ECONOMIC VALUE AND NET INTEREST INCOME FOR A BANK WITHOUT CAPITAL

The EV is an economic measure of performance. If the value of assets is above face value, it means that their return is above the market rates, a normal situation if loans generate a spread above market rates. If the bank pays term deposits at a rate lower than market rates, such deposits cost less than market rates. Their market value gets below their face value. This results in a positive EV, because assets are valued above face values and liabilities are below face value. Accordingly, the EV increases when spreads between customer rates and market rates widen, and the N11 also improves. We now expand the relationship between economic value and N11 through the use of an example.

Sample Bank Balance Sheet

The current market risk-free rate is 5%. The bank funding is a one-year debt at the current rate of 6%, with a spread of 100 basis points over the risk-free rate, 5%. This rate is fixed for one period and is reset after. The asset has a longer maturity than the debt. It is a single bullet loan, with 3 years maturity, with a contractual fixed rate of 8%. The bank charges to customers the current market rate plus a 3% spread and pays a 1% spread above risk-free rate. Note that we include a credit spread for the bank financing, assuming that the bank has only financial debt and no deposits. For simplicity, we use a flat interest rate curve, which is not restrictive. The net interest income is immune to interest rate changes for the first year only, since the debt rate reset occurs only after one year. The balance sheet is shown in Table 26.1. The bank's equity is zero, an assumption relaxed subsequently.

The stream of cash flows from assets and liabilities is fixed from these data (Table 26.2).

TABLE 26.1 Example of a simplified balance sheet

Assets

Liabilities

Amount

1000

1000

Fixed rate

8%

6%

Maturity

3 years

1 year

TABLE 26.2 Stream of cash flows generated by assets and liabilities

Dotes

0

1

2

3

Assets

1000

80

80

1080

Liabilities

1000

1060

0

0

The cash flows are not identical to the NIL The differences are the principal repayments. For instance, at year 1, two cash flows occur: the interest revenue of 80 from the asset and the repayment of the bank's debt plus interest cost, or 1060. The net interest income depends only upon interest revenues and costs. It is equal to 80 - 60 — 20. For subsequent years, the projection of Nil requires assumptions, since the debt for years 2 and 3 has to be renewed. Nil beyond the first period depends upon the cost of debt, which might change after the first year.

The horizon is the longest maturity, or 3 years. For projecting Nil beyond one year, we have to roll over the debt at the market rate prevailing at renewal dates and project Nil changes with interest rates. The contractual cash flows of assets do not change. The debt has to be renewed until the longest maturity, given the prevailing rate starting from period 2 and up to 3. Keeping the risk-free rate at 5% after the first year, the N11 is projected using again 5%. Table 26.3 shows the cash flows and the Nil over the 3 years.

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