A 2-year or 24-month EVE simulation just doesn’t make sense
Originally published 5/05/2011 © 2021 Olson Research Associates, Inc.
Since last week’s post about earnings versus equity simulation I received a few emails telling me that content was just a little too basic:
…earnings is a flow measurement and equity is a point-in-time measurement. No arguments here, but your point seems to be more appropriate for an Accounting 101 course rather than on a blog about Asset/Liability Management…
I agree, it is a basic concept. But I wrote that post in order to follow it up with this one.
Ever since the FDIC’s 2010 Advisory on IRR we’ve been inundated with requests to run a two-year earnings stress-test. I have no problem with the request – in fact it is an easy one to fulfill.
The problem is that people also expect there to be a “2-year equity simulation”. There isn’t**. Most clients are a little confused by this at first. They understand that we normally have two ways of measuring IRR at the end of the quarter:
short-term via a 1-year earnings simulation, and
long-term via an equity simulation.
They mistakenly think that running another earnings simulation for a 2-year period also means running an additional “2-year” equity simulation. It doesn’t. And if you read the IRR Advisory carefully you’ll notice that the regulators are not asking for this either, they simply talk about a 2-year earnings simulation.
By design the equity (EVE) simulation is already a long-term view of your bank’s interest rate risk. It is a point-in-time measurement, it’s not measured over a specific time frame. A “2-year” or “24-month” EVE simulation just doesn’t make sense.
**You true data heads out there will know that there is such a thing as a “forward shock”. Since Equity simulation measures EVE at risk at a point-in-time you could run an equity simulation at a point-in-time two years in the future. This type of forward shock can be useful in certain situations, but I think it’s way beyond the needs of most community banks. Most executives and boards have trouble digesting the results of a standard equity simulation anyway. I can’t imagine trying to explain a forward shock to them.
(This post is part of a series which provides a basic overview and discussion of interest rate risk stress-testing.)