Fractional reserve bullion banking and gold bank runs - a bullion bank's "assets"

Yesterday I did promise to discuss how bullion banking is run differently and the implications for a gold run, but I realised that before I discuss the factors affecting a gold bank run I need to explain the types of gold “assets” a BB can hold. Only then can we understand the risks associated with them and then the dynamics of a gold run (no, I did not plan these posts out in advance).

In the case of gold lending, there are two types of borrowers as there are only two things you can do with borrowed gold (no one borrows gold just to keep it at home to look at):

1. Use it as inventory in your gold business (eg jewellery, minting)
2. Sell it (that is, short the gold price to benefit from it falling), composed of
  2a. investors/speculators (hedge funds, individuals)
  2b. mining companies

If you are someone without creditworthiness, which just means that a BB makes an assessment that you cannot be trusted to repay your debts, then a BB will require some security or collateral which they can access if you don’t pay. An example of this in consumer lending is a bank holding a mortgage on “your” home.

In the gold business case the BB can be reasonably sure you have the gold to repay and can put in place some sort of lien or mortgage type arrangement against the physical inventory and/or other assets of the business. There is still a risk that the business goes bankrupt with the gold being sold and not replaced or maybe the owners just steal the gold. However I think the short sell borrower is more important from a risk point of view, primarily because:

• lending to and monitoring business is what banks do, and generally do well and while there is interest in the gold market the risk of default is low for these businesses (if the gold market was to go into a protracted bear market that may be a different thing)
• there is a lot more of short selling borrowing compared to industry inventory funding type borrowing
• neither the BB or the short selling borrower has any physical gold to mortgage as it has been sold.

The short selling speculators may be considered low in risk because generally BBs will lend you the gold but also insist on selling it for you and keeping the resulting cash from the sale as collateral. Since the gold price is volatile, the BB will require you to put up additional margin. So a BB has both cash from the sale + margin to cover themselves.

Mining companies are sort of like our jeweller or minter, in that they are a business, just that the gold they hold is in the ground and not in a factory. This is a bit more risky than a gold business as they may not be able to get the gold out of the ground at a reasonable cost or have some other operational problems. They are also more risky than a speculator as the mine used the cash to pay expenses or buy equipment, so there is no cash left to use as collateral (the BB could mortgage equipment etc, but resale value of that and an unprofitable mine would be low, so little security there).

If you are someone with creditworthiness, then the bank will let you do the above things without a need for margin or collateral, at least up to whatever credit limit they set for you. This is obviously a lot more risky than some sort of secured lending.

Finally, I mentioned yesterday that a BB can also "lend" gold to themselves in the process of creating derivative products. Maybe best explained by two examples.

Lets say there are a lot of speculators who want to sell futures contracts. A BB will make a market for them and take the other side, going long futures. Now if they let it run to maturity, they would receive physical gold. To offset that, or hedge, they borrow gold (from their on call depositors) and sell it. They can then use the resulting cash to pay for the futures contract when it is delivered, and deliver that gold to their on call depositors. In the meantime, therefore, the on call depositors' accounts are “backed” by the long futures contract the BB is holding.

Another more complex example would be someone wanting to buy a put contract on gold (they have the option to sell gold to a BB). If a BB sells a put contract that means they have a potential obligation to buy gold in the future. The hedge that obligation by borrowing gold and selling it. So in this way the on call depositor’s account is “backed” by a put option the BB sold. (technical note, with options the amount of gold the BB will sell varies depending on the volatility of the gold price, for example, against a put option for 1000oz, a BB may only sell 500oz of gold – this is called delta hedging)

From the above, we can construct what sort of gold “assets” a BB can hold:

• Unsecured mine short sales
• Unsecured speculator short sales
• Unsecured gold business lending
• Secured mine short sales
• Secured speculator short sales
• Secured gold business lending
• Futures (long)
• Options (sold puts, purchased calls)
• Other derivatives
• Unallocated gold held with other BBs or central banks
• Allocated gold held with other BBs or central banks
• Physical gold in vaults under their control

On top of these (except for the last three, which are on call) you then have different dates at which all of these contracts will mature, that is, the BB gets the gold back (this is one half of the maturity transformation we mentioned yesterday).

By now you should be getting the sense that these “assets” are not entirely certain and have some risk attached to them. Tomorrow I’ll discuss where I think the risk lies, and where I think BBs, and banks in general, underestimate the risks. Nassim Taleb's book Antifragile will be helpful in that regard.