Arnold Kling  

Thoughts on Banking

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This post returns to the deep topic of banking theory. I am very unhappy with the state of banking theory in economics. People make very strong empirical claims about what they call the risk-taking process based on shallow thinking about that process. I think that Mencius Moldbug is giving the wrong answer, but at least he is asking the right question, which is more than I can say for, well, just about the entire economics profession.

1. No information asymmetries

If you assume away information asymmetries, then I think you have two choices. You can read and absorb the thinking of Fischer Black; or you can build an ad hoc model that is fundamentally erroneous. Essentially everything in the economics journals and in textbooks is in the latter category.

Let us return to a world where investment projects are fruit trees,which take time to mature and which involve risk. The risk, which might be thought of as a disease that harms trees, does not strike every tree identically. There is also an asset (fruit?) that can be stored risk-free instantaneously.

An efficient portfolio of tree investments will have optimal risk-return characteristics for every investor, regardless of risk tolerance. That is the Capital Asset Pricing Model, which says that the most efficient way to dial risk up or down is to change your weighting of the riskless asset and the efficient portfolio in your personal portfolio. If you are particularly risk averse, you hold less of the market portfolio and more of the riskless asset.

Personal time horizons do not matter. The fact that I might want to save for retirement five years from now means nothing. The issue is my risk tolerance. If I can tolerate lots of risk, I put a lot of my savings into the market portfolio. If not, then I use the riskless asset. Also, I can start out with a lot in the market portfolio, but if the market goes down I can re-allocate in favor of the riskless asset. That way, I can limit my risk dynamically over time.

Banking is a simple service. The bank keeps track of everyone's accounts. Customers who have accumulated more wealth than they have spent have positive balances. Customers who have spent more than they have accumulated have negative balances. I don't think of the people with negative balances as over-stretched consumers (although they could be). I think of them as tree-planters.

Every instant, the bank calculates an interest rate on all of its accounts. Interest is paid in fruit. Customers who have positive balances receive interest. Customers who have negative balances pay interest. The bank gets a service fee from its customers to cover the cost of keeping the accounts straight. The bank itself takes no risk. It is just an accounting firm.

Let me elaborate on the last point. Suppose that I am a fruit-tree planter with a negative balance. My fruit tree, which does not yet bear fruit, nonetheless has a market value that exceeds my negative balance. As time passes, suppose that the prospects for my fruit tree worsen. The instant that the market value of my fruit tree threatens to drop below the value needed to cover my negative balance, the bank forecloses on my fruit tree. I am forced to sell my fruit tree in time to ensure that the bank never loses money.

In fact, my wealth is not going to be concentrated in one fruit tree. I am going to have shares in the market portfolio of fruit trees. When the market portfolio falls in value, the bank will force me to liquidate my shares. People who still have positive balances will not have to liquidate their portfolios.

Think of the economy as having two intermediaries. One is a mutual fund that assembles the market portfolio of shares in fruit trees. The other is a bank that handles people's accounts. Customers take money out of the bank when they buy consumer goods or when they increase their investment in the market portfolio. Customers put money into the bank when they earn wages or when they liquidate shares in the market portfolio.

The economy is subject to real business cycles. As the saying goes, stuff happens. The fruit trees suffer a lot from disease. Everybody is poorer, with the biggest risk-takers suffering the most. The bank does not fail. But the value of shares in the mutual fund drops.

Fischer Black's model ends here. If you ask why people don't all hold the same market portfolio, the answer is "I don't know'" If you ask why real-world banks operate in ways that allow them to fail, the answer is "I don't know." If you ask why people write long-term debt contracts, the answer is "I don't know."

Fischer Black would argue that all of these observed deviations from his model are second-order phenomena. To a first approximation, you can think of the economy as following a real-business-cycle model. In the late 1990's, rational investors thought that we needed to increase fiber capacity on the Internet by a factor of 1000 within three years. It turned out they were "way off," in the sense that it took several more years for Internet traffic to grow to the level that it was assumed to require in 2001. The result of that, and other risks that were rational ex ante, was a real business cycle slump from 2000-2002. Similarly, today we may suffer a loss of wealth because people made some calculations about the return on housing investment that, ex post, turned out poorly. Stuff happens. Nothing you can do about it.

