Question

Banks are financial intermediaries engaged in maturity transformation. Explain what it means for banks to engage in maturity transformation and what are the risks associated with it for banks and depositors. How do banks make profits?

Answer 1

For the bank, engaging in maturity transformation means borrowing the short terms finances from different sources like depositors who deposit their money into bank account at the bank and making a long term loans for example, loan to a firm or household mortgages.

The risk associated with maturity transformation for banks and depositors are as follow:-

for bank ​​​​​, there is the possibility that sudden panic might errupt among depositors and they all start demanding their deposited money back all at the same time, it will cause problem to the bank to meet everybody's demand because bank has lent out the money.

In the other scenario it is also possible that bank will find there is no lender to deposit money into bank account. Because of it bank won't be able to make loans.

for depositors there is always the chance that the money they have deposited into bank account and bank has made too many bad loans from it. Then bank would find difficult to retrieve it's loan out money. In that case bank can go bankrupt and depositors might loose all their savings if it is not backed by government or insurance.

Bank make profit by charging high interest rate on the loan they provide and pay lower interest rate to the depositors. Larger will be the interest gap, larger will be the profit of bank.