The Bank of Lithasia plans to increase its revenue by using demand deposits held with the bank for long-term investments. What is this process known as? Is there any risk associated with this process? If yes, how can the risk be reduced?

Question

What will be an ideal response?

Answer 1

The process that Bank of Lithasia is planning to apply is known as maturity transformation. Maturity refers to the time until debt must be repaid. Maturity transformation refers to the process by which banks take short-term liabilities and invest in long-term assets. This process allows society to undertake long-term investments.
One of the implications of such maturity transformations is that it creates a mismatch between the short-term maturities of deposits held with the bank and the long-term maturities of the investment made by the banks. Hence, if a large number of depositors simultaneously want to withdraw money from the bank, it can create a problem for the bank, as they may not have enough funds to allow for the withdrawal. Moreover, it is not possible for banks to recover the money they have used for long-term investments in such a short notice to repay the depositors. Hence, maturity transformations can place banks in a risky position.
One possible method for banks to minimize the risks associated with maturity transformations is to maintain some fraction of the deposit pool as reserves or some other form of cash-like security. A small reserve usually suffices because only a small fraction of depositors are likely to withdraw their deposits on the same day.