Tuesday, December 04, 2012

Short-term Risk-averse Capital - Solution

The solution to the glut of short-term risk-averse saving is matched lending and borrowing (see Sound Banking). If every bank has to match the terms of loans and deposits, behaviour would have to change. Demand for longer-term loans will continue to be large, whereas demand for shorter-term loans will decline. The supply of short-term deposits will be greater than the supply of long-term deposits. Borrowers will not be able to change their behaviour much, because the best capital investments are longer term, so interest rates will have to adjust to clear the market. Interest rates on long-term deposits will rise and rates on short-term deposits will fall.

Interest rates on deposits less than two years might drop to zero, as there would not be much demand for loans of these terms, except for consumer borrowing. However, as the Kingdom of God grows, contentment will increase, so the demand for consumer loans will decline too. The interest rate on deposits on call might be negative. The lender would have to pay a fee to buy the transactions services provided by the bank.

This change in interest rates would shift savers away from short-term deposits towards those with longer terms. To get acceptable interest rates, depositors would have to agree too much longer terms for their fixed deposits. Terms for five to ten years might become the norm, if the rates on short term deposits are close to zero.

Deposits will be pooled, so that the risk of an individual loan defaulting is shared across many depositors. However, some risk cannot be avoided. Pooling can cover the risk of failure by a few businesses, but it cannot deal with risk of widespread default during a serious collapse of the economy.

If lenders understand that loans always involve some risk, some might decide to purchase equity or shares instead. This will enable them to capture a greater share of the return on their contribution to businesses activity.

Equity is better for the business. It used to be argued that it does not matter whether a business is funded by equity or debt, but the GFC showed that is wrong. Debt has two serious problems for businesses. First a debt has a fixed date on which it is due. Even if it is not a convenient for the business, the debt has to be repaid on that date. Equity does not have a due date. It may decline in value during difficult times, but it does not have to be repaid by the owner at an inconvenient.

The other problem with debt is that it is fixed in nominal dollars. If the value of the assets purchased has declined in value, the borrower may have to put up extra security. The business would not be able sell the asset to repay the loan, so they will have to put other money to get out of debt. In contrast, the value of equity adjusts with the state of the business and the economy.

A shift from debt funding to equity funding would increase the stability of the economy.

Whether savers decide to buy equity or increase the terms of their bank deposits, their change in behaviour will create a much larger pool of long-term risk-informed capital to sustain productive investment in capital goods. That would be good for the economy.

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