The 21st Century Bank Run

What bankers fear most is a bank run. Yet for how many weeks now have we lived with the event affectionately named Bank Fail Friday with nary a jog? How is this possible?

Seemingly our monetary patriarch Ben "POTY" Bernanke his Holiness has eliminated the greatest systemic threat of the Great Depression, the bank run. Is this possible?

Before we peer into what the 21st Century Bank Run is going to look like, let's first jump back into our history lesson from last week...

Coming to terms with the dollar and with money
by Aragorn III

(a continuation from earlier)
My good friend Aristotle has relayed to you much of the modern story. (Where has he been these days?) I am pleased it met with acknowledgements regarding its assistance, and would like to continue with perhaps some additional background for assistance to some in the understanding of money. Please forgive me the many oversights for which haste may have to play the fall guy. As later time allows, I shall attempt to repair what is necessary, but meanwhile this should help continue our dialog on these matters.

Aragorn III (08/09/99; 03:06:13MDT - Msg ID:10714)--Looks good, Peter
Yes, indeed, this is a good way to view our currency, such as it is...

Peter Asher (08/08/99; 22:51:59MDT - Msg ID:10701)--Fractionalization limits are just a regulation.
<<"Lets try this possibility.--- The extra [FED "liquidity"] can get into circulation by withdrawal of deposits, or my writing loans. If they write loans, up goes the Money Supply. If people withdraw their demand deposits, all that has happened is a ledger entry has been replaced by a receipt. That's really what a banknote is. Not an IOU as some have said, but a UOI. 'You the people of this country owe me this numerical value of goods or services.' So in a sense, when you take that currency out of the bank you are saying, "Hey tear me out that piece of the page where you have my deposit written down. I'd rather hold on to it myself."">>

Very nice! As the only "value" which is to be found in our currency exists entirely within an elaborate accounting system of "who owes how many numbers to whom", the physical dollar we may carry in our wallets is truly nothing more than a portable and transferable piece of the official ledgers; one that has been duly certified to stand alone as one of those ledger numbers with the proper pedigree to pass as currency. Numbers that remain in ledger form may only be added or removed through official banking channels, such as we see in the example of the check clearing house of the Federal Reserve. This has been Aristotle's attempt recently to explore with others why his simple act of typing "$17" does not create 17 spendable dollars; because it does not have the proper pedigree of origination within the banking system. Specifically, it was not borrowed into existence by the Treasury from the Federal Reserve, or even perhaps borrowed by you or me from our own Main Street bank.

Fancy designs with presidents on paper is an assurance that these "ledgers to go" so to speak do bear the proper pedigree as numbers acceptable for legal tender. When they exist in ledger form, they demonstrate this proper pedigree by the integrity of the database that tracks their movement. Nothing more, nothing less.

This gets us back to the thread I began a few hours ago in an examination of the dollar and money, and I shall now try to return to that...

This is where we left off from before, more or less...
Aragorn III (08/08/99; 17:19:07MDT - Msg ID:10664)
"...It should be obvious by the nature of our topic (money) that our conversation is focused on tomorrow, in addition to today. Were we to be truly concerned about today only, we would instead discuss whether our needs of food, clothing, and shelter had been adequately met, we would not speak of money. To speak of money is to speak of today's confidence in our ability of meeting tomorrow's needs."

A currency with an unknown expiration date is arguably of limited use for the role we expect our money to play...to hold its value within acceptable limits of fluctuation based on normal market pressures and thereby successfully fulfill its ultimate destiny to be spent as a medium of exchange for our future needs (food, clothing, shelter, hardware, medicine, etc.). No one wants to be the one left holding the bag when the purchasing value drops out the bottom.

Prior to 1971 the dollar was truly money (gold standard defined the dollar as gold) in the international economy, freely convertible with gold, with an equivalency of 1 oz. @ $35 -- FIXED, no questions asked! (Though it is fair to say there was squawking from time to time when overseas paper came home for redemption). Unfortunately, the U.S. had painted itself into a corner and was trapped. Here is how it happened.

