What is maturity risk? Describe some of the ways in which this risk can be managed by financial intermediaries. Also, explain its link with funding and liquidity risks.
Maturity risks are yet another significant portfolio risk. Typically, the maturity dates of the credit assets in the portfolio vary. To avoid liquidity issues, the portfolio’s maturities should be appropriately handled. In a bank, the asset tenure (i.e., loan or investment) might range from a few days (overdrafts) to 15–20 years (e.g., mortgages or project finance). Deposit tenors, on the other hand, are considerably shorter (i.e., usually up to five years). The tenor mismatch is obvious. As a result, controlling tenor mismatches is an important function with liquidity consequences. Banks and financial intermediaries must manage their balance sheets in order to lend for long periods of time without jeopardizing their ability to meet potential depositors’ cash demand. How do banks and other financial intermediaries accomplish this? They rely on money and capital markets to borrow and lend for short periods of time. Access to money and capital markets during a crisis can be disastrous for institutions that face maturity risks.
Given the need for liquidity, it is frequently not advisable to have excessive portfolio exposure to long-term credits unless it is matched against long-term funds. Worries about the soundness of US banks or financial institutions caused the money and capital markets to freeze during the 2008 Credit Crisis, causing problems for institutions that relied on these markets to handle maturity mismatches. As a result, Basel III focuses on this risk, which has significant liquidity consequences. As we will see in Chapter 16, Basel III includes a Net Stable Funding Ratio (NSFR), which is expected to ensure that enough long-term sources of funding are available.
Maturity risks occur outside of the financial sector as well. Longer credit terms are typically offered by providers of industrial and capital items. If a credit portfolio contains long-term credits, it should be linked with long-term funds. Otherwise, average portfolio maturities would be prolonged, leading to liquidity problems.
Let us look at a few scenarios in which a non-banking company could experience challenges due to maturities in its credit or debtor’s portfolio.
- For example, government contractors may discover that the payout is excessively delayed due to the normal red tape of budgetary limits. While receivables are favorable for collection, they take a long time to collect, implying that the maturity of such portfolios is on the longer side. This can result in liquidity issues.
- Although the credit may have been extended for a short period of time, as in the instance of a wholesale dealer who expects the bills to be cleared in less than three months, there may be a delay in the settlement and, especially during times of economic crisis, the delay may exceed a year. In effect, short-term credit becomes medium-term or long-term credit.
- Another example is a consumer durables trader who offers two forms of credit sales: I 30 days’ conventional credit period and (ii) installment credit, which allows for 24 monthly installments to clear the dues. The impact on the cash flow of the two categories differs. The credit exposure in the first category is only 30 days; but, in the latter category, the credit exposure (sales price + interest) is extended over up to two years. The trader must establish a balance between the two forms of credit sales in order to maintain an adequate cash flow situation. In most cases, the longer the duration, the greater the risk.
The funding risk is a corollary to the maturity risk at the portfolio level. It is also critical to consider how a bank funds its credit portfolio. A solid credit portfolio can only be sustained with a solid funding policy. A balance between asset and liabilities maturity must be maintained. The funding risk is best exemplified by Northern Rock Bank’s collapse in the United Kingdom in 2007.
In July 2007, there were concerns that the US subprime mortgage crisis was affecting the short-term funding market, resulting in a suspension in inter-bank lending. BNP Paribas closed three investment entities with exposure to US subprime mortgage assets in August 2007. As a result, investors in the financial industry with exposure to the US sub-prime market were concerned about the quality of their assets. As a result, investment vehicles that relied on short-term funding began to have difficulty rolling over their short-term borrowing.
Joseph, J. 2013.