Interest Rate Risk in the Banking Book (IRRBB) is a crucial element of risk management in banks, reflecting how changes in interest rates affect a bank’s financial performance and stability. Two primary metrics are used in IRRBB: Net Interest Income (NII) and Economic Value of Equity (EVE). While both measure interest rate sensitivity, they serve different purposes and, importantly, rely on different balance sheet assumptions.
Understanding these assumptions is essential for accurate IRRBB modeling and sound risk management decisions.
NII: Business-as-Usual with a Constant Balance Sheet
The Net Interest Income (NII) approach focuses on the short-term (typically a rolling 12-month period), assessing how changes in interest rates impact a bank’s expected income from interest-earning assets and interest-bearing liabilities.
To maintain a realistic view of ongoing operations, NII is calculated under a constant balance sheet assumption. This means:
- Maturing or repricing cash flows (from loans, deposits, etc.) are assumed to be replaced by new instruments with identical characteristics — such as amount, maturity, and spread.
- The bank is modeled as a going concern, continuously originating new business in line with its current structure.
- This reflects a business-as-usual scenario, where the institution actively manages its balance sheet in response to market conditions.
Example: A ₹100 crore fixed-rate loan maturing in 6 months is assumed to be replaced by another ₹100 crore loan with similar pricing and tenor under the same market conditions.
EVE: Long-Term Perspective with a Run-Off Balance Sheet
In contrast, the Economic Value of Equity (EVE) metric evaluates the long-term impact of interest rate changes on the present value of future cash flows from all interest rate-sensitive assets and liabilities.
Here, the assumption is that of a run-off balance sheet, which means:
- The existing portfolio is assumed to amortize over time, and no new business is originated.
- As loans and deposits mature, they are not replaced — the bank effectively winds down its book.
- This assumption isolates the pure interest rate risk embedded in the current balance sheet, without the noise of future growth or management actions.
This makes EVE a valuable tool for understanding how interest rate shifts affect the economic value of a bank’s equity over its lifetime.
Why the Difference Matters
The divergence in balance sheet assumptions between NII and EVE is not accidental — it reflects their distinct purposes:
| Feature | NII | EVE |
| Time Horizon | Short-term (usually 12 months) | Long-term (full life of assets/liabilities) |
| Focus | Earnings impact | Value impact |
| Balance Sheet Assumption | Constant – business-as-usual | Run-off – no new business |
| Reinvestment | Maturing items are replaced | Maturing items are not replaced |
| Use Case | Earnings stability, budgeting | Capital planning, structural interest risk |
These assumptions ensure that the risk metrics remain aligned with their specific management objectives — one focused on earnings volatility, the other on long-term value at risk.
Conclusion
Balance sheet assumptions form the backbone of IRRBB modeling, and choosing the right one is key to meaningful risk analysis. By using a constant balance sheet for NII and a run-off balance sheet for EVE, banks can generate insights tailored to both short-term income sensitivity and long-term economic value exposure — leading to more informed, balanced risk management strategies.
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