Maturity mismatch interest rate risk

[sahajiabhijit]

How maturity mismatch between retail loans and retail deposit result in interest rate risk.. which can be mitigated by using bucketing..i m not able to explain this point... Can any one help me to understand this point?

 

[QuantMan2318]

Dear @sahajiabhijit

This can be explained from multiple standpoints:

• Banks are involved in the business of maturity transformation, it is not possible for a Bank to fund all its loans with deposits of equal tenors, hence most often deposits of shorter maturities fund the longer duration loans
• Therefore, this mismatch causes various kinds of risk:
  • Interest Rate Risks
  • Liquidity Risks
  • Prepayment Risks
  • Basis Risks
• The most important component are the first two, IRR and Liquidity Risks
• When you fund the longer term loans which are illiquid and and are of higher interest rates with deposits of shorter maturity which are basically of a lower cost, you run the risk of loading the bank with Illiquid Assets that are not available when the times require it the most - in other words, the Banks will not have cash to tide over repayment of deposits or during times of crisis (Liquidity Risk)
• And, it will be the responsibility of the bank to refinance the deposit repayment, if the deposit rate for new deposit rises or the cost of funding the deposit rises, the banks cost of funding will increase and it will lower the Net Interest Margin (In addition, the existing loans will involve opportunity costs as they will be expensive in terms of lost additional revenue)

To tide over these risks, Banks basically assign a cost to the loan products on the basis of their maturity to ensure that there is no incentive to get involved in reckless financing, this cost is charged based on the base cost (based on market interest rates) of the loan as well as the liquidity profile on the basis of the period of time the loan can be expected to be with the bank as well as its repayment schedule (This will involve time buckets and associated interest rates)

In the same vein for deposits, income is assigned to them on the basis of the stickiness of funds, in other words, for Longer term deposits, higher interest rates are given to them as opposed to lower rates for hot money deposits

Similarly charges are assigned for prepayment risks, so that the banks are protected when interest rates fall

Hope this clarifies to some extent