Interest Rate Risk Grader uses standard, time tested tools to measure and quantify bank interest rate risk.
But just because tools are recognized doesn't mean they are easy to use or well understood. Here's a brief primer on each of the major methods we use for measuring interest rate risk.
Rate Sensitive Assets/Rate Sensitive Liabilities (RSA/RSL). As the name implies, we simply examine a ratio of the bank assets that mature or reprice within a year to the bank liabilities that mature or reprice within a year. A balanced position would result if the amount of repricing assets were exactly offset by the repricing liabilities (ratio = 1.0). Ratios less than 1.0 indicate a bank that is laibility sensitive (liabilities reprice quicker than assets), while a ratio greater than 1.0 indicates that the banks assets reprice faster than liabilities (asset sensitive).
Gap. Gap is the simplest cash flow matching process performed in the asset liability arena. Gap compares the scheduled maturity and repricing of assets with the scheduled maturity and repricing of liabilities. For any given time bucket, the difference between the repricing assets and the repricing liabilities is known as the gap. Given its simplicity, gap still works well as long as substantial amounts of optionality are not introduced into the balance sheet.
Earnings at Risk. Earnings at risk builds upon the gap process. By simulating net interest income, as interest rates are varied, earnings at risk seeks to more accurately model the cash flow matching started by the gap process. Prepayments and optionality can be more fully included in earnings at risk. Earnings at risk is generally thought of as a more reliable management tool. Typically, earnings at risk analysis is performed over a 12 month period, although more accurate results may be shown with different time periods.
Economic Value of Equity. Economic value of equity extends the simulation process of earnings at risk into long-term time horizons. While earnings at risk, even if done for a longer time horizon, includes some fixed rate assets or liabilities, economic value of equity, or EVE, is performed over a long enough time horizon that all assets and liabilities reprice to current interest rates. Properly interpreting an EVE report can be as simple or complex as you care to make it. The key take away here is that EVE measures interest rate risk for the bank over a longer time horizon.
Note: These tools measure interest rate risk, and do not measure or judge strategies. Risk is defined by compliance within established interest rate risk parameters. Banks rated as having little or no interest rate risk will tend to have net interest income results that will not increase as interest rates change. On the other hand, these banks' results will not decrease due to interest rate changes either. Similarly, some banks with relatively poor interest rate risk indicators will increase earnings rapidly as rates change. But simply because favorable results are experienced does not mean that the banks invoved did not accept increased risk levels. Others may experience significant interest rate income declines as rates vary. It is this variability in net interest income and earnings that we are measuring.
Data used in the Echo Partners Interest Rate Risk Grader comes from sources both private and public, including the bank regulatory agencies themselves, that we believe to be reliable, but we do not warrant its completeness or accuracy. Interest rate risk results may be changed by other factors, including the use of financial derivatives. Echo Partners as a bank consultant and advisor, organizes this process, but we are not providing accounting, regulatory, or legal services. All information, discussions, and conclusions are provided for general informational use only, and you must determine if this information and guide is suitable for your specific needs.