Time and interest are not so interesting

I wanted to add a quick follow-up to the previous post, inspired by its very excellent comment thread. (If you do not read the comments, I’ve no idea what you are doing at this site; I am always pwned by brilliant commenters.)

Cribbing Minsky, I defined the core of what a bank does as providing a guarantee. Bill Woolsey and Brito wonder whatever happened to maturity transformation, the traditional account of banks’ purpose? Nemo and Alex ask about interest, which I rather oddly left out of my story.

Banks do a great many things. They certainly do charge interest, as well as a wide variety of fees, both related and unrelated to time. Banks do borrow short and lend long, and so might be expected to bear and be compensated for liquidity, duration, and refinancing risk. Banks also purchase office supplies, manage real estate, and buy advertising spots. Banks do a lot of things.

But none of those are things that banks do uniquely. Banks compete with nonbank finance companies and bond markets for the business of lending at interest, and nearly every sort of firm can and occasionally does borrow short to finance long-lived assets. There is no obvious reason why any special sort of intermediary is needed to mediate exchanges across time of the right to use real resources. As Ashwin Parameswaran points out, there is no great mismatch between individuals’ willingness to save long-term and requirements by households and firms for long-term funds. Banks themselves largely hedge the maturity mismatch in their portfolios, outsourcing much of the whatever risks arise from any aggregate mismatch to other parties. Once upon a time, before we could swap interest rate exposures and sell bonds to pension funds, perhaps there was a special need for banks as maturity transformers. But if that was banks’ raison d’être, we should expect their obsolescence any time now.

But that is not and never was banks’ raison d’être, however conventional that story might be. Banks’ role in enabling transactions is and has always been much more fundamental than their role in lending at interest over long periods of time. It is not for nothing that we sometimes refer to cash money as “bank notes”. In some times and places, paper bills issued by private banks served as the primary means of commercial exchange. Here and now, the volume of exchange of bank IOUs to conduct transactions entirely dwarfs the scale of loans intended to survive for an extended length of time. When we buy and sell with credit and debit cards, merchants pay a fee for nothing more than a banks’ guarantee of a customers’ payment. Banks issue deposits to merchants with varying degrees of immediacy for these purchases, but charge no interest at all to debit and nonrevolving credit card customers.

Interest over time is, of course, at the center of how banks make money. But the question is why banks have any advantage over bond investors and nonbank finance companies in earning an interest spread. One traditional story has to do with relationship banking: local banks know local businesses (in part by having access to the history of their deposit accounts, in part because of social and community connections), and are able to lend profitably and consistently to firms whose creditworthiness other lenders could not evaluate, and can helpfully smooth over time variations in lending interest rates due to changes in the firm’s financial situation over time because the ongoing relationship prevents firms from jumping during periods when they are “overcharged”. I think there is something to this story historically, but fear it’s growing less and less relevant as the business consolidates into megabanks that require “hard” centrally verifiable statistics rather than “soft” local information to justify making credit decisions. In any case, if managing relationships actually is banks’ special advantage, note that it has nothing to do with maturity transformation and everything to do with evaluating creditworthiness and providing a guarantee.

Even if there’s something to the relationship banking story, it’s not sufficient to explain the resilient centrality of banks. Why can’t local nonbank finance companies couldn’t enter into persistent relationships with firms, evaluate creditworthiness, and earn the same smoothed interest rates as banks? Banks’ advantage in earning an interest rate spread comes ultimately not from anything special about their portfolio of assets, but from what is special about their liabilities. Banks pay no interest at all or very low interest rates on a significant fraction of their liabilities, low-balance checkable demand deposits. The class of bank creditors called “depositors” accepts these low rates because 1) they deem the bank to be highly creditworthy, and so don’t demand a credit spread; and 2) they gain an in-kind liquidity benefit because “bank deposits” serve as near perfect substitutes for money.

