From: "Danny Van den Berghe" <[EMAIL PROTECTED]> > If the bank is known to be in serious trouble, everybody will want to cash > out his gold on deposit, no matter what interest rates they promis. > In fact, the very high interest rates will be taken as an indication that > the bank is in big trouble.
Correct, the problem is 'bank trouble' i.e. decapitalised banks, lending losses, not lack of reserves. A well capitalised bank that runs out of reserves can easily and quickly replenish reserves by selling unimpaired assets and/or offering more attractive interest rates. In cash markets i.e. very short term borrowing and lending, long term assets such as bank bonds and government bonds can be used as collateral for loans at what is called the cash interest rate. This is normally intraday, overnight and day to day credit, and is available to any banks with collateral (i.e. high grade credit securities). These loans can be arranged by repurchase agreements, e.g. if you have a parcel of bank bonds with a face value of $10 000 000, and a market value of $9 900 000 with the next interest payment in two months time, and you need $9 000 000 now, you can sell your bonds to a counterparty for $9 000 000, and agree to buy it back at $8 998 000 two days later, on the condition that your counterparty deposits the bonds with an escrow agency or clearing house until your repurchase it or you default and he gets it (or gets to sell it to recover the loan, and refund you any excess). If the transaction costs are, say $25, the spread between borrowing and lending rates is just 0.05% p.a. in this hypothetical example. So these markets are used for wholesale short term borrowing and lending, and allows any bank to get as much liquidity as it needs, so long at it has assets qualifying repurchase assets. The liquidity difference between high quality credit securities and ordinary bank loans is one of degree rather than kind. The less liquid the asset, the greater capital is required to cover for losses associated with liquidation as well as lending losses. For this reason banks use adjustments and provisioning when assessing capital adequacy. And provided capital is adequate, and the bank has the means to get liquidity. That's not to say that the bank should not use risk management to assess its sources of funding and the term structure of its sources and investments, and take care to hold enough reserves and liquid assets, but the fundamental point is that it is *possible* to get liquidity from sources other than reserves, i.e. from selling assets. That said, it is impossible for a bank to maintain liquidity if it is decapitalised, even if it only has reserves. For example a bank with $10 000 000 in demand deposit liabilities, and $8 000 000 in reserves, will run out of reserves whatever it does. It's a grossly over-reserved decapitalised bank. And its directors have a duty to declare the bank insolvent, and wind it up, rather than leave the last $2 000 000 in deposits in default and pay out the first $8 000 000 in deposits. > > This is correct, bank capitlisation is the baliwark against running out of > > reserves. If the bank is well capitalised, it can liquidate its assets as > a > > discount to replenish reserves as its depositors withdraw as much as they > > want. > > > Wait a minute. There is only 1000oz of real gold in our country. > The bank's customers want to cash out their 8000oz of gold on deposit. > The bank can liquidate as much assets as it wants, it can at the most > collect 1000oz of real gold since there is only that much available. > So, they are not able to redeem the 8000oz of deposits, no matter how much > assets they want to liquidate. > There is simply no way out. No one bank will have the world's total gold reserves, rather, it will be distributed between many banks, each with a small proportion of total bank demand deposits. Any withdrawal demand therefore will either transfer those gold reserves where they are demanded, if one bank has the demand, or transfer reserves out of the banks if all the banks have the demand. In the former case, the bank assets are liquidated for the reserves where they are used for the withdrawals. Asset prices and interest rates are unaffected, provided the bank is small in relation to the banking industry. In the latter case, assuming that the demand is significant in relation to the banking industry, the net withdrawal demand depleates the reserve ratio of the banking system and increases the interest rate and reduces the prices of (most) capital goods. This increases the opportunity cost of holding reserves outside the banking system, and a new initial equilibrium is established with the elevated interest rate. This brings about a macroeconomic response of falling capital, factor and goods prices (i.e. deflation), which increase the profitability of gold mining and reduces gold consumption demand, creating a surplus in the bullion market, to replenish the banks' reserves. In a free market there are always very low risk opportunities to earn interest, e.g. in the cash market you can lend against the security of bank bonds and other high quality credit securities. In fact, demand deposits in banks are rightly considered among the safest types of investment one can make. So if you can get attractive interest from high credit rated banks and cash management trusts etc. the motive get these attractive rates is strong, compared to holding reserves outside the banks. There is no reason ever, in a free market, no matter how depressed, that you can't find a safe investment opportunity. A properly capitalised cash management trust that holds a diversified portfolio of high quality bonds will never go broke and will always be able to liquidate its assets to pay its depositors at short notice or no notice. > These banks have only 500oz of 'assets' in your example. > They have created 8000oz of 'deposits' by makings loans. > These 8000oz of deposits can be redeemed by the customers. > As I said, these banks (or the government in this country) will sooner or > later be forced to announce that deposits can no longer be redeemed for real > gold, just like the USA did in the 70's > Or as you put it so nicely: they will 'suspend withdrawals' pending an > orderly wind up. > At least something we agree on. This is not a correct treatment of the arguments made. Firstly, the banks have assets of 9 000 oz and 8 000 oz in liabilites, in the example I have offered, but each bank has 550 oz in assets and 500 oz in liabilities. So each bank is capitalised and no bank has more liabilities than the total stock of reserves. However, obviously, each bank, and the banks