Mind the Income Gap - Partial Hedging of Interest Rate Risk within Banks' Business Model

Abstract

Does maturity transformation inevitably expose banks to interest rate risk? We apply a recently established approach to a sample of banks mainly conducting traditional savings and loan business with extensive engagement in maturity transformation. Therefore, we contribute to the emerging literature going against modern banking theory on maturity mismatches and the corresponding interest rate risk. We find evidence for an alignment of banks' interest income and expense sensitivities, indicating that their business model includes an implicit hedge against interest rate risk. However, we also confirm a remaining exposure to changing market rates. When we include information on banks' use of derivatives, we find that the sensitivity alignment is mainly induced by derivatives rather than the business model itself. This suggests maturity transformation induces rather than hedges interest rate risk. Our results shed light on an implicit hedging mechanism within the banks' business model, its (in)completeness, and implications for adequate regulation.

Keywords: interest rate risk, maturity transformation, banking regulation

JEL Classification: G21, G28