macroresilience

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Maturity Transformation and the Yield Curve

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Maturity Transformation (MT) enables all firms, not just banks to borrow short-term money to invest in long-term projects. Of course, banks are the most effective maturity transformers, enabled by deposit insurance/TBTF protection which discourages their creditors from demanding their money back all at the same time and a liquidity backstop from a fiat currency-issuing central bank if panic sets in despite the guarantee. Given the above definition, it is obvious that the presence of MT results in a flatter yield curve than would be the case otherwise (Mencius Moldbug explains it well and this insight is implicit as well in Austrian Business Cycle Theory). This post tries to delineate the exact mechanisms via which the yield curve flattens and how the impact of MT has evolved over the last half-century, particularly due to changes in banks’ asset-liability management (ALM) practices.

Let’s take a simple example of a bank that funds via demand deposits and lends these funds out in the form of 30-year fixed-rate mortgages. This loan if left unhedged exposes the bank to three risks: Liquidity Risk, Interest Rate Risk and Credit Risk. The liquidity risk is of course essentially unhedgeable – it can and is mitigated by for example, converting the mortgage into a securitised form that can be sold onto other banks. But the gap inherent in borrowing short and lending long is unhedgeable. The credit risk of the loan can be hedged but often is not, as compensation for taking on credit risk is one of the fundamental functions of a bank. However, the interest rate risk can be and often is hedged out in the interest rate swaps market.

Interest Rate Risk Management in Bank ALM

Prior to the advent of interest rate derivatives as hedging tools, banks had limited avenues to hedge out interest rate risk. As a result, most banks suffered significant losses whenever interest rates rose. For example, after World War II, US banks were predominantly invested in fixed rate government bonds they had bought during the war. Martin Mayer’s excellent book on ‘The Fed’ documents a Chase banker who said to him in reaction to a Fed rate hike in 1952 that “he never thought he would live to see the day when the government would deliberately make the banking system technically insolvent.” The situation had not changed much even by the 1980s – the initial trigger that set off the S&L crisis was the dramatic rise in interest rates in 1981 that rendered the industry insolvent.

By the 1990s however, many banks had started hedging their duration gap with the aim of mitigating the damage that a sudden move in interest rates could do to their balance sheets. One of the earlier examples is the case of Banc One and the HBS case study on the bank’s ALM strategy is a great introduction to the essence of interest rate hedging. More recently, the Net Interest Income (NII) sensitivity of Bank of America according to slide 35 in this investor presentation is exactly the opposite of the typical maturity-transforming unhedged bank – the bank makes money when rates go up or when the curve steepens. But more importantly, the sensitivity is negligible compared to the size of the bank which suggests a largely duration-matched position.

In the above analysis, I am not suggesting that the banking system does not play the interest carry trade at all. The FDIC’s decision to release an interest rate risk advisory in January certainly suggests that some banks are. I am only suggesting that if a bank does play the carry trade, it is because it chooses to do so and not because it is forced to do so by the nature of its asset-liability profile. Moreover, the indications are that many of the larger banks are reasonably insensitive to changes in interest rates and currently choose not to play the carry game ( See also Wells Fargo’s interest rate neutral stance ).

What does this mean for the impact of MT on the yield curve? It means that the role of the interest rate carry trade inherent in MT in flattening the yield curve is an indeterminate one. At the very least, it has a much smaller role than one would suspect. Taking the earlier example of the bank invested in a 30-year fixed rate mortgage, the bank would simply enter into a 30-year interest rate swap where it pays a fixed rate and receives a floating rate to hedge away its interest rate risk. There are many possible counterparties who want to receive fixed rates in long durations – two obvious examples are corporates who want to hedge their fixed rate issuance back into floating and pension funds and life insurers who need to invest in long-tenor instruments to match their liabilities.

So if interest rate carry is not the source of the curve flattening caused by MT, what is? The answer lies in the other unhedged risk – credit risk. Credit risk curves are also usually upward sloping (except when the credit is distressed) and banks take advantage by funding themselves at a very short tenor where credit spreads are low and lending at long tenors where spreads are much higher. This strategy of course exposes them to the risk of credit risk repricing on their liabilities and this was exactly the problem that banks and corporate maturity transformers such as GE faced during the crisis. Credit was still available but the spreads had widened so much that refinancing at those spreads alone would cause insolvency. This is not dissimilar to the problem that Greece faces at present.

The real benefit of the central bank’s liquidity backstop is realised in this situation. When interbank repo markets and commercial paper markets lock up as they did during the crisis, banks and influential corporates like GE can always repo their assets with the central bank on terms not available to any other private player. The ECB’s 12-month repo program is probably the best example of such a quasi-fiscal liquidity backstop.

Conclusion

Given my view that the interest rate carry trade is a limited phenomenon, I do not believe that the sudden removal of MT will produce a “smoking heap of rubble” (Mencius Moldbug’s view). The yield curve will steepen to the extent that the credit carry trade vanishes but even this will be limited by increased demand from long-term investors, most notably pension funds. The conventional story that MT is the only way to fund long-term projects ignores the increasing importance of pension funds and life insurers who have natural long-tenor liabilities that need to be matched against long-tenor assets.

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Written by Ashwin Parameswaran

April 4th, 2010 at 5:54 am

10 Responses to 'Maturity Transformation and the Yield Curve'

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  1. Very fine post – and an unusually informed one compared to the blogosphere standard for this subject as it pertains to actual banking operations.

