You're the chief risk officer at a bank in Lima. The portfolio is full of government bonds and long-term mortgage loans —assets of the highest credit quality. The board sleeps soundly: "we don't hold junk, we hold sovereign debt." But those 7-year assets are funded with deposits that reprice within months. If rates rise, the bank loses value through a door nobody on the board is watching.
The situation
The bank has S/1,000M in assets with a 7-year duration (long-term bonds and loans) and S/900M in liabilities with a 1-year duration (short-term deposits). Equity is S/100M. That difference —assets react far more than liabilities to a change in rates— is the duration gap. When rates rise, the value of the long assets falls sharply while deposits barely move: the entire loss lands on equity.
Here's the trap keeping the board calm. Credit quality is not the same as interest-rate risk. A sovereign bond doesn't default, but its price falls when rates rise just like any other long bond. A duration mismatch funded short-term is a huge bet that rates won't rise —and a 200-basis-point increase can wipe out the bank's equity even if every asset is AAA. It's the risk that, mismanaged, sank so many savings institutions.