A bank is an institution that borrows short and lends long. It takes deposits payable on demand and makes loans that mature over years. That maturity transformation is the source of the bank's profit and the source of every banking crisis in history.
- 01State the business model of a bank in one sentence.
- 02Explain maturity transformation and its risks.
- 03Read a bank's income statement at a working level.
Borrow short, lend long
A depositor puts $1,000 in a checking account. The bank uses that liability to fund a mortgage that repays over thirty years. The bank profits from the spread — the difference between what it pays the depositor and what it earns on the loan — and it accepts the risk that the depositor asks for their money before the loan repays.
The three things that can go wrong
Credit risk: the borrower does not repay. Liquidity risk: too many depositors ask for their money at once. Interest-rate risk: rates rise and the bank is locked into a low-yielding long asset while paying more on short liabilities. Every banking failure in the modern era maps to one of the three.
The income statement
Net interest income is the spread on the banking book. Fee income is service revenue. The efficiency ratio — noninterest expense divided by revenue — tells you how much of every dollar of revenue is consumed by operations. Below 55% is well-run; above 70% is trouble.
- Maturity transformation is the business.
- Credit, liquidity, and rate risk are the three failure modes.
- Efficiency ratio is a fast read on operating discipline.
- Mishkin, The Economics of Money, Banking and Financial Markets, Ch. 9 — The reference textbook on the banking business.