Could This be the Simple Formula That has Wrecked Two Civilizations, Going on Three?

If everyone Asked the Banks for their Money Tomorrow, only the first few would be successfully served. Cyprus? No. The US of A.

The Case Against the Fed, Chapter 8, “Problems for the Fractional-Reserve Banker: Insolvency.” By Murray Rothbard. (Slightly edited for publication as a separate article – Tom Dennen)

And they’d use their one point seven billion hollow points to back it up…

Today’s banks are insolvent by definition and if customers lose confidence in their holdings and decide to cash out, it’s called a ‘run on the bank’ and the doors close.

Why?

If banks were legitimate businesses with ‘normal’ constraints, they would be legally liable to meet their contractual obligations, one of which is to ‘pay you, on demand’ your money.

A loss of confidence is always fatal because, by the very nature of fractional-reserve banking, no bank can honor all of its contracts.

HOW IT WORKS

A bank has two “customers”: people who make the initial deposit of cash and those who borrow the bank’s issue of warehouse receipts against its deposits or ‘reserves’.

The fractional-reserve process works because the law treats a deposit of cash in a bank as credit rather than a ‘bailment’ or a loan to the bank.

A deposit is a loan, and you expect a return of interest on it – it’s a transfer of custody, not ownership.

Assume that I set up a Rothbard Bank, which adheres strictly to a 100-percent reserve policy. Suppose that R20,000 is deposited in the bank. Then, abstracting from my capital and other assets of the bank, its balance sheet will look like this:

Assets Equity & Liabilities

CASH                       Warehouse Receipts to Cash

$20 000                    $20 000

So long as Rothbard Bank receipts are treated by the market as equivalent to cash, and they function as such, the receipts will work as cash. So if Mr John Smith has deposited $3,000 at the Rothbard Bank, buys a painting from an art gallery and pays for it with his deposit receipt of $3,000, it’s valid.

The art gallery need not bother redeeming the receipt for cash, trusting its promised value.

So neither the cash itself nor the bank’s receipt for it circulates as money and as long as deposit banks adhere strictly to 100-percent reserve banking, there is also no increase in the money supply; only the form in which the money circulates changes. Thus, if there are R2 million of cash existing in a society, and people deposit $1.2 million in deposit banks, then the total of #2 million of money remains the same; the only difference is that $800,000 will continue to be cash, whereas the remaining R1.2 million will circulate as warehouse receipts to the cash, redeemable in cash.

Then the Rothbard Deposit Bank decides to create $15,000 in warehouse receipts, unbacked by cash, but redeemable on demand in cash, and lends them out with interest in various loans or purchases of securities. Now the Rothbard Bank’s balance sheet looks like this:

Assets                       Equity & Liabilities

CASH                         Warehouse Receipts to Cash

$20 000                      $35 000 (plus extra interest on $15 000)

IOUs from Debtors:

$15 000 (plus interest)

TOTAL                        TOTAL:

$35 000                       $35 000

Something very different has happened in the bank’s lending operation. There is an increase in warehouse receipts circulating as money, but there has also been a total increase in the supply of money because warehouse receipts are circulating that are redeemable in cash but not fully backed by cash.

Thus, if the society starts with $800,000 circulating as cash and $1.2 million circulating as warehouse receipts, as in the previous example, and the banks issue another $1.7 million in ‘fractional’ warehouse receipts, the total money supply will increase from $2 million to $3.7 million, of which $800,000 will still be in cash, with $2.9 million now in warehouse receipts, of which only $1.2 million is backed by actual cash in the banks.

Suppose that the Rothbard Deposit Bank decides to make a quick killing and go all-out: upon a cash reserve of $20,000, decides to print unbacked warehouse receipts of $10,000,000, lending them out at interest to various borrowers?

Suppose it lends out these receipts to the Ace Construction Company, which is not going to borrow money and pay interest on it without using it as quickly as possible and so pays out these receipts in exchange for various goods and services. If those who receive the receipts from Ace are all customers of the Rothbard Bank, then all is fine; the receipts are simply passed back and forth from one of the Rothbard Bank’s customers to another.

But suppose, instead, that the receipts go to people who are not customers of the Rothbard Bank, or not bank customers at all, who pitch up at the Rothbard Bank demanding $10 000 000 when there’s only $20 000 there?

Obviously an abuse of trust has occurred.

Have banks yielded to this temptation? Do they create warehouse receipts that exceed cash on hand, and lend these receipts out?

Yes. And the strictly separate functions of loan and deposit banking, of ownership and custody become muddled; the deposit trust is violated and the deposit contract cannot be fulfilled if all the “creditors” try to redeem their claims on the ‘extra’ warehouse receiptsat the same time, called a ‘run on the bank”.

That is fractional-reserve banking, a discovery made over three thousand years ago .

Every time it reared its head, it was crushed and its perpetrators exiled, as from Rome around AD 27 and from England in 1290 … or jailed as in Iceland last year, the only nation today with the courage to do so.

