Narrow banking: barking up the wrong tree

The report written by John Kay, "Narrow banking: the reform of banking regulation" and ensuing discussion in the mainstream media, e.g. Martin Wolf in the FT, Anthony Hilton in The London Evening Standard and John Kay himself in The Daily Telegraph is worth analysis.

The growth of balance sheets (i.e. deposits and loans) can be classified according to risk and complexity as follows:

- 100% reserve banking, i.e. no risk, all deposits are repayable immediately on demand; this implies loan to deposit ratio 0%; this means that banking becomes a utility business which is what John Kay appears to be arguing for in his report.

- fractional-reserve banking, i.e. a certain level of risk as banks keep only a fraction of deposits; this model has worked for centuries based on trust in banks and a statistical principle that not all depositors need to withdraw money at the same time; therefore a "bank run" was possible if depositors lost trust, or there was no sufficient reserve accumulated; to counter the former governments routinely guarantee deposits to counter the latter loan to deposit ratio must be comfortably below 100% and banks were lending money to one another (including a central bank, the lender of last resort); as example to have 10% fractional-reserve banking i.e. £1 cash has to "serve" £10 on the balance sheets liabilities, loan to deposit ratio must be 90%; to have 25% fractional-reserve banking i.e. £1 cash has to "serve" £4 on the balance sheets liabilities, loan to deposit ratio must be 75%; to have 50% fractional-reserve banking i.e. £1 cash has to "serve" £2 on the balance sheets liabilities, loan to deposit ratio must be 50%; and incidentally to have 100% fractional-reserve banking i.e. £1 cash has to "serve" £1 on the balance sheets liabilities, loan to deposit ratio must be 0%.

- no reserve banking, i.e. banks lend with loan to deposit ratio of 100% (accumulating no cash reserves), a liquidity risk is 100% in a finite time (the growth of balance sheets to underlying liquidity is linear).

- depleting reserves banking, i.e. banks lend with loan to deposit ratio above 100%, not do they not accumulate any cash reserves, but they deplete the existing reserves, a liquidity risk is 100% in a finite time (the growth of balance sheets to underlying liquidity is exponential, therefore it is a very short time indeed). Depleting reserves banking amount to a classic and rudimentary example of a pyramid scheme.

It is important to have a debate whether we, as society, taxpayers, should have 100% reserve banking with no liquidity risk at all, or a fractional-reserve banking with some element of liquidity risk. However, this debate has very little to do with the causes and mechanics of the current crisis. It is similar to any debate what level risk society is prepared to accept: be it air travel, road travel, building nuclear electric plants and so on. It is a cost-benefit debate. For centuries, fractional-reserve banking on a level of 20% - 25% worked well circulating money in the economy. In this process sufficient reserves were accumulated and bank runs were a rarity.

A sufficient cause of the current financial crisis was the fact that banks were lending with loan to deposit ratio above 100%. They committed a crime of fraud: building a pyramid scheme. The current liquidity crunch is simply a collapse of this financial pyramid. (In the same way, a liquidity crunch was caused in Albania in 1996 – 1997.)

It seems that arguments in the financial community are moving with a grace of a drunkard walking in a corridor: from wall to wall, from one extreme to the other, from pyramid scheme practices to arcane 100% reserve banking. Whilst this may be a result of a lack of understanding of the fundamentals of mathematical complexity and risk assessment (based on probability theory), it also obfuscates the picture that the financial industry committed a massive fraud on the taxpayers using a pyramid scheme mechanism.

Even if 100% reserve banking will get its way, governments must prosecute many from the financial community (as well as regulators) not for practicing fractional reserve banking (which may be risky but still within what has been legally acceptable as commercial risk taking), but for practicing depleting reserve banking (which was excessive risk taking and amounting to an illegal financial pyramid selling).

Borrowers are bailing out the banks

Yesterday's episode of BBC Panorama, "Banks behaving badly" showed a new and growing pathology of the financial system.

