1. Introduction

IRRBB arises from changes in interest rates that can affect the economic value of a bank's equity (EVE) and its net interest income (NII). Managing IRRBB is essential to ensure stability in a bank's capital and earnings. The Basel Committee on Banking Supervision (BCBS) provides detailed principles and regulatory expectations for IRRBB, emphasizing robust risk identification, measurement, and mitigation. The interest-rate risk can be divided into three different subcategories, which can be modeled and measured separately.

1.1 Gap Risk

Gap risk describes the risk arising from imbalances or “gaps” between interest-rate receivables and payables at different points in time from an income perspective as well as shifts in the balance sheet structure due to their revaluations. A change in the yield curve potentially influences the cashflows of positions held in the banking book and consequently also their valuation. In the gap report different maturity buckets are evaluated to avoid potential risks resulting from gaps between the asset and liability side.

1.2 Behavioural Risk

Behavioral risk is present when customers act upon changes in the interest-rate structure and alter their financial behavior. Starting from simple cash deposits ranging to more complex credit structures with prepayment options, bank customers usually act upon interest rate changes to optimize their financial well-being. Sometimes this behavior can be eruptive, sometimes rather sluggish and sometimes quite irrational. Special models arising from the field of behavioral economics and historical observations can help to estimate the impact of interest rate changes on the reaction of clients.

1.3 Base Risk

The Base is defined as the spread between reference rates which different financial products price off. Hence base Risk emerges, when two financial products are held in the same tenor and the base changes in a way that impacts the net interest income negatively.

Table 1. Exemplary gap report

3. Calculation of Economic Value of Equity (EVE) and Net Interest Income (NII)

3.1 Economic Value of Equity (EVE)

EVE measures the long-term impact of interest rate changes on the bank's economic value, assuming a run-off balance sheet. Even though the financial products held in the banking book usually mark as ‘held to maturity’ rather than ‘marked to market’, changes in interest rates affect their value. All future cash flows from assets, liabilities, and off-balance-sheet positions are mapped by repricing date. The present value of each cash flow is then discounted using a riskfree rate or a risk-free rate including commercial margins, in accordance with the bank’s reporting policy The procedure for estimating the impact of interest rate changes on the Economic Value of Equity is the following:

• Cash Flow Estimation: Identify interest rate-sensitive cash flows from assets, liabilities, and off-balance sheet items and create the gap report by categorizing them into buckets based on their time of repricing.
• Discounting: Apply discount rates to estimate present values of the netted sum of items in the various repricing buckets and accumulate them. Use either a risk-free curve or include commercial margins where appropriate.
• Scenario Analysis: Calculate EVE under various prescribed interest rate shock scenarios, including parallel shifts and yield curve changes. Comparing the scenario EVEs with the EVE calculated using current market conditions yields a change in EVE for every scenario. This change in EVE (ΔEVE) is the regulatory focus: it’s the difference between EVE under baseline and shocked scenarios.
• Evaluation of Results: Evaluate if the impact of the different scenarios on the EVE is within the tolerated risk bounds of your institution.

3.2 Net Interest Income (NII)

In contrast to EVE, NII evaluates the short- to medium-term effects of rate changes on a bank’s earnings. It assumes a rolling 12-month horizon, assuming a constant balance sheet where maturing assets and liabilities are replaced by similar new business. It measures the difference between projected interest income and expected interest expense from all rate-sensitive assets and liabilities under both baseline and shock scenarios. This approach also uses the gap report plotting out the expected incomes and expenses, collecting them in buckets corresponding to their time of repricing and netting them.

• Projection of Income and Expenses: Firstly, the expected cash inflows and outflows based on current interest rates are estimated. It is assumed, that the balance sheet positions are constant over the period considered. Based on this data, a gap report is created that represents the mismatch or gap between interest income and interest expenses. Again, these positions are divided into their respective repricing buckets.
• Scenario Analysis: Compute ΔNII under predefined shock scenarios in which the interest rate curves are subject to parallel shifts, steepening and flattening that are assumed to be sustained for twelve months. For each shock scenario a separate gap report is created. The “gap” amount between inflows and outflows of every maturity bucket is multiplied by the respective rate shock and multiplied again with the share of time within the twelve months observation period for which every specific bucket is affected by the interest rate shock. E.g. for the 3-month maturity bucket only the nine months after its repricing are relevant for the predefined 12-month observation window.
• Evaluation of Results: The key regulatory measure is the change in NII. Evaluate the impact of the various interest rate shocks on the interest income for the predefined maturity buckets and calculate the difference to the baseline scenario.

3.3 Comparison of the Two Perspectives

In summary both methods give a different perspective on the underlying question: “What impact does a change in interest rates have on the banking book?” While the EVE focuses on the balance sheet and therefore is rather farsighted, covering the full life cycle of the observed instruments, the NII takes a complementary view on the income statement and uncovers potential liquidity issues in the upcoming months.

3.4 Behavioral Risk

Behavioral risk stems from uncertainties in customer behavior, particularly for products like non-maturity deposits (NMDs) and loans with optional prepayment features. Since contractual maturity may not reflect actual cash flow timing, regulators require specific modeling and governance approaches: Banks must develop data-driven behavioral models to estimate cash flows where customer actions may deviate from contractual terms. For NMDs, this involves segmenting deposits by customer and product type, identifying stable balances, and forecasting likely withdrawal patterns; for prepayable loans, it means estimating prepayment rates based on historical observations and behavioral economics models. This structured approach ensures that behavioral risks are transparently reflected in both EVE and NII calculations, using bank-specific data under regulatory oversight. 3.5 Basis Risk Regulators require banks to explicitly identify, measure, and manage basis risk as part of their regulatory guidelines for IRRBB. Basis risk occurs when assets and liabilities in the same maturity bucket reference different benchmark rates (e.g. EURIBOR vs. EONIA). Even if repricing dates align, shifts in these rate spreads can negatively impact both net interest income (NII) and economic value of equity (EVE). Banks must systematically map exposures to different reference rates across their banking book, segmenting cash flows by both maturity and the underlying rate index. In various scenario analyses, the effects of changes in the spread between these rates on NII and EVE are tested, even when repricing gaps appear neutral. In practice, this means banks stress-test their portfolios for basis movements alongside standard parallel or non-parallel rate shocks, that we have seen under the EVE and NII perspective.

4. Conclusion

Effective Interest Rate Risk in the Banking Book (IRRBB) management is vital for a bank's stability. By understanding and actively managing gaps, behavioral, and basis risks, banks can protect both economic value (EVE) and earnings (NII). Adhering to this regulatory framework ensures robust measurement enabling financial institutions to navigate interest rate fluctuations and safeguard their financial health.