07 February 2014

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

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.

15 comments:

Strannick said...

Bron creates a hypothetical current account ratio, then from it, extrapolates that bullion banks have a 50% reserve ratio. From that specious reasoning and obfuscation worthy of Jeff Christian, Bron starts claiming that gold commentators don't use precise terms correctly, like rehypothecation. This article is truly worthless. The questions is whether its useless because of ignorance or useless because it is deliberately deceptive.

Anonymous said...

The current gold story underway is a multi-decades long story that still has many years to play out because TPTB, the BB's and CB's aren't ready or willing to capitulate back into any type of gold standard.

Anyone in the blogosphere thinking otherwise (or continually claiming that a gold/silver price explosion is around the corner while it's done nothing but drop) is full of BS and full of themselves and more then likely a subscription or bullion selling shill.

Jake said...

Strannick says, "...This article is truly worthless. The questions is whether its useless...."

Doth inspires a limmerick:

This article is truly worth-less. The questions is whether its use-less.
Use the data, don’t just-guess,
Knowledge saves you great dist-ress,
Helping you your skills as-sess.
Our Great Society Of Larg-ess

Mencius Moldbug said...

The $64K question in my mind, to which I've never seen a really satisfactory answer from either the shills or the loons, is:

We can take it for granted that BBs run matched, not maturity-matched but at least value-matched, metals books. They also have some physical to cover their liabilities. But what are their other assets?

Someone - not the BBs themselves - is issuing virtual gold. It doesn't seem like all this virtual gold can be backed by forward production commitments from, you know, actual gold mines, in an era when the hedgebook is negligible.

So what is this stuff? There are only three possibilities I can think of. One, somewhere at the end of the chain there's a naked short. Two, somewhere at the end of the chain there's a CB position. Three, some combination of 1 and 2...

Jake said...

As for My Respect For Bron's Articles on Fractional Reserve Banking":

Try to earn a small return, the earning's not too tough;
Be more bold and go for gold, that's when the going's rough.

Anonymous said...

"... Anyone in the blogosphere thinking otherwise (or continually claiming that a gold/silver price explosion is around the corner while it's done nothing but drop)..."

This is a lie. Have a look at the gold price since 2000. It has risen. So if you are going to tell us that the price has dropped maybe, include a time-frame, eg. between March of year nnnn & September of year nnnn, it has dropped, and THEREFORE based upon these facts, the price will never explode.

What a load of complete nonsense. This anon isn't Dave from Denver, or Turd Ferguson, or ranting Andy is it? What is readily apparent, is that one of these anon's who has started posted here recently, is really antagonistic to Bron. I guess that says it all...

Bron Suchecki said...

Strannick,

You missed the bit "..., in our example." In no way was I claiming that any or all BBs have a 50% current ratio. The fact that you set up that deliberately deceptive straw man says a lot.

No one know what a BBs current ratio is, as BBs do not reveal their gold balance sheets, just their overall balance sheet. Sometimes you can get a bit of an insight, see here http://goldchat.blogspot.com.au/2010/04/king-world-news-scotia-certificates.html

Bron Suchecki said...

Mencius Moldbug,

Shills or loons, are those my only two choices?

Looking across the assets listed here http://goldchat.blogspot.com.au/2014/02/fractional-reserve-bullion-banking-and_4.html my opinion (as there is no data) is that there is significant naked shorts. Some meager evidence for that is the fact that the BBs decided to provide quotes for GOFO and have lease rates derived. You would think it would make more sense to quote the lease rate (like they do for all fiat currencies) and derive GOFO, particularly as the lease rate would be use in the calculation of many other derivatives.

The inference is that they picked GOFO as that is the rate/market where the volume/action is - that is the rate what their clients (miners and speculators) want, not a lease rate from which the client then has to dervie GOFO.

Secondly, GOFO is the rate that "nets" lease and interest rates and is what the speculator earns/pays if they leave the cash with the bank with whom they are going short.

Thus the emphasis on GOFO by the BBs tells us that this is the market with the volume and that these naked positions are collaterised by the BB with the cash from the sale. That is why I focused on the trading/execution risks associated with collateral - volatility, liquidity, gap etc.

Another issue is that for the BB to pay the naked short an interest rate on the cash from the short sale it has to then lend that cash out, does it not. So as we peel the onion, we find that the collateral against client shorts is some non-gold bank loan asset.

Thanks for the question, I'll incorporate this answer into a subsequent post.

Anonymous said...

Bron, just make sure that you keep PMGold in top shape, don't worry about what the other banks are doing. Another thing that Perth mint can do is take product off the market whenever the manipulators of the gold price and silver price manipulate.

Justin said...

"a default can occur because of a failure on the asset side, not just from a run from the liability side"

You have it mixed up Bron, a run on a bank is ALWAYS the result of a failure on the asset side.

Forget Fekete & go straight to where he took most of his theory from, Melchior Palyi, who was only laying out classical banking practice.

A liquid bank can never liquidate - suffer a run. If its assets are of a quality "as good as gold" then gold will bid for the banks assets at next to no discount, since those assets should mature within 90 days.

Of course the only way for a banks "paper" assets to remain "as good as gold" is for them to mature into gold.

Reserve ratios & any other mathematical constructs mean nothing. There is no limit to the quantity of paper gold a bank can have if it remains a standard quality.

What's the superior standard of quality? If you don't know that by now Bron, you are lost.

Anonymous said...

Hey golduggers, how come you get butt-hurt about naked gold shorts, but not about naked gold longs, nor about naked shorts in other markets such as stock futures or commodity futures markets?

Anonymous said...

I would be more interested in the parties (entities) that make use of the BB during those raids. If I were such an entity, had a lot of gold and wanted some more, either in fiatmoney (for new position) or gold (physical), and sold a big lot (covered), waited for the price to drop and bought it back, that would be an easy gain wouldn't it. This all can be arranged in minutes. And if the lots of physical I took out of the market are not too big at one time, who would notice.

Bron Suchecki said...

"the only way for a banks "paper" assets to remain "as good as gold" is for them to mature into gold"

Justin, my series of posts are not about banking, but about bullion banking - all of a BBs assets mature into gold.

Anonymous said...

" This all can be arranged in minutes." Yeah, Einstein, one doesn't need physical to gamble like this, and one can try to do the same in other markets too. Except that it's going to be a crapshoot, and you might lose some. Unless, of course, you're one of those gold conspirators who only believe gold manipulation, but only gold manipulation, always works.

Anonymous said...

The problem is that it's not a real gamble for the big entities. And yes a trade might fail, although there's little chance it will at those levels. Don't forget that these are players for the long run. It sure is a gamble for those whose intention it was to gain fiatmoney and not the physical gold in the first place. These people might take the short position in going naked short. If you want to be a really big player you've to put some gold on the table, otherwise they can call your bluff too easily.
I get the impression you do not understand the long and short side of a trade. And for your information, yes, this is also applicable to other markets too.
And I do not believe in gold manipulation, but in fiatmoney manipulation, but that's another story, although there probably are some overlaps.
It is quite common to make some (small) sacrifices to get a better position for the end game. Do I need to remind you of Rothschild after the battle of Waterloo? When you have enough influence in the market at a particular moment, you'd be able to steer its direction and make your trades. And the Bullion Banks interact in between.