Prime Minister, sort out this mess, please

Over the last week in Britain there has been a parliamentary festival "what to do with the public debt". The government is arguing that it must cut the public debt very quickly, and harshly, or otherwise the UK will lose its credibility to the markets, its rating will go down and costs of servicing the debt will eventually skyrocket. The opposition is putting their point across that if the public spending is cut then the economy will not get a necessary investment in order to guarantee future tax receipts that will eventually bring the public debt down. It is an argument between "cut and save" now and "spend, invest and earn more". There are merits to both arguments: but they are both missing the point how to solve the existing financial mess that the last Labour government financially engineered for the UK.

Let us deal with credit rating, and its possible downgrade, for the UK. Originally when credit ratings were invented some years ago they were meant to be an objective tool of assessing the risk of default of a debtor. As long as they were done by creditors, at no conflict of interest situation, they played their objective role.

In the last decade or so, the sense of credit rating has changed. The financial institutions that were selling the financial products (thereby getting into debt themselves) started commissioning the ratings for their own products. The higher the rating the lower the costs of the debt. Ultimately many products that were clearly of no value whatsoever were sold with the highest possible credit rating. Credit rating does not mean any more what it used to mean. Now it is a crude tool used by the financial players to make money and very frequently it has nothing to do with the underlying credit worthiness.

The current public debt has to be seen against this backdrop and the fact that the banks are still full of the financial instruments which they cannot cash on the open market. The massive UK debt means that the government is unable to borrow any more money and pump into the banks. If the banks executive turned up now on the Number 10 doorstep and requested yet another cash injection into the financial system, like they did in September 2008, for example in order to prop up massive bonus schemes for the bankers, they would have had to be turned down. The government simply would not be able to hand over more money. But the bankers need it so they are not going to give up easily.

Now the credit rating is used. The UK is threatened by the financial institutions that unless it cuts its pubic debt its rating would go down and the costs of debt servicing would increase thereby increasing the annul spending by the government. There is nothing far more from the truth. If the rating were cut and the debt could not be serviced, then the government would have to take emergency steps and the banks would not get any more money. The whole Greece saga only happened because the banks assessed that there would be a bailout. If there had not they would not have done anything as they would not gain anything by putting a pressure on Greece. This is a rational economic behaviour. Now they try the same basic crude method with Spain and are testing the ground with the UK.

However the game with the UK is a bit different. The financiers know they cannot risk bringing UK economy down. In fact they are unable to do so as the government would have introduced emergency measures to prevent it, and many financial institutions would have come out as losers from it. So using a crude tool of "credit rating" (which has nothing to do with real credit rating) they are trying to force the UK government to cut the debt, thereby increasing the government capacity to borrow more – at the taxpayers’ costs – in the future. Once the government makes all the big savings, of hundreds of billions of pounds or more, cutting many public services and making everyone feel it, the bankers are very likely to turn up again at Number 10 doorstep with begs of toxic waste that remains in the system and will demand another bailout (or else the banking system will collapse). At that point it will be too late. Like Gordon Brown, David Cameron will have little choice but to cough up another few hundreds of billions to the bankers. All those money saved by savage public spending cuts.

However as there is more than one way to skin a cat (sorry, taxpayers), the process of the bankers skinning (again) the taxpayers may actually be not that conspicuous as asking for another multi billion rescue package. It may also take a form of continuous dripping of money from the Exchequer into the banks (by, for example, so called market operations). In which case we will never see any savings made and the pundits who tend to protect the bankers are likely to comment that even the savings were not sufficient to reduce the public debt. They are also likely to peddle a nonsense how much worse it would be if the cuts were not done.

These scenarios and their mechanisms were presented in the first article of this blog, "The largest heist in history" over a year ago. It is astounding that neither the government nor the opposition, then and now, can foresee such glaringly obvious very high risk scenario.

What could and should the government do to bring to order the financial system that became a vampire squid on the face of taxpayers? How can the government remove a risk of taxpayers being treated by the financial industry in the same way as loan sharks treat their victims? It is not a rocket science. There is a basic five point action plan that deals holistically with the current crisis: resolves the current mess and prevents it from happening in the future.

1. Banks must be broken up so none of them is "too big to fail".

As explained before on this blog a "too big to fail" bank enjoys free insurance against failure. This is anti-competitive and is also a continuous burden on public finances by carrying risked costs of the potential failure, hence this is a free public subsidy. For both reasons such behaviour is completely unacceptable under free market rules and should be, if it is not already, made illegal.


2. Separation of high street consumer banking from investment banking.

In the process of breaking up the banks into businesses each of which is not "too big to fail" consumers banking, typical high street deposit and lending activities must be separated from the high risk investment banking. Under Glass-Steagall Act there has been such a rule and it worked for over half a century. It did not take even a decade after it was repelled and we ended up in the current crisis. Therefore whilst theoretically it may not be necessary, the experience strongly indicates that it is a good practice to separate high street consumer banking from investment banking.


3. Deleveraging of the financial system and write downs of toxic waste (i.e. liquidation of the financial pyramid).

As Mr Will Hutton observed on the Dispatches programme last Monday, the banks leverage is around 50. I.e. around £50 of banks liabilities are covered by £1 real cash. Such leverage is unsustainable. A typical sustainable leverage is 5 – 10, 10 only in times of good market confidence. Therefore between 80% - 90% of so called assets are simply toxic waste. The financial assets must be ring-fenced and the proper orderly process of write downs must be done. The aim of this process is to reduce the leverage to a sustainable level between 5 – 10.

The crux of solving the current crisis is the reduction of unsustainable leverage (50 or more) to a sustainable level (5 - 10) and who are going to be losers of this process.

As there will be losers: i.e. people and companies whose assets will be destined to be written down, the government must find a way to deal with it in form of providing a limited security. The ultimate test of the government guarantees and how they are discharged should be of a public interest. For example if a pension fund goes bust as a result of such assets write downs and ultimately the pensioners are the losers, the government must consider taking over a liability for these pensions (at a level, e.g. 50% or 80%, that it can afford or with a possible cap). Another example is if a bank goes bust. Then the government, through one of the nationalised banks would take over accounts and operations and guarantees individuals and businesses their interest. This will no doubt require some government spending but it is likely to be far cheaper than propping up the entire system with no limits as is happening now. Any new government stimulus package that may be necessary will not end up in the financial institutions black hole of toxic waste but in a newly healed banking system, as described in this point and two proceeding points. The banks will not have a problem to start lending again as they will not have an issue of dealing with massively excessive historical leverage. The losers of such operations whose assets were ring-fenced to be written down will be able to resort to private litigation against all those individuals (bankers, regulators) who brought such misery on them.

There is nothing unusual in this step: write downs are typical actions in corporate restructuring and recovery. However in case of the financial industry it is the sheer unprecedented global scale that is daunting. In that respect banks that hang on to bogus assets, which are in fact toxic waste that should have been written down or significantly valued down, and present them as genuine assets on their books, are no different in their accounting practices from Enron. Whilst Enron was using such "creative" approach to extort money from the banks and private investors, banks are extorting money from the taxpayers. Hence banks must be dealt with as decisively as Enron was: it is far better to pick up the pieces now than to allow such a scam to keep on growing.


4. Setting up an effective deterrant against a future crisis happening (i.e. prosecuting the fraudsters).

This crisis is a result of a massive pyramid scheme whose fraudulent mechanism has been lending with loan to deposit ratio greater than 100%. As it has been argued already on this blog, the financiers, bankers, regulators and some politicians that engineered or are responsible in any other way for this financial crisis must be prosecuted. They must end up in jail and their wealth (or any wealth that was "generated" by them as a result of this crisis) must be confiscated. This is not only a basics fairness, the scammers and fraudsters are not allowed to get away with their crimes and spoils of their crimes, but it will help to fund any compensation resulting from the assets write downs as described in point 3 above. Ultimately there is no better way of preventing the next crisis than prosecuting perpetrators of the current one. Enforcing the law is the best regulator.


5. Reducing the public debt.

The last point will be reconciling the public debt against what is recovered from the scammers, as described in point 4 immediately above, and also against any liabilities of the institutions to the government that resulted from orderly dealing with assets ring fencing and write downs as described in point 3 above. For example if the government owes debt to an investor (e.g. bank, financial institution) but at the same time due to a write down (as described in step 3) such an investor ends up owning money to the government (directly or indirectly, e.g. pensioners, individuals, businesses who lost in such write down and were taken care of by the government), then the government subtracts such write down from its debt to the investor. This is likely to reduce the government debt, possibly quite significantly: it seems that a good portion of a near trillion pounds rescue package can be offset against the government debt. And only then if it is not enough the government must do necessary cuts in public spending to balance the books and bring public finances into black.