Once embarked upon, there is no reason – other than a run’s exposure of insolvency – not to increase the amount of receipts, but trust must remain intact for the system to work – and that only dissolves when the amount of fractional lending is exposed or gets out of hand as it has now… and not only in Cyprus, but all over the world.

Debt is not such a simple thing.

“IT CAN HAPPEN HERE” by Ellen Brown

Confiscating the customer deposits in Cyprus banks, it seems, was not a one-off, desperate idea of a few Eurozone “troika” officials scrambling to salvage their balance sheets. A joint paper by the US Federal Deposit Insurance Corporation and the Bank of England dated December 10, 2012, shows that these plans have been long in the making; that they originated with the G20 Financial Stability Board in Basel, Switzerland (discussed earlier here); and that the result will be to deliver clear title to the banks of depositor funds.

New Zealand has a similar directive, discussed in my last article here, indicating that this isn’t just an emergency measure for troubled Eurozone countries. New Zealand’s Voxy reported on March 19^th:

The National Government [is] pushing a Cyprus-style solution to bank failure in New Zealand which will see small depositors lose some of their savings to fund big bank bailouts . . . .

Open Bank Resolution (OBR) is Finance Minister Bill English’s favoured option dealing with a major bank failure. If a bank fails under OBR, all depositors will have their savings reduced overnight to fund the bank’s bail out.

Can They Do That?

Although few depositors realize it, legally the bank owns the depositor’s funds as soon as they are put in the bank. (Ownership rather than Custody – t.d.) Our money becomes the bank’s, and we become unsecured creditors holding IOUs or promises to pay. (See here and here.) But until now the bank has been obligated to pay the money back on demand in the form of cash. Under the FDIC-BOE plan, our IOUs will be converted into “bank equity.” The bank will get the money and we will get stock in the bank. With any luck we may be able to sell the stock to someone else, but when and at what price? Most people keep a deposit account so they can have ready cash to pay the bills.

The 15-page FDIC-BOE document is called “Resolving Globally Active, Systemically Important, Financial Institutions.” It begins by explaining that the 2008 banking crisis has made it clear that some other way besides taxpayer bailouts is needed to maintain “financial stability.” Evidently anticipating that the next financial collapse will be on a grander scale than either the taxpayers or Congress is willing to underwrite, the authors state:

An efficient path for returning the sound operations of the G-SIFI to the private sector would be provided by exchanging or converting a sufficient amount of the unsecured debt from the original creditors of the failed company [meaning the depositors] into equity [or stock]. In the U.S., the new equity would become capital in one or more newly formed operating entities. In the U.K., the same approach could be used, or the equity could be used to recapitalize the failing financial company itself—thus, the highest layer of surviving bailed-in creditors would become the owners of the resolved firm. In either country, the new equity holders would take on the corresponding risk of being shareholders in a financial institution.

No exception is indicated for “insured deposits” in the U.S., meaning those under $250,000, the deposits we thought were protected by FDIC insurance. This can hardly be an oversight, since it is the FDIC that is issuing the directive. The FDIC is an insurance company funded by premiums paid by private banks. The directive is called a “resolution process,” defined elsewhere as a plan that “would be triggered in the event of the failure of an insurer . . . .” The only mention of “insured deposits” is in connection with existing UK legislation, which the FDIC-BOE directive goes on to say is inadequate, implying that it needs to be modified or overridden.

An Imminent Risk

If our IOUs are converted to bank stock, they will no longer be subject to insurance protection but will be “at risk” and vulnerable to being wiped out, just as the Lehman Brothers shareholders were in 2008. That this dire scenario could actually materialize was underscored by Yves Smith in a March 19th post titled When You Weren’t Looking, Democrat Bank Stooges Launched Bills to Permit Bailouts, Deregulate Derivatives. She writes:

In the US, depositors have actually been put in a worse position than Cyprus deposit-holders, at least if they are at the big banks that play in the derivatives casino. The regulators have turned a blind eye as banks use their depositaries to fund derivatives exposures. And as bad as that is, the depositors, unlike their Cypriot confreres, aren’t even senior creditors. Remember Lehman? When the investment bank failed, unsecured creditors (and remember,depositors are unsecured creditors) got eight cents on the dollar. One big reason was that derivatives counterparties require collateral for any exposures, meaning they are secured creditors. The 2005 bankruptcy reforms made derivatives counterparties senior to unsecured lenders.

One might wonder why the posting of collateral by a derivative counterparty, at some percentage of full exposure, makes the creditor “secured,” while the depositor who puts up 100 cents on the dollar is “unsecured.” But moving on – Smith writes:

Lehman had only two itty bitty banking subsidiaries, and to my knowledge, was not gathering retail deposits. But as readers may recall, Bank of America moved most of its derivatives from its Merrill Lynch operation [to] its depositary in late 2011.

