Indirect Maturity Transformations

This paper compares `direct maturity transformations' (DMTs), in which risky long-term assets are directly financed with short-term debt, with `indirect maturity transformations' (IMTs), in which such assets are financed with long-term debt that is financed with short-term debt in a second, separate step. Analyzing the properties of debt contracts I show that the default probability of short-term debt is higher in case of an IMT than in case of a direct transformation - for the same assets and the same level of short-term debt. Based on a model of financial intermediation I suggest two reasons why IMTs can be privately optimal although they entail a higher solvency risk than DMTs: first, the indirect reference of short-term debt to the underlying assets can decrease liquidity risk; second, IMTs allow for regulatory arbitrage in case of capital requirements that do not take account of the different solvency risk of IMTs and DMTs.