**Quick Reference**

- Lowest net interest earnings at risk
- Lowest economic value of equity (EVE) at risk

Since future interest rates are always uncertain, a bank is exposed to interest-rate risk because it owns financial assets. A bank is also exposed to interest-rate risk because it owns financial liabilities. Interest-rate risk is defined as the possibility that interest rates will change in the future, and that such changes will cause losses to interest income, equity value or both. Practically, interest rate risk can be viewed in both a short-term and long-term perspective. To examine short-term interest rate risk (IRR) we look at Net Interest Earnings-at-Risk. Conversely, we use Economic Value of Equity (EVE)-at-Risk to measure long-term IRR.

**Earnings-at-Risk - Short-Term view of IRR**

By most definitions, accounting or otherwise, when we communicate something as short-term, we usually refer to a time frame of one year or less. When measuring interest rate risk on an earnings perspective, this same concept applies. Short-term interest rate risk is measured by initially establishing a one year earnings forecast. This base forecast assumes that both the level and structure of market rates of interest are held constant from the last historical period. The balance sheet, in terms of overall size and mix, is constructed using a managerial forecast or a projection.

IRR is a measure of possible loss caused by interest rate changes. Therefore the model introduces two instantaneous, parallel "shocks" to the base set of rates (common practice is to use +/-200bp movements) and then re-computes the expected earnings.

The Earnings-at-Risk is the largest negative change between the base forecast and one of the "shock" scenarios. The measure is usually stated as a percentage change of either net interest income or net income.

**Equity-at-Risk (EVE) - Long-Term view of IRR**As a means for evaluating long-term interest rate risk, an economic perspective is necessary. This approach focuses on the value of the bank in todays interest rate environment and that value's sensitivity to changes in interest rates. This concept is known as Equity-at-Risk. It requires a complete present value balance sheet to be constructed. This is done by scheduling the cash flows of all assets, liabilities, and off balance sheet items and applying a set of discount rates to in turn develop the present values. The present value of equity is derived by calculating the difference between the present value of assets, liabilities and off-balance sheet items. (Equity = Assets- Liabilities +/- OBS)

Similar to Earnings-at-Risk, two instantaneous, parallel interest rate "shocks" are applied to the base set of rates and all present values are re-computed. Equity-at-Risk is the largest negative change in the present value between the base and one of the "shock" scenarios. The risk is usually stated as a percentage change.

Once you have determined the relative priority your team will place on Interest Rate Risk (1=high priority, 6=low priority), you will need to select which ratio you will focus on. BANKdynamics offers you two selections:

**Net interest earnings at risk**

The goal is to have the lowest net interest earnings at risk as of the end of the of simulation (December 31, 2022). Net interest earnings at risk will be

measured be examining the sensitivity of the 12-month projection (simulation year 2023) given a 200bp shock to market rates. A rule of thumb limit for net interest earnings at risk is -10%. The average measurement is 7-8%.**Economic value of equity (EVE) at risk**

The goal is to have the lowest EVE at risk as of the end of the simulation. EVE at risk will be measured be using a balance sheet shock analysis (+/- 200bp) as of December 31, 2022 (the end of the simulation). A rule of thumb limit for EVE at risk is -20%. The average measurement is 12-13%.