Greg Pytel: Example/exercise - how does it work?

For those who cannot visualise how lending with loan to deposit ratio above 100% pumps out cash of bank reserves and creates a financial pyramid below is a simplified example based on two banks financial system. Please go with pen and paper line by line and follow the growth of bogus balance sheets.

1. Two Banks A and B are set up. Both have zero on deposit and loan books. Bank A has $104.91 and Bank B has 166.38 cash reserves. They have no non-cash reserves. Both decide to lend with loan to deposit ratio (L/D) 130%. i.e.

Bank A:
- Capital reserves: $104.91 cash and $0 non-cash
- Deposits: $0
- Loans: $0

Bank B:
- Capital reserves: $166.38 cash and $0 non-cash
- Deposits: $0
- Loans: $0

2. 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.)

Therefore the both banks’ books look as follows:

Bank A:
- Capital reserves: $104.91 cash and $65 (i.e. $130 x 50%) non-cash
- Deposits: $100
- Loans: $130

Bank B:
- Capital reserves: $136.38 (i.e. $166.38 - $30) cash and $15 (i.e. $30 x 50%) non-cash
- Deposits: $0
- Loans: $0

3. Someone who took $130 loan from Bank A paid it to Bank B. The Bank B decided to lend $169 (i.e. at L/D 130%) not depleting its own cash reserves. It borrows additional $39 from Bank A. Bank A considers this loan from its reserves with risk 50% and Bank B also considers the loan of $169 with the risk 50%.

Therefore the both banks’ books look as follows:

Bank A:
- Capital reserves: $65.91 (i.e. $104.91 - $39) cash and $84.5 (i.e. $65 + $39*50%) non-cash
- Deposits: $100
- Loans: $130

Bank B:
- Capital reserves: $136.38 cash and $99.50 (i.e. $15 + $169*50%) non-cash
- Deposits: $130
- Loans: $169

4. Bank A takes $169 (lent by Bank B) as deposit and decides to lend $219.70 (i.e. at L/D 130%). Bank A decides not to deplete its own cash reserves but borrow additional $50.70 from Bank B. Bank B considers this loan from its reserves with risk 50% and Bank A also considers the $219.70 loan with the risk 50%.

Therefore the both banks’ books look as follows:

Bank A:
- Capital reserves: $65.91 cash and $194.35 (i.e. $84.5 + $219.70*50%) non-cash
- Deposits: $269 (i.e. $100 + $169)
- Loans: $349.70 (i.e. $130 + $219.70)

Bank B:
- Capital reserves: $85.68 (i.e. $136.38 - $50.70) cash and $124.85 (i.e. $99.50 +$50.70*50%) non-cash
- Deposits: $130
- Loans: $169

5. Bank B takes $219.70 (lent by Bank A) as deposit and decides to lend $285.61 (i.e. at L/D 130%) not depleting its own cash reserves. It borrows additional $65.91 from Bank A. Bank A considers this loan from its reserves with risk 50% and Bank B also considers the loan of $285.61 with the risk 50%.

Therefore the both banks’ books look as follows:

Bank A:
- Capital reserves: $0.00 (i.e. $65.91 - $65.91) - cash and $227.30 (i.e. $194.35 + $65.91*50%) – non-cash
- Deposits: $269
- Loans: $349.70

Bank B:
- Capital reserves: $85.68 cash and $267.65 (i.e. $124.85 + $285.61*50%) – non-cash
- Deposits: $349.70 (i.e. $219.70 + $130)
- Loans: $454.61 (i.e. $285.61 + $169)

6. Bank A takes $285.61 as deposit and decides to lend $371.29 (i.e. at L/D 130%). Bank A decides not to deplete its own cash reserves but borrow additional $85.68 from Bank B. Bank B considers this loan from its reserves with risk 50% and Bank A also considers the $371.29 loan with the risk 50%.

Therefore the both banks’ books look as follows:

Bank A:
- Capital reserves: $0.00 - cash and $412.94 (i.e. $227.30 + $371.29*50%) – non-cash
- Deposits: $554.61 (i.e. $285.61 + $269)
- Loans: $720.99 (i.e. $349.70 + $371.29)

Bank B:
- Capital reserves: $0.00 (i.e. $85.68 - $85.68) cash and $310.49 (i.e. $267.65 + $85.68*50%) - non-cash
- Deposits: $349.70
- Loans: $454.61

7. After these operations the system looks like:

- cash taken from the banks is the last loan: $371.29

- cash reserves held by both banks is $0.00 (i.e. no cash reserves - cash is gone from the banks)
- non-cash reserves: $723.43
- combined reserves: $723.43

- deposits: $904.31
- loans: $1,175.60 borrowed to pay for assets (which were booked with 50% risk discount as banks capital).

Having started with $271.29 reserves (Bank A $104.91 plus Bank B $166.38) and $100 initial deposit, the Banks A and B have no cash any more. 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. As, apart from his $371.29, there is no liquidity on the market, he can drive the price of the assets down (making them crash) and drive banks into bankruptcy (unless a government bails them out :-)

The loan to deposit ratio above 100% destroys banks’ cash reserves pushing liquidity on the market, inflating the assets price and ballooning the balance sheets, whilst below 100% cash reserves are guaranteed. However, on the books in this example, the banks’ $723.43 non-cash booked reserves to $904.31 deposits look extremely healthy. Unfortunately the assets booked at $723.43 have very little value. As there is no more liquidity their price goes to the floor: they become toxic assets.

This is a simplified model of the current liquidity crisis and assets value crash. It also shows why cash is the king on the current markets.

Therefore Basel compliant banking system went bust. But this is not a full story: this system was also a pyramid scheme, therefore illegal. Basel regulations have to be looked at in conjunction with law that prohibits pyramid schemes. And they together were sufficient to prevent the current crisis. However they were breached by financiers, regulators and government officials.

Financial pandemic

For the last few days a threat of swine flu pandemic is in the headlines. There was an outbreak in Mexico and some infections in a few countries: barely more than 200 in the world population of over six and a half billion. Yet WHO alarms that it is too late to contain it. All countries with responsible governments share these concerns and have taken urgent preventative steps.

Why do a handful of cases only in a population of billions cause such urgent actions? It may even give an impression of unnecessary panic.

During a pandemic outbreak the growth of numbers of infections is exponential: very fast with speed of rate of spreading compounding with every infection. This is why even a few cases occurring in a pandemic pattern give immediate causes for concerns and result in immediate actions. If the exponential growth is not stopped, through isolation, vaccination, treatment, etc the infection would spread quickly encompassing almost the entire population, causing a complete chaos, leading to some kind social or biological collapse of humanity.

When financiers, with regulators and government officials blessing, started lending money with loan to deposit ratio above 100%, they started a financial pandemic. A ratio of banks balance sheets to cash available on the market started growing at exponential rate. With every step of growth, banks balance sheets were becoming more bogus creating a massive financial pyramid. It is exactly a pandemic pattern.

However unlike during the current outbreak of swine flu, this insane financial pyramid growth was not stopped at the outset when it was only a risk and the first adverse effects could have been easily dealt with. It was not even stopped when it was obvious that the growth of banks balance sheets did not bear any relationship to actual economic growth indicators. According to the financial establishment, collecting huge payouts, it was a new economy with new type of growth. Governments acquiesced. It looked as if epidemiologists and biologists were convincing the governments and public during a pandemic that illness symptoms are a new and natural kind of behaviour that our bodies evolved to and we just have to accept them as the evolutionary progress. And governments would let it grow uncontrollably.

Pandemic risks are too serious to be managed by historians, philosophers, psychologist or other liberal art graduates, the kind of establishment that dominates the financial world. Epidemiologists are scientists who understand issues of exponential growth and lethal effects of pyramid structures. A pandemic outbreak is a natural phenomenon difficult to predict and prevent, that we have to deal with when it happens. The current financial pandemic however was engineered by the financial establishment with regulators’ and government officials’ blessing.

