Inside Earnings at Risk
Posted by Howard Lothrop on Thu, Apr 22, 2010 @ 12:51 PM
I guess almost every community bank asset liability specialist is familiar with the standard earnings at risk graph. Today we're going to take a look at the story behind the earnings at risk numbers and consider how to interpret them.
As you can see from the graph, this bank is asset sensitive. Net interest income increases as interest rates increase. It's good to know that the bank will perform this way, but it's even more important to know why. The answer boils down to a combination of relative asset liability mix and timing.
If we look at the right side of the earnings at risk detail, shown below, you will see that base net interest income in the first 12 month period is expected to be $1.36 million. If rates rise 200 basis points, the twelve-month projected earnings at risk increases to $1.477 million, an increase of $117,000, or 8.6%. Now, if we look at the asset liability mix, we see that this bank has securities and loans that take a significant period of time to reprice to the market. On the other hand, their CDs reprice very quickly.
So how is it with slow adjusting assets and quick adjusting liabilities that this bank is asset sensitive? The answer is the relative size and mix of the components. This bank has relatively few interest-bearing liabilities, while enjoying substantial transaction and non-maturity accounts. Their cash and interest bearing deposits alone are twice the size of their CD balances. Once again we see the benefits of core deposits.
Even more interesting, if we look at the left side of the chart, where the net interest margin impact is shown using a basis point perspective, we see that the net interest margin is actually projected to fall slightly and flatten out over the first two years. Finally, over five years, as the securities and loans fully reprice, the net interest margin increases significantly. How can the net interest margin fall, and yet the net interest income in dollars increase?
Here, it's more about the timing. As expressed in this earnings at risk chart, the basis point perspective is a forward-looking measure. What it really says is that after an immediate initial repricing within the first three months, you would look for a slight net interest margin decrease over the upcoming periods. Because this bank has a significant amount of interest-bearing cash that reprices immediately and has limited amounts of CDs, even though the CDs reprice more quickly their net interest margin impact is outweighed. It might be easier to see this if we again look at the dollar figures.
The three-month base net interest income is $340 thousand. In the up 200 scenario this increases to $366 thousand, an increase of $26 thousand. That's a 7.6% net interest income increase in just 3 month, an unsustainable rate of over 30% annually. By virtue of this initial repricing benefit, which is already baked in the cake, future periods have a net interest income head start. Over the entire initial 12 months, this $26 thousand quarterly benefit accounts for $104 thousand of the total $117 thousand annual net interest income increase. So what's the bottom line?
This bank benefits from an immediate pickup in net interest income, being significantly asset sensitive in the shortest term. It then treads water for several years as repricing assets and liabilities roughly offset. Then, finally, as securities and loans reprice, net interest income rises yet again as asset sensitivity fully plays out.
The bottom line is that it would be easy to make the wrong net interest income adjustments if you were not aware of both the timing and the mix of the component pieces.
Photo provided by xmatt.
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