In response to the assertion by the author of this blog that the financial system was turned into a pyramid scheme, the CEO of one of the world largest and best known banks wrote to the author, justifying his denial of this assertion (calling it ”completely baseless” ):
"Banks certainly undertake a process of maturity transformation – that is the fundamental responsibility of banks: to borrow short and lend long. In doing so, banks take what I would call liquidity risk: the risk that at any point in time a creditor might demand repayment, but the bank is unable to provide that because it does not have cash to hand because the borrower is not due to repay their loan for some time. That is wholly different from a pyramid scheme where the borrower has no idea where the funds are going to come from when the obligation is constructed."
The author of this blog responded:
The understanding of a pyramid scheme as "where the funds are going to come from when the obligation is constructed" is manifestly insufficient. On one side even if a bank lends money to someone (like a small business) applying in the process loan to deposit ratio below 100%, ultimately it may also have "no idea where the funds are going to come from" as a borrower must get his funds from somewhere and so on. This is how a value chain is created. Yet it will not constitute a pyramid scheme although it may possibly be a risky and irresponsible lending.
On the other side a pyramid scheme is not about an idea "where the funds are going to come from when the obligation is constructed" but sustainability of deposit – loan cycle, or more generally circulating money in the economy. Therefore if a loan to deposit ratio is above 100%, such cycle is unsustainable as an exponential growth of balance sheets is unsustainable. (Incidentally a name "pyramid" comes from the shape of a graphic presentation of exponential growth which looks like, surprise, surprise, YES: a pyramid!) This is a conclusion well known for centuries in many different walks of life, starting from children's game of sending a postcard to an addressee at the top of the list of 10 (and then removing it from the list), adding own name in the bottom and finding, say, 10, other kids who would repeat the process. (If it worked every kid in that game would have received 1010, 10 billion, postcards.) This universal principle is not changed by the fact that banks think they know "where the funds are going to come from when the obligation is constructed".
A good example is lending with loan to deposit ratio of 117%. If a trader was lending with loan to deposit ratio of 117% and a pace of a cycle was one a day (not an unrealistic assumption on the current electronically powered markets), and s/he did it for a year (approx. 220 working days) then, out of every £1, his/her last advance in a year (220th) would have been over a £1 quadrillion (1.17220), having totally advanced in a year over £5.89 quadrillion. So in terms of liquidity, £1 cash, would have to cover over £5.89 quadrillion worth of potential demands (liabilities). And, if lending with loan to deposit ratio continued at over 100% loan to deposit ratio, there is no supremum: technically it can go to infinity very fast, at exponential pace. Therefore in terms of what was called by the CEO "liquidity risk", this risk keeps growing approaching very fast 100% (certainty). Such a risk is, of course, not acceptable as it is a near-certainty of collapse. ("Near" is a technical term put for correctness: in practice it may be omitted.)
Due to non-sustainability of lending with loan to deposit ratio above 100%, the expected known sources of the funds when the obligation was constructed would default in great numbers at some point in not too distant future, i.e. "liquidity risk" is practically 100%. This point is called a pyramid scheme collapse. Because of practical "liquidity risk" of 100%, pyramid schemes are illegal.
By contrast, whilst lending with loan to deposit ratio below 100%, called "fractional reserve banking" still carries "liquidity risk", it is a contained risk. E.g. with loan to deposit ratio of 90% every £1 has to cover maximum £10 of potential demands.
Putting in layman’s terms: fractional reserve banking brings a risk that we, as society, decided to live with, as in a long run and not without its problems it ensures very efficient economic development; lending with loan to deposit ratio above 100%, that can be called depleting reserves banking, is a sheer madness, a pyramid scheme guaranteeing a quick and spectacular failure.
The CEO also wrote further:
"Your [i.e. the author of this blog] logic assumes that all original money in the economic system, and all money extended as credit from then on, eventually returns to banks in the form of deposit. That assumption may have approximated reality some years ago, but it does not today. In fact, a significant, and growing, portion of households savings, for example, is invested directly in money markets and mutual funds. Some of that investment (what would have otherwise been deposits), in turn, flows back to banks in the form of wholesale funding because those money market and mutual funds purchase banks debt. But it clearly isn't captured in the loan-to-deposit ratios you quote."
The author of this blog responded:
Fractional reserve banking, which is based on loan to deposit ratio below 100%, is about creating a reserve at every point of circulating money in the economy when money is passed with a risk (traditionally it was a deposit turned by a bank into a loan and banks were risk brokers). The above example of investment turned into wholesale funding on money markets is exactly the same thing under a different name: someone’s investment turned into wholesale funding ends up on the market, say, as a mortgage, which in turn, through, for example, a purchase of a house and then house seller's investment, may come back on the market as investment and then as a part of wholesale funding, and so on. Basically "investment – wholesale money market cycle" must be considered as a part of "deposit – loan cycle" for the purpose of loan to deposit ratio. And, if it were not, it would be perverse.
