Guest Post: Duration Mismatch Will Always Fail

Tyler Durden's picture

Submitted by Keith Weiner of the New Austrian School for Economics,

I have written a number of pieces on fractional reserve banking and duration mismatch.  I have argued that the former is perfectly fine, both morally and economically, but the latter is not fine.  I have dissected the arguments made against fractional reserve banking, and pointed out that it is nothing more than a bank lending out some of the money it takes in deposits.


I have debunked the most common errors made by opponents of fractional reserve:

  1. Banks print money
  2. They lend more than they take in deposits
  3. They inflate the money supply
  4. Money is the same as credit
  5. Fractional reserves banking is the same thing as central banking
  6. It is the same thing as duration mismatch


Duration mismatch is when a bank (or anyone else) borrows short to lend long.  Unlike fractional reserve, duration mismatch is bad.  It is fraud, it is unfair to depositors (much less shareholders) and it is certain to collapse sooner or later.  This is not a matter for statistics and probability, i.e. risk.  It is a matter of causality, which is certain as I explain below.


This discussion is of paramount importance if we are to move to a monetary system that actually works.  Few serious observers believe that the current worldwide regime of irredeemable paper money will endure much longer.  Now is the time when various schools of thought are competing to define what should come next.


I have written previously on why a 100% reserve system (so-called) does not work.  Banks are the market makers in loans, and loans are an exchange of wealth and income (  Without banks playing this vital role, the economy would collapse back to its level the previous time that the government made it almost impossible to lend (and certainly to make a market in lending).  The medieval village had an economy based on subsistence agriculture, with a few tradesmen such as the blacksmith.


But I have not directly addressed the issue of why duration mismatch necessarily must fail, leading to the collapse of the banks that engage in it.  The purpose of this paper is to present my case.


In our paper monetary system, the dollar is in a “closed loop”.  Dollars circulate endlessly.  Ownership of the money can change hands, but the money itself cannot leave the banking system.  Contrast with gold, where money is an “open loop”.  Not only can people sell a bond to get gold coins, they can take those gold coins out of the monetary system entirely, and stuff them under the mattress. This is a necessary and critical mechanism—it is how the floor under the rate of interest is set.


This bears directly on banks.  In a paper system, they know that even if some depositors withdraw the money, they do not withdraw it to remove it altogether  (except perhaps in dollar backwardation, at the end.  See:  They withdraw it to spend it.  When someone withdraws money in order to spend it, the seller of the goods who receives the money will deposit it again.  From the bank’s perspective nothing has changed other than the name attached to the deposit.


The assumption that if some depositors withdraw their money, they will be replaced with others who deposit money may seem to make sense.  But this is only in the current context of irredeemable paper money.  It is most emphatically not true under gold!


There are so many ills in our present paper system, that a forensic exploration would require a very long book (at least) to dissect it.  It is easier and simpler to look at how things work in a free market under gold and without a central bank.


Let’s say that Joe has 17 ounces of gold that he will need in probably around a month.  He deposits the gold on demand at a bank, and the bank promptly buys a 30-year mortgage bond with the money.  They assume that there are other depositors who will come in with new deposits when Joe withdraws his gold, such as Mary.  Mary has 12 ounces of gold that she will need for her daughter’s wedding next week, but she deposits the gold today.  And Bill has 5 ounces of gold that he must set aside to pay his doctor for life-saving surgery.  He will need to withdraw it as soon as the doctor can schedule the operation.


In this instance, the bank finds that their scheme seems to have worked.  The wedding hall and the doctor both deposit their new gold into the bank.  “It’s not a problem until it’s a problem,” they tell themselves.  And they pocket the difference between the rate they must pay demand depositors (near zero) and the yield on a 30-year bond (for example, 5%).


So the bank repeats this trick many times over.  They come to think they can get away with it forever.  Until one day, it blows up.  There is a net flow of gold out of the bank; withdrawals exceed deposits.  The bank goes to the market to sell the mortgage bond.  But there is no bid in the mortgage market (recall that if you need to sell, you must take the bid).  This is not because of the borrower’s declining credit quality, but because the other banks are in the same position.  Blood is in the water.  The other potential bond buyers smell it, and they see no rush to buy while bond prices are falling.


