If you are new to this blog, you are invited to read first “The Largest Heist in History” which was accepted as evidence and published by the British Parliament, House of Commons, Treasury Committee.

"It is typically characterised by strong, compelling, logic. I loosely use the term 'pyramid selling' to describe the activities of the City but you explain in crystal clear terms why this is so." commented Dr Vincent Cable MP to the author.

This blog demonstrates that:

- the financial system was turned into a pyramid scheme in a technical, legal sense (not just proverbial);

- the current crisis was easily predictable (without any benefit of hindsight) by any competent financier, i.e. with rudimentary knowledge of mathematics, hence avoidable.

It is up to readers to draw their own conclusions. Whether this crisis is a result of a conspiracy to defraud taxpayers, or a massive negligence, or it is just a misfortune, or maybe a Swedish count, Axel Oxenstierna, was right when he said to his son in the 17th century: "Do you not know, my son, with how little wisdom the world is governed?".

Thursday, 30 April 2009

Greg Pytel: Example/exercise - how does it work?



For those who cannot visualise how lending with loan to deposit ratio above 100% pumps out cash of bank reserves and creates a financial pyramid below is a simplified example based on two banks financial system. Please go with pen and paper line by line and follow the growth of bogus balance sheets.

1. Two Banks A and B are set up. Both have zero on deposit and loan books. Bank A has $104.91 and Bank B has 166.38 cash reserves. They have no non-cash reserves. Both decide to lend with loan to deposit ratio (L/D) 130%. i.e.

Bank A:
- Capital reserves: $104.91 cash and $0 non-cash
- Deposits: $0
- Loans: $0

Bank B:
- Capital reserves: $166.38 cash and $0 non-cash
- Deposits: $0
- Loans: $0

2. Bank A takes $100 as deposit and decides to lend $130 (i.e. at L/D 130%). This loan (as all other loans in this example/exercise) are mortgages secured on residential properties. Bank A decides not to deplete its own cash reserves but borrow additional $30 from Bank B. Bank B considers this loan from its reserves with risk 50% and Bank A also considers the $130 loan with the risk 50%. (In fact both loans can be deemed as secured on properties, so 50% is in compliance with Basel.)

Therefore the both banks’ books look as follows:

Bank A:
- Capital reserves: $104.91 cash and $65 (i.e. $130 x 50%) non-cash
- Deposits: $100
- Loans: $130

Bank B:
- Capital reserves: $136.38 (i.e. $166.38 - $30) cash and $15 (i.e. $30 x 50%) non-cash
- Deposits: $0
- Loans: $0

3. Someone who took $130 loan from Bank A paid it to Bank B. The Bank B decided to lend $169 (i.e. at L/D 130%) not depleting its own cash reserves. It borrows additional $39 from Bank A. Bank A considers this loan from its reserves with risk 50% and Bank B also considers the loan of $169 with the risk 50%.

Therefore the both banks’ books look as follows:

Bank A:
- Capital reserves: $65.91 (i.e. $104.91 - $39) cash and $84.5 (i.e. $65 + $39*50%) non-cash
- Deposits: $100
- Loans: $130

Bank B:
- Capital reserves: $136.38 cash and $99.50 (i.e. $15 + $169*50%) non-cash
- Deposits: $130
- Loans: $169

4. Bank A takes $169 (lent by Bank B) as deposit and decides to lend $219.70 (i.e. at L/D 130%). Bank A decides not to deplete its own cash reserves but borrow additional $50.70 from Bank B. Bank B considers this loan from its reserves with risk 50% and Bank A also considers the $219.70 loan with the risk 50%.

Therefore the both banks’ books look as follows:

Bank A:
- Capital reserves: $65.91 cash and $194.35 (i.e. $84.5 + $219.70*50%) non-cash
- Deposits: $269 (i.e. $100 + $169)
- Loans: $349.70 (i.e. $130 + $219.70)

Bank B:
- Capital reserves: $85.68 (i.e. $136.38 - $50.70) cash and $124.85 (i.e. $99.50 +$50.70*50%) non-cash
- Deposits: $130
- Loans: $169

5. Bank B takes $219.70 (lent by Bank A) as deposit and decides to lend $285.61 (i.e. at L/D 130%) not depleting its own cash reserves. It borrows additional $65.91 from Bank A. Bank A considers this loan from its reserves with risk 50% and Bank B also considers the loan of $285.61 with the risk 50%.

