Maturity transformation refers to a role played by banks in which they use short-term funds to finance long-term projects. For example, banks could use deposits that can be withdrawn by their customers at any point in time to give out loans that are repayable over many years by borrowers. Depositors generally like to have ready access to the deposits that they entrust with a bank. Borrowers, however, prefer to take out loans with tenures that are ideally as long as the tenure of the projects in which they invest the borrowed money. Banks try to act as intermediaries trying to bring together depositors with short time horizons and borrowers with long time horizons.
In order to manage the mismatch between the maturity profile of their assets and that of their liabilities, banks repeatedly roll over their deposits. They do this by paying current short-term depositors who demand their money back with fresh money that they receive from new short-term depositors. This makes the business of banking a risky venture as banks need to correctly forecast when their liabilities (customer deposits) and assets (loans) will mature, and how to manage any mismatch in these maturities. If a bank’s depositors demand their money sooner than the bank’s borrowers can repay their loans, this can lead to trouble as the bank will be unable to make good on its promise to return money to its depositors on demand. The bank may even be forced into a fire sale of its assets in order to immediately pay back depositors, which in turn could cause the bank to go insolvent. Banks may try to extend the maturity of their liabilities by rolling them over with fresh deposits. They may also use instruments such as bonds, fixed deposits, etc., which have a defined maturity date in contrast to current deposits that can be withdrawn at any time. Some economists believe that banking is inherently unstable due to the mismatch in the maturity of assets and liabilities of banks. Hence, they believe that banks need help from the government in the form of bailouts whenever they get into trouble. Bank bailouts are seen by these economists as a small price to pay to facilitate the role of banks in effectively channelling the savings of people into investments. Other economists, however, believe that banks need to adjust their loan-making practices in such a way that it is consistent with the maturity profile of their deposit base. Some particularly note that it should be illegal for banks to promise their short-term depositors that they can withdraw their money whenever they want since banks loan these to borrowers. Instead, they argue that short-term funds should be treated as safe-keeping deposits and banks should be barred from using these funds to give out loans.
The maturity transformation role of banks should not be confused with the practice of fractional reserve banking. Under a fractional reserve banking system, banks are allowed to create loans without sufficient actual deposits backing these loans. This leads to the risk of depositors demanding a sizable amount of cash from the bank all at the same time. Such an event could lead to a possible run on the bank unless the central bank quickly intervenes to bail the bank out of trouble with cash to pay the depositors.