Economic Value of Equity (EVE)
Banks typically employ a couple of methods to measure interest rate risk and to comply with banking regulations. The first is net-interest income (NII) which reflects short-term interest rate risk. The other is Economic Value of Equity (EVE), which analyzes long-term interest rate risk.
An internationally accepted standard for determining interest rate risk is to stress-test EVE. EVE’s added benefit occurs when banks use it for long-term strategy and to measure franchise value.
When banks subject EVE to a series of interest rate scenarios, they can assess the long-term interest rate risk contained in the balance sheet since the value of most bank assets and liabilities has a direct correlation with interest rates. Stress-testing EVE to create models showing how the bank’s capital changes with fluctuations in interest rates gives insight into the bank’s earning capacity and risk.
Using extended time horizon, models re-price and adjust maturity of assets and liabilities and present values them. EVE is difference in the net present value of assets and liabilities. When there are more fixed assets than liabilities on the balance sheet, EVE decreases as interest rates rise.
Stress-testing EVE allows bank management to take the proactive steps that would minimize negative impacts. These steps could include establishing policies to limit EVE fluctuations to a defined range; accelerating future cash flows to lock in profits; taking advantage of positive earnings spreads by entering into new positions; raising capital to invest in income-producing assets and implementing hedges.
EVE is helpful for calculating actual risk as a going concern. EVE enables bankers to visualize what could happen in a period of interest rate volatility causing significant deposit withdrawals and loss of earnings. In that way, EVE has more value than a short-term tool such as NII which falls short in giving bankers insight to proactively respond to detrimental market developments.
This is why the Basel Committee on Banking Supervision recommends a plus and minus 2% stress test on all interest rates and why US bank regulations require regular analysis of EVE.
To learn more about loan pricing and interest rate risk, please contact us.
Alan Lee
www.HurdleGroup.com
www.TheSchoolOfBanking.com