How do banks respond to limits on maturity transformation?

Abstract We study the response of banks to the removal of a limit on maturity transformation, similar to the Net Stable Funding Ratio. We formalize the testable hypotheses using a simple banking model where the profitability function depends on the level of maturity transformation and the risk profile. We show that after the regulatory change, banks rebalanced the composition of their assets and liabilities. They increased their exposure to interest rate risk, while we find no effect on credit risk. Our evidence supports the common theoretical view that banks have an incentive to engage in maturity transformation and that this implies higher interest rate risk exposure. We also show that bank profitability is not affected. However, banks take advantage of the greater flexibility provided by deregulation to engage in some cross-selling associated with the increased supply of mortgages, which is consistent with the theory emphasizing the importance of increasing market power.