The CEO continued:
"All that said, banks increased reliance on wholesale funds was one factor that exacerbated the banking crisis of last year, because it heightened liquidity risk. All those market participants that used wholesale funding, but particularly banks like Northern Rock and Lehman Brothers, rediscovered last September that wholesale funders demand their money back in large volume and more quickly than retail depositors. Put differently, wholesale funding isn't nearly as 'sticky' as retail deposit funding."
The author of this blog responded:
By associating with mutual funds earlier on, the CEO suggested that there was no structural reason for wholesale funding to be less "sticky" than retail deposit funding. Quite the contrary, considering typical maturities of mutual funds and deposits, wholesale funding should be more "sticky". Therefore this is a good indication that investment and wholesale funding money market constituted a pyramid scheme (in a technical, legal, sense). As "liquidity risk" of pyramid scheme is practically 100% (guaranteed collapse), "stickiness" of wholesale funding was decreasing at exponential pace, guaranteeing liquidity crisis as a matter of a short time. [More on "stickiness" in Appendix A below.]
If, as it appears, a loan to deposit ratio below 100% was not applied to "investment – wholesale money market" transactions, this would prove that one of mechanisms of pyramid scheme construction was "investment – wholesale money market" transactions. It is not wholesale market as such that failed, but that wholesale market was turned into a pyramid scheme, and the failure was not only inevitable but easily predictable. It looks like a very serious crime.
APPENDIX A
"Stickiness" is an average demand level of a depositor in a bank or investor in a fund to demand his/her money back. It depends on two factors:
- an average willingness of depositors (i.e. who are creditors of a fund, bank, etc) to withdraw money; there is an element of unpredictability (like general economic conditions, political situation, panic, at worst "bank run") but more less it is an equal playing field for all competing funds/banks; depositors may move money between them due to better prospective returns but money stays on the same market;
- loan to deposit ratio (i.e. a proportion of deposits/investment that is advanced further by a fund/bank with a risk) defines how much money is kept as reserve for any payment demand by depositors; if loan to deposit ratio is below 100% it guarantees a pre-defined level of reserves (e.g. loan to deposit ratio of 90% guarantees 10% reserve, in practice it means that every £1 of real money has to serve up to £10 of potential demands resulting from willingness to withdraw money); if loan to deposit ratio is above 100% then no reserve is created (in fact, it the existing reserves get depleted) but potential demands keep growing at exponential pace with no maximum (e.g. in practice, it means that that every £1 has to serve £2 then, very soon, £4, very soon, £8, and …. , soon, £1024 and so on, technically, infinity)
Therefore it follows that even if an average willingness of depositors to withdraw money is very low, with loan to deposit ratio above 100%, this low willingness will become irrelevant, as quite soon in that process, there will be not enough real money to serve any demands to withdraw money. Due to exponential pace, this is a matter of a short time, regardless how low an average willingness of depositors to withdraw money is. Lending, or turning an investment cycle, with loan to deposit ratio above 100% guarantees an exponential, i.e. extremely fast, growth of "liquidity risk" to 100%. For practical reasons it should be assumed as 100%. This also has to be combined with an "aftershock" effect: once a word starts going around that depositors cannot withdraw money, the confidence goes down and willingness to withdraw money grows, causing a "bank run" which in case of lending with loan to deposit ratio above 100% is a pyramid collapse. The case of Northern Rock showed that mechanism vividly: only government guarantees, assuring liquidity, prevented the inevitable collapse.
This is a very likely reason why some investments, like through mutual funds, on wholesale market that traditionally would be expected to be more "sticky" than typical high street bank deposits turned up to be less "sticky". Surprise? Not to a reasonably competent financier.
Financial press commentators, like Ms Gillian Tett of the FT, very often talk about market confidence without understanding that the real, based on numbers on the banks' balance sheets, effect of a pyramid scheme (i.e. a massively unsustainable size of banks’ balance sheets that each £1 cash has to serve), can easily override any psychological attempt of confidence restoration. More analysis on "A matter of confidence".
"Banks certainly undertake a process of maturity transformation – that is the fundamental responsibility of banks: to borrow short and lend long. In doing so, banks take what I would call liquidity risk: the risk that at any point in time a creditor might demand repayment, but the bank is unable to provide that because it does not have cash to hand because the borrower is not due to repay their loan for some time. That is wholly different from a pyramid scheme where the borrower has no idea where the funds are going to come from when the obligation is constructed."
