Enforcing law is the best regulator

The ongoing debate about the response to the current financial crisis in a way of “improved” regulations ranges from arguments for liberal, light touch approach, blaming for the crisis the state authorities, to heavy handed, strict approach, blaming for the crisis the financial industry.

However the current crisis happened in the presence of laws that prohibit institutions taking monopolistic positions and setting up and operating financial pyramid schemes. As it was demonstrated in the article "The largest heist in history" the root cause of the current financial crisis was lending by financial institutions with loan to deposit ratio above 100%. This constituted a pyramid scheme and, as such, was prohibited by law. The current crisis did not happen because of lack of sufficient laws and regulations but despite of them. They were not sufficiently monitored and enforced.

At present the major reason of not being able to deal with the current crisis effectively and swiftly by letting market forces doing all the work (and that includes bankruptcy) is the existence of the banks that are “too big to fail”. Their market position enforces governments’ rescue packages. The raise and growth of these “too big to fail banks” happened despite the existence of anti-monopolistic and competition laws and regulations designed to ensure a level playing field, free market economy. A bank that is “too big to fail” holds too dominant position. It is about dictating terms of business from the strength of their position in the presence of lack of sufficient competition as governments effectively underwrite their commercial risks. A bank that is “too big to fail” heavily curtails market competitiveness. Apart from dire consequences that are seen now, it imposed unfair competition environment on smaller players that were not “too big to fail” (and a lot of them are failing now). Larger banks took more risk as they had effectively a massive, free of charge, government sponsored insurance policy.

Before debating any change in laws and regulations, giving false impression as somehow the existing ones have been insufficient, we should revisit the existing laws and regulations and ensure that they are enforced. In practice, it would mean prosecuting a large number of financiers, regulators and some politicians who created or allowed to create and operated or allowed to operate a giant global pyramid scheme in a form of banks that were “too big to fail”. They are guilty of contravening existing laws and regulations related to pyramid schemes and monopolies.

This does not mean that there is no room to revisit some regulations with a view of making them more effective, like using a maximum loan to deposit ratio as a regulatory tool alongside interest rates. But this is a side issue.

It is highly unlikely that it is possible to create bullet proof regulations that would cater for any future financial product in any economic context. Financiers will always find a way to outsmart or corrupt regulators and politicians. The best way to ensure future probity is a mass prosecution of the perpetrators of the current crisis on the grounds of building and operating pyramid schemes and breaking anti-monopolistic, competition laws. If they end up in jail for lengthy period of time (some of them, no doubt, will commit suicide) and their wealth is confiscated, their successors, a new echelon of bankers, regulators and politicians, will ensure effective self regulation bearing in mind the demise of their disgraced predecessors. And this will be far more effective than any new regulations.

Investment banking perverse casino model

Dr Vincent Cable, a Member of the British Parliament and ex-Chief Economist of Shell, compared investment banking to a casino. Respectfully it seems to me that he holds too benevolent view upon the financial industry. In fact the modern investment banking business is operated like a casino whose owner lends tokens to punters at a very high interest rate. However the punters’ loans and interest become only payable to a casino owner out of their winnings.

No sane casino owner would have ever accepted such a self defeating business model. Yet the banks are such casinos. Banks’ stakeholders (shareholders and depositors) are such casino owners. And bankers are the punters.

On capital requirement v loan to deposit ratio

(This is a technical article justifying the assertion that if banks are lending with loan to deposit ratio above 100% then no capital requirements are going to prevent the financial system collapse.)

The banks are lending with loan to deposit ratio (L/D). Their balance sheets grow at exponential pace adding X*L/D^n at each deposit multiplication cycle, where X is an initial deposit. The value of the balance sheets at some point in time equals the sum of values at each cycle over a number of cycles from initial deposit until this point in time plus the initial deposit.

The regulatory approach is that banks should hold a certain fixed percentage of the value of their balance sheets as a reserve (R).

1. "Fractional-reserve banking" - case of loan to deposit ratio < 100%, i.e. in fraction representation L/D < 1

(Please note that R is also represented in fraction rather than percentage.)

If a L/D is below 100% (in a deposit multiplication) then the value of banks’ balance sheets at cycle n is represented by a formula: X*((1-L/D^n)/(1-L/D)). Accordingly the upper limit of the value of banks’ balance sheets generated from initial deposit X is X*(1/(1-L/D)), i.e. it is finite.

Let us assume that reserve R is required by a regulator. Then the difference between banks’ balance sheets and the reserves is X*((1-L/D^n)/(1-L/D)) – R* X*((1-L/D^n)/(1-L/D)), i.e. (1 – R)* X*((1-L/D^n)/(1-L/D)). Therefore the upper limit, i.e. when n tends to infinity, is (1 – R)*X*(1/(1-L/D)), i.e. it is finite.

It should also be noted that the difference between a loan given out and reserve generated, according to a prevailing requirement, at each deposit multiplication cycle tends to zero.


Blue line shows growth of balance sheets at L/D = 90%

Red line shows growth of reserves at L/D = 90% and R = 20%

Green line shows the growth of difference between balance sheets and reserves (i.e. balance sheets not covered by reserves) at L/D = 90% and R = 20%

Please note that L/D = 90% generates automatically a reserve 10% so another 10% would have to come from something else.

2. "Depleting-reserves banking" - case of loan to deposit ratio > 100%, i.e. in fraction representation L/D > 1

(Please note that R is also represented in fraction rather than percentage.)

If a L/D is above100% (in a deposit multiplication) then the value of banks’ balance sheets at cycle n is represented by a formula: X*((1-L/D^n)/(1-L/D)). Accordingly there is no upper limit of the value of banks’ balance sheets generated from initial deposit X since X*((1-L/D^n)/(1-L/D)) tends to infinity.

