13 February 2014

Fractional reserve bullion banking and gold bank runs: bank run theory

A key question in bank run dynamics is whether the information/event points to one specific bank. George Kaufman notes that if people just "switch their deposits to other banks [and] their concerns about the bank’s solvency are unjustified, other banks in the same market area will generally gain from recycling funds they receive back to the bank experiencing the run." As we have seen with the interconnectedness between the key BBs via the LPMCL and also the role of the central banks who can step in between the BBs, such "a run is highly unlikely to make a solvent bank insolvent."

System wide bank runs are therefore not going to occur from a rumor believed to be about just one bank. However, an academic paper on bank runs by Diamond and Dybvig concludes that all depositors have the incentive to withdraw immediately as the early movers get all their money back, the later ones part or none. The result is that bank runs can be self-fulfilling.

This BIS paper by Haibin Zhu notes that Diamond and Dybvig assume that people don't know whether other people are withdrawing their money. One does not have to be a master of game theory to realise that if you come across some information about the solvency of a bank that you don't think is true, if you can't tell whether other people don't think it is true, then you're best precautionary action is to take your money out anyway.

Zhu considers this assumption is unrealistic, saying that in the real world people "are able to observe partial or complete information about those that make decisions before them". Selgin also notes that "panics happen because liability holders lack bank-specific information about changes in the banking systems’ total net worth" but that this would not occur in a true free banking system "where bank liabilities are competitively bought and sold there would not be any risk-information externality" - depositors would be able to see current market discount rates for each bank's banknotes.

Opacity, however, is a defining feature of the gold market and the quality of information about whether a gold BB run is in play is poor given that:
  • Bullion banking is not a true free banking system;
  • BBs don't have physical branches where people can see people taking physical gold out;
  • Initial liquidity problems would result in increasing inter-BB gold borrowing rates, but GOFO/lease rates are LIBOR style estimates by the BBs themselves rather than actual market/executed rates on an exchange, so subject to conflict of interest;
  • Continuing liquidity problems would result in increasing premiums on wholesale bars, as BBs compete to acquire physical, but this information is restricted to the professional markets and when revealed to the retail market by people like myself, it will be largely ignored anyway (see why here and here);
  • Anecdotal stories about "I couldn't get my gold" are likely to be ignored by mainstream gold investors due to a "cry wolf" effect, given past reports of such events have been pushed by websites as "this it is" yet no run eventuated and the BB system continued to operate.
Zhu notes that "when information becomes noisy, the banking sector is more vulnerable to runs and the probability of [panic] bank runs increases." Now while the BB system may have a higher risk to a run, how would one start if holders of BB-unallocated lack information on the solvency of a BB's gold balance sheet or whether a run is starting?

One may argue that there are no standalone BBs, BBs are just divisions within a larger fiat bank, and as such a trigger may come from a concern about the parent bank's solvency. However, with "too big to fail", and the ability and demonstrated willingness of central bankers to print money to back up the banking system, I would consider it doubtful that a gold run would start this way.

So for a gold run to occur, there would need to be a non-bank specific piece of information/event which gains the attention of mainstream gold investors (not goldbugs, by definition, goldbugs don't hold BB-unallocated) who still have some faith in banks.

Many goldbugs are going to have a problem with that last sentence but I ask you to cast your mind back to before you became aware of gold and fiat fractional reserve banking etc and remember that you once believed in "the system". You also have to consider that there are investors out there who hold gold for portfolio diversification reasons, or as a hedge against non-catastrophic financial problems but who do not want to see themselves, or be seen, as one of those "crazy goldbugs" as the mainstream financial media paint it. This image is reinforced by gold websites which hype up stories that play well to a goldbug audience (and drive clicks), but these just create a "cry wolf" effect to mainstream investors when the claims of "imminent failure" never eventuate and make them see much of the gold internet as inaccurate and sensationalised claims.

