Fractional Reserve Ratios
In our last post we showed a simple bullion bank balance sheet. In reality, there are many different types of assets and liabilities that mature over a range of different time periods. Below is a more complex gold balance sheet.
I’ve also added in an additional column called Due Date, which shows the date the asset or liability comes due.
In our example above many would say that the bullion bank is running a 10% fractional reserve ratio – 5oz of physical in their vault plus 5oz at the Bank of England divided by 100oz of liabilities. However, 80oz of the bank’s gold liabilities cannot be called by the holders until they are due and there are only 20oz of unallocated liabilities that customers could demand the bank to repay immediately. In this case the bank only has risk to 20oz, against which it holds 10oz, giving it an on-call fractional reserve ratio of 50%.
The bullion bank’s ratio changes over time as the assets and liabilities mature. In one month’s time the bank receives 20oz from its expiring long futures contract, giving it 30oz against 20oz of liabilities, a ratio of 150%. In three months however it has to pay back a 30oz loan to bullion bank B and at that point in time it would have zero physical gold to back its unallocated liabilities.
By six months it receives 40oz and has to delivery 20oz into its short contract, leaving it with 20oz and a 100% reserve ratio. Finally, after one year, its maturing liabilities are matched by maturing assets and it remains covered 100%.
While banks do publish information about the maturity of their assets and liabilities, their bullion banking activities are usually so small relative to the size of the whole bank that they are not required under accounting standards to disclose their precious metal activities separately. It is therefore impossible to establish the ounce reserve ratios for bullion banks.
It is worth noting that the following terms are often confused:
- Fractional – ratio of physical gold to total liabilities
- Leverage – how much capital (your own money, also called “equity”) you invested into an asset. The rest is borrowed. Leverage increases your returns but also your losses, making your investment more risky.
- Turnover – trading volumes versus total stock on issue/available.
Jeff Christian, of precious metal advisory firm CPM Group, indicated that bullion banks generally operate with a fractional reserve ratio of 10% and that the turnover ratio is around 100:1.
A bullion bank manages the risk that its on-call unallocated holders request delivery by holding some amount of physical gold. How much depends on its assessment of the make-up of its on-call depositors and their historical redemption rates.
For example, a bullion bank could probably be sure that a large hedge fund is just after cash profits and unlikely to want physical. Gold industry unallocated holders may also be historically reliable, as individually they would hold small balances (using them primarily for settlement purposes) and redemption behaviour as a group would be consistent.
However, there is a risk that a bullion bank gets too confident about the reliability of its historical redemption rates. In 2008, for example, The Perth Mint experienced a surge in demand for its silver coins which exceeded the output from our refinery, so we began to withdraw 20 tonnes of silver a week from London for a number of months, which was well beyond our usual activity.
Even if we assume that a bullion bank has 100% physical backing its on-call liabilities, we could still have a problem in the future where all of the bank’s counterparties could honour their commitments, but the maturities don’t match up, leaving the bullion bank short gold. This is the situation in our example above where after three months the bullion bank B would have zero physical gold to back its unallocated liabilities. The way a bullion bank can manage this maturity mismatch is to:
- request an extension from customer and pay them an interest penalty
- borrow gold from another bullion bank or central bank
Even if all maturities are perfectly matched, a bullion bank can have the problem where a counterparty fails to honour their commitments when they fall due (ie defaults) and the bullion bank is short gold. In this case the bullion bank needs to determine if:
- the counterparty is just having their own liquidity problems, in which case the bullion bank can borrow gold from another bullion bank or central bank and charge their counterparty a penalty
- the counterparty is permanently defaulting (bankrupt), in which case is the bullion bank:
- Secured – then the bullion bank can draw on the collateral and margin and use that to purchase gold
- Unsecured – then the bullion bank has to book a loss and use their own cash to purchase gold (and maybe recover some cents on the dollar from the counterparty later)
You’ll notice a certain commonality in the mitigating controls mentioned above, which gives us another two points of risk:
- will the bullion bank be able to buy enough missing gold with the cash (ie, we have trading liquidity, volatility and gap risk); or
- will another bullion bank or central bank be willing to lend the bullion bank gold (note, depending on the type of depositor, this could just be a need for unallocated, not a physical gold loan)
The size of the problem also matters. In our example above, if the amount redeemed was 11oz then that means the bullion bank only needs to find 1oz but if the amount redeemed was 20oz then the gap is 10% of the bank’s balance sheet. In addition, if the size of the bullion bank’s problem is large relative to the overall market, then buying or borrowing gold may be more difficult.
In our last post we mentioned the risks associated with point 1 in terms of valuing gold derivatives and trading them. In our next post we will discuss point 2 and how the clearing and lending of gold between bullion banks works and the involvement of central banks in the process.