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Wednesday, September 23, 2015

Banks Borrowing Short And Lending Long

Now that there appears to be a chance that the Fed could possibly hike rates by at least a little bit within a few months (maybe), there is increasing interest on what the effects would be on the economy. One area of contention is the effect on the banking system. In my view, you will need a microscope to find the direct effects on banking system profitability (I ignore any macroeconomic feedback from rate hikes, which are an entirely more awkward question). That is not to say that enterprising bank CEOs would not seize upon blaming the Fed for their own failures of leadership. It appears that the belief that the level of interest rates affect bank profitability are based upon inapplicable historical analogies, as well as blurring the distinction between liquidity risk and interest rate risk.

The academic J.W. Mason did an interesting piece of analysis in "Interest Rates and Bank Spreads." He was responding to an internet debate, which I am not directly addressing. In Mason's article, he crunches the published average bank interest rate charges (both lending and borrowing), and shows that they are consistent with a relatively steady spread regardless of the level of interest rates. Luckily, I do not have to download the data and analyse it myself; he did the work for me. Instead, I want to explain why we should expect this spread behaviour to occur, and an interested reader can then consult his analysis to see that the theory matches observed behaviour.

Why Take Duration Risk?

It is certainly true that banks "lend long and borrow short," that is, they own assets with longer average maturities than their liabilities. This is then converted into believing that banks have a perpetual duration* mismatch on their balance sheets, and so they are exposed to interest rate risk. This is augmented by the experience of the early 1990s, which I discuss at the end of this article. Within the economics community, that early 1990s experience has entrenched itself in the received wisdom, and no attempt has been made to keep up with developments within the financial system.

In practice, vanilla interest rate and currency risks are the only risks that can be accurately measured by risk management tools. As soon as we start to incorporate credit, equity or optionality risks, risk models are pretty much an elaborate exercise in validating the dictum "garbage in, garbage out." Regulators and bank executives can monitor the duration risk of a bank quite accurately, and they keep the risk "small" relative to the size of bank.

Of course bank treasury units are not major players in interest rate trading. The risk limits they have are absolutely large when compared to smaller players in fixed income; but even so, their risk is small relative to their parent bank's balance sheet.

Although it is clear that regulators would want banks to be duration neutral, one might cynically think that bankers would want to get around the stodgy regulators and secretly run duration risk. However, this does not take into account real world behaviour. I started in finance in 1998, and during that period, the overwhelming consensus was that bond yields were always "too low." As a result, investors probably underperformed in aggregate versus their benchmarks on the basis of their interest rate exposure (but they tend to bailed out by their credit carry positions). Therefore, bank executives either agreed with their economists and did not want to be long duration, or else they realised that interest rate forecasters are at best unreliable. As a result, the best course of action is neutralise interest rate risk and concentrate on whatever the bank's "core competencies" are supposed to be.

Interest Rate Risk Versus Liquidity Risk

The "borrowing short/lending long" practices of banks do not expose them to interest rate risk, rather liquidity risk. Unfortunately, academics cannot model liquidity risk with a random process, and so they really have no way of grasping the concept. People who believe in perfectly liquid markets in all assets (including forwards out to infinity) where the prices are set by a single perfectly rational household are going to have a very hard time visualising liquidity risk.
  • If you buy a 10-year bond at 3%, and are guaranteed to fund it by rolling 3-month loans every 3 months, your trade will be profitable if the average funding cost is less than 3% over the next 10 years, and unprofitable if the average is above that (assuming no default). These profits or losses are an interest rate risk, and it was standard economic/financial models deal with.
  • If you buy a 10-year floating rate bond which pays a of 3-month LIBOR +1%, and you are guaranteed rolling funding, your position will be profitable if the average funding cost is less than 3-month LIBOR + 1%. Your risk in this case is the possibility of your floating rate funding costs rising, presumably due to a weakening of your balance sheet. This could be termed funding cost risk. A bank that is worried about funding cost risk is a bank that is about to go out of business; you cannot survive as a financial intermediary if your cost of funding is higher than what you are lending at. As a result, this is not normally a topic of discussion.
  • If you buy a 10-year floating rate bond that pays 3-month LIBOR+1% by borrowing for 3 months, you are exposed to the possibility that your lender will not renew the loan. Since the bond will not have matured, you will need to find a means of paying back the original lender. You might be forced to sell the bond in the market, quite possibly at a distressed price. This risk is known as refinancing or liquidity risk. 
Only the first case (interest rate risk) is directly affected by changes to the policy rate. (One might argue that rate hike cycles can trigger a liquidity crisis, but that is debatable.)

How Banks Operate

As always, the real world is complicated. But as a simplification, you can view a bank as being a combination of a number of different lending businesses, with a treasury acting to coordinate activity and manage aggregate interest rate risk.

Each unit has a cost of funding (which depends upon the riskiness of its assets), which it is charged, and holds assets. If those assets have a long duration, the unit creates an internal swap with the bank treasury to convert the asset to a floating rate bond plus a spread. (Other than for units that routinely operate in the capital markets, this presumably would not be an explicit swap. Rather it would be an accounting convention that acts as the economic equivalent of a swap. I refer to it as a swap to give the underlying financial market equivalent of the accounting convention.) This way both sides of the lending units' balance sheets are both floating rate, and immunised against policy rate changes.

