Fractional banking and gold

Maybe you choose to hold your gold in an ‘unallocated’ account. You may be surprised to learn that this unallocated gold, no doubt on deposit in a bullion bank vault, while probably safe from burglars, is not entirely risk-free either. Because when push comes to shove you don’t really own that gold.

That’s because it’s part of the ‘fractional reserve’ system, the system used by commercial banks across the world. Under fractional reserve banking only a fraction of the bank’s deposits are backed by actual cash on hand and immediately available for withdrawal. The clue is in the name. The same is true for that unallocated gold – if everyone who ‘holds’ that gold demanded its redemption there would not be enough to go round. Unallocated gold accounts are really just an exposure to the price of gold.

Proponents of fractional banking argue that such a system creates liquidity; it enables the increase of money and credit supply. Opponents assert that such a system is inherently risky, as it increases the supply of money beyond what actually exists in the bank.

For hundreds of years fractional reserve banking has resulted in bank failures as depositors lost their money because their bank could not immediately pay them the full amount they had on deposit. Anyone who has seen the 1946 movie It’s A Wonderful Life starring James Stewart can see what happens when confidence in fractional banking evaporates. Life falls apart; the difference with real life is that no angel (as in the movie) will come to our rescue. Fractional banking is a kind of Ponzi scheme, whereby fresh deposits are used by the bank to extend credit to new borrowers.

The fractional reserve system underlays the Great Financial Crash of 2007-09; thanks to it, banks such as Northern Rock (in the UK) and Bear Sterns (in the US) succumbed to irrational exuberance and lent excessively, far more than they had on deposit. In the US the fractional banking system enabled banks to give mortgage loans to ‘Ninjas’ – people with ‘no income, no job or assets’. At the height of the boom UK banks were offering so-called ‘suicide loans’ of up to 120% of the value of a house with only self-certification of income.

You would think that banks and regulators had learned some lessons from then. Yet on 26 March 2020 the US Federal Reserve announced it was reducing the reserve requirement ratio for US banks from 10% to 0% across all deposit tiers. The Covid-19 pandemic was used to justify this. There’s no indication that the US Fed is going to re-impose it’s (already light-touch) reserve requirement any time soon. In the UK, the minimum reserve requirement for banks is 12.5% and for ‘finance houses’ at least 10%.

Under a ‘full reserve’ system – whereby a bank would be required to hold sufficient reserves to pay all depositors their full deposit on demand – the inherent risk of that bank collapsing (and the further risk of a systemic meltdown) would disappear. Proponents of a full reserve banking system argue that because it would separate money creation from bank lending, greater economic stability would result – although bankers would no doubt protest at their reduced bonuses, which would happen if they were unable to lend so freely.

What’s this got to do with gold?

Unallocated gold accounts do not physically store ‘your’ gold; they use the gold for other investments or loans, and promise to re-pay you the gold on demand. Unallocated gold accounts are within the fractional reserve system in other words. Unallocated gold is only credited to the investor – the bank or dealer remains the owner. If the gold holder of your unallocated gold goes bust, all you will be left with is a promise that you will get your gold or money back – but you will have to wait in line along with other angry creditors and may eventually lose what you thought you owned.

What about gold held in paper form, in an exchange-traded fund (ETF)? That too is not free of risk. It is standard practice for Authorized Participants, such as banks and brokerage houses, to contribute baskets of purchased or borrowed assets to ETFs; the bullion therein may be borrowed. In the event of a 2008-style financial crisis, the lending institutions would have first claim to the gold when borrowed, leaving shareholders in a precarious position.

Even trying to buy physical gold can run into difficulty. The august Royal Mint in the UK has been swamped recently by customers who have placed orders for gold and silver coins which the Mint has been unable to deliver because the paid-for items are out of stock.

Glint’s allocated gold

If you own gold through Glint you genuinely own it – it’s allocated to you and the gold is held in allocated storage under a custody agreement. Banks or financial institutions cannot lease out those bars, because they can’t access the allocated bullion. Moreover if you buy gold through Glint you have certainty that the price you pay is for the actual amount of gold you want.

And you avoid the inherent risks associated with fractional banking – and burglars. Moreover, unlike physical bullion or unallocated gold, with the gold that you own through Glint, you can also use it for transactions in your daily life, from buying a coffee to a family holiday; online and in-store.