Prior to 1933 the U.S. was on a gold standard domestically, also, at which time the equivalency was 1 oz. @ $20.67 -- fixed, no questions asked. A bank would readily exchange paper currency for the equivalent gold currency on demand. There was a general confidence in the banking institutions, and people were content to use their paper dollar equivalents, and further, were content to let their deposits remain in the bank. Fractional reserve lending privileges allowed banks to expand the money supply--YES...even while on a fixed gold standard! As long as not everyone together would choose to withdraw their money and convert the paper proxies for the gold dollars, this fractional reserve lending privilege did not cause any apparent problems. Did prices stay reasonable as the dollar still appeared "good as gold"? I give you... The Roaring Twenties! When the attendant stock market bubble popped in 1929, the financial system, and much necessary confidence began to unravel, and the bank run became a probationary event for the Olympics. In 1929, 659 banks failed. In 1930, 1352 banks failed. In 1931, 2294 banks failed. Late 1932 and early 1933 witnessed this trend swell to envelop not small or isolated banks alone anymore, but entire communities and statewide banking institutions. (I will tell you that by 1933's end, nearly half of U.S. banks had disappeared...such is the "privilege" of issuing excessive claims on money that cannot be backed through this fractional reserve system!)


You can see why the Roosevelt Executive Order of a bank holiday effective March 6, 1933 was something other than a trip to the beach. In this year, 4004 banks failed, or else were found to be unfit to reopen at the end of the "holiday". In the following year, only 62 failed. Why? Because as you already know, it was at this point that President Roosevelt took the money (gold) out of the domestic dollar, and it should be obvious to us all that a crippling bank run is no longer a threat when a bank need not be held to deliver real money. It could easily deliver the ledger numbers endlessly in portable paper form. A bank run becomes meaningless because the people are not at risk of being cheated by arriving too late, they have all already been cheated 100% in full! The government knew international parties would not fall for such trickery, so the gold convertibility was maintained, but only after defaulting on the paper dollars they held by redefining their equivalency to 1 oz. @ $35 (as was maintained from this point until the Second World War, and reaffirmed at Bretton Woods until 1971).

With domestic U.S. companies and citizens now subject to the inflationary dollar supply through fractional reserve lending, and a new dollar that even with the best confidence was not as "good as gold" within the U.S. borders, the anticipated effect of higher wages and higher prices was soon to follow. Here is the trap we fashioned for ourselves. The U.S. dollar would easily buy overseas products, as simple math and occasional "confidence reassurances" (by testing the success of convertibility) proved that to be paid $35 was truly to be paid one ounce of gold. Foreign goods were then priced accordingly, and imports flowed to American shores in due course as we spent down our national gold savings. And what of our balance of trade...the exports?

Domestically, with higher wages and prices reflecting a paper dollar rather than a gold dollar, American goods were not a bargain to foreign shoppers. The dollar itself (gold) was the best deal they could get from America in exchange for their own goods, and this money would then be used to shop where a gold dollar was properly held in value...anywhere but America! U.S. imports rose and exports fell against each other until the risk of gold exhaustion caused President Nixon to end international convertibility in 1971. This was essentially a world-scale replay of the 1933 Roosevelt action for the same reason...too many claims had been created on the gold money, and when the confidence for convertibility eroded to bring about a "bank run", the paper system failed to continue in its former manifestation. In the 1930's, gold was made available only outside the U.S. and the paper "price" rose from $20.67 to $35...a 70% increase. In 1971, the paper currencies lost their attachment to real money everywhere else in the world, and gold found a paper "price" in the many hundreds. So ended a time period of a fixed notion of a dollar's value.

Today, the international need for long-term reliable money still exists. Only gold can play that role to satisfaction. Speculators aside, the paper gold trade (as largely explained in Aristotle's work) has functioned as a much needed currency of gold in a fashion very similar to that just described for the dollar during the Roaring Twenties...albeit with a floating dollar attachment rather than a fixed one. The paper gold is received and held as a contract that specifies a right to gold delivery, perhaps some as a lump sum, perhaps as installments. (Contracts can be written so many ways!) The key parallel, and purpose of this post is to show you that this works only as long as confidence is retained, and that excessive issues of claims has not jeopardized the real ability to get gold without being the one left holding the bag of paper gold when the bottom drops out.

