Fractional reserve bullion banking and gold bank runs

Below is a series of post explaining how I suspect bullion banking operates, which is necessary for a true understanding of how susceptible it is to a gold bank run, as well as understanding how a price suppression (as opposed to manipulation) would work, in respect of what backs paper gold and how much physical is needed to support the system.

1. Fractional reserve bullion banking and gold bank runs - the setup
2. Fractional reserve bullion banking and gold bank runs - a bullion bank's "assets"
3. Fractional reserve bullion banking and gold bank runs - the model says we are hedged
4. Fractional reserve bullion banking and gold bank runs - unallocated as real (gold) bills
5. Fractional reserve bullion banking and gold bank runs - how can I default on thee? let me count the ways
6. Fractional reserve bullion banking and gold bank runs – inter-bank buddies business
7. Fractional reserve bullion banking and gold bank runs – Frankenstein Free Banking
8. Fractional reserve bullion banking and gold bank runs: the role of central banks
9. Fractional reserve bullion banking and gold bank runs: bank run theory
10. Fractional reserve bullion banking and gold bank runs: a run or stroll?

See also:

Does fractional reserve gold banking = price suppression

Central Bank Non-Transparency

Just a quick post on Jan Nieuwenhuijs/Koos Jansen's article on the refusal of the Dutch Central Bank to publish a bar list. The reason given was that "the conversion of internal lists to documents for publication would create too many administrative burdens."

I find this excuse weak when gold ETFs can produce bar list in the thousands of pages, and do so without creating any security issue. Even if the custodians where they have the gold have given them a pdf bar list that for some reason contains information that could be a security risk, it should not be a problem to ask that custodian to modify the report/query on their inventory database to exclude such information, or output only the relevant fields of data as a csv file or spreadsheet. If the problem with doing that is that the custodian does not operate an electronic inventory system then we have some serious questions about the control and safety of that custodian's operations.

I think the real reason for not wanting to disclose the bar list is as some have noted in the comments to the article - when a central bank leases gold out, they get different bars back (see here on why this is case) and thus the changing bar numbers on the list would reveal what percentage of the central bank's gold was lent to bullion banks during the year.

For a central bank who follows correct accounting rules and show leases separately to physical gold (see here regarding Reserve Bank of Australia) a bar list should not be an issue (although see here for blogger Bullion Baron's problems getting a bar list out of the RBA, which it seems was more of a case of interference from the BoE and a lack of courage by the RBA to stand up to them) but for a central bank who reports physical gold and leased gold as "gold" the bar list would raise questions like "why didn't you disclose the difference, how can you pretend that leased and physical are the same" or questions about the risk the central bank is taking and whether the return they got was worth the risk. Whilst I haven't met central bankers personally, I'm guessing they don't take too kindly to having their actions or judgements questioned. Hence the stonewalling.

PBOC paper recommends leasing its reserves to manipulate gold price

“PBOC paper recommends leasing its reserves to manipulate gold price” should have been the headline Koos Jansen used for his blog post on a paper produced within the People’s Bank of China which recommended that China “consider employing some of the PBOC’s gold reserve for market operations and as a macro-control tool.”

 

For some reason, Koos instead thought that the “key takeaway” from the paper was that in China “the gold on lease is not double counted, leveraged or fractionally backed, as is often the case in Western gold markets” (which is incorrect, but more on that later).

 

Now saying what the headline should have been (from a Winklebottom point of view) isn’t the same as saying it is true. The reason is because the PBOC paper is focused on what I’d call “good” leasing, that is, leasing to businesses involved in manufacturing gold products, and not leasing for short selling purposes. We can confirm this by the quote “gold leasing is a no-leverage, low-risk transaction”, which only make sense in the context of inventory financing and not short selling. Within that context this quote provides more detail on what was meant by “market operations” and “macro-control”:

 

“Therefore, while restricting gold export, taking part of PBOC reserve gold to participate in leasing operation is a win-win policy. Specifically, the PBOC may select commercial banks as counter-party to lease out reserve gold when supply is tight. Gold lease rates may be established through bidding, PBOC participation would increase liquidity.”

 

The paper noted that the supply of physical gold to industrial users was limited at the time, so recommended utilisation of PBOC’s reserves when “supply is tight” and to “increase liquidity” within the lease market to support the gold industry. Assuming the PBOC did implement these recommendations it is likely that today their leasing may be minimal given that the PBOC did implement the recommendation “limitation to imports should be loosened in favor of a policy that is ‘easy in, strict out’” and as such today physical supply to Chinese industry is being met by significant amounts of imported gold.

 

However, in some sense my headline is true, although not that PBOC is explicitly short selling gold. In the paper they recommend that “enterprise participants can be left to commercial banks to be evaluated for risk of doing business, not unlike evaluating business loans.” In other words, you can trust the banks to be prudent in choosing who to lend gold to. Subsequent events indicate that Chinese banks weren’t so prudent, the result being “bad” leasing for short selling.

 

By September 2012 we first hear of abuse of improved liquidity in the Chinese leasing market with growing round tripping and collateral trades (the gold tied up in such would be financed/hedged by leasing). Business Week reported “rapid growth” in precious metals leasing business in September 2014. Koos’ sourcing of PBOC paper also confirms the observation in a WGC report that “most of the gold stuck in financing deals has been built up since 2011” (note the PBOC paper is dated January 2011) and provides evidence that PBOC paid attention to the paper’s recommendations. Later we find out how individuals and non-gold businesses were using gold loans in risky leveraged transactions. How much of Chinese bank leasing was for such short selling we don’t know, but given that the paper recommended

• “increasing gold reserves optimizes the makeup of China’s assets which will lay a good foundation for RMB internationalization” and
• “when gold in the domestic market is sufficient, or for strategic needs, PBOC may purchase gold from commercial banks to reach its gold reserve target”

it is probably not unreasonable to expect that the PBOC wouldn’t be too worried that a light touch approach to regulating gold leasing may result in downward pressure on gold prices.

