Maturity transformation should be illegal.
Maturity transformation is the process by which short-term deposits at banks are lent out as long-term obligations. Deposits, which are redeemable at any time, are not actually available. They are tied up in loans that are not redeemable.
This makes fractional reserve banking even worse than it would be by itself. Though the two are often tied together, they are not the same thing. You can still have fractional reserve banking without maturity transformation.
If an amount of money is to be used for a 6-year car loan, it would need to come from a 6 year CD. If a 30-year mortgage, then a 30 year CD.
Clearly, customers would demand higher interest rates for the demand to keep up with the loans, and so they should. The fact they do not now shows how most people do not realize that they do not know what the bank is doing with their deposits.
If you and even 10% of a bank’s customers went and demanded redemption of all your money on deposit, it would not be accomplished. The bank has loaned it all out.
Fractional reserve banking, even without maturity transformation, could still lead to bank runs and failures. But it would make banking more robust and less susceptible to causing systemic risk.
The next bank run that takes place (which could actually be happening right now, being covered up by the repo market operations) will likely break the system.
This is because, through a series of events over the last ~100 years, (creation of the Fed, Bretton-Woods, closing the gold window by Nixon), our system has changed from one with local fragility and system robustness to one with local robustness and systemic fragility.
When a bank is at risk of failing, it is absorbed by another bank and the bad assets are purchased by the Fed. The Fed only needs to create money out of thin air to purchase these non-performing assets.
This means that local bank failures no longer take place. The risk has been moved, but not destroyed. The risk is then transferred to the system. When enough risk gets transferred to the system, the whole system becomes fragile and vulnerable, because the weak links in the chain have not been allowed to die off.
The process is similar to this: imagine a goldsmith 1,000 years ago. Customers of the goldsmith store their gold with the smith and carry receipts for gold redemption instead, for convenience. The goldsmith gets greedy and starts lending out customer gold without telling them. The customers inevitably find out and go to redeem their gold.
Obviously, there isn’t enough gold to cash everyone out. So instead, the goldsmith decides he will cut each coin in half and melt the coins down into smaller coins. Then, everyone gets the same number of coins back that they were owed. The problem is that each coin can only purchase half of what it could before.
This is the same thing that happens today with money printing, overnight repo operations, quantitative easing, and debt monetization. The Federal Reserve is not making magic happen. You cannot violate the fundamental laws of money. While the amount of money is increasing to fund obligations, the purchasing power of that money is dwindling rapidly.
The difference between the Fed and the goldsmith is 1) the Fed has a legal monopoly on banking, so there is hardly another option and 2) in the case of the local goldsmith, it is easy to recognize and stop. The goldsmith would likely die by mob, so the next goldsmith would be less likely to do the same.
Today’s bankers and the Fed do not have the same “skin in the game”. The risk is simply transferred to the system itself, and when it collapses everyone will claim “black swan” and that no one could have seen it coming. The only problem is that the very people saying that are the ones who caused it in the first place.
You may ask, “but what can be done?” With such a complex system and legal backing of this scam, there is little that will likely be accomplished. However, with the rise of awareness (largely due to cryptocurrencies like bitcoin) people are becoming more and more aware.
And it isn’t as if there are no simple fixes – there are. Outlaw maturity transformation. Enforce bank contracts (outlaw fractional reserve banking). End the Federal Reserve and force risk to stick with those who create it.
But simple doesn’t mean easy, and those in power to change what is necessary are directly benefiting from the status quo (the Federal Reserve prints money to pay for the federal gov budget deficit).
Unfortunately, it will likely take a painful collapse of the current system before we can start doing it the right way.