MP’s came to the bankers rescue

Is it a coincidence that the current scandal with British Members of Parliament (MP) expenses happens in the midst of the current financial crisis? It shocked the entire British nation although the financial significance to the UK budget is minimal. But it showed a complete lack of integrity of a large number of the MP’s.

The timing of the MP’s expenses scandal may be indeed coincidental. It may also be an attempt on a part of establishment, The Daily Telegraph is popularly associated with Conservative Party, to force general elections. Conservative Party does not come through with flying colours, but somewhat better than The Labour Party. At a time of deep government unpopularity caused, inter alia, by the current financial crisis swift general elections are likely to produce a very strong Conservative win. But, by no means, this is certain but it seems to be a good bet.

The MP’s expenses crisis turned up to be a perfect cover-up for the ongoing financial crisis. Now politicians, not the bankers, are public enemy number one. So The Daily Telegraph is trying to hit two birds with one stone.

On emotional level it is completely understandable that MP’s expenses caused such a rage that it pushed ”greedy bankers” off the agenda. On financial level, however, it is rather absurd. The value of the expenses is miniscule compared to the costs of the current crisis. It was caused by the financial establishment (bankers, regulators and government officials) who built a giant pyramid scheme in the same way as Albanian gangsters did in 1996 – 1997. This was a crime. In a law abiding society the financial establishment, like Albanian gangsters, would have been prosecuted and given long jail sentences (creating financial pyramid schemes is a serious felony) and their wealth confiscated (to compensate as much as possible for the costs of this crisis, like rescue packages for the banks).

The timing of the ongoing MP’s expenses scandal may be just coincidental. But the fact is that it created an effective smokescreen protecting the financial establishment. Whilst getting rid off dishonest MP’s is important for the public good, it is also important to prosecute large scale financial fraudsters.

It looks like the stronger financial establishment threw the dishonest MP’s to the blood thirsty public to protect themselves.

Clarification for an expert

A very well known expert wrote to me privately the following critique of the pyramid model that I developed:

"I don't really agree with the pyramid scheme analogy (though no analogies are perfect). In a pyramid scheme, the risk gets greater in every round and is passed further and further from the originator. Here, the risk is still with the bank (though limited liability passes it back to the depositor). Also, the money exists (deposits always equals loans, ignoring investments and securitisations) it is just not necessarily liquid. The Austrians argue that you do not need regulation at all. If you simply applied normal procedure everything would be okay - ie if the bank cannot meet all demands then it is deemed to have folded. As such, they argue, the market will bring about higher reserve ratios (as happened in the past before lenders of last resort)."

I responded:

1. It is a financial pyramid for real - it is not an analogy

As far as I am concerned a pyramid scheme is not really an analogy. If you lend with loan to deposit ratio above 100% IT IS a pyramid scheme (by definition of a pyramid scheme). By very nature of exponential growth lending with loan to deposit ratio above 100% leads to collapse regardless of any other risks. (Here I applied analysis based on Cobham Thesis from computational complexity.) That is why I separated the risk directly stemming from pyramid growth from any other risks in finance.

The risk with pyramid growth can also be looked at in two ways:

- the risk of collapse of the system with a lending with loan to deposit ratio above 100% is practically 100% (it is deterministic)

- the risk when, at which cycle, of a pyramid growth it is going to collapse is far more complex: it depends on others risks, market confidence, uncertainty, etc. but, considering the point above, with every round the risk of collapse gets greater as the collapse becomes closer (this answers your first issue with my approach).

I would suggest the following analogy: if you build a bridge on a major road that can bear maximum 5T load (and do not put any warning sign), it is only a matter of time when a car weighing more than 5T will crash a bridge. But it is really difficult to say when: a traffic pattern on this particular road would have to be studied etc. And this can be quite complex: so whilst, realistically, a collapse of the bridge is deterministic when it happens is not.

This is precisely why pyramid schemes are illegal in law and lending with loan to deposit ratio, as it is building a financial pyramid, is illegal.