    I’ll add that the most important decision facing a commercial bank ALCO on interest rate risk policy is the determination of a “benchmark” for the duration of common equity. This becomes an assumed “hedging” profile around which other hedging or positioning is partially determined. The same holds for the treatment of certain other non maturity items of indeterminate duration (e.g. the book value of real estate).

    Thus, assumptions become a major partial determinate of the consolidated risk position. Different banks use different assumptions.

    Moreover, banks distinguish between net interest margin risk and economic value risk. These risks work in opposite directions. A bank that shows a net profile of long duration assets against equity has low margin and high value risk. A bank that shows short duration assets against equity has the opposite risk profile.

    Commercial banks have risk limits that cover both types of exposure and recognize the trade-off between the two.

    Your themes of active management and generally conservative positioning are accurate as well. Moreover, it is quite possible for customer profiles to deliver positions to banks that result in short duration assets and long duration liabilities – e.g. a customer expectation of falling rates. Given the general interest rate environment, this has been a cyclical and secular factor since 1990. It has been easy for some poorly managed banks to get caught fighting the last war at various times over this full period.

    Nevertheless, the FDIC’s interest rate advisory note was most prudent at this juncture.

    Also, the typical blogosphere presentation of maturity transformation fails to distinguish between liquidity transformation and interest rate risk transformation. These are two intersecting but different profiles.

    And more might be said about the distinction regarding liquidity maturity transformation as between commercial banks and investment banks. Bear Stearns definitely had a problem with liquidity maturity transformation. That said, you make a very interest point about credit spread mismatches.

    And your point about pension/insurer demand for long duration is spot on.

    JKH

    6 Apr 10 at 2:31 am

  2. JKH – Thanks for the added detail on bank ALM. The intention of my post was to challenge the notion that banks are lemmings at the mercy of the markets and the central bank. This may have been true 50 years ago but it’s not even close to being true now. Even before a liquid interest rate derivatives market came into existence, ALM was an active function that aimed at mitigating the market risk exposure of a bank.

    On your point of customer profiles delivering the inverse position to a bank, the Banc One case I refer to above is an example of that – their assets were primarily floating-rate loans and their liabilities were longer-term CP or deposits with “sticky” interest rates. In fact, they use derivatives to flip this exposure because their stockholders expect their balance sheet to be “liability sensitive”. This is similar to why mining companies don’t hedge their commodity price exposure because their stockholders invest in the firm as a synthetic long commodity play.

    This brings me to another point which I’ve hinted at in the post – the conventional story of MT being essential because borrowers prefer long-term fixed and lenders prefer short-term floating is too simplistic. Most corporates have significant floating-rate liabilities – it is in fact the investors who prefer fixed-rate issuances which the corporate swaps into floating. This rush to swap into floating is partially responsible for swap spreads being negative in the long end (demand to receive fixed and pay floating on swap results in swap rates going down). And the increased presence of pension funds/life insurers means that there is significant demand for long duration.

    As you mention, a lot of the confusion comes from conflating the liquidity profile with the interest rate risk profile.

    admin

    6 Apr 10 at 12:14 pm

  3. Well written. You hit the nail on the head.

    David Merkel

    6 Apr 10 at 11:04 pm

  4. I do not think that the Austrian view of bank operations is an accurate one. The Austrian view is that banks take short term deposits, and then lend those out as long term loans (the evil “maturity mismatch” they always whine about).

    In practise, banks make loans, which then create the deposits. They are expanding both sides of their balance sheet, and it is not “maturity mismatching” at all in austrian sense. I do not think austrians even know what a balance sheet is.

    It is true of course that a bank manages its net maturity position as it may prefer to be long reserves more of time and reduce chance it needs to borrow at interbank market, but again, this has nothing to do with austrian view or their concpetion of banking system (which is simply wrong)

    zanon

    21 Apr 10 at 1:02 pm

  5. [...] increase in long-end interest rates? The answer is No – as I explained in a previous post, the most significant proportion of the difference between long-end and short-end rates comes from [...]

  6. We need an update on this.

    http://blogs.forbes.com/investor/2010/11/16/bernanke-to-banks-unwind-your-carry-trades-now/

    Still think the interest rate risk is gone? Also, don’t the regional banks without interest rate swaps in place matter? I understand they’re not a large fraction of all transactions in terms of value, but consumers might not care.

    Michael F. Martin

    18 Nov 10 at 2:54 pm

  7. I stand by the analysis for the large banks. Regional banks are another matter – there’s hardly any public data out there for any of us to take a call on them.

    Even for the large regionals, they probably could swap it out and whatever exposure they’re running is probably overestimated in my opinion (but this is just a hunch).

    The Forbes article is not very convincing – I think it has a little too much faith that QE2 will actually raise inflation!

    Ashwin

    18 Nov 10 at 3:08 pm

  8. One of the best posts I’ve read this year. Very well structured. Insightful. Brilliant.
    Thanks

    jj

    18 May 11 at 8:19 am

  9. jj – Thank you!

    Ashwin

    18 May 11 at 10:55 am

  10. [...] to save long-term and requirements by households and firms for long-term savings. Banks themselves largely hedge the maturity mismatch in their portfolios, outsourcing much of the whatever risks arise from any [...]

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