Maturity Transformation

Maturity transformation is the practice of financing long-term or illiquid assets, such as mortgages and business loans, with short-term liabilities, such as demand deposits or short-dated borrowing, that can be withdrawn at short notice or must be rolled over frequently. It is the defining economic function of commercial banks: savers want their money available on demand, while borrowers want funds committed for years, and a bank bridges the two by pooling deposits and lending them out for longer periods. The same mismatch that makes banking useful also makes it fragile, because a bank cannot repay all its depositors at once if they ask together.

Maturity transformation is closely linked to liquidity transformation, the conversion of illiquid assets into liquid claims, and to credit transformation, the conversion of risky loans into relatively safe deposits. Economists often discuss the three together.

A bank takes in money through demand deposit accounts, savings accounts and short-term wholesale funding. On any given day, only a small share of depositors withdraws money, and new deposits partly offset withdrawals. The bank keeps a buffer of reserves and liquid securities and lends the rest for longer terms. Because long-term rates are usually higher than short-term rates, the bank earns a spread, which forms a large part of its net interest margin. The normal upward slope of the yield curve is therefore part of the economic case for the activity.

Deposits created when banks lend are a form of commercial bank money, a private claim that the public treats as equivalent to central bank money so long as confidence holds.

Liquidity and run risk

If depositors start to doubt a bank's solvency, each has an incentive to withdraw first, because those who wait may not be paid in full. The resulting bank run can bring down even a solvent bank, because its long-term assets cannot be sold quickly without heavy losses. The economists Douglas Diamond and Philip Dybvig formalized this in a 1983 model, showing that banks provide valuable insurance against liquidity needs but are exposed to self-fulfilling runs. Diamond and Dybvig shared the 2022 Nobel Memorial Prize in Economic Sciences with Ben Bernanke for research on banks and financial crises.

Interest-rate risk

When a bank holds long-term fixed-rate assets funded by short-term liabilities, a rise in short-term rates increases funding costs faster than asset income. An inverted yield curve squeezes the spread directly. The failure of Silicon Valley Bank in March 2023 combined both risks: it had invested deposits in long-dated government and agency securities, rising rates produced large unrealized losses, and a rapid withdrawal by concentrated, uninsured depositors forced it to sell at a loss. Banks manage this exposure with asset-liability management and derivatives such as interest rate swaps.

• Lender of last resort. Central banks lend to solvent banks facing liquidity shortages against good collateral, a principle associated with Walter Bagehot's 1873 book Lombard Street.
• Deposit insurance. Insurance schemes such as that of the Federal Deposit Insurance Corporation reduce the incentive for insured depositors to run.
• Liquidity regulation. Under Basel III, developed by the Basel Committee on Banking Supervision, banks must hold enough high-quality liquid assets to survive a 30-day stress scenario (the Liquidity Coverage Ratio) and fund long-term assets with sufficiently stable funding (the Net Stable Funding Ratio).
• Reserves and capital. Reserve requirements, where they apply, and capital rules provide further buffers, alongside active liquidity management.

Non-bank institutions also perform maturity transformation, often with fewer safeguards. Before 2008, structured investment vehicles and asset-backed commercial paper conduits funded long-term securities with short-term paper, and runs on these vehicles were an early phase of the crisis. Money market funds offering instant redemption, and dealers financing securities through the repo market, are other examples. This activity is a defining feature of shadow banking.

Payment firms and stablecoin issuers face a related question. Rules for e-money and payment institutions in many jurisdictions require customer funds to be safeguarded in liquid assets precisely so that these firms do not engage in maturity transformation with money held for payments.

Some economists have proposed narrow banking, in which deposit-taking institutions would hold only reserves or short-term government securities, eliminating maturity transformation in the payment system. Opponents argue that this would reduce credit to the economy and push transformation into less regulated institutions. The mainstream view accepts maturity transformation as socially useful and focuses on managing its risks.