A matter of confidence

Long standing confidence of some can be irrationally based. Confidence of all may be irrational but will only last briefly. As Abraham Lincoln observed: “You can fool some of the people all of the time, and all of the people some of the time, but you can not fool all of the people all of the time.”

Politicians, experts and commentators talk frequently about consumers’ confidence. They refer to it giving impression as somehow this is a panacea for the economic crisis: when consumers’ confidence returns we will all be saved. They do not explain however what consumers’ confidence depends upon and why it disappeared.

Consumers’ economic universe operates between three worlds:
- the world of goods, products, services, etc that consumers buy;
- the world of money, convertible to cash on demand, that consumers earn, save or spend to buy goods, products, services, etc.
- the world of banks balance sheets: consumers borrow, save or invest their money in the financial system with expectations to be able to convert it to cash or spend it at some point.

The balance between these three worlds is critical for economy to function efficiently. It does not mean that there is one-to-one relationship between them in terms of value. For example if every consumer wanted to buy a certain model of a car, or indeed almost any good, product or service, there would not be enough of them on the market. However there is a consumers’ confidence, that should they decide to do it, there will be a product for them.

In a balanced economy, if a demand of certain products or services grows, it becomes more expensive, therefore it is more profitable to produce or provide it, and therefore producers or providers step in balancing a demand with supply. And vice versa: if a demand falls suppliers limit their production.

In a normally functioning healthy economy consumers do not stock products (even those vital for survival grain, water, fuel etc) or get services in advance. They have confidence that it will be always available for them on demand. However in some unusual circumstances, when consumers lose confidence they can make a run on a product. This usually happens at the outset of wars or social unrests. For example, during a war time a loaf of bread can cost a fortune, but even in less extreme situations, in Britain during fuel protests in September 2000, some consumers lost confidence to a level that a lot of them started stocking up gasoline. Similarly there was a run on bottled water in the beginning of the Iraq War in 2003 sparked by rumours of possible poisoning of water supplies in Britain. These are examples when an event breaks consumers’ confidence resulting in panic buying. In this case, restoring confidence is a cure.

However the confidence also can be broken on supply end: if there is a too frequent shortage of certain goods or services, consumers are not confident that they will get them on demand. Therefore they tend to stockpile them exacerbating the shortage. This is typical of countries with high inflation. However in such a case no matter how persuasive, for example, Zimbabwean government would be in asking the consumers not to stockpile goods, this would not restore a balance. There is too much money on the market chasing too few goods.

Confidence is a key for an efficient market of goods and products so consumers do not make run trying to stockpile them. But market cannot be based on confidence only as it is not an irrational belief but an effect of a very rational experience that, for everyone, there are enough goods and services going around on the market.

The same rational foundations of confidence apply to our money that we earn, borrow, save, invest and sometimes spend. Not much of it is kept outside the banking system as cash. To a great extent money ends up in banks as deposits: directly (e.g. savings, investments) or indirectly (e.g. spent and paid in by a retailer). Banks, in turn, lend this money which again ends up back in banks and is lent out again. This is called a multiple deposit creation process. As long as banks were lending with a loan to deposit ratio less than 100%, they were creating a finite amount of money, for every £1 cash, reflected on their balance sheets. For example, at loan to deposit (L/D) ratio 86.5%, for £7.41 on banks balance sheets there was £1 cash in banks reserves, at L/D ratio 90% for every £10 on banks balance sheets there was £1 cash in banks reserves and, at L/D 95%, for every £20 on banks balance sheets there was £1 cash in banks reserves.

Therefore banks worked as a confidence trick. Not everyone needed cash at the same time. Everyone believed that when they needed cash they would get it from the bank. This is the same type of confidence as on the consumers’ products and services market. It was borne out of experience. Any serious dent in that confidence could have ended up in run on the banks, when depositors try to get all their money out and keep it at home as cash. This would inevitably lead to a collapse of the system.

In the last 10 years or so, the banks turned such a healthy system on its head. They started lending more money than they were taking in deposits, i.e. with loan to deposit ratios above 100%. It meant that the ratio of banks balance sheets to cash circulation started growing at exponential (i.e. incredibly fast and compounding) rate, going to infinity if it was not stopped. It meant that for every £1 on the banks balance sheets there was no reserve created in a cycle. In fact the existing cash reserves were depleted and banks balance sheets kept on ballooning. This is a classic financial pyramid creation process. The fact is that with every cycle of multiple deposit creation process, with L/D ratio above 100%, the banks balance sheets were becoming more and more bogus. However, based on erstwhile experience, depositors, individuals and institutions, had confidence and continued to believe in the value of banks balance sheets.

The collapse of the pyramid happens when depositors realise that there is no cash for them when they need it. When a ratio of banks balance sheets to cash on the market is too huge. This is followed by a massive collapse of confidence. This in turn accelerates the pyramid collapse.

This mechanism is described in The Largest Heist in History, the founding article of this blog.

At present many politicians, analysts and journalists are calling for public confidence in the financial system. However confidence is borne out of experience and reality: basic rational facts. And the reality is that in December 2007 the value of outstanding derivatives, which epitomises the global pyramid, was $1.144 quadrillion (now it is very likely to be much higher, possibly in $5 - $6 quadrillion region). This was more than 21 than the world’s GDP (of $53 trillion). The currently committed global stimulus package is 1/572 of that (around $2 trillion). The size of the pyramid, i.e. a value of bogus banks balance sheets, is too huge to be even remotely confident that it is sustainable by the market liquidity. Governments’ rescue packages, miniscule to the notional value of the pyramid, are simply throwing good money after bad. There is also no chance that an economic growth could catch up with it.

Unless this huge financial pyramid is liquidated the difference between its notional value (running into quadrillions of dollars) and cash on the market (trillions of dollars) is so insanely colossal that calling for consumers’ confidence is a futile exercise. Bare figures (as above) show that such calls are not credible.

A US way out?

On 23 April 2009, in its Editorial, “Polish economics”, Washington Times praises the Poland’s way out of the current crisis through cutting public spending and, if possible, cutting taxes. It contrasts it with the US approach of ever-more spending.

Washington Times compares the US model to Franklin D Roosvelt’s New Deal. However the current financial crisis does not resemble the 1930’s depression in its root cause. The current crisis is a result of a giant global financial pyramid collapse that left a quadrillions of dollars liquidity hole. Therefore President Obama’s actions may not be modelled on the New Deal, but on some other premise…

Considering the current US debt and its rate of increase, the US borrow and spend solution reminds an insolvent person who keeps on borrowing money, as long as there is anybody “silly” enough prepared to lend him. He knows that at the end of this process he will not pay anything back but simply declare bankruptcy, write off the entire debt and start its financial life anew.

The US, as the country, is economically and militarily powerful enough to declare that it no longer honours its debt and its currency. Effectively the dollar could be written off as a currency. As around two thirds of world reserves are held in dollar they will be written off. The US will have no debt. Along this action, the US will introduce a “new dollar”. Any internal US old dollar liability will be converted into it, possibly with even 1:1 ratio. This will give seamless continuity to the US internal market. Any international debt will be negotiable. Some nations on which the US depends (like critical suppliers of commodities, e.g. crude oil) may get a favourable treatment. Other nations on which the US does not depend and especially those that may be perceived as prospective threat, rival or with conflicting interests may just get nothing. As a result they will be weakened.

Such actions will mark a completely fresh start for the US. Like a company coming out of Chapter 11 with a great deal negotiated (in this case imposed by the US itself). The entire pyramid collapse will become history in the US. The next year's budget will be hugely relieved from massive debt repayments. The Obama’s administration will be awash with cash to spend on any programme, including green energy, social programmes.

