Money is "perfectly" liquid, more or less by definition. And so, by creating money, banks are creating "liquidity." Perhaps it is natural to confound the creation of liquidity with the creation of money. However, this is a mistake.
Suppose a bank funds 30 year home mortgages with 5 year nonnegotiable certificates of deposits. The bank has created liquidity, but 5 year nonnegotiable certificates of deposits aren't very liquid and are certainly not part of the money supply. The bank has created liquidity because they are more liquid than the 30 year home mortgages.
Generally, the creation of monetary liabilities by banks involves the creation of liquidity. However, not all creation of liquidity is closely associated with the creation of money.
Some adherents of the "Austrian" school of economics, particularly Rothbardians who insist that fractional reserve banking is fraud, have expanded their critique of banks that borrow using monetary liabilities. (I had in mind, Walter Block, and here is a link to a paper with William Barnett. A commentor helpfully provided a link to Bagus.) While claiming that any creation of liquidity must be fraud strains credibility, some have argued that, any creation of liquidity leads to malinvestment. In other words, if banks borrow shorter than they lend, the result is malinvestment.
The idea seems simple. Those borrowing from banks fund investment projects that take a long time to mature and generate consumer goods. Those lending to banks at shorter terms to maturity are only committing to save, that is, refrain from present consumption, for a shorter period of time. When those saving demand repayment and use the proceeds to purchase consumer goods, then there will not be enough consumer goods because the projects that were being funded have yet to mature. The projects that the banks were funding will be abandoned and left incomplete. The partially finished projects represent malinvestment. The losses are caused by the banks' failed effort to create liquidity.
There is certainly an element of truth in this story. If all investment projects were funded by savers who were committed to seeing them through to completion, then the problem described above could not develop. However, having financial intermediaries that borrow short and lend long is not necessary for the problem to occur, so that requiring financial intermediaries to match maturities, fund loans with deposits of an equal term to maturity, is not adequate to avoid the problem.
Further, if draconian government intervention did prevent the problem from developing, for example, implementing Keynes' notion that savers should be married to investment projects (Catholic-style, with no chance of divorce,) then few long term investment projects could be funded.
Suppose the investment project is planting a pine forest for the production of paper. The trees mature after 20 years and will be harvested. It would be possible for the forester to fund the project with his own funds and then plan to wait 20 years, sell the trees, and make a profit. Such a plan marries saving with investment.
However, the notion that this project requires that there be some single individual willing to wait 20 years is an error. The project could be funded by 20 people each waiting one year in sequence. The first person refrains from consumption the first year and that frees up resources to plant the forest. The next person refrains from consumption in the second year. The consumer goods he gives up go to compensate the person who waited the first year. That person can consume the goods the second person didn't. And then, for the third year, a third person refrains from consumption, and the goods go to the person who waited the second year. And so on, until in the final year, when the project matures. The twentieth person gets the product of the investment project compensating for consumer goods that were given to the person who waited for the 19th year.
If this method of providing resources for long term projects is somehow prohibited, and projects are only are permitted if some individual is willing to wait 20 years to get the benefits, then few such projects will be permitted. Forests, homes, durable machinery, and the like, will generate very high returns, but total output will be lower and people poorer. In fact, if it were not for capital markets, then there would be a very strong argument for socialization of investment. How else could society obtain the benefits of long term projects?
So how can the forester avoid waiting 20 years? How can the required saving be passed on to twenty people (or however many necessary?) The forester can sell the forest after the first year. And then the next forester sells it after another year, and so on. Of course, some foresters might hold it longer, and others less. But the notion that someone must commit to holding it 20 years for the project to be profitable is so wrong as to be absurd.
Suppose, the forester specifically plans on selling the forest after only 10 years. Perhaps he is old and will want to retire. Perhaps he has no heirs who want to be foresters. However, this plan entails liquidity risk. It depends on finding a buyer in 10 years for the forest. If there is no one willing to pay anything, then the partially grown forest will be worthless, and the forester will have lost everything. Fortunately, that is unlikely, but what kind of return the forester is going to get for his investment will depend on market conditions at the time he intends to sell. The forester is bearing liquidity risk.
