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?".

Sunday, 12 September 2010

Does Bob Diamond (new CEO of Barclays) understand banking?


The first answer that comes to mind is emphatic: yes. His position proves that. Hence it is worthwhile to reflect on his opinions in the recent Telegraph. As it was reported: "Bob Diamond, the new chief executive of Barclays Bank, has turned on critics of "casino banking" saying that the use of the term "has no basis in reality. [...] [Investment banks] aren't casino businesses. These are real, client-driven businesses. We are providing services to corporate clients, to fund managers, to retail clients through branch banking and high net-worth banking."

Over a year ago the author of this blog observed in his article "Investment banking perverse casino model": "[...] 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."


Casinos are also "client-driven businesses" providing services. Albanian pyramids as well as a Madoff's pyramid were also such businesses. In fact similarly to Albanian pyramids' and a Madoff pyramid's clients many direct (and indirect, like the whole economy) clients of investment banks went bust. As shown in the "The largest heist in history" the entire financial system was turned into a giant global pyramid.

The crux of the matter is that casinos and pyramids do not create any tangible value but are mechanisms of wealth redistribution heavily biased (i.e. giving the disproportionally large proceeds) to those who control them. That is why gambling, which additionally due to its addictive character is considered by many as vice, although legally accepted in many countries is generally heavily regulated. Financial pyramids, which proved lethal to economies on very many occasions throughout history, are banned altogether in the civilised parts of the world.

An unbelievably professionally shallow character of Bob Diamond's comments (e.g. "[Investment banks] aren't casino businesses. These are real, client-driven businesses.") seems to suggest that he does not really understand the fundamentals of banking (in particular the mechanism of money multiplication). And as a PR exercise these comments were insulting to any half-intelligent taxpayer who has to pay, by higher taxes and cuts in public spending, through his (or her) nose for the costs of the crisis caused by the banks' engineered crude financial pyramid. However it is reasonable to assume that Mr Diamond is representative (or rather above the average) of top financial executives. No wonder then we are in such a massive financial and economic mess now, listening to unreasonable and actually irrational excuses type-"it is global, no one could have predicted that". However, thanks to no more competent politicians, thus far the financial establishment is successful preserving the perverted nature of the financial industry.

34 comments:

  1. Would this be the same Barclays who had to shell out hundreds of millions of dollars in fines recently for money laundering? Or was that another Barclays altogether?

    ReplyDelete
  2. Suppose a company needs to raise $100 million of financing and approaches Barclays for help. Barclays advises them to issue a corporate bond which will be purchased by investors. For this advice and underwriting the sale of the bonds, Barclays earns a $500k fee.

    Where is the casino ?

    ReplyDelete
  3. Hi Frederick

    If the only problem of investment banking was giving a trivial advice for inflated price (this is ridiculous) or underwriting bonds issues (this is justified and non-trivial but only with the banks' own money that does not affect, i.e. pass any risk whatsoever, depositors then you would be right. However the situation of banks is not that simple. That's why we are where we are for very trivial and easily predictable reasons.

    For more read "The largest heist in history" here:

    http://gregpytel.blogspot.com/2009/04/largest-heist-in-history.html

    or on the Parliament's pages:

    http://www.publications.parliament.uk/pa/cm200809/cmselect/cmtreasy/144/144w254.htm

    Best

    Greg

    ReplyDelete
  4. Does the buying and selling of company shares from and to their client investors count as a casino activity too ? They earn a fee for that as they assume price risk by holding the equities on their trading book.

    ReplyDelete
  5. I refer you to the answer I gave before. BTW, are savings, ordinary deposits and other investments that are sold by the bank as safe exposed to "assumed price risk by holding the equities on their trading book"? If yes (which I think is generally the case) then indeed you started moving to the realm of casino banking.

    Best

    Greg

    ReplyDelete
  6. Suppose a bank makes a loan to a start up company. Surely that is casino banking by your argument since that also exposes depositors' funds to the default risk of that startup company.

    ReplyDelete
  7. Hi Frederick

    A lending risk is an inevitable risk inherent to high street banking (which is a part of deposit creation cycle). Hence high street banks are justified in taking it in principle provided they assess it and cost it properly. In such case it is not a casino banking. However if banks lend with loan to deposit ratio greater than 100%, then indeed a bank is practicing casino banking. Actually worse: as proved on this blog pyramid scheme which is a "perverse casino banking".