Fischer Black's model can be defended as an "as if" story. Yes, the real world differs in many ways. But perhaps these are not important, and you can treat the real world as if it were following Black's model.

Instead, what economists tend to do is bring in arbitrary forms of financial intermediation ad hoc. Nobody asks why banks are structured so that they can fail. We just start with the assumption that they are so structured, and go from there.

Black might say that bank failures are the particular way that real business cycles manifest themselves in our economy. They are second-order phenomena. The first-order phenomena are the unavoidable risks that come from taking reasonable bets that work out badly due to chance.

2. Information Asymmetries

An alternative approach, which is quite difficult, is to try to start with information asymmetries. Some people know more than other people about some things. The pattern of financial intermediation is determined by these information asymmetries.

Recall that in Fischer Black's world, there is no reason for unstable banks to emerge. The banks that should emerge should be banks that do not fail.

It is amazing, when you think about it, that just about every economist has an opinion about how to prevent bank failures, and yet not one of those opinions is based on a theory of why banks that can fail emerge in the first place. They just start with the assumption that we have banks structured as they are, not as Fischer Black would predict them to be.

By thinking about information asymmetries, I hope to explain the mergence of the phenomenon of banks that can fail. Only then can one make justifiable recommendations about what would be a safer banking system.

In fact, my guess is that our financial system is as complex as it is mostly because information has become increasingly specialized. To anticipate conclusions before doing any analysis, my intuition is that the financial system cannot be "fixed" from the center for the same reason that the system is so complex in the first place. Information is too diffuse to be managed centrally. Trying to plan the financial system is as futile as Russia's attempts to plan agriculture and manufacturing under Communism. But again, that is my intuition rushing ahead of the analysis.

My guess is that in our fruit tree economy, we will gradually add more and more financial intermediaries, each specializing in different types of information. The information pattern will in turn determine the pattern of securities that is traded.

For example, suppose that we start with an entrepreneur who knows more than most people about growing fruit trees in a particular location. That entrepreneur will want to plant fruit trees in that location. The entrepreneur needs funds. The entrepreneur could sell shares in his business, but nobody else knows what the shares are worth. To save on information costs, the entrepreneur chooses to borrow funds and pay interest. The lenders do not have to know exactly what the fruit trees are worth. All they need to know is that they are worth more than enough to pay back the debt. They are presumably worth more because the entrepreneur put in a lot of his own funds, as well as time, in addition to the borrowed money.

Over time, lenders start to compete with one another. A lender realizes that by identifying low-risk fruit-tree entrepreneurs, it can lend at a slightly lower interest rate than competitors are offering but make a more reliable profit. So the lender develops some capability for analyzing fruit tree businesses, although the lender will never know as much as the individual entrepreneur.

As the lender develops information about specific entrepreneurs, the relationship between that lender and those entrepreneurs starts to matter. If the entrepreneur has to switch lenders, the entrepreneur will face a higher interest rate, because a new lender will know less about the entrepreneur's business. In other words, it is costly for the entrepreneur to continuously search for a new lender. Instead, the entrepreneur will prefer a long-term contract with a lender who understands the entrepreneur's business. With a long-term contract, the lender and the entrepreneur share in the benefits of the lender's familiarity with the entrepreneur.

The lender's sources of funds do not necessarily want to engage in a long-term contract. The lender would prefer to be supplied with long-term debt, but savers may prefer to keep short-term deposits with the lender. Thus, the lender acts like a real-world bank, not a Fischer Black bank. If the particular fruit tree projects turn out badly, the lender may fail. Moreover, if customers believe that the fruit tree projects that this bank is backing are not going to do well, then customers may start a run on this bank.

A genuine fruit tree failure is a solvency crisis. A rumored fruit tree failure is a liquidity crisis. Given the information asymmetries, either type of crisis is possible. Deposit insurance can greatly reduce the risk of a liquidity crisis, but it cannot prevent a solvency crisis.

