July 10, 2014

En route to Batumi, Georgia

Earlier this summer, IMF bureaucrats went to Sofia, Bulgaria to study the country’s economic progress.

And roughly a month ago, they released an official report which stated, among other things, that Bulgarian banks are “stable and liquid.”

Talk about epic timing. Because less than two weeks later, Bulgaria’s banking system was in the throes of a full-blown crisis.

There was a run on two of the nation’s largest banks—several hundred million dollars had been withdrawn in a matter of hours.

And the Bulgarian central bank had to step in and take over both of them or risk a collapse in the entire system.

This is the modern miracle of fractional reserve banking.

When you make a deposit, your bank only holds a tiny percentage of that cash.

The rest of it gets loaned out or invested in securities that pay a much higher rate of return than the pitiful amount you receive in interest.

Needless to say, the less money banks hold in reserve, the more money they’re able to invest… and the more profit they make.

This puts their incentives and our incentives at odds. Because as depositors, it’s better for us if the bank holds most (if not all) of our funds.

In typical form, though, governments stepped in to settle this dispute. And a century ago, they sided with the banks.

Because of this, it’s perfectly legal for banks to hold a tiny percentage of customer deposits.

So now, anytime there’s the slightest spook (as happened in Bulgaria), it creates a panic.

Naturally that’s when politicians step in to calm nerves.

In the case of Bulgaria, the EU Commission soothingly announced that “the Bulgarian banking system is well-capitalized and has high levels of liquidity compared to its peers in other member states.”

Whoa whoa wait a minute.

Are these geniuses really saying that the country experiencing a bank run due to its LACK of liquidity is MORE liquid than the rest of Europe??

Yes, that is exactly what they’re saying.

So it begs the question– if Bulgarian banks with their “high levels of liquidity” can suffer such shocks, what can happen to other European banks which are worse off?

I think the lesson here is clear: The people in charge of regulating the system and making these proclamations about bank safety are totally CLUELESS.

Of course they’re going to say that the banks are safe. Of course they’re going to compliment the system’s liquidity and solvency.

But before you entrust your savings to any financial institution, do your research and make sure they are strong enough to withstand any financial shocks.

Start with the jurisdiction first and foremost.

There are many places around the world where banks are literally an order of magnitude safer than those in the West. Hong Kong comes to mind.

Also look at a bank’s liquidity: how much cash do they have as a percentage of customer deposits? Where have they invested the rest of customer funds?

Banks with very high levels of liquidity can better withstand financial shocks. Illiquid banks will have to start selling assets and potentially go bust. Or beg for a bailout.

Some of the biggest names in banking have pitiful levels of liquidity.

JP Morgan, for example, holds 2% of its customer deposits in cash equivalents.

(Conversely I recently met with a bank in Bermuda that holds over 40%…)

This is worth paying attention to. Because the decision of where you hold your hard-earned savings matters.

And Bulgaria shows that the entire system can really be a bunch of smoke and mirrors.