Quote of the Day: How Fractional Reserve Banking System Causes Bank Runs

Economist Tim Worstall writing at the Forbes eloquently explains how the central bank- fractional reserve banking system causes bank runs and originated the 2008 crisis or the Great Financial Crisis

To explain this we need to take a step backwards: we can usefully, if not wholly accurately, divide investors into two types. Those who invest with their own money, those who are unleveraged, and those who invest with borrowed money, the leveraged investors. Further, among the leveraged investors we would want to distinguish between the banks who are doing this (at least, in a fractional reserve banking system we want to) and the others. And the danger comes when those banks, those people working with the deposits made into the banks, invest in either illiquid or volatile assets.

Liquidity is a problem because those depositors can come along at any time and ask for their money back. And banks borrow short and lend long: the things they invest in are notably more illiquid than the deposits they take to finance them. That’s how we get bank runs: people turn up for their money, the bank says that actually, they lent it to someone to buy a house, and then panic starts and everyone wants their money back right now.

Volatility is a problem because they’re using leverage: if prices move so much that the bank loses its capital then it still owes the same amount to depositors but it is also bust. Cue bank run again. What happened to Lehman Brothers was this second, what rocked the other Wall Street banks was the first.

Bottom line: liquidity and volatility problems are mainly symptoms of imbalances from highly leveraged systems brought about by the central bank fractional reserve banking. 

Bulgaria’s Bank Runs: The Europe Commission Rides to the Rescue

With stock markets on a bullish shindig, the idea of financial instability has almost been out of the picture. But wait, one of Europe’s poorest countries just suffered TWO bank runs on "two of the country's biggest lenders" that has prompted the European Commission (EC) to ride to the rescue. 

From the Financial Times:

Bulgaria’s banking system appeared to be stabilising late on Monday after the EU approved a Lev3.3bn (€1.7bn) emergency credit line from the central bank, following runs on two of the country’s biggest lenders in a week.

The public as scapegoats…

The Bulgarian National Bank had warned on Friday of an “attempt to destabilise the state through an organised attack against Bulgarian banks”, as Bulgarians withdrew Lev800m from branches of First Investment Bank, the country’s third-biggest lender.

Those withdrawals came just days after a run on Corporate Commercial Bank, the country’s fourth largest bank.

Six people were arrested over the weekend, accused of sending electronic warnings that FIB was about to collapse; two were indicted on Monday for spreading false information on banks.

Oops, but there is a political dimension… (bold mine)

Rosen Plevneliev, Bulgaria’s president, also announced late on Sunday that after talks with party leaders he would dissolve parliament by July 25 and then name a caretaker administration, ahead of early elections called for October 5. That move helped ease political uncertainty that had fuelled the crisis…

Despite strong fiscal management and a stable exchange rate backed by a currency board arrangement pegging the lev to the euro, Bulgaria is criticised by EU partners for weak governance resulting from close ties between business, politicians and the judiciary.

Corpbank reportedly will be nationalized.

Why would a truly sound banking system be subject to destabilization by merely false information?

The dean of the Austrian school of economics Murray N. Rothbard explains

The answer lies in the nature of our banking system, in the fact that both commercial banks and thrift banks (mutual-savings and savings-and-loan) have been systematically engaging in fractional-reserve banking: that is, they have far less cash on hand than there are demand claims to cash outstanding...

This means that the depositor who thinks he has $10,000 in a bank is misled; in a proportionate sense, there is only, say, $1,000 or less there. And yet, both the checking depositor and the savings depositor think that they can withdraw their money at any time on demand. Obviously, such a system, which is considered fraud when practiced by other businesses, rests on a confidence trick: that is, it can only work so long as the bulk of depositors do not catch on to the scare and try to get their money out. The confidence is essential, and also misguided.

So all it takes is for political uncertainty to surface to expose on the shroud of tenuous confidence from a fractional banking system which has been blamed on to the public.

The bailout means resources from European taxpayers will be used as subsidy to Bulgarian banks.

Yet with almost every nation engaged in their homegrown variety of bubbles, it is just a wonder what would happen if today’s colossal imbalances unravels? Will there be massive bank runs in many countries simultaneously? If so, does the respective governments have resources to bail them out? If not, will multilateral institutions also have resources for these rescues? Or will there be a massive recourse to save banks via deposit levies?

Kazakhstan’s Devaluation Triggers Bank Runs

A few days back I wrote about Kazakhstan’s surprisingly huge devaluation despite what mainstream would see as strong statistical data. 

As one would realize, Kazakhstan’s dilemma has not been revealed by the current and trade balances but on her currency tenga, forex reserves, external debt and importantly M3. And another thing, given the 19% devaluation, this shows that the alleged low inflation figures have also been patently inaccurate.

Well my suspicion seems right, the devaluation exposed on Kazakhstan’s debt problems via a run on three banks

From EuroAsianet.org

Kazakhstan’s central bank is appealing for calm as rumors that some financial institutions are in trouble following last week’s currency devaluation have provoked a run on three banks.

On February 19 the National Bank sent text messages to the public urging people to disregard the “false information” and not succumb to panic.

“All Kazakhstani banks have sufficient funds in national and foreign currency,” the messages read; people should not submit to “provocations” and “keep calm.”

Large queues formed at some banks in the financial capital, Almaty, for a second day on February 19 as customers rush to withdraw funds, fearing a bank collapse.

Media and officials blame it on rumors.

But logic tells us that if the banking system stands on a firm ground then they wouldn’t be vulnerable to rumors. 

