Brief overview of Interest Rate Risk
Originally published 8/30/2007 © 2021 Olson Research Associates, Inc.
When I'm asked, "What sort of work do you do?" I'm never sure quite how to answer. When I started working in this business my answer to this question was, "I help community banks measure and monitor their interest rate risk..." I learned pretty quickly that that was a conversation stopper. Nobody can think of a follow-up question to that. Because most people don't even know what interest rate risk is.
We encounter a similar problem when supporting our bank clients because we're often helping the bank CFO communicate IRR measurements to board and other senior management. The CFOs understand it, but they're frustrated when trying to educate others.
In our A/L BENCHMARKS Board Report we offer what I consider to be a good brief overview of IRR. Those readers who understand IRR well are sure to find holes in the following text. But remember it's meant to introduce IRR to folks who don't "get it".
Except from our A/L BENCHMARKS Board Report:
Interest rate risk (IRR) is the risk to earnings or capital arising from movements in interest rates. Practically, IRR can be viewed from both a short-term and long-term perspective. To examine short-term IRR we look at earnings at risk. Conversely, we use equity at risk and duration to measure long-term IRR.
Earnings-at-risk: short-term IRR
By most definitions, accounting or otherwise, when we communicate something as short-term, we usually refer to a time frame of one year or less. When measuring IRR from an earnings perspective, this same concept applies. Short-term interest rate risk is measured by initially establishing a one year earnings forecast which may include a dynamic market rate forecast, earnings growth, and balance mix & volume changes.
Since IRR is a measure of possible loss caused by interest rate changes, the model then introduces two instantaneous, parallel "shocks" to the base set of rates and then re-computes the expected earnings. Common practice is to use +/-200bp movements. The earnings at risk is the largest negative change between the base forecast and one of the "shock" scenarios. The measure is usually stated as a percentage change from the base income.
There are two significant characteristics of the earnings at risk measurement the bank should review. First, what rate shock, up or down, produces the worst case change? Is the bank exposed to rising or falling rates? Second, what is the amount of projected change or magnitude of risk? How much exposure is there?
Economic Value of Equity (EVE) at risk
As a means for evaluating long-term IRR, an economic perspective is necessary. This approach focuses on the value of the bank in today's interest rate environment and that value's sensitivity to changes in interest rates. This concept is known as Economic Value of Equity (or EVE) at Risk. It requires a complete present value balance sheet to be constructed. This is done by scheduling the cash flows of all assets and liabilities and applying a set of discount rates to develop the present values. The economic value of equity (EVE) is the difference between the present value of assets and liabilities. (Equity = Assets - Liabilities).
Similar to earnings at risk, two interest rate shocks are applied to the base set of rates and all present values are re-computed. EVE at risk is the largest negative change in value between the base and one of the shock scenarios. This is usually stated as a percentage change from the base EVE.
We've found that this introduction, along with a simple graph or two, goes a long way toward educating those who are less fluent in "IRR-speak".