3. Innocent Lost: Alchemy and Banking

What is it that makes banks special? The distinguishing feature of a bank is that its assets are mostly long-term, illiquid and risky, whereas its liabilities are short-term, liquid and perceived as safe. Returns on riksy long-term assets are normally higher than the returns which the bank has to offer on its short-term liabilities. So banking is highly profitable. Unfortunately, the notion that a bank can offer safe returns on deposits that can be withdrawn at a moment's notice by using them to finance long-term illiquid risky invesments is, as common sense would suggest, generally false. The transformation of short-term liabilities into long-term assets - borrowing short to lend long - is known as maturity transformation. And the creation of deposits, which are regarded by the depositors as safe, into loans which, by their nature, are inherently risky constitutes risk transformation. Banks combine maturity and risk transformation. This is what makes them special.