Title. Banking on Deposits: Maturity Transformation without Interest Rate Risk

1. 
   Title. Banking on Deposits: Maturity Transformation without Interest Rate Risk
   

In this paper, the authors challenge the traditional view that banks face significant interest rate risk due to their maturity transformation activities. They argue that banks with a deposit franchise reduce their exposure to interest rate risk. The deposit franchise allows banks to borrow at low and relatively stable rates, unaffected by market interest rates. Despite having a large maturity mismatch between short-term liabilities and long-term assets, banks hedge their deposit franchise by holding long-term fixed-rate assets. Empirical evidence shows that bank profits are not sensitive to fluctuations in interest rates, and banks with a stronger deposit franchise hold more long-term assets. The findings suggest that the deposit franchise provides a natural hedge for the provision of long-term credit, which supports the argument against separating deposit-taking and long-term lending. Furthermore, these results have implications for monetary policy transmission, indicating that banks are insulated from the balance sheet channel of monetary policy. The paper presents a model that explains these findings, showing that the deposit franchise functions like an interest rate swap, with banks paying the fixed leg (operating costs) and receiving the floating leg (deposit spread). The value of the deposit franchise is negatively exposed to interest rate changes, which is hedged by banks' positive exposure through their long-term fixed-rate assets. The paper concludes that banks' interest rate exposure is not captured in their book assets or liabilities, but it is reflected in their profit and loss statements.
The section on related literature provides an overview of previous research conducted on bank interest rate risk and hedging strategies. The authors highlight the significance of understanding and managing interest rate risk for financial stability and the implications it has for monetary policy. They discuss the existing studies that have examined the effects of interest rate risk on banks and the various approaches and techniques employed by banks to hedge this risk. The section emphasizes the importance of this topic in the field of finance and sets the foundation for the subsequent analysis conducted in the study.
The authors investigate the aggregate interest rate risk exposure of commercial banks. They aim to understand the factors that contribute to the variation in banks' interest rate risk across different economic conditions. The analysis is based on a large dataset of U.S. commercial banks' income statements and balance sheets obtained from the U.S. Call Reports. The authors find that banks' interest rate risk is influenced by both macroeconomic factors and bank-specific characteristics. They observe that interest rate risk tends to be higher during periods of economic expansion and lower during economic downturns. This suggests that banks' risk exposure is procyclical, meaning it varies with the overall state of the economy. Furthermore, the study finds that larger banks tend to have lower interest rate risk compared to smaller banks. This can be attributed to their greater ability to diversify their asset portfolios and access funding from a variety of sources. Additionally, banks with higher levels of capitalization exhibit lower interest rate risk, as they have a greater buffer to absorb potential losses. The analysis also reveals that banks with a higher reliance on non-deposit funding, such as wholesale funding, tend to have higher interest rate risk. This is because non-deposit funding sources are typically more sensitive to changes in interest rates compared to stable deposit funding.
The authors present a simple model ( , where 0 < < 1 and ft is the economy’s short-rate process (i.e., the Fed funds rate)) that captures a bank's investment problem and explains their aggregate findings on interest rate risk. The model provides insights into how banks optimize their investment decisions to maximize the present value of future profits while remaining solvent. The model assumes a discrete time framework with an infinite time horizon. The bank funds itself by issuing risk-free deposits and aims to invest in assets that generate maximum future profits. The bank's investment decisions are subject to the constraint of maintaining solvency, ensuring that its deposits remain risk-free. To attract deposits, the bank operates a deposit franchise, incurring costs associated with establishing and serving depositors. The deposit franchise gives the bank market power, allowing it to offer a deposit rate lower than the economy's short-rate process, represented by the Fed funds rate.
On the asset side, the model assumes complete markets and prices determined by a stochastic discount factor. The bank values its profits using this stochastic discount factor and seeks to generate income that covers its interest expenses and operating costs while remaining sensitive to interest rate changes. The model highlights the bank's solvency risk, which is twofold. Firstly, the bank must ensure that its income stream is sufficiently positively exposed to the short rate to cover its rising interest expenses. This requires a portion of the bank's portfolio to consist of short-term assets whose interest payments increase at the short rate. Secondly, the bank's operating costs remain insensitive to the short rate. To cover these costs, the bank must hold sufficient long-term fixed-rate assets, producing an income stream that is unaffected by interest rate fluctuations. This helps hedge against scenarios of low short rates where the bank's deposit franchise generates minimal spread but still incurs the same level of operating costs. The authors emphasize the contribution of the deposit franchise by decomposing the bank's future profits into a balance sheet component and a deposit franchise component. The balance sheet component represents the income generated by the bank's assets and liabilities, while the deposit franchise component captures the income and expenses associated with the deposit spread and operating costs.
The authors describe the data sources used in their analysis of bank interest rate risk. They utilize multiple datasets to gather information on bank-level characteristics, branch-level deposits, retail deposit rates, and Federal funds data. The data covers a substantial period from the 1980s to the 2010s, providing a comprehensive foundation for their empirical analysis.
A. Bank Data:
The authors obtain their bank-level data from the U.S. Call Reports, which are provided by Wharton Research Data Services. These reports contain quarterly observations of the income statements and balance sheets of all commercial banks in the United States. The data include unique identifiers that allow for linkage with other datasets.
B. Branch-Level Deposits:
