Market Risk in the Banking Book

What is interest rate risk in the banking book?

Interest rate risk in the banking book (IRRBB) refers to the potential loss that a bank may incur due to fluctuations in risk-free rates (RFRs). 

For instance, consider a bank that has issued a one-year £100 loan with a fixed interest rate of 3%. The bank's exposure to interest rate risk depends on how it has funded this loan. If the loan is funded with a one-year fixed rate deposit, there is no interest rate risk as the loan and funding cancel each other out. 

However, if the loan is funded with a variable rate deposit that is linked to an RFR such as SONIA, and the RFR increases from 3% to 5%, the bank's funding costs will also increase, which can negatively impact its financial performance.

What is the difference between net interest income (NII) sensitivity and economic value of equity (EVE) sensitivity?

Net interest income sensitivity is a measure of how changes in interest rates will impact a bank's net interest income, which is the difference between the interest earned on its assets and the interest paid on its liabilities. NII sensitivity analysis aims to quantify the potential impact of interest rate changes on a bank's net interest income by comparing the expected net interest income at different interest rate scenarios.

Economic value of equity (EVE) sensitivity, on the other hand, is a measure of how changes in interest rates will impact a bank's economic value of equity, which is the present value of expected future profits adjusted for the bank's cost of capital. EVE sensitivity analysis estimates the impact of interest rate changes on a bank's economic value by comparing the expected economic value of equity at different interest rate scenarios.

Why do NII sensitivity and EVE sensitivity usually give different answers?

Net interest income (NII) sensitivity and economic value of equity (EVE) sensitivity can provide different results when a bank funds its assets with its own equity rather than interest-paying deposits. In this case, a rise in interest rates will not impact NII, as interest is not paid on equity, and NII sensitivity will be zero. However, EVE sensitivity will still show a loss, as the value of the asset will decrease with an increase in interest rates. This means that EVE may indicate that a bank is exposed to interest rate risk even if NII sensitivity shows no risk. It is important for banks to consider both NII and EVE sensitivity when managing their exposure to interest rate risk and to consider their overall risk management strategy when making investment decisions. NII and EVE may return similar results for balance sheet items that behave like bonds.