    Coming back to you previous example about taking "equities price risk". I wrote about "moving to the realm of casino banking". However if a bank assesses this risk , then it rationally justifies it for deposit lending purposes, lends to itself (like to a start up or any other company) an amount of money that is a security for "equities price risk" without exceeding 100% on loan to deposit ratio, no other part of banks capital or deposits are exposed to that risk, keeps repaying such loan with interest like a start up company then a bank looks as it does NOT practice a "casino banking" and your example of lending to a start up company becomes relevant. As you can see in this case the entire banks deposits are not exposed to "equities price risk" but only a specific amount hypothecated by the loan. As I am sure you know banks were not practicing such a basic prudent process. In general many risky banks activities (like taking "equity price risk" you mentioned) were exposing all banks deposits to them.

    However there is a twist. Even such model has a fundamental weakness which in my view disqualifies it. A bank cannot assess a risk of lending to itself of depositors money, as it has to assess the risk of its own activities judgments that it passes onto depositors. A bank uses bank's judgement to assess a risk of lending to itself and to assess "equity price risk". There is no more conspicuous example of conflict of interest than that.

    As you can see the devil is in the details. To summarise, as explained above: lending money to a start up company is not a casino banking, whilst taking "equity price risk" is moving to the realm of casino banking.

    Best


    Greg

    ReplyDelete
  8. Hi Frederick

    Thanks for your input. Response to your points that surely many readers bring to their minds greatly improves the quality of my blog. BTW, I suggest avoiding words "surely" in logical (technical) reasoning to jump many steps. It gives impression of a shortcut to justify a false argument. Well, I used to do the same in many discussions:-) before my maths teacher rooted that out some years ago.

    Best

    Greg

    ReplyDelete
  9. Greg - My point for raising these questions is that I believe that there are many activities of commercial banks which ultimately expose depositors to risk but which are perfectly reasonable activities and if carried out safely and subject to certain limits should be allowed and should not be called "casino banking".

    I therefore think that your attack on Bob Diamond's statement is not fair. These businesses serve the needs of clients be they companies raising debt or investors wishing to trade in and out of securities. By taking some principal risk the banks provide a better service to their clients.

    What you fail to see is that there is another business which banks engage in which is known as proprietary trading. This is what you should call "casino banking" and for many investment banks such as Goldman and Salomon (in the 90s) this was a major source of risk and revenue and in some years losses.

    In my view these activities should not be allowed for deposit taking institutions and this is what the new regulations in the US - the Volcker Rule - will prohibit.

    This is good and is why I would be in favour of a splitting of commercial (deposit taking) and proprietary trading activities.

    ReplyDelete
  10. Hi Frederick

    I can only repeat that the devil is the details of activities. For example taking "equity price risk" as you described in your post amounts to proprietary trading (so I do not think I fail to see anything).

    Talking about taking the risk is too generic. For example there is a massive difference in lending money to someone to establish a casino business and to a gambler who plays in a casino. The problem is that the financiers either pretend not to understand such difference (as it suits their massive income to play stupid on that) or genuinely are too stupid. In my view Bob Diamond's statement, being incredibly shallow, fell into one of these two categories.

    Please do not take it as an offence (just a discussion point), your statement, "These businesses serve the needs of clients be they companies raising debt or investors wishing to trade in and out of securities. By taking some principal risk the banks provide a better service to their clients." amounts to the same. It all depends on the amount and type of debt, risk, its propagation in the system etc. As I stated before, the devil is the details, which quite often are not possible to be generalised by such a wide sweeping statements.

    Best

    Greg

    ReplyDelete
  11. From Frederick (I do not know why this comment was not displayed automatically by the blog):

    I disagree that taking "equity price risk" amounts to a proprietary trading in the sense that the equity price risk is a necessary consequence of the primary aim of the business which is to service the wishes of clients wish to buy or sell the securities which the bank initially issued itself on behalf of a company or was issued by another bank. Here the bank makes its money mainly from the bid-ask spread. Sure it may make money on a day to day basis from price movements depending on its positions, but that is a secondary effect which should be limited by very tight risk limits.

    Proprietary trading is trading the capital of the bank with the sole aim of making money from price movements and is generally a riskier business since these trades are often large and so-called "arbitrage" positions which can often go wrong when the market behaves in an unexpected and untypical fashion, e.g. consider the LTCM crash.

    You say there is a "massive difference in lending money to someone to establish a casino business and to a gambler to play in a casino". Can you please explain what this is.

    As far as I can see it is a question of risk limits, e.g. If I lend $100m to start a casino then I can lose all of my investment if the casino goes bust e.g. it did not have sufficient risk limits or was badly managed or corrupt ... whatever.

