Our Banking System Operates With Zero Reserves

At one stage, the Reserve Bank was forced to order another $4.6 billion in $100 notes. Picture: Luzio Grossi Source: The Australian

According to the US Federal Reserve’s Divisions of Research & Statistics and Monetary Affairs, Australia’s banking system has no monetary reserves.

None.

In a Finance and Economic Discussion Series paper titled “Reserve Requirement Systems in OECD Countries”, researcher Yueh-Yun C. OBrien explains (emphasis added):

Abstract: This paper compares the reserve requirements of OECD countries. Reserve requirements are the minimum percentages or amounts of liabilities that depository institutions are required to keep in cash or as deposits with their central banks. To facilitate monetary policy implementation, twenty-four of the thirty OECD countries impose reserve requirements to influence their banking systems’ demand for liquidity.

Note that well. Only “twenty-four of the thirty OECD countries impose reserve requirements”.

Introduction: Central banks by definition are the sole issuers of “central bank money,” which consists of banknotes and deposit balances held by depository institutions at central banks. This feature provides them the power to implement monetary policy by influencing liquidity in their banking systems in order to achieve their policy (interest rate) targets and thus promote their long-term objectives.

That’s very important to note. Our central bank has ultimate power over the issuance of “central bank money” – the only “money” permitted – in our nation. Discussion of which is to open Pandora’s Box, so we’ll return to that topic another day.

Reserve requirements are the minimum percentages or amounts of liabilities that depository institutions are required to keep on hand in cash (vault cash) or as deposits with their central banks (required reserve balances).

Ok so far?

Twenty-four of the thirty countries that belong to the Organization for Economic Co- operation and Development (OECD) employ reserve requirement systems…

The remaining six OECD countries implement monetary policy without reserve requirements.⁴

Footnote 4 goes on to explain who those six countries are …

⁴ The six countries consist of Australia, Canada, Denmark, New Zealand, Norway, and Sweden.

… and then explains how our banking system operates, vis-a-vis the absence of any monetary reserves:

The central banks of these six countries make interbank payment settlement accounts available to depository institutions subject to certain rules. They provide standing facilities with interest charges and the lending interest rate sets an upper bound on the market interest rate. These central banks also pay interest on end-of-day account surpluses, and that interest rate forms a lower bound on the market rate Thus, lending and deposit rates form a corridor for the target overnight interest rate.

In addition to imposing rules for settlement accounts and providing standing facilities, most of these central banks influence the aggregated settlement balances in the banking systems mainly through open market operations.

Here’s a flow chart helpfully provided by the researcher. It shows (on the left) the monetary Reserve Requirement system used in 24 of 30 OECD countries.

Australia’s “no monetary reserves” banking system is circled on the right (click to enlarge):

Source: US Federal Reserve, FEDS, Reserve Requirement Systems in OECD Countries

Now, it’s very important to make a clear distinction here.  We need to remember that there are actually two basic concepts of what a banking “reserve” actually is.

One is “monetary reserves” … that’s what the US Fed’s paper we are discussing is all about.

The other is “capital reserves”.

Now, Australia’s banking system does have capital reserves.  It is a condition of Australia’s decision (January 2008) to adopt the Basel II Capital Adequacy framework. It is regulated in Australia by the Australian Prudential Regulation Authority (APRA), under Prudential Standard APS 110 Capital Adequacy.

So if our banks have capital reserves, does that mean everything is ok?

Not if you are a customer with a cash deposit in the bank.

The problem here is this.

Capital reserves relate to the question of the banks’ capacity to absorb investment losses.  It is a kind of reserve that is meant to protect shareholders in the bank, against the bank making losses on its investments. That is why the capital reserve requirement is essentially composed of a % of shareholder funds, that are held against the value of the banks’ “risk-weighted assets”.

Monetary reserves, on the other hand, relate more directly to the question of the banking system’s capacity to absorb a run on customer deposits.  That is, a good old fashioned bank run, where people lose confidence in the safety of the bank/s, and try to withdraw their cash … en masse.

In the twenty-four OECD countries that do have monetary Reserve Requirements, the banks are required to hold a certain amount of their customers’ cash deposits as reserves against customers’ withdrawals.

In the six countries – including Australia – that have zero monetary Reserve Requirements, essentially the central bank is the ultimate backstop.

Meaning?

If too many of us decide to go to the bank at the same time, and ask for our money on deposit – they don’t have it.

