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Financial Times Letters

Daniel Aronoff

Financial times

FT

Daniel j aronoff

landon companies

'Con trick' is an integral part of modern finance/FT 6-2-2016

June 2, 2016 11:40 pm

‘Con trick’ is an integral part of modern finance

From: Daniel J. Aronoff

Sir, Since the financial crisis there has been a questioning of the benefits of fractional reserve banking, which has reached a crescendo in Mervyn King’s characterisation of the practice as a medieval form of alchemy that should be discarded (“Central banks as pawnbrokers of last resort”, June 1). Yet, what Martin Wolf calls a fraudulent “confidence trick” — the misleading idea that depositors can withdraw their money whenever they desire — is an integral part of modern finance. No country has become developed without fractional reserve banking.

The practice of lending out short-term deposits on a longer-term basis — which lies at the heart of banking — has arisen because economic activity takes place in time. It takes time to produce things to sell, and households and firms have needs for cash at various points in time. Those with excess cash, on the other hand, often desire access to it on short-term notice for a variety of reasons. There is no way of perfectly matching up the time preferences of savers and borrowers. Fractional reserve banking takes advantage of the “law of large numbers” to provide a solution.

Time also implies uncertainty; things may occur in the future that prevent borrowers from repaying, and a collective loss of confidence among depositors can lead to runs. The liquidity backstops of central banks and reserve requirements are meant to mitigate such risks. These arrangements can, and should, be adjusted in light of what has been learnt from the recent experience of near financial meltdown. But there is no technical fix that will eliminate what Keynes called “the dark forces of time and ignorance which envelope our future”. If we make banking perfectly safe, we will reduce allocative efficiency and innovation. We will be safer and very much poorer.

Daniel J Aronoff

President,

The Landon Companies,

Birmingham, MI, US

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