Bank Management: Liquidity, Credit, and Interest-Rate Risk
A bank manages several things at once: enough liquidity to meet withdrawals, asset management for return, liability management for cheap funding, and adequate capital. It controls credit risk by screening borrowers and interest-rate risk by watching the gap between rate-sensitive assets and liabilities.
Why it matters
A bank holds illiquid loans funded by deposits that can leave at any time, so it must keep buffers and match risks. Too little liquidity and a withdrawal forces a fire sale, too much and returns suffer.
Worked examples
A bank funds 10-year fixed-rate loans with deposits that reprice every month, then short-term rates jump. What happens to its margin?
Its funding cost rises right away while its loan income is locked in, so the net interest margin is squeezed. This is interest-rate risk arising from a maturity and repricing mismatch.
Common mistakes
- ✗A profitable bank is automatically a safe bank. Profit and risk are different, and a bank can earn well while still running dangerous liquidity or interest-rate mismatches.
- ✗Holding more liquid assets is always better. Liquid assets earn less, so there is a trade-off between safety and return that management has to balance.
Revision bullets
- •Manage liquidity, assets, liabilities, and capital together
- •Credit risk: screen and monitor borrowers
- •Interest-rate risk: from asset-liability repricing gaps
Quick check
A bank with long-term fixed-rate assets funded by short-term deposits is most exposed to
Connected topics
Sources
- Mishkin (2018), Ch. 9Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.Banking and the management of financial institutions: liquidity, asset and liability management, credit risk, and interest-rate risk.