Knowledge that Transforms

Term structure intermediation, in which institutions purchase assets and sell liabilities of different maturities, is analyzed theoretically and the results are applied to current policy issues. The theoretical model allows the identification of alternative reasons for mismatched portfolios, including risk-loving utility functions, interest rate forecasts that differ from the market's forward rates, and risk premia in the yield curve. The risk premia case appears empirically relevant, and intermediation in which lending is long (earning the risk premium) and borrowing is short (not paying a risk premium) may offset capital market imperfections. But such intermediation is also risky, creating a dilemma for bank regulators.