Government-run deposit insurance acts like an asset on the bank's books that can be trusted by depositors. There are other possible assets. Private insurance could be one such asset. Reserves could be another asset. Highly-marketable loans (loans where the bank's inside information is not terribly costly for other banks to verify) could be another asset that would reassure depositors, because such liquid assets can be tapped in order to stem a bank run.

As we are learning today, there are many types of financial intermediaries that are important. Some of them, such as Fannie Mae and Freddie Mac, suffered the equivalent of bank runs. In addition, some of them may be insolvent. It is probably not practical for government to insure the liabilities of all of these intermediaries. On the other hand, government officials fear the consequences of not insuring their liabilities.

The rules of the financial system used to be: certain bank liabilities are insured (deposits up to $100 K); other corporate liabilities typically uninsured; some liabilities unclear (Freddie Mac and Fannie Mae; large deposits or debt issued by banks). Under the new rules, a larger set of liabilities is insured.

I think that one consequence of that will be to reduce the competitive viability of intermediaries that issue uninsured liabilities. All of a sudden, you find yourself playing in a game against competitors who have a tremendous potential advantage, playing by new and unknown rules. Until things get sorted out, any intermediary that wants to survive, which includes every corporation in America, has to be searching for an angle to get under the government-insured tent.

Once again, I am rushing ahead to real-world analysis, when the real world is much more complicated than my simple model. I think that the key to making sensible policy recommendations is understanding how the complex financial system emerged. Only then will one be able to make sensible guesses about the consequences of policy actions.

Right now, as Lawrence H. White puts it, the popular belief is as follows:


1: Banking and financial markets are inherently unstable. 2: Government intervention into banking and financial markets can only stabilize (never destabilize).

This is what people want to believe. My guess is that economists who cater to that belief will have credibility. Those who doubt that belief will not.

Just as those who describe the current crisis is a villains/victims/heroes story have credibility. Someone like myself, who looks at securitization as a phenomenon that emerged from arbitrary capital requirements, is not going to be heard. There is no market for my beliefs (readers of this blog excepted, of course).


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COMMENTS (18 to date)
Mencius writes:

It's a little difficult for me to evaluate this model, because I don't understand its microfoundations.

Your positive-balance, negative-balance bank is a curious construct. Why does this bank exist? Where did it come from? What currency does it use - does "wealth" mean "money"? Is there any restriction on the magnitude of a negative balance, or can the bank print and loan as much money as it wants? The bank seems to be making zero-term loans to its clients with negative balances - under what conditions does it call those loans?

For me, the basic pattern of lending is a transaction in which A gives B X units of some good, generally a currency, at date D, in exchange for B's promise to return X+y units at date D+t. If not quite a Euclidean axiom, this microfoundation strikes me as sufficiently founded in reality to require no further turtles down.

In your model, no transactions are made in which t != 0. But, if the bank cannot print and loan infinite money, and if it calls loans under certain conditions (eg, because its depositors withdraw), it may be forced to call fruit-tree loans before the fruit is ripe, resulting in the conversion of budding fruitwood into cheap firewood.

As a fruit-tree grower, I would be highly interested in a lending product which did not incur the risk that my loan would be called in this way, ie, a loan of t = 3 years if that's how long it takes the trees to grow. Your bank does not offer this product. Is there a competitor which does?

Bill Stepp writes:

Under free banking, the loan rate of interest equals the natural rate of interest. The latter clears the time market and the entire capital market. There is therefore no mechanism to set a business cycle in motion.
As for banks, there is no reason why they would over issue bank notes in concert in a free banking system. Under such a system, the market provides automatic stabilizing mechanisms for banks. Under central banking the economic calculations of entrepreneurs seeking loans is distorted when loan rates fall below the natural rate that clears the market for all investible resources (i.e. the capital market, which includes both debt and equity). This leads to a Hayekian discoordination problem, when investors make investments in a structure of production that is revealed to be too long for the supply of savings at hand. This process is reversed when the loan rate rises back toward the narural rate, and a process of forced savings ensues. There is a cluster of entrepreneurial error; bankruptcies and unemployment follow.
The problem is not that banks borrow short and lend long. It's that when they borrow short, they do so at interest rates that have been jimmied up (or rather jimmied down) by monetary central planners, who have as much of a handle on what the "right" interest rates on bank loans should be, as Soviet planners did on the right number of loaves of bread, cars, and shoes to produce.