Desperate times call for well-thought through measures.

Disappointment or hope?

Future of Banking Commission produced the report with very sound and thought-through recommendations: the banks cannot be too big fail and separation of risky investment structures from safe deposit banking. There are other sound recommendations. However, what striking is, that is all so obvious. It begs a question why such basic and trivial rules were not observed in the first instance.

Importantly the report does not recommend prosecuting of all those who engineered the current financial crisis. Bankers, regulators and some politicians. This crisis is a result of a giant global pyramid scheme, the same in its structure and mechanism as in Albania in 1996 – 1997.

The circumstances of producing the Future of Banking Commission report reminds a situation of a neighbourhood where houses were notoriously robbed. Its association established a commission and came to a conclusion that houses needed to have a secure lock fitted. Well, done. However such report did not conclude that the Police should be informed and the thieves must be pursued, caught and prosecuted. Languish years in jail and their wealth confiscated to compensate their victims.

This blog has long argued that enforcing law is the best regulator. The Future of Banking Commission report shows three points. Firstly the politicians, and official authorities, are clearly way out of their depth in dealing with the current financial crisis: present the glaring obvious as some kind of achievement. Secondly the establishment has realised, as Mr David Davis put it on today's Andrew Marr Show, that "if we don't do something, next time [a crisis] happens it will break the country - it will go bankrupt". He confirmed the obvious that the scale of the ongoing financial crisis is enormous. Thirdly, by not recommending pursuing and prosecuting all those who caused the current crisis, the establishment is trying to protect them (as they are part of it).

Or maybe our democratically elected representatives will come to the last point later. Albanian government was prepared to prosecute the scammers. Let's hope that our government will live up to the same standards of probity and integrity.

Comment to: To the Chancellor: UK ain't Canada

For all those who know my blog the comments below should not come as novelty, but it is worth repeating:

1. The banks should be broken up into business units of a size that NONE of them is too big to fail. Any business entity that is or is allowed to become too big to fail enjoys a free survival insurance at the costs to the taxpayers. Not only is this unfair on taxpayers (it is in fact extortion of money through the back door) but it is discriminatory to entities which are not too big to fail. I.e. under the EU rules it a monopolistic and uncompetitive practice which is banned. Hence it begs a question why the authorities allow such illegal practices to exist in the financial sector? Stupidity? Corruption?

For clarity, the current crisis is not a failure of free market rules. It is a result of breaking them and substituting them with communist-like ideology (communism for the rich that is). It is an absolute scandal that the financial sector is run by people who implemented the worst of the communist practices straight from ailing Brezhnev era. The banking communists are the new working class of the 21st century: they successfully executed a revolution of robbing mid-income people and redistributed the spoils to the fabulously rich, making them even richer. Even Soviet communism in its heyday was not that economically perverse.

2. We do not know (and indeed HM Treasury does not know) whether the bailout support the banks got, £850 billion, plugged the liquidity whole. At present it is clear that not more than £70 billion is possible to be recovered by the Treasury and the costs of bailout money is accumulating. Strong signs are that the liquidity hole still exists and may be absolutely massive (possibly even going into quadrillions of dollars globally, and the UK share of it may be huge). Therefore it is likely, above moderate, that the financial institutions in the UK will come to the government for hundreds of billions pounds of more money. (Please note that Greece bailout is in fact a bailout of private banks that lent Greece money.)

3. The basic, intuitive, risk analysis points that the chances of banks asking for hundreds of billions of pounds in form of a new bailout (again) is currently moderate but likely, 3+ (on a classic 1 (min) - 5 (max) scale) but the severity of it is massive, 5 (on the same scale). Hence the overall risk profile - on 1 to 5 scale - is 4+: this is a lot! This means high alert. Just below: imminent. This analysis is intuitive and not mathematically strict. But it is not an argument to ignore it but to prompt the Chancellor to instigate a detailed risk examination.

For the reasons above, whilst the government savings which look reasonable now may turn out to be foolish and for the benefit of the financial sector shafting the taxpayers big time again. How about that?

To the Chancellor: UK ain't Canada

On 6 June 2010 The Daily Telegraph reported that the British Chancellor of the Exchequer planned spending cuts that would be similar to Canadian ones in mid-1990's. These were the very savage cuts of public spending: 20% a year for three years.

Below is a word of caution that the Chancellor is unlikely to get either from the mainstream media or his political friends (and foes).

Canada had to cut its budget deficit because its government overspent on typical public services. The country lived, for some time, beyond its means. Hence its debt had to be repaid and adjusted to an affordable level one way or another.

British budget deficit, in its vast bulk, is of completely different nature. It resulted from the government actions to save the financial institutions at the end of 2008. Although the British government has been spending too much for quite some years on the public services, it were the banks' rescue packages, stimulus packages that were used to plug the financial sector liquidity hole that make up for a vast bulk of the current budget deficit. We are not in debt because we spent too much on schools and hospitals but because we spent absolutely unbelievably extortionate amounts of monies on financial institutions (or, as Gordon Brown said, to "save the world").

As the author of this blog was officially informed (in writing) by HM Treasury, the government does not know the size of the liquidity hole in the financial system. Therefore it does not know how much (if any) more money (billions, trillions?, of pounds) it is still likely to pump into the financial system to assure the liquidity.

Therefore it is reasonably likely that, having completed a serious of savage cut, Canadian-style, the government will save, say, a couple of hundred billions of pounds. Possibly more. At that time, once the financial industry realises that the government liquidity ratio has improved, another liquidity crisis will crop up in the banking industry. And all the monies that government saved, putting a lot of ordinary folk in hardship, will be used to "save the world" again.

The government, hence the taxpayers, will end up back in square one, with the same massive budget deficit as now (or more), but living under massive austerity spending measures. It is quite clear that this is exactly the same mechanism as loan sharks operate, whose victims are squeezed for every penny. In this case the loan sharks is the financial industry who use the government to squeeze the taxpayers for every penny.

The British Chancellor of the Exchequer should be well advised that before he contemplates any cuts, he has to ensure that the financial industry's liabilities (current, potential or future) are completely isolated from the taxpayers. I.e. that, by legal and other arrangements, the government is prohibited from bailing out any financial institution. Otherwise all the savings, done at the huge costs to the taxpayers, destroying lives of many of them, are likely to become savings that, once again, will be pumped into the financial industry like at the end of 2008.

A short tale about a Bailiff and a Good Man (or a brief history of the current financial crisis)

Once upon a time, in a village, a Bailiff lived. He was irresponsible, greedy and whilst he was good in collecting other people's money he was not that that good in managing his business. So the Bailiff himself ended up in a deep, deep debt.

In the same village, at the time, a Good Man also lived. The Bailiff pleaded with the Good Man:

- please lend me some money, a lot of money or otherwise I will go bust. And if I go bust then the whole village will go bust as the debtors will be able not to pay their debt. You have to save me, you have to "save the world".

The Good Man was a… good man. Just that. Not necessarily wise. He turned to Bailiff's friends in the village for advice. They all told him:

- you must help the Bailiff or otherwise our village will collapse. You must "save the world".

The Good Man was not wise. That's why he was not rich either. A simple hardworking man. He did not have his money to lend. So he went to a local Bank. He put all his possessions, all what he earned and inherited, as security. He pleaded all his future income. He borrowed as much as he could. He invested them in the Bailiff's business. That was just enough for a short time as the Bailiff's debt was so huge. The Good Man was even proud and bragged that he "saved the world". But only just and for a short time.

In the meantime the Bailiff was paying himself a handsome salary. The Good Man, being under pressure from his family, inquired whether he could get more in repayments. He also suggested that it was rather unreasonable for the Bailiff to pay himself so much whilst he was in debt.

The Bailiff said to the Good Man:

- you are paying for my great talent as a bailiff. This talent is worth all that and more. If I have to stop paying myself that much I would leave the village and will find a job somewhere else. And the village will collapse.

Being not that wise, rather too optimistic about his income and having underestimated his financial commitments, the Good Man overborrowed. The Bank realised that he would not be able to pay back his debt. The Bank eventually got very anxious and decided to sell the Good Man's debt to a local Loan Shark. The Loan Shark, who knew all the tricks of the trade, decided to make a mint out of the Good Man. That's a loan sharks’ business after all. He started sending demands to the Good Man, making him pay as much as he could. And more. The Good Man was starving. His family was starving. And paying. But his debt kept on increasing with penalties for late payments, additional sky-high interest, administrative charges, etc.