2. Risk growth and propagation in a pyramid

With respect to the argument of your objection to my model (as it is not really an analogy). You wrote: "In a pyramid scheme, the risk gets greater in every round and is passed further and further from the originator. Here, the risk is still with the bank (though limited liability passes it back to the depositor)." As already mentioned above, in my model, risk also gets greater in every round. You consider bank as an originator. In my model I consider individual bankers who made decisions then collected their smaller or larger bonuses for their "performance" as originators (plus regulators and some politicians). As I hope you clearly see in my model, risk, if any at all, is also is passed further and further away from originators (i.e. individual bankers). A bank as such is its shareholders, customers and ultimately taxpayers in case of government rescue. They all are a pyramid scheme customers duped to this rather nasty business. Bankers, regulators and some politicians are pyramid purveyors and I do not see any risk associated with them at all. Moreover, unlike Albanian gangsters who could not force already cheated customers to cough up more bucks, our pyramid purveyors do it by forcing taxpayers to subsidise failing pyramids. So what is the risk of pyramid originators? None. Indeed it looks like a perfect pyramid. It is the same as if Albanian gangsters created a pyramid with customers money only. (It is not an emotive language: this is just reality.)

In fact when you consider pyramid customers: the early customers that participated (e.g. took a loan 5 years ago, bought a property and a year ago sold it and cashed it out) are winners. This also exactly what happened in Albania. These early gains, or gains for some time on the paper, also work as a way of luring customers into a pyramid. If you early enough and do not exit too late, cash it out, you are a winner. In the City and in Albania. So a pyramid has winners: but this is extremely disproportionate to overall loss. (This actually also answers your concern: "the risk gets greater in every round and is passed further and further from the originator". In fact it contributes to validate the pyramid model of this crisis showing its practically recursive character, i.e. every pyramid node is an originating node of a (sub)pyramid.)

The way of passing the risk is still the subject of my studies. But by passing risk around you may stabilise pyramids but as they keep on growing, you will still face inevitable end: a collapse.

3. Money v cash (M0)

I am not clear what you call money. I generally refer to cash (M0): i.e. hard cash and my approach to loan to deposit ratio is based on cash reserve growth/depletion analysis. In that context: with loan to deposit ratio 100% exactly, value of loans equals value of deposit, but banks generate no cash reserves in the process. Technically it is a borderline pyramid; i.e. its growth is linear (a sum over a number of deposit/loan cycles) not exponential that makes the system so lethal. Having written that I would still not recommend it.

The "Exercise/example - how does it work? shows how "not necessarily liquid" money becomes toxic waste (and that this is inevitable) when loan to deposit ratio is above 100%.

4. Regulations

I do not feel at all about regulations: I do not consider myself as financial markets expert so I am quite agnostic on that. My model only infers that if you lend with loan to deposit ratio above 100% for long enough the system will always collapse. (And generally that "long enough" will not be that long.) The financial risk management techniques, spreading and minimising the risk, may ONLY delay this deterministic fact, but if lending with loan to deposit ratio above 100% continues the pyramid gets bigger (i.e. ratio of banks balance sheets to cash on the market) and when a collapse comes it is simply more spectacular (such as the one we observe now as compared to Albanian pyramid collapse). That's why it is important not to over-regulate as, in extreme, it may be even lethally counter-productive. (My mathematician's instinct tells me that the rules, whether tight or "liberal", should be simple, consistent, i.e. free of contradictions and complete, e.g. no loopholes. Human instinct tells me that whenever money is not tightly controlled it gets stolen - look at the MP's expenses now, but tight control hampers human initiative so it is economically counter-productive. The answer is in the balance, which I do not know.)

Having considered your comments, which I greatly appreciate as they "stress-test" my work, I do not see how they undermine my modelling of the financial crisis. I think your concerns are dealt with within the model.

Pyramid model and risk management

A very prominent economist commented to me privately:

“On the other hand problems do arise if a deposit taking institution buys securities and it is taking on risk that is hidden or if it securitises and keeps risk without realising it - these two problems have been serious. The problem is (and I sympathise with regulators here - though not believing in regulation!) it is difficult to tell whether risk is being offloaded from the banking system or whether it is still there.”

In my pyramid model of the current financial crisis, if loan to deposit ratio was to be kept below 100% to prevent the financial system from turning into a pyramid, a bank should handle buying securities for cash in the following way: let us assume a bank wants to buy $900 worth of securities for cash and the loan to deposit ratio was 90%. Then the bank must have $1,000 cash available which is not part of bank existing cash reserves accumulated as a result of compliance with prevailing loan to deposit ratio. For example a bank gets this $1,000 from a loan capital repayment (after any costs and taxes). A bank pays $900 for securities and adds remaining $100 into its cash reserves. (In a way, a bank deposits $1,000 in itself and considers its investment into securities as it was lending cash to itself for the purpose of buying these securities with loan to deposit ratio of 90%.)