The reason banks are prone to runs aside from Kazakhstan’s existing debt problems has been the roots of the monetary system: central bank fractional reserve banking standard.

"The answer lies in the nature of our banking system", writes the great dean of Austrian economics Murray N. Rothbard, that’s because “they have far less cash on hand than there are demand claims to cash outstanding.”

Professor Rothbard further explains:

This means that the depositor who thinks he has $10,000 in a bank is misled; in a proportionate sense, there is only, say, $1,000 or less there. And yet, both the checking depositor and the savings depositor think that they can withdraw their money at any time on demand. Obviously, such a system, which is considered fraud when practiced by other businesses, rests on a confidence trick: that is, it can only work so long as the bulk of depositors do not catch on to the scare and try to get their money out. The confidence is essential, and also misguided. That is why once the public catches on, and bank runs begin, they are irresistible and cannot be stopped.

Given the recent bank run Thailand, it has been interesting to see what seems as increasing frequency of bank runs in emerging markets or failing financial institutions such as in China.

More signs that emerging markets could be the modern day version of "subprime". 

We live in very interesting times

Signs of Emerging Bank Runs?

One can sense trouble when banks impose limits on depositors withdrawal (or even ask depositors reasons why the have to withdraw large amounts of their own money) as with the recent case of HSBC.

More from Simon Black of the Sovereign Man.

It’s happening again. This time HSBC branches in the UK are putting limits on customer withdrawals.

Bank employees there have been telling customers that they first must demonstrate to the bank’s satisfaction WHY they want to withdraw their own money. The bank has simply decided in its sole discretion that it won’t give people their own money back.

This is positively revolting– a breach of a most sacred form of trust between a bank and its customers. It would have been unthinkable just 10-years ago. But today it’s par for the course.

Banks across most of the ‘developed’ world have razor thin liquidity and capitalization ratios—meaning that their margins of safety are extremely low.

If just a small percentage of their assets lose value, they’ll go under. Or, if just a small percentage of their customers want their deposits back, they won’t be able to pay up.

This is ultimately what’s happening to HSBC. It turns out their UK operations are in severe financial trouble, posting a major capital shortfall of over $100 billion.

This should come as no surprise. Less than a year ago, in response to how poorly capitalized British banks were, the banking regulators announced that it would allow banks to use creative accounting to boost their numbers.

In one method that was explicitly condoned by regulators, banks were authorized to count FUTURE earnings (i.e. profit that they may or may not earn in years to come) towards their capital TODAY.

It’s like calculating your net worth based on how much you -think- you might be earning 20-years from now.

This is fraud, plain and simple. And I wrote about this numerous times last year.

Of course HSBC is not alone. With few exceptions, most banks across Europe are in a similarly precarious position– highly illiquid and thinly capitalized.

This isn’t rocket science– it’s what broke banks do. We saw what happened in Cyprus last year when banks got “bailed-in” by their customers.

Read the rest here

In a world of central banking fractional banking system, only a fraction of reserves are held by banks to service depositor’s demand for cash. 

If or when there will be a surge of (simultaneous) withdrawals, banks with insufficient funds either resort to imposing limits or turn to their respective central banks for assistance. If the public senses the latter then this would only aggravate public’s demand to access their deposits. This happened to UK's Northern Rock in 2008 which led to the firm's bankruptcy and eventually was nationalized. 

HSBC’s actions, thus, reveal of possible signs of renewed banking distress via a “quasi” bank run.

Yet the common notion that depositors own or has full access to their money deposited with banks are mistaken. As economics Professor David Howden explains at the Mises Blog

Option clauses, for example, were widely used in the Scottish “free banking” era as a way to get depositors to stop asking for their money. A bank could elect not to hand over a deposit when asked, but would at least remunerate the customer for this inconvenience. At the time this was widely seen as problematic, as it drove a wedge between the motivations of depositors (have their cash safe and available) and bankers (use depositor funds and remain solvent).

Today’s banks don’t even do this – they just change the rules of the game half-way through. Depositors think they have full access to their money when they make a deposit. Not only that, they think they are the owners of their money. Wrong on both counts. According to the law of most lands, when you deposit your money in a bank it becomes property of the bank

(bold mine)

More signs of periphery to core dynamics?

Quote of the Day: The Whole Banking Business is Corrupt

The whole banking business is corrupt from top to bottom today. Part of the problem is that banks are no longer financed by the individuals who start them, putting their personal net worth on the line. Now, they are all publicly traded entities – just like all brokerages – playing with Other People's Money. Management has no incentive to do anything but pad their wallets, so they pay themselves gigantic salaries and bonuses, and give themselves options. These people aren't shepherding their money and that of clients they know personally. They've got zero skin in the game. 

This is true all over the world, not just in the US and Europe. All these banks are going to blow up, and not just in far-off, little countries.

This quote is from investing guru and philosopher Doug Casey at his eponymous website Casey Research 

Quote of the Day: The Roots of the Too Big To Fail Doctrine

For fractional reserve banking can only exist for as long as the depositors have complete confidence that regardless of the financial woes that befall the bank entrusted with their “deposits,” they will always be able to withdraw them on demand at par in currency, the ultimate cash of any banking system. Ever since World War Two governmental deposit insurance, backed up by the money-creating powers of the central bank, was seen as the unshakable guarantee that warranted such confidence. In effect, fractional-reserve banking was perceived as 100-percent banking by depositors, who acted as if their money was always “in the bank” thanks to the ability of central banks to conjure up money out of thin air (or in cyberspace). Perversely the various crises involving fractional-reserve banking that struck time and again since the late 1980s only reinforced this belief among depositors, because troubled banks and thrift institutions were always bailed out with alacrity–especially the largest and least stable. Thus arose the “too-big-to-fail doctrine.” Under this doctrine, uninsured bank depositors and bondholders were generally made whole when large banks failed, because it was widely understood that the confidence in the entire banking system was a frail and evanescent thing that would break and completely dissipate as a result of the failure of even a single large institution.

