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.