It should be also noted that if a bank acquires new securities paying with already held securities then no cash reserve (according to prevailing loan to deposit ratio) has to be made automatically as a result of such transaction since such reserve was made when the old securities were bought by a bank. I.e. the originally made cash reserves for old securities cover new securities that were acquired with old securities.

The risk of investment is another issue: but the point of my model is that by lending with loan to deposit above 100% the banks were turning the financial system into a pyramid scheme (which incidentally is illegal as setting up pyramid schemes is illegal). Therefore the issue of risk management was secondary in its contributory characteristics to the collapse of the pyramid that resulted in the current crisis. (I.e. even if there was no risk, the pyramid was destined to collapse anyway. The maths behind it is really brutal.)

I have also proved mathematically that if a loan to deposit ratio is above 100%, the better management of risks (i.e. less risk overall) delays the collapse of the pyramid and lets it grow bigger! But since its collapse is inevitable anyway when it comes, a pyramid is larger than if risk management was not that good.

Therefore ironically and counter intuitively, the current financial crisis was made worse by the fact that, in the presence of lending with a loan to deposit ratio was above 100%, the risk management was actually quite good in my view. ("We had such an excellent risk management systems and it failed." - this is a frequent underlying scream of despair in mainstream financial media, quite often reduced to emotive comments about the “bankers' greed” - "Exactly! Since you had such excellent risk management system and you were still lending with loan to deposit ratio above 100% you only made things worse compared if you even had no risk management at all"!) The crisis would have been less severe if, in the presence of lending with a loan to deposit ratio was above 100%, there was an inferior risk management. The financial pyramid would have collapsed whilst it was still smaller and the liquidity crisis would have been less severe!

This can be compared to an engineering project of building an inverted pyramid (which is a counterpart of lending with loan to deposit ratio above 100%). The better the balance stabilisation system of an inverted pyramid (which is a counterpart of risk management in finance), the larger a pyramid can become without losing balance. However as there is no stability system that can keep an inverted pyramid in balance up to infinite size, a collapse is only a matter of time. The better the balance stabilisation system the larger the inverted pyramid that eventually collapses.

However my model does not address the investment risk element (apart from stating that if you are lending with loan to deposit ratio above 100% you are building a pyramid which is bound to collapse regardless of other risks, circumstances, etc; basically the risk of pyramid collapse is getting quickly, at exponential pace, to 100%). But it is not intended to. It is not a panacea for all economic problems/potential problems. I do not consider it as a foundation of a great economic unification theory but merely a model that explains why and how the current crisis happened and why it was deterministic to happen (i.e. fully predictable).

The economist also wrote:

“Our suggestions for depositors being primary creditors would mean that banks other creditors would have much stronger incentives to ensure that risks were transparent.”

I completely agree with this but provided that a loan to deposit ratio is kept below 100%. Otherwise, in the light of my comments above, you will still end up building a pyramid which will be bound to collapse anyway. But this time it will be even larger… So rather than making situation better it will be worse.

Breaking through open door

On 12 May 2009, Edmund Conway of The Daily Telegraph published an analysis "Who is to blame for the financial and economic crisis?" based on a letter from experts of Institute of Economic Affairs (iea).

Mr Conway is not correct to state that no one and everyone is to blame for the crisis. The current crisis is a result of collapse of a pyramid scheme(s). Creating a financial pyramid scheme is a criminal offence. Therefore anyone who did it, and there are people responsible for that professionally, quite a number of them, must face justice. They cannot be treated any better than Albanian gangsters who engineered their own pyramid schemes in 1996 – 1997 and a number of them languish in jail. It is clear that Mr Conway is trying to shift a criminal responsibility of financiers, regulators and government officials, who organised or allowed to organise, financial pyramids onto a general public who were, unwittingly, customers and now are victims of this criminal activity. Again, it looks like establishment protecting establishment. Please also read "Cover up and blame shifting".

In fairness to iea experts, Mr Conway’s conclusions cannot be logically inferred from their letter to The Daily Telegraph.

Below is a response to this publication:

Dear Sirs

I have read your letter, on iea headed paper, printed in yesterday’s Daily Telegraph (B5 page) with great interest. It seems to me that you are going in the right direction but at the same time you make it overcomplicated.