These various gold contracts have been a temporary patch in the monetary system, filling a niche in the economic environment of the world. You see why the dollar failed in 1933...too many claims issued on the available gold. You see why the "new dollar" failed in 1971...too many claims issued on the available gold. You see why the "new patchwork currency" of paper gold contracts will fail in due course...too many claims issued on the available gold. The caution is that more is in jeopardy than only the viability of this paper gold system. The dollar stands to fall with it as the excess paper side is firmly attached to dollars. In the 1920's, you might run to the bank with your "paper side of the deal", and the bank would be expected to make the contract "whole" by honoring the gold side or else it would FAIL trying--with no where else to turn. The parallel in today's system is that you might run to your contract writer (bullion bank) with your "paper side of the deal", and when the bank cannot itself produce the gold to settle the claim, it will have no choice but to turn to the spot gold market (if central banks will not stand for the clearing of gold reserves--such as the U.S. would not in 1971!) to buy gold with dollars, or else FAIL the dollar and themselves in the attempt.

Look for signs of lost confidence in the paper gold system to read the road ahead. Abnormally high lease rates on borrowed gold. The Bank of England, in the backyard of the LBMA, is selling much of its preciously small gold reserves into the hands of this same LBMA. The BoE has been the primary agent to push for IMF sales of gold. LBMA average daily turnover has been slowing, (to be taken as a sign of failing support of this paper system perhaps?) The ECB has called for a halt to gold lending activity among the euro system of member banks. This aggravates the fractional reserve system that depends on new loans to out pace loan repayments to the extent not provided by dishoarding and new production. And on those accounts, Y2K and low prices have brought record bullion sales, and these same low prices have brought failing mine production through shutdowns and curbed exploration. The warning signs are plentiful. When this paper system collapses, the gold metal that always remains will inherit the value currently spread thin throughout the expansive paper system.


Now I am aware of some relatively new and modern monetary theories that claim our system is no longer a fractional reserve system at all. Fine, but let's at least agree on some truths. Ever since gold was removed from the modern banking system and "bank credit money" system, the system has operated such that "private bank credit money" is a derivative of fractionally reserved "central bank credit money". CB credit money being the monetary base, physical cash plus reserves held at the Fed.

Whether or not the actual fraction is controlled or regulated is irrelevant to the fact that a fraction exists. It may not be 10%. It may not even be 1%. It may not even have the least bit of constraining function anymore. But there does exist, at any given time, a fraction at which "commercial bank liabilities" circulating in the economy relate to base money or Central Bank liabilities. And it is these Central Bank liabilities that settle imbalances between private banks when clearing their circulating liabilities, the role previously held by gold.

Some of you know exactly what I'm talking about and others, I'm sure, are a little bit lost at this point. But don't pause if you are lost. It will make sense in a moment.


Physical gold, like physical dollars within the "private bank credit money" system, is also fractionally reserved within the gold banking system... what we like to call "paper gold". This in and of itself is not necessarily bad or dangerous. But there is still disagreement as to whether this "paper gold" system is fractional at 100:1... or at 10:1, to wit this post from Bron Suchecki at his Gold Chat Blog:

London unallocated: Fractional Fubar or Benevolent Banking?

A number of readers of my blog have asked me to comment on the 100:1 comment by Mr Christian of CPM Group in his CFTC testimony and whether London unallocated metal accounts are fractional. Well short answer is no, they are only 10:1 fractional. Do you feel much better now?

The 10:1 statement was made by Mr Christian in a April 10 interview with Jim Puplava of Financial Sense. Mr Christian is interviewed at the 26 minute mark and explains his 100:1 statement at the 36 minute mark. However, it is the comments at the 44 minute mark that are most illuminating, which I have transcribed below:

If you are a bank in the United States and you take in a deposit the office of the controller of the currency says you have a reserve requirement of 12.5% or something which means that for every dollar you take in deposits you can lend out 8 and that's how the money in banking 101 works.