The reform that needs to be made is not to remake commercial banks into Misesian banks (100% reserves), but rather to remake them into free banks, with the rule of law, not the rule of regulators, overseeing them.
That means of course abolishing central banks, and getting rid of statist rules governing freedom of entry into banking and freedom of banknote issue.

It's an issue of calculational chaos, which was worsened because of the effects of regulation of banking and the housing and mortgage markets.
The resulting discoordination and malinvestments revealed a banking industry that was short of capital. Many banks had weak balance sheets that had to be repaired by merging with stronger banks or by raising capital.

Panettore writes:

Also the Economist is pointing somehow the attention to capital requirements, as you have been saying. In the last issue they write:

The authorities did make a more fundamental attempt to regulate the banks with the Basel accord. The first version of this, in 1988, established minimum capital standards. Banks have always been a weak link in the financial system because of the mismatch between their assets and liabilities. The assets are usually long-term loans to companies and consumers. The liabilities are deposits by consumers and investors that can be withdrawn overnight. A bank run is hard to resist, since a bank cannot realise its assets quickly; worse still, doing so—by calling in loans—may cause economic havoc by prompting bankruptcies and job losses. The Basel accord was designed to deal with a different problem: that big borrowers might default. It required banks to set aside capital against such contingencies. Because this is expensive, banks looked for ways around the rules by shifting assets off their balance-sheets. Securitisation was one method. The structured investment vehicles that held many subprime-mortgage assets were another. And a third was to cut the risk of borrowers defaulting, using CDSs with insurers like American International Group. When the markets collapsed, these assets threatened to come back onto the balance-sheets, a prime cause of today’s problems.
E. Barandiaran writes:

Arnold,
1. On banking theory. First, in the past 25 years, there have been important developments (see: Gorton&Winston's 2002 survey of financial intermediation; the new 2ed. of Microeconomics of Banking by Freixas&Rochet). Second, despite the developments, there is not yet a theory good enough to explain some critical issues of the modern banking industry, in particular those related to its stability. Third, a main reason for this failure is that modern banks provide many services in addition to traditional payment services (around 1980, E. Fama argued for separating the analysis of payments and financial services). Fifth, if you think you can contribute to further develop the theory, you'll have to go well beyond what you have presented in your post.
2. On Mencius Moldbug's post. First, although it is a very good presentation of the Misesian and Bagehotian banking systems, it does not explain why the former has been rejected and the latter accepted by all countries. In every banking crisis, the Misesian system is proposed as a solution, but it has never been implemented (perhaps the first bankers in history were prudent enough to back deposits 100% with gold or silver, but the history of bank credit is about the management of pools of deposits to be transformed into some other forms of credit). Second, it is not true that "The end result of Bagehotian banking is that, without any government protection, it is incredibly unstable and will melt down at a drop of the hat." In theory you can show that such a system maybe stable or unstable depending on the particular assumptions you make about shocks and people's behavior, but in practice you cannot ignore that governments have ALWAYS intervened in money and banking. Most episodes of monetary and banking instability has been caused directly by government intervention (I'm talking about policies actually implemented, not about the expectation of government intervention). As the long discussion about "free" banking makes clear, it is difficult to assess what would have happened with a Bagehotian system in the absence of government intervention.
3. On Lawrence H. White's two assumptions. He's right that the two assumptions underlie the positions taken by a large majority of economists (he refers to Krugman but I assume he has in mind many other economists). He's right that the two assumptions are false. We should not be surprised that they underlie the positions of people like Krugman, however. Although reading Bryan Caplan we may think that voters are the problem, reading Tom Sowell we know that intellectuals and politicians are (in particular, intellectuals like Krugman struggling to get power). Theory will never be an obstacle for these intellectuals to argue their preferred positions and to manipulate the political process to achieve their goals. Thus, although I'm looking forward to further developments in banking theory, I know that any improvement in our understanding of modern banking will hardly translate into a better policy.

