“Where is someone that will pay me 1.5X book?; that’s what my Interest Rate Risk model says my bank is worth.” That statement, along with “there is no way this bank could be sold for 1.5X book”, are two comments I’ve heard a few too many times lately from bankers and examiners. While I will let you figure out which group is responsible for each statement, both illustrate a somewhat common misconception that capital values (sometimes called “market value of equity”) from interest rate risk models are meant to reflect actual current and projected institution sales prices.
The misconception really is related to what interest rate risk models are intended to do, which is to assess the risk to both short-term earnings and longer-term capital from changes in market rates. They are not systems intended to provide the institution with an estimate of its real market value (what it could be sold for in the open market). In reality, institution sale prices/true market values are impacted by many factors, most of which are well outside of an interest rate risk model. Most significantly, market values are generally a function of current and projected earnings, facility/branch network, balance sheet structure, loan quality, fixed asset values, comparable market sales, etc.
While I have seen non-interest rate risk valuation models built for this purpose, it is not the purpose of an interest rate risk model. The capital valuation function in interest rate risk models is used to assess the longer-term risk in the balance sheet structure. To do that, most interest rate risk models use a present value calculation discounting future cash flows from both assets and liabilities. Essentially, the model calculates both the PV of assets and PV of liabilities using the noted assumptions (loan and deposit repricing, asset prepayments, non-maturity deposit decay rates, discount rates, etc). The difference between the present value of assets and the present value of liabilities is the present value, or value of capital. That is, it is just the discounted present value of capital. While some models refer to it as the “Market Value of Equity,” I continue to argue that “economic value of equity (EVE)” or even “present value of equity (PVE)” are far more appropriate terms. The calculation is not by any means meant to be an estimate of what the bank could be sold for on the open market (as it does not consider all the other factors I previously noted, such as earnings, asset quality, branches, etc). In fact, I would argue that the actual dollar value of capital as determined in an interest rate risk model is largely meaningless; rather the focus should be on the percentage change in that value at the various parallel and non-parallel shock levels. This percentage change is the true indicator of longer-term interest rate risk (risk to capital).
Lastly, it is important to highlight that all interest rate risk model results are based on the assumptions in the model, which should be determined through a comprehensive process using institution-specific data. That process, and its findings, should be thoroughly documented with supporting studies/workpapers maintained and updated at least annually.
Please give us a call or let us know if you would like assistance developing and documenting institution-specific interest rate risk model assumptions. However; while we’ve helped many clients in this area, we still won’t be able to tell you what your real market value is.