Is EVE at Risk a Useful Management Tool .pdf

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Is EVE-at-Risk a Useful Management Tool?

1

by

Patrick D. Gehring, CPA
Town & Country Bank
Las Vegas, NV

pgehring@tcbanknv.com

Submitted in partial fulfillment of the requirements of the Pacific Coast Banking School conducted at the
University of Washington.
Seattle, Washington, April, 2015
1Ron

Wheeler. (1995) “The Crowd May Be Wrong,” Web Comic. https://www.crossway.org/tracts/the-crowd-may-be-wrong-2872/.

EXECUTIVE SUMMARY

Is EVE-at-Risk a Useful Management Tool?
By Patrick D. Gehring, CPA

The purpose of this paper is to bring clarity, and one day, closure, to a longstanding debate on
the effectiveness of Economic Value measures in assessing a bank’s sensitivity to Interest Rate
Risk. I chose this topic because like many bankers caught in the debate, I didn’t know my
position.
The following issues are covered in the paper:


EVE-at-risk is thought to be a leading indicator of long-term interest rate risk.



There is significant disagreement in both the modeling and banking community over
EVE’s effectiveness.



Mandated policy limits on EVE sensitivity may needlessly compromise earnings without
significantly reducing risk.

Sources of information for this project included interviews and email correspondence with
bankers, regulators, scholars, modeling vendors, and policy makers responsible for drafting
original regulatory guidance. Published works reviewed included regulatory guidance and a wide
assortment of periodicals, online journals, and blogs. Original research included the modeling of
dozens of balance sheet configurations to answer research questions. I would like to thank the

ii

Risk Management Association for incorporating several of my research questions into their 2015
Interest Rate Risk survey to financial institutions.
The sources of information provided the following findings related to the topic of this paper:


EVE sensitivity measures were implemented in the wake of the Savings & Loan Crisis to
protect against insolvency. Today they are considered a proxy for earnings sensitivity.



What is considered an acceptable level of EVE Risk has changed over time; limits appear
arbitrary and lacking in substance.



EVE-at-risk’s effectiveness cannot be back-tested, and almost all of the literature
surrounding this topic is based on theory.



Prevailing arguments against EVE relate to its measurement and interpretation.

Analysis led to the conclusion that banks with high EVE exposures are not always exposed to
unacceptable declines in future earnings, and that EVE-at-risk does not provide information on
the timing of and magnitude of future repricing mismatches.
If the conclusions of this paper hold true after more rigorous testing, regulatory agencies
should move away from enforcing EVE sensitivity limits, toward requiring limits on the postshock EVE ratio. In the meantime, with several caveats, banks should not be penalized for
having higher EVE-at-risk measures. Finally, management should not limit itself to regulatorprescribed metrics for measuring risk.
This paper will be of particular interest to Asset-Liability Committee (ALCO) Members,
regulators, and members of the modeling community for community banks, thrifts, and credit
unions. The subject matter and explanations were written to be challenging but understandable
for ALCO members with limited financial backgrounds.

iii

TABLE OF CONTENTS
Page
Executive Summary

i

Table of Contents

ii

List of Tables and Figures

iii

Chapter
I. Introduction

1

II. Background
a. Origins of EVE
b. EVE and the Savings and Loan Crisis
c. Epilogue

5
5
5
8

III. Discussion of Existing Arguments Surrounding EVE
a. EVE Strengths
b. Common Criticisms

13
13
16

IV. Searching for Empirical Evidence

23

V. Dissecting EVE

25

VI. Conclusion

35

VII. Recommendations

36

Exhibits

42

Bibliography

48

Certificate of Originality
53

iv

TABLES
Table

Page

1. Thrift Bulletin 13 Suggested Limits

10

2. Thrift Bulletin 13a Supervisory Guidelines

12

3. EVE gives greater weight to near-term interest rate risk

27

4. Earnings at Risk Percentages

27

5. Non-Maturing Deposit Average Life Assumptions

33

v

GRAPHS AND ILLUSTRATIONS
Figure

Page

I. Banks make money by borrowing short and lending longer

2

II. EVE Risk / Reward Trade-Off

3

III. Illustration of Long-Term Interest Rate Risk

13

IV. The trouble with using fixed discount rates

18

V. Rates can ‘shock up’ almost overnight

20

VI. Relation of EVE-at-risk to long-term IRR

26

VII. Sometimes risk management tools disagree

26

VIII. Linear relationship between EVE-at-risk and EAR

28

IX. Results of varying EVE-at-risk levels

29

X. Adverse effect on NII

30

XI. There are many ways to create the same level of EVE-at-risk

31

XII. Moderate Severity / Long Duration Mismatch

32

XIII.