(italics original) 

This is from Austrian economics professor Joseph Salerno at the Mises blog

Central Bank Fractional Banking System: Bank Runs or Inflation

The incumbent central bank fractional banking system means a choice between bank runs and price inflation.

The great dean of Austrian school of economics Murray N. Rothbard explained. (bold mine)

1. Why fractional reserve banks are uninsurable

The answer lies in the nature of our banking system, in the fact that both commercial banks and thrift banks (mutual-savings and savings-and-loan) have been systematically engaging in fractional-reserve banking: that is, they have far less cash on hand than there are demand claims to cash outstanding. For commercial banks, the reserve fraction is now about 10 percent; for the thrifts it is far less.

This means that the depositor who thinks he has $10,000 in a bank is misled; in a proportionate sense, there is only, say, $1,000 or less there. And yet, both the checking depositor and the savings depositor think that they can withdraw their money at any time on demand. Obviously, such a system, which is considered fraud when practiced by other businesses, rests on a confidence trick: that is, it can only work so long as the bulk of depositors do not catch on to the scare and try to get their money out. The confidence is essential, and also misguided. That is why once the public catches on, and bank runs begin, they are irresistible and cannot be stopped.

We now see why private enterprise works so badly in the deposit insurance business. For private enterprise only works in a business that is legitimate and useful, where needs are being fulfilled. It is impossible to "insure" a firm, even less so an industry, that is inherently insolvent. Fractional reserve banks, being inherently insolvent, are uninsurable.

2. Money Printing as camouflage. The political choice of inflation over bank runs.

What, then, is the magic potion of the federal government? Why does everyone trust the FDIC and FSLIC even though their reserve ratios are lower than private agencies, and though they too have only a very small fraction of total insured deposits in cash to stem any bank run? The answer is really quite simple: because everyone realizes, and realizes correctly, that only the federal government--and not the states or private firms--can print legal tender dollars. Everyone knows that, in case of a bank run, the U.S. Treasury would simply order the Fed to print enough cash to bail out any depositors who want it. The Fed has the unlimited power to print dollars, and it is this unlimited power to inflate that stands behind the current fractional reserve banking system.

Yes, the FDIC and FSLIC "work," but only because the unlimited monopoly power to print money can "work" to bail out any firm or person on earth. For it was precisely bank runs, as severe as they were that, before 1933, kept the banking system under check, and prevented any substantial amount of inflation.

But now bank runs--at least for the overwhelming majority of banks under federal deposit insurance--are over, and we have been paying and will continue to pay the horrendous price of saving the banks: chronic and unlimited inflation.

The political choice of inflation over bank runs can be seen via the loss of US dollar’s purchasing power.

Since the establishment of the US Federal Reserve in 1913, one US dollar in 1913 has an equivalent of buying power of $23.45 today according to the BLS inflation calculator. This means the US dollar have lost nearly 96% of their purchasing power. Chronic and unlimited inflation indeed.

The other implication is that the choice of inflation over bankruns means a subsidy to banks at society's expense.

 

3. Abolish the central banking system and ancillary regulators. Restore sound money

Putting an end to inflation requires not only the abolition of the Fed but also the abolition of the FDIC and FSLIC. At long last, banks would be treated like any firm in any other industry. In short, if they can't meet their contractual obligations they will be required to go under and liquidate. It would be instructive to see how many banks would survive if the massive governmental props were finally taken away.

Emerging Markets Eye Insurance Against the US Dollar, Euro

Aside from the pledge to assist in the rescue of the EU, key emerging markets led by the BRICs and South Africa discussed insurance options that goes around the US dollar.

From the China Money Report,

The BRICS countries said on Monday that they’re considering setting up a foreign-exchange reserve pool and a currency-swap arrangement as financial problems threaten to spread across the global economy.Leaders of the five-member group —Brazil, Russia, India, China and South Africa— also said BRICS is “willing to make a contribution” to increase the International Monetary Fund’s ability to rescue troubled economies. President Hu Jintao joined his counterparts from other BRICS nations on Monday morning in the Mexican resort city Los Cabos ahead of the start of the G20 Summit.

According to the Chinese Foreign Ministry, the leaders discussed the currency swap and foreign-exchange reserve pool ideas and tasked their finance ministers and central bank chiefs to implement them, according to China’s Foreign Ministry.

Swap arrangements, which allow nations’ central banks to lend to each other money to keep markets liquid, and the pooling of foreign-exchange reserves are contingency measures aimed at containing crises such as the one roiling the eurozone, analysts said.

Zhang Yuyan, director of the Institute of World Economics and Politics affiliated with the Chinese Academy of Social Sciences, said the new mechanisms established by the emerging markets themselves, who “know their current conditions and demands
much better”.

Amid the global economic slowdown, the pooling of foreign-exchange reserves will help BRICS countries to fight the lack of market liquidity, beef up their immunity to financial crises and boost global confidence, Zhang said.

