Asset-Liability and Liquidity Management

CHAPTER 10Equity and Earnings at Risk

In previous chapters we discussed how the economic value of equity (EVE) and net interest income (NII) are obtained. We then followed with a study of the impact of change in different risk factors on those metrics. We focused on one scenario at a time when a risk factor, such as interest rate, was shocked, and the impact on ALM metrics was analyzed. Scenario analysis is a very useful tool in ALM analysis; however, its use is limited only to those scenarios considered. For example, what we learn from the results of a +100 bps parallel shock to the spot curve is applicable only to that scenario. The management team of a bank is often interested in gaining insight on scenarios that would produce extremely adverse conditions for the bank, both from a balance sheet management point of view as well as the earnings. However, identifying those extreme scenarios may not be possible and, even when identified once, they may change as economic and market conditions change or as the balance sheet and products of the bank evolve.

A common approach in the analysis of extreme scenarios is to use simulation to construct probability distribution of an ALM metric and use that distribution to obtain information on likelihoods of extreme cases and their potential impacts on the bank balance sheet and earnings. This approach is based on a very popular risk management technique known as value-at-risk (VaR). VaR methodology was first introduced by the risk management ...