William Dudley recounts the conventional story on how society benefits from maturity transformation here: “The need for maturity transformation arises from the fact that the preferred habitat of borrowers tends toward longer-term maturities used to finance long-lived assets such as a house or a manufacturing plant, compared with the preferred habitat of investors, who generally have a preference to be able to access their funds quickly. Financial intermediaries act to span these preferences, earning profits by engaging in maturity transformation—borrowing shorter-term in order to finance longer-term lending.” The debate on maturity transformation then focuses on comparing these benefits of maturity transformation with its role in creating fragility and moral hazard in the financial system. This post explores a different tack and argues that even the purported benefits of maturity transformation are overstated – structural changes in the economy have drastically reduced and even possibly eliminated the need for society to promote and subsidise maturity transformation.
Ceteris paribus, most borrowers prefer to match the maturity of their liabilities to the maturity of their assets. For example, a corporate borrowing to fund a nuclear plant will seek to borrow long-term funds whose repayment schedule closely matches the expected cashflows from its project. It is important to realise that longer is not always better from the borrower’s perspective. A corporate that needs to fund its working capital will borrow on a short-term basis, and many borrowers (such as homeowners) are willing to pay a premium to retain prepayment options. So if we sum up the demand from all borrowers in an economy, we face a term structure of loan demand rather than a simplistic need to borrow long-term funds. This term structure of loan demand primarily depends on the nature of investment opportunities available at any given point of time. For example, if the economy is undergoing a major upgradation in key infrastructure as in the case in many emerging markets, loan demand will be skewed towards longer-term funds.
Now what about investors’ preference for shorter term maturities? Again, it’s too naive and simplistic to state that all investors simply prefer shorter maturity investments – in particular, it ignores the increasing assets under management of pension funds and life insurers who strongly prefer longer-tenor investments that match their natural long-tenor liabilities. The growing role of pension funds in the long-end is of course a relatively recent phenomenon driven by many factors such as increased longevity and the phase-out of defined benefit and pay-as-you-go pension schemes, the result of which is to divert an increasing portion of investor funds into long-tenor investments. Indeed, pension funds and life insurers are the dominant player in the long-end of the interest rate curve in Europe even though Europe is behind the curve in the transition away from a defined-benefit, pay-as-you-go pension model – a situation that will be exacerbated by the adoption of Solvency 2. In the United Kingdom, pension demand in the long-end meant that the interest rate curve was perennially inverted until the financial crisis hit and short rates plummeted.
The obvious objection to the above story is as follows: even if there is significant investor demand for long-tenor investments, won’t removing bank demand for them still lead to a catastrophic increase in long-end interest rates? The answer is No – as I explained in a previous post, the most significant proportion of the difference between long-end and short-end rates comes from the interest rate differential which most banks hedge out to a large degree (ironically with pension funds and insurers). The part that is usually left unhedged is the credit risk and the liquidity risk. Removing maturity-transformers from the long-end will only lead to a small rise in rates to the extent of the quantum of this unhedged credit risk – what’s more, some of this lost demand may be made up for by pension funds who choose to allocate a higher proportion of their assets towards fixed income investments in response to the rise in rates. But more fundamentally, even if rates do rise at the long-end it is not at all clear that this reduces the welfare of society in any manner. Suppose financial intermediaries are forced to move away from the long-end to the short-end – the resultant reduction of rates at the short-end may even be beneficial if the natural distribution of investment opportunities is more skewed towards the short-end.
It’s worth reiterating that my preferred solution is not to ban or to artificially limit maturity transformation. As Rajiv Sethi points out, all firms can engage in maturity transformation and many do so after explicitly considering the risks involved in it – not surprising given that even on an interest rate hedged basis, short-tenor loans usually cost less than long-tenor loans due to the usually upward-sloping credit spread curve. The question is whether we need to protect maturity transforming banks against the liquidity risk inherent in their actions in order to prevent bank runs – Ideally not but in a second best world where the past weight of protected maturity-transforming actions by banks have made the system too fragile to remove this protection all at once, it is worth putting in place an explicit limitation on the practice of maturity transformation in the future.