To enforce his "rights" and collect as much money as possible from the Good Man the Loan Shark hired… the Bailiff. And the Bailiff was thriving proving to be a man of many talents indeed.

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For those who still not get it:

1. The Bailiff are the financiers and bankers (especially investment bankers).

2. The Good Man are taxpayers (represented by our democratically elected governments).

3. Friends of the Bailiff are all kind of consultants and advisors that work for governments.

4. The Bank are the financial markets.

5. The Loan Shark are the hedge funds, offshore funds and many shadow banking institutions.

6. The Good Man investment in a Bailiff's business is called "stimulus package".

7. The Good Man costs cutting and saving to repay the loan to the Loan Shark is called "austerity package".

… and so on.

Kill your saviour: currencies' crisis is looming

In February this year [2010] the author of this blog wrote a report which was commissioned by an organisation of sovereign wealth funds, "Money Multiplier effect on currency risk" ^*. The conclusion was inescapable at that time, which was well before the Greek crisis. The currencies of countries which are heavily in debt are facing realistic to high risk of collapse. This was true especially with respect to eurozone which was (and still is) facing a break-up or major realignment. The US dollar is not much on the radar but does not look much better. Since then German Chancellor, Angela Merkel, confirmed "The euro is in danger".

The global pyramid scheme which was engineered by bankers and financiers (with help and blessing of regulators and some politicians: how are you Mr Gordon Brown?) resulted in a very high Money Multiplier. I.e. $1 (£1, €1) real cash has to service to many dollars (pounds, euros) of liabilities on banks balance sheets. This resulted in ongoing liquidity crisis. Governments "rescued" the banks by pumping cash (and cash guarantees) into them thereby putting economies heavily in debt to a tune, globally, of trillions of dollars. However this has been only a temporary reprieve since it covered only a very tiny portion of banks liabilities (especially toxic papers on their books). Although Money Multiplier was reduced (i.e. improved) as described in "The largest heist in history" the improvement was insignificant and, very likely, it has grown since then. This put the economies into a deep financial trouble. Now chickens are coming home to roost: as predicted at the time (end of 2008) rather than curing the problem in the private financial sector, governments decided to buy their time by spreading it and making it much worse dragging taxpayers (and future generations of taxpayers) into it.

To repeat the advice from the end of 2008: "If governments do not liquidate the global pyramid scheme [as explained in this article what it was but primarily write offs of many financial instruments and liabilities of so-called "casino" banking], 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 dependant 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."

The ongoing liquidity (banking) crisis and the sovereign debt crisis, that just blew up, are two sides of the same coin: much too high Money Multiplier, or in simpler terms the global financial pyramid is simply too huge and keeps collapsing.

There is a perverse, sinister side of this process: the very same bankers and financiers whose institutions (i.e. the vehicles of their actions and source of rather exuberant income; this must not be confused with proper ownership, shareholding) were saved from spectacular collapse with "stimulus packages" are now using their institutions, saved by taxpayers' money, and taxpayers' money to attack the budgets of governments (i.e. taxpayers). Kill your saviour if you have an opportunity to do so and it brings you benefits: it is a free market version of an old rule "dog-eat-dog". In fact a prediction made on this blog over a year ago that the financial system – society relationship would turn into a relationship akin to loan sharks and their victims has materialised. As it is taxpayers, and their children, have to keep on paying ever more, as much as they possibly can, with no hope of any recovery. This is called "austerity packages". Loan sharks developed such ideas for their victims in the past and now the mainstream financial industry has learnt such methods and is scaling it up to encompass entire economies. This was a predicted result of "stimulus packages" exposing governments as weak, incompetent and corrupt.

The next step on this path is very likely to be a currency crisis. We already see its beginning with euro. The US dollar will also not escape a reality check. But as pointed out in April 2009 in an article "A US way out?" this make take some time and end up in a somewhat unorthodox solution.

There is only one way out: a combination to a greater or lesser degree of the two processes:

- Zimbabwe way: inflating this crisis out (printing money will reduce Money Multiplier by increasing the volume of cash available to satisfy liabilities on banks balance sheets);

- Chapter 11 way: write offs of liabilities on banks and countries balance sheets (removing liabilities on banks and countries balance sheets will reduce Money Multiplier by reducing the size of liabilities that cash available has to satisfy): an extreme form of such scenario, which is quite likely, was presented over a year ago in a short article mentioned above "A US way out?".

(And of course banks must be banned from recreating the same problem again, for example by lending with loan to deposit ratio above 100%. This is all on this blog: a bit complicated for a paragraph of explanations here.)

From banks liquidity crisis and banking collapse to sovereign debt crisis to currency crisis. These are the stops on the same path: a collapse of the global financial pyramid scheme engineered by the financial world (or technically a result of much too high Money Multiplier). The Great Depression that started in October 1929 reached its grand finale in 1939 with the World War Two. Whether the end of the current crisis will be as dramatic and "spectacular" time will tell. But there is very little to feel optimistic since politicians live in a state of denial and do not tackle the root cause of the current situation. Well, they are unlikely to have a clue about it.

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^* If you would like to obtain a complete copy of this report published by Arab Financial Forum titled ”Sovereign Wealth Funds – Where Are They Going?”, please send a request to Arab Financial Forum Secretariat: info@meconsult.co.uk

Gordon the Firefighter

Whilst listening to Gordon Brown during the 2010 General Election campaign it is difficult to escape an impression that he behaves like a firefighter in dealing with the current financial crisis. He gets into a combative rhetoric and posture and lambastes his opponents as threats to economic recovery. In 2008 Gordon was "the world saviour". Now he got into even a hotter role.

However one must not forget that the current economic crisis was caused by the government and regulators responsible for the probity of the financial world, at best by monumental incompetence that let the financial institutions behave fraudulently, at worst by a criminal conspiracy to defraud the taxpayers.

Indeed Gordon is a firefighter. But either a stupid one or, worse, one with a hero syndrome. All in all, "the world saviour" in the current firefighting role comes across as a bit of a Walter Mitty.

Since writing this article, the author found that Lord Lamont also compared Gordon Brown to an arsonist posing as a firefighter in his article over a year ago (albeit in a different context). It seems it is not only an unbridled imagination.

FSA is coming back to their senses

The UK regulator, FSA, appears to be coming back to their senses. Today an actuarial professional who works for a retail bank, has written to the author of this blog:

"I attended a presentation on liquidity from a senior figure in my banks Treasury department - the FSA are proposing a ratio which would in effect mean LTD < 100%."

On one side it is good news, but on the other it is worrying: even if FSA do something right they do not really understand what they are doing. But it is a progress from much-celebrated "Turner Review".

Election 2010 - short of ideas or lack of guts

All three major parties, Conservative, (New) Labour and Liberal-Democrats, talk the same about the impact of the financial crisis. "We are all in it together" say their leaders. The discussion is on the issues how we are made to pay for that: a combination of public expenditure cuts and raise in taxes. In the last few days, the media brought a story of Goldman Sachs facing fraud charges in the US and the Financial Services Authority investigating the same in the UK. This accompanies the stories of banks' (again) bumper profits and huge bonuses paid to individual bankers.

In contrast, yesterday during the three parties leaders debate an elderly lady, who worked hard all her life, asked a question whether it was fair for her, at the age of 84 years, to live on £59 a week pension.

"We are all in it together.": retired folk on £59 a week pensions and individuals from financial institutions that, allegedly, committed serious fraud and who are responsible for the current crisis and, thanks to the mechanism that caused the current crisis, collect hundreds of thousands or even millions of pounds in bonuses. And if it were not enough, in her article in yesterday's FT, Gillian Tett clearly suggested that individuals in these institutions, or at least in one of them, operate like mafia under a code of silence.

"Irrespective of what Goldman’s clients and service providers have really thought about the bank, most have been reluctant to antagonise the bank, since they feared that Goldman was so powerful that any critic would face some backlash. Hence the fact that so few law firms, consultants – or even bankers – have ever testified in public against the firm, on CDOs or anything else."

Thus far the only action that politicians proposed to curb excessive, if not dishonest, bonuses was to tax banks and bankers on their future income, forcing banks to pay more in shares than in cash. Any effective action was frustrated by those who argued, rather irrationally, that such actions would lead to bankers leave the country. Hence not only would very little be collected but the industry would be damaged as it would relocate abroad, away from the City. This is not only nonsensical. This is also looking through the wrong end of the telescope.

