Is the pyramid collapse about to resume?

Not unexpectedly for the author (and hopefully the readers, e.g. "Is another loot going on now?") of this blog the media are full of warnings of the double dip recession. After Joseph Stiglitz Nariman Behravesh gave similar warning.

It appears that it will not be a double dip recession but a continued recession. Readers are invited to revisit the first article on the blog "The largest heist in history".

In a nutshell, in 2007 the global pyramid scheme which is the root of the current crisis started collapsing reaching its peak at the end of 2008. The governments stepped in and pumped in trillions of dollars of taxpayers' money, so-called stimulus packages, into the financial system and stopped the collapse. It appears to have been a temporary reprieve and indeed a massive waste of taxpayers' money. The size of the financial pyramid is so massive that as soon as these stimuli are exhausted, the inevitable financial pyramid collapse will resume.

So let us relax and watch undoubtedly exciting events coming. Happy New Year 2010.

Will extra tax levy on the bankers' bonuses really "damage" the City?

Last August the author of this, being no self publicist, published anonymously, in extenso, a letter that he received from the CEO of one of the largest and best known banks in the world together with the blog's author commentary. The title of the post was: "Liquidity risk".

Although the CEO did not request or implied confidentiality, it was intended that the CEO's identity would be kept secret. It is the intention of the author of this blog to keep the discussion on its merits without undue personal self-publicity. However the above mentioned CEO recently publicly criticised planned extra 50% company tax levy on top bankers' bonuses (over £25,000). In the circumstances the author of this blog decided that it was in the public interest to disclose the said CEO’s identity. The CEO's concern was that "Banks are competing globally - this bank, Barclays, competes with banks all around the world and we have to be able to compete on a level playing field," Mr Varley told the BBC."

The readers are invited to assess the articles "Liquidity risk", "Loan to deposit ratio and banks liquidity" and "Commentary to an article 'Loan to deposit ratio and banks liquidity" and the exchange of arguments, and decide for themselves whether it would "damage" the City and the financial industry in general if such talents as Mr Varley's (who is frequently referred to as one of the very top bankers) were eradicated.

Of course, any discussion – on the merits - from Mr Varley (and indeed anyone from Barclays) are welcome and will be published on this blog.

Banks are behaving like loan-sharks

The recent comments of Joseph Stiglitz confirmed what the author of this blog has been writing from months: the banking business model degenerated into the same relationship as loan-sharks have with their victims.

Stiglitz told reporters in Singapore: "The likelihood of this slowdown is very, very high, There is a significant chance that the number will be in the negative range." He called on Washington to make more funds available to state governments who face a drop in tax revenue.

It appears that unless the taxpayers keep pumping up ever more money into economy, it will come to halt again. As this crisis is the direct effect of the collapse of the giant pyramid scheme engineered by the financial industry, more financial stimulai would be a classic example of an attempt to stop its collapse. In this process the financial industry is extracting taxpayers paid maney as profits, bonuses and dividends as the system operates resembling loan-sharks "business model".

It is very disconcerting that politicians, our democratically elected representatives, simply ignore such criminal arrangements.

A new (old) model of the largest heist in history

The last events of pumping ever more money into the financial system seems to have revealed how it works and why banks are still making profit despite the economic gloom.

The government gets into debt as it pumps in taxpayers money into the financial system. The financial institutions take the money and lend it back to the government charging interest. Not exactly a rocket science of the financial engineering. This is one of the mechanisms how banks make money despite gloomy economics. The government is borrowing money from the banks that it put there in the first place. This puts the government into further debt. Quantitative easing (QE) is a part of the same process.

Then, the financial institutions, having made money (by exploiting taxpayers) pay back some in taxes. However they will get it again, and more, from the government in form of some subsidies, bail-outs, QE etc and the cycle repeats.

This is a loanshark's business model of spiralling the country into ever more debt.

The lending with loan to deposit ratio above 100% cleared the capital reserves out of cash causing the liquidity crisis. It appears that the heist is continued. This time government is giving money to banks only to borrow (the same money) from them at the costs later. As a result banks are making money and pay taxes. This is used as a false argument that banks, in the shape as they are, are good for the economy making profit despite economic gloom. It all looks like an organised scam as these are bogus profits.

This cycle of getting taxpayers further into debt also has an exponential growth like lending with loan to deposit ratio above 100%. With base slightly above 1 (i.e. 1% - 2% - 3% interest) it will increase at first slowly. But it is a time bomb as at some point it will start accelerating very rapidly.

The bankers’ bonuses are the ultimate insult. It is like paying a burglar for doing your home. Although emotive, it is financially of little significance to the system. In reality there is a risk of a complete break-up of the public finances as this taxpayers robbing scam is a pyramid which may reach a tipping point and collapse leaving the country with unrepayable debt. Then only hyperinflation, on a Weimar Republic or Zimbabwe scale, could balance the financial books of the country.

Will the UK go bust after the elections?

Sir Howard Davis made some very refreshing comments at recent HSBC clients gathering in London. It is clear that the public do not understand the scale of the crisis which was caused by a collapse of the giant pyramid scheme. The demands of those who are still at work, from postal workers to university professors, make it clear that the current crisis appears as something unreal. And, ironically, it is.

The government have no idea of the size of liquidity hole they are trying to plug. It may still be some hundreds of billions, if not trillions, of pounds. On top of that they keep on spending money to sustain artificially the lifestyle the UK cannot afford any longer (if it ever afforded at all). This puts the country in even more debt. As the government does not want to lose the next elections (or to lose them by the least possible margin), they keep the public in delusion of affluence like someone who got unemployed and is draining his credit cards to their limits.

The Conservatives, seeing the public mood and appetite for continued high lifestyle, are too afraid of telling the harsh truth: that the UK is already in a very deep debt hole and tightening of the belt has to start now. They do not want to be accused of scaremongering by the Labour, which may well result in scuppering their elections chances of near-certain (at the moment) victory.

It is this rather unholy alliance of interests of both sides of political spectrum: the Labour's and the Conservatives' that contributes not only to irresponsible but economically irrational behaviour. We try to live financially as nothing has happened. After the publication of the recent economic figures, the time till the next elections increasingly looks like the last dance on the Titanic. The reality check will come after the elections. Doesn't matter who wins: there is a pretty good risk that the UK will be bust by then.

We seem to believe that what happened to Albania in 1996 – 1997, Argentina in 1999 – 2002 and is happening in Zimbabwe now will never happen to us. That all these can happen to others. Well, it may already have started happening…

The Economist exonerate the bankers

(The author of this blog has to declare his personal interest in this article as a person who was brought up on The Economist and is still a very keen reader. Therefore this article might be too benevolent to The Economist than it possibly should have been.)

On 8 October 2009 The Economist wrote in a Leader "It wasn’t me" that banks bosses "were mostly useless, not venal." This may actually be correct, to some degree, but it does not justify the key premise as somehow this crisis was a giant global cock up caused by "useless" bankers.

Cautious conclusions, based on other fraud investigations, indicate that a bunch of quite (not that) clever financiers changed the banking system practice from "fractional reserve banking" (i.e. lending with loan to deposit ratio below 100%) to, what the author of this blog called, "depleting reserves banking" (i.e. lending with loan to deposit ratio above 100%, which technically and legally is a pyramid scheme).

"Depleting reserves banking" rather than accumulating cash reserves at every deposit – loan cycle, depletes them. To cover this up a lot of instruments and methodology were invented (so-called "financial innovations") giving an illusion that whilst banks' reserves were rid of cash they somehow still had the reserves to cover for cash liabilities. This has nothing to do with whether cash is a paper or electronic record, but who is the guarantor of liability. Cash is guaranteed by a state. This is the key to understand this crisis: whilst capital reserves appeared to have been sufficient at the start of this crisis they collapsed in value as there was no sufficient cash on the market and only a state intervention prevented the financial system from a melt down.

"Depleting reserves banking" practice needed an army of incompetent "professionals" to run it. Incompetent to such a degree that they did not understand that this was a crude pyramid scheme that was bound to collapse. Hence a huge bunch of history, anthropology, other social sciences and, importantly, lawyers were employed as banks executives to execute heist designed that way. Typically these people's career in banking was very often based on hang-ups. A huge majority of them were very poor in math in school and banking environment gave them a sense of massive self-importance and belief. They became "masters of the universe" whilst many of their friends who were so much better at it in school were left behind in pretty poorly paid and mundane engineering jobs. This was very important to the heist organisers. It created a mindless and incompetent army of financiers, like child soldiers in Africa. It also built a massive lobbying army protecting heist organisers from criminal consequences. It is rather impossible to lock up thousands of influential thieves, most of whom did not even understand they were stealing. A lot of them still believe they were "creating value". Psychologically it is like prosecuting child soldiers in Africa. However this time we deal with the adults who should have known not to do jobs they were not suited for. Like a butcher should know that he cannot operate on humans: even taking appendix out which is a surgically trivial operation.