In a "true" spirit of globalisation, the US will unload the costs of coming out of this crisis onto the rest of the world. Only will the US decide which other country will be compensated with “new dollar”, at what rate and on what terms.

Sounds like an economic and political fiction? Indeed it looks unbelievable. But any financial risk analyst must see this as a realistic scenario. The history books are peppered with even more drastic actions, like Opium Wars in the 19th century. If the history of the collapse of Lehman Brothers (in particular $8 billion transfer to the US from the UK that proceeded it) is anything to go by such US actions cannot really take anyone by surprise. The more the US borrows the higher the chance. On the risk-benefit balance, whilst the adverse risk will stay more-less constant, the benefit element to the US keeps increasing with every dollar currently borrowed by the US on the international markets. Not forgetting that there is also a long standing tradition in the US business culture of going bankrupt, this option must look more and more tempting to the President Obama's administration.

It is rather unlikely that Chinese leaders do not realise this. They were on the receiving end of Opium Wars. After starting the Iraq War in 2003, no US unilateral action can be excluded. No wonder China looks somewhat nervous. It has been calling for a new reserve currency and is unloading its dollar reserves on other countries by a way of acquiring natural reserves assets, commodities, buying gold, etc.

Therefore, after all, giving Poland as an example to the US may not be such a clever idea, as some options that are available to the latter are not available to the former. "Desperate times call for desperate measures".

A horror budget

The British Finance and Treasury Minister (known as the Chancellor of the Exchequer), Alistair Darling, announced the 2009 Budget. Based on very optimistic growth assumptions, that Dr Vincent Cable MP (a very prominent politician, economic expert, ex-Chief Economist of Shell) called as “totally dishonest” in assuming “spectacular recovery and rates of growth” , the expected national debt will reach an unprecedented level of over £1.4 trillion (above $2 trillion) but in reality it is very likely to be much higher.

As experts and politicians agree the current economic crisis in Britain was caused by the financial crisis. The financial crisis in turn, as it was proven, was caused by a prolonged and sustained loan to deposit ratio above 100% in a multiple deposit creation process. This transformed the financial system into a classic pyramid scheme. (In essence, it is the same case as of Albania in 1996 – 1997.)

However unlike the Albanian government, the Britain’s decided not to liquidate the pyramid scheme but instead they made all the British taxpayers the last participants who were forced to join the scheme The tax system is used to subsidise and sustain the pyramid. Unlike the Albanian government, the Britain authorities did not try to apprehend and prosecute the creators of pyramid schemes but instead let them continue to manage the financial system. It is a truly farcical arrangement.

The notional book value of this pyramid is massive. It is very likely to be in quadrillions of pounds in the world and still growing at a faster rate than a rate of putting money into the financial system.  As a result the British taxpayers are in the same position as customers of loan sharks. They lend the money to their victims in a “structured” way that makes the victims keep on repaying forever. Irrespective of the repayments the debt keeps on growing.

The figures given in the Budget delivered by Alistair Darling reinforce the view that the financial system plays the same parasitical and indeed criminal role on the British taxpayers as loan sharks on their customers. Unless and until the British government liquidate the financial pyramids in Britain (in practice this means letting failing banks go bankrupt whilst at the same time securing vital social interests) there will be no end to this dishonest madness. As it stands, the current Budget showed that, realistically, there is no end in sight.

…but would anyone care to follow.

On 7 April 2009, Professor Nassim Taleb published an article in the FT “Ten principles for a Black Swan-proof world”. It gives very sensible, indeed common-sense, recommendations which are worthwhile analysing in the context of pyramid model explanation of the causes and dynamics of the current financial crisis .

It is also worthwhile comparing Professor Taleb’s views with those of Professor Goodhart’s.

Professor Charles Goodhart: more historians and fewer mathematicians and physicists in finance

On 22 January 2009, at a seminar in Warsaw, Poland, Professor Charles Goodhart (of the London School of Economics, ex-Chief Economic Advisor and External Member of the Monetary Policy Committee of the Bank of England) stated: “One of the lessons of the recent crisis, a lesson for bankers and for regulators, is, hire fewer mathematicians and physicist who build models on the basis of data that they can observe over relatively short period, and hire a few more historians who know what can go wrong even if they don’t necessarily have a good data basis to put into particular models”.

This is a kind of statement that shows either a complete lack of understanding of a speaker or is a smokescreen based on assumption of a lack of understanding of the audience, how the financial world is structured. This makes it easier to understand that this widespread ignorance made the current crisis was inevitable (i.e. deterministic with near 100% risk), the crisis is unlikely to go away anytime soon and that the history will repeat itself in the future anyway.

For years the British banking system has had a systemic problem that no one has dared to address thus far. It is an aberration, which has been widely discussed amongst mathematicians and physicists working or related to the City.

The financial products were created by mathematicians, physicists, quantum mechanics experts, engineers and so on. This is the kind of people that understood very well the products they were making, their limitations, associated risks, how these products affected one another (including effects on risks of events that were related to one another or independent). They were also creating products descriptions/manuals that contained all such information. But…

These products were traded on the markets by historians, philosophers, modern linguists, psychologists, lawyers, etc. A massive majority of them did not even have a faintest clue what they were dealing with. And their intuition was even worse: how can you explain to these professionals, art graduates, the characteristics of exponential function, issues resulting from Cobham Thesis or even basic principles of probability? Basically they were unable to understand product descriptions/manuals. (But they had “broader look”, “wider perspective”, i.e. precisely the capabilities that Professor Goodhart referred to. For example, when they were calculating a monthly interest rate from an annual one, they were dividing the latter by 12 rather than taking 12th degree root. They were justifying the correctness of such approach by stating that it was simpler [!!!] and that results were not that different. This is a bona fide example from Halifax.) But they loved financial products since these let them make a lot of money, and over-intellectualised names of these products made them feel as if they were geniuses. They did not realise, however, that, in fact, they had been building a gigantic global pyramid scheme. A great majority of financial institutions’ top executives (boards, senior advisors, etc) had similarly useless professional background. The whole situation looked as though a bunch of kids unable to read were given a lorry load of dynamite with an excellent instruction how to handle it. Is there any surprise that they eventually blown themselves up?

(Having written that, an allowance must be made that it is a precise but broad description of the mechanism. In terms of individuals there were some exceptions, e.g. historians who could understand science properly. Going further back in history: Louis de Broglie, a founder of quantum mechanics, was a… historian. Moreover it is almost certain that there were top decision makers, amongst them science graduates, who understood that they were engineering a pyramid akin to Albanian gangsters’ enterprise but far bigger in size. These are the real conscious engineers of the current crisis which was described as “the largest heist in history”.)

For years a lot of City mathematicians and physicists were privately laughing their socks off and were quite openly saying that the financial system would go bust. And soon. The word “nuts” was possibly the mildest adjective they used to refer to their trader colleagues and financial top executives. But very few believed in these warnings: money, status, lifestyle were too attractive to the beneficiaries of this conspicuously exuberant madness.

Returning to Professor Goodhart’s suggestion: the solution is actually the opposite. Mathematicians and physicists should be employed in banks but mainly in decision making roles. They are unlikely to build a pyramid. They are unlikely to be fooled by historians when it comes to finance. Professionals with no science capabilities should steer well clear of the financial system. Interest rates, NPV’s, compounded risk assessment, are not exactly a rocket science, but are well beyond their intellectual capabilities. They may have a role in PR, social policies, corporate responsibilities.

This is assuming that Professor Goodhart does not propose a return to a very traditional banking with the most sophisticated models calculated on fingers, with more diligent bankers using abacus (but only for addition as using it for multiplication is likely to be too challenging). One has to rule out using a slide rule, as a logarithmic scale and its applications will be well beyond their reach. There is nothing wrong with such an approach in principle, but soon India and China will leave us far behind.

