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Exposing the Severity of Tenor Mismatch: From Repricing to Basis risk

ARTICLE| Tue May 16 2023

Most banks collect money in the short term and use the resulting funds to make loans in the long term. But managing the ‘tenor mismatch’ between these assets and liabilities can be a challenge for the treasury, especially in times of market volatility and fluctuating interest rates – threatening liquidity, solvency and revenue.

To safeguard against the tenor or maturity mismatch risk, banks needs to know how much are they earning from the tenor mismatch. Second, the volatility attributed to tenor mismatch, which is driven by market movements and the customer.

If there is a shift in interest rates, tenor mismatch poses two implicit risks for banks. The first is for the bank’s solvency, its economic value. In a worst-case scenario, an especially high market rate hike can send a bank into bankruptcy if it has relied too much on tenor mismatch for capital. For example, if an institution is using too much short-term money to make long-term loans, and suddenly needs to pay a higher rate of interest to depositors, the loss of margin can seriously eat into their equity.

However, if the bank is well capitalized it doesn’t matter too much, in terms of solvency at least, where interest rates go.

Secondly, if an institution’s main line of business is retail banking, the loss of interest income from a rate hike will have a significant impact on its bottom line, which itself can be an important source when it comes to generating additional equity. And over time, thanks to interest rate movements, customers may look to switch products or move off the balance sheet altogether, to get better rates elsewhere.

This is an important issue at the moment for many banks. Saving deposits have begun to account for the bulk of their liabilities due to the continued risk aversion of bank customers – and without these deposits on its books, a bank may have to look for other means of funding. To retain customers and their funds, then, banks may need to raise the interest rates they pay on deposits. Any increase paid to the customer that’s not mirrored in the market rates will effectively reduce the bank’s income. From a bank’s perspective, this is considered as the ‘basis risk’.

If the reality in terms of what is paid to the client differs from the reality on the interest rate markets, this leads to massive revenue pressure, particularly if the bank relies heavily on saving deposits for funding.

As well as carrying risks for solvency and revenue, tenor mismatch has a close association with liquidity risk. Banks are, after all, structurally illiquid, and there is always the chance that, in times of crisis, people will run in their hoards to a bank to take out their money. Again, an over- reliance on short-term deposits for funding could make such a run on liquidity disastrous for a bank.

Bank treasuries need to effectively use funds transfer pricing (FTP) to isolate the risks posed by tenor mismatch, and hedge them using interest rate derivatives. Combining FTP with a solid asset liability management framework will help today’s treasurers protect the whole balance sheet.