior approach because it takes into account current yield curves and product growth. Obviously, both of those involve assumptions - what rate do you apply to mortgages maturing 6 months from now? Or how fast do you assume your premium savings account is going to grow. The answers will impact on your interest rate risk.
One of the problems with income simulation is that you can assume your interest rate risk away. For instance, assume you are exposed to falling rates. Falling rate exposures can be corrected by increasing the amount of fixed term mortgages (long assets) or variable deposits (short liabilities). So, if your model assumes a fast growth rate in these items - presto, no interest rate risk.
Income simulation assumptions are also work intensive. Every product must be mapped to how interest rate chnages affects that product's rate. Also you must specify that product's gowth rate and it's rollover assumptions. When a product like a fixed term mortgage matures, what term does the borrower renew at? One year? Five years? You must specify. Its very labour intensive.
Gap calculations were the financial industry's initial approach to interest rate risk. Gap is income simulation, without the growth rate, interest rate, and rollover assumptions. So its much simpler to calculate. That is actually a strength over income simulation, because you can't assume your interest rate risk away with gap.
However, gap's assumptions are pretty extreme. Gap assumes no growth and it assumes that anything that matures will rollover to the same maturity and to the term. So a mortgage with a remaining term of 3 months and a rate 3% over the current market is assumed to rollover to a three month term with the same very high rate (plus or minus the shock rate). Those are the exact assumptions that get corrected by using income simulation. Taht is why income simulation is the stronger approach.
There is an expression - Gap is crap - and there certainly is some truth to that expression. However, if done correctly, gap provides a very useful answer. We'll explore both opinions (useful or crap) in the next few posts.
If we look at the measure a little closer, we realize that it more accurately can be said to be a measure of the effect on net interest income, or financial margin. That is because the main things that effect EAR are those balance sheet items with interest rates. So, non interest expenses and revenues (like salary expense or fee revenue) usually do not impact on the calculation of EAR.
There are two measurement tools for EAR - gap and income simulation.
Income simulation is the better of the two approaches, but it is more complicated and asumption bound. Income simulation works by modelling the income statement and then seeing how the chnaging of rates affects the bottom line. It's a superior approach because it takes into account current yield curves and product growth. Obviously, both of those involve assumptions - what rate do you apply to mortgages maturing 6 months from now? Or how fast do you assume your premium savings account is going to grow. The answers will impact on your interest rate risk.
One of the problems with income simulation is that you can assume your interest rate risk away. For instance, assume you are exposed to falling rates. Falling rate exposures can be corrected by increasing the amount of fixed term mortgages (long assets) or variable deposits (short liabilities). So, if your model assumes a fast growth rate in these items - presto, no interest rate risk.
Income simulation assumptions are also work intensive. Every product must be mapped to how interest rate chnages affects that product's rate. Also you must specify that product's gowth rate and it's rollover assumptions. When a product like a fixed term mortgage matures, what term does the borrower renew at? One year? Five years? You must specify. Its very labour intensive.
Gap calculations were the financial industry's initial approach to interest rate risk. Gap is income simulation, without the growth rate, interest rate, and rollover assumptions. So its much simpler to calculate. That is actually a strength over income simulation, because you can't assume your interest rate risk away with gap.
However, gap's assumptions are pretty extreme. Gap assumes no growth and it assumes that anything that matures will rollover to the same maturity and to the term. So a mortgage with a remaining term of 3 months and a rate 3% over the current market is assumed to rollover to a three month term with the same very high rate (plus or minus the shock rate). Those are the exact assumptions that get corrected by using income simulation. Taht is why income simulation is the stronger approach.
There is an expression - Gap is crap - and there certainly is some truth to that expression. However, if done correctly, gap provides a very useful answer. We'll explore both opinions (useful or crap) in the next few posts.
Wednesday, June 17, 2009
Relative Measures
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.
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
Let's step back and review 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.
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
If you are a credit union that stopped lowering it's prime lending rate some time ago to preserve income, you likely have this Low Rate EAR that we have been talking about. That means, when rates start to rise again, your credit union will start to lose income as compared to what it is earning today. And we know that the next movement in prime rates will be to higher levels.
The first step is measuring how much income you will lose. Here's how:
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
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.
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:
- 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.
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