Explaining Economic Value of Equity Policy Exceptions to Your Board

First, we much establish what is net economic value, also known as the Economic Value of Equity, is the difference between the fair value of assets and the fair value of liabilities. Economic value of equity (EVE) is a longer term look at interest rate risk. Over the course of the pandemic, with market interest rates at historic lows, fair value of deposits declined. Consequently, EVE finances have declined significantly for most banks and credit unions. It is not uncommon for some deposits to be valued below par in the flat rate scenario.

Also causing difficulties for banks and credit unions is the sensitivity of economic value of equity in rate shock scenarios, especially in downward rate shocks. Sensitivity of EVE finance refers to how much EVE changes when interest rates change. In the current interest rate environment, it is not uncommon for EVE sensitivity to fall outside of policy limits in downward rate shocks, sometimes to a substantial degree. It is also not unusual to estimate that economic value of equity will decline 20% or more after a -100 basis point rate shock. The Office of the Comptroller of the Current (OCC) publishes a semi-annual Interest Rate Risk Statistics Report for national banks and thrift banks. The most recent version (Spring 2021) indicates that the median policy limit for change limit for EVE in the -100 rate shock scenario is -10%.

When an important EVE risk management measure falls outside of policy requirements, most policies requires some action by management to correct the situation or manage the policy exception. However, given the low rate environment, available options to correct this type of policy exception are usually limited. So, how can this situation be explained to the Board of Directors? Or to bank and credit union examiners? If there are few, if any, options for corrective action, how can management reassure the Board that appropriate EVE risk management measures are implemented?

Absent any available and appropriate corrective action measures, the best course is to provide increased levels of information to show mitigating factors. Here are some ideas:

• With interest rates at historically low levels, the chances of additional interest rate decreases by the Federal Reserve are small. The general narrative in the market is now focused on inflation and when the Fed will begin raising interest rates. Thus, deposit values are likely at their lowest level in the current economic cycle.
  
  
• Where EVE sensitivity falls outside of policy in the downward rate shock scenarios, a mitigating factor is where post-shock economic value of equity ratios remain appropriate and within policy limits. The EVE ratio is EVE divided by the fair value of total assets.
  
  
• Stress test EVE finance using alternate methods of valuing deposits. For example:
  • Run economic value of equity calculations with deposits valued at book. Even though discounted cash flow methods may result in deposit values below par, actual values in the marketplace likely remain at premium prices. Valuing deposits at book provides a reasonable alternative.
    
    
  • If you have a source for recent deposit purchase transactions that can provide guidance on deposit premiums, use those premiums in lieu of a discounted cash flow calculation.
    
    
  • Along the same lines, the NCUA established a NEV supervisory test for non-maturing deposits (NMDs) that establishes set premiums for each rate shock scenario. Since NMD valuations are widespread from institution to institution, the idea is to put all NMD valuations on an even playing field to identify other areas of the balance sheet where EVE risk exposure exists. While this test is officially applicable only for credit unions, banks can also run a similar stress test with these set values to determine their effects on EVE sensitivity calculations. Although the NCUA supervisory test only looks at the flat and +300 rate shock scenarios, those premium assumptions can be extrapolated into the other common rate shock scenarios that are run. Doing so yields the following premium/discount amounts above or below book value:
    
    

• Most banks and credit unions experienced unprecedented deposit growth during the pandemic. These inflated balance sheets are also a current source of downward pressure on EVE. A stress test that eliminates transitory deposit balances related to the pandemic may show improvement in EVE results.

Both bank and credit union examiners appear to be showing some patience with out-of-policy EVE results in downward-rate shock scenarios. But it’s always a good idea to remain proactive in managing this risk. Increasing stress testing and other types of analyses noted above can provide valuable contextual information to demonstrate that Economic Value of Equity policy exceptions does not constitute undue risk to the capital of your organization.