How does Funding Maturity Gap affect Banks?

What is the Funding Maturity Gap?

  • A bank funding substantial long term assets like a fixed-rate mortgage or long term infrastructure loans by short-term liabilities like deposits or commercial papers is a classic case of maturity gap which is also known as maturity mismatch or asset-liability mismatch.
  • To put it in simple terms, a maturity mismatch (gap) occurs when the tenure of maturing loans (which are on the assets side of the balance sheet of a bank) does not match the tenure of the sources of funds on the liabilities side.

Consequences of Funding Maturity Gap

The two main risks of funding maturity gap for the banks are LIQUIDITY RISK and INTEREST RATE RISK

Liquidity Risk

  • The liquidity risk in the banking book can also be called funding liquidity which arises from mismatches in the maturity pattern of assets and liabilities. Funding liquidity risk refers to the risk that a company will not be able to meet its short-term financial obligations when due or refinance its debt.
  • A bank having good asset quality, strong earnings and sufficient capital may fail if it is not maintaining adequate liquidity. Now, why would a bank with good asset quality, strong earnings, and sufficient capital still fail due to liquidity crunch?

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Consider the following example –

  • Let’s assume X Bank Ltd. has given a long term infra loan (10 years) which is funded by issuing a 1-year certificate of deposit. Now, what will happen at the maturity of CD? Since the bank has given a 10-year loan, the bank would face funding liquidity risk because the liability would require cash outflow while the asset would not have earned any cash flow (except the possible interest on the loan). The bank may roll over the maturing CD. However, the need to roll over maturing CD generates the risk that investors may not be willing to refinance maturing CD. This risk is often called roll-over risk. In this case, the bank needs to find financing elsewhere to repay maturing CD which results in two – Higher transaction costs 2. Higher interest rate which will impact a bank’s profitability (Net interest margin).
  • Even if X Bank Ltd. succeeds in rolling over CD, investors may not be willing to lend every time since the bank has to roll over multiple times to refinance. If the bank is unable to roll over or refinance, the bank may have to sell off its assets to repay investors. This may result in deterioration of asset quality and deterioration of capital affecting return on assets (ROA) and capital adequacy ratio (CAR) ultimately weakening of balance sheet. This also creates a reputational risk in the market where a bank may have difficulty in accessing the credit market to borrow which results in defaults and bankruptcy which was exactly happened with companies like DHFL and IL&FS.

Interest Rate Risk

How do changes in interest rates impact the bank’s profitability in case of an asset-liability mismatch?

  • Take, for example, a bank that funds with certificates of deposit that have a maturity of one year. This bank makes mortgage loans with a maturity of 15 years. Should interest rates rise in the future, the bank would face a decline in its expected income. Why? The monthly inflows of cash to the bank from the mortgages are fixed for 15 years. When the certificates of deposit come due before the mortgages, the bank will have to pay more to receive funding so cash flows out of the bank will increase.
  • Now, even if the bank funds mortgage loans with fixed deposits of say two years, the bank will have to re-price its deposits frequently, which have a faster turnover compared to the long-maturing loans. Banks are constrained by the fact that the deposit rates have to be in sync with the market rates. If the market rates were lower, it would become difficult to attract depositors, which means that sources of funds may well dry up. This poses liquidity risk as well because they have to repay the depositors faster but their funds are caught up in long-term assets. The ultimate impact of all this will be on the net interest margins of a bank.

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How do changes in interest rates impact the bank’s net worth in case of an asset-liability mismatch?

  • Changes in interest rates also affect the economic value of a bank’s equity (Net worth). When interest rates change, the present value and timing of future cash flows change. This, in turn, changes the underlying value of a bank’s assets, liabilities, and off-balance sheet items and hence its economic value.
  • Consider a bank with INR 80 million in assets having an average maturity of 10 years and a duration of 6 years, INR 60 million of it in liabilities having an average maturity of 5 years and duration of 3 years and INR 20 million in equity capital. If the market interest rate increases by 100bps, the asset value of the bank will drop to INR 75.2 million while the value of liabilities falls to INR 58.2 million. The change in net worth for this bank would be negative 3 million, implying that equity capital is worth only INR 17 million.

Case Study: How Asset Liability Mismatch resulted in Bankruptcy of DHFL

  • A housing finance company DHFL disburses loans that have repayment periods of about 20 years. But borrowing at cheap rates comes with a caveat — DHFL can’t take 20 years to pay back the loans. DHFL borrows funds with short repayment periods by issuing a Commercial Paper (CP).
  • Once the repayment period is complete and the CP is due after 6 months, the company simply issues a new set of commercial papers and borrows once again. And again. This way the company can keep “rolling over” funds to meet their short-term obligations.
  • How long DHFL can continue this? When DHFL ran out of liquidity, out of cash, it started defaulting on CP and other obligations. Ultimately, RBI decided to intervene and was taken to the bankruptcy court.

Author: Keval Shah

About the Author: Keval Shah is a Chartered Accountant and FRM 2 Candidate. He is passionate about financial markets and loves to play Chess.

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