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Would You Loan Money to Your Bank?

Banking Back in the DayDecember 20, 2014 | by J. Hayes & M. Gooch

Did you know that every time you deposit money in your account you are making a loan to your bank and that the bank takes legal title to your money?  When the teller accepts your deposit you become an unsecured creditor of the bank, and your deposit slip is simply an acknowledgement that the bank promises to pay you back upon demand, usually without interest, whenever one of your signed “checks” is presented to the bank for payment?
 

 

What recourse do you think you would you have if the bank ran out of money, or if it simply decided it was not going to pay you back? What would you do?

Most Americans view their deposits as sacrosanct, and assume they have an inalienable right to their money, whenever they want it. Yes, they know banks sometimes fail, but they don’t worry about that, because they are assured their deposits are fully insured up to $250,000.

Well over the past five years, very quietly and with little fanfare, preparations for revolutionary changes in banking have been put into place by the world’s central bankers and monetary authorities. A vast majority of the public is completely unaware of these changes and the risks and ramifications they present for all investors, savers, and depositors.

Warning! There is a “New Normal” for Checking & Savings Accounts

 

During the great financial crisis in 2008 Americans were constantly bombarded by theLehman Brothers Closing phrases “too big to fail” and “bail out.” “Too big to fail” meant that the cost to the taxpaying public of letting the troubled institution fail would be far greater than the cost of bailing it out with taxpayer money (the bail out). This was particularly true with banks, where it was believed that, due to the interdependence, interconnectedness, and widespread fragility of the thousands of banks comprising the global monetary system, the failure of one bank would be contagious, and start a domino effect of other bank failures.

Many otherwise bankrupt companies were deemed too big to fail and were bailed out with billions of dollars of taxpayer money. The huge bailouts were highly unpopular politically and politicians and central bankers alike got the message that they could only be used sparingly. In the aftermath of the bail outs, the authorities have devised a brand new device to navigate around “too big to fail” and at the same time end taxpayer bailouts.  Their new mechanism is called the “Bail In.”

Simply stated, a bank bail in is a way to recapitalize the bank as a going concern without taxpayer money or new external financing. In a bail-in, new bank capital is created simply by the forcible conversion of creditor claims into newly created common stock in the bank. If you remember from above that as a depositor you are a bank creditor, you will begin to understand the bail in.

Cyprus Bail InIn most of the G-20 countries measures are either now in place or soon will be authorizing bank regulators to arbitrarily convert bank deposits into shares of bank equity if in their sole judgment doing so will save banks from failure. The era of the Bail In dawned on March 30, 2013, when depositors in Cyprus lost much of their life savings in the dead of night when their deposits were forcibly converted into shares of stock in a worthless bank.

At the recent Brisbane G-20 Summit the new bail in measures were formally adopted to deal with the thirty (30) GSI (“Globally Systemically Important”) banks. The banking industry lauded this move as a “triumph for taxpayers,” ensuring that they would never again have to bail out banks. In terms of rescuing mismanaged, insolvent banks, Bail Ins are now the new normal.

G20 Summit 2014
Recent G20 Summit in Brisbane, Australia Where Bail Ins Were Discussed

Banking Today – Myth versus Reality

 

In a famous scene from the great 1946 classic “It’s a Wonderful Life,” George Bailey faces down a run on his Bedford Falls Building and Loan by confronting his depositors to tell them how banking actually works. He explains that when they deposit their money in the bank it doesn’t just sit there, but instead the bank loans it out to other customers so that they can buy houses and start businesses, thereby benefitting everybody in Bedford Falls.

The public’s perception of banking largely conforms to George Bailey’s description. They believe when they deposit $10 in the bank the bank loans that $10 to customers, and the bank lives on the difference between what they pay the depositor for his money and whatBank Run in Bedford Falls they charge the borrower for his loan. They know that banks have reserve requirements, and they know their deposits are insured, so they never doubt that if and when they want their $10 back it will be sitting there waiting for them.

