Sunday, January 13, 2013

Mutilated money and central bank breakage

Mutilated Bank of Thailand baht notes

A couple of years ago Mike Sproul and I worked on a short project. Mike wanted to know what portion of outstanding central bank notes are actually held by the public and what percentage has been lost, destroyed in fires and foods, buried, and misplaced. The implications are that if a large percentage of notes have been destroyed over the years, then the central bank holds significant "free" assets in its vaults for which a corresponding liability no longer exists. If you're interested in what backs "money", then this amount is important.

This is a similar concept to the idea of a "breakage". Businesses that sell gift cards, which are really just liabilities of the issuer, would prefer if those cards were lost and never redeemed. After all, the issuer will no longer be on the hook for anything and can book a pure profit. Gift card liabilities that are never redeemed are called breakage. The loyalty point industry also makes use of the term breakage. Around 18% of points that loyalty point issuers sell to their partners will never be redeemed—which is huge breakage. (That statistic come from this publicly-traded loyalty point issuer.)

The term breakage also pops up in Breaking Bad which, I should add, is one of the most realistic TV shows out there from a moneyness perspective. In the fifth episode of season two, Walt gets angry at Jesse for losing money:

Walt: So you're saying that your guy got robbed--or rather you got robbed--but it doesn't matter.
Jesse: Dude, it's called breakage, okay? Like Kmart. Shit breaks.
Walt: And you're thinking this is acceptable?
Jesse: It's the cost of business, yo. You're sweating me over a grand?


Unlike Jesse and Walt, any business that issues bearer liabilities (like central bank notes, gift cards, and loyalty points) isn't afraid of breakage—they want breakage. Specifically, they want people to "break" ie. lose/forget their cards and points.

How much breakage do central banks enjoy? Mike's idea was to use conversion data from the pre-Euro currencies like the franc, deutsche mark, and lira. As a condition of the euro's debut, each nation's national central bank (NCB) was required to withdraw its existing note issues. Any one who owned legacy bank notes was given a horizon over which they could convert them into euros.

I've pulled the amounts of legacy bank notes not submitted for conversion from the financial statements of most European NCB's. This allows us to get a rough idea of how many notes may have been lost, burnt, or buried. I've focused on the Bundesbank, the Banque de France, De Nederlansche Bank, and Banca d'Italia—which should be a sufficient sample size. Below are the numbers in chart format.


As you can see, most legacy notes have been returned to their respective NCB. Italians and French lead the pack in returning francs and lira, with only 1.23% and 0.85% of the issue still outstanding. The Dutch and the Germans have been a bit lazy, with 2.44% of all deutsche marks and 2.79% of all guilders still unconverted.

What probably explains this discrepancy between the two groups is the horizon set for conversion. All lira had to be converted by December 2011, and all francs by February 2012. If you've still got lira or francs, you've missed the window. Guilders, on the other hand, can be converted into euro until January 2032. Deutsche marks have an even wider window—unlimited. If George Jetson still has some deutsche marks, he can take them in for conversion, assuming the euro still exists in 2062. These incentives (or lack thereof) no doubt explain some of the tardiness among the Dutch and Germans. Here is a list of time limits for redemption of each national issue of bank notes.

On the question of breakage, only ~1% franc and lira bank notes were never redeemed. A large portion of this 1% has probably been retained by the collecting community. Would it be reasonable to assume at least half? Both Mike and I were surprised that after decades of issuing currency, so little was lost to fires, flooding, rotting, misplacement, and whatnot. Maybe 0.3%-0.5%? Are people really that responsible and notes that indestructible?

One reasons for this low number is that damaged central bank notes can almost always be reclaimed. As long as more than half of the note remains, banks are required to accept it for deposit. If one-half or less of the note remains, it cannot be directly deposited. The Fed refers to this as "mutilated currency". But these notes aren't valueless since owners can send it to the Bureau of Engraving and Printing where it will be examined to determine its authenticity. A letter must be enclosed with the mutilated currency explaining why it was damaged. Presumably as long as all tests are passed, the owner of a small corner of a burnt US $100 bill will be issued a brand new bill by the Bureau.

The Fed provides a hyper detailed article here on the management of cash and mutilated currency. It's so precise that it's amusing. Learn how to properly stack, band, bag, strap, and bundle notes, and see pictures of burnt, liquid damaged, buried, and chemically damaged currency like the one below.

Federal Reserve example of burnt currency

The Fed/Bureau of Engraving aren't the only institutions to adopt the policy of exchanging damaged currency—the European Central Bank does too. Perhaps these sorts of programs help explain the surprisingly low amounts of legacy European bank notes still outstanding.

The last question is this: who benefits from central bank breakage? The Banca d'Italia should be a good model for us since it just recently retired its entire issue of lira. One way for the Banca d'Italia to allocate breakage would have been for it to give the windfall to remaining bank note holders, say as a reserve fund to back the note issue going forward. Or each note holder might enjoy a special dividend if they provided evidence of their note holdings (could get complicated). Secondly, breakage could be distributed to central bank shareholders. Here is a list of Banca d'Italia's shareholders. Lastly, the Banca d'Italia could send the profits to the state. Here's what the Banca d'Italia actually did, taken from its 2011 annual report:
Accordingly, the Bank of Italy transferred the sum of €600 million to the Treasury, being the provisional balance of lira banknotes not yet presented for conversion by the deadline.
There you have it. Profits from breakage go to the state. And when we crunch the numbers, central bank breakage really doesn't amount to much.

9 comments:

  1. JP,

    An excellent post as usual! (and quite entertaining)

    Is it possible counterfeits of a certain quality were retired by the CBs and helped lower the unclaimed %-age number?

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    1. Thanks!

      You're right, counterfeiting will probably have a non-negligible effect on the final percent retired. Can we ever get statistics on how many counterfeit notes the Banca d'Italia has accepted over the years? Not sure how since the people collecting the statistics are the same ones who are being fooled.

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    2. It's possible they can see that they have more bills of a certain serial number than they have issued but just can't tell them apart--maybe it's just not cost effective to do so?

      In this case I wonder if they report the statistic..

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    3. I don't know very much about counterfeiting. May have to do a post on this in the future. Does the central bank actively cross check serial numbers? Would they tell us if they didn't? A lot of the information on central bank anti-counterfeiting procedures will be private (justifiably so). Interesting questions though.

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    4. Yes quite interesting. Thanks again.

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  2. On a completely different topic, what's your view on quantity vs. interest rates?

    Could I ask you to opine on this?

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  3. The SCC has an interesting decision on destroyed bank notes.
    Here's the reference: Bank of Canada v Bank of Montreal [1978] 1 SCR 1148
    Peter in Fiji

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  4. One could also make the argument that the breakage benefits accrue to the remaining note holders who have greater assets relative to liability coverage and circulating currency depending on how the issue is addressed and managed.

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