On Fractional Reserve Banking

Fractional Reserve Banking is not the problem.  Term Transformation is the problem. Australia and Singapore ban substantial term transformation, came through the recent financial crisis without problems. 

The banker borrows short term at 1%, lends long term at 4%. People deposit their money short term in case of rainy day. One day it rains on everyone, they all want to withdraw their money at the same time, problem.

The financiers run to the government and tell the government, quite truthfully, that they cannot fulfill the promises that they made, and unless the laws of economics are suspended in favor of corrupt and badly behaved bankers, the masses will be hurting.

The ensuing bank runs and financial panics cause widespread economic hardship, there is clamor for the government to ease the pain and prevent similar things from happening in the future, bingo, centrally planned finance. Capitalism continues as crony capitalism in which the favored financiers earn guaranteed profits dependent on government favor and regardless of competence or performance. Power and wealth slides into the hands of unproductive idiots selected for their political ideology.

Suppose, however, term transformation is forbidden. In that case, you cannot borrow long term at fixed interest rates, or if you do, you face exorbitant rates. So, when everyone wants to withdraw their money at the same time, interest rates soar.

This causes pain for borrowers, but since financial institutions remain solvent, we don’t get a self amplifying panic, we do not get runs. The masses suck it up, business as normal continues, and in due course, another crisis of capitalism passes with capitalism unchanged and continuing to work just fine.

In an anarchic society, if depositors monitored their financial institutions solvency and liquidity (liquidity of a financial institution being largely the extent of its term transformation) thus discouraging term transformation, crises would not get out of hand. In Singapore, the government just asks financial institutions to report on the extent of their term transformation, with the implication that anyone who goes out too far on a limb will be invited to jump, thus no one engages in excessive term transformation. If a financial institution were to have excessive term transformation, and the Singaporean government were to make it known it found this excessive and destabilizing, there would be a small run, analogous to firefighters lighting a small fire in the woods so that a big fire in the woods will not have fuel.

20 Responses to “On Fractional Reserve Banking”

  1. Handle says:

    Any links to the Australian ban on maturity transformation?

    How do you three-quarter of a century of a culture of generous deposit guarantee insurance affects this explanation?

    The problem is that it’s very hard to make ‘bank-deposit-like’ products illegal, like money-markets and some other instruments, that offer more yield for more tail risk. Capital flows into these products which erases the risk premium signal, and people treat them as is they are insured and guaranteed like regular bank deposits.

    You can tell people ‘this isn’t a bank account, it’s a kind of very liquid, very low-risk mutual/hedge fund. it is possible for this money market to break the buck and for you to lose money’ – but since it ‘feels’ like a bank account, they don’t act like they internalize the warnings, and depositors as well as banks go begging to the government in a crisis. And then you get runs on this parallel bank-deposit-like system.

    Part of the problem with the old central bank theory was that all you needed to do was keep the system afloat until the panic died away because all the money people withdrew had to go somewhere, through purchases or redeposits, and that place would, naturally, would be back into the banking system, perhaps with a different distribution amongst companies than when the panic began.

    The market has a kind of optimal aggregate portfolio and post-panic it’s unlikely the fraction composed of bank-deposits would permanently shift downward. But that’s not necessarily true when the size of secondary ‘banking-like’ systems becomes very large.

    More generally, irrational ‘runs’ are possible in any market, not just money markets. Johnny Carson can make a joke in 1974 and everyone in the country goes out and buys every roll of toilet paper they can get their hands on. Folks late to the party have a sticky problem on their hands, and have to borrow from their more culturally-plugged-in and panic-happy neighbors until wayerhauser and georgia pacific can restock all the shelves. But, since there’s a fairly … regular … expendation of the product, ordinary market activity will be restored whether Johnny gets back on TV and says “It was all a joke!” or not.

    • jim says:

      Part of the problem with the old central bank theory was that all you needed to do was keep the system afloat until the panic died away because all the money people withdrew had to go somewhere, through purchases or redeposits, and that place would, naturally, would be back into the banking system,

      Yes, and with the wise and the good managing the central bank, all will be well, and sometimes this has been what actually happened. Unfortunately, with actual mortals operating the central bank, chances are you do not actually keep the system afloat, but convert it into a socialist command economy run by the politically connected.

      • VXXC says:

        Actually as Pundita has been pointing out, what we have with Central Banking in the US [and it’s USG Dollar Empire] is Bankers Collectivism. Macro-Economists must think in the aggregate, that is to say “collective”. When they’re the Central Economic Planners [The Fed] they have to act as collectivists. That’s been her Central point recently. [Punditablog].

