Why do we need maturity transformation?

By Felix Salmon
January 12, 2011
responded to the government's report on the subject, as has Blackrock.

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There’s a new flurry of commentary today on money-market funds: the Independent Directors Council has responded to the government’s report on the subject, as has Blackrock.

The problem which needs to be solved here is that money-market funds are in the business of maturity transformation: the funds are instantly available to investors in the funds, but they’re lent out for non-negligible periods of time. As David Merkel says, “financing illiquid assets with liquid liabilities is unstable, and begs for bankruptcy at the first significant loss of confidence.”

Merkel’s solution to the problem — requiring that liabilities match assets — is a simple one, and I like it a lot. If money-market funds promise investors their money back on demand, then they should only lend out money overnight.

How much downside would be associated with eradicating maturity transformation in this way? Not much, says Ashwin Parameswaran, who argues that “structural changes in the economy have drastically reduced and even possibly eliminated the need for society to promote and subsidise maturity transformation”.

I’m inclined to agree with him, since the downside of eliminating maturity transformation is higher interest rates, and a move towards equity and away from debt. Which would be very welcome, and make the economy as a whole much more robust.

This doesn’t mean, of course, that deposit insurance should be abolished. Deposit insurance does indeed act as means to promote maturity transformation, but it also acts to safeguard the savings of people with very little money, and encourage them to move their money out of the mattress and into the banking system.

But when people put their money in uninsured vehicles like money-market funds, they’re effectively trying to get interest rates associated with longer-term investments, on the order of a few weeks, while refusing to lock up their money for any time at all. If they want to make those longer-term investments, they should do so, rather than having their cake and eating it as they do right now.

Maturity transformation has, historically, been a helpful thing in terms of providing credit to grow the economy. But its time might have come and gone. At this point, there’s too much debt, not too little. And requiring assets to match liabilities would help move us back to a healthier state.


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David Merkel’s article is about banks, not money market mutual funds. Money market mutual funds (the clue is in the name) do not “promise investors their money back on demand”. They promise investors a proportionate share in the pooled investments of the fund; the “break the buck” taboo is a convention, not a requirement. They do not “finance illiquid assets with liquid liabilities”; they are 100% equity-financed. If they issued debt-like liabilities which promised investors their money back, they would be banks.

And I don’t understand the underlying analysis. If there is no need for maturity transformation, what’s so great about equity (a claim of indefinite maturity)? What banks and securities provide is *liquidity* transformation – the ability to finance long dated projects out of pooled savings while allowing those savings to be instantly realisable. Pension funds want long-dated claims to lock in their payment profile, but they don’t want wholly illiquid claims. You can actually dramatise this by noting that Northern Rock did not carry out maturity transformation – it financed its book by bond issuance and swapped out its interest rate risk. The UK and most European banking systems are structured in more or less exactly the way that David suggests.

Posted by dsquared | Report as abusive

dsquared above is correct, but another point occurs to me. Islamic finance is all about creating debt-like instruments out of equity-like transactions. Accordingly, this suggests that there is a demand for capital by such businesses that is not met by purely equity investments. One assumes that eliminating debt finance would leave the same problem for western businesses, and lead to the same kinds of structures to create debt-like instruments.

Posted by DrFuManchu | Report as abusive

I should add that just because some participants in the economy have too much debt, and need to deleverage, it does not mean that there is too much debt in general, or indeed that reducing the total stock of debt by reducing the leverage of parties not in trouble, will help anyone one bit.

Posted by DrFuManchu | Report as abusive

dsquared almost always provides superb commentary, so I am left scratching my head a little here. The view that maturity transformation is liquidity transformation is mainstream, not some alternative, and Felix has explicitly stated that interpretation in his post. Neither he nor Merkel is talking about IR market risk. Merkel wants banks to “approximately match cash flows for assets”, and his proposed solution is to fund long-dated assets with long-dated floating rate loans. His remark about “using interest rate swaps to achieve the same result” is a bit cryptic, but in order to “achieve the same result” it would be necessary to fund assets with long-dated *fixed* loans and swap into floating to generate some bonus IR risk. Exactly why anybody would want to do this is a mystery, but that is Merkel’s problem not mine; it is the clear meaning of the very next sentence: “the risk is that a bank locks in what proves to be a low spread on the asset, while funding costs are volatile.”

Regarding money market funds, I doubt that Felix misunderstands the letter of their legal obligations. Sure, they aren’t *obliged* to return money on demand, but as a practical matter that is the basis of their existence. We ran the experiment in 2008: money market fund investors are not truly willing to bear the risk of illiquidity, and as soon as it seems they are not being paid money for nothing, they run for the exits. The trouble is that the funds are now such an important part of funding in the de facto (“shadow”) banking system that we cannot bear the consequences of their sudden collapse. They are therefore benefiting from the same sort of moral hazard subsidy as the official banks. The only reason that this is not a higher profile political issues is that fund investment is sufficiently broad-based that undermining its premises is seen as a vote-loser.

