By Emily Hollis, CFA Partner
Net Interest Income (NII) simulation measures the volatility of net interest income as a consequence of different interest rate conditions. The credit union’s balance sheet (generally for a one- to five-year period) is entered into a system to execute a base-case model where there is no change in the market interest rate environment and to record the resulting net interest income. NII is defined as interest income less interest expense (neither operating expenses nor fee income are included). The balance sheet is then subjected to extreme interest rate scenarios and the NII generated is compared to the base case. A higher variance in these results equates to higher interest-rate risk within the balance sheet.
Net Economic Value (NEV) is the difference between the net present value of the credit union’s assets (including the value of the asset’s embedded options), and the net present value of the credit union’s shares and liabilities (including the value of the liabilities’ embedded options). Cash flows are generally valued using a market rate for the assets and an alternative borrowing cost for the liabilities; however, no value is given to future development such as growth of membership, branch openings or new products since the purpose of the analysis is to isolate interest rate risk. This base economic value is compared to the up-and-down, 300 basis point (bp) scenarios as a measure of risk. If the balance sheet contains longer-term assets, a substantial amount of economic value risk likely exists. Generally, a variance greater than 50 percent in a shock-up, 300 bp environment borders an unacceptable level.