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.
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.