 

Back to Koos’ statement that “the gold on lease is not double counted, leveraged or fractionally backed, as is often the case in Western gold markets”. Regarding double counting, the IMF paper Koos quotes is referring to how many central banks report physical gold and gold loans as one line item. When done this way, the addition of such figures with other figures of gold holdings will result in double counting of physical gold.

 

However, Koos incorrectly thinks that the SGE rulebook that possession/title of gold from lessor to lessee somehow gets around this problem. The very same transfer occurs in the situations the IMF is referring to, and this doesn’t solve the problem. It is not about transfer but about reporting. To the extent that Chinese bank’s financial reports do not break down physical gold stocks from gold loans, there will be double counting. To the extent that banks following accounting standards, like the Reserve Bank of Australia does, there won’t be double counting.

 

In respect of Koos' claim that Chinese gold leasing is not fractional backed, well, by definition gold leasing results in a bank being fractionally reserved. As Koos notes, the SGE rules result in transfer of physical gold from the bank, in which case, they no longer have physical gold backing their gold liabilities! Hence they only have a fraction of physical gold against all their gold liabilities. Hence “the gold on lease IS … fractionally backed”. Chinese bullion banks are no different from their Western counterparts, as Koos himself reported: “ICBC launched gold accumulation schemes, swaps, forward hedging, lease/financing, collateralized loans and other financial services ahead of time”. That sounds exactly like what bullion banks do in Western gold markets to me.

GLD amendment refers to "unforeseen reasons" for unallocated failure

GLD has some amendments to its terms up for vote, one of which is "that creations may only be made after the required gold deposit has been allocated to the Trust Allocated Account from the Trust Unallocated Account" (hat tip I Shrugged; see here for an explanation of the existing creation process). What is interesting is the explanation of why they are making this amendment:

"This amendment provides additional security for Shareholders by eliminating potential risks related to issuing baskets of Shares against unallocated gold if the Custodian was to become insolvent or if the unallocated gold was otherwise not allocated for some other unforeseen reason."

My emphasis on the bold bid. The risk they are referring to here is because the Authorised Participants only deliver unallocated to the Custodian and it is up to the Custodian to find the physical to allocate. This puts all the pressure on the Custodian. The amendment does raise the following questions:

• Why the need to clarify this now, is there something the World Gold Council (who sponsors GLD) knows about the state of the market that didn't exist before?
• Why would unallocated gold now have a risk of not being allocated?
• Is there an increased risk of intra-day failures for large unallocated allocations?
• What are these unforeseen reasons?
• And why are none of the more excitable gold commentators hyping this up as more proof of the end of the London bullion banking system? :)(Probably because they didn't get the letter as they are smart enough not to hold GLD, which has numerous other issues which only make it suitable for short term trading IMO).

I don't think this is a case of the WGC responding to public criticism, as I haven't seen any commentary on this detail/technical matter of ETF operation. Maybe they just thought they would close up this risk point while they were making changes to the management fee revenue. However, that would beg the question of when did they become aware of the "potential risks" in the creation process and why didn't they fix it earlier?

At this point I would just note it as a data point, rather than a sign of "an imminent LBMA default", which was first predicted by one commentator in April 2013, which, even by the lax standards of internet accountability, is a fail (don't shoot the messenger, but clearly the fractional reserve bullion banking system is more robust than many give it credit for).

For the Perth Mint at the moment wholesale and retail demand are weak at best. Kilobar demand was so low we were considering shipping gold TO London but there has been a little pick up in kilobar interest this week. The recent GLD additions are positive but other ETFs have had liquidations so this indicator is unclear. All considered I don't see this as a situation where London is under pressure.

The other amendment to GLD is a rejig of who pays its costs and gets its management fee. Currently the Trustee pays (by selling gold behind the ETF):

• Sponsor (ie WGC): 0.15%
• Marketing Agent: 0.15% 
• Custodian: approximately 0.066%
• Administration Fees: approximately 0.03% to 0.04%
• Trustee: $2 million

The proposal is that the WGC will take on all costs and only charge the Trust 0.40%. It just formalises the existing "Fee Reduction Agreement" by which the WGC was absorbing any costs above 0.40% so that GLD holders only paid 0.40%.

I can't see any material change here. Possibly the WGC feels they may be able to control or reduce costs better now that GLD is established and hence it sees an opportunity to make a bit more profit out of GLD beyond the current arrangement, as noted in the amendment letter "the net amount earned by the Sponsor could be greater or smaller than the fee of 0.15% of the daily ANAV of the Trust it currently earns, depending on the actual expenses of the Trust."

Coincidental this happens when two large South African miners (Gold Fields and AngloGold Ashanti) dropped out of the WGC and thus the WGC lost a big revenue source? While that announcement happened after the amendment letter, the WGC would have know about this move by the miners for some time. Just another move towards the WGC becoming more self funded.