Well, well, well… the British Prime Minister (and previously Chancellor of the Exchequer for years) that has presided over the current mess, Mr Gordon Brown, is a historian. Do we need more of this profession responsible for the financial system? It seems to me that Professor Goodhart’s lecture in Warsaw was not really his finest hour.

Incidentally, if anyone wonders upon the FT's coverage of the current crisis and why it is so devoid of data and models, so thin on financial substance, look no further than professional credentials/qualifications of the Editor, Mr Lionel Barber, or its “star” reporter on the subject, Ms Gillian Tett.

More reporting confirming the analysis above: “Recipe for Disaster: The Formula That Killed Wall Street”.

Financial pyramid ain’t a Concorde

In the FT Professors Viral Acharya, Matthew Richardson and Nouriel Roubini compared “the global financial system of the pre-subprime era to Concorde. It was fiercely innovative and grew at a record pace for close to two decades”.

The current financial crisis was caused by the financial institutions’ lending at loan to deposit ratio above 100%. This is not highly innovative. It is not innovative at all. It is a well known pyramid scheme. We know it from Ponzi, Lech Grobelny (Poland in 1990) and Albanian gangsters (1996 – 1997). Bernie Madoff is the latest epitome of the financial system “fierce innovation”.

A comparison to Concorde is an insult to this aircraft’s inventors. Whilst if ideally constructed and maintained, it would have been able to fly without accident infinitely, a financial system based on loan to deposit ratio above 100% (i.e. it was turned into a pyramid scheme) was bound for failure at exponential pace. By design. Indeed the current crisis was engineered that way to happen. Quite basic mathematical understanding is sufficient to prove that.

Wrong parallel leads to wrong analysis. Whilst it is correct that “the biggest contributor appears to be that capital allocation at large, complex financial institutions (…) was broken, focusing myopically on circumventing capital requirements at the expense of long-term economic value creation”, it does not explain the mechanism that caused it. Why did it happen? Or even why did it have to happen? A loan to deposit ratio above 100% assures precisely that. It is a sufficient condition to ensure such phenomenon. This is an intrinsic feature of any financial pyramid scheme. Capital allocation must always be broken due to its insufficiency in the course of financial pyramid exponential growth. It is a classic phenomenon that triggers its collapse. This is when euphoria of the markets transforms into fear, yet another phenomenon of the current crisis (that Alan Greenspan referred to recently). Three professors conspicuously do not even mention that.

Wrong analysis leads to wrong conclusions. The suggested changes to “fix the system” are unlikely to have a desired effect as they are not full proof of preventing another credit binge of banks giving credits at loan to deposit ratio above 100%. It is more striking however that in order to prevent a financial crisis like the current one, the financial system does not need more or new regulations. Financial pyramids have been illegal for some time. Sufficient law and regulations are in place. They need to be enforced (with respect of pyramid schemes). In practice this also implies that the creators of the current crisis (bankers, regulators and some government officials) must languish in jail and their properties and chattels must be confiscated to compensate for the loses caused by the current crisis. The perpetrators of the current crisis, the financial pyramid scheme purveyors, must share the same fate as some of their Albanian gangster counterparts.

This is quite uncomfortable truth for bankers, politicians, financial experts, journalists and academics. The three professors appear to defend theirs, and their professional and academic colleagues, hitherto distinguished careers, at the same time creating a smokescreen on the root cause of this crisis. It all would have been academic if we, the taxpayers, were not forced, at huge expense, to finance supporting the global financial pyramid. Whilst Albanian government was wise enough to let the pyramids collapse, our leaders seem to have better ideas. But can we, the taxpayers, afford them?

The Turner Review

Lord Turner seems to suggest in his report (The Turner Review), that in the future there should be a regulatory measure based on loan-to-value ratio and loan-to-income.

Let us imagine situation whereby loan-to-deposit ratio is above 100% whilst loan-to-value ratio is whatever the regulator thinks is sensible. Then the supply of credit to the market (compared to cash in banks, i.e. deposits) will grow in an exponential way. It will start creating a financial pyramid (by definition of a pyramid). At the same time, because there will be good supply of credit, value of assets will keep on increasing thereby keeping loan-to-value ratio on a regulatory acceptable level, even suppressing it down. (This is a stage when a bubble will be created.) At some point, that will come fast due to exponential speed of growth of the pyramid (i.e. loan-to deposit ratio above 100%), the market will run out of cash and then the value will collapse. (This is a point when bubble bursts.) The loan-to-value ratio will go steeply up due to the lack of market liquidity. So here we are: the current story will be repeated.

It might be possible to keep loan-to-value ratio at such a level as to keep loan-to-deposit ratio below 100%. (This would an indirect control of loan-to-deposit ratio.) But then why not state precisely: as loan-to-deposit ratio above 100% constitutes a financial pyramid it must be banned. Only in very unusual circumstances, and under a very controlled regime, it might be periodically relaxed to stimulate the economy. But then such actions will come with risk (of ending up with a financial pyramid) and they must be taken as the last resort.

A very similar argument applies to loan-to-income ratio.

The Financial Services Authority are still behaving like a drunk child in the fog … or are in a state of denial the obvious.

Pundits are slowly making progress...

The FT (full text) and Professor Roubini have started noting what has been obvious for months (and for years in terms of predictable causality): that the current financial mess has resulted from a collapse of the giant pyramid scheme. Better late than never. However they still fail to identify that the actual mechanism of a global pyramid was loan to deposit ratio above 100%. So still some way to go: but watch this space.

The scale of pyramid collapse is running into quadrillions of US dollars. Refer to posts below.

Raghuram Rajan in The Economist

On 10 April 2009, Professor Rajan published an article in The Economist.

Below is my full commentary:

Professor Raghuram Rajan argues for a regulatory system that is immune to boom and bust, the co-called “cycle-proof regulation”. This implies that he considers the current financial crisis as a typical cyclical boom-and-bust phenomenon and that existing regulatory system was incapable of preventing it.

Professor Rajan does not define in a strict way what he considers as the “current crisis”. However it is quite clear from his narrative that it is the current inability of banks and other financial institutions to perform the core of their business activities: inability of lending money to individuals, businesses and other banks due to the lack of liquidity. I.e. the banks ran out of cash to the extent that any further lending activities by many of the banks would jeopardise the access to funds by depositors.

This is not a typical characteristics of economic cycle referred to as boom-and-bust. This is a typical characteristics of criminal financial activities called pyramid scheme selling that the world witnessed not that long ago in Poland (in 1990) and in Albania (in 1996 – 1997). In this context the current Madoff’s case is not even a tip of the iceberg, but rather an epitome what the global financial system has become in reality in the recent years.

Professor Rajan does not describe the root cause (or the set of root causes) of the current crisis. In theory it is, of course, possible to prescribe a correct remedy without making a diagnosis. In practice however without it even the best of recommendations, and even if they were correct, are not presented in a credible way. Therefore even a theoretical statistical chance of correctness is destroyed by lack of credibility, as financial markets rely on credibility and confidence in its framework.

Professor Rajan begins with a rather trivial, albeit absolutely correct, observation: “(…) faith in draconian regulation is strongest at the bottom of the cycle, when there is little need for participants to be regulated. By contrast, the misconception that markets will take care of themselves is most widespread at the top of the cycle, at the point of most danger to the system.”

