Maturity Mismatch

Debt instruments have two basic components: maturity and interest rates. Maturity is the length of the obligation. The interest rate defines how much the borrower pays in order to get access to the money. So a 10-year bond with a 5% rate has a maturity of 10 years and a rate of 5%.

You own a restaurant. You borrow $100,000. You then use that $100,000 to build a new patio, or buy ingredients for the food, or you just run off with the cash to Croatia. Whatever the details, the debt situation is a one-way street. Money comes in and then gets spent.

For banks, the debt situation goes both ways. Banks borrow money. And while they might spend some of it (for instance, on stocking the big bowls of suckers in front of each teller station), most of the cash they borrow gets lent back out.

So the financing gets...complicated. The bank has money coming in, and money getting lent out. Meanwhile, it also needs some cash just to run its business...to make payroll, to give to depositors who want withdrawals, to buy more suckers...all the normal day-to-day stuff.

As such, the bank has to have money available for these expenses. So it can't borrow a bunch of money with short-term maturities and lend it all out for the long-term. Do this, and the firm would end up with the It's A Wonderful Life scenario: a bunch of near-riotous depositors gathered around the teller, with the owner standing on a table shouting "The money's in Phil's house! And in Jerry's house! And in Earl's house!" Basically, the bank doesn't have the money for its immediate needs, because it's all sunk into long-term investments.

This situation is known as a maturity mismatch.

Too many long-term assets paired with too many short-term liabilities. Or it can go the other way. If a bank ends up with everything clustered on the short end, it won't have a large enough profit. Longer-term loans pay off at higher rates, and the longer term means that more cash ultimately comes in from those investments.

So the bank doesn't want to avoid longer-term loans. It just wants to make sure that both sides of the ledger match up. In other words, it wants to avoid the maturity mismatch.

Note: a maturity mismatch is different than a maturity gap. The mismatch describes assets and liabilities where the maturities don't align...the maturities on the asset side need to match the maturities on the liabilities side. Meanwhile, a maturity gap describes a way to track the difference in interest rates between assets and liabilities, within given maturity intervals. It's actually a measure of rates, not of maturities.