by Michelle Huempfner and LuAnn Bunch

When most financial institution presidents and CFOs hear the terms Economic Value of Equity (EVE) or Net Economic Value (NEV), a chill runs down their spine. Just the thought of explaining what EVE is, let alone the results of an EVE analysis, to a board of directors can be daunting. But EVE can be a useful tool in an institution's interest rate risk measurement arsenal, so it is important for those involved in the asset/liability management (ALM) process to understand what EVE is, what to consider when modeling EVE, and what the resulting EVE numbers truly mean.

Getting to know EVE

Basically, the definition of EVE is the present value of the expected cash flow of assets minus the present value of the expected cash flow of liabilities.

EVE measures an institution's long-term interest rate risk and identifies what the long-term effects of interest rate shock are on the organization's balance sheet at a particular point in time. It takes into account all embedded options within a balance sheet including prepayment, call, and decay rate options.

The focus of the EVE approach is on the change in the market value of equity versus the change in net interest margin for various rate shocks. It represents a measure of change in value versus change in net interest income. Typically, the change in net interest income is a short-term measure where the institution's balance sheet is shocked for a 12-month period. EVE is a measurement that takes into account the entire life of the institution's balance sheet by calculating each account's present value and then shocking that account and measuring the resulting change in present value.

It is important to keep in mind that EVE is a point-in-time measurement. Normally, the balance sheet and projected rates are kept flat. Rates are shocked in 100 basis-point increments, up to 400 basis points, moving up and down from the base-rate projection.

Key considerations when modeling EVE

By calculating EVE, an institution can construct models to illustrate the effects of various interest rate changes on its total capital, but there are some considerations to keep in mind.

For one, it's important that accurate assumptions, such as prepayments, caps and floors, call options on investments, and decay rates on nonmaturing deposit accounts be included in the institution's EVE calculation when applicable.

The aforementioned assumptions affect the length and timing of asset and liability cash flows on the institution's balance sheet, which in turn, affect duration and market value. The larger the variation of the length and timing of cash flows, the greater the change in market value.

Duration is expressed in months and
represents how price-sensitive an
account is when interest rates change.

A financial institution should also document how it derived and consequently verified its assumptions. Likewise, when communicating EVE results to the asset/liability committee (ALCO) and board of directors, it is important to explain that EVE is assumption-driven, and that the assumptions are subjective.

Interpreting the meaning of EVE

Once an institution arrived at its calculation, it's important to translate its meaning in regard to interest rate risk.

For instance, the higher the EVE percentage, the greater the risk embedded in the institution's balance sheet. And since risk equals return, the higher the risk, the greater the return.  In addition, the greater the organization's long-term assets, the more likelihood that the EVE risk will be higher.

An institution will need to determine just how much risk it is willing to assume and define those EVE parameters within its asset/liability policy. From there, it can measure, monitor, and manage interest rate risk through policy limits. Typical limits are 15-30% for 100 to 300 basis point rate shocks.

A blended approach

Using EVE is a great complement to other interest rate risk tools, such as GAP analysis, net interest margin simulation, and interest rate shocks. With a workable understanding of EVE, an institution can look beyond short-term market fluctuations and compete with confidence.