Unfortunately, banking today bears little resemblance either to George Bailey’s description or to the general public perception. First, as we outlined above, when you deposit money to your account it is technically no longer yours. The deposit becomes the bank’s money and you become a bank creditor. Second, there is no requirement limiting what the bank does with your deposit. It can make loans with the money, but it can also simply buy things, inlcluding an almost endless variety of stocks, bonds, and derivative contracts.

Third, the banking system is a fractional reserve system, meaning that banks can leverage deposits to extraordinary levels, restricted only by financial ratios mandated by the Federal Reserve. The principal financial ratios to which banks must adhere are the “capital ratio” (aka “capital requirement,”) and the “liquidity ratio” (aka “reserve requirement”).

The capital ratio is defined as the percentage of its “risk-weighted” assets that the bank must maintain as capital. According to Basel II regulations, the effective minimum capital ratio is currently 8%. (Basel III is being phased in between now and 2019, and it will presumably raise the capital ratio).

The liquidity ratio is defined as the percentage of the bank’s demand deposits (checking accounts) that it must maintain as vault cash or reserve deposits. Currently, the minimum liquidity ratios banks must maintain are as follows:

Demand Deposit less than $13 million                             0%
Demand Deposits $13 to $89 million                                3%
Demand deposits over $89 million                                  10%

Uncle Wants Your MoneyHow and Why Bail Ins Pose a Serious Threat to Your Accounts

 
The official and frequently heralded “dual mandates” of the Federal Reserve System are to control inflation and minimize unemployment. Politicians like to tout those mandates because both would ostensibly protect taxpayers, instead of banks.
 
In reality, however, the Federal Reserve has one, primary, all-consuming objective, and that is to protect the US banking system. In this section we will describe how bail ins can help the Federal Reserve meet its objective, even when it means disaster for innocent depositors.
 
Much of the legislative and regulatory language that has been proposed and/or adopted for the new bail in regimes is highly objectionable to lawyers and bank creditors for two reasons: first it vests virtually unlimited authority in bank regulators, and second, it ignores hundreds of years of legal precedent in resolving insolvencies and bankruptcies.
 
Time honored legal precedent provides that all creditors of an insolvent institution first be divided into classes, and that then all members of each class be treated equally. But this is not the case with the bail in proposals.
 
A key paragraph in a recent bail-in directive states that “the bank resolution authorities would have discretion as to which classes of debt would be written down or converted to equity in each case, the extent of the write-downs, and the relevant rate of conversion. The resolution authority’s exercise of its discretion might take into account, among other things, the systemic risks of writing down certain creditors.” 
 
Another instructive piece of language was included in the bail in proposal adopted for the GSIBs at the recent G-20 Brisbane summit. It provides that bank’s derivative obligations to each other be assigned higher priority than large deposits in the preparing the confiscation and conversion hierarchy. We will discuss the problems presented by derivatives below.
 
If there were ever any doubt about who regulators are trying to protect, these documentation The Bank Bail Insnippets should end it.
 
Let’s use an example to illustrate how a bail in might work. We will assume that a troubled US bank (your bank in the example) defaulted on its capital ratio and was unable to cure the default in the prescribed time. Instead of closing the bank or arranging a takeover by a stronger institution, bank regulators decided on a bail in. Here is a hypothetical list of the bank’s liabilities along with the bank regulator’s proposed resolution:

Hypothetical Bank Liabilities- Bail In
($ in thousands)

Deposits - Insured Retail                   $    10,000    Convert to Shares
Deposits - Uninsured Retail      
           10,000    Convert to Shares
Deposits - Uninsured Banks                      5,000    No Action
Notes Payable - Banks                             12,000    No Action
Bonds Payable - Banks                            10,000    No Action
Bonds Payable - Retail                             25,000    Convert to Shares
Derivative Obligations                                 3,000    Write Off
Derivative Obligations - Banks                50,000    No Action

TOTAL LIABILITIES                             $  125,000                

In our example the bank regulators converted $48 million of bank liabilities to equity with the stroke of a pen. They took no action against any of the bank’s liabilities to other banks due to concerns about systemic risk. If you were a retail creditor of the bank you would learn of the bail in after the fact, just as the Cypriot depositors did in 2013.

