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.
The solution to the glut of short-term risk-averse saving is matched lending and borrowing (see Sound Banking). If every bank has to match the terms of loans and deposits, behaviour would have to change. Demand for longer-term loans will continue to be large, whereas demand for shorter-term loans will decline. The supply of short-term deposits will be greater than the supply of long-term deposits. Borrowers will not be able to change their behaviour much, because the best capital investments are longer term, so interest rates will have to adjust to clear the market. Interest rates on long-term deposits will rise and rates on short-term deposits will fall.
Interest rates on deposits less than two years might drop to zero, as there would not be much demand for loans of these terms, except for consumer borrowing. However, as the Kingdom of God grows, contentment will increase, so the demand for consumer loans will decline too. The interest rate on deposits on call might be negative. The lender would have to pay a fee to buy the transactions services provided by the bank.
This change in interest rates would shift savers away from short-term deposits towards those with longer terms. To get acceptable interest rates, depositors would have to agree too much longer terms for their fixed deposits. Terms for five to ten years might become the norm, if the rates on short term deposits are close to zero.
Deposits will be pooled, so that the risk of an individual loan defaulting is shared across many depositors. However, some risk cannot be avoided. Pooling can cover the risk of failure by a few businesses, but it cannot deal with risk of widespread default during a serious collapse of the economy.
If lenders understand that loans always involve some risk, some might decide to purchase equity or shares instead. This will enable them to capture a greater share of the return on their contribution to businesses activity.
Equity is better for the business. It used to be argued that it does not matter whether a business is funded by equity or debt, but the GFC showed that is wrong. Debt has two serious problems for businesses. First a debt has a fixed date on which it is due. Even if it is not a convenient for the business, the debt has to be repaid on that date. Equity does not have a due date. It may decline in value during difficult times, but it does not have to be repaid by the owner at an inconvenient.
The other problem with debt is that it is fixed in nominal dollars. If the value of the assets purchased has declined in value, the borrower may have to put up extra security. The business would not be able sell the asset to repay the loan, so they will have to put other money to get out of debt. In contrast, the value of equity adjusts with the state of the business and the economy.
A shift from debt funding to equity funding would increase the stability of the economy.
Whether savers decide to buy equity or increase the terms of their bank deposits, their change in behaviour will create a much larger pool of long-term risk-informed capital to sustain productive investment in capital goods, strengthen the economy.