Term Deposits (5) - Liquidity Crisis

A number of finance companies based in New Zealand been placed in receivership during the past few months. This is blamed on the liquidity crisis. The truth is that they were all borrowing short and lending long. When depositors stopped rolling over their deposits as they came due, the finance companies came under pressure. When large numbers of depositors withdrew money, the finance companies were unable to continue. The money of the remaining depositors is now at risk, and they may only get part of their money back.

Most of the subprime crisis has the same cause. The institutions concerned all borrow in short term markets and lend long term. When investors decide to do something different with their money, these institutions get into trouble, because they have made long term loans assuming they will continue to be able to obtain money. Recent events have proved that this assumption was wrong.

Commentators blame the problem on investors losing confidence in financial institutions. Investors losing confidence is not the cause of the problem. Investors are entitled to change their minds about what they do with their money. The problem is the false confidence of the banks and financial institutions that depositors will not change their minds. They were confident that they could continue to obtain the money they needed to support their long term loans, but this confidence was unfounded. Their false confidence is the real problem.

We should all understand that the entire banking system is based on the practice of borrowing short and lending long. New Zealanders are finding that trusting finance companies, which borrow short and lend long, is very risky. If we cared about the security of money, we would demand that banks give up this practice. Why would sensible people lend their money to banks and other financial institutions that have a false confidence about the future?

Americans assume that Federal Deposit Insurance will protect their bank deposits. Gary North has shown what a vain hope this is in his article Deadly Assumption.