The Economist should not rush to any conclusion. Exonerating the bankers does not look like a balanced and objective judgement. Their leader writer does not have to agree with the analysis above. However in old Economist tradition it should advocate a thorough forensic examination of the causes and mechanics of this crisis which is too big for half a page broad brush editorial judgment.

UK government officially confirmed it does not have a clue about the size of the liquidity hole

On 28 March 2009, the author of this blog wrote to the British Chancellor of the Exchequer (top Minister for Finance and State Treasury in the UK), Alistair Darling, asking a question:

"What is the size of the liquidity hole in the banking system that the government is currently trying to plug?"

On 1 October 2009 HM Treasury official, Paulette Wright, responded with a lengthy letter listing measures that the UK government has undertaken to ensure the financial system stability, including Assets Protection Scheme (APS). However with respect to the crux of the question the response stated:

"It is not possible to set out estimated costs for certain at this point: part of the point of this scheme is to insure assets the market cannot value at the moment, and due diligence on these contracts is continuing. The Treasury will report any losses through the normal budgeting and accounting process."

Garages and garden sheds up and down the country are full of "assets the market cannot value". They are called 'junk'. Clearly the financial industry have gone bonkers: they hold reserves for cash liabilities not in cash (as if a refinery were holding oil reserves in, say, coal), they call pyramid scheme operations: "value creation" and they call a resulting unsaleable junk: "assets". Where is the limit to this absurdity?

The UK government admitted that it does not have a clue about the size o the liquidity hole it is trying to plug and signed a blank cheque underwriting any future costs of further bailouts.

This resonates dangerously with Joseph Stiglitz' opinion that banks stress tests may not reflect the financial industry health, as he stated: "You worry that the stress test was designed to make sure that they passed."

The signs are that the liquidity crisis is far from over. The financial pyramid that was created by the financial industry and caused this crisis in the first place collapsed only partially. By buying and underwriting massive volume of bogus assets, the government is trying to support the remains that may be far larger than the losses that have already been suffered. It is spending hundreds of billions of taxpayers' money to buy junk, throwing good money after bad. Notwithstanding continued government spending spree on junk, it looks increasingly likely that these remains may collapse causing another liquidity crisis wave, far larger than ones that we have experienced thus far.

Even if these pyramid remains do not collapse, the costs of supporting them are incredibly high, in a long run far higher than taking one off hit of a complete collapse, which may prove inevitable anyway. The scheme whereby taxpayers are paying banks for junk has the financial structure of extortion racket run by loan sharks: their victims keep on paying as much as they can forever.

Apology from the bankers

The Chairman of HSBC, Mr Stephen Green, told the BBC that the financial industry "owes the real world an apology". This is a move in the right direction, but…

The current crisis resulted from a collapse (one could argue near-collapse) of a giant global pyramid scheme akin to Albanian gangsters' of 1996 – 1997 which drove the country into anarchy. Setting up and running pyramid schemes is a fraud, a crime. Therefore apology is simply too little.

The causes and mechanics of the current crisis require a proper legal investigation. The perpetrators of a pyramid that caused the current crisis must languish in jail (like some Albanian gangsters or Mr Madoff) and their wealth (including stashed offshore) must be confiscated. Governments (including the UK and US) must make their position clear in this respect. Incidentally HSBC appears to have been acting prudently all along with healthy Loan to Deposit ratio of 90% and seems to have been affected by other banks’ actions. Such investigation may be in HSBC own interest. But are they prepared to stand up to the rest of the industry?

How to make money? (revisited)

On 4 October 2009 the FT reported that "Goldman Sachs stands to receive a payment of $1bn – while US taxpayers would lose $2.3bn – if embattled commercial lender CIT files for Chapter 11 bankruptcy protection".

It appears that it is in Goldman Sachs interest that CIT files for Chapter 11.

Without making or implying any judgment or even suggestions on Goldman’s investment strategy and tactics with respect of CIT, readers are invited to revisit articles: "How to make money?" and "The government must get a grip on large private investors".

FSA: coming back to their senses

(...or facing the abyss?)

It has taken months, if not years, for the Financial Services Authority, FSA, to understand the glaring obvious: that banks have liabilities in cash therefore they must have also good reserves in cash for that purpose. As explained in the article "Economic world remains confused", refineries need crude oil to maintain operations, hence they keep reserves in crude oil. Not, for example, in hard coal with a hope that they will be able to sell it and buy oil in case of its shortage.

It is astounding that it has taken the FSA such a long time to understand the obvious. One would ponder whether this is a testimony to substandard level of professionalism or, possibly, a rather too close (read: corrupt) relationship with the financial industry.

The financial industry is not too happy. They criticised the FSA that their action was "posing a risk to economic recovery and hindering London’s position as an international financial centre".

It is possible that the financial industry is run by such incompetent individuals that they cannot understand the glaring obvious. But it is also possible that the existing liquidity hole is so great, and the bankers are aware of that, that trying to plug it with additional liquidity will bring the system to a halt. Even the government does not have an idea about its size. Therefore the bankers' criticism may be correct not for the reasons that they appear to suggest or are publicly disclosed. The effect of the giant global pyramid scheme created by the financial industry may still prove lethal.

Experts at odds (John Kay vs Charles Goodhart)

In his analysis, "Narrow banking: the reform of banking regulations", John Kay wrote, in the context of near-collapse of the financial system last year:

"The issue of robustness is central. No systems, however well designed, can eliminate mistakes and failures. While good systems seek to reduce the likelihood of mistakes and failures, a central feature of all well designed engineering – and biological – systems is that they are robust to the failures that will inevitably occur.

Robust systems are structured so that failures can be contained within a single component, or so that error correction mechanisms come into play. In other interconnected utilities, such as water or electricity, substantial resource – both technical ingenuity and capital expenditure – is devoted to ensuring that such failsafe measure exist, which is why major disruptions are rare. Financial services are different. But they should not – and need not – be different.

Robust engineering systems are designed with modularity – so that one component can fail, and be replaced, with little damage to the whole. They have independent back up systems. They are loosely coupled, so that small disruptions are easily absorbed. All financial institutions apply these principles to their technology, but similar measures are not in place – or widely thought relevant – to substantive operations of these institutions, or for the financial system as the whole."

This is very refreshing but pretty much obvious to any scientist like mathematician, physicist, chemist, computer programmer or engineer. This is the crux of any logical or engineering design. For any first year student of engineering this is blindingly obvious concept.

However in the beginning of this year, Charles Goodhart argued that:

"One of the lessons of the recent crisis, a lesson for bankers and for regulators, is, hire fewer mathematicians and physicist who build models on the basis of data that they can observe over relatively short period, and hire a few more historians who know what can go wrong even if they don't necessarily have a good data basis to put into particular models".

Wishing good luck to historians, political scientists, social anthropologists and so on if indeed few more of them are hired by the banks, and they are in charge of designing modular complex failsafe systems. Is it not astonishing that they are not employed in a similar capacity in an automotive industry, shipbuilding or by airline manufacturers? It would be surprising if many of them understood what John Kay is writing about.

Economic world remains confused

(On capital reserves requirements and other regulations)

The recently published report by John Kay, "Narrow banking: the reform of banking regulations" shows that the financial and economic world is confused about banks’ capital reserves requirements. Let us start with an example.

In world of energy resources there is a parallel requirement in terms of holding adequate reserves of various energy sources. Typically, subject to energy industry structure, a country needs to hold sufficient reserves of crude oil and hard coal. Both sources of energy can be seen as "liquid" between each other. In the world of science the equivalence is in energy units. However in the world of trading the equivalence is in prices. Therefore a country could hold crude oil reserves in coal: in case of shortage of crude oil, a country would sell its coal reserves and buy required amount of crude oil. This would be especially attractive for countries that have massive coal resources and limited crude oil resources.

Despite such appealing "innovative" structure of holding energy sources reserves, no country practices this approach. In fact it would be considered as foolish. When a shortage of crude oil comes, the value of coal is very likely to decrease dramatically to the original equivalence assessment and the energy producers, like refineries, are very unlikely to accept delivery of coal instead of crude oil.

