The Interest Rate Brake on Maturity Transformation

Abstract

Must banks match asset and liability maturities, as William Barnett and Walter E. Block (2009, 2011), as well as Ivan Jankovic (2011), surmise? While we agree with these authors that issuances of fiduciary media breed financial instability, we disagree that maturity transformation represents such a case. Maturity transformation — otherwise known as borrowing short-term and lending long-term — guided by several base legal principles, does not result in the issuance of fiduciary media. Most notable among these principles is that any credit issued must be funded by borrowing of a positive duration, i.e., not via a demand deposit. We demonstrate that two factors instigate larger degrees of maturity transformation than would otherwise be the case, breeding potential instability: a continual increase in the credit supply and the provision of a lender of last resort. We also show that the interest rate is a natural stabilizing brake on the over-issuance of longer-dated credit against short-term financing.

Keywords:

• bank assets
• deposits
• loans
• maturity mismatch

JEL Classification Codes:

• G2
• K22

Notes

¹ Other factors are relevant besides the ability of banks to honor redemption requests on demand. In Greece’s recent history, the outflow of money is partly caused by this reason, although it is also a reaction against expected capital controls prohibiting depositors from moving their money to safer banking systems in the future, as was the case in Cyprus in 2013.

² If a fee is not explicitly stated, the depository is including the service at a loss which it will — optimistically — recoup through other business activities (Bagus and Howden 2009, 400 fn5).

³ While the specific legal obligations heaped on depositories are a question for the legal system, the existing framework of the law does not necessarily have to be correct or optimal (Bagus, Howden and Block 2013), whether through faulty logic in constructing laws in civil law jurisdictions, or as a result of poor case precedents in areas subject to common law.

⁴ That in practice there is a continuum of availabilities is of no immediate concern to us here. Philipp Bagus and David Howden (2012b) address this issue, arguing that even if availabilities are only vaguely defined, the legal system is the appropriate institution to determine whether money has been deposited or loaned.

⁵ Typically, economic disruptions put in motion by issuances of fiduciary media fall under the category of Austrian Business Cycles (Garrison 2001; Hayek 1935; Mises 1971; Rothbard [1962] 2000). Either the schema of relative prices is upset (von Mises [1928] 2002, 100-103), or entrepreneurial knowledge of the origin or sustainability of the new money is lost as fiduciary media is issued (Howden 2010). In either case, inter-temporal consumption and investment plans are upset, thus breeding instability in the real economy. Alternatively, one could view the rise in interest rates on the eve of the business cycle’s bust phase as a response to the expectations of falling income and a withdrawal of loanable funds from the market.

⁶ By promoting this destabilizing practice, the central bank creates a net negative welfare effect on the economy. In addition, it also causes a situation that necessitates its facilities to create fiduciary media. By engendering economic instability, central banks create the appearance that it is necessary to provide credit to keep the system liquid (Bagus and Howden 2012a, sec. 3).

⁷ Included among these cetera is a lack of a lender of last resort. One result of this function is a diminished importance placed on the interest rate as a brake on present maturity transformation.

Additional information

Notes on contributors

David Howden

David Howden is a professor of economics and chair of the Division of Business and Economics at Saint Louis University – Madrid Campus. Amadeus Gabriel is an associate professor in the Department of Finance and Economics at the Groupe Supérieure de Commerce de la Rochelle (France).

Amadeus Gabriel

David Howden is a professor of economics and chair of the Division of Business and Economics at Saint Louis University – Madrid Campus. Amadeus Gabriel is an associate professor in the Department of Finance and Economics at the Groupe Supérieure de Commerce de la Rochelle (France).