In defense of borrowing short and lending long

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Maturity mismatch is taking something of a beating in the comments, including from smart people like former co-blogger Winterspeak.  They urge the end of fractional reserve banking and its replacement with maturity matched investments--someone who wants to borrow for two years has to find someone who wants to lend for the same period of time.  That's much less unstable, they say, than a fractional reserve system.

That's true, it is.  It has the appeal of perfect simplicity.  But I am not a huge fan of perfect simplicity.  A wheelbarrow is simpler than a car.  It is less likely to break, and less expensive to fix when it does break.  But I would still rather have a car to do my shopping.

So what are the reasons to favor fractional reserve banking?  Threefold:

1)  Stopping it would require a huge regulator to keep people from doing what they naturally want to do, which is lend short and borrow long.  As long as a big fractional reserve banking system exists, it will require periodic government interventions.  You cannot credibly commit to not intervening when a failure to do so risks a double-digit GDP contraction.

So keeping people from doing this will require constant watching.  You will have to aggressively invade company books to ensure that all of their borrowing is duration-matched.  Remember, money market funds were very close to maturity matched--they borrowed in weeks and months, and lent in same. 

2)  Fractional reserve banking vastly increases the supply of savings available for investment.  I don't know about you, but I can't afford to lock up a chunk of my savings for six months to two years.  The money in my savings and money market accounts is there for a reason--I don't know when I'll need it.  I have longer term savings in stock funds, but that's superfluous money.

Hedge funds and private equity can demand long lockups because they are using surplus money that their investors don't expect to need--really need--any time soon.  The less affluent have to have a reasonably large cushion they can get their hands on in case of emergency, such as car repairs or a really good deal on a jet ski.  Without fractional reserve banking, that would be dead money, sitting in a vault somewhere.  Indeed, they'd probably end up paying someone to guard it for them.

Maturity-matched lending also has enormous transaction costs.  Most companies don't want to borrow in $2,000 increments.  The search costs of finding someone who wants to loan the amount you want at the time period you want, or a pool of same, is huge.  There's a reason that private equity has big minimum buy-ins, and tends not to disburse amounts in the size of an auto loan.  Trying to maturity match loans would essentially kill the market for both borrowing and lending in small amounts.

Fractional reserve banking puts that money to work.  It gives us periodic crises.  But by putting all that extra money to work in productive investments, it also gives us the wherewithal to pay for the periodic crises.

3)  The financial market can still have big crises.  AIG went down on credit default swaps--aka insurance (or, if you prefer, gambling)--not short paper.  Huge defaults on duration-matched securities can take down institutions in a domino-like fashion (remember Latin America?  Russia?)  Borrowing and lending money are risky endeavors.  They are unfortunately necessary in a society where the people with the good ideas aren't always the people with the money.

Maybe I should add

4)  It's a political nonstarter.  Maybe in some mad moment you could prohibit fractional reserve banking.  Right up to the point where people find out that instead of getting interest on their checking account they have to pay the bank to guard their money, and can't prepay their mortgage.  I doubt even my credit hawk commenters would like to find that, like companies, they might be stuck with paying 10% for all thirty years of their loan if they happened to borrow in a bad year.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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