Last year the government stepped in and injected a lot of money, billions of pounds, to rescue banks from inevitable bankruptcy. The government control over the banks and their practices has been illusory to say the least despite the government being a large shareholder. Nevertheless the banks are very keen on to pay back the government subsidies and get out, completely and formally, of any ownership control. The government may get under pressure from the public and be forced to act in a way that the banking industry would not like. The current tension regarding bonuses is a gauging example. Having repaid the subsidies and financial help, the banks will be able to claim that their reforms worked and the government will be able to announce a success. Therefore any further government intervention could only destroy a revival of the financial system.

This is yet another organised scam. It is as primitive scam as the one that originally led to the current crisis (which was a pyramid scheme). This time banks have massively increased the margins on the mortgages (and other loans): a difference between a rate charged by a bank on a loan and Bank of England base rate. This is designed to give banks massive profits.

The banks are repaying the debt to the government by charging the public (i.e. taxpayers) far more than otherwise they would have done. Through the government actions, taxpayers bailed them out in the first instance. This however brought about rather unwelcome, by the banks, government's ownership. Now, with the government's blessing, the banks found a way to force taxpayers, who are banks' customers, to pay for the banks getting rid of the government's ownership control.

The banks behave like sharks. Loan-sharks. Once they taste the blood they will come back for more. Even when banks repay government subsidies with money extorted from taxpayers, which is a scam, they are very likely to continue with this practice. They will keep on making massive profits: but it will not be a profit in an economic sense. Banks will acquire a right, like the government's, to tax people. In practice it is a relationship like between low-life loan-sharks and their "customers" (i.e. victims).

It is very likely, that unless the ministers are dim, the government participates in this scam. It is far better, from popularity perspective, for the government to let the banks "tax" the public to pay for the costs of the crisis than to increase taxes. It is revolting however: the former is a licence for the banks to extort money from taxpayers and enrich themselves. The latter would be a genuine tax (within the government prerogative) retaining banks' ownership in the public hands. The key is that the government can blame (already unpopular) banks for the former, whilst the latter would not be exactly a vote winner for the politician in a run-up to the elections. Effectively, through banking system the government is introducing (not that) stealth tax to pay for the costs of this crisis, additionally making the public paying for it with the rescued banks’ equity.

Apart from obvious criminality of such arrangement, like any high taxes, it will impede economic development.

Late Brezhnev era in finance

After a year since the outbreak of the financial crisis, it is time to reflect and look for some meaningful parallels in recent history. Another anniversary this autumn, the 20 years since the collapse of communism, can be a point of reflection.

Last year governments' intervention to save the financial system resulted in a setting akin to the communism from late Brezhnev era. In Britain New Labour effectively nationalised the financial system. Ironically, having rejected not that long before Clause IV. The financial establishment has become modern days' commie-style nomenklatura. Their enjoyed privileges and lavish lifestyle is all at taxpayers' expense as they are a direct result of governments’ bailouts, subsidies and guarantees. "Knowing it better"-arrogance of the bankers is very similar to that of communist party apparatchiks of the Brezhnev era. They also proclaimed that it would be a tragedy if they had gone, they had lost their roles and a country "lost talent". This is how at present the financial establishment justifies their continued stratospheric bonuses at taxpayers’ expense and governments do not seem to know what to do about it. It is a farce: in a democratic society the public cannot afford to continue to watch this pathetic and amateurish pantomime. The overall production costs and, hence costs to the audience, the taxpayers, are incredibly high, running into trillions of dollars already.

In the same way as communism could not have been reformed and had to collapse, as this new nomeklatura rules, the financial system cannot be turned around. (No pun intended, Lord Turner.) Turkeys are rather reluctant voters for Christmas. We have already seen attempts of reforms and calls for deeps systemic changes. The Turner Review, the French attempts to curb the bankers' pay and so on. No doubt, we will see more of it. But they can be expected to have a similar effect on the financial world as Kadar's reforms in Hungary or Gorbachev's perestroika and glasnost in Russia had on communism. They should speed up the inevitable collapse. They are paving a way to deep changes.

Time will tell whether these changes will have a Czech's velvet revolution softness or ruthlessness of a Romanian angry mob.

New Labour: a cunning plan of Old Labour

BBC news piece showed a very sad real face of the current crisis. A decent working class father who, having been made redundant as a railway maintenance man, is scraping every single copper coin to get a few pounds (if that) to buy food. Who is "pinching" his child's savings and it is still not enough. So local charity supplies the family with the food.

