He can sell you a promise to deliver gold. Similarly, a bank could sell you a promise to give you money at a certain time, a bond in other words. The difference to the current fractional reserve systems would be that the promise would not be legal tender, you couldn’t pay taxes with it or force other people to take it as payment. You could try to convince other people though, probably for a discount.

The FDIC is protected by the formal responsibility of the US treasury to keep the FDIC liquid (full faith and credit of the US government). Fannie and Freddie, on the other hand, had nor formal protection, but were deemed to be too big to fail. Now we pay.

Otherwise, I really enjoyed your description, Mencius, and saved it for later reference.

Its simply a matter of not selling or lending what you don’t own. And the other thing would be to keep matters in a state of growth-deflation.

Stop this idiotic subterfuge Reynolds. Nothing is easier than banning this once its phased out. If they practice it, onces its illegal, they get closed down, fined, or thrown in prison.

Its just the same as making embezzlement illegal. The bank does very well stopping its own employees from embezzling funds from it. Well this is the same thing.

Why would it be difficult to ban? If its a crime, its outlawed, so its banned.

So supposing you have a gold dealer. He cannot sell what he does not have. He cannot pretend to sell gold on fractional reserve. Currently this is what is happening. Gold and silver shortages everywhere. You cannot take delivery of the stuff. Because people have been making trades in ponzi-gold, ponzi-silver.

So the regulations are just about stopping people from selling or borrowing what they don’t own and cannot supply.

You are just being dishonest to even so much as suggest that there is some difficulty with this.

A one week term deposit? How could this be profitable? And if it could be profitable how would it be a violation of fractional reserve in the first place.

Banks aren’t going to play these silly games in a hard money situation Andrew. And if they did it wouldn’t be fractional reserve would it.

The view that fractional reserve banking is fraudulent and inflationary is simply wrong. A customer deposits 100 paper dollars in a bank. The bank lends $90, promising that the customer can get his money not quite 100% of the time, but only 99.99% of the time. The customer accepts the deal because the bank pays him interest in return for any inconvenience. It’s voluntary trade, not fraud.

As for inflation: A checking account dollar is a call option on a paper dollar. The issue of call options does not affect the value of the base security. The call option is the liability of the call writer, and not the liability of the issuer of the base security. Someday, economists might understand that a checking account dollar is the liability of the private bank that issued it, and not the liability of the Fed. Therefore, issuing checking account dollars is not inflationary.

Profits can be made “in the interim” because, since long rates are naturally higher than short rates (again, see my blog), any system which can arbitrage the two by transforming maturities can produce positive return. But this return has to be adjusted for the probability of a maturity collapse, ie, bank run.

First, there is no way to predict a bank run using the statistical tools generally used to analyze default risk. You are depending on the kindness of strangers. To predict this, you need to be Hari Seldon. You are not Hari Seldon.

Just to start, I would not claim to be Hari Seldon – nor, from what I remember of reading the Foundation series, would even Hari claim to be able to do this as psychohistory generally did not work on small numbers of people, certainly on a typical bank’s depositors.
On to the main point – I would disagree (to an extent) that you are dependant on the kindness of strangers – it is not kindness but that more stable of motivators – greed. Like all commerce, banking is based on the balance between greed and fear. Provided the desire to earn interest on deposited funds overcomes the fear they will be lost the deposit base will remain stable – or at least stable enough. The trick to preventing a run is to manage what bankers call “name risk” – the failure of your good name. Northern Rock failed this test – see here for my take on this – but there is no reason for an institution in a similar position to also fail. Any poorly managed business, even with no maturity mismatch can still fail, so even getting to a point where banks had no mismatch would guarantee stability.

