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Why Banking Works One Big Confidence Trick

ARTICLE December 8, 2011

by Zoltan Pozsar

Banking is one large, clever, and finely tuned, confidence trick.

On the one hand are bank notes which are “legal tender for all debts, public and private”, trade at par and are referred to as money. They are liabilities of the sovereign. On the other are demand deposits – from savings to cheque accounts – which also trade at par and thus function as money. But, unlike bank notes, they are the liabilities of banks.

As long as the public knows it can get bank notes for its deposits, it will not ask for them and banking works just fine. In other words, the genius of banking is the arbitrage of the public’s ex-ante and ex-post  demand for instruments that trade on demand at par. This allows banks to conduct credit, maturity and liquidity transformation: holding assets that are riskier, longer dated and less liquid (and hence higher yielding) than its liabilities.

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