The forester bears many risks. There are risks associated with production. Perhaps there will be a forest fire or an outbreak of disease. There is also the risk that the demand for pulp wood will be lower or even nonexistent at harvest time. And if the forester plans to sell the forest before harvest, then he also bears liquidity risk.
Could government interventions be introduced that would prevent the forester from taking this risk? The answer is yes. Simply prohibit sales of capital goods. Then the forester could not plan to use this approach to shift the need to wait to some other investor. Of course, forests will only be planted by individuals willing to wait 20 years for the output. Presumably, the returns will be higher and paper more expensive.
Rather than operating as a sole proprietorship, suppose the forester incorporates, and sells out. Assuming he profits, then the forester-promoter can take all of his funds from the forest project, buy a 10 year bond (or whatever) and bear no further risk. While the stock investors could each plan to wait 20 years for the harvest, each can instead plan to sell their stock to someone else at any time. The firm has no leverage and the stockholders bear all the risk. This includes risk for failed production and reduced demand for pulpwood. For each of them, any desire to sell to someone else before the forest matures and is harvested involves liquidity risk. Will there be someone else willing to take their place in funding the project? And on what terms?
Could government intervention be introduced to avoid the liquidity risk? Again, by prohibiting a secondary market for stock--a stock market, this particular means of generating liquidity could be prohibited. Of course, if the corporation sold the forest and paid out the proceeds as a dividend, liquidity still could be provided. So, outlawing the sale of capital goods by corporations, as well as prohibiting a secondary market in equity would be necessary.
Suppose that instead of funding the project entirely with equity, the project is funded partially with debt. The firm funding the forest buys out the initial forester by selling stock and 20 year negotiable bonds. So, just like the stock investors, those funding the project bear liquidity risk to the degree they intend to sell the bonds before maturity to someone else who will take over funding the project.
In some sense, those holding the equity continue to bear all of the other risks--fire, disease, and less demand for pulpwood. They also bear some residual liquidity risk. The stock investors may want to sell out and obtain their funds before the project matures in 20 years. However, the reality is that the equity investors' risk is limited by owners' equity. If the losses are too severe, then the firm will become bankrupt, and the bond holders will receive only partial payment.
Could the government prevent the bond investors from bearing this liquidity risk? Yes, by outlawing negotiable bonds. Then only those willing to wait the full twenty years would be willing to buy the bonds.
Now, suppose that rather than fund the project by issuing stock and 20 year bonds, the project is funded by stock and 1 year bonds. When the bonds come due, the corporation must sell new bonds to pay off the old bonds. Of course, it might sell the forest or new shares of stock. But it must somehow come up with the needed funding. Those providing funding for the project by purchasing the 1 year bonds appear to bear insignificant liquidity risk. The stockholders still bear all of the risk for fire, disease, and a loss of demand for pulpwood, and they bear all the liquidity risk.
Of course, like all the risks of the project, the stockholders bear the risk up to the limit of their investment. If the losses are too great, then the firm will fail and become bankrupt. The one year bond holders will receive only partial repayment and take a loss.
Could government intervention prevent a firm from creating liquidity by funding a long term project with short term bonds? While it would require substantial regulation, something like the SEC could protect stockholders and bondholders from this sort of risk by requiring that projects be funded with bonds of at least equal maturity. Of course, this just means that these projects are funded by long term bonds, and those bond holders will bear more liquidity risk. Avoiding all liquidity risk would require that the long term bonds be nonnegotiable, that there be no secondary market for stock, and finally, that capital goods not be alienable.
And now, for banks. It would be possible for a bank, as financial intermediary, to fund the project by purchasing 20 year bonds. If the bank obtained to funds by selling 20 year CDs, it would be matching maturities and creating no liquidity. If the 20 year CDs were not negotiable, then the depositors would bear no liquidity risk, but would need to wait until the project matures. There would remain the risk of fire, disease, or reduced demand for pulpwood. The stockholders of the forestry corporation would bear any such losses to the extent of their investment. If losses were so great as to wipe out the firm's equity, then it would become bankrupt and fail. If it fails, then the bank would take a loss. If the losses are so great to wipe out the capital, or owners' equity of the bank, then it too will fail and be unable to pay off its depositors. And then, the depositors would take a loss.