That is one of the reasons why I disagree with this contention: “Since all market forces have been removed, there is only one conceivable answer: the State.” Market forces have not been removed – they have been ignored (IMHO) in your argument. Investors will still invest and depositors will still deposit if the greed outweighs the fear.
For example – if I need to deposit funds, and want call access to those funds to deal with my own uncertainty of cash flow I have several options – 1. Keep them under my mattress;
2. Form what amounts to my own Wisselbank and put the funds in a safety deposit box at my local bank. I will not earn interest – in fact I will pay fees – but, ignoring the theft risk I will have secure, if inconvenient, access to my funds.
3. I can also choose to deposit them in an immediate call account with the bank, and earn at least some interest or I can put them on longer term (with a call option for a fee). In either case the bank will transform the maturity and earn more interest than they pay me.
There are (of course) many other options, but they will do for the moment.
Which do I choose? Option 1 is only as good as the security in my home and the hope a thief will not find them. with option 2, I pay for extra security – but even that is not perfect. Option 3, provided I believe the bank is “sound” is not only the sensible course it can provide benefits the other cannot – like 24 access to the funds through an ATM or the internet. Of course, the risk there is that the bank goes phut and I lose access to, or even the amount of, the deposit.
The banking system does not rely on “the kindness of strangers”, but that old mainstay of any good free market system – greed.
I would agree that this is much more important than a bit of warm weather – but thanks to the banking system we can go on holiday to Bali (in the spice islands) and do what the VOC would have really liked to be doing – earning returns on deposited money and still have instant access to it through an ATM in Denpasar or using our Visa Debit card to purchase something on eBay.
Just read back through that and apologies if it seems a bit flippant – not intentional. Maturity mismatch, though, is what I see as providing the benefits of a modern banking system. We can deposit funds on the maturity we need as depositors and the banks can then lend it back to others (or even back to us) at a differing maturity to match our needs as borrowers. Essentially, we pay for that in two ways – the interest gap between what we receive as depositors and pay as borrowers and through the risk that the bank itself may collapse.
To me, the argument is a risk management one – is it worth taking that risk? Provided the risk is appropriately managed then I see that as a risk that is worth taking.

Thanks for your interesting responses! If you don’t mind I will point UR readers at this discussion – I think it may answer others’ questions as well.

I will concede your point on the Wisselbank straight up. I shouldn’t disparage modern risk management. I don’t think anyone would be so bold as to claim your profession has solved the problem of liquidity risk. But it certainly has its statistical ducks in a row on entrepreneurial default risk – of which the spice voyages are a textbook example. Mea culpa.

In fact, I would be tempted to say that if there is a one-sentence explanation of the present financial crisis, it’s that it’s what happens when exquisite mathematical systems perfectly optimized for normal, entrepreneurial default risk are confronted with the irreducible and unquantifiable game-theoretic uncertainty of liquidity risk, with its savage feedback loops, its correlations that pop up out of nowhere, and of course its linkage to the political system.

(Perhaps you have read Satyajit Das’s new book? The one that is actually written in English? Here is an excerpt which I think makes the point quite well. You may also have seen Nassim Taleb making basically the same point.

Das and Taleb do not explicitly connect the failure of statistical risk management to the liquidity problem, the game theory of bank runs, and the problem of maturity mismatches. It’s not clear to me that Mises, Rothbard and de Soto have come to the attention of the Dases and Talebs of the world. If this is the case, I can only describe it as a serious communication failure.)

In any case, my point about the Wisselbank was meant to preempt a fallacious argument that you did not make. Without accusing you of making this argument, let me answer it even more directly, because it is a common argument and I often see it.

The argument is that in a “temporally solvent,” “100%-reserve,” or “narrow” banking system, no one would take financial risks, and profitable opportunities for productive investment would go unserved. The theoretical answer to this is that risks remain profitable – the time structure of risk and investment just needs to be matched. The empirical answer is the existence of the VOC.

Not that I am endorsing crucifixions and torture, although I do confess to the opinion that the world would be a smaller, duller place without heavy cannon. But we have subtler, more effective ways to enforce our monopolies these days! I hope you’re not under some illusion that your intellectual property laws originate in Canberra

Your “important question” is I think a pair of questions. But they are both important! Let me try and take a whack at them.

