Policy Limits for Market value of Equity
by Sean Doherty
Market Value of Equity (MVE), Economic Value of Equity (EVE), Net Portfolio Value (NPV) are all names for a measurement of the volume and volatility of Capital in various Shock Rate Environments.
Our BancPath® model has implemented a 3 part test for several years, designed to further understand the implications of MVE on the institution and the balance sheet’s capacity to generate earnings over the life of each asset or liability. Our 3 part test is explained as follows:
MVE Test 1: Does the Market Value of Equity exceed the Policy minimum for each scenario tested?
For example, if the requirement is for a minimum of 6% capital, does the calculated MVE meet or exceed this minimum by scenario?
MVE Test 2: Does the Change in Market Value of Equity fall within the Volatility Guidelines set forth in the Policy?
This volatility test generally involves the change in MVE for each scenario as compared against the Base Case, or Flat Rate scenario. We will typically see a guideline for each scenario; something like 10% +/-100 bp; 20% +/-200 bp; 30% +/- 300 bp, etc.
This is often where most banks will stop; with a statement that suggests that they are in or out of this policy guideline. Our approach, however, is that there must be one more step that needs to be tested that determines not only that violation of the policy has occurred, but more importantly, does this violation impair the institution in any way. After all, that is why we have policy guidelines, isn’t it, so that we can demonstrate to the Board and to our regulator that we are managing the institution properly and that we are not taking any undue risks with the capital entrusted to management.
To this end, we have developed this third test:
MVE Test 3: If there is a violation of the volatility test in Test 2 above, does this volatility impair the bank, or the capacity of the bank to maintain earnings given this violation. Is the resulting MVE greater than 90% of current book capital? If so, then we would maintain that there has been no impairment to the bank, or its earnings capacity, and the bank will have “deemed to have passed” the volatility guideline.
This is how we present these 3 tests in the BancPath® model: