Tuesday, 9 June 2015

The fatal flaw in maturity transformation and fractional reserve banking. Part I.

Summary.         This is the first of a mini-series of three articles. The first, or “Part I” argues that maturity transformation achieves nothing. Reason is that while it increases liquidity, and even creates a form of money, people will then try to spend away that extra liquidity / money which raises inflation. Thus government has to confiscate the extra liquidity / money via extra tax, which in turn means the net effect of maturity transformation is zero.

Part II argues that the same flaw lies at the heart of fractional reserve banking. That is, while switching from full to fractional reserve does produce extra liquidity, the state has to tax away the extra liquidity. I.e. fractional reserve achieves nothing. Thus there would seem to be little difference between full and fractional reserve.

Part III argues that while there is no difference between full and fractional reserve on what might be called a strictly accounting criterion, there is nevertheless an important difference. It’s that fractional reserve banks are very vulnerable. Witness the fact that they go bust regular as clockwork. In THEORY that deficiency can be countered (but not eliminated) if such banks are backed by deposit insurance and lender of last resort implemented on a COMMERCIAL basis. However the idea that those two backups ever will be implemented on a commercial basis is just a joke. The reality is that bankers will always bribe and cajole politicians into implementation in a manner that SUBSIDISES banks. And the scale of those subsidies is ASTRONOMIC as the recent crisis demonstrated.


Where people and firms lend DIRECTLY to each other, each creditor’s asset (the loan) is relatively illiquid. That is, a creditor probably will be able to sell the loan if need be, but it may be at a loss and may take time.

In contrast, if savers / lenders deposit their spare money at a bank, the bank can lend out the money while saver / lenders retain instant or near instant access to their money. That’s called maturity transformation (MT): the short term maturity of bank deposits is “transformed” into long term maturity loans.

Saver / lenders get what might be called a “twin benefit”: they get some of the relatively high interest that comes from making long term loans at the same time as having instant access to their money. Two things that might seem to be irreconcilable are reconciled. Everyone seems to be a winner, including the bank which of course takes a cut.

The flaw in that idea is that MT raises aggregate demand because lenders find their assets are more liquid, thus they tend to spend away that excess liquidity, which causes inflation, which in turn means the state has to confiscate that excess money or liquidity. It’s back to square one! MT has achieved nothing.

Risk sharing and money creation.

Note that when “person to person” lenders switch to lending via a bank, there are in fact TWO changes there. First, lenders pool risks. That is, if the debtor goes bust in a person to person loan, the lender may lose out big time. In contrast, lenders are highly unlikely to lose everything where lenders pool loans or risks.

The second change is thus. A person to person loan is relatively ILLIQUID. That is, creditors when making such loans lose instant access their money.  In contrast, money deposited in a bank retains its liquidity: it remains instant access unless the money is put into a term account.

Now clearly there is nothing wrong with risk pooling, so let’s forget about that. I.e. it is money / liquidity creation that is under consideration here. 

An illustration.

The above point about MT being pointless because the state has to tax away the liquidity created by MT can be illustrated more clearly with an actual example. The rest of this article sets out such an example.

Take a hypothetical economy (called “Hypoland”) where half the population are creditors and half are debtors. Assume to start with the only form of money is base money. The assets of each creditor consist of $10k of base money, $10k of loans to debtors and $100k of illiquid assets like cars and houses. As to debtors, their assets and liabilities are: $10k of base money, and $100k of cars and houses plus they have a LIABILITY in the form of $10k owed to the above creditors. Also assume that’s the PREFERRED stock of assets and liabilities of the population.

Assume that people and firms lend direct to each other, i.e. not via a bank. Also assume that that stock of base money is enough to induce the population to spend at a rate that brings full employment, but not to spend so much as to bring excess inflation.

A private bank sets up in business.

Then a hitherto unheard of organisation called a “private bank” sets up in business. Like real world private banks, it offers to accept deposits and grant loans to viable borrowers.

The bank also tells depositors (as in the real world) that they can have instant or near instant access to their money AT THE SAME TIME as reaping the rewards that come from locking up one’s money for extended periods, as mentioned above.

Incidentally, if you don’t like the idea of JUST ONE private bank setting up, then assume that SEVERAL private banks set up and replace the phrase “private bank” below with “private banks” or “private bank system”.

The macroeconomic problem.

But there is a problem.

As it explains in economics text books, most people adopt the perfectly rational policy of minimising their stock of cash. In fact the text books normally give TWO motives for holding cash. The first is the TRANSACTION motive: clearly everyone (and every employer) needs enough cash for day to day transactions.

The second motive is often called the PRECAUTIONARY motive: that’s the desire to have a stock of cash to deal with unforeseen problems. A possible third motive is the desire to save up to buy something.

And most people when they find their stock of cash is IN EXCESS of that required for the above two or three reasons, tend to spend away the excess.

Now the arrival of the private bank with its MT in Hypoland means that those loans or debts held by creditors are effectively turned into money. Or put another way, creditors then find they have excess liquidity, so they’ll try to spend that away.

But if the economy is already at capacity, that extra spending is not possible, else inflation will ensue.

Incidentally, George Selgin set up exactly the same hypothetical scenario, and his conclusions, at least as regards the above mentioned inflation were very similar to mine, (which is not to suggest he and I see eye to eye on all bank related matters.)

Anyway, government and/or central bank will have to deal with that excess demand / inflation, e.g. by raising interest rates or by running a budget surplus. And both those measures will withdraw liquidity / money from the private sector. Rather looks like we’re back where we started!

In fact, and to keep things simple, if government were to deal the excess demand SIMPLY BY grabbing money off creditors via extra tax, the amount that would have to be “grabbed” would be $10k: that’s the amount of excess liquidity or excess money in the hands of each creditor.

So the introduction of MT to Hypoland INCREASES the money supply by $10k per creditor, but government then has to tax that $10 away. Net result: zero. It’s back to square one!

Creditors’ total stock of assets.

The introduction of MT to Hypoland and the subsequent rise in tax WOULD leave creditors with less than their preferred TOTAL STOCK of assets. That is, each creditor’s total stock would then be worth $110k rather than the $120k we started with.

But that’s not a problem: creditors would then presumably work extra hours for a year or two and accumulate an extra $10k in the form of sundry assets, e.g. larger houses, a second car, or whatever.

Note that that extra work by creditors WOULD NOT be inflationary. Reason is that an attempt by a portion of the population to work extra hours equals an increase in AGGREGATE SUPPLY. And an increase in aggregate demand  is no problem if aggregate supply increases by the same amount.


* The quote is from Friedman’s book, ‘A Program for Monetary Stability.’ (1960),  New York.  Fordham University  Press, Ch 3.

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