In 1997 when New Labour came to power they imposed a retrospective "windfall tax" on "the excess profits of the privatised utilities".

Leaving aside arguments about legality of the bankers profits, there is a uniform agreement amongst three parties, Conservative, (New) Labour and Liberal-Democrats, that bankers pay has been excessive for some years. Therefore all three parties should have proposed a similar windfall, retrospective tax on the individuals working in the City (including any source of future income like pension pots). The tax should go at least as far back as 1997, when the change to financial regulations was introduced and, to avoid any accusation of unfairness, it should tax net income above a reasonable threshold.

For example, as a reasonable guide (i.e. a template for the politicians), for any tax year since 1997/1998, an individual must pay a 90% tax on any net income received above £200,000. Not only would this recoup billions of pounds for the Exchequer, but it would also go some way in resolving such disgraceful cases like Sir Fred Goodwin's pension as his pot would have been reduced accordingly.

No one can question that £200,000 a year net income is generous especially if it comes from the industry that has been proved to be such a financial disaster and massive liability to the taxpayers. If the politicians are really concerned about the bankers leaving the UK as a result of such measure, they can give an incentive for the bankers to stay. For example, they can allow a 1% tax refund for every year that an individual stays in UK and pays taxes up to maximum 10%. I.e. if an individual stayed and paid taxes for the next 10 years he would have paid 80% tax on all his net income above £200,000 for every year between tax year 1997/1998 and 2009/2010.

As this would be basic tax legislation, like windfall tax in 1997 on "the excess profits of the privatised utilities", all other options against the financial institutions and individuals working for them would still remain open. In 1997 some opponents of the windfall tax argued then that it would damage utilities industry. It did not. By the same token, such tax will not damage banking. This would not be a tax on banks, that might be struggling now as institutions. This would be a tax on individual bankers who collected massive payments whilst they were driving the industry into a disaster. This measure would not be about justice but recouping billions of pounds that the Exchequer needs so badly.

So are our leaders short of ideas or they do not have guts?

Communism (for the rich) is alive (and well)

In yesterday's Financial Times Martin Wolf published an article "The challenge of halting the financial doomsday machine". It appears that the mainstream analysts are slowly reaching the correct diagnosis albeit in a descriptive manner and in a roundabout way.

What Martin Wolf describes as the financial system has all classic hallmarks of a pyramid scheme (for example, of an Albanian type). However, being clearly out of his depth, he simply still does not realise that banks continue to lend with loan to deposit ratio (LTD) greater than 100% which perpetuates this doomsday machine. (Whilst writing about "leverage" could be interpreted in that way, it is far too imprecise as lending with LTD less than 100% is also leveraging).

Banning lending with LTD greater than 100% would not automatically have made financial system safe. However it would have removed a single mechanism that guarantees that financial system is a doomsday machine. (i.e. you can do whatever but if you do not remove this mechanism the system will continue operating like a classic Albanian pyramid that is guaranteed to fail).

Surprisingly (or maybe not) Martin Wolf appears to be an adversary of a free market competitive economy. He clearly does not like an idea of not bailing out failing banks. Alongside a pyramid scheme operated by the banks, they are classic anti-competitive oligopolies. For centuries, until the current crisis, banks had been allowed to fail and indeed sometimes they had. In that respect there is no reason to consider banks any different than other companies (like oil and gas). Indeed the chief issue is that "banks are too big to fail". If the banks are broken up into much smaller businesses (in a similar way as Standard Oil was broken up nearly 100 years ago) with a clear and transparent ownership (that provides reserve capital, in cash of course) and accountability, then banks can be let go bust. And if this happens individual owners will lose their investment, so they will ensure the safety ofthe system. And even if they fail, as the number of the banks will be very large, a collapse of one or two (or three) banks will be easily absorbed by the system. The kind of communist thinking ("communism for the rich") that Martin Wolf presents will ensure that the problems will not go away any time soon. Lenin is dead, long live... Martin Wolf.

Just a start?...

Surely the recent news that US' Securities and Exchange Commission accused Goldman Sachs of fraud did not come to this blog readers as a surprise. The author of this blog argued for a long time that the financial industry is the hotbed of pathological behaviour: both in professional substance and in style.

At a time when the western world has been in deep in recession, banks were making "profits". Where could this "profit" come possibly from? Banks themselves are not creating directly any economic wealth. They are a service industry: if their clients, businesses and individuals, are not making money, how possibly banking industry keeps on making money. The only rational answer is that the financial system is in a pathological state: it is designed and set up to fleece the mainstream economy. The actual service provided is nothing more than a cover-up of thieving practices.

There still exists a myth of intellectual sophistication and professional complexity in finance. But, in fact, the industry strategies that amount to, by example, insuring a house before deliberately burning it down are not particularly sophisticated or complex. Rather primitive, dishonest and criminal. Incidentally whilst such strategies in the world of insurance are almost impossible (a role of insurance excess is to prevent that, i.e. that an insurance owner does not have a commercial interest in causing a damage), in the world of financial engineering it is possible to insure a prospective "loss" many times over (i.e. a perverse arrangement whereby a policy holder may have an interest in causing a damage in order to claim insurance exceeding the actual loss).

The SEC's move is good news and hopefully the start of the process of holding financial industry to account. There is no doubt that Goldman Sachs case is not even a tiny bit of the tip of the iceberg, measured in quadrillions of dollars, of what is happening in the world of high finance. It is promising that historically the US' authorities have a pretty good record on trying to root out the pathology from the economic free market. Hopefully Goldman Sachs case is just a good start that will lead to unravelling real causes and mechanics of the current financial crisis, the largest heist in history. As Brad Hintz of the US brokerage Bernstein said: "There is rising public appetite for punishment of the guilty parties that caused the credit crisis."

From rags to riches

Recently a post (see below this short article) can be found on numerous blogs: a "from rags to riches" recipe. If it worked, we could all make, on average, $11,390,625 ($1 x 15⁶). The whole world would become rich! (Just rich, not fabulously rich.) The financial crisis would be irrelevant. Wouldn't it be great?

But for the same (technical) reasons as the credit crunch happened, the "from rags to riches" recipe will not make us rich. It will fail miserably. Like the causes of the current financial crisis, it is yet another example of a pyramid scheme.

You've been warned.

====

Hi guys/gals,

This is the real thing $6 PayPal fast Cash in few Weeks
FAST CASH $6 PAYPAL as seen on OPRAH and 20/20

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IF A 15 YEAR OLD BOY COULD MAKE $71,000 IN JUST 5 WEEKS AND OTHERS $250,000 IN A FEW MORE WEEKS -- SO CAN YOU!!!
THIS REALLY CAN MAKE YOU EASY MONEY!! IT WORKS!!! BUT YOU HAVE TO FOLLOW The LETTER FOR IT TO WORK!!!!

THE PAYPAL $6 DOLLAR MONEY-MAKING METHOD:
This is all you need:

1) An email address
2) A Pay Pal account
3) Then POST, POST, POST..........

THIS IS A 2009, CURRENT EMAIL LIST
Ever since the internet became popular, the word "scam" has become a daily term. I have never once tried any moneymaking "system" outside of this because of that very reason. However, after reading reports on the validity and reputation of this money making system (seen on Oprah, CNN, and other media forums) I gave it a try. Only hours after implementing this exact system I just about fell out of my chair as money ACTUALLY started rolling in. I couldn't believe it and for that reason, I became a believer in this system.

HERE IS HOW IT WORKS...
There is a list of 6 email addresses (you'll see it as you read further). Each of these people has already taken part in this system. When someone new comes along (such as yourself) he/she removes #1 off of the list, moves the other five email addresses up one position (i.e. #6 goes to #5, #5 to #4, etc.), and adds their Pay Pal email address in the 6 position. This process is what develops the power of compounding. The bottom line is this... Honesty and Integrity creates Profitability. Following this EXACT process is what creates the money, and that is why this system has been raved about. Altering the system creates weak results. The legality of this system comes from the idea that you are of course creating a mailing list, and a "service" is being provided (more on that later.)

