Identify Your Risk Capacity in a Rising Rate Cycle  
key words: duration, risk culture, risk-based budgeting, risk capacity, clean OAS, risk-adjusted margin  
THC Asset-Liability Management (ALM) Insight Issue 1  
Your target EVE duration, a liability sensitivity measure, may deviate significantly from that of the peer  
group average because there is a significant underlying factor that is seldom discussed affecting your bank’s  
balance sheet risk capacity  
Re-Examine Your Risk Culture  
An institution’s risk culture may be driven by the historical experience and professional background of the  
management. The S&L crisis of the 1980’s and the financial crisis of 2009 experiences have greatly reduced  
some banks’ perceived Risk Capacity. Some banks may manage the balance sheet focusing on the investment  
portfolio to enhance performance. By contrast, some banks may rely more heavily on the traditional book  
value financial ratios to measure risks. Others rely on EVE duration, liquidity coverage ratios, CECL, EVE ratio,  
coverage after Liquidity Crisis Action Plan (LCAP) Initiation, and other recently introduced risk measures that  
identify your Risk Capacity.  
Yet, we must also note that there is a sea change in the risk management culture as banks are adopting new  
ways in measuring, monitoring and managing risks. This change is broad based and fundamental, a change  
that cannot be detected by anecdotal cases nor by several trend analyses but by sharing ALM views with  
banks across the country.  
This growing risk management culture will affect bank’s structural balance sheet in product mix, funding  
sources, and, of course, durations. To remain competitive, when you develop your budgeting or balance  
sheet strategy, you may first re-examine your Risk Culture. Identify your Risk Culture by specifying your  
balance sheet Risk Capacity, which should be consistent with the current ALM risk management practice.  
Your Risk Capacity  
Risk Capacity refers to your interest rate, liquidity, capital, and credit risk exposure targets that generate  
optimal performance. The duration of the Economic Value of Equity (EVE) or Net Equity Value (NEV) is a risk  
measure that determines your interest rate risk capacity. An explanation of the EVE duration is provided in a  
footnote.1 Likewise, you can specify your Liquidity Coverage Ratio target (for liquidity capacity), CECL target  
(for credit risk capacity), EVE ratio and equity ratio target (for capital risk capacity.)  
THC Research reports that banks have shortened their EVE duration significantly in Q3 2017, dropping over  
1 year, from an average 4.47 years to 3.62 years, in anticipation of rising rates. But the EVE durations vary  
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Definition of EVE duration. Under regulation, the long-term interest rate risk is measured by the % change of EVE under interest  
rate shocks in increments of 100 bpt. EVE duration is the % change in EVE under a 100 bpt shock. Duration is measured in years.  
Positive (negative) duration implies the balance sheet is liability (asset) sensitive. The balance sheet is interest rate risk immunized  
when the duration is zero.  
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significantly across banks, with the durations ranging from -5 years to over 10 years. This great divergence of  
Risk Capacity is attributed less on the variance in market views and more on each bank’s risk culture, as most  
of THC clients agree that the rates are expected to rise.  
Market Rate Outlook  
You may consider adjusting the EVE duration to be consistent with your risk capacity based on your market  
outlook.  
Feddie Mac forecasts an increase in new home sales but a decrease in refis. The net origination  
volume is projected to be down to $1,695 billion in 20182 in this rising rate environment.  
2016  
3.7  
2017  
4.0  
2018  
4.4  
30 year PMMS (%)  
Total home sales (mm)  
Home price growth (%)  
Total origination ($B)  
6.01  
6.4  
2.125  
6.18  
6.3  
1.800  
6.30  
4.9  
1.695  
The Fed maintains 2017 and 2018 rate forecast. The Federal Reserve expects the fed funds rate to be  
at 1.4% at the end of 2017 and 2.1% by the end of 20183. This may be the beginning of a rate rising  
cycle.  
Yield Curves: The Market Spreads  
Quarterly Treasury Curve Trend shows that the current Treasury Curve (orange) has continued to  
flatten as the short rates rise. If the fed fund rate rises to 2.1%, then the curve would be flatter if the  
10 year rate is to stay at 2.3%.  
Yield vs Duration Graph of Funding Sources graph shows the brokered CD and FHLB Advance rates  
steepen beyond 12 months relative to the Treasury curve. The spread increases with maturity term.  
The graph suggests that the loan rate should remain upward sloping, with longer weighted average  
life yielding higher income.  
