Rising Rates, Bank Failures Highlight EVE’s Strengths, Limits

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Are rising rates good for banks, or bad for them?

One way banks can answer that question— and position themselves to benefit from rising rates — is by measuring and managing their interest rate risk, or IRR. One way banks can calculate their long-term interest rate risk is using an economic value of equity, or EVE, model, which can show how interest rate movements will change the fair, or market, value of its assets, liabilities and equity. But rising deposit costs and changing depositor behavior is complicating those calculations. 

“Economic value of equity (EVE) measurements allow for longer-term earnings and capital analysis. The analysis may be useful for long-term planning and may also indicate a need for short-term actions to mitigate IRR exposure,” the Federal Deposit Insurance Corp. wrote in its  examination manual. 

EVE is the difference between a bank’s asset cash flows and the liability cash flows, which includes deposits, says Matthew Tevis, a managing partner at Chatham Financial. This figure differs from a bank’s total equity because EVE includes the franchise value of deposits; bank deposits become more valuable as rates rise because they’re usually stable and less sensitive to price. But how a bank should model deposit costs and runoff — especially as rates rise — are the biggest unknowns in EVE calculations, Tevis says. In contrast, it’s easier for banks to calculate the market value of assets. 

“The real challenge [with EVE] is on the liability side, because you have to assume that a certain amount of your deposit is going to be there for a period of time,” he says. 

Tevis helps banks perform rate modeling exercises so they can see how their EVE changes with different interest rate movements — for example, rates rising by 200 basis points or falling 100 basis points. These exercises can show where the bank is carrying risk that could exceed its predetermined IRR policy limits. 

Poor interest rate risk management played a large role in the March failure of Santa Clara, California-based Silicon Valley Bank, according to the Federal Reserve’s postmortem report. The April report found that the bank’s management “ignored potential longer-term negative impacts to earnings highlighted by the EVE metric.” 

Silicon Valley reported in its 2021 annual report that its EVE was $20.7 billion, which was $4.1 billion above its total equity, but that EVE would fall sharply if rates jumped, The Wall Street Journal reported in May. The bank did not include EVE in its 2022 annual report, which was filed weeks before its March failure. 

The Fed found that Silicon Valley’s risk appetite statement, set by the board, only included net interest income metrics and not EVE. But the bank did calculate EVE, and breached it multiple times before failure. Instead of addressing the underlying risks generating these breaches, management changed assumptions, like the duration of its deposits. 

“No risk had been taken off the balance sheet,” the Fed wrote. “The assumptions were unsubstantiated given recent deposit growth, lack of historical data, rapid increases in rates that shorten deposit duration, and the uniqueness of [the bank’s] client base.”

The report goes onto say that the full board should understand and regularly review IRR reports that detail the level and trend of a bank’s exposure. 

The board of Citizens Bank of Edmond discusses EVE during the monthly asset/liability committee meetings, says CEO Jill Castilla, who shared the privately held bank’s modeling on her Twitter feed recently. The spring banking crisis was an opportunity for the $388.5 million bank, based in Edmond, Oklahoma, to revisit and potentially update its EVE assumptions. The bank commissions deposit studies periodically to analyze how funding behaved in different rate environments and economic cycles, to bolster the credibility of its liability assumptions. Castilla adds that the committee invites input from two separate third-party experts and back-tests its ALCO model to see how closely bank performance mirrored what they modeled.

“It’s important for boards to be asking for deposit studies,” she says. “These are conducted by a third party and they’re able to feed into the assumptions in the model and the disclosure of any changes within the model … We’re questioning if our assumptions are still valid and correct and we’re making some adjustments based upon what we think, but it’s important as a management team to have studies to validate those observations.”

There are two common ways banks can address interest rate risk: changing the actual assets and liabilities, or laying hedges on top of the balance sheet inputs that counteract the impact of interest rates. 

Banks are concerned that rates are going to continue rising, Tevis says: 75% of Chatham’s hedging work for banks right now is directed toward mitigating the risk from rising rates. 

Ultimately, EVE isn’t a perfect mirror of bank interest rate risk: It’s an internal calculation done by the bank that is full of assumptions. Its outputs are only as accurate as its inputs. And while bank EVE may be stressed in the high interest rate environment, the Federal Open Market Committee’s pausing rate increases, or even potentially lowering rates, could shift the calculations and assumptions that go into the model or the result itself.

“When you’re doing an EVE analysis, you’re modeling both increases and decreases and you’re protecting yourself in either environment,” Castilla says. “As managers of banks, we’re also supposed to be expert risk managers and that includes interest rate risk. We have to protect ourselves on the upside and the downside.”

Risk issues like these will be covered during Bank Director’s Bank Audit & Risk Conference in Chicago June 12-14, 2023.

Finding Opportunities in a Rising Interest Rate Environment

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Over the course of a year or so, the Federal Reserve has raised short-term interest rates more than 475 basis points.

Bankers with a portion of their balance sheet assets invested in fixed income securities are all too aware of the “Finance 101” lesson of the inverse relationship between interest rates and the market value of fixed income securities. While the recent Fed actions certainly have negative implications for parts of the bank’s balance sheet, they also have some positive ones.

For instance, banks with available liquidity have some great buying opportunities currently in the market. In addition to obviously investing in government securities with durations on the short end of the yield curve, the cash value yields on certain types of bank owned life insurance, or BOLI, are currently the highest they have been in at least 15 years.

Regulators allow banks to use BOLI to offset the cost of providing new or existing employee benefits. Part of the way BOLI offsets these employee benefit costs is by providing compelling cash value rates of return, which are generally provided by life insurance carriers that carry high credit quality. Another benefit of BOLI is that most types have cash values vests on a daily basis — the cash value doesn’t reduce in a rising interest rate environment. This eliminates the mark-to-market risk associated with other assets on the bank’s balance sheet, such as fixed income securities or loans.

Other higher yielding, high credit quality opportunities are also currently available in the market. Many of the same high credit quality life insurance carriers that offer BOLI have begun offering, or are creating, a guaranteed investment certificate or GIC. GICs are sometimes referred to as a financial agreement or FA. The GIC works much like a certificate of deposit, where the purchaser deposits money with the offering entity — in this case, the life insurance carrier — and earns interest on the deposited money. Much like a CD, the money must be deposited for a fixed length of time and interest rates vary according to the duration. GICs are nothing new; insurance companies themselves have been investing in them for decades.

Another interesting development over the last few months is the ability for banks to invest in a collateralized loan obligation, or CLO. A CLO is a single security that is backed by a pool of debt. As a floating-rate security, it offers income protection in varying market conditions while also minimizing duration. Additionally, CLOs typically offer higher yields than similarly rated corporate bonds and other structured products. We have also seen CLO portfolios added as investment options of private placement variable universal life BOLI designs to provide a bank with additional benefits. This structure has the advantage of giving bank owners the ability to enhance the yield of assets that are designated as offsetting employee benefit expenses. The advantages of this type of structure are obvious in the current inflationary environment.

So while the actions of the Fed have certainly added challenges to the typical banks’ balance sheet, for those institutions who are well positioned, it has also created numerous opportunities.