Then Professor Rajan goes on to offer his prescription. He seems to present it as if it was a panacea for any future threat of boom-and-bust cycle. Such approach seems to lack credibility due to its universality but looking in the context of the current financial crisis at his remedy, his proposed “three C’s” does not seem to be any better than the market already has. Indeed the mechanisms he proposes already exist and have already been used by financial institutions. For example, “contingent capital” is a form of derivative that is already wide-spread on the existing markets and is indeed at the heart of the cause of the crisis. Professor Rajan proposes different way of packaging and even further non-transparency. Similarly, buying “fully collateralised insurance policies (from unleveraged firms, foreigners [quite a bizarre proposal for global marketplace], or the government)” seems rather superfluous vis-à-vis capital requirements. Moreover there would hardly be a difference between the current government cash injection of, say, £90 billion and of policy payout of £100 billion (if bought for £10 billion premium). Indeed such arrangements would commercially incentivised financial institutions to engineer circumstances that would allow them to make claims. Not only would this be a way to recoup the premium, as otherwise it would have been lost, but it would also be a new way of making money!

The current financial crisis was caused by the fact that the financial institutions were giving out credit with loan-to-deposit ratio above 100%. Such phenomenon, by its very nature, transforms the financial system into a giant pyramid scheme. The spread between banks overblown and, in fact, bogus balance sheets and the cash on the market increases at exponential rate (i.e. dramatically fast). This is a counterpart of inflation on Zimbabwean scale where the spread between cash on the market and good available exploded to gargantuan proportions. There is no cure or regulation that would prevent such processes from leading to a sudden economic seizure and resulting crisis. That is why pyramid schemes have already been made illegal.

Therefore with respect of the causes of the current crisis, the existing regulations were already sufficient. Pyramid schemes have been illegal for some time. If the bankers had not breached this law, and/or regulators had prevented such breach and/or government agencies had supervised this properly the current crisis, which had been trivial to predict, would not have happened. This, alongside Professor Rajan’s point of possible over regulating, should be kept in mind in any discussion about introducing reforms to the financial industry.

However anti-pyramid scheme laws, sufficient for preventing the current crisis if they were administered properly, are not going to prevent cyclical problems of the economy. In this context Professor Rajan presents some noteworthy proposals, like limits on “too big to fail” institutions and, more concrete, “shelf-bankruptcy”. But interesting as they are (the latter actually quite ingenious), he seems to fall into a trap he is well aware of: the temptation to over-regulate. And in the presence of a pyramid scheme, like the one that caused the current crisis, they are irrelevant: even if they had delayed the collapse, the effect would have been ever more lethal. (Ironically this seems to have been a contribution to the current crisis of the existing derivatives and other financial instruments.)

To summarise, even assuming that Professor Rajan is correct on his cycle-proof regulation proposals, they are rather irrelevant to the current financial crisis. Is a time of collapse of the global pyramid scheme as the current crisis is, the right time to debate about cycle-proof regulation that would be immune to any hypothetical boom and bust? It appears to be an intellectual luxury quite detached from the financial reality on the ground. Or would it be more appropriate to recommend instructing law enforcement agencies to carry out investigations into criminal activities of global pyramid scheme selling and assets seizure from the perpetrators?

Gillian Tett in the FT

On 2 April 2009, in the FT Ms Gillian Tett has eventually started asking a question, implying that the answer was not known: “how big the toxic rot really is, let alone when it might end”? A bit late my dear. I asked this question back in October last year giving an estimated answer $1 - 2 quadrillion (qn) dollars at the time. By now it is likely to be of the order of $5 - 6 qn. It is quite depressing that it takes an FT's journalist over 6 months to ask the most fundamental and trivial of questions (an estimated size of a loss). In any financial trouble, any competent financial adviser asks the question: “what is the loss”. Ms Tett also appears to be still some way from understanding that a global pyramid scheme is the crux of the current mess.

Here are further clues what I expect to read in the FT (and other high profile press) in some weeks or rather months to come. The size of globally committed stimulus package is $2 trillion dollars i.e. 1/572 of the outstanding notional value of derivatives (as estimated in December 2007 by BIS in Basel), which is $1.144 qn. And this is about 23 times the world’s GDP. This is an optimistic look at the figures.

It begs a question why papers like the FT or The Economist do not even consider such basics.

Please also refer to an article by Hernando De Soto in the WSJ

Alan Greenspan in the FT

On 27 February 2009 Mr Alan Greenspan published an article in the Financial Times. (Full text)

In response I sent a letter to the Editor.

Dear Sir

On the front page of today’s Financial Times there is a picture of Mr Alan Greenspan with a following punchline: “Greenspan: what went wrong. ‘we have never successfully modelled the transition from euphoria to fear’”.

This is a manifestly incorrect statement. A pyramid scheme structure is a correct model for transition from euphoria to fear. Especially it reflects its dynamics accurately: at the time when a financial pyramid keeps growing, pyramid customers get euphoric over their wealth on the paper (basically on the basis of their bank statements, they think they rich). However at some point, which happens quite fast due to exponential nature of pyramid growth, a financial pyramid cannot be sustained by market liquidity, i.e. a gap between a value of balance sheets and money available on the market is too huge. At that point a pyramid collapses and euphoria turns into fear, even panic and/or anger. (That happens when pyramid customers realise that not only are they NOT rich anymore, but in fact they lost a lot of money.)

This model is very well known. It was described and tested many years ago. I can refer you to financial pyramids in Poland in 1990 of Lech Grobelny (BKO) and Albanian gangsters in 1996 – 1997. But there are plenty other examples.

There is nothing mysterious or complex about the current financial crisis. There is nothing sophisticated about the financial markets (like financial instruments which are mathematically quite trivial). Basically bankers, regulators and some politicians engineered a global classic pyramid scheme that collapsed. The truth is that simple and that brutal.

Is anyone going to face criminal charges, do you think?

Yours sincerely

Greg Pytel

Greg Pytel: The Largest Heist in History

October - December 2008

Building the Great Pyramid: The Global Financial Crisis Explained

This essay was accepted as evidence and published by the British Parliament, House of Commons, Treasury Committee.

When the financial crisis erupted at the end of September 2008, there was an unusual sense of incredible panic among banking executives and government officials. These two establishment groups are known for their conservative, understated approach and, above all, their stiff upper lip. Yet at the time they appeared to the public running about like headless chickens. It was chaos. A state of complete chaos. Within a few weeks, however, decisions were made and everything seemed to returned to normal and back under control. The British Prime Minister Gordon Brown even famously remarked that the government “saved the world.”

But what really caused such an incredible panic in the establishment well known for its resilience? Maybe there are root causes that were not examined publicly and the government actions are nothing more than a temporary reprieve and a cover-up? Throwing good money after bad money, maybe?

Money Making Machine

In order to answer these questions we have to examine the basic principles on which the banking system operates and the mechanisms that caused the current crisis. Students at the A-level are taught about “multiple deposit creation,” It is the most rudimentary money creation mechanism for banks, which if administered properly serves the economy and public at-large very well. In the deposit creation process a bank accepts deposits and lends them out. But almost every lending returns soon to the bank as a deposit and is lent again. In essence, when people borrow money they do not keep it at home as cash, but spend it, so this money finds its way back to a bank quite quickly. It is not necessarily the same bank, but as the number of banks is limited (indeed very small) and there is — or was — a very active interbank lending. In terms of deposit creation the system works like one large bank.

Therefore, the same money is re-lent over and over again. If all depositors of all banks turned up at the same time there would not be enough cash to pay them out. However, such a situation is highly unlikely. Every borrower repays his loan and pays interest on it. In principle, the difference between a loan and a deposit interest rate is a source of the banks’ profit. Naturally, banks have to account for some creditors that will default and reflect it in the lending interest rate, or all the creditors who repay cover the costs of defaults. On top of it, the banks possess their own capital to provide security.