On existential level this is no drama. Britain is not becoming, let's hope, another failed state like Zimbabwe where there is an outbreak of near-famine. So let's keep it in perspective. But it is so humiliating, heartbreaking and gut-wrenching.

We have to accept that only very few of us are clever. Most simply want to live ordinary lives doing socially useful jobs and earn a decent living. This is practically it. These are basic expectations of civilised part of the world that have been taken for granted for a few generations. They were brutally thrashed by the common criminality of the financial world. They robbed us using a primitive pyramid scheme method and were not even intelligent enough to cover their tracks. All these happened under New Labour watch characterised by their love of the City and their practices. For years we have had to watch rather unsavoury spectacle of New Labour elite brownnosing captains of the financial industry.

For these pyramid purveyors and their protectors it is business as usual. Not only are they not made accountable for their crimes (apart from few minor exceptions like Madoff who only ended up in trouble as he robbed rich and powerful) but they continue to enjoy stolen riches, live at the taxpayers' expense and expect that to continue. This is in startling contrast with a railway maintenance man who was made redundant living below the breadline on charity handouts.

The cynicism of pyramid purveyors and their protectors is such that they suggest as somehow free market failed and the economic system needs improvements. Politicians, regulators and financiers are busy discussing this. But the truth is simple and shocking. Free market is not faultless, however on this occasion the crisis is not a result of free market failure but of a primitive fraud called a pyramid scheme. Albanians experienced the same in the late 1990's.

Thus far it has been usually a domain of loony lefties and others of "The Socialist Workers" creed, but this time also reasonable conservative folk and family men have to wonder whether we might see soon angry pitchfork and torch bearing mobs at the gates of the Downing Street.

Alexis de Tocqueville famously observed that revolutions and social unrests do not happen amongst poor and dispossessed at the depth of misery. Third world countries are socially quite stable. Revolutions happen when ignited high expectations of ordinary people come to a crashing end. Here after over a decade of seemingly unprecedented prosperity "things only got better" and climaxed with "Cool Britannia", the current crisis could be such a tipping point.

After all it may well be the case that New Labour project was a cunning plan of Old Labour who used de Tocqueville's textbook recipe to try to spark off the revolution. And if it works, Baldric will be proud.

NOTE:

Pyramid scheme is an ideal mechanism for testing de Tocqueville’s recipe: as the pyramid grows and people think they become richer, and indeed many of them are but only for some time, their aspirations grow with that too. An inevitable pyramid collapse brings these aspirations to a crashing end. An Albanian pyramid crisis of 1996 – 1997 is another good example how it works.

Sir John Gieve on Newsnight, 14 September 2009

On 14 September 2009 on BBC Newsnight, Sir John Gieve, an ex-Deputy Governor for Financial Stability of the Bank of England between 2006 and 2009, gave an interview. (To watch Newsnight click HERE.) During the interview, at around 31:55 of the programme, Sir John referred to the way the crisis happened comparing it to "rather like a network effect you get with a flu pandemics" which "if it reaches the tipping point it then accelerates and it is exactly the sort of thing we saw happening in the financial markets".

Readers of this blog are invited to read (again) a short article from April this year "Financial pandemic".

Sir John did not seem to realise that this sort of "network effect" he was talking about, had exponential growth and as such constituted a pyramid scheme. Not realising this, he did not seem to be concerned that we, as society, are victims of a massive crime perpetrated by the financial industry, although in fact he confirmed it.

Sir John, warm welcome to the club. I do hope you will become its conscious member and realise a true significance of your statement. I also hope that you will put a pressure on relevant authorities to pursue criminal prosecutions of pyramid purveyors (i.e. bankers, regulators and some politicians), which will also include sequestration of their assets, who are behind the current crisis.

Even more uncomfortable truth

An accounting firm BDO Stoy Hayward (the same firm that was commissioned by the British government to produce a report on the MG Rover saga) published recently an analysis:
"Time to break the silence?".

"It is no secret that due to the recession, the bank bail-out and corporate mis-management, that the UK is now facing a £175bn deficit. It's also no secret that one of the principal options to address the increasingly urgent need to 'balance the books' is by raising tax. BDO's Prudent estimates put this figure at an additional £25bn a year! Tax on you, me, our families and our businesses.

