Abstract
We propose a model of banks’ exposure to movements in interest rates and their role in the transmission of monetary shocks. Since bank deposits provide liquidity, higher interest rates allow banks to earn larger spreads on deposits. Therefore, if risk aversion is higher than one, banks' optimal dynamic hedging strategy is to take losses when interest rates rise. This risk exposure can be achieved by a traditional maturity-mismatched balance sheet, and amplifies the effects of monetary shocks on the cost of liquidity. The model can match the level, time pattern, and cross-sectional pattern of banks’ maturity mismatch.
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