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Intermediation, maturity mismatch and maturity transformation (The 2007…
Intermediation, maturity mismatch and maturity transformation
Intermediation: The process of moving funds between savers and borrowers in return for interest paid by a borrower to an intermediary, such as a bank, who in turn pays interest at a lower level to the saver
One of the principal functions of banks and building societies is intermediation, whereby institutions receive deposits from those with excess liquidity and lend to those who need or wish to borrow
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Typically savers wish to retain a good degree of liquid and thus want to deposit with access to their money either at short term or even straight away whereas borrowers quite often need or wish to borrow over the longer term. Therefore a situation arises known as maturity mismatch
Maturity Mismatch: When a bank or institution has substantial long term assets like fixed mortgages but short term liabilities such as deposits. This can be measured by a duration gap which calculates risk due to changes in interest rates
In addition to engaging in intermediation, banks and building societies need to engage in maturity transformation, which means that these institutions need borrow short and lend long
Maturity transformation: An acceptance by an institution of short-term deposits which are lent out on a different basis - usually long term
Banks provide many loans at short term (and overdrafts are theoretically repayable upon demand), whereas maturity transformation can be even more pronounced in the case of building societies because most of their lending is for financing the purchases of houses and apartments
Unless banks and budding societies are managed prudently, there is a considerable risk of them becoming illiquid given that depositors may withdraw their funds faster than borrowers repay their loans
Banks can be vulnerable to rising rates, for example a mortgage lender taking floating rate short term deposits but lending in the long term at fixed rates
The 2007 credit crisis
The crisis originated from the build up of large savings in Asia over many years; these savings kept world interest rates and inflation rates low. They provided liquidity to Western banking systems.
The credit crisis from 2007 onwards arose because banks and other institutions lent money to many real estate purchasers who did not have sufficient earnings to support repayment of the loans given to them
These loans were added together and sold as a safe property package to institutions seeking an income stream
The package was securitised (made into a tradable investment) and sold to investors who miscalculated the risk value of the package. Unfortunately when borrowers began to default on their loans, the low risk which had supposedly been offset through the credit default swaps market (a supposed insurance against default) was found to be inadequately covered by the counter party to the swap arrangement
Confidence quickly fell with the collapsing real estate market and the packages of loans bought by banks around the world ceased to have the value expected. They were given the name 'toxic assets'
The enormous sums of money involved caused a liquidity criss. The banks and financial institutions that bought these investments found that they did not have sufficient assets to back their everyday bank business as require under Basel II. They therefore had no choice but to ask for government backing or go bankrupt
Government backing was not forthcoming in all cases. The firm of Lehman Brother was allowed to collapse. In contrast the insurance giant AIG was rescued. AIG had failed to provide sufficient liquid funds to cover the counterparty risk it had undertaken. The US government had little choice but to support AIG because the consequences of a default for AIG would have been disastrous
The crisis caused a lack of confidence in the world baking system. Liquidity dried up and governments had to step in to fund the banking system to prevent complete economic collapse. Without liquidity, the trading of goods and services ceases to function
The UK also found itself with several buildings societies and other mortgage lenders lacking sufficient assets to survive when their short term loans could not be renewed and depositors withdrew their money. One of the reasons that certain building societies in the UK found found themselves in difficult was because they 'borrowed short and lent long' to a level greater than their loan book could support, which is not how a sound society or bank should conduct its business
Borrowing on a short term basis from the money market and lending on a long term basis to a house of flat purchaser, is known as maturity transformation. This only works if there is a beneficial difference between interest rates paid to the market and charged by the bank or building society to the borrower and if short term market loans can be renewed at maturity
Response to the criss
New laws, regulations and supervisory arrangements are still being proposed by the USA and the European Union to ensure that it is less likely to occur again
At the Group of 20 meeting in June 2010, the major economies reaffirmed their commitment to regulation of over the counter derivatives by making OTC trades use regulated exchanges or other trading platforms to ensure clearing houses process the transactions. This is now being implemented in Europe and the USA