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.