WesCorp, Callahan & Associates Team Up to Demystify Net Economic Value via Webinar

SAN DIMAS, Calif. – With lowly interest rates and rapid growth in mortgage lending, credit unions may want to gauge the interest rate risk on their balance sheets and how net economic value (NEV) can help them measure long-term risks, but NEV can be a complex tool to use. More than 400 participants logged on to a NEV Webcast on Aug. 21 sponsored by WesCorp and Callahan & Associates to learn all about NEV. An online poll of participants found that 64% currently use NEV, 25% would consider it, 1% would not use the model and 10% were not sure. Originating during the S&L crisis in the 1980s, NEV is the present value of assets minus the present value and liabilities that was identified as a better way to measure interest rate risk, said Jay Johnson, Callahan’s EVP. Johnson said NEV is also used to “get an accurate reading of a credit union’s balance sheet and in determining interest rate volatility.” Still, some credit unions “absolutely hate” NEV because it’s based on an expectation, said Bob Burrell, WesCorp’s EVP and Chief Investment Officer. “Because it is an attempt to correlate market value with income volatility, NEV is not all things to all people.” Most agree that in addition to measuring the short-term effect of interest rate changes on income, it is equally important to measure the long-term effect on capital or net worth. Credit unions are flush with liquidity right now and “it’s great to ride the wave,” Johnson said, but NEV comes into play because it helps identify other options such as borrowing. “It’s also a good way to prepare for dialogue with the regulator,” Johnson said. “If (an examiner) comes in and asks what you’re using on core deposits and you answer with a blank stare, there may be problems.” With NEV, market values of the assets and liabilities are calculated by taking into account all cash flows from the individual items on the balance sheet. Any changes in cash flows will be reflected when the calculations are performed and most agree that NEV analysis is a more valuable tool than either the gap analysis or the net income simulation when assessing the credit union’s overall risk position. Major declines in a credit union’s NEV under different rate forecasts can indicate a degree of weakness in the overall balance sheet, said Jeff Hamilton, Director of WesCorp’s ALM consulting group. Credit unions should also put some type of risk management policy into place with regards to NEV that will allow them to effectively define and limit the amount of interest rate risk that they are willing to accept. WesCorp has been a strong proponent of NEV, asserting in an April 24, 2002 NCUA letter that it, combined with interest income simulations “provides the most comprehensive and effective balance sheet management regime.” By using a combo of NEV and income simulation, this allows the credit union to stay proactive in their risk management as the management team can see what the potential effects of a strategic decision will be before it is implemented, the letter stated. All of the Webinar presenters emphasized NEV analysis is a reflection of the current balance sheet and while it provides useful information under present conditions, the information may be a little too late. The items that are creating an adverse risk profile are already on the books so management must work to make changes in the future to correct the problems that exist, Hamilton said. Indeed, NEV “is not the only game in town,” Burrell told viewers,” but “it’s a valuable tool.” At WesCorp, Burrell said the process starts with collecting balance sheet data; then projecting cash flow; calculating the current value of those cash flows; calculating the NEV; and then doing an interest income simulation. “You should repeat the process for different scenarios,” Burrell suggested. “Once you have all of that information, look at what will happen to the balance sheet going forward. Run the NEV calculation and what it will be in the future and if we don’t like it, we start the whole process again.” Hamilton pointed out “economics is not accounting but recognizing benefit of cost.” “Credit unions should be familiar with delivering benefits to their members and that benefits translate into today’s dollars,” Hamilton explained. “Risk management is a forward looking process – what we think will happen.” [email protected]