Todd writes:

Arnold, I'm confused by this argument:

"The lender's sources of funds do not necessarily want to engage in a long-term contract. The lender would prefer to be supplied with long-term debt, but savers may prefer to keep short-term deposits with the lender. Thus, the lender acts like a real-world bank, not a Fischer Black bank."

If bank investors don't want to engage in long-term contracts, how do the Fischer Black banks of the world engage in long-term lending? Do they manage to persuade the investors to drop their reservations, or do they simply commit fraud, promising one thing, and then doing another?

Arnold Kling writes:

One way to think of the first financial system is that banks take zero risk. All of the risk is in the mutual funds that invest in fruit trees.

Banks are simply accounting firms. Your account balance can be either plus or minus. Incidentally, in Israel banks actually work this way. Most people have overdraft privileges, and having a negative bank balance is known as "living in minus." Think of that as a substitute for credit card debt.

Anyway, in the financial system imagined here, there is no risk in these negative bank balances. They are always brought back into zero or positive balance.

Because all information in the economy is available to everyone (no asymmetries), fruit trees are always a liquid asset. You can always trade shares in fruit tree mutual funds, even though the fruit is not yet ripe. The share values may rise or fall as we learn more about the prospects for disease, but there is always a market.

As a result, the bank is taking no risk. It is merely keeping the accounts while people with excess saving make risk-free loans to people with excess spending. The loans are risk-free because there is no secret information in the economy. The only risk in the economy is fruit tree disease, and that risk is embedded entirely in the price of the mutual fund that invests in fruit trees.

Bad news in the fruit tree market drives down the price of mutual fund shares. This does not affect the bank, but it does affect some customers. Those who were living in minus might have to sell some shares, because otherwise if there is more bad news they will have too little wealth to be able to bring their negative bank balance back to zero. They sell some of their shares to other bank customers who were not living in minus. The sellers use the proceeds from the sales to reduce the magnitude of their negative balances.

Josh writes:

Arnold, you've mentioned Fischer Black several times. Could you recommend a good book on him and/or his theories? Preferrably one that is technically interesting, but does not require a PhD in economics to understand (my degree is in reading economics blogs)?

JKH writes:

“A genuine fruit tree failure is a solvency crisis. A rumored fruit tree failure is a liquidity crisis. Given the information asymmetries, either type of crisis is possible. Deposit insurance can greatly reduce the risk of a liquidity crisis, but it cannot prevent a solvency crisis.”

This is the crux of the thing – the nexus between solvency, liquidity, maturity transformation, and information asymmetry.

Information asymmetry is as fundamental to banking and standard banking theory as maturity transformation, perhaps more so.

But I’m still not sure what it is that you “believe” that is different from this.

Arnold Kling writes:

A good place to start on Fischer Black is Perry Mehrling's biography

winterspeak writes:

Arnold: I'm afraid I'm confused by the model you're suggesting in your story. I'm not sure what the key elements are, and what you're trying to highlight.

I understand the notion of a financial intermediary being a pure intermediary and not taking on any risk itself. It would essentially just "tally" credits and debits. As you say, banks in Israel actually work like this. It was also quite common in Europe back in the day -- a "tally" (matching credits and debits). Note that in this system a bank would need *no reserves*. There is no concept of actual physical money being held in a vault.

That said, this tally system would need the bank to be very careful to match the duration of the credits and debits on its books. So the MT problem does not go away -- if the bank MTs, it can experience a run and we're right back where we started (this is why I don't think reserves, or leverage, are an important part of this current crises.)

If you don't like the Misean argument to maturity match, maybe you'll like one from Mosler:
http://www.moslereconomics.com/mandatory-readings/what-is-money/
"It must be remembered that a credit due for payment at a future time cannot be set off against a debt due to another banker immediately. Debts and credits to be set off against each other must be “due“ at the same time."

MT risk is real in a very soft, fiat money system (a tally, just a list of credits and debits) as well as a hard money, gold standard system.

Given the reality of information asymmetries and human nature, there is no way to prevent bubbles. I think the key focus needs to be on keeping the inevitable popping of the bubble from being so systematically destabilizing. It is easy for an economy of quickly and smoothly leverage, it is very hard for it to de-leverage, and that is a bug, not a feature.