Now if you're a bank in the United States and you take in gold and silver deposits not on an allocated basis but on an unallocated basis the same way you take in dollars when you put them in – when people put money into a savings account or a chequing account that's an unallocated account and the bank is allowed to lend it out. If they put the money in their safety deposit box that money belongs to the investor and the bank can't lend it, the bank can't hypothecate it, it stays there, and it means nothing to the money in circulation.

In the gold market if you put your gold and silver in a safety deposit box or an allocated account the bank can't touch it legally but if you put it in an unallocated account that is now an asset on the bank's book, they have a liability to give it to you if you ever want it back but in the meantime they can lend it out. Now if you give the bank in the United states money the law, the office of the controller of the currency says the bank can lend it out 8 times. If you give it gold and silver the office of the controller of the currency says the bank can lend it out in a “prudent fashion” and the bank has the discretion to decide what's a prudent multiple for its credit lending. Most of the banks I know, commercial banks, 8, 10, maybe 12 as a leverage factor.

AIG was not a bank, was not a commercial bank, and under the US laws non-commercial banks don't come under the law, the guidance of the office of the controller of the currency. AIG used a leverage factor of 40, so if people gave them a million ounces of gold to hold for them, they could lend out 40. I mean, I have friends who are metals traders who were looking for job years ago and, you know, they went to AIG and AIG said “we use a leverage factor of 40” and the trader is a seasoned guy and he's worked at major banks and investment banks, he said “I can't operate at that level of leverage its just too risky more me” and AIG trading said “well this is what we do”, right, so there is a loophole in our regulatory system, its doesn't really have anything to do with gold and silver per se but it allows non-banks to participate in banking activities in a way that skirts banking regulations that are designed to promote stability in the banking system.

In the interview, Mr Christian recommended that listeners go to the CPM Group website where there was a free download Bullion Banking Explained. I took him up on the offer. Below are some extracts that fill out his statements above.

This article may help to clarify the complex world of commodity banking, in which gold, silver, and other commodities are treated as assets, collateralized and traded against. When we explain these processes to clients, we often refer to the same mechanics as they are applied to deposits, loans, and assets by commercial banks in U.S. dollars and other currencies. Banks treat their metal deposits in much the same way as they do deposits denominated in money, as the reserve asset against which they lend additional money to borrowers. ...

Many banks use factor loadings of 5 to 10 for their gold and silver, meaning that they will loan or sell 5 to 10 times as much metal as they have either purchased or committed to buy. One dealer we know uses a leverage factor of 40. (Long Term Capital Management had a leverage factor of 100 when it nearly collapsed in 1998.)

A bank does not even have to be buying gold at a particular time to be able to use it as collateral against which it can trade, sell forward, and lend gold. If a bank has gold held in an unallocated account, or a forward purchase on its books committing a producer to sell it gold later, it can use these gold assets as collateral for additional gold trades.

Is London unallocated fractional fubar or just benevolent banking? Maybe this statement by Mr Christian in a presentation to the International Cotton Advisory Council in October 2002 will help you decide:

A producer should use an advisor such as CPM Group, which is not trading against the producer. Banks and dealers have a conflict of interest between their own trading positions and the hedges they advise their clients to take.

Or maybe Recent Lessons Learned About Hedging (January 2000):

Hedgers should not rely on their trading counterparts for hedging strategies. These entities take the opposite side of the hedge transactions, have inherent conflicts of interest, and always keep their own best interests in mind, even if these are the short-term best interests and arguably not in the banks’ own long term best interests.
________________________________________________________


You see, when a Bullion Bank issues new paper gold, what we like to call a "naked short", it is constraining itself by making sure it has at least 10% reserves, according to Mr. Christian, in case someone decides to take delivery. Now in the case of a commercial bank, 10% reserves of physical cash may not be such a problem during a modern bank run because new cash can be printed relatively quickly. But with gold this is not the case. So even at 10% reserves, any bank run on the Bullion Banks would be a disaster.