Contributions to this “virtual” bailout fund, as Brazil’s Finance Minister Guido Mantega put it, would be tied to the size of each BRICS member’s currency reserves, he said. The five leaders also discussed BRICS’ participation in replenishing the IMF’s lending capital. Hu said the G20 should encourage and support the eurozone countries’ adoption of fiscal controls and spending cuts as efforts to improve confidence in world markets. The leaders also urged the IMF to carry out promised reforms of its quota and governance systems. Mexico, which was hosting the G20 Summit on Monday and Tuesday, has said it will use the meeting to press the world’s largest economies to increase IMF resources and build the fund’s capacity to intervene in the European debt crisis.

While these may be constitute added signs that much of the world seem to be getting antsy with the unfolding events in the developed economies, swaps and foreign reserve pools won’t do much when the whole paper money system goes into flame.

The reason for this is that much of the world’s banking and financial system remains anchored on fiat currencies of the western world, where the US dollar and the euro constitute 90% of global reserve currencies (see chart from Wikipedia.org).

Besides, the monetary system of emerging markets operates from the same fractional reserve system as their developed peers, which means that like their developed peers, EM politicians will be seduced to used inflationism to achieve political goals.

Instead, what these economies should do would be to ramp on gold acquisition, and possibly consider a quasi-gold standard possibly through a gold based currency board (as proposed by Professor Steve Hanke) or a return to the gold standard or allow for currency competition with the private sector (free banking, free currency competition as proposed by Ron Paul and Professor Lawrence White).

Since any of the proposed monetary reforms would entail restriction in political actions and simultaneously require massive liberalization of respective economies, these won’t likely be palatable with incumbent political agents, who under such circumstances, lose much of their current privileges (Europe’s deepening crisis are manifestations of these).

Thus, it would likely take a deeper crisis (most likely a currency crisis) to force real reforms in the system.

Will the Eurozone’s Deposit Insurance Policies Hasten the Unraveling of the Euro?

The great dean of the Austrian school of economics Professor Murray N. Rothbard once called deposit insurance a swindle. (bold emphasis mine)

The very idea of "deposit insurance" is a swindle; how does one insure an institution (fractional reserve banking) that is inherently insolvent, and which will fall apart whenever the public finally understands the swindle? Suppose that, tomorrow, the American public suddenly became aware of the banking swindle, and went to the banks tomorrow morning, and, in unison, demanded cash. What would happen? The banks would be instantly insolvent, since they could only muster 10 percent of the cash they owe their befuddled customers. Neither would the enormous tax increase needed to bail everyone out be at all palatable. No: the only thing the Fed could do — and this would be in their power — would be to print enough money to pay off all the bank depositors. Unfortunately, in the present state of the banking system, the result would be an immediate plunge into the horrors of hyperinflation.

Current crisis in the Eurozone seems to be partly actualizing what Professor Rothbard warned about: Europeans appear to be awakening from the “swindle” and have intensified demand for cash, which has been putting severe strains on the EU’s fractional reserve banking system.

From Bloomberg, (bold emphasis mine)

The threat of Greece exiting the euro is exposing flaws in how banks and governments protect European depositors’ cash in the event of a run.

National deposit-insurance programs, strengthened by the European Union in 2009 to guarantee at least 100,000 euros ($125,000), leave savers at risk of losses if a country leaves the euro and its currency is redenominated. The funds in some nations also have been depleted after they were used to help bail out struggling lenders, leading policy makers to consider implementing an EU-wide protection plan.

“These schemes were not designed to deal with a complete meltdown of a banking system,” said Andrew Campbell, professor of international banking and finance law at the University of Leeds in the U.K. and an adviser to the International Association of Deposit Insurers. “If there’s a systemic failure, there needs to be some form of intervention.”

With European officials openly discussing a Greek exit from the euro for the first time, savers in Spain, Italy and Portugal may start to withdraw cash on concern that those countries will follow Greece and their funds will be devalued with a switch to a successor currency. None of those nations has the firepower to handle simultaneous runs on multiple banks.

Pulling Deposits

Households and businesses pulled 34 billion euros from Greek banks in the 12 months ended in March, 17 percent of the country’s total, according to the ECB.

Deposits at banks in Greece, Ireland, Italy, Portugal and Spain fell by 80.6 billion euros, or 3.2 percent from the end of 2010 through the end of March, ECB data show. German and French banks increased deposits by 217.4 billion euros, or 6.3 percent, in the same period. Bank-deposit data for April will be released starting this week.

Using the Argentina crisis as precedent…

Savers pulled 27 percent of deposits from Argentina’s banks between 2000 and 2003 during a currency crisis, Nedialkov wrote. If Ireland, Italy, Portugal and Spain follow a similar pattern, about 340 billion euros could be withdrawn, he estimated.

Companies have already started to remove cash from southern Europe as soon as they earn it. Many already are sweeping funds daily out of banks in those countries and depositing it overnight with firms in the U.K. and northern Europe, according to David Manson, head of liquidity management at Barclays Plc in London, who advises company treasurers.

If the scale of bank run escalates, will the ECB, then, resort to massive inflationism to the point of hyperinflation just to rescue their banks??

Reasons Why The US Could Play A Major Role In Greece's Bailout

In last week's report Why The Greece Episode Means More Inflationism, we conjectured that perhaps the US taxpayers could play a tacit role in the Eurozone's efforts to bailout Greece.

Then came recent news reports which revealed that Wall Street seem to have had lent a hand in the shielding of Greece's liabilities via the use of currency swaps since Greece joined the EU.

