Banking on Deposits: Maturity Transformation without Interest Rate Risk

We show that in stark contrast to conventional wisdom, maturity transformation does not expose banks to significant interest rate risk. Aggregate net interest margins have been near-constant over 1955–2013, despite substantial maturity mismatch and wide variation in interest rates. We argue that this is due to banks’ market power in deposit markets. Market power allows banks to pay deposit rates that are low and therefore relatively insensitive to interest rate changes, but it also requires them to pay large operating costs. This makes deposits resemble fixed-rate liabilities. Banks hedge these liabilities by investing in long-term assets, whose interest payments are also relatively insensitive to interest rate changes. Consistent with this view, we find that banks match the interest rate sensitivities of their expenses and income one for one. Furthermore, banks with lower interest expense sensitivity hold assets with substantially longer duration. We exploit cross-sectional variation in market power and show that it generates variation in expense sensitivity that is matched one-for-one by income sensitivity. Our results provide a novel explanation for the coexistence of deposit-taking and maturity transformation. JEL: E52, E43, G21, G31