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?".

Saturday, 9 May 2009

Towards improved regulations – maximum loan to deposit ratio

The current crisis led academics, analysts, journalists and politicians to discuss how to change/improve regulations so such a crisis is not repeated again. It comes with a warning that at a time of a crisis it is very easy to unnecessary over-regulate.

The fact is that this is a smokescreen. If the existing law that prohibits financial pyramids and regulations, like Basel I and II that require minimum capital to be held by the banks, were obeyed the current liquidity crisis would not have happened. The current crisis is a typical result of criminal pyramid selling akin to events in Albania in 1996 – 1997.

However we can examine the financial system and discuss how it would work if a government and/or regulator in a country was setting a maximum required loan to deposit ratio for financial institutions. This would address the shortcomings of The Turner Review recommendations.

How would it operate?

A maximum required loan to deposit ratio at a certain level stipulates that a bank cannot lend more out of accepted deposits than it is stipulated by that ratio. A bank would consider any cash stream into it, as a potential deposit. A deposit, for the purpose of this regulation, can only be cash (no other form of security can be considered as cash). For example, a typical cash deposit of a customer is a deposit. Any cash revenue retained by a bank that it would use for lending, e.g. loan repayments, interest payments or any bank’s charges, is considered as a deposit once costs, taxes, dividends, or any liabilities and contingent liabilities are subtracted from them. It is as if a bank was depositing money in itself.

This does not preclude a bank from borrowing from another bank and lending it to a customer. However this bank would be acting as a broker earning money on the margin: a difference between their costs of borrowing and their charges on lending. Furthermore and importantly this bank would not be allowed to underwrite its borrowings to an extent that would effectively increase its loan to deposit ratio above a regulatory level.

Loan to deposit ratio would operate at each currency level to preclude any fluctuation, especially depreciation, in a currency to affect the ratio. For example if a bank is lending money in dollars, it must have sufficient dollars reserve to comply with the loan to deposit ratio in dollars. (And if it does not, it has to convert from a different currency reserve at the time. It can only do it provided it will still stay within a required loan to deposit ratio in that currency too.)

The regulations outlined above would result in banks having always a certain level of liquidity. In practice, if a loan to deposit ratio was always, say 90%, there would always be 10% cash reserves in banks for cash deposits per each currency.

How would it work?

Setting up a maximum loan to deposit ratio would also be a very helpful tool for governments in running their economic policy. Apart from precluding a financial pyramid in an explicit regulatory way (rather than, like at the moment, in an implicit legal way), a government would gain a tool to control sustainable economic growth.


1. At a time when economic growth is stagnant a government may decide to increase a maximum loan to deposit ratio from, say, 85% (if that was the required one at the time) to, say, 90%. This would create additional liquidity on the market stimulating the growth.

2. At a time when economic growth is becoming too exuberant, a government may decrease a maximum loan to deposit ratio from, say, 92% to, say, 88%. This would result in taking liquidity from the market (curtailing borrowing in a similar way as a hike in interest rates). It would also cool down the economy but at the same time bank, by storing more cash, would increase its cash reserves.

3. At a time of economic recession, governments could, in theory, increase temporarily a maximum loan to deposit ratio even above 100% to increase cash availability on the market very fast. As this would result in a very fast (at exponential pace) depletion of cash reserves held by banks, indeed it is a pyramid, this would have to be considered as a very unusual step. This would be a step of the last resort that would have to be monitored very carefully. It is a very similar measure to currently implemented "quantitative easing".


Built-in counter-cyclical measure

The measures outlined above have built in natural counter-cyclical characteristics. Cooling down of economy through decrease of loan to deposit ratio, results in increase of cash reserves held by banks (i.e. storing reserves for bad times). This also limits assets value depreciation at the time of economic downturn, since there is always a guaranteed level of liquidity held by banks. In fact during a downturn banks capital, cash, position is strong and improving, ready to support lending during recovery part of a cycle.

Interest rates stability

Maximum loan to deposit ratio can also be used as a fine tuning tool of governments in controlling economic growth to stabilise interest rates level. A decrease in loan to deposit ratio maximum requirement is very likely to reduce the need to increase interest rate, as it will reduce credit availability.

Improved financial sector productivity

A regulated maximum loan to deposit ratio would also have a very healthy impact on banks' productivity. The banks would not be able to create bogus money, through financial instruments, in order to support increased lending in response to market demand. Banks would be forced to be more efficient to attract more deposits in order to do more lending. This would put a squeeze on a difference in interest rates (and other costs) that banks charge for lending and a return they pay to depositors. Banks will have to look more for profit margins in productivity measures. This means better deal for the consumers and less waste in the economy. (It should be noted that whilst all other industries and indeed a public sector are a subject of massive productivity pressures, thus far by generating bogus money, banks escaped these pressures. Therefore there is a need to bring banks into a real world of productivity and implementing this proposal will facilitate this process.)

Final comments:

A regulatory controlled maximum loan to deposit ratio is in itself not a panacea for all economic problems or potential problems. In fact it is another tool, alongside, interest rate control that would allow governments to stimulate, maintain or cool down economy. Therefore all would depend how this tool would be used by governments to control economy.

It would also explicitly let governments to ensure that loan to deposit ratio is below 100%, therefore that a financial pyramid is not built and a crisis of the same type as the current one is not repeated. Any relaxation of a maximum loan to deposit ratio above 100% has to be a very unusual measure, since it results in a pyramid growth of liquidity on the market.

In its mechanism it is a very powerful tool but at the same time it is very simple. It does not lead to over-regulation and it is easy to control and monitor.

Last but not least, a proposal of governments setting up a maximum loan to deposit ratio requires further consideration, discussion and modelling. But the historical information is in its favour. It must also be kept in mind that lending with loan to deposit ratio above 100% is turning the financial system into a pyramid scheme and therefore at the current state of the law it has been illegal for some time.

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