Bank gambling with long-term loans and short-term deposits

Turning short-term deposits into long-term loans is one of the main reasons banks exist, enabling customers to have the comfort of deposits that can be withdrawn at any time together with the certainty of mortgages that might last for 25 years.

This statement from a columnist in The Economist  contradicts what I always thought was prudent bank policy – that the time term of a loan should be matched by a deposit of an equal time term.  To mismatch these terms is to use other people’s money to gamble on which way interest rates are going to move.

I know of a Canadian financial institution that purchased a pile of government bonds at ten percent expecting interest rates to go down in which case the deal would have been profitable.  This was just before interest rates went up to 19 percent and this business lost a pile of money as it had to pay a lot more on short-term deposits than it received on its long-term bonds.

This was an extreme case but with the current economic instability we should probably be asking banks to publish information about how the time-terms of their deposits and loans are matched.  Banks should make their profits on the spread between deposits and loans.

 

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