If banks have cash liabilities (and a lot of them are precisely these), the reserves must be in cash and in currencies in which these liabilities exist (Zimdollars would not be good reserves for Norwegian Kroners liabilities, would they?). There is a room for a margin of "reserves" being held in other forms, but these are NOT reserves but investments that attract a certain liquidity risk of not being convertible into the original liability.

John Kay observed in his analysis:

"During the crisis, several banks continued to report compliant capital ratios although the pricing of their equity and subordinated debt indicated that the market believed that they were insolvent."

The business world understands that you cannot keep copper reserves in iron ore, crude oil reserves in coal, or timber reserves in polymers. Similarly, the financial world had also understood for centuries, until a couple of decades ago, that liquidity reserves had to be kept in cash. Fractional reserve banking, with loan to deposit ratio below 100%, in reality below 90%, has been a great risk management achievement: putting more money into economy whilst still keeping adequate cash reserves to cover ongoing liquidity needs.

As pointed out in the "The largest heist in history" and other articles on this blog, in the last couple of decades this system has been turned upside down. Fractional reserve banking was replaced by depleting reserves banking i.e. lending with loan to deposit ratio above 100%, depleting cash reserves by pushing them onto the market (into deposit – loan cycles). This system was possible as financial papers and instruments other than cash were allowed to serve as capital reserves intended to assure banks liquidity. A complete and obvious lunacy: it was like if, in a different industry, timber was an accepted reserve for a polymer stock (or the other way round). It is possible, but only to a very limited degree. The nonsense of such reasoning still seems not to be appreciated in the world of finance, despite the fact that any, even a small investor, knows that the value (i.e. cash value) of financial papers and instruments can go up as well as down. This is despite the fact that until a couple of decades ago, bankers had understood this for centuries.

The liquidity crunch happened a year ago (and still continues) precisely because the banks did not have sufficient cash reserves. The capital reserves were to a massive extent bogus created as a result of a global massive pyramid scheme. (The article "Exercise/example – how does it work?" shows how once well-priced capital becomes bogus in the presence of depleting reserves banking.) It is almost certain that it was a scam premeditated to steal cash for banks' reserves and taxpayers (through bail-outs and subsidies). Of course a lot of bankers were just silly (i.e. criminally negligent), but quite a few of them were crooks who designed, operated (and still operate) this system.

John Kay is not correct in asserting that regulatory requirements proved inadequate (let alone massively inadequate). Laws and regulations of any civilised country prohibit creation and running pyramid schemes such as the one that caused the current crisis. And this is precisely what bankers (with the blessing of regulators and some politicians) were doing. Therefore it is somewhat vacuous to think about knew regulatory framework. Prosecution of all pyramid purveyors that caused this crisis should be an urgent priority.

In this context it is very refreshing to read John Kay's observation: "Financial services activities are particularly attractive to sophisticated criminals. Preventive and punitive activity against fraud is essential". You can say it again, Professor Kay.

Narrow banking: barking up the wrong tree

The report written by John Kay, "Narrow banking: the reform of banking regulation" and ensuing discussion in the mainstream media, e.g. Martin Wolf in the FT, Anthony Hilton in The London Evening Standard and John Kay himself in The Daily Telegraph is worth analysis.

The growth of balance sheets (i.e. deposits and loans) can be classified according to risk and complexity as follows:

- 100% reserve banking, i.e. no risk, all deposits are repayable immediately on demand; this implies loan to deposit ratio 0%; this means that banking becomes a utility business which is what John Kay appears to be arguing for in his report.

- fractional-reserve banking, i.e. a certain level of risk as banks keep only a fraction of deposits; this model has worked for centuries based on trust in banks and a statistical principle that not all depositors need to withdraw money at the same time; therefore a "bank run" was possible if depositors lost trust, or there was no sufficient reserve accumulated; to counter the former governments routinely guarantee deposits to counter the latter loan to deposit ratio must be comfortably below 100% and banks were lending money to one another (including a central bank, the lender of last resort); as example to have 10% fractional-reserve banking i.e. £1 cash has to "serve" £10 on the balance sheets liabilities, loan to deposit ratio must be 90%; to have 25% fractional-reserve banking i.e. £1 cash has to "serve" £4 on the balance sheets liabilities, loan to deposit ratio must be 75%; to have 50% fractional-reserve banking i.e. £1 cash has to "serve" £2 on the balance sheets liabilities, loan to deposit ratio must be 50%; and incidentally to have 100% fractional-reserve banking i.e. £1 cash has to "serve" £1 on the balance sheets liabilities, loan to deposit ratio must be 0%.

- no reserve banking, i.e. banks lend with loan to deposit ratio of 100% (accumulating no cash reserves), a liquidity risk is 100% in a finite time (the growth of balance sheets to underlying liquidity is linear).

- depleting reserves banking, i.e. banks lend with loan to deposit ratio above 100%, not do they not accumulate any cash reserves, but they deplete the existing reserves, a liquidity risk is 100% in a finite time (the growth of balance sheets to underlying liquidity is exponential, therefore it is a very short time indeed). Depleting reserves banking amount to a classic and rudimentary example of a pyramid scheme.

It is important to have a debate whether we, as society, taxpayers, should have 100% reserve banking with no liquidity risk at all, or a fractional-reserve banking with some element of liquidity risk. However, this debate has very little to do with the causes and mechanics of the current crisis. It is similar to any debate what level risk society is prepared to accept: be it air travel, road travel, building nuclear electric plants and so on. It is a cost-benefit debate. For centuries, fractional-reserve banking on a level of 20% - 25% worked well circulating money in the economy. In this process sufficient reserves were accumulated and bank runs were a rarity.

A sufficient cause of the current financial crisis was the fact that banks were lending with loan to deposit ratio above 100%. They committed a crime of fraud: building a pyramid scheme. The current liquidity crunch is simply a collapse of this financial pyramid. (In the same way, a liquidity crunch was caused in Albania in 1996 – 1997.)

It seems that arguments in the financial community are moving with a grace of a drunkard walking in a corridor: from wall to wall, from one extreme to the other, from pyramid scheme practices to arcane 100% reserve banking. Whilst this may be a result of a lack of understanding of the fundamentals of mathematical complexity and risk assessment (based on probability theory), it also obfuscates the picture that the financial industry committed a massive fraud on the taxpayers using a pyramid scheme mechanism.

Even if 100% reserve banking will get its way, governments must prosecute many from the financial community (as well as regulators) not for practicing fractional reserve banking (which may be risky but still within what has been legally acceptable as commercial risk taking), but for practicing depleting reserve banking (which was excessive risk taking and amounting to an illegal financial pyramid selling).

Borrowers are bailing out the banks

Yesterday's episode of BBC Panorama, "Banks behaving badly" showed a new and growing pathology of the financial system.

Last year the government stepped in and injected a lot of money, billions of pounds, to rescue banks from inevitable bankruptcy. The government control over the banks and their practices has been illusory to say the least despite the government being a large shareholder. Nevertheless the banks are very keen on to pay back the government subsidies and get out, completely and formally, of any ownership control. The government may get under pressure from the public and be forced to act in a way that the banking industry would not like. The current tension regarding bonuses is a gauging example. Having repaid the subsidies and financial help, the banks will be able to claim that their reforms worked and the government will be able to announce a success. Therefore any further government intervention could only destroy a revival of the financial system.

This is yet another organised scam. It is as primitive scam as the one that originally led to the current crisis (which was a pyramid scheme). This time banks have massively increased the margins on the mortgages (and other loans): a difference between a rate charged by a bank on a loan and Bank of England base rate. This is designed to give banks massive profits.

The banks are repaying the debt to the government by charging the public (i.e. taxpayers) far more than otherwise they would have done. Through the government actions, taxpayers bailed them out in the first instance. This however brought about rather unwelcome, by the banks, government's ownership. Now, with the government's blessing, the banks found a way to force taxpayers, who are banks' customers, to pay for the banks getting rid of the government's ownership control.

The banks behave like sharks. Loan-sharks. Once they taste the blood they will come back for more. Even when banks repay government subsidies with money extorted from taxpayers, which is a scam, they are very likely to continue with this practice. They will keep on making massive profits: but it will not be a profit in an economic sense. Banks will acquire a right, like the government's, to tax people. In practice it is a relationship like between low-life loan-sharks and their "customers" (i.e. victims).

