You are probably too young to know about the 1950 movie "All About Eve," but it has relevance today so we start here. In the movie, actress Bette Davis played an aging Broadway star that was threatened by her young ing?nue, Eve. Critics loved the movie and it was nominated for 14 Academy Awards, a record unmatched until "Titanic" toppled it decades later. Still, "All About Eve" is the only film in Oscar history that received 4 female nominations. Kudos to the enduring success of Eve.
In the banking industry, EVE may not be quite as glamorous as a Hollywood icon, but its namesake tool is just as dear to bankers. Economic Value of Equity (EVE) is pretty successful in projecting long-term risk exposure when it comes to interest rate risk. In fact, according to the Fed, IRR is all about measuring and managing the potential impact on bank earnings or capital due to changing market interest rates, so bankers use tools to handle that. Given the Fed is likely to increase rates soon, we thought we would help everyone get better prepared.
To begin, Fed literature points out that IRR management basically breaks down into using short-term measures (like static gap and earnings at risk) and longer-term measures (like long- term earnings at risk and economic value of equity).
The basic goal of the short-term measurements is to quantify the potential reduction in earnings that could occur due to changing rates over a 1Y to 2Y time horizon. Meanwhile, longer- term measurements are used to quantify the potential impact on earnings and capital over a longer time horizon.
This is where EVE comes in and can be useful. EVE begins by projecting cash flows from assets and liabilities over the life of each one assuming rates will not change. Then, cash flows are discounted back to determine their present value. After that, the present value of liabilities is subtracted from the present value of assets in order to determine EVE in the base case. Once you have that, cash flows can then be projected for a range of different rising and falling rate scenarios. These are all then discounted back (at higher or lower rates) to recalculate EVE for each scenario.
At the highest level, the modeler now has a variety of EVE data points that can be used to determine the bank's exposure to interest rate risk movement. These can then be compared to capital and earnings and the bank's management team can then determine how risky the current balance sheet structure is. For instance, if the analysis shows EVE drops when rates rise, Fed research shows financial performance is expected to deteriorate in the years that follow those when rates are increased. Given we are in that environment now, perhaps it is time to check your own asset liability modeling results to look at this more closely.
No matter where your reports come from or whether they are generated internally or externally, it is important to understand the assumptions first and foremost. Common mistakes include using basic assumptions that don't fit your bank or assuming that because the model says things are fine it will work out that way in real life. A model is a model, so be sure to ask questions, evaluate assumptions, and address issues before rates begin to move. We will cover other IRR measurements in a future edition, so stay tuned, but until then this one is all about EVE as life imitates art.