Basis Risk | When Two Interest Rates That Usually Move Together Stop Cooperating

The simplest basis mismatch

Suppose a bank earns interest on a loan at Benchmark A + 2% and funds the loan with deposits whose cost behaves roughly like Benchmark B + 0.5%.

If Benchmark A and Benchmark B normally move together, the spread looks stable. If A rises by 0.25 percentage points while B rises by 1 percentage point, the bank’s funding cost increases much faster than its asset yield.

asset benchmark moves +0.25 → funding benchmark moves +1.00 → spread narrows by 0.75.

The bank guessed the general direction of rates correctly. It lost because the relationship between rates changed.

Basis risk is not the same as ordinary repricing risk

Risk	Core mismatch
Repricing risk	Asset and liability rates reset at different times.
Basis risk	Asset and liability rates reset from different reference curves or pricing behaviours.

The two can occur together. A loan can reprice every month from one index while deposits reprice irregularly from another. Timing and index relationship both matter.

Read Repricing Risk for the timing owner.

A hedge can create basis risk if it references the wrong benchmark

A bank owns a floating-rate asset tied to Benchmark A. It wants to reduce interest-rate risk but the deepest derivatives market is linked to Benchmark B.

The bank hedges with Benchmark B because the two have historically moved closely. The hedge reduces broad rate sensitivity but leaves the spread between A and B unhedged.

If that spread widens, the asset and hedge stop offsetting perfectly.

hedging one risk factor with a correlated but non-identical risk factor replaces some outright risk with basis risk.

Deposit pricing creates behavioural basis risk

Customer deposits often do not pay a formal market benchmark plus a fixed spread. Banks set deposit rates using competition, customer behaviour, product features and funding need.

A bank can therefore hedge loans against a market benchmark while deposit costs follow a behavioural rate determined by customer competition.

If customers suddenly become much more rate-sensitive, deposit pricing can rise faster than the benchmark relationship assumed in the hedge.

This connects basis risk directly to Interest-Rate Risk in the Banking Book.

Tenor basis appears when similar indexes cover different maturities

A three-month rate and a six-month rate are related but not identical. Their spread can change with expectations, funding demand and market stress.

If an asset resets every six months while the hedge or funding resets every three months, the bank has exposure to that tenor relationship even if both positions reference the same broad rate family.

Cash instruments and derivative indexes can diverge

A bank can hedge the rate risk of a corporate loan with an interest-rate swap. The loan’s pricing includes borrower spread, liquidity features and contractual floors while the derivative references a cleaner market index.

The swap can hedge the benchmark component well while leaving changes in the loan’s own spread or contractual behaviour unhedged.

The hedge should therefore be understood as a map of which risk factors are removed and which remain.

Floor and cap features can create non-linear basis

Suppose a loan rate cannot fall below 2 per cent, but the derivative hedge can continue falling with the benchmark. When rates move below the floor, the loan and hedge stop changing together.

The same problem can arise with caps, collars and other embedded options.

An instrument can therefore be linked to the “same” benchmark and still carry basis because contractual optionality changes the response.

A worked miniature

A bank has S$200 million of business loans paying Benchmark A + 2 per cent. It funds the position with deposits costing Benchmark B + 0.5 per cent.

Initially both benchmarks are 3 per cent. The simplified asset yield is 5 per cent and deposit cost is 3.5 per cent, giving a 1.5 percentage-point spread before other costs.

Later Benchmark A rises to 3.5 per cent while Benchmark B rises to 4.5 per cent. The loan yield becomes 5.5 per cent, but funding cost becomes 5 per cent.

The spread has compressed from 1.5 points to 0.5 points even though both benchmark rates rose.

Basis risk can be small for years and then widen quickly

Correlations look strongest during the periods used to build models. Stress often changes behaviour. Banks become more cautious about lending. Particular funding markets become scarce. Investor preference changes. One benchmark reflects liquidity stress more than another.

The spread that appeared stable can therefore become the risk factor that matters most.

