Regulators expect a well-managed financial institution to look at interest rate risk through two different lenses:
- Earnings at risk (EAR)/income at risk (IAR) – Measures short-term risk; changes to the income statement.
- Value at risk(VAR)/economic value of equity (EVE) – Measures long-term risk; the change in value of instruments, and ultimately the potential for long-term earnings.
Both earnings at risk and economic value of equity measure the impact on earnings, but the time horizon of each metric is the differentiator and informs management of two separate, but equally important measurements. Another article in this series will expand on the value at risk perspective, but below is a focus on the earnings/income at risk perspective.
With the earnings at risk analysis, the goal is to measure the impact on net interest income (NII) resulting from movements in market rates, which impacts an institution’s return on assets (ROA) and ultimately shareholder returns, or return on equity (ROE).
Even small changes to an institution’s NII can have significant impact on ROA and ROE, which is why managing and monitoring all aspects of interest rate risk is paramount in ALM modeling.
Interest rate risk requirements
Prudential regulators expect financial institutions to measure the level of potential interest rate risk in their portfolios. In 1997, all members of the Federal Financial Institution Examination Council (FFIEC) except the National Credit Union Administration, added the “S” (Sensitivity to Market Risk) measure to the CAMELS rating to account for interest rate sensitivity within institutions.
For institutions to receive a “Well Managed” rating for Sensitivity, they must:
- Measure both EAR and EVE
- Extend simulation of earnings at risk to at least two years
- Run a static balance sheet for comparison if the institution is using dynamic balance sheet modeling (see below)
For credit unions, the NCUA in 2021 finalized a rule adding the “S” component to its CAMEL rating system to clearly distinguish between evaluating a credit union’s sensitivity to interest rate risk and the liquidity risk (which is evaluated by a revised “L” component in the ratings). The rule is effective for credit union examinations starting on or after April 1, 2022, and examiners will focus on compliance with this component in upcoming exams, according to the NCUA’s 2022 Supervisory Priorities.