The banks, desperate to stay liquid (not to mention solvent!) sell bonds to raise cash (gold) to meet the obligations to their depositors.  But the weakest banks fail.  Shareholders are wiped out.  Holders of that bank’s bonds are wiped out.  With these cushions that protect depositors gone, depositors now begin to take losses.  A bank run feeds on itself.  Even if other banks have no exposure to the failing bank, there is panic in the markets (impacting the value of the other banks’ portfolios) and depositors are withdrawing gold now, and asking questions later.


And why shouldn’t they?  The rule with runs on the bank is that there is no penalty for being very early, but one could suffer massive losses if one is a minute late (this is contagion


What happened to start the process of the bank run?  In reality, the depositors all knew for how long they could do without their money.  But the bank presumed that it could lend it for far longer, and get away with it.  The bank did not know, and did not want to know, how long the depositors were willing to forego the use of their money before demanding it be returned.  Reality (and the depositors) took a while, but they got their revenge.  Today, it is fashionable to call this a “black swan event.”  But if that term is to have any meaning, it can’t mean the inevitable effect caused by acting under delusions.


Without addressing the moral and the legal aspects of this, in a monetary system the bank has a job: to be the market maker in lending.  Its job is not to presume to say when the individual depositors would need their money, and lend it out according to the bank’s judgment rather than the depositors’.  Presumption of this sort will always result in losses, if not immediately.  The bank is issuing counterfeit credit (  In this case, the saver is not willing (or even knowing) to lend for the long duration that the bank offers to the borrower.


Do depositors need a reason to withdraw at any time gold they deposited “on demand”?  From the bank’s perspective, the answer is “no” and the problem is simple.


From the perspective of the economist, what happened is more complex.  People do not withdraw their gold from the banking system for no reason.  The banking system offers compelling reasons to deposit gold, including safety, ease of making payments, and typically, interest.


Perhaps depositors fear that a bank has become dangerously illiquid, or they don’t like the low interest rate, or they see opportunities offshore or in the bill market.  For whatever reason, depositors are exercising their right and what they expressly indicated to the bank: “this money is to be withdrawn on demand at any time.”


The problem is that the capital structure, once erected, is not flexible.  The money went into durable consumer goods such as houses, or it went into partially building higher-order factors of production.  Imagine if a company today began to build a giant plant to desalinate the Atlantic Ocean.  It begins borrowing every penny it can get its hands on, and it spends each cash infusion on part of this enormous project.  It would obviously run out of money long before the plant was complete.  Then, when it could no longer continue, the partially-completed plant would either be disassembled and some of the materials liquidated at auction, or it would sit there and begin to rot.  Either way, it would finally be revealed for the malinvestment that it was all along.


By taking demand deposits and buying long bonds, the banks distort the cost of money.  They send a false signal to entrepreneurs that higher-order projects are viable, while in reality they are not.  The capital is not really there to complete the project, though it is temporarily there to begin it.


Capital is not fungible; one cannot repurpose a partially completed desalination plant that isn’t needed into a car manufacturing plant that is.  The bond on the plant cannot be repaid.  The plant construction project was aborted prior to the plant producing anything of value.  The bond will be defaulted.  Real wealth was destroyed, and this is experienced by those who malinvested their gold as total losses.


Note that this is not a matter of probability.  Non-viable ventures will default, as unsupported buildings will collapse.


People do not behave as particles of an “ideal” gas, as studied by undergraduate students in physics.  They act with purpose, and they try to protect themselves from losses by selling securities as soon as they understand the truth.  Men are unlike a container full of N2 molecules, wherein the motion of some to the left forces others to the right.  With men, as some try to sell out of a failing bond, others try to sell out also.  And they are driven by the same essential cause.  The project is non-viable; it is malinvestment.  They want to cut their losses.


