NEV is measured by calculating the present value of assets minus the present value of liabilities, plus or minus the present value of the expected cash flows on off-balance-sheet instruments (such as some interest rate derivatives). NEV quantifies the economic value of the entire balance sheet expressed as a single amount, and it may serve as a proxy for a market-based valuation of an institution’s net worth. NEV analysis quantifies the degree to which the economic values of a credit union’s balance sheet positions change under different rate scenarios. By calculating NEV changes, credit unions are able to simulate impacts for different rate scenarios and understand the potential effects on net worth. As a capital-at-risk measure, NEV provides important insights about the threats and vulnerabilities posed by various rate environments and, in turn, how the results potentially affect a credit union’s level of net worth and overall solvency.
The economic values of all interest-bearing assets and liabilities are directly linked to interest rates. NEV can be used to measure a credit union’s long-term IRR by capturing the impact of interest rate changes on the value of all future asset and liability cash flows. It measures the long-term IRR exposure on a credit union’s balance sheet at a fixed point in time. NEV measures and quantifies IRR by capturing the impact of interest rate changes on the present value calculation of all future cash flows on both sides of the balance sheet. An NEV model projects the value of a credit union’s economic capital for a base case scenario, and then compares the base measure to resulting NEVs for stress scenarios. Generally, NEV computations demonstrate the economic value of net worth under current interest rates and shocked interest rate scenarios, which typically include an instantaneous, parallel, and sustained shift in the yield curve (up and down), as well as alternative scenarios for changes in the yield curve.
Importantly, declines in a credit union’s NEV measures signal a reduction in a credit union’s overall economic position (that is, losses) just as increases in NEV measures signal an improvement (gains). When model results show a falling NEV level, it implies that a credit union’s earnings would be negative. Conversely, results that show NEV increasing indicate earnings in that scenario are favorable. Producing NEV analysis for rising and falling rate scenarios provides important long-term foresight into how specific rate environments may favor or threaten the level and accumulation of net worth.
Economic values, which will differ from reported book values due to GAAP, can provide a number of useful insights into the current and potential future financial condition of a credit union. Economic values reflect one view of the ongoing value of the credit union. Economic values can offer comprehensive insights into the potential future direction of earnings performance, since changes in the economic value of a credit union’s net worth reflect changes in the present value of the credit union’s future earnings arising from its current holdings at current market rates. Most economic value models use a static point-in-time approach, in which the analysis does not incorporate any new or projected activities and all financial instruments are held until the contractual or expected maturity. The economic value analysis quantifies the risk to net worth at a point in time, from a balance sheet’s mismatched re-pricing of asset and liability cash flows.
Because NEV uses a time horizon that spans to the time of the last cash flow, it identifies IRR that short-term measures (such as gap analysis and NII simulation) may not. Therefore, credit unions with material positions in long-term balance sheet accounts (such as fixed-rate mortgages and mortgage-backed securities) should compute NEV. This is especially important when a credit union’s balance sheet also has significant embedded options (such as interest rate caps on ARMs and prepayment options on fixed-rate mortgages). The impact of these options may not be evident if the impact of interest rate changes is evaluated only over a short time horizon.
To compute the present value of the balance sheet, all projected cash flows for all balance sheet instruments, including any optionality, are modeled and then discounted using current interest rates for the respective interest rate markets. The concept of discounted cash flows represents a basic financial tool that captures the relationship between interest rates and fair value. Understanding the process of discounting cash flows can help a credit union value its balance sheet and interpret the results of its NEV model.
Present value is the amount of money an individual must invest today at a specified rate of interest to realize a future amount. In other words, present value is today’s value of the dollar amount the recipient will receive in the future. Accordingly, present value represents the discounted value, and the interest rate used is often called the “discount rate.” The price of purchasing any financial instrument (for example, a mortgage or investment) is the present value of its future cash flows.
The value of all interest-bearing assets and liabilities are directly linked to interest rates. The following example demonstrates how a change in interest rates can affect the fair value of an investment or loan. The example applies the formula to a hypothetical million dollar face value fixed-rate security. It first discounts the cash flows at the coupon rate (3.5 percent) and then again 300 hundred basis points higher (6.5 percent).
Note that the present value of the 3.5 percent coupon bond equates to its face amount of $1 million when the cash flows are discounted at the 3.5 percent coupon rate. This would equate to a no-rate change or “base case” scenario when computing NEV. However, the present value decreases by about $74,000 when the cash flows are discounted at 6.5 percent. This would approximate a potential 300 basis point rate shock when computing NEV. The decline in value underscores how an increase in market interest rates can reduce the fair market value of an asset such as a security or a loan. This decline also represents potential changes to capital under a NEV rate shock scenario.