Now you have no money, but you own stock in your bank. However, you will probably not be able to sell your newly acquired shares until a long lock-up period expires, because, if you and all the other new shareholders immediately dumped your shares, the Bank’s stock price would plummet.

It should also be noted that this bail in did little to improve the bank’s liquidity. We decreased the bank’s demand deposits by $20 million, leaving them under the $13 million floor for the liquidity ratio, which would free up $1.35 million of vault cash reserves.

Three Things You Should Know About FDIC Deposit Insurance

 
FDIC PlaqueYou might be thinking that your FDIC deposit insurance will save you from being bailed in, and in it might in fact deter the bank regulators, but we advise against taking comfort from FDIC protection for several reasons. First, the argument could be made that although you lost your deposits you received compensation of equal value, and thus did not incur a loss. Second, the people who control the bail in are part of the same institution that manages the FDIC, and third, the Deposit Insurance Fund (DIF) is grossly inadequate to pay depositor claims if multiple banks fail.
 
The aggregate numbers are fluid and change daily, but, on average the FDIC insures approximately $6 trillion in deposits, and the DIF is approximately $25 billion, or less than one-half of one percent of the insured risk. In the United States there are 36 individual banks with insured deposits that exceed the Deposit Insurance Fund, so the failure of just one bank could conceivably wipe out the entire DIF.
 
James RickardsAccording to the science of complexity theory, banks are part of a highly complex global financial system with unusual levels of interdependence and interconnectedness. According to noted monetary expert James Rickards, the global financial system is currently in a “critical state.”  Rickards believes it is highly unlikely that any bank bail in or bank failure will be a one-off, isolated event, but will instead be part of a larger “phase transition.” In a phase transistion, the system moves from "complex" to "chaotic." If Mr. Rickards is correct then depositor insurance claims would quickly overwhelm the FDIC’s DIF as it is currently funded.

 
The US Banking System is in the "Complex" Arc, Moving Toward "Chaotic"
 

Will Bail Ins Make the Banking System Even More Toxic?

 
The bail in concept was developed in part as a result the public outrage over the government’s use of taxpayer money to bail out poorly managed banks. However, the widespread adoption of the bail in as the new normal is heightening instead of lowering fears about the outlook for vulnerable banks. Banking officials worry that bail ins will erode the very consumer and business confidence upon which the banking system depends.
 
They fear that as consumers and businesses see their savings and their capital confiscated by government regulators they will begin leaving the system, compounding rather than solving its problems.
 
Bank credit rating agencies Standard & Poors and Moody’s also are both on record as opposing bail ins. They point out that bail ins reduce implied government support for the banking sector and also decrease the predictability of government help.
 
Moody’s has already downgraded the Canadian and UK banking sectors based upon their announced plans to force bondholders and depositors bear the cost of bailouts, and has warned other European countries about bail ins in recent months. S & P in March of this year warned European banks that the move toward bail ins poses significant risks to their credit ratings.  
 
And in addition to these concerns, bail ins do very little to improve bank liquidity. Converting liabilities to capital boosts capital, but it does not create cash. Most of the major historical banking crises, including the Great Depression and the Lehman Brothers Crash, were liquidity crises, not capitalization crises.

Frightening Facts About Financial Derivative Contracts

 

Buffet QuoteAny useful discussion of systemic weakness in the global banking system would be incomplete without devoting some attention to financial derivative contracts. Famed investor Warren Buffet refers to derivatives as “FWMDs” – Financial Weapons of Mass Destruction.
 
The vast preponderance of banking assets and liabilities in Western Democracies are forms of derivative contracts. In the United States, the derivative market is more than 10 X larger than the stock market and the bond market combined. In March, 2013, the aggregate value of derivative contracts on US bank balance sheets was $297 trillion, which was more than 30 X larger than total aggregate deposits of $9.3 trillion. The four largest US banks have combined derivative contracts that exceed the GDP of the entire world by almost 4 times.
 