together, have fractional reserves, i.e. they have most of their assets in the form of loans secured against capital assets (capital stock is worth 16 000 oz). That is, after all, the main business of banks, as credit intermediaries, to make loans and take deposits. Banks finance capital with loans, and finance loans with deposits. Banks make an interest rate margin for profit, and have a net worth or owners equity as a buffer against losses, and hold reserves to fulfill their trade of borrowing and lending. Banks do not create deposits, they accept deposits. Lent funds can be accepted as deposits or withdrawn, like any demand deposits or funds. Let's examine an extreme example of reserve demand, and withdrawal of reserves from banks under free banking, and direct redemption to gold by individual banks rather than by a statutory monopoly central bank. Suppose that initially, using the details we have already established, that there were 16 banks with 500 oz in deposits and loans and 50 oz in reserves each. (The previous figure of 20 banks was an error). Suppose that there was initially 250 oz in reserves held outside banks initially, rather than none as previously assumed. Suppose that the initial interest rate was 4% p.a. and the capital stock was worth 16 000 oz. One bank makes some terrible lending losses and/or scandal and/or incompetent management and becomes decapitalised. Some depositors withdraw their funds because they are insiders or because they picked up some clues about the bank's troubles, aver a period the troubles become more evident and the bank makes an announcement suspending withdrawals, or fails to and runs out of reserves, making the problem public. The banks now hold 850 oz of reserves and 400 oz is held outside the banks. The interest rate increases to 5% p.a. and the value of the capital stock falls to 14 500. Bank shares fall in value and depositors get worred about three other banks whose funds leave for other banks and to be held as resrves outside banks. Two of the other three banks also fail, and 600 oz is held outside banks and 650 inside the banks. The interest rate has risen to 7% p.a. and the capital stock is not valued at 12 000. Bank shares are trading at low levels and everyone is worried about more borrowers and banks failing. So where do we go from here? Do the rest of the reserves leave the banks and do the rest of the banks fail? To answer this question we need to consider the process of liquidation and correction and shakeout of the banking industry and the weakest borrowers. The increased interest rate acts right away to reduce capital prices and kill investment demand. It's no longer profitable to develop and construct new capital and to develop land. This reduces demand for all factors and goods, and reduces wages, rents and prices. Uses of capital and labour based on low interest rates and low gold prices are liquidated and resources are allocated to uses based on high interest rates and high gold prices. Gold mining firms see this correction developing and increase mining output. Gold consumers find gold more expensive compared to other goods and reduce consumption. The surplus of mining output over consumption increases the stocks of gold for use as bank and non-bank reserves. Weak borrowers have defaulted and liquidated, leaving strong and profitable borrowers. Credit quality is improved and risk premiums decline. Reserves move back into the banking system, the interest rate falls, capial prices go up, and investment and lending activity increase. So: there is no reason to expect all the banks to fail or all the reserves to leave the banks. Some banks fail and some reserves leave the banks, but not all. In Hong Kong, since 1997, office property rents have fallen by 75% and the banks have suffered a surge in bad loans. Deflation has occured in every month since then, and unemployment is over 7%, up from about 2%. But the banks have not all failed and the currency remained convertible, even when the risk premium on HKD vs USD went through the roof in 1998. This is not entirely similar to the hypothetical example, but it does show that even under extreme changes in conditions and considerable panic, there are always banks in acceptable health and no end of liquidity. I understand in the 19th century the US went through some very sharp depressions and bank failures without suspending the gold standard, devaluation or inability of investors to find safe banks. > > But this orderly wind up will never come, and the suspension of withdrawals > will be more than just temporary. Why won't a liquidator carry out his professional duties and effect a speedy and effective liquidation of the bank? > The only way to engineer an 'orderly wind up' would be by suspending all > further borrowing until all loans are paid back (which could take 30 years > or more, depending on what terms the loans were made). > Once all loans are paid back, there is again enough gold to redeem all > deposits. Nonsence. The banks assets are liquidated, i.e. sold for cash. The new owners take over the loan books. > > Staying on a strict gold standard, and allowing for borrowing and interest, > simply can't go together. It depends what you mean by 'strict gold standard.' If you mean a 'gold coin standard' which makes debts legally payable in coin, this is perfectly at home with people making debt contracts denominated in coin. If you mean a 'gold exchange standard', which makes bank notes and depisits legally payable in coin, then this is perfectly at home with people making dety contracts in either gold coin or in bank notes or bank deposits. The historical problem with the gold exchange standard was that it criminalised the possession of gold by banks and US citizens, and therefore made the Unites States Federal Reserve Bank the sole gold debtor in the US, paving the way for its eventual default. If the proper bankruptcy procedures had been undertaken, the United States Federal Reserve Bank would have been liquidated, and the banks would have open accounts with BIS or IMF, or incorporated or established new reserve and clearing banks for their needs, and the gold exchange standard would have remained. The IMF has never defaulted on its SDRs, which continue to be as good as 1/35th of an ounce of gold. The BIS has never defaulted on its gold debts either. David Hillary --- You are currently subscribed to e-gold-list as: [EMAIL PROTECTED] To unsubscribe send a blank email to [EMAIL PROTECTED] Use e-gold's Secure Randomized Keyboard (SRK) when accessing your e-gold account(s) via the web and shopping cart interfaces to help thwart keystroke loggers and common viruses.