    On the other hand, suppose I lend $100m to my super smart gambler who knows how to count cards in blackjack. He enters the casino and I set him a risk limit of $0.25m per hand and impose a stop loss at $10m. I would say that playing in the casino is no more risky than lending to the casino since the maximum loss is capped at $10m versus $100m. In fact it may also be more profitable since if my gambler is good he may earn more than the interest on the $100m ... until at some point the casino will probably revoke his membership.

    ReplyDelete
  12. Hi Frederick

    1. I was very specific when I wrote: "taking 'equity price risk" AS YOU DESCRIBED IN YOUR POST amounts to proprietary trading". In general I agree that there is a way for banks to take equity risk which does not amount to proprietary trading. Broadly speaking this is when savers deposits, etc. are not exposed to such risk in any way. Again the devil is in the details.

    2. The fundamental difference between investing in a casino business and a gambler is that games in properly set up casinos are designed probabilistically in such a way that a casino will ALWAYS win in a long run and gamblers will ALWAYS lose. That's why gambling is sometimes called tax on stupidity. It is also said sometimes that the biggest problem of a gambler is that s/he sometimes wins or, in case of national lottery, that there are winners very often.

    Incidentally there are theoretical ways to beat it but they in practice do not work. For example a very simple method to ALWAYS win in a casino is whenever you lose your next bet is such that it will cover all your loses thus far. As you bet in games with a probability greater than 0 (usually well above zero). This method GUARANTEES that you will always make money. If you are smart (and know anything about gambling) you would know why such a trivial and seemingly 100% method does not guarantee success.

    It seems that's the financial industry was was run by "super smart gamblers" whose luck simply ended (or their formula got exhausted, if you prefer that way) and the taxpayers are paying their casinos bills now.

    The understanding of the above required basics of probability theory which seems so alien to the financial industry practices.

    Best

    Greg

    ReplyDelete
  13. ...to add to the above the fact that you may invest in a casino business and lose money and invest (or lend money) to a gambler and make money does not alter the fundamental difference in "business model" of the two. It all comes down to understanding probability and a concept of fair game.

    Best

    Greg

    ReplyDelete
  14. Greg

    You are splitting hairs here. I deliberately chose blackjack because that is a game where a card counter has a probability of winning a hand in excess of 50%. Over time they can make money with probability 1.

    Anyway I had a longer reply which also argued that "casino banking" had little to do with the crisis but it got deleted by google for some weird reason when I went to post it. So here is a summary.

    My main point was that it was caused by good old mortgage lending which I assume you do not consider to be a "casino game". The rising property prices and "race to the bottom" among banks under pressure from their shareholders to match the high ROEs of other less strict banks made them weaken their underwriting standards. Regulators did not intervene because Tony B had told them to leave the city alone. And the rest is history.

    ReplyDelete
  15. From Frederick (I do not know why this comment was not displayed automatically by the blog):

    Greg

    I am unconvinced by your argument about the difference between investing and playing in a casino especially as I said that the gambler was counting cards in blackjack which is a known way to beat the casino (if they don't kick you out first).

    Remember too that a casino can go bust in the short term for the reasons I listed above.

    As far as I see there is no difference between investing in a casino or playing in a casino other than a different loss distribution.

    I would add however that lending is a core skill of commercial banks and in order to protect depositors it should be done with all sorts of risk limits.

    The latter is proprietary trading and is something that sits better within an investment banking world where depositor funds are not at risk. These banks should also be regulated so that they cannot "blow up the world" but their risk limits can be looser so that they can blow themselves up. In the end, the shareholders should lose their shirts if it all goes wrong.

    I disagree with what you say about the financial industry. If you read any financial research or looked at the Basel II technical reports you would see that there is loads of probability maths and to an extent I think there is an over-reliance on models. Knowing some of these people I can state that they understand probability very well.

    What caused the financial crash which led to the current predicament we are in now was nothing to do with "casino banking". It was far more humdrum than that.

    It was ordinary high-street banks in the UK, Ireland, Spain and the US making loans to people to whom they should not have lent because these people were not able to make the repayments. All of this was predicated on a stupid belief that property prices would carry on rising and the LTV would fall protecting the lender. It was a "credit bubble".

    This was mixed in with a large amount of fraud (NINJA loans etc...), an excessive amount of complexity and a lack of transparency in the securitisation methods used to move some of these loans (but not all) off bank balance sheets, and a lack of proper due diligence.

    Why? Because there was an effective "race to the bottom" as banks competed with other banks to grab market share and underwriting standards went out the window in the process.

