I’ve been following a floury of recent conversations that has taken place in the last months in regard to the presidential working group’s report on money market funds and the subsequent responses to the report including the IDC’s and BlackRock’s. The report outlined a few options that address the vulnerabilities of the money market funds that contributed to the financial crisis and proposes alternatives to increase MMF’s resilience to severe market stresses. The bottom line however, as many individuals have pointed out, is that banks need to remove the concept of maturity transformation due to asset-liability mismatch.
Maturity Transformation (MT) enables all firms, not just banks to borrow short-term money to invest in long-term projects. Of course, banks are the most effective maturity transformers, enabled by deposit insurance/TBTF protection which discourages their creditors from demanding their money back all at the same time and a liquidity backstop from a fiat currency-issuing central bank if panic sets in despite the guarantee.
Banks have become to essentially be in the business of borrowing short and lending long and that activity heavily caused the crisis.
The fundamental mismatch in debts that finance assets is that the ultimate assets being financed are longer-dated than the financing. We fund land, houses, buildings, plant & equipment, and do it off of deposits, savings accounts and CDs. Some financial companies finance off of short-dated repo funding. The reason that this mismatch is hard to avoid is that average individuals who save want short-dated assets that can be used for transactions. That doesn’t fit well against the need to fund long-term assets.
‘Hard to avoid’ has or is well on its way to indeed become one of those technical terms in regulation that may in the future be on par with ‘too big to fail’. Historically, I can understand the need of a such technical control in terms of banks businesses. It has grown however to be a principle within the industry, as articulated here by the New York Fed President William Dudley.
In contrast, the Japanese has traditionally relied on a strict silo-ing of finance. Where, under Matsukata Masayoshi’s many reforms, banks had evolved into three categories – commercial, industrial and savings. These banks were in essence allowed to operate within their designated industries and proved to be specialized towards the needs of the industries’ clients. Industrial banks, for example, met the long term needs of firms by specifically acquiring capital from lenders who willingly extend capital for a long period of time. As time passes, these banking segments became even more specialized and designated to meet particular maturity needs of their respective sectors.
The options are limited but in light of the given historical account, the possibility does exist to mitigate or even remove the concept of maturity transformation from the industry. And no this will not lead to catastrophic increase in long-end interest rates as many has set forth for counterargument. It is a form of magic from the banks that inadvertently contributed to the crisis. Some may ague for the complete ban of the idea from the system, however, I do believe that firms can engage in the practice and should only do so after explicitly considering the risks involved which should include an acknowledgement of such transactions as being unprotected by tax payers’ dollars.