The author of this blog responded:
The understanding of a pyramid scheme as "where the funds are going to come from when the obligation is constructed" is manifestly insufficient. On one side even if a bank lends money to someone (like a small business) applying in the process loan to deposit ratio below 100%, ultimately it may also have "no idea where the funds are going to come from" as a borrower must get his funds from somewhere and so on. This is how a value chain is created. Yet it will not constitute a pyramid scheme although it may possibly be a risky and irresponsible lending.
On the other side a pyramid scheme is not about an idea "where the funds are going to come from when the obligation is constructed" but sustainability of deposit – loan cycle, or more generally circulating money in the economy. Therefore if a loan to deposit ratio is above 100%, such cycle is unsustainable as an exponential growth of balance sheets is unsustainable. (Incidentally a name "pyramid" comes from the shape of a graphic presentation of exponential growth which looks like, surprise, surprise, YES: a pyramid!) This is a conclusion well known for centuries in many different walks of life, starting from children's game of sending a postcard to an addressee at the top of the list of 10 (and then removing it from the list), adding own name in the bottom and finding, say, 10, other kids who would repeat the process. (If it worked every kid in that game would have received 1010, 10 billion, postcards.) This universal principle is not changed by the fact that banks think they know "where the funds are going to come from when the obligation is constructed".
A good example is lending with loan to deposit ratio of 117%. If a trader was lending with loan to deposit ratio of 117% and a pace of a cycle was one a day (not an unrealistic assumption on the current electronically powered markets), and s/he did it for a year (approx. 220 working days) then, out of every £1, his/her last advance in a year (220th) would have been over a £1 quadrillion (1.17220), having totally advanced in a year over £5.89 quadrillion. So in terms of liquidity, £1 cash, would have to cover over £5.89 quadrillion worth of potential demands (liabilities). And, if lending with loan to deposit ratio continued at over 100% loan to deposit ratio, there is no supremum: technically it can go to infinity very fast, at exponential pace. Therefore in terms of what was called by the CEO "liquidity risk", this risk keeps growing approaching very fast 100% (certainty). Such a risk is, of course, not acceptable as it is a near-certainty of collapse. ("Near" is a technical term put for correctness: in practice it may be omitted.)
Due to non-sustainability of lending with loan to deposit ratio above 100%, the expected known sources of the funds when the obligation was constructed would default in great numbers at some point in not too distant future, i.e. "liquidity risk" is practically 100%. This point is called a pyramid scheme collapse. Because of practical "liquidity risk" of 100%, pyramid schemes are illegal.
By contrast, whilst lending with loan to deposit ratio below 100%, called "fractional reserve banking" still carries "liquidity risk", it is a contained risk. E.g. with loan to deposit ratio of 90% every £1 has to cover maximum £10 of potential demands.
Putting in layman’s terms: fractional reserve banking brings a risk that we, as society, decided to live with, as in a long run and not without its problems it ensures very efficient economic development; lending with loan to deposit ratio above 100%, that can be called depleting reserves banking, is a sheer madness, a pyramid scheme guaranteeing a quick and spectacular failure.
The CEO also wrote further:
"Your [i.e. the author of this blog] logic assumes that all original money in the economic system, and all money extended as credit from then on, eventually returns to banks in the form of deposit. That assumption may have approximated reality some years ago, but it does not today. In fact, a significant, and growing, portion of households savings, for example, is invested directly in money markets and mutual funds. Some of that investment (what would have otherwise been deposits), in turn, flows back to banks in the form of wholesale funding because those money market and mutual funds purchase banks debt. But it clearly isn't captured in the loan-to-deposit ratios you quote."
The author of this blog responded:
Fractional reserve banking, which is based on loan to deposit ratio below 100%, is about creating a reserve at every point of circulating money in the economy when money is passed with a risk (traditionally it was a deposit turned by a bank into a loan and banks were risk brokers). The above example of investment turned into wholesale funding on money markets is exactly the same thing under a different name: someone’s investment turned into wholesale funding ends up on the market, say, as a mortgage, which in turn, through, for example, a purchase of a house and then house seller's investment, may come back on the market as investment and then as a part of wholesale funding, and so on. Basically "investment – wholesale money market cycle" must be considered as a part of "deposit – loan cycle" for the purpose of loan to deposit ratio. And, if it were not, it would be perverse.
The CEO continued:
"All that said, banks increased reliance on wholesale funds was one factor that exacerbated the banking crisis of last year, because it heightened liquidity risk. All those market participants that used wholesale funding, but particularly banks like Northern Rock and Lehman Brothers, rediscovered last September that wholesale funders demand their money back in large volume and more quickly than retail depositors. Put differently, wholesale funding isn't nearly as 'sticky' as retail deposit funding."
