What’s the most hazardous financial activity that you can engage in?
It’s not investing in penny stocks. It’s not buying foreign currencies. It’s not even playing futures and options, as risky as they may be.
No, there’s one financial activity that could certainly end in catastrophe. And I bet you’d never guess what it is.
I’m talking about depositing money in a bank.
Not many people give much thought to the financial standing of the banks to which they entrust money. That’s a mistake. When you deposit money in a bank, you become an unsecured creditor holding an IOU. That IOU is only as good as the financial standing of the bank.
In return for assuming this risk, what do you get? The highest interest account I have in the US pays me a whopping 0.46% annually.
Decades ago, both shareholders and managers often had to reimburse depositors out of their own pockets when their financial institutions failed. Starting in the 1930s, federal deposit insurance shifted this responsibility to taxpayers. In the US, the Federal Deposit Insurance Corporation (FDIC) now offers 100% coverage for deposits in insured banks up to a maximum of $250,000 per depositor.
But that reassuring FDIC logo on your bank’s front door masks the fact that the FDIC Insurance Fund has a reserve ratio of 0.79%. For every $100 on deposit, the FDIC has only 79 cents to back it with.
This is still a lot of money – $45.7 billion at the end of 2013. But it’s dwarfed by $5.7 trillion in insured deposits, plus another $3.3 trillion that is completely uninsured.
It’s more than a little unsettling to consider that the failure of just a single major Wall Street bank could exhaust the FDIC Insurance Fund. In that event, federal law authorizes the FDIC to borrow money from the US Treasury to make up the shortfall.
But when a banking crisis hits, it’s not likely to occur in a vacuum. Just consider the cascade of events that began in 2007, leading to the worst global economic downturn since the Great Depression of the 1930s:
August 6, 2007. American Home Mortgage, the 10th largest retail mortgage lender in the US, files for bankruptcy.
September 28, 2007. Internet banking pioneer NetBank declares bankruptcy.
November 1, 2007. The Federal Reserve creates $41 billion to inject into undercapitalized banks.
March 14, 2008. Bear Stearns collapses; JP Morgan acquires its assets for 8% of the pre-crisis price.
May 7, 2008. Vallejo, California, declares bankruptcy.
July 30, 2008. Congress increases debt ceiling by $800 billion to pay for the federal bailout of the Fannie Mae/ Freddie Mac mortgage business.
July 31, 2008. IndyMac Bancorp declares bankruptcy after being seized by US regulators – the third largest bank failure in US history.
September 7, 2008. The US Treasury takes over Fannie Mae/Freddie Mac.
September 15, 2008. Lehman Bros., with assets of $639 billion, files the largest bankruptcy in US history.
September 16, 2008. Crisis in the money market funds escalates when the Reserve Primary Fund redeems shares at 97 cents to the dollar.
September 16, 2008. The Fed lends $85 billion to AIG Insurance.
September 25, 2008. After a $17 billion bank run, US regulators seize Washington Mutual in the largest bank failure in US history.
October 3. 2008. President George W. Bush signs legislation authorizing US Treasury to spend up to $700 billion to purchase distressed assets and inject cash into the banking system.
October 6, 2008. The Fed begins making $900 billion in short-term cash loans to banks.
October 11, 2008. The Dow Jones Industrial Average caps its worst week in history with the highest volatility day ever recorded. The Dow loses 22.1%, down 40.3% since reaching an all-time high almost exactly one year earlier.
October 21, 2008. The Fed unveils a $540 billion plan to shore up money market funds.
November 24, 2008. The Fed and US Treasury rescue Citigroup after its stock price falls 60% in a week. The total capital infusion comes to $45 billion.
December 30, 2008. Foreclosures decrease the value of the average home 18% from previous year – the largest drop in history.
In other words, the next banking crisis is likely to coincide with a collapse in stock prices, real estate, and other assets. And if the crisis coincides with a falling US dollar – which didn’t happen in 2008 – the Fed won’t be able to create trillions of dollars out of thin air to soothe matters. It might take some time to retrieve funds from your insured bank account, even if the feds honor their commitment to pay 100% of the principal and interest owed you on insured funds.
What about uninsured deposits? The new global model is the “bail-in,” first seen during the Cyprus banking crisis that began in 2013. The agreement Cyprus reached with the EU and international lenders forced uninsured depositors and bondholders to pay some of the costs of the restructuring. Depositors with balances under €100,000 suffered no loss. But the agreement wiped out all bondholders and depositors with holdings exceeding €100,000 at the worst-capitalized bank (Laiki Bank). Uninsured deposits at the Bank of Cyprus took a 47.5% "haircut."
In return, bondholders and uninsured depositors received newly created shares in the failed banks. At the Bank of Cyprus, uninsured funds were forcibly converted into equity at €1 per share. But this wasn’t nearly enough to recapitalize the bank. One year later, the Bank of Cyprus announced plans to raise at least €1 billion in additional share capital. This offering, of course, will dilute the value of the shares even further.
Despite the obvious shortcomings from the perspective of uninsured depositors, Cyprus proved the viability of the bail-in model. For instance, the FDIC and the Bank of England agree that a failed bank in either the US or the UK could by “exchange or converting a sufficient amount of the unsecured debt from the original creditors of the failed company [meaning you, the bank depositors] into equity [stock in the bank].”
How can you protect yourself? I can think of five ways to minimize your risks:
- Minimize your exposure to the banking system. Precious metals are ideal for this purpose, although prices could go considerably lower if, as with Cyprus, future rescues of a country’s banking system are conditioned on the sale of national gold reserves. The most secure way to own precious metals is to purchase fully “allocated” physical gold.
- Keep a healthy supply of cash at home. If your bank fails, you’ll lose the ability to withdraw cash from your accounts at an ATM. Try to store enough cash to pay living expenses for at least six months. The most secure way to keep the cash is in a floor safe encased in concrete. Keep in mind that the government considers large cash holdings evidence of criminal activity, which may subject it to civil forfeiture.
- Diversify your savings across different banks, different countries, and different currencies. In Australia, a one-year CD in Australian dollars pays about 3.5%. Short-term US dollar CDs in Panama accounts typically pay 3% interest – far more than you can get at home. These aren’t especially high rates by historical standards, but they are a start to compensate you as a bank depositor for the risk of a possible bail-in scenario.
- Keep bank balances well below the insured maximums. Use only strong, well-capitalized banks to hold the funds you keep in the banking system. In the US, one excellent bank rating system is Veribanc.
- Avoid large money-center banks. These are the banks that are most likely to be bailed in during the next financial crisis.
More and more people have decided to prepare themselves for the plundering of their wealth by getting nest-egg assets out of the financial system. Can you think of any reason not to join them?