Question

If you set the maturity of the asset portfolio equal to the maturity of the liability portfolio then there is absolutely no remaining interest rate risk for the bank.

A. True

B. False

Answer 1

Solution:-

Interest rate risks for banks refers to the risk of loss in net interest income due to change in interest rates in the economy. One of the primary reasons of such loss is the difference in maturities of assets and liabilities. Let's take a look at the following example:

A bank accepts deposits with an average maturity of 2 years @10%, and issues loans with average maturity of 10 years @15 years. In this case the bank's net interest margin is 5%. Now, if the interest rates increase, the banks will have to pay higher interest rates on deposits when they are renewed after 2 years while it will not be able to charge higher interest rates from the loans that have been issued for a longer duration. This is why its a loss from the net interest income perspective and hence the interest rate risk.

Given situation:

However, as the question states that if a bank sets the maturity of asset portfolio equal to the maturity of liability portfolio, will this eliminate the interest rate risk completely?

The answer is no. This will not completely eliminate the interest rate risk. This is because while the maturities of assets and liabilities are same, there could still be interest rate risks due to mismatch in the nature of assets and liabilities.

Banks have both fixed rate and variables rate assets and liabilities. Fixed rate assets are the loans which will have a fixed interest rate during its tenure while a fixed rate liabilities are deposits that will earn interest at a fixed rate for its entire tenure. On the contrary, variable/floating rate assets and liabilities have their interest rates changed as per the changes in base rates in an economy.

So, lets say if a bank has higher proportion of variable rate liabilities than variable rate assets and the interest rates go up, it will have to pay higher rates of interest to that larger portion of liabilities than the increase in interest income from variable rate loans. Similarly, if a bank has higher proportion of variable rate assets than variable rate liabilities and the interest rates go down, its interest income from loans will go down more than the decrease in interest it has to pay to variable rate liabilities.

Thus, interest rate risks are not solely dependent upon the maturities of assets and liabilities. Due to the above reason, we can say that equating the maturities of assets and liabilities portfolio doesn't completely eliminate interest rate risks for a bank. Therefore, the correct option is 'False'.