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:

1. 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.
2. 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.)
3. Take the difference between the total variable liabilities and the total variable assets. That difference is the source of your Low Rate EAR exposure.
4. 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.
5. 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.

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.

Low Rate EAR

As the prime rate dropped further and further, cutting into spreads and reducing profitability, some credit unions made the unilateral decision to freeze their prime rate. The moment they made that decision, their Earnings at Risk (EAR) exposure immediately became zero. Why? Most credit unions have a lot of variable assets and too few variable liabilities to offset them. That's why they are exposed to falling interest rates and that's why their income was getting decimated as the Bank of Canada kept on cutting rates. By freezing their asset rates, the problem was solved - most variable asset rates would no drop, so the exposure was eliminated.

Let's be careful with our terms here. What is an exposure to interest rates? If your organization has an exposure to interest rates, that means it will lose something (earnings or economic value) when interest rates change. Of course, interest rate changes could also mean that you gain something (earnings or economic value), but that is not an exposure. Exposures only concern themselves with the downside, favourable results are not a concern - so favourable results are not an exposure.

For the credit unions that froze their prime rates, interest rates rising to higher levels was not an exposure. And rates falling was not an exposure either, after prime was frozen. But their EAR was not zero. They would make more income (or economic value) when rates rose and, somewhat surprisingly, some credit unions would make more income when rates fell - substantially more.

To see why, we have to take a closer look at a very popular demand account - the premium savings account. The simple fact is that the rate on premium savings accounts is too high. In normal market conditions, no deposit rate should be higher than the swap curve, which is the same as the BA curve for terms under one year. Why? Because the swap curve is roughly where the major banks can borrow (or invest) as much money as they desire. Why pay a retail investor more for their $1,000 deposit than the rate where you can borrow millions, even billions of dollars? That should mean the rate for this account should be under 0.50%. And yet the rate persists as a full percent higher. Even the major banks offer premium savings account deposit rates higher than 1.00%.

So why is the rate on premium savings accounts so high? Most likely it is competition - everyone is offering high savings account rates, so not doing so likely means losing market share. But why is anyone paying such high rates? The premium savings account was practically invented by ING. They raised tons of money with this account and used those funds to finance loans - mostly mortgages. So they tend to watch the spread between 5 year mortgages and this savings account rate. So, this rate tends to change with 5 year mortgage rates rather than prime. Mortgage rates remained stubbornly high, as prime rates fell. And so did the rate on the premium savings account remain stubbornly high.

The chart to the left shows the Bank prime rate and ING's savings and 5 year mortgage rates. It may not be obvious (you get a clear picture by clicking the graphic), but prime rates fell 4% while mortgages rate only fell 2.15% and the prmium savings rate only fell 2.25%. That was very bad news for many credit unions. Many credit unions finance their variable rate assets with variable rate deposits, like the premium savings account. While their variable rate returns on prime-based assets fell off a cliff, the savings account rate only fell half as much. In fact, the chart shows how the savings rate was almost touched the prime rate at one point - for almost a month there was only 30 basis points difference between prime and the savings account rate, as compared to the more normal 2 or 3 percent. (You can see that the relationship between mortgage and savings account rates stayed relatively in synch for the entire period.) It was only when mortgage rates started to crack, that there was any relief on the savings account rates. That's the reason for the high savings account rate - it is tracking the 5 year mortgage rate rather than short term rates like BAs or prime.

No wonder, many credit unions took the unusual step of freezing prime to preserve income. Let's say the credit union froze their prime at 3.50%. Since then, the prime rate has fallen 1.25% and the premium savings account rate has fallen 1.20%. That represented a gain in income for these credit unions. The variable asset rates were stuck, but the variable liability rates continued to fall. That created interest rate risk. Now when prime rises, the variable asset rates will stay constant as they did on the way down. But chances are the savings account rates will also rise. And, in many cases, there is nothing to hedge this expense that is due to interest rates changing. That is a rising rate EAR exposure.

And this is a very unusual interest rate risk.

1. The magnitude of this EAR will vary as prime rates rise, such that this EAR will be zero again when bank prime equals the credit union's prime. The magnitude of normal EAR does not change significantly with interest rates.
2. This EAR is an exposure to rising rates, whereas credit unions are normally exposed to falling rates. The falling rate exposure still exists, but is currently hidden by the low rate environment. Eventually, rates will rise again and the falling rate exposure will be there again.
3. This new EAR is pretty tricky to hedge.

So we now have two types of EAR. We need to give this new form of EAR a name to avoid confusion with the completely different normal EAR. As this EAR will only occur when rates are low, we'll call it Low Rate EAR. So we have normal EAR and, now, Low Rate EAR.

What to do about Low Rate EAR next.

New EAR and Masked EAR

Let's review the main points of the last post.

1. It seems that the prime rate will not go down anymore. The Bank of Canada indicates that a 2.25% prime rate is the floor; we will not see prime at 2.00%.


2. Most credit unions have a falling rate exposure. That falling rate exposure is now $0 because rates likely will not drop any further. In other words, most credit unions now have no Earnings at Risk (EAR) interest rate risk.


3. The Bank of Canada forecasts rates will stay at these levels for a year. If true, credit unions will have zero falling rate interest rate risk for the next year.

So falling rate exposures have been eliminated, but that doesn't mean they should be ignored. When rates rise again, they will come back. Instead of relaxing, take this time as an excellent opportunity to optimize (or eliminate) your EAR interest rate risk.

