I am constantly looking for ways to better explain the concept of Economic Value of Equity (EVE) at risk to our customers. When looking at interest rate risk exposure it’s often difficult for bank management to look beyond the simpler and more straightforward earnings-at-risk measurement. One popular way I explain the need for measuring EVE at risk is to show bankers the drawbacks of using only an earning simulation. I highlight how easily earnings-at-risk can miss or even hide exposures.
A useful analogy occurred to me this past weekend as hurricane Sandy barreled through Baltimore, Maryland. Thankfully we were left mostly unscathed. Unfortunately much more severe damage occurred farther up the coast in New Jersey and New York City.
One of the key things Meteorologists talked about during their media coverage was how low the “barometric pressure” was dropping. The incredibly low pressure was an ominous sign of real storm intensity and danger. According to the NWS advisory issued at 8:00pm ET on October 29 the barometric pressure for Sandy reached as low as 946 millibars (MB). To give you some perspective, the lowest pressure for “The Perfect Storm” in 1991 was 972 millibars. The lowest pressure recorded for “The Storm of the Century” in 1993 was 960 millibars. Both storms had significant impact on the East Coast of the US. Generally speaking the lower the pressure the more severe the weather is likely to be, so you can see why the forecasts for Sandy were so dire.
Barometric pressure is a measurement that helps us forecast the weather. It’s why we see all those big arrows labeled “H” and “L” on weather maps. Low pressure usually means there is a increased risk of severe weather, although it’s not a guarantee (By the same token, high pressure doesn’t always mean there’s NO chance of rain, only that it’s less likely.) I can’t help but see some similarities between pressure as a measure of severe weather risk and EVE as a measure of long-term interest risk.
Most of us don’t give the measurement of barometric pressure a second thought. Is the weather going to be nice or crappy? Is my game cancelled or not? etc. We’re more concerned about the temperature outside than we are the pressure. Temperature is a much more tangible, observable measurement. It has a clear and immediate impact – should I wear shorts or long pants? Are hat and gloves necessary or not? We usually associate powerful hurricanes with more tropical climates (tropical from my Maryland-centric point-of-view). They typically hit the Gulf Coast or somewhere in the south-Pacific where the temperatures are typically warmer. But in Maryland and West Virginia hurricane Sandy packed a slightly different punch. One hundred and seventy miles west of our office in Columbia, Maryland they got over a foot of snow! Same storm, same very low pressure, different temperature.
Similarly, we usually don’t give the measurement of EVE at risk a second thought. Not surprisingly it is earnings sensitivity, just like temperature, that gets all the attention. Some of the most popular metrics of bank performance are directly related to earnings: Return on Equity, Return on Assets, and Net Interest Margin. So naturally we’re interested in measuring the impact of rate changes on earnings. But unfortunately (again, similar to temperature) earnings-at-risk doesn’t tell us everything we need to know about longer-term interest rate risk.
The EVE-at-risk measurement itself, just like barometric pressure, is pretty intangible. There are relatively few easily observable signs it’s increasing or decreasing. But high EVE-at-risk, similar to low pressure, can be foreboding. I mentioned this last year in a post entitled, “Eventually when rates rise”:
…[the data shows signs of] increased risk-taking…especially long-term interest rate risk. There has been a noticeable increase in EVE-at-risk over the past 5 years. While EVE at risk is an often misunderstood measurement, it does function very well as a barometer for long-term interest rate risk.
Back then I observed a significant increase in the level of EVE-at-risk for banks between $100M and $300M. Their average EVE-at-risk moved from –12.6% to –21.5% over a five year period. Since last year things haven’t change all that much. If anything, it’s gotten worse. As of June 30, 2012, average EVE-at-risk worsened to –22.3%. Given the latest communication from the Fed I don’t expect this to change anytime soon. Eventually when rates do rise, the storm could be pretty intense.