According to the New York Times, ``In 2001, just after Greece was admitted to Europe’s monetary union, Goldman helped the government quietly borrow billions, people familiar with the transaction said. That deal, hidden from public view because it was treated as a currency trade rather than a loan, helped Athens to meet Europe’s deficit rules while continuing to spend beyond its means."

David Kotok of Cumberland Advisors suspects that perhaps there is more than meets the eye, (bold highlights mine)

``It appears that Greece clandestinely attempted to use currency swaps as a deferral technique to project their payment obligations into the future and to hide them. Greek officials claim to the contrary; they say the transactions were reported. But an initial scan of the reports that were used in the early part of this decade does not find them. Hmmmm?

``Let’s make this clearer for readers: the use of this type of swap accomplishes the movement of debt off the balance sheet and into the currency balances. There can be legitimate economic reasons for this type of transaction as an offset to trade flows. And the same transaction can be used for outright deception if the user wants to hide a rising debt ratio.

``Now an investigation is underway by Europe’s statistical office, Eurostat. News reports have also been confirmed that Greece has a history of using this allegedly deceptive technique in the past. We now know it was done in 2001 and was contemporaneous with other actions that Greece was taking so it could become the twelfth member of the Eurozone.

``It also appears that these transactions were arranged through Goldman Sachs and that subsequently GS hedged its position to a neutral one by shorting or constructively shorting Greek debt. Did Goldman act improperly? That now also is a subject of debate. Investigations are certainly coming. Witch-hunting about Goldman Sachs and their book of derivatives is very popular these days. We expect to see more of it on both sides of the Atlantic Ocean.

``There will be much EU political outcry about this transaction which currently is measured at 1 billion euro. The key question for markets revolves around whether or not this is a single event or if there are more such transactions that will be revealed in the books of Greece or other EU member states."

Based on the above, there could be three reasons that would prompt for the US via the US Federal Reserve to intervene:

one, Wall Street has more exposure (perhaps indirectly) to the Greek (PIIGS) than is publicly known or declared and

two, there could be official efforts to cover the tracks of Wall Street's subterfuge.

three, to ensure the US dollar hegemony (by ensuring the survival of Wall Street who serve prime agents of the Federal Reserve and their alternate egos in Europe)

Congressman Ron Paul raised the same concerns; (bold highlights mine)

``Is it possible that our Federal Reserve has had some hand in bailing out Greece? The fact is, we don’t know, and current laws exempt agreements between the Fed and foreign central banks from disclosure or audit.

``Greece is only the latest in a series of countries that have faced this type of crisis in recent memory. Not too long ago the same types of fears were mounting about Dubai, and before that, Iceland. Several other countries (Spain, Portugal, Ireland, Latvia) are approaching crisis levels with public debt as well. Many have strong ties to Goldman Sachs and the case could easily be made that default could have serious implications for big US banking cartels. Considering the ties between the Fed and these big banks, it is not outlandish to wonder if the US taxpayer is secretly bailing out the entire world, country by country, even as our real unemployment tops 20 percent...

``This global financial crisis is a predictable result of secretive central banking and unsound fiat currency. Governments are entirely committed to this system of fiat money and fractional reserve banking for obvious reasons: it enables them to do what they love most, namely, spend hoards of money with near impunity. Without the limitations of sound money, governments will spend without limit. They will spend money to hire their cronies, pay off special interests, give out favors, create dependence and generally distract from the terrible job they do at their chief mandate, which is to protect the liberties of the people. Fiat money is a blank check to government, which is very dangerous, and we are witnessing the death throes of the system as the bills come due and the underlying capital is squandered away."

The ramifications of which appear to be headed in the direction of our much feared 'Mises Moment'.

Nassim Taleb 'The Risk Maverick': We May Be Experiencing Something That Is Vastly Worst

This insightful PBS News Hour Interview with great thinkers in Nassim Nicolas Taleb (author of Black Swan: The Impact of the Highly Improbable) and Fooled by Randomness and Benoit Mandelbrot (The (Mis)Behavior of Markets)







Some noteworthy quotes from the interview:

From Nassim Taleb:

"The banking system the way we have it is a monstrous giant built on feet of clay and that topples we’re gone. Never in the history of the world have faced so much complexity combined with so much incompetence and understanding its properties.

"We live in a world that is way too complicated for our traditional economic structure it’s not as resilient as it used to be we don’t have slack it is over optimized."

"Let me tell you what is happening in the ecology of the banking system, there is swelling of large banks because it vastly more optimal to have one large bank than ten small banks. It’s more efficient. And that consolidation is putting us at risk because when one large bank makes a mistake, it’s ten times worst than a small bank making a mistake."

"I think we may be experiencing something that is vastly worst than we think it is."

"The network effect of globalization means that a shock in the system can have much larger consequences."

From Benoit Mandelbrot:

"The word turbulence is one which is actually common to physics, social sciences to economics, everything about turbulence is enormously complicated not just a little bit complicated not just one year more school it’s enormously complicated.

"The basis of weather forecasting is looking from the satellite and seeing the storm coming but not predicting that the storm will form...the behavior of economic phenomenon is far more complicated than the behavior of liquid and gasses."

"Tools have been developed which assume changes are always very small,...then nothing bad happens, if several of them come together bad things can happen and the theory does not take account of that. And the theory does not take account of very large and sudden changes in anything, the theory thinks that things move slowly gradually and can be corrected when in fact they may change extremely brutally."

My comment: Both Mr. Taleb and Mr. Mandelbrot seems to be worrying about the US dollar based global banking system which is getting to be "too big to fail".