Such websites may well have desensitised mainstream investors to the really important information when it comes out, and thus be indirectly helping to support the BB-unallocated system. Indeed one of the key motivations for my blogging activities is to pull up such inaccuracies and exaggeration for this very reason, but the need for fact based professionalism in gold commentary is lost on them and I'm accused of being a shill if I dare to critique any meme.

Tomorrow: what could cause a run to start, and how vulnerable is the system-wide gold balance sheet to a run.

6 comments:

  1. That fact is Bron, your application of "theory" to analyze this subject is flawed.

    Bank runs/gold runs or any "runs" are a result of a disruption and collapse of "the system" and are EMOTIONALLY-BASED. These events don't happen as a result of some pointy-headed assessment by a zombie-ized public before panicking.

    That fact is, these events happen before most people hear about it. By then, it's too late to stop it. A zombie-ized public isn't going to stop and smell the roses before panicking Bron.

    You really think that if a long line at a bank develops, the news wouldn't spend like wild-fire? Come On You Shill!
    This event happened in my town when Washingto Mutual closed it's doors right before the Chase takeover. The long line stated hours before the bank opened that day. The news spead like wild-fire. A panic didn't start because the cause of this "run" quickly became known. It was the result of one bank that forced a takeover. It was not the result of some perceived system-wide breakdown.

    However, my point is made with this analogy. The whiff of something going wrong spread fast. If it had been the result of a real system confidence break down, your "theories" get sent to the back of the line.

    As for the notion of fact-based commentary, I must say you are at least devoid of hypester-ism. So, if you want a complement from what you refer to as a "goldbug" you just received it. I'm on your side when I see hypesters such as Silverdoctors or Jim Willie "predict" the future of gold at $10,000---$100,000/oz nonsense.

    But while I'm on the subject of goldbug-ism, I don't see why this is a debatable point with you shill-ish types.

    Gold is money and paper is currency. That's all anyone needs to know. It's not complicated. You can SAVE only that which you can hold to preserve purchasing power.

    Gold and silver (money) just sits there---period. It's value is determined by the future labor required to produce those goods and services needed or wanted by that holder.

    Therefore, no one is ever going to panic about the value of their gold. However, any whiff or hint that confidence has been compromised regarding the "temporary purchasing power" of currency, will cause all hell to breaks loose. Once this panic event starts, you can take your theories and stuff 'em up your ass.

    Which inspires me to write today's limerick:

    Analysis based on theory might not seem too sceory,
    But could be traps for the un-weory.

    ReplyDelete
  2. THIS IS AN EDIT OF THE PREVIOUS POST REMOVING TYPOS AND PROVIDING BETTER CLARIFICATION:

    That fact is Bron, your application of "theory" to analyze this subject is flawed.

    Bank runs/gold runs or any "runs" are a result of a disruption and collapse of "the system" and are EMOTIONALLY-BASED. These events don't happen as a result of some pointy-headed assessment by a zombie-ized public before panicking.

    That fact is, these events happen before most people hear about it. By then, it's too late to stop it. A zombie-ized public isn't going to stop and smell the roses before panicking Bron.

    You really think that if a long line at a bank develops, the news wouldn't spread like wild-fire? Come On You Shill!
    This event happened in my town when Washington Mutual closed it's doors right before the Chase takeover. The long line started hours before the bank opened that day. The news spread like wild-fire. A panic didn't start because the cause of this "run" quickly became known. It was the result of one bank that forced a takeover of another. People lined up to cash their accounts from Washington Mutual while they still had a chance. It was not the result of some perceived system-wide breakdown.

    However, my point is made with this analogy. The whiff of something going wrong spread fast. If it had been the result of a real system confidence break down, your "theories" get sent to the back of the line.

    As for the notion of fact-based commentary, I must say you are at least devoid of hypester-ism. So, if you want a complement from what you refer to as a "goldbug" you just received it. I'm on your side when I see hypesters such as Silverdoctors or Jim Willie "predict" the future of gold at $10,000---$100,000/oz nonsense.

    But while I'm on the subject of goldbug-ism, I don't see why this is a debatable point with you shill-ish types.