The financial crisis’ causes and mechanism appear to be very simple indeed:

1. The current crisis is a classic result of a collapse of the financial pyramid akin to Albanian crisis in 1996 – 1997. However this time it is a much larger collapse on international scale.

2. The mechanism of pyramid was lending with loan to deposit ratio above 100%. This gives an exponential function base above 1, i.e. it is a pyramid. Indeed this is one of the most classic mechanisms of constructing a financial pyramid. To make it clear: this mechanism was a sufficient condition for the current crisis to come about. Therefore the current crisis was inevitable and completely predictable. (My conclusions do not have an element of benefit of hindsight but are rudimentary conclusions from existing science as it has been known for decades if not centuries.)

There is, of course, a question if the current crisis would have occurred at all or to what extent should a loan to deposit have been kept below 100% (and how much below). Whilst some kind of crisis, typical to economic cycle, would have happened at some point, I doubt that its scale and depth would have been comparable at all to the current crisis. (At this point we could go by history and look into typical crises, e.g. early 1990’s.) There are also factors - other than loan to deposit ratio above 100% - that exacerbate the effects of the collapse of the pyramid: but they are contributory and by themselves would not have had comparable effect.

3. Since creating financial pyramids has been illegal for some, there was no failure in law and regulations. The failure was that the existing law that prohibits financial pyramid schemes was broken. Therefore I do not see a necessity but I do see a need (see point 4 below), based on the current crisis, to regulate more. However I see a must to administer law and regulations, as they are, effectively. If anyone creates a pyramid scheme, this process must be stopped at once, and a perpetrator must be prosecuted.

For more analysis you can refer to my blog: "Financial crisis? It’s a pyramid, stupid.".

In particular:

- "The largest heist in history" especially Appendix A at the very bottom of article; this article was accepted as a memorandum by the Parliamentary Treasury Select Committee.

- "Example/exercise – how does it work?".

4. I also proposed that loan to deposit ratio be regulated. For more please refer to: "Towards improved regulations – maximum loan to deposit ratio".

Yours faithfully and respectfully

Greg Pytel

Towards improved regulations – maximum loan to deposit ratio

The current crisis led academics, analysts, journalists and politicians to discuss how to change/improve regulations so such a crisis is not repeated again. It comes with a warning that at a time of a crisis it is very easy to unnecessary over-regulate.

The fact is that this is a smokescreen. If the existing law that prohibits financial pyramids and regulations, like Basel I and II that require minimum capital to be held by the banks, were obeyed the current liquidity crisis would not have happened. The current crisis is a typical result of criminal pyramid selling akin to events in Albania in 1996 – 1997.

However we can examine the financial system and discuss how it would work if a government and/or regulator in a country was setting a maximum required loan to deposit ratio for financial institutions. This would address the shortcomings of The Turner Review recommendations.

How would it operate?

A maximum required loan to deposit ratio at a certain level stipulates that a bank cannot lend more out of accepted deposits than it is stipulated by that ratio. A bank would consider any cash stream into it, as a potential deposit. A deposit, for the purpose of this regulation, can only be cash (no other form of security can be considered as cash). For example, a typical cash deposit of a customer is a deposit. Any cash revenue retained by a bank that it would use for lending, e.g. loan repayments, interest payments or any bank’s charges, is considered as a deposit once costs, taxes, dividends, or any liabilities and contingent liabilities are subtracted from them. It is as if a bank was depositing money in itself.

This does not preclude a bank from borrowing from another bank and lending it to a customer. However this bank would be acting as a broker earning money on the margin: a difference between their costs of borrowing and their charges on lending. Furthermore and importantly this bank would not be allowed to underwrite its borrowings to an extent that would effectively increase its loan to deposit ratio above a regulatory level.

Loan to deposit ratio would operate at each currency level to preclude any fluctuation, especially depreciation, in a currency to affect the ratio. For example if a bank is lending money in dollars, it must have sufficient dollars reserve to comply with the loan to deposit ratio in dollars. (And if it does not, it has to convert from a different currency reserve at the time. It can only do it provided it will still stay within a required loan to deposit ratio in that currency too.)

The regulations outlined above would result in banks having always a certain level of liquidity. In practice, if a loan to deposit ratio was always, say 90%, there would always be 10% cash reserves in banks for cash deposits per each currency.

How would it work?