It is very likely, that unless the ministers are dim, the government participates in this scam. It is far better, from popularity perspective, for the government to let the banks "tax" the public to pay for the costs of the crisis than to increase taxes. It is revolting however: the former is a licence for the banks to extort money from taxpayers and enrich themselves. The latter would be a genuine tax (within the government prerogative) retaining banks' ownership in the public hands. The key is that the government can blame (already unpopular) banks for the former, whilst the latter would not be exactly a vote winner for the politician in a run-up to the elections. Effectively, through banking system the government is introducing (not that) stealth tax to pay for the costs of this crisis, additionally making the public paying for it with the rescued banks’ equity.

Apart from obvious criminality of such arrangement, like any high taxes, it will impede economic development.

Late Brezhnev era in finance

After a year since the outbreak of the financial crisis, it is time to reflect and look for some meaningful parallels in recent history. Another anniversary this autumn, the 20 years since the collapse of communism, can be a point of reflection.

Last year governments' intervention to save the financial system resulted in a setting akin to the communism from late Brezhnev era. In Britain New Labour effectively nationalised the financial system. Ironically, having rejected not that long before Clause IV. The financial establishment has become modern days' commie-style nomenklatura. Their enjoyed privileges and lavish lifestyle is all at taxpayers' expense as they are a direct result of governments’ bailouts, subsidies and guarantees. "Knowing it better"-arrogance of the bankers is very similar to that of communist party apparatchiks of the Brezhnev era. They also proclaimed that it would be a tragedy if they had gone, they had lost their roles and a country "lost talent". This is how at present the financial establishment justifies their continued stratospheric bonuses at taxpayers’ expense and governments do not seem to know what to do about it. It is a farce: in a democratic society the public cannot afford to continue to watch this pathetic and amateurish pantomime. The overall production costs and, hence costs to the audience, the taxpayers, are incredibly high, running into trillions of dollars already.

In the same way as communism could not have been reformed and had to collapse, as this new nomeklatura rules, the financial system cannot be turned around. (No pun intended, Lord Turner.) Turkeys are rather reluctant voters for Christmas. We have already seen attempts of reforms and calls for deeps systemic changes. The Turner Review, the French attempts to curb the bankers' pay and so on. No doubt, we will see more of it. But they can be expected to have a similar effect on the financial world as Kadar's reforms in Hungary or Gorbachev's perestroika and glasnost in Russia had on communism. They should speed up the inevitable collapse. They are paving a way to deep changes.

Time will tell whether these changes will have a Czech's velvet revolution softness or ruthlessness of a Romanian angry mob.

New Labour: a cunning plan of Old Labour

BBC news piece showed a very sad real face of the current crisis. A decent working class father who, having been made redundant as a railway maintenance man, is scraping every single copper coin to get a few pounds (if that) to buy food. Who is "pinching" his child's savings and it is still not enough. So local charity supplies the family with the food.

On existential level this is no drama. Britain is not becoming, let's hope, another failed state like Zimbabwe where there is an outbreak of near-famine. So let's keep it in perspective. But it is so humiliating, heartbreaking and gut-wrenching.

We have to accept that only very few of us are clever. Most simply want to live ordinary lives doing socially useful jobs and earn a decent living. This is practically it. These are basic expectations of civilised part of the world that have been taken for granted for a few generations. They were brutally thrashed by the common criminality of the financial world. They robbed us using a primitive pyramid scheme method and were not even intelligent enough to cover their tracks. All these happened under New Labour watch characterised by their love of the City and their practices. For years we have had to watch rather unsavoury spectacle of New Labour elite brownnosing captains of the financial industry.

For these pyramid purveyors and their protectors it is business as usual. Not only are they not made accountable for their crimes (apart from few minor exceptions like Madoff who only ended up in trouble as he robbed rich and powerful) but they continue to enjoy stolen riches, live at the taxpayers' expense and expect that to continue. This is in startling contrast with a railway maintenance man who was made redundant living below the breadline on charity handouts.

The cynicism of pyramid purveyors and their protectors is such that they suggest as somehow free market failed and the economic system needs improvements. Politicians, regulators and financiers are busy discussing this. But the truth is simple and shocking. Free market is not faultless, however on this occasion the crisis is not a result of free market failure but of a primitive fraud called a pyramid scheme. Albanians experienced the same in the late 1990's.

Thus far it has been usually a domain of loony lefties and others of "The Socialist Workers" creed, but this time also reasonable conservative folk and family men have to wonder whether we might see soon angry pitchfork and torch bearing mobs at the gates of the Downing Street.

Alexis de Tocqueville famously observed that revolutions and social unrests do not happen amongst poor and dispossessed at the depth of misery. Third world countries are socially quite stable. Revolutions happen when ignited high expectations of ordinary people come to a crashing end. Here after over a decade of seemingly unprecedented prosperity "things only got better" and climaxed with "Cool Britannia", the current crisis could be such a tipping point.

After all it may well be the case that New Labour project was a cunning plan of Old Labour who used de Tocqueville's textbook recipe to try to spark off the revolution. And if it works, Baldric will be proud.

NOTE:

Pyramid scheme is an ideal mechanism for testing de Tocqueville’s recipe: as the pyramid grows and people think they become richer, and indeed many of them are but only for some time, their aspirations grow with that too. An inevitable pyramid collapse brings these aspirations to a crashing end. An Albanian pyramid crisis of 1996 – 1997 is another good example how it works.

Sir John Gieve on Newsnight, 14 September 2009

On 14 September 2009 on BBC Newsnight, Sir John Gieve, an ex-Deputy Governor for Financial Stability of the Bank of England between 2006 and 2009, gave an interview. (To watch Newsnight click HERE.) During the interview, at around 31:55 of the programme, Sir John referred to the way the crisis happened comparing it to "rather like a network effect you get with a flu pandemics" which "if it reaches the tipping point it then accelerates and it is exactly the sort of thing we saw happening in the financial markets".

Readers of this blog are invited to read (again) a short article from April this year "Financial pandemic".

Sir John did not seem to realise that this sort of "network effect" he was talking about, had exponential growth and as such constituted a pyramid scheme. Not realising this, he did not seem to be concerned that we, as society, are victims of a massive crime perpetrated by the financial industry, although in fact he confirmed it.

Sir John, warm welcome to the club. I do hope you will become its conscious member and realise a true significance of your statement. I also hope that you will put a pressure on relevant authorities to pursue criminal prosecutions of pyramid purveyors (i.e. bankers, regulators and some politicians), which will also include sequestration of their assets, who are behind the current crisis.

Even more uncomfortable truth

An accounting firm BDO Stoy Hayward (the same firm that was commissioned by the British government to produce a report on the MG Rover saga) published recently an analysis:
"Time to break the silence?".

"It is no secret that due to the recession, the bank bail-out and corporate mis-management, that the UK is now facing a £175bn deficit. It's also no secret that one of the principal options to address the increasingly urgent need to 'balance the books' is by raising tax. BDO's Prudent estimates put this figure at an additional £25bn a year! Tax on you, me, our families and our businesses.

None of the political parties are currently standing up and speaking out about how they intend to reduce the national debt. Now it's time for politicians to speak out and Break the Silence over potential tax policies."

The entire report makes a very uncomfortable reading for both the Labour and the Conservatives. The former do not want to lose the next elections (held by spring next year at the latest) or lose it by the least possible margin. The latter do not want to scare the electorate too much. Labour keeps spending as there was no tomorrow (to survive till election) and the opposition stays almost quiet about it. As a result the public stays deluded that everything will be all-right.

However the whole truth is even more uncomfortable than it transpires from the BDO report. Firstly the government, as it admitted, does not have an idea of the size of the liquidity hole that it still may have to plug. There are already signs that the next wave of liquidity crunch may be on the way. Other governments, like German’s, are gearing up for it. BDO report assumes, implicitly, that the scale of deficit will not increase dramatically. This appears to be an optimistic assumption.

Secondly the scale of financial burden that the taxpayers will have to bear – even assuming rather optimistic picture that the report paints combined with the recent approach to bankers’ pay scales - shows that the relationship between the financial industry and taxpayers evolved into loan sharks and their victims arrangement. Taxpayers will keep paying through their noses forever to support opulent life-style and massive earnings in the financial industry.

Indeed it is high time for politicians to tell the truth about the scale and consequences of the current crisis. It is also high time they confront the financial industry and instigate prosecutions (including wealth confiscation) of all those responsible. This crisis is not a failure of capitalism or free market economy. It is a result of common criminality: centuries old fraudulent methods that resulted in turning the financial system into a giant global pyramid scheme.

The government must get a grip on large private investors

(The article below argues on the basis of Michael Spence and Joseph Stiglitz asymmetric information markets theory and Gresham’s law that:

1. Large private investors (e.g. hedge funds, private equity, venture capital firms) must be regulated so their activities are completely transparent.

