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.