    Where were the regulators when all of this was going on ? Nowhere to be seen as Tony Blair had told them to lay off the city.

    Central banks at the behest of politicians were also complicit to the extent that they encouraged the boom - they kept interest rates low and pushed like crazy the whole buy-to-let market (the UK's version of the subprime market). After all, who wants to call time on the best bubble since 1930.

    As for "casino banking", it was not the super highly paid goldman sachs proprietary trader who caused the crisis. It was the previously staid and traditional bankers at RBS and other commercial banks who say other banks with ROEs of 20% plus who under pressure from their shareholders decided that mortgages with 120% LTV and 6 times joint earnings were a good idea.

    In fact I would boil it down to a combination of greed and group-think.

    No need for "casino banking".

    However, although I do not think that "casino banking" caused the crisis, I am happy to see it regulated out of the commercial (deposit taking) banking world since it poses too great a risk to deposits,

    ReplyDelete
  16. Hi Frederick

    I think we exhausted arguments and will start going around. I think the readers will be able to draw their conclusions. I admit that I am splitting heirs as with the process of money multiplication and banking risk the devil is in the details. (It is very easy to show that something is OK on individual level, like investing in a smart gambler, but then it simply does not scale up for the entire system. Incidentally this is what pyramid schemes are all about too.)

    Best

    Greg

    ReplyDelete
  17. hi Fred - lol - i thought all gamblers believe they are a 'smart gambler' - i wouldn't expect my bank to lend them any money though. A legitimate business can and does include casinos (more so since Blair went on holiday to a casino owners multi million mansion) which obviously are exposed to the same pressures of any fledgling business proposition, i.e. bad management, wrong location, unpopular operating regimes etc etc etc - it is not comparable to an investment from a bank in a 'gambler' - your very notion terrifies me, to think that we have got to the situation where someone (who does seem to have some financial knowledge), actually thinks a 'smart gambler' is a preffered customer for a bank loan than is a fledgling legitimate casino operator and fails to see the error?? Is the whole world similar in opinion??

    Keep up the good work greg and any comment yet on the 7% reserve banking regulation agreed in switzerland this week??

    Best Regards

    ReplyDelete
  18. HI RedTez

    I still have to look closer into Basel III. However the first observation, based on your comment is that 7% reserve is too little (especially at times of low confidence in banks). 7% reserve means above 14 money multiplier and this sounds way to high. (Historically "proven" good level of money multiplier is around 6 - 8.) But let me have a closer look and I will write more.

    Best

    Greg

    ReplyDelete
  19. At the risk of butting in on this absorbing and detailed discussion - could someone tell me why we are discussing Barclays bank as though it were an exercise in pure mathematics when the organisation has just agreed to cough up $298,000,000 in settlement of a fine for money laundering? As have Lloyds and Credit Suisse for that matter.

    As long as these organisations are run by the likes of Harold Shand there would seem to be little point in discussing them in dry acedemic terms.


    http://online.wsj.com/article/SB10001424052748703431604575468094090700862.html?mod=WSJEUROPE_hps_MIDDLETopStories

    ReplyDelete
  20. Hi Caratacus

    Your question is rhetoric on one side. But on the other mathematics is a tool that I use to prove that bankers committed crime by engineering the current financial crisis by turning the financial industry into a pyramid scheme. I am not talking a proverbial pyramid scheme but a real one. And you can only show that using maths.

    Best

    Greg

    ReplyDelete
  21. Greg:

    I've just posted this in old thread that you probably do not look at any more. Since you seem interested in liquidity risk, I'll reproduce it here in order to to clarify some points:
    ===
    Greg,

    Unfortunately, this ( http://gregpytel.blogspot.com/2009/04/exampleexercise-how-does-it-work.html) contains some serious bookkeeping errors with respect to accounting for cash flow which is a critical issue in your liquidity discussion.

    E.g. in Step 2 Bank A takes a deposit. Now, at step 0, Bank A sheet is as follows:

    Cash: $104.91
    Loans: 0
    Deposits: 0

    Therefore, after taking a $100 deposit, it should be:

    Cash: $104.91+$100 = $204
    Loans: 0
    Deposits: $100

    I.e. taking a deposit causes both the asset as well the liability sides of the balance sheet to grow. So, the reason you lose liquidity (cash) in your example is due to faulty bookkeeping rather than excessive loan taking.

    ReplyDelete
  22. Hi VJK

    The "Example/exercise - how does it work?" is read/studied by thousands of my blog readers. Hence no re-posting was necessary. Many thanks for your input. I think you are wrong. Step 2 (as well as other steps) do not only involve taking a deposit (like $100 in Step 2) but also lending it out in the same step (which for some reason you omitted).