        I’ve been calling it Bankers Communism. You might call it Bankers Socialism.

    • jim says:

      More generally, irrational ‘runs’ are possible in any market, not just money markets.

      A run on fashionable shoes is unlikely to result in a socialist command economy and crony capitalism

  2. rightsaidfred says:

    Suppose, however, term transformation is forbidden. In that case, you cannot borrow long term at fixed interest rates, or if you do, you face exorbitant rates.

    This overly penalizes long term projects.

    Better to just raise reserve rates. There should be an amount banks keep in reserve to cover any runs. Let’s be conservative here and avoid financial panics.

    But the usual (liberal) suspects are anxious to mash the accelerator pedal down even further, and call for smaller reserves. Europe is pretty bad in this regard.

    • jim says:

      Suppose, however, term transformation is forbidden. In that case, you cannot borrow long term at fixed interest rates, or if you do, you face exorbitant rates.

      This overly penalizes long term projects.

      Long term projects in Australia, and for the most part in Singapore, are generally financed at flexible interest rates. It does not seem to be huge problem.

      There should be an amount banks keep in reserve to cover any runs

      Seems to me the countries that handled the crisis, and handled it without turning crony capitalist, were those that profoundly discouraged term transformation, not those that had higher requirements for reserves.

      Term transformation is fundamentally impossible, a fraud. The volatility does not go away, it just gets shifted into fat tail events.

  3. rightsaidfred says:

    Fundamental here is people paying back their loans. If Singapore banks make a bunch of housing loans to people who don’t pay it back, they still have a crisis. When the bank announces a negative interest rate because their loans to Filipino homeowners have gone bad, people may well decide the mattress is better than a bank. When they line up for their money, the bank needs to call in the short term loans. The same game is afoot, even without term transformation.

    • jim says:

      Dud loans are made for political reasons, thus follow political takeover and political dependency of banking. Financial institutions that engage in term transformation are more dependent on political favor, hence more apt to make dud loans.

  4. Red says:

    How does banking actually fit in with the capitalist system? Most stories I read about businesses needing loans are businesses that should have been allowed to fail to clear the path for more successful business. Consumer credit and home loans seem to be a net drag on life and don’t see anything positive about it.

    • jim says:

      Capitalist bankers, who want to make a profit, lend money to profitable businesses that want to expand, rather than unprofitable businesses that want to pretend they are continuing in business. The problem is that we have a largely socialist banking sector, which makes loans politically.

      • Red says:

        If a business is profitable why not save up the profits and expand? Seems to me that having a company save up so that it can expand would be just as beneficial as having consumers who save for big purchases.

        In general I’m not convinced that usury is useful for anything other than funding large war time armies and ripping people off. But I could very well be wrong. I know very little on the subject beyond propaganda yarns from one side or the other.

        • jim says:

          Consider the most common example of borrowing large amounts of money – to build or purchase a house.

        • rightsaidfred says:

          If a business is profitable why not save up the profits and expand?

          Self financing is slow and conservative. Borrowing is fast and liberal. We are in a liberal world. We’ve got illegal aliens to feed, and campaigns to finance. We’ve gotta get some velocity on our money.

    • spandrell says:

      I’d say that history shows that usury allows for (way) faster expansion, and enabled much greater scale for enterprises than without usury. Britain had a big financial system since the 18th century and could mobilize more resources faster than France or Germany.

      Banking in China is almost exclusively used to finance state enterprises, so private companies rely almost completely in underground lending networks, which are pervasive. So there is real demand for credit even in informal economies.

  5. pwyll says:

    I’d be very interested if you have links with more detail on the ban on term (maturity) tranformation in Australia and particularly in Singapore. If true, that just gives me one more reson to admire those countries… I agree that maturity transformation should be discouraged but it’d be good to get more info on how bans have been implemented in practice – how closely have the strucutre and results matched theory? Thanks…

    • jim says:

      I cannot answer this because it seems to be, particularly in Singapore, an officially unofficial policy.

      It is a readily observable fact that in Australia, long term financing is difficult, perhaps impossible, to obtain except at flexible interest rates, rates that can, in a crisis, suddenly get very high. The same is substantially true in Singapore.

      In Singapore, we sometimes see the this unofficial policy being unofficially enforced, as the government requests reports from businesses it suspects of term transformation. In Australia, you never see a thing. When the Singaporean government asks about term transformation, it never says in so many words “Don’t do that”, at least not in public that I have heard of, but businesses act guilty.

  6. SOBL1 says:

    I do like this policy proposal or idea, but the core problem is the political desire for growth and full employment as the main problem around which we center our political focus. It has been the case since ’32.

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