33

Aggressive vs. Conservative NMD Assumptions

XIV. EVE can be broken into time buckets

40

XV.

43

EVE-at-risk Illustration

vi

EXHIBITS
Exhibit

Page

A. A Brief Refresher on EVE

42

B. Interest Rate Risk Model Specifications

44

C. Questions to Ask Your Model Vendor

46

D. Related Research Topics

47

vii

I. Introduction
The use of Economic Value to measure a bank’s sensitivity to changing interest rates has
grown in popularity due to heightened regulatory emphasis and the availability of greater
computing power at less cost. In addition to estimating an institution’s liquidation value under
stressed conditions, Economic Value of Equity (EVE) sensitivity is thought to be a leading
indicator of risk to an institution’s future stream of net interest income. As a result, decisions to
balance profitability against long and short term interest rate risk (IRR) are influenced by banks’
EVE exposure limits.
EVE-at-risk has found wide favor within regulatory and modeling communities. According to
the 2010 Advisory on Interest Rate Risk, “Evaluating the impact of adverse changes in an
institution’s economic value also is useful as it can signal future earnings and capital problems.” 2
Emily Hollis, principal of a leading ALM advisory firm, has stated that EVE is “a more robust
measurement in that it captures the risks inherent in longer cash flows outside the NII simulation
horizon.”3 Blaxall et al. note that “EVE gives banks a long-term view of interest rate risk.”4
However, concerns over its accuracy and usefulness as a management tool persist. According
to Mark Haberland of Darling Consulting Group, “By focusing too much attention on
instantaneous and permanent rate shocks, or EVE results, ALCOs can inadvertently manage to
overstated, worse yet, non-existent exposure.”5 Sally Myers warns that some of EVE’s

2

FFIEC. (2010). Advisory on Interest Rate Risk Management. Page 3.

3

Hollis, Emily. (August 2012). Net Economic Value and Net Income Simulation Analysis. Credit Union Times.

4

Blaxall, Hugh et. Al.(2008). Economic Value of Equity for Community Banks. Bank Accounting & Finance. Page 1.

5

Haberland, Mark. (2014). Building an Effective Modeling Process. Financial Manager’s Society.

1

underlying assumptions are “dangerous and misleading.”6 At a 2004 CFO conference, one
expert’s advice was more to the point: “Don’t manage to it.”7
The preliminary results of an RMA survey on Interest Rate Risk are endemic of this ongoing
debate.8 Asked to rate its usefulness as a management tool on a scale of one to seven,
respondents gave EVE an average score of 3.9 compared to 5.9 for the earnings at risk (EAR)
measure. Additionally, eleven of the forty-one respondents indicated that they would eliminate
their policy limits for EVE, if no longer required by their primary regulator; five more
respondents were unsure. By way of comparison, all but one participant indicated that they
would continue to track and monitor earnings at risk limits, if no longer explicitly required.9
In the words of one banker “It takes a certain amount of interest rate mismatch to make
money.”10 This simple but critical statement is illustrated below.
5.00%

C

4.50%

4.00%
Interest Rate

3.50%

B

Interest earned on
loans.

3.00%

2.50%
2.00%
1.50%

Interest paid on
deposits.

A

1.00%

0.50%
0.00%
0

2

4

6

8

10

12

Years to Maturity

Figure I. Banks make money by borrowing short and lending longer
6

Myers, Sally (2004). The NEV Bandwagon Has A Flat Tire. C Myers Corporation.

7

Meadows, Greg. (2004). Economic Value of Equity (EVE): What It Is – and What It’s Not. ALX Consulting.

8

Risk Management Association (RMA). 2015 Interest Rate Risk Management Survey. April, 2015.

9

One participant left the answer blank.

10

Financial Manager’s Society. (2005). IRR Exposure Survey Results.

2


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