Maturity Transformation
Maturity transformation is the practice of funding long-term, illiquid assets with short-term liabilities that can be withdrawn or must be renewed quickly. It is the core economic function of banking and the source of its fragility.
Also called: borrowing short and lending long · liquidity transformation · maturity mismatch
Savers want access to their money at any time; borrowers want loans they can repay over years. A bank stands between them, promising depositors instant access while lending their money out for long periods. It earns the difference between the low rate paid on short-term funding and the higher rate earned on long-term assets.
The arrangement creates two risks. The first is liquidity: if short-term funders leave together, the long-term assets cannot be sold quickly without loss, which is the mechanism of a bank run. The second is interest-rate risk: when rates rise, funding costs go up at once while long-dated assets keep earning the old rate and fall in market value.
Banks are allowed to do this because they are subject to capital and liquidity rules and have access to the central bank. Shadow banking does it without those protections. Payment and e-money institutions are generally forbidden to do it at all with customer money: safeguarding rules require client funds to be kept in liquid, low-risk form so they can be returned on demand.
Example
A fund promises investors same-day redemption and holds six-month commercial paper. In calm markets nobody notices the mismatch. When a fifth of investors redeem in one week, the fund must sell paper into a falling market, and remaining investors have a reason to leave too.
See also
- Bank RunA bank run is a rush by depositors or other short-term creditors to withdraw their money from an institution because they fear it will fail. Because no bank holds enough liquid assets to repay everyone at once, the rush itself can cause the failure.
- Shadow BankingShadow banking is credit intermediation carried out by institutions and markets outside the regular banking system: money market funds, finance companies, hedge funds, securitisation vehicles and repo markets doing what banks do without bank licences, deposit insurance or central bank backing.
- Money Market FundA money market fund (MMF) is an investment fund that holds short-term, high-quality debt such as Treasury bills, repo and commercial paper, and aims to keep a stable value while offering daily access. Investors use it like a deposit, but it is not one.
- Commercial Bank MoneyCommercial bank money is the money that exists as deposits at commercial banks. It is a private bank's promise to pay, created when banks lend, and makes up the large majority of the money that households and businesses actually use.
- SafeguardingSafeguarding is the statutory requirement that an authorized payment or e-money firm keep customer funds apart from its own money, by a method the rules prescribe, so the funds are identifiable and returnable to customers if the firm fails. It is a licensing condition, not best practice.
- FloatFloat is customer money sitting with a payment firm between the moment it is received and the moment the beneficiary is paid, together with the working-capital and interest effects of holding that balance. Whether the firm may keep those benefits is set by its regime and its customer terms.