    Therefore if, in Step 2, you add $100 to Cash reserves (as a result of taking $100 deposit) and you also subtract it immediately as a result lending it out ($100 + $30 in Step 2).

    You are correct that taking a deposit causes both assets as well as liability side of the balance sheet to grow. However giving a loan (in the same step in my example) makes assets to shrink by a loan amount and grow by the risked value of the loan, $130 x 50% in Step 2 of my example (which you omitted in your analysis).

    To summarise, it seems to me that you made an error as you did not consider the effect of the loan giving on the balance sheet as, in Step 2, I did not split $100 deposit taking and $130 loan giving (which you omitted). I.e. your example is correct the way you present it but is irrelevant and in fact it misrepresents my example.

    Best

    Greg

    ReplyDelete
  23. Greg:

    Thank you for your response.

    Let's go step by step:

    Step 2a:
    ---
    Bank A takes a $100 deposit:
    Bank A sheet:
    A:
    Cash: 104.91+100=204.91
    L:
    Deposits: 100

    Bank B sheet:
    A:
    Cash: 166.38
    L:
    Deposits: 0


    Step 2b:
    ---
    Bank A lends $130 which is deposited at Bank B:
    Bank A sheet:
    A:
    Cash: 204.91-130=74.91
    Loan: 130
    L:
    Deposits: 100

    Bank B sheet:
    A:
    Cash: 166.38+130=296.38
    L:
    Deposits: 130

    Step 3a:
    --
    Bank B borrows $39 from bank A:
    Bank A sheet:
    A:
    Cash: 74.91-39=35.91
    Loan: 130+39=169
    L:
    Deposits: 100

    Bank B sheet:
    A:
    Cash: 296.38+39=335.38
    L:
    Deposits: 130+39=169

    Step 3b:
    --
    Bank B lends $169 which is deposited at Bank A:
    Bank A sheet:
    A:
    Cash: 35.91+169=204.91
    Loan: 169
    L:
    Deposits: 100+169=269

    Bank B sheet:
    A:
    Cash: 335.38-169=166.38
    Loans:169
    L:
    Deposits: 169

    Step 4a:
    --
    Bank A borrows $50.70 from Bank B:
    Bank A sheet:
    A:
    Cash: 204.91+50.70=255.61
    Loan: 169
    L:
    Deposits: 269+50.70=319.70

    Bank B sheet:
    A:
    Cash: 166.38-50.70=115.68
    Loans:169+50.70=219.70
    L:
    Deposits: 169

    Step 4b:
    --
    Bank A lends $219.70 which is deposited at Bank B:
    Bank A sheet:
    A:
    Cash: 255.61-219.70=35.91
    Loan: 169+219.70=388.70
    L:
    Deposits: 319.70

    Bank B sheet:
    A:
    Cash: 115.68+219.70=335.38
    Loans:219.70
    L:
    Deposits: 169+219.70=388.70

    Step 5a:
    ---
    Bank B borrows $65.91 from Bank A:

    Mission impossible: Bank A does not have $65.91 to lend to Bank A -- it has only $35.91 in cash left.

    As I wrote earlier, cash flow bookkeeping is incorrect: at Step 2 you did not add $100 to Bank A cash holdings as a result of the $100 deposit and at Step 3 you did not subtract $130 from Bank A cash holding when Bank A granted a loan.

    It appears that you account for cash flows only for interbank loans and not for deposit/loans from/to non-banks -- this is incorrect.

    You message about liquidity importance is valid and Basel III is the first Basel that recognizes it too, but bookkeeping should be fixed.

    ReplyDelete
  24. Greg:

    Also, note that the amount of cash in your stylized economy should remain unchanged:

    The original 104.91+166.38+100 = $371.29 should remain constant throughout the transaction flow regardless of loan/deposit permutations -- you cannot just lose it into a black hole.

    ReplyDelete
  25. Hi VJK

    Of course I accounted for $100 but I considered $100 deposit into Bank A and $100 loan given by Bank A as one step. So what I had to add as $100 in the bank at the same time I had to subtract as $100 out of the bank. (i.e if you take $100 from someone and you give it to someone else at the same time your position is $0 afterwards, not $100). In a similar way I dealt with $30 that Bank A borrowed from Bank B in order to make a loan. (It was added to Bank A cash position when it was borrowed from Bank B and subtracted at the same time as it was lent out by Bank A.)