But the real problem comes from what these Bullion Banks consider reserves. You and I obviously realize that the only reserves that will suffice in a bank run are actual physical pieces of gold. But these banks are presently relying on certain "paper gold" items as their "physical reserves".

During the CFTC hearing Mr. Christian admitted that the CPM group uses the term "physical" in a very loose way. That "physical" actually means paper claims and physical combined. So these Bullion Banks are holding paper liabilities from other Bullion Banks and mining operations and calling them "physical reserves". Very circular, don't you think?

So under this loose definition of "physical gold", perhaps Mr. Christian was not lying. Perhaps the banks do constrain their naked shorting with at least 10% paper longs from "credible sources". And if so, I would guess that those credible sources also have 10% "reserves" behind their paper. And so on, and so forth.

Well, I hope you can clearly see the problem here. When the bank run finally begins people and entities will want real physical gold, not paper longs, or liabilities from credible sources.

It all comes down to gold, the actual physical stuff. That's what the people wanted during the bank runs of the 1930's. It is what brought down the London Gold Pool. It is what forced the closing of the Nixon gold window. And it will be what people want this time too. That's the real bank run... to actual physical gold in your own possession.

Think back to Exter's pyramid, and how demand collapses downward during a crisis. Think about "commercial bank credit money" as being higher on the pyramid than FRNs, actual physical cash. This is true. As we collapse downward to gold the banks themselves will shun each other's credit receipts in favor of central bank liabilities.

This is where all those excess reserves held at the Fed will finally come into play.


Not through economic lending, but through interbank clearing preference, as the banks first try to jettison each other's "digits" as fast as possible. Once the bank run on physical gold begins, these banks are going to be very nervous about holding each other's liabilities, even over night. They will only "sleep well" holding Central Bank liabilities.

This is how the transition from plastic to wheelbarrow begins. We may not see a bank run on Fed cash by the people before we see it within the banks themselves, as interbank faith vaporizes during the run on gold.

By this time, the bond will be gone. As the people are running on the Bullion Banks the Fed is going to be very busy monetizing the entirety of US federal spending, from Social Security to Medicare, national defense and even Nancy Pelosi's entourage's per diem. It will all have to be monetized. Meanwhile the Fed will have to keep its remaining banks happy with Fed liabilities to clear the private liabilities, or else they will cease to circulate. Printing dollars and buying up private equity so that each bank only has to hold Fed liabilities.

And as the US Government starts spending its fresh new Fed credit, the Fed will have to supply the banks receiving those trillions in USG payment transfers fresh cash to back the massive inflow of new Fed liabilities.

You see, this is what hyperinflation is all about. It is about not only demand collapsing down the pyramid, but the system itself also collapses down a pyramid, from modern monetary theory on down to Austrian monetary theory. What seems antiquated in today's digital age still lies dormant beneath the surface, just waiting to emerge with a vengeance.

Our physical world didn't change just because we invented the 1971 purely symbolic fiat dollar or the fictional reserve banking system. These were merely derivative layers atop an inverse pyramid no different than CDS or IRS, and just as fragile in times of systemic collapse.


Alternatives?

Jim Rickards gave another fantastic interview with King World News this week. Here's the link...

Jim Rickards interview on KWN

In it he makes a very convincing argument for the US dollar to return to a gold standard, backed by the physical gold the US still owns. He explains that the remaining US gold hoard, assuming it is not encumbered and/or swapped for paper longs from "credible sources", mining operations or Germany, is enough at present market values to back the M1 monetary measurement at a 20% fractional reserve (5:1).

And furthermore, that a full 1:1 backing of the M1 would restore the credibility of the $-global reserve currency so that the US could resume rolling over its insurmountable debt until it finally reaches infinity. And that this 1:1 backing of M1 would require only a 5-fold increase in price, to say $5,500/ounce or so.

Now I do agree with Jim that full backing is not necessary under normal circumstances, but that it would be necessary in order to repair severely damaged credibility. I am not one of the "hard shell gold standard people", but instead, I look for what actually can work, and what will happen.