Allocated Gold at Bank of England declines 755 tonnes

The Bank of England's just released 2014 Annual Report discloses that it was holding 5,485 tonnes of gold as a custodian, down 755 tonnes to around the level it was in 2011 and 2012. Below is a chart of the data against the average gold price over the Bank's financial year ending February, which shows that the amount of gold has basically followed the gold price, very much like the behaviour of the gold ETFs.

The table below details the figures and calculations back to 2005, when the Bank first started reporting its custodial activities.

As at Date	Allocated Gold (GBP billions)	London PM Fix (GBP)	Allocated Gold (tonnes)	Year on Year Change (tonnes)
28/02/2005	29	226.514	3,982
28/02/2006	36	318.078	3,520	-462
28/02/2007	43	338.964	3,946	+425
28/02/2008	72	488.854	4,581	+635
28/02/2009	102	669.809	4,737	+155
28/02/2010	125	746.149	5,211	+474
28/02/2011	156	868.682	5,586	+375
28/02/2012	197	1110.484	5,518	-68
28/02/2013	210	1046.719	6,240	+722
28/02/2014	140	793.931	5,485	-755

In this June 2014 Quarterly Bulletin, the Bank reports on page 134 that 72 central banks hold gold with them (which is 65% of the 113 central banks that the World Gold Council records as having gold reserves). It also noted that the "Bank also acts as a bank to certain other financial institutions. One example is central counterparties". Included in that the latter group would be the six London bullion market clearing banks. As it is unlikely that the Bank runs allocated gold accounts for banks that are not central to the gold market, it would be fair to conclude that the majority of the allocated gold it holds is for central banks.


Given there was nowhere near 755 tonnes of central bank selling in the year ending February 2014 it would therefore be fair to conclude that this gold outflow was from the allocated accounts that bullion banks had with the Bank of England. This is not surprising considering that the major gold ETFs lost in excess of 600 tonnes over that same period.


Just one final observation from World Gold Council central bank holdings data: it wasn't until the year ending Q1 2010 that central banks were net buyers. Prior to that they were net sellers (1,011t for 4 years to March 2009), yet the table above shows customers of the Bank of England adding to their holdings (753t for 4 years to February 2009). Now if we remove central banks that most likely don't store with the Bank, this 1,011t net sell figure may change, but I doubt enough to turn it around to anywhere near 753t of net buying. Tentative conclusion is that bullion banks were accumulating a lot of allocated gold with the Bank of England.


Combining the above figures with detailed LBMA turnover figures, UK gold import/exports, London ETF flows, and central bank activity is more work than I have time for at the moment, but it certainly would give us a better picture of the London gold market.

Fractional reserve bullion banking and gold bank runs: a run or stroll?

The fact that Australia's Prime Minister referred to the global financial crisis as a "shitstorm" will probably just reinforce Americans' Paul Hogan/Steve Irwin view of Australians. Shitstorm is also the title of a book about that Prime Minister's first term and how close Australia came to financial disaster. In that book they cover the bank run that was developing at the time:

"It was a silent run, unnoticed by the media. Across the country, at least tens and possibly hundreds of thousands of depositors were withdrawing their funds. Left unchecked, there would soon be queues in the street with police managing crowd control ... It's a long time since Australia has had a serious run on a financial institution, but it's all about confidence, and you cannot allow an impression to develop generally in the public that there is any risk."

So how did the Australian government stop this bank run? Simples, they just told people they would guarantee bank deposits. End of run. I think it worked because the average Westerner can't conceive of a government becoming bankrupt. If pushed, the government would just print physical cash and send it to bank branches and take on the bank's assets and the average person would feel safe as long as they had that physical cash in their hands.

Now the holders of BB-unallocated are a step ahead of the average person because they hold gold, but the fact that they hold it with a bank tells you they still trust the system. Certainly if there was a fiat bank run, these BB-unallocated holders would request physical gold, but our focus here is if/when and how would a gold run occur, independent of a fiat run.

As I said in yesterday's post, the opacity of the gold market works to suppress run dynamics but paradoxically, that lack of information also means that if a credible rumour can gain hold (ie a narrative develops) then the run will be fast and thus the BB system is more unstable than the fiat banking system in this respect, particularly as even the most naive investors knows you can't print gold.

My best guess as to what could cause these BB-unallocated holders to begin redeeming in large numbers would be multiple reports of failures to deliver. If that coincided with reports of coin shortages it would help. But it has to be multiple reports - this bank, that bank - around the same time. The one off reports/events we have had are not enough to trigger a mass redemption. The fact is people rationalise away such single events. I mean, look at MF Global - people are still trading futures and there has not been any uptick in deliveries vs open interest. I think it needs a clustering of multiple events, and it would help if some of those were picked up by more mainstream news/blogs.

Also, it would be necessary for a large number of people to redeem at the same time. I believe that the gold market is already experiencing a slow gold run, more of a gold walk or stroll. The fact that Perth Mint clients have been increasingly preferring allocated, that non-bank storage services are growing, and other anecdotal stories I've heard (plus a soon to be launched product we are working on with a big bank) show that more and more clients are withdrawing away from BB-style unallocated and becoming risk adverse.

However, the reason I spent so many posts on the structure of the BB system was to show that this slow shift is not a problem for the BBs as they can handle such a move between themselves and central banks - it gives them time to let their gold assets mature into physical.