Let us assume that reserve R is required by a regulator. Then the difference between banks’ balance sheets and the reserves is X*((1-L/D^n)/(1-L/D)) – R* X*((1-L/D^n)/(1-L/D)), i.e. (1 – R)* X*((1-L/D^n)/(1-L/D)). Therefore there is no upper limit since (1 – R)*X*((1-L/D^n)/(1-L/D)) tends to infinity.

It should also be noted that the difference between a loan given out and reserve generated, according to a prevailing requirement, at each deposit multiplication cycle tends to infinity. It is practically very important, albeit irrelevant matter in this analysis, where this reserve is going to come from if L/D is above 1.


Blue line shows growth of balance sheets at L/D = 160%

Red line shows growth of reserves at L/D = 160% and R = 20%

Green line shows the growth of difference between balance sheets and reserves (i.e. balance sheets not covered by reserves) at L/D = 160% and R = 20%

The green line shows the growth of a pyramid scheme in the banking system despite the compliance with 20% reserve requirement.

Please note that when L/D is above 100% there is no reserve generated from a deposit multiplication cycle, so 20% reserve would have to come from something else. But this issue is irrelevant to this proof.

ANALYSIS:

It does not matter how large R is, even if it is ridiculously high like 99.999999%, this would only slightly slow the growth process, as 0.000001% coefficient of exponential function a^x (where x > 1) makes very little practical difference compared if R was 0%. It is still a pyramid scheme.

The difference between banks’ balance sheets and reserves grows to infinity at exponential pace. when L/D is above 1. Such process constitutes a pyramid scheme that is bound to collapse. Therefore even assuming that banks’ reserves are as good and as liquid as cash, since the difference between banks’ balance sheets and reserves grows without any upper limit at exponential pace, no fixed R (even 99.999999%) will prevent a pyramid building.

Consequently even assuming that banks reserves are as good as cash (or cash only) banks balance sheets are turned into toxic waste by lending with loan to deposit ratio above 100% since if it were not the case, the difference between banks' balance sheets and reserves would grow to without any bounds to infinity at an exponential pace (which is not possible).

If banks are lending with loan to deposit ratio (L/D) above 100% the financial system will still collapse being a pyramid scheme, regardless of how arbitrary high the reserve requirement (R) is and the banks’ compliance with it.

NOTES:

1. Please note that this proof does not even rely on the fact that banks’ reserves were turned into a toxic waste.

2. It is in my view criminally negligent that financial professionals responsible for running and oversight of the system especially regulators like Lord Turner do not appear to have a slightest clue about such basic and rudimentary arguments. A reader is invited to draw his/her own conclusions on the future of the financial system and indeed the economy.

3. The case of loan to deposit ratio equal 100% is left to an interested reader.

4. I would like to thank Stuart AJ, whose inquiry prompted finalisation and improvement of this proof.

Is another liquidity crunch on the way?

It is impossible to be a prophet in this crisis. But it is possible to assess the causes and mechanics on the crisis and do risk assessment. The first massive liquidity crisis occurred in September 2008. The market got drained of cash. Then the governments stepped in and injected billions of cash.

However the market was, and still is, full of toxic waste. This is going into quadrillions of dollars. They are completely worthless papers but with notional value. They can be redeemed for cash.

The next liquidity crunch came in January 2009. Timing was important: not before Christmas to dampen the public mood for a festive season, but after the New Year when people suffered from hangover and mood misery anyway. Their perception to outside events was somewhat limited then.

As it appears the January liquidity crisis was caused by the banks converting their toxic waste into government injected cash. Very little of that cash found its way to main street economy. Governments again injected huge amounts of cash, reaching a few trillions of dollars. And again we do not see this cash reaching main street economy. Now banks like Goldman Sachs and JP Morgan are posting record profits. We will see whether others will follow.

One has to wonder whether banks are not converting the toxic waste they hold (and they have absolute mountains of it) into taxpayers’ cash (injected by governments) draining the market of liquidity. If this is the case, then the next crunch (or some setback) may come very soon. And governments are likely again to react by injecting even more taxpayers’ cash, which again is unlikely to find its way to main street economy. This time it would be during a summer season when people are away enjoying their holidays, not really focused on the world events. And the story will go on and on and on...

The pyramid scheme that was the cause of the current crisis turned the economy into a perverse arrangement: financial institutions’ profits is a very bad news as these profits are at the costs of main street economy liquidity.

Held by the throat

Goldman Sachs announced record quarterly profits: $3 billion. But these are not normal times. Any profits made by financial institutions deserve a careful analysis.

When the current crisis started banks were sitting on a huge pile of toxic instruments, notionally worth quadrillions of dollars. This is a massive pile of toxic waste worth on the market nothing but having a massive face value.

Then the US government, and and other governments too, pumped in billions, trillions of dollars of liquidity into the system. It should be examined then whether Goldman Sachs found a way of converting some of this massive pile of toxic waste that would be normally worthless (that must have been written off as such last autumn), to convert into government injected cash. And whether they will continue doing that posting big profits in months to come whilst ordinary business and consumers market will see very little liquidity that governments (stupidly) expected when they injected liquidity into the system.

If that was the case that would have confirmed a well predicted (last autumn) scenario: effectively banks, with the help of governments, developed a control method of the economy (and hence taxpayers) that work in the same way, as loan sharks control their "customers" (or rather victims). No matter how much the victims pay, their debt keeps on growing and the sharks are able to extract every dime earned by their victims. In essence, the financial "elite" holds the taxpayers by their throats.

It may (or may not) be coincidental that in this scenario that Goldman Sachs is so close to the US government. British government also pumped billions into the banking system. It will not be surprising, or it may be to some, if JP Morgan, that is very close to the British government, posts large profits too.