Setting up a maximum loan to deposit ratio would also be a very helpful tool for governments in running their economic policy. Apart from precluding a financial pyramid in an explicit regulatory way (rather than, like at the moment, in an implicit legal way), a government would gain a tool to control sustainable economic growth.

Examples:

1. At a time when economic growth is stagnant a government may decide to increase a maximum loan to deposit ratio from, say, 85% (if that was the required one at the time) to, say, 90%. This would create additional liquidity on the market stimulating the growth.

2. At a time when economic growth is becoming too exuberant, a government may decrease a maximum loan to deposit ratio from, say, 92% to, say, 88%. This would result in taking liquidity from the market (curtailing borrowing in a similar way as a hike in interest rates). It would also cool down the economy but at the same time bank, by storing more cash, would increase its cash reserves.

3. At a time of economic recession, governments could, in theory, increase temporarily a maximum loan to deposit ratio even above 100% to increase cash availability on the market very fast. As this would result in a very fast (at exponential pace) depletion of cash reserves held by banks, indeed it is a pyramid, this would have to be considered as a very unusual step. This would be a step of the last resort that would have to be monitored very carefully. It is a very similar measure to currently implemented "quantitative easing".

Effects:

Built-in counter-cyclical measure

The measures outlined above have built in natural counter-cyclical characteristics. Cooling down of economy through decrease of loan to deposit ratio, results in increase of cash reserves held by banks (i.e. storing reserves for bad times). This also limits assets value depreciation at the time of economic downturn, since there is always a guaranteed level of liquidity held by banks. In fact during a downturn banks capital, cash, position is strong and improving, ready to support lending during recovery part of a cycle.

Interest rates stability

Maximum loan to deposit ratio can also be used as a fine tuning tool of governments in controlling economic growth to stabilise interest rates level. A decrease in loan to deposit ratio maximum requirement is very likely to reduce the need to increase interest rate, as it will reduce credit availability.

Improved financial sector productivity

A regulated maximum loan to deposit ratio would also have a very healthy impact on banks' productivity. The banks would not be able to create bogus money, through financial instruments, in order to support increased lending in response to market demand. Banks would be forced to be more efficient to attract more deposits in order to do more lending. This would put a squeeze on a difference in interest rates (and other costs) that banks charge for lending and a return they pay to depositors. Banks will have to look more for profit margins in productivity measures. This means better deal for the consumers and less waste in the economy. (It should be noted that whilst all other industries and indeed a public sector are a subject of massive productivity pressures, thus far by generating bogus money, banks escaped these pressures. Therefore there is a need to bring banks into a real world of productivity and implementing this proposal will facilitate this process.)

Final comments:

A regulatory controlled maximum loan to deposit ratio is in itself not a panacea for all economic problems or potential problems. In fact it is another tool, alongside, interest rate control that would allow governments to stimulate, maintain or cool down economy. Therefore all would depend how this tool would be used by governments to control economy.

It would also explicitly let governments to ensure that loan to deposit ratio is below 100%, therefore that a financial pyramid is not built and a crisis of the same type as the current one is not repeated. Any relaxation of a maximum loan to deposit ratio above 100% has to be a very unusual measure, since it results in a pyramid growth of liquidity on the market.

In its mechanism it is a very powerful tool but at the same time it is very simple. It does not lead to over-regulation and it is easy to control and monitor.

Last but not least, a proposal of governments setting up a maximum loan to deposit ratio requires further consideration, discussion and modelling. But the historical information is in its favour. It must also be kept in mind that lending with loan to deposit ratio above 100% is turning the financial system into a pyramid scheme and therefore at the current state of the law it has been illegal for some time.

Budget: more horror

The current crisis was triggered last autumn by the collapse of the pyramid that the financial system had become. This collapse resulted in a huge liquidity hole, or rather a number of “black holes” that suck in the liquidity, of a total notional value of quadrillions of dollars: at least $1.144 quadrillion (more than 21 times the world's GDP) and very likely in the region of $5 – 6 quadrillion. We do not know what proportion of this can be attributed to the UK’s market. But considering the size and the role of the City on the global markets it is likely to be very substantial.

