Long ago, physical commodities were used as a mediums of exchange… gold and silver were quite popular because they were scarce, divisible, durable, and hard to replicate.
If you had a few extra ounces laying around and wanted to store it securely, you would seek out the people who dealt with precious metals all the time and had the right equipment and staff to keep it safe. At the time, those were goldsmiths.
In exchange for keeping your wealth safe, goldsmiths would charge a fee… and for that fee, you could drop by any time and withdraw some of your gold on demand.
In other cases, if you wouldn’t be needing your gold for a while, you could leave it with him for a fixed period, say 1-year. In this case, the goldsmith would pay you interest on the deposit, knowing that he could loan out the gold to someone in need of capital at a higher rate for the same duration.
It was a simple, admirable system. When you wanted your money, it was there; if you didn’t need it, you could earn a return.
Over time, the system changed. Goldsmiths (turned bankers) began issuing paper notes which were redeemable for the gold that was secured in their vaults. The paper notes circulating around town were ‘as good as gold,’ depending on the bank’s reputation.
Occasionally, a greedy banker would circulate too many notes around town– $100,000 worth of gold in the vault, $110,000 worth of notes circulating around town. The banker got rich, and no one really noticed… until $110,000 became $150,000 became $200,000.
Then suddenly, noticing the spike in money supply, the townspeople would lose confidence in the note and descend on the bank to demand their gold. The banks collapsed and depositors took it on the chin.
Naturally, governments eventually became involved. They standardized a single paper currency for the country and took charge of securing the nation’s gold reserves. In the United States, perhaps the greatest change took place in 1913.
After intense Congressional deliberation, Woodrow Wilson signed the Federal Reserve Act into law in December of that year. Aside from creating the United States Federal Reserve, the Act created a regulatory structure for a nationwide fractional reserve banking system. And from that day forward, every bank in the country became effectively insolvent.
Fractional reserve banking is the practice of loaning out more money than is on deposit. Someone deposits $10 in a bank; the banker keeps $1 in the vault and loans out the other $9. That $9 makes its way through the economy and is eventually deposited in the bank. The banker keeps $0.90 and loans out the other $8.10.
This scheme is repeated over and over again until there is $100 floating around the economy based on a single deposit of $10. An additional $90 was conjured out of thin air by the bank.
Suppose you went to a storage facility and paid them to secure your furniture… if the facility owners went behind your back and loaned out your kitchen table, this would constitute fraud. Yet in banking, this is standard practice thanks to the Federal Reserve Act.
The Fed governs the ‘reserve ratio,’ which is the amount of deposits that banks actually have to keep on hand. Depending on the type of deposit, it ranges from 0% to 10%.
The system works when everyone has confidence. When they don’t, banks go under– and that is exactly what is happening right now. Between balance sheet deterioration and loss of depositor confidence, banks are dropping like flies… but hey, don’t worry, the taxpayers have you covered.
Personally, I want to put my money in a place where the bank will actually hang on to it and no one has to rely on a taxpayer bailout.
One solution that you won’t hear too many people talk about is Islamic Banking. Based on the ‘Shariah’ principles of Islamic law, Islamic banks in theory must hold 100% of their demand deposits in reserve.
In practice, thanks to creative deals and a bit of leniency from Muslim scholars, the reserve ratio is a bit less than 100% for Islamic banks… but as a whole, their reserves and financial strength are extraordinarily higher than western banks that are on the fractional reserve system.
If you are concerned about what another financial meltdown will do to your bank account, consider opening an account at an Islamic bank. Abu Dhabi Islamic Bank in the UAE is one example– they work with US citizens and even have safety deposit boxes for rent. ADIB has branches across the country, including in Dubai.
Outside of the Gulf region, Singapore and Malaysia are two up-and-coming Islamic Banking centers that have interesting tax advantages. Malaysia is particularly interesting because of its tax-free Labuan region. I’ll be discussing this in future letters.
As a final note this afternoon– I know Turkey day is tomorrow in the United States even though it will just be Thursday here in Asia, but I will likely refrain from email for the next two days and talk with you again on Monday.
And don’t forget that next Tuesday will be the 2nd release of the Panama Black Paper– only 25 copies will be sold, so if you want a copy, make sure you sign up to be on our pre-notification list. 12/1/2009 update: We received a lot of feedback from subscribers around the world in ‘inconvenient’ time zones that would be unavailable for the pre-notification launch… I understand this more than most people– 12pm on the east coast is the middle of the night in Sydney. Consequently, we are sending out a public notification on December 1st will keep it open for 24-hours.