    Could you describe what the banks are doing with the money at every step as your separation into steps like 2a and 2b (and so on) does not represent my example at all.

    Let's start:

    At step 2a for Bank A @ Cash you added 104.91 + 100 = 204.91.

    Then at step 2b for Bank A @ Cash you subtracted 204.91 - 130 = 74.91.

    This is wrong (see the first paragraph of this post): I made it clear that Bank A lent $100 from the deposit that was paid in. The remaining $30 was borrowed from Bank B. You did not accounted in your example that $30 of a $130 loan given by Bank A actually comes from Bank B.

    You also included, at step 2b, in Bank B deposit $130. It is a step 3 when $130 lent by Bank A (as a loan) is paid into Bank B as a deposit. Basically you also started changing the way I track my example. Whilst nothing wrong with it it makes it error prone.

    Once you start going wrong it never comes out right.

    What I do not track specifically in my example are interbank entries: Bank A to Bank B and vice versa loans. But they can be easily added, as they are accounted for in the operations anyway. Ultimately banks borrowed their initial Capital reserves (which were cash), Bank A from Bank B $166.38 and Bank B from Bank A $104.91, end put them into deposit-loan cycle that was going at LTD 130%. (So you can add inter bank liability as a difference, and you can add this at every step.)

    Indeed I could make my example more detailed/fine grained: i.e. when a bank takes a deposit add it to Capital reserves (Assets), when it lends it out subtract it. When a bank takes a loan from the other bank add it to capital reserves (and account for it), and when it is lent out subtract it. However I think it is clear anyway and it would obfuscate the process of growth of a financial pyramid based on LTD 130%.

    I agree with you that , "the amount of cash in your stylized economy should remain unchanged". Indeed it is conspicuously clear throughout. Proof: have a look at step 7.

    I encourage you to read what's written above each step. Otherwise you basically create your own example (irrelevant to mine) which, you are quite right, is incorrect.

    Best

    Greg

    ReplyDelete
  26. Greg:

    Ok, let's take a look at Step 2 only and see if we are on the same page:

    At Step 1 (initial condition), we have:
    --
    Bank A sheet:
    A:
    Cash: 104.91
    L:
    Deposits: 0

    Bank B sheet:
    A:
    Cash: 166.38
    L:
    Deposits: 0

    You wrote: "2.Bank A takes $100 as deposit and decides to lend $130"
    So, you describe, in effect, two transactions: making a $100 deposit at Bank A by a depositor and granting a $130 loan to a borrower by Bank A.

    Step 2 transaction 1, Bank A takes a deposit:
    --
    Bank A sheet:
    A:
    Cash: 104.91+100=204.91
    L:
    Deposits: 100

    Bank B sheet: Unchanged

    Step 2 transaction 2, Bank A grants a $130 loan and disburses $130 in cash (check disbursement does not change much, but we can discuss that too if you wish):
    --
    Bank A sheet:
    A:
    Cash: 204.91-130=74.91
    Loan: 130
    L:
    Deposits: 100

    Bank B sheet: Unchanged (the borrower has not deposited anything yet at this point -- the $130 deposit will happen at Step 3).

    If you agree with the balance sheet state as shown, we can move on to other steps. If you disagree, please explain why.

    ReplyDelete
  27. Hi VJK

    I do not agree. Please read carefully MY step 2 description, paying a special attention to words in capital:

    "Bank A takes $100 as deposit and decides to lend $130 (i.e. at L/D 130%). This loan (as all other loans in this example/exercise) are mortgages secured on residential properties. BANK A DECIDES NOT TO DEPLETE ITS OWN CASH RESERVES BUT BORROW ADDITIONAL $30 FROM BANK B. Bank B considers this loan from its reserves with risk 50% and Bank A also considers the $130 loan with the risk 50%. (In fact both loans can be deemed as secured on properties, so 50% is in compliance with Basel.)

    So in effect there are three transactions in step 2:

    1. Bank A takes a deposit of $100 from a customer.
    2. Bank A borrows $30 from Bank B.
    3. Bank A lend $130 to a customer.

    BTW, you are simply trying to make my example more granular (detailing every single transaction, which I was reconciling on the fly), and make mistakes (or rather misrepresent) my example (like ignoring transaction 2 above). Once you follow my example you will have the same result. (If you wish you may also consolidate inter banks' loans with deposit on the balance sheets, which effectively are customer loans to banks: this will not change anything.)

    I do not think there is anything wrong with your example. (I have not check it beyond step 2, so there could be a mistake beyond this step.) It is simply a different example than mine. Hence you are getting different results.

