Arbitraging the Yield Curve: A Free Lunch?

Abstract

Banking crises can occur due to the mismatch of assets and liabilities. One of the main assumptions behind maturity mismatching is the incentive to arbitrage the yield curve in the market of loanable funds. Banks borrow at low rates and lend at higher rates to increase their profitability. The equilibrium in the evenly rotating economy (ERE) is a flat yield curve that equals the originary interest rate. This article challenges the notion that banks will always attempt to arbitrage the yield curve in a free market and explores how the price mechanism via interest rates acts as a brake to maturity mismatching. Maturity mismatching is a risky activity that is penalized through a higher cost of funding by different types of lenders. If this is true, it follows that a flat yield curve is not attainable in an uncertain world because financial intermediaries that engage in maturity mismatching will create a further spread between themselves and financial intermediaries that do not engage in this practice in the market of loanable funds. In addition, following Mises, the article discusses how economists should proceed with caution when applying equilibrium constructs, such as the ERE, which can disregard the function and properties, belonging to financial instruments such as debt and equity, of allocating risk in an uncertain world.