Financial pyramid ain’t a Concorde

In the FT Professors Viral Acharya, Matthew Richardson and Nouriel Roubini compared “the global financial system of the pre-subprime era to Concorde. It was fiercely innovative and grew at a record pace for close to two decades”.

The current financial crisis was caused by the financial institutions’ lending at loan to deposit ratio above 100%. This is not highly innovative. It is not innovative at all. It is a well known pyramid scheme. We know it from Ponzi, Lech Grobelny (Poland in 1990) and Albanian gangsters (1996 – 1997). Bernie Madoff is the latest epitome of the financial system “fierce innovation”.

A comparison to Concorde is an insult to this aircraft’s inventors. Whilst if ideally constructed and maintained, it would have been able to fly without accident infinitely, a financial system based on loan to deposit ratio above 100% (i.e. it was turned into a pyramid scheme) was bound for failure at exponential pace. By design. Indeed the current crisis was engineered that way to happen. Quite basic mathematical understanding is sufficient to prove that.

Wrong parallel leads to wrong analysis. Whilst it is correct that “the biggest contributor appears to be that capital allocation at large, complex financial institutions (…) was broken, focusing myopically on circumventing capital requirements at the expense of long-term economic value creation”, it does not explain the mechanism that caused it. Why did it happen? Or even why did it have to happen? A loan to deposit ratio above 100% assures precisely that. It is a sufficient condition to ensure such phenomenon. This is an intrinsic feature of any financial pyramid scheme. Capital allocation must always be broken due to its insufficiency in the course of financial pyramid exponential growth. It is a classic phenomenon that triggers its collapse. This is when euphoria of the markets transforms into fear, yet another phenomenon of the current crisis (that Alan Greenspan referred to recently). Three professors conspicuously do not even mention that.

Wrong analysis leads to wrong conclusions. The suggested changes to “fix the system” are unlikely to have a desired effect as they are not full proof of preventing another credit binge of banks giving credits at loan to deposit ratio above 100%. It is more striking however that in order to prevent a financial crisis like the current one, the financial system does not need more or new regulations. Financial pyramids have been illegal for some time. Sufficient law and regulations are in place. They need to be enforced (with respect of pyramid schemes). In practice this also implies that the creators of the current crisis (bankers, regulators and some government officials) must languish in jail and their properties and chattels must be confiscated to compensate for the loses caused by the current crisis. The perpetrators of the current crisis, the financial pyramid scheme purveyors, must share the same fate as some of their Albanian gangster counterparts.

This is quite uncomfortable truth for bankers, politicians, financial experts, journalists and academics. The three professors appear to defend theirs, and their professional and academic colleagues, hitherto distinguished careers, at the same time creating a smokescreen on the root cause of this crisis. It all would have been academic if we, the taxpayers, were not forced, at huge expense, to finance supporting the global financial pyramid. Whilst Albanian government was wise enough to let the pyramids collapse, our leaders seem to have better ideas. But can we, the taxpayers, afford them?