Case study 10 Economic Value of Equity (EVE)

EVE is a cash flow calculation that takes the present value of all asset cash flows and
subtracts the present value of all liability cash flows. This calculation is used by banks
for asset/liability management.

The value of a bank's assets and liabilities are directly linked to interest rates. By
calculating its EVE, a bank is able to construct models that show the effect of different
interest rate changes on its total capital. This risk analysis is a key tool that allows
banks to prepare against constantly changing interest rates.

To evaluate the potential impact of interest rate movements on assets and liabilities:

• the effect on a bank's earnings (the earnings or accounting perspective);

• as well as on its underlying economic value (the economic or capital perspective)

should be considered.

Earnings perspective

• focuses on the effect of interest rate risk changes on net income and net interest
income over one or two years;

• Accrued income is backwards looking.

Economic value perspective

• accounts for the impact of intermediate (two years to five years) and long-term (more
than five years) positions on future financial performance;

• forwards looking;

• focuses on the price sensitivity of assets and liabilities to changes in interest rates;

• considers the potential impact of interest rate changes on the present value of all
future cash flows;
• it provides a more comprehensive measure of the interest rate risk embodied in the
entire balance sheet of a bank.

Economic value

• is a long-term target of Asset & Liability Management policies:

– controlling the economic value sensitivity corresponds with controlling the risk
of the complete stream of interest incomes up to the longest maturity.

• also capture interest rate risk obscured by accrual accounting

– Every bank should also include guideline limits on EVE and NPV volatility of
risk monitoring within its ALCO policy.

• EVE can thus be defined as:

– Present Value (PV) of the expected cash flows of assets;

– minus the PV of the expected cash flows of liabilities;

– plus the PV of the expected cash flows of off-balance sheet positions;

(These days almost everything is on balance sheet and not off-balance
sheet).

– Thus, also called the NPV approach!!

• Primary forms of interest rate risk

– Can be divided into four broad categories:

– repricing (or maturity mismatch) risk;

– yield curve risk;

– basis risk; and

– option risk.
 – Repricing risk and basis risk, in particular, are the major sources of risk
underlying the interest rate risk exposures of banks that are active in retail
banking activities.

• These risks pose threats to a bank's earnings and capital base:

– influence earnings by altering interest rate sensitive income and expenses;

– influence the underlying value of the bank's assets, liabilities, and off balance
sheet instruments, because the present value of future cash flows, and in
some cases, the cash flows themselves, change.

Why is economic value important?

• Captures interest rate risk from all time periods;

• Does not require assumptions for new business or business scenarios;

• Provides a specific and understandable measure of interest rate risk exposure;

• Focuses on the interest rate risk in the bank’s current position.

Weakness of economic value

• Economic value results can be contorted by average life assumptions;

• Managing economic value sensitivity can increase earnings volatility;

• EVE ignores the impact of new business and thus future portfolio changes;

• Does not provide any insights into which time periods pose the risk;

• Assumptions require careful development, analysis, increased controls and

testing.

EVE Techniques

• Gap (Repricing) Analysis

 • Duration Gap (DGAP) Analysis

• Simulation approaches

– Static Simulation

– Dynamic Simulation

– Value at Risk (VaR) models

Gab analysis

• Used to estimate the EVE sensitivity for a given change in the interest rate.

– This is done by multiplying the static gap in each bucket by a sensitivity

weighting factor, which is based on the duration of assets and liabilities;

– The weighting factor thus roughly accounts for the time value of the cash
flows.

• The sum of the resulting weighted positions is then related to capital to produce
an estimate of the potential change in economic value given the hypothetical
interest rate change.

DGAP

• The steps in DGAP analysis are:

– Forecast interest rates;

– Estimate the market value of bank assets and liabilities;

– Calculate the Macaulay Duration (C) of each asset, liability and off-
balance sheet instrument;

– Calculate the weighted duration of assets & liabilities;

– Calculate the duration gap (DGAP);

 – Calculate the sensitivity of economic value of equity (ΔEVE).

Simulation approach

Static simulation

• The basic steps:

• Calculate economic value using current interest rates;

• Calculate economic value under different interest rate scenarios;

– Each scenario should reflect all interest rate dependent factors such as
changes in the amount and the timing of cash flows;

– Every cash flow should be valued separately with an appropriate discount

rate for its tenor;

• Subtract the result of step 1 from step 2 to obtain economic value sensitivity.

Dynamic simulation

– Make assumptions about the future course of interest rates and the
expected changes in a bank's balance sheet over time;

– These assumptions are then used to project expected cash flows and
estimate dynamic earnings and economic value outcomes;

– Incorporate models like Monte Carlo simulation approach.

Value-at-Risk (VaR) models

• Calculates the potential loss from unfavourable market conditions during a given
period (holding period / time horizon) with a certain confidence level;

– Being able to assign a probability to a given EVE outcome, and can be

used to assess the volatility of EVE;
 • The steps in VaR simulation are:

– Discounting all future cash flows associated with a bank’s assets, liabilities
and off-balance sheet positions;

– Summing all discounted cash flows to determine the net present value;

– Repeating step 1 and 2 for several hypothetical interest rate changes;

– The differences in EVE for the different interest rate scenarios reflect the
interest rate exposure.

EVE and Basel II

• Banks will be required to determine the potential decline in the bank’s EVE (or
adverse EVE sensitivity) if it’s banking book was subjected to a specific interest
rate shock;

• Regulators can determine whether a bank should reduce its risk profile and/or
hold additional capital against the interest rate risk;

• Although there is no Pillar 1 capital requirement against interest rate risk in the
banking book, Pillar 2 and Pillar 3 address the measurement and reporting
thereof;

• When measuring interest rate risk, banks must express the decline in economic
value relative to the sum of Tier I and Tier II capital, using a standardized interest
rate shock;

• If the decline in EVE related to capital exceeds 20%:

– the bank qualifies as an ‘outlier bank’.

– Supervisors must require the bank to reduce its risk or to hold a specific
additional amount of capital or a combination of both.