Short-term Risk-averse Capital

The modern banking system allows unmatched lending and borrowing. The reason for this is that lenders and borrowers have different needs. Depositors want high returns with low risk and flexibility. They prefer to deposit on call or a short-term fixed deposit, so they can withdraw their funds, if their situation changes or the economy weakens.

Borrowers need low interest rates, continuity and certainty. They will be using the borrowed money to purchase productive assets or real estate, which cannot be sold quickly, so they will not be in a position to repay back a loan earlier than expected, if that is required. They will often want to roll over the loan when it is due, rather than repay it.

Banks manage these different needs by recording unmatched loans on their balance sheets, and charging a margin between the interest on short-term deposits and the rate on long-term loans. This margin compensates them for the capital they have to hold to cover the liquidity and default risks created by the mismatch between lenders and borrowers.

However, resolving this mismatch on the banks’ balance sheet makes the banking system unstable. I have explained how this solution is immoral in Deposits and Loans. However, the balance sheet solution creates another problem for the economy. Most of the savings by households end up in short-term deposits, because savers want low risk. This provides banks with a glut of short-term risk-averse capital, which is of very little use to the economy.

The growth and efficiency of an economy depends on investment in productive capital assets, such as information technology, plant, equipment and factories. These are long-term investments, which often take a number of years before they bring a return to the investor. A factory may need to operate for ten to fifteen years to be efficient. These investments can only be undertaken, if equivalent savings are made available elsewhere in the economy (ignoring overseas funding). Banks undertake an important role by intermediating between households and businesses to channel savings into investment in capital goods. see Capital.

The problem is that most of the deposits held by banks are short-term and risk-averse. The depositors want to be able to get their money back at any time, but that is not what the economy needs. Investment in capital goods that will make us more productive can be quite risky. Not all projects will succeed, and some will fail. They will mostly be long-term ventures. A large pool of short-term risk-averse capital does not support the type long-term investment in capital that an economy needs.

Economists assume that savings are available to fund investment in capital goods, but they are not. Most savings are locked up in short-term risk-averse deposits. Banks responded to depositors preference for short-term risk-averse by channelling these savings into mortgages and real estate, because they were considered to be low risk (as house prices always go up). This means that the glut of short-term savings tends to feed real estate price booms, which makes the economy unstable.

The risk adversity of lenders actually increases economic risk, if their savings are used to fund real estate speculation. Whereas the flexibility of short-term deposits makes lenders feel secure, it increases risk for the economy by encouraging real estate bubbles and creates liquidity risk that will eventually come back to bite those who want security.

The reality is that risk cannot be avoided. All economic activity is risky. Banks offering depositors high interest rates on short-term deposits (with government guarantees) create an illusion of low risk that is unreal. Depositors think their money is safe, but they are participating in an unstable system that is weakened the economy that they are trusting for their future security. A more realistic attitude to risk is essential.