What is basis risk in ALM and when does it bite?

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AcadiFi · Accepted Answer

Basis risk arises when assets and liabilities reprice off different reference rates that are historically correlated but not identical. A bank funding SOFR-linked loans with Fed Funds-linked deposits has nearly matched maturity but differing rate drivers; the SOFR-OIS spread can widen or tighten independently of the level of rates. Measurement uses a basis-scenario approach: shock one curve while holding the other fixed and observe the NII or EVE change. Typical basis scenarios include SOFR vs Fed Funds (secured vs unsecured overnight), 1M vs 3M USD LIBOR replacements, Prime vs SOFR, and domestic vs foreign currency rates. Example: bank holds $2B in SOFR + 150 bp loans and funds with $2B in Fed Funds + 100 bp brokered deposits. Normally the spread between SOFR and Fed Funds is near zero. If SOFR widens by 20 bp relative to Fed Funds during a quarter-end funding squeeze, NII gains $2B * 0.0020 = $4M — here basis risk was actually favorable, but it reverses in a liquidity easing. IBOR transition created fresh basis risk because legacy LIBOR-linked assets were replaced with SOFR-linked replacements that carry different term structure, spread adjustments, and forward-looking vs backward-looking conventions. Hedging basis risk uses basis swaps (paying one index, receiving another) or adjusting the natural mix of reference rates on new production. For FRM, recognize basis risk as one of three IRRBB components alongside gap and option risk, and explain that standard duration and gap analyses assume parallel shifts so they miss it.

What is basis risk in ALM and when does it bite?

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