None of the political parties are currently standing up and speaking out about how they intend to reduce the national debt. Now it's time for politicians to speak out and Break the Silence over potential tax policies."

The entire report makes a very uncomfortable reading for both the Labour and the Conservatives. The former do not want to lose the next elections (held by spring next year at the latest) or lose it by the least possible margin. The latter do not want to scare the electorate too much. Labour keeps spending as there was no tomorrow (to survive till election) and the opposition stays almost quiet about it. As a result the public stays deluded that everything will be all-right.

However the whole truth is even more uncomfortable than it transpires from the BDO report. Firstly the government, as it admitted, does not have an idea of the size of the liquidity hole that it still may have to plug. There are already signs that the next wave of liquidity crunch may be on the way. Other governments, like German’s, are gearing up for it. BDO report assumes, implicitly, that the scale of deficit will not increase dramatically. This appears to be an optimistic assumption.

Secondly the scale of financial burden that the taxpayers will have to bear – even assuming rather optimistic picture that the report paints combined with the recent approach to bankers’ pay scales - shows that the relationship between the financial industry and taxpayers evolved into loan sharks and their victims arrangement. Taxpayers will keep paying through their noses forever to support opulent life-style and massive earnings in the financial industry.

Indeed it is high time for politicians to tell the truth about the scale and consequences of the current crisis. It is also high time they confront the financial industry and instigate prosecutions (including wealth confiscation) of all those responsible. This crisis is not a failure of capitalism or free market economy. It is a result of common criminality: centuries old fraudulent methods that resulted in turning the financial system into a giant global pyramid scheme.

The government must get a grip on large private investors

(The article below argues on the basis of Michael Spence and Joseph Stiglitz asymmetric information markets theory and Gresham’s law that:

1. Large private investors (e.g. hedge funds, private equity, venture capital firms) must be regulated so their activities are completely transparent.

2. Short selling of shares of companies must be banned.

Whilst it is completely understandable that the editors of mainstream financial media such as the FT, due to their educational background, are unable to deal with technicalities of the current crisis, the article below presents a type of arguments that must be within their grasp and must have been published by them in the interest of debate on the state of the financial system. The fact that such arguments have not been published - regardless whether one agrees with them or not - raises further questions about competence and also about vested interests. Readers of this blog are invited to draw their own conclusions.)

Last week London Mayor, Boris Johnson, visited Brussels. He was openly lobbying the European Union MP’s and officials for non-introduction of tighter regulation on large private investors operating under various hedge funds, private equity firms and venture capital firms. Johnson’s argument was that these firms pay so much in taxes that it would be significantly damaging to London and the UK, if tight regulation forced them to relocate abroad. Johnson however did not address a question whether there are any costs to London, the UK economy and indeed the entire world of these private investors’ entrepreneurial exploits.

“Secrets of trade”

Investors who can bring returns on investment in good and bad economic times are widely admired. Hedge fund managers are legendary for such abilities. They never explain what makes them so successful: what kind of investment strategies they deploy. Jeeves’ “secrets of trade” is a typical response, implying deep sophistication.

Let us examine then a possible successful investment strategy based on short selling. Short selling is a relatively old strategy. If it is deployed on a macro level, like currencies or commodities, it brings balance and improvement into economic growth.

A classic example was British Black Wednesday in 1992. The government hoped to keep the value of the pound higher than the markets thought that it was worth. The investors were short selling the pound. Eventually the markets won. Although this was a defining moment of the last Conservative government, it was also arguably the turning point during the previous economic downturn. Whilst the Major’s government completely lost credibility for economic competence, devaluation of the pound made British economy more competitive encouraging exports and discouraging imports. From that point “things only got better” but despite that Conservatives lost the elections in 1997. (Conservatives’ economic electoral misfortunes were also exacerbated by a long sequence of events that went into history under the “sleaze” headlines.)