INSTRUCTIONS:

STEP 1:
The first thing to do COPY, PASTE and SAVE this entire post in word or notepad on your computer so you can come back to it later. After that, if you are not already a Pay Pal user you need to go to the Pay Pal website at https://www.paypal.com/ and SIGN UP. To receive credit card payments from other people you must sign up for a PREMIER or BUSINESS account (not just a PERSONAL account). This is highly recommended to allow others easy payment options. To place the initial $6 into your account, you will have to verify your bank account with PAYPAL (which may take a few days). PAYPAL is 100% secure and is used by millions of people worldwide.

STEP 2:
Here is where the action occurs. Next send a $1.00 payment to each of the 6 email addresses on the current list from your Pay Pal account. To do this quickly and successfully, follow these simple steps:

1. Login to Pay Pal and click the "Send Money" tab near top of screen
2. In the "Recipient's Email" field type: the email address
3. In the "Amount" field type: "1" (your $1.00 payment)
4. In the "Category" field select: "Service" (Keeping it legal)
5. In the "subject" field type: "EMAIL LIST",
6. In the "message" field type: "PLEASE PUT ME ON YOUR EMAIL LIST". (By doing this, you are creating a service and maintaining the legality of the system by "paying" for the service.)
7. Finally, click on the "Continue" button to complete the payment.
8. Repeat these steps for each of the 6 email addresses.

That's it! (By sending the $1.00 payment to each address, you are implementing the compounding POWER of the system. You will reap what you sow!)


Here is the current e-mail list:
*************************************************
The email list:

1) [1]@gmail.com
2) [2]@gmail.com
3) [3]@gmail.com
4) [4]@gmail.com
5) [5]@gmail.com
6) [6]@gmail.com

*************************************************


STEP 3:
Now take the 1 email off of the list that you see above (from your saved file), move the other addresses up (6 becomes 5, 5 becomes 4, etc.) and add YOUR email address (the one used for your Pay Pal account) as number 6 on the list. This is the only part of the document that should be changed. **Make sure to use the email address you registered with Pay Pal**

STEP 4:
now post new file created in STEP 3 to at least 200 newsgroups or message boards. Keep in mind that there are tens of thousands of groups online! All you need is 200, but remember the more you post the more money you make as well as everyone else on the list!
Use Netscape, Internet Explorer, Fire fox, Safari, or whatever your internet browser is to search for various news groups, on-line forums, message boards, bulletin boards, chat sites, discussions, discussion groups, on-line communities, etc.

For example? Log on to any search engine like Yahoo.com or Google.com and type in a subject like 'MILLIONAIRE MESSAGE BOARD', MONEY MAKING DISCUSSIONS', 'MONEY MAKING FORUMS', or 'BUSINESS MESSAGE BOARD', etc. You will find thousands and thousands of message boards. Click them one by one and you will find the option to post a new message. Fill in the subject, which will be the header that everyone sees as they scroll through the list of postings in a particular group, and post the article with the NEW list of email addresses included. THAT'S IT!!! All you have to do is jump to different newsgroups and post away. After you get the hang of it, it will take about 60 seconds for each newsgroup.

HOW THE MONEY WORKS:
When you post 200 messages in various forums, it is estimated that at LEAST 15 people will respond and send you a $1.00 ($15.00). Those 15 will Post 200 Posts each and 225 people send you $1.00 ($225.00), etc. through 6 levels of email addresses. For comprehension purposes, here is an easy viewing chart:

1) 15(1) = 15 people ($1) = $15
2) 15(15) = 225 people ($1) = $225
3) 15(225) = 3375 people ($1) = $3,375
4) 15(3375) = 50625 people ($1) = $50,625
5) 15(50625) = 759375 people ($1) = $759,375

Within a few WEEKS you begin to see results, thanks to the speed of the internet! When your name is no longer on the list, take the latest posting in the newsgroups and begin the process again. Simply amazing...Follow the system as described, and enjoy your PROFITS!!!


REMEMBER... HONESTY AND INTEGRITY = PROFITABILITY
YOUR NAME COULD CYCLE FOR A LONG TIME!
THIS MAKES IT THE GIFT THAT KEEPS ON GIVING.
REMEMBER, THE MORE NEWSGROUPS YOU POST IN, THE MORE MONEY YOU WILL MAKE!! GOOD LUCK!!

Remember that most news servers will leave the posted messages on there servers for about 2 weeks. If you will post your message again, it WILL again start from the beginning. So you can repeat this over and over again. There are tons of new honest users and new honest people who are joining the Internet and newsgroups everyday and are willing to give it a try. Estimates are at 20,000 to 50,000 new users of the Internet, every day.
!!!!! REMEMBER!!!!! Follow every step, and IT WILL WORK!!!

Make Today A Great Day. Wish U Well...

Computational complexity analysis of Credit Creation

This article presents a rigorous analysis of many issues discussed on this blog already sometimes in a less formal manner. Especially a banking practice of lending with Loan to Deposit Ratio above 100% that has been shown to constitute a sufficient condition of causing liquidity shortage in the banking system (i.e. it was a sufficient condition that caused the current financial crisis).

It is estimated that Cash (narrow money) constitutes around 2% of money circulation in the economy. The reminder 98%, sometimes referred to as broad money, is created by banks through Deposit – Loan Cycles. It is called Credit Creation. When money is paid into a Bank it is

either:

• a disbursement (cost) that a Bank has to pay out (but even, in this case, unless it is stored privately, it will end up in a Bank as someone else’s Deposit); a dividend to be paid by a Bank to its shareholders is also considered as a disbursement

or

• a Deposit; any other money than disbursement is considered as a Deposit paid into a Bank (e.g. if it is a Bank’s retained profit, Bank’s own money is a Bank’s Deposit on its own books; if a Bank uses its own money to buy an investment product, from Deposit – Loan Cycle perspective, in this model it is considered as if a Bank was lending money to itself).

A Bank can lend out Cash that is paid in as a Deposit: this is Credit Creation.

A liquidity risk is a risk of a situation when a demand made by a Depositor to withdraw Cash (narrow money) cannot be met by a Bank. If Money Multiplier is 1 (or less) liquidity risk is 0%: $1 (or more) Cash Reserves covers every $1 Deposits on a Bank’s Loan/Deposit Balance Sheet. If Money Multiplier tends to infinity liquidity risk is 100% in a finite time: at the limit, $1 Cash would have to cover infinite amount of dollars of Deposits on a Bank’s Loan/Deposit Balance Sheet.

Liquidity risk is directly associated with a phenomenon called “bank run”, when depositors, in large numbers, would like to withdraw money from a Bank to either pay it to another bank or worse, from liquidity point of view, keep it privately. As some depositors cannot withdraw their money it results in destruction of a Bank’s credibility. Then even more depositors follow suit leading to a Bank’s collapse.

1. Full Reserve Banking

When a Bank retains all Deposits paid in, a Bank is not lending. It acts as a Product/Service Supplier of storing cash. This is also called 100% Reserve Banking.

For every $1 paid as Cash Deposit, Bank’s Loan/Deposit Balance Sheet shows Loan = $0, Deposit = $1, Cash Reserves = $1. Money Multiplier is 1 (i.e. in every day’s language money is multiplied by 1, i.e. it is not multiplied, no Credit is created).

Conclusion: Full Reserve Banking is a case of complexity of no growth (O(1)). Ignoring theft and fraud, the liquidity risk of Full Reserve Banking is 0% (i.e. 100% Deposits paid in are always in a Bank and can be withdrawn on demand at any time.)

2. Fractional Reserve Banking

When a Bank lends part of Deposits paid in, a Bank is Creating Credit. A proportion of a Loan to a Deposit from which a Loan is given is called Loan to Deposit Ratio (which may also be expressed in percentage terms: for example, LTD = 0.9 is equivalent to 90%.).

For example, for initial $1 paid in if the Loan to Deposit Ratio is LTD, a Loan given is $1 x LTD. Generally in the money-based economy it can be assumed that, on the whole, this Loan, $1 x LTD, will end up in a Bank as a Deposit and then it is re-lent again. Assuming the same Loan to Deposit Ratio, the next Loan is $1 x LTD². Generally after n iterations from the initial $1, the Loan given is $1 x LTDⁿ. Since LTD is less 1 (100%) then it is a regressive geometric series with limit 0 and the total Credit Created from the initial $1 Cash is $1 x 1/(1-LTD).

Money Multiplier is a ratio of Deposits on a Bank’s Loan/Deposit Balance Sheet to Cash Reserves accumulated. It tells us how many times Cash (narrow money) was multiplied by Credit Creation process (into broad money). Therefore based Loan to Deposit Ratio, LTD, we can calculate a Money Multiplier, MM. It is: MM = 1/(1-LTD). Money Multiplier tells us how many Deposited dollars on a Bank’s Loan/Deposit Balance Sheet are covered by $1 Cash.

