Does Prudential Regulation Contribute to Effective Measurement and Management of Interest Rate Risk? Evidence from Italian Banks

This paper contributes to prior literature and to the current debate concerning recent revisions of the regulatory approach to measuring bank exposure to interest rate risk in the banking book by focusing on assessment of the appropriate amount of capital banks should set aside against this specific risk. We first discuss how banks might develop internal measurement systems to model changes in interest rates and measure their exposure to interest rate risk that are more refined and effective than are regulatory methodologies. We then develop a backtesting framework to test the consistency of methodology results with actual bank risk exposure. Using a representative sample of Italian banks between 2006 and 2013, our empirical analysis supports the need to improve the standardized shock currently enforced by the Basel Committee on Banking Supervision. It also provides useful insights for properly measuring the amount of capital to cover interest rate risk that is sufficient to ensure both financial system functioning and banking stability.