Net Interest Income vs. Net Economic Value
Credit unions are encouraged to use a variety of measurement methods to assess their IRR profile, and NII and NEV simulations are both widely used within the industry. By combining earnings-at-risk (NII) and value-at-risk (NEV) approaches, credit unions will gain a more comprehensive perspective on both near-term and longer-term IRR factors. NEV is useful in identifying risk within assets of longer duration and with optionality, especially when a material amount of cash flow occurs beyond an NII simulation’s horizon. NII simulations provide more detailed information about the structure and timing of instrument cash flows and are useful in determining when notable risk events transpire within the model horizon. Each approach provides unique aspects and helpful information about potential risks and should be used together, especially when portfolio compositions are long in duration, complex, and/or have material amounts of option risk.
Despite being different methodologies, NII and NEV methods generally provide a consistent view of IRR trends. However, the two approaches may also generate divergent outcomes. In many cases, NII simulation models provide shorter-term results, while NEV models provide a longer-term risk profile. An NEV approach measures all estimated changes to the balance sheet and earnings, as opposed to gap models and NII simulations, which generally measure shorter-term balance sheet and earnings projections. These divergent outcomes can result from a variety of factors, such as the structure of the balance sheet, including the credit union’s derivative positions and off-balance-sheet items; interest rate environment; timing of asset/liability mismatches; sensitivity of funding sources to interest rate changes; and volume of fixed- or floating-rate assets. Divergent outcomes do not mean models are incompatible, but they do require practitioners to understand what underlying factors drive the respective results.
Regardless of the methods used, an institution’s IRR measurement system should be sufficiently robust to capture all material on- and off-balance-sheet positions and incorporate a stress-testing process to identify and quantify the institution’s IRR exposure and potential problem areas.
Last updated on December 06, 2024