It is important to note at this point that while BB engages in maturity transformation just like fiat banking, it is mostly short term in nature - BBs don't lend gold out for 30 year mortgages. Even at the height of the miner short selling, a WGC August 2000 report on gold derivatives stated that most of the global mine hedge book was concentrated in the first 4 years and did not extend past 10 years. Today we have hardly any mine hedging, as this chart from Sharelynx.com shows:

Note that the the blue line representing miner hedging is a delta hedged figure where as the OCC figures are notional. The notional miner hedging figure would be much more but I don't have any figures on it. Even so, it would not account for all of the OCC notional figure. The balance would be other short positions (eg Comex hedges, OTC forwards and options, etc) as well as gold lent to industry for inventory funding purposes.

So in a slow burn scenario, BBs can just let their gold leases mature. Indeed, the chart above shows that this is exactly what has been happening, with gold derivatives declining from 10,000t in 2000 to 2,500t today. If miner hedging is basically nil at the moment, what makes up the 2,500t and more importantly, how long is it lent out?

Obviously, part of those OCC figures would reflect Comex and other futures. But note the open interest in futures - there is hardly any volume outside the current contract. This indicates that most speculators are playing short term. As far as the OTC markets are concerned, note that GOFO rates are only quoted up to terms of 1 year. Again an indicator of where most of the volume is, in the short stuff. Finally, the Perth Mint's understanding of the extent of central bank leasing is that the majority, if not all, of it is for terms of one year or less.

The other significant part of the 2,500t figure would be lending to industry for inventory and consignment funding/hedging purposes. The WGC derivatives report estimated this at 1465t as at December 1999. Demand for gold is much higher today so, say, 2000t of gold tied up in refiners/mints/coin dealers (plus jewellery distribution and retailing) is highly realistic.

So my reading of the BB assets is that most of the short selling lending is very short term in nature and thus can mature quite quickly, in months. However, that which is lent to industry, even if terms are less than one year, are more ongoing in nature. While industry could liquidate inventory if lease rates rose (which they would if BBs were desperate for physical), that would not be overly quick, particularly as it would bump up against refinery capacity limitations and in any case, the industry needs a base amount of gold in process to function. So industry inventories can mostly be considered locked out in respect of meeting any BB-unallocated redemptions.

What the OCC chart does not tell us is the size of the unallocated pool and how much of it is backed by physical. In the WGC report, they estimate the total gold lending supply at 5,230t as at December 1999. Whether the OCC notional 10,000t would delta hedge down to 5,230t I don't know, but for our purposes whether the WGC estimate is understated is not as relevant as the estimate that only 520t of that lending came from non-central bank sources - 10%.

With the gold bull market there is no doubt that unallocated balances have increased but if this ratio of central bank to investor lenders then BBs don't have much risk of a run as private investor are only a small part of their borrowings and may be able to be met by repayments from their short term gold loans.

The other interesting data point is the red star in the chart above. That marks the date when BBs started to charge professional investors for holding unallocated. It is not coincidental I think that this happened after the amount of derivatives and mining hedging peaked and started to decline. I also coincides with the beginning of the gold bull market. Why would BBs start to charge a small fee on unallocated, thereby discouraging it? They would if they were facing two trends:

1. A decline in the demand for borrowing gold, which means they don't need as much unallocated (particularly as they can get what they need from central banks).
2. More investors starting to buy gold, of which some would be doing by holding unallocated.

The result of these two trends would be increasing amounts of physical gold that the BBs had to hold against their unallocated. If you had OCC derivatives declining by 7,500t but as the same time increasing unallocated balances, then there is no one to lend that unallocated to and the only way to cover it is to hold gold. This increases your costs and thus the need to start recovering some of that by fees. I would note that the fees are in basis points and quite small, so this whole thesis is speculative and possibly overstated. Nevertheless, beginning to charge for unallocated is an interesting data point that should be considered.

 

Now the picture painted so far is not one which leads to much chance of the BB system being caught out by a slow run. It is possible as well that BBs may be running a much higher amount of reserves against unallocated than many would consider possible. However, I think that this series of post has shown that the BB system is still quite vulnerable. We will discuss that further tomorrow and how central banks may respond to a gold run.

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.

Fractional reserve bullion banking and gold bank runs: the role of central banks

Yesterday I finished with the statement that central bank lending of gold allows the bullion banking system to expand gold credit and this extra supply suppresses the price. I think a simple example may be useful. Let us consider a market with a BB with the following balance sheet:

The Books of BB#1

Assets – 100 oz of Loans

Liabilities – 10 oz of Unallocated to Ms Strong Hands

Liabilities – 90 oz of Borrowings

Let us say no physical holders or Ms Strong Hands are interested in selling at the current price but we have a Mr Naive with an account at BB#2 who wants to buy. Mr Naive would have to increase his bid to induce someone to sell. If a Mr Short Seller approached BB#1 wanting to borrow 5oz of gold to sell to Mr Naive, BB#1 would be unable to lend gold as they have no reserves with which to settle any unallocated transfers. However BB#1 can approach a CB to borrow gold. This would give BB#1 some unallocated with the CB:

The Books of BB#1

Assets – 100 oz of Loans

Assets – 5 oz of Unallocated with CB

Liabilities – 10 oz of Unallocated to Ms Strong Hands

Liabilities – 95 oz of Borrowings

The Books of CB

Assets – 5 oz Loan to BB#1

Liabilities – 5 oz of Unallocated to BB#1

BB#1 can then lend Mr Short Seller the 5oz:

The Books of BB#1

Assets – 105 oz of Loans

Assets – 5 oz of Unallocated with CB

Liabilities – 15 oz of Unallocated to Ms Strong Hands and Mr Short Seller

Liabilities – 95 oz of Borrowings

Mr Short Seller can then sell the 5oz to Mr Naive. On settlement of that trade, BB#2 would require BB#1 to settle with it, which BB#1 can do by asking CB to transfer 5oz to BB#2. The end result is:

The Books of BB#1

Assets – 105 oz of Loans

Liabilities – 10 oz of Unallocated to Ms Strong Hands

Liabilities – 95 oz of Borrowings

The Books of CB

Assets – 5 oz Loan to BB#1

Liabilities – 5 oz of Unallocated to BB#2

The Books of BB#2

Assets – 5 oz of Unallocated with CB

Liabilities – 5 oz of Unallocated to Mr Naive

Some observations:

• BB#1 was able to expand their loan book by 5oz, earning more interest;
• Mr Naive did not need to bid up the gold price as Mr Short Seller arrived into the market with "gold" at the current price;
• The CB did not need to sell any physical gold;
• While BB#2 wasn't willing to extend credit to BB#1 and hold its unallocated, it was willing to hold the CB's unallocated;
• The CB's unallocated was really just backed by a loan to BB#1;
• Therefore, system wide BB#2 was really extending credit to BB#1, the CB was just acting as a guarantor in the middle.

The role of the CB here is to plug the gap in any lack of trust between BBs, in other words, if inter-BB lending broke down. That should sound familiar, as it is exactly what CBs did in the financial crisis regarding the fiat banking system.

 

I don't want to get sidetracked in this series of posts into manipulation theories (that is worth its own posts) but for now note that as long as Mr Naive is willing to hold BB unallocated and Mr Short Seller is willing to take price exposure, neither the BBs or CBs need to sell physical or go short themselves. It is the Mr Naives themselves who facilitate the price suppression. Only if the Mr Naives preferred physical would the CBs need to actually sell their gold if they wanted to suppress the price.

 

Back on topic. In normal markets the fractional reserve banking system is highly flexible and stable. The LPMCL provides an efficient inter-BB clearing system and if any bank experiences a maturity mismatch liquidity problem, other BBs can extend it temporary credit and can make a nice profit charging higher than normal lease rates for such emergency funding, or if required, lend against cash or other collateral. In the case of a lack of trust and collateral shortage, CBs can step in to mediate any inter-BB "friction". One may be able to infer this market action via changes in reported GOFO and lease rates.

 

One of the reasons I think so many gold commentators have been wrong on calls that the bullion banking system is about to fail is that they are not aware of the market structures I have been discussing in these posts, and thus do not appreciate how much stress the gold market can withstand. Because they are not aware of the role of BBs and CBs in the facilitation between  paper gold longs AND shorts, they think that price suppression can only have been achieved via physical sales and thus naturally when they run the numbers on that, they conclude that the CBs have run out of physical gold. But surprise, the game continues! I would suggest such commentators should reconsider their theory and recast it based on a more sophisticated understanding of the market.

 

Let me put it another way. On Comex it is clear from the very low percentage of physical deliveries versus open interest that Comex is primarily a market where leveraged paper longs (who don't have the cash) trade against leveraged paper shorts (who don't have the gold). The BB-LPMCL-CB system described in these posts is just an OTC version of this Comex structure, with BB unallocated account credits taking the place of futures contracts. Any look at the London OTC clearing statistics should tell you there is a lot of BB unallocated paper being held.

 

To the extent that people are willing to hold this paper, be it futures or BB unallocated, then those longs facilitate and support the game. The question then is when (if?) will they "run", which I will discuss tomorrow.

Fractional reserve bullion banking and gold bank runs – Frankenstein Free Banking

The bullion banking and inter-BB clearing system described yesterday has a lot in common with free banking, which is "the competitive issue of money by private banks as opposed to the centralised and monopolised issuance of currency under a system of central banking."

That quote comes from George Selgin's 1988 paper The Theory of Free Banking: Money Supply under Competitive Note Issue, which provide a good explanation of it. It is 192 pages however, so I would only recommend it to the most dedicated. I'll do my best to draw out the parts of Selgin's paper relevant to our topic.

The key features of a free banking system as described in Selgin's paper include:

• no central bank, ie no monopoly of currency issue
• each bank issues its own branded bank notes
• banks compete against each other for deposits and loans
• banks hold physical gold as reserves (not government fiat)
• people are paid in different branded bank notes and deposit these with their bank
• banks settle/clear the notes of other banks deposited with them by their clients with gold
• banks establish a clearinghouse to facilitate inter-bank settlements

For the moment let us leave the question of a central bank and consider the above in terms of what I have described over the past few posts. In the case of bullion banking, while there are no physical gold notes circulating, we can consider unallocated accounts as equivalent of the branded bank note - unallocated is specific to the BB with whom you hold it. The BBs do compete with each other in a light touch regulatory environment, depending on the jurisdiction., and the BBs hold physical gold reserves and settle in physical gold via a clearinghouse.

Note: I'm going to refer to a number of conclusions Selgin comes to in his paper, which he bases on logic and historical evidence of episodes of free banking. I am not a monetary expert but to this lay reader his conclusions seem well argued. Happy for people to disagree with his conclusions but if you haven't bothered to engage with Selgin's work, don't expect me to engage, particularly if you are rasing criticisms he addresses in his paper.

One of the key conclusions that Selgin comes to in his paper is that under free banking the supply (creation) of money only responds to changes in demand for money by people. In other words, central bank created inflation as we know it does not occur and "the value of the monetary unit is stabilized, and events in the money market do not disturb the normal course of production and exchange."

