Net Economic Value: 1 Tip on Effective Discount Rates
February 4, 2016
There are many tools that can be used to perform a model reasonableness check, or a model validation. Below we share a simple “sniff test” to help credit union CFOs and financial analysts assess one key assumption driving net economic value results, the effective discount rate applied to each loan category.
Tip: Compare the effective discount rate in the current interest rate environment to the applicable loan portfolio yield. Understand the reasons for material differences.
You might be thinking – “Why do I need to see the effective discount rate in the current environment if I can see the values?” Well, how do you know if the starting value is reasonable?
Seeing the assumed effective discount rate and comparing it to the loan portfolio yield would help you think in terms you deal with every day. For example, if you could see the weighted-average yield of your auto loan portfolio has been holding steady at about 5.50% yet the assumed effective discount rate in the current environment is 2.75%, you would probably want to understand why there is such a disparity. You begin asking questions.
Are we charging our members above market rates? If not, what might be the reason that our yields are so much higher than market? Do we accept a higher than typical credit risk? Perhaps insufficient credit spreads are being applied to the assumed discount rate.
Are there other unique lending practices that we perform that might account for higher than market yield in our portfolios? For instance, if your mortgage rates are materially higher than the effective discount rate, dig deeper. Maybe your mortgage loans are non-conforming and the discount rate has not been adjusted appropriately. Ask yourself why a purchaser of non-conforming loans would not want to be appropriately compensated for a potentially higher risk and less liquid asset.
Even if your ALM model touts that a unique spread is being applied for every single loan, you should still step back to determine the reasonableness of these assumptions and understand the overall portfolio effective discount rate for the current interest rate environment relative to your portfolio yield.
Performing this quick reasonableness test helps bring a common sense approach to values and ultimately NEV results.
