I was reading through the speech that Ben Bernanke gave this week on liquidity. It was fascinating because of his candid discussion of the nature of the banking system.

Bernanke started off quoting from a book written in 1873 by Walter Bagehot called Lombard Street, in which Bagehot describes the role of a central bank during a financial crisis. According to Bernanke, this book is a classic among central bankers.

Bagehot wrote that the basis of a successful credit system is confidence (note that our entire banking system is a credit system). “Credit means that a certain confidence is given, and a certain trust reposed. Is that trust justified? and is that confidence wise? These are the cardinal questions”. Indeed, they are. Bernanke did not divulge whether Bagehot answered those questions and I did not get the sense that Bernanke answered them either; perhaps they were meant to be rhetorical questions. My answer would be emphatically “No” while I suspect Bernanke, all bankers and a majority of the population would reply “Of course!”

Confidence and trust are part of all commercial transactions, even part of all human interaction, but in the case of banks they are particularly relevant. That’s because banks are purposely set up to be insolvent and could not exist without the public’s confidence.

A bank typically borrows money on a short term basis then turns around and lends the same money out on a longer term basis. The short term deposits that the bank takes are often demand deposits while the loans the bank makes with the money are not. Therefore, should the bank’s depositors demand their money the bank would quickly go bankrupt due to the insolvent nature of its business. That is why Bagehot wrote in his book that confidence is particularly important in banking: the lender’s own liabilities (customer deposits) are viewed as very liquid by its creditors (customers) while its assets (loans) are illiquid.

Bernanke goes on to point out that meeting creditors’ demands for payment requires holding liquidity – cash, essentially, or close equivalents. But neither institutions, nor the private sector as a whole, can maintain enough cash on hand to meet a demand for the liquidation of all, or even a substantial fraction of, short-term liabilities, says Bernanke. He goes on to explain that “Doing so would be both unprofitable and socially undesirable. It would be unprofitable because cash pays a lower return than other investments. And it would be socially undesirable, because an excessive preference for liquid assets reduces society’s ability to fund longer-term investments that carry a high return but cannot be liquidated quickly.”

Bernanke explains that if banks were to deal ethically with their clients and hold sufficient cash and short-term assets to meet potential liquidity demands, their potential profits would be reduced. Obviously, there is a great incentive for them to remain insolvent. The banks rely upon the public’s confidence in their ability to pay their creditors on demand rather than relying on good business practices, such as holding sufficient liquid assets. For this reason we can see that the answers to Bagehot’s questions are “no”: the trust is misplaced since the banks are, by design, insolvent and the confidence is therefore not warranted.

Bernanke’s assertion that it is undesirable for banks to hold sufficient cash and liquid assets to meet creditors’ demands is true from the perspective of the banks, but not true from the perspective of the banks’ clients, or the population at large.

Banks usually pay no interest on checking accounts and very little, if any, interest on other short term demand deposits. They then use those funds to make longer-term loans such as car loans, real estate mortgages, etc., on which they charge interest. The banks derive profit from the difference in the cost of their capital, which in a checking account for example, is zero, and the income from these longer-term loans. If banks had to forego making some of the longer-term loans in order to have sufficient cash on hand to meet creditor demands their profit margins would be reduced, and so we see why Bernanke says that it would be undesirable. But that is only from the bank’s perspective. Its customers, I am sure, would prefer that the bank keep sufficient liquid assets on hand to meet liquidity.

As for it being socially undesirable for banks to keep sufficient liquidity to meet creditor demands, that is total hogwash. If banks had to better match the duration of their assets and liabilities they would have to pay higher rates of interest on longer-term savings deposits, for instance, to attract capital and match those liabilities with auto loans of a similar duration, for example. It’s not difficult to do, but it would eat into the profitability of the banks since they would have to pay more for the capital they are deploying.

However, if banks were to better match the duration of their assets and liabilities it would be far more ethical, since their creditors (bank customers) would then have the choice of earning more income on longer-term deposits while foregoing liquidity. The capital would flow to such longer-term deposit accounts if the interest rates were sufficiently attractive. And if interest rates had to increase to attract the capital it would merely lead to higher interest rates on auto loans and real estate mortgages. These rates would then be set by the market and under such an environment the feedback system of the market would make capital more, or less, available depending on conditions.

This letter is too short to detail all the ways that consumer demand for longer-term loans could be met. Suffice it to say that the crux of the matter is that banks do not want to forego, or share, the spread between the cost of short-term money and the income from longer-term loans.

In the current system, which is totally dominated by the central bank and commercial banks that hold virtually no reserves, the supply of money is essentially infinite while interest rates are being kept artificially low. The net result is wild speculation on assets bought with borrowed money.

What happens in today’s world is that depositors (the banks’ creditors) are leaving their money with the banks thinking that they can demand it at any time, while in reality the money does not exist. Should a bank face withdrawal demands it cannot meet, it can ask the central bank for help. In a fiat money system, the central bank can, in theory, create an infinite amount of money out of nothing and so there is no reason why any bank should go bankrupt. But here’s the problem: if the central bank creates more money to help ease liquidity demands the new money created reduces the value of all the money outstanding. This means that the bailout, in the form of inflation, is borne by the very same consumers and bank creditors whose capital was deployed in the first place but who did not get a return on their capital commensurate with the risk that was taken with it.

Bernanke, and in fact all central bankers, do not hide the fact that they are engaged in a confidence game -- they pride themselves on it. A system that exists purely as a result of confidence is colloquially referred to as a con game and we are all being duped into giving our money to banks that speculate with it, keep the profits, and expect us to foot the bill when they make mistakes and need to be bailed out.