The UK government do not know the size of the liquidity hole they are trying to plug with banks’ bail out packages and other measures. They seem to be pumping money into the banks’ vaults, read ”black holes”, without an idea of their size. The recent budget, already considered as optimistic or even "totally dishonest", does not take into account a possibility that the UK government will be forced, again, to commit further hundreds of billions of pounds in case of yet another huge liquidity crunch. Considering that the liquidity “black holes” have the ability of sucking of quadrillions of pounds from the financial markets such a scenario is likely to happen. Unless the global pyramid is liquidated, the UK government (and consequently taxpayers) are at the mercy of the bankers: by converting securities into cash they can, and very likely will, cause another wave of the liquidity crisis. Or it can be a creeping drain. It is only a question “when” and "how" it is done. It is a time-bomb. The aim of the financiers, (actually, perversely their professional duty towards their clients), is to realise all, or as much as possible, toxic securities at the best possible price: such price to be paid by the taxpayers. And the taxpayers will end up owning worthless papers. Sounds like an idea of ”bad bank” or continuing the largest heist in history.

What this is going to do to the British economy is too frightening to think about. Especially that the government is oblivious to the scale of the problem. Propping up the economy in a way that looks like serving the last expensive drinks on The Tytanic, the current government appear to be transfixed on surviving till the next elections (May 2010 at the latest). They may not achieve even that. "Après nous, le deluge", Gordon Brown, a City lover, is taking on a role of Madame de Pompadour.

Lights are on

Mr Dan Roberts, a very respected British financial journalist, published a presentation: "The global financial pyramid scheme explained".

On one of the slides he observed: “An unstable pyramid? Viewed from the bottom up, the explosion in debt and assets prices that occurred during the boom years looks unstable and top-heavy. It even bears similarity to the pyramid, or ‘Ponzi’, schemes carried out by fund managers like Bernard Madoff.”

Well spotted. If it walks like a duck, quacks like a duck, looks like a duck, it must be a duck. Indeed the current crisis is a result of a classic criminal financial pyramid scheme akin to the ones created by Albanian gangsters in 1996 - 1997.

It is very disappointing that, apart from rare exceptions on a pretty rudimentary, descriptive level, mainstream financial analysts, economists and journalists do not look at the current crisis as a pyramid scheme. Is it a sign of their substandard aptitude and intelect? Or is it an orchestrated, not too sophisticated, action designed to cover up criminal activities and protect the pyramid's beneficiaries? Establishment protecting establishment maybe?

Gillian Tett at the London School of Economics

On 30 April 2009 Ms Gillian Tett of the FT gave a lecture, titled "Fool's Gold" at the London School of Economics. It was an interesting story telling with attractive words and acronyms making an impression that somehow it was a complex subject. Ms Tett performed a balancing act of blaming on one side the financial world’s innovation but on the other generally admitting that innovation was good.

To her credit, Ms Tett realised very early, some years ago, that there was something wrong with the way credit was handled. However, as social anthropologist, she did not realise the obvious. That it was a classic way of turning the financial system into a pyramid. So rather than making a complaint to the public prosecutor (as creating financial pyramids is a criminal offence), she was writing stories considering all these as may be unwise, complex, non-transparent, etc but still legal. Ironically the rule of thumb is that, in the financial world, non-transparency is very often a cover-up of crimes. Do you still remember "innovative"  "Cap'n Bob"? Social anthropologists should know more about it.

Not surprisingly for a social anthropologist, Ms Tett was trying to take a holistic approach. But she could not see the wood for the trees as she did not seem to be able to distinguish between the root cause of the crisis and the mechanisms that made this root cause propagate. She did not even directly touch upon it, as talking about too much credit is vastly imprecise. She missed the point that all these “complex”, as she called them, financial products were merely tools used for lending with systemic loan to deposit ratio above 100%. This is the root cause of the current crisis. This was a classic pyramid building: it led to financial overliquidity on the markets (pumping money out of the banks reserves), inflation of value of the assets and then a collapse (i.e. classic pyramid collapse), once there was no more money to be pumped out of the banks.

It is not surprising then, but still quite disturbing, that Ms Tett did not see a cause of legal action against the bankers (and, I guess, regulators and government officials either). She stated that somehow the use of financial products was broadly effective in circumventing the law as it was written. It does not stand the test of fact: the law as it is currently written makes creating financial pyramids illegal. It does not matter how a pyramid is created. Whether it was created using “complex” financial products or even more sophisticated Albanian pyramid structures (as it happened there in 1996 – 1997) it was still a crime. In a holistic approach you look at the action of the bankers (action with approval of regulators and government officials): they created a financial pyramid, i.e. committed a criminal offence for which they must be prosecuted and their wealth confiscated. This is based on the law as it is written. “Complex” financial products were merely the tools of this crime. It would be perverse to imply that since the tools, i.e. "complex" financial instruments, were legal then a criminal act committed using them, i.e. creating a financial pyramid, was legal too.