The first question is the accounting treatment of rollovers. This is fundamental to the entire distinction between “scalar” and “temporal” solvency.

What is a rollover? Perhaps you think of it as a mature obligation which is not “called.” A classical checking-account “demand deposit,” for example, can be seen as a loan from the depositor to the bank with a term of zero. Except when the depositor “calls” the deposit, it is automagically rolled over. If the term of this loan was, say, one second, the reality would be almost the same – the depositor would have to wait one second for his or her check to clear.

In the ABCP markets that have been imploding lately, the term is not zero or one second, but 30 or 90 days. Nonetheless, the situation is basically the same – short-term obligations are balanced by long-term revenues, and the system is stable (or at least appears stable) only because of rollovers. Next to a 30-year mortgage, 90 days is basically still epsilon.

In a frictionless digital financial system, which is admittedly an entity that does not exist on this planet, has never existed in the past, and may never exist in the future, we could do away with this concept of a “call” and a “deposit.” Logically, a rollover is not one transaction but two. You make a mandatory payment to your creditor. Your creditor turns around and makes a voluntary loan to you.

When we see a rollover as two transactions, we realize that from the perspective of the bank, the fact that the old creditor who we just paid off, and the new creditor who has just been so kind as to extend us a new loan, happen to be the same person, is quite irrelevant.

So what we have constructed is a financial structure which is dependent on a continuous supply of new loans. And, most importantly, we can identify no entity or entities who is contractually obligated to make these loans. This is a key difference between “liquidity risk” and ordinary “default risk.” The latter is dependent on the contractual obligations of strangers. The former is dependent only on their kindness.

So when you ask should a bank be considered solvent when all the deposits that can be called are fully covered or should it be only those that will conceivably be called?, your real question is whether the solvency of a bank should depend on the kindness of strangers.

And if this is what modern banking and risk management is founded on, I would definitely have someone in as soon as possible to look at the foundations! As I will explain, though, they are a bit more stable than this. But not as stable as I feel they ought to be.

Because “scalar solvency” – which is of course the current definition of bank solvency, ie, the net market price of your assets exceeds the sum of your contractual obligations, considering both as scalar values – actually solves the rollover problem. In theory. Unfortunately, the theory is not quite right.

A scalar-solvent bank can, in theory, meet all its obligations without depending on the kindness of its creditors. If they refuse to roll over, if it cannot find new short-term loans, it can just sell assets and convey the proceeds.

For example, consider the case of a bank all of whose obligations are demand deposits, and all of whose assets are mortgage securities. One day, for god only knows what reason, its creditors demand all their deposits, and no fresh customers appear to replace them.

No problem! Since the bank’s assets are held on the books at their market price, and since the net market price of all these assets exceeds the sum of the bank’s deposits (scalar solvency), we can meet all our obligations by selling said assets. In a modern digital financial market, this can happen just as fast as the depositors can demand their money. In the end, the bank is closed, but it is certainly not broken. The shareholders retain their equity.

This is the implicit scenario we are thinking of when we describe any bank whose assets exceed its liabilities, calculated as scalars, as “solvent.”

Of course, in real life, it does not work out that way. Because when we hold this fire sale for mortgage securities, we depress the price of said securities, driving implicit mortgage interest rates through the roof, driving down housing prices, feeding back into mortgage default risk, causing everyone who holds short-term obligations backed by mortgages to refuse to roll over their loans, further depressing the price of mortgage securities, und so weiter.

This is the game-theoretic degringolade I described on my blog – for “dragons,” read “mortgages.” As we can see, this process is not at all theoretical. It can happen in reality. It is happening right now. It is this that scalar solvency “misses,” and it is this that makes scalar solvency an inadequate description of a bank’s financial soundness.

