Why not force banks to duration match?

A popular solution for the credit crisis in right wing circles is forcing banks to duration match their assets and liabilities--i.e., do away with interest bearing demand deposits (aka savings and checking accounts). Why is this a bad idea?

1. It would involve a massive, massive credit contraction. Hello, Great Depression.

2. Actually matching pool credit to particular loans would be a much more expensive business than the current banking system.

3. The expansion of credit has historically enabled a lot of things we like, such as homeownership and entrepreneurship.

4. How many people want to pay the bank to hold onto their money?

5. A smaller credit system will not ultimately prevent inflation/deflation. Without interest bearing accounts, savings become a wasting asset.

6. To the extent that it does prevent inflation, this is not necessarily a good thing--a little inflation greases the labor market, mitigating the effects of demand shocks.

Comments

The toughest nastiest regulator of them all, the invisible hand, is already leavying rather heavy fines for that.

Posted by j mct | June 11, 2008 3:56 PM

Which right wing circles are suggesting this?

Posted by Wushby | June 11, 2008 3:59 PM

Megan,

Depositors would also have to duration-match. For example, if I want a checking account, then the bank is serving as a custodian and check processor. I pay for this service under either scenario, whether I am aware of it or not. With fractional reserve banking, the bank simply pays me an interest rate too low to recover the inflation loss, and under a 100% reserve system, I will pay a direct fee for service. Under a 100% reserve system, to earn a real return, I will have to make a deposit that I can't withdraw anytime I choose, but that will be restricted by contract.

On a more fundamental level, I also object to the assertion that there will be a credit crunch. Savings, real savings, is not money, but rather, is the surplus that is not consumed by the producers. A priori, I see no reason that this pool of savings would shrink.

Posted by Yancey Ward | June 11, 2008 3:59 PM

Another Great Depression may be the best we can hope for.

Posted by dearieme | June 11, 2008 4:24 PM

Where to even begin on this, Megan_McArdle?

1) If implemented gradually, there's no need for a credit crunch.

2) You can already get a near-savings-account equivalent that matches short term liquidity needs on the part of the saver, with short term high-grade loans. They're called money market mutual funds.

3) Since when have savings accounts actually paid you? Yes, they "pay" something like under 3% now, while inflation is more. Oh, and dock off the taxes I have to pay on that interest. In real terms, we are all already losing money on our savings if they're in savings accounts, and probably most other kinds of low-risk bonds as well. (Seriously, the guys buying long-term treasuries with yields of 4% need a BIG smack upside the head.)

4) It's *not* expensive to match saving and investments. Again, mutual funds, but bonds this time.

Posted by Person | June 11, 2008 4:39 PM

I thought that this was big in left-wing circles, along with all kinds of other regulation. It doesn't strike me as consistent with "right-wing" or libertarian thought in any way.

And it's also silly. There a so many risks inherent in investing money. Duration is just one of many. And even now, if we would have had duration matching to CDO tranches that went to bid 20, we would still have massive losses. Maybe we should then mandate risk matching as well?

Posted by JoshK | June 11, 2008 4:54 PM

It's hard to make a clear case for managerial moral hazard as a result of the Bear Stearns bailout--they all lost their jobs.

In terms of its net effect, the difference, between being sent to Buchenwald and being 'bailed-out' at Bear Stearns was that, at the end of the day, you got to walk home in New York without your assets.

Posted by Michael | June 11, 2008 4:59 PM

(Seriously, the guys buying long-term treasuries with yields of 4% need a BIG smack upside the head.)

Could it be, that with US public debt levels at 36% of GDP, and Switzerland at 50%, German & France nearly 70% and Japan at 180% the US is the only major industrialized nation that has any real chance of making good on its long term obligations?

I mean considering the demographic trends in the US vs. Europe and Japan it doesn't look good for them long term... I mean if you can only invest in the long term debt obligations of first world nations the US seems like the best option...

Posted by jmo | June 11, 2008 5:04 PM

jmo: Thanks for the info, and good point. But I'm not just worried about credit risk (although with the massive medicare/SS crisis coming on, you've got to be VERY myopic to treat the USA's promises as golden): there's inflation risk too. Inflation's pretty bad now -- probably above the yields on the securities they're buying! And the buyers are betting that it will *fall*, and not come back up to its current level ... for 30 years ... and for taxes on that investment money not be taxed more, etc.

Posted by Person | June 11, 2008 5:24 PM

1. Unwinding the current system would not be easy, but it is doable. During the transition time, there would still be a role for the Fed to step in and "provide liquidity".

2. This could not be more wrong. Our entire financial system is based on a pool of money that's sloshing around from one asset to another, trying to find a place where inflation cannot erode its value. Savings accounts, bonds, and CD's are now useless as intruments of savings. Money moves from stocks to real estate to commodities, as the only way to protect against inflation is to buy assets of limited supply. But no asset ( other than oil and precious metals) is truly limited, and so eventually a bust happens, and the money must move elsewhere. And you do realize that the Fed has given Wall St. $500 billion dollars of bailouts in the past few months? I can't believe that you seriously suggest that people having to divide their savings into 1 year, 5 year, and 10 year bonds would be more expensive than our current financial insanity.

3. Please, read some history. Any endeavor that would earn a return on investment that's better than the alternatives, would get funded. People right now are taking out way too many loans, because interest rates have been lower than money supply growth. Credit expansion does not fund useful services, it funds Pets.com and McMansions in the exburbs. Read Panic, Manias and Crashes

4. Today people pay a very steep inflation tax to keep money in the bank. Also, remember, we are just talking about demand deposits. Very little money would be kept in demand deposits, and longer term CD's would pay interest rates that were actual positive in real terms.