This helps to explain why, during the GFC’s Peak Fear period in late 2008, the Reserve Bank of Australia had to supply billions in extra cash to our banks.

The following quotation is slightly lengthy, but truly a must-read if you wish to gain a rare insight into what really went on behind the scenes during the GFC.

From Shitstorm, edited extract via The Australian (emphasis added):

Ian Harper, one of Australia’s leading financial economists, spent much of the weekend of October 11-12, 2008, reassuring journalists that Australian banks were safe.

Harper was an expert: he had been a member of the Stan Wallis financial inquiry in the mid-1990s, which had designed the system of banking regulation.

He explained that the Australian Prudential Regulation Authority already required banks to keep enough capital to cover any likely level of bad debts*. More importantly, the banking legislation provided that, if a bank failed, depositors would rank ahead of all other creditors. There was absolutely no reason for concern.

[*Note carefully what we observed above – the Basel II rules for “capital reserves” are to cover bad debts – investments gone bad. Not a bank run by customers wanting their cash deposits.]

But there was something about the calls Harper was getting from reporters over that weekend that worried him.

“There was a whiff of panic,” he recalls. It had been building all week. He had no doubt that the government and the Reserve Bank would be able to manage a run on cash, but it might take days to arrest. Panic has been an unpredictable force in the history of banking. And the instant world of electronic banking had never been tested with a full-scale crisis of confidence.

He talked about media calls with his wife. “Come Monday morning and they tell us one of the banks is in strife and internet banking is down, I can’t look you in the eye and say you can pay this week’s grocery bills.”

The man who had just been reassuring everyone there was nothing to worry about went down the street to the ATM and made a sizeable withdrawal to make sure his wife would have enough cash.

All around the country, banks were facing unusual demands for cash. Small businesses in Queensland and Western Australia were switching their deposits from regional banks to accounts with the big four banks.

An elderly woman turned up in the branch of one bank in Queensland with a suitcase and asked to withdraw her term deposits of $100,000 or more. Once filled, she took the suitcase down to the other end of the counter and asked that it be kept in the bank’s safe.

A story did the rounds of the regulators about a customer who wanted to withdraw his six-figure savings. The branch manager said he did not have that quantity of cash on hand, but offered a bank cheque, which the customer accepted, apparently unaware that the cheque was no safer than the bank writing it.

It was a silent run, unnoticed by the media. Across the country, at least tens and possibly hundreds of thousands of depositors were withdrawing their funds. Left unchecked, there would soon be queues in the street with police managing crowd control, as occurred in London at the Golders Green branch of Northern Rock a year earlier.

“With a bank run, or any rumour of a bank run, you can’t play games with that,” says Treasury Secretary Ken Henry.

“You can’t pussyfoot around that stuff. It’s a long time since Australia has had a serious run on a financial institution, but it’s all about confidence, and you cannot allow an impression to develop generally in the public that there is any risk.”

[In other words, when it comes to our savings, the notion of bank “safety” is a con-fidence trick. It is as simple, and as shocking, as that.]

The private banks keep reserves of cash distributed in 60 storerooms across the country with an average of about $35 million in each. They get topped up by the Reserve Bank before Christmas, when demand for cash typically rises by about 6 per cent, and at Easter, when there is a smaller increase.

But in early October, the Reserve Bank started getting calls from the cash centres for more, especially in denominations of $50 and $100.

The Reserve Bank has its own cash stash. It is coy about exactly how much it holds, but it is understood to be in the region of $4 billion to $5bn.

As the Armaguard vans worked overtime ferrying bundles of $10,000 out to the cash centres, the Reserve Bank’s strategic reserve holdings of $50 and $100 notes started to run low and the call went out to the printer for more. The Reserve Bank ordered another $4.6bn in $100s and another $6bn in $50s…

Households pulled about $5.5bn out of their banks in the 10 weeks between US financial house Lehman Brothers going broke – the onset of the global financial crisis – and the beginning of December. That is roughly 80 tonnes of cash salted away in people’s homes. Mattress Bank is doing well, was the view at the Reserve. A year later, only $1.5bn had been put back.

Think about those numbers for a moment.

Very carefully.

Households pulled “about $5.5bn out of their banks” in 10 weeks.

According to the ABS, at December 2008 there were 10.916 million employed persons in Australia.