Basically, even with her social anthropologist’s background, Ms Tett’s holistic approach appears not to be holistic after all. She also does not understand that if the law (as it was) that prohibits financial pyramid schemes was observed and Basel regulations were complied with the current crisis would not have happened. It is not the failure of the law and regulations. It is the problem of criminals who were allowed to breach them and even now they are not prosecuted but are still benefiting from their crime. Therefore it seems that all Ms Tett’s criticism of the financial establishment is yet another attempt of saving the perpetrators of the current crisis (i.e. financial pyramid peddlers) from criminal responsibility and assets seizure by venting social outrage. But is the FT not a part of financial establishment after all?

Cover-up and blame shifting

Recently, a very respected and authoritative public figure of impeccable integrity commented to the author that he is inclined more than the author of this blog to accept that the current crisis is a result of “madness” rather than premeditated criminal activities. The jury is out. So let us help the jury of public opinion by examining the matter in detail.

It is beyond a reasonable doubt that the current crisis was caused by lending with loan to deposit ratio above 100%. By a very nature of multiple deposit creation, this constitutes a classic pyramid building mechanism which is illegal.

Looking from a “madness” theory perspective, it is a secondary matter if people in the financial community did not realise this. If they were not educated well enough to realise immediately that they were building a financial pyramid, they were grossly incompetent or criminally negligent. Therefore either they (for criminal negligence) or people responsible for putting them as unsuitable (i.e. grossly incompetent) into their roles must face criminal charges.

Therefore madness may be somewhat an extenuating circumstance, when it comes to sentencing, but it does not absolve the perpetrators from responsibility for a criminal act which was a pyramid building.

Looking from a premeditated criminal perspective, it is unthinkable that senior financial executives, regulators and government officials did not realise that lending with loan to deposit ratio above 100% was a pyramid building. Any properly educated person suitable for work in finance must have known that. Therefore this only adds further charges of, for example, premeditation, conspiracy, another criminal negligence, i.e. knowing the system was getting into inevitable disaster and not trying to prevent it.

The legal test is that any reasonably well educated person suitable for employment in the financial sector (be it a banker or a regulator) knew or must have known, that lending with loan to deposit ratio above 100% was a pyramid building. If his judgement was clouded by greed or personal gain, this would constitute another serious criminal charge.

To summarise, even if at best those who were responsible for the banking system did not know that they were turning the financial system into a pyramid scheme, they are still responsible for criminal negligence. They should be tried for that and their wealth must be confiscated. It is unacceptable to let people be beneficiaries of their own negligence committed at the costs of others, in this case society at large.

In an interview, Professor Roubini points out that most US households have been “Ponzi businesses”. A corollary that “we can’t imprison most of the population” seems rather obvious. However it seems that Roubini wants to shift the responsibility for pyramid building from financiers, regulators and government officials to population at large. Every “Jo the plumber” is guilty. Indeed a shifty move. Whilst it was financiers, regulators and government officials responsibility to ensure that the banking system was not turned into a pyramid scheme, a typical member of the population (a customer of a bank) was not responsible for that. Suggesting that a prospective loan customer should ask a bank manager about loan to deposit ratio of the bank’s lending and other details like risk weighing is unreasonable. It was, and still is, banks, regulators and governments responsibility not an individual customer duty or even a slightest concern. Therefore Roubini’s argument seems like an attempt to get the establishment of the hook: by painting a picture that somehow we are all to blame.

No doubt, as this crisis keeps developing, mainstream analysts, scientists and journalists will continue putting forward arguments covering up the criminal responsibilities of financial establishment. As they are part of it. They already do it, using influential media and famous names, by attributing the responsibility for the current crisis to some form of unexpected outcome and by implicating the entire population to blame (“we were all on the financial binge”).

Whilst the cash beneficiaries of this crisis, mainly but not only financiers, keep their wealth and continue to benefit further , we all should feel guilty, since we are also to blame, and… keep on paying through our noses, the tax system to be precise, to support the said beneficiaries.

As they influence all mainstream media and are very powerful, the concern is that they will be able to convince very honest and thoughtful political decision makers who find it difficult to believe that the current crisis is a direct result of crimes committed by the financial establishment on their watch.