Unfortunately, someone must take the losses as real capital is consumed and destroyed.  A bust of credit contraction, business contraction, layoffs, and losses inevitably follows the false boom.  People who are employed in wealth-destroying enterprises must be laid off and the enterprises shut down.


Busts inflict real pain on people, and this is tragic as there is no need for busts.  They are not intrinsic to free markets.  They are caused by government’s attempts at central planning, and also by duration mismatch.

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ArkansasAngie's picture

Banks need to be banks and ... AND ... casinos need to be casinos -- Regulated accordingly.


ArsoN's picture

Is there really enough of them to make a dent though?  

ItsDanger's picture

Duration mismatch fraud?  Not always that easy to exceute every day.  Concentrate on the other issues of which there are numerous and of more import.

i-dog's picture

Indeed! The propaganda (and disinformation) is flowing thick and fast today!!!

adr's picture

Over the past few weeks commodity futures volume has exploded. It looks like the hedge funds are pulling money out of stocks and plowing the cash into commodities, forcing prices higher in a vain attempt to store wealth.

Of course they release a few stories of how bad the harvest will be, that gasoline draw downs are because of demand, all to cover their tracks to make it look like demand forces are causing the price to go up.

In reality it is just more of the same manipulation. The higher commodities go, the worse the economy will get.

world_debt_slave's picture

Like so many marriages.

Seize Mars's picture

I have debunked the most common errors made by opponents of fractional reserve:

    Banks print money
    They lend more than they take in deposits
    They inflate the money supply
    Money is the same as credit
    Fractional reserves banking is the same thing as central banking
    It is the same thing as duration mismatch

You lost me at "debunked."
This is bullshit.

To all further readers: skip this article, don't waste your time.

Bunga Bunga's picture

The money supply could never increase, if the banks would only "lend" out the deposits.

I stopped reading here too.


Burnbright's picture

I was also going to comment on this 

I have debunked the most common errors made by opponents of fractional reserve:

    Banks print money

The money supply is not neccessarly how much money is printed by the Federal Reserve, it is also affected by credit growth and it is credit growth primarly that creates bubbles. Expansion of the money supply usually occurs after a bubble has burst to fill the hole because no one wants to deal with the pain.

surfer's picture

I have to concur, what an absolute load of crap. Jeez what happened to the content filters.

David Wooten's picture

When banks loan money from demand deposit accounts such as checking accounts, there is always   a duration mismatch because a the depositor can write a check against the deposit as soon as the funds clear.  Therefore, banks should never loan demand deposit money, not even to buy short term Treasuries.

ArsoN's picture

Duration mismatch is an interesting way of pinpointing the problem.  It makes a lot of sense.  

Doesn't the latest version of Basel implicitly take some of this into account by considering the liquidity of the assets in addition to the traditional capital/leverage ratios?  (providing that liquidity holds up during times of strife, which of course is more than a bit optimistic)


chockl's picture

You can stuff your matress with fed notes to.

Nothing To See Here's picture

Hard to convince me that fractional reserve banking is moral. It relies on the fact that money is fungible and on the assumption that depositors do not all withdraw at the same time, but the real nature of a deposit is to be safeguarded, not lended. In order to support fractional reserve banking, you have to turn a deposit into a loan from the depositor. This is upside down.

AmCockerSpaniel's picture

It is moral, as long as they tell us this is what they do with the money we leave with them. We don't have to walk in to the bank to start with. Yes; I know it's near to imposable to live out side the banking system, but if one really wants to...... So that is what is one to do? Start with keeping as little of our money as required to function out of the banks (safes).

blunderdog's picture

   a deposit into a loan from the depositor.

A deposit IS a loan from the depositor.  That's why they used to pay interest on accounts.

andrewp111's picture

A deposit is a loan from the depositor except in one case - when the deposit is with the currency issuer itself. For instance, certain large European industrial companies (like Siemens AG) have the special privelege of depositing their Euros with the ECB. The ECB can never run out of Euros.

blunderdog's picture

Yes, true, but central banks aren't really "banks."  They're government institutions. 