EAR falling rate exposures is temporarily hidden, but when rates rise again it will reappear. Depending on your credit unions shock test and depending how quickly the Bank of Canada raises rates this might be a step-wise process. Here's a few cases:

1. If the shock test at your credit union is 25 basis points, the next rise in rates will immediately bring back all of your falling rate EAR.


2. If the shock test is 50 basis points and the next move in rates is 25 basis points higher, your falling rate EAR will be one-half of normal. The next move higher after that brings all your EAR all back.


3. If the shock test is 100 basis points and the next move in rates is 25 basis points higher, your falling rate EAR will be one-quarter of normal. Each quarter point move higher adds another quarter of EAR exposure.

Having said all that, chances are good that no matter your shock test level, the next move in rates will bring all of your EAR exposure back. Why? The Bank of Canada has engineered rates all the way down to what it calls the effective lower bound - in effect, as low as they can. This would obviously be tremendously inflationary in a normal economy, and one of the main functions of the Bank of Canada is to keep inflation within a tight range. On the other hand, we are in such a bad recession right now that the Bank has lowered rates to the very lowest level it can go. Any rise in rates now could make things worse and could squelch any emerging economic growth. So the Bank won't move rates higher until it is convinced that the economy is rebounding. But, when the economy does seem to be coming back, it will want to move quickly to keep inflation in check. For those reasons, the first rate change is unlikely to be a quarter-point move - more likely it will jump a half percent or more.

If that is correct, the next move in rates will bring back all of your credit union's falling rate EAR. So, it is definitely not a good idea to ignore it. That's why you should take this time of zero EAR to get this masked/hidden exposure under control.

Another thought. As mentioned last time, most interest rate risk models have a 0.0% interest rate floor. This prevents the possibility of negative interest rates. Given the Bank of Canada's last statement, this now seems incorrect. The floor should be set at .25%, which roughly where the current over night rate is. 0.25% is where the Bank of Canada has set the floor. Also, clearly the floor is much higher for variable rate assets. For loans at the prime rate, the floor is 2.25%. If there is a loan with spread over prime, the floor would be 2.25% plus the spread. Some savings account rates are already below 0.25%. For those cases, the floor is the current rate.

Next post we will cover the very interesting ramifications for those credit unions that froze their prime rate at higher levels.

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.

Zero Interest Rate Risk

Here's something I expect to write a few times in this blog. There are two kinds of interest rate risk - Earnings at Risk (EAR) and Economic Value at Risk (EVR). Both are important and both should be measured and monitored by all credit unions.

(For some reason, the regulators seem more concerned about EAR interest rate risk than they are about EVR. In Ontario for instance, credit unions don't even report EVR to the regulators. So, they have no idea what risks lurk in the long end of their credit unions' portfolios. Sorry - one of my pet peeves.)

Having stated that EVR is important, this blog is only about EAR. There is something you can do to completely eliminate this interest rate risk at your credit union. Well, you can if you are exposed to falling interest rates - and 90% of credit unions are.

It's pretty simple. One, have your variable asset rates tied to the credit union prime rate not the prime rate at the major banks. And two, do not drop your prime rate when the major banks do. Voila, your EAR is now zero. Now when interest rates fall, your asset rates stay constant but your variable liability rates will still fall. That's why EAR is zero.

Won't the members scream? I am told they do not and that has been true for years, not just this crazy interest rate cycle.

For these loans, a member can refinance without penalty. Won't your credit union become uncompetitive? Yes, the major banks have been dropping prime in lock-step (pretty much) with the Bank of Canada, so their prime will be lower than yours. But they have also been increasing spreads as quickly as they can. Retail line of credit spreads have jumped. Remember those prime minus 0.75% variable closed mortgage rates from a few years ago. Now they are more like prime plus 0.75%. So, no - you likely will not be uncompetitive. Should a member check your rate against the competition, chances are good that you are OK.

I should have written this blog about 6 months ago because now it is too late. We are now sitting at the bottom of the interest rate cycle. (In fact, the all time bottom. In fact, the absolute bottom.) If you freeze your variable rates now, it won't matter because the Bank of Canada is now done. They've reached their 'lower effective bound'. Still, there is always next time. And, if you are really hurting, conceivably you could raise variable asset rates and then freeze them. Or, perhaps more palatable, you could increase spreads instead of increasing your prime.

Here's an interesting thought. Given that the Bank of Canada has (more or less) stated that they will not drop rates any further, every credit union in Canada has had its falling rate exposure eliminated.

And, many credit unions did freeze the rates on their variable loans. They did it to protect income, but they also achieved zero EAR interest rate risk. Now there are some big ramifications. More on that next time.

Oh, and by the way - this 'freezing your variable asset rates' strategy has no effect on EVR.

My First Post

Well, here's a good place to state the objective of this blog. I would simply like to help credit unions better manage their operations. And, if in that process, a few of the services of BiLd Solutions Inc. get considered - well, all the better.

Topics will usually be centred around Accounting/Finance. There will likely be a heavy emphasis on interest rate risk. Hopefully you will find an idea or two that will save or make your credit union some money because that is what BiLd Solutions is all about.

Comments/questions/suggestions are all welcome. In fact, it would be nice to get some serious discussions going. Also, check out the RSS link. That way you will see all my posts as soon as they are published

Check out the website at bild.ca or drop me a line at bill@bild.ca

Thanks for your time. Let me know what you think.