To me, a bank is any entity that can issue liabilities that are widely accepted as near-perfect substitutes for whatever trades as money despite being highly levered. Bill Gates can issue liabilities that will be accepted as near-perfect substitutes for money, but Gates is not a bank: his liabilities are viewed as creditworthy precisely because he is rich. The value of his assets far exceed his liabilities; he is not a highly levered entity. Goldman Sachs, on the other hand, was a bank even before it received its emergency bank charter from the Federal Reserve. Prior to the financial crisis, despite being exorbitantly levered and having no FDIC guarantee, market participants accepted Goldman Sachs’ liabilities as near substitutes for money and were willing to leave “cash” inexpensively in the firms care. The so-called “shadow banks”, the conduits and SIVs and asset-backed securities, were banks before the financial crisis, because their highly rated paper was treated and traded as a close substitute for cash despite the high leverage of the issuing entities. Shadow banks wrapped guarantees around a wide variety of promises that, after a while, we wished they hadn’t.

Maturity transformation, issuing inexpensive liquid promises today in exchange for promises that pay a high rate of interest over a period of time, is one strategy that banks use to exploit the advantages conferred by the resilient moneyness of their liabilities. Issuing guarantees for a fee — swapping their money-like liabilities in exchange for some other party’s less money-like IOUs — is another way that banks exploit their special advantage. These activities are not mutually exclusive: lending at interest over time and bundling the price of the guarantee into a “credit spread” embedded in the interest rate combines these two strategies.

But maturity transformation is really nothing special for banks: depositors’ willingness to hold the liabilities of highly levered banks at low interest means banks can invest at scale in almost anything and earn a better spread than other institutions. Whether that spread comes from bearing maturity risk or credit risk or currency risk or whatever doesn’t matter. What is uniquely the province of banks is their ability to issue, in very large quantities relative to their capital, money-like liabilities in exchange for the illiquid and decidedly unmoneylike promises of other parties, and thereby effectively guarantee those promises. It is this capability that makes banks special and so central in enabling commerce at scale among mistrustful strangers.

A final point about banks as I’ve defined them is that they simultaneously ought not exist and must exist. In financial theory, the interest demanded of an entity by its liability holders should increase in the leverage of the institution. There ought not to be entities that can “lever up” dramatically, often against opaque and illiquid assets, without creditors demanding a large premium to hold its deposits. Yet banks exist, and existed long before deposit insurance immunized some creditors from some of the risks of bank leverage. They existed in spite of financial theory, with the help of marble columns and good salesmanship and perhaps the small assurance that came from knowing that if depositors were ruined, the banker would be too. Under a wide range of political and institutional settings, banks come into the world and gain people’s trust despite their inherent fragility, because humans are susceptible to elevating gods, because commerce requires scalable and trustworthy guarantors. People require commerce enough to collectively hope for the best and overlook the inherent contradiction between leverage and trustworthiness. Nowadays, we mostly rely on the state to overcome this contradiction. But recall that no one thought that AAA tranches of structured vehicles had a state guarantee, yet they were often treated as near-money assets. It was just unthinkable that the rating agencies could be so wrong on so vast a scale. If you think about it, you’ll come up with other examples of entities that became able to act as banks, to issue near-money paper despite high leverage, because failure became conventionally unthinkable, even in the absence of any state guarantee or ability to extract one via the knock-on costs of failure. Our propensity to anoint banks is ultimately a social phenomenon, not a product of economic rationality.

Then the state itself is a special kind of bank. Like any bank, the state is perfectly creditworthy in its own banknotes. But unlike other banks, many states make no promise that their notes should be redeemable for anything in particular. “Currency-issuer” states (as the MMTers put it) are highly creditworthy because they don’t make clear promises they might be ostentatiously forced to break. That the failure of states is conventionally unthinkable lends another layer of resilience to the state-as-bank. Successful states use their capacity to intervene in economies — both gently through good stewardship and roughly via taxation — to ensure that the liabilities they issue remain valuable and liquid in commerce. This capacity to intervene renders states and state-guaranteed banks somewhat more resilient than private banks, although not infinitely so. Ultimately the value of any state’s irredeemable notes depends on its capacity to organize and tax valuable real production.

