Banks’ Maturity Choices and the Transmission of Interest-Rate Risk

Abstract:

I study the role of financial intermediaries in the transmission of interest-rate risk. I develop a quantitative model where banks can invest in assets of different durations and choose optimally their exposure to interest-rate fluctuations. I embed this portfolio problem in a heterogeneous-banks framework with financial frictions and endogenous default. The model predicts that in periods of loose monetary policy banks face weaker financial constraints. As a result, they become more tolerant of interest-rate risk and invest more extensively in long-duration assets. However, when the economy undergoes a sudden monetary tightening, this portfolio shift amplifies contractions in asset prices, credit, and output. I validate the model by showing that it can reproduce aggregate and cross-sectional patterns related to banks’ maturity mismatches, the level of the interest rate and leverage. A quantitative application to the 2022 monetary tightening shows that a lengthening of duration in periods of low interest rates gives rise to significant financial amplification. A liquidity requirement that restricts banks’ investment in long-term assets makes the economy less vulnerable to sudden interest-rate raises.