The primary reason why banks may be incentivized to finance long-term loans with short-term deposits is the difference in interest rates. Typically, interest rates on long-term loans are higher than those on short-term loans. This is primarily due to the yield curve, which is generally upward sloping. This means that the longer the maturity of a loan, the higher the interest rate that can be charged. Therefore, by financing long-term loans with short-term deposits, banks can earn a higher return on their investments. This practice, however, exposes the banks to rollover risk. Rollover risk is the risk that the short-term debt cannot be refinanced, or can be refinanced only on highly disadvantageous terms. Despite this risk, the potential for higher returns often incentivizes banks to engage in this practice.

Choice A is incorrect. It is not necessarily easier to find long-term deposits than short-term deposits. In fact, the opposite may be true as short-term deposits offer more flexibility and are therefore often more attractive to depositors.

Choice C is incorrect. The ease of finding clients for long-term financing does not directly relate to the decision of banks to finance long-term loans with short-term deposits. This choice does not address the risk-return trade-off that banks consider when making such decisions.

Choice D is incorrect. Long term facilities are not inherently less risky than short term ones. The risk associated with a loan or facility depends on a variety of factors including the creditworthiness of the borrower, interest rate fluctuations, and market conditions among others.

Things to Remember

• Yield curve: The yield curve is a graphical representation of the relationship between the interest rates and the time to maturity of debt securities. It typically slopes upward, indicating that longer-term securities have higher interest rates.

• Rollover risk: Rollover risk is the risk that a borrower will not be able to refinance or