The author of this blog responded:
By associating with mutual funds earlier on, the CEO suggested that there was no structural reason for wholesale funding to be less "sticky" than retail deposit funding. Quite the contrary, considering typical maturities of mutual funds and deposits, wholesale funding should be more "sticky". Therefore this is a good indication that investment and wholesale funding money market constituted a pyramid scheme (in a technical, legal, sense). As "liquidity risk" of pyramid scheme is practically 100% (guaranteed collapse), "stickiness" of wholesale funding was decreasing at exponential pace, guaranteeing liquidity crisis as a matter of a short time. [More on "stickiness" in Appendix A below.]
If, as it appears, a loan to deposit ratio below 100% was not applied to "investment – wholesale money market" transactions, this would prove that one of mechanisms of pyramid scheme construction was "investment – wholesale money market" transactions. It is not wholesale market as such that failed, but that wholesale market was turned into a pyramid scheme, and the failure was not only inevitable but easily predictable. It looks like a very serious crime.
APPENDIX A
"Stickiness" is an average demand level of a depositor in a bank or investor in a fund to demand his/her money back. It depends on two factors:
- an average willingness of depositors (i.e. who are creditors of a fund, bank, etc) to withdraw money; there is an element of unpredictability (like general economic conditions, political situation, panic, at worst "bank run") but more less it is an equal playing field for all competing funds/banks; depositors may move money between them due to better prospective returns but money stays on the same market;
- loan to deposit ratio (i.e. a proportion of deposits/investment that is advanced further by a fund/bank with a risk) defines how much money is kept as reserve for any payment demand by depositors; if loan to deposit ratio is below 100% it guarantees a pre-defined level of reserves (e.g. loan to deposit ratio of 90% guarantees 10% reserve, in practice it means that every £1 of real money has to serve up to £10 of potential demands resulting from willingness to withdraw money); if loan to deposit ratio is above 100% then no reserve is created (in fact, it the existing reserves get depleted) but potential demands keep growing at exponential pace with no maximum (e.g. in practice, it means that that every £1 has to serve £2 then, very soon, £4, very soon, £8, and …. , soon, £1024 and so on, technically, infinity)
Therefore it follows that even if an average willingness of depositors to withdraw money is very low, with loan to deposit ratio above 100%, this low willingness will become irrelevant, as quite soon in that process, there will be not enough real money to serve any demands to withdraw money. Due to exponential pace, this is a matter of a short time, regardless how low an average willingness of depositors to withdraw money is. Lending, or turning an investment cycle, with loan to deposit ratio above 100% guarantees an exponential, i.e. extremely fast, growth of "liquidity risk" to 100%. For practical reasons it should be assumed as 100%. This also has to be combined with an "aftershock" effect: once a word starts going around that depositors cannot withdraw money, the confidence goes down and willingness to withdraw money grows, causing a "bank run" which in case of lending with loan to deposit ratio above 100% is a pyramid collapse. The case of Northern Rock showed that mechanism vividly: only government guarantees, assuring liquidity, prevented the inevitable collapse.
This is a very likely reason why some investments, like through mutual funds, on wholesale market that traditionally would be expected to be more "sticky" than typical high street bank deposits turned up to be less "sticky". Surprise? Not to a reasonably competent financier.
Financial press commentators, like Ms Gillian Tett of the FT, very often talk about market confidence without understanding that the real, based on numbers on the banks' balance sheets, effect of a pyramid scheme (i.e. a massively unsustainable size of banks’ balance sheets that each £1 cash has to serve), can easily override any psychological attempt of confidence restoration. More analysis on "A matter of confidence".
Greg I have been researching the banking crisis for 5 years and arrived on your blog when searching "Loan to deposit Ratio and Banking liquidity" [12.08.2009]. I couldn't get my head round the figures being bandied about - despite a Cambridge Degree and A level maths! so i followed you through to your "Liquidity Risk" debate [02.09.2009] with John Varley and I am still confused .... unless the way the show "loan to deposit %" is a complete and utter scam/fraud? Am I correct in suspecting that if a bank has say 2% liquid assets/deposits - eg £500bn loan account and £10bn liquid assets [more or less RBS's position in 2008!] they call the loan to deposit ratio 98% - an absolute nonsense - which implies the loans only represent 98% of the assets; which of course might be near the truth if all assets including loans are counted but gives absolutely no indication of liquidity! Going on from there ... when a bank proudly says their loan to deposit ratio is only say 120% in theory this would mean, if the above surmise is correct, that their liquid assets are minus 20% according to their way of calculating the ratio. If this is so what does it mean/represent?
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