Reply To: Short-term rates & ABCT

#17486
jmherbener
Participant

When banks intermediate credit, they tend to match the time structure of their loans (assets) with the time structure of their borrowings (liabilities). Also, interest rates tend to rise across the time structure because of increased intensity of time preferences, i.e., shorter term loans have lower rates than longer term loans. Arbitrage by banks from shorter term borrowing to longer term lending would be possible if banks find a stable renewal by savers of some portion of their short term lending to banks. Doing so would flatten the yield curve make banks less liquid,. Both of these factors would eliminate the profitability of further such arbitraging.

With fiduciary media and credit creation under central banking, these restrains are relaxed. The central bank targets the federal funds rate (i.e., the interest rate banks pay to borrow reserves from other banks) by supplying banks with more (or less) reserves through larger (or smaller) purchases of bank assets. Banks must decide how to allocate the credit they create across the yield curve without the guidance of savers’ preferences. Whether they lend long or short term, their balance sheets will be illiquid, so that does not constrain them. Their liabilities (i.e., the fiduciary media) are instantaneous) while their assets (i.e., their loans) have time structures. If the central bank has policies that shield banks from the ill effects of their illiquidity (e.g., bailouts, deposit insurance, soft bank audits, and so on), then they will tend to allocate credit longer term to earn higher interest rates. Government policies shielding banks also lead them to reduce their equity.

You might take a look at the relevant articles by Guido Huelsmann:

http://guidohulsmann.com/#publications