The treasury ends up facing all of these "internal swaps," and it then has to manage the aggregate risk position of the bank. If the lending units own a lot of assets with fixed interest rates, the Treasury will end up with an unbalanced duration position. It will need then to trade with other fixed income investors in order to balance it's (and the aggregate bank's) books.

It can do this by:
  • issuing term deposits;
  • using swaps and futures;
  • issuing fixed coupon bonds or preferred shares;
  • taking a small amount of proprietary trading risk.**
This means that only the Treasury is managing aggregate interest rate for the bank. It would make no sense to have one lending unit going massively long duration, and another going short with the net effect of the two bets balancing out. If interest rates moved, one group or the other would be successful (and paid bonuses), while the bank in aggregate would make no money on interest rates. By centralising interest rate risk at the treasury unit, it is clear who is responsible for interest rate risk management.

The data shown in J.W. Mason's post are consistent with this type of operating procedure, in which interest rate risk is largely hedged out.

Post-Script: What About The Early 1990s?

The early 1990s cycle saw the Greenspan Fed keeping interest rates as "unsustainably" low interest rates as a means of allowing banks to rebuild their balance sheets after previous misadventures. Since the level of rates was presumably affecting bank profitability, it is clear that banks then did not have the duration of their liabilities and assets matched.

As this affected the level of the policy rate, this greatly impressed monetary economists, and so this episode is burned into their memories. As a result, this mechanism ("low interest rates are good for bank net lending spreads") is kept in mind.

However, they did not notice the Great Bond Bear Market of 1994. A few firms blew up when interest rates where "renormalised," and it scarred a generation of financial market participants. (It possibly explains why senior people in finance are dedicated bond bears.) At the same time, advances in digital computing allowed for widespread risk measurement. (Before 1994, it in unclear how many non-specialists even understood what duration was, never mind having the ability to measure the DV01 of a swaps book.) As a result, regulators and the banks themselves clamped down on interest rate risk, leading to the environment that I described above.


* Duration is a measure of the sensitivity of an asset's price to changes in interest rates. A bond with a higher ("longer") duration will have a greater percentage loss in value than one with a lower duration, if the yields on both bonds increase the same amount. Increasing the maturity of a bond will increase its duration, all else equal. (A bond could have a lower duration than a bond with a closer maturity date, if its coupon was higher.)

** In the United States, the residential mortgage market is somewhat unusual in that it features long-term fixed interest rates, where the borrower can prepay with little penalty. This creates a hard-to-model optionality in residential mortgages. To a certain extent, the banks can offload that optionality onto the bond market by securitising the loans into mortgage-backed securities (MBS). However, my guess is that many smaller banks would not attempt to deal with the optionality embedded within mortgages that are left on their balance sheet; it is unclear which business unit within the bank would face the optionality.

 (c) Brian Romanchuk 2015


  1. Originally I had the naive layman's view of a flattening yield curve being a vise that squeezed net interest margins for banks. A view challenged by JW Mason's piece, upended by what I found from the FDIC on the topic ( and now thoroughly dislodged by your further explanation.

    So my question then becomes, if the naive yield curve net interest margin story isn't the answer, what is it then that has so many big bankers clamoring for rate liftoff? What book are they talking?

    1. It's just the conventional bias towards "hard money." Michal Kalecki wrote about that, and the article by JW Mason I linked discusses the political economy side of the debate. I might discuss that later, but I just wanted to focus on the technical, banking part of the discussion.

      As Keynes famously noted, bankers strive to follow other bankers. And bankers' views about monetary economics are pretty much unchanged since Keynes' day.

  2. A traditional bank, at any point in time, would hold a portfolio of loans with relatively fixed expected interest income, and would issue a mix of equity and debt with expected dividend and interest rate payments. Since bank liabilities mature sooner than long term assets an increase of money market interest rates should temporarily reduce the net interest margin of the aggregate bank sector. To avoid this loss the aggregate financial sector would have to put the charge to another sector of the economy via derivative contracts or public policy when an adverse change in interest rates occurs.

  3. "If those assets have a long duration, the unit creates an internal swap with the bank treasury to convert the asset to a floating rate bond plus a spread. "

    Could you run up a worked example of that concept. I can't quite visualise it.

    1. I should probably have drawn up a diagram. I might be able to do that later.

      Let's assume the lending unit creates a loan which is the equivalent of a 5-year bond, with a fixed interest rate of 3%. What is done is that an "internal swap" is created, between it and the treasury Assume that the 5-year swap rate (which is observed in the market) is 2%.

      The treasury would create an "internal swap" of 2%; the lending unit pays the treasury 2% fixed, while the treasury pays the lending unit LIBOR. For the lending unit, the net interest received is LIBOR +1% (3%-2%), which means that it is now receiving a floating rate plus a spread.

