JGenerations of bank and thrift bank apprentices have become familiar with the basic principle by which a bank active in the traditional deposit and lending business makes its money: it pays low interest on short-term deposits from its clients and charges much higher interest rates. of the clients to whom the bank gives long-term loans. This principle is based on the experience that long-term interest rates often (though not always) exceed short-term interest rates. Hence, interest income from long-term lending business is not only sufficient to pay interest to depositors on their short-term deposits.
The bank can usually cover its costs and make a surplus profit from the interest business. Technically, this principle is called the term transformation. The dazzling German financial broker Rudolf Munmann described it with the following words: “Short makes long.”
Whatever the apprentices learned, this principle conflicts with the venerable “golden banking rule” dating back to the mid-19th century, according to which the maturities of deposits and loans must match. After all, what happens when the bank lends money in the long term, but depositors suddenly want to withdraw their short-term deposits? Is the bank in danger of falling? This seems understandable at first. However, the problem with the “golden banking rule” is that working without a vesting turnover is a low-risk business, but also significantly less profitable.
The solution to the problem, found as early as the nineteenth century, is based on the observation that in fact many customers leave short-term official money in their bank for a long time. In recent years, this has been observed even for deposits on which the interest on fines had to be paid. According to the Law of Large Numbers, a bank or savings bank with a large number of customers should not experience short-term and unexpected withdrawals of funds from all customers. Since the so-called “bottom” of short-term deposits is officially available in the long-run, long-term loans can be granted to the extent of this “bottom” in order to take advantage of the maturity shift. This is the so-called banking “dregs theory”.
It does more harm than good
Of course, one question remains unanswered: what happens in the case of the operation of the bank when several customers want to withdraw funds at once? Fortunately, running is rare these days. But if they do occur, there is a risk of significant economic damage.
Some former interns who have learned these relationships using banking textbooks may be surprised that in 2022 economists were awarded the Nobel Memorial Prize for Economics who, among other things, dealt with the role of maturity shift in banks.
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