Fundamental to this deposit creation principle is the percentage of deposits that a bank lends out. The description above used a 100% loan-deposit ratio, meaning that all deposits are lent out. In traditional banking this ratio was always below 100%. For example, years ago, Westminster Bank (before it merged into National Westminster Bank), intended to lend out 86.5% of every deposit. For every £100 deposited, the bank lent out £86.5, while the remaining £13.50 was retained in the banks reserve with a small portion of it kept in the Bank of England. In practice, this ratio was the bank’s control tool on deposit creation process, ensuring that the amount of money supplied to the market was limited. According to this principle, for every £1 deposited, a bank lends out £0.865. After only 5 cycles the amount is reduced to below £0.50 and after 32 cycles it is below 1 penny. If this process continued forever the total amount of money lent out of a pound would be less than £6.41. With every cycle of deposit creation, a bank built up its reserves, ultimately collecting almost entire £1 for every £1 initial deposit. Added to capital repayments, interest payments on loans and the bank’s own capital base this system ensured that that there was always enough money in the bank for every depositor. For years banks worked as a confidence trick – the notional value of deposits and liabilities to be paid by the bank exceeded the value of money on the market. Since only a very small number of depositors demand cash withdrawals at the same time and almost all these paid-out deposits are deposited in a bank again quickly the banks ensured that every depositor got his money while circulating money in the economy and stimulating growth. The loan-deposit ratio was a self-regulating tool. As with every cycle it multiplies, the reduction of amounts created decreases exponentially and quickly. The faster the deposit creation cycles occur the faster the reduction progresses, thus accelerating with every cycle. The total “created” from the original £1 deposited in a bank is a finite, not more than £6.41 at the 86.5% loan-deposit ratio, backed by nearly £1 reserve. It is an inverted pyramid scheme starting from a fixed initial deposit base and quickly reducing through deposit creation cycle to zero.

Building a Pyramid
In a City bar back in 1998, an academic was discussing modern banking with his City colleagues from university. He was encouraged to invest in shares as their growth was well above inflation. He pointed out, however, that the inflation index does not take into account the growth of share price and as a consequence the market will run out of cash to pay for shares at some point. The only way would be down—a shares price crash. His City colleagues argued that there would be additional money coming in from different economies preventing a crash (a pretty thin argument in the world of global banking as foreign investors were already market players.) They also argued that the modern financial instruments allowed “securitisation”, “hedging” the risk and “leveraging” the original investment. Indeed it was a killer argument.

The deposit creation process is at the heart of the banking system servicing the public and stimulating economic growth. The modern banking instruments of securitisation, hedging, leveraging, derivatives and so on turned this process on its head. They enabled banks to lend more out than they took in deposits. According to Morgan Stanley Research, in 2007 UK banks loan-deposit ratio was 137%. In other words the banks were lending out on average £137.00 for every £100 paid in as a deposit. Another conservative estimate shows that this indicator for major UK banks was at least 174%. For others like Northern Rock it was a massive 322%. [For more details, refer to Table A.] Banks were “borrowing on the international markets” and lending money they did not have but assuming to have in the future. Likewise, “international markets” were doing exactly the same. At first sight it might not seem so much different than deposit creation. Deposit creation is lending money by the banks they do not have on the assumption that they will get enough back in sufficient time in the future from borrowers.

On closer examination there is a remarkable difference. With every cycle of the 86.5% loan-deposit ratio every £1 deposited is reduced becoming less than £0.50 after 5 cycles and less than 1 penny after 32. With a loan-deposit ratio of 137% — lending £137 for every £100 — not to mention 174% or indeed 322%, the story is drastically the opposite. Imagine a banker gets the first £1 deposit in the first week of a new year and lends it out. Imagine that twice every week in that year the amount lent out comes back to him as a deposit and he sustains such deposit creation process with a ratio of 137% twice every week for the year. This is a perfectly plausible scenario on the current electronic financial markets. By the following New Year’s Eve, the final amount he finally lends out from the original £1 is over £165 trillion (165 with 12 zeros, or over 16 times the amount governments have so far injected into economy). The total amount lent out in a year by a banker is over £447 trillion. Significantly with a loan-deposit ratio 100% or above no reserve is created.

It is an acknowledged monetary principle that the lending interest rate cannot be below 0%. This would allow borrowers to borrow money and banks would keep paying them for doing so. Indeed, there would be no incentive to lend and borrowing would have become a source of income for a borrower. Ultimately, lending would have stopped completely. It is a very similar principle that the loan-deposit ratio cannot be 100% or above, as in such circumstances, an amount of money coming from economic activities into deposit creation cycle would be multiplied very rapidly to infinity. Economic growth and inflation would not be able to catch up with it, which happens if loan-deposit ratio is below 100%.

The loan-deposit ratio below 100% that traditionally served as a very strict self-regulating mechanism of money supply stimulating the economy becomes a killer above 100%. The banking system becomes a classic example of a massive pyramid scheme. But as with every pyramid scheme, as long as people and institutions are happy not to demand cash withdrawals from the banks it is sustainable. Any bank can always print an impressive account statement or issue a new deposit certificate. The problem is whether the cash is there.

The qualitative and quantitative difference between loan-deposit ratio of 0% and 99% is infinitely smaller than between 99% and 100% or 101%. With ratios between 0% and 99%, we always end up with a money-making machine that creates a finite amount of money out of the initial deposit with a reserve nearly equal to the original deposit. If a ratio climbs to 100% or above the amount of money created spirals to infinity, if above 100% with exponential speed and no reserve is generated in this process. It is little wonder that Northern Rock which used the ratio of not less 322% collapsed first well ahead of others, HBOS with a ratio of around 175% ended up in a meltdown scenario later, while HSBC that used the ratio of not more than 91% was relatively safe (being a part of the global banking system, however, it has been at a risk stemming from the actions of other banks). [For more details, refer to Table A.]

Facing the Inevitable
For years the impressive-looking banks results brought a lot of confidence and the City was hailed as a beacon of the British economy. Bank executives, traders and financiers collected huge bonuses — not surprisingly, a lot of it in cash, rather than financial instruments. Influential economists and politicians alike justified stratospheric bonuses and hailed the City as the workhorse of the economy. Government strategic decisions were quite often subordinate to the objective of keeping the City strong. Irrational exuberance triumphed. Ultimately, City executives, traders and financiers proved to be pyramid purveyors not any more sophisticated (although perhaps better mannered) than their Albanian gangster counterparts who carried out a similar scheme 1996-97.

As with any pyramid scheme (and as long as there is still cash in the scheme) the beneficiaries are the operators of the scheme and “customers” who know when to get out of it. During the hectic dawn of the current financial crisis it is very likely that bank executives realised that it was the time that their pyramid started collapsing. This easily explains why banks stopped trusting one another and interbank lending collapsed. It was impossible to predict which node (financial institution) of a pyramid scheme would collapse next. There was a very distinct risk that if a bank lent money to another, the next day the bank-borrower may be bust and the money would be gone.

The collapse process, always an instant one, is accelerated by a dramatic loss of confidence amongst the pyramid customers. Once a single customer cannot withdraw his deposit, a great number of others start demanding payouts. City executives must have known this mechanism and explained to the government officials that unless the state shifts its weight injecting cash, guaranteeing deposits and lending, the system was bound to collapse. The Northern Rock case was a good dry run that pyramid purveyors gave government officials in September 2007. Facing a complete meltdown and an “Albanian scenario” the government acquiesced to the bankers’ demands by injecting cash on an unprecedented scale and giving wide guarantees.