Another example of short selling was a crude oil market collapse in 1997 – 1998 when a price of a barrel dropped below $10. This curtailed exploration activities, drove less efficient players from the market and forced consolidation. In effect the price of oil rose again with remaining oil companies being more efficient. However at the time there were concerns, one voiced by The Economist, that the price of oil could collapse to $5 per barrel driving all but a handful of huge producers with low operating costs (like Saudi Arabia and the Persian Gulf states), who could have monopolised the market and then could have started dictating high prices. Fortunately it did not happen and indeed was not very likely to happen. On macro level it is rather impossible to get a control of the market.

The story is different on an individual company level. If an investor buys a stake in a company it is in his interest to ensure its growth. And it is not an easy task, but at the end of this process, through competition amongst companies, there are benefits to the entire economy. If an investor is short selling a company shares it is in his interest to drive the company down, even to bankruptcy so his return is maximised. Although for a small investor buying shares in a huge company it is rather impossible to have such impact, the story is different if a multi billion hedge fund is short selling small and medium size publicly quoted companies or even large corporations at a time of either such corporation’s trouble or general economic uncertainty.

Not a rocket science

Returning to a sample hedge fund investment strategy which is based upon the observation of the market activities in the last decade. A fund buys a significant stake and invests in a successful medium size publicly quoted company (or it does so with a private company and takes it to floatation). The share price goes up: this is a point of the first return on investment. But any rational investor knows that there is a limit to short term growth of company value. Large private investors are famous for their short term investment windows. Further growth involves more competition, mergers and acquisition, dilution of ownership and high uncertainty. So the time comes for profitable exit whilst a company is still doing well. A fund lends, for example through some offshore entity technically not even associated with the fund, significant amounts of monies to a company. Offshore holdings in non-transparent jurisdictions, non-direct association through large individual investors and trust funds with confidential structures, make such operations at present absolutely non-traceable. A fund also buys credit defaults swaps against the money it lent (possibly many times over the amount lent) and when the share price is still up it sells the shares and starts short selling. The success is achieved by a company making some “unwise” investment decisions or a fund calling back the loans. Such heavily leveraged company quickly ends up in trouble and a fund makes a nice exit return on investment: making money on short selling shares and cashing on default swaps.

The perverse nature of short selling on individual company level stems from the fact that significant investors, like hedge funds, are capable of bringing down a company that they are short selling on their shares. This came clear last autumn when even the largest banks shares were short sold to the extent that it threatened the entire financial system. Rather than banning short selling altogether, the government only temporarily suspended it.

No wonder short selling became a very popular way of making money. It is not a rocket science. At present there is a massive crowd of very powerful and influential investors in whose interest is driving the economy down. The share market is turned asymmetric, with shares of the companies being short sold by large private investors being turned into “lemons”. It is also tantamount to Gresham’s law “bad money drives out good”: since it is far easier to drive company down than to grow it, the interest in short selling will only increase, especially during downturns or times of uncertainty, with potentially disastrous effect to the economy. This goes to show that indeed markets behave rationally when it comes to immediate beneficiaries of an investment decision-making process. This however can be a parasitical arrangement at massive costs to the society at large.

Rooting out the pathology

It appears that Boris Johnson’s views on hedge funds are rather naïve. The recent scandal of MP’s expenses taught us that even amongst the most trusted individuals of the highest integrity if there is any opportunity or loophole left to make money it will be ruthlessly exploited to its limits and beyond. The current crisis showed us that the exploits of the financial sector can cost economy trillions of dollars. Whilst from free market standpoint there is a case for passive short selling even on individual shares of companies (i.e. on condition that an investor short selling shares of a company cannot influence it at all), in practice, in a global market with non-transparent offshore financial centres and multi billion pounds investors it is a breeding ground for pathology. The risk, in practice certainty, of costs of market abuse massively outweighs any possible benefits therefore short selling of shares must be banned.

Not only must the government regulate private investors, like hedge funds, and scrutinise their investment strategies and actions, it must also examine them retrospectively in detail in methodical way. The transparency of the entire financial industry practices, retrospective and current, is the key. There will be a lot of interesting lessons learnt about the “sophistication” of large private investors. Little doubt they will tell us a lot about the background of the current financial crisis.

