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A
Venetian Tale
A
Venetian merchant lost his ship of cargo on the reefs of the Dalmatian coast.
As he was sitting in a cove lamenting his loss, a mermaid appeared and
inquired what was the matter. Feeling sorry for the
merchant who lost his entire fortune in the accident, she dived into the sea
and brought up a boat laden with silver, and asked him if that were the boat
he had lost. When the man said that it wasn't, the mermaid dived again and
fetched up the merchant's own boat. "That's the right one." he said
gratefully. The mermaid, so delighted with his honesty made him a present of
the other boat as well.
When he returned to Venice and told his colleagues about his
good fortune, one of them thought that he could pull off a similar coup. He
loaded his boat with merchandise, sailed to the Dalmatian coast and scuttled
his ship. Then he sat down in the cove and wept. The mermaid appeared again. Upon
hearing the cause of his tears, she dived and soon produced a boat laden with
gold. asking if it were the same one that had been
lost. The man, who has never seen that much gold in his life. cried ecstatically: "0 yes, indeed!"
The mermaid was so shocked at this unblushing
impudence that, far from giving him the boat with its gold cargo, she did not
even restore his own to him. "You are not only a liar," she said,
"but also an impostor." She sailed away leaving the man alone in
the deserted cove.
The propensity to save
As we have seen in the Seventh Pillar, there is a
significant difference between commercial banking and investment banking
(including savings banks). The former depends on the people's propensity to
consume, and the latter, on their propensity to save. The banks pool the flow
of savings from individuals, and make this pool feed the flow of investments
to every part of the national economy. The banks borrow funds from the savers
for various fixed terms, and lend them out to producers, entrepreneurs,
speculators, for various fixed terms. The banks have a double balancing act;
they must balance their liabilities with assets not only dollar for dollar,
but also maturity for maturity. That is to say the banks must see to it that
their assets mature no later than their liabilities. This is known as the Principle
of Matching Maturities.
Since there is no investment without prior saving,
the minimal rate of interest is determined by the propensity to save (or by
its reciprocal, time preference). The higher the propensity to save, the
lower is the minimal rate of interest (or, the lower the time preference, the
lower is the minimal rate of interest) and conversely.
Borrowing short and lending long
The Principle of Matching Maturities is often quoted
in its negative form: a bank must not borrow short and lend long. This is the
one commandment most often violated by the banking fraternity. To understand
the underlying temptation, we have to examine the source of bank profits. The
investment bank derives its profits from the spread between the interest it
earns on its assets and the interest it pays on its liabilities. The bank
could, illegitimately, increase its profits by borrowing short at an even
lower rate, and lend long at an even higher rate because longer term borrowing
and lending normally command higher interest rates. The bank guilty of this
illegitimate practice is an impostor, as it misrepresents the true state of
affairs in the balance sheet, just as the greedy Venetian sailor
misrepresented his situation to the mermaid.
The practice of borrowing short and lending long is
no less dangerous than it is illegitimate. The bank would obviously have to
borrow again and again, before its assets matured. No one knows the future,
and the bank is no exception. Future borrowing conditions may be worse than
those at present. The bank may be confronted with borrowing costs higher than
the earnings it has locked itself into or, in an extreme case,
the bank may not be able to borrow at any price.
A bank guilty of borrowing short and lending long is
not only an impostor but a liar as well. It lies in overstating the value of
its assets and understating its liabilities in the balance sheet. The bank in
fact pretends that it can use short term funds to balance its long term
liabilities.
Short debt makes long friends
The American banking system is in deep trouble on
account of its long-standing addiction to the drug of borrowing short and
lending long. Worst offenders are the savings banks loaded with mortgages
maturing in 20 years or longer, held against liabilities maturing daily. That
this situation is preposterous should be clear to every impartial observer. The
bank has sunk liquid funds into brick and mortar, against which it holds
liabilities subject to withdrawal without notice (or on short notice). The
banks are sitting on mountains of paper losses, which will become real losses
at the first test of extensive cash withdrawals.
Federal deposit insurance is hardly a fig leaf. The
assets of the insurer cover only a minuscule part of its contingent
liabilities. Worse still, these assets are carried in the form of government
securities, and even a minor asset liquidation would
embarrass the government and break the market.
Had the American banks taken to heart the ancient
wisdom of the English proverb: "short debt makes long friends."
They could have avoided diverting enormous resources into loan-loss reserves.
Vicious circle
If bank liabilities mature faster than bank assets,
then two things will happen. (1) Interest rates will rise, as the banks are
forced to resort to asset-liquidation, and the public will acquire these
assets only at a concession in price. (2) The maturity structure of the debt
will shrink, as the banks are forced to issue short-term debt in exchange for
long-term debt. In other words, the banking system, led by the central bank,
is forced to finance a massive exodus of the savers from long to short term
debt. As the banking system has to absorb more and more long-term debt, unwanted
by the saving public, and give short-term credit in exchange, it becomes
clear that the only cure for the condition caused by that drug abuse is more
drug abuse.
The central bank is helpless. Any hesitation on its
part to make available the reserves needed to meet the maturing liabilities
of banks would bring down the house of cards immediately. The central bank
would therefore continue to buy the long-term bonds dumped by a disgruntled
public. That is to say the central bank would continue to borrow short and
lend long on an ever larger scale.
The vicious circle, however, cannot continue
indefinitely as the average maturity of the debt cannot shrink to zero. Before
that happens the bond market, like a rotten apple,
will fall into the lap of the money market. The money supply will explode,
the supply of savings will implode, and the new brave world of borrowing
short and lending long will come to a sorry end.
Antal E. Fekete
September, 2005
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