In a rising rate environment why does the model show net interest income increasing but EVE decreasing?

Originally published 3/15/2011 © 2021 Olson Research Associates, Inc.

This is a really great question. It's also a very common one. I can appreciate the difficulty bank management has trying to explain this to the Board. I've been in that situation many, many times with a number of our clients over the years.

I've written a few articles in the past that I think will help explain this well. I've tried to present them in a logical order here for you to read:

  1. Earnings at risk is only a short-term view of interest rate risk

  2. Relationship between earnings-at-risk and EVE-at-risk

  3. When rates rise, how can income increase, but overall equity value fall?

The bottom line answer is that earnings-at-risk measures short-term risk exposure, and EVE-at-risk measures long-term risk exposure.

It comes down to a short-term/long-term trade-off. We all can think of things that help us in the short-term, but are not good over the long haul.

For example, buying longer-term 7-10 year bonds will probably have a positive impact on your overall margin today and in the immediate future (because it creates more spread). But continue that strategy long enough in a rising rate environment and your gains from investing longer-term will be eaten up by rising funding costs over time.

Here's a non-financial example: Suppose I start drinking two full pots of coffee per day, every day. I think you would agree that over the next few weeks or even months (the short-term) I would be an extremely alert and attentive worker. But what if I continued that habit for the next 5 years (the long-term)...I'd probably burn out.