Commentary to an article “Loan to deposit ratio and banks liquidity”

An article "Loan to deposit ratio and banks liquidity" shows inter alia:

- why control over liquidity was lost at all levels (individual banks, regulator, The Treasury) and the crisis and its scale came as a surprise

- why the scale of liquidity depth is very difficult to assess (based on traditionally reliable parameters like total loans to total deposits ratio and money multiplier)

- why banks are not lending and it is rather irresponsible to expect them to do so (this is a statement valid under the current circumstances; if the government took certain appropriate actions then the banks could be in position to start lending on a greater scale again).

As many politicians complain that banks are not lending to good businesses it seems not to be understood that a reason why lending remains severely restricted is not really creditworthiness of borrowers. Any lending deteriorates already fragile banks’ liquidity. Banks look like a rabbit caught in the headlights: if they start lending they deteriorate further their existing fragile liquidity position, and, if they do not, the economy goes down resulting in increased credit defaults and further deterioration of the liquidity position. A classic Catch 22.

Additional problem is that certain market players, who bought default swaps, possibly many times over the underlying credits, have an interest in defaults occurring as it is their way of making profit. This adds to the point expressed that short selling of shares is perverse in free market economy. If this happens on a small scale it does not matter and may be regarded as some kind of economic freedom. However on a macro scale this creates a perverse situation whereby there are huge and influential market players in whose interest is NOT the growth but deterioration of the economy. It appears that the government still did not get a grasp on the complexity of the current crisis.

ADDITIONAL COMMENT:

The banks' management lost control over liquidity under the following scenario. Liquidity is a direct function of money multiplier: i.e. how many liabilities on banks balance sheets a real £1 cash has to cover. Traditionally loan to deposit ratio (LTD) was the basis for calculating money multiplier (on a macro level). It is MM = 1/(1 – LTD) (LTD expressed decimally). But it only works if, at every deposit – loan cycle, LTD is below 1 (i.e. below 100%). Once LTD is above 1, at any deposit – loan cycle (even if it later goes down below 1, this macro control is lost. Money multiplier (MM) cannot be reliably calculated based on total loans to total deposits on a bank's balance sheet.

Calculating Money multiplier using straight reserve ratio is flawed. (It appears that this method was used by the banks.) It comes from the original notion, that with loan to deposit ratio below 1 (below 100%) reserve ratio R equalled 1 – LTD. So MM = 1/R.

However if loan to deposit ratio is equal or more than 1 (100%), and you use a formula MM = 1/R, it means that you consider your reserves (which are not strictly cash), as good as cash. As you keep lending with LTD above 1, you push cash on the market inflating assets prices and artificially improving your reserves. However each £1 cash has to serve more and more (at exponential pace) pounds on the balance sheets. So whilst your real money multiplier goes up extremely fast (£1 cash has to serve ever growing number of pounds on the balance sheets), you seem to maintain healthy balance sheets (in terms of R and, based on it, calculated MM = 1/R). However when a pyramid collapses, R goes down to the floor, and MM, as banks calculated, becomes astronomic. This leads to the banks losing liquidity and becoming insolvent.

The above shows the mechanics of the collapse of a pyramid that caused the current crisis.

Loan to deposit ratio and banks liquidity

(This article is a technical analysis dedicated to John Varley, the CEO of Barclays Bank, of one of the largest and most famous banks in the world, referred to in the article “Liquidity risk”, who took care to write to the author of this blog.)

The key issue about banks liquidity is money multiplier. Money multiplier is a ratio of banks balance sheets to cash in circulation. It answers a question: how many pounds on the banks balance sheets does £1 real cash has to cover?


When a loan to deposit ratio is below 100% a money multiplier (MM) is expressed by a formula: MM = 1/(1-LTD) where LTD is loan to deposit ratio expressed in decimal terms. The loan to deposit ratio can fluctuate: i.e. if LTD is 50% then MM is 2, if LTD is 75% then MM is 4, if LTD is 90% then is 10, if LTD is 99% then MM is 100.

Ultimately, if loan to deposit ratio is always kept below 100% then, at any one time, the ratio of total loans to total deposits on the books gives an average loan to deposit ratio (ALTD). This average may be done for a particular bank or for a group of banks or for entire economy. A money multiplier calculated on the basis of such average, 1/(1-ALTD), is a measure of a particular bank’s liquidity, a group of banks liquidity or entire economy liquidity position. A bank's CEO can look at such figure and have an immediate good idea about the liquidity of his bank. A Chancellor of the Exchequer (a Minister of Finance) may look at such figure calculated on the basis of total loans and total deposits for all banks and have a good idea of the liquidity of the banking system.