    Best

    Greg

    ReplyDelete
  28. Oops, I've lost the $30 loan from B to A at Step 2. Please, see the correct transaction flow from step 2b onward:

    Step 2a:
    ---
    Bank A takes a $100 deposit:
    Bank A sheet:
    A:
    Cash: 104.91+100=204.91
    L:
    Deposits: 100

    Step 2b:
    --
    Bank A borrows $30 from Bank B:
    Bank A sheet:
    A:
    Cash: 204.91+30=234.91
    L:
    Deposits: 100+30=130

    Bank B sheet:
    A:
    Cash: 166.38-30=136.38
    Loan: 30
    L:
    Deposits: 0


    Step 2c:
    ---
    Bank A lends $130 which is deposited at Bank B:
    Bank A sheet:
    A:
    Cash: 234.91-130=104.91
    Loan: 130
    L:
    Deposits: 130

    Bank B sheet:
    A:
    Cash: 136.38+130=266.38
    Loan: 30
    L:
    Deposits: 130

    Step 3a:
    --
    Bank B borrows $39 from bank A:
    Bank A sheet:
    A:
    Cash: 104.91-39=65.91
    Loan: 130+39=169
    L:
    Deposits: 130

    Bank B sheet:
    A:
    Cash: 266.38+39=305.38
    Loan: 30
    L:
    Deposits: 130+39=169

    Step 3b:
    --
    Bank B lends $169 which is deposited at Bank A:
    Bank A sheet:
    A:
    Cash: 65.91+169=234.91
    Loan: 169
    L:
    Deposits: 130+169=299

    Bank B sheet:
    A:
    Cash: 305.38-169=136.38
    Loans:30+169=199
    L:
    Deposits: 169

    Step 4a:
    --
    Bank A borrows $50.70 from Bank B:
    Bank A sheet:
    A:
    Cash: 234.91+50.70=285.61
    Loan: 169
    L:
    Deposits: 299+50.70=349.70

    Bank B sheet:
    A:
    Cash: 136.38-50.70=85.68
    Loans:199+50.70=249.70
    L:
    Deposits: 169

    Step 4b:
    --
    Bank A lends $219.70 which is deposited at Bank B:
    Bank A sheet:
    A:
    Cash: 285.61-219.70=65.91
    Loan: 169+219.70=388.70
    L:
    Deposits: 349.70

    Bank B sheet:
    A:
    Cash: 85.68+219.70=305.38
    Loans:249.70
    L:
    Deposits: 169+219.70=388.70

    Step 5a:
    ---
    Bank B borrows $65.91 from Bank A:
    Bank A sheet:
    A:
    Cash: 65.91-65.91=0
    Loan: 388.70+65.91=454.61
    L:
    Deposits: 349.70

    Bank B sheet:
    A:
    Cash: 305.38+65.91=371.29
    Loans:249.70
    L:
    Deposits: 388.70+65.91=454.61

    Step 5b:
    --
    Bank B lends $285.61 which is deposited at Bank A:
    Bank A sheet:
    A:
    Cash: 0+285.61=285.61
    Loan: 454.61
    L:
    Deposits: 349.70+285.61=635.31

    Bank B sheet:
    A:
    Cash: 371.29-285.61=85.68
    Loans:249.70+285.61=535.31
    L:
    Deposits: 454.61


    Step 6a:
    --
    Bank A borrows $85.68 from Bank B:
    Bank A sheet:
    A:
    Cash: 285.61+85.68=371.29
    Loan: 454.61
    L:
    Deposits: 635.31+85.68=720.99

    Bank B sheet:
    A:
    Cash: 85.68-85.68 = 0
    Loans:535.31+85.68=620.99
    L:
    Deposits: 454.61

    Step 6b:
    --
    Bank A lends 371.29:
    Bank A sheet:
    A:
    Cash: 371.29-371.29=0
    Loan: 454.61+371.29=825.90
    L:
    Deposits: 635.31+85.68=720.99

    Bank B sheet:
    A:
    Cash: 0
    Loans: 620.99
    L:
    Deposits: 454.61

    --------

    In your description, the loan/deposit balances are still incorrect due to faulty bookkeeping. However, your main point, for which the incorrect balances are relevant, seems to be that the banks do not have cash left after Bank A granted that last loan.
    The flaw in you logic is that $371.29 did not disappear without a trace but was deposited at a third bank account and can be borrowed, to settle projected cash outflows, exactly in the same way as the two banks borrowed from each other in your description.
    Another flaw is that no bank should be so crazy as to deplete its cash account completely (well, except possibly Northern Rock) -- that's called liquidity management.

