London unallocated: Fractional Fubar or Benevolent Banking?

A number of readers of my blog have asked me to comment on the 100:1 comment by Mr Christian of CPM Group in his CFTC testimony and whether London unallocated metal accounts are fractional. Well short answer is no, they are only 10:1 fractional. Do you feel much better now?

The 10:1 statement was made by Mr Christian in a April 10 interview with Jim Puplava of Financial Sense. Mr Christian is interviewed at the 26 minute mark and explains his 100:1 statement at the 36 minute mark. However, it is the comments at the 44 minute mark that are most illuminating, which I have transcribed below:

If you are a bank in the United States and you take in a deposit the office of the controller of the currency says you have a reserve requirement of 12.5% or something which means that for every dollar you take in deposits you can lend out 8 and that's how the money in banking 101 works.

Now if you're a bank in the United States and you take in gold and silver deposits not on an allocated basis but on an unallocated basis the same way you take in dollars when you put them in – when people put money into a savings account or a chequing account that's an unallocated account and the bank is allowed to lend it out. If they put the money in their safety deposit box that money belongs to the investor and the bank can't lend it, the bank can't hypothecate it, it stays there, and it means nothing to the money in circulation.

In the gold market if you put your gold and silver in a safety deposit box or an allocated account the bank can't touch it legally but if you put it in an unallocated account that is now an asset on the bank's book, they have a liability to give it to you if you ever want it back but in the meantime they can lend it out. Now if you give the bank in the United states money the law, the office of the controller of the currency says the bank can lend it out 8 times. If you give it gold and silver the office of the controller of the currency says the bank can lend it out in a “prudent fashion” and the bank has the discretion to decide what's a prudent multiple for its credit lending. Most of the banks I know, commercial banks, 8, 10, maybe 12 as a leverage factor.

AIG was not a bank, was not a commercial bank, and under the US laws non-commercial banks don't come under the law, the guidance of the office of the controller of the currency. AIG used a leverage factor of 40, so if people gave them a million ounces of gold to hold for them, they could lend out 40. I mean, I have friends who are metals traders who were looking for job years ago and, you know, they went to AIG and AIG said “we use a leverage factor of 40” and the trader is a seasoned guy and he's worked at major banks and investment banks, he said “I can't operate at that level of leverage its just too risky more me” and AIG trading said “well this is what we do”, right, so there is a loophole in our regulatory system, its doesn't really have anything to do with gold and silver per se but it allows non-banks to participate in banking activities in a way that skirts banking regulations that are designed to promote stability in the banking system.

In the interview, Mr Christian recommended that listeners go to the CPM Group website where there was a free download Bullion Banking Explained. I took him up on the offer. Below are are some extracts that fill out his statements above.

This article may help to clarify the complex world of commodity banking, in which gold, silver, and other commodities are treated as assets, collateralized and traded against. When we explain these processes to clients, we often refer to the same mechanics as they are applied to deposits, loans, and assets by commercial banks in U.S. dollars and other currencies. Banks treat their metal deposits in much the same way as they do deposits denominated in money, as the reserve asset against which they lend additional money to borrowers. ...

Many banks use factor loadings of 5 to 10 for their gold and silver, meaning that they will loan or sell 5 to 10 times as much metal as they have either purchased or committed to buy. One dealer we know uses a leverage factor of 40. (Long Term Capital Management had a leverage factor of 100 when it nearly collapsed in 1998.)

A bank does not even have to be buying gold at a particular time to be able to use it as collateral against which it can trade, sell forward, and lend gold. If a bank has gold held in an unallocated account, or a forward purchase on its books committing a producer to sell it gold later, it can use these gold assets as collateral for additional gold trades.

Is London unallocated fractional fubar or just benevolent banking? Maybe this statement by Mr Christian in a presentation to the International Cotton Advisory Council in October 2002 will help you decide:

A producer should use an advisor such as CPM Group, which is not trading against the producer. Banks and dealers have a conflict of interest between their own trading positions and the hedges they advise their clients to take.

Or maybe Recent Lessons Learned About Hedging (January 2000):

Hedgers should not rely on their trading counterparts for hedging strategies. These entities take the opposite side of the hedge transactions, have inherent conflicts of interest, and always keep their own best interests in mind, even if these are the short-term best interests and arguably not in the banks’ own long term best interests.