The Route to Recovery
This is only the beginning of the story. According to some estimates there are around $2 quadrillion worth of financial instruments (like securities) that cannot be redeemed due to the lack of cash in the system — so-called toxic waste. These instruments are in the financial system and there are prospective beneficiaries of these instruments when they are redeemed, however. Furthermore they appreciate in value and attract interest so their notional value continues increasing over time. Governments around the world injected cash into the global banking system to a tune of around $10 trillion, or 200 times less than $2 quadrillion. At the same time they allowed bank executives and financiers who organised this pyramid scheme to remain at their posts to manage the injected money. Governments became the ultimate customers of pyramid purveyors with the hope that when they offer their custom it would somehow stop the giant pyramid scheme from collapsing. This is extremely naïve and very dangerous. The incredibly fast growth to infinity of pyramid schemes, which is only accelerating, will ensure that the government will not stand a chance to sustain it, unless this massive pyramid scheme is brought to a halt and liquidated. But there is no sign of governments contemplating doing that yet.

If governments do not liquidate the global pyramid scheme, the money they injected will be, in time, converted into toxic instruments (e.g. securities) and cashed in by organisers and privileged customers of these schemes (or in the case of Albania, gangsters and their customer friends). As the amount injected is around 200 times less than the notional value of toxic instruments, the economy will not even see a difference. It will be a step back to September 2008, only now with trillions of dollars of taxpayers’ money spent to sustain the pyramid scheme. It will be merely throwing good money after bad. But can governments afford to come up again with the same amount money and do it 200 times over or more? This is based on a very optimistic assumption that the notional value of toxic instruments is not increasing. If governments take the route of continuing to inject money, they will make taxpayers dependent on the financial system in the same way that criminal loan sharks control their customers — their debt is ever increasing and customers keep on paying forever as much as it is possible to extract from them.

In a normal free market economy a business that fails should be allowed to collapse. If a business is a giant pyramid scheme, like the current financial system, it must be allowed to collapse and its executives and operators should face prosecution. After all running pyramid schemes is illegal. Letting the banks collapse would have been a far more commercially sound solution than the current approach, provided the governments would have secured and guaranteed socially vital interests directly. For example, individual deposits would be guaranteed if a bank collapsed. Deposit accounts records, along with mortgage and genuine business accounts, would be moved to a specially created agency of the Bank of England which would honour them with government help. If a pension fund collapsed due to a bank collapse, individual pensioners would continue receiving their unchanged pensions from the social security system. This would guarantee social stability and a normal flow of cash into the economy.

The hard part would be to liquidate financial institutions while sifting through their toxic waste and to distinguish genuine non-toxic instruments and the results of pyramid scheme operation. Deposits, mortgages and business accounts are clearly non-toxic in principle. However, in the modern banking they were mixed with potentially toxic assets. This would be a gargantuan task.

The current “quantitative easing” (printing cash) is an attempt to convert more toxic instruments, like securities, into cash, albeit at some inflationary costs, and make them state-guaranteed, as cash is guaranteed by the state. It is just another trick of the financial pyramid purveyors to extract even more cash from taxpayers through the governments on the back of the scheme. Looking back to the 1990s, Albanian gangsters must feel really crossed considering that they were not offered such a “rescue” package first by Albanian government, and then by the World Bank and International Monetary Fund.

Unless and until the governments identify, isolate and write off toxic instruments held by financial institutions every pound put into “rescue” is very likely to end up being good money thrown after bad. (The governments, as ultimate customers of the global pyramid scheme, are supplying the pyramid purveyors and beneficiaries with tax payers’ cash and the largest heist in history continues.) Alongside the liquidation process, but after the toxic waste has been isolated and fenced off in failed financial institutions, governments must launch a fiscal stimulus package and go after the pyramid purveyors and beneficiaries to recover any cash and assets from them and bring them to justice. As the financial pyramid scheme is global, any action — including the recovery cash and assets — must be global, too. It is intriguing that banks in traditional offshore financial centres like Belize, US Virgin Islands, Bermuda, do not appear to suffer from liquidity problems. They do not require rescue packages even though a lot of them are subsidiaries of much larger banks which are affected by the current crisis. Is it a sheer coincidence that, for example, the loan-deposit ratio at US Virgin Islands banks is at a very prudent 42%? Little doubt there is a lot of cash there not created in those little economies. Mr John McDonnell MP [Member of Parliament in the UK] wrote in The Guardian on 20 February 2008:

“One series of offshore trusts associated with Northern Rock were called Granite (presumably a witty pun on the Rock bank). Granite holds approximately 40% of Northern Rock's assets, around £40bn. Yesterday, the Treasury minister told the house that "Granite is and has always been a separate legal entity".

Let's look at that: Northern Rock does not own Granite, that's true. It is however, wholly responsible for it: it's officially "on" its balance sheet in its accounts. But it is legally "off" its balance sheet when it comes to getting hold of its assets as the basis for the security of the sums owed the Treasury.

Granite is based in Jersey, an offshore tax haven where Northern Rock's best assets sit outside the reach of taxpayers. So the bill to nationalise Northern Rock will, in fact, be nationalising only dodgy debt, which will increase the burden on the taxpayer and put at risk the jobs of Northern Rock workers. The sad truth is that by failing to regulate the financial sector adequately, the government has been hoist by its own neoliberal petard. The participants in this tax dodge will be allowed to walk away with millions, when workers may lose their jobs and the taxpayer risk billions."

Epilogue

Some economists see overvaluation of financial instruments as the root cause of the current financial crisis. Overvaluation was not a necessary factor, but only a contributory and accelerating factor that worsened the crisis. The crux of the matter is that financial institutions have considered financial instruments, like securities, as good as cash and added them as cash in the deposit creation cycles at a rate that brought the loan-deposit ratio to 100% or above. Without non-cash financial instruments considered as cash it is impossible to go above 100% in a deposit creation cycle. And it does not matter if these instruments were given proper risk characteristics individually discounting their notional, face value. As long as with any residual value, they have been added in deposit creation process to an extent that its ratio was 100% or above, the disaster was only a matter of time. Because of exponential character of the creation it was a matter of a short time.

Loan-deposit ratio above 100% is like (untreated) AIDS. As it progresses it weakens the immune system of economy that safeguards against adverse events: natural disasters, wars, etc or sometimes unpredictable mood swings of market players. The current crisis was triggered by the collapse of subprime mortgage market (effectively overvaluation of assets). This time the system, for years having had been weakened by loan-deposit ratio above 100%, also collapsed altogether. It was a giant pyramid and it was bound to crumble anyway (for whatever direct cause). It was like a human suffering from AIDS whose death was not caused by AIDS directly, but by pneumonia, flu, infection, etc. However it is AIDS that made the curable illnesses lethal.

Until recently the world enjoyed a sustained period of high growth and low inflation and the fact that it came to such an abrupt end does not come as a surprise. It was in the very nature of the pyramid scheme mechanism. The deposit creation process with a ratio above 100% guaranteed impressive-looking economic growth figures. At the same time there were no extra cash hitting Main Street, as there was no extra cash printed. In this context, the high growth of property prices is no surprise. In their huge majority and extent, these are, in practice, cashless interbank transactions. The world stayed oblivious in this economic miracle like customers of a pyramid scheme being happy with the figures on their statements until they wanted to withdraw money. But like with any pyramid scheme, the financial system ran out of cash, with the outcome of a lack of liquidity, not high inflation.

GRAPH A

The graph below shows exactly an exponential growth of Money Multiplier (this time it is expressed as a ratio of broad money to currency supplies in the United States): (source: US Federal Reserve)


Looking at the diverging trend of M3 (broad money) to currency on this graph, it is simply too terrifying to discuss what happened after 2006, when the reporting was ceased. The graph HERE shows even faster increase till 2008, then a decrease of growth, deleveraging between 2009 and mid 2011 and back to the old pyramid pattern. So the current collapse should not come as a surprise.

This is precisely what is achieved by lending with loan to deposit ratio greater than 100%. It is a classic representation of a pyramid scheme. (Both top and bottom graphs: top one showing broad money exponentially diverging from currency and the bottom one - as near linear as near linear on a logarithmic scale - showing a pretty steady pace of exponential growth.) This is what is called a Depleting Reserve Banking (not Fractional Reserve Banking any more). This is what the model presented in the analysis above captures (as said: "the proof of the pudding is in the eating").