      However, the Treasury is paying LIBOR, and receiving fixed. This is the equivalent to a levered long bond position. It has to balance its books. It could do this by taking on an offsetting swap with a counterparty, or by doing something like issuing a 5-year fixed bond. This has the effect of balancing the total bank's interest rate exposure.

      Since all of the other units are assumed to have no interest rate exposure, the net internal exposure of the treasury is the true economic exposure of the aggregate bank.

      In reality, banks do not hedge each exposure individually. Additionally, I do not think that they would structure the transaction as a swap, rather they would use an accounting convention which ends up being equivalent. They would be charged a floating cost of funding, and assets would be accounted for on a floating rate basis. (I worked for a fund manager, and we used internal swaps as each fund had an independent profit & loss account.)

    2. "It could do this by taking on an offsetting swap with a counterparty"

      Who would be the counterparty and what position are they trying to hedge by taking the other side?

    3. And thanks for the explanation. I've got it straight in my head now.

    4. A typical counterparty would be a pension fund (or insurance co) that wants duration to match its liabilities. It can receive fixed from the bank, creating a synthetic levered bond position. It could then sell one of the bonds it was previously holding to generate duration, and invest in something that the firm believes will offer a higher return (equities, real estate...).

  4. I recall reading that Sallie Mae was an early pioneer in writing financial swap contracts around 1982. I am not sure why Sallie Mae would do so but typical motives relating to stock price growth are smoothing of reported earnings and predictable earnings growth. These features would let managers with stock options and stock positions cash out at a large liquid gain in the stock market. According to a report by Treasury (The Privatization of Sallie Mae) Sallie Mae had a line of credit to Treasury via the Federal Finance Bank (FFB) and held assets with default insurance guarantees provided by the federal government. The federal subsidy would put Sallie Mae in a unique position to act as financial innovator. During the 2007-2008 financial crisis Fed bailed out AIG which had sold much of the cash flow insurance contracts called credit default swaps. If a loss is going to occur with insurance not provided by government bailouts then either banks or non-banks must write off the loss somewhere in the balance sheet system when the contingency (loss) event eventually occurs. Since non-bank non-financial firms own assets which are liabilities of financial intermediaries the write-off causes investors to be reluctant to rollover such investments forcing the government to do a bailout. In short the financial system cannot insure itself against systemic risk that finance managers generate while running the big casino for pay, bonus, and equity compensation.

    1. Credit default swaps are a very different beast than the interest rate swaps that I am writing about. With a credit default swap, you can lose a significant portion of your principal. With interest rate swaps, you are exposed to interest rate risk, which is normally not a huge percentage of your principal.

      There is certainly a lot of gambling in the swaps market, but they are a critical component of institutional interest rate risk management. (In the 1994 cycle, there was a lot of gambling going on.) You could survive without them, but it would be clumsy to modern eyes.

  5. I agree with you that the expected loss on CDS is probably magnitudes larger than an expected loss associated with interest rate swaps. However I don't see how an aggregate financial sector can insure against the risks caused by borrowing short term funds and lending long term funds without putting that risk to the government or non-financial sector. If a single bank in a small region cannot keep its liabilities on par with gold or silver over long periods of time then it cannot self-insure. If a single bank cannot self-insure then an aggregate bank sector cannot self-insure. I conclude from the lessons of history that systemic risk is inherent in the motives of investors and the structure of financial intermediaries. Since risk is inherent and cannot be insured I call this the big casino.

    1. The private sector is massively short duration versus its retirement liabilities. (You need to look at insurance companies that sell annuities, as well as pensions. Banks can offload their duration risk to those firms.) The problem is that there has been a lack of duration issued, not an excess. As a result, there is little aggregate risk associated with rising interest rates for the private sector.

    2. Then it appears asset owners want to rollover short duration assets at higher rates as soon as possible. So banks and other financial intermediaries cannot lock investors into long duration assets/liabilities while the economy treads water at the zero interest rate boundary.

  6. Brian,

    Very interesting analysis. Now, you will notice on Friday when most risk assets sold off, US banks, especially regional banks, took off on talk of a Fed rate increase. But if the Fed increases rates and the yield curve flattens or worse, inverts, financials are toast! Can you briefly discuss your thoughts in relation to the comments above? Thank you.

    1. There is an effect that flatter curves are associated with wider corporate bond spreads. This will feed through into bank loan pricing. This would cause a mark-to-market hit on existing loans (if they were marked to market, which they generally aren't), but it would be supportive on the spreads for new loans. My guess is that the net effect for banks is neutral.

      However, yield curve inversion has been associated with recessions, and modern recessions are associated with financial crises. Correspondingly, yield curve inversions have historically been bad news for risk assets. Therefore, the inversion is not the problem, just that it is potentially a signal for problems that are developing elsewhere. Given the unusual rates environment, I would not automatically assume that we can assume that we can use historical comparisons to make forecasts based on the yield curve. (I see a lot of people write things like "whenever the curve does X, Y happens in 6 months". Although I respect the predictive power of the yield curve, those statements are based on data-mining a small sample.)

      As for what is happening to regional banks, I am not entirely convinced that such short-term market moves contain useful information. If there is any logic to the move at all, it is probably based on historical regressions some analysts did, without controlling for the macro environment.


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