-winterspeak

fundamentalist writes:

E. Barandiaran: "In every banking crisis, the Misesian system is proposed as a solution, but it has never been implemented (perhaps the first bankers in history were prudent enough to back deposits 100% with gold or silver, but the history of bank credit is about the management of pools of deposits to be transformed into some other forms of credit)."

Austrians would say that 100% reserve banking is never implemented because there is no money in it, whereas in fractional banking there is a lot of money to be made by banks. My understanding of banking history is that the original bankers were the gold merchants and they did practice 100% reserves. But around 1200 they figured out how to make a lot of money off fractional reserves and the business cycle began.


E. Barandiaran: "Second, it is not true that "The end result of Bagehotian banking is that, without any government protection, it is incredibly unstable and will melt down at a drop of the hat." In theory you can show that such a system maybe stable or unstable depending on the particular assumptions you make about shocks and people's behavior, but in practice you cannot ignore that governments have ALWAYS intervened in money and banking."

Begehotian (I assume that is fractional reserves) banking is inherently unstable 1) because of the high leverage involved and 2) because the creation of new money ex nihilo launches the business cycle according to the Austrian Business Cycle. Without the ABC theory, we're left with no theory of the business cycle other than "stuff happens" which is the non-technical translation of shocks.

Arnold Kling writes:

Winterspeak,
In the model with no asymmetric information, the bank is not duration mismatched. Its assets and its liabilities are both instantaneous. Somebody who is in minus might hold long-term fruit trees, but they can sell shares at any time. There is always a liquid market when there are no information asymmetries. If somebody in minus has fruit tree shares that would just cover the minus, that person is forced to sell fruit tree shares before they might drop any further.

studd beefpile writes:

How can a tally bank have 0 risk? The people in the red are spending money, they have to be borrowing it from someone. If not from the bank, then from whom?

And what happens to fruit bank when a number of growers fail at once, and they are left with lots of sick trees(and the various expenses surrounding them), but no actual fruit with which to pay interest?

winterspeak writes:

Arnold:

OK, it was not clear to me that perfect information would eliminate MT. But they'd need to be perfectly rational also.

I'm thinking off the individuals queuing outside Wachovia (or was it WaMu--hard to keep track these days) to get their deposits back, even though the deposits were FDIC insured and they were 100% guaranteed to be paid out in full.

There was zero information asymmetry there, and yet we saw people standing in line anyway.

What you're saying is that with perfect transparency, you would always be able to roll over short term obligations ("there is always a liquid market when there are no information asymmetries"). I'm not sure that's the same thing as saying there is no MT, I think you're saying that MT would never turn off.

Is that right?

-winterspeak

Mencius writes:

Arnold,

Looking more carefully at this, the following paragraph strikes me as a lacuna:

As the lender develops information about specific entrepreneurs, the relationship between that lender and those entrepreneurs starts to matter. If the entrepreneur has to switch lenders, the entrepreneur will face a higher interest rate, because a new lender will know less about the entrepreneur's business. In other words, it is costly for the entrepreneur to continuously search for a new lender. Instead, the entrepreneur will prefer a long-term contract with a lender who understands the entrepreneur's business. With a long-term contract, the lender and the entrepreneur share in the benefits of the lender's familiarity with the entrepreneur.

The reason that entrepreneurs prefer to borrow long-term rather than short-term is not simply, as you imply, the transaction overhead of finding a new lender.

Entrepreneurs should prefer to match the duration of their financing with the duration of their project, because this relieves them of the risk that they may not be able to refinance under favorable terms, and may be forced to liquidate at a loss instead.

If there is no LLR and a systematic duration mismatch across the entire loan market, this risk becomes a certainty. Systematically match 1-month loans to 1-year projects, and at month 1 the borrower who seeks to refinance must row upstream against a vast river of money flowing in the other direction.

Or forget entrepreneurs - think homeowners. People sign a 30-year mortgage contract, whether the loan is fixed or adjustable, rather than refinancing month-to-month, because they are not willing to put themselves in a position where at the end of any month the bank can say, even just for its own shits and giggles, "we're calling the loan - sell the house and pay us."