So, our quiet run on the banks, a silent mass withdrawal demand amounting to a mere $504 cash per employed Aussie, was more than our banks actually had.

Forcing the Reserve Bank to print up an extra $10.6bn – that’s $971 per employed person – to keep our banks liquid and able to feed the ATM’s.

Really think about that for a moment.

Our banks did not have enough cash money to give every employed Australian a mere $504 in cash, on demand.

And yet, lemming-like, we accept their making multi-billion profits for executives and shareholders, every year.

If that’s not enough to crease your brow with concern, then consider this.

The fact that our banking system operates with zero monetary reserves may also help to explain why the RBA secretly borrowed US$53bn (around AU$88bn at the time) from the US Federal Reserve during the GFC panic (emphasis added):

National Australia Bank Ltd, Westpac Banking Corp Ltd and the Reserve Bank of Australia (RBA) were all recipients of emergency funds from the US Federal Reserve during the global financial crisis, according to media reports.

Data released by the Fed shows the RBA borrowed $US53 billion in 10 separate transactions during the financial crisis, which compares to the European Central Bank’s 271 transactions, according to a report in The Australian Financial Review.

NAB borrowed $US4.5 billion, and a New York-based entity owned by Westpac borrowed $US1 billion, according to The Age.

The RBA is all too aware of this critical danger to our financial system.

Consider this, from The Australian in July 2008, a couple of months before the GFC peaked (emphasis added):

The Reserve Bank of Australia has a dark worry about our banks: they get 90 per cent of their cash from each other. If one bank gets into trouble, the Australian financial system could be snap-frozen overnight.

This concern was laid out by the RBA’s assistant governor for the financial system, Philip Lowe, and the chief manager of domestic markets, Jonathan Kearns, to a private RBA gathering at Kirribilli House in Sydney last week.

Banking systems of other countries do not have the same level of mutual dependency, they claim, and it was not the case in Australia until about eight years ago…

Australia’s banks are, as the RBA governor Glenn Stevens tirelessly says, in great shape. Stockbrokers agree, even as they field the sell orders from overseas clients.

“The banks are trading at 12 or 13-year lows in terms of their price-to-earnings ratios,” UBS equities strategist David Cassidy says.

“Given what is happening in the US, they can always trade more cheaply. But since our economy still looks on track for a soft landing, it looks like they’ve been way oversold.”

But it does not look that way from abroad. At a recent conference held by one of the world’s largest banks, the Australian banking system was identified as one of the best investment opportunities, for going short.

The argument is that Australia’s banks hold more of their assets in mortgages than banks elsewhere and Australia’s housing is more overvalued relative to average earnings than the US housing market at its peak, or the British, Irish or Spanish markets.

This will ring alarm bells for regular readers.  All this was said – in a private RBA gathering – before the GFC really hit.  And yet, nothing has changed regarding our banking systemic risk.

We have seen previously that Australia’s banks (allegedly) hold some $2.66 Trillion in On-Balance Sheet “Assets” between them.

But, 66% of those “assets” are actually loans.  And the highest proportion of those loans are for mortgages.  In a property market where house prices “are the most overvalued in the world” – and where those prices have just had their biggest quarterly slump in 12 years. And where arrears on mortgages have recently exceeded their GFC highs.

A fall in the property market, or a rise in unemployment putting even more mortgage-holders into arrears, are real risks that could wipe out the value of the banks’ “assets” – our loans, and the “collateral” backing those loans (our houses).

In fact, that is just what happened – very briefly – during the GFC.  Mortgage arrears began to rise as the RBA kept increasing interest rates into the teeth of the storm.  Our property market began to fall.  Unemployment began to rise.  The banks’ usual lifeblood – borrowing money from overseas to lend to Australians at a profit – had already begun to freeze up due to the dark woes abroad.  And so, our banks had to borrow tens of billions from the RBA using what are called “repos” – short term cash loans from the RBA, secured against banks’ collateral.

Estimable blogger Houses and Holes documented this in a September 2010 post aptly titled “Invisopower!”. The following chart is his work. It graphs the value of repos borrowed by our banks from 2004 through 2010. You can clearly see that our banks were regularly borrowing over $15 Billion per month throughout 2008, with a peak of almost $50 Billion per month during the height of the GFC in late 2008.  Just to stay solvent. This massive liquidity support from the RBA only ended when the Government put taxpayers on the hook by introducing the government (taxpayer) guarantee to prop up our banking system:

Now, some may try to argue that Australia’s banks having “capital reserves” under the Basel II banking concord means that our banks have plenty of cash, and so retail customers with bank deposits – you and me – have nothing to worry about.