However, regarding the value of maturity transformation, I back dsquared completely. Extraordinary claims require extraordinary evidence, and Felix’s evidence is remarkable only for its non-existence. You’ll have to do better than this feeble hand-waving, Felix.

I should also mention that I think both of DrFuManchu’s insights are excellent.

Posted by Greycap | Report as abusive

DrFuManchu, surely the opposite is true. To get round the limitation on interest rates, islamic finance transforms debt instruments into equity like investments.

By the way, equity came about in the first place, because of Christian restrictions on usury.

Posted by Danny_Black | Report as abusive

I don’t think I am sophisticated enough for the nuances of all of this.

When I want to be guaranteed to be able to access 100% of my money immediately, I put it in an FDIC-insured checking account.

When I want to be able to get my money out in a relatively short period of time (one day day to a couple of weeks), it goes into an FDIC-insured savings account or a US-Treasuries money-market account.

If I am putting money in a “cash” form that I don’t plan on needing to access all of it immediately, then it can go into non-Treasury money markets or laddered FDIC-insured CDs.

It has always been clear to me that the increasing level of risk is both access-time and potential to “break the buck” issues if a borrower defaults and I expect to get greater interest rates as a result. I believe that the various prospectuses (those wads of paper I often use as fire starter) are generally quite clear on this.

I couldn’t figure out what all the fuss was about with the Reserve Fund when it became $0.99. I had always assumed that this was a potential risk in a crisis and was the reason why there would be a higher interest rate than in my FDIC-insured checking and savings accounts.

Posted by ErnieD | Report as abusive

Greycap – the thing is that the unclear thing in Merkel’s plan is exactly that he’s failing to make the distinction between maturity transformation (having a borrowed position at the short end of the curve and lent at the long end) with liquidity transformation (having liabilities of short maturity and assets of long maturity). If I fund a 10 year fixed rate loan by issuing a 10 year floating rate note, then I have carried out maturity transformation but not liquidity transformation, for example.

Alternatively, if as under Merkel’s plan I were to fund my 10 year fixed rate loan by overnight money, but to enter into a receive-floating-pay-fixed 10 year swap (ie, to swap out my interest rate risk), then I would not be carrying out maturity transformation. This is what the UK banks actually did; unlike US banks, they tended to run “flat books” with respect to interest rate risk.

However in the second example, I would still be carrying out substantial liquidity transformation; if I lost access to the overnight money market, I would be bust.

As I read him, the problem with Merkel’s analysis is the one you identify – that “matching cash flows” in the swaps market doesn’t actually achieve the same result as matching them with contractual liabilities. It’s confusing though because he uses the phrase “funding loans off of short-dated lending”; I think that the word “lending” is used to mean “deposits” here.

Posted by dsquared | Report as abusive

ErnieD, if you can’t see the difference between 1.01NAV and 0.99 NAV then you are far far far too sophisticated to be a fund manager :p.

It has to be with money markets being “safe”. Why people have difficulty with the fact that a product paying more than the risk-free rate has to have risk is beyond me.

Posted by Danny_Black | Report as abusive


I believe that one of the problems is that the lawyers are writing the prospectuses. They always seem to use the same language regardless of actual risk. As a result, it usually seems like much of the risk language about a money market fund is about the same as a leverage small cap equity fund.

As a result, we get conventions and assumptions about what risk is instead of understanding what risk actually is. I think one of the lessons from the financial crisis is that small investors may actually have a better handle on the actual risks that they are undertaking than the “pros.”

I think by now, many small investors realize that they are continually swimming in shark-infested waters with powerful currents. It seems like the pros were seduced by the Greenspan put and their own computer models into thinking they had actually tamed risk when they really were just creating more of it.

Since the typical small investor isn’t hovering over his money-market fund NAV on a daily basis, fluctuations between 1.01 and 0.99 would be nearly irrelevant and probably barely even noticed, especially if the prospectuses and advertising for the fund make a clear, rational relationship between the higher interest rate and the NAV fluctuation. Unfortunately, that would require lawyers to write a clear informative document which would probably require genetic modifications to be done to the lawyers.

Posted by ErnieD | Report as abusive

Felix would be happy to know that the largest money market firms are expecting their business to dwindle by at least half and perhaps as much as 75% in just a few years. They are all diversifing out into other areas of the investment business. In the current enviroment nearly all funds are being subsizied by their sponsors while they still offer returns near zero. The first quarter point increase in the overnight rate will not be passed on to money market mutal fund shareholders… at that point assets will begin to migrate in force.

Prior to the reserve fund breaking the buck funds had dozens of tricks to get securities that had maturities over a year into money market funds. They are mostly gone now.

The big issures of debt into money market funds (GE, GMAC, investment banks, commercial banks are all strongly incouraged to be constantly lowering their reliance on short term funding. The money market fund is not going to go completely away but it will continue to decline over time.

Posted by y2kurtus | Report as abusive