The first problem that struck me with this idea of repairing US credit with a gold revaluation was the use of M1 as the measuring stick of dollars in existence. Again, this could work under normal circumstances, but most of the world's perceived wealth held in dollars is not in M1 holdings. And in the case of credit reparation, I intuit that M3 would be the bare minimum starting point. And to his credit, Jim points out that a mere $20,000/ounce would take care of this concern.

But this is not the big problem I see with this plan. The biggest problem is what stands in the way of this controlled revaluation. And that is the paper gold market that is already fractionally reserved at 100:1 if we define reserves strictly as physical gold in immediate possession.

A Fed revaluation of gold is different than Freegold because it aims to control the revaluation and set a new fixed parity. As nice as this sounds to those of us with some gold, it will always be unsustainable and in the case of today's gold market, is completely impossible without wiping out all of Wall Street and the dollar in the process.

Don't get me wrong. I'm not saying that NOT doing it will save Wall Street and the dollar. I am simply saying that this Catch-22, no-win situation the dollar finds itself in just doesn't have an out as easy as this.

Here's what would happen if the Fed tried this tomorrow: For those that own gold today, gold would suddenly become their most prized possession. And all of those paper gold holders would suddenly start thinking about what we have been saying for 12 years now. There would be a run on the Bullion Banks and the scramble to find physical gold and stay alive would drive its price well above $5,500 or even $20,000/ounce, driving the dollar and the Fed/US credibility into the dirt simultaneously.

Or the Bullion Banks would be backstopped by the Fed and delivery made in paper currency at the new price. Again, people would start to take seriously what we and so many others have been saying and at least some would decide, just to be on the safe side, to turn that paper money into physical.

And just imagine, paper delivery being needed even at $5,500 or $20,000 per ounce would destroy the new image the Fed was trying to establish of 1:1 gold backing. How is that going to help the crippled US credit rating in its resumption of debt rollover?

Jesse suggests it is more likely the US will issue a new dollar, let's call it an "Amero" for lack of a better name, at 100:1 parity with the old dollar. This is certainly possible. Every fiat currency in all of history has had "an unknown expiration date" as Aragorn III put it above.

The point of doing something like this would be to keep some things at nominal parity while devaluing others 100x. Obviously the debt would be devalued, otherwise what would be the point? And this would include the savings of those who held debt. Of course it would give the government the power to pick and choose who and what suffered the devaluation, printing new currency for a few special friends.

But again, the biggest problem with a scheme like this is the paper gold market, presently leveraged 100:1 under a strict physical perspective. One would assume a reset of gold at 100x the current price in old dollars if this was attempted. In other words, gold would still be $1,150 in new Ameros, while a debt of 100 old dollars is now only $1 (new Amero). So what happens to a debt denominated in gold instead of dollars?

A Bullion Bank that is short an ounce of gold before the reset owes the equivalent of $1,150 old dollars. After the reset it owes the equivalent of $1,150 Ameros. At 100:1 old dollar:Amero exchange that is $115,000 old dollars, for one ounce of gold. So while debt in dollars drops by a factor of 100, debt in gold does the exact opposite, it RISES 100x! Buh bye Wall Street... buh bye reserve status... buh bye USG credibility.

The bottom line is that any debt denominated in gold must be unwound BEFORE the Fed or the USG even THINK about something like this. Otherwise it is "advance to Freegold and collect wealth transfer as you pass Go". And to unwind the paper gold market today means exactly "advance to Freegold and collect wealth transfer as you pass Go". The only alternative, pretend and extent, what the Fed is doing right now, means only one thing...... wait for it...
"Advance to Freegold and collect wealth transfer as you pass Go".


This is The 21st Century Bank Run! It is a run on the gold banks, which is a run on Wall Street (because they are the bullion banks), which is a run on the entire $IMFS and on the dollar itself in the end. And for those of you inside the US, this will be the second best thing that ever happened to America, because it will kill the long march toward socialism dead in its tracks. Just be sure to protect your own wealth so that you can be part of the rebuilding effort.

Sincerely,
FOFOA