With the US government's increasing influence in the consolidation of the banking sector, directly and indirectly, where deal making has surpassed $3 trillion, such risk concerns may not be exaggerated.

Courtesy of Wall Street Journal/dealogic

Could Mr. Taleb be referring to our Mises moment?

It’s a Banking Meltdown More Than A Stock Market Collapse!

``The argument that the government is somehow pumping new capital into the market is absurd. Government is actually borrowing the money from the capital markets that it is in turn injecting into the capital markets. There is no additional source of funding; there is only a diversion of funds from more-productive outlets to less-productive outlets, with government acting as the middleman.” -Scott A. Kjar, University of Dallas, Henry Hazlitt on the Bailout

It’s amusing how many people believe that today’s financial crisis is just a “headline” material. They carry this notion that the meltdown seen in the stock market are just confined to within the industry. They believe in media’s assertion that these are all about just banking related losses and perhaps a prospective recession. Yet, importantly governments will successfully come to the rescue. And that banking deposits will be safeguarded by sanctity of government guarantees. We hope that such smugness is correct and don’t turn out to be chimerical.

From our side, the current global stock market meltdown is like utilizing a thermometer to a gauge the body temperature of a patient. From which the mercury’s position indicates of the degree of normality or abnormality in the patient’s temperature than of its cause. Hence, the thermometer signifies as the medium and the mercury’s position the message. In the stock market we see the same message See Figure 1.

Figure 1: Mercury Indicator: Stock Market Meltdown or Banking System Meltdown?

The Performance chart from stockcharts.com shows that since the whole bubble bust cycle episode unraveled, the losses of world equity markets have been far less than the damage suffered by the housing and the entire swath of financial and banking sector.

True, everyone directly or indirectly involved in the financial sector seems to be afflicted. But some are suffering more than the others. This means that like the thermometer, the public’s attention have been on inordinately transfixed to the freefall in global equities but have glossed over the significance of the ongoing risk dynamics in the US financial sector.

From our point of view, the stock market “meltdown” has been a symptom of a deeper underlying disease: the risks of a US banking sector collapse. And this is not just about your typical banking losses, but a representation of the real risks of a total freeze of the entire global banking network system as we discussed in Has The Global Banking Stress Been a Manifestation of Declining Confidence In The Paper Money System?

As had been pointed out, the US dollar standard monetary system has been anchored upon a global banking system from which operates on a fractional reserve banking platform from where the entire global banking network revolves or interacts upon. In short, deposits, credit intermediaries, clearing and settlement, maturity transformation, asset markets etc… are all deeply interconnected.

Since the US dollar standard banking system has been at the core of our troubles, all the network of banking nodes connected to such intertwined system have likewise been bearing strains, see Figure 2 from the IMF.

Figure 2: IMF’s GFSR: The Evolution of the US Banking System From Deposits to the Shadow Banking

According to the IMF’s Global Financial Stability Report (emphasis mine), ``Banks have been shifting away from deposits to less reliable market financing. “Core deposits” dominated U.S. banks’ liabilities in the past, but have been gradually replaced by other “managed liabilities”…At the same time, near-banks—which are entirely market financed—have grown sharply. This is related to the “originate-to-distribute” financing model that relies heavily on sound short-term market liquidity management. Euro area and U.K. banks also rely more on market financing than in the past, as in the United States. Similarly, the share of deposits by households (defined roughly the same as U.S. core deposits) has been gradually declining over time, while deposits held by nonfinancial corporations, other financial intermediaries, and nonresidents have steadily increased. In addition to these “managed deposits,” financing through repurchase agreements and issuance of debt securities, both in domestic and foreign markets, have expanded, indicating that European banks are also increasingly exposed to developments in money markets. At the same time, the share of household deposits for Japanese banks has been stable and even increasing over time. This may partly reflect the prolonged low interest environment since the late-1990s.”

In other words, from a depository based banking system the US has evolved into gradual dependency on “near banks” or what is known as the “shadow banking system” (we previously featured a schematic chart from the Bank of International Settlements The Shadow Banking System) which basically relies on short term financing or maturity transformation borrow short and lend or invest long.

Thus, when the collaterals backstopping the entire short term financing channels began to deteriorate, whose chain of events included the Lehman bankruptcy, this resulted to a collapse in the commercial paper market (forbes.com) and the “breaking the buck” in the money markets (edition.cnn.com) as banks refused to deal (borrow and lend) with each other on perceived “rollover risks”.

Consequently, major financial institutions dumped the banking channels and stampeded into US treasuries. This exodus or flight to safety set a record yield of .0203% for 3 months bills last September 17^th (Bloomberg), which we described last week as an “institutional run”. And these strains reverberated throughout the network of banks all over the world which raised credit spreads and resulted to a dearth of US dollars and lack of liquidity in the system as banks and companies hoarded cash. Thus as a result to the credit gridlock the liquidity crunch inspired the sharp selloffs.

So while the defensive mechanism for the global banking system has been designed against isolated instances of retail depositors run via a depositors insurance (e.g. FDIC, PDIC etc…), an institutional run has not been part of such contingencies.

Hence what you have been witnessing is an unprecedented monumental development which has a potential risk of a downside spiral.

To consider, the assets of Shadow Banking system was estimated at some $10 trillion dollars which is almost comparable to the assets of traditional banking system. According to a report from CBS Marketwatch (all highlights mine),

``By early 2007, conduits, structured investment vehicles and similar entities that borrowed in the commercial paper market and bought longer-term asset-backed securities, held roughly $2.2 trillion in assets, according to the Fed's Geithner.

