Modelling Italian Bank Retail Interest Rates Under an Error Correction Framework : Implications for Banking Risk Management

The treatment of demand loans and deposits is crucial in measuring a bank's actual exposure to the interest rate risk in the banking book. The repricing gap model, the most popular approach to measure this kind of risk, is based on a maturity/repricing schedule, according to which interest-sensitive assets, liabilities, and off-balance sheet positions are allotted into different time bands, based on their maturity or time remaining to their next repricing. Due to the possibility for the depositor (borrower) to withdraw (drain) the money without any notice, these accounts should be allotted in the “at sight” time band. Nevertheless, empirical evidence shows that bank interest rates are characterized by a sluggish and sometimes asymmetric reaction to changes in the market rates. To overcome this limit, we first develop an error correction model to study the interest rate pass-through for the Italian banking system, with specific regard to the retail bank interest rates on the sight deposits and on the overdraft accounts; then, we translate the response dynamic of the interest rates of these two items into coefficients that we use to allot them in the regulatory maturity ladder, thus making the distribution process much more realistic