Swapping

While killing time at YYC airport, I had one of the most interesting conversations with Gemini that I have ever had.

I got to thinking about the Silicon Valley Bank failure (a couple of years ago) and how banks manage the risks of borrowing money short term (eg. demand deposits) and lending it long term (eg. 30 year mortgages). In Canada and most countries, "long term mortgage" usually means 5 years; USA is an outlier in selling very long term fixed rate mortgages. But the same general problem applies in all countries.

Here's what I learned:

1. Indeed, banks in general do not really try to match maturities of their assets to their liabilities. Eg they are quite happy to sell $1B of 5 year fixed rate mortgages and fund them with $1B of floating rate demand deposits.

2. They offset this risk (of interest rates that they pay for the deposit going higher than the fixed rate they receive on the loan) by buying swaps that convert the floating rate expense into fixed rate expenses that more or less coincide with the loans that they have issued; leaving them with, in theory, no risk.

3. This is achieved by finding someone (typically a big company or a pension fund) that has done the opposite: eg. borrowed at a fixed rate and is using that money to generate income at a floating rate. 

4. Banks have trading departments that arrange this sort of transaction, the outstanding values of which are in the 100's of trillions. It's all standardized and electronic, like options.

5. Regulators monitor that banks are doing this effectively.

6. The problem with SVB is that in the US, the regulations only apply to money center banks (like Citibank), not smaller banks like SVB, that are everywhere. SVB had "only" about $200B in deposits (Citibank has around $3T) and had used them to buy fixed rate treasury bonds. When interest rates went up, SVB was stuck paying more than they were earning, and the house of cards came down.

Who can say for sure, but we can hope that in Canada, these "maturity risk matching" rules apply to all banks and are properly enforced.