IAI Actuarial Core Principles · Business Economics · Role, structure and stability of the financial system
A bank takes in demand deposits and lends the funds as 5-year loans. Which risk is most directly created by this maturity transformation, and which feature of the system makes it more likely to cause wider instability?
Maturity transformation exposes the bank to liquidity risk, since depositors may withdraw together while long loans cannot be recalled quickly. Interbank lending and shared confidence let one bank's trouble spread to others, which is why such transformation can threaten the stability of the wider financial system.
- ALiquidity risk, because many depositors could withdraw at once while the loans cannot be quickly recalled, with contagion spreading through interbank linksCorrect
- BExchange rate risk, because deposits and loans are in different currencies, with contagion spreading through tax changes
- CInflation risk only, because loans are always repaid in real terms, with contagion limited to the borrower
- DUnderwriting risk, because the bank guarantees share issues, with contagion spreading through stock exchange rules
- Operational risk only, because loans mature later than deposits, with no spread to other institutions
Explanation
Borrowing short and lending long exposes the bank to liquidity risk: a run cannot be met from loans that are illiquid. Because banks lend to and borrow from each other and confidence is shared, one bank's failure can spread to others. The other options misidentify the risk or deny any contagion.
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