The Asset Transformation Function of Financial Intermediaries

Financial intermediaries like commercial banks, savings banks, or savings and loan associations — we call them banks for short in the following — perform various kinds of intermediation functions in the capital market, e.g. pooling of supply and demand, providing market participants with arbitrarily sized loan or deposit volumes, supply of perfectly liquid investments, risk sharing, and asset maturity transformation. This paper focuses on the last issue, i.e. the transformation of market rate sensitive, short term liabilities (deposits) into fixed—rate, long term assets (loans). In the case of a normal (rising) yield curve, the usually resulting positive gap in the bank’s balance sheet — the volume of fixed—rate loan contracts exceeds that of fixed—rate liabilities — provides the bank with a positive net interest rate margin which is the main source of profits for most depository financial institutions. Besides this rather “classical” reasoning, more recent contributions ground the intermediaries’ asset transformation function on maturity preferences of credit customers (v. Furstenberg 1973), on trade-offs between different kinds of bank risk as, for example, interest rate risk vs. default risk (Santomero 1983, Kiirsten 1991), or on stochastic cumulation effects between market rates and future loan demand (Morgan/Smith 1987).