Since generally longer duration loans provide higher income, bank’s EVE duration remains positive in  
a rising rate cycle.  
Yield vs Duration Graph of Funding Sources  
Quarterly Treasury Curve Trend4  
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Source: www.freddiemac.com/research/outlook/20170921_looking_ahead_to_2018.html  
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4 Source: THC Network™  
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Loan Pricing: Clean OAS (Option Adjusted Spread or Risk Adjusted Margin)  
Loan production decisions underscore the importance in identifying your Risk Capacity. Do ARMs always have  
shorter durations than FRMs? Can all ARMs be treated the same in terms of earnings and risk? Let me use  
the Risk-Adjusted Margin to illustrate how loan production decisions should be related to the Risk Capacity.  
Currently, a 30yr FRM rate is about 100 bpt above the 3% 30 yr TBA5 at par.  
An ARM’s rate depends on multiple factors including the 1st repricing date, and liquidity/credit  
charges. Further, the ARMs rate also depends on the index after the 1st repricing date, and therefore  
the yield must depend on the projected index rate in the future as well.  
So, ARM’s yield must depend on the projected interest rates, and the yield cannot be easily used as  
relative valuation measure.  
A useful measure of margin is the Clean Option-Adjusted Spread (Clean OAS). Clean OAS is the yield  
after adjusting for the match funding cost based on Treasury rates, and charges for credit risk,  
extension/prepayment cap/floor option risk. Clean OAS is a Risk-Adjusted Margin. For example, a  
FICO 700-759 conforming FRMs loan has a Clean OAS of 116 bpts.  
A comparison of Clean OASs estimated by THC Capital Market research is given below. Investments  
typically have lower clean OAS, or lower returns, than loans.  
Loan Types 30 yr TBA 3% 30 yr FRM 7-1 ARMs 3.72% 5/1 ARM 3.79% 3/1 ARM 3.86%  
Clean OAS  
65 bpt  
116 bpt  
162bpt  
182bpt  
220bpt  
If your balance sheet Risk Capacity allows for extending the EVE duration further, then you can consider the  
additional yield pick-up by originating loans with duration longer than that of the funding. This calculation is  
illustrated below.  
Loan Pools on the Market  
THC Risk Adjusted Performance (TRAP) Report provides a detailed explanation of loan pool as illustrated  
below. Loan pools are available in the THC Loan Central. The loan Clean OAS is 68.3 bpt, typically higher than  
a 30 yr MBS at par, but, lower than the Clean OAS of a loan at origination. Of course, the actual transaction  
price and therefore, the Clean OAS, will be negotiated via the THC Network™ Loan Central anonymously.  
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THC research white paper ALM and CECL provides a model of the TBA-FRM pricing relationship. Contact THC for additional  
information  
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The report above provides the loan pool’s funding cost 2.363% and duration 5.37 year. If you fund this  
$1,853,670 pool with cash with rate 1.25% and 0 duration, then the transaction will pick up an additional  
1.113%(= 2.363% - 1.250%) to the clean OAS (Risk-Adjusted Margin) 0.683%. The transaction would need to  
assume that your balance sheet has the Risk Capacity to increase the EVE duration. (This balance sheet  
strategy is often called Fund Transfer Pricing, and the underlying yield curve, in this case, the Treasury  
Curve, is called the Transfer Pricing Curve, a benchmark pricing curve for all balance sheet items.)  
Summary:  
This THC Insights suggests that you re-examine your risk culture in this changing risk management  
environment to stay competitive. Adjust the EVE duration as the market condition changes.  
Next issue, I will discuss the specifications of Risk Capacity in developing a Risk-Based Strategic Planning in  
this budgeting season. Thomas Curry OCC on the Value of Strategic Planning in “put(ting) themselves in the  
best possible position for successOctober 2014 involves a process “…thinking, assessing, vetting, planning,  
executing, and measuring.” I will discuss how Risk Capacity should be an integral part of each step of this  
Strategic Planning process.  
I welcome your comments.  
Regards,  
Tom Ho PhD  
President  
1-212-732-2878  
About THC  
THC is a financial technology company founded by Dr. Thomas Ho, a former professor at New York  
University, who introduced the first balance sheet valuation (Ho-Lee model 1986) called "option model" by  
regulators and key rate durations (1992), one of the most popular interest rate risk measures.  
THC was selected as the sole provider of the risk reporting to all regulated institutions under a federal bank  
regulator. THC continues to dedicate its research and resources to supporting community banks.  
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