Evaluating the validity of regulatory interest rate risk measures – a simulation approach

This paper assesses the validity of changes in the economic value of equity (EVE) and the net interest incom (NII) as regulatory risk measures for a bank’s interest rate risk in the banking book. We develop a novel simulation approach and evaluate the measures retrospectively from the time of a bank’s default as a consequence of stressed market interest rates. Our results show that both measures significantly indicate inherent interest rate risk. We find the EVE to be a robust and conclusive risk measure, whereby the results concerning the NII measure are against the economic intuition, less robust, and might depend on the prevailing level of interest rates. Further, we derive critical values of quarterly changes in risk measures serving as indicators for substantial risk levels. Our findings validate the EVE and contribute to a thorough understanding of the risk measures.