Therefore the both banks’ books look as follows:

Bank A:
- Capital reserves: $0.00 (i.e. $65.91 - $65.91) - cash and $227.30 (i.e. $194.35 + $65.91*50%) – non-cash
- Deposits: $269
- Loans: $349.70

Bank B:
- Capital reserves: $85.68 cash and $267.65 (i.e. $124.85 + $285.61*50%) – non-cash
- Deposits: $349.70 (i.e. $219.70 + $130)
- Loans: $454.61 (i.e. $285.61 + $169)

6. Bank A takes $285.61 as deposit and decides to lend $371.29 (i.e. at L/D 130%). Bank A decides not to deplete its own cash reserves but borrow additional $85.68 from Bank B. Bank B considers this loan from its reserves with risk 50% and Bank A also considers the $371.29 loan with the risk 50%.

Therefore the both banks’ books look as follows:

Bank A:
- Capital reserves: $0.00 - cash and $412.94 (i.e. $227.30 + $371.29*50%) – non-cash
- Deposits: $554.61 (i.e. $285.61 + $269)
- Loans: $720.99 (i.e. $349.70 + $371.29)

Bank B:
- Capital reserves: $0.00 (i.e. $85.68 - $85.68) cash and $310.49 (i.e. $267.65 + $85.68*50%) - non-cash
- Deposits: $349.70
- Loans: $454.61

7. After these operations the system looks like:

- cash taken from the banks is the last loan: $371.29

- cash reserves held by both banks is $0.00 (i.e. no cash reserves - cash is gone from the banks)
- non-cash reserves: $723.43
- combined reserves: $723.43

- deposits: $904.31
- loans: $1,175.60 borrowed to pay for assets (which were booked with 50% risk discount as banks capital).

Having started with $271.29 reserves (Bank A $104.91 plus Bank B $166.38) and $100 initial deposit, the Banks A and B have no cash any more. If someone who is paid with the last loan of $371.29 keeps it as cash, he can start cherry picking the assets. They all cost $1,175.60 to buy. As, apart from his $371.29, there is no liquidity on the market, he can drive the price of the assets down (making them crash) and drive banks into bankruptcy (unless a government bails them out :-)

The loan to deposit ratio above 100% destroys banks’ cash reserves pushing liquidity on the market, inflating the assets price and ballooning the balance sheets, whilst below 100% cash reserves are guaranteed. However, on the books in this example, the banks’ $723.43 non-cash booked reserves to $904.31 deposits look extremely healthy. Unfortunately the assets booked at $723.43 have very little value. As there is no more liquidity their price goes to the floor: they become toxic assets.

This is a simplified model of the current liquidity crisis and assets value crash. It also shows why cash is the king on the current markets.

Therefore Basel compliant banking system went bust. But this is not a full story: this system was also a pyramid scheme, therefore illegal. Basel regulations have to be looked at in conjunction with law that prohibits pyramid schemes. And they together were sufficient to prevent the current crisis. However they were breached by financiers, regulators and government officials.

9 comments:

  1. Hello,

    I have appreciated your analysis. Even though I do not entirely agree with it, I see it as positive as it represents the application of knowledge in the coherent development of an idea.

    As to this example, I think there is an extra basic factor you have not taken into account: the difference between the interest rates applicable to lending and deposit. In my opinion, this difference (in cash), in favour of the bank, may jusfify the breach of your basic principle...

    Kind regards,

    Pedro Boullosa Gonzalez

    ReplyDelete
  2. Pedro

    Thanks for your comment. I would greatly appreciate if you spelled out your points of disagreement (this will help me develop my idea or presentation of my idea).

    You are right pointing out that I did not take an interest rate factor into account in this example. I omitted it for simplification. I did so as I did not agree that the difference between interest in lending and deposits could justify going above loan to deposit ratio above 100% (in fact this makes no difference). You can quite easily model it: interest payments paid to banks, including liabilities paid out, go into deposit - loan cycles in the financial system like any other money. In essence loan to deposit ratio is applied to any money in circulation. For more analysis, please refer to: http://gregpytel.blogspot.com/2009/05/towards-improved-regulation-regulation.html

    As far as my example is concerned you may well assume, which is plausible, that these transactions happened in one day

    Best

    Greg

    ReplyDelete
  3. In sum, concerning your idea/analysis, which - again - I applaude for being innovative and brave (not affraid of going against what is politically correct).

    I agree on a certain relevance to be given to the loan/deposit ratio.
    Nevertheless, I do not see it as the decisive issue concerning regulation of financial entities.
    In my opinion, the loan/deposit ratio issue becomes almost irrelevant if there is a mandatory capital (cash) reserves ammount.

    ReplyDelete
  4. Pedro

    Thanks for your input. Greatly appreciated.

