HOW DOES FUNDING MATURITY GAP AFFECTS BANKS

INTRODUCTION

The maturity gap is the weighted-average time to maturity of financial assets less the weighted-average
time to maturity of liabilities. A bank funding substantial long term assets like fixed rate mortgage or
long term infrastructure loans by short-term liabilities like deposits or commercial papers is a classic
case of maturity gap which is also known as maturity mismatch or asset liability mismatch. Practically,
this would be the only case for maturity gap since no bank will fund short term assets by long-term
liabilities.

To put it in simple terms, a maturity mismatch (gap) occurs when the tenure of maturing loans (which
are on the assets side of the balance sheet of a bank) do not match the tenure of the sources of funds
on the liabilities side. The liabilities side of the balance sheet of a bank includes sources of funds and for
a bank one of the main sources of funds are the deposits or short term papers.

In an ideal world, each duration bucket / term assets should be financed by a similar tenure of funds.
However, illiquid bond markets in a country, lower credit rating, debt covenants or unavailability of
funds in longer tenures could result in heavy maturity gap.

CONSEQUENCES OF FUNDING MATURITY GAP

The two main risks of funding maturity gap for the banks are LIQUIDITY RISK and INTEREST RATE RISK

LIQUIDITY RISK

Liquidity risk is the risk arising out of unexpected fluctuation in cash outflows and cash inflows. It is the
potential inability to meet the bank's liabilities as they become due. The liquidity risk in the banking
book can also be called as funding liquidity which arises from mismatches in the maturity pattern of
assets and liabilities. Funding liquidity risk refers to the risk that a company will not be able to meet its
short-term financial obligations when due or refinance its debt.

Liquidity risk is considered as one of the concern and challenges for modern era banks. A bank having
good asset quality, strong earnings and sufficient capital may fail if it is not maintaining adequate
liquidity. Now why would a bank with good asset quality, strong earnings and sufficient capital may still
fail due to liquidity crunch? Consider the following example –

Let’s assume X Bank Ltd. has given a long term infra loan (10 years) which is funded by issuing 1-year
certificate of deposit. Certificate of deposit (CD) is a zero coupon money market instrument where it is
issued at a discount and repaid at par, the difference of which indirectly represents interest. Now what
will happen at the maturity of CD? Since the bank has given 10-year loan, bank would face funding
liquidity risk because the liability would require cash out flow while the asset would not have earned any
cash flow (except the possible interest on the loan).The bank may roll over the maturing CD. However,
the need to roll over maturing CD generates the risk that investors may not be willing to refinance
maturing CD. This risk is often called roll-over risk. In this case, the bank needs to find financing
elsewhere to repay maturing CD which results in two - 1.Higher transaction cost 2.Higher interest rate
which will impact bank’s profitability (Net interest margin).

Even if X Bank Ltd. succeeds in rolling over CD, investors may not be willing to lend every time since the
bank has to roll over multiple times to refinance. If the bank is unable to roll over or refinance, bank may
have to sell off its assets to repay investors. This may result in deterioration of asset quality and
deterioration of capital affecting return on assets (ROA) and capital adequacy ratio (CAR) ultimately
weakening of balance sheet. This also creates a reputational risk in the market where a bank may have
difficulty in accessing credit market to borrow which results into defaults and bankruptcy which was
exactly happened with companies like DHFL and IL&FS.

INTEREST RATE RISK

Interest rate risk is the risk where changes in market interest rates might adversely affect a bank’s
financial condition. It is the current or prospective risk to the bank’s capital and earnings arising from
adverse movements in interest rates that affect the banks’ banking book positions.

How does changes in interest rates impacts bank’s profitability in case of asset liability mismatch?

Interest rate risk largely poses a problem to a bank’s net interest income and hence profitability.
Changes in interest rates can significantly alter a bank’s net interest income (NII) [Net interest income =
Interest Income – Interest expense], depending on the extent of mismatch between the asset and
liability interest rate reset times.

Take, for example, a bank that funds with certificates of deposit that have a maturity of one year. This
bank makes mortgage loans with a maturity of 15 years. Should interest rates rise in the future, the bank
would face a decline in its expected income. Why? The monthly inflows of cash to the bank from the
mortgages are fixed for 15 years. When the certificates of deposit come due before the mortgages, the
bank will have to pay more to receive funding so cash flows out of the bank will increase.

Now, even if the bank funds mortgage loans with fixed deposits of say two years, bank will have to re-
price its deposits frequently, which have a faster turnover compared to the long-maturing loans. Banks
are constrained by the fact that the deposit rates have to be in sync with the market rates. If the market
rates were lower, it would become difficult to attract depositors, which means that sources of funds
may well dry up. This poses liquidity risk as well because they have to repay the depositors faster but
their funds are caught up in long-term assets.  So though the bank might be asset-rich it does not have
the necessarily liquidity, on the one hand, to repay its depositors and on the other hand even to lend for
projects.

The ultimate impact of all this will be on the net interest margins of a bank. Banks with lower asset
liability mismatches will have more room to maneuver with respect to their pricing of loans and
deposits, while those with a high level of mismatches will find it difficult to reset their interest rates
frequently and will have to face narrowing of margins.
How does changes in interest rates impacts bank’s net worth in case of asset liability mismatch?

Changes in interest rates also affect the economic value of a bank’s equity (Net worth). When interest
rates change, the present value and timing of future cash flows change. This in turn changes the
underlying value of a bank’s assets, liabilities and off-balance sheet items and hence its economic value.

Consider a bank with INR 80 million in assets having average maturity of 10 years and duration of 6
years, INR 60 million of it in liabilities having average maturity of 5 years and duration of 3 years and INR
20 million in equity capital. If market interest rate increases by 100bps, the asset value of the bank will
drop to INR 75.2 million while the value of liabilities falls to INR 58.2 million. The change in net worth for
this bank would be negative 3 million, implying that equity capital is worth only INR 17 million.

Let’s summarize how funding maturity gap will impact bank’s financial conditions –

 Liquidity Risk-

i) Lower net interest margin

ii) Deterioration of asset quality and lower return on assets
iii) Deterioration of capital and lower capital adequacy ratio
iv) Reputational Risk
v) Possible defaults and bankruptcy

 Interest Rate Risk-

i) Adverse earnings
ii) Risk to banks’ net worth

HOW ASSET-LIABILITY MISMATCH RESULTED INTO BANKRUPCTY OF DHFL AND IL&FS

A housing finance company DHFL disburses loans that have repayment periods of about 20 years. But
borrowing at cheap rates comes with a caveat — DHFL can’t take 20 years to pay back the loans. DHFL
borrows funds with short repayment periods by issuing a Commercial Paper (CP). Once the repayment
period is complete and the CP is due after 6 months, the company simply issues a new set of commercial
papers and borrows once again. And again. This way the company can keep “rolling over” funds to meet
their short-term obligations. How long DHFL can continue this? When DHFL ran out of liquidity, out of
cash, it started defaulting on CP and other obligations. Ultimately, RBI decided to intervene and was
taken to bankruptcy court.

Similar saga with a infrastructure development and finance company IF&FS having loans worth of over
INR 94,000 crores (total group loans) defaulted on several payments including commercial papers, inter
corporate deposits and bonds where one of the main factors for defaulting was asset liability mismatch.
IL&FS’ asset-liability returns showed that in the 14 days-1 month bucket, the negative mismatch was
very high at -79.36 percent. The negative mismatch reflects a far higher proportion of short-term
liabilities coming due than the company could pay. The negative mismatches continued for up to the five
year maturity.