For example, let LTD = 0.9 (i.e. 90%), i.e. MM = 10, then for every $1 of initial Cash Deposit (narrow money), the first loan is $0.9, the second $0.81, the n^th $1 x 0.9ⁿ, the total value of Deposits on a Bank’s Loan/Deposit Balance Sheet is $10 and there are $9 of Credit Created (circulated in money-based economy) and Cash Reserves are $1.

Conclusion: Fractional Reserve Banking, with Loan to Deposit Ratio above 0 and below 1, is a complexity case of no growth (O(MM)) of a Bank’s Loan/Deposit Balance Sheets to underlying Cash Reserves as Money Multiplier is a constant number in relation to Loan to Deposit Ratio. We observe that it entails liquidity risk below 100%, since it is always possible that demand for withdrawals, at one time, exceeds Cash Reserves.

It is not a purpose of this paper to argue what level of liquidity risk is acceptable or beneficial for money-based economy and what factors ultimately determine this risk in reality. This may depend on many phenomena that affect human decision making process.

3. No Reserve Banking

We also observe that as Loan to Deposit Ratio is less than 1 and approaching it, the Money Multiplier tends to infinity, and nearly no Cash Reserves are created, the liquidity risk keeps increasing up to 100% at the limit. Nearly all the money paid in as Deposits are turned into Credits. Loans and Deposits tend to infinity on a Bank’s Loan/Deposit Balance Sheets, whilst Cash Reserves tend to remain finite and constant.

If Loan to Deposit Ratio is 1, at the limit, it is a linear growth of Loans and Deposits on a Bank Loan/Deposit Balance Sheet, Money Multiplier is infinity, Cash Reserves’ growth is 0 (i.e. they stay on the level which was when Loan to Deposit Ratio of 1 was started) and liquidity risk (in a finite time) tends to 100%. It is a case of trivial geometric series with common ratio 1 (which is also an arithmetic series).

Conclusion: No Reserve Banking is a complexity case of linear growth (O(n)) to infinity of both Loans and Deposits on a Bank’s Loan/Deposit Balance Sheet. A Money Multiplier is infinity resulting in liquidity risk of 100% in a finite time. No Reserve Banking is also called 0% Reserve Banking.

4. Depleting Reserve Banking

Depleting Reserve Banking, lending with Loan to Deposit Ratio above 1, is not possible, unless there are already Cash Reserves. It is, effectively, a Credit Creation with a “top up” from already existing reserves (this top up may come as a Loan from another bank’s reserves and a lending bank may consider borrowing bank’s debt papers as good as Cash). A Bank is Creating Credit by lending Deposits paid in and topping up from existing Cash Reserves (or a Loan from another bank’s reserves). A proportion of a Loan to an underlying Deposit is called Loan to Deposit Ratio.

For example, for initial $1 paid in if the Loan to Deposit Ratio is LTD, a Loan given is $1 x LTD. Generally in the money-based economy it can be assumed that, on the whole, this Loan, $1 x LTD, will end up in a Bank as a Deposit and then it is re-lent again. Assuming the same Loan to Deposit Ratio, the next Loan is $1 x LTD². Therefore after n iterations starting with the initial $1, the Loan given is $1 x LTDⁿ. Since LTD is above 1 (100%) then it is a progressive geometric series with exponential growth to infinity. The total Credit Created from the initial $1 Cash tends exponentially to infinity: $1 x ((LTDⁿ – 1)/(LTD – 1))

As Loan to Deposit is above 1, and the geometric series is diverging, it is impossible to calculate Money Multiplier based on a ratio of Loans to Deposits on a Bank’s Loan/Deposit Balance Sheet at any one time. We also must know how many times a Deposit – Loan Cycle was executed at what Loan to Deposit Ratio. The general formula to calculate Money Multiplier (when Loan to Deposit Ratio is above 1) is:




i = 1, …. , n

LTD_i is a Loan to Deposit Ratio

ki is a number of Deposit - Loan Cycles with a Loan to Deposit Ratio LTD_i (LTD_i+1 is a Loan to Deposit Ratio that follows LTD_i).

It is a side note but we observe that it looks unlikely that Deposit – Loan Cycles (Credit Creation) starting with initial $1 Cash are uniform processes in money-based economy. Therefore it may be practically impossible to calculate accurate and reliable Money Multiplier when Loan to Deposit Ratio is above 1.

For example, let LTD = 1.17 (i.e. 117%) then for every $1 of initial Cash Deposit (narrow money), the first loan is $1.17, the second $1.3689, the n^th $1 x 1.17ⁿ, i.e. for n equal 220 the 220^th Loan value is over $1 x 10¹⁵. The total value of Deposits on a Bank’s Loan/Deposit Balance Sheet is over $5.8 x 10¹⁵ and there is also over $5.8 x 10¹⁵ Credit Created and circulated in money-based economy. Cash Reserves are initial Cash Reserves minus $5.8 x 10¹⁵. Money Multiplier is over 5.8 x 10¹⁵. In other words, whatever the initial Cash Reserves had been at the start of Credit Creation with Loan to Deposit Ratio of 1.17 (117%), after 220 Deposit – Loan Cycles executions, starting with initial $1 Deposit, the Cash Reserves were depleted by over $5.8 x 10¹⁵.

It is a side note but in practice banks’ Cash Reserves, on a Bank’s books, may be replaced with credit collaterals or other non-Cash financial instruments, being considered as good as Cash. This may result in, nominally, retaining any required reserve ratio, but this reserve would not be in Cash. These financial instruments are a part of Products/Services Supply and their market value/price (in Cash) depends on Products/Services Demand (Money Supply), see the graph on page 2.

Conclusion: Depleting Reserve Banking, with a Loan to Deposit Ratio above 1, LTD > 1, is a complexity case of exponential growth (O(LTDⁿ)) of a Bank’s Loan/Deposit Balance Sheets to underlying Cash Reserves. As Money Multiplier tends to infinity the liquidity risk is 100% in a finite time.

5. Brief computational complexity analysis summary

Let us consider Credit Creation as an algorithm that we would like to implement on a computer. (It is actually a very basic algorithm.)

The cases of Full Reserve Banking and Fractional Reserve Banking, of O(k) where k is a constant equal 1/(1 - LTD), are tractable algorithms. They can be considered as contained algorithms: the requirement on resources is a constant multiple of an underlying parameter of Credit Creation (i.e. Cash).

No Reserve Banking (of O(n)) is also a tractable algorithm but it takes more resources than Full Reserve Banking or Fractional Reserve Banking. In fact it would be a case of concern that at some point, in linear time depending on a number of executions of Deposit – Loan Cycles, the demand on resources will eventually exceed availability threshold. This is non-containable case as there is no upper limit of demand on resources in relation to underlying parameter of Credit Creation (i.e. Cash).

Depleting Reserve Banking, of O(LTDⁿ), is an intractable algorithm. The growth of demand on resources is exponential. This type of algorithms is considered impractical for implementation on computers. (In general, in computer science algorithms with complexity above polynomial are not accepted as general solutions to underlying problems.)

In the cases considered above, containable algorithms of Credit Creation present liquidity risk below 100%. They are of manageable risk as a part of a risk portfolio. Non-containable algorithms present liquidity risk of 100% in a finite time, i.e. it is unmanageable risk as liquidity shortage is a matter of a finite time. In the case of Depleting Reserve Banking, due to exponential growth of a Bank of Loan/Deposit Balance Sheet and Money Multiplier (and also exponential depletion of Cash Reserves) such finite time is assumed to be very short: short enough, in practice, for the liquidity shortage to occur. By computational complexity standards, Credit Creation using Depleting Reserve Banking is intractable, i.e. non-practical for implementation.

6. Depleting Reserve Banking and loss of control of Money Multiplier

Essential to managing liquidity risk is the knowledge of Money Multiplier (MM), i.e. how many dollars of Deposits on banks’ Loan/Deposit Balance Sheets are covered by $1 Cash. As already showed in the preceding sections of this article, if a Loan to Deposit Ratio is always below 1 then the total value of Deposits and total value of Loans on banks’ Loan/Deposit Balance Sheets are the basis for calculation of Money Multiplier: MM = Total Deposits/(Total Deposits – Total Loans).