Addendum: Note that the subsidy to sellers described in the previous post depends specifically on the notion of banking systems organized and guaranteed by the state, rather than the more general definition of banks used in this piece. A person who surrendered some real good or service directly for the AAA paper of some CDO bore risk and probably got screwed. But if the same vendor surrendered a real resource for Citibank deposits which had been issued to the buyer against that same AAA paper as collateral, the seller was protected from the risk engendered by her semi-transaction. (“Semi”, because she surrendered something real, but received nothing real in return, creating a risk of nonreciprcation that did not exist before, see e.g. Graeber). It is the state guarantee of bank IOUs, whether explicit or tacit, that effectively socializes the risk of a sale, rather than merely obscuring it or rendering it conventionally unthinkable.

Update History:

  • 15-Jul-2012, 8:15 p.m. EEST: Added addendum re importance of state guarantee to the engineering of a subsidy to sellers.
  • 16-Jul-2012, 4:55 a.m. EEST: Fixed an ambiguously phrased sentence, many thanks to Ritwik for pointing out the issue: “requirements by households and firms for long-term savings funds.”
  • 16-Jul-2012, 5:05 a.m. EEST: “somewhat more resilient than more circumscribed private banks”, “against the that same AAA paper as collateral”

21 Responses to “Time and interest are not so interesting”

  1. Harald Korneliussen writes:

    So you’ve read Graeber’s book? I wondered about your thoughts on it. I found the anthropology bits fascinating, the history bits OK, and the other bits I’m not too sure about.

  2. vbounded writes:

    Mr. Waldman, “Ultimately the value of any state’s irredeemable notes depends on its capacity to organize and tax valuable real production.”

    Not exactly, character is only 1 of the 4 C’s of credit. The value of fiat paper also depends a great deal on character, meaning the willingness of political factions (often with conflicting interests) to make good on a country’s promises. The technocrat economists usually forget about character because they live in a fantasy-land where people care about maximizing global GDP, instead of reality where blocks of voters spell utility like this: I-I-I-I-I-I-I.

  3. Ritwik writes:


    “there is no great mismatch between individuals’ willingness to save long-term and requirements by households and firms for long-term savings” in para 3.. I think you meant requirements by households and firms for long-term borrowings?

    [Thanks for pointing out the ambiguous phrasing! I’ve replaced “savings” with “funds”, which I hope is a bit better. —SRW]

    Other than that, note perfect. I think not enough people realise the central importance of Ashwin’s point that the accumulation of financial wealth has fundamentally changes the saving and investing process. The time numeraire is not necessarily immediate, there is ample equity, and there is ample demand to be compensated 10 years or 20 years down the line for current savings. The traditional case for maturity transformation just doesn’t hold water any more.

    In ‘The New Lombard Street’ Perry Mehrling makes the interesting and not oft-recognised point that borrowing short and lending long is a rather unique feature of American banking hisory, with banks intricately involved in the finance of agriculture and capital investment. In Britain, banking was for the longest time purely about trade financing (the real bills doctrine), with little or no maturity transformation involved at all.

    I do think that the ‘relationship’ and information about local requirements arguments still hold a lot of promise. It seems that this will be one of the more salient changes in the banking model that will happen over the next few years – the return to local better-evaluation-of credit risk banking. But you are right, that’s just generic financial intermediation.

    Your point about a bank being a bank due to low funding costs despite high leverage is absolutely critical. Makes you wonder why one needs a bank bank at all. Why should the money market and the 3 month Treasury bill market co-exist?

    Great post.

  4. Bryan Willman writes:

    The transformation you are talking about – where a bank transforms risky claim A into reliable claim B, is actually one of two very important properties of money (the other being time displacement of a transaction.)

    It’s also a big part of how money is created. Alice posts collateral to borrow $$$ which are paid to Bob who deposits them (in some bank somewhere.) Alice then defaults. NOT BOB’S PROBLEM. Without this “from this point on money is money” break in the chain of debt and start of a chain of reliable claims, economies could not grow. (Because the “note” I get from SRW turns to be a “note” he got from some MMT’er who got it from Lehman brothers and now it’s no good.)

    In short, without the transformation described above, or some equivalent, there would be no “cash” only long debt chains, and *being paid* would be as risky and uncertain as lending.