2. Short selling of shares of companies must be banned.

Whilst it is completely understandable that the editors of mainstream financial media such as the FT, due to their educational background, are unable to deal with technicalities of the current crisis, the article below presents a type of arguments that must be within their grasp and must have been published by them in the interest of debate on the state of the financial system. The fact that such arguments have not been published - regardless whether one agrees with them or not - raises further questions about competence and also about vested interests. Readers of this blog are invited to draw their own conclusions.)

Last week London Mayor, Boris Johnson, visited Brussels. He was openly lobbying the European Union MP’s and officials for non-introduction of tighter regulation on large private investors operating under various hedge funds, private equity firms and venture capital firms. Johnson’s argument was that these firms pay so much in taxes that it would be significantly damaging to London and the UK, if tight regulation forced them to relocate abroad. Johnson however did not address a question whether there are any costs to London, the UK economy and indeed the entire world of these private investors’ entrepreneurial exploits.

“Secrets of trade”

Investors who can bring returns on investment in good and bad economic times are widely admired. Hedge fund managers are legendary for such abilities. They never explain what makes them so successful: what kind of investment strategies they deploy. Jeeves’ “secrets of trade” is a typical response, implying deep sophistication.

Let us examine then a possible successful investment strategy based on short selling. Short selling is a relatively old strategy. If it is deployed on a macro level, like currencies or commodities, it brings balance and improvement into economic growth.

A classic example was British Black Wednesday in 1992. The government hoped to keep the value of the pound higher than the markets thought that it was worth. The investors were short selling the pound. Eventually the markets won. Although this was a defining moment of the last Conservative government, it was also arguably the turning point during the previous economic downturn. Whilst the Major’s government completely lost credibility for economic competence, devaluation of the pound made British economy more competitive encouraging exports and discouraging imports. From that point “things only got better” but despite that Conservatives lost the elections in 1997. (Conservatives’ economic electoral misfortunes were also exacerbated by a long sequence of events that went into history under the “sleaze” headlines.)

Another example of short selling was a crude oil market collapse in 1997 – 1998 when a price of a barrel dropped below $10. This curtailed exploration activities, drove less efficient players from the market and forced consolidation. In effect the price of oil rose again with remaining oil companies being more efficient. However at the time there were concerns, one voiced by The Economist, that the price of oil could collapse to $5 per barrel driving all but a handful of huge producers with low operating costs (like Saudi Arabia and the Persian Gulf states), who could have monopolised the market and then could have started dictating high prices. Fortunately it did not happen and indeed was not very likely to happen. On macro level it is rather impossible to get a control of the market.

The story is different on an individual company level. If an investor buys a stake in a company it is in his interest to ensure its growth. And it is not an easy task, but at the end of this process, through competition amongst companies, there are benefits to the entire economy. If an investor is short selling a company shares it is in his interest to drive the company down, even to bankruptcy so his return is maximised. Although for a small investor buying shares in a huge company it is rather impossible to have such impact, the story is different if a multi billion hedge fund is short selling small and medium size publicly quoted companies or even large corporations at a time of either such corporation’s trouble or general economic uncertainty.

Not a rocket science

Returning to a sample hedge fund investment strategy which is based upon the observation of the market activities in the last decade. A fund buys a significant stake and invests in a successful medium size publicly quoted company (or it does so with a private company and takes it to floatation). The share price goes up: this is a point of the first return on investment. But any rational investor knows that there is a limit to short term growth of company value. Large private investors are famous for their short term investment windows. Further growth involves more competition, mergers and acquisition, dilution of ownership and high uncertainty. So the time comes for profitable exit whilst a company is still doing well. A fund lends, for example through some offshore entity technically not even associated with the fund, significant amounts of monies to a company. Offshore holdings in non-transparent jurisdictions, non-direct association through large individual investors and trust funds with confidential structures, make such operations at present absolutely non-traceable. A fund also buys credit defaults swaps against the money it lent (possibly many times over the amount lent) and when the share price is still up it sells the shares and starts short selling. The success is achieved by a company making some “unwise” investment decisions or a fund calling back the loans. Such heavily leveraged company quickly ends up in trouble and a fund makes a nice exit return on investment: making money on short selling shares and cashing on default swaps.

The perverse nature of short selling on individual company level stems from the fact that significant investors, like hedge funds, are capable of bringing down a company that they are short selling on their shares. This came clear last autumn when even the largest banks shares were short sold to the extent that it threatened the entire financial system. Rather than banning short selling altogether, the government only temporarily suspended it.

No wonder short selling became a very popular way of making money. It is not a rocket science. At present there is a massive crowd of very powerful and influential investors in whose interest is driving the economy down. The share market is turned asymmetric, with shares of the companies being short sold by large private investors being turned into “lemons”. It is also tantamount to Gresham’s law “bad money drives out good”: since it is far easier to drive company down than to grow it, the interest in short selling will only increase, especially during downturns or times of uncertainty, with potentially disastrous effect to the economy. This goes to show that indeed markets behave rationally when it comes to immediate beneficiaries of an investment decision-making process. This however can be a parasitical arrangement at massive costs to the society at large.

Rooting out the pathology

It appears that Boris Johnson’s views on hedge funds are rather naïve. The recent scandal of MP’s expenses taught us that even amongst the most trusted individuals of the highest integrity if there is any opportunity or loophole left to make money it will be ruthlessly exploited to its limits and beyond. The current crisis showed us that the exploits of the financial sector can cost economy trillions of dollars. Whilst from free market standpoint there is a case for passive short selling even on individual shares of companies (i.e. on condition that an investor short selling shares of a company cannot influence it at all), in practice, in a global market with non-transparent offshore financial centres and multi billion pounds investors it is a breeding ground for pathology. The risk, in practice certainty, of costs of market abuse massively outweighs any possible benefits therefore short selling of shares must be banned.

Not only must the government regulate private investors, like hedge funds, and scrutinise their investment strategies and actions, it must also examine them retrospectively in detail in methodical way. The transparency of the entire financial industry practices, retrospective and current, is the key. There will be a lot of interesting lessons learnt about the “sophistication” of large private investors. Little doubt they will tell us a lot about the background of the current financial crisis.

Commentary to an article “Loan to deposit ratio and banks liquidity”

An article "Loan to deposit ratio and banks liquidity" shows inter alia:

- why control over liquidity was lost at all levels (individual banks, regulator, The Treasury) and the crisis and its scale came as a surprise

- why the scale of liquidity depth is very difficult to assess (based on traditionally reliable parameters like total loans to total deposits ratio and money multiplier)

- why banks are not lending and it is rather irresponsible to expect them to do so (this is a statement valid under the current circumstances; if the government took certain appropriate actions then the banks could be in position to start lending on a greater scale again).

As many politicians complain that banks are not lending to good businesses it seems not to be understood that a reason why lending remains severely restricted is not really creditworthiness of borrowers. Any lending deteriorates already fragile banks’ liquidity. Banks look like a rabbit caught in the headlights: if they start lending they deteriorate further their existing fragile liquidity position, and, if they do not, the economy goes down resulting in increased credit defaults and further deterioration of the liquidity position. A classic Catch 22.

Additional problem is that certain market players, who bought default swaps, possibly many times over the underlying credits, have an interest in defaults occurring as it is their way of making profit. This adds to the point expressed that short selling of shares is perverse in free market economy. If this happens on a small scale it does not matter and may be regarded as some kind of economic freedom. However on a macro scale this creates a perverse situation whereby there are huge and influential market players in whose interest is NOT the growth but deterioration of the economy. It appears that the government still did not get a grasp on the complexity of the current crisis.

ADDITIONAL COMMENT:

The banks' management lost control over liquidity under the following scenario. Liquidity is a direct function of money multiplier: i.e. how many liabilities on banks balance sheets a real £1 cash has to cover. Traditionally loan to deposit ratio (LTD) was the basis for calculating money multiplier (on a macro level). It is MM = 1/(1 – LTD) (LTD expressed decimally). But it only works if, at every deposit – loan cycle, LTD is below 1 (i.e. below 100%). Once LTD is above 1, at any deposit – loan cycle (even if it later goes down below 1, this macro control is lost. Money multiplier (MM) cannot be reliably calculated based on total loans to total deposits on a bank's balance sheet.

Calculating Money multiplier using straight reserve ratio is flawed. (It appears that this method was used by the banks.) It comes from the original notion, that with loan to deposit ratio below 1 (below 100%) reserve ratio R equalled 1 – LTD. So MM = 1/R.

