Q&A with Emily Hollis

Emily Hollis
September 23, 2009 | COMMENTS

Question: Should you use the same rates for reinvestments in the net interest income (NII) simulation as the discount rates in the net economic value (NEV) analysis?

The short answer to this question is absolutely not. Going back to the basics of asset liability risk assessment, the net interest income simulation (NII) is vastly different than the net economic value analysis (NEV). The NII is a measurement of earnings volatility, while the NEV is an assessment of fair value volatility.

The NEV should capture the “exit” price of assets and liabilities; what they are worth in the markets upon liquidation. As financial institutions attempt to shrink balance sheets, deleverage, increase capital to asset ratios, or be rid of non-performing assets, fair value becomes critical. Upon the sale of an asset class, cash flows in their entirety need to be evaluated, not just the first one to five years (generally the time period of an NII simulation). The sale of the asset class is contingent upon rates required from a willing buyer, not the rates that are being offered internally. Therefore different discount rates are imperative.

Reinvestment rates for purposes of the NII should be the credit union's offering rates. The base case scenario of the net interest income simulation assumes a static balance sheet, where maturing cash flows are assumed to go back into the respective asset or liability. If a credit union elects to offer a loan at a rate lower than the prevailing market rate in order to gain market share or reward a member, the income will obviously be affected. Should that same lower rate be used in the NEV analysis, the loan is then assumed to be sold at par, with no gain or loss. However, the reality is a market value loss would occur.

It has been our experience that the practice of using different rates is not typically performed by financial institutions because it is more complex and requires a good amount of research in order to establish consistent secondary market rates. Additionally, given a dislocation in the secondary markets, this method can produce distorted values. Should these distorted values occur, the credit union must evaluate the changes to the NEV analysis in a more “normal” market prior to any change in strategy. Typically, primary market rates will equal those in the secondary market, because financial institutions prefer not to offer loans at levels where they cannot liquidate them. However, these are not “typical” times; the credit crisis has caused a severe dislocation in the markets with secondary rates being materially higher and financial institutions being unable to sell loans in the secondary markets without incurring severe losses.

The current environment warrants further reporting and analyses or perhaps a temporary adoption of primary rates for use in the NEV analysis. This can be achieved through “what if” analysis and will be touched upon in a future article.

Emily Hollis is a CFA and president of ALM First Financial Advisors in Dallas, Texas. Contact Hollis at 800-752-4628 or ehollis@almfirst.com.