Derivative contracts were a major culprit in the financial crisis of 2008. The Lehman Brothers Derivatives in Major Bankscrisis was a liquidity crisis, and it was caused by massive credit defaults on securitized, sub-prime mortgages. The mortgage loan defaults triggered payoffs on thousands of sub-prime mortgage insurance policies called “credit default swaps,” which were a form of derivatives. The magnitude of the defaults coupled with payouts required to honor the credit swap derivatives drained the system’s financial resources and gave rise to massive bank bail outs and the first round of quantitative easing.
 
The Dodd-Frank Wall Street Reform and Consumer Protection Act (aka “Dodd-Frank”) was signed by the President in 2010 in the aftermath of the Lehman Brothers crisis. Its provisions are being implemented on a phased basis until 2019. Among other things, the Bill seeks to end derivative trading by banks by re-imposing certain provisions of the Glass-Stegall Act of 1933, which prohibited commercial banks from engaging in securities trading or from affiliating with securities firms. These provisions are being challenged by Republicans and have not yet been implemented.   
 
Meanwhile, thousands of sub-prime mortgage contracts and credit swaps (known by regulators as “toxic assets”) remain on the books of major US banks and are still carried at cost rather than market value.

Deivative Web of Banks
Interdependence and Interconnectedness of Bank Derivative Contracts

 
Side Note: A Shocking Treasury Department Revelation 

On December 10, as this article was being written, the Washington Free Beacon uncovered a Request For Proposal (RFP) from the US Treasury Department which can only be described as bizarre. The RFP solicits quotes for 3,814 personal survival kits, one each for every employee of the Office of the Comptroller of the Currency (OCC), which conducts on-site reviews of banks throughout the country.
 
No Happy EndingEach kit must include a “reusable solar blanket,” (50) “water purification tablets,” “ a dust mask,” “a rechargeable lantern with built-in radio,” and “Air-Aid Emergency Mask,” and a “33-piece personal first aid kit,” among other items. The kits must be delivered in a fanny pack or back pack.
 
The survival kits will be delivered to every major bank in the United States, including Bank of America, American Express Bank, BMO Financial Corporation, Capital One Financial, Citigroup, JPMorgan Chase, and Wells Fargo.
 
No reason is given for the order, so we are all left to wonder what the government knows that we don’t know, and just what it is that they believe will happen at the banks in the near future. Treasury officials might of course have a logical rationale for the RFP, but not withstanding an explanation, this development is definitely not a confidence builder.
 

What to Do? Alternatives to Traditional Banking

 

The global banking system is a critical state, and bail ins represent just another risk to savers and customers world-wide. Depositors should begin thinking of their deposits as potentially fair game for confiscation by desperate banks and governments, and should no longer regard having deposits in a bank as the safest way to save, protect capital, and grow wealth.

If you are among those who believe that the convenience that banking provides via debit cards, check writing and on-line payments justifies the risks that we have described herein, then you should at least spread your accounts among different banks and even different countries. Choose your banks based upon their financial stability, the magnitudes of their investments in derivatives and mortgage loans, and the political climates in the venues in which they operate.

You might also consider maintaining minimal balances in banks sufficient only to satisfy the ongoing need for bill payment and shopping convenience, but not for savings or investment.
Try to own all of your financial assets outside the banking system, and avoid ETFs and structured investments requiring custodians and trustees. If you own precious metals that are not in your physical possession, make sure they are in insured, allocated accounts outside the banking system. Go by the old dictum "If you can't touch it, you don't own it!" Your objective should be to totally bullet-proof your portfolio by eliminating all counterparty risk.

This website and our free Survive & Prosper Newsletter are designed specifically to help guide you through the financial crisis by keeping fully abreast of events as they happen. Both website and newsletter are packed full of interesting and innovative ideas on how to protect and grow your net worth during this time of financial peril, and you can begin enjoying the free S & P Newsletter immediately by registering here.
 

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