Ok we know the loanable funds theory is false, banks create money through loans and go looking for reserves later. One day, despite Noah Smith’s (as usual and deservedly much mocked) recent claim on twitter that modern macro really believes in endogenous money now, the standard textbooks might catch up.
But despite this underlying empirical fact there is surprisingly little agreement about the mechanisms by which money is created, transmitted and influenced, for example, by central bank operations and reserve movements between banks.
One of the main themes of this blog (see here, here, here, here, here, here, here and here) has been that even with an endogenous monetary base reserves matter and maturity transformation matters and need to be correctly modelled. A correct double entry model of banking needs to be able to explain the fractional reserve mechanism and even the ‘money multiplier’ though the causality may be reversed. Indeed if you trawl back through the banking theory textbooks of the early 20C (and indeed earlier), before Hansen and Freidman popularised the exogenous theory, you find that thinking about issues such as the money multiplier emerged from debates about how to properly model endogenous money. The model of banking built up on this blog is modual, with an endogenous money base and modules adding complication such as risk, collateral and maturity transformation. This has led some to say hey what about maturity transformation, what about risk etc, which is not to see the model as a hole and distinguish the necessary from the contingent elements.
Part of the thinking of this is that banks though not reserve constrained are cash flow constrained (see my posts on this here), and the ultimate determinant of positive cash flow is profitability. In a profitable bank cash flow can be secured through a fund of equity and/or the positive receipts from loans and/or ‘excess reserves’ created by the wealth of customers or the purchase of bonds (exogenous money creation).
So ultimately a comprehensive model of banking needs to be a hybrid one, including both the endogenous creation of money by banks, the exogenous creation of money by central banks (less important quantatively) and the creation of profits through positive cash flow management by banks (maturity transformation). It is the correct modelling of the last factor I want to talk about today. (note this post was prompted by the incomplete help notes to the latest version of Steve Keen Minsky where he talks about creating a hybrid banking model whereby the maturity transformation component would be a ‘patience’ impatient’ one like Krugman & Eggerson and Kiyotaki & Moore.
It is common to talk about the function of banks being maturity transformation. This is a functionalist fallacy, the function of banks to make money by making money, maturity transformation is one of the means by which they optimise the endogenous creation of money. Maturity transformation is not restricted to banks, it is part of the core business model of insurance for example (as Warren Buffett profitable discovered) One of the ways that the modelling of maturity transformation has crept into the New Keynsian literature is through assuming that the ‘patient’ lend to the ‘impatient’. This of course is simply the old loanable funds model and it is false. The loanable funds model has been criticised as being empirically false. The earliest critique I think was from Taussig who argued that it was the anticipation of future cash flow , not the size of loanable funds on hand now that constrained bank lending. But there needs to be a wider critique, because savings matter, as Viner pointed out even if you hold a pure liquidity preference theory regarding interest then there needs to be a prior act of saving before one has cash on hand to be able to fulfil a transactions motive, or any other financial motive for holding liquidity. Indeed even if you have no motive for holding cash at all (such as cash remaining in a balance after the holders death, incapacity or senility) then this can be used by the process of maturity transformation by banks to create and leverage loans.
This process of maturity transformation is not best modelled by the ‘patient’ lending to the ‘impatient’, indeed very often we can find examples of the ‘impatient’ lending to the ‘patient’ Here I am going to assume a double entry model of banking. Such models can be controversial even within the post – keynsian community as some claim that ‘this bank doesn’t hold an account called x’ where x is the name given to an account within a double entry model. These criticisms miss the point of rigorous accounting. An economic agent doesn’t have to keep correct accounts, indeed in the cash in hand world few do, the point of accounting is to show the current current cash position and projected future positions – to tease the underlying reality in profit and loss terms’ Imagine a friend is flying out of a country with exchange controls, he gives his mate $1000 dollars, saying ill be back in three months keep in for me. The friend then uses that money tpo buy goods which he sells at a profit, after three months giving me the original balance back. This is a classic example of maturity transformation, exactly like a time deposit or even a checking deposit held over this period (it is like a checking deposit if the ‘bank’ correctly predicts it wont be withdrawn for two months. It does not matter for I have kept a proper ledger of assets and liabilities, these are implicit and if my cash flow position falls short of this I will be in trouble with my friend. So then a proper double entry approach to economics gives us some flexibility, there are implicit accounting relations even where these are not explicit –good examples being intangible assets and implicit equity (such as the implicit equity a state holds in a central bank). This flexibility aside even your accounting schema varies too much from real cash flow positions you will get in trouble, so it is with the ‘patient’ and ‘impatient’ model.
You are buying a home you are really really impatient to buy a home so you take a loan, the bank however says you have to save a deposit of 10%, damn that’s going to take you two years, so you accumulate balances in a time deposit. These idle balances (excess reserves) are used by the bank in the fractional reserve process we explain here. Providing after two years the bank can pay me back it can do what it likes with the excess reserves in the interim. Let say you want a mortgage over 20 years, it might use them to grant a mortgage over 30 years. Who then is the most impatient, here the more impatient person is lending to the more patient person. What matters is the relative liquidity position of the two parties, and that position may be held for numerous motives, financial, transactional etc. That liquidity position is also a function of wealth, income and patience, not patience alone.
The cash flow position a banks needs to have to settle draw down of balances is governed but what I call its fractional liquidity requirement. This is a function of:
- –ve The rate of outflow of loans granted and investments made
- +ve The rate of inflow of reserves
- –ve The rate of outflow of reserves
- +ve The rate of inflow of loan repayments and interest.
- -ve Any reserves lodged with a central bank
- +ve interest on other investments
If at any point a bank finds that it is illiquid it can use the reserve window and interbank lending to maintain a positive cash flow. Maturity transformation is the taking advantage of the fact that 3) is smaller than 2) in a growing economy where people are accumulating wealth in idle balances or term accounts. It is not a sign that people are increasing or decreasing in their ‘patience’ or’ impatience’ – this confuses the causality. If you are poor then you will have no access to bank finance, you will have no alternative but crusoe like savings, you are forced to be patient. If you are rich and your wealth is growing you can afford to be impatient, you will have a good credit rating and can take out a loan. As with everything is economics post Keynes it is income which creates demand which creates investment, including the creation of money and the demand and supply of ‘waiting’. (note: seen in this manner the liquidity preference theory is compatible with the classical ‘waiting’ theory of interest – see here).
Edit: The more I think about it Maturity Transformation is the wrong term, liquidity transformation would be much better. Maturity simply being illiquidity, but not its only cause.