The implication for bullion banking is that, if it operates along free banking lines, then there is no excess unallocated gold created, that is, no "inflation" in gold credit and thus no resulting deflation/fall in the fiat price of gold (eg if there was 10oz vs $10 then the price is $1 per oz; if you double the ounces, then 20oz chases $10, price becomes $0.5 per oz).

 

The reason for this is that if an individual BB creates/lends too much gold credit (unallocated) then when its clients use/transfer that unallocated to clients with accounts at other BBs, it will result in that BB owing gold to its competitor BBs and they will request physical to settle the growing LPMCL imbalance resulting from that BBs over lending. So all BBs are restricted in their unallocated gold lending to the extent of their physical reserves.

However, Selgin notes that the mathematics of inter-bank clearing mean that if all banks expand credit at the same rate, then there will not be any adverse inter-bank clearing balances between them. He notes only two controls over such collusive (or game theory type response - ie if you are expanding credit, I will/have to as well) behaviour:

1. The growth in money supply will result in a grow in clearings, which will bring with it a growth in the variability of clearing debits and credit. This will require banks to increase their precautionary reserves, and this increase in reserves constrains money creation.
2. The redemption of physical gold by the public (ie, the reduction in bank reserves).

For bullion banking, the implications are that inflationary gold credit creation (which would push the fiat price of gold down) is restricted only if there are a few prudent BBs that do not follow their competitors. If not, and all BBs increase at the same rate, there will be inflationary gold credit but it will stabilise at some higher level (than than required by legitimate gold credit demand) due to the variability of clearing issue.

However, we know that central bankers hold gold and lend it to BBs, so we do not have a true free banking system. However, it is also not like a fiat system as gold can't be printed, so it is a half way house with bits from both, or a Frankenstein Free Bullion Banking system.

 

Selgin notes that with a monopolised currency supply, central banks can create more reserves and "since such expansion is a response to the exogenous actions of the monopoly bank and not to any change in the money-holding behavior of the public, it involves “created” credit and is disequilibrating".

 

So in our Frankenstein Free Bullion Banking system, the lending of gold to the BBs by a central bank increases the BBs reserves and thus increases the BBs' ability to create more gold credit (unallocated). This inflation in gold supply naturally results in its fiat price falling. If so, why then would a central bank actually sell its precious physical gold if it wanted to manipulate the gold price when it can do so via reserve expansion instead? An answer to this rhetorical question tomorrow.

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.

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.

Fractional reserve bullion banking and gold bank runs - unallocated as real (gold) bills

I must apologise for jumping around a bit with these posts on fractional reserve bullion banking. I haven’t planned this series out and each day I think of additional things worth noting if one is to have a more nuanced understanding of how a gold run would play out. I’ll get there in the end.

So another slight diversion. I forgot to mention in this post that BBs can create gold credit (ie unallocated) just like with fiat currencies. So their gold balance sheet can consist of unallocated liabilities backed by promises to repay gold. "That sounds fraudulent" I hear you say. A practical example may help.

Consider a simple world with one Miner, one Refiner, one Bullion Bank, and an Investor.

A Miner delivers dore to the Refiner for refining. Due to competition, these days Refiners pay Miners for their dore once an assay has been completed, which is usually in a couple of days and well before the Refiner has been able to actually refine the dore. The assay reveals that the dore contains 12oz of pure gold and the Refiner quotes an outrageous  (but easy for me to calculate) charge of 2oz in refining fees.

As the Refiner does not have any gold to pay the Miner, it asks the Bullion Bank for a 10oz gold loan. The Bullion Bank agrees to do so at an outrageous rate of 10%, and creates unallocated gold credits out of thin air. At this point the Bullion Bank’s balance sheet looks like this:

Asset – 10 oz Loan to Refiner

Liabilities – 10 oz of Unallocated to Refiner

The Refiner then instructs the Bullion Bank to transfer unallocated gold to the Miner, as payment for the dore (usually done via loco swaps). The Bullion Bank’s balance sheet now looks like this:

Asset – 10 oz Loan to Refiner

Liabilities – 10 oz of Unallocated to Miner

Note, while the Bullion Bank does not hold one ounce of physical (more cries of "fraud"), the Refiner is holding physical, making their promise to repay the gold loan credible. The Miner needs cash, rather than gold, to pay wages and other expenses, so they enter the marketplace to sell their “gold”. As it happens there is an Investor who is interesting in holding some (unallocated) gold. There are cries of “no” from our audience, “don’t you know that paper gold is evil, don’t trust that bullion banker”, but our Investor ignores them and agrees a price with the Miner. The Miner instructs the Bullion Bank to transfer gold to the Investor. The Bullion Bank’s balance sheet now looks like this:

Asset – 10 oz Loan to Refiner

Liabilities – 10 oz of Unallocated to Investor

Meanwhile, the Refiner diligently works to turn the dore into 99.99% pure 1 oz gold bars. After one year (very inefficient), the Refiner delivers 11 x 1 oz gold bars to the Bullion Bank as repayment of the loan and interest of 10%. The Bullion Bank’s balance sheet now looks like this:

Asset – 11 oz of physical gold bars

Liabilities – 10 oz of Unallocated to Investor

Equity – 1 oz of retained earnings (interest profit)

Now many have been convinced that this is fractional fraud, but what would you say if the Refiner just issued the Miner with a real bill for 11 oz of gold and the Miner discounted that bill with the Bullion Bank for 10 oz of gold? While there are no bills issued, the process above in effect is no different to a gold real bill (see here for a discussion of real bills by Professor Fekete and I look forward to comments explaining why he is wrong). It is why Keith Weiner says that the gold lease rate is really a discount rate. People who understand the real bills doctrine may find it interesting that in the professional market, bullion banks charge a small fee on unallocated balances – discounting in another form perhaps?

