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.