This effect has nothing to do with information asymmetries or transparency, at least as I define them.

A central bank which maintains liquidity support can obviate this problem. Or, of course, the central bank can just make the long-term loans itself. This is uglier to the eye, but much simpler, and achieves exactly the same purpose.

Personal time horizons do not matter. The fact that I might want to save for retirement five years from now means nothing.

Sure it does. It means you are willing to purchase a five-year bond, which can be sold to you by an entrepreneur with five-year fruit trees. More, it means it is systemically safe for you to purchase this bond (assuming you are a member of a similarly behaving rational herd). Whereas it would not be systemically safe, absent of course an LLR, for you to purchase a ten-year bond.

A crucial Misesian point is that by investing at term, you are giving up the option of using your money to purchase goods and services across that term. You don't get something for nothing.

The fact that in maturity-mismatched banking you do get something for nothing - ie, you earn the long-term interest rate without allowing your investment to be locked up - is a point that Mises and Rothbard make over and over again. It explains the basically inflationary nature of maturity mismatching / credit expansion / fractional-reserve banking. Eg: this is how we get to the strange, strange situation in which MZM == 10 * M0.

Perfect information about the future in fact makes the Misesian argument more compelling, because lenders not uncertain about the maturity at which they need their return would never roll over; they would always invest for the desired term exactly.

Mencius writes:

Also, the existence of the mutual fund and the fruit tree shares in this model is, as far as I can tell, not germane.

For the purpose of the bank and the lenders to it, why does it matter what the equity structure of the fruit farms is? Couldn't they be owned by public shareholders, by Donald Trump, by the oppressed workers, by the King of Spain, etc, etc? Of course, if the farm defaults, debt should be converted to equity, but isn't that outside the scope of the discussion?

The idea of a risk-free loan strikes me as an oxymoron. A loan is a debt that must be repaid. If it is not repaid, it defaults. Are you saying that the loan is collateralized by the fruit farm, or shares thereof? And that if the market price of the fruit shares falls below the balance of the loan, the shares are sold and used to pay off the loan? If so, this sounds a lot like portfolio insurance to me - not exactly a recipe for stability.

MattYoung writes:

Banks as intermediaries, sharing in the conspiracy.
Farm banks do that. The farm bank is a specialized estimator of the local agriculture capital value, and they share secret information with the farmers.

Their valuable function is risk estimation (or inventory control in other models). There being no specialized estimators of risk, there being no basis for economic decisions.

parviziyi writes:

Safety and soundness of the banking system would be improved if banks did their mortgage and other long-term lending with adjustable interest rates only, and forced the interest-rate risk onto the borrowers. One of the good things about an adjustable-rate regime is countercyclicality: when every mortgagee is affected by interest rate changes, the whole economy is more responsive to central bank modulations, and the modulations can be smaller. Consumer spending is 70% of US GDP (and government spending is most of the rest). The central bank's rate adjustments either take money from or give money to the home mortgagee and consumer, when mortage rates are adjustable.

If adjustable rates were in place, together with the government deposit insurance we have today, systemic bank risk would be just systemic borrower default risk. Since a risk-free loan is always an oxymoron, it's possible in principle for a large number of banks to become genuinely insolvent at the same time after having made the same kind of loans to a large number of the same kind of borrowers. I believe the mainstream economists are correct that this systemic insolvency risk (a) can never be completely eliminated, (b) poses a danger to the whole society, and (c) can be reduced in probability through systemic rules and regulations -- in other words government regulations written in contemplation of this risk. Arnold's presuppositions lead him to suppose that you can't satisfactorily forfend against this risk in the top-down or Politbureau way, but he doesn't give us an inkling of how it could be done from the bottom up.

By the way, in the abstract case of no information asymmetries, where the banks are only accountants, if the society invests too much of its resources in fruit trees that end up getting decimated by disease, it's slim comfort to the society that its banking system remains solvent. The real question is how can the society be forfended from a systemic investment error. In the society we really have, where the banks are a lot more than accountants, and are creating money ex nihilo, the main answer is laws that limit bank leverage.

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