Rate Shock Income vs. Market Value of Equity

The KeyState Companies - April 2013 
 
How is it possible that your bank’s rate shock income analysis shows positive results in a rising rate environment while the corresponding market value of equity analysis reflects a decline? These results can be confusing to directors, ALCO members, senior management, and even regulators due to their seemingly contradictory nature. 

Measuring Rate Shock Income helps banks project and manage the future impact on earnings from various potential interest rate scenarios. Measuring the bank’s Market Value of Equity helps banks assess the impact of future rate movements based upon the duration of the assets and liabilities comprising the bank’s balance sheet. This technique calculates the net present value of the bank’s earning assets and paying liabilities. 

The current economic and interest rate environment is encouraging banks to employ strategies such as 1) booking longer duration loans because of customer demand and competitive pricing, 2) matching off those loans with longer term funding past two years, and 3) within the investment portfolio, shortening up cash flows or putting on floating rate assets. Each of these strategies contributes to a balance sheet that appears increasingly asset sensitive from a rate shock income perspective while showing a negative market value of equity trend to rising rates.

To illustrate how this may occur, we have created a simplified balance sheet within our ALCO model containing the following: 

OVERALL BALANCE SHEET MODEL ASSUMPTIONS 

•  $100,000,000 in assets 
•  $90,000,000 in liabilities 
•  $10,000,000 in equity 
   

ASSETS 

• No cash 
•  $20,000,000, or 20%, in bullet US Agencies with a weighted average maturity of 5 months 
•  $80,000,000, or 80%, in longer term non-amortizing loans with a weighted average maturity of 57 months 
   

LIABILITIES 

•  $18,000,000, or 20% in short CDs split evenly between two ladders with weighted average maturities of 4 and 16 months, respectively 
•  $72,000,000, or 80% in longer CDs with a weighted average maturity of 25 months
  
  

RESULTS 

•  Rate Shock Income Analysis – The balance sheet is structured so that 80% of assets and 80% of liabilities  re-price out longer than two years. The remaining 20% of the balance sheet that re-prices in less than two  years is asset sensitive.

This results in the overall balance sheet being asset sensitive to both one-year and two-year parallel rate shocks.

1 Year Rate Shock - Income

	-400	-300	-200	-100	0	100	200	300	400
Total Interest Income	3,318,229	3,318229	3,318,229	3,318,229	3,344,063	4,473,229	3,602,396	3,731,563	3,860,729
Total Interest Expense	828,143	828,143	828,143	828,143	841,045	902,710	964,375	1,027,542	1,089,656
Net Interest Income	2,490,086	2,490,086	2,490,086	2,490,086	2,503,018	2,570,519	2,638,021	2,704,021	2,771,073
Earnings Change	-12,932	-12,932	-12,932	-12,932	0	67,501	135,003	201,003	268,055
Percentage Change	-0.52%	-0.52%	-0.52%	-0.52%	0.00%	2.70%	5.39%	8.03%	10.71%

2 Year Rate Shock - Income

	-400	-300	-200	-100	0	100	200	300	400
Total Interest Income	6,616,229	6,616,229	6,616,229	6,616,229	6,682,063	7,011,229	7,340,369	7,669,563	7,998,729
Total Interest Expense	1,629,123	1,629,123	1,629,123	1,629,123	1,678,583	1,888,204	2,097,824	2,311,871	2,522,619
Net Interest Income	4,987,106	4,987,106	4,987,106	4,987,106	5,003,480	5,123,026	5,242,571	5,357,691	5,476,110
Earnings Change	-16,374	-16,374	-16,374	-16,374	0	119,546	239,092	354,212	472,631
Percentage Change	-0.33%	-0.33%	-0.33%	-0.33%	0.00%	2.39%	4.78%	7.08%	9.45%

Market Value of Equity Analysis – As depicted in the tables below, the change in market value of equity is driven primarily by the 80% of the balance sheet that is longer than two years. The net change from the 20% of the balance sheet that re-prices in less than two years is actually positive to upward moving rate shocks because the liabilities are longer in duration than the assets. Within the other 80% of the balance sheet, we modeled longer 
duration assets to simulate the current trend toward longer maturity loans while keeping the deposits longer than two years, but overall shorter than the asset side of the balance sheet.This results in the overall balance sheet showing a reduction in the market value of equity as rates rise.

Rate Shock - Market Value of Equity

Assets	-400	-300	-200	-100	0	100	200	300	400
US Agencies - WAM 5 mo	20,026	20,026	20,026	20,026	20,010	19,931	19,853	19,775	19,697
Comm'l Lns - Fixed - WAM 57 mo	87,311	87,311	87,311	84,077	80,519	77,124	73,883	70,789	67,835
Total Assets	107,337	107,337	107,337	104,103	100,529	97,055	93,736	90,564	87,532
Liabilities
CD's - WAM 4 mo	9,008	9,008	9,008	9,008	9,002	8,969	8,937	8,905	8,874
CD's - WAM 26 mo	9,038	9,038	9,038	9,038	9,001	8,879	8,759	8,640	8,524
CD's - WAM 25	72,357	72,357	72,357	72,357	71,911	70,445	69,010	67,606	66,232
Total Liablities	90,403	90,403	90,403	90,403	89,914	88,293	86,706	85,151	83,630
Market Value of Equity	16,934	16,934	16,934	13,700	10,615	8,762	7,030	5,413	3,902

Change in Total Assets					0	-3,474	-6,793	-9,965	-12,997
Change in Total Liabilities					0	-1,621	-3,208	-4,763	-6,284
Equity Change	6,319	6,319	6,319	3,085	0	-1,853	-3,585	-5,202	-6,713
% Change in MV of Equity	59.53%	59.53%	59.53%	29.06%	0.00%	-17.46%	-33.77%	-49.01%	-63.24%
Mark to Market Capital Ratio	15.78%	15.78%	15.78%	13.16%	10.56%	9.03%	7.50%	5.98%	4.46%

The bank ALCO model simulation presented above depicts a simple example to illustrate how a bank’s balance sheet may be both asset-sensitive from a rate shock income perspective while also showing a decline in its market value of equity to the same rate shocks. Both measures are important tools in helping the bank measure the potential risks from future changes in interest rates. Evaluating interest rate risk using one and two-year rate shocks assists the bank in interpreting and managing the risk it has to the net interest margin over these time periods. Evaluating the bank’s market value of equity position, along with the duration of its assets and liabilities, provides the bank with a tool for evaluating and mitigating the risks associated with placing longer-term assets and liabilities on the balance sheet. 

The KeyState Companies and its affiliates provide Municipal Credit Reviews, Portfolio Management, Domicile Services, and Asset and Liability Management for community banks throughout the United States.