Measuring banks’ interest rate risk: issues arising from regulatory and internal methodologies

This research contributes to the development of sound risk management practices to estimate the interest rate risk in the banking book (IRRBB), given the current regulatory framework and the debate originated by the recent revision proposal. Appropriate estimates of internal capital to cover potential losses from IRRBB are crucial for both banks and supervisory authorities. In addition to the current regulatory methodologies, we propose two alternative methods to model interest rates changes that are based on historical and Monte Carlo simulations and can be easily adopted by banks within their internal measurement systems. We also develop a backtesting procedure to assess the effectiveness of IRRBB estimates, based on whether and to what extent they are both consistent with actual bank riskiness and adequate from a prudential perspective. Referred to a representative sample of Italian banks over the period 2006-2013, our empirical analysis provides useful insights for properly assessing a bank internal capital in order to ensure financial system functioning and banking stability.