However if loan to deposit ratio is equal or more than 1 (100%), and you use a formula MM = 1/R, it means that you consider your reserves (which are not strictly cash), as good as cash. As you keep lending with LTD above 1, you push cash on the market inflating assets prices and artificially improving your reserves. However each £1 cash has to serve more and more (at exponential pace) pounds on the balance sheets. So whilst your real money multiplier goes up extremely fast (£1 cash has to serve ever growing number of pounds on the balance sheets), you seem to maintain healthy balance sheets (in terms of R and, based on it, calculated MM = 1/R). However when a pyramid collapses, R goes down to the floor, and MM, as banks calculated, becomes astronomic. This leads to the banks losing liquidity and becoming insolvent.

The above shows the mechanics of the collapse of a pyramid that caused the current crisis.

Loan to deposit ratio and banks liquidity

(This article is a technical analysis dedicated to John Varley, the CEO of Barclays Bank, of one of the largest and most famous banks in the world, referred to in the article “Liquidity risk”, who took care to write to the author of this blog.)

The key issue about banks liquidity is money multiplier. Money multiplier is a ratio of banks balance sheets to cash in circulation. It answers a question: how many pounds on the banks balance sheets does £1 real cash has to cover?


When a loan to deposit ratio is below 100% a money multiplier (MM) is expressed by a formula: MM = 1/(1-LTD) where LTD is loan to deposit ratio expressed in decimal terms. The loan to deposit ratio can fluctuate: i.e. if LTD is 50% then MM is 2, if LTD is 75% then MM is 4, if LTD is 90% then is 10, if LTD is 99% then MM is 100.

Ultimately, if loan to deposit ratio is always kept below 100% then, at any one time, the ratio of total loans to total deposits on the books gives an average loan to deposit ratio (ALTD). This average may be done for a particular bank or for a group of banks or for entire economy. A money multiplier calculated on the basis of such average, 1/(1-ALTD), is a measure of a particular bank’s liquidity, a group of banks liquidity or entire economy liquidity position. A bank's CEO can look at such figure and have an immediate good idea about the liquidity of his bank. A Chancellor of the Exchequer (a Minister of Finance) may look at such figure calculated on the basis of total loans and total deposits for all banks and have a good idea of the liquidity of the banking system.

This money multiplier can be then considered within a concept of “stickiness” of different types of money deposited in banks (current accounts, deposit accounts, investments, etc). The lower the money multiplier the higher the “stickiness” of any kind of deposits. In other words, if £1 real cash covers lower amount of pounds on the banks’ balance sheets, the likelihood (under the same circumstances) that a bank will not have sufficient cash to cover the demand for withdrawals is lower than if £1 real cash covers higher amount of pounds.

Therefore if loan to deposit ratio is below 100%, the lower the loan to deposit ratio, the lower the money multiplier, the higher the “stickiness” of funds and the lower the liquidity risk. A ratio of total loans to total deposits gives a money multiplier at any one time and a good idea about underlying liquidity risk. Then a consideration can be given to "stickiness" of individual financial products (from current accounts to long term investments such as pensions).


When a loan to deposit ratio (LTD) is above (or equal) 100%, money multiplier (MM) is infinite. Of course it does not make sense to state that £1 of real cash has to cover infinite amount of pounds on banks balance sheets, at any one time, but it would be so if this continued forever. If a LTD is above (or equal) 100% then we have to calculate MM based on the number of deposit – loan cycles. For example if LTD is 100% and initial deposit is £1, after 20 deposit – loan cycles, this £1 has to cover £20 on the banks balance sheets and after 220 deposit – loan cycles, this £1 has to cover £220 on the banks balance sheets and so on. This is a staggering but still linear growth. If LTD is above 100%, then the financial system becomes a classic example of a pyramid scheme. For example if LTD is 117% and initial deposit £1, after 20 deposit – loan cycles, this £1 has to cover over £130 on the banks balance sheets and after 220 deposit – loan cycles, this £1 has to cover over £5.89 quadrillion on the banks balance sheets and so on. This is a runaway exponential growth.

As it is a cycle, whereby deposits become loans which become deposits and so on, if loan to deposit ratio is above (or equal) 100%, the higher loans result in deposits that result in even higher loans and so on. Therefore in terms of liquidity if at any one time a ratio of total loans to total deposits is taken (which is higher than one) – per bank, a group of banks or entire financial system - it does not give any idea about the prevailing money multiplier as, unlike when loan to deposit ratio is below 100%, it also depends on a number of deposit – loan cycles and loan to deposit ratio of each of them. Therefore a bank’s CEO or a Minister of Finance does not have an idea about the liquidity based on total loans to total deposits ratio. Perversely, model-wise for the sake of clarity of argument, if there were, say, 20 full cycles with loan to deposit ratio of 117% followed by a full cycle of 0%, then the total loans to total deposits ratio would be below 100% whilst money multiplier would be over 130, i.e. liquidity would be extremely fragile. (It should be noted that whilst deposit – loan cycles do not occur in such a uniform, synchronised, way, the model presented gives an accurate account of how they work and what outcomes they produce in reality.) For example information that a bank reduced loan to deposit ratio from 138% to 129% does not carry information whether its liquidity improved or got worse. If a bank stopped giving loans and started keeping deposits building up liquidity buffer, this would imply that liquidity improved. However if a bank continued to lend with, say, loan to deposit ratio of 105% which could have resulted in overall reduction from 138% to 129% (total loans to total deposits), this would have implied that liquidity actually got worse. As presently the banks have reduced lending heavily, the former rather than latter seems to be the case (but this is a guess) and it is foolish of the government to expect banks to lend more.

We know however that a money multiplier keeps growing very fast (at exponential pace, i.e. it is a pyramid scheme, if loan to deposit ratio is above 100%), and if this continued forever, ultimately, £1 real cash would have to cover the balance sheets that would be infinitely high. As this is impossible, a liquidity crunch is 100% certain in a finite time.

It follows that if loan to deposit ratio is above (or equal) 100%, the higher the loan to deposit ratio, the faster the money multiplier growth. However, in any event, the liquidity risk is 100% in a finite time. It follows that the traditional notion of “stickiness” of funds becomes vacuous as no funds are “sticky” anyway. It is a question when (in a finite time) and in which part of the system the liquidity crunch starts. This depends on various factors such as access to information or sophistication of depositors/investors in particular financial products who realise first that £1 real cash cannot cover ever growing, and without a limit, banks balance sheets and decide to withdraw their funding first. Therefore it is not surprising at all, in the context of the current financial crisis, that traditional retail deposits turned up more “sticky” than wholesale, investment-based, funding.

Interesting autumn (and years) ahead…

Holidays ended. A rather sunny summer is coming to close. Large credit card bills will start dropping on our doorsteps throughout September. It is appropriate to ask what economic conditions we find in the forthcoming autumn. Is unemployment going to increase? How well will we be geared to pay these bills and indeed ongoing living costs?

Rather than writing poetry about "green shoots" of recovery, or painting apocalyptic picture about imminent doomsday coming, let us list objective facts and reflect what they mean.

Almost a year ago, and last January, the government saved the financial system that was turned into a giant pyramid scheme. Hundreds of billions of pounds, and even more in future commitments and guarantees, was spent to prevent a classic case of pyramid collapse. It was quite a spectacle: the government was committing week after week billions and billions of cash and guarantees to help private financial industry wobbling pyramid, whilst for years the government had been convincing the public that it could not have found even a fraction of that to improve public services (health service, education, state pensions).

At first it was hailed as a permanent cure. The British Prime Minister, Gordon Brown, even famously remarked that he "saved the world". Subsequently to the action of saving the pyramid from collapse, the government, under a name "Quantitative Easing" , printed nearly a couple of hundreds of billions of pounds, to provide additional liquidity on the market in order to support (from collapse) banks' balance sheets ballooned to pyramidal proportions.

All these, so called stimulus package, cost taxpayers massive amount of monies: hundreds of billions of pounds. We are in trillions realm. It will take generations to repay. But the government has reached (or is very closely to reach) a point that it cannot borrow or print more cash anymore (unless it is prepared to turn the UK into Zimbabwe).

Despite all that, it clearly does not look that the economy was jumpstarted. It appears that the pyramid which the government has been preventing from collapse for over two years (if we take Northern Rock case into account) will lose that support. So we may expect another liquidity crunch, but its scale is uncertain. Indeed other governments, e.g. German, are already bracing seriously for another such event. However, if it happens, will the government be able to commit another serious tranche of cash to keep on supporting the wobbling financial pyramid? We talk about tens or hundreds of billion of pounds?

