Assess how important it is to examine maturity and currency mismatches in the combined balance sheets of the entities within a consolidated group.
The idea
A bank's currency and maturity mismatch is easy to miss if you look at one legal entity or one office at a time. Inside a group, a head office may lend dollars to a foreign branch, and the branch looks funded. Yet the head office raises those dollars from outside through short-term borrowing or foreign exchange swaps. The correct step is to consolidate. Eliminate intragroup claims and liabilities, then restate assets and liabilities currency by currency and by maturity bucket. The consolidated dollar funding gap is dollar assets minus the stable dollar liabilities owed to outsiders, such as deposits from non-banks. The short-term part of that gap measures rollover need. A balanced total balance sheet in one reporting currency can hide a large dollar gap. The exam point is to consolidate first, then look at each currency separately, including off-balance-sheet swaps.
Formulas
Consolidated dollar funding gap
Dollar gap = Assets − Liabilities
- Assets
- the group's dollar assets, after intragroup claims are eliminated
- Liabilities
- the group's dollar liabilities to outside non-banks, after intragroup items are eliminated
Consolidate before measuring, or an intragroup loan makes a branch look funded. Short-term swap funding fills the gap but does not close it: its short-term part is the rollover need.
A practice question
Why do analysts of dollar funding risk consolidate the balance sheets of the entities in a banking group before measuring mismatches?
- Because consolidation removes the need to measure maturities, since the group's total assets equal its total liabilitiesWhy not: Total assets equal total liabilities by construction; the mismatch lies in the currency and maturity composition.
- Because intragroup claims and liabilities offset, so the consolidated view shows the group's true net position against outsiders - correct
- Because each entity is legally liable for the others' debts, so any one entity's balance sheet is enoughWhy not: Legal liability does not make one entity's balance sheet representative; separate entities can hide group exposures.
- Because consolidation converts all positions into a single reporting currency, which removes currency mismatchWhy not: Converting to one currency hides currency mismatch rather than measuring it; the analysis must stay currency by currency.
An office that borrows from head office looks funded on its own, but the head office may fund that loan in short-term markets. Netting out intragroup items shows the dollars the group must raise from outside.
A harder one
A supervisor reviews only the US branch of a foreign bank. The branch shows no dollar shortfall because the head office lends it all the dollars it needs. Which conclusion about the group is justified?
- The group is funded in dollars, since the branch's dollar assets are matched by dollar liabilitiesWhy not: The matching liability is owed to the head office, which may itself be short dollars; the match is only internal.
- The group has no maturity mismatch, since intragroup loans are long termWhy not: Intragroup loan terms say nothing about the maturity of the group's outside funding.
- The group's dollar risk equals the branch's, because the branch is the only entity that holds any dollar assetsWhy not: Head offices often hold dollar assets of their own, and the dollar funding gap sits where the outside borrowing happens.
- None, because the head office's source of those dollars may be short-term wholesale funding or swaps - correct
Single-entity views can hide the group's dependence on outside short-term dollar funding. Only the consolidated, currency-by-currency analysis reveals where the dollars are ultimately sourced.
The hardest tier
A banking group has total assets and total liabilities of 400 in euro equivalent. Of its assets, 270 are in dollars; of its liabilities, 150 are dollar deposits from outside non-banks, and the remaining 120 of the dollar assets are funded by short-term euro borrowing converted into dollars through three-month FX swaps. What does a currency-by-currency consolidated analysis reveal that the single-currency total does not?
- The group faces a large unhedged exchange rate loss on the 120, because it owes dollars while funding itself in euros, and a euro fall raises its costWhy not: The swap fixes the rate for the dollars to be returned, so exchange rate risk is hedged; what remains is the need to renew the swap.
- A dollar shortfall of 120 covered by short-dated swaps: the main exposure is rollover risk, not a net exchange rate position - correct
- The group has no currency mismatch, because assets and liabilities are both 400Why not: Equal totals say nothing about currency composition; per currency the dollar assets exceed dollar deposits by 120.
- The group's dollar position is long by 150, because the dollar deposits are the group's largest dollar itemWhy not: Dollar deposits of 150 against dollar assets of 270 leave a short position; the 150 is not a net long position.
Dollar assets 270 less dollar deposits 150 leaves a 120 gap, financed by swapping euros into dollars at short tenors. The swap hedges the currency but not the liquidity risk: if swap markets close, the group cannot raise the dollars it needs.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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