Cross-currency basis is the currency version of the same principle

A bank can transform Singapore-dollar funding into US dollars through FX swaps. In a frictionless textbook model, the swap price would line up neatly with the interest-rate difference between the currencies.

In real markets, demand and balance-sheet constraints can create a cross-currency basis. The cost of synthetic dollar funding can therefore move differently from domestic interest rates.

This connects basis risk to How Foreign-Exchange Risk Enters a Bank.

Credit spreads can create another imperfect relationship

A bank can hedge the general interest-rate duration of a corporate bond while the issuer’s credit spread widens. The risk-free benchmark hedge works, but the bond still falls because a different spread moved.

Not every residual spread is formally IRRBB basis risk, but the operating lesson is identical: hedging one observable factor does not hedge every factor embedded in the asset.

Read Why Securities Can Create Market Risk Inside a Bank.

Benchmark reform can create temporary basis risk

When markets transition from one reference rate to another, legacy assets, liabilities and derivatives can migrate on different dates or under different fallback terms.

Even if the new benchmark is robust, the transition can create mismatches between old and new contracts. Contract review and hedge alignment therefore become part of rate-risk management.

Basis risk affects earnings first when spreads feed through quickly

If loan and funding benchmarks diverge, net interest income changes immediately as reset dates arrive. Treasury therefore monitors margin sensitivity to basis moves, not only parallel interest-rate shocks.

A small spread change across a very large balance sheet can create a material earnings effect.

Basis risk can affect economic value too

When future asset and liability cash flows are discounted from different curves or repricing assumptions, changes in the relationship between those curves alter present value.

This is why the Basel IRRBB framework assesses both earnings and economic-value effects.

Historical correlation is evidence, not a guarantee

A hedge can be justified because two rates moved closely together for ten years. That history is useful evidence. It is not a contractual promise that they will continue doing so.

Banks therefore stress the basis itself rather than assuming the historical relationship survives every market regime.

Basis limits make residual mismatch visible

Treasury can measure exposure by benchmark, tenor and product, then set limits on how much unhedged spread sensitivity the bank is willing to carry.

This prevents the institution from describing a correlated hedge as a perfect hedge.

A hedge can reduce total risk even while basis risk remains

The existence of residual basis risk does not mean hedging failed. A hedge can remove most broad interest-rate sensitivity while leaving a smaller relative-rate exposure.

The correct comparison is not “perfect hedge or no hedge.” It is “which risk was reduced, which risk remains, and is the residual acceptable?”

Liquidity stress can widen basis dramatically

If one funding market becomes scarce, the rate associated with that market can rise relative to another benchmark. The bank can then suffer basis widening at the same time it is trying to raise liquidity.

This is another reason rate risk and liquidity risk should be stress-tested together.

Read The Contingency Funding Plan.

Basis risk is a reminder that financial variables are relationships, not isolated numbers

A bank does not earn one interest rate and pay another in isolation. It earns a spread between them. Hedging does not depend only on the direction of rates; it depends on relationships among indexes, tenors and customer behaviour.

Basis risk becomes visible when that relationship itself is treated as a risk factor.

Four misconceptions to remove

Misconception	Better model
“If both rates rise, the position is matched.”	The amount and timing of each move can differ, changing the spread.
“A correlated hedge is the same as a perfect hedge.”	Correlation can break, leaving basis exposure between the two risk factors.
“Basis risk exists only between named market benchmarks.”	Behavioural deposit pricing and tenor differences can create basis too.
“Residual basis means the hedge was useless.”	A hedge can remove most outright rate risk while leaving a smaller, measurable basis risk.

A mastery test

1. What distinguishes basis risk from repricing risk?
2. How can a hedge be directionally correct and still lose money?
3. Why can deposit pricing create behavioural basis risk?
4. How can cross-currency funding create basis exposure?
5. Why should historical correlation be stress-tested rather than assumed?

If those answers connect, basis risk becomes visible as banking’s mismatch between relationships: the bank expected two rates to travel together, but neither the contract nor the market ever promised that they would.

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