Accurate and timely IRR measurement is a critical component of any IRR management system and is one of the most challenging to effectively execute. A bank’s IRR measurement system is expected to be appropriate for the size, nature, complexity, and risk profile of the bank’s products, services and balance sheet.
Types of IRR Measurement Systems
The most commonly used systems involve models to predict possible future outcomes based on certain events. These include earnings-at-risk (EAR), economic value models, and gap reports. Effective IRR measurement systems typically employ all three methods to measure all of the related interest rate risk types (Part 2 of this series defines the different types of IRR).
Earnings-at-risk models measure short-term earnings exposure, repricing risk, basis risk, and yield-curve risk. Sophisticated EAR models can also provide some limited measurement of long-term earnings exposure and options risk.
Economic Value models measure long-term earnings exposure, repricing risk, yield-curve risk, and options risk. Some sophisticated EV models ban also provide limited measurement of Basis risk.
Gap reports are used to measure both short and long-term earnings risk and repricing risk.
EAR models forecast changes to net interest income (NII), or net income (NI) if the bank has significant noninterest sources of income. EAR models measure short term IRR, preferably over a two-year time horizon.
EAR models are used to create pro-forma future balance sheets and income statements under different interest rate scenarios that would include changes in the overall level of interest rates as well as relative changes in rates that would result from shifts in the shape of the yield-curve. The process could use simple scenario analysis, or more sophisticated stochastic path models or Monte Carlo simulations depending on the size, nature and complexity of the bank’s activities.
The most basic EAR model measurements are based on a bank’s current exposure assuming no business growth, but many banks need to also use dynamic models that utilize detailed assumptions to changes in business size, product mix and management objectives.
Economic Value Models
Economic value models simulate changes to the long-term economic value of existing assets, liabilities and off-balance sheet instruments based on changes in future cash flows as the result of interest rate fluctuations.
Economic value of equity (EVE) is the most common economic value model, but net present value (NPV) is also used. Economic value modeling is particularly important for banks with option risk exposure to measure the impact of these options, including interest rate caps and floors, adjustable rate mortgages, prepayment options on fixed rate mortgages, and early withdrawal options on deposits. The analysis of option risk exposure would typically entail using multi-path or options-adjusted pricing models (See Part 2 of this series for additional information regarding options risk).
Economic value models project cash flows from assets and liabilities over the economic life of each instrument, assuming interest rates will not change. Cash flows are then discounted to determine their present value, and the present value of liabilities is subtracted from the present value of assets to determine the bank’s economic value base. Cash flows are then projected for various rising and falling interest rate scenarios and discounted at higher and lower discount rates to recalculate the present value. The percent change in value between the various scenarios provides a meaningful measure of the bank’s long-term IRR exposure relative to capital.
Gap reporting is one of the oldest and most basic models used to measure interest rate risk and can be useful to determine a bank’s asset or liability sensitivity to changes in interest rates. Gap reports include ratios of rate-sensitive assets (RSA) and liabilities (RSL) over defined time periods. For any given period, a bank can have a positive gap (RSA to RSL ratio greater than one), negative gap (RSA to RSL ratio less than one), or neutral (RSA to RSL ratio equals one).
Because gap reports only capture repricing mismatches, most banks use them in conjunction with EAR and/or economic value models. Few banks have balance sheets that are simple enough to justify using only gap reports and it is only appropriate with banks with IRR that is limited to repricing risk. These banks should be prepared to provide regulators with a clear rationale for supporting why gap reports alone are adequate.
Interest rate risk is a complex and technically challenging subject that is critical to the financial stability of every bank and something that senior management and the board need to understand and manage accordingly. Bank management needs to have a thorough understanding of the different types and sources of IRR, including less obvious risks presented by imbedded options, both stipulated and implied. Our next article will dive deeper into IRR measurement by looking at risk measurement processes, developing model assumptions, and computing risk levels.
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