The loss of further, unsustainable, stimulus combined with the necessity to service debt (resulting from stimulus thus far) or even its growth (due to not servicing it sufficiently) is also very likely to hamper the recovery process. On top of that, banks, with pyramidal balance sheets, will be a massive drain to the economy, sucking out money from the market in order to reduce their loan to deposit ratios. (In this context it is not surprising at all that the banks are still not lending. In fact the government's expectation last autumn that the banks, after the government's cash injection, would start lending is possibly the best testimony of the government's dreadful economic incompetence.) There is no benefit of hindsight in this statement: it is just trivial.

Generally as, with the support of the government, the banks created a relationship with taxpayers akin to loan-sharks’ with their customers, if this criminal and parasitical arrangement continues, we should expect the same fate as loan-sharks’ customers suffer: we will be squeezed by the government and by the banks (directly and indirectly), and be left only with as much as is needed just about to survive. It can look like a very slow downward spiral. In this context does it matter what happens to the economy? Survive will we. But regardless of the situation this is as much as we can expect. Some of us will lose jobs, some homes. It will not be a massive tragedy as homes will not just stay unoccupied with people living in the streets; people will still keep on doing useful things. Without sounding disparaging to council estates, the UK will slowly, and selectively: middle-class, not the rich, start resembling a huge under funded council estate with run down services. This seems to be the likely costs, for generations, of the financial industry engineered "greatest heist in history" using a crude and classic pyramid scheme, like Albanian gangsters in 1996 – 1997.

(This article should be read as a risk assessment. Hopefully it will not materialise, but the signs are that it is likely it will.)

Lord Mandelson concluded that bankers were scammers

Lord Mandelson stated that "The rewards (for bankers) need to be linked to risks. The problem is when excessive rewards start driving excessive risk taking." An enterprise has no choice: it must take a risk in the course of the business operations. This is in a nature of the economy. However it must always be a calculated commercial risk. It can be never an "excessive risk". Taking "excessive risk" is a legal wrong and, if it caused any damage, it must be pursued under civil law to obtain compensation from "excessive risk takers". It must also be investigated under criminal law. As Lord Mandelson effectively admitted bankers were rewarded for "excessive risk taking" since he was referring to the current crisis not some hypothetical situation. Hence, according to Lord Mandelson, bankers committed fraud. As explained in the seminal article on this blog, "The largest heist in history" the mechanism of this "excessive risk taking", i.e. fraud, was turning the global banking system into a giant pyramid scheme.

It is very refreshing and encouraging that a very senior British government official, effectively the Deputy of the Prime Minister, admitted that the financial community committed fraud from which it benefited. He was very clear that "taking excessive risk" was a euphemism for committing fraud. The taxpayers have all the right now to demand that the government will draw the conclusions from the Lord Mandelson's words: pursue a huge number of financiers on the charges of fraud and confiscate their wealth in order to compensate the taxpayers for the result of this fraud.

Curbing City pay will give it competitive advantage

In the wake of financial collapse in autumn last year, after the British government pumped in massive amounts of taxpayers' monies into the financial system to prevent a complete meltdown (and the government became a large shareholder in the banks), the government (and the regulator, FSA) promised to curb huge salaries and bonuses of financiers. As the time passed, these promises have not materialised. Quite the contrary, in terms of bankers pay, it is business as usual. FSA published a proposal which is a grotesque version of the original promises. Assuming that taxpayers are half-intelligent, it looks like a deliberate insult to them.

The reason given why bankers' pay packages cannot be drastically reduced is that this would drive the top banking talent out of the City; that the best bankers will be poached to work abroad.

Behind such reasoning, there is an underlying assumption that the most talented people's choice of career is only financially driven. It is clearly not the case. If it were the case specific to the financial industry, it would also be true across the industries. Yet whilst some clever young scientist, doctors, analysts move to financial industry, this brain-drain is very limited. Top research institutions and universities, health service, civil service, oil and gas industry and so on, do not lament that the market is short of top talent as it is drained by the banking sector. There is no attempt of others, including very rich sectors like oil and gas, to match City salaries and bonuses.

This is no different to sport: we do not observe a lack of top talent in cycling and rowing, because football and golf pays much better. The lack of success in some sports is simply down to lack of tradition, infrastructure and resources to develop talent.

Huge majority of young people choose their career path based not only on financial reward, but also on what they like to do. Their interests, ambitions, prestige and a mission they sense play a big part. In any profession with a reasonably good pay and career prospects there is no shortage of young and talented newcomers. Only a small number of youngsters, very often not very talented or lacking clear interests, cynically decide on their career path based on financial rewards. In effect, perversely, astronomically paid banking jobs do not attract the top talent suitable for finance, but the greediest with loose morals, determined to do what it takes to make a lot of money for themselves. The pathology of that situation reached such a high point that stating this openly has been in vogue amongst the City "highfliers".

There is also evidence that it is not the most talented that get promoted to top jobs in finance, but the most greedy, aggressive, who know how to play company politics. It is enough to go to professional fora to realise that there were banking industry insiders, who were warning that a crisis such as the one that is happening was only a matter of time, since the business model became unsustainable. They were professionals but not the ones that were fast-tracked on their career ladder. The scale and character of the current financial crisis has shown that, to a massive degree, so called "financial professionals", especially on the top level, are unable to distinguish between taking a legitimate commercial risk and acting fraudulently or, worse, some of them choose to act fraudulently but use "taking a commercial risk" argument as an excuse for their actions. There is evidence that the CEO of one of the largest banks in the world does not understand such basics as mechanisms that govern balance sheets dynamics. Yet somehow he became a CEO.

Indeed it looks that big pay packets in finance attract the top talent: but not the one that banking really needs. It is a talent to use greed, skills in company politics, arrogance, posturing to cover monumental incompetence in climbing a corporate ladder. This ilk of people has hijacked the financial industry. No wonder the current crisis was caused by a criminally engineered pyramid scheme (as it was described in the first article on this blog "The largest heist in history") which is exactly the same in mechanics as Albanian pyramid schemes in 1996 - 1997.

But why did it happen that the bankers are paid so much? They are the first in the pecking order of financial management of a value creation. They manage billions and trillions of pounds, so only a tiny fraction of a percent of such amounts makes them millionaires. But this does not give them an automatic right to such a "tiny" fraction of the funds under their management. Interestingly bankers are not unique. Tax officials also collect and manage a huge number of billions of pounds. Yet no one argues that their pay should be based upon a revenue of their tax collection in such a direct way as the bankers', although they are the first in the pecking order of a state tax revenue collection and state finances depend heavily on their performance. However historically, in Biblical times as well as more recently (like in France in the 18th century) tax officials’ pay was also based, like bankers, directly upon the revenue under their management. Indeed, in those days, tax collectors had gained the same notoriety as the bankers did in the last few decades, since "greed is good" philosophy became an acceptable moral standard in finance. History proved that such approach was massively inefficient and, quite often downright fraudulent, as tax collectors were working, like today’s bankers, for their own benefit. There was also an argument, like today, that if their rights to pay had been curbed they would have been able to collect even less for a state. However modern states reasserted their authority in that respect and tax officials are paid now very decent salaries (even with some performance related pay), but in line with top professional jobs. This is how should be with the bankers as well.

And if, what is called, "top talent" leaves the City, it will be a great and desirable result of such policy. It will, hopefully, cleanse the City of greed, criminal incompetence and downright criminality that drove the banking industry to fraudulent activities (like pyramid schemes referred to above). If they get jobs in different financial centres, it will give the City competitive advantage: let them wreck competitors.

The financial sector will not be short of top talent. Assuming that top bankers' pay will be on a level, say, of top geologists' or economists' in the oil and gas industry, or brain surgeons, there will be plenty of very clever people with integrity, not driven by a sheer greed, that will develop their talents as real top financiers, not pyramid purveyors. This approach is not egalitarian or driven by some kind of equality: this is about eradicating pathology and restoring commercial sense to the financial industry.

PS. Cityboy on City bonus culture: "A banker's guide to bonus day".

Liquidity risk

In response to the assertion by the author of this blog that the financial system was turned into a pyramid scheme, the CEO of one of the world largest and best known banks wrote to the author, justifying his denial of this assertion (calling it ”completely baseless” ):

"Banks certainly undertake a process of maturity transformation – that is the fundamental responsibility of banks: to borrow short and lend long. In doing so, banks take what I would call liquidity risk: the risk that at any point in time a creditor might demand repayment, but the bank is unable to provide that because it does not have cash to hand because the borrower is not due to repay their loan for some time. That is wholly different from a pyramid scheme where the borrower has no idea where the funds are going to come from when the obligation is constructed."

