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For example, a bank that chose to borrow entirely in US dollars and lend in Russian rubles would have a significant currency mismatch: if the value of the ruble were to fall dramatically, the bank would lose money. In extreme cases, such movements in the value of the assets and liabilities could lead to bankruptcy, liquidity problems and wealth transfer.
A bank could also have substantial long-term assets (such as fixed-rate mortgages) funded by short-term liabilities, such as deposits. If short-term interest rates rise, the short-term liabilities re-price at maturity, while the yield on the longer-term, fixed-rate assets remains unchanged. Income from the longer-term assets remains unchanged, while the cost of the newly re-priced liabilities funding these assets increases. This is sometimes called a maturity mismatch, which can be measured by the duration gap.
An interest rate mismatch occurs when a bank borrows at one interest rate but lends at another. For example, a bank might borrow money by issuing floating interest rate bonds, but lend money with fixed-rate mortgages. If interest rates rise, the bank must increase the interest it pays to its bondholders, even though the interest it earns on its mortgages has not increased.
Mismatches are handled by asset liability management.
Asset–liability mismatches are important to insurance companies and various pension plans, which may have long-term liabilities (promises to pay the insured or pension plan participants) that must be backed by assets. Choosing assets that are appropriately matched to their financial obligations is therefore an important part of their long-term strategy.
Few companies or financial institutions have perfect matches between their assets and liabilities. In particular, the mismatch between the maturities of banks' deposits and loans makes banks susceptible to bank runs. On the other hand, 'controlled' mismatch, such as between short-term deposits and somewhat longer-term, higher-interest loans to customers is central to many financial institutions' business model.
Asset–liability mismatches can be controlled, mitigated or hedged.
- Bodie, Zvi (2006). "On Asset-Liability Matching and Federal Deposit and Pension Insurance" (PDF). Federal Reserve Bank of St. Louis Review. 88 (4): 323–29.
- Definition of asset-liability mismatch