The gold credit creation process above is in my opinion a legitimate function of bullion banking that facilitates the gold manufacturing and distribution business of getting gold into investors’ hands, a good thing we would all agree. The Investor in our example is saving in gold and financing the industry by the act of holding unallocated and deferring a desire for physical gold.

Our simple example can be expanded to many more participants, like bullion distributors and the like. Indeed, most of the Perth Mint’s large bank distributors pay for coins by unallocated credits and the Mint uses these unallocated credits to pay Miners for dore, which is made into coin and so on in a continuous flow. Another quote from Professor Fekete is relevant here to explain why this type of fractional bullion banking is OK (and 100% reserve banking is flawed):

“The notion that the bank's promise, if it is to be honest, forces it to have a store of gold on hand equal to the sum total of its note and deposit liabilities stems from a fundamental confusion between stocks and flows. The promise of a bank, as that of every other business, refers to flows, not stocks. The promise is honest as long as they see to it that everything will be done to keep the flows moving. In the case of the bank, the promise is honest as long as the bank carries only self-liquidating bills, other than gold, in the asset portfolio backing its note and deposit liabilities.”

Before some goldbugs start having cognitive dissonance with someone as respected as Professor Fekete is endorsing that which they have been told is bad, I would direct their attention to the last sentence in that quote. Bullion banking is only legitimate “as long as the bank holds only gold and self-liquidating bills [ie loans to the gold industry] to cover the bank note [ie unallocated] issue, it changes neither the supply of nor the demand for credit”. The problem is that much of the assets a BB holds do not fit this definition as they are not maturing into physical gold within a few weeks or months. It is my guess that while BBs are involved in this legitimate and useful banking function for the gold industry, it is only a small part of their assets, with the bulk of unallocated on call deposits being used to fund outright speculative short selling and much longer term financing (introducing maturity risk). You can rest easy in your hate of unallocated.

At this point I’ve learned my lesson and I am not going to commit to what I’m going to talk about tomorrow regarding fractional bullion banking and banks runs, as I’ll probably think of something else I’ve forgotten to mention. At this time, these are the topics I think I have left to cover:

• The dynamics of a gold run on a single bank – who are the unallocated holders an how likely are they to “run” and can the BB's assets satisfy the demand for physical
• Introduce multiple banks and inter-bank account transfers, settlement and clearing - bullion banking as freebanking
• The role of central banks in inter-bank clearing and liquidity provision via paper leases vs physical leases – is it still freebanking?
• Central bank support of bullion banking system vs individual BB support in a run (difference between domestic BBs vs overseas BBs?); free rider problem for the US?

Feel free to suggest any other topics for discussion around this gold bank run issue.

Fractional reserve bullion banking and gold bank runs - the model says we are hedged

In yesterday's post I discussed the various types of gold assets that sit on a BBs gold balance sheet. Often goldbugs refer to these generically as “paper gold”, but I think this hides the great differences in riskiness between the various types of paper gold assets and is so overused that people fail to appreciate the real risks involved. So what are these risks?

 

For some paper gold instruments it is quite easy to estimate the size of the exposure, for other more complex derivatives, a BB would rely on something like Black Scholes model and it is here that a lot of risk is introduced. Consider these limitations of Black Scholes from the Wikipedia link:

• the underestimation of extreme moves, yielding tail risk, which can be hedged with out-of-the-money options;
• the assumption of instant, cost-less trading, yielding liquidity risk, which is difficult to hedge;
• the assumption of a stationary process, yielding volatility risk, which can be hedged with volatility hedging;
• the assumption of continuous time and continuous trading, yielding gap risk, which can be hedged with Gamma hedging.

The article I think naively says some of these risks can be hedged, with other derivatives! But then how are these valued, using similar formulas? Ultimately, there is often just another counterparty on the other side and we get back to these assets being either an outright promise (unsecured) or a promise covered by collateral or margin. But that collateral itself needs to be valued, by those same formulas in many cases. And how to determine the amount of margin? By those same formulas.

It is the false assumption underlying much of the formulas used by the BBs to work out how to “hedge” themselves that I think is the problem, as this article The mathematical equation that caused the banks to crash explains.

In it Professor Ian Stewart notes that even though the Black-Scholes equation was based on false assumptions “the model performed very well, so as time passed and confidence grew, many bankers and traders forgot the model had limitations.” Are the people within BB are considering tail, liquidity, volatility and gap risks? And if they are, are they looking at it from the same viewpoint that gold investors do, which is one that looks over a long timeframe and is more adverse to extreme events? Doubtful.

By way of example, some years ago the Perth Mint was looking at Treasury software packages. I remember the salesperson saying that the software had all the complex “formulas” inside it and worked them all out for you. I asked where it got the key inputs from, like volatility. The answer was from one year’s worth of data of the underlying asset! That didn’t seem to me to capture events like the 1980 $850 boom and bust.

I can’t say I’m totally confident that BB are taking into account the new branch of mathematics called complexity science, which Professor Stewart explains “models the market as a collection of individuals interacting according to specified rules” which reveal that “virtually every financial crisis in the last century has been pushed over the edge by [traders] the herd instinct. It makes everything go belly-up at the same time.” Therefore the gold assets of a BB are, to my mind, barely robust in the face of extreme events.