This money multiplier can be then considered within a concept of “stickiness” of different types of money deposited in banks (current accounts, deposit accounts, investments, etc). The lower the money multiplier the higher the “stickiness” of any kind of deposits. In other words, if £1 real cash covers lower amount of pounds on the banks’ balance sheets, the likelihood (under the same circumstances) that a bank will not have sufficient cash to cover the demand for withdrawals is lower than if £1 real cash covers higher amount of pounds.

Therefore if loan to deposit ratio is below 100%, the lower the loan to deposit ratio, the lower the money multiplier, the higher the “stickiness” of funds and the lower the liquidity risk. A ratio of total loans to total deposits gives a money multiplier at any one time and a good idea about underlying liquidity risk. Then a consideration can be given to "stickiness" of individual financial products (from current accounts to long term investments such as pensions).


When a loan to deposit ratio (LTD) is above (or equal) 100%, money multiplier (MM) is infinite. Of course it does not make sense to state that £1 of real cash has to cover infinite amount of pounds on banks balance sheets, at any one time, but it would be so if this continued forever. If a LTD is above (or equal) 100% then we have to calculate MM based on the number of deposit – loan cycles. For example if LTD is 100% and initial deposit is £1, after 20 deposit – loan cycles, this £1 has to cover £20 on the banks balance sheets and after 220 deposit – loan cycles, this £1 has to cover £220 on the banks balance sheets and so on. This is a staggering but still linear growth. If LTD is above 100%, then the financial system becomes a classic example of a pyramid scheme. For example if LTD is 117% and initial deposit £1, after 20 deposit – loan cycles, this £1 has to cover over £130 on the banks balance sheets and after 220 deposit – loan cycles, this £1 has to cover over £5.89 quadrillion on the banks balance sheets and so on. This is a runaway exponential growth.

As it is a cycle, whereby deposits become loans which become deposits and so on, if loan to deposit ratio is above (or equal) 100%, the higher loans result in deposits that result in even higher loans and so on. Therefore in terms of liquidity if at any one time a ratio of total loans to total deposits is taken (which is higher than one) – per bank, a group of banks or entire financial system - it does not give any idea about the prevailing money multiplier as, unlike when loan to deposit ratio is below 100%, it also depends on a number of deposit – loan cycles and loan to deposit ratio of each of them. Therefore a bank’s CEO or a Minister of Finance does not have an idea about the liquidity based on total loans to total deposits ratio. Perversely, model-wise for the sake of clarity of argument, if there were, say, 20 full cycles with loan to deposit ratio of 117% followed by a full cycle of 0%, then the total loans to total deposits ratio would be below 100% whilst money multiplier would be over 130, i.e. liquidity would be extremely fragile. (It should be noted that whilst deposit – loan cycles do not occur in such a uniform, synchronised, way, the model presented gives an accurate account of how they work and what outcomes they produce in reality.) For example information that a bank reduced loan to deposit ratio from 138% to 129% does not carry information whether its liquidity improved or got worse. If a bank stopped giving loans and started keeping deposits building up liquidity buffer, this would imply that liquidity improved. However if a bank continued to lend with, say, loan to deposit ratio of 105% which could have resulted in overall reduction from 138% to 129% (total loans to total deposits), this would have implied that liquidity actually got worse. As presently the banks have reduced lending heavily, the former rather than latter seems to be the case (but this is a guess) and it is foolish of the government to expect banks to lend more.

We know however that a money multiplier keeps growing very fast (at exponential pace, i.e. it is a pyramid scheme, if loan to deposit ratio is above 100%), and if this continued forever, ultimately, £1 real cash would have to cover the balance sheets that would be infinitely high. As this is impossible, a liquidity crunch is 100% certain in a finite time.

