Fractional reserve bullion banking and gold bank runs – inter-bank buddies business

A couple of posts ago I gave an example of the transferring of unallocated gold between accounts. In reality the sender and recipient would likely bank with different BBs. If our Refiner banked with BB#1 and our Miner banked with BB#2, this is what would happen if the Refiner requested a transfer to the Miner’s account:

The Books of BB#1

Asset – 10 oz Loan to Refiner

Liabilities – 10 oz of Unallocated to BB#2

The Books of BB#2

Asset – 10 oz of Unallocated with BB#1

Liabilities – 10 oz of Unallocated to Miner

There would be many of these transfers during the day, including clients of BB#2 wanting to transfer to clients of BB#1. At the end of the day a BB would net out its transfers with other BBs leaving it either owing gold to each BB or being owed gold from each BB.

Now while BBs are likely to be willing to extend credit to other BBs, that is, hold unallocated balances with them, each BB has an internally set credit limit given to the other BBs beyond which it will not want to hold unallocated. For example, if BB#1 only had refining clients, and BB# only had mining clients, we would expect BB#1 to owe BB#2 an ever growing large amount of gold.

Once a BB reaches this limit, if it wants to request any more transfers to the accounts of clients of another BB, it would have to ship physical gold to that other BB in settlement. Once you start adding more and more BBs, it would result in a lot of gold moving between vaults.

To the make the settlement of these positions between many BBs more efficient, the six major BBs formed a not for profit organisation called London Precious Metals Clearing Limited (LPMCL), which is a daily electronic settlements matching system that “avoids the security risks and costs inherent in the physical movement of metal.”

Each member of the LPMCL has the right “to call for any one, or a combination of the following actions:

a) Physical delivery of metal.

b) Transfer of all or part of a credit balance to another member where the caller has a debit balance.

c) Allocation of metal.”

The innocuous quote above actually gives us a lot of insights:

1) If a BB has requests for physical delivery from its clients and not much physical reserves of its own, it would choose a).

2) If a BB owes other BBs (ie it has debit balances) and other BBs owe it (ie it has credit balances), it would choose b) to minimise being called upon by the other BBs for physical delivery or allocation.

3) If a BB has too much unallocated (credit balance) with another BB (that is, it is exceeding the internal credit limit it set on the other BB), then it would choose:

3.1) Action b) if it had debit balances to minimise

3.2) Action c) if it did not have any debit balances.

4) In the case of 3.2), a BB could also reduce credit limit exposure by choosing a). Whether it did so would depend upon balancing out the shipment costs of a delivery versus the storage cost charged to the BB for allocated. Action a) would only be chosen if the BB expected to continue to accumulate credit balances with the other BB such that storage fees would accumulate and exceed any shipment cost.

5) There is no “cash settlement” option, only net out or cough up physical.

The LPMCL notes that the key purpose of the system is “to ensure that excessive exposures are minimised”; for BBs to “to minimise their credit risk exposures” to other BBs. This is reinforced by the fact that a LPMCL BB member must provide “same-day allocation of metal to a creditor member and it is expected that such allocation will be provided within one hour under normal circumstances.”

The same-day allocation within one hour requirement means that when the clients of a BB request the transfer of unallocated gold to accounts at other BBs, then that request will require the BB to have physical gold if:

a) it expects on a net basis across all the other LPMCL BBs to have a debit balance (ie it net owes other BBs); and

b) it expects that the amount it will end up owing to the other BB(s) will exceed the credit limit that the other BB(s) have given it.

Note that Action b), the transferring credit balances, allows a BB to choose who it ends up owing gold to, so it has a little bit of control over the probability of whether it will be required to allocate or deliver physical, as it can pick a BB with whom it expects it still has credit with. Ultimately, the total extent to which all other BB’s are willing to extend credit to a BB will impact on how much physical reserves that BB needs to keep. It will also determine how much of a BB’s unallocated liabilities end up being “backed” by unallocated claims on other BBs, which just means it is “backed” by the quality of the gold assets held by those other BBs.

One final observation. Each of the six major BBs also hold accounts with the Bank of England, with the LPMCL noting that being a BB clearing members involves “close liaison with the Bank of England”. The Bank of England acts as a bullion banker to the bullion bankers, a neutral counterparty, but is not part of the LPMCL itself. So allocations could also occur by a BB requesting transfer of its allocated with the Bank of England to another BB’s account with the Bank of England.