You deposit money in a bank right? Do you happen to know the duration gap of the bank assets and liabilities. Is it positive? How positive is it? Will an increase in interest rates wipe out their asset base? What is the overall duration gap of the asset-liabilities held by US banks? If it is true that defaults reduce M3 and M3 is in fact declining will interest rates go up as money becomes scarcer? Did you know that we are starting to see less appetite for the 30 year T bond. Seems like investors are ever so gradually shying away from it because they do not want to get trapped in a long position if interest rates go up. In other words the money is starting to think interest rates will go up.
I have read that the duration gap of most of the banks holdings are strongly positive meaning that if interest rates ever go up they stand to lose a lot of money as their assets lose a tremendous amount of value because of the asset liability mismatch caused by their huge overleveraged derivatives holdings. If the destruction of credit money continues putting downward pressure on the M3 money supply interest rates will have to go up. Below I have copied and pasted information from Wikipedia regarding what the duration gap is and what it means.
The duration gap is a financial and accounting term and is typically used by banks, pension funds, or other financial institutions to measure their risk due to changes in the interest rate. This is one of the mismatches that can occur and are known as asset liability mismatches.Another way to define Duration Gap is : it is the difference in the sensitivity of interest-yielding assets and the sensitivity of liabilities (of the organization ) to a change in market interest rates (yields).The duration gap measures how well matched are the timings of cash inflows (from assets) and cash outflows (from liabilities).When the duration of assets is larger than the duration of liabilities, the duration gap is positive. In this situation, if interest rates rise, more assets than liabilities will lose value, thus reducing the value of the firm’s equity. If interest rates fall, more assets than liabilities will gain value, thus increasing the value of the firm’s equity.Conversely, when the duration of assets is less than the duration of liabilities, the duration gap is negative. If interest rates rise, more liabilities than assets will lose value, thus increasing the value of the firm’s equity. If interest rates fall, more liabilities than assets will gain value, thus reducing the value of the firm’s equity. By duration matching, that is creating a zero duration gap, the firm becomes immunized against interest rate risk. Duration has a double-facet view. This can be as risky as gambling or playing bingo. It can be beneficial or harmful depending on where interest rates are headed.
Some of the limitations of duration gap management include the following:
- the difficulty in finding assets and liabilities of the same duration
- some assets and liabilities may have patterns of cash flows that are not well defined
- customer prepayments may distort the expected cash flows in duration
- customer defaults may distort the expected cash flows in duration
- convexity can cause problems.
When the duration gap is zero, the firm is immunized only if the size of the liabilities equals the size of the assets. In this example with a two-year loan of one million and a one-year asset of two millions, the firm is still exposed to refinancing risk after one year when the remaining year of the two-year loan has to be financed.
To be able to compare firms and banks of different size the equation has to be normalized by dividing everything by total assets giving the formula for the duration gap.
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