It follows that if loan to deposit ratio is above (or equal) 100%, the higher the loan to deposit ratio, the faster the money multiplier growth. However, in any event, the liquidity risk is 100% in a finite time. It follows that the traditional notion of “stickiness” of funds becomes vacuous as no funds are “sticky” anyway. It is a question when (in a finite time) and in which part of the system the liquidity crunch starts. This depends on various factors such as access to information or sophistication of depositors/investors in particular financial products who realise first that £1 real cash cannot cover ever growing, and without a limit, banks balance sheets and decide to withdraw their funding first. Therefore it is not surprising at all, in the context of the current financial crisis, that traditional retail deposits turned up more “sticky” than wholesale, investment-based, funding.

Interesting autumn (and years) ahead…

Holidays ended. A rather sunny summer is coming to close. Large credit card bills will start dropping on our doorsteps throughout September. It is appropriate to ask what economic conditions we find in the forthcoming autumn. Is unemployment going to increase? How well will we be geared to pay these bills and indeed ongoing living costs?

Rather than writing poetry about "green shoots" of recovery, or painting apocalyptic picture about imminent doomsday coming, let us list objective facts and reflect what they mean.

Almost a year ago, and last January, the government saved the financial system that was turned into a giant pyramid scheme. Hundreds of billions of pounds, and even more in future commitments and guarantees, was spent to prevent a classic case of pyramid collapse. It was quite a spectacle: the government was committing week after week billions and billions of cash and guarantees to help private financial industry wobbling pyramid, whilst for years the government had been convincing the public that it could not have found even a fraction of that to improve public services (health service, education, state pensions).

At first it was hailed as a permanent cure. The British Prime Minister, Gordon Brown, even famously remarked that he "saved the world". Subsequently to the action of saving the pyramid from collapse, the government, under a name "Quantitative Easing" , printed nearly a couple of hundreds of billions of pounds, to provide additional liquidity on the market in order to support (from collapse) banks' balance sheets ballooned to pyramidal proportions.

All these, so called stimulus package, cost taxpayers massive amount of monies: hundreds of billions of pounds. We are in trillions realm. It will take generations to repay. But the government has reached (or is very closely to reach) a point that it cannot borrow or print more cash anymore (unless it is prepared to turn the UK into Zimbabwe).

Despite all that, it clearly does not look that the economy was jumpstarted. It appears that the pyramid which the government has been preventing from collapse for over two years (if we take Northern Rock case into account) will lose that support. So we may expect another liquidity crunch, but its scale is uncertain. Indeed other governments, e.g. German, are already bracing seriously for another such event. However, if it happens, will the government be able to commit another serious tranche of cash to keep on supporting the wobbling financial pyramid? We talk about tens or hundreds of billion of pounds?

The loss of further, unsustainable, stimulus combined with the necessity to service debt (resulting from stimulus thus far) or even its growth (due to not servicing it sufficiently) is also very likely to hamper the recovery process. On top of that, banks, with pyramidal balance sheets, will be a massive drain to the economy, sucking out money from the market in order to reduce their loan to deposit ratios. (In this context it is not surprising at all that the banks are still not lending. In fact the government's expectation last autumn that the banks, after the government's cash injection, would start lending is possibly the best testimony of the government's dreadful economic incompetence.) There is no benefit of hindsight in this statement: it is just trivial.

Generally as, with the support of the government, the banks created a relationship with taxpayers akin to loan-sharks’ with their customers, if this criminal and parasitical arrangement continues, we should expect the same fate as loan-sharks’ customers suffer: we will be squeezed by the government and by the banks (directly and indirectly), and be left only with as much as is needed just about to survive. It can look like a very slow downward spiral. In this context does it matter what happens to the economy? Survive will we. But regardless of the situation this is as much as we can expect. Some of us will lose jobs, some homes. It will not be a massive tragedy as homes will not just stay unoccupied with people living in the streets; people will still keep on doing useful things. Without sounding disparaging to council estates, the UK will slowly, and selectively: middle-class, not the rich, start resembling a huge under funded council estate with run down services. This seems to be the likely costs, for generations, of the financial industry engineered "greatest heist in history" using a crude and classic pyramid scheme, like Albanian gangsters in 1996 – 1997.

(This article should be read as a risk assessment. Hopefully it will not materialise, but the signs are that it is likely it will.)