The author of this blog responded:

The understanding of a pyramid scheme as "where the funds are going to come from when the obligation is constructed" is manifestly insufficient. On one side even if a bank lends money to someone (like a small business) applying in the process loan to deposit ratio below 100%, ultimately it may also have "no idea where the funds are going to come from" as a borrower must get his funds from somewhere and so on. This is how a value chain is created. Yet it will not constitute a pyramid scheme although it may possibly be a risky and irresponsible lending.

On the other side a pyramid scheme is not about an idea "where the funds are going to come from when the obligation is constructed" but sustainability of deposit – loan cycle, or more generally circulating money in the economy. Therefore if a loan to deposit ratio is above 100%, such cycle is unsustainable as an exponential growth of balance sheets is unsustainable. (Incidentally a name "pyramid" comes from the shape of a graphic presentation of exponential growth which looks like, surprise, surprise, YES: a pyramid!) This is a conclusion well known for centuries in many different walks of life, starting from children's game of sending a postcard to an addressee at the top of the list of 10 (and then removing it from the list), adding own name in the bottom and finding, say, 10, other kids who would repeat the process. (If it worked every kid in that game would have received 10¹⁰, 10 billion, postcards.) This universal principle is not changed by the fact that banks think they know "where the funds are going to come from when the obligation is constructed".

A good example is lending with loan to deposit ratio of 117%. If a trader was lending with loan to deposit ratio of 117% and a pace of a cycle was one a day (not an unrealistic assumption on the current electronically powered markets), and s/he did it for a year (approx. 220 working days) then, out of every £1, his/her last advance in a year (220th) would have been over a £1 quadrillion (1.17²²⁰), having totally advanced in a year over £5.89 quadrillion. So in terms of liquidity, £1 cash, would have to cover over £5.89 quadrillion worth of potential demands (liabilities). And, if lending with loan to deposit ratio continued at over 100% loan to deposit ratio, there is no supremum: technically it can go to infinity very fast, at exponential pace. Therefore in terms of what was called by the CEO "liquidity risk", this risk keeps growing approaching very fast 100% (certainty). Such a risk is, of course, not acceptable as it is a near-certainty of collapse. ("Near" is a technical term put for correctness: in practice it may be omitted.)

Due to non-sustainability of lending with loan to deposit ratio above 100%, the expected known sources of the funds when the obligation was constructed would default in great numbers at some point in not too distant future, i.e. "liquidity risk" is practically 100%. This point is called a pyramid scheme collapse. Because of practical "liquidity risk" of 100%, pyramid schemes are illegal.

By contrast, whilst lending with loan to deposit ratio below 100%, called "fractional reserve banking" still carries "liquidity risk", it is a contained risk. E.g. with loan to deposit ratio of 90% every £1 has to cover maximum £10 of potential demands.

Putting in layman’s terms: fractional reserve banking brings a risk that we, as society, decided to live with, as in a long run and not without its problems it ensures very efficient economic development; lending with loan to deposit ratio above 100%, that can be called depleting reserves banking, is a sheer madness, a pyramid scheme guaranteeing a quick and spectacular failure.

The CEO also wrote further:

"Your [i.e. the author of this blog] logic assumes that all original money in the economic system, and all money extended as credit from then on, eventually returns to banks in the form of deposit. That assumption may have approximated reality some years ago, but it does not today. In fact, a significant, and growing, portion of households savings, for example, is invested directly in money markets and mutual funds. Some of that investment (what would have otherwise been deposits), in turn, flows back to banks in the form of wholesale funding because those money market and mutual funds purchase banks debt. But it clearly isn't captured in the loan-to-deposit ratios you quote."

The author of this blog responded:

Fractional reserve banking, which is based on loan to deposit ratio below 100%, is about creating a reserve at every point of circulating money in the economy when money is passed with a risk (traditionally it was a deposit turned by a bank into a loan and banks were risk brokers). The above example of investment turned into wholesale funding on money markets is exactly the same thing under a different name: someone’s investment turned into wholesale funding ends up on the market, say, as a mortgage, which in turn, through, for example, a purchase of a house and then house seller's investment, may come back on the market as investment and then as a part of wholesale funding, and so on. Basically "investment – wholesale money market cycle" must be considered as a part of "deposit – loan cycle" for the purpose of loan to deposit ratio. And, if it were not, it would be perverse.

The CEO continued:

"All that said, banks increased reliance on wholesale funds was one factor that exacerbated the banking crisis of last year, because it heightened liquidity risk. All those market participants that used wholesale funding, but particularly banks like Northern Rock and Lehman Brothers, rediscovered last September that wholesale funders demand their money back in large volume and more quickly than retail depositors. Put differently, wholesale funding isn't nearly as 'sticky' as retail deposit funding."

The author of this blog responded:

By associating with mutual funds earlier on, the CEO suggested that there was no structural reason for wholesale funding to be less "sticky" than retail deposit funding. Quite the contrary, considering typical maturities of mutual funds and deposits, wholesale funding should be more "sticky". Therefore this is a good indication that investment and wholesale funding money market constituted a pyramid scheme (in a technical, legal, sense). As "liquidity risk" of pyramid scheme is practically 100% (guaranteed collapse), "stickiness" of wholesale funding was decreasing at exponential pace, guaranteeing liquidity crisis as a matter of a short time. [More on "stickiness" in Appendix A below.]

If, as it appears, a loan to deposit ratio below 100% was not applied to "investment – wholesale money market" transactions, this would prove that one of mechanisms of pyramid scheme construction was "investment – wholesale money market" transactions. It is not wholesale market as such that failed, but that wholesale market was turned into a pyramid scheme, and the failure was not only inevitable but easily predictable. It looks like a very serious crime.

APPENDIX A

"Stickiness" is an average demand level of a depositor in a bank or investor in a fund to demand his/her money back. It depends on two factors:

- an average willingness of depositors (i.e. who are creditors of a fund, bank, etc) to withdraw money; there is an element of unpredictability (like general economic conditions, political situation, panic, at worst "bank run") but more less it is an equal playing field for all competing funds/banks; depositors may move money between them due to better prospective returns but money stays on the same market;

- loan to deposit ratio (i.e. a proportion of deposits/investment that is advanced further by a fund/bank with a risk) defines how much money is kept as reserve for any payment demand by depositors; if loan to deposit ratio is below 100% it guarantees a pre-defined level of reserves (e.g. loan to deposit ratio of 90% guarantees 10% reserve, in practice it means that every £1 of real money has to serve up to £10 of potential demands resulting from willingness to withdraw money); if loan to deposit ratio is above 100% then no reserve is created (in fact, it the existing reserves get depleted) but potential demands keep growing at exponential pace with no maximum (e.g. in practice, it means that that every £1 has to serve £2 then, very soon, £4, very soon, £8, and …. , soon, £1024 and so on, technically, infinity)

Therefore it follows that even if an average willingness of depositors to withdraw money is very low, with loan to deposit ratio above 100%, this low willingness will become irrelevant, as quite soon in that process, there will be not enough real money to serve any demands to withdraw money. Due to exponential pace, this is a matter of a short time, regardless how low an average willingness of depositors to withdraw money is. Lending, or turning an investment cycle, with loan to deposit ratio above 100% guarantees an exponential, i.e. extremely fast, growth of "liquidity risk" to 100%. For practical reasons it should be assumed as 100%. This also has to be combined with an "aftershock" effect: once a word starts going around that depositors cannot withdraw money, the confidence goes down and willingness to withdraw money grows, causing a "bank run" which in case of lending with loan to deposit ratio above 100% is a pyramid collapse. The case of Northern Rock showed that mechanism vividly: only government guarantees, assuring liquidity, prevented the inevitable collapse.

This is a very likely reason why some investments, like through mutual funds, on wholesale market that traditionally would be expected to be more "sticky" than typical high street bank deposits turned up to be less "sticky". Surprise? Not to a reasonably competent financier.

Financial press commentators, like Ms Gillian Tett of the FT, very often talk about market confidence without understanding that the real, based on numbers on the banks' balance sheets, effect of a pyramid scheme (i.e. a massively unsustainable size of banks’ balance sheets that each £1 cash has to serve), can easily override any psychological attempt of confidence restoration. More analysis on "A matter of confidence".