    ReplyDelete
  29. Please read "for which the incorrect balances are IRrelevant,

    ReplyDelete
  30. Hi VJK

    What you appear to be doing you are doing consolidating inter bank lending with customers' loans and deposits.

    e.g.

    Step 3a:
    --
    Bank B borrows $39 from bank A:
    Bank A sheet:
    A:
    Cash: 104.91-39=65.91
    Loan: 130+39(!!!)=169
    L:
    Deposits: 130

    I kept this separately on purpose. Basically do not keep telling me I am doing something incorrectly whilst making basic mistakes along the way. It is quite irritating. I can easily adjust my example to your methods of accounting and it will not change anything. But I believe, based on the feedback, that my way of records is more clear.

    Of course $371.29 did not disappear without a trace. Just read my post carefully (and try to understand it before you dish out quite silly remarks irrelevant to my example). BTW, there is no third bank in this example: so again you are making this up. This is what I wrote:

    "If someone who is paid with the last loan of $371.29 keeps it as cash, he can start cherry picking the assets. They all cost $1,175.60 to buy."

    The banks were not that crazy to go down exactly to zero. (You are forgetting that I am giving example how pyramid was constructed.) Anyway a lot was funnelled out of the system (through bonuses and shadow banking instruments). It is most likely in properly and prudently run offshore banks.

    Best

    Greg

    ReplyDelete
  31. Greg:

    "I kept this separately on purpose. Basically do not keep telling me I am doing something incorrectly whilst making basic mistakes along the way. It is quite irritating."


    My basic mistake was missing the $30 loan and I apologized for that.

    Your fundamental mistake is broken bookkeeping because you did not include interbank liabilities -- that's not my accounting, that's how real banks account for their mutual obligations. As a result of incorrect bookkeeping, your banks swapped their capital -- an impossible feat given your transaction flow:

    At the beginning:
    Bank A capital/net worth: 104.91
    Bank B capital/net worth: 166.38

    At the end:
    Bank A capital: 720.99-554.61 = 166.38
    Bank B capital: 454.61-349.7 = 104.91

    As for being "irritated", you may consider fixing your 101 bookkeeping errors as a first step on the way to not being irritated.

    ReplyDelete
  32. Hi VJR

    Your first basic mistake was not to realise that I do not record adding a deposit to Capital reserve as it is lent out in the same step.

    Your second basic mistake was missing $30 loan from Bank B by Bank A.

    Your third basic mistake is an assumption that I am doing what you call "real banks account". I do not. I do not make a mistake: it is my way of presenting it. I am doing an example showing a mechanism of a pyramid. (And as you clearly see my example can easily be adopted to "real bank account" practice, which simply proves what I am doing is correct (maybe not for official reporting purposes, but to explain a pyramid mechanism).

    Your fourth mistake was alleging: "The flaw in you logic is that $371.29 did not disappear without a trace somehow in my presentation." $371.29 is well accounted for in my presentation.

    Your fifth basic mistake is misrepresenting what I write. Again I wrote: "Basically do not keep telling me I am doing something incorrectly whilst making basic mistakes along the way. It is quite irritating." It does not mean I am "irritated" as you allege. It means what I stated: "it is quite irritating". That's it. For the record, I am not irritated.

    I am not saying that the way you do it is wrong. Indeed it may be within accounting standards. However this was not the purpose of the way I presented my example. Therefore I used a bit different way absolutely compatible with yours.

    Best

    Greg

    ReplyDelete
  33. Greg:

    No worries ;)

    When I looked at your example yesterday, I immediately noticed that bank capital amounts were swapped while they should have stayed unchanged during the entire transaction flows whichever way you consolidate them. That's what led to those long and boring posts.

    The swap is the direct result of recording transactions incorrectly, and I am not sure why you don't want to fix that.

    Thanks.

    ReplyDelete
  34. Hi VJK

    What you call capital "swap" is your interpretation. Not mine.

    I thought that the way I presented the process of a pyramid building was clear. Your comments indicate that I think I should still take into account your approach (which does not change anything in reality of the process presented). I will think about it as my view is that formal accounting is not clear for people who are not familiar with it (and my presentation was an accurate and clear representation).

    What I did may be incorrect in terms of formal accounting (but you did not say that). However it is absolutely accurate and correct as a way presenting my example.

    Thanks for your input: I think I will use it (possibly add a formal presentation based on your posts and acknowledge it to you:-)

    Best

    Greg

    ReplyDelete