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Handling Negative Market Value of Equity Changes in Down Rate Scenarios

By David Farris, Asset Management Group, Inc.


With the increase in interest rates over the course of the last year, there is now talk of recession down the road which could result in interest rates moving lower.  In 2020, with rates near zero, risk measures down 200, 300 or 400 basis points were irrelevant, except for those who believed in negative interest rates.  Today, those scenarios are more relevant since interest rates would still be positive at those levels.  In these down rate scenarios, bank asset / liability measures for Market Value of Equity (MVE) may be approaching or even be outside policy limits.  How should banks approach and deal with these risk measurements from a risk management standpoint when they are close to or over policy limits?

Decreases in MVE from current value is a typical pattern for community banks in the down rate scenarios. This is caused by the duration mismatch between a bank’s assets and liabilities. The typical asset side of the balance sheet for a community bank will consist of loans and investments of 1-5 years in duration. A typical liability structure for a community bank will generally have a large percentage of liabilities in longer duration non-maturing deposits such as checking, NOW, savings and money market deposit accounts with the remainder in shorter term retail and wholesale CDs, FHLB Advances, REPO’s and brokered CDs. The duration mismatch between the bank’s assets and these non-maturing deposits is usually the main cause of the expected losses in MVE as rates decrease.  Typically, calculated durations for non-maturing deposits are higher than the asset side and can range anywhere from 3 to 15 years.  This results in the bank having a decreasing MVE profile as rates go down.

From a risk management standpoint, scenarios down 300 or 400 basis points and even 200 represent large movements in interest rates that are way out of the money.  There are usually not cost-effective alternatives for community banks to immediately address this.  Banks could improve the down rate by going longer on the asset side or shorter on the liability side but that would also increase the risk to the up rate which is something the bank may not be willing to do.  Another alternative is to buy interest rate options or interest rate floors, but spending money on options to fix risks that are way out of the money probably does not make economic sense.  Other asset / liability tools that can improve down rate measurements are to get floors on adjustable rate loans, prepayment penalties on fixed rate loans and issue callable CDs.  The point here is that banks will adjust for these risks over time in the normal course of business and are certainly aware of the risks they face in down rate scenarios but that doing something now to bring a number back into policy that is far out of the money may not make economic sense.

If a bank has far out-of-the-money scenarios that are outside policy and chooses not to correct them currently, they should acknowledge this in their investment committee minutes and state that the reason no action is being taken at this time is due to the scenarios being so far from the current interest rate environment and that the situation will be monitored. 

Banks should also examine their policy limits to determine the most appropriate limits and test structure for the bank.  Asset Management Group, Inc. (AMG) can assist with this.  Our test structure in our reporting has three MVE tests.  Test 1 looks to see if the MVE is greater than 6.00%.  Test 2 measures the percent change in MVE as rates move.  If Test 2 is not passed, the report looks to Test 3 which is MVE>=90% of Book Equity.  If Test 3 passes, that overrides Test 2 and the MVE is deemed not outside policy limits.  Whatever policy limits and test structures a bank chooses to use for MVE should be documented in the bank’s investment policy for interest rate risk.

Every bank should set policy limits based on the risk tolerance and objectives of management and the Board.  Peer information on policy limits can be informative in this process.   Below is a table from The Office of the Comptroller of the Currency’s (OCC) semiannual Interest Rate Risk Statistics Report.  This shows the average of policy risk limits for a percent change in MVE (AMG Test #2) for parallel shocks in interest rates for all banks and was published in the fall of 2022.


It is interesting to note that even this analysis from the OCC published just last fall only looks at data down 100 bps.  Policy limits are normally the same up rate and down rate so it is fair to assume that the limits shown in the table for up rate scenarios are the same for the down rate as well.  Banks should review their own MVE risk limits and compare them to peer information such as the chart above to determine where they fall within these measurements and use that information in the process to determine the best policy limits for their bank.  AMG also provides this type of information on risk measurements that it sees being used in the market. 

In summary, banks should discuss and document the alternatives and cost effectiveness of addressing negative changes in MVE in the down-rate scenarios.  The policy limits should be reviewed and compared with peer information to ensure that these reflect the risk tolerance of management and the Board.  Policy limits should be documented in the bank’s investment policy.  Finally, whenever MVE limits are outside policy limits, these events should be documented as acknowledged and discussed in the bank’s investment committee minutes.

Please feel free to call AMG at 800-226-1923 if you have questions regarding this article or our Asset Liability Reporting and Consulting Service in general.

  Source: Bloomberg, LLP

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