Its “depositary” is the arm of the bank that takes deposits; and at B of A, that means lots and lots of deposits. The deposits are now subject to being wiped out by a major derivatives loss. How bad could that be? Smith quotes Bloomberg:

. . . Bank of America’s holding company . . . held almost $75 trillion of derivatives at the end of June . . . .

That compares with JPMorgan’s deposit-taking entity, JPMorgan Chase Bank NA, which contained 99 percent of the New York-based firm’s $79 trillion of notional derivatives, the OCC data show.

$75 trillion and $79 trillion in derivatives! These two mega-banks alone hold more in notional derivatives eachthan the entire global GDP (at $70 trillion). The “notional value” of derivatives is not the same as cash at risk, but according to a cross-post on Smith’s site:

By at least one estimate, in 2010 there was a total of $12 trillion in cash tied up (at risk) in derivatives . . . .

$12 trillion is close to the US GDP. Smith goes on:

. . . Remember the effect of the 2005 bankruptcy law revisions: derivatives counterparties are first in line, they get to grab assets first and leave everyone else to scramble for crumbs. . . . Lehman failed over a weekend after JP Morgan grabbed collateral.

But it’s even worse than that. During the savings & loan crisis, the FDIC did not have enough in deposit insurance receipts to pay for the Resolution Trust Corporation wind-down vehicle. It had to get more funding from Congress. This move paves the way for another TARP-style shakedown of taxpayers, this time to save depositors.

Perhaps, but Congress has already been burned and is liable to balk a second time. Section 716 of the Dodd-Frank Act specifically prohibits public support for speculative derivatives activities. And in the Eurozone, while the European Stability Mechanism committed Eurozone countries to bail out failed banks, they are apparently having second thoughts there as well. On March 25^th, Dutch Finance Minister Jeroen Dijsselbloem, who played a leading role in imposing the deposit confiscation plan on Cyprus, told reporters that it would be the template for any future bank bailouts, and that “the aim is for the ESM never to have to be used.”

That explains the need for the FDIC-BOE resolution. If the anticipated enabling legislation is passed, the FDIC will no longer need to protect depositor funds; it can just confiscate them.

Worse Than a Tax

An FDIC confiscation of deposits to recapitalize the banks is far different from a simple tax on taxpayers to pay government expenses. The government’s debt is at least arguably the people’s debt, since the government is there to provide services for the people. But when the banks get into trouble with their derivative schemes, they are not serving depositors, who are not getting a cut of the profits. Taking depositor funds is simply theft.

What should be done is to raise FDIC insurance premiums and make the banks pay to keep their depositors whole, but premiums are already high; and the FDIC, like other government regulatory agencies, is subject to regulatory capture. Deposit insurance has failed, and so has the private banking system that has depended on it for the trust that makes banking work.

The Cyprus haircut on depositors was called a “wealth tax” and was written off by commentators as “deserved,” because much of the money in Cypriot accounts belongs to foreign oligarchs, tax dodgers and money launderers. But if that template is applied in the US, it will be a tax on the poor and middle class. Wealthy Americans don’t keep most of their money in bank accounts. They keep it in the stock market, in real estate, in over-the-counter derivatives, in gold and silver, and so forth.

Are you safe, then, if your money is in gold and silver? Apparently not – if it’s stored in a safety deposit box in the bank. Homeland Security has reportedly told banks that it has authority to seize the contents of safety deposit boxes without a warrant when it’s a matter of “national security,” which a major bank crisis no doubt will be.

The Swedish Alternative: Nationalize the Banks

Another alternative was considered but rejected by President Obama in 2009: nationalize mega-banks that fail. In a February 2009 article titled “Are Uninsured Bank Depositors in Danger?“, Felix Salmon discussed a newsletter by Asia-based investment strategist Christopher Wood, in which Wood wrote:

It is . . . amazing that Obama does not understand the political appeal of the nationalization option. . . . [D]espite this latest setback nationalization of the banks is coming sooner or later because the realities of the situation will demand it. The result will be shareholders wiped out and bondholders forced to take debt-for-equity swaps, if not hopefully depositors.

On whether depositors could indeed be forced to become equity holders, Salmon commented:

It’s worth remembering that depositors are unsecured creditors of any bank; usually, indeed, they’re by far the largest class of unsecured creditors.

President Obama acknowledged that bank nationalization had worked in Sweden, and that the course pursued by the US Fed had not worked in Japan, which wound up instead in a “lost decade.” But Obama opted for the Japanese approach because, according to Ed Harrison, “Americans will not tolerate nationalization.”

But that was four years ago. When Americans realize that the alternative is to have their ready cash transformed into “bank stock” of questionable marketability, moving failed mega-banks into the public sector may start to have more appeal.

Ellen Brown is an attorney, chairman of the Public Banking Institute, and the author of eleven books, including Web of Debt: The Shocking Truth About Our Money System and How We Can Break Free. Her websites are webofdebt.com and ellenbrown.com. For details of the June 2013 Public Banking Institute conference in San Rafael, California, see here.