``Another $2.5 trillion in assets were financed overnight in the so-called repo market, Geithner said.

``Geithner also highlighted big brokerage firms, saying that their combined balance sheets held $4 trillion in assets in early 2007.

``Hedge funds held another $1.8 trillion, bringing the total value of asset in the "non-bank" financial system to $10.5 trillion, he added.

``That dwarfed the total assets of the five largest banks in the U.S., which held just over $6 trillion at the time, Geithner noted. The traditional banking system as a whole held about $10 trillion, he said.”

So as hedge funds continue to shrink from redemptions, TrimTrabs estimates a record $43 billion in September-liquidity requirements, margin call positions, maintaining balance sheet leverage ratio or plain consternation could risks triggering more negative feedback loop of more forced liquidation.

Besides, risk of a deep and extended recession could imply larger corporate bankruptcies and larger defaults from corporate leveraged loans that could trigger credit events in the CDS market that could give rise to new bouts of forcible liquidations. All these could similarly shrink the capital base of existing banks, even under those buttressed by capital from the US treasury.

In addition, the risks of heavy damages in the asset markets could spread to the insurance and pension funds which risks reinforcing the downside spiral. In short, the shadow banking system poses enough risk to destabilize the entire US banking system.

Global Governments Throws The Kitchen Sink And the House

Governments have virtually thrown not just the proverbial kitchen sink but the entire house to deal with such outsized dilemma. The US government pledged to “deploy all of our tools” as the G7 counterparts have “committed to a global strategy”.

Specifically the US government will earmark some $250 billion for its “capital purchase program” to be infused as capital to the banking system in return for preferred shares of which 9 of the major banks have “agreed” or “coerced” to participate, a temporary guarantee by the FDIC on the “senior debt of all FDIC-insured institutions and their holding companies, as well as deposits in non-interest bearing deposit transaction accounts”, the broadening scope Commercial Paper Funding Facility (CPFF) program which will “fund purchases of commercial paper of 3 month maturity from high-quality issuers” (Federal Reserve) and unlimited swap lines or “Counterparties in these operations will be able to borrow any amount they wish against the appropriate collateral in each jurisdiction” with major central banks as the Bank of England (BoE), the European Central Bank (ECB), the Federal Reserve, the Bank of Japan, and the Swiss National Bank (SNB) as “necessary to provide sufficient liquidity in short-term funding markets”. (Federal Reserve)

Figure 3: Wall Street Journal: Europe’s Bailout Package

Of course, it’s no different with the European counterparts which have committed aggressively some €1.8 trillion (US $2.4 trillion)-AFP.

So overall, including the US Congress’ contribution of $850 billion plus the Federal Reserves liquidity infusion via US dollar swaps these should amount to over $3 trillion or over 5% of global GDP (2007) of $54.62 trillion based on official exchange rate-CIA.

Such astounding financial theater of operations reminds us of the D-Day 1944 Normandy Landings. Bernanke’s helicopters have not only been operating on round the clock sorties, but they are also flying all over the globe as the Fed has essentially outsourced its printing press functions to international Central banks!

The Illusions of Government Guarantees

If only those unlimited injections of liquidity can translate to REAL capital.

The unfortunate part is that government guarantees depend on the hard currency that backs the system.

For instance, in the case of Iceland which basically guaranteed deposits of its financial system and nationalized its major banks, the lack of hard currency has precipitated a crisis (See our Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?).

As the Icelandic government operated on a huge current account deficit in the face of a paucity of global liquidity, rising risk aversion, global bear markets, global deleveraging and the monumental debt incurred by its banking system, investors withdrew funding and sold the currency aground. Last October 9^th the Iceland Prime Minister even pleaded to the public to restrain from withdrawals (Reuters).

Now goods shortages have emerged and consumer price inflation has soared. If Iceland can’t obtain the sufficient funding from overseas lenders (IMF or Russia or etc.) soon enough, then it would have to resort to the printing press or our developed country equivalent of Zimbabwe.

In a varied strain, Pakistan’s economy and banking system has allegedly been suffering from “some” depositor’s run (thaindian.news) on rumors that the government might impose withdrawal restrictions. Global volatility has exposed Pakistan’s vulnerability to its heavy dependence on short term debt financing and huge current account deficits (see our Increasing Signs of Pakistan's Depression?). Pakistan is now seeking a bailout package from China.

In both examples, government guarantees won’t serve any good if governments can’t support such claims.

Think of it, government revenues basically derive from three channels: taxpayers, borrowing through debt issuance or the printing press.

Even if your government guarantees deposits or other loans, assets etc…, if taxpayer’s can’t pay up, or if the government can’t raise enough borrowings to fund its present expenditure or settle its liabilities seen via fiscal or current account, your government ends up using the printing press to meet its needs.

This means that in the assumption that your government remains functional under a banking system collapse, whatever money guaranteed by the government will surely have its purchasing power evaporated!

If for instance the Philippine government allows deposit guarantees to increase at P 500,000 per depositor (from the present Php 250,000-PDIC) and our doomsday scenario occurs, such an amount which can momentarily buy a second car will eventually (perhaps in just months) buy up only a bottle a beer! That is if government even allows you to withdraw your money. In Argentina’s case during its 1999-2001 crisis, particularly in December of 2001, the Argentine government restricted depositors from withdrawing money to only a specified amount (BBC).