Most important: this is not a quantifiable risk. It is not in any way analogous to an Indonesian spice voyage. It is a fundamental systemic instability. It is a textbook example of a critical state. Like the sandpile collapses on which Buchanan’s book is based, it is a state transition between multiple equilibria. And it cannot be predicted by any algorithm or market.

The only way to deal with it is to avoid not only maturity transformation, but all markets in which prices may be affected by maturity transformation, or similar inherent instabilities. For example, in the mortgage case above, even a temporally solvent bank which holds mortgages will find its solvency tested by the wave of defaults which the collapse will create.

My belief, again, is that in a free financial market with no Bagehotian lender of last resort, creditors will demand temporal solvency. Here is why.

You argue: The trick is to manage the risk of catastrophic loss well enough so that it is low enough to allow profits to be made in the interim. If you can do this then you have a good, sustainable (if occasionally volatile), business.

Profits can be made “in the interim” because, since long rates are naturally higher than short rates (again, see my blog), any system which can arbitrage the two by transforming maturities can produce positive return. But this return has to be adjusted for the probability of a maturity collapse, ie, bank run.

First, there is no way to predict a bank run using the statistical tools generally used to analyze default risk. You are depending on the kindness of strangers. To predict this, you need to be Hari Seldon. You are not Hari Seldon.

Second, the ability to accept a statistical profit over a long term, at the expense of volatility, is the very definition of a long-term investor. But when you are engaged in maturity transformation, your creditors are not long-term investors! People make demand deposits and buy AAA-rated commercial paper because they think the real default risk is not just low, but negligible. When this changes, they flee. How’s that TED spread doing?

As a banker, you profit by taking risky investments and aggregating them to diversify the risk. Risk goes in one end and does not come out the other. This is a tremendous service not only to humanity, but also to your creditors. If you are not actually disarming the risk, if you are actually just pretending to disarm it and in reality passing it through, you are not doing good business.

Third, a financial system in which temporal solvency is the generally accepted definition of bankerly rectitude is stable – by definition, no one in this system will invent the new criterion of scalar solvency. Moreover, if someone does, the attractive force of scalar accounting is relatively minor – the lure of slightly higher rates on short-term money.

Whereas an outbreak of temporal accounting in a world of scalar accounting has a name. It’s called a “bank run,” and its power of contagion is legendary. So temporal accounting is stabilized by the force of massive existential fear, and destabilized by the force of mild picking-up-nickels greed. Whereas scalar accounting is stabilized by mild greed and destabilized by massive fear. You do the math.

The puzzle therefore is: why do we live in a world of universal scalar accounting? Since all market forces have been removed, there is only one conceivable answer: the State. Considering the human consequences of the last 300 years of financial panics in the Anglo-American banking system, this is a rather incendiary accusation! But I can find no way to avoid it.

It is interesting to learn that Australia has no formal deposit insurance scheme. I was unaware of this fact. As you point out, however, the importance of this is unclear. What is clear is that Australia has a political system which has the power to monetize in a crisis. It also has the incentive to monetize in a crisis. Given these facts, the formalities are probably irrelevant. (See under: Northern Rock. See also: Fannie and Freddie.)

In fact, FDIC itself is protected by the same informal power to monetize. It does not have a zillionth of the capital it would need to survive as an actual private institution. The US banking system is protected not by the formal, contractual responsibilities of FDIC, but by the informal political understanding that FDIC itself is too important to default. (Ie, “too big to fail.”)

What I find troubling about this is that informality is another name for lawlessness. Since these kinds of informal loan guarantees are both pervasive in the present Western financial system, and absolutely essential to its continued survival, we can say without risk of hyperbole that “modern banking and risk management” is fundamentally rooted in official lawlessness. The foundations look impressive, but they are poured on sand.

If this is an accurate analysis of the situation, I hope you’ll agree with me that the issue is quite a bit more important than, say, a bit of warm weather. We are awfully dependent on this here financial system. Is there a way to repair it, without mass panic, riots, starvation, war, cannibalism, etc? Possibly. But the first step is to understand that we do indeed have a problem.