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
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.