If Loan to Deposit Ratio is above 1 then the above equation does not hold. In order to calculate Money Multiplier we need more information about each Deposit – Loan Cycle (which may be impractical or even impossible to gather). This is even more complicated: it is possible to execute any number of Loan – Deposit Cycles with Loan to Deposit Ratio above 1 (achieving any arbitrary high Money Multiplier in this process) and then with one cycle only reduce a ratio of total value of Loans to total value of Deposits below 1 on a Bank’s Deposit – Loan Balance Sheets. This may look like an “average” Loan to Deposit Ratio below 1. However this value used in the formula presented above, MM = Total Deposits/(Total Deposits – Total Loans), will not produce a true value of Money Multiplier (most likely, in practice, a real Money Multiplier will be much higher).

Therefore, concluding this computational complexity analysis, Credit Creation with Loan to Deposit Ratio above 1 must not be practiced since:

• exponential growth of banks’ Loan/Deposit Balance Sheets is intractable

• liquidity risk, in a finite time, is 100%

• practical macro control of growth of Money Multiplier is lost

It is a side note but due to exponential growth of a Bank’s Loan/Deposit Balance Sheet and exponential depletion of reserves, Depleting Reserve Banking is a classic example of a pyramid scheme.

It is also a side note but the present liquidity crisis and resulting economic crisis was preceded by a prolonged period of Credit Creation with Loan to Deposit Ratio above 1.

7. Consequences of Depleting Reserve Banking on Mark-to-market and Value-at-risk (VaR)

Depleting Reserve Banking results in Money Multiplier growing at exponential pace without any upper bound (i.e. infinity is the limit) such that each unit of cash has to satisfy ever growing demand on banks balance sheet. In a finite time (in practice, due to exponential growth, very short time), banks run out of cash to service their payment obligations like deposit withdrawals: all cash becomes tied to servicing such obligations and the shortage keeps growing presenting liquidity shortage. Consequently there is a decreasing volume of money (cash) to pay of any non-cash financial (and other) products. This volume decreases at exponential pace (i.e. practically very fast) to zero [as Money Multiplier grows at exponential pace to infinity, cash available to service non-cash obligations decreases to zero]. Hence a Mark-to-market price of any non-cash financial products also decreases to zero, as there is a decreasing volume of cash available to complete a transaction. In such scenario a probability of a non-cash asset losing 100% of its value in a finite time tends to 100%. In other words, as a result of Depleting Reserve Banking, for any arbitrary high loss less than 100% of a non-cash asset, there is always a finite time horizon (in practice, due to exponential characteristics, very short) such that probability of such loss is 100% (it is a certainty).

Conclusion: The effect of Depleting Reserve Banking is such that, if continued, it turns all non-cash financial products into worthless assets (so-called “toxic waste”): Value-at-risk (VaR) as a loss of 100% of a value of non-cash financial products is practically 100% in a finite time.

8. Financial perpetuum mobile

Depleting Reserve Banking (i.e. Credit Creation with Loan to Deposit Ratio above 1) can lead to unusual, unintuitive effects. As noted above a Bank, as a Credit Creator, makes profit, on the whole, by paying out less for taking Deposits than charging Creditors for Loans. It is not typical for a Bank’s customer to expect to be paid more in interest on a Deposit put in a Bank than to pay for a Credit taken out. It is even less typical to expect a Bank to make a profit in such a scenario. It would be a perfect business model, “win – win “, for a customer and a Bank: financial perpetuum mobile.

Let L be a Loan taken by a Bank customer which she immediately deposits in a Bank. Let I₁ be an Interest Rate paid on a Loan by a customer to a Bank and I₂ be an Interest Rate paid on a Deposit by a Bank to a customer. I₁ < I₂. Let D be a total Deposits accepted by a Bank from which it Creates Credits, C = D x LTD. Let LTD > I₂/I₁. (A customer’s Deposit and Loan, both equal L, are, in practice, much smaller than D.)

Customer’s perspective:
L x I₂ - L x I₁ = L x (I₂ – I₁) > 0: since I₂ > I₁ a customer makes profit.

Bank’s perspective:
C x I₁ - D x I₂ = D x LTD x I₁ - D x I₂ = D x (LTD x I₁ – I₂) > 0: since LTD > I₂/I₁ a Bank makes profit too.

A Bank is making profit since it is lending out more than is taking in Deposits with LTD > I₂/ I₁. But such lending is unsustainable: it can only last as long as Cash Reserves are sufficient to top up Loans. However Cash Reserves are depleting at exponential pace. Hence this financial perpetuum mobile will have to come to a halt.

From bail-in to bail-out: letter to The Economist

On 28 January 2010 The Economist published a guest article authored by Messrs Paul Calello, the head of Credit Suisse' investment bank, and Wilson Ervin, its former chief risk officer, who proposed a new process for resolving failing banks, "From bail-in to bail-out".

On 3 February 2010 the author of this blog sent the following letter to the Editor of The Economist. The reader are invited to draw their own conclusions why it was not published.

===

To the Editor of The Economist

Sir

The "bail-in" proposed by Paul Calello and Wilson Ervin "bail-in" "From bail-out to bail-in" fails to address the real reason for the banks' liquidity crunch: that the loan to deposit ratio was greater than 100%, creating rapid growth via the money multiplier (which every economics student studies as the process of "deposit creation"). This makes a liquidity risk a certainty, a probabilistic inevitability. When the banking system's exploding liabilities outstripped their ability to get hold of cash, central banks stepped in, in effect printing money to restore banks' liquidity through quantitative easing.

The Calello-Ervin proposal does not deal with this. It does not state at what level the money multiplier would be sustainable and how to keep it below that limit. Instead, it spreads the liquidity risk among shareholders and creditors of different financial institutions, meaning that the next (and inevitable) credit crunch will be more severe and still more widespread than the one at the end of 2008.

An analogy would be a tank in which gas pressure is growing at an uncontrolled rate. Making the tank stronger only delays the inevitable (and much larger) explosion.

In short, "innovative" risk management mechanisms such as the Calello-Ervin proposal cause more harm than good, rather as credit-default swaps have done.

Yours sincerely

Greg Pytel

Nothing happened

In his article "Against All Odds", Daniel Gross is trying to prove that, very likely, "AIG might just pay the Fed back" the costs of the bailout. He concludes: "Nobody at Treasury or the Fed is bold enough to predict that taxpayers will ultimately be made whole. Some rough math suggests that final cost to the taxpayers for the AIG debacle could be between $12 billion and $20 billion. Yes, that’s a bitter pill to swallow. But it’s a much smaller pill than we have imagined even a few months ago."

Mr Gross' analysis and arguments are supported by pretty detailed calculations. Yet his "rough math" has the major flaw. It does not take into account the costs of the downturn of the economy caused by the financial crisis in which AIG played a key role. The financial crisis is not really a crisis but, as shown in the seminal article on this blog, a collapse of the pyramid scheme engineered in order to funnel cash from the economy into individuals' hands. The costs of the economic downturn go into trillions of dollars in national budgets’ deficits and far more if we were to add losses of individuals and families that lost their jobs and homes.

The enormity of the current global financial mayhem that will be paid for by generations to come brings a question about a true motivation of publishing articles painting a rather rosy picture as if nothing really has happened.

Money creation and circulation in the economy

(This is a draft version of an article. Therefore any comments, corrections and suggestions for improvement are welcome as they will be used to improve it.)

1. Money in economic universe

Economy universe consists of two sets of processes:

• Products/Services Creation, Trading and Consumption /Destruction


• Money Creation, Multiplication and Destruction

They interact in the following way:

- all Products/Services (including financial) are Supplied onto the Marketplace

- Cash (narrow money) is as the medium of exchange and store of value

- through Market Transactions such as producing goods, selling/buying goods, destroying (consuming) goods, selling/buying services, consumer banks operations (depositing money in a bank, lending money by a bank, withdrawing deposits, paying back loans)

- Credit Creation by circulating Cash through Deposit – Loan Cycle: by accepting Deposits and Lending them out, money is circulated in the economy multiplied in the process (also sometimes referred to as broad money), this is reflected on Loan/Deposit Balance Sheets and Cash Reserves; Loan to Deposit Ratio defines Money Multiplier (an underlying attribute of Credit Creation)

- Central Bank operations such as Creating or Destroying Cash, setting up Interest Rates, Open Market Operations, lending as the Lender of Last Resort

The graph below shows the structure and flow of money in the economy:

Economic universe has the following characteristics:

- ownership/supply of Product/Service

- value/price of Product/Service

- Cash Reserves and Loan/Deposit Balance Sheets

- Credit Creation (Deposit – Loan Cycles) information

2. Economic activities

An economic activity is a Market Transaction which is a transfer of ownership/supply for a price or Depositing or Lending money through as a Deposit – Loan Cycle (Credit Creation).

