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 theregulatory approach to measuring bank exposure to interest rate risk in the banking book by focusingon assessment of the appropriate amount of capital banks should set aside against this specific risk. Wefirst discuss how banks might develop internal measurement systems to model changes in interest ratesand measure their exposure to interest rate risk that are more refined and effective than are regulatorymethodologies. We then develop a backtesting framework to test the consistency of methodology resultswith 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 theBasel Committee on Banking Supervision. It also provides useful insights for properly measuring theamount of capital to cover interest rate risk that is sufficient to ensure both financial system functioningand banking stability.