Fractional reserve bullion banking and gold bank runs

07 February 2014

Fractional reserve bullion banking and gold bank runs - how can I default on thee? let me count the ways

http://goldchat.blogspot.it/2014/02/fractional-reserve-bullion-banking-and_7.html

A crude view often promoted in the gold blogosphere is that a gold run will result in a default when on call depositors ask for delivery/physical. The reality is more complex.

The composition of a BB's gold balance sheet has many different assets and liabilities but when looking at a gold run our interest is only in on call (or to use accounting terms, current) assets and liabilities versus those assets and liabilities which have committed maturities or terms (non-current). As an example consider this simple setup:

	Assets	Liabilities
Current	10 oz	20 oz
Non-Current	90 oz	80 oz

As Professor Fekete noted, what matters in fractional reserve banking is flow, so let us assume clients have been redeeming at a constant rate of 5oz.When looking at the 20oz of client on call deposits, the are a number of run scenarios:

a) Rate of redemption increases to 11oz

b) Rate of redemption increases to 20oz

c) Clients redeem at the expected 5oz, but another BB with whom the BB held 2oz of unallocated fails to supply physical as it had done reliably in the past.

So a default can occur because of a failure on the asset side, not just from a run from the liability side, of a BB's gold balance sheet. The other thing that matters is what is the current rate of redemption and how much it is increasing by. In the case of a) the BB may be able to survive that by cash settlement or just buying physical gold, as the "gap" is small. However in the case of b) the amount of the "gap" is 10% of their balance sheet and default would be probable.

A BB manages this risk by holding physical gold. How much would depend on its assessment of the make up of its on call depositors and their historical redemption rates. Where I see the first point of risk is a BB getting too confident about the reliability of historical redemption rates. They could probably be sure that a large hedge fund is just after cash profits and unlikely to want physical, but large private investors - maybe one day they might get spooked by goldbug chatter.

Gold industry unallocated holders may also be historically reliable, as individually they would hold small balances (using them primarily for settlement purposes) but as a group there would be a fair balance held across them at any one time and redemption behaviour as a group would be consistent. However, take the example of the Perth Mint in the 2008 demand surge. The silver flow we obtained as a by-product of gold refining was enough for our normal bar and coin demand, but in 2008 we had so much demand we began to withdraw 20 tonnes of silver a week from London for months on end. This was unexpected (BTW, there was never a problem with delivery).

Even if we assume that a BB holds all current assets as physical gold, we still have a maturity mismatch problem. On top of that, a BB has a "certainty of counterparty meeting their promises" problem. This can lead to the following scenarios:

1) BB could have perfect maturity matching, but a counterparty fails to honor their commitments when they fall due and the BB is short gold

2) All counterparties honor their commitments, but maturities don’t match up, leaving the BB short gold

What are the BB’s mitigating controls for these risks? In the case of 1) the BB needs to determine if:

1.1) the counterparty is just having their own liquidity problems, in which case the BB can borrow gold from another BB or CB and charge their counterparty a penalty

1.2) the counterparty is permanently defaulting (bankrupt), in which case is the counterparty:

1.2.1) Secured – then the BB can draw on the collateral and margin and use that to purchase gold

1.2.2) Unsecured – then the BB has to book a loss and use their own cash to purchase gold (and maybe recover some cents on the dollar later)

In the case of 2), a maturity mismatch, the BB can:

2.1) request an extension from their non-BB client and get charged a penalty

2.2) borrow gold from another BB or CB

You'll notice a certain commonality in the mitigating controls, which gives us another two points of risk:

i) will the BB be able to buy enough missing gold with the cash (ie, we have trading liquidity, volatility and gap risk, particularly if we are talking large amounts); or

ii) that another BB or CB will lend the BB gold (note, depending on the type of depositor, this could just be a need for unallocated, not a physical gold loan).

The second point ii) leads us into a discussion of inter-bank dealings and clearing, which we will cover on Monday.

Just one final point. In our example above many in the blogosphere would say that the BB is running at a 10% fractional reserve ratio. This is technically true but yet another simplification. This 10% or other claimed much lower numbers do sound very shaky and is used to scare people. What I've never seen talked about in the gold blogosphere is that the bank is only running a 20% fractional reserve liability ratio, in our example.

The correct way to look at it is that the BB is running a 50% reserve - 10oz of current assets against 20oz of current liabilities. The complete lack of any discussion of this is surprising to me, as in many cases gold commentators are financial analysts and you'd think they would be aware of a basic financial metric like the current ratio. So for analysing a gold run it is the current (I'd toughen it up to on call, not the usual 12 months) ratio that matters, not the fractional reserve ratio.

To be fair, I have not focused on the current ratio either. I suppose this is the benefit of doing a series of posts in detail on a topic like this, as it forces you think through the topic. But thinking is a lot harder than just loosely throwing around terms like "fractional", "hypothecation", "leverage" to make it sound like you know what you are talking about and to scare goldbugs with fairy tales of an evil Blythe Masters who will trick you into an unallocated house. Don't get me wrong, fairy tales have a lesson to teach and with unallocated, for example, you do need to know what sort of risks are involved if you are not dealing with a straight up facility like the Perth Mint (and that is the point of this series of posts). However, you shouldn't think the fairy tale is an accurate representation of reality and thus a helpful tool for assessing if/when a system will blow up.