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Anti-Fragile Banking

We've been big fans of the author and academic, Nasim Nicholas Taleb, for some time. We have enjoyed his best-selling book, 'The Black Swan', his media appearances and have used his work to find other interesting works by the likes of Benoit Mandelbrot.

A central theme in Taleb's writing is that systems should be built not just to withstand 99% of scenarios, but all scenarios. A bit like saying we should build a house that stands for 365 days a year, not one that stands for 364 days only to be toppled by the perfect storm.

Taleb draws lessons from Mother Nature, who takes a long term outlook and offers systems built to last. Mother Nature builds 'redundancy' into her designs; we have two kidneys and two lungs to counter organ failure. No species would survive if it out competed all others for 364 days of the year, only to be wiped out by a single freak weather event.

Mother Nature's designs are described by Taleb as evolving and strengthening as they weather and react to crises and experiences. With Taleb's latest book, 'Anti-Fragile', coming out this autumn to a backdrop of a withering European banking system and a debt afflicted global economy, he launches his latest release to a fertile market and with his ideas in demand.

Mother Nature and banking

Compare the long term thinking of Mother Nature, with her insistence on longevity and durability, to today's highly leveraged banking system where even 'steady' commercial banks (Spanish Cajas anyone?) are often leveraged 20 times. We read of slow bank runs taking place in Spain and Italy, whilst they might not be quite so slow at the moment in Greece.

In case any reader is new to this (no shame in that), we currently have a fractional reserve banking system. In such a system a bank is able to take £5,000 of deposits and lend it out 20 odd times, or more. Assets in said bank of £100,000 are backed by only £5,000 of collateral.

During periods of calm and steady growth such a system goes unquestioned, but its volatility and vulnerability are shown in unflattering light in times of crisis. We are experiencing such a time now.

An overly leveraged reserve banking system is highly vulnerable to bank runs, where depositors panic and pull their deposits out in a fearful hurried rush. That 5% of bank reserves can disappear pretty quickly! Such banks are similarly vulnerable to insolvency; the bank only has to experience a 5% decline in the value of its assets to be technically insolvent.

This is because the banking system is built on tiny foundations that can be withdrawn at any time. It's a bit like building a house as an upside down pyramid, with foundations 5% as large as the building above; it wouldn't last.

Listening to the stewards on the Titanic

We're not the only ones saying this. Two high profile stewards of the financial system, and close to home for our British investors, have raised concerns with the model of our banking system since the financial crisis began five years ago.

In 2010, when referring to today's leveraged reserve banking system, Mervyn King, Governor of the Bank of England, argued that: "of all the many ways of organising banking, the worst is the one we have today."

In the same year Lord Adair Turner hit out at this structural flaw in the banking system, suggesting that holding reserves (deposits or good collateral) of 33% might be more prudent. Such a system would be only three times leveraged and far less vulnerable to bank runs and crises of confidence. Such a system would be better placed to meet the tests of time.

With the European banking system unravelling before our eyes, and Mediterranean depositors rushing to get their money out of their bankrupt native banks, Taleb's points appear more salient than ever (we know he also extends his argument beyond simply banking, to derivatives as well).

Some stewards of the system have spoken out against it, but little has changed. We are continuing full steam ahead.

What about the foundations of this system?

The system we have discussed above is built upon this narrow base of deposits and collateral. But, we should examine what constitutes this collateral, and whether this is a good foundation to build on.

What banks can hold as part of their regulatory capital varies, with cash deposits being Tier I capital as well as certain government bonds. If we take cash deposits as being safe and good collateral, we need to then look at the suitability of certain forms of government debt being deemed quality capital for regulatory purposes.

This is where we find further concern with the structural basis of the banking system.

How can the bonds of heavily indebted nations (USA, UK, Germany, and certainly France), whose rate of borrowing shows no sign of slowing, and whose ability to pay back such debt appears to continually be diminishing, be deemed quality collateral?

For its quality, this collateral depends on governments balancing their budgets, prudently running their economic affairs, paying their debts and responsibly managing their currencies. How well do you see politicians and central bankers doing this today?

The storm that is raging in the financial system at the moment is unfortunately compounded because the collateral and very basis of the system is questionable.

In search of proven collateral…

The collateral of the financial system, unquestioned for decades during an unprecedented bond bubble, is now in the spotlight.

The manager of the world's largest bond fund, Bill Gross, sheds some interesting light on this matter. Mr Gross manages such a large portfolio (a super tanker of a portfolio) that he needs to steer it gently through the long term market trends he sees, achieving a steady return. He manages so much money he cannot jump in and out of markets like a smaller more nimble fund or day trader; his trading size is big enough to move markets.

Mr Gross has this year compared Chairman of the Federal Reserve, Ben Bernanke, to Satan, and argued that UK gilts and US treasury bonds may need to be "exorcised" from model portfolios and replaced with more attractive alternatives. Investment in such bonds is wittily described as 'return free risk'.

One of the world's most influential money managers is urging that his previous bread and butter is becoming unpalatable.

Amidst this backdrop we have also noted with great interest movements to instate gold bullion as a Tier I capital asset. Prior to this we noted financial exchanges and institutions making gradual moves to accept gold as collateral as well. It has also been suggested that certain PIIGS nations should back some of their debt with gold bullion in their central bank. With other collateral being found wanting, gold stands tall above all other financial assets.

We see such events and movements as an inevitable part of gold's return to the heart of the monetary system.

How and in what forms gold will return to the centre of the monetary system is impossible to predict exactly, but gold is increasingly being recognised as the most proven and trustworthy collateral.

We recently had the pleasure of interviewing John Butler, money manager and author of The Golden Revolution (highly recommended). Mr Butler predicts the financial markets moving to a 'de facto gold standard', where market participants interact with universal reference to gold.

Mr Butler's predictions and forecasts chime closely with excellent recent analysis from Lew Spellman, in his April article, the 'New Calculus of Gold'.

…and rediscovering gold

At times like this you need to see what the smart money is doing. What are those with long term horizons doing?

The creditor nations and central banks of the world are buying gold in size.

Ignore the current 'noise' about the gold price this last nine months. We invest in gold as an insurance policy; with our primary motive being the return of our money, rather than the return on our money.

Gold is the secure foundation of a portfolio, as well as the financial system. It'll be there long after the current banking system is a historical footnote and the current dollar managers have been found wanting with their bankrupt economic theories. Anyone with a historical appreciation of money understands this; paper money comes and goes, as do 'paper assets', but gold always remains.

When it comes to gold investment, the burden of proof in decision making has shifted demonstrably; today you need to ask yourself not 'why should I invest in gold'?, but 'why am I not invested in gold?'