macroresilience

resilience, not stability

Questioning the Benefits of Maturity Transformation

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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.

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Written by Ashwin Parameswaran

October 21st, 2010 at 7:54 am

Posted in Financial Crisis

12 Responses to 'Questioning the Benefits of Maturity Transformation'

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  1. I love the subject of your blog. I have thought about this before the crisis and a lot since the crisis. I like two possibilities one is reducing, maturity transformation. The other is free banking were the banks print their own currency backed in nothing but bank assets. They can still use gold (or as Gorge Selgin advocates treasury notes) to value different bank currency on par but and option clause can still protect a bank against a runs. In effect this means that money is only backed in bank assets. With such a system the failure of one bank does weaken other banks, it strengthens them.

    The way that I see it the feedback is the problem. Also I think that CPI targeting is problematic and free banking would produce level spending rather than level prices.

    Floccina

    26 Oct 10 at 12:40 pm

  2. After years of trying to understand it, that is the best and most accessible explanation of maturity transformation and its factors I’ve read. Thanks you.

    Kevin

    27 Oct 10 at 5:54 am

  3. Hi Ashwin,

    This is an excellent discussion of maturity transformation. I do think, however, that there’s another factor you haven’t addressed yet and that is the role of maturity transformation in expanding the money supply. I think the issue is not so much that there is a “demand” for short-term liabilities. Instead the demand is for a circulating medium of exchange and this is what the banks offer to their borrowers whenever they lend (long or short term).

    The protection of maturity transformation by banks is really about protecting the stability of the money supply. When we talk about other firms getting into the business of maturity transformation, we should ask ourselves whether they are increasing the money supply — and thus increasing the danger of a sudden collapse in the money supply.

    BTW Thank you for the tweet recommendations of my posts!

    csissoko

    29 Oct 10 at 11:15 am

  4. Hi Carolyn

    Thank you! You are, of course, spot on. The purpose of this post was just to refute the argument that in the absence of banking as it is constructed right now, long-term investment will collapse or long-tenor rates will skyrocket. And to establish the minor but corollary argument that longer tenor is not always better from the investor’s perspective – it’s about matching assets and liabilities as closely as practicable.

    The topic of maturity transformation and money supply deserves atleast a separate post but to try and put it briefly: In my opinion, the current structure of banking where banks undertake the public function of money creation via maturity transformation and extract private rents is the worst of all worlds.

    Mervyn King in a speech last week made a point that I rarely see central bankers admit: “”financial engineering” allows banks to manufacture additional assets without limit.” When you combine this removal of limits with the irrelevance of bank reserves in determining money supply, it’s fair to say that the central bank has already lost control of broad money supply, apart from losing control of the banks’ ability to extract rents.

    I am increasingly certain that we can only attain stability in the money supply at the expense of an increased risk of an ultimate collapse. Either we have occasional and moderate falls in money supply or rare and catastrophic falls – perfect stability is not a resilient and long-run sustainable option, atleast not in the context of anything that resembles a capitalist economy.

    On the tweets – you’re welcome. Your posts are always superb.

    Ashwin

    29 Oct 10 at 12:10 pm

  5. Floccina, Kevin – Thank you.

    Ashwin

    29 Oct 10 at 12:11 pm

  6. Ashwin, I thought of your blog today while reading this speech. The remarks are a couple years old and a tad on the long side, but they repay the reader’s patience.

    John

    5 Nov 10 at 9:07 pm

  7. ps I see Floccina mentioned George Selgin… I think he and Larry White have written on the option clause Lacker discusses. Supposedly it was a common feature of early modern Scottish banking, till the government banned it.

    John

    5 Nov 10 at 9:12 pm

  8. John – Thanks. I remember reading that speech. Even by Lacker’s standards, it’s one of the best. Jeff Lacker is always good on moral hazard which is not surprising given that him and Marvin Goodfriend have done a lot of the better academic research on the topic.

    And yes, I’m familiar with Selgin’s work on free banking – I’m not sure though that it would result in a system free of bank runs and crises but the crises would probably be much smaller in magnitude even if they were more frequent. In a ecological sense, that’s an improvement over the current system of infrequent but catastrophic crises.

    Ashwin

    6 Nov 10 at 1:05 am

  9. I think that’s right about free banking. There’s no panacea, and the most cleverly designed contracts can’t anticipate and provide satisfactorily against every eventuality. The virtue would lie rather in the system’s adaptability over time.

    John

    6 Nov 10 at 7:39 pm

  10. Or so I’d assume, but you would know better than I would.

    John

    6 Nov 10 at 10:06 pm

  11. We agree! Preserving the adaptability and resilience of the system is key rather than trying to attain some utopian ideal of stability.

    Ashwin

    7 Nov 10 at 9:57 am

  12. [...] what if there is no maturity mismatch for banks to intermediate? In a previous post I have argued that “structural changes in the economy have drastically reduced and even possibly [...]

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