A process whereby a financial institution capitalizes on mismatches between the two sides of its balance sheet (assets and liabilities). Financial intermediaries conduct several types of financial transformation: (1) size transformation; (2) maturity transformation; (3) credit transformation; (4) liquidity transformation; and (5) risk transformation.

• Size transformation: small amounts from saver-lenders (surplus units) are aggregated into large amounts in order to meet the needs of borrower-spenders (deficit units) for financing.
• Maturity transformation: the liabilities of intermediaries, such as banks, are typically much more short-term than their assets. However intermediaries pool deposits (short-term sources of funds) in order to meet the demand of borrower-spenders for long-term funds. In other words, maturity transformation involves the financing of long-term assets with short-term liabilities.

• Credit transformation: the process of enhancing credit quality by means of the securitization. This involves the pooling of assets, and then the tranching of these pools into separate sets of claims with different priorities. It also encompasses the re-allocation of specific cashflows from loans to different claims, within different ranges of seniority and duration, along with an associated range of risk and return, from short-term investment-grade liabilities down to equity.
• Liquidity transformation: the funding of illiquid assets (long-term loans) with liquid liabilities (short-term deposits). Liquidity transformation and maturity transformation lead to similar results but each uses its own means. For example, a bank can create a liquid security from a pool of illiquid collateral assets by playing on credit rating to lessen the information asymmetry between deficit units (borrowers) and surplus units (lenders).
• Risk transformation: financial intermediaries hold assets with higher risk of default than their own liabilities. They can reduce these risks to a minimum level and gain from yield differentials by applying a combination of techniques such as diversification, pooling, screening and monitoring of assets, formation of reserves, and so on.

In this particular sense, financial transformation is also referred to as risk redistribution.

Sometimes, the term “financial transformation” is interchangeably used with leverage (e.g., corporate financial transformation or corporate leverage and personal financial transformation or homemade leverage).