Dr. Engali's picture


 "I have debunked the most common errors made by opponents of fractional reserve:

  1. Banks print money
  2. They lend more than they take in deposits
  3. They inflate the money supply
  4. Money is the same as credit
  5. Fractional reserves banking is the same thing as central banking
  6. It is the same thing as duration mismatch"

Who is this guy? He certainly doesn't understand the fractional reserve system. Maye he's Roboturds alternate identity.

Flakmeister's picture

Duration mismatch cannot be avoided, it is an inherent feature of any credit based system.  Someone must take the risk no matter how you arrive at the discount rate...

Tell me how you can orginate mortgages without creating the mismatch...

Panafrican Funktron Robot's picture

Yeah this article is all over the place and mostly incorrect, I think the only way you can eliminate duration mismatch is to fund loans similar to Lending Club, ie., when enough people agree to fund a project for a set rate and time period such that it's 100% funded, the funds are then disbursed and the project proceeds.  The broker collects a brokering fee and they otherwise have no capital risk in the loan.  This would be the honest way to do banking.  Demand deposits should actually cost money, ie., it should cost you a fee to store your money at a bank (which is effectively how the banks are running now net of various fee add-ons to accounts).  

See how banks are actually not necessary to fund capital projects?  Lending Club is a currently existing example of this.  Fractional reserve banking is totally unnecessary.    

Bartanist's picture

As long as there is fiat money creation banks will be needed. They are the distribution arm of the money creating power. One entity cannot do it alone.

My inclination is to say: "screw growth created from inflation" and "screw misallocation of assets" and "screw cronyism" ... free the market and let the chips fall where they may. And, my main reason for this opinion is that there will be a greater chance for people to SIMPLY DO WHAT IS RIGHT ... rather than feel as if they are a failure if they are not scamming the Joneses for their life savings.

Give people a chance to get out of their meat sacks and off this rock if they want. Don't stack the deck against them so that it is very difficult to eliminate greed, anger and jealousy (I would also add fear) from their character.

(and for the clueless who do not understand this ... go back to watching the NBA and Dancing With the Stars and don't bother trying to figure it out...)

Flakmeister's picture

Recall the history of the Templars and their banking arangements for pilgrims to Jeruselem... There was a method to the madness that led us to the current brink...

Bennie Noakes's picture

Templar "banks" did not charge interest. Funding was provided by various shared-equity arrangements, something like current "rent-to-own" agreements.

Flakmeister's picture

I was referring to their treatment of deposits....

Thisson's picture

30-year certificates of deposit.  And a 2ndary market for same.

Jack Sheet's picture

The most common form of duration mismatch is probably when you come before you girlfriend does.

slackrabbit's picture

Just out 

BoE emails show Sir Mervyn King was aware of Libor 'misreporting' fears in 2008 via @Telegraph


Bartanist's picture

Like many things a secret that is not a secret, but not admitted until it causes a problem.

Joe Sixpack's picture

There was all kinds of talk of LIBOR frad in 2008. Suddenly it is a surprise? This is financial alzheimer's at work.

delacroix's picture

I prefer the old  austrian school for economics

Bartanist's picture

Been saying that borrowing short and lending long is an inherently flawed system for years. It is obvious and I have even written comments to that effect on ZH. The obvious solution for the banks has been to lay off the risk on counterparties, speading it around ... but when everyone lays off the same risk on everyone else in the form of derivatives, then interest rates can NEVER go up again because the entire system is hedged equally and in the same direction.

The solution is obvious, but impossible to implement because bankers are hooked on stupid ridiculous salaries and power that they do not deserve and in no way have EARNED and will do anything they possibly can to protect their fraudulent "privilege".

The answer is to make all hedges illegal, free the markets and let the banks take the risk. They will either lend or they will not. It is their choice. Sure it stops Ponzi growth ... but who said growth is guaranteed anyway? It is simply a broken paradigm that has been proven false.

one_fell_swoop's picture

I'm so tired of these gold-backed monetary system posts.  Duration mismatch is the MAGIC of banking, when combined with federal deposit insurance.  It's the FUNCTION of banks.

blunderdog's picture

I thought the function of banks was to aid productive investment/development by assessing credit risk.

css1971's picture

Um... Do I really have to point this out?

