Economic Value of Equity (EVE) at Risk continues to Rise

Changes in interest rates not only impact a bank’s earnings, they also impact a bank’s equity value. We can measure this exposure by calculating an institution’s Economic Value of Equity (EVE) at Risk. EVE at Risk is a long-term measure of interest rate risk. It focuses on the value of the bank in today’s market rate environment and that value’s sensitivity to changes in market rates. (See side bar for a discussion of EVE.)

The level of EVE at Risk for banks has increased for the past several quarters. In September 2003 the average EVE at risk for the industry was -13.28% up from -11.78% in March 2002.

The number of banks whose EVE at Risk occurs in a rising rate environment (i.e. EVE exposed to rates up) is also increasing. In March 2002 the percentage of banks whose EVE was exposed to rising rates was 90.59%. This number was up 2.33% by September 2003 to 92.93%.

There are two main reasons for these increases. First, there has been a tremendous amount of turnover in banks’ security and loan portfolios and all new purchases are at new rates in this low interest rate environment. And second, banks have been extending the maturity terms of their portfolios to reach for higher returns. Both low rates and longer terms create added risk exposure to rising interest rates.

Resetting the portfolio
“The high premiums that once existed in a bank’s portfolio are gone,” says Mark Williams, an investment advisor and President & CEO of Heber Fuger Wendin, Inc. “There has been a real decline in overall loan and security yields. High prepayment levels and calls have caused many bank portfolios to reset. This has had a big overall effect on market value to equity ratios.”

Indeed it has. The lower market value to equity ratios are illustrated dramatically by the level of unrealized gain/loss (UGL) in a bank’s available-for-sale (AFS) securities portfolio. In just one calendar quarter this measure was cut in half. In June 2003 UGL on AFS securities was 1.60%, by September 2003 it was down to 0.80%. “The overall adjustment to equity for unrealized gains is beginning to erode. At some point the cushion may be gone,” says Williams. In general, as rates rise, values fall, and these changes will have a negative impact on equity.

Stretching the term
In September 2003 the industry’s average duration for total securities reached 2.8 years. This number has been increasing steadily over the past 8 quarters. It is reflective of the behavior some examiners have called “yield-chasing”. To combat falling net interest margins, banks have invested in longer duration, higher yielding securities to reach for higher spreads. This behavior can also be observed by looking at the regulatory measure of long-term assets to total assets. In September 2003 it was 26.56% up 5% from December 2001 when it averaged 18.56%.

While duration doesn’t specifically measure interest rate risk, it does give some insight into the level and magnitude of risk. The inherent mismatch between the duration of a bank’s assets and its liabilities can help determine the exposure the bank’s EVE has to changes in interest rates. Banks with longer-term assets funded by shorter-term liabilities will generally have a duration gap that is positive. This means the EVE of a bank in this situation is likely to decline if interest rates rise. The greater the duration gap, the more exposed the bank’s EVE is to rising rates.

Industry data shows that by stretching their security durations, banks have lengthened their overall asset duration. In December 2002 total securities duration was 2.6 years and total asset duration was 1.8 years. By September 2003 total asset duration had been pushed out to 1.9 years. In contrast, over the same time frame, total liability duration remained basically unchanged at 1.3 years. This widening duration gap is a good indicator of increased EVE at risk.

What lies ahead?
The value of longer-term assets can be very susceptible to changes in interest rates. “What lies ahead could be a very rocky road,” says economist Scott Hein, Briscoe-Chair of Bank Management for Rawls College of Business at Texas Tech University. “Long-term rates have been very volatile, as financial markets are trying to assess the uniqueness of the economic situation.”

The average quarterly long-term yield curve rate moved up over 50 basis points in one quarter, from 4.30% in June 2003 to 4.87% in September 2003. The most dramatic shifts occurred in the 10-year treasury yield which jumped from 3.33% in June 2003 to 4.45% in August 2003, a movement of +112 basis points.

“For right now there are clues in the futures market which suggest a belief that the Fed will keep the federal funds rate close to the 1% current target through most of the first half of next year,” says Hein. “[But] the yield curve is very steep and upward sloping. Although it’s been that way for over a year now, in general it suggests that we will see rates rising.”

Are you prepared?
The IRR peer data shows that rising rates will have a negative impact on the EVE for most banks. Those institutions with equity to asset ratios above 10-11% may be adequately prepared to handle the drop. But what about the banks that don’t have high levels of capital? What about the banks that continue to invest in longer-term assets to support their narrow margins?

With the data and tools available today are you adequately assessing your interest rate risk? Indications are that market rates will begin to rise again. The questions are when, by how much, and how fast will rates rise? Is your bank positioned for rising rates? If not, how quickly can you reposition so that your bank can withstand a change in equity value?

This A/L BENCHMARKS Industry Report article was published
and is ©2004-2005 by Olson Research Associates, Inc.