While this discounted cash flow example is very basic, it is the fundamental concept behind what an ALM program does to compute NEV. NEV models become more detailed when the user adjusts discount factors for credit, option, and liquidity risks. But essentially, modelers are calculating a discounted cash flow measure for every instrument on the balance sheet, aggregating the results and then subtracting the net liability measure from the net asset measure to get the NEV.
Typically, an NEV model projects the value of a credit union’s economic net worth for a base case scenario (the current NEV calculated with the prevailing yield curve), and then compares it to a specified stress scenario. These models go by various names and acronyms, such as EVE, MVE, MVC, Net Portfolio Value, or Net Present Value. Regardless of the name, they are computed the same way.
Credit unions can benefit from the use of NEV, and should establish NEV risk limits and integrate NEV simulations into their IRR measurement procedures. Limits should generally be based on both the percentage change of NEV from the base measure and the post-shock level of the NEV ratio, which is NEV divided by the economic value of total assets.
For example, policy risk limits could be established for immediate, parallel, and sustained rate shocks for ranges of +/- 300 basis points, and should also address rate shocks of +/- 100 and 200 basis points, as well. Risk limits should address the:
- Minimum level for a post-shock NEV ratio, and
- Maximum percentage change in NEV (from base level to shock level) permitted.
For credit unions that use NEV to measure their IRR, management should disclose how the NEV calculation results compare to the policy risk limits. Management should report this comparison to the board and senior management at least quarterly. When policy risk limits are exceeded, management should promptly enact strategies to reduce IRR and report the status of this monthly to the board and ALCO.
Most credit unions perform static NEV simulations, meaning they produce single point-in-time assessments of the economic value that do not reflect any changes in the balance sheet composition (such as through potential loan growth, changes in investment strategies, or other changes). A static NEV measure shows the risk inherent in the current balance sheet, and is beneficial as a benchmark of IRR.
Some credit unions may also perform dynamic NEV simulations, which estimate NEV at a future point in time (for example, 6 months, 1 year, and/or 2 years from the measurement date) and incorporate forecasted changes to the balance sheet (like minimum asset replacement and new business). Dynamic simulations rely on detailed assumptions regarding changes in existing business lines, new business, and changes in management and member behavior. The value of generating dynamic NEV is that it will measure the potential IRR to net worth associated with planned business activities along with changes to balance sheet asset and liability composition. This information can inform decision makers about the potential IRR associated with planned business activities, bringing a more risk-adjusted discipline to bear on strategic decisions.
NEV estimates the future cash flows for all of a credit union’s assets and liabilities, including products with no contractual maturity dates. Developing estimated cash flows for instruments that have no contractual maturity is a complex and challenging modeling issue. This can be especially true for non-maturity shares. (Non-maturity shares include those share accounts with no defined maturity, such as share drafts, regular shares, and money market accounts.) Measuring the IRR associated with these accounts is difficult because the risk measurement calculations require management to define the assumptions for their products. For example, in order for a credit union to compute present values of non-maturity share accounts for its NEV inputs, management must make assumptions about how long each member share account will remain and how sensitive it is to changes in market rates. These assumptions will drive the estimate of the expected stream of cash flows associated with each member account that, in turn, will be discounted to a present value computation in the model.
Non-maturity share accounts that are assumed to have a long life (maturity) and be insensitive to changes in market rates (that is, are indifferent to the rate of interest paid by the credit union) have a higher intrinsic value to the credit union and thus benefit the NEV measure more than accounts with shorter lives and greater rate sensitivity. A credit union may attribute value to these shares (a value “premium” based on positive expected behavior) because they assume these shares will remain a lower cost of funds than market sources and will stay relatively insensitive to the rate paid by the credit union even if market rates rise elsewhere. Therefore, the underlying assumptions of the shares require scrutiny. Credit unions that forecast share behavior and incorporate those assumptions into their risk identification, monitoring, and measurement process should perform sensitivity analysis also.
When a credit union has a complex balance sheet with embedded options, the importance of proper data aggregation should be applied to all simulations. Complex or structured investments should be modeled on an individual basis, and homogenous balance sheet accounts should be aggregated by common IRR attributes. For example, loan portfolios should be aggregated by product type, coupon, maturity, and prepayment volatility. For adjustable-rate portfolios, simulations should include more IRR attributes, such as coupon reset dates and indexes, embedded caps and floors, and any prepayment penalties.
Workpapers & Resources
- FFIEC Advisory on Interest Rate Risk Management (January 6, 2010)
Last updated October 11, 2016