  5. john c. halasz writes:

    So, as a severe conceptual reduction, a basic explanation of the system of banking and credit, as it has historically emerged and evolved together with capitalism. Suppose there is an economy whose production system exactly matches its money supply. (This, of course, ignores the issue of the “velocity” of the money supply, itself one of those bad physics metaphors amongst economists, since it is really a frequency measure and not a velocity, a stock/flow confusion). Now suppose there is suddenly invented an entire new production system that would double the productivity of labor and thus greatly lower unit output costs and thus greatly increase actually and potentially the real distributable surplus product, but it will take 2 years to build and put into operation. So in order to replace the current production system, workers will have to be withdrawn from current production of consumption goods and replacement capital stocks, which means that either prices will inflate or wages will be cut, but, either way, current output cut back and the economy deflated. In which case, when the new production capacity comes on line, though it will greatly lower output costs and thus increase real wages, it will nonetheless enter into a depressed level of demand, which is sub-optimal for realizing the new production potential. Hence the provision of credit for the building of future improved production capacity attenuates this conundrum.

    Now you might object that the current money stock exactly corresponded to current output, so credit couldn’t have added to real current economic resources. But there is always slack in “real” resources: machines might be run at a faster pace, (since they are soon to be replaced anyway), or workers might work longer hours, and the like, but the point is that current monetary demand and its payment system needn’t be diminished. But then why can’t future investment capacity be financed out of current profits? Indeed, to the extent that current profits aren’t needed for replacement investment, it can, so credit only serves to accelerate investment in improved future investment capacity, depending on the availability of opportunities for such investment.

    At any rate, this conceptual reduction goes to the emptiness at the core of the system of banking and credit, “money for nothing and the chicks for free”, which, though it doesn’t operate without constraints, nonetheless self-expands beyond any current basis in “value”. Obviously, there is never any such instantaneous and foreseeable improvement in the whole production system and opportunities for investment in productive improvements will vary periodically, sometimes with rapid disruptive technical change and sometimes with only piecemeal improvements. But the basic point is that credit is “justified” by future productive improvements, (which always contain a speculative element, due to the unknowability of future contingencies, endemic uncertainty), and that, in real terms, investments produce savings rather than vice versa, since improvements in productive capacity that lower output costs and increase the real distributable surplus product are what enable credit/debt to be repaid and then some. (To economize means to produce more from less, to decrease the costs per unit output in terms of real economic resources).

    There are other basic functions of credit, such as short-term trade credit to manage business cash-flows and other contingencies, and financing long-lived consumer durables such as houses, which otherwise would scarcely have a market, but the future expansion of output is the key basis for such a system of banking and credit, which is why credit is a crucial to maintaining READ. However projects for productive investment might well fail, (or become misaligned and inter-sectorally disproportionate), while the credit system can readily outrun the production and income-generating capacities of the real economy, resulting in accumulations of fictitious capital at the expense of real production. Which is why such a system is so crisis prone, requiring careful regulation.

  6. […] Time and interest are not so interesting – interfluidity […]

  7. Carter the Examiner writes:

    This whole debate is an echo of Corrigan’s 1982 “Are Banks Special?”


    The essay suggests that banks perform three essential functions: (1) they issue transaction accounts (i. e., they hold liabilities that are payable on demand at par and that are readily transferable to third parties); (2) they are the backup source of liquidity to all other institutions, financial and nonfinancial; and (3) they are the transmission belt for monetary policy.

  8. Diego Espinosa writes:

    I think what is new is that the shadow banking system provides “money-like” liabilities not because the real economy demands it, but to speculate on maturity and liquidity transformation. By “speculate”, I mean use high leverage write put options on interest rate volatility and liquidity events. The shadow banking system exploded in size after 2001. This was by design: to ward off deflation, the Fed essentially offered to hedge rate volatility and liquidity risk for free. It did so by communicating the path of interest rates (extended period, measured pace) and by providing evidence that it will act to maintain liquidity at all costs. The GFC can be seen as a gradual fraying of this put, from early exercises (the ABCP crisis in 2007 and the resulting liquidity backstops), to an important exercise (protection of Bear creditors), to the first abrogation (GSE pref’s not honored), to full reneging (Lehman).

    Shadow banks have little to do with asymmetric information and arbitraging the credit risk premium. This is why they tend to hold mostly AAA-rated (i.e. virtually risk-less) assets. What’s striking is the level of shadow bank strategic homogeneity. All converged on essentially the same policy-directed strategy. This homogeneity is part of what created so much systemic risk. Their reliance on low rate volatility and the presence of liquidity was probably the biggest financial bet in history.