If you  prevent the duration mismatch you end up with full reserve banking. It is the fractional reserve which allows borrowing short and lending long... Isn't that obvious to you?

Isn't that the whole point of the fractional reserve? It's so that you can give people the appearance that they can take "their" money back immediately... i.e. short term.

 If you force them to match the lending terms for duration, then you have just implemented full reserve banking... There is no reserve, their money is not there it is with the borrower and they can't have it back until the loans are repaid.


DaveA's picture

Conclusion: When fiat money collapses, our current banking system will dissolve. After losing their life savings, no one will entrust precious metal to any of today's bankers. Besides, nothing they learned in banker school is relevant to a hard-money economy.

As dollars evaporate, large retailers like Walmart might start assaying jewelry and accepting Bitcoin for store credit, and their store cards could become an informal currency. New banks will appear, luring depositors with competitive interest rates and loaning their money at much higher rates to people with good collateral (nice homes, virgin daughters, unbroken kneecaps, etc.)

It won't surprise me if many people escape starvation by selling themselves into slavery. Freedom is hard when you don't have a welfare system to fall back on.

Vidar's picture

Banks in a free economy need to offer two distinct services.

1. Demand deposits, for which the customer will pay a fee and be able to access his money at any time (100% reserve requirement).


2. Certificates of deposit where the customer loans money to the bank for a specific time at a specific interest rate, and the bank then lends out that money at a higher rate and profits from the difference.


Trying to combine these two functions is what leads to the problems associated with fractional-reserve systems. Of course, all of this applies only to a hard (commodity) money system. As long as we have fiat money we will have bigger problems than how banks handle their deposits.

Bohm Squad's picture

Probably the worst article I've ever seen...anywhere.  And that's saying something.


New Austrian School = New Coke??

canary's picture

All banks (that take depositss) have duration mismatch drongo.  Haven't you heard of balance sheet risk management??

andrewp111's picture

What he is saying is that all models based on borrowing short and lending long will eventually fail on a long enough timeline. There can be risk management, but not risk elimination.

Since borrowing short and lending long is the very definition of banking, so that is just another way of saying that no bank can live forever. Of course, real people can't live forever either.

andrewp111's picture

This statement is not completely true

"In our paper monetary system, the dollar is in a “closed loop”.  Dollars circulate endlessly.  Ownership of the money can change hands, but the money itself cannot leave the banking system. "

It is not a closed loop. Circulation is not endless. It is a loop with a starting point and an ending point. The US Government is the source and the sink for the US Dollar. Dollars come into existence when the USG creates them, and vanish when the USG takes them back as tax revenue. If you view the USG as a single consolidated entity, this is obvious.

Actually, the Euro is a much closer approximant to the closed loop than the dollar. The ECB is the issuer of the Euro, but all the governments of the EZ are currency users analogous to US States, and those Euros never leave the Eurosystem.

SHRAGS's picture

Steve Keen: Mish & Steve Debate: Steve Says (I) on fraction reserve banking:

Not a Fractional Reserve System

My second observation is that we don’t live under a Fractional Reserve System at all; we live under a private banking system in which there is a Central Bank that once sort-of attempted, unsuccessfully, to regulate private lending by imposing a ratio requirement between private bank money creation and government-created reserves.

GMadScientist's picture

Really good points on both sides there. Great stuff.

I think you could use Keen's jubilee as a transition to sound money if you wanted to, by giving people decreasing amounts of "jubillee bucks" over time while simultaneously moving back to gold-backed dollars with a fixed ratio that you ramp up as the jubilee winds down. Smart savers would move into gold, debtors would end up debt-free in a world with sound money, and banks would be more constrained than under a fiat regime.

We'd still need to fix the structural horrorshow and eliminate or at least reduce the insanity of fractional reserve lending (2X instead of 40X say), but it's doable. Not painless, but doable.


Ned Zeppelin's picture

This article is gibberish for so many reasons.