Introduction

Since the early 1980s, American banks have been using ‘economic-value-of-equity’ (EVE) models to help measure and manage their banking-book interest rate risk (IRR). These models estimate the fair value of the institutions' financial instruments as a function of the current interest rate environment (the ‘base-case’ EVE). The modeller then specifies alternative stress scenarios, and estimates the resulting change from base-case EVE. This change is usually expressed as a percentage of the base-case estimate.

Banks develop and use internal EVE models to quantify and control their interest rate risk. For executive management and bank supervisors, a common benchmark interest rate scenario is an instantaneous plus/minus 200-basis-point shock to the current yield curve. That benchmark is typically used to set a risk limit, e.g., the banking-book IRR manager will tolerate an exposure of no more than 20 per cent of base-case EVE for the 200-basis-point shock.

Banking supervisors also have their own EVE models. The OCC uses these to estimate banks' exposure under a common set of assumptions, allowing peer comparisons. This provides a basis for supervisory actions against banks that have excessive exposures relative to industry norms.

For the middle management responsible for interest rate risk, EVE models are used for day-to-day management. For that purpose, the shocks are estimated in a comprehensive range, e.g., 10-basis-point increments up to the 100-basis-point shock, or whatever is deemed the maximum shock likely before the manager can react.