Question

1. We’ve discussed that banks would prefer to “lend long” and “borrow short” referencing thematurity of assets and liabilities respectively. If this is the case, why wouldn’t a bank only make30+ year loans and borrow money overnight to finance the long-term loans? What are the risks this bank would be taking? (Hint: consider implications related to NIM, duration, and credit risk)

Answer 1

The banks would prefer to "lend long" means that it would like to provide loans for a longer term as it would mean stickiness and long term interest income for the bank.

"Borrow Short" would mean that the bank would like to borrow for a very short period of time as ti would incur interest cost on the same. The bank would like to repay it off as soon as possible.

For long term loans that the bank lends to, there are certain risks. The most important being the credit risk. The longer the term the higher is the risk that the corporate may suffer from credit downgrade in some years. If loans are given for a shorter period this risk gets reduced. NIM stability is there definitely if the loan if for a longer term as the bank has consistent stream of income. However if there is a credit risk issue, then this NIM also gets affected.

There are practically less risks for banks to borrow money on a short term basis. The advantages here are that the bank would have to pay lesser interest cost.

A bank has to make sure that there is a match in the asset liability duration and that it is not skewed towards long term loans as this may have a serious repercussion should things go wrong. The bank has to adjust and keep a match between the duration. It can intermittently play with the same but with certain caveats and well within banking regulations.