Managing interest rate risk with EVE

U.S. regulators and examiners continue to focus on interest rate risk and its management. The FDIC requires that a bank’s board of directors ensure management identifies, measures, monitors, and controls interest rate risk by implementing programs that include strategies, risk limits, and controls; risk identification and measurement; monitoring and reporting; and independent review. Bankers have an often misunderstood tool available to help accomplish this process: EVE – Economic Value of Equity.

The value of a majority of a bank's assets and liabilities are directly linked to interest rates. By calculating its EVE, the theoretical value if the bank were to liquidate all positions and pocket the difference between assets and liabilities, and then evaluating the impact of fluctuations in interest rates on EVE, a bank can construct models that show scenario-based changes in its total capital as interest rates go up or down … and assets and liabilities increase or decrease. Understanding EVE provides significant insight into the trend of a bank’s earnings capacity and the risk-to-earnings caused by changes in interest rates and credit spreads.

While EVE is similar to Earning at Risk (EaR), it has an importance difference: EaR typically looks at a 12 month time period (although regulators have recommended a 24 month period), whereas EVE considers a much longer time horizon to allow for the repricing and/or maturity of all assets and liabilities on the balance sheet to provide a long-term perspective on interest rate risk. The cash flows of these repriced assets and liabilities are then present valued and the difference is EVE. (A bank’s EVE will decrease when interest rates rise if they have more fixed rate assets than liabilities.) However, bankers should remember that EVE calculations assume a static balance sheet while, in reality, bank leadership has the power and the responsibility to change the balance sheet make up to manage risk and maximize earning potential.

Here’s why: if EVE interest rate stress test results indicate a high level of interest rate risk, it’s an opportunity for bank management to take corrective action that will have a compounded effect over time. Due to the long-range nature of EVE, adjustments can be made to near-term risks to decrease the potential negative impacts revealed in the EVE stress testing scenarios.

Other possible proactive options to positively manage EVE and strengthen the bank’s balance sheet include:

  • Setting policy limitations for EVE fluctuations, such as a 10%- 25% change
  • Entering into new positions at positive earnings spreads
  • Speeding up the transition of future cash flows into earnings to capture profit potential earlier
  • Hedging to avoid degradation of EVE due to projected balance sheet incongruities
  • Raising capital that is invested in additional earning assets

The Basel Committee on Banking Supervision recommends +/- 2 percent instant shock in all interest rates when measuring EVE.

Click here to read the FDIC’s Examination Policies For Sensitivity to Market Risk, including a discussion about EVE.

Meet The Rehmann Team

Start typing a name ...
Searching for "{{nameQuery}}"...
Start typing an experience ...
Searching for "{{experienceQuery}}"...
Start typing a location ...
Searching for "{{locationQuery}}"...
Or view a list of team members

get rehmann expertise to drive your business in your inbox every week