At this point it is worth discussing the liability, or sources of funding, side of a BB’s balance sheet. It is obvious that people buying and leaving gold with a BB, as unallocated, is a big source of funding. But BBs can also acquire funding via derivatives, or to be more accurate, net off their assets with opposite ones of a similar type. For example, long futures against short futures, or options against options.

However, these would rarely line up in terms of maturity, so on top of the misestimation of the value of these paper golds, outright counterparty exposures, inadequacy/variability of the collateral/margin calculation, you have maturity transformation – a deliberate mismatching of maturities of these products to their sources of funding, which assumes that if needed, new sources of funding can be found or existing ones rolled over.

Considering all this complexity and room for error one would conclude that we have a highly unstable system, one that Nassim Taleb would call fragile and sensitive to stress, randomness and disorder.

However, the fact is that the bullion banking system has not failed. For example, in 1998 open interest vs stocks exceeded 40:1 (when from 1975 to today it has never been over 15:1), yet there was no failure. What about LTCM, or AIG (40:1 gold leverage as per Jeff Christian). Shouldn't that have been enough to blow up the system? So how do we explain this apparent robustness?

Hmm, but wasn’t it in 1999 that “We looked into the abyss if the gold price rose further”. So tomorrow we look at the interaction of BBs with each other via their clearing firm and whether bullion banking is thus a freebanking system, and the role of central bankers.

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.

Fractional reserve bullion banking and gold bank runs - the setup

I finished yesterday's post on central bank transparency with a statement that the stability of the fractional reserve bullion banking system and its gold run-proofness depends on the extent to which central banks have lent gold physically or only via book entry to bullion banks.

First a recap on bullion banking. Unallocated bullion bank accounts are fractionally backed, no different to fiat banking. Indeed most unallocated accounts are, as it is impossible to offer a 100% backed account with no storage fees unless you are a physical user of gold like the Perth Mint. However, the refiners, jewellers, or coin dealers that offer 100% backed unallocated do not amount to much relative to the total unallocated held globally.

So a bullion bank has no real need for physical gold. Unless they are storing it on an allocated basis on which they can charge storage fees, having a (free, or very small fee) unallocated account backed by physical gold in a vault is, if not an outright loss (note that the marginal cost to a bullion bank of storage is often zero, that is for another post), at least a not very productive and profitable use of their client's gold deposits.

Therefore bullion banks are incentivised to lend gold (or "lend" it to themselves in the process of creating derivative products). This naturally leads to the question of how much do they lend and how much do they keep as physical reserves. The fact is no one really knows. Jeff Christian of CPM Group gave us an insight into the possible fractional reserve ratio here, where he says that most banks are operating on a 10:1 ratio, but notes that AIG was operating at 40:1.

A side note here - the following terms are often confused (and indeed in Jeff's interview he seems to use fractional and leverage interchangeably), this is how I understand and use them:

• Fractional - how much physical gold versus total on call (unallocated) deposits
• Leverage - how much capital (your own money, the rest borrowed) you invested into an asset
• Turnover - trading volumes versus total stock on issue/available (the infamous Jeff Christian 100:1 statement was about turnover, not fractional)

The focus of this post in on a gold bank run and fractionalisation is really only what matters in assessing whether the bullion banking system will "blow up". By way of explanation, while a drying up of turnover (ie liquidity) or excessive leverage may lead to people to want to redeem their unallocated, if bullion banking was running at 100% fractional then a bank run would not be a problem.

 

Note that fractional is defined in terms of "on call deposits", not total liabilities. For example, if a bank has borrowed gold on a term of 1 year and lend it out for 2 years, that cannot create a bank run problem now, because the lender to the bank has no right to the gold now, only in 1 year. That may be a problem in 1 year, but for lets just consider demand deposits.

Now obviously banks lend these on call deposits for longer terms into the future. This is called maturity transformation and I tend to agree with this blogger that it is a bad thing and "that, without any government protection, it is incredibly unstable and will melt down at a drop of the hat. With full government protection, it is stable".

So in addition to how much physical does a bank hold relative to on call deposits (fractionalisation), how long a bank has lent out gold for also matters. For example, if a bank only had 10% as physical but had lend the remaining 90% for no longer than, say, 1 week, then you may conclude that they are unlikely to suffer from a bank run as they will quickly get gold back to repay those on call depositors.

Well, that is assuming the people they lent it to actually deliver against their promise to repay their gold loan. In other words, to whom did the bank lend and how credit worthy are they? This is unsecured counterparty exposure.

But, the bank may claim, we have collateral against the loan, so if the client doesn't pay up we can sell their collateral and buy the missing gold. This of course assumes that either, or both, the collateral does not go down in value, or the gold price does no go up, in a market stress situation. So we have price exposure.

So a bullion bank's risk towards a run on its unallocated accounts depends on their:

• physical fractional reserves
• extent of maturity transformation
• credit worthiness of unsecured counterparties
• collateral and gold price exposure for secured counterparties

All of these factors apply to fiat banking as well, but as our blogger friend notes, fiat banking is ultimately backed by government. This is possible because a government can print fiat and exchange it for a bank's long term assets, suddenly increasing its physical (banknote) fractional reserves and thus avoiding a bank run.

However, as you would have often heard, you can't print gold. You shouldn't be surprised that bullion banks also know this fact, which leads me to believe that as a result they run bullion banking slightly differently to fiat banking. What they do differently, and what it means for a gold bank run, I will discuss tomorrow.