Nexus Between Interest Rate Risk and Economic Value of Equity of Banks

Abstract

This analytical study looks to provide recommendations to the banking sector on different policies and regulations by examining certain aspects of the Basel III accord, which was designed to manage specific operational, capital and market risks of banks. A review of extant literature reveals that only a few papers have been written on simulation-based approaches, using basis and re-pricing risks. We look to connect this as a source while attempting to define and measure the impact of interest rate risk (IRR) on the economic value of equity (EVE) of banks. We propose to use the driver—driven method, wherein interest rate shocks are derived through prime lending rate (PLR) for the period of 2016–2019 in the context of India. Monte Carlo Simulation and OLS regression was performed to predict the IRR; Granger causality was used to examine the cause and effect relationship; the impulse response function (IRF) was used for sensitivity analysis; and the vector error correction model (VECM) technique was used for co-integrating relationships. Notably, the EVE movement caused due to shocks in interest rates had to be traced as it envisages probable EVE losses. Importantly, our study is among the first few to show the relationship between IRR and EVE of banks, especially after the deregulation of Indian banking sector.