Iceland's Banking System Was Heavily Engaged in Maturity Mismatching

Iceland has something in common with other developed economies that the recent economic crisis has affected: its banking system was heavily engaged in maturity mismatching. In other words, Icelandic banks issued short-term liabilities in order to invest in long-term assets. Thus, they had to continuously roll over (renew) their short-term liabilities until their long-term assets matured. . . .

The question that immediately comes to mind is, why did Icelandic banks engage so heavily in this risky practice in the first place? One reason is that maturity mismatching can turn out to be a very profitable business involving a basic interest arbitrage. Normally, long-term interest rates are higher than the corresponding short-term rates. A bank that sells short-term rates (borrows money short-term), while buying long-term rates (investing money long-term) may profit from the difference (the “spread”) between short- and long-term rates. Yet while maturity mismatching can turn out to be profitable, it is also very risky, because the short-term debts require continual reinvestment (that is, there must be a continual “rollover”).

--Philipp Bagus and David Howden, Deep Freeze: Iceland's Economic Collapse (Auburn, AL: Ludwig von Mises Institute, 2011), 7-8.