AQA Specification focus:
‘Why a bank might fail, including the risks involved in lending long term and borrowing short term.’
Introduction
Banks play a critical role in modern economies, but they are inherently vulnerable to instability. Their failure often arises from maturity mismatch risk, where lending and borrowing horizons diverge.
Understanding Maturity Mismatch
What is Maturity Mismatch?
When banks use short-term borrowing (e.g., customer deposits) to fund long-term lending (e.g., mortgages or business loans), a mismatch occurs between the maturity of assets and liabilities.
Maturity Mismatch: The situation where a bank’s liabilities (borrowed funds) are due in the short term, while its assets (loans) are repayable over the long term.
This creates liquidity pressures and exposes banks to risks if short-term funds are withdrawn before long-term loans are repaid.
Why Banks Might Fail
Liquidity Shortages
Customers typically deposit funds in easily accessible accounts.
If large numbers of depositors withdraw money simultaneously (a bank run), banks may lack the cash to meet demands.
Because loans are tied up long term, the bank cannot liquidate assets quickly without heavy losses.
Solvency Issues
If loans default or lose value, the bank’s long-term assets fall short of its liabilities.
This undermines confidence, encouraging further withdrawals, worsening instability.
Refinancing Risk
Banks often rely on continuously rolling over short-term borrowing.
If lenders refuse to renew funding, the bank faces sudden liquidity crises.
The Mechanism of Maturity Mismatch
Step-by-Step Process
Bank collects short-term deposits from customers.
These deposits are used to issue long-term loans.
Deposit holders expect instant access to their funds.
Borrowers repay over years, meaning assets are not liquid.
If withdrawals rise sharply, the bank cannot respond quickly.
This structural imbalance leaves banks highly sensitive to market shocks.
Key Risks Linked to Maturity Mismatch
1. Liquidity Risk
Liquidity Risk: The danger that a bank cannot meet short-term obligations because it lacks liquid assets.
Even if solvent on paper, a bank may collapse if unable to pay depositors immediately.
2. Credit Risk
If long-term borrowers default, the value of bank assets shrinks.
Combined with short-term repayment pressures, this accelerates failure.
3. Interest Rate Risk
Rising interest rates increase the cost of short-term borrowing.
Fixed-rate long-term loans provide less income, squeezing profitability.
4. Confidence Risk
Banking relies on trust.
Fear of insolvency can spark mass withdrawals, turning risk into reality.
Historical Lessons
Global Financial Crisis (2007–2008)
Banks borrowed short term from money markets to fund long-term mortgages.
When interbank lending froze, they lacked liquidity.
This maturity mismatch was central to widespread banking failures.
Northern Rock (UK Example)
Relied heavily on short-term wholesale funding.
When markets lost confidence, refinancing dried up.
Bank runs highlighted the fragility created by maturity mismatch.
Why Regulation is Needed
Prudential Requirements
Regulators impose liquidity ratios and capital ratios to reduce maturity mismatch exposure.
Banks must hold a minimum proportion of liquid assets.
Lender of Last Resort Role
Lender of Last Resort: The central bank provides emergency liquidity to financial institutions unable to borrow elsewhere.
This function prevents short-term funding shortages from immediately triggering systemic collapse.
Deposit Insurance
Protects depositors up to a limit.
Helps maintain confidence and reduce the risk of bank runs.
Interaction with Systemic Risk
Contagion Effects
The failure of one bank can spread panic to others.
Because most banks use similar models of short-term borrowing and long-term lending, maturity mismatch risk is systemic.
Financial Stability Concerns
Multiple failures reduce lending, hurting households and businesses.
Real economy suffers from investment declines, unemployment, and recessionary pressures.
Summary of Key Points
Maturity mismatch occurs when banks borrow short term but lend long term.
Creates liquidity risk, credit risk, and interest rate risk.
Can lead to bank runs, insolvency, and systemic crises.
Regulation, central bank support, and deposit insurance are essential to mitigate failures.
FAQ
Depositor confidence is vital because banks rely on customers keeping their money in short-term accounts. If confidence falls, depositors may withdraw funds rapidly, causing a bank run.
Maturity mismatch worsens this because banks cannot immediately liquidate long-term loans to repay depositors, amplifying liquidity pressures.
Central banks assess banks’ balance sheets to check the ratio of short-term liabilities to long-term assets.
They require regular stress tests, where banks are evaluated under scenarios of sudden deposit withdrawals or market shocks. These measures allow central banks to ensure financial institutions hold enough liquid reserves.
Wholesale funding relies on financial institutions lending to each other, often for very short terms.
If market confidence collapses, these funds can dry up instantly.
Retail depositors are less mobile, but wholesale lenders may withdraw billions overnight, creating rapid systemic instability.
Banks can adopt several approaches:
Holding higher levels of liquid assets.
Diversifying funding sources beyond short-term borrowing.
Using long-term bonds instead of relying heavily on deposits.
Employing asset-liability management committees to monitor mismatches.
If one bank fails due to maturity mismatch, panic can spread across the financial system.
Other banks may be perceived as vulnerable if they share similar funding structures. This contagion effect can restrict credit availability, damage interbank trust, and cause widespread disruption in the economy.
Practice Questions
Define maturity mismatch and explain briefly why it can create liquidity problems for banks. (2 marks)
1 mark for a correct definition of maturity mismatch (e.g. banks borrow short term but lend long term).
1 mark for recognising the link to liquidity problems (e.g. deposits can be withdrawn quickly but loans are tied up over time).
Explain how maturity mismatch can lead to bank failure. Use examples to support your answer. (6 marks)
1–2 marks: Basic explanation that banks borrow short term and lend long term.
1–2 marks: Explanation of liquidity problems, e.g. banks may not have sufficient liquid assets to repay depositors.
1 mark: Reference to risks such as refinancing difficulties or loan defaults.
1 mark: Use of an example, such as the Northern Rock crisis or the 2007–2008 financial crisis, showing how maturity mismatch contributed to failure.