If the CDs are negotiable, then the depositors bear the liquidity risk to the degree they plan to sell the CDs before maturity. Both the stockholders of the bank and the forestry corporation bear some residual liquidity risk. But to the degree the project is funded by negotiable long term CDs, and the holders of the CDs intend to sell the bonds before they mature, then they they bear a substantial portion of the liquidity risk.
Could the government protect the CD holders from bearing this liquidity risk? It simply could ban negotiable CDs. If banks were required to match maturities, then only those depositors willing to wait 20 years for the proceeds of the project would buy the CDs. Liquidity risk would not be a problem.
Finally, the forestry corporation might sell 20 year bonds to the bank. And the bank might purchase them, but this time the bank could obtain funding by selling one year CDs. Finally, the bank is creating liquidity. The stockholders of the forestry company bear the risk of loss due to production failures or a decrease in product demand. They have a residual liquidity risk to the degree they want to sell out before the project matures. The bank bears liquidity risk to the degree the project is funded with the 20 year bonds. It bears some risk that the project will fail, and the losses will be greater than the forestry company's capital. This is called credit risk.
By creating liquidity and funding the 20 year bonds with one year CDs, the bank has shifted liquidity risk away from the depositors. It has also shifted credit risk as well. However, there remains residual credit and liquidity risk for the depositors. If the bank suffers losses, perhaps because of credit risk, but also due to liquidity risk, and those losses are greater than the bank's capital, then it will fail, and the depositors will take a loss too.
How does liquidity risk appear for the bank? As the short term CDs come due, the bank must find funds to pay them off. It must sell new CDs, or else sell the bonds it is holding, or perhaps sell new stock.
A banks is solvent but illiquid if it would be able to pay off CDs as they come due if only it can borrow funds at reasonable interest rates or else sell off some or all of the bond portfolio at reasonable prices. It is the absence of such "reasonable" interest rates or prices, perhaps what is better described as changes in what interest rates are reasonable, that results in the losses relevant to liquidity risk.
Could the depositors be protected from this residual liquidity risk by government intervention? Yes, banks could be required to match maturities and not create liquidity. Of course, that means that the bank would be funding the long term project with long term CDs. Assuming those are negotiable, the depositors are being protected from residual liquidity risk by requiring them to bear all of the liquidity risk. As explained above, by making the CDs nonnegotiable, they could be protected from that liquidity risk too.
The point of these examples is to show that the creation of liquidity by banks is just one way of sharing the risks that are inherent from having savers share the funding of long term projects. As always, the savers retain some residual risk. Those who are bearing risk for them might become bankrupt, and provide only partial repayment.
So where does that leave concerns about malinvestment? If draconian interventions are implemented, of which requiring banks to match maturities on deposits and loans would be just the start, then every project will have savers who wait until it matures. But if savers are allowed to share the funding responsibilities, then it is possible that there will be a demand for consumer goods before the project matures.
If the forester cannot find someone to buy the forest after 10 years, then he will not be demanding any consumer goods. More realistically, the amount of consumer goods he can obtain after 10 years depends on what someone else is willing to pay for a forest that will be mature in 10 more years. On the other hand, if these losses are shifted to stockholders, long term bond holders, or even a residual risk to short term depositors, the effect is the same. If the corporation is funded with short term bonds, then it may be bankrupt, but the forest that will mature in 10 years is still there for a reorganized firm. Similarly, if a bank fails, the bonds with 10 more years to maturity and the forest that will be harvested in 10 years remain. Just because there is a bankruptcy, there is no need to abandon the valuable forest.
It is, however, possible that an increase in the demand for consumer goods in 10 years would result in the abandonment of the forest project. Suppose that each year, forest management requires additional resources. Forest fighting, cutting away diseased trees, clearing brush--any number of things are possible. If the demand for consumption in 10 years is so great that those resources are more profitably used to produce current consumer goods, then they will be stripped away from the forest, and it will sit abandoned. If the unmanaged forest is worthless, at harvest time, then it will be a total loss. And if that is that is the better allocation of resources, then the forest should be abandoned.
Avoiding such losses would be the benefit of draconian regulation to require that savers be married to investment projects. And the added productivity of all of those long term projects that could not be undertaken because they lack a spouse, would be the cost.