    I think it is the other way round. I am not innovative. I simply bring back conventional wisdom obvious to bankers for some centuries. In fact it was the banking world in the last couple of decades that challenged that conventional wisdom in an idiotic and criminal way. It was even thought to have been “innovative”. But, after all, it was not innovative but building primitive good old giant pyramid scheme (a technique known for centuries). Nothing new, old style of financial criminality.

    I simply proved in my first article (http://gregpytel.blogspot.com/2009/04/largest-heist-in-history.html) that lending with loan to deposit ratio above 100% amounts to building a pyramid scheme (which is bound to collapse). Setting up pyramid schemes is a criminal act. If you do not believe in a decisive aspect of lending with loan to deposit ratio above 100% think about the following example: you start with lending $1 with loan to deposit ratio 117% (this is your leverage at every deposit – loan cycle). You do it every day for 220 working days in a year. After a year you would have released over $5.8 quadrillion into circulation. And you collected no cash reserve. Maybe that $5.8 quadrillion would have been backed by assets (valued at that, or above, at the time of transactions: “Mark to Market”) but there would still have been only $1 circulating around serving these $5.8 quadrillion on the balance sheets. So I trust you have no doubt what is going to happen to this $5.8 quadrillion seemingly worth of assets value: it is going to nose dive to the floor. And suddenly all these $5.8 quadrillion of assets is worth next to nothing. I.e. becomes toxic waste. If you do not see this as decisive argument I cannot help.

    There is more than one way to skin a cat. Loan to deposit ratio regulation or capital (but, importantly, in form of hard cash) requirement can do the same job if administered properly. With the former is just much easier to achieve avoiding building pyramid schemes (which is illegal).

    Having written all the above, please bear in mind that creating pyramid schemes has been illegal. So rather than talking about new regulations (capital requirements and all that) we should ensure that criminals are prosecuted (for building pyramid schemes), they end up in jail and their wealth confiscated and the system will sorted out itself.

    Best

    Greg

    ReplyDelete
  5. A very coherent series of articles, I await the next dip in the recession trough with interest, pun intended.

    Best regards

    Brian

    ReplyDelete
  6. Pardon my ignorance, but you have stated that setting up a pyramid scheme is illegal. Whilst I am sure you can back this up, where and when is this the case that it is in fact illegal?

    ReplyDelete
  7. Hi Nicholas

    Thanks for reading my blog. If you think it is worth it, please spread link to it around.

    I am not a lawyer but I was advised by the lawyers that pyramid schemes are illegal. Wikipedia is NOT an authoritative source (for example their description of pyramid scheme is a bit simplistic) but I am sure they are not wrong on this either. http://en.wikipedia.org/wiki/Pyramid_scheme

    Best

    Greg

    ReplyDelete
  8. From VJK (for some reason his/her comment was not published automatically):

    Greg:

    I've just posted this in old thread that you probably do not look at any more. Since you seem interested in liquidity risk, I'll reproduce it here in order to to clarify some points:
    ===
    Greg,

    Unfortunately, this ( http://gregpytel.blogspot.com/2009/04/exampleexercise-how-does-it-work.html) contains some serious bookkeeping errors with respect to accounting for cash flow which is a critical issue in your liquidity discussion.

    E.g. in Step 2 Bank A takes a deposit. Now, at step 0, Bank A sheet is as follows:

    Cash: $104.91
    Loans: 0
    Deposits: 0

    Therefore, after taking a $100 deposit, it should be:

    Cash: $104.91+$100 = $204
    Loans: 0
    Deposits: $100

    I.e. taking a deposit causes both the asset as well the liability sides of the balance sheet to grow. So, the reason you lose liquidity (cash) in your example is due to faulty bookkeeping rather than excessive loan taking.

    ReplyDelete
  9. Hi VJK

    The "Example/exercise - how does it work?" is read/studied by thousands of my blog readers. Hence no re-posting was necessary. Many thanks for your input. I think you are wrong. Step 2 (as well as other steps) do not only involve taking a deposit (like $100 in Step 2) but also lending it out in the same step (which for some reason you omitted).

    Therefore if, in Step 2, you add $100 to Cash reserves (as a result of taking $100 deposit) and you also subtract it immediately as a result lending it out ($100 + $30 in Step 2).

    You are correct that taking a deposit causes both assets as well as liability side of the balance sheet to grow. However giving a loan (in the same step in my example) makes assets to shrink by a loan amount and grow by the risked value of the loan, $130 x 50% in Step 2 of my example (which you omitted in your analysis).

    To summarise, it seems to me that you made an error as you did not consider the effect of the loan giving on the balance sheet as, in Step 2, I did not split $100 deposit taking and $130 loan giving (which you omitted). I.e. your example is correct the way you present it but is irrelevant and in fact it misrepresents my example.

    Best

    Greg

    ReplyDelete