5. Again, people would put their retirement savings in interest bearing 20 year bonds. Only the money people actually want "on demand" would not be available for investment. And that's as it should be.

6. Except every significant demand shock has been caused by maturity mismatching. Also, a lot of the sticky wages of the great depression were because of active government policy and intervention.

In the long term, ensuring duration matching does not even require regulation. All it requires is not bailing out banks that engage in the practice, and allowing comptetiors and speculators to try and fleece banks engaging in dodgy practices. Most of the woes in our financial system can be traced back to a policy of actively bailing out and subsidizing banks who duration mismatched, starting in the 1870's. There never would have been a Great Depression had the government not instituted this policy of propping up shoddy banks.

Posted by Patrick | June 11, 2008 5:48 PM

Person,

Think of it this way. You are the Chief Investment Officer of a Chinese insurance company or the Kuwait Investment Authority. You are required by law to invest 40% of your money in the extremely liquid long term sovereign debt of major first world nations. Where do you put your money? You have no choice (considering that countries like German France and Japan have much more precarious finances than we do) to bid on US Treasuries. As those bids pour in they drive down the yield.

Or just consider yourself. You want to invest long term in something safe. What do you put your money in? Real Estate? Too risky and illiquid. Commodities? Too volitile and we could be in a commodities bubble. Stocks? too risky and volitile. EUR Bonds? No, demographics are poor and debt levels are too high.

US Treasuries are the only way to go. Your not betting the yield will beat inflation - you just have nothing better to invest in that meets your needs for stabilty and liquidity.

Posted by jmo | June 12, 2008 8:20 AM

grr and that should read You're not your.

Posted by jmo | June 12, 2008 8:26 AM

A popular solution for the credit crisis in right wing circles is forcing banks to duration match their assets and liabilities--i.e., do away with interest bearing demand deposits (aka savings and checking accounts).

Sorry Megan, this post is sloppy and ill informed. By law federally regulated banks are required to maintain the interest rate value at risk (IR VaR) for their assets below defined thresholds as determined by their capital, so duration matching is already an implicit part of the regulatory landscape. Moreover, the credit crisis is a result of unhedged credit risk (duh!) not interest rate risk, that is, when banks couldn't roll their short term funding (the situation with, for example, Citibank's SIVs) they had to de-lever and realize mark to market credit spread losses. In other words, the problem was not too much interest rate duration, but too much credit spread duration. And, BTW: who are these nameless "right wing" types advocating a patently irrelevant response to the recent unpleasantness? I suspect they're strawmen used to motivate this largely bogus post. (And since they don't really exist, you may as well make them "right wing" and earn some street cred with your lefty Atlantic peeps.)

Posted by Martin Gale | June 12, 2008 8:56 AM

If you're asking what I would do if I wanted a long-term investment and considered stocks too risky, then I'd buy corporate bonds: better yields than treasuries, not much more risk.

And as for SWFs, I really don't know enough about their alternatives to answer...

Posted by Person | June 12, 2008 9:28 AM

Which right wing circles are suggesting this?

Yes please, some citations would be welcome to ensure that “right wing circles” isn’t just another name for “Ron Paul supporters.”

Posted by Thorley Winston | June 12, 2008 11:09 AM

Megan,

in addition to some of the contentions already raised, a couple more I have to raise:

2. I'm not so sure about this. If deposit contracts are clearly defined between demand and time deposits, and loans may only be made out of the pool of time deposits, then I'm not really sure where the new expense comes in. I certainly don't see the source of any new transactions costs.

3. With regard to home purchasing, I'm not really sure why we should be encouraging this in particular at all, which we do through our current system of credit expansion and the tax code. We are essentially encouraging people to borrow rather than save, and as I'm sure you're well aware, this is a bad signal to send long-term if we want capital accumulation, growth, and not laying a huge cost on the taxpayer to subsidize retirement. Furthermore, I don't really know why we should be expanding massive amounts of credit access to people who are ultimately going to default. Yes, I know; homes often serve as an "investment" for families. But as I'm sure you're well aware, real estate markets are the one of the most volatile out there, so I'm not sure why we should encourage "investment" in more volatile assets. Furthermore, from the perspective of efficiency, this financial capital is much better served being invested in productive capital, not in retirement nest eggs.

I'm all for stimulating entrepreneurship, as I'm firmly in the Schumpeter column (greatest economist EVER). However, just throwing more entrepreneurs out there with credit expansion (and idiotic SBA loans) isn't the way to go. Why should we be expanding credit to the point where massive amounts of poorly skilled, non-innovative businessmen are getting loans, driving their businesses into the ground, and ultimately tying lenders up in legal proceedings over the bad debt? (This is another area where I don't buy the argument that full reserve banking would be a more expensive form of banking.) If we want to stimulate and develop entrepreneurship, this starts with the education system.

With artificially expanded credit, we get the same inefficiency effects that we get with government subsidization of industries and price fixing.

5 and 6. No, this won't completely end inflation or deflation. However, I would contend that over the long-run, inflation would be greatly reduced, and there would be much less volatility. Inflation that is organic is fine. Inflation that is artificial isn't, and, again, can be just as inefficient as subsidies to private firms and price-fixing.

I've never really bought the argument that inflation is necessary to "grease" the labor market. For one, there's a differentiation to be made between inflation in the broad sense and inflation in certain markets. Furthermore, I don't really know why the labor market needs "greasing." It's a market just like any other market, and it works most efficiently when it is left alone.

Posted by Paige Michael-Shetley | June 12, 2008 12:15 PM

4. How many people want to pay the bank to hold onto their money?

Well, considering interest rates on checking and most savings accounts are currently lower than inflation, plenty. But point taken.

Posted by brooksfoe | June 14, 2008 3:30 AM