Banks are financial intermedia
Banks are financial intermediaries engaged in maturitytransformation. Explain what it means for banks to engage inmaturity transformation and what are the risks associated with itfor banks and depositors. How do banks make profits?
Answer:
For the bank, engaging in maturity transformation meansborrowing the short terms finances from different sources likedepositors who deposit their money into bank account at the bankand making a long term loans for example, loan to a firm orhousehold mortgages.
The risk associated with maturity transformation for banks anddepositors are as follow:-
for bank , there is the possibility thatsudden panic might errupt among depositors and they all startdemanding their deposited money back all at the same time, it willcause problem to the bank to meet everybody’s demand because bankhas lent out the money.
In the other scenario it is also possible that bank will findthere is no lender to deposit money into bank account. Because ofit bank won’t be able to make loans.
for depositors there is always the chance thatthe money they have deposited into bank account and bank has madetoo many bad loans from it. Then bank would find difficult toretrieve it’s loan out money. In that case bank can go bankrupt anddepositors might loose all their savings if it is not backed bygovernment or insurance.
Bank make profit by charging high interest rate on the loan theyprovide and pay lower interest rate to the depositors. Larger willbe the interest gap, larger will be the profit of bank.
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