The model presented on the graph above separates and abstracts a Service of depositing and lending money from a process of Multiplying Money, i.e. Credit Creation, which is a result of lending deposits out. The former is modelled on the graph by a Market Transactions process (of Supplying a Product/Service) while the latter is modelled by Credit Creation. This a dual role of a bank as a Credit Creator and, possibly through it, as Product/Service Supplier is central to money creation and circulation in the economy.

2.1 Products and Services Demand and Supply

Products and services are created and they are ready for sale on the market in exchange for money. This constitutes Supply and Demand characteristics whose balance may be described, for example, by a Fisher’s “Equation of Exchange”, MV = PT. As an example we can observe that if we do not control the growth of Supply of Products and Services (due to its complex structure, natural and unpredictable phenomena, etc.) and we control growth of Money Supply (for example by setting Interest Rates or controlling Loan to Deposit Ratio) then additional Money Supply, through Credit Creation, will result in inevitable Inflation to balance Supply with Demand. A gradual increase of Demand results in gradual increased economic activities to satisfy it on a Supply end.

It is not a purpose of this model to argue the correctness of any theory or equation of Supply and Demand but to show that the model presented in this paper can accommodate any Supply and Demand theory.

2.2 Market Transactions

Money received for provision of Products/Services is either held outside of a Bank e.g. by a Product/Service Supplier), spent on Products/Services (Direct Cash Exchange, No Credit Creation) or is Deposited in a bank (in a form of Deposit or repayment of a Loan previously obtained).

2.3 Credit Creation (Deposit – Loan Cycle)

Banks (modelled as Bank on the graph above) provide Deposits back to the market (to depositors: Deposits paid out) or give loans (to creditors: Loans given), which is Credit Creation. Loans are given using Fractional Reserve Banking method. In extreme cases:

- if Loan to Deposit Ratio is 0% then effectively no loans are provided only deposits paid in are paid out to depositors (Cash Reserves equals liabilities on Loan/Deposit Balance Sheet); in such case a Bank is a store of Cash (in other words Cash Reserves are 100%). This is called Full Reserve Banking (or 100% Reserve Banking).

- if Loan to Deposit Ratio is 100% then all Deposits are turned to Loans and no Cash Reserves are created. This is called No Reserve Banking.

In the first instance, banks do not play a role as a (re)-lender but are a store for money. In the second instance (no Cash Reserves are accumulated to secure demands of depositors to pay out), if loans were 100% secure repayable on demand then such a model could have practically functioned. Typically banks lend with Loan to Deposit Ratio between 0% - 100%. For example, if Loan to Deposit Ratio were 90% than for every $10 on the Loan/Deposit Balance Sheet of liabilities banks accumulated $1 Cash Reserves, i.e. Money Multiplier is 10.

Such a model is possible to function in practice, since money is circulated through banks and not all depositors demand money at the same time, only a fraction of liabilities (on Loan/Deposit Balance Sheet) need to be satisfied at any one time. However, since there are demands on Deposits to be paid out and some creditors may default (not pay back a Loan) Cash Reserves are necessary. Inter-bank lending makes the system function as one big bank balancing supply and demand of liquidity by different banks. Furthermore a role of Central Bank is to act as a Lender of Last Resort in the event that banks’ Cash Reserves are not sufficient to satisfy demand for Deposits withdrawal (State guarantees of Deposits play an ultimate role in a credibility of such system, which works as a statistical machine).

It is not a purpose of this paper to argue a safe or practical level of Loan to Deposit Ratio which determines Money Multiplier and Cash Reserves level (or that Fractional Reserve Banking with Loan to Deposit Ratio above 0% should be accepted as a model). We observe that it is a philosophical debate what level of risk the society should accept, similar to safety of road, train or air travel, or nuclear power stations. We observe that the higher the Loan to Deposit Ratio the larger the Money Supply in economy, however at the same time, the greater the risk of liquidity shortage as the size of Cash Reserves are relatively smaller to overall banks’ liabilities on Loan/Deposit Balance Sheet.

2.4 Central Bank’s role

Apart from acting as the Lender of Last Resort, a role of Central Bank¸ as a creator of Cash (narrow money), is to set control on Money Supply (through Credit Creation) by setting an Interest Rate and acting through Open Market Operations. For example, a higher Interest Rate encourages saving and discourages borrowing thereby reducing Money Supply by reducing volume of Credit Creation, i.e. amount of broad money in circulation. This, in turn, reduces Products/ Services Demand which reduces pressure on Supply, typically resulting in reduction of Inflation. This, in turn, usually results in reduction of Interest Rates by Central Bank. This is a balancing act that a Central Bank plays (in practice, typically using principles behind MV = PT equation as a guide).

3. Additional comments

3.1 Financial Products/Services

Financial (banking) Products/Services are considered like any other Product/Services in the economy. There is no reason to consider them differently: they are simply Products/Services sold as a part of Market Transactions. The importance of banks’ role as Credit Creators (by executing Deposit – Loan Cycles) suggests that if banks collapse the economy will collapse too. Whilst this may be reasonably assumed as a correct hypothesis, this does not make banks unique suppliers of Products/Services in the economy. For example a collapse of electricity producers/suppliers or water producers/suppliers would bring economy to a collapse too. Therefore whilst banks role may be seen as vital, it is not unique.

In this context we separated and abstracted banks’ role as Credit Creators (through Deposit – Loan Cycles) and a role of Product/Services Suppliers.

- when a bank issues a Loan out of a Deposit, on one side it Creates Credit AND, at the same time, it is selling a Product/Service (provision of a Loan) for which a Creditor pays;

- when a bank accepts a Deposit (which may be later issued as a Loan), on one side it makes the first step in Credit Creation AND, at the same time, it is buying a Product/Service for which it pays a Depositor. We consider a Depositor as a Lender to a bank (i.e. a bank is a Creditor to a Depositor).

As noted before, this approach separates and abstracts a mathematical process of Money Multiplication (resulting from Loan to Deposit Ratio above 0%) from a Products/Services Supply of lending money (and other financial Products/Services). A Bank, as a Credit Creator, makes profit, on the whole, by paying out less for taking Deposits than charging Creditors for Loans. Pensions, endowments, savings, wholesale funding, insurance policies, derivatives and so on are financial Products/Services.

3.2 A role of a State in the model

In this description there is no reason to separate a State impact on economy from other providers of Products/Services. For example, taxation is a Market Transaction whereby taxpayers pay for Products/Services delivered by a State. (Whether efficiently or not is another matter and this question also applies to privately sold Products/Services.) Government bonds are financial products sold on the market. For avoidance of doubt, this model does not imply or support any argument whether a “larger State” is better than a “smaller” one, the State sector is as efficient as private sector etc. It also does not imply that such Market Transactions are voluntary (in some case like payment of taxes or law enforcement services, clearly they are not).

4. Economy dynamics

At any point in time a state of the economy is characterised by a set of information about it. This would include all the information at every level of economic activity: all information about every single Product/Service, its price/value, amount of money in circulation and its allocation, Loan/Deposit Balance Sheet, Cash Reserves, Interest Rate and so on. Any economic activity in such a system is a transition from the existing state to a new one. Examples of transitions to a new state:

- a Product or Service is sold at a certain price

- a new product is offered on the market at a certain price

- a prospective buyer of a service agrees a reduction of a price

- such a buyer (as above) completes a transaction

- a bank lends money to a borrower

- a borrower repays (a part) of a loan

- a deposit is made money in a bank

- Central Bank changes an Interest Rate

- … and so on

In general a transition from one state to another, changes the information defining ownership/supply of Product/Service or value/price of Product/Service or Creating Credit or other attributes in the model.

We can consider any economic activity as a transition from one state of economy to a new one. Some economic activities may be null transitions, i.e. result in no change to information about the state of the economy. For example, a re-evaluation of the price of a Product/Service resulting in the same price is an example of a null transition.

The presented model does not imply whether deposits create loans or vice versa. This is akin to “chicken and egg” dilemma. Money circulation is of cyclical nature with iterative or recursive characteristics and description has to start somewhere which may possibly give a wrong impression of any assumed starting point of a cycle. In the context of this model it is a purely philosophical issue of no practical consequence.