What is the asset-liability time mismatch that all banks face?

The heart of the banking business lies in the management of money flowing in from depositors and flowing out as loans or credit to borrowers. This continuous flow is a balancing act, as banks strive to meet the immediate needs of depositors while providing substantial loans that typically mature over longer periods.

Depositors often have the right to demanding their funds back at short notice, while borrowers are granted time to repay their loans. This discrepancy leads to a fundamental challenge for banks: how to ensure there is enough cash on hand to satisfy withdrawal demands and how to invest deposit funds profitably.

Banks usually tackle this challenge by diversifying their asset portfolios and carefully monitoring the ladder of liabilities to match cash inflows with cash outflows. They also maintain a cash reserve mandated by regulatory authorities along with additional liquidity to handle unexpected large withdrawals.

Liquidity risk is the specter that haunts any banking institution. It's the risk that occurs when the bank might not have sufficient liquid assets to meet its short-term obligations. This can spur from a bank’s inability to convert an asset into cash without significant loss in value, or a sudden and unusual large withdrawal by depositors.

Banks must constantly assess their liquidity risk and predict cash flow scenarios, both typical and atypical. They must have strategies in place, such as maintaining a mix of short and long-term liabilities and a buffer of high-quality liquid assets, to be deployed when necessary.

Failure in managing liquidity risk can lead to dire consequences. For instance, even a solvent bank, if illiquid, can face a bank run where multiple depositors withdraw funds simultaneously out of fear or loss of confidence, pressuring the bank's cash reserves and possibly leading to insolvency.

Interest rate risk is another significant challenge for banks, arising when there is a mismatch between the rates at which they borrow and lend. This risk affects the bank's net interest income and the economic value of its assets.

When interest rates rise, the interest that banks pay on their deposits and other borrowed funds usually increases more quickly than the interest they receive from fixed-rate loans. This squeeze on the margin can erode a bank’s profitability. Conversely, if rates fall, the return on assets can decrease, while the cost of liabilities doesn't reduce proportionately.

To mitigate interest rate risk, banks employ various financial strategies such as engaging in interest rate swaps, adjusting the duration of their assets and liabilities, holding government securities which are quickly sellable, and relying on interest rate hedging instruments. Effectively managing interest rate risk is pivotal in ensuring a robust and stable banking system.