Banking, Demystified: Maturity Transformation 101

Originally a thread on X/Twitter:

Every business has a core function. Some businesses make athletic shoes while others make wide screen televisions.

What’s become clear over the past week is that many people don’t understand what Banks actually do.

A simplified explanation if you’re interested:

Everyone knows Banks safely store and allow access to their money at-will.

They store it. They protect it. You can claim it. You can move it.

Somehow, depositors don’t pay for these services. In fact, they expect to get paid for depositing their money with a Bank (interest).

This isn’t easy for a Bank to do.

It costs money to park your car in a secure garage with 24/7 access.

It costs money to store and insure jewelry in a 3rd party vault.

But Banks pay you for your deposits because they engage in something known as Maturity Transformation.

What Is Maturity Transformation?

Maturity Transformation is the function of taking short-term sources of capital (deposits) and turning them into long-term borrowings (loans).

That’s it. It’s a major function performed by Banks. They borrow short and they lend long.

This isn’t a risk-free endeavor. Maturity transformation is about taking risk to generate yield.

And risk comes in many forms. Credit risk. Interest rate risk. Compliance risk. Etc.

It takes skill and oversight to manage these risks. And it doesn’t always work out as planned.

But we wouldn’t have a vibrant lending ecosystem if Banks weren’t playing this role.

How many people could find someone willing to lend them money for 5 years to buy a car? How about money for 30 years to buy a house? How about the money needed to start a business?

If you like having access to 30-year mortgages and 5-year auto-loans and credit cards and small business loans then you’re a big fan of maturity transformation.

Think about what life would be like if these loans went away. How would our economy function?

It wouldn’t.

But when things go wrong at a Bank, every Tom, Dick and Harry on social media seems to suddenly know how to re-invent Banking.

These “nouveau experts” think Banks should be fully reserved, match funded and invest deposits only in “extremely safe” instruments (i.e. – not loans).

To be clear, there are places you can park your money to earn investment returns. They’re called Investment firms. But this isn’t what Banks do.

Banks originate, underwrite and manage a book of loans. It’s a critical function to our society so we should be glad they do it.

But it’s impossible for a Bank to have a perfectly deposit/loan ratio all the time. Sometimes they have idle deposits lying around waiting for new loans to be originated.

And idle deposits still earn interest which means they cost the Bank money.

As a result, Banks manage a liquidity portfolio to reduce the cost of deposits that aren’t currently backing loans.

The liquidity portfolio is meant to invest in safe investments (like Treasuries) but it isn’t meant to be the primary source of yield for a Bank.

But in the case of SVB, their liquidity portfolio was being asked to work in overdrive because they were flush with deposits and didn’t have a similarly cranked up machine that could originate assets (i.e. – loans).

And their strategy for generating yield from their liquidity portfolio assumed a lot of interest rate risk. Rates went up while their deposit base was shrinking which created a problem.

But maturity transformation also relies on another important concept called leverage.

Banking is all about leverage. Banks are highly leveraged institutions that manufacture loans that are backed by a fractional amount of equity (deposits). Leverage allows Banks to multiply the impact of their deposit base.

Here’s how our system works:

Bank deposits are moved to the Central Bank which then lends the Bank a multiple of the deposit amounts for the purpose of making loans.

With the marginal reserve requirement standing at 10%, it means that Banks are able to lend customers 10X more than their deposits.

Leverage is powerful but it can also be dangerous if not managed correctly.

But the alternative is also problematic. A system that insisted on Banks being “full reserved” would dramatically reduce the availability and increase the cost of lending products to customers.

As a result, governments have set up minimum regulatory requirements and standards around governance, risk management and internal controls.

These requirements are designed to ensure that the high leverage that’s built into the banking model is carefully managed.

But even with these controls in place, some Banks run into liquidity or credit risk issues.

Additional safety nets like FDIC guarantees and the Federal Reserve’s discount window are in place to ensure that depositors are minimally impacted by mistakes made by their Banks.

The net result is that the banking system has assets with a duration of just over four years with a deposit base that has a duration of just under half a year.

This is what Banks do. They transform short-term deposits into longer duration assets that generate yield.

So while there are many issues that the Banking system is working through, challenging the core premise of what Banks do isn’t where we should be focused. The “how” and the governance can always be improved, but the “what” and the “why” is very clear.