TABLE A
UK BANKS
[source: http://news.bbc.co.uk/today/hi/today/newsid_7648000/7648508.stm, http://www.timesonline.co.uk/tol/money/property_and_mortgages/article5106455.ece]

BANK LOAN/DEPOSIT RATIOS MARKET SHARE
HSBC 90% 2.8%
RBS 112.3% 6.2%
Barclays 123.45% 6.3%
Lloyds TSB 140.84% 8.1%
Alliance & Leicester 172.41% 3.6%
Bradford & Bingley 172.41% 3.9%
HBOS 175.43% 20.1%
Northern Rock 322.58% 8.1%

Weighted average LOAN/DEPOSIT RATIO = 174.26%

Additional information:

- the RBS position includes ABN AMRO – without it RBS position was around 135% [source: MS Research/Howard Davies Presentation - http://www.lse.ac.uk/collections/meetthedirector/pdf/Banking%20and%20the%20State%2002.10.08.pdf]

- Abbey position after acquisition of Bradford & Bingley was 75% [source: http://www.santander.com/csgs/StaticBS?blobcol=urldata&blobheader=application%2Fpdf&blobkey=id&blobtable=MungoBlobs&blobwhere=1205449310144&cachecontrol=immediate&ssbinary=true&maxage=36000]

TABLE B
[source: MS Research/Howard Davies Presentation - http://www.lse.ac.uk/collections/meetthedirector/pdf/Banking%20and%20the%20State%2002.10.08.pdf]

COUNTRIES/REGIONS LOAN/DEPOSIT RATIOS
UK 137%
Germany 121%
USA 105%
France + Benelux 103%
UK + Asia 89%

TABLE C
[source: Asian Banks? Is Credit Crunching Asia. - http://www.fidelity.com.sg/pdf/volatility/FD%20-%20Asian%20Banks.pdf

Singapore, Taiwan, Philippines, Malaysia, India, India, Indonesia Thailand, China. Hong Kong had loan/deposit ratio between 80% - 60%, whilst South Korea had nearly 130%.

APPENDIX A
MECHANICS OF THE FINANCIAL CRISIS 2008 – 2009: WHY CAPITAL REQUIREMENTS DID NOT WORK
Below is a draft of explanation (in a rigorous way) why financial institutions, technically, complied with Basel 1 and/or Basel 2 of capital requirements (8%), yet they collapsed.

1. Definitions: CR(T) – total capital held (requirements by Basel @ minimum 8%); CR(I) – capital held in financial instruments (taking into account risk, i.e. discounting for it); CR(C) – capital held in cash; L/D – loan to deposit ratio.

2. CR(T) = CR(I) + CR(C); when L/D is above 100% then CR(C) portion of CR(T) tends to 0; this means that a ratio of cash reserves to balance sheets also goes to 0. It happens with exponential speed (i.e. this process constitutes a pyramid scheme). In practice, this means that in banks balance sheets growing at exponential rate (base above 1), there is less and less cash, i.e. cash reserve to balance sheet ratio also goes to 0 at exponential speed.

3. Initially in the first phase, this process sucks the cash out of reserves, CR(C), and replaces them with instruments (so-called assets) CR(I) as CR(T) has to be maintained. The initial gains and increase in values of assets CR(I) is achieved with additional liquidity on the market (at the costs of CR(C) depletion). This drives the price of assets that constitute CR(I) high.

4. The assets of CR(I) are valued using price-to-market method. This creates a lethal cycle: the higher assets of CR(I) go up, the more cash of CR(C) is sucked from bank reserves, which results in even higher assets of CR(I) valuation (in price-to-market model). This cycle has exponential growth of cash, CR(C), being sucked out of the banking system, therefore, by definition, it is a pyramid. This constitutes a period of exuberant growth. However it is a bogus growth: statistics are induced by incredibly fast growing balance sheets and consumer confidence is induced by temporary massive availability of cash (being sucked out from cash reserves, CR(C)).

5. Like in any pyramid, as long as there is still enough cash in the banking system to sustain high price to market CR(I), it allows financial institution to maintain the right level of capital requirement of CR(T), technically complying with Basel 1 and Basel 2. However the element of CR(C) of CR(T) becomes smaller and of CR(I) becomes larger. A ratio of cash to balance sheets gets smaller at exponential speed, i.e. it is a pyramid scheme.

6. Any pyramid scheme collapses when due to an exponential speed of growth of balance sheets, availability of cash becomes inadequate. This creates the second lethal cycle: due to shortage of cash confidence goes down, value of assets CR(I) valued at price to market goes down, this creates a necessity for bank to start withholding cash supply to make up for the fall of CR(I) with CR(C) to comply with CR(T), which leads to even greater lack of cash and further loss of confidence and so on. And the cycle becomes a meltdown.

7. With L/D ratio below 100% such cycles look completely different. For example if CR(T) is 8%, L/D ratio of 92%. Using financial instruments as part of capital requirement does not lead to an exponential growth of balance sheets but it is always limited by a final amount of money. In case of CR(T) 8% and L/D 92% the total money put in circulation from $1 is $12.5. (Unlike when L/D ratio is above 100% this becomes massive. Technically it can even go to infinity.) Therefore price to market method works as valuation method when L/D is below 100% as it reflects cash in circulation at all times, rather than inflated and continuously growing balance sheets when L/D ratio is above 100% (see paragraph 4 above). Interestingly HSBC kept L/D ratio at 90%, thereby assuring 10% CR(T) but importantly with L/D below 100%.

8. When L/D ratio is below 100% an economic crisis is a readjustment sometimes even caused by consumers’ confidence. That is why in such situations consumers are encouraged to spend as the cash they hold rebalances back cash to balance sheets and CR(T) ratios to correct level.

9. When L/D ratio is above 100%, at a point of collapse consumers are very short of cash to spend and big debts, banks do not have money anymore to lend as any cash put in as deposits by the consumers (or injected by government) has to rebalance the balance sheets to get CR(T) to a right level. Due to a huge disparity this rebalancing process is ineffective and it is unrealistic to expect it to be effective. (Over $2 quadrillion of unbalanced balance sheets was thus far met to around 1%.)

10. Example: when L/D ratio is below 100%, price to market valuation of companies reflects their fair value. Normally if an investor wants to take over a company he has to pay a premium (as control has a value to an investor). When L/D ratio is above 100% after a point of collapse, even depressed price to market valuation of companies overall does not reflect a market value, but actually overvalues them. If an investor wants to take over a company for cash he is likely to negotiate a good discount (as the market is cash hungry).

11. One can generalise: when L/D is below 100% price-to-market valuation method reflects market liquidity with an element of confidence factored in it; when L/D is above 100% (or equal) price-to-market valuation method reflects misguided confidence in banks balance sheets until a collapse of this pyramid.

Summary:
1. The analysis above is not made with benefit of hindsight: anyone who understands basics of computational complexity (issues around Cobham’s Thesis) would have done it 10 years ago. Therefore avoiding the exiting crisis was extremely trivial.

2. This analysis is deterministic and events are predictable. The exact point of collapse is not easily predictable, but since it is a pyramid scheme it is inevitable in short time. (I.e. it was as predictable as Albanian pyramid scheme collapse.) It appears to be a reason why lawmakers made it illegal.

3. It is clear that there was no failure in terms of law and regulations: Basel 1 and Basel 2 stipulate CR(T) at 8% and pyramid schemes, i.e. L/D ratios above 100%, are outlawed. The failure came from non-enforcement of existing law and regulations.

4. The rigorous mathematical proofs and quantitative analysis is available on request. You may also wish to look into a basic example how it all works.