    How can the Fed reduce systemic risk? Stop being transparent about liquidity and the path of policy rates, let the system self hedge, and stop using rent-seeking arbitrage as a key policy transmission mechanism.

  9. Mikael Olsson writes:

    Many comment on the necessity of banks for providing credit for investment. Quite true; that money has to come from somewhere.

    I encourage you to read up on the Binary Economy model for investment. The short short is: the central bank prints the money. The money is given to the company that needs the investment. There is no interest. There are only two major rules:
    1. Ownership must be diluted to new owners (ratio and mechanism defined in government policy)
    2. The money needs to come back via profits, with different rules between large and small companies that I won’t go into here.

    (Obviously there needs to be someone evaluating the general soundness of the loan, too. Goes without saying.)

    Now imagine this cycle repeating several times over with many companies. Brain-teasing, isn’t it? =)

  10. Mikael Olsson writes:

    Oh and you don’t need a revolution for Binary Economy, either. It can coexist with current economy just fine. It just needs a legislation change for what the CB is allowed to do and set some parameters for the ownership distribution.

  11. nemi writes:

    So, a bank is simply a place which accepts deposits?

    If I buy something on store credit, that store will act as a bank with respect to risk, interest etc. The difference is that the store will sell me something beside money in exchange for my promise of future payments, but that is hardly of any significance (the amount, however, probably is of significance).

    However, while I can understand why computer stores have to buy in order to sell computers, I do not see the reason while banks should do that. Why doesn’t everyone simply have a savings account with the CB instead (given that the savings are going to be protected by deposit insurance anyway)? Banks could still be allowed to create loans in accordance with their capital acquirement, but would have to lend money directly from the CB (or, as currently, from the treasury who holds the risk anyway).

    I.e. what is the point of having deposits distributed over private banks when they in any economically meaningful way, from the depositors point of view, are deposited with the state anyway (through the deposit insurance)? Couldn’t we simply subsidies the banks directly instead (if that is the goal)?

  12. Mikael Olsson writes:


    Banks would function perfectly fine without deposits. We could indeed deposit into the CB directly (but the logistics of it would of course end up being a cost with the state instead), but, as it stands, banks must accept deposits to have a banking license.

    The biggest reason for banks to accept your deposits is to form a relationship with you, so that you (hopefully) come to them when it’s time to take out a loan. And here is where it gets interesting.

    Loans are hugely lucrative for the banks. But not for the reason you think. The interest that you pay is mostly insurance against inflation and salary costs for people at the local office.

    The real reason banks want your loans is that they in turn can be used as leverage to make MUCH bigger money. The bank owns a % of your house as collateral. This makes it a high security loan, which is basically = free money when you go to the shadow banking sector (google it). MMFs, SIVs (oops they all crashed in 2008 despite being AAA ranked, imagine that!), CDOs etc are huge moneypumps in the who-fools-who-the-best game. And your loan is what enables their gambling.

    There are voices being raised here and there in the world about separating commerce banks (what you think of as “a bank”) from investment banks (which is something else entirely). I think it’s an excellent idea, personally, but I don’t work in finance. I’m quite sure the 0.1% will never allow it to happen.

  13. Mikael Olsson writes:


    Oh and store credit is almost never given by the store itself, there’s usually something bank-ey in the background that takes the risk. The store has interest in providing it to you because it makes you buy NOW rather than later. They get their money immediately from the bank, and don’t take risk.

    And yet again you have a bank holding debt, which can be be used as a money-like instrument. (Though less secure since it’s not against a house or somesuch, so can’t be leveraged as much, unless you find a Whale that doesn’t mind playing with unsecured loans)

  14. greg writes:

    You might want to watch: Money as Debt II http://www.youtube.com/watch?v=lsmbWBpnCNk

    About 34 minutes in, he shows one of the reasons we have banks: They are profitable institutions,
    capable of gobbling up everything, in particular the real assets owned and created by those who produce real things. What is remarkable is not the existence of banks, but the continued existence of society in their presence.

