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Banking Holiday in the Works?

Some Wall Street professionals are now openly talking about the possibility of a "bank holiday" in the near future. Are you ready? [Extensive commentary by Chris]

As I've long been concerned, this credit crisis is intimately coupled to an unknowable and opaque world of derivatives which, truth be told, are barely understandable in the singular by even the barest fraction of financial professionals. As a complex system of interrelating contracts now larger than 6x the entire world GDP? Sorry. No chance that even one person, let alone geographically and politically isolated policy makers, has any clue as to how this thing works, which means that solutions are simply out of the question as probable outcomes.

– As advisers to Bear Stearns struggle to find a buyer or funding in the next 28 days, Wall Street, the City and the financial district in Tokyo were scrabbling to find out who is the most exposed to Bear Stearns, either through loans or trading positions.

Traders in all three centres were panicking even for those banks not directly exposed to Bear. They feared that the problems experienced at the stricken bank signalled that the credit crisis has deteriorated to a new level.

However, Chris Whalen, of the Wall Street consultancy Institutional Risk Analytics, said: “This is going to go all the way up the chain. There is a risk that all broker dealers are going to become an endangered species if the credit crisis is not sorted out. If they can’t fund themselves, they will have to shrink. All the other firms are in danger, too.”

He said that should the US Federal Reserve, the US Treasury and the Securities and Exchange Commission not devise a broad rescue plan to address the credit turmoil on Wall Street this weekend, “I would not be surprised to see an emergency bank holiday announced. That hasn’t happened since Roosevelt.” During the Depression, 75 years ago almost to the day, Franklin Roosevelt declared a four-day bank holiday, which stemmed a frantic run on banks.

Well, now that a trial balloon for the concept of a banking holiday has been floated today, we have to consider it as being a more likely proposition than it was yesterday.

Such surprising outcomes don't always, or even very often, come to pass, but we at this site are about hedging our bets and preparing for possible outcomes like responsible adults. So, what would it mean if a 'banking holiday' was called?

Well, that's a darn good question and I wish I could peer around the corner I see ahead, but my crystal ball is pretty murky on this one.

Since I've long considered that a 'banking holiday' was in the mix of 'possible events' I've spent considerable time both thinking about and preparing for such an outcome. Now, I want you to remember that I am a scientist trained in the discipline of pathology. To me, everything is about recognizing and controlling risks and possibilities. While I view a banking holiday as still a remote possibility, it is a non-zero probability and recent events make it even more likely than before.

Here's one way to think about it though. We could imagine several scenarios that could play out.

Stage 1: Limited duration (~1 week), shallow impact banking holiday.

In this example, the Treasury announces that certain types of transactions are suspended but that very limited customer transactions will be allowed. In order to allow system limits to be placed, banks are shut for two days and then opened but with limits. Perhaps no more than $200 in cash per person per week will be allowed, or checks will be limited to $2000/account per week, or some combination of withdrawal limits that will help to stabilize the balances of the banking system and buy time while back room deals are cut in an attempt to fix whatever ails the larger banking system.

Unthinkable? Well, it's already happened in this country back in the 1930's during the first bankruptcy event of this country. And, most recently, this near exact scenario played out in Argentina. the only difference is that when the Argentinian authorities re-opened the banking system after two weeks people discovered that their US dollar denominated bank accounts had been replaced with an exactly matching numerical value of Argentinian pesos for an appauling loss of two-thirds of their original value. Imagine finding that your bank accounts had all been trimmed by two-thirds when the banking system re-opens.

Regardless, under this scenario we might expect that we go to work as normal, goods remain on the shelves of stores and are re-stocked, and that we have something extra to talk about over the water cooler.

Actions: Prior to the holiday, have 1-3 months (3 is much better) of living expenses in cash out of the bank. Wait, watch, be frugal with your cash, and stay as informed as possible. Avoid listening to official proclamations and find alternative paths to better information. Know anybody who works on Wall Street? Get tapped into the financial rumor mill.

Stage 2: Medium duration (2 to 3 weeks), medium impact banking holiday

In this example we might imagine that the interbank transfer mechanism between and among several of the larger banks no longer work because none of their checks or transfers will clear with each other because its unclear who is solvent and who is not. Here we might imagine that ATMs will largely not work because they rely of a spider web of transfers and clearances. People will discover that not all banks are created equally and some will be penalized for having selected insolvent banks.

However, many people will be able to continue doing business as their banks, typically smaller regional or local banks with less exposure to exotic derivatives and toxic mortgage assets, will remain open and solvent. Some confusion reigns because some credit and debit cards work while other do not. Cash becomes scarce in the banking system as the 4% of bank deposits that exist as actual cash are quickly withdrawn. The Treasury department comes on TV and assures everyone that more cash is being printed as rapidly as possible and a great show is made on TV of the armored cars rolling out of the mint towards their destinations.

Towards the end of the 'holiday' tempers grow short and some goods begin to disappear from shelves as both distribution breakdowns and limited hoarding begin to show their effects.

Actions: Prior to the holiday, have 1-3 months (3 is much better) of living expenses in cash out of the bank. Be psychologically prepared to lose a lot of your stock portfolio balance when the markets re-open. If you have specific medical needs, such as needing insulin, be sure to have stocked up prior but, if this did not happen, or couldn't happen, make it a priority and don't count on things working smoothly at the last minute.

One more stage to consider….

    Stage 3: Long duration (1 month or more), high impact banking holiday

    OK – here's where we don't really have a model to work from so this is pure conjecture and your guess is as good as mine. The scenario I imagine that will let me know we're in for a stage 3 event is if the announcement calls for an indefinite and complete shut-down of all banking activities. Nobody stays open, no cash, no credit or debit cards, and no checks. Now, I can't possibly imagine how things could get this bad but being prepared instead of surprised can be a bit of an advantage.

    Should the announcement come out that all banking has been suspended, I personally will immediately seek to convert cash into basic living supplies. Here, you will know better than I what sorts of things you consider vital and my hope would be that you'd have a plan for obtaining them. In case you'd like a guideline to work from I am currently working hard on creating configurable lists of basic items which I hope to have ready by later this week for you to download.

    A few things to consider though in the meantime:

    Before:

    1. Be sure to have 2-3 months of prescription medications if that is a necessity of yours
    2. Have at least 3+ months of cash out
    3. Be sure to have other 'cash like' items at hand that others may find more useful than cash. Vodka comes to mind.
    4. Have 3 months worth of basic food (minimum) stored in your house.
    5. Consider that one of your enemies may be a whole lot of extra time as we all wait around for things to get back towards normalcy. Stock up on books you always meant to read, games, dvds and the like.
    6. Think about the unthinkable. What if the electricity in your area went out for an extended period of time as a consequence of the fiscal crisis (perhaps your utility couldn't pay for the natural gas it needed?). What would you do if your stock portfolio were destroyed? What if your house lost a significant portion of its value? What if your job disappeared in the process? Do you have plans for remaining in contact with friends and loved ones in all circumstances? Will someone be coming to live with you and have you prepared for that? Having some sense of how you'd respond could provide you invaluable maneuvering room later on.

    During:

    1. Immediately curtail or cancel travel plans. Best to be close to home.
    2. Assuming things have already happened and you are calm and at home, take a careful inventory of what you've got. What I mean, is write everything down and assess how long it would last if you used each stock at a normal, frugal and a stingy pace.
    3. Check up on your friends, relatives and neighbors to be sure they are coping or if they need anything. My time in hurricane alley taught me that crises can be important moments of connection within families and across communities.