Simplified and standardised methodology for interest rates affecting EVE and NI

Guidelines on the simplified and simplified standardised methodologies for Economic Value of Equity (EVE) and Net Interest Income (NII).

This is the second of a two-part article following Interest Rate Risk in the Banking Book (IRRBB) changes. Read our first article introducing the Banking book IRRBB templates.

Interest Rate Risk in the Banking Book (IRRBB) refers to the potential impact of interest rate movements on a bank's financial position. Banks can hold a variety of assets and liabilities with different maturities and interest rate characteristics. Changes in interest rates can affect the profitability and value of these instruments, leading to interest rate risk.

There are two key items described in IRRBB; economic value of equity (EVE) and net interest income (NII). The EVE signifies the distinction between assets and liabilities based on their market values. It serves as a measure of the potential income or loss a business could experience within a specified time horizon. Consequently, EVE provides an indication of how assets and liabilities might adjust to variations in interest rates. NII is a metric gauging financial performance, denoting the variance between the earnings derived from a bank's interest-bearing assets and the costs related to interest payments on its liabilities. It represents the surplus revenue resulting from the interest earned on assets exceeding the interest disbursed on deposits. The European Banking Authority (EBA), within their report, has developed a Standardised Methodology (SA) and a Simplified Standardised Methodology (S-SA) for the evaluation of risks arising from the potential changes in interest rates that affect the EVE and NII of an institution’s non-trading book activities.

Key takeaways

The EBA’s final report has resulted in an attempt to present a standardised, holistic approach. It has resulted in specified common definitions, components and steps for institutions to apply, which will lead to estimates comparing the EVE and NII between a baseline scenario and an interest rate shock scenario. These common definitions and steps largely focus on rules on the slotting of cash flows. The EBA has developed several steps and assumptions in the calculation of EVE and NII which include:

Behavioural cash flows

They have further specified the methodology provided in the 2016 Basel SA on EVE.

Calculation risk free-rate and commercial margin assumptions

i) The risk-free curve is left for institutions to select.

ii) They employ a double slotting approach, combining repricing and original maturity time buckets to create a matrix guiding the determination of forward rates. The use of time buckets simplifies implementation, eliminating the need for calculating unique forward rates for each product.

iii) The rate used in the commercial margin component of NII is based on the commercial margin of instruments originated in the last year.

Simplified standardised approach

The S-SA differs from the SA through the following simplifications:

i) EVE and NII:

  • The proportion of the core component of Non-Maturity Deposits (NMDS) is fully prescribed.
  • The SA prescribes a linear slotting of up to 4-5 years, depending on the scenario.
  • Institutions calculate the impact of automatic optionality on the basis of pay-outs.

ii) NII:

  • Can slot cash flows based off average original maturity for entire product category.
  • Only a breakdown of product categories is required for empirical determination of commercial margins.
  • An approximation for interest payments up to and including the repricing date can be made.

Overall conservatism of the SA compared to IMS

Supervisors could require institutions to use the standardised methodology to measure IRRBB if internal systems are not satisfactory. Therefore, an appropriate level of conservatism must be assured, when applying the standardised methodology.

Monitoring of market value changes of instruments held at fair value

The EBA has included a component in the SA on NII so that institutions can measure the market value changes for these instruments. In particular, the calculation is based on a calculation like that for the EVE but excludes instruments that are not fair valued. Moreover, cash flows that fall within the NII horizon are excluded from the calculation of market value changes to avoid double counting.

Inclusion of basis risk in the NII

The EBA has included a component in the SA on NII requiring institutions to estimate and add the impact of basis risk. The calculation is mainly based on the notionals of floating rate instruments. This is only calculated where the sum of floating rate instruments other than those with the overnight reference rate/benchmark exceeds 5% of interest rate sensitive assets.

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