As we have seen, the real world events of late 2008 decry any such attempts at reassurance, as pure and utter nonsense.

A Big Lie.

More tellingly, there is evidence to show that the bankers themselves do not consider their APRA-regulated “capital reserves” as being available to provide retail customers with their own cash back, in the event of a bank run.

Following is a quote taken from a letter to the Australian Treasury, from the Australian Bankers Association in December 2006.  The letter relates to new “draft regulation 7.602AAA designed to reach a balance between consumer protection and the cost to businesses in relation to mandatory compensation arrangements under Chapter 7 of the Corporations Act 2001” (emphasis added):

Regulation for Compensation for loss in the Financial Services Sector

For related entities that are not APRA regulated entities it should be noted that APRA supervises the capital adequacy of a locally incorporated ADI on both a stand-alone and consolidated group basis (see AGN 110.1 – Consolidated Group, paragraph 1). It follows that account has been taken of the ADIs related entities for the purposes of the capitalisation of the ADI. Whilst these capital reserves are not available for use in a related entity’s compensating a retail customer for loss, their mere existence mitigates the risk that the related entity within the conglomerate would lack the capacity to meet that compensation claim. It is understood that these rules do not apply to all other APRA regulated bodies suggesting that a distinction should be made in the case of ADIs by removing the requirement for a guarantee in their case.

The context here is the issue of banks and their “related entities”.  A draft regulation proposed a requirement for banks to guarantee their related entities.  In lobbying to change this (!?!), the Bankers Association stated that “the requirement for the parent to provide its guarantee of the related entity’s obligations should be removed” or “clarified to confine the limit of the propose guarantee.”

In other words, we do not want to guarantee our “related entities” against losses.

And the basis for the Bankers Association argument was truly astonishing.  And very revealing.

In essence, their argument was that, even though capital reserves “are not available for use” in compensating retail customers for loss, “their mere existence mitigates the risk that the related entity… would lack the capacity to meet a claim”.

This is no different to saying, “We have money that can not be used to compensate retail customers, but you should just pretend that it can.”

Banking is a pea-and-thimble trick.  “Our” cash, that we are led to believe is really there under the banksters’ thimble, just isn’t.

The claim that Australia’s banks are “the safest in the world” is quite simply, a monstrous lie.

Like all government-approved banking systems, Australia’s banking system too is nothing more than a Ponzi scheme.

A huge con-fidence trick.

Backstopped by the so-called “independent” Reserve Bank of Australia.

And, by the taxpayers of Australia … thanks to the Labor government’s Guarantee Scheme for Large Deposits and Wholesale Funding.

Just as in the USA, UK, Ireland, Spain, and elsewhere in Europe, when our housing market collapses – taking our banks solvency with it – you already know what is going to happen.

The banks will be bailed out. By our government, who will borrow the “necessary” bailout billions against ours and our children’s children’s future taxes.

In the good times, banks profits are privatised – massive salaries, bonuses, perks and parties.

And when it all goes bad – as every Ponzi scheme must – their losses are socialised.

In my firm view, the concept of “banking” and “money” as practiced by government decree throughout the world, is arguably the greatest evil afflicting the entire human race, and impeding human progress.

Banking is a vile parasite on the human host. It must be abolished, and replaced with something better. A system whereby “money” is rendered a true servant of humanity … never again to be our master.

I know how this can be achieved. But that vision must wait for another day, and another post.

For now, just remember the Moral of the Story today.

Ignore all the “con-fidence” building reassurances spruiked to the public by our politicians, regulators, and so-called banking “experts”.

Instead, use your commonsense, and follow the advice that Australian banking system design “expert” Ian Harper gave to his own wife in the GFC:

“Come Monday morning and they tell us one of the banks is in strife and internet banking is down, I can’t look you in the eye and say you can pay this week’s grocery bills.”

The man who had just been reassuring everyone there was nothing to worry about went down the street to the ATM and made a sizeable withdrawal to make sure his wife would have enough cash.

Tags: APRA, bank run, banking system, Basel II, big four, capital reserves, endogenous money, fiat currency, four pillars, fractional reserve banking, GFC, monetary reserves, ponzi, RBA, US Federal Reserve