    Gold is money and paper is currency. That's all anyone needs to know. It's not complicated. You can SAVE only that which you can hold to preserve purchasing power.

    Gold and silver (money) just sits there---period. It's value is determined by the future labor required to produce those goods and services needed or wanted by that holder.

    Therefore, no one is ever going to panic about the value of their gold. However, any whiff or hint that confidence has been compromised regarding the "temporary purchasing power" of currency, will cause all hell to break loose. Additionally, anyone with any brains at all is going to put their gold where they think it's safe. If that safety is perceived to have become compromised by banksters running the comex, gold runs should intensify at even faster pace than what we "goldbugs" have been observing.

    Once this panic event starts, you can take your theories and stuff 'em up your ass.

    Which inspires me to write today's limerick:

    Analysis based on theory might not seem too sceory,
    But could be traps for the un-weory.

    ReplyDelete
  3. "You really think that if a long line at a bank develops, the news wouldn't spend like wild-fire"

    Jake, did you actually read my article? This is exactly what the academic theories I quoted say: "bank runs can be self-fulfilling".

    But I'm not talking about a fiat bank run, I'm talking about a BB run. How can a long line develop at a BB, they don't have branches? Your comments about fiat runs are correct, but we are talking about a BB run here.

    ReplyDelete
  4. Jake,

    Gold is not money, not anymore. Modern money is credit.

    Central banks are not stockpiling silver reserves. Gold will remain an important reserve asset.

    Bron,

    Thanks for the thought provoking articles.

    ReplyDelete
  5. Bron, I just want you to know that there are readers of your postings who very much appreciate them, even if the emotionalist spouters of ad hominem invective may outnumber us in some comment threads.

    ReplyDelete
  6. Bron, did you actually read my comment? I referred to any "run"---(fiat or gold). What do you think these institutions are?---Empty buildings? Of course not. They are full of people.

    Whether the institution has branches or has been subject to hypester "cry-wolf effects" or not, a run on any of them will not be a result of your pointy-headed academic theories where the general public stops to smell roses before contemplating their navels while reading up on some professed theories on "bank runs".

    Mutual funds have suffered "runs" (redemptions) in the past, based on confidence breakdowns, yet there are no bank branches--just what do you think if a number of mutual funds were to suffer a "break of the buck"?---Would cash mutual fund holders analyze this with theories? HAHAHAHA!

    I think you forgot what I was trying to tell you. Your application of "theory" to analyze this subject is flawed.

    These are people you are talking about. And as such, are going to respond EMOTIONALLY to perceived event that affects the stability of their complacent confidence in "the system"--whether it be fiat or gold.

    Yes, up to now, all "THIS IS IT" proclamations have been rendered false. However, the fundamentals are in place for a eventual collapse regardless of how many hypesters try to "predict" the future. I'm not one of them and I complemented you on this in my comment.

    But let's look at an example of what I'm talking about. Just look at the drain rate of the gold comex inventory over the last year. Do you think that if the real reason for its quick gold losses were revealed to the general population of zombies, by the MSM, that this current "silent run" on its inventory wouldn't result in an enormous emotionally driven drop in confidence?

    Had CNBS reported the drop in comex gold and had compared it to the INCREASE in comex silver over the same period where both metal prices had dropped, don't you think we'd be far beyond a comex default and well into a complete breakdown in the confidence levels of the comex system? Why--all we'd hear would be cries of China accumulating western gold! Again, your pointy-headed theories would be more appropriately shoved up your ass.

    Annon:
    Gold is money.
    Credit is an electronic equivalent of fiat-based paper currency.

    Money must have intrinsic value---etc etc...The only reason why the general public believes credit, fiat paper has value is because they have not experienced a confidence breakdown yet.

    Once confidence in a "system"---any "system"---gold banking or fiat banking, (credit), becomes compromised, the general public will not stop to smell roses or contemplate any theories, they will panic.

    And Now---A limerick for annon:

    From tunnel vision insight freed us,
    To branch along where fresh thoughts lead us.

    ReplyDelete