Term Deposits (4) - Borrowing Short and Lending Long

Modern banks tend to borrow for short terms and lend for long terms. For example, most mortgages have a term of 15 to 20 years, but some of the funding comes from term deposits with a term of less than a year. This creates problems, because banks are lending money that they do not own or control. If the bank only controls the money for 6 months lending it for a twenty year term is odd. We need to think clearly about what this means.

The depositor is in a strange situation. They have lent their money to the bank for six months. The bank has taken this money and lent it to someone for twenty years. It has taken this action knowing that it will not get the money back from the borrower, when the term deposit is due to be repaid. Unless the bank has other mortgages that will to be repaid at that time, it will have to obtain the money to repay the depositor from some other source.

A term deposits at a bank is supposed to be of the safest things that a person can do with their money. This is not true. The reality is that the bank is making a commitment to return the depositor’s money at the time when the term is complete, without knowing where or how they will obtain the money to fulfil this commitment. Most of this risk rests with the bank. They should normally be able to get the finance from another source, but they do not know what the future holds. Economic conditions might have changed dramatically by the time the term deposit matures. If economic conditions have deteriorated, the bank might have to offer a much higher interest rate to get the finance they need.

The security of a term deposit depends on the ability of the bank to guess what will happen in the future. A prudent bank might be able to manage the risks involved, but if it guesses wrong about the future, it might face significant losses. If the bank really gets thing wrong, the depositor might lose their money. If depositors understood the risks involved, they might not feel their money is safe.

This full series can be read at Bank Deposits and Loans.