    He shows that loans are indeed created from thin air. I also recommend his discussion of the origins of the business cycle. But the whole movie is enjoyable and informative.

  15. JKH writes:


    Try splitting maturity transformation as it pertains to interest rate risk versus liquidity risk.

    That’s how banks attempt to manage it.

    You get some interesting conceptual challenges as a result.

    Also, try tackling the problem of how to hedge interest rate risk as it arises specifically against the use of funds corresponding to the book value of equity funding for a bank. That is a different problem than the assignment of the same book value in the allocation of capital for credit risk across various business lines, for example.

    That is also interesting.

  16. Brito writes:

    “There is no obvious reason why any special sort of intermediary is needed to mediate exchanges across time of the right to use real resources.”

    There absolutely is, without an intermediary this whole process is extremely costly and inefficient; it is very difficult to enforce a contract determining the terms of a loan to or from say an individual to or from a company, and, furthermore, the risk is greatly increased, given the lack of diversification or ability of the parties to absorb losses, requiring a much higher risk premium. So the legal fees and large interest rates alone prevents most loans that can be made by the banking system from being made by individuals alone. Economic theory tells us that without any kind of institutional/intermediary structure, most loan negotiations would fall apart at the contract stage.

  17. Alex writes:

    “But none of those are things that banks do uniquely. Banks compete with nonbank finance companies and bond markets for the business of lending at interest”

    This seems impracticable for most personal loans.

  18. kris writes:

    About 6 or 7 years ago, when my interest about finance was zero, a jewish acquaintance told me a story during a conversation. About 100 BC in roman Israel used to be two schools of thought that debated with each other, the school of Shamai and the school of Hillel. Shamai and Hillel were famous at the time and their debates are studied today in rabbinic schools. The story went something like this:
    – Shammai would say that the rich are evil people and if they do not lend money to the needy God will punish them (ring a bell?). The needy would be somebody who had lost 3 out of 6 sheep and could feed the family. He would need money (gold or silver) to buy 3 more sheep, produce 2 or 3 more lambs and by selling the lambs he would pay back the debt.
    – Hillel would say: I don’t think rich are bad people, it’s just not sure that the needy would pay back the debt and the rich would be ruined if he lent out all his money.

    However, Hillel once came with this idea: Let’s propose that all the rich place all their Gold in the synagogue close to the Holy of Holies. If a needy person would need money, the synagogue council would lend the money out to him since not every rich guy needed the money all the time (ring a bell?). The synagogue was accepted by everybody as the absolute guarantor of the personal holdings of the rich since it was God’s house. Well, well, well. The rich accepted. There we have the FIRST MODERN BANK.

    The first ever reason to create a bank: A NEED FOR A (DIVINE) GUARANTOR OF TRANSACTIONS.

    Reference for you

  19. […] Steve Randy Waldman at Interfluidity points out it’s not, contrary to popular belief, their ability to create credit. Indeed, as we have also […]

  20. Minja writes:

    A few thoughts:

    I think you’re looking at the idea of a bank primarily from the focus of the consumer. It’s perfectly consistent to say that a bank provides guarantees (to the consumer) while also saying that its primary economic function is maturity transformation. What exactly is being guaranteed? That a customer’s funds will be available to her in the short term (at any time, if a demand deposit). We could rent out safety deposit boxes if that was the end of it. But the bank then takes those short-term funds and uses them to finance its long-term investments– maturity transformation– which is why we get to keep our principal and make a little bit of interest (above and beyond inflation). This structure is economically useful because it takes our funds and leverages them for presumably useful purposes (as opposed to sitting in a box, untouched). But it is also vulnerable to runs, principal-agent issues, etc.

  21. Minja writes:

    Also, you ask what the difference is between non-bank finance companies and bonds. W/r/t the latter, depends how long of a duration you’re talking. But I can use demand deposits to pay for my utilities, my credit card bills, or an emergency hospital visit. I can’t do that with bonds.

    W/r/t the former, it depends what kind of finance company you’re talking about. But obviously, one of the key points of the “shadow banking” hypothesis was that in fact we had allowed banking to essentially become re-created into structures outside the regulated, insured banking system. So many of these companies might actually be understood to engage in “banking”.