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.