Pyramid model and risk management

A very prominent economist commented to me privately:

“On the other hand problems do arise if a deposit taking institution buys securities and it is taking on risk that is hidden or if it securitises and keeps risk without realising it - these two problems have been serious. The problem is (and I sympathise with regulators here - though not believing in regulation!) it is difficult to tell whether risk is being offloaded from the banking system or whether it is still there.”

In my pyramid model of the current financial crisis, if loan to deposit ratio was to be kept below 100% to prevent the financial system from turning into a pyramid, a bank should handle buying securities for cash in the following way: let us assume a bank wants to buy $900 worth of securities for cash and the loan to deposit ratio was 90%. Then the bank must have $1,000 cash available which is not part of bank existing cash reserves accumulated as a result of compliance with prevailing loan to deposit ratio. For example a bank gets this $1,000 from a loan capital repayment (after any costs and taxes). A bank pays $900 for securities and adds remaining $100 into its cash reserves. (In a way, a bank deposits $1,000 in itself and considers its investment into securities as it was lending cash to itself for the purpose of buying these securities with loan to deposit ratio of 90%.)

It should be also noted that if a bank acquires new securities paying with already held securities then no cash reserve (according to prevailing loan to deposit ratio) has to be made automatically as a result of such transaction since such reserve was made when the old securities were bought by a bank. I.e. the originally made cash reserves for old securities cover new securities that were acquired with old securities.

The risk of investment is another issue: but the point of my model is that by lending with loan to deposit above 100% the banks were turning the financial system into a pyramid scheme (which incidentally is illegal as setting up pyramid schemes is illegal). Therefore the issue of risk management was secondary in its contributory characteristics to the collapse of the pyramid that resulted in the current crisis. (I.e. even if there was no risk, the pyramid was destined to collapse anyway. The maths behind it is really brutal.)

I have also proved mathematically that if a loan to deposit ratio is above 100%, the better management of risks (i.e. less risk overall) delays the collapse of the pyramid and lets it grow bigger! But since its collapse is inevitable anyway when it comes, a pyramid is larger than if risk management was not that good.

Therefore ironically and counter intuitively, the current financial crisis was made worse by the fact that, in the presence of lending with a loan to deposit ratio was above 100%, the risk management was actually quite good in my view. ("We had such an excellent risk management systems and it failed." - this is a frequent underlying scream of despair in mainstream financial media, quite often reduced to emotive comments about the “bankers' greed” - "Exactly! Since you had such excellent risk management system and you were still lending with loan to deposit ratio above 100% you only made things worse compared if you even had no risk management at all"!) The crisis would have been less severe if, in the presence of lending with a loan to deposit ratio was above 100%, there was an inferior risk management. The financial pyramid would have collapsed whilst it was still smaller and the liquidity crisis would have been less severe!

This can be compared to an engineering project of building an inverted pyramid (which is a counterpart of lending with loan to deposit ratio above 100%). The better the balance stabilisation system of an inverted pyramid (which is a counterpart of risk management in finance), the larger a pyramid can become without losing balance. However as there is no stability system that can keep an inverted pyramid in balance up to infinite size, a collapse is only a matter of time. The better the balance stabilisation system the larger the inverted pyramid that eventually collapses.

However my model does not address the investment risk element (apart from stating that if you are lending with loan to deposit ratio above 100% you are building a pyramid which is bound to collapse regardless of other risks, circumstances, etc; basically the risk of pyramid collapse is getting quickly, at exponential pace, to 100%). But it is not intended to. It is not a panacea for all economic problems/potential problems. I do not consider it as a foundation of a great economic unification theory but merely a model that explains why and how the current crisis happened and why it was deterministic to happen (i.e. fully predictable).

The economist also wrote:

“Our suggestions for depositors being primary creditors would mean that banks other creditors would have much stronger incentives to ensure that risks were transparent.”

I completely agree with this but provided that a loan to deposit ratio is kept below 100%. Otherwise, in the light of my comments above, you will still end up building a pyramid which will be bound to collapse anyway. But this time it will be even larger… So rather than making situation better it will be worse.