Data on deposits at the branch level are sourced from the Federal Deposit Insurance Corporation (FDIC). The dataset covers all bank branches in the United States and is available on an annual basis from 1994 to 2017. It provides detailed information on branch characteristics such as the parent bank, address, and location. The authors match this data with the bank-level Call Reports using the FDIC certificate number as the identifier.
C. Retail Deposit Rates:
Information on retail deposit rates is obtained from Ratewatch. Ratewatch collects weekly branch-level deposit rates by product from 1997 to 2017, covering approximately 54% of all U.S. branches as of 2013. The data indicate whether a branch actively sets its deposit rates or if the rates are determined by a parent branch. To avoid duplicating observations, the authors focus on active branches. They merge the Ratewatch data with the FDIC branch identifier to combine information on deposit rates with branch-level characteristics.
D. Fed Funds Data:
The authors acquire the monthly time series of the effective Federal funds rate from the H.15 release of the Federal Reserve Board. To match the frequency of their analysis, they convert the data to a quarterly frequency by taking the last month in each quarter. The Federal funds rate serves as a key indicator of short-term interest rates and plays a crucial role in assessing interest rate risk for banks.
By leveraging these various data sources, the authors gather comprehensive information on bank characteristics, deposit rates, and interest rate movements. This rich data set enables them to conduct a detailed analysis of bank interest rate risk and its implications on bank performance and profitability.
The arguments presented by the authors in the paper are as follows:
Banks reduce their interest rate risk through maturity transformation: Contrary to the conventional view, the authors argue that banks actually reduce their exposure to interest rate risk by matching the sensitivities of their income and expenses. They achieve this by borrowing short-term in the form of retail deposits and lending long-term through holding long-term fixed-rate assets. This approach allows them to effectively manage their interest rate risk despite maintaining a significant maturity mismatch.
Market power in retail deposit markets reduces expense sensitivity: Banks exercise market power in retail deposit markets, enabling them to pay lower deposit rates compared to the short-term interest rates. By doing so, they obtain a low sensitivity on the expense side of their balance sheet. This helps to mitigate the impact of rising interest rates on their interest expenses.
Holding long-term fixed-rate assets reduces income sensitivity: Banks hold long-term fixed-rate assets that generate income streams that are relatively insensitive to short-term interest rate fluctuations. This helps to offset the potential decline in interest income when interest rates are low. By managing their asset composition in this way, banks can maintain stable Net Interest Margins (NIMs) and Return on Assets (ROAs) even in a volatile interest rate environment.
Sensitivity matching ensures stability in NIMs and ROAs: The authors argue that by actively matching the sensitivities of their income and expenses, banks are able to maintain stable NIMs and ROAs despite wide fluctuations in interest rates. This sensitivity matching strategy helps to offset the impact of interest rate changes on their bottom line and contributes to overall stability.
Implications for monetary policy and financial stability: The authors suggest that their findings have important implications for monetary policy and financial stability. They highlight that banks' sensitivity matching approach reduces their vulnerability to interest rate risk, challenging the notion that maturity mismatch is inherently risky. Furthermore, the authors argue that narrow banking, which advocates for holding only short-term assets, may actually expose banks to greater risk if they lose their market power.
The arguments and suggestions made by the authors in the paper offer an alternative perspective on how banks manage interest rate risk through maturity transformation and sensitivity matching. Their findings challenge the conventional view that banks inherently expose themselves to risk through maturity mismatch.
The authors argue that banks can effectively mitigate interest rate risk by matching the sensitivities of their income and expenses. By exercising market power in retail deposit markets, banks can keep their expense sensitivity low, while holding long-term fixed-rate assets helps reduce income sensitivity. This sensitivity matching strategy allows banks to maintain stable NIMs and ROAs even in the face of interest rate fluctuations.
While the authors' arguments provide a compelling case for the effectiveness of sensitivity matching, it's important to consider other factors and perspectives. Different banks may have varying risk profiles and strategies for managing interest rate risk, and the effectiveness of sensitivity matching may depend on the specific market conditions and regulatory environment. It's also worth noting that the paper's conclusions are based on specific data sources and methodology. The findings may not necessarily apply universally to all banks or capture the full complexity of interest rate risk management. Ultimately, the validity of the authors' arguments and suggestions would require further analysis, empirical evidence, and consideration of alternative viewpoints within the broader context of banking and financial stability.
In conclusion, the authors challenge the conventional view that banks expose themselves to interest rate risk through maturity transformation. They argue that banks actually reduce their interest rate risk by actively matching the sensitivities of their income and expenses, despite maintaining a significant maturity mismatch. This risk reduction is achieved through market power in retail deposit markets, which allows banks to obtain a low sensitivity on the expense side, and by holding long-term fixed-rate assets to achieve a low sensitivity on the income side. This sensitivity matching strategy results in stable Net Interest Margins (NIMs) and Return on Assets (ROAs) even in the face of fluctuating interest rates.
The implications of their findings are significant for monetary policy and financial stability. Traditionally, monetary policy is believed to impact banks through their exposure to interest rate risk arising from maturity mismatch. However, the authors' results suggest that banks, through their sensitivity matching approach, are largely insulated from this risk. This challenges the notion that maturity mismatch is inherently risky for banks. Additionally, concerns about financial stability and calls for narrow banking, where deposit-taking institutions hold only short-term assets, may be misguided. The authors suggest that, as long as banks have market power, narrow banking could actually expose them to greater risk. I agree with arguments and suggestions of authors which make sense.

2.