Ask Emily: ALM Expert Evaluates Analysis Methods

Emily answers the question, Our credit union performs both NEV and NII analyses. Which analysis does your firm focus on, and what are you typically looking for?

 
 

Emily Hollis has been president of ALM First Financial Advisors, LLC, since the company was established in 1995 as a CUSO of Eastern Corporate Federal Credit Union. The firm currently has some $8 billion of investments under management, with clients representing more than $65 billion in assets. The following is part of a monthly, “Ask Emily” column she publishes.

Our credit union performs both NEV and NII analyses. Which analysis does your firm focus on, and what are you typically looking for?

ALM First looks at a number of things when analyzing so-called shock tests. The macro, or top down results are the main focus, after which we look deeper into the balance sheet for a better understanding of the drivers of risk and return.

We tend to focus more on net economic value (NEV) than net interest income (NII) simulation because NEV is a value-based measure. When performing NII, a limited, forecast horizon must be selected (e.g., one year) because the longer the horizon, the less likely it is to accurately project the future interest-rate environment and management’s behavioral response. NEV, on the other hand, is a timeless measure. It considers capital at risk at a moment in time.

The limitations of a NII short-term forecast horizon can be demonstrated in the following example. Suppose you opted to invest in a 10-year asset at 5 percent rather than a one-year asset at 2.50 percent. A subsequent sharp rise in interest rates in years two through five would underscore the weakness of this decision. NEV analysis would have made this clear by valuing each asset in higher-rate environments. The first asset would lose as much as 20 to 30 percent of its value, while the second would decline by only 2 to 3 percent. NII simulation, over short horizons, would not capture this effect. Because NEV relies on a standard discounting of cash flows, regardless of how far out they are, it eliminates the forecast horizon problem altogether.

Of course, the long-term consists of many short-term segments and the more information you have, the better prepared you are to deal with the future. So, the bottom line is it’s important to focus on both analyses; the NII for short-term earnings projections, and the NEV for value at risk. Here are some key metrics used by ALM First:

  • NEV ratio: This is a “mark-to-market” capital ratio. If it is higher than the capital ratio, value has been added to historical accounting measures.
  • NEV percent change from the base: This gives us an idea of the amount of capital at risk due to a change in the interest rate environment.
  • NII change from base: This allows us to quantify how much NII will change over a given rate change and forecast horizon. We focus mainly on one-year horizons because it matches the typical budget cycle and is easier to forecast.

We also study line-item assets and liabilities, in particular for the products that cause changes outside of risk-tolerance levels, so that we can suggest ways to rebalance the balance sheet by using tools such as leveraging, hedging, selling/buying assets, and extending liabilities.

That’s when the fun really begins!

 

 

 

Nov. 22, 2004


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