Fractional Reserve Banking: It’s Not Your Money… You Only Think It Is!

In the aftermath of the forced confiscation of bank accounts in Cyprus, the question that clients ask me most is, “could it happen here?” “Here” is wherever the client lives or invests, and could be the United States, Canada, Australia, New Zealand, Switzerland, or any other country. The answer is yes. This result stems from the nature of our modern financial system, built as it is on the flawed foundation of a poorly-understood concept called “fractional reserve banking.”

In the Middle Ages if you had gold, silver, or jewelry you didn’t want to store at home, you could take it to a secured warehouse or a goldsmith to store it. You gave the warehouse-keeper a sealed bag of coins and received a receipt for it. The warehouse-keeper didn’t lend out your valuables; he only kept them secure, in return for a fee. As long as no one (including the warehouse-keeper) stole your valuables, your wealth was secure. Such safekeeping arrangements remain popular today in bonded warehouses throughout the world.

Not all depositors, however, insisted on receiving the same bag of valuables back from the warehouse-keeper. They were satisfied to receive back equivalent value. Depositors could now use the receipts warehouse-keepers issued as a medium of exchange.

Warehouse-keepers understood that not every receipt would likely be redeemed simultaneously. They began lending out some fraction of the valuables stored in exchange for interest payments. In this manner, warehouse keepers and goldsmiths evolved into interest-paying fractional-reserve banks.

This strategy, of course, wasn’t (and isn’t) risk-free. The biggest risk, of course, is the “bank run.” If a bank lends out too much of the funds on reserve, and every depositor wants their money at once, the bank won’t be able to pay everyone back what they’re owed. Deposit insurance schemes evolved to shield bank customers from this reality. As a result, during the lifetime of anyone alive today, bank customers have treated their bank deposits as if they were 100% backed by actual reserves. The seemingly unlimited ability of central banks to conjure money out of thin air tended to lend credence to this assumption.

Then came Cyprus. The bailout agreement was, in effect, a “bail-in,” as it forced uninsured depositors to pay some of the costs. Those with deposits under than €100,000 suffered no loss, but uninsured depositors lost billions of euros under the agreement.

This is actually a healthy, but painful result. It’s a reminder that when you deposit money in a bank, you are turning over your property to that institution in return for a debt claim. The money is no longer your own: it belongs to the bank. You become an unsecured creditor holding an IOU.

The Cyprus bailout is also a reminder that taxpayer-funded bailouts and helicopters of fiat cash created by a central bank may not always be available to banks that take huge risks with their depositors’ money. It is good to be reminded of this risk at least once in a lifetime.

Cyprus proved the viability of the bail-in model. Indeed, over the last few weeks, I’ve confirmed bail-in plans in the following countries:

  • Canada. The 2013 budget proposes to implement a “bail-in” regime for systemically important banks.
  • New Zealand. The Central Bank plans to manage bank failures by putting depositors on the hook for bailing out their bank.
  • Italy. Germany’s influential Commerzbank has called for a one-time 15% tax on private savings accounts to reduce Italian debt levels.
  • United States & United Kingdom. Under a plan agreed to in 2012 by the Federal Deposit Insurance Commission and the Bank of England, a failed bank could by “exchange or converting a sufficient amount of the unsecured debt from the original creditors of the failed company (meaning you, the bank depositors) into equity (stock in the bank).” In other words, the FDIC could forcibly convert money you have in your bank accounts into shares in potentially worthless banks.

Some pundits claim that bail-ins could never occur in countries with strong banking systems. I wouldn’t count on it. If banking regulators in any country deem a bail-in necessary, it will occur. This risk is the inevitable consequence of fractional reserve banking.

This new reality is harsh, but as I said before, it’s healthy. People need to be reminded that money deposited in a bank converts their wealth into a debt-claim.

How can you protect yourself? I can think of three ways to minimize your risks:

  • Minimize your exposure to the banking system by keeping the bulk of your wealth in other assets. Precious metals are ideal for this purpose, especially at current depressed price levels, although prices could go considerably lower if as with Cyprus, future bailouts are conditioned on the forced sale of national gold reserves. Keep a healthy supply of cash at home, too.
  • Use only strong, well-capitalized banks to hold the funds you keep in the banking system.
  • Keep funds you deposit in banks off the banks’ balance sheet if you can. This means, for instance, using your deposits to purchase securities that the bank holds for you in safekeeping, off its balance sheets.

With this new reality, how are you protecting your wealth? Please comment below.

Source: Nestmann

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