To Austrian economics, such restriction is equivalent to “Confiscatory Deflation”, which according to Joseph Salerno in his Austrian Taxonomy of Deflation, ``There does exist an emphatically malign form of deflation that is coercively imposed by governments and their central banks and that violates property rights, distorts monetary calculation and undermines monetary exchange. It may even catapult an economy back to a primitive state of barter, if applied long and relentlessly enough. This form of deflation involves an outright confiscation of people’s cash balances by the political and bureaucratic elites…

``Confiscatory deflation is generally inflicted on the economy by the political authorities as a means of obstructing an ongoing bank credit deflation that threatens to liquidate an unsound financial system built on fractional-reserve banking. Its essence is an abrogation of bank depositors’ property titles to their cash stored in immediately redeemable checking and savings deposits.” (highlight mine).

Yet when government mandated money loses trust among its constituents people tend to find a substitute, as example see our previous, The Origin of Money and Today's Mackarel and Animal Farm Currencies.

So as shown above, government guarantees do not constitute as an outright safety net. These will all depend on government’s access of available financing at future costs.

Under the same line of thought, the idea that the US dollar as the international foreign currency reserve with unlimited lending capacity is another mirage.

The US economy has been supported by the financing of its current account deficits by foreign exchange surpluses of current account surplus countries mostly found in Asia and Gulf Cooperation Council (GCC). This vendor financing scheme effectively recycles money earned from exports of EM economies by buying into US financial papers to keep their currencies from appreciating.

Hence, the US economy’s ability to provide unlimited finance is moored upon the willingness of foreigners as China, Japan and GCCs to sustain the present system. Said differently, for as long as these financers continue to buy US financial claims, they automatically provide the wherewithal or the “quiet bailout” to the US government.

So China, Japan and others essentially determines the guarantee provisions the US extends to its financial institutions aside from the world’s faith on its printing presses.

Besides, guarantees in the banking system as we previously discussed represent as “beggar-thy-neighbor” policy which keeps at a disadvantage countries offering less amount of guarantees, like the Philippines, since the former tend to attract more capital or savings because of the higher amount of safety.

Hence, guarantees signify as subsidies to those who apply more and a tax to nations who apply less. Thus, the policy regime of surging guarantees on deposits by Europe and the US tend to put into the downside pressures to the Philippine Peso.

Yet, our discussions above are some examples of isolated banking crisis and not of a systemic banking collapse, a domino effect from a prolonged cardiac arrest of the US banking system, the ultimate recipe for a global depression, where guarantees will just be that- a political rhetoric.

US Banking Collapse: You Can Run, But You Can’t Hide; Revival of Bretton Woods?

We proposed last week that this could mark the beginning of the end of the current form of paper money system or even signify as a harbinger to a new paradigm shift from our present monetary system.

Perhaps European Central Bank’s Jean Trichet heard our whispers and began to talk about the revival of a modern version of a “Bretton Woods” (see Did ECB’s Trichet Fire The First Salvo For A Possible Overhaul Of The Global Monetary Standard? and Bretton Woods II: Bringing Back Gold To Our Financial Architecture?)

So aside from the rapid aggressive policy response (bailouts, liquidity injections, nationalization, blanket guarantees), some European leaders have also raised the idea for a shift in the global financial architecture.

As the Reuters report indicates ``Italy's economy minister said a reform of the Bretton Woods institutions should also review trade, foreign exchange and capital markets and questioned whether the dollar should remain the reference currency under a new system.” (highlight mine) So it won’t be a far fetched idea for a movement among nations to address the need to reform the present monetary system.

Yet as the crisis continues to unfold, everything now seems to depend on how the global markets will respond to the massive stimulus applied and how it will measure up to remedy the apparent weakening of the foundations of the US banking system.

Nonetheless the threat remains real.

This means that should the US banking system collapse, there will probably be no escape for almost everyone dependent directly or indirectly on the global banking system, not even for those who aren’t invested in the stock market. While it is true that alternative sources for financing such as microfinancing and trade finance may be picking up on some of the slack, it won’t be enough for it to replace the rapidly mounting losses in the financial system that risks becoming a financial black hole.

We can only guess what implications of a global depression as an offshoot to the US banking collapse could be: pension, insurance, and other money market funds will perhaps evaporate, stock markets will close, a collapse in the international division of labor means each country will have to fend for themselves or dominant “protectionist” policies will prevail (hence some countries will experience hyperinflation and others will suffer from deflation), a run of the US dollar or the present paper money system, rising crime and security risks, civil wars, return of authoritarianism etc…

On the other hand, some sectors would be quite happy- the extreme left will glee with the resultant equality from a depression, as well as bureaucrats and political leadership who will benefit from more government spending. Outside these sectors, everyone will probably be equally poor!

Sorry for the gloom.

Conclusion

Thus, it is an arrant misguided fairy tale to suggest that today’s stock market meltdown is just seen for its “media feed”.

Today’s stock market meltdown is representative of the real risks of a US banking collapse. While I am not betting that this devastation is gonna happen, a US banking collapse would have deep adverse repercussions to our domestic and global banking system, aside from the global economy which practically means the ushering in of the great depression (version 2008) . Why would global central banks have earmarked over $3trillion of bailout money? Why would Bernanke’s Federal Reserve Helicopters be doing simultaneous missions globally to drop “helicopter money”?

So it is equally myopic to suggest that our banking system will be “immune” to such extreme risk scenario. If the issue is only about banking losses and some disruptions in the system then yes the Philippine banking system will escape with some bruises.

Nonetheless if the US banking industry does collapse, not even those out of the stock market will be spared unless their money is stashed under their pillowcase or buried underground.

That is if street muggers don’t figure them out.