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Maturity transformation
Prashanth Perumal J.

~4 minutes

Maturity transformation | Photo Credit: Getty Images

Maturity transformation refers to a role played by banks in which

they use short-term funds to finance long-term projects. For
example, banks could use deposits that can be withdrawn by
their customers at any point in time to give out loans that are
repayable over many years by borrowers. Depositors generally
like to have ready access to the deposits that they entrust with a
bank. Borrowers, however, prefer to take out loans with tenures
that are ideally as long as the tenure of the projects in which
they invest the borrowed money. Banks try to act as
intermediaries trying to bring together depositors with short time
horizons and borrowers with long time horizons.

The right balance

In order to manage the mismatch between the maturity profile of

their assets and that of their liabilities, banks repeatedly roll over
their deposits. They do this by paying current short-term
depositors who demand their money back with fresh money that
they receive from new short-term depositors. This makes the
business of banking a risky venture as banks need to correctly
forecast when their liabilities (customer deposits) and assets

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(loans) will mature, and how to manage any mismatch in these

maturities. If a bank’s depositors demand their money sooner
than the bank’s borrowers can repay their loans, this can lead to
trouble as the bank will be unable to make good on its promise
to return money to its depositors on demand. The bank may
even be forced into a fire sale of its assets in order to
immediately pay back depositors, which in turn could cause the
bank to go insolvent. Banks may try to extend the maturity of
their liabilities by rolling them over with fresh deposits. They may
also use instruments such as bonds, fixed deposits, etc., which
have a defined maturity date in contrast to current deposits that
can be withdrawn at any time. Some economists believe that
banking is inherently unstable due to the mismatch in the
maturity of assets and liabilities of banks. Hence, they believe
that banks need help from the government in the form of
bailouts whenever they get into trouble. Bank bailouts are seen
by these economists as a small price to pay to facilitate the role
of banks in effectively channelling the savings of people into
investments. Other economists, however, believe that banks
need to adjust their loan-making practices in such a way that it
is consistent with the maturity profile of their deposit base. Some
particularly note that it should be illegal for banks to promise
their short-term depositors that they can withdraw their money
whenever they want since banks loan these to borrowers.
Instead, they argue that short-term funds should be treated as
safe-keeping deposits and banks should be barred from using
these funds to give out loans.

The maturity transformation role of banks should not be

confused with the practice of fractional reserve banking. Under a
fractional reserve banking system, banks are allowed to create
loans without sufficient actual deposits backing these loans.

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This leads to the risk of depositors demanding a sizable amount

of cash from the bank all at the same time. Such an event could
lead to a possible run on the bank unless the central bank
quickly intervenes to bail the bank out of trouble with cash to
pay the depositors.

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