Maturity Mismatch

Maturity Mismatch for banks and its role in financial crisis 2008

Very few companies are able to have perfect matches between the financial terms for their assets and liabilities. There are mismatches in terms of maturity, underlying currency denomination and interest rate structures. Banks play a significant role in society towards bridging the maturity gap.

Maturity mismatch is illustrated by a balance sheet of a business that possesses more short term liabilities than short-term assets and has more assets than liabilities for medium and long term obligations. Banks earn a substantial share of their profits by borrowing short-term (deposits and CDs) and lending long-term to finance business investment. This maturity mismatch reflects the underlying structure of the economy in which individuals have a preference for liquidity but the most profitable investment opportunities take a long time to pay off.

Banks are susceptible to maturity mismatching due to a number of inherent features of banks way of functioning.

1. Debt Maturity Transformation (borrowing short, lending long).

2. Pro-cyclicality in lending and borrowing (borrowing short to meet higher demand for loans during an upturn of business cycle).

3. Relationship banking (rolling-over credit for loan customers to nurture long-term relationships, even when they face liquidity shortages).

Since deposits are lent out, they are not available at all times to be withdrawn by depositors. Thus to avoid the possibility of all depositors withdrawing at once/ to avoid a bank run, guarantee is given by FDIC in the form of deposit insurance and also the banks are capitalized. The capital requirements are determined by the regulators (as per Basel Accord). Maintaining capital is costly as you earn no interest on it and it is just a buffer/ safety cushion. Banks were able to get away with capital requirements in two ways. They temporarily placed assets in off-balance sheet entities/conduits which...